This paper considers elements of macroeconomic policy central to Ireland’s objective of being among the first countries to enter into European Economic and Monetary Union. The paper analyzes the main determinants of the Irish pound/sterling exchange rate, an issue brought to the fore by the currency turbulence of March 1995, which saw a sterling-inspired decline in the Irish pound against the deutsche mark. It also considers fiscal developments and prospects, highlighting tax reform measures undertaken to accelerate job creation, the growth of spending in recent years, and the medium-term fiscal outlook.

Abstract

This paper considers elements of macroeconomic policy central to Ireland’s objective of being among the first countries to enter into European Economic and Monetary Union. The paper analyzes the main determinants of the Irish pound/sterling exchange rate, an issue brought to the fore by the currency turbulence of March 1995, which saw a sterling-inspired decline in the Irish pound against the deutsche mark. It also considers fiscal developments and prospects, highlighting tax reform measures undertaken to accelerate job creation, the growth of spending in recent years, and the medium-term fiscal outlook.

V. The Significance of Transfer Pricing in Ireland and Its Impact on Output Estimates 1/

1. Introduction

The Irish economy has experienced a very rapid expansion of its multinational sector during the 1980s and early 1990s. Multinational companies (MNCs) currently account for around 70 percent of Ireland’s net manufacturing output and have been the main driving force behind the country’s export growth and substantial trade surplus. Yet, the fact that this rapid growth of the foreign-owned sector has taken place under the shelter of a generous tax regime raises questions about the extent to which MNC activities in Ireland have been driven by transfer pricing and about the resulting implications for key macroeconomic statistics.

The objective of transfer pricing is to minimize the worldwide tax bill of a MNC by shifting taxable profits from high to low tax countries. This can be done through intra-firm transactions on terms which would not apply if the firms were at “arm’s length.” For instance, a subsidiary operating in a low-tax country can artificially inflate its profits by understating the price of its inputs purchased from a subsidiary in a high-tax country or by overstating its sale prices for subsidiaries in high-tax countries. Since tax rates on manufacturing activities in Ireland are among the lowest in the OECD, 2/ there is an incentive for locating and declaring profits there.

One side-effect of transfer pricing is the distortion it imparts to official statistics for production and exports. 3/ As the transferred profit is included in the value added reported by those firms, net output figures in the low-tax country are inflated accordingly. The higher the participation of MNCs in the domestic economy and the more these firms are engaged in such practices, the more distorted official statistics tend to be. Also, if the presence of MNCs in the economy increases or decreases over time, transfer pricing will distort not only the reported level of output but also its growth rate.

Section 2 presents evidence on the existence of transfer pricing in Irish manufacturing using the most recent census data. A review of the existing estimates of transfer pricing in Ireland and the extent to which transfer pricing appears to distort official statistics is presented in Section 3. Section 4 concludes by arguing that transfer pricing distortions are largely eliminated if one uses GNP rather than GDP as a measure of aggregate output.

2. Evidence of transfer pricing in Ireland

Prima-facie evidence of the existence of transfer pricing in Ireland can be gauged from cross-section data on manufacturing. 1/ As shown in Table 5, net output per person in the foreign-owned manufacturing sector is two to three and one half times higher than in the indigenous manufacturing sector. Over 64 percent of the gross output of foreign firms is exported, as opposed to only 33 percent by indigenous firms. These differentials in both labor productivity and export shares are especially large when one focuses on non-EU foreign companies. Output per head in non-EU firms is over three and one half times higher than that of indigenous companies and 93 percent of their gross output is exported.

Table 5.

Ireland: Manufacturing Industry by Ownership, 1990

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Source: CSO, Census of Industrial Production, 1990.

