Ever since Ireland was forced off international capital markets for protecting European banks, there has been a lot of discussion at European level about its corporate tax rate. UK blogger Duncan Weldon, for example, wanted any funding to be contingent on changes in corporate tax. The chatter hasn’t died down and if anything, with restructuring for Greece looking inevitable, the debate may be intensifying. BusinessInsider reported in the last few days that French Finance Minister, Christiane Lagarde, is going to dig her heels in on this issue: no help for Ireland until it gives up its sovereignty on corporate tax.
For context, France has a headline rate on corporate tax of 33%. Ireland’s headline rate is just 12.5%. Whereas Ireland sees its rate as central to competitiveness and job creation, France sees it as a cheap trick that diverts economic activity, rather than creates it. Or is it that simple?
Corporate tax: just part of taxes on profits
Global business services firm PwC release a report every year entitled Paying Taxes. Its aim is to understand the true cost of taxes, by focusing firstly on the actual rates paid and secondly on the administrative burden that taxes impose, through for example filling out forms. Their most recent report is out and has a wealth of information on practically every country in the world (erm, except Eurozone member Malta, for some reason). PwC find that in the typical country, their “case study” company pays nearly half of its profit over in various different taxes, spending seven weeks of the year dealing with its tax affairs and making a tax payment every 12 days.
Among their ten key findings are two very relevant for the corporate tax discussion. Firstly, corporate tax typically only accounts for about two fifths of the total tax burden faced by firms – in the EU in particular, employer taxes on labour such as social security contributions are much more important. Secondly, the headline rate of corporate tax is – and let’s quote verbatim here – “not a good indicator of the amount of tax a company pays”.
Instead of using headline rates, PwC calculate the true “Total Tax Rate” paid by companies on their income. This is the sum of (1) the effective corporate tax rate, (2) taxes on labour and (3) other taxes and fees. The graph below shows the effective corporate tax rate across the Eurozone (the blue line) and also the headline rate (orange). What is instantly striking is that France (and Belgium) have the two highest headline rates of corporate tax but two of the lowest effective rates, significantly lower than the effective rate in Ireland.
The effect of high tax rates
The model adopted by countries like Ireland and Cyprus is: set a tax rate and charge it. This transparent, open model is one that encourages new business to set up by virtue of its simplicity. You can’t really game the system, but you don’t need to. As simple as it sounds, it is practically revolutionary when compared to the model adopted by countries like France and Belgium. Such a system bears all the hallmarks of an insider-outsider set-up, where insiders know how to pay very low rates of corporate tax but investment by new business is hampered, because outsiders won’t know all the tricks.
Whatever about the effects of a large gap between the headline rate and the true rate, what about the economic impact of changing the rate? If Ireland is digging its heels in pointlessly on an issue that could genuinely help it close its deficit, maybe sovereignty isn’t as important as a bit of cop-on.
It turns out that there are very real risks associated with increasing Ireland’s corporate tax rate. In a study that uses PwC’s data on the true rate of corporate tax, rather than the headline rate, a group of authors including Andrei Shleifer (the world’s top academic economist, according to RePEc), found that increasing the true corporate tax rate by ten percentage points has a range of detrimental effects on an economy:
- It decreases total investment, by 2.2 percentage points [pp] of GDP, and in particular foreign direct investment (by 2.3pp).
- It reduces entrepreneurial activity, with a 10 pp increase in corporate taxes associated with a fall in new business registrations by a fifth on average.
- In truth, it probably doesn’t reduce entrepreneurial activity so much as push it into the black economy, whose share of economic activity rises by nearly two percentage points.
- Lastly, it makes companies more dependent on debt, than on equity, raising the debt-equity by 40 percentage points.
Given all of that, it is more important than ever that our Government is armed with graphs like the one above when they go into discussions about Ireland’s corporate tax rate. Increasing Ireland’s corporate tax rate in response to French pressure:
- Flies in the face of the sovereignty enjoyed even by constituent States of the USA, let alone fully independent members of the European Union.
- Is to give in to hypocrisy on the part of the French, who actually tax profits less than Ireland does.
- Runs the risk of lowering economic growth by reducing investment and enterprise.
- Is a self-defeating measure as by lowering growth and jobs, it would widen the Government deficit and may Ireland more dependent on French and German loans.
Particularly if the French are all while flaunting their low rates to attract overseas business, the message from Ireland on corporate tax must be clear: just say “non”.
Postscript: Can we trust PwC’s figures on the effective rate? To judge that, it is necessary to know a little about the methodology. The methodology was developed by the World Bank and PwC. To produce any information from the muddle of tax systems worldwide, they used a standardised company in each country. The standardised company is a limited liability company with 60 employees, start-up capital of 100 times average income and turnover of 1,000 times average income. What the methodology accounts for is very specific (and has to be to produce like-for-like comparisons): the company produces ceramic flowerpots at a gross profit margin of 20%, is domestically owned, does not trade internationally and operates out of the country’s largest city. There are also specifications for what it owns and leases (land, machinery, trucks, etc.). It does not qualify for any incentives or tax reliefs other than those it can get due to its age or size.