Resource Revenue – Income or Wealth?

“So for the Norwegian people, the oil revenue is not revenue at all, it’s just wealth being moved into a more diversified portfolio for the future.”

Yngve Slyngstad, CEO of Norges Bank Investment Management (NBIM)

Reading this quote immediately got me thinking of almost all oil & gas-exporting countries, in particular Malaysia. Our revenues derived from these non-renewable resources are treated as income in our national budget. We take it in as part of our federal revenue, and a substantial part of it goes into financing our annual operating expenditure (essentially the year-to-year costs of running the country).

However, implicit in this action is the belief that this revenue belongs to us. By ‘us’, I mean the current generation in Malaysia at the time when the resources are being extracted. While this will certainly split opinions, I believe this money is wealth belonging to our country. Our country in my view includes both our generation as well as future ones. I thus believe the Norwegian model has many merits.

In Norway, the Government Pension Fund Global was set up to ‘support long-term management of Norway’s petroleum revenue’. Firstly, the capital is invested overseas. This prevents an overheating of the Norwegian economy arising from these large resource flows, which maintains competitiveness of the Norwegian economy (something other resource-rich nations have had issues with).*

More importantly, there is a rule that the “non-oil budget deficit shall correspond to the real return on the fund, estimated at 4 percent”. In simple words, this means that on average, the government is only allowed to spend the return on the investment of the oil revenue, rather than spend the oil revenue itself. This ensures the oil revenue obtained now will be there to generate returns for future generations to enjoy. It is also said the fund can also cushion short-term economic fluctuations as well as meet the challenges of the country’s ageing population and future drop in petroleum revenue.

An analogy to this is inheriting a huge house from your parents. The Norwegian model means you keep the house, spend only the rental income, and pass it on to your children. The conventional attitude is to sell the house (oil) and use the money (oil revenue) now.

Whether or not you agree with the Norwegian way, it is certainly food for thought.** I’ve personally taken for granted the fact that our oil and gas revenue was for us to spend until reading the above quote. I hope this will spark your thoughts too.

Please see the first comment for footnotes


20 thoughts on “Resource Revenue – Income or Wealth?

  1. Footnotes

    * This paragraph highlights the classic Dutch disease argument. When a country enjoys huge export revenues from resources, all else equal, there will be a large appreciation in the real exchange rate. This can harm competitiveness of other exporting industries as their products become more expensive overseas and foreign competing products become cheaper domestically. Due to the fact industrial structure has persistence; this could lead to a permanent impairment of some of these industries. This becomes highly problematic when the oil revenue runs out, potentially leaving the country with a negligible export base. Norway’s strategy of investing the money overseas ensures the inflow of revenues is balanced by these investment flows, outwards, preventing an immediate appreciation of the real exchange rate. This allows Norwegian industries to be somewhat competitive, certainly more than they would have been if the government spent or invested the money domestically. This article is an excellent explanation of it

    ** One argument against this is that we should give the money to the people directly, who can then choose to invest for themselves how they see fit for future generations. However, a problem with this is that individuals do not always choose to save enough for future generations on their own. This then becomes an ethical argument, of whether it is the right of the current generation to decide what to do with the money or if it should be saved for future generations, who by virtue of not being born, have no say in the current democratic process).

  2. Also good to add that in 2004, Norway put in place a series of ethical guidelines to make the holdings of the fund more ‘moral or ‘virtuous’. Essentially, the guidelines state that the Fund “should not make investments which constitute an unacceptable risk that the fund may contribute to unethical acts or omissions, such as violations of fundamental humanitarian principles, serious violations of human rights, gross corruption or severe environmental damage.”

    While this sort of thing may be scoffed upon in the global investing community (being returns-oriented), this form of investing is actually quite in line with Norway’s largely egalitarian society. And given that the decisions on which companies to exclude from investments consideration are transparent and made public, seems like an overall feel-good story. Companies that have been “blacklisted” include, but are not limited to, Boeing, Honeywell, Rio Tinto, Wal-Mart and, wait for it, Singapore Technologies Engineering (take that!).

