Ronan Lyons | Personal Website
Ronan Lyons | Personal Website

Irish Economy

Another fine mess! So you want to value some properties…

Dear Government,

Well, you can’t say you weren’t warned. Yes, it was a noisy time for all concerned, with plenty of people telling you they didn’t want to pay any sort of property tax, no matter how cleverly designed. But still, there were those of us who argued all year long for a smart tax with a smart design. One that got lots of information into the system, to enable the auditing that means everyone is paying the fair amount. And perhaps more importantly one that kickstarted economic activity, rather than just another form of income reduction.

Really, the whole thing was quite messy. One of your own agencies, the Land Registry – who can tell you who owns what plot of land and what’s on the land – was apparently not consulted once. The debacle of the Household Charge shows the same happened GeoDirectory, which is a database of addresses and their physical locations, maintained by An Post and Ordnance Survey Ireland, two more of your agencies.

The mess continued on Budget Day, when people were told they had to self-assess the value of their homes – but were given no good incentive to do so well. Some of us advised giving people a tax credit in Year 1 to have their property professionally assessed and in their tax return give the Revenue Commissioners the kind of information needed for good auditing. Instead, the door was left wide open for a most unwelcome experiment in game theory, where neighbourhoods come together and coordinate their valuations at below-market rates, leaving Revenue Commissioners powerless to find any individual resident guilty of tax evasion. Which is why they have decided to value the properties themselves, apparently. But of course, not least thanks to a rather detail-sparse Property Price Register, they have none of the direct information needed to do this.

So, as you’re quite fond of saying yourself, we are where we are. Now what?

As it happens, I actually spend quite a bit of my time worrying about how best to value properties, segment the property market, etc. I’m actually just fresh from a renovation of some of those models. And the good news is that with the right information – in particular a property’s size and location – it’s quite easy to come up with reliable estimates of a property’s worth.

So, between breakfast and starting work this morning, I developed the following estimate of Irish property values. It should work in all areas, urban and rural, and for all major property types (apartments, bungalows, terraced, semi-d and detached) and sizes (one- to five-bedrooms).

So how does it work? To work out the value of a property, simply take the starting point (a 3-bed semi-d in Louth) and then multiply it by whatever factors you need. In particular, pick your county or urban area, if different; and pick your property type and size. So for a four-bed bungalow in Sligo, the €108,000 starting point is multiplied by 0.875 (prices in Sligo relative to Louth), by 1.355 (prices for 4-beds compared to 3-beds) and 1.221 (prices for bungalows, compared to semi-ds). Multiplying them all together gives an estimate of the property’s value in Q4 2012: roughly €156,000.

A rough guide for valuing an Irish property in early 2013 (see accompanying text)

Hopefully, Mr. Government, this table is of some use as you try and disentangle yourself from yet another fine mess!

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Some notes on the above table:

  • Clearly, this is by no means meant to capture every last factor affecting property values. (One simple extension is number of bathrooms – roughly speaking, every additional bathroom is associated with a 10% higher price.) This model captures just under two-thirds of variation in house prices in Ireland, which – given the small number of factors included – is pretty good. But there’s still a third out there to explain. (Including effects for areas within counties would explain a significant chunk of the remaining variation, as it happens.) On average this will be right, and it will for the vast majority of cases be close but of course there are always properties that have unobserved factors that dwarf what matters for most homes. The method underpinning the figures above explicitly excludes outliers, so as to better improve the estimates for the vast majority of homes.
  • The table above is based on 60,000 listings on Daft.ie over the year 2012, and allows for the fact that prices varied throughout the year. “Aha”, a sceptic might say, “these are only asking prices and sure we all know they are [insert pet peeve here – too high, too low, etc]”. As it happens, some pretty detailed research comparing asking and transaction prices shows they move together remarkably tightly, once controls for location and size are included (as they are here). Properties that sell typically sell for about 10% less than their asking price, so for that reason the starting point of €108,000 is actually 90% of the figure returned by the model. The key thing about the model is what it tells us about relativities (prices between counties), not necessarily levels.
  • Lastly, lest there be any confusion, I offer this table as a public service but can’t offer it as any more than what it is – one academic economist’s analysis of the market.

Property tax – it’s not rocket science!

Ireland’s struggle to introduce a property tax continues, as does the public’s fixation with it. A minor bullet point in this update to the IMF-EU “troika”, confirming what was already decided – that Ireland is going to bring in a value-based property tax – is (along with that other staple of Irish debate, abortion) leading the news this morning.

