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Wednesday, 24th April 2024 |
| Varney’s analysis - tied up in knots |
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| PAT WALL reviews the UK Government-commissioned report by Sir David Varney which dismissed the possibility of a special lower corporation tax rate for Northern Ireland and highlights the contradictions therein. He says that in any case there is a potential for the North to grow as a financial centre by building on its strengths - strengths that can overcome the lack of a lower tax rate to match that of the Republic. |
In December, Sir David Varney published his Review of Tax Policy in Northern Ireland (NI). Some commentators were disappointed but few were surprised that he concluded that Northern Ireland should not get any special tax breaks and in particular the Republic’s 12.5 per cent corporate tax rate should not apply in NI.
The review has some interesting things to say about the role of tax policy in the creation of the Celtic Tiger and makes compelling reading for anybody interested in the subject of international investment flows and the impact of taxation on cross border investment decisions. A good portion of the review is devoted to undermining the notion that low taxes are a significant influencer on international investment decisions. This conclusion is intriguing given the experience of the Republic of Ireland (RoI) and the weight of empirical evidence that taxation does have a major impact on foreign direct investment decisions.  | | Pat Wall |
Tax not the key driver in Celtic Tiger!
Varney not only argues that the potential benefit to NI cannot be extrapolated from the RoI experience but goes further and questions the notion that low taxes were the major driver of the Republic’s economic success in recent decades. While acknowledging that the corporation tax regime was seen as attractive to foreign investors but points out that FDI flows into Ireland were undiminished and improved in quality notwithstanding that the RoI corporate tax rate actually increased over time, from zero (export sales) to 10 per cent (manufacturing) to 12.5 per cent (general rate). He questions the assertion that business will go to the place where the tax rate is lowest and cites academic evidence that ‘skills, rule of law, industrial relations, the potential for innovation and the quality of infrastructure’ are more important in determining the ‘business fit’ of potential investment.
‘Profit shifting’ would lower UK tax take
On the one hand Varney challenges the view that low taxes are a main driver of international investment decisions and on the other he acknowledges the weight of empirical evidence to the contrary, especially that of the Republic of Ireland. He attempts to reconcile the two views by drawing a distinction between genuine (my word) investment and what it terms ‘profit shifting’. He acknowledges that low taxes have a major impact on international capital flows and even cites the potential loss to the UK exchequer resulting from transfers within the UK. To quote from the review:
‘On an assessment of the costs and benefits to the UK, there is not a case for a lower corporation tax rate in Northern Ireland. Such a policy would run the risk of encouraging profit shifting from the rest of the UK to Northern Ireland.
Elsewhere in the review he says:
‘From a UK-wide perspective, the overall case against a reduction in the corporation tax rate in Northern Ireland is more marked. The likely displacement of both capital and profits from the rest of the UK, and the fact that this would be subject to a lower rate of corporation tax, mean that a reduced rate of corporation tax for Northern Ireland would certainly come at a long-term cost in reduced resources to be shared by the UK regions or in the financing of public services. The policy would result in a net cost of about ?2.2 billion over 10 years, with no prospect of full cost recovery over the long run.
Does reducing taxes work?
There is an apparent contradiction in his assertion that reduced taxes are not a pre-eminent driver of international investment decisions and his warnings about the impact of tax reduction on capital flows. He seems to contradict himself by acknowledging that reducing tax rates could lead to a counter attack from close economic neighbours. To quote again from his report:
‘It is counter-intuitive to think that if tax had a significant effect on investment and profit into a particular economy, that the closest neighbouring ‘losers’ would not re-evaluate their own policy. This in turn could change the cost-benefit assessment presented above in a way that would heighten the costs relative to the benefits for Northern Ireland and the UK.
To paraphrase this he seems to be saying that reducing taxes will not have an impact on investment flows but even if it did work it would not work because other jurisdictions would respond by cutting taxes!
Most experts would accept that low corporate taxes alone will not generate long term sustainable economic activity. They would also accept that differences in tax rates will encourage a degree of tax avoidance through tax arbitrage. Those who are opposed to fair international tax competition often cite these arguments and they are the classic arguments put forward by the larger capital exporting countries. Varney points out that smaller, less developed countries will tend to adopt lower corporate tax rates to counter the force of attraction of the larger better developed economies. He seems to acknowledge that lower taxes have a legitimate role to play in economic development but he views the debate from the context of the UK as a large capital exporter (and importer).
Practical problems and UK policy issues
From a UK perspective granting a special corporation tax rate to NI would open up a whole range of thorny issues. How would the UK deal with the issue in its tax treaties with fellow OECD members? How would the EU Commission view such a move? What would be the reaction of the other UK countries - Scotland and Wales? While the review concludes that these issues could be overcome, one is left with the feeling that granting special tax status to NI is simply a road that any UK government will not go down. The arguments in the review against low corporate taxes as an instrument of economic development policy must be viewed in the light of overall UK tax policy. It is hard to escape the conclusion that the review finds against the case for low corporate taxes in NI, not because the strategy would not work but because it does not fit with UK tax policy. That is fair enough given NI’s status in the UK.