  3. Pingback: new entry at Teh Tarik Economists! | the school of zhi

  4. I stumbled across this article when preparing for class discussion that gives an insight on the path that Norway had taken early on. It’s a real wonder that they get it done right from the start.

    “The Iraqi who saved Norway from oil”

    “Brazil’s oil boom: Filling up the future”

    One commentary said the Dutch disease isn’t necessarily about oil; the discovery of oil merely accelerates the process and the key is to tackle on any dependency on natural resource. Malaysia could learn much from Norway and Brazil.

    p.s. – looking forward to more post!

    • Thank you R.R., they’re both brilliant articles. I particularly love the FT article on Norway. Norway’s story is truly a brilliant one. The more I read about it, the more I’m amazed.

  5. Excellent article.

    To really evaluate the (de)merits of using a nation’s wealth, one must really compare it to the alternative.

    The fact that the government owns rights to natural resources can be thought of as a nondistortionary lump sum transfer from the people to the government at the birth of the nation. A lump sum transfer is usually the most efficient way of performing a transfer.

    Suppose we need to spend X today. Let’s be silent on every other issue surrounding X.
    How does the government raise X?

    Does the government have a way of raising X that does not distort? Under commonly acceptable government preferences, probably not.

    Does that influence how you think about usage of natural resources to fund X?

    • Thanks Tzuo Hann for the comment. From your comment, I’m guessing you are an economist, but if I am mistaken and you need me to clarify any of the terminology here, please do tell me. What you say makes a lot of sense, but I’m not inclined to change my way of thinking much. Here’s why. I agree with you in the sense that from the perspective of our generation alone, this is indeed true. This is the least distortionary way of raising revenue to finance our government expenditure, far less distortionary than say income taxation. I have two issues however;

      a) Once we start looking at “inter-generational efficiency” (for lack of a better word), the analysis will change. Economic theory suggests that the deadweight loss increases not linearly but at an increasing rate as we raise the tax rates. I think I recall a formula with a quadratic term of the tax rate in it. By using the revenue to keep tax rates low, we may lock in efficiency gains now, but at the expense of higher tax rates in the future. If we place equal weight on efficiency gains in all periods, the way to minimise the deadweight loss is to try and smooth out the tax rates over time. There is a smaller overall loss from medium tax rates in all periods as compared to the deadweight loss of very low tax rates now and very high tax rates later given the above non-linear nature of deadweight loss. Once we consider this, I’d argue the efficient thing to do is to save a significant proportion of these revenues, assuming we place a high enough weight on the welfare of future generations.

      b) I personally place a lot of emphasis on inter-generational equity. So even if not using all the revenue now is inefficient in some ways, there is still justification saving some of it at least for future generations who may not have these revenues to enjoy.

      • Hey,
        That’s a lot of stuff. Lets focus on just 1 issue: Can we control spending or not? In your world, yes. I asked if your position changes if you cannot control spending but can only control the funding of that spending.

        “Suppose we need to spend X today. Let’s be silent on every other issue surrounding X.
        How does the government raise X?”

        In (b) you are going after how we should spend wealth. I agree.

        In (a), you seem to go along the same lines. There is a lot more there, so I might have gotten confused. Correct me if I am wrong “Once we consider this, I’d argue the efficient thing to do is to save a significant proportion of these revenues, assuming we place a high enough weight on the welfare of future generations.” How do we spend it, that is your question. I agree as well.

        I’m with you (in its entirety, in fact) when it comes to what we SHOULD do. But my comment wasn’t about that.

        What I am going after is this: When spending is inevitable, it may not be a bad idea to fund it with natural resources, even if we care a lot for future generations because any other form of funding will distort capital accumulation and will result in future generations being born to poorer families than they otherwise would have.

        Can you think of a case where the government should not use natural resources when it HAS/MUST/MESTI spend X today? There are such cases. But they are funky.

      • Hi Tzuo Hann. My answer to that is that if the government must spend X today, then it should not use most of the natural resources to do so but rather raise it through taxation. I was under the impression that the reason you thought this might be a bad idea is that almost all forms of taxation is distortionary in some way. This is why I went on that long explanation as to why I would still justify not using natural resource revenue despite the fact raising taxes instead creates deadweight losses in the economy at present.