While the large differences in export shares between non-EU foreign-owned and indigenous firms can be explained by the fact that the former use Ireland as an export platform for entry into EU markets, the large productivity differential between non-EU firms and the remainder of the industry is hard to rationalize. One possible reason is greater capital intensity. However, this still leaves unexplained the substantial productivity gap between non-EU and EU foreign firms; as both tend to be highly capital intensive, the large gap between them is difficult to explain solely on the basis of relative capital intensities or of differences in total factor productivity. 2/

A counterpart of the very high productivity levels in the foreign-owned sector is the fact that its profit rates tend to be remarkably high, not only compared with the indigenous sector but also relative to MNCs in other countries. After deducting wages and salaries, interest and depreciation, and the expenditures on services, profits averaged 34 percent of the net output of foreign firms; this contrasts with an average profit rate of 4 percent for indigenous manufacturing. 1/ Some relevant international comparisons are provided in Table 6. Rates of return of U.S. manufacturing firms operating in Ireland are reported to have been over twice as high as the average for twelve EU countries and over three times higher than the rate of return of U.S. firms operating in the United Kingdom in 1992. 2/

Table 6.

Ireland: Comparative Performance of U.S. Investment

(In percent)

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Source: “Survey of Current Business” July 1993 and “U.S. Direct Investment Abroad: 1989 Benchmark Survey,” Bureau of Economic Analysis, U.S. Department of Commerce.

Net assets include net property, plant and equipment. Based on figures for 1989.

The high import content of output by foreign firms constitutes an obvious channel through which transfer pricing can take place. According to IDA data, 3/ only about 30 percent of inputs used by foreign firms are purchased in Ireland, as opposed to 70 percent by indigenous industry. It has also been observed that such shares have remained relatively stable over the past decade, 4/ thus suggesting that these firms have not developed local linkages as foreign firms in other countries usually do. In particular, a large part of the gross output of these firms is spent on imported services. Imported services account for nearly 30 percent of total expenditure on services by foreign firms (about 9 percent of their output), as opposed to an average of 12 percent for indigenous firms (5 percent of their net output). 5/ Service trade is also more difficult to price than commodity trade, making it difficult for custom authorities to assess whether it is being undertaken at arm’s length. Data presented in Table 6, indicate that U.S. MNCs in Ireland have higher rates of return than those located elsewhere and spend proportionately greater amounts on services imported from the parent company. 6/

3. Estimates of transfer pricing in Ireland

As pointed out above, transfer pricing masks the true contribution of the MNCs to domestic economic activity. It attributes to the national economy value added generated elsewhere and, in doing so, tends to distort official data on output and other related statistics.

Several attempts have been made to measure the extent of transfer pricing in Ireland. Although no one doubts that the bias on output is in the upward direction, there is no commonly agreed estimate. All existing methods should be seen as tentative, as they involve a number of assumptions whose validity is disputable. This section presents a range of likely estimates which provide a lower and upper bound to the actual magnitude of the phenomenon, with a view to choosing the one that appears to be the most operational.

One estimate is based on the assumption that the unexplained large productivity differential between EU and non-EU foreign firms is entirely due to transfer pricing. In other words, the “true” labor productivity in the non-EU foreign sector in Ireland should be the same as actual labor productivity in the EU foreign-owned sector. Based on data from the 1990 industrial census, such “excess” of profit in the non-EU foreign sector amounts to 47.6 percent of the reported net output in that sector. Since foreign non-EU firms account for 53 percent of total manufacturing net output, this excess profit imparts a 25.3 percent upward bias to the official statistics on total manufacturing net output. This is equivalent to 8.3 percent of GDP.

The main shortcoming of this method, however, is that it makes no allowance for possible transfer pricing by EU foreign firms. An alternative pursued by some analysts is to focus on particular industries which are more likely to be engaged in transfer pricing. In an early study of the pharmaceutical industry, Honohan (1984) 1/ finds that its capital stock as a proportion of the capital stock in manufacturing is much lower than the share of pharmaceutical output in total manufacturing output; this implies that a substantial chunk of profits in that sector is left unexplained and thus likely to be associated with transfer pricing. The author then identifies four other sectors with abnormally low labor share in value added and assumes that transfer pricing accounts for all the deviations from the average labor share of manufacturing. Based on these findings and assumptions, Honohan estimates that transfer pricing amounts to 12 1/2 percent of recorded industrial output or about 5 percent of GDP.

