Mentioned in the context of Yahoo’s decision in February to shift all of its European tax affairs from the ‘high tax’ Switzerland to the ‘fully tax-transparent’ Ireland, it required a high level intervention. Aptly, the Irish Taoiseach (prime minister) was standing by to point out that Ireland’s effective corporate tax rate is close to 12 percent, and above France’s 8 percent.
This exchange – surreal in terms of its tonality and selective focus on specific aspects of the overall tax regime for companies trading through Ireland – is a part of an ongoing global debate about the international tax structures and the role of national legislation and institutions in shaping corporate tax compliance, reporting and accounting.
In recent months, the Irish corporate tax regime has featured prominently in these debates, especially within the context of European tax reforms, high-profile corporate earnings and multinational investment. The G20 and the G8 mentioned it, as did German, Finnish, Italian, French, U.S. and U.K. leaders.
As financial repression sweeps across the OECD member states in the wake of the Great Recession and the sovereign debt crises, this debate is far from over.
Since the onset of the global financial crisis, European policymakers have increasingly resorted to both traditional and unorthodox measures for securing funding for public expenditure. Having largely exhausted their traditional avenues for raising tax receipts (income taxes, social security taxes, VAT and indirect taxation measures), European, and to a lesser extent U.S., leaders have shown some serious determination to uncover new funding streams.
Known as policies of financial repression, these measures range from raising new types of taxes, including on previously untaxed transactions (the financial transactions tax), to indirect capital controls and restrictions on investment flows. Less benign measures included limited expropriation of private property, exemplified by Greek and Cypriot bail-ins of private investors, and an Irish levy on private pension funds that taxes not pension income, but actual investment funds. Bank levies, insurance companies levies, solidarity charges and other measures abound.
Acceleration of the euro area fiscal crisis has also witnessed a rise of media and policymakers’ attention of the international tax policies, primarily relating to measures and facilities permitting or facilitating tax avoidance and optimization. Thus, since roughly 2011, through today, various international bodies (including those cited above, plus the EU Commission and the IMF) have raised the issue of ‘unfair tax competition’ in the case of corporate taxation.
In Ireland’s case, the attention of international policymakers and public opinion in relation to the debates about tax optimization and avoidance has been focused on two sides of the same issue. On the one hand, there is the consideration of effective tax rates for companies trading through Ireland. On the other, there is an ongoing consideration of the specialist tax arrangements that allow some companies to reduce their tax exposures in Ireland to virtually zero.
Last month, Professor James Stewart of TCD School of Business (Stewart, 2014) produced an insightful and well-researched analysis showing that the effective tax rate for U.S. multinationals in Ireland was as low as 2.2 percent back in 2011. Methodology bickering aside, Professor Stewart’s study challenges the core research used to support Ireland’s corporate tax regime – the PWC studies that focus on domestically-trading small and medium enterprises. The problem, of course, is that the official discussions of Irish corporate tax regime are nothing more than a tactic of diffusing the issue by deflecting the real debate.
Professor Stewart’s research hints at this forcefully. The real issue with Ireland’s corporation tax is not the headline rate, nor its transparency, but a host of loopholes that riddle the system and that allow companies to dramatically reduce their global tax exposures well below the 12.5 percent rate. Some of these loopholes, such as the notorious double-Irish scheme, are the subject of the EU Commission and OECD scrutiny as potentially anti-competitive, subsidy-like measures. Contrary to what public exhortations by the government suggest, the threat is real. The 2014 budget saw a very public closure of one of the more notorious features of Irish tax law that allowed companies to be registered in Ireland without having a tax residency anywhere in the world.
The core focus of the EU analysis, discussed by the Commissioner Almunia back in February, centers on an even more worrisome feature: tax base shifting by the ICT services multinationals. The same subject formed the cornerstone of the G20 summit debates at the end of last month. De facto, the G20 agreed to develop a joint set of rules on cross-border taxation that will attempt to shut down some of the more egregious loopholes aggressively used by the services sector multinationals, such as Google, Facebook, Apple, Amazon, Microsoft, Twitter and Starbucks. Much of this optimization takes place via Irish entities.
The practice basically permits MNCs to book vast revenues earned elsewhere in Europe and outside into Ireland in order to move these revenues to tax havens. The issue is non-trivial to Ireland: tax-optimizing MNCs currently underwrite virtually all growth officially registered in the crisis-hit economy.
Not all of their activities are driven by tax optimization alone, but Ireland’s tax regime does serve as a major attractor and does generate significant uplift to the economy. Absent their activities, the Irish economy would be in a recession, the exchequer would be in an unenviable position worse than that of Portugal, and the GDP would be at least one fifth lower than it is today. Instead of the headline rate of corporate taxation, two core questions about the entire tax regime operating in the Irish economy should be at the heart of the public debates.