The on-going poor quality of information doing the rounds is a big frustration so I’ve decided to continue my crusade for good policymaking in Ireland and post (yet again for long-standing readers) about property tax.

Why a property tax at all?

The yawning gap between what the Irish government takes in and what it spends means that both spending cuts and new tax revenues are needed in coming years. Comparing Ireland’s tax structure with other countries, the country already has among the highest marginal rates of direct (income) and indirect (VAT) tax in the world. What’s missing? Well, the third type of tax, after direct and indirect, is wealth tax.

And real estate comprises the bulk of wealth – not just in Ireland, but everywhere. Ireland’s homes are collectively worth roughly €300bn – a huge chunk of our balance sheet. What’s missing, when you compare Ireland with other developed economies, is a property tax. Those who argue against property tax are not taking a principled stand against bank bailouts. They are arguing for even higher income or consumption taxes. And thus missing the chance to tax wealthy non-residents who own property in this country.

What is a value-based property tax?

Ultimately, I’m not sure why the Government is making a mountain out of a molehill. There are basically four types of property tax out there – flat charges, bands, full value and site value – and they are fairly easy to rank. The worst kind of property tax is the flat charge, what was introduced here earlier this year. It is obviously regressive and unfair and is also just a temporary measure so little more needs to be said about it.

The next worst type of property tax is the bands system. Under such a system, if your property falls under certain thresholds, it benefits from a lower tax rate than others. This is similar to how stamp duty used to work in Ireland. It is also how council tax works in the UK. Until this morning, I hadn’t heard anyone argue in favour of it, although there had been some mumblings in newspaper reports – this morning, though, Fergal O’Rourke of PWC actually called for a bands system.

What has happened in the UK should be a salutary lesson for Irish policymakers. Bands means trouble because in any given year people want to be under the threshold, thus distorting prices, while over time unless bands change every year, they become ridiculously outdated. So in England, your property tax is based on what the value was in 1991, not today, because no-one can agree on updating them. Even aside from our preferences having changed over the last generation, this is plainly bad policymaking. Why anyone, least of all a tax expert, could think is a runner at all is a mystery!

Should we pay relative to the market value?

An improvement on bands is a full value tax – you pay a percentage of what your property is worth every year. Those with more property wealth pay more in property tax. Straight away, some of the dodgy side-effects of a bands system are overcome. If property prices rise or fall, you don’t have to worry about political will to update bands. However, a moment’s thought should point out some pretty weird features of a full-value property tax.

For example, the Minister for the Environment is a big fan of regenerating town centres, which have fallen victim to edge-of-town retail centres in recent years. However, under a full-value tax, the owner of a derelict city-centre site has no incentive to redevelop it because if he does, he’s faced with a higher property tax bill. What sounds like an issue for developers also affects households. If you make your home more energy efficient, up goes your annual property tax bill. New extension? Up goes the bill. Anything at all that involves you using scarce land in socially more useful ways is punished.

This is the major theoretical problem with full value tax: the last thing you want is for your tax system to punish those who use a scarce resource well. And then in practice, there are huge issues of implementation. Is that extra room upstairs a bedroom or a study? (Each will have a different price.) Is that attic properly converted? Is that outhouse part of the main building? All of these are prices that have to be measured and updated, creating lots of work for people like me but ultimately very little use to the taxpayer.

What is “site value” and why should we tax it?

The fairest form of property tax is the site value tax. This is not as complicated as some try to make it out. The value of your property has two components: the land and what you put on the land. Subtract the latter from the total value and you have site value. How might we measure the value of land around the country? Happily, it’s already been done and is available free of charge from smarttaxes.org. There’s even a map outlining the contours of site values in the country. Pages 14-16 of that report also go through options in relation to those on low incomes and those in negative equity, as well as a number of other issues.

There are many arguments in favour of site value tax and few against. It rewards, rather than punishes, households that make their home more energy efficient. At a deep level, site value tax is inherently fair – after all, why is land worth more in some places than in others? It is because society and nature – not individuals – have created amenities that people value and pay for. Is it too much to ask people to pay back a small part of the benefit they are getting from society? Site value tax is also really handy because it can be applied to all types of land, residential, commercial, public and agricultural land, with huge beneficial side-effects in terms of land use and – dare we say it – economic recovery.

Site value tax is also a tax on hoarding land and speculating, as residential land banks on the edges of towns would incur the same as developed estates. This also removes the incentive for people to get their land banks zoned residential on the off chance they could become millionaires. If it’s zoned residential, use it as residential or pay the price!

