Policy at war with itself: UK Government support for domestic equity market, home bias in the context of integrated global capital markets and tax systems biased to debt and against equity

The tax treatment of balance sheet debt and double taxation of savings held in equities has contributed to the atrophy of equity markets: UK tax decisions have aggravated an international problem.

Over the last seven years the UK has had a myopic debate about its capital markets, domestic saving and the financing of public sector infrastructure and business investment. Right of centre think tanks, trade organisations, the City of London Corporation and Conservative politicians have all contributed to it; the columns of the Financial Times, The Economist and the Investors Chronicle have explored it.

It has drawn on a longer standing Whitehall objective to combine local authority pension funds into either a single or several very large, combined pension funds. The purpose of this is to replicate other pension funds such as CALPERS and the Ontario Teachers Pension Fund. The argument for this is that these larger funds can take more risk in a diversified portfolio and invest in illiquid long-term assets such as UK infrastructure in general and specifically in local regional regeneration projects. The model that has inspired this has been local authorities in North America investing in their own economies, using their own pension funds to build their future infrastructure.

The London stock market has underperformed other stock exchanges. Over many years, delisting of shares has exceeded new shares brought to the market by initial public offers. In the British national policy debate this is normally framed as a specifically UK problem associated with the London Stock Exchange. This is a parochial perspective, although there have been some dimensions to the structural changes to the London stock market that reflect particular UK matters that reflect post-war inflation, regulation and taxation.

Duncan Lamont, Head of Strategic Research, Schroders in the report  How should investors respond to the stock market's dwindling status? notes that ‘In 1996 there were over 2,700 companies on the main market of the London Stock Exchange. At the end of 2022 this had collapsed to 1,100 – a 60 per cent reduction’. As he points out this is not something confined to London , this ‘has been a global trend’. ‘Companies are abandoning the stock market in their droves’. 

Far Fewer Public Companies than in the past

Number of pubic companies 

Source Schroders

In recent years the London Stock Market has become less dynamic with fewer Initial Public Offerings IPOs, and turned into a market dominated by older mature dividend generating international companies in the mining and oil sectors, rather than in the growth tech and luxury segments of the international world equity portfolio.  London’s equity valuations have disappointed compared to other markets dominated by technology and growth stocks.  

London as a modern international financial centre is based around money and bond markets not its domestic equity and other markets

This has led to a desperate anxiety about London’s place as a financial centre in the world economy especially after Brexit. In other pieces this Substack has explained that the London Stock Exchange as an equity market was never central to London’s remarkable growth as a financial centre in the 1960s and 1980s. This was driven by the growth of euro-dollar deposits, the development of the euro-bond market after Kennedy administration introduced a withholding tax and effectively closed the foreign Yankee Bond Market to foreign bond  issuers in 1963; and the recycling of the Petro-dollars following the quadrupling of oil prices after the Arab-Israeli war in 1973 and the syndicated loan market that supported the process. The UK’s domestic exchange based equity market was a bystander in this process that transformed the City of London into a modern financial centre conducting huge volumes of money, bond and related derivative transactions in wholesale markets using principally the dollar and other non-sterling currencies such as the euro, yen and Swiss-franc in over-the-counter markets that are not linked to a physical exchange.

None of these developments had anything to do with the British Government or the Bank of England. They were merely passive bystanders as these developments took place, neither helping nor hindering. The British Government, however, made one decisive contribution to London as an international financial centre when it announced the abolition of foreign exchange controls in 1979.

The British cult of equity investment from the 1950s

What Britain did have in the post-war years was a large and distinctive fund management industry that contributed to the international investment zeitgeist, by creating and embracing the cult of equities. This emerged in the UK in the 1950s when fund managers embraced equites as the real rate of return on gilts was eroded by persistently high inflation and the market value of gilt portfolios was devastated by rising interest rates and the iron operation of the inverse relationship between bond yields – on newly issued bonds and the value of existing bonds that were outstanding and trading on the secondary market. Necessity caused fund managers to abandon gilts and turn to equites. For several decades the long-term higher total returns on equities relative to bonds had been demonstrated by investment writers such as Edgar Lawrence whose book An American Study of Shares versus Bonds as Permanent Investments, was famously reviewed by Maynard Keynes in the the Nation and Athenæum in 1925. The high priest of the new cult of equity was Mr George Ross-Goobey, an actuary who was chief investment officer of the Wills Tobacco Company. 

