I am all in favour of two-way traffic. I would like to address the question of our engagement with Northern Ireland and the UK. The Minister for Finance engages on a regular basis with the Chancellor of the Exchequer and his Northern Ireland counterpart in respect of European and North-South bilateral issues.
Taxation strategies, in general, reflect the political choices made by governments towards meeting the specific needs and requirements of countries. In this regard, Ireland has focused on achieving a low taxation economy, especially in the area of direct taxation, both income and corporation taxes, which has delivered significant advantages in competitiveness. In ensuring a relatively low level of direct taxation on income, we have, therefore, had marginally higher indirect taxation. Recent developments have led to widening of the differential arising from indirect taxation as a result of a reduction in the UK VAT rate. However, the UK Government has signalled that this reduction is a temporary measure to be reversed at the end of 2009.
The Comprehensive Study on the All-Island Economy, to which the Deputy refers, sets out a strong rationale for beneficial all-island economic activity. The study, which was published in 2006, highlights the "market widening effect" of a larger market on the island of Ireland, within which previously unexplored business opportunities can be exploited. It is an inevitable feature that where there are two jurisdictions, with two different currencies and two different tax regimes, there will be distortions at different times in the marketplace. The balance in trade has switched at various times to different sides of the Border, giving rise to swings and roundabouts for both sides in terms of who benefits or loses in the local economies and sub-regions over time.
The increase in cross-Border trade in recent months was to be expected, particularly given the size of recent exchange rate movements. While this movement of retail activity to the North has implications for the Government's tax revenue — the Minister gave a specific figure in an earlier debate — it is consistent with the logic of an increasingly all-island economy in which competition and customer mobility are greater than ever before. In a time of increased financial turbulence in the wider markets, there may also be opportunities for companies, North and South, to expand their market-share on an all-island basis and develop stronger customer relations and become more responsive to customers. They will also have to pay closer attention to managing costs.
The current economic difficulties put into clearer focus the need for all of us to work as policy makers to see how we can collaborate more effectively to address the challenges and get ready to make the most of the opportunities when they arise, as they inevitably will. Our economies face similar challenges in the context of the world economic downturn and it is clear that we both need to position ourselves to take advantage of the upturn when it emerges.
With respect to divergences in indirect taxation, I have noted our overall taxation policy of lower direct taxation and resulting relatively higher indirect taxation. Our VAT and excise duty policies reflect this overall approach. With regard to VAT arrangements, the temporary nature of the cut in the UK's standard VAT rate must be noted, as must the offsetting arrangements announced simultaneously in the area of excise duties. In cutting its standard rate from 17.5% to 15% from 1 December 2008, the UK signalled that this measure will be reversed by the end of 2009. With regard to excise duties, the UK announced a simultaneous increase in excise duty on alcohol, cigarettes, petrol and diesel to offset the 2.5% reduction in VAT on these items. Consequently, there was no reduction in the price of these products in Northern Ireland as a result of the reduction in the UK VAT rate.
It must be recognised that the VAT rate is only one factor in the price differential north and south of the Border. I mentioned the significant currency movements and the considerable weakening of sterling has had a more significant impact on relative prices than VAT changes. For example, sterling has weakened by 36% since early August 2007 and by approximately 18% since early October 2008. Past experience has shown that fluctuations in the relative exchange rates can have a direct effect in terms of the level and balance of cross-Border trade with Northern Ireland.
The Government's decision to increase the standard VAT rate by 0.5% was part of a general package of revenue raising measures to fund key public services. We are borrowing to fund day-to-day public services, which is unsustainable, as future generations will be required to pay higher taxes unless we correct our public finances. The Minister recently published a report, Implications of Cross Border Shopping for the Irish Exchequer, prepared by the Office of the Revenue Commissioners and the CSO. In addition to the rapid depreciation of sterling against the euro, the report notes that the other main causes of price differentials between goods in Northern Ireland and the Republic are operating costs, profit margin mark-up and taxes. While changes in the standard VAT rates have widened some price differentials, their impact remains small compared to the impact of currency movements.
In broader terms, our general tendency towards somewhat higher indirect taxation also reflects other policy objectives. For example, in the case of alcohol and tobacco products, it has been a long-standing policy for sound health and social reasons to apply higher excise rates to such products. Our excise rates on these products are, therefore, higher than those in the UK and most other EU member states.
I refer to the question of indirect taxation and EU competition law. The code of conduct for business taxation is a political agreement designed to curb harmful competition in business taxation. It focuses on national tax measures, which have a significant effect on the location of business within the Community and which provide for a significantly lower effective rate than the rate generally applying in the member state in question. The code was specifically designed to detect only measures that unduly affect the location of business activity in the Community. It focuses on measures, which are targeted merely at non-residents and which seek to provide them with a more favourable tax treatment than is generally available in the member state concerned. In the circumstances, it is apparent that the indirect taxation divergence in question would not come under the remit of the code of conduct.
With regard to EU competition law and the EU VAT directive, the VAT directive sets out the rules governing the structure and operation of the VAT system by member states. In this regard, a degree of flexibility is afforded to them regarding decisions on the choice of VAT rates within the boundaries set out by the VAT directive. For example, they may set their standard VAT rate within the range 15% to 25%. In addition, they may operate reduced rates between 5% and 15% and they may retain zero rates, which were in operation on 1 January 1991. The flexibility available under the VAT directive is important in allowing member states to develop VAT arrangements appropriate to their individual needs. The resulting differentials in VAT rates between neighbouring member states are, therefore, not unusual across the European Union.
