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Ireland Vol.7 (FDI and Irish Economic Development over Four Stages of European Integration)

Here is also a paper, FDI and Irish Economic Development over Four Stages of European Integration (PDF, January 2006) | Frank Barry, University College Dublin. Underlines, italicization, excerpts, et al. are on our own.

  1. Introduction

Ireland is the most FDI-intensive economy in Europe.  Foreign-owned firms account for almost 50 percent of Irish manufacturing employment.  This compares to an average figure of 23 for the Western European EU member states and a figure of 33 for the three largest Central and Eastern European economies.  Of the 17 EU countries plus the US and Norway for which OECD (2005, E7) provides data, Ireland also records the highest share of services-sector employment in foreign-owned firms.  These figures are reflected in the value of the stock of foreign direct investment (FDI).  Per head of population, the Irish inward FDI stock is a multiple of the EU average.

The distinguishing feature of the country’s development strategy over the last four decades of outward orientation has been the emphasis placed on attracting FDI.  The country had been remarkably successful in this regard even before the “Celtic Tiger era” of the 1990s and beyond.  Having stumbled upon the strategy, it turned out with hindsight to accord well with Ireland’s advantages:  its Atlantic location and English-speaking environment, relatively low labour costs by Western European standards, cultural connections with the US and Western European standards of governance.

The present paper analyses the co-evolution of institutional features of the Irish economic environment and the types of FDI available to European economies. We divide the period of Irish outward orientation into four distinct phases.

The first phase of Irish trade integration with Continental Europe began in the late 1950s when the country moved away from protectionism, dropped its restrictions on foreign ownership of industry and adopted a zero rate of corporation tax on manufactured exports.  These moves drew in substantial numbers of US firms who exported into mainland Europe (as opposed to the UK, which remains to this day the dominant export destination of most Irish domestic firms) even though substantial tariff barriers remained against Irish-produced goods.  Increased openness saw the country adopt the main proposals of an influential OECD report on primary and secondary education in 1965, which sparked a dramatic educational expansion at all levels.

The second phase began when Ireland joined the EU in 1973.  This brought a substantial increase in FDI inflows which – in response to the upgrading of the Irish tertiary educational system – began to locate in higher-technology sectors.  Macroeconomic instability over the period of the oil shocks however prevented Irish convergence on average Western European living standards over this period.

The third integration phase was driven by the Single European Market, the global high-tech boom and domestic policy adjustments in Ireland.  The outlawing of restrictive public procurement practices on the part of EU governments allowed Ireland’s locational advantages come more strongly to the fore; the low-corporation tax environment proved especially beneficial to high-tech MNCs who are better able to exploit its benefits; Ireland’s continued educational upgrading remained an important magnet for such firms, while fiscal consolidation, EU regional aid and the institutions of social partnership brought further competitiveness gains.  Furthermore, the EU-enforced inter-sectoral harmonisation of corporation tax rates in Ireland brought the Irish rate on services down dramatically just as global services-sector offshoring began in earnest.

The fourth phase arose as a consequence of Ireland’s convergence on average Western European living standards over the Celtic Tiger era and the accession of other low corporation-tax states to the EU.  This required Ireland to focus more on developing its national system of innovation in order to target the increasingly technology-sourcing foreign direct investment flowing into and across Europe.

  1. Phase 1: from Protectionism to EU Accession (1958-1973)

Ireland remained protectionist for about a decade after most of the rest of Western Europe had moved towards freer trade. The post-war boom of the 1950s saw Western Europe achieving growth rates of almost 6 percent per annum while protectionist Ireland stagnated with a growth rate of less than 2 percent, and an employment growth rate of less than 1 percent.  The need to import the more sophisticated capital and consumer goods that the country could not produce for itself led to balance of payments crises and macroeconomic instability, exactly as happened in protectionist Spain at around this time. The depressed economy of the 1950s saw more than 400,000 Irish people emigrate, out of a total population of less than 3 million.

