Fears for dividends: City on watch against tax changes to reduce payouts

IT WAS NOT so much what Kenneth Clarke said as how he said it. As he and other senior Cabinet ministers assembled at Lancaster House last week to unveil the White Paper on Competitiveness, the Chancellor said that the Government was 'very actively looking' at what it should do about dividends in the Budget.

Dividends have proven a sore point in recent months. The City fears that tax changes may be on the way to discourage high dividend payouts. At present the tax system treats pension funds favourably.

A report by the Trade and Industry Select Committee, published in April, explored the two most common criticisms: that dividend levels are too high in relation to profits; and that they are too inflexible, failing to vary as profits rise and fall.

Despite vigorous rebuttals from institutional investors, the committee concluded that there was indeed a link between high dividends and low investment in research and development. It added that the pressure for consistent dividends represented a conflict of interests between the City and industry. 'In our view what is required is not consistent dividends but consistent investment by industry,' it observed.

Institutional investors were dismayed. They are happier with what they see as the 'open-minded' attitude of Stephen Dorrell, Financial Secretary to the Treasury, who has been conducting a review of savings and the flow of finance to industry. In a speech to the CBI two weeks ago, Mr Dorrell signalled his concern about dividends, but said that 'a government should only consider tax changes if the result would be a clear and identifiable economic improvement'.

Institutional investors were all the more surprised, then, by the Chancellor's latest remark. 'We don't quite understand his point of view. It doesn't seem to be at one with Stephen Dorrell's comments,' said Peter Jones, head of research at M&G Investment. M&G has long been one of the most outspoken City institutions, advocating high payouts. 'The dividend is a discipline. Companies choose their capital investment much better if they're a bit short of capital,' Mr Jones said. He argues that companies should maximise dividends, boosting the share price so they can enhance shareholder value and make it easier to secure external capital.

It is not a view with which all the institutions agree. 'To distribute too much and then raise capital through a rights issue is an inefficient way of running a business,' says Geoff Lindey, chairman of the investment committee of the National Association of Pension Funds.

But where they concur is in opposing the view that high dividend payouts detract from investment in R&D. 'What is undoubtedly rubbish is that companies working out how much dividend to pay are sitting there looking at their R&D expenditure,' Mr Lindey said.

He notes that a 30-year history of high inflation and correspondingly high interest rates - together with a greater degree of volatility than in Japan and Germany, for example - has forced British industrialists to seek very high rates of return on capital investment. He said: 'It is quite conceivable that companies do not hold back on long-term projects because they are required to pay dividends but that, on the contrary, they pay high dividends because they are unable to find capital projects which are likely to meet their target returns.'

The problem is the extent to which politics and economics mingle. Mr Jones bluntly attributes the recent interest in dividends to a particular political agenda. 'This whole debate appears to be the Government saying, 'here am I, trying to get capital into industry and boost the number of jobs,' ' he said. 'But we regard ourselves as responding to the needs of savers, who are just as much voters as those who are looking for jobs.'

Mr Jones insists that we should not just swallow the latest 'government propaganda'. Yet it is easy to forget that the shift in the payout ratio that has taken place over the past decade is equally the product of political manoeuvring. As Mr Lindey notes, it was a Labour government that first imposed restrictions on dividends as a way of keeping wages down. When the Conservatives lifted those restrictions in 1979, industry raised dividends rapidly.

In the boom days of the mid-1980s, most companies were willing and able to make substantial payouts. But in the recession many failed to make the necessary cuts until they had eroded their dividend cover entirely. While the management of a company bears much of the blame for errors of judgement on this score, it is true that the Government created the climate in which it was expected that more than half of earnings might be distributed each year.