Wednesday, April 04, 2007

Corporate Profitability at a Record High

The FT today reports that corporate profitability is at a record high:

Official figures on Tuesday showed the net rate of return on capital in non-oil UK companies rose to 14.7 per cent in the fourth quarter last year; the highest rate of profitability since quarterly figures were first published in 1989.

Including profits made on North Sea operations, the 15.1 per cent net rate of return for the whole of 2006 showed UK corporate profitability was at its highest level for more than 40 years.

I thought it was important to point this out amidst the ongoing row about the pensions crisis. It's hard to believe pension funds are in "crisis" when the shares they invest in are so profitable. Return on capital is calculated based on pre-tax operating profit, but the overall corporate tax framework and macroeconomic conditions play their part in increasing operating profit.

There had been a lot of emphasis on the abolition of ACT, but no coverage at all of the fact that it was done to simplify corporate taxation and it was accompanied by and paid for a cut in corporation tax. Dividends to shareholders (including pension funds) are paid out from profits after tax. A cut in corporation tax means that companies can either choose to pay a higher dividend, or to retain the money within the company to grow the business to improve future profits and hence future dividends. In the long term this is better for the pension fund shareholders than keeping corporate tax high to pay for a tax credit to pension funds.

The fact that corporate profitability is at a 40 year high proves that the government's strategy of cutting corporation tax (which is now 28% compared to 33% in 1997), combined with providing a steady macroeconomic framework, is the correct one for the long term health of Britain. Is there anyone out there who wants to put corporation tax back to 33% to pay to reinstate the dividend tax credit for pension funds? I doubt it.


JRD168 said...

Is this susggesting then Snowflake, that any shortfall in pensions should have been paid for from the increasing profits of our companies? Was it naive to expect some of the fall inm corporation taxes to have been diverted into pensions?

snowflake5 said...

No, jrd, I'm not talking about money being diverted to pensions in the form of increased contributions. I'm talking about the situation of the pension funds as shareholders.

As shareholders, they receive dividends. They can also realise the value of the shares they hold by selling them. The current row about pensions concerns the abolition of ACT. Pension funds used to be able to claim a tax credit on on dividends for the ACT the company had paid. When ACT was abolished, the tax credit disappeared too, but corporation tax was cut to offset this.

This had two effects - the cut in corp tax increases Earnings Per Share, other things being equal. Share values are based on earnings per share. It also meant that companies can choose whether to distribute the extra money via an increased dividend, or retain the money within the company for reinvestment to grow the company. Either way, as a shareholder, you benefit. Therefore the pension funds as shareholders benefitted - what they've lost on the tax credit on dividends, they've more than made up with corporate profitability increasing so strongly.

JRD168 said...

So, any shortfall in pension contributions should have been covered by increasing share prices, and therefore increased value of pension funds. And this has at least partly been brought about by cuts in corporation tax? It seems to make sense, is it not a somewhat risky strategy thoughy, relying on the whims of the stock market?

snowflake5 said...

The pensions row isn't about pension contributions jrd, it's about tax relief on dividends. I'm merely pointing out that whatever the pension fund shareholders lost on the tax credit on dividends, they gained through increased corporate profitability, which means that future dividends will be higher.

Pensions contributions are a separate issue. Nigel Lawson in 1988 decided to tax pension surpluses at 40%, forcing many companies to take pension contribution holidays, to avoid being penalised. However, there arn't any companies taking pension contribution holidays anymore. Changes in legislation on minimum funding changed that.

Regarding your point about the "risk" of depending on corporate profits: It's a truism that no matter what system you have, state pension or a private pension provision, it's paid for one way or another out of corporate profits. State pensions are paid out of tax. In pure nominal terms, the more profits corporations make, the more tax they pay. If the corporate sector is not profitable, they pay no tax and don't employ people, who in turn don't then pay tax. Pension fundholders too depend on the corporate sector producing dividends, which can only be paid out of profits after tax. If the company makes a loss they are free to cancel the dividend.

It's a complete fallacy to assume you can divorce pension funding from corporate profitability. The only way to make the UK's future secure, for both pensioners and the young, is for the corporate sector to be in rude health. Therefore the first duty of government is to ensure this. I'm proud that the Labour government has done this far better than the Tories ever managed.

Anonymous said...

For once I would actually agree with your closing question and answer, but it's the wrong question.

The cut in corporation tax from 33% to 30% (28% won't come in for a year at least) was itself more than cancelled out by the increase in Employer's NI from 10% to 12.8%. Total salaries paid out are about five times as much as taxable profits, so the total taxes received go up a lot as a result of this switch.

If you then rephrase your final question to say "Would you like to increase corporation tax to 33% and cut Employer's NI to 10%" then my answer would be yes, with or without ACT credits.

JRD168 said...

Snowflake, thanks for taking the time to consider my comments. I don't think that we are to far apart in opinions, I worry sometimes about what people think of Mr Brown, but generally agree that he has done an excellent job!