According to media reports, the Government is currently of the opinion that a site value tax “would throw up anomalies” such as a rundown property and a modern property on similar sites having the same property tax bill. That is not an anomaly. That is the tax system encouraging us all to use as well as possible a scarce and valuable resource, i.e. land.

I agree that a property tax should be easy to understand. A range of bands and tax rates creates a complicated system that people want to game. That is only one consideration, however. After all, it is very easy to understand a €100 household charge but that was hardly publicly accepted. A simple flat site value tax rate is well within the grasp of a population that frequently votes in referenda on constitutional and foreign policy issues.

What do other countries do?

One of the oddest arguments I have heard yet against the site value tax is “no-one else is doing it”. Even if it were true, what an odd argument! In-built bias towards the status quo means that most countries are stuck with property taxes very similar to what they had fifty or a hundred years ago. Ireland – by dint of auction politics since the 1970s – is in the oddly lucky place of being able to choose the best system without the constraints of status quo.

But even then, it is not true to say that no-one uses site value tax. There are numerous states and cities around the world, from South-East Asia to North America, that have it. Two other small open economies in the EU – Denmark and Estonia – use site value tax consistently and successfully. Rather than ape the failed system of our nearest neighbour, perhaps we could take a leaf out of their book instead.

The lack of a property tax means we have the opportunity. With Land Registry records on who owns what site where, as well as existing research on the contours of land value around the country, we have the means. And with the positive side effects that only a site value tax can bring, we have plenty of motive. Hopefully our Government won’t let us down.

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The post above is based on an op-ed piece I wrote in the Sunday Business Post earlier in the month.

Sovereignty is over-rated, society is under-rated – address to this year’s Parnell Summer School

After a bit of a break from blogging for a variety of reasons (not least getting married!), an invitation to speak at this year’s Parnell Summer School provided the perfect opportunity to find my voice again. Based in Parnell’s family home, in Avondale House, County Wicklow – one of the most picturesque spots in arguably Ireland’s most picturesque county – the annual Summer School builds on the memory and works of Parnell. This year being the centenary of the Home Rule Bill, the theme was ‘Sovereignty and Society’ particularly in light of all that has happened in Ireland in the last five years.

I took the opportunity, during my lecture, to outline what an economist thinks of the concepts of (economic) sovereignty and society. In particular, I argued that I felt that the concept of economic sovereignty was one that was significantly over-valued, while society was a hugely under-valued concept.

Sovereignty is over-rated

In short, my argument in relation to sovereignty is just specialisation and the division of labour recast. People happily cede sovereignty all the time to give themselves a better future. No-one tries to build their own home or produce all their own food. They pool their sovereignty in a community where these tasks are shared and so are better done. Perhaps a clearer analogy is when an individual borrows to further their education or a household borrows to buy a new home. These are decisions that immediately subject that person or family to scrutiny, in relation to spending and lifestyle patterns and plans for the future. A lender has taken some of the borrower’s “sovereignty” – and yet, the borrower is happy to pay that price, because they want a better future. And if you put yourself in the shoes of the saver, giving your hard-earned savings over to someone else, it’s not hard to see why saver-lenders want this scrutiny.

This works at the level of the country, too. No country has ever provided a high standard of living for its citizens by abstaining from investing in its future, and investment involves large-scale borrowing. So, as soon as we want what’s best for our community, straight away we should be prepared to yield some of our “independence” to deliver it.

Quite why there is such a fuss about lost sovereignty because Ireland is currently borrowing from ‘our mates’ (the other countries that make up the EU and IMF) at preferential rates, rather than borrowing from the international capital markets is beyond me. No matter who we borrow from, mates or markets, we will need to have a fiscally responsible set-up for them to do so. And the Irish Government spending €20bn more than it takes in in revenues is not fiscally responsible by anyone’s measure.

Society is under-rated

In relation to society, it’s my firm belief that the policy-making in Ireland – and indeed in most countries – systematically under-values society, which comprises market and non-market activities. Non-market activities are sometimes free (friends and family, for example), often not (roads, coastguards and primary education cost resources, for example) but inevitably, they are not included when we take stock on an annual basis.

This is not to suggest for a minute that we should scrap GDP and measure happiness instead. This would be to subject public policy to the vagaries of human sentiment, vagaries that only just being understood by behavioural economists and psychologists. Instead of scrapping using dollars and cents to guide our decisions, we should extend the principle to include non-market activities. After all, “priceless” to an accountant means zero. Let’s replace those zeros with numbers.

