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NORTHERN IRELAND ASSEMBLY COMMITTEE FOR ENTERPRISE, TRADE AND INVESTMENT

SUBMISSION TO THE REVIEW OF THE ROLE OF TAX POLICY IN SUPPORT
OF GROWTH AND INVESTMENT IN NORTHERN IRELAND BY SIR DAVID VARNEY

INTRODUCTION  
  1. This response to the Review of the Role of Tax Policy in Northern Ireland sets out the views of the Assembly Committee for Enterprise, Trade and Investment. The Committee welcomes this opportunity to respond to the review. Lower corporation tax is a critical step in the road to achieving a more balanced and dynamic economy. It is imperative that the Northern Ireland economy is able to improve its competitiveness and is empowered to move from a position which is based on low costs to one based on higher value added, innovation, creativity and high workforce skills. The Committee believes that a reduction in corporation tax would set this train in motion ultimately strengthening our private sector and reducing our undue economic dependence on the public sector.  
  2. The call for evidence, has requested that responses address the following areas:

This response addresses the three key areas outlined above and provides an evidence-based approach to the questions listed under each of the three headings. The Committee has primarily focused on issues it regards as most relevant to its area of work  

  1. In addition to the points made below, the Committee would also wish to refer you to the four reports by the Committee on the Preparation for Government of the Transitional Assembly (September 2006 - January 2007), sub-group on the Economic Challenges Facing Northern Ireland. In particular, the Committee would wish to draw your attention to the recommendations on fiscal issues contained in these reports. The reports were agreed by consensus by the five political parties represented on the Committee and its sub-group.
  2. In its first report, the sub-group acknowledged the need for radical change if the economy was to close the productivity and wealth gap between Northern Ireland, the rest of Great Britain and the Republic of Ireland. The Sub-group recommended that the Government needed to address the problems head on by establishing a fiscal environment that attracted much needed high productivity international companies and encouraged local businesses to develop and grow through research and development into the export market.
  3. In the second report, the recommendations focused on fiscal issues to alleviate Northern Ireland’s position as the UK’s poorest area (in terms of productivity and household income). It also highlighted the comparative priority for reduced corporation tax and/or R&D tax credits.
  4. The third report highlighted the key findings from Economic Research Institute of Northern Ireland, which highlighted the case for a competitive rate of corporation tax for Northern Ireland if the region was to successfully compete for FDI.
  5. The fourth report considered the Government’s response to the three reports and reiterated the need for Government to consider the benefits identified in the ERINI research. It concluded that corporation tax would quickly produce a Northern Ireland economy less dependent on a subvention from taxpayers in the rest of the UK.
  6. The following substance of this response will address issues identified in the Call for Evidence  
BACKGROUND
  1. Northern Ireland has historically lagged behind the rest of the UK in terms of its economic performance. Recent forecasts suggest that it will continue to do so for the foreseeable future. The region has had its economic development held back by over 30 years of societal divisions and political instability and currently has a GVA per capita equivalent to just 80 per cent of the UK average. Fundamentally, the local economy can be characterised by an imbalance in the contribution of the public and private sectors to economic activity. The private sector is relatively small in Northern Ireland with a bias towards relatively low value added sectors. This has resulted in comparatively low private sector wages with limited profit related activity, which is why there remains a lack of regional convergence. Consequently, the attraction of high-value added FDI to Northern Ireland has been identified as a means of restructuring the economy towards higher-value business sectors which would provide the opportunity for the fast track regional convergence desired by the Executive and HM Treasury.
