1 The Centre for the Study of Small States, The Source of Wealth in Small States University of Reykjavik…

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The Centre for the Study of Small States, The Source of Wealth in Small States

University of Reykjavik

Small States as Financial Centres Ireland as a Case Study

Brendan WalshUniversity College Dublin

14th September 2007

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Jan 1988

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May 1997

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Oct 2004

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The Irish ExperienceBetween the 1980s and the end of the

1990s, Ireland moved quickly up the international league tables in terms of

average living standards.The Irish labour market was also transformed from one of the worst-

performing to one of the best-performing in Europe.

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Rising living standardsDespite the opening up to external trade and investment in the 1960s and entry to the EEC

in 1973, Ireland in the 1980s remained relatively poor by western European standards.However, between the late 1980s and the year

2000, very rapid growth in GNP raised Irish income per person (adjusted for differences in

purchasing power) to or even above the EU average.

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GNP/GDP growth ratesIreland and EU

-2

0

2

4

6

8

10

12

1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005

%

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Comparison of living standards in 1986 (EU average = 100)

0

20

40

60

80

100

120

Ireland (GNP) Portugal Spain Greece

•

9

Comparison of living standards in 2004(EU average = 100)

0

20

40

60

80

100

120

Ireland (GNP) Portugal Spain Greece

•

10

Comparison of standards in 1986 and 2004(EU average = 100)

0

20

40

60

80

100

120

Ireland(GNP)

Portugal Spain Greece

19862004

•

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Not “just” wealthier . . .Healthier also Irish life expectancy had been

slowing rising, and mortality rates slowly declining

But since the late 1990s they have surged ahead and caught up with the most advanced nations

Belies the complaints over the poor delivery of state controlled health services

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During the boom

The rich got richer and the poor . ..Got richer tooDramatic decline in absolute povertyThe the biggest cause of social exclusion –

unemployment – fell extraordinarily raidply during the second half of the 1990s

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The Irish labour market was completely transformed

Since the early nineteenth century Ireland had been a prime example of a “labour

surplus economy”• Overt unemployment kept in check

– By emigration– By large subsistence agricultural sector– By low labour force participation rates

Until the 1980s….

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Irish unemployment rate, 1961-1986

02468

1012141618

%

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Surge in employment in the 1990s

1,000

1,200

1,400

1,600

1,800

2,000

2,200

1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005

thou

sand

s

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Irish unemployment rate, 1986 - 2004

0

2

4

6

8

10

12

14

16

18

%

17

Irish unemployment rate, 1961-2004

0

2

4

6

8

10

12

14

16

18

%

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Irish and EU unemployment rates, 1961-2005

0

2

4

6

8

10

12

14

16

18

%

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A renewed population

Net emigration turned into net immigrationso that by the end of the 1990s Ireland had

the fastest growing population and labour force in the EU

– reversing the long decline in our population that was the clearest symbol

of our national failure after Independence

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-15

-10

-5

0

5

10

15

20

1988 1990 1992 1994 1996 1998 2000 2002 2004 2006

per

1000

pop

ulat

ion

Net Migration Rate

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Explaining the boom

• No single “magic bullet”

We can classify the key factors into

• Favourable demand side shocks and

• Favourable supply-side responses

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Demand-side developments• Fiscal correction and renewed confidence

– Reduced tax burden

– Cross party support for tough policies

• Falling real interest rates– Run-up to Euro

• Strategic exchange rate weakness

• Global boom

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Supply-side developments• Increased inflow of FDI

– Full integration into the EU

– Increased attractiveness of Ireland’s low corporation tax

regime

– Investments by premier US companies in IT and

Pharmaceuticals

• Increased inflows of EU structural funds

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Supply side developments• Elastic labour supply– High initial unemployment

– Return migration– Low initial participation rates

• Rising educational attainment of outflow from education system

• Wage moderation – Role of centralised wage bargains

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Structural labour market reforms

• Stricter social welfare regime

• Falling unemployment benefit

replacement ratio

• Active labour market policies

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Changes in social welfare code• Stricter eligibility criteria

• Reduced replacement ratio – (facilitated by cuts in income tax rates)

• Some reclassification of the unemployment into “inactive”

• More spending on active labour market policies, less on income support

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The Contribution of Tax Policy

• The rising burden of taxation, and widening tax wedges, contributed to the protracted recession of the 1980s

• The reversal of these trends contributed to the rapid recovery of the 1990s.– A return of “social partnership” in 1987

facilitated these developments– Trade of nominal wage claims for income tax

cuts

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The facts• During the first part of the fiscal

correction, the economy seemed to shrinking

• When the emphasis shifted to expenditure control – rather than tax increases – the economy grew strongly

• Cause and effect less straightforward!

