Taxing questions in need of answers: Posers offered by Stephen Dorrell have fired City interest but, Peter Rodgers writes, it is his solutions that matter

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The Independent Online
STEPHEN DORRELL is an engaging, open-minded Treasury minister, who has been tipped for a cabinet seat this summer and may well prove the Tory left's answer to Michael Portillo.

But his popularity in the City will depend less on his promotion prospects than on the answers he gives to some frank questions he has been raising this spring.

They cover such delicate matters as whether companies have been paying out excessive dividends and if the money would be better spent on investment, subjects aired more often in the past on the Labour benches.

As financial secretary to the Treasury Mr Dorrell is in a position to recommend all sorts of unwelcome changes, including a renewed attack on the tax privileges of pension funds.

Mr Dorrell is delving, at the Chancellor's request, into the arcane subject of the flow of savings to industry.

This is the stuff of a dozen tomes over the past 50 years, all of which - like the Wilson report in 1979 - have failed to come to any radical conclusion.

But Mr Dorrell says he is not going to publish a report, boring or otherwise. He says: 'The review is very much focused on whether the policy levers available to us should be moved.'

Dividends in particular are sensitive, since the Treasury changed advance corporation tax rules at the expense of pension funds.

The City has been reminding Mr Dorrell of what actuaries will say about any further hit to pension funds' earnings. Contributions to funds will have to be raised to maintain pension-buying power. Much of what firms save in dividend payments they will lose in propping up pension funds.

But Mr Dorrell's thoughts have been moving so fast that it is hard to guess where he will end up. Indeed, some in the City suspect he is on the retreat, because he has been treading on ground long occupied by the Labour opposition, risking a slap over the wrist from his right-wing Tory colleagues.

For example, he began by noting that dividends are a higher proportion of profits here than in continental Europe and Japan.

The implication of this line of thought has always been that high dividends should be discouraged by taxation.

There is authoritative support for this line of thinking. Stephen Bond of the Institute for Fiscal Studies says the tax treatment of dividends favours high payments, reduces internal financing and is likely to have an adverse impact on investment spending.

The Commons trade and industry committee made similar claims last month. But in a speech this week to the CBI council, Mr Dorrell described the comparisons with lower payouts in Germany and Japan as an 'old chestnut'.

Britain has much bigger capital markets, size for size, than either country. As companies raise more outside equity, dividends naturally play a bigger role.

More important is the claim heard in the City that lower dividend payouts in Germany and Japan may have nothing to do with their much higher national investment. M&G, the unit trust group, says where bank lenders are the main providers of finance they insist companies keep more cash in their balance sheets to cover future interest payments. So money saved on dividends in Germany is not marked for investment.

Indeed, it is questionable whether dividend cuts would make the crucial difference claimed here. Rolls-Royce saved pounds 22m a year with its 1992 dividend cut, compared with R&D and capital spending last year of pounds 357m.

Mr Dorrell says he now accepts the argument that the UK's approach is more efficient: 'Both because it creates a pressure on managers to deliver returns from their companies, and because it allows capital markets to re-allocate capital away from under-performing companies towards those most likely to deliver attractive returns.' Market enthusiasts in the Tory party will like that.

But he is still concerned about the rapid rise in dividends during the 1980s and early 1990s, and about companies' reluctance to cut them when profits fall in the recession (see chart).

Directors hand the money out and then pay City underwriting and advisory fees to get it back again in rights issues, says Mr Dorrell. Why not keep it in the first place, through lower dividends?

And if dividends go up but never down, it undermines the idea that equity investors reap a high return for high risks.

Dividends were controlled before Mrs Thatcher came to power, and part of the 1980s surge was probably a one-off readjustment. The rise in the payout ratio towards the end of the recession is typical of the lag between the start of recovery and renewed investment, which leaves many firms temporarily cash rich.

As Mr Dorrell acknowledges, the payout ratio fell back for 1993, just as expected, when earnings began to reflect recovery. And dividend decisions reflect future prospects as well as the previous year, so calculations made on earnings forecasts show more modest payout ratios.

But the macro-economics is less important than what happens on the ground. There are plenty of examples of what occurs when companies retain large amounts of cash and then spend it badly. Look at East Midlands, the electricity company that frittered its money away on loss-making projects.

Or in a more positive vein take Sainsbury which, like Tesco and Argyll, invested heavily in the 1980s. Its pounds 168m dividend last year was 36 per cent of profits, a level Mr Dorrell might think reasonable.

But Britain has enough supermarkets and Sainsbury has reached a plateau of expansion. It should be paying out far more of its profits as dividends so the money can be recycled through the markets to engineering companies that are short of cash for investment. That would also ease the temptation for Sainsbury's to invest for the sake of it, perhaps on unprofitable foreign expansion.

But even if Mr Dorrell accepts all that, there are some other tougher questions to answer, such as the high cost of rights issues, the difficulty of doing them frequently when investment needs are rising and their irrelevance to many smaller companies. Perhaps he will suggest the City helps by slashing its underwriting fees.

(Photograph omitted)

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