Outlook: Pressure on Chancellor to follow Bush's dividend revolution

No excuses are offered for returning to the subject of George Bush's plans to eliminate tax on dividends. Assuming they happen, and that's a big if given the level of dissent which is already building on Capitol Hill, the proposals seem to me to amount to one of the most seismic shifts in the investment landscape to have occurred in many a long year.

We needn't concern ourselves too much here with whether the removal of tax on dividends, worth some $364bn over 10 years, is the correct or most effective way of providing a short-term fix for the US economy. Almost certainly it is not. But as a piece of tax reform which in the long-term should strengthen and enhance US competitiveness, it looks inspired.

One of the most significant effects would be to switch the focus of investment away from capital appreciation to companies with income producing attributes. It would also increase the pressure on companies to start paying out decent levels of dividend. Microsoft, for instance, would come under intense pressure to start distributing its cash mountain in the form of tax-free dividends, rather than spending it on share buybacks, acquisitions and research and development.

Companies that already pay big dividends might on the other hand be tempted to distribute less and plough more back into the business. Since so much of the dividend at present ends up with the taxman, companies could reduce the payout and still leave the shareholders no worse off than they were before. Investors are not always better in their judgement of where capital should be allocated than companies, but making dividends tax free would certainly remove a key distortion in the process. Shareholders will become that much more demanding in ensuring that their money is being spent wisely.

While America charges down the tax-free dividend highway, Britain has been busy moving in the other direction. Individuals have always had to pay tax on dividends in the UK, but until six years ago, pension funds were exempt. The Chancellor's removal of this exemption arguably helped kick start the present crisis in the British pensions industry.

If the Bush administration succeeds, it will put enormous pressure on Britain to reverse its stance. The pensions crisis alone would seem to justify renewed tax breaks on dividends to encourage people into longer-term forms of saving. Nor could the UK afford to ignore for long the increased competitiveness achieved by American business and capital markets by excluding dividends from tax. The Chancellor will pray the proposals fall foul of legislators. But he'd be unwise to bank on it.

UK interest rates

Very few predictions can be made with certainty, but one of the safest ones around at the moment is that the Bank of England won't be cutting interest rates at this week's meeting of the Monetary Policy Committee, or indeed raising them either. Sir Edward George, Governor of the Bank of England, virtually said as much in a radio interview last week.

What happens further out is much harder to read, but again the suggestion from Sir Edward is that interest rates wouldn't need to change by very much. According to him, there is much more likely to be a recovery in the economy than a recession, with growth returning to trend, defined by the Bank as around 2.5 per cent. Ergo, interest rates won't need to be adjusted either way.

Of course, this is a bit of a circular argument, since the Bank is obliged to balance its targeting of inflation with awareness of the risks to growth. If it thought there was a big risk to growth, it would also judge there to be a significant risk of undershooting the inflation target, so it would cut rates accordingly. To leave rates on hold is to imply, as the Bank did in its last Inflation Report, that inflation and growth will remain just as the doctor (the Chancellor) ordered.

But just consider the following. Outside the Treasury, few forecasters believe the economy will grow this year at the rate predicted in the pre-Budget report, which was 2.5 per cent to 3 per cent. Most City forecasters would put the likely growth rate at closer to 2 per cent, with some going for even less. If the economy does grow by as little as this, then inflation would probably undershoot target, and interest rates cent would seem too high at 4 per cent. The Bank plainly doesn't buy the consensus view. Or perhaps it does, but still finds it necessary to be more optimistic on growth so as to justify the present monetary stance.

Interest rate policy is being gradually refined by the MPC into a form of high art, but at its centre lies a basic pragmatism which prevents further rate cuts as long as the housing market remains as buoyant as it has been. Again, Mervyn King, governor-elect, virtually said as much in a speech last autumn, in which he put rampant inflation in the housing market right at the centre of the policy debate.

If the housing boom were allowed to go on unchecked, he said, the risks of an eventual crash and consequent demand shock in the economy would grow all the greater. One way of interpreting these remarks might be that interest rates are being kept deliberately higher than they perhaps need to be in order to guard against a painful adjustment at a later stage.

Or in other words, it may be worth giving away a bit of growth now to prevent a more dramatic downturn further down the line. In any case, I suspect that 4 per cent interest rates are not compatible with growth at 2.5 per cent or more. To achieve it, the Bank will have to cut further.

Boom in car sales

As an example of profitless prosperity, they don't come more striking than the UK car industry. Last year cars were driven off the forecourts in record numbers (once again) and yet dealerships went bust left right and centre and not one of the nine UK-based car manufacturers made a brass penny in profit.

The reasons are well-rehearsed. Dealers virtually had to give cars away in order for domestic sales to break through the magic 2.5 million barrier, while the strong pound and the UK motor industry's heavy dependence on exports did for those brave enough to manufacture here.

A handful of foreigners drove off with indecent amounts of money, of course, in particular the Germans and French, who exploited the weakness of the euro to maximise profits on imports of BMWs, Mercs and even the ghastly new Renault Mégane. But overall, the picture is bleak and there is no reason to suppose it will change for the better any time soon. The steady dismantling of the Block Exemption, that European juggernaut that has for so long prevented the car market becoming genuinely competitive, will inexorably increase the pressure for harmonised prices across Europe.

But for manufacturers, the bigger problem remains one of over-capacity. Europe still has enough production lines to make five cars for every four it sells, notwithstanding the valiant efforts of Ford and Vauxhall to turn the UK into a place where they sell rather than build the things. Rover's Longbridge plant could go the same way as Dagenham some day, but not until the £500m dowry that BMW paid in order to offload its English patient runs out. As for the Japanese transplant manufacturers, their only hope of profit in the near term remains British entry into the euro, which may now be a non-starter in this Parliament.

The answer, as always, is to make a product that people actually want, rather than one which they have to be bribed to buy. BMW has managed it with the new Mini, which is not only selling like hot cakes over here but has just been named car of the year over there in the States. Alas, for every Mini, there are any number of turkeys still on the roads.

jeremy.warner@independent.co.uk