Ireland: A Lesson in Corporate Tax Rates and Gaming

Irish situation isn't as pretty as once thought.The news out of Ireland is monumental for more than just the headline implications.  You know these days how watching sports games every little stat is some sort of “first of its kind” or “first since whatever year?”  This global financial crisis is no different.  With the Irish bailout we now have two belt notches to make that are somewhat significant:

  • Ireland was the first European country to embrace austerity (a full 2 years ago) in this global financial crisis and they’re now the first country to undertake austerity measures and subsequently require a bailout.
  • With Ireland’s bailout, it’s now official that the two developed countries ranked #1 and #2 (Iceland is the other) for lowest corporate tax rates have essentially gone bankrupt.

Now these are two contentious points in the politic-economic debate in the United States and one can only wonder where there are reasonable inferences to be drawn here.  Since austerity is seemingly (and thankfully) off the table in the short-run, let’s focus on the corporate tax rate.  The Larry Kudlows of the world would have you believe that the American economy is struggling today because our tax rates are simply too high.  Well clearly economic woes can stem from other catalysts because if lower corporate tax rates were the cure-all they are chalked up to be, then Ireland would not be in its present predicament.  So lets dig in to see if there’s anything we can learn.

The way I see it, Ireland and its corporate tax rate create a “friends with benefits” situation whereby corporations and Ireland engage in a relationship that is mutually beneficial for the time being, but founded on only a short-term, unemotional and purely physical attraction.  It’s not that companies see Ireland and love how deeply attractive the country is for establishing a long-term, enduring marriage, through thick and through thin.  Let’s look at an anecdotal story and you’ll see exactly what I’m getting at.

Not too long ago Google’s (NASDAQ: GOOG) aggregate corporate tax rate became a big story, as the company pays a mere 2.4% overseas tax rate.  Here’s the relevant part (Bloomberg):

Google, the owner of the world’s most popular search engine, uses a strategy that has gained favor among such companies as Facebook Inc. and Microsoft Corp. The method takes advantage of Irish tax law to legally shuttle profits into and out of subsidiaries there, largely escaping the country’s 12.5 percent income tax. (See an interactive graphic on Google’s tax strategy here.)

The earnings wind up in island havens that levy no corporate income taxes at all. Companies that use the Double Irish arrangement avoid taxes at home and abroad as the U.S.

The whole article is worth a read for the explanation of how widespread the use of this particular maneuver is and how much money is on the line.  Essentially Google and other technology companies use what’s called the”Double Irish” technique, which allows for firms who own intellectual property to shift their income to another jurisdictional (typically a corporate tax haven in the Caribbean) in order to avoid the majority of their tax obligation.   So not only does Ireland already entice corporations with some of the lowest tax rates in the entire world, they also provide a convenient loophole whereby firms can escape the majority of their tax obligation to the country.

Now that Ireland finds itself in the proverbial financial pickle today, it should come as no surprise that a company like Google, whose motto is “don’t be evil” will simply threaten to leave the country altogether should the tax policy change.  Wait what?  Yes, the company has publicly made clear its intention to leave should the tax policy change. So really, this is your “friends with benefits” relationship where one side becomes emotionally vested and wants more while the other remains committed to the status quo.

Clearly it would be in Google’s financial interest to find a “friendlier” location, but this highlights exactly what is wrong with creating illusory prosperity through tax rate engineering rather than a commitment to true growth initiatives.  Ireland for so long had been the talk of the town in US academia for how well they embraced free market initiatives in order to rack up some of the most impressive growth metrics in the developed world, but now that things are coming undone we’ve learned that in reality, the prosperity was based on a whole bunch of “friends with benefits” relationships that would cease as soon as the benefits expire.  After all, in such a relationship moving on isn’t “cheating” it’s just part of the game.

And I see a second ripple effect of such relationships.  The “Double Irish” maneuver is a form of financial engineering that’s not based on any corresponding increase in value or production.  In this particular crisis, financial engineering is one of the primary culprits behind our present economic woes.  Therefore, it should come as no surprise that a country which explicitly allows for financial engineering and the gaming of the system would find itself in a deep banking crisis that ultimately necessitates a sovereign bailout of the financial sector and a global bailout of the sovereign.  Now Ireland finds itself in a lose-lose situation whereby they need to raise taxes in order to pay down the fiscal deficit but can’t because most of the business domiciled there would just leave.

If a country wants to lower the corporate tax rate to stimulate its own economy, that  does make sense in some particular instances.  However, if a country’s real goal is to attract a long-term corporate presence then an unjustifiably cheap corporate tax rate with wiggle room for gaming is nothing more than a call for a “friends with benefits” relationship or maybe even just a one night stand.  Sure Ireland got 2.4% of some Google profits in years it would not have, but that’s just a short-term band aid, not long term prosperity.

Ireland disproves the supply side solution to this particular financial crisis.  They embraced austerity a full two years ago and have the lowest corporate tax rates in the world, yet the situation deteriorated to the point of a sovereign bailout.  My problem here isn’t necessarily with Ireland, it’s with those who think that in the US the lowering of our corporate tax rates can change any of our longer term problems.  Corporations establish enduring long-term relationships where there’s underlying demand, tax rates are just part of the broader game.

Disclosure: Long GOOG