Payroll Taxes, Capital Grants and Irish

The Economic and Social Review, Vol. 21, No. 1, October, 1989, pp. 122-125

Payroll Taxes, Capital Grants and Irish Unemployment: A Comment FRANCES R U A N E Trinity College, Dublin

I

n this paper Frank Berry examines the issue o f the appropriateness o f capital versus labour subsidies i n the Irish economy, i n the context o f three different models, namely a neo-classical small-open-economy model, a demand-constrained Keynesian m o d e l and a structuralist model, i n w h i c h o u t p u t is constrained by informational-type barriers-to-entry i n export mar­ kets. D r a w i n g o n a series o f earlier papers w h i c h consider each o f these models in greater depth, Frank Barry analyses the effects o f b o t h capital and labour subsidies i n terms o f o u t p u t and substitution effects and shows that i n the case o f all models a labour subsidy w i l l be more effective than a capital sub­ sidy i n generating e m p l o y m e n t . He argues that "a strong case can be made for at least partial replacement o f the current I D A capital-grants scheme by a p o l i c y o f payroll-tax reductions for newly-created j o b s " , i.e., replacing the grants to new capital investment installed w i t h grants to new labour employed. I agree completely w i t h the general tenor o f the argument and analysis i n the paper, and confine m y comments to making three points, namely, a qualifi­ cation to the i n t e r p r e t a t i o n o f what is meant b y a capital or labour subsidy in the Irish p o l i c y c o n t e x t , a caveat on the j u s t i f i c a t i o n o f using either type o f subsidy i n the barriers-to-entry export framework, and a recommendation for an extension o f the neo-classical model used i n this analysis.

123

COMMENT ON BARRY

I

I D A G R A N T : C A P I T A L OR L A B O U R S U B S I D Y ?

I n the analysis i t is presumed that the payment o f a labour subsidy does not result i n an increase i n the wage demanded o n the subsidised projects, and does n o t create a negative signal to employers about the q u a l i t y o f Irish labour. This latter argument has been used to j u s t i f y the policy o f subsidising capital rather than labour b y the I D A , as has the argument that, for foreign investors in particular, a lump-sum payment up-front is more valuable than an on-going payment, because i t guarantees that the government cannot renege o n its agreement. Such arguments have resulted in the type o f policy suggested i n this paper not being given serious consideration b y policy makers, despite there having been a widespread, although not unanimous, consensus on this issue among economists for more than a decade. 1

However, the basis for calculating the grant and the m e t h o d o f payment of the grant need not be identical, although this is often presumed. I t is, for example, possible to relate the payment o f a grant, calculated o n the basis o f a percentage o f fixed-asset capital, to the e m p l o y m e n t o f labour, and vice versa. What matters for efficiency and factor choice is the basis on w h i c h the size o f the grant is determined. As long as the investor is aware o f h o w a parti­ cular grant is determined, there is no reason w h y payment o f the grant cannot be related to capital purchases or labour employed, i f this is administratively more convenient. Indeed, i t is often claimed b y I D A personnel that since the I D A " c a p i t a l " grant depends on expected e m p l o y m e n t , i t actually operates as a labour subsidy. The validity o f this argument can be demonstrated i n a simple one-period, two-factor m o d e l where the cost o f p r o d u c t i o n o f net out­ p u t (C) is defined simply as the sum o f the cost o f labour ( w L ) and the cost of capital ( v K ) : 2

C = wL + rK

(1)

I f the grant were strictly paid as a capital grant (g), then the expression for the cost o f capital w o u l d be C

= wL + r(l-g)K

(2)

Comparison o f Equations (1) and (2) shows the o u t p u t effect [ C < C ] and the substitution effects [ w / r < w / r ( l - g ) ] o f a capital subsidy, as noted b y

1. See, for e x a m p l e , G e a r y , W a l s h a n d C o p e l a n d ( 1 9 7 5 ) , F l y n n a n d H o n o h a n ( 1 9 8 4 ) a n d R u a n e and J o h n (1984). 2. T h i s simple m e t h o d of d e m o n s t r a t i n g the equivalence of the " c a p i t a l " grant a n d the l a b o u r subsidy is due to Peter N e a r y .

