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).
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.
Economic historians and others interested in the Great Depression still turn to the economic publications of the League of Nations as a basic source for understanding the economic catastrophe of the 1930s. While I don’t want to give anyone in Washington DC stage fright, the publications of today’s international organisations, such as the IMF’s World Economic Outlook which was published in full last week, will also serve as a first port of call for the historians of decades hence. So: how are they shaping up?
Extremely well, is my reaction after having finally given the April WEO the attention it deserves. This is essential reading for people seeking a global overview of the crisis, and advice as to how to get out of it.
Those interested in keeping up with the latest thinking on the financial crisis may be interested in checking out Jim Corr’s interview with Matt Cooper on today’s Last Word radio show.
The Fed is using an impressive range of firepower to counter the greatest deflationary threat since the Great Depression. With such massive injections of liquidity, however, it is not surprising that leading figures are already debating exit strategies and the extent of the longer-term inflationary threat. It is a fascinating debate to watch.
John Taylor worried in the FT last month that “extraordinary measures have the potential to change permanently the role of the Fed in harmful ways.” He said, “The success of monetary policy during the great moderation period of long expansions and mild recessions was not due to discretionary interventions, but to following predictable policies and guidelines that worked.”
Writing this week in the FT, Martin Feldstein is also anxiously looking ahead: “[W]hen the economy begins to recover, the Fed will have to reduce the excessive stock of money and, more critically, prevent the large volume of excess reserves in the banks from causing an inflationary explosion of money and credit. This will not be an easy task since the commercial banks may not want to exchange their reserves for the mountain of private debt that the Fed is holding and the Fed lacks enough Treasury bonds with which to conduct ordinary open market operations. It is surprising that the long-term interest rates do not yet reflect the resulting risk of future inflation.”
Robert Hall and Susan Woodward strike a more optimistic note in a piece on the VOX site: “[T]he Fed can control inflation by varying the interest rate it pays (or charges) banks on their reserve holding. Consequently, the Fed’s exit strategy need not be constrained by concerns about inflation – reserve interest-rate policy can take care of inflation, but the Fed should publically announce this policy.”
Paul Gillespie writes on this topic in today’s Irish Times, covering Kevin’s recent work and some of the other work cited on this blog: here.
I linked last weekend to former Swedish Finance Minister’s Bo Lundgren’s appearance on the Marian Finucane show.
Lundgren also appeared recently before the TARP Congressional Oversight Committee, chaired by Harvard Law Professor Elizabeth Warren and his written testimony was the basis for the section on Sweden in the committee’s latest report. Here’s a webpage containing the written testimony of Lundgren and three other experts on other banking crises (Great Depression, 1980s S&L and 1990’s Japan) who all appeared before the committee at the same time.
The webpage also has full video of this meeting. The experts delivered short verbal testimony (Lundgren’s starts about 14 minutes in) and about 40 minutes in there is a question and answer session. Prof. Warren’s opening line of questioning about arguments against nationalisation was of particular interest to yours truly but the whole session is really useful.
The financial crisis has been going on long enough now that we are starting to see a lot of serious research and policy papers addressing the various issues that the crisis has raised.
This material may be a bit more complicated than most of the reports this blog usually links to but I think some of our readers may appreciate getting a sense of the stuff that we’re reading in trying to understand what’s going on and where we should be heading.
So, here’s some stuff I’ve been reading in between my nationalisation blogging …
Barry Eichengreen and I have a short piece on Vox comparing the two global depressions that began in 1929 and 2008. Hopefully this one will not last as long as the one 80 years ago.
The prospects for the Irish economy are very sensitive to the resumption of global growth. The VoxEU website provides some ‘instant’ analytical responses to the London Summit, including essays by some of the key UK civil servants involved in organising the summit: the link is here.
I will be answering reader questions about the G20 summit on Monday at this website.
Here is an interesting profile of Nouriel Roubini.
