Sunday, 23 January 2011

Corporation Tax Cuts Don’t Lead To Prosperity

By Michael Burke

In George Osborne’s Budget in June 2010 it was announced that the rate of corporation tax will be cut in a series of steps from 28% to 24%. This was part of a series of measures which, it is claimed, would boost growth. In fact they comprised part of a series of tax cuts for companies and the highly paid which amount to a giveaway of £12.4bn in 2014/15, almost exactly equal to the yield from the VAT hike of £13.45bn – which in contrast will come overwhelmingly from the pockets of the poor.

But, just as the package of tax measures are not about deficit-reduction at all, but a transfer of incomes from the poor to the rich, so the claim that lowering tax rates will lead to growth is also incorrect. The claim is that lower taxes increase the flow of Foreign Direct Investment (FDI). But the recent FDI Barometer produced by Think London, the agency that promotes FDI in London, shows that overseas investors are less likely to invest in London, not more likely because of recent developments in UK economic policy. In a survey of over 300 executives responsible for making FDI allocations, 60% said the lower tax rate would not change the attractiveness of London as an investment destination, 13% said it would make them more likely to investment, but 22% said it would make them less likely to invest. Therefore a net balance of 9% said lower corporate taxes would make London less attractive to investors!

In fact those surveyed were much more agitated about racist immigration policies - with 48% opposed to the Tory-led Coalition’s cap on non-EU immigration.

This is because FDI is not driven by corporate tax rates. At one end of the scale the highest corporate tax rates in the OECD are imposed by the US and Japan at 39%. Germany has a 30% rate. The lowest rates are in Iceland (15%) and Ireland (12.5%), which should be more a warning than a model!

FDI, in common with all investment, is driven by prospective rates of return. Some factors, such as geographical location are outside policymakers’ hands. But the quality of road, rail, air and port infrastructure are not. Likewise, the size of the market is outside policymakers’ hands, except over the very long run, but economic growth rates are not. In particular, studies repeatedly show that it is the quality and skills of the workforce that is the main policy-driven factor in attracting FDI.

Ireland, with the lowest corporation tax rate in the OECD, demonstrates this reality. It is an article of faith for the Dublin government and its supporters that the 12.5% rate is the key to attracting FDI. Both the Taoiseach Brian Cowen and the Finance Minister Brian Lenihan have taking to describing it as “our international brand”. In the 1998 Budget (introduced in December 1997) their predecessor as Finance Minister, Charlie McCreevey, introduced the legislation for a new regime of corporation tax that led to the phased introduction of the 12.5% rate of corporation tax from 1 January 2003 – down from 32%.

Figure 1 below shows what actually happened to FDI in Ireland before and after the cut to 12.5% corporation tax. In the period since the corporation tax was slashed there have been many quarters where there was a net outflow of FDI and the annual average total was an inflow of just €2.3bn. Before the rate was cut that annual average inflow was €17.7bn, and there was only one quarter of net outflow in FDI.

Figure 1


If FDI were measured relative to either the level of GDP or as a proportion of total investment, the before and after contrast would be even starker.

Clearly, low corporate tax rates did not leads to higher inflows of FDI, and are not responsible for it. But over a prolonged period the Irish economy has had a much greater share of world FDI inflows than would be suggested by the small size of the domestic economy.

Figure 2 below shows one of the main reasons why that is the case. It shows the percentage of the 20-24 year old population in EU countries who achieved at least an upper second level education. Ireland comes out top.

Figure 2



This also helps to explains why FDI investors don’t relish tax cuts. They aren’t fools. They know that low-tax economies do not have the resources to pay for investment in infrastructure, transport links and above all education- the factors that actually attract FDI. Low corporate taxes therefore do not attract, even deter FDI, as the London survey and the Irish experience demonstrate.

But George Osborne is a long-time fan of his fellow Thatcherites in Ireland. In fact the current Dublin government has far more fans in Downing Street than in Ireland, with its opinion poll rating dropping to 14% even before the latest resignations of nearly half the Cabinet. Determined to emulate the effects of Ireland’s Thatcherite economic policymaking, the Tory-led government has set out a course to lower corporate taxes. This will not attract FDI, but it does have the effect of allowing established companies to retain a greater proportion of their profits- and lowering wages and increasing capital’s ability to generate profits remains the essence of government policy. Reality shows there will be no increase in FDI to Britain due to lower corporate taxes.

12 comments:

Anonymous said...

It isn't perssuasive to correlate two variables (eg Irish tax rate and FDI) without controlling for other things going on. It is perfectly true that other things matter for FDI and matter more than corporate taxes. But it is implausible to suggest that tax has no influence or a perverse one. Infrasstructure development and education spending depend on the whole tax system, including user charges; they don't depend on the rate of corporate tax, which is less important than income tax or VAT in nearly all countries.

