Further submission to the review of the role of tax policy in support of growth and investment in Northern Ireland by Sir David Varney
1. The Committee for Finance and Personnel made an initial written submission to the Varney Review on 25 May 2007, prior to a meeting between Committee representatives and Sir David Varney and his team. This initial submission commended the reports by the Committee on the Preparation for Government on the economic challenges facing NI. Following the Varney Review’s call for evidence from all interested parties, the Committee agreed that it would make a further submission to the Review. This was considered and agreed at the meeting on 4 July 2007.
The Committee’s Approach
2. Given that the Review’s call for evidence is open to all interested stakeholders, in the limited time available, the Committee agreed not to attempt to gather evidence from a wide range of groups. The Committee therefore contacted those organisations and individuals who contributed to the work of the previous economic sub-groups (set up by the Committees on the Preparation for Government and Programme for Government respectively) and who fell within the Committee’s broad remit. The purpose of this contact was twofold: to inform the stakeholders of the arrangements for contributing directly to the Review and to seek responses to the Committee on specific fiscal issues, which are detailed below. These fiscal issues relate to a number of the themes and issues set out in the Review’s call for evidence.
The Committee received responses from the following two key stakeholders:
- Economic Research Institute of Northern Ireland (ERINI); and
- Sir George Quigley, Chairman, Industrial Task Force.
A summary of the evidence from the respondents is provided below.
3. The Committee also contacted other relevant statutory committees in the NI Assembly to inform them of this approach, so that each committee would have the opportunity to focus on the issues in the Review, which fall within the remit of its respective department.
4. In addition, the Committee engaged with the Department of Finance and Personnel (DFP) on the proposed areas to be covered in the NI Executive’s submission to the Review. The Committee agreed with the overall approach of the Executive’s submission, and with the range of issues being covered, though the timing of the start of summer recess meant that the Committee did not have sight of the full submission before finalising this paper.
Summary of Evidence Received
5. ERINI and Sir George Quigley provided responses to the Committee on specific fiscal issues which the Committee believe the Varney Review will wish to consider. The Committee understands that both organisations intend to submit directly to the Review, but some of the key issues have been highlighted below.
Reducing the risk of ‘Brass Plating’ (whereby GB-based companies register in NI to avail of the lower corporation tax rate)
6. ERINI suggests the introduction of a ‘commensurate activity test’ for enterprises seeking to avail of a lower rate of corporation tax in NI. This would mean that the proportion of a company’s profit eligible for the lower rate of corporation tax would be commensurate with the underlying economic activity arising from the company’s permanent establishments in NI. It also highlights the fact that ERINI’s recent study on corporation tax does not rely on displacement of activity from elsewhere in the UK.
7. Sir George Quigley, Chair of the Industrial Task Force, points to various European court rulings introducing the notion of ‘genuine economic activity’ in a particular location as the criterion for assessing an entity’s tax status and suggests that this could be used to prevent abuse of a differential tax regime in NI.
8. The Committee is aware that the Inland Revenue tried and failed in the European Courts to stop Cadbury Schweppes from relocating part of its UK operations to the Irish Republic. However brass plating did not occur on the scale expected in RoI.
Regulation of Transfer Pricing (to prevent companies from artificially shifting profit to NI)
9. ERINI states that the legislation already exists to control this practice should NI acquire a lower corporation tax and also refers to the fact that the scale involved would be very modest. It states that HMRC have extensive experience of policing transfer pricing and constantly change the legislation as new schemes are devised by companies.
10. Sir George Quigley does not see this as an issue as UK legislation is already in place to prevent undesirable transfer pricing practices within the UK in the same way as they have been controlled in transactions across borders.
Short-Term Revenue Loss versus Long-Term Gains
11. If a lower corporation tax rate is achieved by NI acquiring corporation tax powers in legislation, the Azores ruling means that the short-term loss of revenue resulting from the lower tax rate will have to be met from the resources of the devolved administration. The Committee believes, however, that the NI Executive can address any revenue shortfall positively and in a prudent and balanced way.