The related issue with how society divides out its resources is the lack of any connection between how money is raised (in large pools such as VAT, income tax and PRSI) and how money is spent (in large pools such as health, education and social welfare). Thus, when spending cuts have to be made, they are only ever done in reference to the costs of a particular public service, never its benefits.

Changing these resource allocation decisions so that they are based on the return enjoyed by society on money spent – and not just on the amounts spent – is the single biggest challenge for public finances in the OECD over the next generation, in my opinion. There’s no reason Ireland can’t be at the forefront in developing proper accounts for public spending.

The slides I used at the Summer School are available on SlideShare and are embedded below.

What price freedom?

The lecture I gave was the preamble to a panel discussion about economic sovereignty by Richard Boyd Barrett, Paul Murphy (Socialist MEP), IBEC’s Brendan Butler and Pascal Donoghue of Fine Gael. I’ll post my thoughts on that later in the week. To give that post a bit of steer, though, I’ll finish up with a little poll.

Suppose we knew for definite that not giving up some of our economic sovereignty (inter alia, ability to choose tariffs, exchange rates, interest rates or taxes) meant we’d have a lower income than doing so (this is in fact the assumption implicit in any country joining the EU). If average income missing some sovereignty was €40,000, how much of that would you be willing to pay to retrieve that sovereignty back? Zero means you’re not particularly bothered by sovereignty – perhaps things like peace and prosperity are more your bag. At the opposite end, clearly, an answer of 100% means “freedom at all costs”!

What percentage of Ireland's €40,000 average income would you be prepared to concede to have full economic sovereignty (over things like tariffs, exchange rates, taxes, etc)?

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The Austerity Games: Ireland’s Fiscal Treaty referendum redux

A few important concepts have gone out the window as the debate in Ireland about the referendum on the Fiscal Compact has descended into political games. Perhaps the first victim was cause-and-effect, with the  mere correlation of banking debts and government deficits being translated by many into iron-cast causation.

A close second in the casualty list was the concept of opportunity cost: in other words, it’s not how bad or economically illiterate the Fiscal Compact is in and of itself, it’s about how attractive it is relative to the other options. As of now, the most important attribute of the Fiscal Compact is its ability to get Ireland the funding that it otherwise would not be able to get, to allow the country to gradually close the deficit. By 2020, that may be completely unimportant and we may want to ditch the Compact. But we are voting in 2012, not 2020.

With all that in mind, I decided to develop a flow-chart that aims to illustrate the point that this is not about absolutes, it’s about options. If you click on the image, it should open up in a larger and more legible size. Hopefully you find it useful – if so, feel free to share it. If you’ve any suggested changes, pass them on and I’ll work them in.

Ireland's austerity choices

For more text on why the IMF will not be a panacea, Karl Whelan has an excellent blog post here.

Wealth taxes and property taxes in Ireland: understanding the tax base

The end of the first quarter of 2012 saw not just the usual quarterly reports – such as the Q1 2012 Daft.ie House Price Report discussed elsewhere on the blog – but also the deadline for paying the €100 Household Charge. The charge has been the focus of a campaign of resistance that is surely more to do with the principle than its size (the increase in Band A motor tax was almost as large as the Household Charge but I don’t recall anyone complaining against that particular flat tax).

In fact that campaign has succeeded in one way already: while it had originally talked about the charge applying for 2-3 years on an interim, the Government is now not going to go through all this again and desperately wants to bring in a fairer property tax with Budget 2013 this coming December.

Where’s all the property wealth?

What sort of base is there for property tax? The latest Daft.ie Report gives county-by-county figures, which can be combined with information from 2006 and subsequent completions (or alternatively Census 2011 information) to reveal what wealth there is in residential real estate around the country.

The total amount of wealth in residential property peaked in 2007Q4, at €564bn. 37% of all this wealth (€208bn) was in Dublin (home to just 28.5% of households in 2006). A further €37bn was in the four other cities – their 6.5% being roughly in line with their 7% share of all households. Since then, the trickle of new completions has not been nearly enough to offset the fall in property values. The stock of homes as of Census 2006 has fallen in value from €525bn to €255bn, as of Q1 2012, while including the value of new completions in the years since 2006 increases the total value of all residential property to €294bn.

Households and housing wealth in Ireland

Dublin is now home to just under €100bn of housing wealth, as of early 2012, while the rest of Leinster and all of Munster are home to €70bn and €76bn in housing wealth respectively. Connacht and the three Ulster counties are home to about €48bn of housing wealth. The relative proportions that each of four regions makes up of Irish housing wealth and Irish households is shown in the two pie charts above – you can see that rural households need have no fear that any property tax will hit them hardest. Quite the reverse: any property tax will have to make sure that it doesn’t overly punish urban life, which is so crucial to subsidising the rest of the country.