Alex said...

Drivel. You omit to mention that prior to the reduction in the general rate of corporation tax in Ireland, all inbound investment eas made at into tax free zones in Shannon or special economic zones in the Dublin Docks where profits were taxed at 10%.

The 12.5% tax rate was introduced in response to an EU atack on the Irish split rates, and so the 12.5% tax rates that applied to all Irish companies was therefore a tax increase for mopst inbound investors rather than a potential tax decrease.

Very poor analysis. Try again.

J Gill said...

Was the corporate tax rate in Ireland for manufacturing not 10% since the 80s? Was it not 12.5% since 1987 for those working out of the IFSC? Presumably manufacturing made up a significant amount of FDI in the boom years?

Can anybody point to infomation on what proportion of FDI did not fall under either of the above categories prior to 2003?

Can the drop in FDI from 2003 be extricated from the eastward expansion of the EU & the provisions of Accession Treaties & full membership of our Eatern brothers? I’m just trying to get my head around all this. Even so, prior to Accesion Treaties other agreements were forged with future members, including Free Trade Agreements. I’d be interested to know exactly what access these agreements gave inward FDI to the Single Market. Perhaps profitable use can be made of these circumtances to bolster your case? Maybe the cut in the manufacturing corp tax rate in the 80s will how up similar figures.

All the best Jake

Georges said...

Stripping out the polemics of the post, it appears the author is stating the percentage of the 20-24 year old population who achieve at least an upper second level education is a greater impetus in attracting FDI vs. rate of corporate taxation. Maybe, maybe not.

If this is the claim, would it not be better to have a chart showing some measure of FDI (as a % of GDP, on average, whatever) ranked in order of those countries with the education attainment level? Alongside a similar chart showing the same only by rates of taxation? That would give the reader a better pricture as to which of the two (if even) have a greater influence on attracting FDI. As Anonymous points out, it could be some other combination of variables.

One polemic note, Germany is touted as having a highish rate of corporate taxation with the implication it has no problem attracting FDI, fine. But as the second chart shows, Germany ranks near the bottom on the education attainment level, rather defeats the argument put forward.

Michael Burke said...

Thanks to all for the comments.

The research cited in the piece comes from the OECD. A key conclusion is that, "The most powerful attraction [for FDI] may be found in its workforce." It goes on to cite statistical and cross-country analyses, including from the World Bank and UNCTAD, in support of that view.

Lower taxes inevitably lead to lower rates of government investment in education and infrastructure - and that potential allocators of FDI are aware of that dynamic too.

No assertion is made that higher corporate taxes lead to higher rates of FDI. What is disproven is the Thacherite notion that lower taxes lead to higher FDI. The opposite was the case for Ireland and likely to be so for London.

Despite the successes of the German economy its stock of FDI is much lower relative to its economic size than many other European countries. It is also lower in absolute terms than France, Belgium, and Britain, all of whom have measured higher educational attainment, as shown in the published chart.

Stocks of FDI for selected countries shown here http://www.gtai.com/homepage/german-business-location/foreign-direct-investment/fdi-data/

Compared to te rest of the EU, Germany does generate high levels of doemstic investment, including government investment. It can only do that with a much higher rate of tax than Ireland.

In relation to Ireland, or any other country, it can be highly productive to offer selective tax incentives. But a general 12.5% corporate tax rate lowers domestic tax revenues and has led to lower FDI inflows, much lower than when the general rate was 32%. This lowers the government funds to invest in education, transport and infrastructure.

IBEC, which is dominated by small producers and fast food outlets, is the staunchest defender of 12.5%, while INTEL and the Quinn Group want investment in education, infrastructure and R&D.

http://www.progressive-economy.ie/2010/01/who-benefits-from-current-policy.html

Alex said...

Sorry, but your analysis is not borne out by the facts. It is quite possible for small countries such as Ireland or Luxembourg to generate substantial government revenues by offering low tax rates to high margin businesses that sell their products and services to surrounding countries. Typical businesses would be group treasury management (ie. Dublin Docks IFSC), fund management (Luxembourg), aircraft engine maintenance (Shannon) and PC assembly (Dell in Ireland). The economic value of such businesses may be out of all proportion to the economy of the host country, but provide substantial tax revenue. This is quite feasible in a small EU country such as Ireland or Luxembourg, but it would not be feasible for one of the larger EU countries because they are not surrounded by neighbours many times their size that can provide a market on a comparable relative scale to produce a proportionate level of tax revenue if tax rates were at the same level as in Ireland.

