You Can Pry our 12.5% Rate from our Cold, Dead Fingers

Once again, the Government has gone on record that it will not be increasing the corporate tax rate. This firm stance is based on the idea that without our attractive tax rate, foreign firms will flee for other locations, increasing the speed of our downward spiral. Nevertheless, there has been little attempt to provide any suggestion as to how much such a move would hurt tax revenues or employment, or even whether it is a foregone conclusion that a tax increase would lower FDI at all.

The first thing required to address the issue is to estimate how much FDI will respond to a corporate tax rate increase. As with everything else in economics, the answer is it depends (although one can reasonably rule out an increase). As summarized by a 2008 OECD report, on average, studies find that a 1 percentage point increase in the effective corporate tax rate leads to a 3.7% decline in FDI.

This average, however, masks a lot of important variation that we would need to consider before coming up with an answer for Ireland. First off, there is the issue of how to calculate the effective corporate tax rate (what firms actually pay) from statutory rates. In particular, for FDI coming from foreign tax credit countries like the US, foreign earned income is added up as are foreign taxes paid when calculating what is owed upon repatriation (and yes, a host of evidence does indeed indicate that multinationals repatriate income even from low tax locations). To get an idea of what this means, let’s use a simple example. A US firm earns €100 in Ireland, on which it pays €12.5 in taxes to the Irish government. At the same time, it earns €200 in Germany, where it pays a 50% tax rate (which is the sum of the federal tax, surtaxes, and the municipal trade tax), resulting in payments of €100 to the Germany government. So the firm’s worldwide income is €300 and its foreign tax liability is €112.5, implying an effective foreign tax rate of 37.5%. When it repatriates this income back to the US, where the corporate tax rate is 35%, the Americans compute a tax bill of €105, which the firm’s excess credits more than wipe out. Therefore the firm’s effective tax rate on income is 37.5%. Now consider a second firm, also with €100 of Irish income but with €200 income earned in the UK where the tax rate is 30%. This firm pays €72.5 in foreign taxes, implying it is in an excess limit position when it repatriates its income to the US. This means that when the US tax authority applies the €72.5 tax credit to the €105 tax liability, the firm still owes €32.5 to the Americans. As such, the effective tax on its foreign income is 35%.

Now increase the Irish tax rate to 15% (the level, coincidentally of the German federal corporate tax). This is an increase of 2.5% in the Irish statutory tax rate. For the firm also in Germany, this increases its Irish tax liability to €15, increasing its foreign tax payments to €115 and its effective tax rate from 37.5% to 38.3%. Given the average elasticity of 3.7, this implies that worldwide FDI overseas would fall by 3.7*(38.3-37.5) = 2.96%. If it decreases operations in Germany and Ireland in proportion to income, this indicates a less than 1% decline in Irish FDI. For the firm also in the UK, the Irish tax increase increases its foreign tax liability to €75, still less than the US tax rate, implying that its effective tax on foreign earned income remains constant at 35%, suggesting no change in FDI.

So the first issue is where did these firms come from (crediting nations like the US, the UK and Germany, our three biggest investors coincidentally) or from foreign tax exempting countries (such as France). Further, where else other than Ireland are they operating and how big are those operations relative to the Irish one? Put simply, it is incorrect to state that a rise of the Irish tax from 12.5% to 15% implies a decrease in FDI by 2.5*3.7= 9.25%. And it is important to note that this example is extremely simple and doesn’t include issues such as tax planning (especially the retention of assets by young multinationals – see Altshuler for a good discussion), triangulation strategies (Altshuler and Grubert), and the myriad other factors influencing the actual taxes paid by multinationals. To come up with a much more accurate prediction in the effective tax rate, you’d need a lot more firm specific information to which I am not privy.

Outside of this, there remain questions about the applicability of the 3.7 elasticity. There is evidence that the tax elasticity of investment has grown over time (see Altshuler, Grubert and Newlon), which suggests that taking the results from our previous tax changes may not give a good indication of what would happen today. In addition, the evidence of Hines suggests that an increase of 1% has differential impacts depending on whether the baseline tax is something low (like zero) or something higher (like 12.5%). Looking at variation in taxes across US states, he finds that when including the zero tax states (like Delaware) an increase in the tax rate reduces FDI with the biggest reductions for low-tax states. When excluding the zero tax states, he actually finds no significant impact on FDI from higher taxes. This again warns us against using past changes to predict future ones.