  2. The case for a differential tax treatment in Northern Ireland rests upon the fact that existing policy measures are inadequate to attract substantial high-value FDI and promote true economic convergence with the rest of the UK. It is important to stress at the outset that the majority of fiscal incentives are materially different from a differential corporation tax rate and are designed to encourage the longer-term development of the local economy and local businesses in particular. This is not to say that they are not important if Northern Ireland is to develop a balanced economy, but they do not, on their own, offer the potential to rapidly transform the economy and significantly boost value added FDI.
  3. Northern Ireland ’s main locational advantage to date is in its relatively lower wage costs. In turn these lower wage costs attract FDI but only in those lower value adding sectors that depend upon lower wages. There are some exceptions to this, most notably in computer and related services, however, the overriding issue for external business investment is access to comparatively low wages (in the UK context). Location decisions reflect the underlying operating realities of most business sectors. Higher wage, higher value added sectors tend also to generate higher returns on capital (higher profits). In this regard the rate of corporation tax is critical and Northern Ireland has had to try to compete against a much lower corporate tax regime in the Republic. The paradox is that Northern Ireland has relatively high employment (708,000) and yet remains stuck at around 80% of average UK GVA per capita. This is because Northern Ireland is simply not able to compete in the attraction of the right kind of FDI. It can be argued that other lagging UK regions face the same FDI competitive challenge but the territorial dimension of the Northern Ireland situation adds weight to the campaign for a more competitive corporate tax regime. The economic challenge facing Northern Ireland is deeply structural in nature and there is a requirement for similarly structural policies to tackle it.
CALL FOR EVIDENCE QUESTIONS.
Effect of tax on business decision-making.
(a) Effect of the tax system on the sustainability of business growth in NI.
  1. There has been some recent research into the impact of lower corporation tax on the Northern Ireland economy. Analysis elsewhere also demonstrates the specific impact of a lower profits tax on small open economies, principally the RoI. It can be argued that Northern Ireland might have experienced a much more rapid rate of business growth if it had benefited from the demonstration effects of a large high-technology foreign-owned sector. For example, it is now acknowledged that one of the less celebrated aspects of the so-called Celtic Tiger has been the transformation in the performance of indigenous Irish businesses since the late 1980s. Eoin O'Malley, one of the leading researchers on Irish industrial performance observes that "Other sectors, and substantial parts of Irish indigenous industry, have had quite an impressive growth performance compared to other countries in the EU. But this has tended to be overshadowed by the exceptionally rapid growth of foreign-owned industry in Ireland". (O'Malley, 2005) The output performance of Irish businesses since the introduction of the broader 12.5% rate of corporation tax has been significant. Clearly a lower rate of corporation tax enables growth-oriented SMEs to undertake investments that would not be profitable at a higher rate of taxation and thus improve their output performance.
(b) The ability of the tax system to attract long-term investment in Northern Ireland.
  1. In its research report into the effects of a competitive rate of corporation tax on the Northern Ireland Economy, the Economic Research Institute for Northern Ireland (ERINI) found that an additional 184,000 private sector jobs would be created by 2030 (to help rebalance the public and private sectors in the NI economy), GVA growth would average 5% p.a. over the period and the net exchequer subvention would decline after 2013. Apart from the ERINI report, the Centre for Economic and Business Research (CEBR) research undertaken for the Taxpayers' Alliance (copy enclosed) shows a very strong relationship between the rate of corporate taxation in the UK and the level of FDI. Both the CBI and the IOD have expressed concerns in recent years about the UK's relatively uncompetitive corporate tax rate. Finally there is the evidence on our doorstep. Where would the Republic of Ireland's economy be today without a competitive rate of corporation tax? It can be argued that Northern Ireland possesses many of the other necessary characteristics to support higher volumes of higher value-added FDI as evidenced by Professor Frank Barry in his written evidence to the Committee on the Preparation for Government, November 2006:

"EU membership, a western European seaboard location and an English-speaking environment;