By the end of the 1950s it was clear that economic policy would need to be completely overhauled.  The First Programme for Economic Expansion, which removed protectionism, encouraged foreign direct investment and promoted exports, was introduced in 1958.  The Anglo-Irish Free Trade Agreement, which aimed to liberalise trade with the country’s major trading partner of the time, the United Kingdom, came into force in 1966, and both countries acceded to the then European Economic Community (EEC) in 1973.  The move towards openness was accompanied by the introduction of a zero tax rate on profits derived from manufactured exports and a liberalisation of the law on foreign ownership of companies. As the bulk of the country’s exports at that time were agricultural in nature, there was little diminution of the tax base when the concessionary tax rate was adopted.

O’Hearn (1987) has estimated employment levels in the new foreign firms that entered Ireland to avail of the zero tax rate on manufactured exports.  By the time of EU entry these firms accounted for slightly more than half of all foreign-firm employment in manufacturing, with the remainder accounted for by the mainly UK firms that had entered Ireland to cater to the home market, whether under protectionism or in the outward-oriented era. …

…most of the growth prior to EU entry was in traditional or low-tech sectors such as Textiles and Clothing, Metals Industries (such as aluminium extrusions, shipbuilding, cranes, metal nuts), Pulp and Paper, and Rubber and Plastics.

The FDI inflows of this period led to Ireland developing a revealed comparative advantage (at the SITC-1 level) in Chemicals (whose share of exports grew from less than one half of 1 percent at the end of the 1950s to 6 percent at the time of EU entry) and in “manufactured goods classified by material” and “miscellaneous manufactured articles”.

The growth in foreign industry also contributed to a substantial diversification of Irish exports away from the UK market, with the then 6-country EU share of manufacturing exports rising by 10 percentage points between the late 1950s and the early 1970s.

It is of interest to note that though the numbers of new foreign firms establishing operations in Ireland accelerated as EU accession drew closer, the impact of EU membership on inbound FDI would have been unclear a priori, since accession entailed the loss of Ireland’s preferential position in the UK market.

The increased intellectual openness of the period saw Ireland (and later Austria) volunteer to allow the OECD conduct a survey of the entire national education system.   An important feature of the subsequent report, issued in 1965, was that – almost for the first time – technocratic expertise was now to be heard alongside the party political and denominational interests which had previously dominated ministerial councils (Logan, 1999).  The report was scathing in its assessment of the Irish system, noting that over half of Irish children left school at or before the age of thirteen.  This finding generated newspaper headlines and presaged the introduction of ‘free’ second-level education and free access to special transport networks for all second-level school pupils in 1967.  These measures sparked a dramatic educational expansion over the course of the 1970s and subsequently.

Notwithstanding Ireland’s early successes in attracting FDI, there was no convergence on average Western European living standards over this period, nor indeed until the late 1980s.  This is arguably ascribable to Ireland’s “regional economy” character, where, because of the historic ease of emigration to the UK, Ireland can be thought to have little control over its net-of-tax labour costs (though there were substantial insider-outsider problems in the labour market also).  This would have prevented Ireland from industrialising through the development of low-wage consumer goods exports as each of the other traditionally less developed Western European economies – Portugal, Spain and Greece – did in the 1960s…

  1. Phase 2: From EU Accession to the Single Market Era (1973-87)

Although Ireland was already relatively FDI-intensive at the time of EU entry, the number of jobs in foreign-owned manufacturing industry grew by 23 percent between 1973 and 1980, before declining subsequently as a consequence of macroeconomic mismanagement.

Although Ireland’s low corporation-tax environment is particularly attractive to high technology firms, the increasing technological intensity… would not have been possible without the educational advance touched upon in the last section.

The structure of the Irish education system that emerged in the wake of the OECD report is unusual in that while Ireland just matches the OECD mean in terms of those with university qualifications, it has far higher proportions than the average OECD country with specific post-secondary and sub-degree tertiary educational qualifications…

The post-secondary education system that emerged in Ireland was based on a realisation that, unlike in the UK – whose early industrialisation had ensured the evolution of a well-developed system to provide an intermediate layer of technicians – the education system in Ireland would need to provide this intermediate layer from scratch if human resources were to be available to sustain the industrial expansion… that followed on from Ireland’s relatively late trade-liberalisation-driven industrialisation.

The main components of the technical-education system developed in Ireland over the course of the 1970s were the Regional Technical Colleges (later rebranded as Institutes of Technology), for which there was no UK model.  These offered subdegree programmes of shorter duration than those at universities and concentrated in the fields of engineering and business studies, and their curricula had a practical orientation designed to be responsive to the needs of local industry and business.

