The dangerous game of tax competition
Ireland's economic success is partly due to our low corporate tax rate, which attracted multinationals, making Ireland the most profitable global location for US firms. But wages and costs have increased in Ireland and corporations are looking elsewhere.
Ireland's successful economy is built, as everyone knows, on massive levels of investment from multinational firms, mainly American, and traditionally manufacturing. US firms come here for many reasons. They like our EU membership, political stability and minimal cultural differences. The thing that marks us off from other countries, though, is our remarkable approach to company taxation. Since the 1970s, we have manipulated our tax system to lure in foreign investment, a process known as tax competition. And we are very, very good at it.
Ireland's first strategy was to follow the standard economic advice for peripheral economies, and refrain completely from taxing foreign companies who made goods here for export. When this export sales relief came to an end, it was replaced by widespread manufacturing relief, whereby manufacturing profits were subject to Irish tax at the reduced rate of 10 per cent. Critically, “manufacturing” was defined by case law rather than legislation, and came to mean any irreversible process producing something commercially different to the raw materials. This led to the rather ridiculous outcome of red diesel made from plain diesel and red dye, basic computer components assembled from imported parts, and even bananas artificially ripened in fruit warehouses being “manufactured in Ireland” and subject to low taxes. The 10 per cent rate also applied to firms operating in the Shannon Free Zone and the IFSC, subject to certain conditions. So manufacturing companies, mainly foreign, paid 10 per cent tax, while other companies in the state, mainly Irish, paid 40 per cent.
When the 10 per cent tax rate was due for renewal, it came under attack from the EU, led by Germany, which had lost considerable tax revenue to the IFSC, and the UK, which was skeptical about manufacturing relief. Ireland's response was to increase the tax rate marginally, to 12.5 per cent, and to extend it to trading income in all companies, manufacturing or not. By offering the same low rate to all local and multinational enterprises, Ireland slipped past OECD rules that might have designated it a tax haven, and the country retained international status as a tax treaty partner. These treaties are important to multinationals, as they ensure that profits can be repatriated to the US with minimal adverse tax consequences. Manufacturing investment flooded in throughout the 1990s. Our economy was transformed, and by 2004, Ireland was the most profitable global location for US firms.
We excelled at the game of tax competition. While other countries reduced their tax rates in response, Ireland's unique selling point was political consensus on the issue. All parties, left and right, agreed that the 12.5 per cent rate was sacred. In the weeks before the May election, for example, even Sinn Féin rowed back on their modest proposal to increase the tax to 17.5 per cent. Multinationals invest here, secure in the knowledge that no matter who is elected in the foreseeable future, the 12.5 per cent corporation tax rate will not be changed.
However, a low tax rate is only useful to a company that is making high profits. Inevitably, Ireland is becoming the victim of its own success. Prosperity has brought high wages, impossible property prices and inflation. This has become an expensive place in which to live and do business. Basic products can be manufactured more cheaply elsewhere, and basic manufacturing jobs are beginning to move to Eastern European and developing countries. The low rate strategy was simple, effective, and inherently unsustainable. Tax competition produced a “race to the bottom” in terms of tax rates, and average rates tumbled across the EU. Ireland's tax rate is still among the lowest at 12.5 per cent, but Poland's 19 per cent may be more attractive to a company that can make more profit there.
The idea that tax competition is healthy is a questionable one. Competition is often held to be inherently good, where it reduces inefficiencies and produces a better product or service at a better price for the customer. This only works if the customer is free to shop around and find the cheapest offering. The idea that most taxpayers are mobile and can shop around for a suitable jurisdiction in which to live and work is patently ridiculous. The only taxpayers who can do this are multinational firms, who can easily move their coveted factories to avail of a better offer elsewhere. Most of these firms have relatively more power than Ireland does. Intel, for example, has invested over €5 billion in its Leixlip plant, a staggering amount for the area, but a figure that represents less than four per cent of the market capitalisation of the firm. Dell employs 4,500 people in Ireland, with perhaps three times that number working in supply firms, directly dependent on Dell. If they move their manufacturing plant from Limerick, the local economy will be devastated. But Dell has seven other manufacturing plants up and running, with more in the pipeline, including one in Poland headed up by an Irishman, Sean Corkery.
They matter more to us than we do to them. It's far easier for them to leave than for us to persuade them to stay. We built our economy on the single plank of tax competition, other countries followed our lead, and we are now rapidly running out of options to sustain it.
At first there was coyness about our success in the game of tax competition. Companies said they were not here for the low taxes, but because Ireland was a great place to do business. We congratulated ourselves on the Celtic Tiger economy, as though it were something we had built from scratch, rather than imported. With the honeymoon over, large manufacturing firms now openly talk about the importance of the tax rate to their continued presence in Ireland, and the fact that they would have to “reconsider their commitment” to Ireland if the tax rules become unfavourable.
In an effort to hold them, the government has produced incentives for Research and Development (R&D) activities. The hope is that intellectual capital will be built up in R&D, which will be less mobile, less easily replicated, and will anchor the company more firmly in Irish soil. Manufacturing jobs will go, but the plan is to replace them with higher value, technology-driven jobs.
The first anchoring strategy was a 20 per cent tax credit on any increase in R&D spending since 2003. The second was a complete exemption from Irish tax on patent income, where the associated R&D work had been carried on in Ireland. The idea was that companies would increase their R&D facilities here, employing Irish graduates in the process, and patent their technologies. When the manufacturing facilities relocated to cheaper jurisdictions, the Irish R&D operation could charge patent royalties to the manufacturing plant. This stream of royalties would not be taxed in Ireland, and could be distributed with minimal tax to overseas parents or, indeed, executives resident in Ireland.
The patent income exemption ran into difficulties at EU level. The rule that the work had to be done in Ireland violated competition laws. From 2008, it will be amended to include work done in any EU country, and capped at €5 million a year for any company. This significantly undermines its original purpose of rooting R&D activity in Ireland. Nonetheless, the energy put into the development of technology, and the tax breaks that exist for R&D are having some effect. Forfás reports that R&D expenditure is up, especially in the computer, electronic and pharmaceutical sectors.
The problem is that this second round of the tax competition game is also unsustainable. Ireland attracted foreign investment using low tax rates as bait, built up a prosperous economy over a number of decades, and now that manufacturing is too expensive here, is moving to a knowledge economy and pitching for R&D investment from multinational firms. There is nothing to stop other countries from following our lead. As manufacturing jobs move to cheaper locations such as developing countries, prosperity will follow, education will improve, and in a decade or so, they will be competing with Ireland for the higher-value R&D facilities.
Anyone familiar with the levels of poverty in developing countries would not begrudge them the employment and prosperity that comes with foreign investment. Irish people have been particularly generous in supporting development NGOs and charities in Africa and Asia. We now need to make the connection between this generous impulse and the damage caused by our aggressive competition for foreign investment. It makes no sense, for example, to support the funding of orphanages in Calcutta, and then compete with India for the location of a multinational plant that would give those orphans jobs.
We are now a wealthy country, with well-educated citizens. We shouldn't need to compete with poorer countries for American investment. We have grown up, in economic terms. It is time for us to develop our own innovation, foster our own indigenous base for employment and entrepreneurship, and reduce our reliance on tax competition. Such tax competition strategies worked brilliantly in the past, but are unsustainable in the future, for ourselves, and for the developing countries that more desperately need investment.
Sheila Killian lectures at the Kemmy Business School, University of Limerick, and is chair of Soweto Connection, which works with South African communities affected by HIV/Aids. www.sowetoconnection.org