Where’s all the wealth?

These are statistics that the political class would do well to heed. To recap our Econ1010, there are three main types of tax: those on incomes, those on consumption and those on wealth. Ireland is also home to some of the world’s most punitive rates of taxation on income and consumption, so hence there is increasing interest in wealth taxes.

There are four main forms of wealth: (1) cash/deposits, (2) equities/shares, (3) debt/bonds, and (4) real estate/property. In Ireland, as of 2006, deposits made up 10% of Irish wealth, equities a further 8%. Pension and investment funds – wealth holdings of unknown type but likely to be a mix of mainly equities and bonds – made up a further 11% of wealth. But it was property that was the overwhelming type of wealth in Ireland, making up 72% of all wealth. The vast bulk of this was residential property. And that picture is not likely to have changed substantially with so much of Irish equity wealth being invested in the banks, which are now all next to worthless.

So when people talk about taxing wealth in this country, they are talking principally about taxing the homes that we live in. In second place comes taxing the deposits we have in the bank. Make sure to mention this to the next person who says “We don’t need a property tax, we need a wealth tax”.

The Fiscal Compact – Vote Yes to Silliness (It’s all about the cash)

Last week, I outlined some of the many reasons why the EU’s Fiscal Compact should have been sent back to the drawing board when first seen by European leaders and their economic advisers. The experience of Spain since then sums these up pretty well. Spain had been given a target deficit of 4.4% of GDP this year. But it turns out the deficit is going to be closer to 6% of GDP.

The Pain in Spain

And with good cause. Firstly, the Spanish government doesn’t control GDP. It barely controls its own spending, let alone its own receipts. So what happens GDP should not be enshrined in laws and constitutions. The Fiscal Compact should be about government spending relative to government receipts, and not relative to some arbitrary concept of national accounting. For example, if the Government makes up about 50% of the economy, an 8.5% deficit relative to GDP actually means that 17% of spending is unfunded by current receipts.

Secondly, the Spanish government fears the effects of actually getting the deficit down to 4.4%. Halving that 17% unfunded spending down to just 9% in one year would mean cutting roughly 10% of Government spending… in one year! And all this while an economy is on the verge of recession, defeating the purpose of fiscal policy as one of the remaining tools of economic stabilisation for economies within a currency union.

However, Ireland does not have the luxury of saying no to the EU’s Fiscal Compact. The reason why is simple: cash. Until someone comes up with an alternate plan for sovereign funding as Ireland closes its deficit, borrowing from our EU partners and the IMF at what are – relative to the markets – low interest rates is the only game in town.

Bear in mind that our borrowing requirements are substantial. We’ve roughly €120bn in debt that needs to be rolled over at various intervals (although some of this is owed to Irish citizens, for example in the form of Prize Bonds) while an optimistic scenario sees us borrowing a further €14bn this year, €12bn next year, €10bn the year after… and so on meaning our national debt will be something like €170bn before it is close to stabilisation.

If not EU, who?

The plan, of course, was to go back to the markets in a substantial way next year. The question is, though, with the sovereign debt markets as they are, who would lend to Ireland at anything close to the 3% medium-term growth rate we are hoping for? (When national debt is the roughly the same size as the entire economy, the quickest way of assessing sustainability of debt is to compare the interest rate with the growth rate. If the interest rate is higher than growth, debt repayments would ultimately dwarf all other spending.)

Not only that, any institution that would lend to Ireland would attach conditions that would be effectively identical to the Fiscal Compact: i.e. Ireland’s government would need to get its spending back into balance and fast. The only alternative would be to balance the books overnight – this would be an extremely painful overnight adjustment, with public servants and social welfare recipients experiencing a dramatic reduction in their income.

Compared to that, the EU Fiscal Compact is quite attractive. The “path of adjustment” outlined in the Compact gives Ireland a full two decades upon exiting the bailout programme in 2015 to reduce the debt from, say, 120% of GDP, to 60%. That’s right – only in 2035 will the full EU Fiscal Compact and all its silliness apply to Ireland.

So, as an economist, I think the EU Fiscal Compact should be completely rewritten, this time with an understanding of fiscal policy. But it will go ahead, with or without Ireland’s assent in a referendum – the referendum is really only about whether Ireland wants to opt in for further funding from 2013 if needed. So as an Irish citizen, it has to be a yes for the EU Fiscal Compact.

