Hamish McRae: Bush's dividend tax plans promise to bring about an American investment revolution

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The Independent Online

The new US tax plan has been greeted with some disdain. The key provision, ending tax on dividend payments, has been criticised as an inefficient way of boosting the US economy; as a partisan and cynical way of helping the US rich; and as a not-very effective way of helping US business.

The new US tax plan has been greeted with some disdain. The key provision, ending tax on dividend payments, has been criticised as an inefficient way of boosting the US economy; as a partisan and cynical way of helping the US rich; and as a not-very effective way of helping US business.

I think it is probably all of that – and yet if it is indeed passed in more or less its present form, never a certainty in the States despite the President's dominance of Congress, it may still change the world. So if you think of this as a quick fix to help support the faltering US expansion you would be disappointed. It is not that big a deal.

If, on the other hand, you think through the long-term possible structural effects on the way global capitalism is organised, it could be of seismic importance.

The case for the prosecution first. The conventional fiscal analysis runs like this. The total tax cuts in year one, of which the dividend tax abolition and the income tax cuts are the largest elements, amount to about $75bn. That is equivalent to about 0.7 per cent of GDP, which is quite a lot but only quite. After all, it is not much larger than the estimated fiscal cost of a short Middle East war, where figures of $50-60bn are being cited. In any case, additional spending already announced will amount to a further $30bn.

So, yes, this is a sizeable additional boost but there was already the prospect of a large fiscal boost this year. And this boost will not be particularly effective in generating new demand. Dividends are largely re-invested – perhaps 70 per cent of them are. If you had wanted to boost demand you would find a tax cut or an additional spending measure that would feed straight into the system.

One obvious candidate would be for the federal government to help the municipalities and states that are suffering from a fall in tax revenues and so are having to cut back on services.

Finally, there is the objection on equity grounds: these tax cuts go overwhelmingly to the rich and, whatever view you take on that, it seems an odd time to be making such a shift.

There is a further concern, which I have not heard much mention. This is that fiscal policy may not be as effective now as it used to be. In the case of Japan, huge budget deficits of up to 8 per cent of GDP, year in, year out, have failed to generate sustained growth. We don't know why. An admittedly smaller deficit of a bit over 3 per cent does not seem to be generating much additional demand in Germany.

At any rate we should not expect too much in fiscal terms; though the tax package was sold as an economy-boosting measure, it isn't likely to be a very good one in the short run.

And in later years? Well, I don't think it makes much sense to try to calculate what will happen in seven or eight years' time. The variables are too large.

Step back from the fiscal maths, though, and ponder the implications, first in the US and then globally.

American companies are not profitable enough. I had not quite grasped how the share of GDP attributable to private sector profits had shrunk over the past half-century until the economics team at ABN Amro drew it to my attention (see the top chart). As profits shrank and dividends went out of fashion, the market in its wisdom decided that it would get its returns instead in capital gains. So the price-earnings ratio went haywire – see next graph.

Thus we stumbled into a world where companies did not make enough profits and were not expected to pay decent dividends. The result was a lack of discipline on the corporate sector not just in the US but also in other parts of the world where the "need to pay a dividend" culture was downgraded. For different reasons Japanese and to some extent continental European companies felt that objectives such as market share were more important than dividends. Couple this with the fact that interest on loan capital was and is a business expense, whereas dividends are paid out of profits, and the world developed an unstable corporate financial structure.

It was also a structure that tended to misallocate resources. The key point about paying dividends is that investors then reallocate the capital, rather than managers – and as we have recently seen too many managers tend to be self-serving in their decisions.

We are now in the early stages of a sea-change in the relationship between the different forms of investment capital, moving, I think, back to the 19th century presumption that shares should yield more than bonds. That was only sustainable at a time when inflation was zero or (as it was for the second half of the century) slightly negative. In a world of inflation the shares in a decently run company ought to trend upwards in nominal terms, even if not in real terms, while the capital value is relentlessly depressed.

Well, we are not back to zero inflation quite, but look at that bottom graph. For any company in the US that makes or sells goods, as opposed to services, prices are falling. So it cannot rely on inflation to lift its output; rather the reverse. If it merely carries on business as usual it will gradually shrink, so the main way in which its investors are likely to make any return will be by dividends.

The upshot of all this is that dividends were already coming back into fashion. Now the Bush plan gives this movement a huge boost. True, for US residents who held their securities in a pension plan, dividends were already tax-free, just as their were for British residents until Gordon Brown changed tax practice in his first Budget.

An additional chunk of US shares are held in other forms, such as charitable trusts, that also escape dividend tax. But something like two-thirds of US dividends do still attract the liability and this will change. Bush is pushing at an open door.

This will affect companies worldwide, not just in the US, and they will affect investment flows. I am not clever enough to be able to think through precisely how multinationals will adapt to cope with the different preferences of their different classes and nationalities of investors. But I suspect that US tax practice will give an advantage to US-registered companies and also of course to US-resident investors.

This will lead to dynamic effects. Money is mobile and people are increasingly mobile too. It will pay people who already have several bases around the world to rebalance their lives so that they become US-resident. London could become a serious loser, though I think will be a couple of years before that becomes evident.

Finally, do not expect this US tax change to happen in isolation. In the next few years, if it is seen to give a boost to US investors, expect it to be copied elsewhere, including here in the UK. In a world where people need to be persuaded to invest for their future, this may be a Big Idea whose time has come.

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