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Taxes as % of GNP

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

1970

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

Taxes on incomeTaxes on ExpenditureTotal

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Taxes as % of GNP and Real Growth

20%

25%

30%

35%

40%

45%

1970

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

-4%

-2%

0%

2%

4%

6%

8%

10%

12%

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Change in tax burden and real growth rates

Change in tax burden

Change in tax burden

-23

-13

-3

7

17

27

37

1979-88 1989-2003

%

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The tax reductions delivered under social partnership

0%5%

10%15%20%25%30%35%40%45%50%

Average tax rate (incl employeesocial security contirbutions)

Marginal tax rate (incl employeesocial security contirbutions)

1979 1984 2002 2007

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Corporation Tax Policy

The tax regime experienced by business in Ireland has remained stable over long periods and consistently favour a low tax rate on profits:

• A zero tax rate on profits from exports lasted from 1954 to 1980.

• A 10% tax rate on manufacturing profits applied from 1980, and will continue until 2010 for those entitled to it in July 1998.

• A 12½% tax rate on corporate trading income applies from 1/1/2003 and is EU approved.

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Corporation Tax Policy

Full repatriation of profits was always permitted

However, a generous corporation tax regime not sufficient to attract FDI:

But when combined with a well-educated labour force, competitiveness wage levels, and open access to the large EU market, it worked wonders

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Not all the effects of this policy are positive

Transfer pricing and the growth of an entrepôt economy

Sectors with extraordinarily high value added per employee

Round Island One (Microsoft)• Turnover $3.9 billion• Value added per employee $2.5 million• Corporation taxes paid in Ireland: $3.8 million

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Impact of transfer pricing

Very marked in sectors such as • Pharmaceuticals• Soft ware• Microelectronics• Certain food concentrates (Coca Cola)The gap between GDP and GNP is now

15% of GDP – a world record

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Corporation Tax Policy

The present uniform low rate of corporation tax has been used in particular to drive the development of Ireland’s international financial services sector, where employment has grown spectacularly.

It has also generated uneasy among some EU members, who fear that “tax competition” will lead to a “race to the bottom”

Ireland is strongly opposed to “tax harmonization” as a response to this.

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International Financial Services

The International Financial Services Centre (IFSC). established with EU approval as a tax-incentive zone in 1987.

Initially a ring-fenced tax jurisdiction in a designated area in the north inner city of Dublin.

Since December 2000 new cross-border international-financial services companies are taxed at the new standard rate of 12.5 per cent

The Centre has become an integral part of the jurisdiction of Ireland

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International Financial ServicesThe initial employment target of 8,000 jobs has long been

exceeded. The level of employment in the wider Irish international

financial services sector has reached 22,000 by 2006. The largest single sub-sector was banking, which employs

9,923, followed by Fund Management, with 9,227, and Insurance, with 3,027.

Thus the original scheme has been extremely successful, exceeding its overall employment targets and creating a significant international financial service centre in what was until recently a derelict area of Dublin.

Attracted large inflow of service FDI

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Fallout from US sub-prime mortgage market

• On 15th August 2007 Sachsen LB Europe plc confirmed that its Dublin subsidiary in Dublin, the Ormond Quay conduit, had to be rescued by a loan of €17.3 billion.

• This episode highlights the need to have a single financial regulator across the Eurozone and drew some unwelcome attention to the nature of some of the firms in Irish International Financial Services Industry.

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SummaryMany favourable factors came together to create

the Irish economic “miracle”Rapid economic growth was facilitated by

• Favourable external developments• A successful fiscal correction

• An elastic labour supply and increased flexibility of the labour market• Increased inflows of FDI

• Increased flows of EU structural funds

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SummaryThe reversal of the upward trend in the burden of

taxation after the mid-1980s was undoubtedly a key feature of the fiscal adjustment

This reduced tax wedges, especially on labour, and stimulated an increased supply of work

effortIt was facilitated by the return to “social

partnership” in 1987The effectiveness of Ireland’s low corporation tax

rate greatly increased in the new global economic environment of the 1990s.

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SummaryThe extension of Ireland’s low corporation

tax rate to a ring-fenced International Financial Centre in Dublin in 1987

proved hugely successfulThere are now 22,000 people employed in

International Financial Services in Ireland and the sector has been

integrated into the economy.

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The future…The economy has now entered an

adjustment phase.The construction sector, which accounts for

12.5% of employment and fuelled a very high level of immigration, is now

contractingHow rapidly?

The exceptionally buoyant fiscal situation is deteriorating

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The future

It remains to be seen how steep the slowdown will be and which sectors of

the economy will be the engines of growth going forward