Is Ireland a tax haven? Let’s ask investors

Over the last few days, there has been a lively debate on Ireland’s corporate tax affairs. It all started when Stephen Kinsella declared “Let’s say it out loud: Ireland is a tax haven”. Stephen pointed to this not to make the case that we should change our policy on the 12.5% rate – as he himself notes, “we need all the investment we can get”, but to highlight the threats associated with being dependent on tax motives for investment – in particular threats from the US political system, as it struggles with high unemployment and anger at big business.

Op-Ed Wars: It’s getting fiscal

The following day, and in the same newspaper, Brian Keegan of Chartered Accountants Ireland responded. Taking the OECD’s definition of how a region earns “tax haven” status, Brian went point by point through, outlining that Ireland has far more than nominal rates of tax, is very clear on tax issues, does share information with other jurisdictions and – at least according to the ECJ – does require a significant presence in the economy from taxpayers.

With a further response by Stephen, it’s now all kicked off on irisheconomy.ie. For me, the top comment has come from Kevin Denny: it’s probably not very useful to use a value-loaded term like “tax haven” because that gets people’s backs up and instead we should focus on the core point that Stephen was trying to make: it could well be the case that changes to tax codes, either domestically driven or more worryingly elsewhere (especially the US), could have a significant impact on Ireland’s investment performance.

Formally testing for the “elasticity of foreign direct investment with respect to the corporate tax infrastructure” is not an easy ask. In fact, while you might be able to measure the impact of the headline rate on FDI, there are a multitude of factors above and beyond the headline rate that comprise the corporate tax infrastructure – many of these are very difficult to measure.

So in the absence of that exercise, what can do we do? Well, a tax haven is only useful if companies know about it and are using it. So why don’t we ask just investors what they think of Ireland?

Why don’t we ask them?

Yesterday, a report I authored entitled “Investing in Ireland – A survey of foreign direct investors” was launched. The EIU report involved a survey of over 300 executives that had both responsibility for foreign direct investment decisions in their company and familiarity with Ireland. The survey was complemented by ten face-to-face interviews, with executives of companies that have significant operations here, such as Google, those with small operations here (such as Goldman Sachs) and those that could have chosen Ireland but didn’t (such as Kayak).

The survey asked respondents why they set up overseas, what they look for in potential investment locations, whether Government incentives matter (and it so which ones), and which locations (other than Ireland) are most attractive to them for FDI. It also asks them specifically about Ireland: what Ireland’s strengths and weaknesses are as a location for investment, if they have operations here why they came, if they are expanding why – and if they are not based here, why. The survey did not shirk the tax issue either: respondents were asked about the importance of the headline tax rate, the ability to transfer price and Ireland’s network of double taxation treaties.

There will of course always be quibbles about what exactly this sample represents but policymakers do not have the luxury of ignoring all surveys until the One True Survey comes along to answer all their questions. They need to act based on available information, knowing the strengths and weaknesses of that information. Like any good survey, a significant number of cohort questions were also asked of respondents so we do know a good deal about responding companies, including sector, size, number of countries and HQ country.

Ireland’s four pillars

So what do investors say about Ireland? Is it all about the tax? Well… no. There are four reasons Ireland is so successful attracting investment – tax is but one. The foundation of Ireland’s competitiveness is market access: the principal reason companies go international is not to cut costs, it is to access new markets. Ireland offers companies outside the EU access to the world’s largest market. When asked what Ireland’s top three competitive advantages were, by far and away the most popular one was access to EU (and EMEA) markets.

But Ireland has no more access to the EU markets than Birmingham, Barcelona or Bavaria. What else does Ireland have? Access to skill is a second pillar of investment in to Ireland. This can sound like patting ourselves on the back – as Paul Duffy, CEO of Pfizer Ireland, says, “The reason that Pfizer has expanded in Ireland so extensively is the country’s proven ability, from as early as the 1960s, to deliver. The people are reliable and can handle complexity.” But the facts remain: Ireland has a larger proportion of young people with higher education than most other EU countries.  And crucially, Ireland is open to skill from elsewhere in the EU: access to skills from across the EU was chosen by almost as many respondents as one of Ireland’s competitive advantages (23%) as local skills (26%).

Ireland's competitive advantages, according to investors

A third key pillar is the regulatory environment – as you can see from the graph above (taken from the report), both the ease of doing business and Ireland’s legal and fiscal stability were highlighted by between one quarter and one third of investors.