  1. Apart from a low and competitive rate of corporation tax, Northern Ireland is similarly endowed in terms of the factors of production to the Republic of Ireland and is in a position to benefit from FDI in much the same way as their near neighbours to the south.  
(c) Sectors that would benefit most from a differential tax policy.  
  1. There is some evidence to suggest that a number of sectors in particular would benefit from a lower tax regime - Information and Communications Technology (which includes software development), Creative and Digital Media and Financial / Business services.  In addition there is potential to expand the pharmaceuticals sector and to build upon the success in bio-sciences research at the two universities. The link between these sectors and high wages was well made in the “Second Report of the Sub-Group on the Economic Challenges Facing Northern Ireland”. Northern Ireland’s FE and HE institutions have for several years produced significant volumes of ICT graduates and most have found employment in GB’s and the Republic’s large ICT sectors.  
(d) Changes in tax policy and administration to promote sustainable growth and long-term investment in Northern Ireland.  
  1. There are several alternative approaches to using tax policy to promote investment and sustainable growth. They all share one common starting point mainly that Northern Ireland cannot compete with its near neighbour in the attraction of high value-added FDI and they are therefore designed to enhance the region's investment attractiveness.
    (i) Enhanced Tax Allowances.

    Apart from lowering the rate of corporation tax for Northern Ireland, a similar effect can be achieved by using enhanced tax allowances. For example if the first 55% of corporate profits in Northern Ireland were to be taxed at 0% and if the remaining 45% of profits were taxed at 28% this would give an average rate of 12.6%. There is a precedent for the use of enhanced tax allowances. In 1998 the Chancellor of Exchequer announced 100% first year capital allowances only for SMEs in Northern Ireland.

    The use of enhanced tax allowances would require the agreement of the European Commission. During his recent visit President Barroso pledged support for the new Assembly and Executive and announced the establishment of a NI Task Force with the Commission. HM Treasury should work with the Executive to address any state aid issues arising from financial incentives being granted uniquely in Northern Ireland. It should also be remembered that Northern Ireland has already been granted differential tax policy treatment on the basis of the disproportionate impact the border makes on the Northern Ireland economy. For example, Northern Ireland was uniquely granted a derogation from aggregates levy that was secured with state aid approval.

    (ii) Tax credits .

    The body of research on the effectiveness of R&D tax credits both as a mechanism for attracting FDI and for boosting the performance of existing businesses is mixed. Research by Harris (2006) showed that enhanced R&D tax credits improve the performance of existing businesses but that there is a significant time-lag between operating the tax credit and improving output performance. The scale of any improvement is also less than might be expected from a lower corporation tax regime. The research indicates there are so relatively few businesses currently in Northern Ireland that could avail of R&D tax credits that the measure might have limited effect. Nonetheless, the analysis indicated that gross output could be 10% higher if enhanced R&D tax credits are introduced in Northern Ireland.

    (iii) Other fiscal measures.

    The Business Alliance put forward a package of enhanced tax credits and allowances that they argued would collectively improve existing businesses and make Northern Ireland more attractive to foreign investors. Apart from the aforementioned research on the effects of R&D tax credits there is little in the way of hard evidence in support for using enhanced marketing allowances. Evidence from the United States suggests that enhanced training allowances can encourage greater investment in some business sectors. These other fiscal measures should be seen as complementary to and not as substitutes for a more competitive rate of corporation tax which this Committee believes is necessary to rebalance the economy. The introduction of 100% first year capital allowances would stimulate investment in some sectors such as tourism and hospitality in which it is recognised that Northern Ireland has potential and where initial capital costs can be a real barrier to growth.

    (iv) Double jurisdiction models

    This is a more radical model that would, in a sense, create an ' All Island' corporation tax regime. The Committee would want to consider this model further before arriving at a unanimous view on its merits and implications.

    The basic idea is that FDI companies locating in Northern Ireland would be allowed to pay corporation tax on profits made in the region in the ROI. This would be done by establishing a subsidiary in the ROI and transferring profits to it. The net result is that the company pays lower corporation tax and the 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. Northern Ireland gets additional jobs. To work this model clearly needs to be able to discriminate against existing companies and only extend the double jurisdiction treatment to new FDI or to genuinely mobile indigenous investment that threatens to move elsewhere. If this is not successful then there would obviously be a mass migration of tax to the ROI and very large losses to the UK. However, this might be countered by the ROI 'recycling' its windfall tax gains back to Northern Ireland in the form of higher public expenditure on agreed projects. Precautions would need to be taken to prevent HMT offsetting such investment by reducing the NI Block.