The first week of April sees two big economic events: the April 7th Irish budget is preceded by the G20 summit on April 2nd. There is an interesting article by Simon Johnson on The Atlantic’s website: you can read it here.
Remember last spring? It seems an age ago now. The fear then was of resource scarcity: of rising oil prices, and of rising food prices, as biofuels crowded out food production and population continued to grow. Environmental worries also reflect resource scarcity, albeit of another type. Once this crisis is over, whenever that is, all these concerns will inevitably come back on the agenda, and could easily dominate it for the rest of the century.
In that context, one of the most alarming news stories, to me, of last year, was that involving Korea’s Daewoo Logistics leasing almost half of Madagascar’s arable land on a 99 year basis. Here is a pretty positive account of the deal in Time magazine. Why my alarm? Because the deal reflected the fact that
“[Food-importing countries] have lost trust in trade because of the price crisis this year,” says Joachim von Braun, director of the International Policy Food Research Institute in Washington.
Thus, from a Korean point of view,
“We want to plant corn there to ensure our food security. Food can be a weapon in this world,” said Hong Jong-wan, a manager at Daewoo. “We can either export the harvests to other countries or ship them back to Korea in case of a food crisis.”
The latter quote, taken from this FT piece, should send shivers down the spine of anyone with a sense of history. (The article also makes it clear that the agreement was far less positive for Madagascar than had at first been reported.) Markets are a political institution. The deal they represent is straightforward: if you are willing to pay the going price, then you can buy what you need. When countries start to doubt whether that deal will remain valid going forward, and in consequence act to carve out sources of supply for their own exclusive use, the geopolitical consequences can be catastrophic.
As I contemplated this story, I idly wondered what would happen if, in a decade or two, some African or Latin American country decided that it wanted to renege on such a deal which had been struck by a previous government with, say, China or India. And so it was with considerable interest that I read this from the BBC. I don’t suppose the Koreans will invade Madagascar! But one can predict that this will not be the only occasion on which such a domestic backlash occurs. Why on earth would anyone assume otherwise?
The moral is straightforward. In addition to tackling the underlying problems of resource scarcity, we need to credibly commit to keeping international markets open over the decades to come. And in order to be able to do that, governments need to get the macroeconomics right, now. Otherwise, as the example of the Great Depression shows, this will just be a taste of things to come. And that won’t just be bad news for the economy.
Official details here and here. It’s pretty much as I described yesterday and I’m no more impressed than before. In particular, it hardly takes a corporate finance expert to figure out that “The equity co-investment component of these programs has been designed to well align public and private investor interests in order to maximize the long-run value for U.S. taxpayers” is a bit of a fib. Funnily, toxic (or troubled) assets have now been renamed “legacy assets”! This terminology might be appropriate if we were dealing with newly-cleansed banks with new ownership and management. However, as I’m reminded every time I see this man’s happy smiling face, that just ain’t the case.
Details of Tim Geithner’s plans for dealing with toxic assets at US banks have been leaked: The New York Times article is here. From an Irish point of view, these plans are of interest not only as an example of how another country is dealing with its banking problems (the Minister for Finance has explicitly stated that he intends to learn from the approaches taken elsewhere before launching an Irish plan) but also because a successful resolution of the US banking problems seems like an essential ingredient in getting a world economic recovery going.
Kevin has raised the issue of differing attitudes in Europe and the US about the need for expansionary fiscal policy, with the Germans being particularly reluctant to adopt expansionary policies. This piece in today’s FT shows that some of the difference in attitudes reflects German concerns about US monetary policy.
The piece cites Christoph Schmidt, an adviser to Angela Merkel, as saying:
I see an inflationary risk in the US in the medium term because of the development of money supply there.
It also cites Klaus Zimmermann, president of DIW:
The central banks in the US and the UK are now literally printing money. This creates an inflationary potential that is difficult to stop.
In other words, rather than recommending that Europe follow the US in providing more fiscal stimulus, these influential German economists prefer to argue that US policy has already become dangerously expansionary and provides a bad example.
