The charts below (see charts 15.1 and 15.2)illustrate how total profits have been allocated to taxation, interest and dividends and retained income since 1989.

The high tax and interest and dividend payments made in the early 1990s meant that retained earnings were necessarily squeezed, averaging just 30% of total income in 1990 to 1992, a period when total income was also in decline.

As the economy recovered, corporate profits also benefited allowing a greater proportion to be retained. In the period since 1992, retained earnings have accounted, on average, for around 40% of total income.

In the recession years of 1990 to 1992, interest and dividend payments which are by far the major outgoing for UK companies, accounted for just under three fifths of total income, well above the average share recorded in the period 1993 on.

Partly this reflected the high level of interest rates in the period and, therefore, higher debt repayments. Base rates, for instance, averaged 12% over these three years.

Partly it stemmed from companies being under pressure from institutional shareholders to maintain dividend payments even when profits themselves were under pressure from adverse economic conditions.

Since then, the proportion of income paid out in interest and dividends has remained relatively stable at around a half of total income

Source: ONS

In addition to above average dividend and interest payments in 1990 and 1991 the percentage of total income paid out in taxation was also high. Taxation reflects profits made in the previous eighteen months so that taxation in the opening years of the 1990s was a result of the strong growth in profits which had accompanied the economic boom of the late 1980s.

The proportion of income paid out in taxation since the early 1990s has been much more consistent, averaging 10% compared with an average 12.5% in 1990 and 1991.

Total corporate income slipped in 2008 reflecting the downturn in the general economy and is likely to have fallen further in 2009 as conditions worsened domestically and overseas.

Although companies were able to cut dividend payments slightly in 2008, tax payments, based on previous years’ more buoyant earnings, rose and the net effect was to squeeze retained earnings, albeit marginally. This pressure on retained earnings will be a characteristic of the next few years, repeating the pattern which was seen in the early 1990s.

Source: ONS

Shareholder pressure

The need for companies to keep shareholders happy has led to claims that, compared with companies in Europe, British firms adopt a very short-term attitude.

Failure to offer shareholders an adequate return, even when the financial results do not warrant it, will put downward pressure on a company's share price, it is argued, and make it vulnerable to a takeover.

There have even been a number of high-profile examples of quoted companies which have reported losses but which have still made payments to shareholders.

Shareholders, moreover, are supposed to be impatient and unsympathetic to companies proposing to invest for the long-term.

Rather than see funds tied up for years before making a satisfactory return, shareholders are said to want immediate returns. Unable to finance investment from retained earnings, the cheapest source of finance, companies are, therefore, forced to raise more expensive money externally, thus pushing up the cost of capital. This was particularly important when for long periods UK interest rates were in double figures. In Europe, in contrast, where there appears to be a greater reliance on bank financing, businesses have, it has been argued, been able to take a longer-term view.

Concerns over-stated?

Recent experience suggests that these concerns about short-termism have been overstated. If the number of shares traded on a typical day is related to the total number of shares in issue, it is clear that shares on average are held for a period of years rather than weeks or months.

The performance of the UK economy relative to the major European economies during the 1990s and 2000s, moreover, suggests that the discipline implied by the need to deliver a return to external shareholders has made British companies more responsive to market pressures.

The European system, on the other hand, has led to accusations that their companies are complacent and too slow to change.

The effect of low interest rates

Finally, along with economic stability in the UK came an historically low level of nominal interest rates and, for a short period an improvement in public finances (which reduced gilt issues and, therefore, gilt yields). With alternative investment opportunities offering lower rates of return, there was less need for companies to pay out returns to shareholders that were not justified by their performance.

Return to relative stability

Once the current downturn has passed, it is likely that the UK economy will return to relative stability and the low inflation and low interest environment enjoyed in the 1990s and most of the 2000s. The deterioration in the public sector finances following the recession and the need to bail out parts of the banking system, however, means that public sector borrowing and, therefore, the issue of gilts will remain high for the foreseeable future.