The legacy of Gordon's tax grab

The present system of tax credits encourages companies to pay out dividends rather than reinvest their profits. This cannot be the best way of encouraging investment for the long term.' So said Gordon Brown in his first budget as he removed the tax credit that pension funds could reclaim on dividends paid by British companies.

Seven years later, his mantra is unchanged. Brushing aside criticism of the measure in an interview last Monday, he said it had been made 'to reward investment and give [companies] greater incentives to invest in the economy'.

Pension funds and their advisers were up in arms when Brown first withdrew the tax credit, warning that it would drive many funds into deficit and force others to increase their contributions. Seven years and £40 billion of lost tax credits later, these prophecies have largely come true: the financial position of our occupational pension schemes has deteriorated sharply and Brown's tax grab is seen as a contributing factor.

But has the change achieved what the Chancellor claims was its aim? Have British companies increased the amount that they invest in their businesses now that there is no longer any point in pen sion funds pushing for higher dividends?

If research by the Institute for Fiscal Studies is anything to go by, the answer is a resounding 'no'. In a paper due to be published shortly, it will show that there is no evidence of an increase in investment by companies following the removal of the dividend tax credit. The study compared the behaviour of companies affected by the change with those that were not.

'Their investment behaviour is exactly the same as before,' said Alex Klemm, a senior research economist with the IFS. 'We found some other effects - for example dividend payments were reduced in some firms - but there was nothing on investment.' He points out, however, that the removal of the tax credit was accompanied by a reduction in the corporation tax rate from 33 to 31 per cent. 'That may have had a positive effect which we can't pick up.'

The government's own statistics support the IFS's findings. Martin Weale, director of the National Institute for Economic and Social Research points out that, in 1997, companies invested 11 per cent of our gross domestic product. Now it is 9.5 per cent. 'Of course, that does not prove that tax credits haven't encour aged investment but, overall, it is plain that investment is not higher than it was in 1997,' Weale said. 'Quite correctly, [Brown's] enthusiasm for [encouraging investment] has waned. It is clear that Britain has a productivity problem but it is less clear than it is because it invests less: that is the consequence rather than the cause of our production problems.'

Of course, few believed that boosting investment was really the Chancellor's intention. Christine Farnish, chief executive of the National Association of Pension Funds, snorts derisively when it is mentioned. 'I would have thought one of the virtues of equity investment was dividends,' she said.

In reality, it was seen as both a way of raising revenue - the Treasury's estimate was that it would raise £5.4 billion in the year to April 2000 but that will have risen sharply as the level of dividends increased - and of getting rid of the complicated and widely disliked advance corporation tax, which companies had to pay on their dividends.

If Brown cannot take the credit for boosting investment, can his removal of the tax credit be blamed for causing the current pensions crisis?

'You can't blame the tax raid by Gordon Brown for the whole of the pension crisis but it certainly is a contributing factor,' said Farnish. Pension experts estimate that UK plc had a collective pension deficit of around £60bn at the end of 2003. 'If you add up the losses they have suffered since 1997, it is £40 bn in total - a significant part of the deficit in larger FTSE 100 companies,' said Farnish, although she admits that a number of other factors have contributed to growing pension fund deficits, including the stock market crash, falling interest rates, improved benefits for pensioners and an aging population.

But Stephen Yeo, senior consultant at Watson Wyatt, points out that not all of that cost of the removal of the tax credit was suffered by defined benefit schemes - the pension funds that guarantee members a pension payment related to their salaries - where the deficits lie. More and more companies are switching to defined contribution schemes - a quarter last year alone, according to the NAPF - where pensions are determined simply by the amount in an individual member's fund.

Kevin Wesbroom, a consultant with actuaries Hewitt, said that pension funds would still be in deficit even if Brown had not removed the tax credit. 'We would still be up the creek but it is possible that the paddle would be in sight.'

The move could, however, have contributed to another aspect of the pension crisis: the reduction in benefits for many employees. The IFS's Klee thinks Brown's move is likely to have encouraged companies to abandon their defined benefit schemes, which, because the switch is usually accompanied by a reduction in contribution rates, leaves employees worse off.

'I conclude that the only ones that really suffered were pension funds,' said Klee. But he adds that means there could also have been a negative effect on the companies that run these pension schemes 'to the extent that they have had to increase contributions for their employees in defined benefit schemes'.

Very few companies have escaped that requirement - indeed some big employers, like Marks & Spencer, ICI and BT, have had to make special payments into their schemes to finance large deficits.

Peter Spencer, professor of economics and finance at the University of York - who has called on the government to replace the tax credit - has calculated that the damage is roughly equal to a 30 per cent fall in the value of pension funds. 'If companies wanted to offset the effect of the abolition of the tax credit, they would have to increase contributions by 30 per cent.'

The NAPF's Farnish speaks for most commentators when she says there is 'not a hope in hell' of getting Brown's move reversed. 'But we should not stop asking for a better regime of incentives without which we will see what had been a very good pension system wither on the vine.'

On the other hand, the NIESR's Weale confesses to being one of only two people - Brown being the other - who is prepared to support the removal of the tax credit. 'We have to pay taxes and have to collect them somehow.'