From having had a tiny short-cycle third-level sector before 1970, by 1981 Ireland had internationally, after the Netherlands, the highest proportion of third-level students taking sub-degree courses.  Since the late 1970s, furthermore, the universities themselves – at the behest of the national development agency, the IDA – had begun to accept increased responsibility for ensuring that manpower needs were met.  The Manpower Consultative Committee was established in 1978 to provide a forum for dialogue between the IDA and the education system.  The state agency, concerned by the looming disparity between electronics graduate outflows and its own demand projections, convinced the government to fund a massive expansion in educational capacity in these areas.  The output of engineering graduates, as a result, increased by 40 percent between 1978 and 1983, while the output from computer science increased tenfold over the same short period.  The IDA in turn was able to use the rapidity of this response – exemplified by the immediate introduction of a range of one-year conversion courses to furnish science graduates with electronics qualifications –  as a further selling point to foreign investors; MacSharry and White (2000).

…the major expansions were in computing equipment and electronic components, pharmaceuticals and medical and optical devices, and these expansions continued into the following “Celtic Tiger” era.

Once again over this period however, notwithstanding the continued success in upgrading the country’s sectoral FDI allocation, no convergence was recorded on average Western European living standards.  Unlike in the previous era (1960-73) however, this lack of convergence was replicated across all the poorer Western European economies… Barry (2003) identifies deficient macroeconomic policymaking across all these four countries in the wake of the oil shocks as a common factor behind their weak performance, suggesting that poorer countries may be structurally less capable of adhering to appropriate monetary and fiscal policies in the event of a downturn in the world economy.  Convergence is also known to be more difficult to achieve when the encompassing world economy is performing poorly.

  1. Phase 3: The Single Market, Services Offshoring and the Celtic Tiger

In this phase, running from 1987 to the present, all four cohesion economies converged substantially on average Western European living standards, with Ireland’s performance being particularly dramatic. The various factors behind the Irish performance are discussed in detail elsewhere, e.g. in Barry (2004).  Here we focus solely on the contribution of FDI.

Manufacturing FDI into and within Europe expanded in the late 1980s. …with respect to US investments in Europe, with the US Department of Commerce Survey of Current Business (March 1991) attributing much of this to the lead up to the introduction of the Single European Market in 1992.  The figure also shows that Ireland captured a growing share of US investments in Europe. MacSharry and White (2000) explain this latter effect by describing how several larger EU countries, in the pre-Single Market era, “had suggested to potential investors that publicly funded purchases of their products might be blacklisted if the new investment was located in Ireland” (rather than in the countries from which the threatening noises issued).   With the outlawing of restrictive public procurement practices under the Single Market initiative, the attractiveness of Ireland as a destination for FDI increased.  This effect would undoubtedly have been dampened without the concurrent restoration of macroeconomic stability.

The increasing share of high-tech sectors in European manufacturing over the 1990s also helped, as did the high profitability of the era, since both increase the attractiveness of a low corporation-tax environment.  Altshuler, Grubert and Newlon (2001) argue, furthermore, that US foreign investment has become more sensitive to differences in host country taxes in recent years, and Ireland has had – until the recent enlargement – the lowest rate of corporation tax in the EU.  The Single Market programme may also have allowed Ireland achieve a critical mass of US firms in certain sectors, allowing agglomeration and demonstration effects to come into play (Barry, Görg and Strobl, 2003).

Thus the number of jobs in foreign-owned manufacturing in Ireland expanded by almost 50 percent between 1987 and 2000.

Combined with this increase in manufacturing FDI, Ireland also began to attract increasing services-sector FDI inflows (Grimes and White, 2005).  Starting from a base close to zero in the late 1980s, by the new millennium, foreign-firm employment in each of Ireland’s strong FDI-intensive manufacturing sectors is now matched by foreign-firm employment in several offshore services sectors located in Ireland.  Thus computer software now matches hardware, international financial services matches pharmaceuticals and other business-process offshored (BPO) activities match employment levels in instrument engineering.  Furthermore, as Barry and Van Egeraat (2005) show, as computer hardware firms have shifted their manufacturing facilities to Asia and Central and Eastern Europe, they have upgraded their operations in Ireland into services activities.