12. ERINI argues that NI public expenditure is not constrained by revenue raised in the region so the existing amount of corporation tax attributable to NI is irrelevant to the Executive. It has identified various options for managing any short-term loss of revenue, including restricting the application of lower corporation tax (e.g. deny the concession to retail banks or utility companies because of their market power) or collecting more revenue from taxes and charges under the Executive’s control.
13. The Committee concludes that the issue of any short-term revenue loss is ultimately a matter for the Executive and should not, therefore, feature in the Review’s considerations. In the view of the Committee, there is a range of options open to the Executive, not least the fact that, if NI achieves a lower rate of corporation tax, there may be potentially significant savings from efficiencies (building upon the present 3% across-the-board efficiency savings target) and as some of the current economic policies may no longer be relevant. Moreover, the Committee contends that any consideration of short-term revenue loss should not lose sight of the longer-term benefits accruing from a reduced rate of corporation tax.
14. The ERINI Report Assessing the Case for a Differential Rate of Corporation Tax in Northern Ireland (November 2006), concludes that halving corporation tax in NI would set in train changes in the economy through new investment and increased activity that would reach break even in tax terms in 2013, after incurring an initial cost of £310m in the first year. Beyond 2013 there would be a net gain to both NI and UK public finances. ERINI projected around 184,000 additional jobs under this scenario by 2030, compared to base forecasts which assume no change in existing policies, producing an extra £30bn GVA. GVA growth would average 5% per annum over the forecasts, representing a doubling of the present growth rate and significantly reducing the prosperity and productivity gap with the UK. The latter could be eliminated in a decade.
15. The Committee believes that the additional jobs arising from increased FDI would correct the recent pattern in NI of low value-added and low paid jobs, by creating significant numbers of high value-added and higher paid jobs, which would have the added benefit of enabling NI to retain more of its graduates. In short, the Committee considers that the benefits of a lower rate of corporation tax in NI far outweigh the costs, both for NI and for the UK.
16. The Committee was aware of the risk of the self-employed forming companies simply to avoid income tax in favour of low corporation tax and asked how this might be addressed. ERINI’s submission states that the solution lies in the tax treatment of dividends, as this is the means used to obtain income by the newly incorporated self-employed. It recommends the approach adopted in RoI, where dividends are treated on a par with income for taxation purposes, and thus self incorporation is not regarded as a significant problem.
17. Sir George Quigley sees this being prevented by adjusting tax levels on the earnings from the incorporated entity and, similar to ERINI, points to the success of RoI in preventing such abuse. He states that anyone worse off should be allowed to opt to remain in the existing regime.
Responsiveness of FDI to reduced corporation tax in NI
18. ERINI points to the huge academic literature on the relationship between corporation tax and the attraction of FDI, which is supported by those who own and run FDI companies and the agencies whose job it is to attract them. Whilst ERINI accepts that other factors are important for location decisions such as workforce skills and infrastructure, it highlights that, other things being equal between two regions, the one with the lower corporation tax has an enormous advantage. According to ERINI, the average effective rate of corporation tax is more important than the statutory rate and RoI has an effective rate which is half that in the UK.
19. Sir George Quigley advocates the Assembly economic sub-group reports (and the accompanying evidence) to which the Varney Review has already been referred, and the ERINI report on corporation tax as evidence that a competitive corporation tax rate would enhance NI’s ability to attract high value-added, export-driven FDI on a scale to make a very significant difference. He points to a mass of published research on the worldwide importance of company taxation as a crucial factor in the location decisions of multinationals and to the RoI experience as fully validating the case for the efficacy of corporate taxation. The Republic’s current stance on European moves towards harmonisation of the tax base, he says, further demonstrates its determination to fight to retain its tax competitiveness. Sir George Quigley argues that countries, such as the Baltic States, model themselves on the Republic and successfully use the tax weapon in their campaign to access FDI.
Legislative and administrative arrangements for devolved administration in NI to exercise powers in respect of corporation tax
20. ERINI state quite rightly that the arrangements to be implemented depend on the chosen route for implementing a competitive corporation tax regime, but that the one suggested in the Azores judgement, by the European Court of Justice, which would mean transferring tax legislation powers to NI is the most complex of the options.
