After a highly controversial Treasury review, the Tories ruled out dividend control. Not so corporation tax reform, explains Peter Oborne, but do they have the courage to anger their traditional allies?
Last summer Chancellor of the Exchequer Kenneth Clarke called his most trusted Treasury protege into his office and told him that he wanted to give him a crucial assignment: the launch of an in-depth and potentially explosive investigation into the funding of British industry.
He told him that the shortage of industrial investment was a critical concern - some claim that it has halved in the past 20 years. He wanted to find out why - and put in place measures to reverse it.
It was no coincidence that the man he chose to carry out the enquiry was Stephen Dorrell. Of all Clarke's high-powered Treasury team he was the closest to the chancellor both in attitudes and background.
Both came from middle England - Clarke from Nottingham, Dorrell from Worcester. Both were frozen out during the Thatcher years - Clarke time and again deprived of the Cabinet office he craved and clearly merited, Dorrell, for all his obvious promise, left to languish on the back-benches. Above all, both shared a deep-seated suspicion of the City of London and prejudice in favour of manufacturing industry.
It was a magnificent chance for Dorrell to make his mark, for he is a man many believe capable of going right to the top. Privately John Major is fond of saying that he sees the capable, softly spoken yet deeply ambitious 41-year-old as his most likely successor as Tory leader - in July he propelled him into the Cabinet as Heritage Secretary.
For almost a year Dorrell and his Treasury team, led by high-flying official Craig Pickering, worked quietly behind the scenes. But all hell broke loose when Dorrell finally decided that the time was right to speak out, in an address to the Confederation of British Industry on 9 March this year.
The speech precipitated Dorrell into a row that hammered the stock markets, jeopardised relations between the Tory Party and its business backers, delighted Labour, threw his own reputation for competence and smooth handling into question, and ended up earning him a semi-public rebuke from the Prime Minister. So damaging did the dispute become that Dorrell, normally the most accessible of ministers, refused to be interviewed by Management Today on the subject.
Dorrell's speech, like everything he does, was well-argued; a lucid analysis of the complex issues linking industry, commerce and finance. It is a post-Thatcherite document, assuming a role for government in the private sector that would have been heresy in the 1980s.
But it was the tone of his comments about dividends that really upset the City. Ignoring the contrast in capital structures between Britain and the Continent, he listed the high level of dividend pay-outs compared with Germany as a weakness of the British economy.
The fact that Dorrell was happy to turn a highly controversial debating point into a bald assertion was bad enough. British institutions believe high pay-out ratios are a strength, not a weakness. But it got worse. He went on to call for a public debate into some of the most cherished prejudices of the City: 'Do institutions place too much emphasis on dividend yield? Does the high level of dividend pay-outs in the UK economy result in unnecessary and expensive churning, or is it a useful discipline on management to ensure that assets are made to sweat?' Behind the Dorrell rhetoric was the belief, strongly held by the Labour Party, endorsed by the Institute of Fiscal Studies, probably shared by many Treasury officials, that Britain's high dividend payments, compared with industrial competitors such as Japan and Germany, have proved a fatal obstacle to industrial progress over the past 20 years. It is a worry that grew sharper during the recession, when the dividend pay-out ratio collapsed to a record low of 1.6:1.
Much of this was fanciful, even preposterous, in particular Dorrell's comparison with Japan and Germany. Companies in both countries operate under completely different conditions, and dividends are meted out in the same spirit as contributions to the church collection box. Anyway, according to classic economic theory, none of this matters at all: dividend payments, of whatever size, should be irrelevant to investment decisions and simply form part of the normal working of the market and efficient allocation of resources.
Theoretically it is absolutely proper - indeed desirable - that the market should strip cash out of mature businesses. Many fund managers are still smarting from the disastrous consequences of leaving too much liquidity in the hands of poorly managed companies. 'If you encourage companies to hold large cash balances rather than spending it on capital investment they will spend them on acquisitions, most of which are likely to be dud. Think of the TSB, for example, or the electricity companies,' says Finsbury Asset Management's Max King.