An indicator of Ireland recent successes in offshore services… Though Ireland has only around 1 percent of the EU15 population, it attracted 50 percent of new shared services projects in the EU15 and 8 percent of regional headquarters projects in the period to which the data refer.

It is well known that the share of services in international FDI flows has been increasing over recent decades (UNCTAD 2004).  Ireland’s ability to attract an increased share of services was facilitated by substantial reductions in the rate of corporation tax on services over the course of the 1980s and 1990s… These changes were generally made of the behest of the European Commission.   Export Profits Tax Relief, for example, began to be phased out in 1978, to be replaced by a special 10 percent rate for manufacturing industry.  From 1987 this special rate was extended to qualifying activities carried out at the newly opened International Financial Services Centre in Dublin. Most other market services meanwhile continued to be subject to the standard 32 percent rate that prevailed at that time.  The European Commission had been pushing for some time for tax harmonisation across sectors, implicitly hoping that Ireland’s rate would be pushed much closer to the EU average.  The Irish government instead decided in 1998 on a harmonised rate of 12.5 percent –to be instituted from 2003 – which yielded substantial benefits to most services sectors in order to cushion the impact on manufacturing.

Table 7: Ireland’s corporation tax regime

  • 1956: Finance Act introduces Export Profits Tax Relief (EPTR), primarily for manufacturing industry, with 50 percent tax remission on profits (increased to 100 percent two years later). The measure provided full relief for fifteen years and tapering relief for a further five years.
  • 1969: EPTR extended to 1989-90.
  • 1978: Government abolishes EPTR and replaces it with a special 10 percent rate of corporation profits tax for all manufacturing industry from 1981-2000. Those qualifying for export-tax relief before 1981 continue to benefit until 1990.
  • 1987: Financial Services Act establishes International Financial Services Centre in Dublin. Profits of qualifying activities carried out from the Centre are taxed at 10 percent until 2005.
  • 1990: Government extends the 10 percent corporation profits tax rate to 2010.
  • 1998: Agreement with European Commission on universal 12.5 percent corporation tax for all trading companies from 2003. All existing commitments to the 10 percent tax rates for manufacturing industry to the year 2010 to be honoured. The current 28 percent standard rate applying to most Services to be reduced by 4 percent annually in 2000, 2001 and 2002, and by 3.5 percent in 2003, giving a 12.5 percent rate at that date.

The Finance Act 2004, furthermore, established a new headquarters regime aimed at attracting international corporations to establish their regional HQ in Dublin.  This has further served to attract other activities such as shared services and treasury management (Finance Dublin Yearbook, 2004).

  1. Phase 4: Science, Technology and Innovation Policy and the Offshoring of R&D Functions

Offshoring of R&D facilities is a growing phenomenon.  Kuemmerle (1999a) tracked 32 MNCs in the pharmaceutical and electronics industries and found that their overseas R&D staff increased from 6 percent in 1965 to more than 25 percent today, while the number of overseas R&D labs increased from 14 to 84.  His study distinguishes between “home-base-exploiting” R&D sites (which are associated with traditional FDI, where firms set up overseas to exploit on a larger stage the advantages, such as brand names, that they had already accumulated) and “home-base-augmenting” or technology-sourcing cites.  The former are found to be more likely to be located close to existing factories and important markets, while the latter are more likely to be located close to universities.  The proportion of R&D labs that Kuemmerle categorises as home-base-augmenting rose from 7 percent to 40 percent over the period he studied.

The 2005 UNCTAD World Investment Report provides broader and more detailed evidence on the recent growth in global offshoring of R&D functions.  This provides the context for recent developments in science, technology and innovation (STI) policy in Ireland.

Given the growth in offshoring of R&D, along with Ireland’s convergence on average Western European living standards by the early years of the new millennium –  and perhaps also in response to the threat of increased corporation-tax competition from Central and Eastern Europe – science, technology and innovation policy has recently moved to the heart of the Irish policy agenda.

This was heralded by the release in 1996 of the first-ever Irish Government White Paper on Science, Technology and Innovation.  It is underlined by the five-fold increase in investment in these areas under the current National Development Plan (2000-06), by the launch in 1998 of the Programme for Research in Third-Level Institutions (which established 24 major research centres as well as major programmes in human genomics and computational physics), by the establishment of Science Foundation Ireland (SFI) in 2000, and by the introduction of a 20 percent tax credit for incremental R&D in the Finance Act of 2004.

