Obama’s tax moves are not all bad for Ireland Sunday, May 10, 2009 By Ronald B Davies The Obama administration’s proposed changes to US international tax policy have caused so me panic in Ireland. Fears have been expressed that these changes will prompt an exodus by US multinationals which came here to take ad vantage of our low tax rate.
While this protectionist move by the US does not help us, it is not true that it necessarily means significant bad news for jobs here.
Of the Obama proposals, the removal of deferral on overseas investments and reductions in overseas cost deductions have attracted the most discussion.
To understand what these changes mean and how they could affect Ireland, we first need a brief overview of US tax policy.
The US taxes its firms on a worldwide basis, meaning that it combines a firm’s worldwide income into a basket and then applies the US tax of 35 per cent to this amount to calculate the US tax liability.
Recognising that firms have already paid taxes on this income to overseas governments, the US credits the overseas taxes against the US tax liability.
If the US tax liability exceeds the combined foreign payments, firms must pay the difference to the US, implying a 35 per cent tax rate on their investment. If the overseas tax payments exceed the US liability, the firm has excess credits, and no payment is made to the US. Deferral affects the timing of when overseas income enters the income basket and thus becomes liable to US tax.
When a US multinational reinvests its overseas earnings in its overseas affiliate, the earnings do not enter the tax ‘basket’.
This means that US tax liability is deferred until those funds are either repatriated to the US or invested passively.
Therefore, in theory, a firm can perpetually defer its US tax liability by continually reinvesting earnings into its subsidiary.
This means that, for an investment in Ireland, the firm pays the Irish corporate tax rate of 12.5 per cent, rather than the US rate of 35 per cent.
The fear is that eliminating deferral would then increase taxes on income earned in Ireland by around 20 per cent - from 12.5 per cent to 35 per cent. In addition, if, as proposed, US firms can no longer reduce the tax basket by claiming Irish expenses, this increases their tax burden.
If firms are investing in Ireland primarily for tax purposes, this might lead them to shut down Irish operations and add to Irish unemployment.
However, there are reasons to believe that, even if the proposed changes go through, the impact on Ireland may be minimal. Why? The answer lies in how US taxes work and how taxes fit into the overall decisionmaking strategy of multinational firms.
First, remember that the US adds up the overseas income and the overseas taxes from across the globe. A removal of deferral may well increase the tax burden on a firm that earns overseas investment only in Ireland, since the Irish tax of 12.5 per cent is less than the US tax.
However, for firms with investment in multiple locations, what matters is their average overseas tax. Thus, excess credits from a high-tax location such as Germany can be used to offset liability on Irish earned in come. In practice, most US multinationals have excess credits.
This suggests that there is already a buffer that can absorb some of the tax increases US president Barack Obama’s proposals would create, either due to restricted deferral or reduced deductibility of overseas costs.
Thus, elimination of deferral will not imply an increase in Ireland’s effective tax of 200 per cent as feared, but of something less than that.
Secondly, we must recognise that taxes are only one factor that influence multinational location choices. While evidence repeatedly indicates that taxes do matter, their impact is minor relative to other factors.
In surveys of firm owners, taxes generally rank ninth in importance. Invariably, labour costs are the primary factor, followed by energy costs, infrastructure and market access, a ranking that is borne out by empirical analysis. Thus, all else being equal, taxes may be a deciding factor.
Rarely, however, is all else equal. At the dawn of the economic boom, in line with the surveys, foreign firms were drawn to Ireland because of its access to European markets and low wages compared to the rest of the EU. If taxes alone were all that mattered, all investment would locate in tax haven countries with tax rates well below our 12.5 per cent rate.
Furthermore, to understand how Obama’s recommendations would affect Ireland’s ability to attract foreign direct investment (FDI), it is important to consider who we are in competition with. If our competitors are high-tax locations like Germany, then ending deferral might place us at a disadvantage because deferral is of no use in such locations (although our use as a way to utilise excess tax credits would remain).
However, our largest competitors for investment are new EU member states, such as Polandan d the Czech Republic, countries whose low labour costs, increasing skill levels and market access mirror the attraction of Ireland20 years ago. How will repealing deferral affect our competitiveness vis-a'-vis these nations?
The answer is not much, because, like us, they are low-tax countries. Eliminating deferral affects all countries with taxes lower than the US. Therefore, such a move would not greatly affect our position relative to these competitors.
Thus, there are several reasons to expect the impact of such a move on Irish employment to be minimal. In fact, recent history gives an example supporting such hopes. In 2004, the US government offered a limited tax holiday on profits repatriated from abroad, lowering the tax temporarily from 35 per cent to 5 per cent. This prompted repatriations of $312 billion.
That flow of money, however, had no impact on the real activity of US firms, either at home or abroad. In fact, the lack of any real impact is one of the major criticisms of Obama’s proposal in the US. Therefore, if the money in Ireland due to deferral is not driving employment here, the impact of its departure may be minimal.
This is not to say that Obama’s proposed changes will not have any effect on Ireland.
With confidence in Ireland already fragile, announcements like this certainly do not help. Furthermore, we must also consider how this change would affect Ireland’s balance of payments.
If these changes go through, the monetary value of foreign investment may fall substantially if those funds are here for tax purposes, not employment purposes.
Nevertheless, if Ireland is committed to attracting job creating overseas investment, rather than focusing on US tax policy, our government should give more attention to the other factors which earned us investment 20 years ago and a recosting us investment now.
Ronald B Davies is Professor of Economics, University College Dublin
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