Tax magic is an illusion

Kenneth Clarke could find it hard to repeat his predecessor's successful trick with ACT. Peter Rodgers reports

It Looks deceptively like the perfect tax cut, a dream for any Chancellor looking for extra revenue: reduce the rate of advance corporation tax and, hey presto, the Treasury's tax revenue actually rises rather than falls.

The losers are investing institutions such as pension funds and insurance companies, not always the nation's favourite people, and also higher-rate taxpayers with share portfolios, who represent a small minority of voters and unlikely to kick up much of a fuss.

Norman Lamont used this smart trick in 1993 when he raked in an extra pounds 1bn by cutting the ACT rate from 25 to 20 per cent. A further reduction is bound to have been put on the list of options for this year's Budget.

The reason the Inland Revenue gains when the tax is reduced is that ACT is basically a deduction at source of income tax on shareholders' dividends, using the company as the tax collector.

When companies pay less ACT, higher-rate taxpayers face bigger bills from the Inland Revenue. More significantly, pension funds and insurance companies are tax exempt and are allowed a rebate on their ACT. Drop the rate of ACT and the rebate falls, a windfall for the Treasury.

Tax is never so simple, of course. When Mr Lamont reduced ACT, share prices fell. Less tax rebate equals lower net company earnings.

If that were the only problem, the Chancellor could shrug it off, because the market fell just a few percentage points in 1993. However, a second drawback is that if future after-tax dividends are likely to be lower, final-salary company pension schemes may begin to slip into deficit.

This is because actuaries value pension funds on the basis of the dividends they expect to receive. The whiplash effect of an ACT reduction is that any shortfall in the pension fund would have to be made good by the companies, a drain on resources that could damage investment.

Nevertheless, if Mr Lamont can get away with it, why not Mr Clarke? When Mr Lamont whisked away that pounds 1bn three years ago, the fuss was all over before the pensions industry woke up to complain.

One reason Mr Clarke may be wary of trying it this time is that institutions have made a lot of progress in persuading the public that they are not faceless representatives of an overpaid City, but managers of peoples' savings.

They have been helped by the shift in the savings market to personal pensions and personal equity plans (PEPs), and away from reliance on final- salary company pension schemes, which are remote and hard to understand. Mr Clarke can be sure of a much swifter and louder reaction if he cuts ACT again.

The Institute for Fiscal Studies, in its Green Budget last week - an attempt to get behind the Chancellor's thinking - put forward a second and more technical reason why the Treasury is likely to hesitate. Intriguingly, this makes it more likely that Labour will make the change itself if it wins the election.

Mr Lamont reduced ACT to the same level as the starting rate of income tax, where it remains today. The IFS believes that if ACT were cut even slightly below the lowest rate of income tax, the City would interpret this as an indication that the Government was beginning to phase out the system altogether.

The original thinking behind ACT was, after all, to remove double taxation of dividends, which would otherwise face both corporate and income taxes. There is a logical justification for keeping the ACT rate the same as the bottom income tax rate.

The so called imputation tax system, of which ACT is the key part, is already under attack in Europe because it discriminates against some companies that operate across borders.

Hoechst and Pirelli are challenging the imputation system as unlawful under European law. There are other arguments against ACT in its present form within the UK, mainly because some companies cannot reclaim it all against ordinary corporation tax.

The IFS believes that even if the actual cut announced is quite small, the City would read the move as a sign that ACT would eventually disappear and share prices would react accordingly - which would cost billions. With the stock market overvalued, it might even prompt the big plunge in share prices that is widely feared.

So another attack on ACT would be dangerous for the Conservatives just as they are trying to persuade the City that it is Tony Blair who should not be trusted.

It so happens that Labour is thinking of cutting the starting rate of personal taxation to 10 per cent. Since Mr Lamont set the precedent of keeping the ACT rate in line with the bottom rate of income tax, an incoming Labour Chancellor would have a good justification for a further cut in both rates at the same time. One would help pay for the other.

However, it would be a serious mistake to do this in haste. Changes in ACT go to the heart of the question of the tax treatment of savings - and whether they should maintain their special privileges or have them phased out.

How can pension-fund tax be changed without looking at PEPs, Tessas and all the other exemptions? The only honest way to attack ACT would be to link it with a broad review of the taxation of pension funds and other savings.