In my opinion, these statements illustrate three popular misconceptions.
The BBC and several other media report continuing Franco-German opposition to the calls by the US administration, the president of the World Bank, and many others, for the coordinated global fiscal expansion that would seem to be essential at this time. Irish auditors will however be interested in the following from Larry Summers:
“There are some for whom it would be imprudent,” he said, noting that the crisis-hit countries in eastern Europe – which have large foreign currency debts – could not increase spending. “But for a very large majority of the world economy, [a fiscal expansion] is appropriate.”
The BBC further reports:
But European governments have indicated they are unlikely to strain their finances by agreeing to much more spending until they have seen some results from the first round of stimulus programmes already launched, says our correspondent.
Now, if accurate, this report raises some fascinating questions. Given the lags involved with macroeconomic policy, how long a wait would this imply, even if the fiscal stimuli worked according to a Keynesian textbook plan? And what would such a wait then imply for the health of the economy? And, given that the stimuli are small, and that the contraction in the economy is enormous, what sort of ‘results’ is it realistic to expect? I would have thought that the results will be purely counterfactual — the economy will shrink less than would otherwise be the case. In that case the ‘results’ would have to be guaged with reference to the predictions of some model of the economy. Is that what is meant here? Or, are the governments concerned hoping that the stimuli will lead to an actual increase in GDP? And if so, are they implicitly ruling out further fiscal stimuli unless the economy stops shrinking?
Now, that would be an interesting policy stance.
Oh, and a happy St Patrick’s Day weekend to everyone.
“We have reached our limits,” said Axel Weber, president of Germany’s Bundesbank, in Frankfurt on Tuesday. “The expectation that we could neutralise this synchronised recession through short-term fiscal policy measures is false. We should not even try. There will be costs.”
From this. Apparently they think that the SGP is the key to preserving monetary union, rather than, say, preventing mass unemployment.
For those of us in secure employment, this is shaping up to becoming a fascinating natural experiment in applied political economy.
Update: Christina Romer has a very nice introduction to the lessons of the Great Depression for today’s policy makers here.
It looks like the CPI will fall by a substantial amount during 2009 due to the economic slowdown, the weakness of Sterling and the cut in mortgage interest rates, amongst other factors.
This provides an opportunity to raise VAT and excise taxes, in view of the fiscal situation (less painful to raise indirect taxes when the CPI is in decline than when the CPI is increasing). The is the mirror image of the situation several years ago, when Ireland’s relatively high inflation rate led to widespread calls for cuts in indirect taxation in order to combat inflation. While there would be undoubtedly some leakage across the border, an increase in indirect taxes should be a significant source of revenue.
In a way, an increase in indirect taxes can be interpreted as a mechanism by which the government can reap some of the gains from the terms of trade improvement that is embedded in the appreciation of the euro against Sterling: this provides a real income gain for Ireland vis-a-vis other euro area countries, since Ireland imports much more from the UK than is the case for other euro area countries.
The regressive nature of indirect taxes can be taken into account in terms of the overall package of tax and welfare policies.
Eurointelligence kicks off today with an FT story which makes depressing reading: European finance ministers appear to have turned down Larry Summers’ eminently sensible call for a coordinated global macroeconomic stimulus package. The eurozone is not the gold bloc, to be fair, but one wonders whether a political generation that has invested so much political capital in the SGP will be capable of averting the disaster that faces Europe. (And even if individual policy makers do understand what is needed, European fiscal fragmentation appears an almost insuperable obstacle to the Europe-wide Keynesian policies that are needed now, as events in our own little country dramatically illustrate.)
Europe may be a second class political power on the world stage, but it is a first class economic power, and so all of this is very bad news indeed. Has the April conference failed before it even opens?
L’Homme est instinctivement protectionniste et seule la raison le pousse au libre-échange.
(Celso Amorim, Brazilian foreign minister, in today’s Le Monde.)
