How much is a 1% reduction in bailout interest rates actually worth? (Part 2 of 2)

Yesterday there was an entry here which explored the effect of a 1% cut in the interest rate on the EU-sourced bailout which concluded, that under a specific set of assumptions, a 1% cut would be worth €4.2bn to the nation over the course of the next 10 years. This entry compares the financial effect of this cut with the financial effect of other relevant issues.

(1) Changes to our corporate tax system. Ireland has a headline tax rate of 12.5% which is amongst the lowest in the EU – Cyprus’s is 10% but the bigger economies in Europe have headline rates of 25%-plus. The effective tax rate, as claimed in a recent Pricewaterhouse Coopers global tax report, in Ireland is estimated to be 11.9% whereas the estimated tax rate in some larger economies is considerably less than the headline rate, for example in France it is 8.2% (headline 33.1%), Germany 22.9% (headline 30%), UK 23.2% (headline of 28% dropping to 26% in April 2011). There have been calls both domestically and internationally for Ireland to increase her headline tax rate. Last year, according to the 2101 year end Exchequer Statement, Ireland generated just €4bn in corporation tax compared with €11bn for income tax, €10bn in VAT and €5bn in excise duty and other taxes of €2bn to give an overall total of €32bn.

The domestic supporters of an increase to corporation tax argue that corporations, many of them Multi-National Corporations (MNCs) with little presence in Ireland beyond a name-plate on some office, should contribute more. In truth it seems that our corporation tax income which represents some 12% of our total tax take of €32bn is similar to our neighbours in the UK where 9% of their total tax take is classified as corporation tax. The domestic supporters of an increase might also claim that each 1% increase in corporation tax rates we should see an extra €300m in taxes per year if corporation profits remain flat. The fear of course is that corporation profits will not remain flat and that corporations will react to higher tax rates by diverting income from Ireland and we may deter potential investors from setting up shop here in the first place in future. For those of you who have not come across the concept of the Laffer Curve and how different tax rates affect total tax receipts, you could do worse than spend five minutes on the subject here.

So if Ireland were pressed to increase her headline corporation tax rate from 12.5% to say 15%, it may well give a temporary short-term increase of €0.8bn per annum, but all things being equal, corporations would seek to reduce the amount of taxable income reported in Ireland so it is unclear what the longer term effect would be. And “longer term” might only be a matter of months as corporations react to new rates. And of course a change to our corporation tax rates will have an effect well beyond the term of the EU loan (all set to be repaid by 2021 as far as I can see). To compare the relative worth of a reduction in an interest rate on our EU-bailout with an increase to our headline corporation tax rate, we would need project the effect of any new corporation tax rate on corporations. The short term impact might be positive in that corporations might take time to re-arrange their affairs to divert income away from Ireland but the long term adverse effects could be significant. The same could be said of any other change to our tax system including a change to the tax base.

(2) Burning the bondholders. It seems that this subject is again back on the table even if it was the clearly-signalled wish of the ECB last year to ensure there was no default by the banks in respect of their commitments to bondholders. The Central Bank of Ireland made an unprecedented disclosure on 2nd March, 2011 when it published aggregated totals of bond holdings in the six State-guaranteed Irish banks.

The disclosure was, according to the CBI, “in the interests of providing public information on the level of senior and subordinated debt issuance currently in issue by the six Irish credit institutions and held by third parties”. There wasn’t a great deal of public debate around the disclosure, and what there was, tended to simplistically demanded the burning of some or all of the disclosed bond holdings. But to extract some figures, what if the proposition with our bailout partners was that we could either burn the unsecured, unguaranteed senior bonds at Anglo and INBS totaling €3.748bn or we could get a 1% reduction in our bailout which would save us €4.2bn over 10 years, which would be better? Actually the former would financially be better because the benefit of the €4.2bn from a 1% reduction in interest rates would be over 10 years and the benefit of the bondholder burning would be today. If we expressed the reduction to the bailout interest rate in Net Present Value (NPV) terms then the benefit would fall from €4.2bn to €3.9bn at a discount rate of 2% (target inflation rate in EU) or just €3.2bn at a discount rate of 6% (minimum borrowing rate deemed sustainable in 2010).

Before leaving bondholders, I think it is worth reminding ourselves that last Friday 25th March, INBS paid some €29m to unguaranteed subordinated bondholders whose bonds were due for redemption between 2016-2018. Unless there is some information on the transaction which hasn’t been placed in the public domain, this transaction appears to have constituted a scandalous waste of public money as INBS is 100% owned by the State and by 2016, the probability is that INBS will have been wound down.

(3) Deleveraging. The tone of the demands for Irish banks to deleverage seems to be softening with a growing appreciation by all our partners that rapid deleveraging in the present market will only crystallise additional losses which will need be met with additional capital injections. That said, a calculation similar to that with the consideration of bondholders above would be appropriate, that is, the losses that would be crystallised in the banks today would need be compared with the NPV of the benefit of any reduction in bailout interest rates.