    A more limited version of this approach would be to allow firms already in the ROI to locate employment centres in Northern Ireland while continuing to pay corporation tax in the ROI. This would bring investment and employment benefits to Northern Ireland, provide tax and national insurance benefits to the treasury and relieve some labour/locational pressure in the ROI without threatening a run on investment or employment elsewhere.

National and International Context.
(a) The effect of the Republic’s tax policy on business in Northern Ireland.
  1. The lower corporation tax regime in the Republic of Ireland causes severe distortion of economic activity on this island. To illustrate, 24 of the Fortune 100 top North American companies have major manufacturing and production investments in the Republic of Ireland. Northern Ireland has perhaps a handful of such investments (DuPont, All State). Furthermore consider Newry and Dundalk. Newry’s economy is doing very well but is dominated by retailing, warehousing and distribution with very little manufacturing industry (Norbrook Laboratories excepted). Dundalk is also booming and it has lots of retailing, warehousing and distribution. It also has some significant FDI - Xerox, Littlefuse, ABB, Beckton Dickinson, Bose, Quantum Peripherals and Abbott Laboratories.

The distortionary effects of the Republic's low corporate tax regime may also be seen in the performance of Invest NI. On the positive side, Invest NI has been able to attract a reasonable share of UK FDI flows in recent years but a majority of these jobs has been in lower value added services such as shared services and call centres. Due largely to the lower rate of corporation tax in the Republic, Invest NI is not competitive in the attraction of higher value-added FDI. Recently one of the world's largest pharmaceutical companies announced the creation of 200 R&D jobs in Tipperary town. Northern Ireland could very well have supplied these jobs but stood no chance of persuading the company to invest here.

Unless there is significant change in the competitiveness of Invest Northern Ireland's FDI package Northern Ireland will continue to attract mainly lower wage lower value adding investment from overseas. In respect of attracting FDI Northern Ireland’s main comparative advantage remains its relatively low operating costs particularly wage costs. Northern Ireland's average annual private sector wage is just £15,235 pa which is 79% of the UK average and Northern Ireland has the lowest private sector wage of all the UK regions. Clearly this presents the region with difficulties in developing a high value added / high wage economy.   

(b) How and whether an ‘all-island economy’ would improve the business environment in Northern Ireland and what practical steps could be taken to move towards this.  
  1. Within the context of the single European market, greater integration of the two regional economies on this island is desirable. There has been some effective collaboration between the two jurisdictions in recent years. The joint promotion of tourism and the creation of a single energy market (due to begin later this year) are positive achievements and further co-operation is planned. Discussions between the Executive and the Irish government are progressing. There are limits to the extent to which such integration is practicable. As far as possible any economic integration should be driven by commercial advantage and market forces. A recent report "Comprehensive Study on the All-island Economy" set out the framework within which greater North-South economic co-operation should take place. This framework centres on the correction of market failure due to the existence of the border. If it can be demonstrated that a market failure exists and further if this market failure can be corrected more cost-effectively by the two jurisdictions working together then they should do so.

In recent years there have been significant changes in the ownership of businesses on both sides of the border; to this extent there has been some business integration. In terms of the two labour markets barriers to the free movement of labour such as social insurance differences should be examined by both administrations. There is also an argument for examining the extent to which Further and Higher Education and Vocational Education provision can be co-coordinated, for example, in the context of the Workforce Development Forum and establishing how best to build on this important area of mutually relevant work. Intertrade Ireland has been proactive in engendering greater levels of North-South business to business activity and it is expected to intensify efforts in the years ahead.