The fourth pillar is tax. But even here, we should be careful not be caught like a rabbit staring at the headlines, so to speak. The headline corporate tax rate is just one component of Ireland’s corporate tax infrastructure. Perhaps more of interest to firms is the effective rate of corporate tax (i.e. once all allowances and loopholes have been applied). And while Ireland has one of the lowest headline rates of corporate tax in the Eurozone, its effective rate (as per the World Bank Doing Business report) is in line with the Eurozone average (both median and mean).

Other components of the tax infrastructure also matter – the network of double taxation treaties matters, particularly to financial services firms (22% of FS firms mentioned it as one of Ireland’s top three competitive advantages). And the ability to transfer price matters too – it was the third most important fiscal incentive for respondents, after the headline rate and double taxation treaties.

Tax Haven? Yes with an if, no with a but

While Stephen is right to highlight the risks of changes in the international taxation environment, Ireland is not a tax haven in the true sense of the word. Tax is not the only reason companies are here – if they were after low taxes on profits, there are plenty of jurisdictions that will charge them zero.

Firms have significant operations in Ireland because of the bundle of factors Ireland offers. I’m sorry I can’t give a more dramatic answer but this is the truth. But in a way, the answer is already dramatic enough. If Ireland were to lose its attractiveness completely on any one of the four factors highlighted – market access, skills, regulatory regime or tax – its phenomenal competitiveness at attracting FDI would be under threat.

So if by “tax haven” you mean that Ireland could no longer continue to attract investment if it had an uncompetitive tax infrastructure, then that it is true. Ireland is also a skill haven, an ease of doing business haven and a market access haven.

PS. There’s lots more to the EIU report than just tax – Ireland’s cost competitiveness, for example, the threat posed by high marginal rates of income tax or recent financial regulation, and indeed the plans they have to create new jobs here. I’ll probably post again on this report but if you get the chance, give the report a read – it’s not long.

Send Merkozy back to Econ101 – Economic illiteracy and the EU fiscal compact

This year, I’m teaching first year undergraduates at Trinity. I’ve a gang of about 400 and they’re mostly students not interested in studying Economics after this course. My job is to try and make them economically literate as they head off into the world. Part of the course is about macroeconomics in their everyday life: how the jobs market works, how the housing market works, that kind of thing.

But the first part of the course is about giving them the grounding to understand the bulk of major headlines at the moment. Unemployment, negative equity, emigration, bailouts, quantitative easing, bondholders, recessions and business cycles… it is hard these days to be an educated citizen without a thorough grasp of what monetary and fiscal policy are and indeed how the modern banking system works.

Back to school for some

Surprisingly hard, it turns out, to be an educated policymaker or politician these days too. Leaders of twenty-five European countries have signed up to a fiscal compact that would, I hope, be soundly trashed by a II.1-standard student if I set this in the summer exam.

Any first year undergrads that have been paying attention to my lectures will know that there is a limited number of tools available to policymakers to smooth out the bumps (recessions) that modern economies face as living standards grow from one generation to the next. Trade policy – using tariffs or quotas to protect domestic producers (at the expense of domestic consumers) – was a classic response but is not an option for members of the World Trade Organisation.

The next most popular instrument has traditionally been monetary policy, in particular a Central Bank setting the interest rate in an economy. The lower the interest rate, the cheaper it is for firms and households to borrow – and thus economic activity (even if it’s just buying homes) should be stimulated. Members of a currency union, however, such as Wales within the UK, Florida within the US or Ireland within the Eurozone, don’t have this option either.

In the middle of a huge recession, it may seem odd that most economies (particularly if you view the US as a collection of cities and states at very different points in the business cycle) have no recourse to either trade policy or monetary policy. But there is clear justification for both: trade policy is all about protecting domestic producers at the expense of domestic consumers (and producers elsewhere). Having your own currency and interest rate exposes you to the vagaries of international exchange rate markets, meaning – as older Irish borrowers know all too well – high and volatile interest rates, which reduce investment.

The importance of fiscal policy

This leaves just one set of tools for policymakers to smooth the ups and downs that modern economies inevitably face: fiscal policy, the government’s taxing and spending decisions. Given that spending has to rise in bad times and fall (at least relatively) in the good times, the watchword is discretion. You need judgement to be exercised, based on context, when thinking about how to use fiscal policy.

Unfortunately, though, the Fiscal Compact has gone the opposite way. It is as though it has been designed by diehard fans of the recent fashion in monetary policy for rules and automatic mechanisms, people who think that what worked so well in one area (by ‘well’, I mean sort of well at least until the Great Recession came along) can be copied and pasted into another area.