Frank Barry. However, suppose that the I D A actually determines the grant b y saying that the grant to capital per u n i t labour employed must not exceed some f i x e d amount ( m ) , t h e n the grant constraint facing the f i r m is [rgK/L] < m

(3)

I f this constraint binds, i.e., r g K = m L , then E q u a t i o n (2) can be r e w r i t t e n : C

= w L + r K - rgK = wL + r K - mL = (w - m ) L + r K

(4)

Thus, i f the I D A operates at the fixed m a x i m u m per j o b for all o f its projects, and i f i t insists on a repayment of the grant i f the e m p l o y m e n t projections o n w h i c h the grant is calculated are not realised, then the policy proposals in this paper could be being realised by the existing grant system. However, it w o u l d be essential that the policy be advertised i n such a way as to make i t clear to the p o t e n t i a l investor that the size o f the grant w h i c h w o u l d be paid depends o n the actual e m p l o y m e n t generated. Failure to do this w o u l d mean that the policy w o u l d not have the desired incentive effects, as what matters here is the perspective o f the investor and not the I D A personnel. To achieve this effect w o u l d of course mean that there w o u l d be no reason to attempt to operate a discretionary system. Indeed, the difficulties encountered by government agencies w o r l d w i d e i n operating discretionary policies effectively w h e n dealing w i t h b o t h foreign and domestic investors, suggest that such policies may be i n practice inoperable, as negotiators are inevitably b i d up to their m a x i m a . 3

4

I I B A R R I E R - T O - E N T R Y I N E X P O R T M A R K E T : E X P O R T SUPPORT FOR A L L ? Frank Barry notes in his discussion of factor subsidies under imperfect c o m p e t i t i o n that i n f o r m a t i o n a l barrier-to-entry can be used to justify finan­ cial support f r o m the government for new firms, and he recommends labour rather than capital subsidies as described above. The only caveat I w o u l d make here is that the justification for a general subsidy to exporting firms 3 . I t is c l a i m e d by I D A p e r s o n n e l that this is c u r r e n t p o l i c y though it has n o t been so for m o s t of the p e r i o d i n w h i c h I D A grants have been available. 4. I n other w o r d s , i n incentive terms, if the investors believe that the grant s y s t e m operates as a capital s u b s i d y , the effect w i l l be that of a capital subsidy, irrespective of w h e t h e r or n o t the I D A operates the s y s t e m as a l a b o u r subsidy.

depends o n the argument that (a) consumers judge quality b y c o u n t r y rather than f i r m q u a l i t y , and (b) quality is u n i f o r m . Hence any e x p o r t subsidy w h i c h increases Irish exports convinces the foreign consumer that all Irish products are good, and hence this subsidy is justified i n terms o f enhancing the sales potential o f all future e x p o r t s . However, i f firms produce products o f dif­ ferent q u a l i t y , and consumers judge c o u n t r y quality o n the basis o f any individual p r o d u c t , then an indiscriminate subsidy t o all firms may result i n poor products being e x p o r t e d , w h i c h w o u l d be detrimental to the country's reputation. This w o u l d suggest that the argument for supporting firms because they face i n f o r m a t i o n a l barriers-to-entry w o u l d only be j u s t i f i e d i f the quality of such exports could be assured. Such assurance w o u l d p r o b a b l y require the firm's proving some i n i t i a l success is e x p o r t i n g , before assistance could be j u s t i f i e d o n economic grounds. 5

6

I l l TWO-SECTOR N E O - C L A S S I C A L M O D E L : A N E X T E N S I O N WITH POTENTIAL The paper could be extended i n a number o f ways, one o f w h i c h w o u l d be to develop the small open economy m o d e l to incorporate a second sector. This w o u l d p e r m i t an analysis o f the effects o f factor subsidies o n the relative factor intensities i n different sectors and o f the impact o f relative sectoral promotion.

REFERENCES F L Y N N , J . , and P. HONOHAN, 1984. "Notes on the Cost of Capital in Ireland", Journal of Irish Business and Administrative Research, Vol. 6, pp. 58-69. G E A R Y , P.T., B.M. W A L S H , and J . C O P E L A N D , 1975. "The Cost of Capital to Irish Industry", The Economic and Social Review, Vol. 6, pp. 229-311. GROSSMAN, G.M., and H . H O R N , 1988. "Infant Industry Protection Reconsidered: The Case of Informational Barriers to Entry", Quarterly Journal of Economics, Vol. 102, pp. 767-787. M A Y E R , W., 1984. "The Infant-Export Industry Argument", Canadian Journal of Eco­ nomics, Vol. 17, pp. 249-269. R U A N E , F.P., and A .A. J O H N , 1984. "Government Intervention and the Cost of Capital to Irish Manufacturing Industry", The Economic and Social Review ,V'ol. 16,pp. 31-50.

5.

T h i s is the t y p e of a r g u m e n t m a d e by M a y e r ( 1 9 8 4 ) .

6. A n analogous a r g u m e n t is m a d e by G r o s s m a n a n d H o r n ( 1 9 8 8 ) in a n i m p o r t - s u b s t i t u t i o n f r a m e ­ work.