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The Irish elephant in the European tax room

June 30, 2017

The recent European Commission case against Apple in Ireland received a significant amount of media coverage as one would expect with the world's possibly most famous company being involved. However, it also brought along a much broader issue - namely through highlighting areas in which the European Union is not so united after all. Starting at the level of corporate taxation, we might soon discover that the cleavages run much deeper among the member states with a very dangerous potential for the future.

 

Irish corporate paradise

It is the sad truth of politics that the majority of citizens usually do not care about public policy until it's served in front of their eyes in a sensationalist, overblown form of newspaper headlines, which seem to be one of the very few occurrences actually able to create a public backlash. This was exactly the case last year, when the European Commission (on behalf of the Competition Commissioner Maghrete Vestager) imposed a fine of €13 billion on Apple, which had to be repaid to the Irish government. It marked the continuation of a much stronger, more confident attitude the Commission adopted under Mrs Vestager, leading to quite an impressive performance. The decision to fine Apple was cutting-edge as it pertained to taxation, a matter of policy deeply embedded in the powers of the member states that fiercely refuse to give it up in favour of the EU in almost any form. Previously, tax subsidies were not eligible for fines from the Commission. However, commissioner Vestager has decided to interpret the unprecedentedly low corporate tax rate of 0.005% for App

 

le as so excessive that it actually constituted state aid, unfairly favouring the Silicon Valley company against its competitors. State aid is on the contrary strongly prohibited by the EU, as it distorts the competition principle within the Single Market.

 

This decision, although seemingly justified, led to a bizarre situation in which Apple refused to pay the fine to the Irish government and the Irish government in turn refused to receive the $13 billion from Apple. The reason for that is rather simple - even the standard corporate tax rate in Ireland is very low, set at just 12.5%. The Irish economy, whose rapid growth was hailed in the 80s as the Celtic tiger is to a large extent based on attracting large multinational corporations to base their headquarters for the operations in the Single Market in Ireland. The Irish economy lures them in by a mixture of the aforementioned low corporate tax level on trading income, other tax incentives and subsidies and relaxed rules on transfer pricing (allowing also for so-called Double Irish arrangement or tax inversions).

 

This setting has persuaded a number of companies: Apple, Google, Facebook, Intel, HP, Pfizer, Boston Scientific just to name the largest and most famous. In turn, Ireland gets still relatively high tax revenues in nominal terms and a large number of jobs provided by these companies, as well as a solid portion of investment and international relevance. It is also worth adding that the relatively shorter distance and overall good historic relationship with the US helps, as does the absence of the language barrier, since a majority of the large corporations based in Ireland are indeed American. Dublin has also been mentioned many times in the recent weeks and months as the possible place of relocation for the services-based companies, consultancies and banks of the City of London after Brexit. The access to the Single Market is crucial especially for the banks, which will fight hard to retain the passporting rights. There is a strong competition for Dublin - Paris, Frankfurt, Milan and other places have also made their claims, while London will want to keep its financial jewel at (almost) all costs - but the corporation-friendly policy mix described above gives Ireland a strong position.

 

The Irish tax system design, which could be to some extent described by the infamous phrase "race to the bottom" - going out of one's way to give better incentives and subsidies for companies, usually in a trade-off for jobs, is merely a part of a bigger picture. As mentioned before, there is no fiscal union and relatively little (voluntary) fiscal coordination among the member states of the EU. Not only that, it is also very unlikely to see much of a progress in the area despite the dire need. Member states have become increasingly hostile to surrender any more sovereignty to the EU, let alone in an area of policy that has been fundamental to the state since its conception in history.

 

Broader implications

However, this situation is nothing short of a paradise for the large multinational corporations, which exploit every loophole or gap in the national tax code to minimize their tax returns. They are usually able to navigate the systems better, quicker and more flexibly then the regulators; sooner or later thy find the ideal design of transfer pricing and tax optimization. As a by-product, they often gain substantial bargaining power in the negotiation with national governments, depending on how many jobs they provide in the respective country.

 

Furthermore, tax incentives, subsidies and cozy attitude to multinationals can have unforeseen and dire consequences. Don't be fooled by the low unemployment figures in countries like Czech Republic - they are not an indication of a good-performing economy but rather a result of competitive devaluations over the past two years and a strong car manufacturing export sector, supplying the growing German carmakers. In fact, the real wages have been stagnating for quite some time, the value added of the Czech employees is woefully low (and also reflected in the wages) and the country has become a source of cheap, unqualified labour; recently dubbed the "assembly line of Europe". Similar description of the situation also applies to other Eastern European countries such as Slovakia, Romania or Hungary.

 

An unused opportunity

Going slightly aside - another problem of the EU is the missed opportunity in events like this, which many people seem not to realize. Competition policy is one of very few policy areas in which the EU (more precisely the Commission) has almost full discretion. Coincidentally, these areas are also one of the areas in which the EU and its institutions have the best results. Yet even here the prevalent lack of the ability to create some good publicity for the EU performance was clear and obvious. Despite the fact that the EU is generally doing a good job in the areas with conferred responsibility and discretion (i.e. the policy areas the EU can realistically influence), its public image in most of the member states is persistently negative. Imagine the headlines "Great performance by Mrs Vestager saves the Irish citizens €13bn to be spent on healthcare and public service from a large corporation" in Irish Times last year. Although a factual description of the events and something that everyone can understand or relate to, it is hardly likely to ever happen.