Fair enough, you might say, but if the rules are good ones, then what’s the worry? Unfortunately, the rules are populist but economically illiterate. For example, the start of Article 3 of the Compact states the overall aim: “The budgetary position of the general government… shall be balanced or in surplus.” In brief, the EU Fiscal Compact takes the last remaining tool for stabilising the economy away from policymakers.

EU to member states: borrowing to better yourself is bad

This is the country-level equivalent of telling a student that they can’t borrow to go to college so that their future earnings will be higher – instead they have to live within their means. Because countries, unlike households, don’t age and die, there is nothing wrong about having a national debt and not paying it back. In fact, unless there’s an abundance of natural resources, only a silly country would ever attempt the pain of paying back the principal of national debt, rather than simply roll it over and keep on growing until the debt is small.

Countries shouldn’t be just allowed to borrow ad infinitum – provided they are investing in projects that boost growth, they should be practically required to borrow. If a government’s capital spending is consistently boosting the country’s output by 5% a year, the markets are not going to stop that government from borrowing 5% of GDP a year, every year. But now the EU Fiscal Compact will ban such spending.

As long as current spending is in balance and capital spending is based on the boost it gives to future output, markets will lend. The trouble is that government finances have not been organised along these lines. In that vacuum, financial markets have come up with their own measures of sustainability, in particular the “primary surplus”.

Who’s measuring what now?

The primary surplus is government’s balance, excluding interest repayments. It is economically meaningless, with only the veneer of sustainability… “but if we didn’t have all this debt, we’d be fine”. But it is mathematically compelling, because it turns the focus to comparing the interest rate on national debt (say 6% if Ireland returned to the markets) and the economy’s growth rate (say 3% in a benign scenario).

Quite how this tool of necessity on the part of financial analysts, due to dereliction of duty by governments, has become one of the measurement tools of choice by governments is beyond me. But that is the lesser of two evils, when it comes to how bad a job EU governments are doing at putting their finances on a sound footing.

The other key measurement of choice – written throughout the EU Fiscal Compact – is deficit relative to “potential output”. Nobody actually knows what potential output is: technically, it’s the level of GDP that would have happened if the economy were in balance… which of course it never is, so how on earth do we know what it is? This didn’t, of course, stop EU policymakers from putting it front line and centre in the Compact. From the same Article 3: “the [above] rule shall be deemed to be respected if the annual structural balance of the general government is at [no worse than] a structural deficit of 0.5 % of GDP at market prices.”

Output and potential output in Ireland 1980-2016, for different years of calculation

Potential output and the potential for error

Why might economists say this is crazy? To show this, let’s consider “potential output” in 2016 – shown in the graph above. As of 1995, real growth in Ireland had been an average of 3.4% a year since 1980 so an economist at the time might have thought this a reasonable basis on which to project potential output. By this calculation, output would have been €114bn in 2005 and €164bn in 2016 (the red line in the graph above; I’m setting aside inflation to show that this point holds even in constant prices).

Output was actually €161bn in 2005 (in today’s prices) so our economist would either have to conclude that Ireland was running well ahead of its sustainable potential or that his model was wrong. So let’s say he thinks his model is wrong and that he now knows Ireland’s potential output grows by 6% a year (which is what it had done on average between 1990 and 2005). He now confidently predicts that potential output in Ireland in 2016 will be €309bn (the green line), almost twice his initial projection for 2016.

Well, as of last September, the IMF expected output in 2016 to be €183bn (the blue line). Even a more level-headed economist, as of 2007, might have thought potential output would grow by 3.4% a year (i.e. back at pre-Celtic Tiger rates), in which case potential output would be €232bn in 2016 (the purple line). Either way, the margin for error is huge. We don’t ever actually see “potential output” (heck, even calculating GDP is dodgy enough) so why would we put it in our constitution?!

In a way, though, the whole potential output thing – while attracting a bit of attention – is a bit of a sideshow. There are two main issues with the Fiscal Compact. Firstly, it brings rules to an area where there should be discretion – fiscal policy is not monetary policy and flexibility is key. Yes, governments don’t have a good track record on spending but surely we should tackle the cause rather than the symptom. Secondly, and much more worryingly, it is bringing the wrong rules. By thinking deficits are a bad thing, it will actually prevent the investment that – in the long run – will boost living standards and repay the interest on the very borrowings the EU is worried about.

And yet, despite all this, Irish citizens should vote yes! I’ll explain why next week.

PS. Similar sentiments are expressed by Karl Whelan here. A more benign assessment of the impact of the EU Fiscal Compact is given by Philip Lane.