Pension funds and equity investment 

There were two broad parts to the fund management industry. The providers of Unit Trusts sold to retail investors, a movement pioneered in Britain in the 1930s and mainly sold to the classic private clients. The doyenne of this movement was Mr Edgar Palamountain. The other and much larger fund management sector was the occupational pension funds. These firm-based pension funds enjoyed tax relief. As more people were drawn into very high  marginal tax rates in the 1950s and 1960s more firms set up ‘superannuation’ funds. As new funds they faced a challenge in having to identify assets that would meet a rising liability  - to pay out pensions as a ratio of an employee’s final salary in an inflationary environment and the advantage of being liquid and having few cash liabilities to meet in terms of immediate pension payments.  They therefore invested in equities rather than bonds.

Unravelling of pension fund bias to equity investment – regulation, changes to valuation technique, greater instability in employer contribution, matching assets to liabilities more closely 

Then a series of changes were made to UK pension fund regulation. Some of them were made in response to the Robert Maxwell Daily Mirror Pension Fund scandal to ensure the beneficiaries of pension funds’ investments were better protected from fraud. This involved more than narrow considerations relating to fraud and custody of assets and included recommendations that touched on matching assets to liabilities more closely. This involved greater use of government and corporate bonds. In addition, the valuation rules that UK actuaries used to value pension fund assets were changed. In effect they moved from a formula that smoothed changes in returns to something that approximated a mark-to-market valuation. This led to greater variability of return and obliged pension funds at triennial valuations to take swifter action  to correct deficits and introduced greater uncertainty in employer contributions. This resulted in further pressure to move from equities to bonds. In addition John Ralfe, the head of Boots Pension fund, became an evangelist for matching pension liabilities to assets very closely to reduce risk, which meant using bonds and gilts in particular. These influences pushed up the long-term cost of providing traditional final salary defined benefit schemes. Many were either shut or increasingly were closed to new members.

Higher taxation of equity dividends arising from the ending of partial imputation and tax credits

There was a further change in taxation in the 1990s, that worked to bias pension fund investment away from equites towards bonds .The tax treatment for pension funds with equity investments changed. The partial imputation system was reduced when the tax credit was lowered by Norman Lamont and then abolished in 1997 by Gordon Brown. 

The Death of Inflation erodes the long-term real outperformance of equites relative to bonds

At the same time the recognition that inflation  was dead for a generation as China, the transition economies and other emerging markets entered into full participation in the world economy. Changes that were brilliantly captured for financial market practitioners by the British economist Roger Bootle in his book The Death of Inflation published in 1996. Low inflation reversed the creeping inflation that gave rise to the imperative that caused the cult of equity to take off in Britain in the 1950s. It gave an already mature long-term bull market in bonds a further dynamic. This diminished the long-standing relative advantage of equities relative to bonds. The proposition that equities  yielded higher long-term real returns than bonds still held, but their relative advantage was eroded. The combination of these things resulted in the London cult of equity ending. 

The shift away from Home Bias to greater international diversification after 2000

Pension funds shifted out of equities towards investment strategies that more explicitly matched their  liability risks with bonds. As long as pension funds chose to retain non-liability matching assets, so-called risk assets, there was a tendency to look towards full international diversification of both risk and opportunity. The Harvard and Yale university endowment funds appeared to demonstrate the advantages of a fully international investment portfolio. So institutional equity investors progressively moved to constructing equity portfolios assessed against international benchmarks. In this environment the UK’s London Stock Exchange represented a modest proportion of the total range of equities that an investor could turn to across international equity and capital markets. 

Increased emphasis on total returns over dividend payments further eroded London’s attractiveness to investors

The progressive reduction of what is sometimes called ‘home bias’, in the UK context, further compounded the structure of the London equity market. It is a home for mature high-quality blue-chip firms with dependable yet slow growing earnings. They are principally multinational companies with significant foreign non-sterling revenues that were not directly tied to the buoyancy of the domestic UK economy. They often are in the mining, oil and gas, defence, pharmaceutical and international manufacturing and branded goods sectors that reflect the heritage of the first country to industrialise and an economy that has always had huge international maritime interests and a large stock of foreign invested direct investment. These companies were not dynamic growth stocks creating potential monopoly rents through innovation, market disruption and patents such as the American technology stock epitomised by Microsoft, Apple and Amazon. 

A UK investor base that was not accommodating a changed more aggressive investment culture where the interests of existing shareholders may be diluted

Traditionally UK institutions and pension funds liked the traditional reliable dividend paying multinational that enjoyed strong foreign earning streams. This meant the London based institutional investors jealously guarded standards of accounting, corporate governance and the interests of existing investors in companies. This irritated entrepreneurs minded to raise capital for innovative growth stocks who wanted to retain control of their businesses. The London based investing institutions were not prepared to compromise what they perceived to be the London Stock Exchange’s high governance standards to accommodate potential issuers of IPOs. In truth most traditional London equity investors were not much interested in investing in that type of company because they did not offer reliable real earnings and steady dividend growth.