One: Can the Irish economy afford the current tax regime in the long run? Two: Is the Irish tax regime sustainable given the direction of European integration in fiscal, monetary and corporate policies development?
Let’s deal with these questions in some details. The current system of taxation in Ireland is directly contradictory to the core growth and development drivers in the country’s economy. Since the collapse of the property lending and public spending bubbles of the 2000s, key sources of growth have rapidly shifted from domestic investment in real estate and infrastructure toward the skills-dependent ICT services, international financial and professional services, as well as specialist agrifood and manufacturing sectors.
All of these sectors share two fundamental features. They employ large numbers of highly skilled and internationally mobile specialists. And, they rely on new value creation via innovation and R&D. These features are based on investments in human capital, rather than investments in traditional bricks and mortar or physical machinery. And human capital gets its returns either from financial capital gains, intellectual property rents, entrepreneurial dividends and/or wages. The latter two dominate the former ones across the entire economy.
Yet, the first two sources of returns can be easily, even if partially, shielded from taxation via existent system of tax codes.
The latter two, meanwhile, are facing rates of taxation of between 33 percent (capital gains) and 55 percent (upper marginal tax rate, plus social security taxes). Faced with an option of having to pay huge direct and indirect tax rates on their labor income, while receiving virtually no services in return for these outlays, the highly skilled workers, attracted into the country by the MNCs, tend to run out of Ireland within one to two years of arriving here.
Forced to compete for talent with tax optimizing MNCs, indigenous Irish entrepreneurs are struggling to generate returns on their own investments worth keeping business in Ireland. And both innovation-based MNCs and indigenous producers are facing high and rising costs of recruiting key employees. The problem is further compounded by an archaic tax code that creates an immediate tax liability equal to the effective marginal income tax rate on any employee shareholding in the company regardless of whether the stake awarded can be sold or not.
The system is not working, neither for the employees nor for the exchequer.
In 2013, corporation tax receipts totaled €4.27 billion, or 11.3 percent of all tax receipts. This compares to 15.3 percent on average in 2000-2004. Over the same period of time, the share of income tax in total tax receipts rose from 31.4 percent to 40.0 percent. VAT receipts share slipped only marginally from 29.3 percent to 28.9 percent.
Thus, the rate of extraction of tax revenues from households’ incomes rose dramatically. The burden of corporate taxation befalling rapidly growing MNCs, meanwhile, declined in relative terms. (See Chart 1)
The Great Recession only partially explains this trend. Instead, the government policy consciously shifted the tax base away from activities with low economic value added, such as property, plus the transfer pricing and double-Irish-driven corporate profits, and onto the shoulders of the households. Given the changes in 2010-2013 in the composition of Irish exports of goods and services, Ireland-based MNCs are now paying less in taxes per unit of exports than in the 1990s. With the tax extraction hitting hard the professional and higher skilled workers earnings, the Irish tax regime is damaging the country’s core source of competitiveness.
You don’t have to troll the depths of datasets to spot this one. Every budget since 2009 attracted numerous proposals for attempting to address the problem of income tax costs across ICT services, international financial services and R&D intensive activities.
These proposals come from both the indigenous sectors and exporters and MNCs, highlighting the breadth of the problem. In the longer run, Irish economy’s reliance on tax arbitrage is similar to the ‘curse of oil.’ Low effective corporate tax rate accompanied by a very high upper marginal income tax and sky-high indirect levies are driving investment, as well as financial and human capital, away from well-anchored indigenous sectors and toward footloose MNCs.
This, in turn, exposes Ireland to cyclical changes in MNCs global production patterns. We have already experienced such events in the late 1990s and early 2000s when ICT manufacturing and dot.com sectors evaporated from this country virtually overnight. And today we are witnessing the global re-allocation and re-shaping of the pharmaceutical industry. Ireland got lucky in the 2000s when domestic economy bubble replaced deflating MNCs presence.
Ireland also got lucky this time around, with a pharma patent cliff being compensated for by growing exports of ICT services. With every iteration of these risks, levels of employment in the MNCs per euro of export revenues have been falling. Next time around, things might not turn out to be as easy to manage.
Of course, exports substitution is not only due to lack, but is instead strongly related to the Irish tax regime which allows for aggressive tax optimization, especially for companies with a significant intellectual property component of their production. (See Chart 2)
Double-Irish and other loopholes are also costing Ireland in terms of reputational and institutional capital – two major contributors to making Ireland an attractive location for international business and key environmental factors supporting indigenous entrepreneurship.
