Dominic Swan is Chairman of Hornchurch and Upminster Conservative Association. He was previously a Senior Vice President at Moody’s Investors Service, Managing Director at HSBC Global Markets, and Global Head of Fixed Income and Private Debt for HSBC’s Asset Manager, where he was responsible for portfolios of over $200 billion.
The article outlines how a simple cost neutral change to the taxation of UK pension funds would encourage significant investments in British companies, discourage companies from borrowing too much and incentivise high growth businesses.
The UK pension system is the second largest in the world. But many, including the Treasury, are asking why it invests so little in British companies.
According to the Pensions and Lifetime Savings Association, UK Defined Contribution pension funds have £1.5 trillion of assets. But only 3% (circa £45 billion) is invested in the shares of listed British companies, while almost five times as much (14% or approximately £210 billion) is invested in foreign shares. The remainder is in debt such as bonds issued by governments and companies (70%), with some property, private equity, cash and other assets.
One key reason for the lack of investment in UK companies is Gordon Brown’s infamous policies on our pensions. Because of this, the UK effectively charges a 25% tax on dividends that our pension funds receive from British companies, but does not tax dividends received from overseas companies or interest received on debt.
The government is actively encouraging pension funds to back Britain, with initiatives such as the Mansion House agreement recently announced by the Chancellor.
Changing the tax treatment of Pension Funds, so that they pay the same effective UK tax rate on UK and overseas shares, and on shares and debt, would significantly boost investments in British business, as follows.
At present, when a UK company earns £100 on its core business activities, it can typically pay this out as interest on its debt, tax free. But if it distributes the same money to its shareholders as a dividend, it must first pay corporation tax at 25%.
This is a long standing quirk of the tax system, but was previously counterbalanced by allowing UK pension funds (the largest investors in the UK system) to reclaim some or all of that corporation tax through a special “Dividend Tax Credit”.
Unfortunately Chancellor Gordon Brown abolished the Dividend Tax Credit during the Blair administration. This was his infamous raid on UK pension schemes in 1997.
Taxing dividends payments but not interest on debt encourages companies to take on more debt. This makes them more likely to go bust, as debt must be repaid regardless of circumstances, while a company can always cut the dividends on its shares if it gets into trouble.
Treating debt more favourably than shares, also discourages investments in entrepreneurial and higher growth companies, as they find it harder to issue bonds or take out debt (which typically needs to be secured against more stable cashflows).
The UK water companies are a sad example of how these perverse incentives can combine. They were previously owned by a mix of pension funds and individuals, and had modest debt levels. But under the system created by Gordon Brown, pension funds found it more efficient to sell their shares and buy additional debt taken on by these companies. This makes it hard to hold these companies to account for their social obligations, without the risk of bankruptcy.
The Government should restore Dividend Tax Credits on UK shares in UK Pension Funds. Ideally, we would simply reduce the tax burden. But if this is not possible, pensions funds could receive the Dividend Tax Credit in exchange for a small tax on all income (but not capital gains) earned within the fund regardless of source. Given how little UK pension schemes have invested in UK shares, that tax rate would likely be 10% or less. There would be no change to the personal tax treatment of pensions.
Pension funds would then be encouraged to sell shares in overseas companies and buy UK shares, as both have similar risk levels. Even they still had twice as much invested abroad at the end of this process as in the UK, it would generate £80 billion for UK companies from Defined Contribution pensions alone.
There will also be some transfers from UK Corporate bonds to UK shares. The smallest reallocation would likely come from Government Debt, as replacing government debt with shares would increase the overall risk profile of a pension fund, which many will not want to do if they have matched their assets and liabilities or want to avoid changes in the stock market impacting the profits of the companies providing the pension.
There are also attractive secondary effects.
First, as the tax would not apply to capital gains, the very highest growth companies, which generate capital growth rather than income, would actually have a small tax advantage in the pension system. This would support the Chancellor’s Mansion House reforms.
Second, more demand for shares would increase the market value of UK companies, and the pool of money available to invest in them. This would encourage companies to list in the UK, particularly as many pension funds actually allocate or benchmark their portfolios to stock market indices (such as the FTSE All Share Index), which contains a mix of companies based in the UK and those that have listed on the UK exchange from abroad. It would give a welcome boost to the City of London.
Let British Pension Funds back British Industry!