Ireland and America face brutal tax challenge

Most investors hate tax rises. But coupled with tax cuts, they may be the least worst option for many countries and markets.

Take Ireland and America as an example. If you own any Irish or American stocks and corporate bonds, you would be frustrated to see company cash flows directed towards governments, unless you held more in Irish government debt or treasuries.

But the deficits in both countries are so severe that you may be happy to see the government get greedy. Tax may put people off spending and investing. But so will public spending cuts if tax does not narrow the deficit.

The problem is executing the changes correctly and striking a balance between spending cuts, tax rises and tax cuts to stimulate the economy. The topic may be dry, but the choices are brutal.

Take Ireland as an example. Germany is afraid its companies will move to Ireland if Ireland retains its 12.5% corporation tax rate after a German-led bailout. It also fears retaining the tax rate is just hitting Ireland’s tax take and hence the amount of money it can pay to its creditors.

As a result, the European Union is still wrangling with Ireland over whether its tax policy should survive a bailout. (article continues below)

However, Ireland keeps corporation tax low for a reason. The rate has attracted multinationals to Ireland’s economy and increased its tax take. Raising the tax now would leave Ireland’s economy not just legless, but armless.

A significant number of American companies have based their operations in Ireland, for instance. The American Chamber of Commerce in Ireland was moved to release the following statements today. Those quoted have a commercial interest in making their statements, but sadly this does not make them any less pertinent.

“The fiscal success of Ireland’s corporate tax policy is clear.  It has attracted leading multinational companies to Ireland and in the process has created hundreds of thousands of jobs that would otherwise have been lost not just to Ireland but to the EU as a whole.  Foreign direct investment accounts for €110 billion [£94 billion] or over 70% of total exports in the Irish economy, 240,000 jobs (100,000 in US multinationals alone), 55% of corporation tax, €19 billion in direct expenditure, €7 billion in payroll costs and 73% of business spend on research, development and innovation,” said Lionel Alexander, a vice president for HP Manufacturing and the president of the American Chamber of Commerce in Ireland.

“The IMF, the European Central Bank and the European Commission must realise that any increase in our  corporation tax rate would ultimately make us more economically dependent, not less so, on our European Union partners,” said Peter Keegan, the country executive for Bank of America Merrill Lynch.

Raising corporation tax may be the obvious thing for Ireland to do in its current situation. But for the reasons above, it would not be the right one.

If they want their bailout plans to work, Germany and others have to accept that a shotgun fiscal union involves more than just one country borrowing off another. It also means, if necessary, risking a minor tax hit to protect your own lending.

Back in America, the problem is the opposite one – trying to coax the economy into any tax rises at all.

Paul Krugman, the American economist, spent the earlier part of last decade worrying about the Bush administration and its gigantic reliance on cheap borrowing from China.

In particular, he attacked Bush’s tax cuts for the rich, saying they boosted the deficit without stimulating the economy. The rich saved too much and spent too little domestically, said Krugman.

The concerns made sense, predictably because they already had more money than they needed to spend in the short term and had more sophisticated wealth management options available.

It was scarcely as if rich people who wanted to avoid paying American tax weren’t going to find a way to do it, even with a low tax rate.

Unfortunately, the presidential administration ignored his advice at the time and most people continue to ignore it now, including to a certain extent Krugman himself.

On the left, the Nobel prize-winner now supports America borrowing unsustainable sums off China and lectures China on its financial irresponsibility – in other words, selling its own currency and lending to America instead.

On the right, the Republicans wish to fix the deficit without reversing the Bush tax cuts on the rich, arguing any tax rises will hit the private sector.

Something in America and Ireland has to give. Even investors have to recognise tax rises must happen at some point. But where, and how, is provoking ferocious controversy.