by Mike Kimel
Ireland – The Questions Nobody Seems to be Asking
Cross-posted at the the Presimetrics blog.
Talk about deja vu all over again. Here’s Tyler Cowen talking about the Ireland bailout, and linking to Megan McArdle discussing the same. Its deja vu, for me, because it seems just about everyone commenting on the issue is ignoring what should be an obvious point, namely that a bail-out is at best a possible solution to the wrong problem. Interestingly enough, this wrong problem has been around for a very long time, and the same cast of characters have been busily ignoring it (or even praising it) for a very long time.
I said this is deja vu all over again for me, because the last time I gave much thought to the issue (back in 2006), I wrote a post that linked to both Tyler Cowen and Megan McArdle (then Jane Galt). I’d like to quote myself extensively if I may:
There seems to be some discussion about why Ireland is growing as quickly as it is.
I am completely ignorant about this, and haven’t even been to Ireland. But I do have a question… Is it possible that part, even a large part, of the Irish boom, is fictional?
By fictional, I don’t mean lacking in physical manifestations such as massive improvements in infrastructure, etc. Consider the effects of something else I’m mostly ignorant about, namely the Menem-and-Cavallo-dollarize-privatize-and-steal plan (as I recall it had a different name, but to me this one captures its essence a little better) in Argentina. For a number of years after it was launched, it looked like Argentina was doing really well. There was all kinds of new investment in infrastructure, the mood in Argentina was upbeat, and many economists (especially the conservative ones) and financial publications such as the Wall Street Journal were breathlessly pointing to Argentina as a country that other developing nations should imitate.
The problem in Argentina was that much of the funding for the short-term but much-hyped prosperity that followed came from the proceeds of the sale of government-owned assets (airline, railroads, etc.), or rather, the portion of the proceeds of the sale of government-owned assets that wasn’t stolen outright. Instead of assuming the proceeds from those sales were a one-time windfall, the Argentine government, foreign economists and the Wall Street Journal acted as if they were recurring sources of funding, leading gullible foreign investors to come running with their money. With so many experts patting them on the back, eventually even the skeptical Argentine public came to believe Argentina had miraculously fixed all its problems. When the windfall ended, the dwindling foreign reserves were not enough to maintain the dollar peg for long, and the whole house of cards came down.
Now… some of the growth in Argentina was real, and both dollarization and privatization may well have created more amenable economic conditions. But not enough to justify all the enthusiasm, or to ignore the very real problems the plan also brought.
So… where does that leave Ireland? Well, the worst year of my life was spent at a Big X (at the time, X was equal to 6) accounting firm, doing transfer pricing. Transfer pricing often amounts to little more than highballing the amount of a company’s activity taking place in low tax jurisdictions and lowballing the amount that takes place in a high tax jurisdiction in order to reduce one’s overall tax burden. It is often done creatively. Say company X transfers ownership of a logo to the subsidiary of company X in the Caymans. Then, every time company X sells a tennis shoe with that logo, it pays a royalty to its subsidiary in the Caymans. If taxes in the Caymans are lower in the US, X hires E&Y or PWC or whoever to argue that most of the value in the shoe sits in the logo (and therefore is income received by the Cayman subsidiary and thus taxable in the Caymans), and not in the shoe itself (which is income received by the parent company and taxable in the US).
So back to Ireland…. Say you’re a pharmaceutical company. You have hundreds of highly paid researchers scattered throughout the globe – in places like the US, Switzerland, Germany, etc. Because taxes are lower in Ireland than in the rest of these locations, when a blockbuster drug is discovered, it is advantageous to play up the contribution of the researchers in Ireland and play down the part of the researchers made elsewhere.
This has at least two obvious effects. The first is the direct artificial boost to Irish GDP (and an artificial reduction elsewhere). Since Ireland is relatively small, if a crumb is taken from the US, another crumb is taken from Switzerland, etc., the effect can be very large in Ireland. The second effect is indirect – in order to pull this stunt off, it is necessary to have at least some facilities in Ireland, leading to more hiring and building in Ireland as more companies get more heavily invested in playing the game. But its in nobody’s interest to say this is being as a tax dodge, so a mythology springs up (as it did in Argentina), and part of that mythology, at least, is self-sustaining.
I would imagine the situation is not quite as artificial as in Argentina – Ireland does have a young, fairly educated population, and a convenient location, whereas the change from hyperinflation to rapid growth in Argentina truly looked like a miracle to those who didn’t look too closely (i.e., almost everyone). The Irish miracle has gone on for at least two decades, and there may well be enough of a solid underpinning for it to continue indefinitely. But, I have no idea how much of the Irish growth is due to these effects, nor a clue how to measure them. Any ideas? Any other thoughts as to why Ireland is growing so rapidly?
(Note – transfer pricing was a favorite topic of the early posters on Angry Bear – Angry Bear, Kash, and PGL all had a number of excellent posts on Transfer Pricing that predated mine.)
About six months after that post, I noted some, er, corroborating evidence:
According to the CBO 20% of the returns on investment abroad by US companies from 1993 – 2003 came from Ireland and Bermuda. Ireland and Bermuda. If there’s some way to explain that 20% of the returns of all American companies abroad came from Ireland and Bermuda without invoking tax fraud on a massive scale, I’d love to hear it.
Now, none of this is intended to suggest that the Irish government wasn’t amazingly stupid in agreeing to take on the debts of private banks. (Hey, the administrations of both GW and Obama did the same amazingly stupid thing, but they disguised it a bit better, and the ability to print dollars buys the US some leeway to deal with it.) However, it does raise important issues:
1. How much of the Irish growth was fictitious?
2. What is the expected rate at which fictitious growth is transformed into real growth? Presumably that rate exceeds zero (if companies set up so much as a pass-through in Ireland to reduce their tax rate, some of the money will stick to Ireland), but presumably it is well less than 100% (if you’re attributing a technology developed by 23 engineers in San Jose, CA and 14 in Frankfurt to a single technician in Dublin, you might reduce your tax rate but the knowledge base still won’t be in Dublin.) I imagine that, paradoxically, the more the American and German tax authorities enforce compliance, the more they help the beggar-thy-neighbor types by essentially forcing their companies to do something real in those jurisdictions. Eventually, some of the engineering work actually does move to Ireland.
3. Are the beggar-thy-neighbor countries (or states, natch) more susceptible to downturns than other countries? After all, when the doo-doo hits the fan, and profits are down, Siemens and Intel and the rest of ’em have less of an incentive to minimize profits in high tax jurisdictions, and more of an incentive to show losses in those same high tax jurisdictions. Activities of any sort in Ireland becomes an afterthought. Additionally, I imagine that the Irelands of this world are disproportionately dependent on financial transactions.
4. How much of a hit do places like the US and Germany (or New York and California) take as a result of beggar-thy-neighbor policies? What should these countries (and states) owe to their citizens or corporations that take advantage of the schemes made possible by the beggar-thy-neighbor policies?
5. Is the stupidity of the Irish government (in taking on the debts and obligations of private banks) something that will have a long term deleterious effect on Ireland’s ability to continue playing beggar-thy-neighbor? The collapse of the housing bubble is a separate matter altogether from the transfer-pricing-milking-operation the Irish government was running, but might it affect Ireland’s ability to keep playing the game? (I don’t know enough about the Irish economy to hazard a guess right now, especially given the baby on my lap has just starting screaming since I started writing this sentence… which I guess is a signal to end this post.)