In Saturday’s Ardfheis speech, the Taoiseach announced:
I will create a new central banking commission. This will incorporate both the responsibilities of the Central Bank and the supervision and regulatory functions of the Financial Regulator. This will build on best international practice similar to the Canadian model. And it will provide a seamless powerful organization with independent responsibility. It will have new powers for ensuring the financial health, stability and supervision of the banking and financial sector.
I interpreted this statement as implying that Canada has something called “a central banking commission” which incorporates both central banking and financial supervision. It turns out, however, that Canada does not have such a structure.
On an annual basis, the volume of world trade fell by 25-30% between 1929 and 1932. If you use quarterly data, you can push the peak to trough Great Depression trade decline up to around 35%.
The latest data indicate that the volume of world trade fell by 13% between August and December 2008. We are not only on track, we are ahead of schedule. Everything now depends on the policy response.
One of the alarming features of the current crisis is that way in which the short run protectionist pressures it is giving rise to are being superimposed upon longer run pressures that having been undermining support for globalization for some time — in particular, the feeling that it is harming poorer workers in richer countries. Equally alarming is the fact that all this is happening at the start of a century which will be marked by a shifting geopolitical equilibrium — which is always risky — and by renewed concerns about resource scarcity — which is riskier yet.
Much of the recent comment on this blog has understandably focused on the specifically Irish angles in saving the banks and getting credit flowing again, getting on top of the government deficit and improving competitiveness. But any progress towards these goals in a purely Irish context will be set at naught if the global economy continues to head south. We thus have a vital interest in the success of the various stimulus packages intended to reverse, or at least reduce, the slide into global recession.
The IMF’s most recent World Economic Outlook update (published January 28th last) presented its third downward revision of its economic forecasts in just four months. It now projects global growth of just ½ per cent in 2009, with advanced economies expected to suffer their deepest recession since World War II. Collectively, advanced economies are expected to contract by 2 per cent in 2009 – the first annual contraction in the post-war period.
The Guardian has an article today on a topic which we will be hearing a lot more about in the months to come, the ways in which many corporations exploit the possibilities afforded them by globalization to minimise their tax burden. It followed a short piece in yesterday’s Tribune on reports that Ireland is on a list of tax havens currently doing the rounds in Washington. According to the paper,
The Department of Finance told the Sunday Tribune the list had been rejected by the previous Bush administration, which said it oversimplified the issue. It said that it shared the Bush administration’s assessment of the list.
So that’s alright then.
This is very worrying.
Jim O’Leary had a piece yesterday in the Irish Times which was worth reading for a couple of reasons. First, he has a nice account of the incentives facing economic forecasters. Second, he draws attention to a truly astonishing forecast, or assumption, in the Central Bank’s recent Quarterly Bulletin: that, while domestic demand will collapse in 2009 (which makes sense: the Central Bank assumes that gross domestic expenditure will fall by 7.6%), our exports will only decline in volume by 0.7%. If true, this would obviously mute the overall fall in Irish GDP, and the Central Bank is forecasting a decline of just 4%.
Jim convincingly shows why the assumption regarding exports is implausible. Here are a few more facts. According to the CPB Netherlands Bureau for Economic Policy Analysis, the volume of world trade fell by 6% last November. That’s right: by 6%, in one month. US imports fell by 7.8%; Japanese exports fell by 10.8%.
The CPB cautions that monthly world trade figures are volatile, and that one should focus on moving averages. Of course, that becomes a less useful strategy when one has just passed the peak! More evidence of the extraordinarily rapid collapse in world trade comes from IATA, which reports that the volume of international cargo shipped by air was 22.6% lower in December 2008 than in December 2007 (HT Calculated Risk).
By way of comparison, the volume of world trade fell by a little more than a quarter over the 3 years 1929-1932.
As Jim says, it seems safe to assume that exports will contract by a lot more than the Central Bank is currently forecasting, and that the same will therefore be true of GDP and employment as well.