What is profit shifting?
Let us return to Varney’s assertion that, what he terms, profit shifting is the major outcome of lower corporate tax rates. The underlying assumption seems to be that lower taxes in one country will encourage multi-national companies (MNCs) to shift existing profits by manipulating results.
It would be naive to deny this but it seems to me that the review greatly exaggerates its impact. The vast majority of MNCs do not engage in profit manipulation without ensuring that there is real underlying economic substance to the profit drivers. In addition the transfer pricing and other anti-avoidance rules of most capital exporting countries are sufficiently robust to prevent organised abuse.
The review cites empirical research that indicates a correlation between profitability and low tax on profits. This is not surprising. Multi-national companies with a global strategy will tend to locate incremental high margin investment in low tax jurisdictions all other things being equal.
Varney asserts that low tax rates in the RoI do not explain the move up the value chain over recent decades. Quite a different interpretation is feasible on the basis that there is little point in locating anything other than high value added activity in a low tax jurisdiction. In a global knowledge economy where value added is a function of mobile intellectual property it is not surprising to see low tax rates attracting high value added projects. The low tax rate becomes a central plank around which centres of excellence can be built resulting in further reinforcement of the advantages of a particular location. Dublin and Luxembourg are good examples within the EU.
Importance of access to markets.
On the subject of location choice the review also has this to say about the main drivers of international investment:
‘Market size, distance and factor prices (e.g. wages) appear to be more significant than tax rates in influencing inward investment. Most research seems to suggest gravitational variables (i.e. distance and market size) as the main determinants of FDI and of more significance than tax. This is consistent with the findings of business surveys showing that the prime motivation for FDI is easy market access with low costs, as well as skills, infrastructure and telecommunications.’
For digital content, including financial transactions, market access is pretty much instantaneous and not a function of distance. For other high value added goods, such as pharmaceuticals, remoteness from consumers and transportation costs are not serious barriers.
Accepting the importance of access to markets it is arguable that the review underestimates the importance of EU membership in the explanation of the RoI economic performance over the last two decades. It fails to mention that access to the EU marketplace was arguably of far greater strategic value to the Republic than regional fund transfers. Particularly in the financial services sector, EU membership has put RoI in the powerful position of being a low tax jurisdiction within a large single market. In the global world of financial services, EU membership allows the Republic to act as a gateway to these markets, particularly for US based companies. All other things being equal tax policy can have a major impact on the pattern of mobile international investment flows.
Not just nominal tax rate - certainty
The impact of tax policy goes beyond the single variable of the nominal corporate tax rate. It is the most visible statement a Government can make about its long term approach to taxation on corporate profits.
Much empirical research highlights the importance of certainty in the investment decision making process. A clear and unambiguous commitment to low corporate taxes goes a long way to creating that certainty. Even if NI was to introduce a 12.5 per cent rate to what extent could it satisfy investors need for certainty? Given the broader UK policy framework it is likely that any reduction the NI corporate tax rate would be seen by international investors as nothing more than a short term expedient. The RoI can point to a consistent policy commitment over five decades regardless of the political make-up of the Government.
NI as a financial centre
The review points out that the UK is very successful in attracting international capital flows and that NI occupies a valuable strategic position in its union with Great Britain and its physical and cultural proximity to the Republic of Ireland. London in particular is a major player in the global financial services industry and Dublin has carved out an impressive presence in niche markets especially in the funds industry. The review has this to say:
‘Forecasts suggest that tradeable services could generate up to 54,000 additional jobs (in NI) over the next decade – the challenge is to ensure that the relative performance of this sector is supported by government policy. In addition, there is scope for increasing the level of collaboration with Republic of Ireland and UK counterparts, particularly with those firms located within the international financial services Centres in Dublin and London.’
The UK is a major player in the international funds industry and its taxation and regulatory regime is has been customised to meet international needs. The key tax policy shared by the UK and RoI is the protection against local taxation that both jurisdictions give to international capital managed on a discretionary basis or through the medium of collective investment funds. This has enabled London to become the major global asset management centre and Dublin and Edinburgh to become significant global players in funds administration. The absence of a low corporate tax rate in NI will impact on its ability to attract high value added projects in certain sectors. For example, high margin pharmaceutical projects are unlikely to chose NI as a domicile. However in the international traded services sectors, especially financial services, the UK tax regime is competitive. As the global market for financial services continues to grow there is no reason why NI and Belfast in particular should not become a significant player. |
Pat Wall is a taxation and corporate partner with PricewaterhouseCoopers. He is chairman of the Pan-European Pensions Task Force of the Irish Government.
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| Article appeared in the February 2008 issue.
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