Thursday, March 19, 2015

The Growth Effect of ‘Contract Manufacturing’

The concept of ‘contract manufacturing’ only began to get some attention after this happened in the second quarter of 2014 [see previous post here]:

QNA v TS

In 2014 the difference between goods exports recorded in the trade statistics and that recorded in the national accounts was €17.6 billion. We could get into the technical reasons for the difference between the two but we will focus on just one point:

  • Only the “value added” in Ireland from the exports contributes to Irish GDP.

We know that MNCs account for around 90 per cent of Irish exports, but equally we know that they account for a similarly large amount of Irish imports (with much of this being royalty payments for intellectual property).  The GDP impact is the much smaller net difference between them and the GNP effect is smaller again when the repatriated profits and retained earnings of these foreign-owned companies are subtracted.

A big issue with the “contract manufacturing” effect in 2014 was that its impact on (goods) exports was very easy to see – as shown above – but its impact on imports was less visible.  When the effect first arose in mid-2014 the CSO indicated that the impact on GDP was not significant due to import outflows (mainly royalty payments). 

However, those who looked at the Balance of Payments didn’t see a clear link.   Some of this may to down to the transition to BPM6 which means that shorter time series are available for some of the BoP series.  Here are the updated figures for service imports in the Balance of Payments.

Service Imports

While there was an increase in service imports in 2014 this really only became noticeable with the release of the Q4 data last week.  However, if we look at royalty imports the 2014 increase is even more noticeable.

Royalty Imports

Royalty imports in 2014 were €10.6 billion higher than in 2013.  While this is the case it is not possible from this to know how much of this increase was due to royalty payments related to contract manufacturing organised by Irish-resident companies that takes place in other countries and how much was due to MNCs paying royalties for activities that take place here.

Usefully, though, the CSO have issued an information note that attempts to throw some light on this.  The note contains the following chart for the last three quarters of 2014 for a subset of companies that engage in contract manufacturing.  The CSO have indicated that “there are currently 16 companies engaged in contract manufacturing” though the number changes from quarter to quarter.

CSO Contract Manufacturing

The chart shows that two of the national accounting adjustments made compared to the trade statistics shown in the external trade data accounting for an adjustment of around €14.5 billion in the final three quarters of 2014.  These figures likely explain the gap shown in the first chart above.

Outbound royalty payments related to these activities were around €10.2 billion in the last three quarters of 2014.  One assumes that this is an estimate by the CSO as outbound royalty payments are reported in aggregate as noted above and are not assigned to particular activities (such as domestic production or external contract manufacturing). 

However, given the data the CSO have it is likely that have a good idea of the relationship between royalty payments and activities that happen in Ireland so are in a position to make a well-informed estimate as to how much is due to contract manufacturing and the like.

The chart shows that there was also around €0.8 billion of other service imports associated with these activities.  That leaves of estimated “gross value added” in Ireland of around €3.5 billion (the green line in the chart above).

However, all the chart does is confirm the CSO’s earlier statements that a significant portion of the inflows from contract manufacturing and merchanting are offset by outflows of royalty payments.  This, of course, was the intention of the note and we can see that this issue had little impact on quarterly growth rates for Q3 and Q4 – the green line is almost horizontal. Unfortunately, what we we cannot see is the impact these factors had on the 4.8 per cent annual GDP growth rate. 

To do that we would need the same data for 2013 but it seems the CSO were happy to make the point that focussing on the impact these activities have on goods exports overstates the final outcome as offsetting royalty imports have to be factored in.  A longer time series is also likely to step further in the realm of guesswork.  In their note they do say:

In the case of the additional products made under contract manufacturing arrangements for Irish companies in 2014 the related addition to value added over and above wages and salaries paid is not particularly significant in explaining the recent growth in Irish GDP (+4.8% in 2014).

It would be nice to be able to quantify “not particularly significant”.  The €3.5 billion of value added for the last three quarters of 2014 in the chart above is significant but we don’t know how it compares to the GVA from these activities in 2013.  For annual growth that is the key.  The CSO conclude their note saying:

Instead the observed growth is more broadly based and reflects improved domestic demand and also the pick up in activity for Irish companies not linked to Multi National Groups.

Finally, for the value added from these contract manufacturing and related activities it is likely that 75 per cent (or more) is operating surplus (profit for foreign shareholders) rather than compensation of employees (wages for Irish employees).  This operating surplus will be counted as a net factor outflow (presumably we do get a 12.5 per cent cut of this! - see below) so the GNP effect of all this is smaller again. 

Corporation Tax on the €3.5 billion of gross value added could be around €250 million depending on what adjustments are made to get the taxable income figure which is ultimately multiplied by 12.5 per cent. 

There isn’t a direct link between tax accounting and national income accounting but they are not entirely unrelated.  They are more related than national accounting is to financial accounting as jurisdictional boundaries influence what is included in each unlike financial accounting where consolidated accounts relates to activities within a firm regardless of where it happens.  Some of the figures used in national accounting for companies are drawn from tax accounting rather than financial accounting, though the subsequent adjustments in national and tax accounting are different. In national accounting it is also the case that what can sometimes be the end figure, such as value added, is actually the starting point and the apparent deductions done above it to get to the final figure are inferred.

Anyway from €3.5 billion of gross value added we will first have to subtract compensation of employees to get gross operating surplus.  GOS is akin to EBITDA (earnings before interest, taxation, depreciation and amortisation) so deductions would have to be made for any interest paid on finance^ and depreciation of assets related to the activity (in tax this will be capital allowances rather than depreciation but the concepts are related). 

A taxable income figure of €2 billion is possible giving the €250 million Corporation Tax figure used above.  We have a limited number of credits for Corporation Tax and it doesn’t appear any them would be applicable for the activities involved.  The R&D credit is a possibility if the research activities take place here but the outbound royalty payments dispels that.  Double taxation relief is not applicable as the profit is sourced in Ireland.

Again we don’t know if this an increase on what was due in 2013 but there should be some dividend to the Exchequer from these activities even if they are yet another previously unseen complication to our national accounts that has now come to light.

^ FISIM interest (financial intermediary services indirectly measured) will be included in the intermediate consumption figure deducted from output produced to get (in an arithmetic sense anyway) gross value added but let’s not go there.

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