A similar approach was adopted in more recent studies by McGuire (1990) and Conroy (1994). 2/ Both single out a few sectors in which labor productivity in Ireland is far higher than the EU average for those sectors. McGuire focuses on pharmaceuticals, office and data processing equipment, soaps and detergents, and engineering instruments. The difference between Irish value added per head and the weighted EU average for each of these sectors is multiplied by the number of Irish employees in the respective sector; this would yield an upper bound for transfer pricing in each of these sectors. Yet, McGuire notes that part of these productivity differentials is due to a higher investment per person in these sectors in Ireland, 1/ relative to the EU average. After allowing for this effect, the author arrives at an excess profit of 7 percent of total net manufacturing output, which is entirely attributed to transfer pricing. This would impart a 2 1/2 percent upward bias to GDP for that year (1986).

Conroy’s (1994) estimates focus on four sectors: pharmaceuticals, office and data processing equipment (ODP), Audio-video, and miscellaneous foods. Labor productivity in these sectors is far higher than the respective EU average—2.5 times higher in ODP and over 7 times higher in miscellaneous foods. Assuming that such large differentials are due to transfer pricing and that the “true” labor productivity in these sectors in Ireland should equal the EU average, it is estimated that net manufacturing output is artificially inflated by 28.7 percent. This is equivalent to 9.5 percent of GDP. 2/

One important limitation of these sector-based estimates is coverage. By focusing on a few industries, McGuire and Conroy may be leaving out other manufacturing firms engaged in transfer pricing. A widely-used alternative is then to use aggregate data on profit remittances from foreign direct investment. Since the bulk of these flows is associated with foreign direct investment in manufacturing, a comparison with previous estimates is straightforward. 3/ Moreover, data from balance-of-payments statistics are produced on a more regular basis allowing frequent updating of the respective estimates. Taking the year of 1990 for comparability purposes, the gross remittance of profits, dividends, and royalties amounts to 31.9 percent of net manufacturing output. This is equivalent to 10.5 percent of GDP.

In addition to being easily available, the latter indicator has other major advantages. First, its two potential biases pull in opposite directions. On one hand, profit remittances exaggerate the magnitude of transfer pricing insofar as repatriated profits also include an amount of genuine profit repatriation by MNCs. On the other hand, remitted profits would not include the part of the surplus associated with transfer pricing which is retained in Ireland. Casual evidence suggests that non-repatriated profits are indeed substantial—about one fifth of total profits in the foreign-owned sector. 1/ Thus, these two biases in the profit remittance indicator offset each other, at least to some extent. The fact that this estimator yields results within the range suggested by the sector-based approaches discussed above provides further support for its use.

Second, the use of profit remittances as a proxy for transfer pricing allows for the fact that transfer pricing may increase or decrease over time as a proportion of manufacturing output and GDP. This in fact appears to be the case, if judged by the percentage share of gross profit remittances in GDP—this ratio rose from 2.7 percent in 1980 to 9.2 percent in 1992. 2/

Last but not least, an implication of accepting gross remittances of profits, dividends, and royalties as an indicator of transfer pricing is that GNP figures would be largely free of such distortions. This is because gross profit remittances are included in net factor payments abroad and thus automatically subtracted from net output in the process of calculating GNP. Thus, the use of GNP figures would provide a “safe”—albeit conservative—estimate of the actual level of net value added in the domestic economy. 3/

A summary of the distinct estimates of transfer pricing in Ireland is reported in Table 7. They span from just over 2 percent (McGuire) to nearly 10 percent of GDP (profit remittance method), with the most recent estimates tending more towards the 10 percent figure—approximately the gap between GDP and GNP.

Table 7.

Ireland: Estimates of Transfer Pricing

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4. Summary and conclusions

This chapter has documented the incentives for transfer pricing in Ireland and pointed to possible channels through which it can take place. Transfer pricing can impart substantial biases to reported output and other related statistics and so can affect the assessment of a country’s economic performance. It is therefore important to try to estimate the magnitude of the phenomenon in Ireland. This chapter has reviewed two sets of methods—those based on comparisons of productivity and profit rates across sectors and countries, and that based on aggregate profit remittance figures. It has been argued that all the existing methods have shortcomings, as they are based on strong assumptions about “normal” patterns of profit rates, productivity gains, profit repatriation and other payments abroad. It is not surprising, therefore, that the resulting estimates for Ireland range from 2.25 percent to about 11 percent of GDP.