21. Sir George Quigley has pointed out that the Government has already stated in its evidence to the Assembly economic sub-group that it would be for Treasury to work out what would be necessary for compliance with the Azores judgement. He notes that the devolved administration would need power to levy corporation tax only if the arrangements envisaged in the Azores case were adopted and that the legislation to confer such powers should be fairly straightforward. In the view of Sir George Quigley, it would be sensible that the existing UK tax authorities should collect the tax on behalf of the devolved administration, rather than setting up separate arrangements.
22. The Committee considers the Azores judgement to be an issue for the UK, as opposed to the EU, and considers that a solution should be found to enable NI to continue to operate within the state aid limits set down by the EU.
Alternative approaches for achieving a competitive rate of corporation tax
23. ERINI suggests the addition of a ‘Northern Ireland Allowance’ to corporation tax calculations. This would be a deduction from taxable profit (calculated in the usual way) after which the full appropriate UK tax rate would apply (e.g. if the Allowance was 55% then the effective tax rate for large companies would be 45% x 28% = 12.6%). This would constitute state aid within the meaning of Article 87 of the EU Treaty and would necessitate derogation from the European Commission.
24. ERINI also provided the Committee with its paper on Differential Corporation Tax in Northern Ireland: Analysis and Policy, which examines variants on the lower corporation tax theme, in contrast to the conventional model which simply lowers the rate in NI to match that in RoI. These options are briefly summarised below:
(i) Discounted Tax Base
This is the option described above, which allows the integrity of the UK national corporation tax rate regime to be maintained but achieves a lower tax in NI by discounting part of the tax base for the purpose of corporation tax calculation. This is similar to the enhanced capital allowance levels applying to smaller firms in NI between 1998 and 2002.
(ii) Restricted Access Models
The Azores judgement obscured the fact that the European Commission had no objection to a lower corporation tax rate in the Azores for non-financial business. They were particularly concerned about ‘inter-group’ financial activities (profit shifting with no underlying economic activity). This model goes some way to alleviating EU concerns by preventing certain elements of NI’s financial services sector from accessing lower corporation tax (e.g. retail banks). As such banks are a major source of existing corporation tax payments, the option also reduces revenue losses from introducing a lower rate. ERINI’s view on this model is that the banks would complain, but are already very profitable and would gain even more from the additional activity brought about by the lower corporation tax regime. A further extension of this model could include industries with local monopoly positions (e.g. gas and electricity companies), since they can manipulate profit to some extent and essentially serve the local market. This model would need a specific derogation from the European Commission as it discriminates against particular forms of business.
(iii) Double Jurisdiction Models
This is a more radical model effectively creating an All-Island corporation tax regime, whereby FDI companies locating in NI would pay corporation tax on their profits in RoI, by establishing a subsidiary in the Republic and transferring profits to it. The net result is:
- the company pays lower corporation tax;
- RoI gets additional corporation tax revenues even though the profits were not made there;
- the UK Exchequer gets additional income tax, national insurance and VAT; and
- NI gets additional jobs.
ERINI’s view is that, to be effective, the model needs to be able to discriminate against existing companies and limit the double jurisdiction treatment to new FDI, or to genuinely mobile indigenous investment that threatens to move elsewhere. If not, there could be a mass migration of tax to the Republic and very large losses to the UK. ERINI sees this as a second best model as NI has no prospect of eventually collecting more corporation tax. However this could be countered by the Republic recycling its windfall corporation tax gains back to NI in the form of public expenditure on agreed projects.
The Committee noted the variety of options presented by ERINI.
25. Sir George Quigley considers EU derogation as the preferred route but sees the issue as one for the Government, after the principle of a lower corporation tax for NI is established.
Scope for improving tax credits to attract FDI and increase productivity
26. ERINI explains that tax credits are incentives that operate at the margin of activities undertaken by firms and as such are not really designed to influence location decisions. ERINI states that it is wrong to view a suitable package of tax credits as a substitute for a competitive corporation tax rate and points to the report by Professor Harris on R&D tax credits as the only available study on the effects of a differential tax credit. He found that if the enhancement was very great there would be positive benefits but over a long period of time and he did not identify enhanced R&D tax credits in NI as a serious instrument for attracting FDI on a significant scale.