(c) Differences between Northern Ireland and other regions of the UK.  
  1. Northern Ireland is the only UK region that has a land frontier with the eurozone. Social cohesion is recognised as an important element in successful regional economies. Northern Ireland's hitherto lack of social cohesion has stifled its economy. In stark terms this is the only UK region that has had its economic development held back by 30 years of societal divisions and political instability. What other UK region contains such deep divisions within its population? These divisions are only now being addressed within a framework of power sharing and confidence-building.
  2. Northern Ireland is the only UK region that sufferers the distortionary effects of the Republic's tax system - not just in terms of corporation tax but also of excise duties, the aggregates tax etc. These represent real constraints on the competitiveness of the economy that are experienced more intensively here than in any other UK region. Even if Northern Ireland could compete eyeball-to-eyeball with the Republic of Ireland in terms of the quantity and quality of its labour force, its industrial relations, its energy costs, its transport costs, its training and vocational education system, a foreign investor might still choose to locate in the Republic to avail of a much lower rate of business taxation. 
  3. These factors have contributed to the imbalance in the Northern Ireland economy where given the small private sector, a disproportionate share of economic activity is generated by the public sector. The bias of the private sector towards relatively lower value added sectors has also resulted in lower private sector wages. One of the consequences of the region’s economic underperformance is the "brain drain" problem – the fact that 26% of Northern Ireland students leave and less than 1/3 return to Northern Ireland after graduation. However on a positive note, this does represent a pool of skilled labour and enterprise which could be encouraged to seek employment and business creation locally if the opportunities were made available.  
Other drivers that improve the business environment.
(a) The most important factors that have affected growth and investment in Northern Ireland.
  1. There is no doubt that Northern Ireland's growth and living standards have been constrained by more than 30 years of civil unrest and political instability. Research to be published by the OFMDFM will show that our economic performance has suffered because of societal divisions. FDI was deterred from locating in Northern Ireland during much of the 1970s, 1980s and early 1990s. It has been estimated that civil unrest cost over 27,000 jobs - equivalent to £225m in lost GDP over the 1983-2000 period. The same research suggests that up to £1.5 billion in tourism revenues were also lost during the period from 1976 to 2005. Tourism activity in Northern Ireland could be described as the Cinderella sector. Only now are we seeing anything like the tourism growth potential being fulfilled. It was unreasonable to expect the private sector to take risks, in addition to the normal commercial risks, during the period known as the Troubles.
(b) Non-tax interventions that are key to sustaining business growth and long-term investment in Northern Ireland.
  1. In its Second and Third Reports on the Economic Challenges Facing Northern Ireland, the Committee on the Preparation for Government highlighted the importance of education and skills formation in complementing industrial development policy. The committee made a number of recommendations including greater co-ordination within secondary and tertiary education to avoid a shortfall in the skills base to support in knowledge-based economy, the application of the lessons learned from the Republic's approach to education and skills development, the enhancement of Sector Skills Agreements and greater support for postgraduate study in the five key technology areas. 
17 July 2007  
References  

Harris, R, Q. Cher Li and M. Trainor, (2006) Assessing the Case for a Higher Rate of R&D Tax Credit in Northern Ireland ERINI Monographs No. 10.
NI Assembly (2006) Second Report on the Challenges Facing Northern Ireland, Committee on the Preparation for Government, October. NI Assembly (2006) Third Report on the Challenges Facing Northern Ireland, Committee on the Preparation for Government, November. O’Connor, TP. Foreign Direct Investment and Indigenous Industry in Ireland: Review of Evidence. ESRC, 2001.
O’Malley, E. (1995) An Analysis of Secondary Employment Associated with Manufacturing Industry, General Research Series Paper No. 167 ( Dublin: The Economic and Social Research Institute).
O’Malley, E. (1998) The Revival of Irish Indigenous Industry 1987-97, Quarterly Economic Commentary, April ( Dublin: The Economic and Social Research Institute).
O’Malley, E, (2004) Competitive Performance in Irish Industry in D. McCoy, D. Duffy, A. Bergin, S. Garrett and Y. McCarthy, Quarterly Economic Commentary, Winter, Dublin: The Economic and Social Research Institute.
Ruane, F. and Gorg, H. (1998) Linkages between Multinationals and Indigenous Firms: Evidence for the Electronics Sector in Ireland, Technical Economic Series, Paper No. 98/13 ( Dublin: Trinity College Dublin).