Money: No need for such high anxiety in the City

The Chancellor said he would encourage investment. This won't happen if he tinkers with the dividend taxation system

It has been a bad week in the stock market, with the Footsie index of big company shares dropping by around 150 points, or around 3 per cent, in four days. Although it is always dangerous to ascribe motives to the market, as if it were a single, living entity rather than a collection of buyers and sellers all with different agendas, there seems little doubt about what has been the major factor behind the fall. This is anxiety about how far Gordon Brown will go in his first Budget next month to change the taxation treatment of dividends, and in particular, what he proposes to do about the system of advance corporation tax (ACT).

The technicalities of how ACT works as far as dividends are concerned is, as even one of the Financial Times' most distinguished economics commentators pointed out this week, a subject so complicated that it can be dismissed as incomprehensible to the vast majority of the public. Fortunately, it is not necessary to rehearse all the technicalities of the so-called imputation system of dividend taxation in order to understand what the underlying issues are and how, on the surface at least, they might affect the stock market.

The temptation for Mr Brown to look at the tax treatment of dividends was one which he was likely to find difficult to resist if Labour won the election. The pension funds and other tax-exempt investment institutions which will suffer most from any change are relatively easy political targets for any Chancellor looking to raise extra cash to fill a hole in the Budget books.

Mr Brown has two options as far as the treatment of ACT on dividends is concerned. One is to reduce the level of the tax credit which investors receive on dividends. The current rate is 20 per cent. The second option is to phase out, or remove altogether, the tax credit on dividends for pension funds and other institutions which are exempt from paying tax on their investments. Both options could affect investors with PEPs.

It is the second option which, so the FT reported on Monday this week, the Treasury is considering for the Budget. Curiously, the day this report appeared, the market fell only very slightly. It was only on Tuesday that the City started to take the issue more seriously.

The National Association of Pension Funds (NAPF) and other lobby groups have been lobbying hard for weeks to try and forestall any change in the tax-exempt status of pension funds, but the FT made the point that if the stock market failed to react adversely to the leaked news that the tax credit might be abolished, it would encourage Mr Brown to believe he could introduce such a move with impunity. Last week's fall in the market should at least, so the optimists argue, prevent the "impunity" argument carrying much force.

With all this manoeuvring going on, it is easy to lose sight of the essence of the matter. What would be the effects of ending the tax credit? The short answer is that it would cut the gross income which tax-exempt investment institutions receive by pounds 5bn a year. Not only would this reduce the demand for shares, but it could also affect the value which investors place on their equity holdings.

Since UK investors have always put a high emphasis on their income from dividends in choosing shares, the implication is that removing the tax credit would send share prices falling, by anything between 5 per cent and 15 per cent. Some of this will have been discounted already by the market, but it would certainly imply a further drop in share prices after the Budget.

Cutting the rate at which the tax credit is set has a slightly different direct effect from eliminating it. Don't ask in detail why, but it has the effect of reducing company cash flow and raising the effective rate of corporation tax that companies pay. As this clearly affects company profitability, it will also have an adverse affect on the stock market, since companies will be generating less profit than before. But the effect would be less marked than cutting the tax credit.

The problem Mr Brown has is that while he would like to raise some extra cash, the effects of grabbing it through tinkering with the dividend taxation system are such that they make a mockery of another of his declared intentions, which is to encourage companies to invest more. Fashionable left-of-centre opinion has it that one of the main reasons for the alleged lack of investment by UK companies is the short-termist attitude of the big City investment institutions, which is reflected in the preference for dividends over capital growth.

Even if you accept this diagnosis, the problem is that it is hard to see how taking a big chunk out of the cash flow of companies or pension funds will help to encourage more long-term investment by the corporate sector. Cutting corporate cash flow will raise the cost of capital for most firms, and hitting the pension funds may merely force companies to have to make even bigger contributions to their own pension funds to keep them fully funded.

Hence the feeling among some analysts in the City last week that, if Mr Brown is serious about encouraging more investment, he is unlikely to want to raise the overall tax take on companies. Any change in the ACT regime which has that effect, for example reducing the tax credit, would have to be balanced by other moves on the corporate tax front. Mr Brown could cut the rate of corporation tax itself or increase capital allowances.

Conclusion, on this line of thinking: the stock market should not be worrying so much, although anything which makes dividends less attractive is likely to hit shares with high dividend yields more than those with low yields. The pension funds and their tax-exempt status could still, however, be a legitimate target on political grounds. Nobody knows how the pension funds would react if their tax privileges were removed.

Chances are the effects would be less dramatic than the lobbyists have claimed, but some adverse effect on market sentiment seems inevitable. Will Mr Brown go for long-term structural reform or the quick revenue fix? The one certain conclusion is that, whatever happens to dividend taxation, it will give us a clue about the balance of rhetoric and sincerity in Mr Brown's grand aspirations. But some adverse market reaction seems more than justified.