27. The report by Professor Harris, titled Assessing the Case for a Higher Rate of R&D Tax Credits in NI and submitted to ERINI in January 2006, concluded that a doubling of R&D tax credits would lead to increased R&D activity and feed through to improved value added and profitability. The fact that the lead in time is perhaps 6-7 years and that the effects may be relatively modest in terms of projected improvements in productivity reflects the current low levels of R&D activity, the inability of SMEs to absorb the benefits of such activity and the structure of the NI economy. Professor Harris noted the very low uptake of the existing tax credit and concluded that firms were either unaware of their eligibility or thought it not worth applying for. Oral evidence taken by the Assembly economic sub-group suggested the latter to be the case. He also reported that when firms were asked about the most effective incentives that the public sector could provide to encourage a higher level of R&D activity, only 3% of firms opted for R&D tax credits.
28. The Committee is aware that the Review Team sought clarification from Professor Harris on his report. His response was copied to the Committee and it was noted that Professor Harris has pointed out that, whilst ‘improving take up may indeed help to increase R&D spending … this would not result in Northern Ireland catching up with other regions’.
29. Sir George Quigley is unaware of any evidence to suggest that tax credits are an effective tool for attracting FDI and also highlights the Harris report as the authoritative study for NI. He points out that the report concludes that it is a long, incremental process and that the impediments to progress are not necessarily the costs which companies would incur on R&D. Sir George Quigley questions whether fiscal incentives to encourage companies to undertake R&D, training or marketing are any more attractive, or effective, than a straightforward grants scheme and points to the fact that the Harris research included evidence that companies preferred a grants scheme to fiscal incentives.
Other fiscal measures to attract FDI
30. ERINI suggests both the possibility of enhanced capital allowances, though these would not be an enormous advantage where a company is not capital heavy, and the more radical approach, specifically for financial services, of reducing stamp duty on certain transactions. However it suggests that an equivalent grant scheme would probably be just as effective.
31. Sir George Quigley is not aware of any fiscal measures which could be used to attract FDI which would compensate for the lack of effectiveness on corporation tax, nor does he think it likely that the Government would find another acceptable fiscal measure if it is averse to NI having a competitive corporation tax regime.
Additional fiscal measures to increase productivity of existing NI businesses
32. ERINI sees no obvious additional tax candidates but is of the view that much could be done on available expenditure instruments, including reform of the Selective Financial Assistance scheme. It commends RoI’s Productivity Improvement Fund for indigenous companies as a flexible and tailored way of effectively helping companies willing to work towards improving their productivity/export performance. The Fund assists Enterprise Ireland’s SME clients to build greater competitiveness by improving their export potential, with the intention that a sustainable productivity improvement will be embedded in recipient companies, thereby establishing a base from which they can develop their exports. Activities which can be supported include: capital; technology acquisition; training/management development and workplace innovation, with the total available funding of 500,000 euros for one project. This is a competitive fund, with payments in the form of a grant, or a repayable grant for capital, 50% of which will be repayable 3 years after each grant cheque is issued. Sir George Quigley also highlights this scheme as offering companies very flexible options to address whatever deficiencies prevent them from successfully accessing export markets. Enterprise Ireland, he says, is achieving considerable success in boosting R&D performance of its client companies and enhancing their export growth.
NI Executive’s Submission
33. As alluded to above, the Committee has been briefed on the approach to the Review which DFP will propose to the Executive. The Committee supports this approach and believes that the Executive’s submission will provide the Review with a comprehensive and robust consideration of the pertinent issues.
34. The Committee understands that the Executive will prioritise supply side issues relating to the NI economy and that action will be taken to ensure that the skills and infrastructure necessary to support the economy are in place. In relation to the supply side, the issue of high levels of economic inactivity in NI was raised during discussions with DFP officials and the Committee enquired whether one possible approach to addressing this would be to seek higher levels of working family tax credit and child tax credit specific to NI, to encourage a return to the workplace. The Committee is aware that this is a reserved matter, but believes it to be within the terms of reference of the Review and worthy of consideration.
