David Smith looks at aspects of the UK economy that could explain low investment levels.
Ever since British governments started taking economic policy seriously, one question has kept coming back; how can you raise the level of investment in the British economy? The response has taken a number of forms. In the 1930s, the Macmillan committee looked at the supply of finance to industry, particularly small and medium-sized firms, and identified the famous finance gap for firms too big for their banks and too small for the stock market.
Post-war governments pursuing Keynesian policies saw public sector investment, including that by nationalised industries, as a way of compensating for inadequate private sector capital spending. In the 1980s, we witnessed the birth of a number of schemes, either aimed at securing a flow of savings from individuals directly into equities (personal equity plans) or new and expanding companies (the Business Expansion Scheme). Some policy initiatives (Tax Exempt Special Savings Accounts) merely had the aim of increasing the overall level of saving in the economy (a low level of saving being the direct counterpart of inadequate investment).
Policy has not always pursued a consistent line. The 1984 Lawson reforms of the corporation tax system, in which stock appreciation was abolished and capital allowances greatly reduced (to 25% over time), in return for a lower mainstream corporation tax rate, was partly based on the perception that the old system of 100% capital allowances had the effect of encouraging investment for the sake of it. As Nigel (now Lord) Lawson said at the time, 'It is doubtful whether it has even been really sensible to subsidise capital investment irrespective of the true rate of return. But certainly, with over three million unemployed, it cannot make sense to subsidise capital so heavily at the expense of labour.' Ten years on, the Treasury is concerning itself again with the question of whether there is something about the UK's economic system which discourages investment. In March Stephen Dorrell, as financial secretary to the Treasury, embarked on a review of the financing of small and medium-sized firms. This is now roughly at its half-way stage, given that any results that are deemed worth publishing or acting on will probably have to wait until the November Budget. Even so, some general points can be made.
The first is that, like the Macmillan committee, ministers and officials believe that there is a financing gap in Britain. This may seem a little odd, in that Britain is recognised to have a venture capital industry that is well ahead, in terms of both the volume of investment and sophistication, of anything else in Europe. The emphasis of the venture capital industry is seen, however, to be too heavily focused on management buy-outs and the development of existing businesses. Even a sophisticated venture capital industry, it appears, does not cater properly for high-risk new and young businesses.
A second strand of criticism is that there is too much reliance on overdraft finance by small and medium-sized firms. This reflects the traditional preferences of both the banks and their business customers. For the former, overdrafts offer the fastest route to reducing exposure to a business if things turn nasty, either for the lender or the borrower. For the latter, the overdraft is flexible, and interest only has to be paid when the facility is used. Unfortunately, this flexibility also works on the side of the lender and can result in sudden, and highly-damaging, withdrawal of overdraft facilities.
The banks have, it is true, taken to placing greater emphasis on longer-term, often fixed-rate finance, and this is a good thing. The Government has, in addition, made much of the possibilities for smaller companies to tap into informal sources of finance, through so-called business angels. The DTI is aiming to set up a register and network of such angels, through its Business Links one-stop shops.
One difficulty can arise from the attitudes of owner-managers of smaller companies themselves, many of whom remain fundamentally opposed to offering outsiders equity stakes in their firms. This is one of those catch-22s. Owner-managers of smaller firms are, by their nature, independent. But the optimum solution to their financing problems may involve giving up a degree of that independence.
The most controversial aspect of the Treasury's exercise is, however, in a third area, that of dividends. The starting point is that something has happened to change dividend behaviour by quoted companies. In the early '80s, UK companies typically paid out 25% to 30% of post-tax profits in dividends. By the early '90s this had doubled.
As the chart shows, there has been no comparable shift in other major countries. Japanese and in particular German companies distribute a much smaller proportion of profits and this has changed little in recent years. In France the proportion has declined. In America it is high, but has not risen in recent years.
There are two possible explanations for this. The first is that the institutions have become more powerful, insisting on higher levels of pay-outs by the companies in which they are major investors. If, at the same time, such pay-outs are at the expense of capital spending by companies this would appear to be a classic example of short-termism. The second possibility is that changes in the tax system have been responsible for driving this shift in dividend policy - in particular, the fact that the system of tax credits on dividend means that pension funds, other institutions and private investors have a clear preference for distributed profits (as opposed to retained earnings and long-term capital gains).
There are two rejoinders to the suggestion that the shift in dividend policy is damaging. The first is that the change, far from being caused by the institutions using their collective muscle or the tax system, may merely be due to the fact that companies have been adjusting to the fact that dividend controls no longer exist. The second is that high levels of retained earnings encourage wasteful investment. On this line of thinking, companies are right to pay out a high proportion of profits to shareholders, and those same shareholders will be happy to stump up cash in rights issues for expansion.
It is a difficult one to call. The Institute for Fiscal Studies has come up with a revenue-neutral tax change in which the tax credit on dividends would be abolished but with an accompanying cut in the main rate of corporation tax to 26%. This would remove any tax bias in favour of dividends and is one of the options the Treasury is studying.
I suspect, however, that this latest review will end up suffering from the shortcomings of previous initiatives in this area. There is no panacea which will turn Britain into a high saving and investment economy of the kind epitomised by Japan, because the investment climate is determined by culture, political stability, the country's long-term economic performance and the quality of economic management. Tinkering with the tax system often ends up making worse the problem it is intended to solve.