Of all the proposed methods to estimate transfer pricing, it appears that the one based on subtracting gross profit remittances from GDP is the most operative and also yields sensible results. In addition, acceptance of the profit remittance method has two important implications for the interpretation of two key indicators of Irish macroeconomic performance. Since gross profit remittances are automatically included in the computation of the current account balance, Ireland’s current account figures should be largely free of transfer pricing distortions. By the same token, GNP figures should also be immune to transfer pricing distortions. This suggests that GNP, rather than GDP, should be the preferred measure for both the level and the rate of growth of domestic activity.

1/

Prepared by Luis Catão.

2/

Ireland has a preferential tax rate of 10 percent for manufacturing and certain internationally traded services. Moreover, foreign firms installed in Ireland have traditionally benefitted from substantial government subsidies and grants from the Industry Development Agency (IDA). Both are part of an industrial policy aimed at making Ireland an attractive destination for foreign investment—a strategy consistently pursued since the 1960s. The Irish government is committed to keeping the 10 percent preferential tax rate for manufacturing until 2010.

3/

Other important implications include disincentives for the development of backward and forward linkages within the domestic economy and limited scope for technology transfer. Transfer pricing favors the expansion of the assembly stages of the production process in the low-tax country and discourages local purchases of intermediary inputs as well as production for the home market. Cost-intensive activities—such as R&D or labor-intensive services—are also discouraged, as tax deductions on such expenditures are higher in high-tax countries. An analysis of these issues, however, is beyond the scope of this chapter.

1/

Transfer pricing practices may also be present in services but the lack of more detailed data on service activities prevents a systematic investigation of the issue.

2/

This unexplained productivity difference between EU and non-EU firms operating in Ireland will form the basis for estimates of transfer price presented in Section 3.

1/

These figures also refer to the year of 1990. Earlier IDA figures, available for 1984, indicate that profits accounted for 39 percent of the net output of foreign firms, as opposed to 6.5 percent for indigenous manufacturing.

2/

US Department of Commerce, Bureau of Economic Analysis, Survey of Current Business (June 1993).

3/

Reported in Kennedy, K.A., “Linkages and Overseas Industry” in Foley, A. and D. McAleese, Overseas Industry in Ireland, Dublin, 1991.

4/

See ibid.

5/

According to the latest data from IDA’s Irish Economy Expenditure Survey of 1990.

6/

This can be seen by comparing royalties and other receipts by Irish-based U.S. firms with that of the total for U.S. firms abroad. While the payment of royalties, license fees and imported services by Irish subsidiaries account for 19 percent of worldwide U.S. receipts on these items, the net asset value of Irish-based U.S. firms represents only 1 percent of the worldwide net assets of U.S. manufacturing firms abroad.

1/

Honohan, P. “Transfer Pricing in Ireland - A Cautionary Note,” Central Bank of Ireland, Research Paper 2R/84, 1984.

2/

McGuire, M. “Transfer Pricing and its Effects on Economic Indicators,” Central Bank of Ireland, mimeo, 1990; Conroy, C. “Low Labor Content Sectors: Implications of the Interpretation of Macroeconomic Data”, Economic and Social Research Institute, mimeo, 1994.

1/

This implicitly assumes that factors such as differences in managerial efficiency are negligible. This may not be unrealistic in light of the very low barriers to flows of managerial manpower across the EU.

2/

These estimates were obtained using data from the latest available industrial census (1990).

3/

Although available BOP data do not permit a sectoral disaggregation of these flows.

1/

If these companies use Ireland as a platform for the European market, there are advantages in retaining part of the profits in Ireland to fund future investment in the EU.

2/

Comparability with 1993 figures is more hazardous due to the introduction of the INTRASTAT system, following the abolition of custom controls within the EU from January 1993.

3/

Net factor payments abroad have been somewhat higher than the gross remittance of profits, interest and royalties. Taking the year of 1990 for comparison purposes, the difference between GDP and GNP—i.e., net factor payments abroad—was IR£3,197 million, or 11.6 percent of GDP.