The Contribution of the Domestic Non-Financial Corporate Sector to Recent Growth and Some Taxing Questions

In an earlier post we went through some of the remarkable improvements for the household sector in recent years.  Of course, an outstanding question is: where did the growth come from?  We can get some insight into this from the same sector accounts. 

Current Account

Here we will look at the Irish-owned non-financial corporate sector which as we will see has been a major contributor to recent growth.  First, the current account. Click to enlarge.

Some of the changes here are very significant.  Between 2013 and 2019, output of domestic NFCs increased by 55 per cent, wage paid by 66 per cent and gross operating surplus by 83 per cent.  Compared to where they were in 2013, last year NFCs produced €53 billion more output, paid employees €18 billion more and generated €12.5 billion more profit. 

These have been a significant factor underlying the economy’s recent growth.  A useful sectoral breakdown is also provided.  Here are the domestic sources of compensation of employees (with domestic financial corporates (NACE K) also included))

The largest relative increase was the 130 per cent rise in employee compensation from domestic ICT companies (NACE J). The largest absolute increase was the €2.6 billion increase in employee compensation from professional, scientific and technical activities companies (NACE M), with mining and manufacturing (B,C), wholesale and retail (G), and administrative and support services (N) as well as ICT also recording increased greater than €2 billion.

Some of the other notable changes in the current account of the domestic NFC sector are the near 1,000 per cent increase the retained earnings of foreign subsidiaries and related entities of Irish-owned NFCs, the 500 per cent increases in dividends received and the 13 per cent increase in Corporation Tax paid. 

Two per cent tax rates?

It is surprising to see such a small increase in Corporation Tax paid by domestic NFCs over a period when all performance indictors improved significant.  The figures are this item are a significant revision on what the CSO reported this time last year. For example, it was previously reported that domestic NFCs paid €1.6 billion of Corporation Tax in 2018.  This is now estimated to be just €0.5 billion. 

It is not clear why there has been such a significant downward revision.  Nor is it clear that the figure is correct.  If we take the figures for depreciation from the capital account we can get the Net Operating Surplus of the sector.  This is probably the closest proxy of the tax base for Corporation Tax in the sector accounts and is akin to EBIT (the FISIM adjustment excepted).  Anyway, using Net Operating Surplus we can get some effective tax rates.

Those certainly are some eye-catching numbers down at the bottom.  Perhaps there is some support for this in the Revenue Commissioners research paper on recent Corporation Tax receipts which shows that non-multinationals (i.e., domestic companies) have the lowest effective tax rates in their data.

However, that conclusion was based on an effective tax rate in 2018 or 7.4 per cent which is almost three times larger than what the national accounts are showing.  Differences in definitions and coverage aside that is a large gap to be explained. No explanation is offered here.

Capital Account

We dipped into the capital account with the depreciation figures used above and here it is in full.

Again, we are looking at some large increases over the period.  In line with the rise in profits (and seeming absence of a rise in taxes) the annual increase in net worth rose significantly over the period.

Of this, ever more was used for gross capital formation, with the investment spending of domestic NFCs rising from €7 billion in 2013 to €19 billion in 2019.  There was no year where this fully exhausted the gross saving available and for each of the past seven years the domestic NFC sector has been a net lender. 

That is, after working through the current and capital accounts there was a residual surplus that was transferred to the financial balance sheet.  And it could be that some this is going on the financial balance of foreign subsidiaries or related companies given the increase in the retained earnings on FDI shown in the current account.

Financial Balance Sheet 

We don’t have a financial transactions account so move straight to the financial balance sheet.  As we said last year this has been exploding.

The financial assets of the Irish-owned NFC sector have gone from €167 billion in 2012 to €513 billion last year.  On the other side of the balance sheet, financial liabilities have gone from €175 billion to €633 billion.   Even with the huge increase in the gross figures, the net financial worth of the sector has been largely unchanged, going from –€108 billion in 2012 to –€120 billion last year.

