Collateral damage? The impact of Ireland’s Tax Strategy on Developing Countries (Part I)

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This is the first of two articles exploring in depth the question of the impact of Ireland’s tax strategies on developing countries. The second article will appear tomorrow.

Through the late 1990s and early 2000s, Ireland built enormous short-term economic growth on the single plank of lowering tax rates to attract in foreign direct investment. This strategy made us the world’s biggest software exporter in 2004, the most profitable location for US investment, the poster child of tax competition. Over recent years, however, increasing prosperity led to rising costs, impossible property prices and inflation. Ireland became an expensive place in which to live and do business. Basic manufacturing jobs have begun to move away. The low rate strategy was effective in the short term, but inherently unsustainable.

Besides being unsustainable for Ireland, the strategy was also broadly damaging for the developing world. This could be classified as collateral damage, since Ireland’s attitude to the Global South, shaped in part by the fact that it shares a post-colonial experience with many developing countries, is supportive[i].

However, the post-colonial experience also left Ireland with little or no native industrial base, a situation which led indirectly to Ireland’s aggressive tax competition and which has unintended downstream consequences in many developing countries.

In this first of a two-part series I describe the dominant tax consensus, and how Ireland has played that game to attract multinationals through the Celtic Tiger years. The second part will discuss the impact of these strategies on developing countries.

The current tax consensus by which multinational firms are taxed – the financial architecture which facilitates their free movement throughout the world – has three main pillars: tax competition through low corporate tax rates, opaque and unchallenged transfer pricing and a network of double tax treaties. For the sake of length, I’ll describe just the first two here.

Tax Rate Competition

These days the world’s largest firms have a presence in more than a dozen countries and can relatively easily move production or other facilities from one jurisdiction to another, or replicate facilities in a new location. Intel, for example, has 15 identical manufacturing plants and 6 fabrication plants worldwide with employees in 45 countries. The main motivation for such corporate internationalism is cost reduction in one form or another – low wages, low costs, low taxes. As firms roam the world in search of attractive locations, they acquire far more power[ii] than the governments that host them. In general, countries seeking to attract such firms try to produce the low-cost environment they prefer by moderating wage demands, subsidising infrastructure, and/or maintaining low taxes. Of the three, taxes are the easiest to manipulate.

Clearly tax is not the only factor, but studies consistently show that it remains a critical element. Where the tax rate is reduced to attract investment, the logical response of multinationals is to quickly locate high-profit, highly-mobile activities within the target jurisdiction. In general these are low-skill activities, such as manufacturing, which can be easily moved again to a new location if tax rates rise, or if a more attractive proposition arises.

The idea that tax competition is healthy is ludicrous. Competition can, of course, reduce inefficiencies or produce a better product or service at a better price to the customer. This only works if the customer is free to shop around and find the cheapest offering. Obviously most taxpayers are not mobile enough to shop around for a suitable jurisdiction in which to live and work. The only taxpayers who can do this are multinational firms, who can easily move their coveted factories to a new location. Tax competition serves their needs far better than anyone else’s, which is why the EU and OECD have established working groups to curtail this harmful practice.

Transfer Pricing

Most multinational firms have a group structure, with companies located in countries with different tax rates. One obvious way for them to reduce their overall tax bill is to ensure that most of the group’s profit is made by the companies paying the lowest rate of tax. It’s not hard to move profit around a group. Companies trade with each other all the time, and it’s common, and legal to set management charges between group companies, royalty charges, rents, interest on intra-group loans, or simple pricing of goods and services provided from one entity to another. In theory, such transactions should be at arms length, and this transfer pricing should be fair and transparent. It’s something that taxing authorities in all countries are aware of and are keen to monitor. However, because of the private nature of transactions between group companies, it’s hard to monitor, and sometimes impossible to establish what a true arms length price should be. In particular, it can be extremely difficult for a country to monitor this in isolation, without the co-operation of the taxing authorities in the corresponding state. Unfortunately, the country into which the profit is flowing is the one best placed to detect any sharp practice, but least motivated to report it, since its tax income is being increased.