Finally, it must be recognized that regardless of whatever average elasticity is estimated, the actual response is going to vary by firms. This is because the benefit of seeking out a lower tax location must be balanced against other factors. It must be remembered that while taxes are a cost to the firm, they are not the only cost to the firm. For multinationals that come to our emerald shores, taxes clearly play a role. However, surveys of multinationals tend to find that their importance lags far behind factors such as effective labor costs (which account for quality as well as wages) and energy costs (see Glickman and Woodward, The New Competitors: How Foreign Investors are Changing the U.S., 1989, for an example). Put simply, if a firm pays €2 million in labor costs and €100,000 in taxes, moving shop to save 2.5% in taxes doesn’t make sense if this comes with anything more than a .125% increase in labor costs. This also highlights the importance of knowing what a firm’s next best location is since the tax/labor tradeoff varies whether you’re comparing Ireland to a zero tax rate tax haven, a comparable tax location like Poland (where the rate is 19%), or a high tax location like Germany. Second, the willingness of a firm to relocate is going to depend on how expensive moving is relative to whatever added tax burden there is. For firms that invest heavily in immobile assets – be they capital-intensive facilities or worker-specific training – relocation is an expensive and time consuming activity. As such, at least in the short to medium run, they are probably less likely to shift production overseas in response to an increase in the Irish tax burden.

Putting these together, which firms are likely to relocate first? Firms with small labor costs, low capital requirements, and that can easily find or train workers to suit their needs. This might describe services (although not if the employees are highly trained, unique, or are privy to firm proprietary knowledge as could arguably be the case for IT) but it does not do a good job of describing manufacturing. As such, whatever the change in FDI measured as sales or assets is following a tax increase, the employment effects in the economy at large are likely to be small, especially in the short to medium term. Further, the employment impacts are likely to be strongest for relatively skilled workers, not those on the factory floor.

What then of the tax take? Given the above, it’s reasonable to assume the elasticity will be greater for services than for manufacturing. Thus to compute the change in tax revenues, one would not only need to know the elasticity for each type of activity (where manufacturing is likely to be close to zero in the short run) as well as the relative size. I don’t have the breakdown of the contributions of foreign multinationals to Irish revenues by industry, perhaps others with better data can give a suggestion. Nevertheless, if the elasticity of services is below one (which if the Irish facility helps to offset high taxes paid by other subsidiaries is certainly a possibility), there is certainly the possibility that tax revenues would increase when the tax rate goes up.

Putting all of this together, two things become clear. First, the precise impact of any tax increases is simply unknown. Second, it is quite likely that the size of those impacts are going to depend on whether one focuses on tax revenues, employment, or some other measure of FDI’s contribution to the state. However, there are serious reasons to question whether blind (as a Batt) adherence to the 12.5% rate is in the state’s best interests.

As a final point, all of this relates to what happens today. Evidence on tax competition suggests that if we increase our taxes, so too may other EU nations (Davies and Voget), offsetting some FDI losses. On the other hand, there is a potentially legitimate concern is that a tax hike today raises the spectre of time inconsistency, deterring future investment. This is one situation where having our ECB overlords force a tax increase on us might be a good thing. If investor perception is that this was not what we would have chosen on our own, it may mitigate damage down to our reputation as a country committed to low taxes. Given our high wages compared to other low tax countries, it is pretty clear that firms are here for a number of reasons in addition to our attractive tax. A small increase in that tax rate doesn’t change that fact.

Suggestions for Ireland’s response to Obama’s tax plan

Trina Vargo of the US-Irish alliance offers some advice on how Ireland should respond to Obama’s proposed clampdown on tax havens here. Although this is more of a political approach to the issue than mine of a few weeks ago, she too cautions against over-reacting.

US FDI in Ireland

What is US foreign direct investment in Ireland up to? A lot of different things. Some firms are here to produce and ship to the EU, others are here for research purposes, and yes, some are here primarily for tax purposes. This latter group is the one that will be most sensitive to changes in tax policy, both in the US and elsewhere as they plan where to have their income accrue for tax purposes. In a previous post, I argued that the Obama administration’s recent proposals would not have a substantial impact on employment in Ireland. Some have taken this to mean that I am suggesting that there will be little impact on the value of FDI here. Not so. The combination of low Irish tax rates and US tax policy give firms a reason to declare their foreign earned income in Ireland and to reinvest those earnings in order to avoid costly repatriation taxes. Do firms take advantage of this? Anecdotal evidence surely indicates that they do. Data from the US Bureau of Economic Analysis gives us a better insight into how this combination makes Ireland a bit unusual. Using 2006 data (the most recent for which data were available on the website), I was able to construct the following table that gives the top eleven countries by the sales/employee, FDI position/employee, and assets/employee (all numbers are in 1000s of US dollars).

Continue reading “US FDI in Ireland”

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 9th 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.