Such is the scale of the increases across the available categories it’s actually pretty hard to determine what is going on.  But for both financial assets and liabilities there has been extraordinary growth in the equity category.  Are there some form of circular transactions taking place?

While the balance-sheet amounts are massive we didn’t really see significant distortions in the current account.  Yes, there has been a surge in the retained earnings of foreign related entities.  This was €3 billion in 2019 and it is possible that some of this should be included in operating surplus.

It would be nice to see the interest figures before the FISIM adjustment but they are only published by Eurostat who do not use the bespoke sectoral breakdown employed by the CSO.

Conclusion

All-in-all it looks like there are two things going on in the domestic NFC sector.  The first is a large, and very real, contribution to the growth of the Irish economy in recent years with significant increases in output, wages and profits.  This has driven a lot of the improvements that occurred pre-COVID.

The second is some kind of financial engineering on the balance sheets of (some) domestic NFCs.  It is possible this involves some sort of circular international transactions with huge increases on both sides of the balance sheet but limited impact on net worth.  To the extent, that there are flows which might, for example, reduce the tax base in Ireland, is unclear.  And, indeed, the tax paid on the tax base of this sector that remains seems unusually low with an estimated effective rate of not much more than two per cent.

So a mix of the good and the unexplained.

The convergence of urban-rural incomes in the SILC

In recent years, the Survey of Income and Living Conditions has shown remarkable improvements for Irish households with significant rises in income and significant falls in inequality.  One feature within the findings has been the narrowing of the urban-rural divide.

To start, just look at real income.

In 2013, median real equivalised disposable income in rural areas was just 85 per cent of that in urban areas.  For the past couple of years it has been 95 per cent or higher.

For the purposes of the SILC, households are classed as living in an urban or rural area based on population density (as measured by the 2016 Census).  Areas with a population density of less than 1,000 per square kilometre are classified as rural.  In 2019, 30.9 per cent of the weighted sample were in rural areas.

With incomes by area we can also look at at-risk-of-poverty rates by area.  This is the percentage of people living in households with an equivalised income below 60 per cent of the national median.  For 2019, the threshold used by the CSO was an income after taxes and transfers of €33,400 for a household of 2 adults and 2 children.

In previous years, as the rural category had a lower income, it had a higher at-risk-of-poverty rate. This reversed in 2019.

We don’t have inequality figures by status but this could be taken to imply that there is less inequality in rural areas at the bottom of the income distribution.

The at-risk-of-poverty rate is a relative income measure.  To help with understanding differences in living conditions we can look at deprivation rates.  This is the percentage of individuals living in households who experience two or more items of deprivation from a list of 11.  According to the CSO for the population as a whole:

In 2019, the most common item of deprivation experienced was the inability to afford to replace any worn out furniture (18.1%), followed by being unable to afford to have family or friends for a drink or meal once a month (13.6%) and being unable to afford a morning, afternoon or evening out in the last fortnight (11.7%).

Here are the rates for urban and rural areas.

These have always been closer than the income levels or at-risk-of-poverty rates might imply.  This is likely because those in rural areas face a lower price set compared to those in urban areas, most notably for housing.

Over the past few years, rural area have had a lower deprivation rate than urban areas and though the fall that had been evident in both since 2013 stopped in 2019, the gap between them increased.  There was no significant change in the deprivation rate for rural areas in 2019 while it rose in urban areas.

Finally, we can look at the consistent poverty rate which is a measure that combines those at-risk-of-poverty and also experiencing deprivation.

Given what this shows it wouldn’t be out of place to talk about urban-rural divergence in the SILC rather than convergence.  In 2019, the consistent poverty rate for rural areas continued to fall and was less than half what it was in urban areas (3.1 per cent versus 6.5 per cent). 

The “rural Ireland being left behind” narrative is a common refrain.  There is no evidence of it here.  

