Thursday, October 1, 2009

Ireland's Hidden Tax Bubble

The success of the Irish Celtic Tiger (1994 - 2008) can basically be divided into two main phases. The first more successful phase witnessed a tremendous expansion in multinational corporate investment in Ireland (largely of US origin). Exports were the main driver of growth during this period dramatically surging from less than €30 bl. in 1994 to over €90 bl. (current prices) by 2000. For anyone who studied these figures an alarming trend however was in evidence post 2000 with merchandise export growth completely stalling. So present figures are now lower (even in current price terms) than almost a decade previously.

Though there were worrying signs in evidence by 2000 that the property boom had already grown out of control, such fears were quickly disregarded. So after a brief slowdown lasting a couple of years (2001-2002) - the second phase of the Celtic Tiger took off almost entirely fuelled by a hugely artificial property bubble.

As we now are now slowly coming to terms with the dire consequences of such madness - greatly aggravated by the international financial crisis - potentially an even greater problem for the long-term stability of the economy lurks in the background. This relates to the nature of multinational activity in Ireland which is largely based on the artificial tax advantages that the country currently offers.

It is hard to overstate the extent to which these multinationals dominate our economy.

Ireland - as is well known - has one of the most open economies of the world so that when the value of merchandise and service trade is combined exports amounts to well over 80% of GDP (and nearly 100% of GNP). Over 90% of the total value of these exports comes from multinational firms. About 70% of these multinational exports in turn relate to US corporations with the vast bulk of activity in the IT and chemicals/pharmaceuticals sectors.

When one examines closely the precise reasons why Ireland is so attractive for these firms, artificial tax considerations loom large. For example research based activity is very important with potentially huge profits to be made from a successful new product (e.g. software or drug). Though most of the research in many cases is carried out by the parent company in the US, because of the much lower corporate tax system in Ireland, a considerable incentive exists to shift much of these profits to the research division in Ireland (so as to avail of the lower tax rates).

Also license fees would comprise the major bulk of earnings for a software company such as Microsoft. As there is no tax on such fees in Ireland, again this offers a reason to route most profits - made on earnings throughout Europe - through Ireland. As mentioned before on these blogs, Microsoft uses little known subsidiaries Round Island One and Flat Island for such purposes. Though these now enjoy an unlimited status, Round Island One in all likelihood remains by far the most profitable company in Ireland (operating from the offices of a South Dublin legal firm).

When one looks at the level of profits and license fee income transferred from Ireland, the figures are truly staggering. With profits repatriated currently running close to $30 bl. and licence fees at over €20 bl. per annum, a combined total of about €50 bl. is thereby generated in this manner (representing close to 30% of current GDP).

Ireland is officially listed as the No. 1 software exporter in the world. However again this is a largely artificial ranking due to the manner in which so much of Microsoft's income is transferred from other countries (mostly European) back to Ireland.

Also, as long recognised a considerable amount of transfer pricing is used by multinationals here artificially reducing costs so as to inflate reported profits. The combined effect of these procedures therefore, together with the sheer magnitude of what is involved makes it extremely difficult to assess the true nature of many Irish statistics e.g. exports, imports, balance of payments, taxation, productivity etc. For example a considerable amount of the corporate profits tax collected by the Government relates to income diverted from higher tax jurisdictions in Europe!

Another damaging feature of all this is that the domestic indigenous sector has been able to hide in the shadow of the success of such multinational activity. The Government and other economic bodies have been pointing to the recent comparative success of "Irish" exports during a time of deep recession (making favourable comparisons with Germany). However this "success" is almost entirely due to the dominant multinational element involved (where again much artificial pricing is involved). In truth there has been a significant collapse of Irish indigenous exports over the last year especially with respect to its key market i.e. the UK.

Therefore the success of Ireland's economy owes a great deal to the fact that it is operating as a very efficient tax haven (especially for US firms). Indeed along with the Bahamas, Ireland currently serves as the largest tax haven in the world for such firms. It is true that we differ from the Bahamas in the sense that these firms have genuine production facilities operating here. However it could be argued that such facilities in fact offer even better cover for tax diversion opportunities.

Paradoxically as the Obama regime attempts to tighten up on the tax diversion activities of its own national companies it could even offer a short term advantage to the Irish economy, as it is likely that the pure tax havens will be tackled first. This could then lead to a further shift to partial tax havens such as Ireland (where more seemingly legitimate reasons can be offered for hiding profits). However ultimately these tax havens will be also tackled which could then have very big repercussions for the Irish economy.

Huge mistakes were made due to the failure to act in time to deal with the property bubble.

Potentially even more damaging consequences may flow from a failure to react to this hidden tax bubble in our midst. Even while enjoying its benefits for some more years we should be formulating new economic directions to deal with economic life after this bubble.

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