Michael Burke said...

Trouble is, Alex, Ireland doesn't generate substantial tax revenues by a low taxation policy.

In the period 2002-2006 (ie, before the recession) Irish govt. revenues as a proportion of GDP were 34.9%, while the Euro Area average was 44.9% (Eurostat). Despite an economic collapse and consequent reduction in the GDP denominator, the official estimate is that government revenues will still be exactly the same proportion this year.

In fact, so loose is the tax regime that many US MNCs end up paying little more than 2%, and often for activities not conducted in Ireland at all (ie employing no-one).

http://www.progressive-economy.ie/2010/03/lies-damn-lies-irish-economic.html

Of course, a 10% increase in government revenues as a proportion of GDP woud eliminate the deficit entirely. But most of the political parties prefer to cut spending, with the disastrous consequences we have seen.

Alex said...

The trouble is Michael that you miss the point. Ireland does not have any natural advantages for industry (small population, no natural resources) so it has only been able to encourage inbound investment of industries where transportation costs are negligible factors (IT/software, pharmaceuticals) and it has been able to do that with a low corporation tax rate.

Without those incentives those industries wouldn't be there. 25 years ago they weren't there, yet now the Irish pharmaceutical industry which formerly benefites from 10 year tax holidays for export related businesses and now benefits from a 12.5% tax rate, has a turnover which is 40% of the urnover of the same industry in the UK.

Without this inward investment the scale of industry in Ireland would have been limited to food processing, building materials (Smurftt) and glass/pottery (Waterford/Wedgewood) and some textiles. There really was nothing else, so the low tax rate has brought in employment and increased the absolute revenue from company taxation even if it is at a lower rate.

This link shows the role of low taxes in encouraging investment into Ireland for 30 years before the 32% tax rate was reduced to 12.5%:
http://www.inti.gov.ar/cadenasdevalor/ireland.pdf

The Irish go for low tax rates because it is their selling point. In Germany indutrial companies will find world leading manufacturers, a highly skilled workforce, a large domestic and international market for goods so the country doesn't need to attract inward investment with low taxes.

Robert Sweeney said...

Michael,

Could you deal with Alex's and J Gill's point that since the 80s corporation tax, through the manufacturing relief scheme, has actually increased from 10 to 12.5% (under EU pressure)? The following article provides some info. but the issue is still not clear. http://en.wikipedia.org/wiki/Corporation_tax_in_the_Republic_of_Ireland
I seem to recall Peadar Kirby in his 2002 book asserting that the effective rate companies paid increased from 10 to 12.5% since the 80s. Low corporation tax not being a major determinant of inward FDI is not supported by Gunnigle and McGuire's January 2001 ESRI paper, "Why Ireland? A Qualitative Review of the Factors Influencing the Location of US Mulitnationals in Ireland ..."

Robert Sweeney said...

Michael,

Could you deal with Alex's and J Gill's point that since the 80s corporation tax, through the manufacturing relief scheme, has actually increased from 10 to 12.5% (under EU pressure)? The following article provides some info. but the issue is still not clear. http://en.wikipedia.org/wiki/Corporation_tax_in_the_Republic_of_Ireland
I seem to recall Peadar Kirby in his 2002 book asserting that the effective rate companies paid increased from 10 to 12.5% since the 80s. Low corporation tax not being a major determinant of inward FDI is not supported by Gunnigle and McGuire's January 2001 ESRI paper, "Why Ireland? A Qualitative Review of the Factors Influencing the Location of US Mulitnationals in Ireland ..."

Michael Burke said...

Robert

The 10% tax rate applied only to manufacturing from 1981 onwards. As previously stated, there may be an argument for selective or temporary tax incentives to boost investment, both FDI and domestic.

But actually, even that didn't happen in Ireland. In the 4 years 1978-1981 avge annual FDI inflows were US$300mn (World Bank database), in the 4 years subsequent to the 10% tax rate FDI averaged US$235mn. The 1978 peak was not surpased in nominal terms until 1990. Of course, in real terms the decline was even more pronounced.

The introduction of a 12.5% rate was phased in to 2003 and was a general tax rate for all companies. (It is not possible to get a breakdown by sector before 1998 as CSO didn't collect separate financial firms' data before then). As shown, that didn't lead to a upturn in FDI either.

The effective tax rate is less than 12.5%. In a previous link, there is a piece showing that for US MNCs the effective rate is often little more than 2%.

Again, as stated previously it is an article of faith for many in Ireland that low taxes spurred growth through FDI. The manufacturing cut to 10% and the general cut to 12.5% and the response of FDI do no support that belief.

What is usually ignored is the transforming role of EU funds - but that's another story.

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