Don't take it out on the dividend
Shareholders' thirst for high returns is often blamed for Britain's poor levels of capital investment. Peter Rodgers says there's a different reason
Sunday 12 January 1997
Some blame institutional investors for making excessive demands of the companies they own, bleeding them dry of cash; the more sophisticated blame the corporation tax system for encouraging companies to pay too much in dividends to shareholders rather than retain it for future investment.
It is actually hard to prove that high dividends eat directly into investment and starve industry of equipment. There may be quite different explanations for the low capital spending that has dogged the British economy. But rightly or wrongly, there is a widespread view that something needs to be done about dividends. Action is increasingly likely under a future Labour government, whose advisers have been studying the dividend conundrum for years.
The theory is that City investors require such a handsome dividend on their shares that finance directors are forced to set very high minimum rates of return - typically of around 20 per cent or more - before they will back new investment projects. So few can leap the hurdle that investment suffers as does the economy as a whole.
The issue is about to resurface shortly in a report by the Commission on Public Policy and British Business, an expert group set up by the Labour-oriented Institute for Public Policy Research. The commission is backing proposals to encourage companies to restrain dividends and retain more cash in their balance sheets for investment.
One option would be a tax allowance against retained earnings which would make it relatively less attractive for companies to make dividend payments. Proposals along these lines have previously been put forward by the Institute for Fiscal Studies, one of the most influential critics of the present corporate tax system. The IFS says the system increases the cost of capital for companies because there is no relief for the cost of using equity finance - and particularly retained profits - to finance investment spending.
Like any tax reform, such changes would have to be paid for. The likeliest way of finding the money is to abolish the 20 per cent rebate on advance corporation tax payments on dividends, which is available to pension funds and other tax exempt institutions. The rebate is worth about pounds 4bn a year but, although there may be good theoretical arguments for reducing it, there are tremendous practical problems, not least the effect on stock market valuations of companies.
Since removal of the rebate would reduce the income and capital value of pension funds at a time when the new Pensions Act is imposing more stringent solvency requirements, the end result could be to drive some pension schemes into deficit. Companies would be obliged to make good the difference, eating into any gains they might make from the new tax relief. It would be a case of giving with one hand and taking away with the other.
And the move would certainly cause a huge row with the City, judging by the reaction to Norman Lamont's modest reduction from 25 to 20 per cent in 1993. Therefore, reforms might have to be spread over a long period .It would be surprising if Labour managed a complex change to the corporation tax system in its first Budget.
But could it be that this focus on high dividends as the cause of poor investment is just plain wrong? Peter Spencer, Professor of Financial Economics at Birkbeck College in London, and a former economist at the City firm Lehman Bros, thinks it is and pins the blame instead on a rather more basic characteristic of the financial system.
In a paper published last month, Mr Spencer accepts the argument that the investment community is demanding unacceptably high rates of return from companies. Shares have outperformed bonds by 6 per cent a year throughout the century, a risk premium which Mr Spencer says is "a problem for everyone in Britain" because of its impact on the cost of capital and on companies' investment behaviour. The premium results from a combination of dividends and capital growth.
Economists have searched for explanations for this high risk premium - theory says it should be far lower - but without much success. Mr Spencer believes the reason is that in a nation obsessed with home ownership, too small a proportion of private wealth is invested in the stock market. Share ownership may have spread over the last 15 years, but it is still heavily concentrated in value terms among a small number of prosperous private investors, pension funds and other City institutions.
This small pool of equity capital providers therefore has a powerful lever to demand high rewards, in the form of dividends and capital growth combined.
The best way to reduce the investors' demands for high rewards and provide cheaper capital for industry is not to restrict dividends but to divert far more of Britain's savings to the equity market. Put simply, if the market is flooded with capital looking for equity investments, it will have to accept lower returns, to the benefit of British industry.
Anything that widens share ownership and increases the proportion of savings that goes into equities would boost the economy. Mr Spencer believes it would even be beneficial to encourage borrowing to finance long-term investment in the equity market.
If Mr Spencer is right, the best way for Labour to reduce the financing costs of British industry would be to push through its plans for a new form of collective pension fund - the so-called stakeholder pensions - which would bring large numbers of new investors into the stock market. This would be a lot more useful to British industry than interfering with the level of dividend payments.
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