Barclays chief executive, Martin Taylor, drily notes: 'Investment is not, of itself, virtuous.' And cash taken out of mature businesses should be recycled into areas of growth. There is not much evidence that the market falls down here either. In its glamour days, the share price of Glaxo always used to spurt upwards when new investment plans were unveiled. Paul Myners, chairman of investment giant Gartmore, declares: 'I think the Treasury is finding that there are very few cases where dividend payments have curtailed savings and investment.' His view is endorsed by managers at the industrial coalface. Senior industrialists simply do not believe that they are starved of resources by rapacious fund managers driven by short-term performance targets.
Sir Christopher Hogg, who has a wide experience of running British industry, turning round textiles giant Courtaulds before moving on to become chairman of news service agency Reuters, declares: 'Even if companies do over-distribute, the good performers can always get access to capital. At Courtaulds we experienced our fair share of difficulties. But I never doubted that for the right projects and the right management the market will supply capital.' Industry is more inclined to blame the politicians than the City for under-investment and short-termism. Chris Miller, chief executive of fast-growing conglomerate Wassall, declares: 'Low dividend yield has never been an issue. The villains are quite frankly the politicians. I know it is difficult but if they were able to give us relatively stable interest rates, inflation and exchange rates for the next 10 years it would all be very much simpler. ' More than that, many fund managers believe - and many in industry accept - that dividends, far from insidiously eating away at a company's strength, represent a vital discipline for managers. Michael McLintock of investment giants M and G - nicknamed Mean and Greedy for its aggressive attitude to dividend pay-outs - asserts: 'If you are bad management sitting around the table the easiest thing to do is to say: "Cut the dividend. I don't want the hassle of reorganising this business, sacking these people, making my company car last for five years and not three and having to work till 8.00pm for a few months to sort this thing out." The dividend should be the last resort and not the first.' He angrily disputes the claim that over-distribution has hindered investment, pointing out that industry's annual dividend bill of £20 billion is a fraction of the £100 billion poured each year into industrial investment. Slashing it by 25% would certainly shatter confidence in the stock market - but it would have a negligible effect on investment spending.
To illustrate his point McLintock cites the case of Rolls Royce's 1992 dividend cut from 7.25p to 5.0p. 'It saved £22 million for a company with research and development and capital expenditure totalling £357 million.
£22 million is going to make very little difference in those numbers.' None of this has stopped, or will stop, the Treasury and others from pursuing the notion that dividends hamper investment. The case is most robustly put by Labour's trade and industry spokesman Robin Cook (though much of what Cook has got to say could have come from Dorrell or Kenneth Clarke: it is a curious feature of this debate how the two main parties tend to agree about the important points.) Cook, undisputably the cleverest member of Tony Blair's shadow cabinet, sets out his stall: 'Industrial investment in Britain is now 2% of GDP. That percentage has virtually halved over the past 20 years in what has been a consistent downward trend. The great bulk of industrial investment is retained profit - much greater than anything raised by new equity.
'The striking feature of industrial profits is the very high proportion distributed in dividends - a proportion which has risen very sharply in the 1980s - exactly the same period during which investment has been falling.
'So it's very difficult to avoid the conclusion that the high dividend payment is the obverse of poor industrial performance.' His views are endorsed by the independent and highly respected Institute for Fiscal Studies. IFS economist Costas Meghir has analysed investment spending by 626 manufacturing companies. He claims: 'Firms have difficulty raising funds on the market either by selling new shares or by issuing bonds. It's cheaper to use internal finance. High dividend pay-outs reduce the amount of cash flow available for investment.' For Cook the solution is clear - radical reform of Britain's outdated corporation tax system to end what he sees as a systematic bias towards distribution.