 

The Irish tax arrangement points to a broader issue of the European Union, which the overwhelming lack of coordination and harmonization in many economic areas (taxation being one of them), resulting in consequential cleavages among the member states and being particularly exposed in times of crises. The problem is somewhat exacerbated by uniting 19 of the countries in the common currency area, yet leaving their fiscal policies determined on the state level.

As the article of my colleague Bruno brilliantly shows, the cleavages in Europe exist and not always follow the trend of convergence outlined in the usual neoclassical economic integration models. The two main cleavages - North-South and East-West - should gradually disappear in an area with perfect production factor mobility. While this applies to the East-West divide, where labour usually moves to the less competitive Western countries, leading to eventual convergence, this is not the case in the North-South divide - North remains more competitive despite higher labour cost.

 

How to move forward?

Having broadly outlined the current problem, we should now turn to the potential solutions. They are, however, expectedly difficult and the political will needed to implement them is lacking. There has been a call for harmonizing the level of corporate tax across the EU, which I personally see as the bare minimum. Similar system to the calculation of the VAT own resource to the EU budget could be applied, setting a minimal base for the corporate tax. European Commission has also been exploring the possibility of introducing a financial transaction tax. Countries that benefit from hosting the multinational corporations are almost certain to oppose it though, and even if this policy somehow passed the institutional barrage of the Union, tax havens outside of the reach of the European bloc would gladly host the fleeting companies. Indeed, this was seen as one of the potential strategies for the United Kingdom once the Brexit negotiations are done. The EU as the vanguard of the free trade and economic liberalism would never comply with any significant levels of capital flow controls and thus it lacks the firepower to effectively tackle the tax havens.

 

At least partial fiscal federalism and autonomy for the EU also seems more and more as a necessity, rather than a fantasy of the European federalists. Indeed, it seems to be a reasonable measure to tackle three substantial issues. Firstly, using the methods of transfer pricing and tax optimization have seen national tax revenues shrinking and thus making the governments less able to offset the negative impacts of globalization on its citizens (the so-called embedded social liberalism). Secondly, one of the four prerequisites for the proper functioning of the single currency area (aside from synchronized business cycle, flexible labour markets and perfect factor mobility) is a national fiscal policy that is able to deal with the eventual exogenous shock. This was meant to be achieved first through the Stability and Growth Pact, which was meant to ensure enough maneuvering room for the fiscal responses and later, through much more strict (and considerably less popular) fiscal compact. Given the rather feeble results and anemic growth in the Eurozone, coupled with growing discontent point towards the fact that indiscriminate monetary policy for the entire bloc is not enough and some form of fiscal union (be it increasing the EU budget, even through discretionary levies; engaging in transfers across regions on a larger scale than just to cohesion policy; or across time through Eurobonds issuance). Thirdly, since the 2004 CEE enlargement and especially the subsequent financial and debt crises, the convergence described in the neoclassical models have been distorted and seems to have stalled. More cooperation in fiscal policy across the EU should provide the much-needed kickstart.

 

Finally, the active attitude and a certain level of fearlessness to take one the big business that Commissioner Vestager adopted has so far been perhaps the greatest achievement. Apart from the well-covered Apple case, she has also confronted other giants such as Google, Facebook, DuPont or Amazon. Her impressive track record so far runs deep - €3.4bn in cartel fines and around €16bn of recoveries before interest for the illegal state aid. Her uncompromising stance in the Apple case has led to a significant pressure from Washington and Apple CEO Tim Cook did not spare some strong accusations, yet Mrs Vestager always seemed rather unfazed. It is this principled attitude and determination that yields results, some of which are quite impressive. They are even more so important because they bear a substantial PR significance for the EU among the ordinary people - fighting for fairness, not being afraid of taking on the big money and using the same measure for everyone. As mentioned before, the EU should take more of a clout for that, since popularity and evidence of delivering among the ordinary people is something it desperately needs in the times of nationalist populism.

 

Corporate tax harmonization and improved fighting against tax optimization and transfer pricing could have another, at least short term benefit for the European Union. The fines imposed on the companies breaking the competition policy of the EU (such as cartel & monopoly breaking, using the leniency policy; market dominance prevention; mergers control and finally the aforementioned state aid, stipulated in the article 107 of TFEU) actually make up a part of the EU budget. Sadly, such a move would require a unanimous approval of the Council - something that will most likely remain in the realm of fantasy given the stakes of Ireland, Netherlands and Luxembourg in corporate tax discretion

 

There are also other options waiting to be explored and proposed to the Parliament and Council. It is difficult to navigate the tradeoff between ensuring the reform goes deep enough to remedy the current unsustainable situation and making the policy palatable to the Council and national government. Either way, the clock is ticking and the need for action becomes greater with every tick.

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