Pension funds defend a skewed playing field

COMMENT: `The fabulous real returns they have enjoyed on equities over the past 10 years hardly support the case for an extra top-up, courtesy of other taxpayers'

The pension funds are getting in early in warning the new Government not to meddle, as well they should, for abolition of the tax credit enjoyed by pension funds on dividend income is an obvious and very probable target for Labour. Having been taken unawares by Norman Lamont four years ago, when he raised pounds 1bn by reducing the ACT rate from 25 to 20 per cent, they are not about to roll over without a well-orchestrated fight.

At stake is the pounds 4bn annually of tax on dividend income that gross funds are able to claim back from the Government. Because the companies that pay the tax are able to offset this advance payment against subsequent corporation tax bills, the only loser in the current system is the Government.

Actually the loss of revenue in the last 12 months has probably been a great deal more, thanks to the flood of special dividends, share buy- backs and other ingenious wheezes the City has dreamt up to leg over the Treasury. If the penny has finally dropped in Whitehall, it is arguable that the City has only itself to blame.

For all its bluster, the NAPF doesn't really have a credible argument against the reformers. The tax credit, designed with the admittedly worthy aim of encouraging retirement savings, represents a severe skewing of the playing field on which pension funds compete with other forms of saving via equities.

The NAPF claim that the abolition of ACT would reduce the real return on shares is also more apparent than actual if you believe figures from PDFM which suggest the scrapping of tax relief would only reduce the inflation- adjusted return by about 0.75 per cent. Furthermore, the fabulous real returns pension funds have enjoyed on equities over the past 10 years hardly support the case for an extra top-up, courtesy of other taxpayers.

Perhaps the only sensible argument against tampering with the system is that companies facing a reduction in the value of their pension funds would be forced to top them up, thus reducing their taxable profits and lowering the tax take through general corporation tax. What the Government takes with one hand it could be forced to give back with the other. Again, the likely effect here is probably exaggerated by the industry.

Set against this is the self-evident truism that the fiscal privilege accorded the pension funds encourages companies to over-distribute their profits at the expense of long-term investment. There is no incentive to keep money within a business taxed at 33 per cent when the marginal rate for dividend payments is only 13 per cent. The effect of the present system, therefore, is to favour short-term indirect investment over long- term direct investment. This is a philosophical justification for abolition added to the more practical one of raising revenue.

The new Chancellor would none the less be unwise to view this pleasing coincidence of purpose as proving the case. At the very least, the abolition or phasing out of dividend tax credits ought to be balanced by matching reductions in corporate tax to provide real incentive to direct investment. Ideally there should be a quite lengthy and wide-ranging review of the whole system of corporation tax. But then this is a Chancellor in a hurry and with a pressing need for revenue.

Don't rule us out of rejoining ERM

A Chancellor who can astound everybody by declaring the Bank of England independent one morning probably would be capable of deciding to take Britain back into the exchange rate mechanism before breakfast the next day. That, at least, seems to have been the reasoning of those traders in the currency markets who accepted the rumour that sterling was about to re-enter the ERM at a rate of DM2.50. After all, the Labour government has been cosying up to the Europeans all week.

The Treasury scotched the rumour, but the fact that it was neither true nor plausible yesterday does not mean that it never will be. Gordon Brown said earlier this week that the UK was very unlikely to join the first wave of the single currency. That means the question of sterling's relationship to the euro will need to be resolved, and it seems very possible that the Government will join the ERM version two planned for "outs". This will not be the ERM as we knew it at the time of our national humiliation in 1992. Sterling would be linked at an agreed rate to the composite euro, rather than being rushed in at an inappropriate rate against the German mark. Furthermore, the permissible bands of variation would be much wider than they were up to 1992. British membership would be seen as a signal of honourable intentions towards eventual membership of the single currency, so sterling would be supported by intervention from the European Central Bank if necessary. And what could be more appealing than announcing sterling's candidature for the ERM when Britain takes over the presidency of the Commission on 1 January?

After all, the UK will be overseeing the process of deciding which other members qualify for the euro despite being one of the countries least likely to want to join.

Labour dances on the bones of Clarke's PFI

Poor old Kenneth Clarke. Labour is truly dancing on his bones. Not content with consigning the Ken and Eddie show to the dustbin of history, Gordon Brown has now taken the shears to another of the former Chancellor's pet projects, the Private Finance Initiative.

Henceforth, Whitehall will no longer have to test its capital spending plans against the PFI to get the go-ahead. Before the mandarins gleefully take out their cheque books, however, there is one small snag. Nor will there will be any more public money to finance their wish lists. In fact there will be less. Mr Brown and his Paymaster General, Geoffrey Robinson, have stuck rigidly to one thing they inherited from Mr Clarke and that is his last set of Red Book forecasts showing a continuing decline in the capital budget and a rising curve of PFI projects. So much for the pretence that the PFI was ever going to be anything other than an excuse for substituting public money with private funds.

The abolition of the universal testing rule nevertheless makes sense. The PFI was becoming so cluttered that deserving cases, such as hospital projects, were in danger of dying before they got out of the waiting room.

By keeping the choke collar in place around the capital budget, the Paymaster General has left Whitehall with an incentive to dream up more PFI projects. The problem he is left with, however, is finding a mechanism to sort the wheat from the chaff. Mr Robinson has asked Malcolm Bates, a one-time member of Harold Wilson's Industrial Reorganisation Corporation (remember that?) to come up with the solution. All contributions will be gratefully received, particularly since Mr Bates has been asked to report back in just a month.