Taxing pension funds could be good for our health

'You get scares followed by denials followed by damaging pledges. The scare/denial/pledge syndrome is the main reason we don't have a broadly based VAT system'

General elections are bad for the health of our tax system, because in election campaigns you get tax scares followed by denials followed by damaging pledges. The scare/denial/pledge syndrome is the main reason we don't have a broadly based VAT system. We've seen it happen so often. Party X accuses Party Y of having secret plans to impose VAT on food. Party Y denies it, but the denial is unconvincing until the Minister makes a formal on-the-record pledge never to impose VAT on food. The result of this process, repeated in many fields, is that when the election is over a number of sensible policy options have been ruled out.

However there is one area of the tax system - the taxation of companies - that seems to be immune to the scare/denial/pledge disease, probably because it is so complicated that nobody understands it. That is a pity because it raises some interesting issues that deserve to be debated in the election campaign. Do we have the best system for channelling national savings into investment? Does the City have too much power? Should we give the managers of our large plcs more influence?

These issues are all raised by the possibility, much discussed in City circles recently, that Gordon Brown might seek to raise revenue by a further raid on the pension funds. It would be easy to do, and difficult for the Conservatives to oppose, because Mr Lamont showed the way in his last (1993) Budget. That raised pounds 1bn (in a way that few could quite understand on Budget day) by cutting the value of the tax credit given on the distribution of dividends. The option of a further reduction in the tax credit is still there, though it will not be so easy now as the pension funds have marshalled their defences.

Mr Brown will not want to offend the City by imposing a net increase in the corporate tax burden (which would lead directly to a fall in share prices). But suppose he were to use the proceeds from reducing the tax credit to cut corporation tax, in a revenue-neutral reform. He would then be able to argue, as I shall explain, that he was implementing a set of measures designed to increase investment and to ensure that a greater share of profits are reinvested in the businesses that generate them.

Such a reform would address an important economic issue: who is the best judge of how the nation's savings should be invested? Is it the companies which generate a substantial portion of those savings themselves and usually have plans to reinvest them in the business? Or is it the financial institutions which advise the vast pension funds that now own over a quarter of British industry? It would be very New Labour to wrest these decisions from the City and empower the managers of UK plc.

At the moment the tax system gives strong incentives to companies to give their profits back to the financial institutions as dividends rather than reinvest them in their own business. Those incentives derive from the highly privileged tax status of the pension funds whose views businesses cannot afford to ignore. The institutions have a duty to get the best deal for the pensioners whose savings they are looking after. And in pursuit of that legitimate duty they put pressure on companies to hand back their profits, so that they can pick up the tax credit, rather than reinvest them.

The privileged tax status enjoyed by the pension funds does not simply derive from the fact that they pay no income tax on their dividend receipts. That is only right and proper. The real privilege is that they also pay very little corporation tax. When a company pays dividends to a higher- rate taxpayer, income tax plus corporation tax is levied at a combined rate of 50 per cent. If the dividends go to a basic-rate taxpayer they bear only corporation tax at 33 per cent. But when dividends are paid to a pension fund, the combined tax rate is only 16 per cent.

There is room for argument as to the proper scale of the fiscal privileges accorded to the pension funds, but what is potentially damaging is that the privilege is limited to distributed profits. Retained profits are taxed at the full corporation tax rate of 33 per cent. The effect of this unequal tax treatment is that if a company reinvests its profits in a project of its own choosing, it has to show a return that is 25 per cent better than the market to satisfy its institutional shareholders. So we have a situation where pension funds are bound to press the managers to distribute rather than retain profits. And that means the City rather than the managers of UK plc determines where the next round of investments are made.

These incentives appear to have had an effect on behaviour. The charts below show that dividend yields are higher in the UK than in any other G7 country, and the proportion of company profits distributed as dividends has increased dramatically since the mid-80s.

In the light of these facts, Mr Brown might well conclude that the pension funds could afford to pay a little more tax, especially if the money were used to give an across-the-board incentive to investment (ie reducing the corporation tax rate). Taxing the profits distributed to pension funds more heavily to tax profits retained in companies more lightly is a way of levelling a playing field tilted in favour of dividend distribution.

It is a policy tailor-made for New Labour. Many unconnected voters probably share the view of the Left (eloquently set out in Will Hutton's book The State We're In) that the City has altogether too much power and influence. They see the financial institutions which provide money to British industry as short-termist and greedy, demanding large, and quick, returns on their investments. Things are better organised, many believe, in Japan and Germany where companies are able, without City institutions breathing down their necks, to retain their profits and reinvest them in sound long-term projects.

Reducing the tax break on dividend distributions would reduce, though not eliminate, the strong incentives to recycle profits via the financial institutions. In that sense it would reduce the power of "the City" and increase the power of managers in UK plc.

Would it be sensible? My own view is that in a completely tax-neutral world, company managers would probably be too inclined to put money in their own pet projects rather than give it back to the shareholders. The incentives to distribute are a powerful incentive to subject all investment to the most rigorous market tests and in that sense they encourage efficient investment. These incentives may have been too powerful in the past, which is why I think Mr Lamont got it about right when he reduced them a bit in 1993, achieving a much-needed reduction in the PSBR at the same time. But then I would say that. I was advising him at the time!

Bill Robinson is a director of the consultancy London Economics