What’s more effective at creating jobs and driving investment, corporate tax cuts or investing in education and skills?

One of the key arguments from advocates of the proposed Corporation Tax cut is that cutting taxes will stimulate job growth and attract foreign direct investment (FDI).  The paper on the DETI website quotes an OECD paper, which states that for every percentage point decrease in Corporation Tax, FDI increases by between 0% and 5%.

However, the OECD paper was published in February 2008, and from an economic point of view, the world is a very different place to what it was then.  What happens if we look at more recent data?

FDI

This graph shows, on the x-axis, the average corporate tax rate between 2009 and 2013, and on the y-axis, the average level of FDI as a percentage of GDP.  There are a couple of items of interest here.  The first is that, excluding outliers, there doesn’t appear to be a particularly strong relationship between corporation tax and the amount of FDI that a country has been able to attract.  Hungary, for instance, has one of the lowest corporation tax rates in Europe, but has had negative total FDI over the last five years, whilst Portugal, with one of the highest rates, have managed to attract FDI of 3.8% of GDP.

The even more notable aspect to this graph are the three outliers: Belgium, Ireland and Luxembourg.  These countries have managed to attract spectacular amounts of investment, with Luxembourg attracting an incredible 42.1% of GDP over the last five years.  Ireland, of course, has a 12.5% Corporation Tax rate, but neither Belgium nor Luxembourg has low rates.  What could these three countries have in common, that has proved so successful in attracting foreign investment?

The answer lies with taxation, but not of the regular Corporation Tax variety.  For instance, Belgium is the only country in the world, apart from China, that has signed a double taxation treaty with Hong Kong.  It has also signed a double-taxation treaty with over 80 other countries. For instance, if an American company establishes a Belgian subsidiary which then sets up a company in Hong Kong, it can trade in China, and then pass along profits back to the US without paying much in the way of tax at all.

Ireland has, for the last few years, allowed companies to avail themselves of the tasty (in many senses of the word), and soon to be outlawed, “Double Irish with a Dutch Sandwich”, which through a complex series of transactions between multiple Irish companies and tax havens, allows companies to avoid paying even the low 12.5% Corporation Tax rate.

The star at attracting FDI, Luxembourg, has an even more attractive tax quirk.  In one of those boring-sounding but actually rather interesting tax rules, Luxembourg allows companies to offset impairment losses on investments made in the country against tax.  Ok, so this doesn’t sound particularly revelatory, so let me put it another way.  It means that companies can use costs that they haven’t actually incurred, and then they can use these “losses” to reduce their tax bill anywhere in the world.

This means that companies can say “whoops, our Luxembourg subsidiary is now worth a few billion less than we thought it was worth yesterday”, and then lend money at a high rate of interest from the Luxembourg subsidiary to the parent company in another country.  It can lower its taxable income by the interest charge in the parent company’s country, but it doesn’t have to pay any tax in Luxembourg because of the loss incurred when the Luxembourg subsidiary had its most unfortunate fall in its value.  The tax, in a sense, just disappears.

It’s as if you came back from a holiday to Luxembourg, and as a permanent souvenir of your happy and carefree weeks exploring Luxembourg City and the Oesling, decided to purchase a plastic bust of Jean-Claude Juncker for €5.  To your own delight, when you get home, you decide that your statue is worth a lot more than you paid for it, and you now value it at €250 billion.  Five minutes later, you burst into tears as you decide it’s only worth €1 billion.  To console yourself, you remind yourself that the loss you’ve just incurred of €249 billion means that you’ll never have to pay any income tax for the rest of your life.  They do say every cloud has a silver lining.

It is left as an exercise to the reader to judge if such an attractive quirk could be the reason why Luxembourg has been, relative to the size of its economy, over forty times more successful at attracting investment than across the border in Germany.  Taxation is a big deal when it comes to attracting FDI, but it’s not the draw of a few percentage points off their local Corporation Tax bill that is that is the big draw.  It’s the allure of paying nothing, anywhere.

With all the understatement one could possibly muster, it is unlikely that any of these wheezes would work in Northern Ireland.  Although possibly amusing to imagine it being tried.  One can see David Cameron and George Osbourne, tetchily wondering what the latest demands are from Belfast today.  “Oh, the usual, flags, parades, language… wait, this is new.  They want to sign a double taxation treaty with Hong Kong now?  And they also mentioned something indecipherable about impairment losses.”

So, if cutting Corporation Tax rates doesn’t have much of a visible impact on FDI, then how about a possible impact on unemployment?  Do countries with lower rates of Corporation Tax have corresponding lower rates of unemployment?

Unemployment

No.  No they don’t.  So if cutting corporate taxes doesn’t lead to low unemployment, is there anything a country can do to create jobs?  As it happens, there is.

Tertiary Education

There is a fairly strong relationship between Tertiary education spending and the unemployment rate, which stands to reason, as countries that invest in endowing their citizens with skills are creating desirable employees.  The large dots show Northern Ireland, as if it was an independent country, as it is today and as it might be after the proposed cuts in tertiary education are implemented.  The draft budget has proposed cuts of up to £49m to the universities budget, which if implemented which would be sizeable enough to reduce university spending from 29% of GDP per capita per student (e.g. Iceland) to 24% of GDP per capita per student (e.g. Estonia).  If unemployment moved accordingly with the reduction in education investment, then it would be expected to lead to a four percentage point increase in structural unemployment.

It is worth bearing in mind that, even given the local context, £49m is fairly small beer.  It is, as W[r]ite Noise Maeve points out, less than half the sum borrowed by Belfast City Council to spruce up a few leisure centres.  In terms of cuts that have the potential to cause severe harm to long term economic prosperity, it would appear to be almost divinely inspired as an act of political foolishness to raid the Higher Education budget to pay for short term tax cuts.

A qualified accountant and data analyst, interested in politics, economics and data. Twitter: @peterdonaghy