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.