35. It is in relation to the demand side of the economy that the Executive needs assistance, in the form of fiscal incentives, particularly a lower rate of corporation tax, to increase FDI and boost productivity. The Committee understands that recent forecasts from the Economist Intelligence Unit are very encouraging in relation to growth in the levels of FDI, and considers that this further underpins the case for fiscal incentives.
Conclusions and Recommendations
36. In relation to corporation tax, the Committee believes that the case has already been well made and that compelling empirical evidence exists as to how a lower corporation tax would increase FDI and improve productivity in NI. The Committee has already referred the Review to the reports made by the economic sub-group to the Committee on the Preparation for Government and to the ERINI research report on corporation tax. It would also draw attention to the recent report from the Centre for Economics and Business Research on behalf of the Taxpayers’ Alliance on the impact of changes in corporation tax rates on investment. The Committee also notes the previous Chancellor’s commitment to international competitiveness on business taxation in his last Budget statement.
37. The Review must also take account of the fact that NI is in direct competition with the lower corporation tax rate in RoI and how that economy has benefited from the policy. The fact that RoI Ministers are extremely concerned with the European Union Commission’s potential tax policy to unify corporation tax across Europe reflects the importance which the Irish Government still attaches to a low rate of corporation tax. The Committee understands that the Review Team recently visited Dublin and was informed of the support in RoI for a lower rate of corporation tax in NI.
38. The evidence indicates that solutions can be found to the legal and administrative barriers to providing NI with a competitive rate of corporation tax. In the Committee’s view, Treasury has both the expertise and the resources to address positively the legal and administrative barriers to a reduced corporation tax in NI. The Committee believes that the issue now is whether the political will exists within the UK Government to recognise the unique circumstances in NI and acknowledge that its ‘one size fits all’ approach for the UK is inappropriate for the NI economy.
39. The Committee received a paper by the University of Ulster economist, Mike Smyth, which demonstrates the need for flexibility in regional policy within the UK. It also shows that NI’s headline gross value added per head remains static and is showing no sign of moving closer to the UK average. The convergence of unemployment rates in the UK reflects the growth in relatively low paid, low productivity service sector jobs in the UK regions and this is what has happened in NI in particular.
40. The Committee agrees with ERINI’s views on the proposal for greater focus on tax breaks for inputs to the production process (e.g. enhancing or extending breaks such as capital allowances and R&D tax credits to cover activities such as training expenses or marketing costs). It is not correct to equate these tax adjustments with the impact of a lower rate of corporation tax. Adjusting taxes on the factors that go into the production process is not the same as altering a tax to influence the strategic location decisions of multinational companies.
41. The Committee does not see amendments to the tax system to reduce expenditure incurred by companies on inputs such as R&D, training and marketing as an alternative to a reduction in the rate of corporation tax. It agrees with Sir George Quigley that the latter is universally accepted as an important means of influencing the location decisions of multinationals and the former are not. The Committee also notes the point by Sir George Quigley that the Harris research argued a strong case for operating an FDI strategy to attract larger companies more likely to have the capabilities to undertake R&D in higher value-added areas, but did not suggest that this would be best achieved by deploying an R&D tax credit scheme.
42. The Committee believes that a tax credit concession on its own, which might be taken up by some companies (many of which will already be doing the R&D, training and marketing which are part of a successful company’s agenda) will leave NI without the tax competitiveness to access FDI sufficiently to get onto a new economic trajectory which only a reduction in corporation tax can deliver. Also, on the basis of the experience to date, the Committee considers that the current suite of economic instruments available will not deliver economic convergence with other parts of the UK.
43. In conclusion, the Committee calls upon the Review to take full account of:
- the weight of evidence in support of the case for NI having a competitive rate of corporation tax;
- the availability of different options for achieving a competitive rate of corporation tax in NI; and
- the range of approaches to overcoming any associated legal or administrative barriers.
Whilst recognising the value of additional fiscal incentives and other measures to boost the NI economy, the Committee sees these as a complement, rather than as an alternative, to a competitive rate of corporation tax.
The Committee awaits the outcome of the Review in the autumn and will carefully examine the conclusions and recommendations together with the evidence on which they are based.