Ireland’s Story

There are several non-tax factors which make Ireland an attractive location for US companies in particular. These include an EU location, a well-educated, English-speaking workforce, minimal cultural differences and a reasonably good infrastructure. They don’t give us any competitive advantage over the UK, for example. Ireland’s very high rate of foreign direct investment cannot be explained without reference to the tax incentives we’ve offered.

Ireland’s original strategy was to refrain completely from taxing foreign investment[iii], to the extent that the goods produced there were exported rather than sold locally. Export sales relief came to an end on 5 April 1990, and was followed immediately by a wide application of manufacturing relief, whereby manufacturing profits were subject to Irish tax at the reduced rate of 10%. Manufacturing relief was very widely availed of, especially by multinationals, but it was due to expire in 2010, and could not be renewed in the face of opposition from the EU. Ireland’s response was to increase the rate marginally, to 12½%, and extend it to all firms, manufacturing or otherwise.

At first, the policy worked. While other countries reduced their tax rates in response, Ireland’s unique selling point was political consensus on the issue. In the weeks before the May 2007 election for example, five of the six main parties agreed that the 12½% rate should not be changed. Multinationals invested in Ireland secure in the knowledge that no matter who was elected in the foreseeable future, the 12½% corporation tax rate was cast in stone.

However, a low tax rate is only useful if you have high profits. Inevitably, Ireland is becoming the victim of its own success. Prosperity brought high wages, impossible property prices and inflation, making business less profitable. The low rate strategy was simple, effective, and unsustainable. Furthermore, tax rate competition produced a “race to the bottom”, and average tax rates have tumbled across the EU. Ireland’s tax rate is still among the lowest at 12½%, but Poland’s 19% may be more attractive if a company can make more profit there.

Anecdotally it seems clear that at least part of Ireland’s success of is due to transfer pricing. While many of the US multinationals have a real presence in the country and employ thousands in their plants, some employ only a few dozen yet generate superprofits in their Irish subsidiary. An example of how transfer pricing might be used is given in a recent Bloomberg article[1],

Typically .. a company like Microsoft develops a product like Windows in the United States and deducts those costs against U.S. income. It then transfers the technology to a subsidiary in Ireland, where corporate tax rates are lower, without charging licensing fees. The company then assigns its foreign sales to the Irish subsidiary so it doesn’t have to claim the income in the United States.

It is generally accepted that multinational firms can easily move manufacturing, replacing low-skill employees in another country. It’s often felt that R&D facilities, skilled engineers and project groups are harder to replicate. This is the logic behind the practice of providing tax incentives for research and development and intellectual property. The hope is that the R&D unit will tie the business to the indigenous employees and anchor the multinational in the local economy.

Ireland offers various such R&D provisions such as an increased deduction for R&D expenditure and a complete exemption from tax for patent royalty income. This new approach in the words of Mary Harney, “places Research and Development at the heart of our economic development strategy” and is likely to continue into the foreseeable future.

In summary, then, Ireland has engaged in the dominant consensus by aggressively competing in terms of tax rates, not questioning the transfer pricing practices of companies which locate high profits here, and creating incentives for intellectual property. The next article in this series will describe the impact of these policies on developing countries

Dr. Sheila Killian is a senior lecturer in Accounting & Finance in the Kemmy Business School, University of Limerick. She writes regularly on tax justice issues, tax and public policy and corporate social responsibility.

Notes:


[1] Donmoyer, R. (2009). Ballmer Says Tax Would Move Microsoft Jobs Offshore. Bloomberg.com, Bloomberg.


[i] For example, the government minister with responsibility for Irish Aid overseas, Peter Power, said in May 2009 that “Our history influences our policy and both national and international level. Power, P. (2009). Development Cooperation between the EU and Africa today. Africa – Moving Forward. Trinity College Dublin.

[ii] Intel, for example, has invested over €5 billion in its Leixlip plant in Ireland, a staggering amount for the area, but a figure that represents less than 4% of the market capitalization of the firm

[iii] a policy described by Avi-Yonah, R. (2001). Globalization and tax competition: implications for developing countries. Instituto para la Integración de America Latina y el Caribe Working paper series. as “the standard advice by economists to small open economies”