He declares: 'The problem is that dividends in Britain bear a smaller tax burden than profits retained for investment. Financial institutions pay half as much tax on dividends as on profits retained. It is rather perverse to create a tax structure in which there is an incentive not to invest.' And Cook has a point. Britain's corporation tax system is very curious indeed, and would never have been invented if it did not exist. When ACT was dreamt up in 1973 it was meant to be a neutral tax, carefully constructed to ensure that the same tax burden would apply whether profits were paid out as dividends or retained in the business. Today it is anything but a neutral tax - indeed it has become a bizarre anomaly - like mortgage tax relief - that politicians and officials would love to get rid of if only they could summon up the courage.
The trouble is that the inventors of ACT calculated without the prodigious growth of tax-exempt funds since the 1970s. From negligible origins they now account, according to varying City estimates, from just under 40% to rather over 70% of stock-market capitalisation. Pension funds, charities, personal pension schemes, PEPs - they are all tax-exempt.
The result has been a giant and unplanned subsidy to institutions worth more than £4 billion a year, since exempt investors are able to regain most of the corporation tax paid by companies by reclaiming the imputed tax on dividends. ACT means that, so far as the taxman is concerned, corporation tax collects a miserable 17% or 18% net from companies rather than the full 33%.
The prospect of this massive subsidy being abolished - a move that would probably be simultaneously matched by a sharp reduction in corporation tax - terrifies a large part of the City. And that, of course, is what Clarke, just as much as Cook, is really about.
The City, dozy as ever about these matters, did not realise that it had a fight on its hands until the moment Dorrell rose on his hind legs to make his speech to the CBI last March. What followed was a fascinating study in the power play between the rival centres of Westminster and the Square Mile.
The first thing to happen was the transformation of the demure Stephen Dorrell - butter was held not to melt in his mouth - into a City demon on a scale that made Cook or shadow chancellor Gordon Brown look entirely benign. For he was unlucky enough to have launched his dividends initiative just four weeks after the spring slide in the bond and stock markets began. It was not long before he was getting most of the blame.
'A rumour of a Stephen Dorrell lunch at a merchant bank was worth 20 points off FTSE,' recalls one dealer. Definite news about it could spark a selling panic.' Belatedly the Square Mile started to mobilise. Letter campaigns were arranged. Alarmist and nonsensical claims were made by usually sensible City firms to the effect that abolishing ACT could drive share-prices down by up to 20%. Lord Hanson, always closer to Lady Thatcher's than John Major's government, fired off an irate epistle to Dorrell asserting that dividends were a matter between companies and their shareholders and had nothing to do with the Government. Dorrell, fumed the predatory peer, 'sounds like a socialist'.
The hapless Dorrell was forced on the retreat in the face of this assault from one of the largest contributors to Tory Party funds. He replied that he 'wholeheartedly' agreed with Lord Hanson - but insisted that he would carry on regardless.
In practice, the Hanson blunderbuss probably did not matter all that much. Of far more significance, however, was the quiet and insistent pressure brought to bear on the Government from the City - all the way up to the highest level. With the stock market continuing to dive, senior business figures made their concern known in Downing Street and John Major was drawn into the row. The Prime Minister chose an interview with the Daily Telegraph given on the eve of the European elections to make his intervention in the affair. He went out of his way to deny that the Government was planning an assault on dividend payments by telling political editor George Jones: 'Dividend control is socialism. I'm a Tory. Dividend control is a non-starter.' The implication was clear: John Major had been angered by Clarke and Dorrell's clumsy handling of the City and had stepped in over their heads.
The City was duly reassured. But perhaps it should not have been. The Prime Minister had ruled out dividend control, which was not on the agenda in any case. But nowhere did he mention the abolition of ACT, and that is still very much on the Treasury agenda. And if the Tories do not have the courage to anger their traditional allies in the City by pushing through such a contentious reform before the election, the Labour Party is ready and willing to do so if and when it wins it. Change is in the air.
Peter Oborne is political correspondent of the Evening Standard.