The Irish Economic Miracle and Tax Policy

A couple of weeks ago Kash challenged a claim that Ireland’s growth was due to low taxation of capital income:

Ireland has indeed been the fastest growing economy in the OECD (that’s the club of the world’s richest countries). But it has HIGH taxes on capital, not low ones.

Since I’m Irish, I have been intending to post something on the economic miracle. While Kash was upset with James Glassman, the right-wings supposed expert on Ireland’s economy seems to be Benjamin Powell who penned Economic Freedom and Growth: the Case of the Celtic Tiger:

Most theories of economic growth can be dismissed as an explanation for the rapid growth of the Irish economy. The thesis of this paper is that no one particular policy is responsible for Ireland’s dramatic economic growth. Rather, a general tendency of many policies to increase economic freedom has caused Ireland’s economy to grow rapidly.

In a way, Kash might be happy to seem Powell rejecting a single theory of economic growth, but as I read Powell’s paper, he attributes Ireland’s growth to only two alleged causes – a reduction in tax rates and some bizarre rightwing index known as economic freedom. As one reads his paper, notice that Ireland’s income tax rates are still high and its tax system is still progressive. It is true that Ireland has a low corporate tax rate – a theme that we will return to. Also notice how Powell rejects Keynesian factors and convergence theory (see Brendan Walsh and Patrick Honohan), and the following measurement issue as possible factors for the rapid increase in Irish income:

One alternative explanation is that there has not been a “Celtic tiger.” As The Economist (1997:21) reported, “Is it too good to be true? Yes a few critics say: it was all done with smoke mirrors and money from Brussels.” One argument is that Ireland’s GDP is much higher than GNP because of the amount of profits that foreign-owned companies send back to their owners overseas. The high GDP numbers, therefore, do not necessarily translate into wealth for the Irish citizens. Yet, The Economist also notes that “Ireland’s GNP has been growing nearly as quickly as its GDP.” The dramatic economic growth in the 1990s is not only evident from the increases in both GDP and GNP but also in other statistics.

But Ireland’s GDP does exceed its GNP by about 20% as noted here, here, and here:

Gross domestic product (GDP) is the total value of all goods and services produced in an economy in a given time period. Gross National Product (GNP) is the total value of all goods and services produced in an economy in a given time period which accrues to the residents of a country. The difference is made up of net factor flows, which in reality includes net profit repatriation by multinationals and interest on the foreign component of the national debt. In Ireland’s case, GDP is significantly larger than GNP because of the large US multinational presence here.

I emphasized the RTE-Business definition partly because the link provides growth rates for GDP and GNP, which indicate that GNP growth was less than GDP. Using data from table 12 of the Budgetary and Economics StatisticsApril 2005, I have graphed the GDP/GNP ratio from 1990 to 2004. It does seem the GDP growth has exceeded GNP growth for much of the past 15 years. For more discussion, see this post.

But I’ll concede the point that real GNP has also be growing quickly over the last several years as does Antoin E. Murphy who also notes the difference between GDP and GNP growth as he discusses the role of transfer pricing manipulation plays in exaggerating Ireland’s reported GDP and the fact that it was employment increases as much as increases in output per worker that led to the growth in output per capita.

Pierre Fortin also attributes the increase in output per capita to an increase in the employment to population ratio:

Over the past decade, Ireland’s real domestic product per head has doubled, and its national unemployment rate has declined from 16 percent to less than 5 percent. This has made the Irish Republic one of the ten richest countries in the world. This economic is the joint outcome of a long-term productivity boom dating back to the 1950s and 1960s, and a sudden short-term output and employment boom that has seen Ireland’s job performance recover, since 1993, all the ground lost during the previous twenty years. It turns out that, for several decades, Ireland has been remarkably supportive of long-term productivity growth through its openness to free international trade and investment, its business-friendly industrial and tax policies, and its free secondary and low-cost higher education. The short-term aggregate demand push experienced since 1993 has been fuelled by the solid economic recovery in Europe and the United States, continued improvement in Ireland’s international cost competitiveness, streamlined public finances, and low (net-of-inflation) interest rates. The aggregate supply response to this expansion in demand has included a sharp increase in women’s labour force participation rate, a large flow of new and return immigrants, and massive foreign direct investment, particularly from U.S. multinational corporations. In combination, these developments in labour and capital markets have kept the boom going with no increase in inflation until late 1999. The extended noninflationary response also owes much to Irish fiscal discipline, consensus-based wage moderation, and participation in the Single European Market and the European Monetary Union.

In other words, one can have an aggregate demand stimulus without reckless fiscal policy – just as George W. Bush has proven the converse. Robert Rubin would be proud even if Benjamin Powell has yet to grasp what the Keynes really meant in the General Theory.

Returning to Powell’s thesis that lower tax rates and increasing economic freedom were the primary cause of the Irish economic boom, the Irish Congress of Trade Unions argues:

Of late, a myth has grown up around the birth and, indeed, the conception of the Celtic Tiger. A growing number of influential commentators and politicians have taken to asserting that tax cuts were the key stimulus for the period of remarkable economic growth Ireland enjoyed between 1994-2001. Indeed, they repeat this assertion as if it were a matter of established economic fact – an irrefutable economic law – rather than the political contention it actually is. To date this claim, dressed up as established fact, has gone largely unchallenged. Yet, an examination of the evidence reveals it has little basis in reality. In fact, the evidence reveals that reductions in taxation followed the economic expansion – tax cuts did not spawn the Celtic Tiger. The promotion of the myth that low taxes created the Irish economic ‘miracle’ is part of a wider, conservative political agenda which, in essence, seeks to limit the role of the state and maintain
the benefits reaped by a small minority, during the Celtic Tiger years.

I do not wish to dismiss the role that the low corporate tax rate played in attracting investment from the technology leaders during the U.S. productivity boom of the late 1990’s. Brendan Walsh provides an interesting discussion of how Ireland’s position in the European Union and its income tax incentives to U.S. multinationals made Ireland an attractive place for foreign direct investment. U.S. tax planners also realized that the Republic of Ireland was expecting them to create employment opportunities as the price of favorable tax rates.

One should also recognize – as did Antoin E. Murphy that much of this attraction was the ability of these multinationals to source their U.S. created income as if it were Irish GDP ala transfer pricing manipulation. For example, a recent article in the Sunday Times by Tom McEnaney notes that Microsoft Ireland had received 7.5 billion euros in gross profits during its latest fiscal year renewing a discussion as to whether Microsoft “uses Ireland to shelter profits”. Microsoft’s worldwide gross profits were over $33 billion. Mr. McEnaney also notes that Microsoft’s effective tax rate for the year was 26%. Whether Microsoft is involved with the type of transfer pricing manipulation we discussed here is not clear.

Mark Cassidy provides more discussion and evidence on the role of foreign direct investment of certain U.S. multinationals in the Irish economic miracle.

The Irish economic miracle was in part an employment boom as it had laid the foundation for a productivity boom many years earlier. This employment boom piggybacked the U.S. technology boom with U.S. multinationals realizing that Ireland not only was a gateway into the European Union that could avoid customs duties but also a means for reducing its effective tax rate by using transfer pricing manipulation to shift U.S. income into tax-advantaged Ireland. The really odd thing about the tax cut jihadists in the U.S. is that they are now complaining that the IRS might actually enforce section 482 of the U.S. tax code. Their hypocrisy is apparent when they claim – as many have been recently doing – that enforcing section 482 will lead to an outsourcing of jobs to low-tax jurisdictions. The Irish know that the lack of enforcement of section 482 has been part of their success in attracting jobs from U.S. multinationals.