The position of the household sector as we entered the crisis

Last week, the CSO published the 2019 Financial and Non-Financial Institutional Sector Accounts.  Obviously, with the emergence of COVID-19 this is a world away from where we find ourselves now but it is instructive to see where we were with the onset of the crisis.  We previously looked at some of the COVID-generated chaos in the household sector with the Q2 2020 sector accounts here.

The non-financial accounts of last week’s publication give the incomes and expenditures of each sector and then how they translate through the positions for items like loans and deposits is shown in the financial accounts. 

Here we will look at the household sector.  First, an extended version of the current account for the household sector. Click to enlarge.

OK, lots more detail there then we need to go through.  The headline results are that Gross Disposable Income rose 7.3 per cent in 2019 to reach €114.2 billion.  Household Final Consumption Expenditure rose 5.6 per cent and was €102.0 billion.  Income rising faster than consumption meant savings rose and the Savings Rate was 12.2 per cent in 2019.

The most significant change for the household sector in recent years has been the rise in employee compensation received.  In 2015, this was €77 billion.  By 2019 it exceeded €100 billion.  The was driven by an expansion of employment and an increase in earnings.

By far, the largest source of the increase were non-financial corporations, and COE from this sector was €15 billion higher than it was at the previous local maximum in 2007 and 2008.  For more recent years, we have a breakdown of this between domestic and foreign NFCs, noting that foreign NFCs include traditional FDI as well as foreign-owned companies with a presence to serve the domestic market.

In recent years, COE growth from domestic firms has outstripped that from foreign firms.  In 2015, were responsible for 35.5 per cent of the COE that arose in NFCs, €16.8 billion out of €47.4 billion.  By 2019, the foreign share was down to 32.6 per cent, €21.4 billion out of €65.7 billion.

Further up the table it can be seen that that the mixed income of the self-employed was much less buoyant than employee compensation. Self employed income, which includes agriculture, went from €11.6 billion in 2015 to €12.3 billion in 2019. 

There was a substantial increase in the Gross Operating Surplus of the household sector from €12.2 billion in 2015 to €18.9 billion in 2019.  The GOS of the household sector is derived from the provision of housing services.  Most of this is income from “imputed rents” said to be paid by owner-occupiers to themselves (this nets out further down the table via “imputed rent” expenditure in consumption). Household GOS also includes the surplus generated from actual rents for housing earned by households who own buy-to-let properties.

In the allocation of primary income account there isn’t a whole lot going on.  We will consider interest flows – though before the adjustment is made for Financial Intermediary Services Indirectly Measured (FISIM). No, let’s not go there. 

Here are the gross interest flows for the household sector from Eurostat.

Interest received is down to less than €300 million while interest paid has been €4 billion or slightly under for the past six years or so.  As stated, most else in this part of the current account has been relatively stable.  There has been a bit of a bounce in dividends received by the household sector which exceeded €2 billion for the first time in 2019.

The next part of the table works through income taxes and social contributions paid, social benefits received and other transfers paid and received.  The net outcome here gives us the difference between Gross National and Gross Disposable Income. 

The gap between the blue and red lines below can be considered part of the contribution of the household sector (including employers’ social insurance contributions) to the non-cash-transfer cost of government.

We can see that back in 2010 there was close to no difference between Gross National and Gross Disposable Income for the household sector.  This means the amount the government collected from income tax and social contributions from household income was almost fully matched by the amount the government paid in social benefits to households. 

Since 2010, the gap has opened significantly and exceeded €15 billion in 2019 as the amount of tax and social contributions collected (Income Tax, USC & PRSI) has risen but the amount of social contributions paid has been relatively stable (n.b. this only goes up to 2019!).

Going back to the previous chart, the gap between the red and green line gives the amount of disposable income that is not used for consumption: household savings.

In 2019, the household savings rate is estimated to have been just over 12 per cent.  There have only been two years since 1995 when it was higher: the crisis years of 2009 and 2010. 

