Has Obama really bombed us?

The recent proposal by the Obama administration to eliminate deferral, under which US multinationals do not pay US taxes on overseas earnings that are ploughed back into their subsidiaries, has sent our local press into a tizzy. The discussion follows the logic that such a move would increase the effective tax rate paid by subsidiaries in Ireland to that in the US. If these firms are here in large part due to our low tax, this would presumably lead to US-owned foreign direct investment (FDI) leaving Ireland en masse furthering our downward spiral.

While this dire scenario makes for good reading for people who like bad news, there are reasons to question the extent of the shift in economic activity this might cause.

The removal of deferral applies only to retained earnings – that is income used actively (US law already removes deferral for passively invested earnings under the subpart F regulations). Thus, this is only for a subset of the earnings attributed to Irish subsidiaries. Nevertheless, it could potentially lead to an increase in repatriations by US owned firms who no longer find it advantageous to “park” them in Irish investment. What does this imply for the Irish economy? As an indication, a tax change in 2004 created a temporary reduction in the US repatriation tax from roughly 35% to 5%. This led to a massive influx of funds (around $312 billion) returning to the US from abroad. However, economic activity by US owned subsidiaries in terms of location or level of investment does not appear to have changed markedly. In fact, in response to a recent call for such a move again, Senator John Kerry noted that “It did not increase domestic investment or employment. The fact is that many of the firms that benefited from this during that period of time laid off workers after they brought that money back. They passed on the benefits to their shareholders.” Thus there was no shift in jobs back to the US before, making it less than certain it would occur under the proposed change. (You can read more about this debate here).

Why might multinational activity not respond as expected? Eliminating deferral does not necessarily increase the tax burden on foreign income. The recent firm-level study of Barrios, Huizinga, Laevan, and Nicodeme finds that multinationals’ subsidiary locations depend negatively on both the parent and host tax. This is true even for countries that offer deferral. This indicates that deferral-offering parent country taxes are already a barrier. This most likely arises because parents and hosts limit tax breaks to locally-owned, locally-undertaken activities (such as accelerated depreciation or R&D tax credits). Thus, the gap the multinationals face isn’t simply the difference between the US statutory rate of 35% and the Irish one of 12.5%, implying that whatever increase in the effective tax may come isn’t going to be the 200% increase being suggested. In addition, the US operates an income basket method of calculating foreign owned tax. What this means is that it adds up worldwide profits to calculate the US tax liability and worldwide non-US taxes to calculate the US tax credit. Thus, the excess credits earned in a place like Germany (where the tax rate exceeds that in the US) can be used to offset the liability that would be owed in an excess limit place like Ireland. Furthermore, since most US firms are in an excess credit position, they already have a buffer to soften whatever increases may result from deferral elimination. As such, it is not in any way clear that this proposed change would necessarily push Irish subsidiaries into an excess limit position (where they would owe US taxes) leading to a reduction in investment.

But all of this presupposes that taxes are a major force in multinational decision making. Evidence indicates that although taxes are useful in attracting investment on the margin, they are generally of second order performance for most investment decisions. In surveys of multinationals, taxes usually rank around 9^th in importance, far behind factors such as labour costs, energy costs, infrastructure, and government stability. Turning to econometric evidence, (see Blonigen for a nice review of the literature) while taxes typically show up as statistically significant, the relatively small differences in effective tax rates across countries compared to, say, labour cost differentials, means that these latter differences are more economically significant when predicting FDI patterns. This then reinforces the survey evidence. Furthermore even the effects of taxes have deeper stories as the sensitivity of FDI to taxes varies along many firm, host country, and source country characteristics. For example, Barrios et. al find that multinationals’ tax sensitivity varies along many parameters including the number of subsidiaries it operates (peaking at 4 subsidiaries). For the US, this could be linked to the income basket described above. Therefore to predict the impact in Ireland, it is necessary to know more about the subsidiaries and their corporate networks than simply where they come from. However, even broad brush stroke predictions suggest that the decline in FDI, although present, will not be the massive outflow being predicted.

Finally, when making a decision, the choice facing a multinational is between Ireland and other location choices. This potential change hits Ireland more than a high tax location like Germany because Ireland has low taxes and benefits more from deferral. But who are we competing with for investment? High tax locations (where our relative advantage might be reduced) or low tax locations (where our relative position will roughly the same)? Given recent headlines, investment leaving Ireland seems bound for low tax Eastern European countries (who not coincidentally have far lower wages than we do). Therefore at first blush, it seems to me this change does little to affect Ireland’s attractiveness relative to our actual competition. The continual focus on taxes as THE central pillar of our foreign direct investment policy is missing the bigger point. To put it simply, taxes are not the only reason for investment in Ireland and they never have been. If they were, we would have zero investment since there are other countries with far lower taxes than we currently have. What needs to be recognized both in this instance and in our overall approach to FDI is that taxes are but one aspect of how firms make decisions. A more balanced approach will leave us far less vulnerable to changes in global conditions and less prone to needless hysteria.

So in the end, has Obama betrayed his Irish roots? To the extent that his proposals affect perceptions, maybe. A quick read of today’s papers leaves one with the impression that the one thing we had going for us is gone. However, this both overstates the change in the taxes firms actually pay and assumes that we are competing with high-tax states for US investment rather than other low-tax countries on the periphery of the European Union. But to the extent that Obama’s proposals will affect actual investment in Ireland, there is still a lot more consideration that needs to be given before Moneygall cancels its plans for an Obama heritage centre.