The origins of Science Foundation Ireland lay in a Technology Foresight Exercise organised by the state body Forfás, which asked client company executives where they saw their companies headed over the next 10–15 years, and what the Irish government could do to respond to those changes. The response was that as Ireland was no longer a low-cost manufacturing location it would have to develop more highly trained engineers, research scientists etc. to become a center for innovation, research, design and development.

The exercise proposed the establishment of a Technology Foresight Fund to promote and finance new basic and applied scientific and technological research in Ireland, and SFI was set up to administer this fund.  Besides providing awards to support scientists and engineers working in designated fields (along the lines of the US NSF), SFI has established a host of joint partnerships between third level research institutions and industry.

Within ICT alone, the last few years have registered a number of significant developments under this new strategy.  Bell Labs has announced its intention to set up a major R&D centre at Lucent Technologies’ Dublin facility, linked with the establishment of a collaborative academic centre at one of the city’s universities. Similarly, Hewlett-Packard announced the establishment of a world-class Technology Development Centre at its manufacturing facility outside Dublin, while its European Software Centre entered into collaboration with NUI-Galway in establishing the Digital Enterprise Research Institute.  Intel has established an innovation centre at its main site outside Dublin and increased its investment in its research centre near Limerick.  It has also partnered three Irish universities in an academic Centre for Research on Adaptive Nanostructures and Nanodevices.  IBM over the same period announced significant investments in its R&D software facility in Dublin – a decision influenced, according to one of the company’s directors, by the availability of the necessary skills, the strong support of the IDA and the increasing role of SFI.  A number of similar investments have also appeared recently in the biotech and pharmachem areas.

Conclusions

Ireland’s success in attracting FDI can be ascribed to the following factors:

  • EU membership, macroeconomic stability, Western European governance standards and an English-speaking environment
  • a low corporation tax rate
  • the skills and experience of the country’s Industrial Development Agency (IDA)
  • the quality of the telecommunications infrastructure, and
  • an educational system that is integrated to a large extent with the country’s FDI-oriented development strategy.

As one of the first countries in the world to adopt an FDI-focused development strategy (in the late 1950s), the country has had an extensive period of time to fine tune its policies and institutions in line with the requirements of international FDI. This has allowed it to continue to succeed as FDI flows into Europe have shifted progressively from traditional to higher-tech manufacturing sectors through services offshoring and more recently into the offshoring of R&D functions.

Though a late starter – by Western European standards – in increasing educational throughput, Ireland by 1981 had, after the Netherlands, the highest proportion of third-level students taking sub-degree courses.  This was a relatively inexpensive option for the country for follow, a strategy arguably justified in the case of a relatively poor European country.  By international standards tertiary enrolments were heavily biased towards science and engineering, which accorded with the requirements of the MNCs that the country was trying to attract.  As convergence on Western European living standards was progressively achieved and as offshoring of R&D has grown, the emphasis has increasingly switched towards university and postgraduate education.

As shown in the appendix, the country’s IDA has also functioned effectively as a learning organisation through its transnational strategic networks. The strong focus on the importance of FDI in Ireland and the position of the IDA in the policymaking hierarchy ensure that the system is configured to respond rapidly to emerging market opportunities as well as changing factor-market conditions in Ireland.

One example, discussed earlier, concerns the pace of response to the looming disparity, once recognised, between electronics graduate outflows and the IDA’s demand projections for such graduates. Another example is provided by the response to an EU Directive in the 1980s which allowed financial services companies, once established and registered with the regulatory authorities of one EU member state, to operate in any other member state. The directive freed firms to locate in countries where they found the regulations to be most favourable. Ireland was the second country after Luxembourg to implement the directive, in 1989. In addition the authorities decided to forego VAT and inheritance taxes on certain investment fund activities and two further items of legislation were enacted in 1990 to facilitate the development of investment funds. The industry’s activities in Ireland expanded dramatically in response and by 2005 the country had become one of the world’s leading locations for the domicile and administration of investment funds (Barry, Thebault and Wojcik, 2006).


Africa Vol.3 (Accelerating South Africa’s Economic Transformation)