When pension funds began to abandon the cult of equity and turn to bonds the cultural shift coincided with another change of investor behaviour. Instead of focusing on dividend yield and income, fund managers increasingly focused on total return. That is the total return of dividend and capital gains in the share price combined. This emphasis on total return drew on the rich economic literature of the theory of corporate finance stimulated by Franco Modiglian’s work on cost of capital, and further reduced institutional investor interest in the traditional reliable strong dividend  paying blue-chip / value stocks that were the backbone of the London stock market. This further amplified the movement of pension fund assets and other fund management portfolios away from the London Stock Exchange and UK equities. 

The general atrophying of public equity markets across advanced economies

The demise of the classic cult of equity in the UK has been part of a wider international atrophying of public equity markets in advanced economies including the US. Over the last thirty years the number of firms whose equity is publicly traded has fallen on American exchanges by 50 per cent . This trend is reflected across advanced economies in the OECD. In advanced economies. such as the UK and the US publicly traded equity account for a smaller ratio of their economies capital stick and the output that it generates measured in national accounts such as GDP. 

Capital markets are reflecting fundamental changes in economies where services and brands are more important and there are wider sources of finance than traditional public equity offerings

This in turn reflects wider radical changes in the structure of advanced economies where services are dominant, much of the value of measured output comes from digital activity and the increased relative value of things such as brands and intellectual property rights. These changes in economic structure have profound implications for economic analysis that conventional tools such as national accounting find difficult to score. Economic commentators and business analysts have had difficulty understanding and explaining these fundamental changes. An economy with a service sector that represents over 80 per cent of output such as the UK does not need large physical capital accumulation in the way that a traditional manufacturing economy once did. Moreover, modern physical capital is smaller in size and in cost relative to other things. such as patents and intellectual property. 

There are wider sources of finance than traditional public equity offerings and debt has tax advantages relative to equity

When capital is needed there are many more sources of investment funding compared to traditional public equity issues. These include venture capital , hedge funds and the full array of private capital funding and debt. Tech startups, not just in the United States but in the UK, can build up businesses worth over a billion dollars, so called ‘Unicorns’, without recourse to using public equity markets. The use of debt on company balance sheets has been further amplified by the tax treatment of debt versus equity by the tax system. Debt is a cost that is set against profit before corporation tax. Income from equity is subject to full taxation. In an income tax system all saving is subject to double taxation. This double taxation is aggravated when there is a corporation tax as well as an income tax. That is why when the modern corporation tax was first introduced by James Callaghan in 1965 it was accompanied by a complex system of tax credit and partial imputation  to mitigate  this aggravating effect of double taxation. That framework of mitigation was eroded and finally abolished in the 1990s.

The greater use of debt on company balance sheets is reflected in their instability whenever there is a wider element of economic disruption or crisis. Mundane business such as chains of restaurants and bakery business quickly become vulnerable with leveraged balance sheets more normally associated with aggressively managed financial institutions. The aggravated double taxation of equity on company balance sheets has further compounded the atrophying public equity in the UK and other jurisdictions. When talking about the future of equity markets in the UK and Europe at a fringe meeting at the Labour Party hosted by Policy Exchange in 2017, Xavier Rolet, the chief executive of the London Stock Exchange identified addressing the different treatment of debt and equity in tax systems, as being essential if public equity markets are to play a greater role in financing capital formation in Europe and the UK. Very loose monetary conditions with exceptionally low interest rates between 2009 and 2022 by artificially lowering the cost of debt further amplified these features of the taxation  of equity and debt that Xavier Rolet identified.

The central challenge is the double taxation of saving that is aggravated when savings are held in the form of equity

Against this complex background of fundamental changes in modern market economies, bigger service sectors relative to manufacturing and extraction industries such as mining, growth in the values of brands and intellectual property; the double taxation of income form saving held in the form of equity; and protracted very low interest rates and bond yields that distorted the structure of money, credit and capital markets have combined to diminish the role of equity and traditional stock exchanges in financing the modern capital stock in advanced economies.

UK Government’s parochial and clumsily mercantilist perception of modern capital markets

In the last couple of years the UK Treasury has responded to anxiety about the decline of the London Stock Market and agreed to various technical regulatory measures in the so-called Edinburgh agenda. The important purpose of them is to ensure that more long-term British savings held in pension funds and by retail investors are available to support infrastructure investment and to finance higher UK business investment. The measures themselves are pedestrian and avoid the obvious impediments that are embedded in the UK tax system that hinder UK equity markets. 