The income of the household sector had been growing rapidly in advance of the COVID-19 crisis but the gains were not being used for current consumption.  What was the household sector doing with the income it wasn’t spending?  The possibilities are that the money was used for capital spending or put on the financial balance sheet.  To assess that we can look at the capital account.

The bottom line here is the household sector has not been using the additional savings from the current account for capital spending.  There are a couple of other minor capital flows to account for but the main take from the capital accounts is [S – I], savings minus investment.

In 2015, households had €8.0 billion of gross saving and did €4.4 billion of capital spending leaving €3.6 billion for net lending,  By 2019, household gross saving was nearly €14 billion and while household capital spending had increased it was still less than €7 billion.  This meant in increase in net lending to €7.4 billion.

Near the bottom of the above presentation of the capital account we can see net capital formation: the difference between gross capital formation and consumption of fixed capital (depreciation).  This shows that there have been very modest net additions to the household sector capital stock. 

Indeed, as recent as 2015, household gross investment was not sufficient to cover depreciation.  In 2019, the net increase in the household capital stock was just €1.1 billion which isn’t much more than the amount investment grants received by the household sector for the likes of retro-fit projects.  It’s probably not a surprise that household capital formation remains muted given the modest increases in the supply of new housing, which is the main capital formation the household sector engages in.

But let’s look at what the household sector did with the €7.4 billion that was left after all current and capital spending has been accounted for.  So we switch from the non-financial to the financial accounts and start with the Financial Transactions Account.

The bottom line here, net financial transactions, is slightly larger than the net lending we saw at the end of the capital account, but not significantly so.  What are the household sector doing with the resources they have left after their spending has changed in recent years. 

Back in 2012, the increase in net household wealth due to financial transactions was mainly happening via loan repayments with only a modest increase due to adding to deposits.  Over the following years this reversed and in 2019 most of the contribution to net wealth due to financial deposits was from increases to deposits.

Of course, this may not simply be due to changes in what the household sector is doing with its net lending surplus.  For example, if one household takes out a mortgage to buy a house from another household who put that money on deposit that will reduce the contribution of loans to net wealth and increase the contribution of deposits in net wealth but in overall terms the impact of this on the net wealth of the household sector is zero.

Anyway, let’s look at the impact on the financial balance sheet of the household sector.

Here we can see that the change from 2015 to 2019 in the values on the balance sheet roughly corresponds to the sum of transactions over the same period as shown in the previous table.  The only significant exception to this is insurance and pensions reserves which, as well as increasing due to household contributions, have also increase due to revaluation effects, i.e. rising asset values.

We can see that the above reflects the rising deposits and falling loans from the financial transactions account.  The stock of loan liabilities of households fell from €146.9 billion at the end of 2015 to €130.9 billion at the end of 2019.  On the asset side of the balance sheet, the amount of current and deposits rose from €129.0 billion to €147.2 billion.

Here is a chart with a longer series highlighting that the reversal of the relative size of loans and deposits takes us back to a position last seen in 2002.

Using these stocks of loans and deposits and the amount of interest paid we can calculated implied interest rates.  The average interest on loans was around three per cent.  The average interest rate on deposits is essentially zero.  After narrowing post 2008, the interest differential or margin between loans and deposits is back to where it was in the early 2000s (around three percentage points).

We can get a better relative position if we put the stocks of loans and deposits as a share of income rather than just looking at the nominal levels.  This shows that the 2019 loan/deposit position of the household sector, in aggregate terms at least, was pretty much back to where it was in 2001/02.

The current account showed us that the income of the household sector has recovered all the losses suffered in the aftermath of the 2008 crash.  And now we can see that the worst of the excesses of the credit bubble have been purged from the household sector financial balance sheet. The COVID crisis is wrecking havoc.  The consequences of that would be far worse if the pre-crisis position of household sector was not as strong as it was.