Sean Whelan on why FDIs come to Ireland

Why do the multinationals come here?

Wednesday 22 October 2014 14.34 By Sean Whelan
by Sean Whelan, Economics Correspondent

ESRI research shows corporation tax is key

New research by the ESRI for the Department of Finance looks at the impact of tax policy in the decision of Multinational Corporations (MNCs) to locate overseas.

The standout finding is that if Ireland had been operating a corporation tax rate at the EU average of 22.5%, fewer than half the multinational companies that have come here since 2005 would have opened in Ireland.

Even moving to a corporate tax rate of 15% could, the ESRI says, have knocked more than a fifth off the number of foreign firms opening here in the period under review.

It has used a database covering 3,228 newly established multinationals subsidiaries across 26 European countries from 2005 to 2012. 130 of these were located in Ireland. Most years around 400 new multinational subsidiaries opened up in the 26 states covered.

The ESRI controlled for a range of factors, including industry type, tax rate, GDP growth, market potential, common language, colonial past, natural resources. From all of this they deduced the effect of both non-tax and tax variables on the decision to locate.

In terms of non- tax variables, growth counts. It found higher levels of GDP and GDP growth increase the probability of choosing one location over another.

Infrastructure also had a positive and significant effect on the probability of location choice. Market potential (how much access to other, neighbouring markets a particular location gives) is also a positive factor in decisions – suggesting geographically peripheral economies are at a disadvantage.

Labour cost and quality measures were deemed to be not robust enough to draw conclusions from.

The ESRI then used four measures of corporation tax to assess its impact on decision making: the policy rate, the mean effective average tax rate (EATR), the total tax rate (which includes all taxes and contributions paid by businesses such as employers PRSI), and cross border EATR, which includes taxes levied by both host and home countries.

The strongest effect of a 1% change in the corporate tax rate was in the Effective Average Tax Rate, suggesting that this is the key to understanding the impact of tax on business decisions. A 1% increase in the policy rate reduces the likelihood of choosing a destination by 0.68%, but a 1% increase in the EATR had twice the impact, reducing the likelihood of choosing a destination by 1.5%.

And the mean EATR has very different effects on the different sectors the MNCs operate in. Services were the least affected by changes to the EATR, followed by manufacturing, but by a country mile the most sensitive to tax rate changes are firms in the financial sector.

This is important, because firms in the financial sector contribute one quarter of Ireland’s corporation tax take. And the bigger the firm, the bigger the impact of changes to the mean EATR. Again this is important for the state, as the big firms pay the most tax.

Unfortunately the data does not give an indication of the employment generated by the firms, so limiting the real economy impact of the research.

So, using this information, the ESRI ran a counterfactual, looking at the possible impact of various changes to the policy rate (not the EATR, which has a bigger impact).

Obviously leaving the rate at 12.5% had no impact, but going up to 15% reduced the number of new multinationals opening up by 22%: a 17.5% tax rate led to a 37% drop in numbers,: a 20% rate led to a 47% fall in the number of firms opening, while applying the EU average rate of 22.5% resulted in a 54% fall.

So instead of 130 multinationals opening here between 2005 and 2012, it would have been more like 60.

Without employment data we can only guess at the impact such an outcome could have had on overall employment levels in the state (and from that the impact on GDP and the debt ratio). But it couldn’t be good.