        So in short, my answer to “Can you think of a case where the government should not use natural resources when it HAS/MUST/MESTI spend X today?” is yes. The government can (and should in my opinion) raise the money through taxation on the current generation instead (especially if the spending is for the benefit of the current generation). Hope this answers things.

      • Interesting.

        Maybe you can explain over teh tarik what you have in mind. I am intrigued by your conviction that natural resources are not to be touched. My main opposition to taxation simply lies on the premise that taxation reduces capital accumulation which has the same consumption equivalent to taxing future generations. Maybe you have in mind a set up where this is not the case. It’s entirely plausible.

        In any case, my views are based off the work of Frank Ramsey in 1927 and the literature that was built off it. Ramsey was a protege of Keynes, and they were romantically involved too.

        This article summarizes nicely:

        Some assumptions are unrealistic. Most are quite acceptable. All in, its a very nice idea and worthy of consideration at the very least.

      • Thanks for the article. It is a really nice summary. Interesting fact I never knew about Frank Ramsey too.

        First, I should clarify I do not believe natural resources definitely shouldn’t be touched. What I do believe is that if we touch it, we need to bear in mind it is wealth rather than income (a stock variable rather than a flow variable). That was the original point I was getting at. In fact, as a friend pointed out to me earlier, as a developing country, we probably could do with more capital accumulation. I would agree with using the revenue on development expenditure, provided it gives us a higher social return than the alternative of putting the money in a fund. However, when we have an amount of X current operating expenditure to be financed, then I think using our revenues rather than raising it through taxation can’t really be justified.

        Coming back to our example. Your worry about taxation reducing capital accumulation is certainly well placed. Nevertheless, I’d like to consider the alternatives. Say we use the resource revenue to finance development expenditure and other investments, while using taxes to cover the expenditure X. The taxes will crowd out both consumption and savings (investment) to some extent, depending on where in the economy it is levied. However, if we were instead to use the resource revenue that would otherwise have gone into investment and capital accumulation to finance X, then this effectively amounts to a full rather than a partial crowding out of capital accumulation. My suggestion would be to use the “wealth” of natural resource receipts for projects/investment that have returns for the future, while raising money for current expenditure via the tax system. To minimise the reduction in capital accumulation, we should perhaps target taxes on consumption goods. In Malaysia’s example, it is even easier (economically not politically) as we have quite a few distortionary subsidies in place that can be removed first. I’m not too familiar with these arguments so I may be getting this completely wrong. So please tell me what you think.

        Thanks for the comments. They’re really interesting!

  6. You obviously do know very much already on the matter.

    However, to come up with sharp predictions on the stuff you mentioned, we need to go to math. I don’t think we have any way of properly modelling all the elements that you are considering all at once. You get that stuff into a structural model, you will be teaching it to your macro professors.

    Things like curvature of utility functions, assumptions on production functions, this, that and just about everything you can think off will begin to matter. They are technical yes, but they will drive the very heart of the discussion. Without pinning them down, we will be trying to describe a nebulous object.

    For instance, what is a fund in your model? What is development expenditure? What are consumption goods versus production goods. What are subsidies? Are they lump sum transfers, or price controls, or what? Without fixing those ideas, I prefer not provide opinion. We will spend a lot of time writing a lot of stuff about different things in our heads. Buang masa.

    I’ll be happy to go model free.
    But for that, beer is the better medium. The more we put in, the more we will agree to. Always works.

    • I certainly agree. I have used those terms without providing specifics of what I mean, and we do need to delve deeper to come up with actual predictions of what should be done. My main goal of the article was not to come up with a conclusion of what we should do with the money, but rather change readers’ mindsets over the nature of these revenues. My concern has always been the treatment of them as income, implying it is a flow variable when it isn’t actually so. Again, thanks for the comments, they’ve certainly got me thinking.

  7. Hey Dhruvs,

    Fun fact: Did you know that the sovereign rating of M’sia is below petronas bond rating because about half of the govt revenue depends on the oil.

    When I found out, I laughed. Then I felt sad.

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