Modern capital markets are integrated investment in good projects does not depend on a particular country’s’ savings ratio

Moreover, the agenda is framed in a form of clumsy mercantilism that implies that the UK is dependent on a closed capital market where investment projects turn on whether UK domestic savings is sufficient to finance them. For some forty years the UK has been part along with the rest of Europe, North America and Asia of a highly integrated network of international money and capital markets. The financing of an investment project in Belgium, Canada, Australia, Singapore, or Texas or Georgia in the US does not turn specifically on the savings ratios of those economies. And the same is true of the UK. There is a globally integrated market in capital that seeks risk and returns and if anything that international market that deploys world savings finds it hard to identify attractive investments that match the appetite for risk and the scale of saving generated not least by Chinese and other Asian households.

The importance of clarifying the primary purpose of a pension fund investment

Sir John Armitt, chair of the UK National Infrastructure Commission, in a speech to Trade Union Congress pension conference reported in the Financial Times in March 2024, explained the international position clearly. He set out the international character of modern capital markets. He also clarified the need for policy makers to understand that savers and pension fund providers trying to provide long-term incomes for retirement face specific challenges in seeking investment returns that should not be muddled up with other policy imperatives. The Financial Times reported that Sir John said it ‘would not be right for pension funds to simply invest in home markets due to ministerial pressure. “Government needs to recognise this as an international, globally competitive market.’’ He went on to say “Frankly, there’s no reason why any of the pension funds here should say ‘oh, I’ve got to invest in the UK’. You’re looking after your pensions and trying to find the best possible opportunity for them.” Much of the political and public policy around these issues in the UK has in recent years been clumsily naïve.

Time for an overdue abolition of the anachronistic Stamp Duty Reserve Tax

Instead of giving guidance to pension funds and other investors on the amounts they should invest in the UK , HM Treasury should be exploring the distinctive features of British policy and the tax system that it is responsible for, to identify features that hinder domestic UK saving and equity investment in particular. Among them the most obviously anachronistic is Stamp Duty. Stamp Duty on shares was supposed to go when paper records were replaced by electronic record keeping by the Stock Market and registrars in the 1990s. This process was christened ‘dematerialisation’ . Yet thirty years later Stamp Duty Reserve Tax is still in place and collects revenue at a higher rate of tax than that of tax systems in other financial centres that London competes against.

Fiscal drag, higher effective  taxes on income compounds double taxation of savings, while higher rates of corporation tax combined with enhanced capital allowances further bias the tax system against equity and in favour of debt

The bigger and more complex matter is to recognise the awkward and aggravated double taxation of income from equity saving compared to the tax advantages that debt finance enjoys on company balance sheets. This will require interrogation of the rate of corporation tax, the taxation of dividends and capital allowances that firms enjoy when they invest. The net effect of policy over the last two years has been to aggravate these complex problems that bias companies to using debt rather than equity on their balance sheets. The combination of enhanced capital allowances, higher rates of corporation tax, a higher effective income tax burden arising through fiscal drag, a higher rate of taxation at £125,000 and the reduction of the ration of dividend income that taxpayer enjoy free of income tax and the reduction in the personal threshold all aggravate the double taxation  of savings income. 

The double taxation of saving income is inherent in an income tax system. While a state raises a proportion of its revenue from income tax and has the other necessary taxes to prevent avoidance, such as a corporation tax and a Capital Gains Tax, a higher income tax burden will aggravate it, unless specific tax measures are taken to partially mitigate it. These include having a ratio  of savings that can be accumulated each year that in future is free of income and capital taxes. This in effect applies a form of expenditure tax treatment to a portion of savings to mitigate its double taxation. This is what ISAs and their predecessors PEPs and Tessas are. The other measure of mitigation that specifically addresses equity is to examine the rate of corporation tax, the payment of dividends and how an imputation system can either partially or fully mitigate their double taxation.

The March 2024 UK Budget Statement failed to address these tax impediments that hinder the functioning of equity markets in the UK. Impediments that have, moreover, been aggravated over the last two years by measures taken by the UK Governments in previous fiscal statements. The decision to launch a consultation of a £5,000 UK equity ISA will raise the ratio of savings that individuals can make that enjoys expenditure tax treatment and is protected from double taxation. Yet it violates the principle of broad economic neutrality where economic agents are left to decide for themselves where they chose to invest their long-term savings. In the context of modern investment returns it provides a tax incentive to invest in a home market that could yield total returns lower than in other equity markets. This invites all of us to remember when making any spending, saving or investment decision, it should not be determined by tax considerations but by the underlying merits of the transaction.

The chosen changes to the tax system made over the last two years, in the context of a Treasury agenda intended to promote UK equity markets amounts to what the great American academic lawyer and federal appeals court judge, Robert Bork, who specialised in competition policy would have called ‘policy at war with itself’, in his 1978 book The Antitrust Paradox.

Warwick Lightfoot

25 March 2024

Warwick Lightfoot is an economist and was Special Adviser to the Chancellor of the Exchequer between 1989 and 1992