Tuesday, 12 April 2011

The Elephant in Ireland's Room

The Irish banking crisis shows no sign of being over yet, as further bank bail-outs were announced recently. There has been much talk about the causes of Ireland's crisis and its severity, but almost no politician or economist has pointed an accusing finger at Ireland's attractive corporation tax (CT) regime. This is considered inviolable and essential to secure Ireland's recovery. Other countries are even scrambling to follow Ireland's example, as the UK announces corporation tax cuts and Northern Ireland's First Minister talks of reducing CT to 10%. So, apparently a low corporation tax rate is far from being harmful to the Irish economy. Or is it? I will argue that Ireland's CT rate (at 12.5%) and more importantly its weak tax regulations were in fact among the three main causal factors in its banking crisis. Let's look at them. Only the first is obvious:

1) Poorly regulated global growth of debt and related structures. This refers to the ability of banks to pump ever more debt into the global economy and for that debt to cross borders almost at will.

2) Ireland's low CT rate and very lax rules on what multinational corporations (MNCs) are allowed to get away with. Note: it isn't just the low rate that is important, but the rules which go with this; they work in tandem.

3) Tax avoidance by MNCs, aided and abetted by banks and accounting firms.This is the elephant in the room.

To put it simply, without 2), Ireland would not have been a target for 3), which greatly inflated the size of its banking sector and left it massively over-exposed when 1) led to a global debt tsunami. Incidentally, the debt tsunami also destroyed the economy of Iceland, which had followed a very similar path to Ireland. It too has a low CT rate (15%), lax regulation and a bloated banking sector which is now killing its economy. How come? In order to understand this, one needs to know a bit about the tricks MNCs use to avoid tax, by shifting profits into lower-tax jurisdictions from higher-tax ones.

If you are a MNC, one of the most popular tricks is to heap a big pile of debt onto your operations in high tax countries, financed by loans from your own subsidiaries in low tax countries. Debt interest payments can be set against tax in many cases, which means you can transfer your profits to a low tax (or no tax) jurisdiction. There's no real trade going on here; it's just an accounting trick, a form of what is called 'transfer pricing'. High-tax countries know about this and have put rules in place to discourage the use of tax havens for this purpose. However, Ireland is not officially regarded as a tax haven, and so escapes these rules. Instead, it is a trusted member of the eurozone club, which puts it in a highly privileged inside position. Nonetheless, Ireland's tax rules are so weak that it should be considered a tax haven, just like the Cayman Islands or Bermuda.

Photo: Peter Morrison / AP

To illustrate this point, consider the case of Google, which moved its HQ to Dublin in order to escape tax. They do it by exploiting two well-known tax avoidance scams called the 'double irish' and the 'dutch sandwich'. These are essentially transfer pricing scams involving the use of debt to shift profits through other poorly regulated jurisdictions like Luxembourg and the Netherlands. Ultimately, Google decants its profits in Bermuda, where it pays no tax at all. The result is that globally, Google gets away with paying just 2.4% tax on all its profits, saving it over $3 billion and leaving the taxpayers of many countries to pick up the shortfall. The irony is that Ireland scarcely benefits at all from all this, since Google largely escapes even Ireland's low CT rate. Many other companies are operating the same scam, all quite legally. Over the past decade, hundreds of companies have moved their IP licensing or Treasury operations to Ireland or set up subsidiaries there to take advantage of the tax avoidance gold rush. In their wake, they leave a trail of debt:

An inevitable consequence of this tax avoidance activity is to create a huge demand for loans from low-tax, weakly regulated countries like Ireland. Irish banks sucked in a huge amount of money, most of which left the country almost immediately in the form of loans between subsidiaries within MNCs. The flow of this money increased from 400 billion to 2.5 trillion euros between 1998 and 2009, which is about 15 times the entire GDP of the Irish economy (see page 3 of this report). This demand for debt led to a rapid increase in the balance sheets of the banks, pumped up like body-builders on steroids. The Irish government even facilitated this growth by setting up the International Financial Services Centre (IFSC) as an offshore centre; a tax haven in all but name.

Cartoon: Kipper Williams

When the global financial crisis struck in 2008, Ireland's bloated banks were left completely exposed, at the mercy of the insane, virtually unregulated credit markets. The debts quickly unravelled, leaving taxpayers all over the world holding the IOUs. Ireland was particularly badly hit because its banks had taken on a disproportionate amount of the bad debt. They got into that position by being the centre of a huge tax avoidance network. 

Most observers like to point to Ireland's property bubble and subsequent bust, but this was really a sideshow. It's true that Ireland suffered a particularly severe property bubble, as did many other countries, but this was a consequence of the inflated balance sheets of its banks, not a primary cause. Banks don't like to leave spare money lying around. If there's the possibility of using it to speculate on an asset price bubble, that's what they will do, and so they did, mainly through commercial property lending. After all, it's so much easier than sound long-term lending to small businesses for genuine investment.

The most remarkable thing is that no one appears to have learned anything from the crisis, least of all Irish politicians and economists, none of whom saw it coming in the first place. They are carrying on as if it were a one-off and a bail-out is going to fix everything. I can confidently predict that articles like this one will be ignored. Banks' balance sheets will gradually recover - all paid for by higher taxes and public spending cuts. The whole insane cycle of tax avoidance and debt-driven growth will start again. The Spectator will run articles on the new economic paradigm, Celtic tigers and how it will all be different this time. A few lefty economists will raise doubts and be dismissed as peddlers of sour grapes. Then one day the financial markets will implode. Again. Only next time it will be much worse, and again, Ireland will be first in the firing line, because it remains a plump target for companies wanting to avoid tax.

The lesson for Ireland and for all of us, is that if you advertise yourself as a cheap whore, don't be surprised when multinational corporations treat you like one. They really don't love us. We have to stop letting them use us. 

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