Excepting the non-standard tax schemes, such as the double-Irish, the Irish system of corporate taxation is transparent, institutionally efficient and economically effective. These features of the system are best evidenced in the context of dual taxation treaties and the headline rates.
It is a well-established fact that bilateral international tax treaties (BITTs) govern the host country taxation, and the overall location and distributional incentives, for the vast majority of the world’s foreign direct investment (FDI) (Chisik, 2002). At the same time, BITTs also serve as mechanisms for alleviating the international spillovers from tax competition, including reputational spillovers. Ireland’s experience with tax policy shows that these two benefits of BITTs are robust and significant, offering both a strong supportive basis for broader policy of lower taxation and for providing more direct links between foreign investment and trade.
For example, Davies et al (2010) show that in the case of manufacturing FDI, tax treaties lead to lower exports to the parent from the FDI-supported multinationals, but the treaties also increase imports of intermediate inputs from the parent entities. This is consistent with treaties increasing the effective host tax returns, as consistent with the evidence shown in Chart 2 above: a higher share of manufacturing exports (in the case of Ireland, some 70-75 percent of these were, at the peak, supplied by the FDI-backed MNCs) was indeed associated with higher tax revenues.
At the same time, tax treaties are commonly seen to reduce the adverse reputational effects of direct tax competition, as noted in Chisik and Davies (2003) and Davies (2003).
Ireland currently has an extensive network of completed bilateral tax treaties, spanning 64 countries with additional seven treaties awaiting ratification. Since 2008, Ireland has completed tax treaties with all OECD countries. Irish tax agreements commonly cover direct taxes, such as income tax, corporation tax and capital gains tax. With the exception of four treaties, all Irish treaties support zero withholding tax on interest accruing to the partner-located enterprises, and many treaties also exempt royalties paid by Irish companies. These two aspects support, in the case of countries by the treaties, an environment where FDI-supported companies trading through Ireland can already avail of significant transfer pricing opportunities relating to both physical and intellectual capital.
On the other hand, the efficacy of tax treaties in reducing the reputational harm from the aggressive tax optimization schemes permitted by the Irish codes may be declining. That tax treaties compel aggressive tax arbitrage locations (and formal tax havens) to share banking and financial information may be ineffective in reducing the volumes of funds flows to tax havens, according to recent research (Johannesen and Zucman, 2012).
In particular, the paper shows evidence that Ireland ranks third in the OECD as the source for deposits in BIS-reporting tax havens over the period of 2007 and 2011, while at the same time ranking in top 10 countries in terms of the number of new tax treaties completed over the same period.
While many multinationals for now have little problem dealing with tax havens, they tend to locate little but a shell presence in these jurisdictions. Ireland, not being an official tax haven, offers an attractive alternative for them to both create tax optimizing structures and put some real activity on the ground. However, should the reputation of Ireland’s tax regime continue to suffer from the publicity it receives around the world as of late, this acceptability of Ireland as a real platform for doing business can change. Reputations are not made overnight and can fall in an instant, and Ireland has plenty competitors in Europe hoping for such an outcome. Which brings us to the question of whether the current tax regime in Ireland is sustainable in the long run, given the policy climate in the EU and across the Atlantic? The answer to this question is “no.”
As recent comments by the EU Commissioner Almunia and the numerous previous statements from the G20, G8 and the OECD clearly indicate, governments across the advanced economies are moving to curb excessive tax optimization strategies by multinationals. In doing so, they are not about to sacrifice their own long-established economic systems.
The main driver for this global resurgence of interest in tax avoidance and optimization is the ongoing process of long-term structural deleveraging of public debts. Another key driver is a long-term restructuring of unfunded pensions and social welfare liabilities accumulated by the advanced economies now staring into the prospect of rapid onset of demographic ageing. Put simply, over the next 16 years, through 2030, advanced economies around the world will be facing a need to fund fiscal and retirement systems gaps of between 9 and 25 percent of current GDP. This funding is unlikely to materialize from growth in GDP alone, and will require significant restructuring of tax revenues. One way or the other, the Irish tax system will have to be reformed.
The longer Dublin resists an open and constructive debate about the entire tax system, the longer the more egregious and visible tax arbitrage mechanisms remain on Irish tax statues, the more likely that these reforms will be imposed onto Dublin by the EU dictate and on the EU terms. To enhance Ireland’s reputational and institutional capital, the country needs to aggressively curb tax optimization schemes.
To develop a domestically-anchored innovation-based economy, it needs also to shift some burden of income-related tax measures onto corporates. The best way to achieve these objectives is by simultaneously protecting Ireland’s low corporate tax rate and closing the egregious loopholes.