| Too early for windfalls? |
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| A windfall tax applied to privatised companies four years after they were sold off generated over ?5 billion for the UK Government. Should the Minister for Finance, Charlie McCreevy adopt the same strategy and generate much needed capital asks Sheila Killian? |
After state bodies are sold off, there is often a concern that the profits, which arise post-privatisation, are inordinately high, and so directors and shareholders are reaping an unacceptable windfall at the expense of the taxpayer. Such disquiet about ‘fat cat directors’ and shareholders reached a high in the UK in 1997. So when Tony Blair’s government first came to power, they set about devising a windfall tax on newly-privatised utilities, which would compensate the exchequer for a sale price that, in hindsight, may have been too low.
The difficulty with such taxes centres on devising a formula, which would be fair to the companies, involved, yet deliver the revenue required. Simple levies based on turnover or assets are open to attack as unprincipled and uneven in application. The UK treasury initially considered a tax on profits, but the difficulty lay in choosing an appropriate period over which to apply it. Taxing a single year’s profit would give an uneven distribution of the tax, and would be unfair. A tax levied over a future period could create an incentive to manipulate earnings downwards, making the yield unpredictable. The tax would therefore have to be levied retrospectively. However, a retrospective tax on profit would amount to double taxation, and be unacceptable politically.
Excess shareholder return was also examined as a potential basis, but dismissed because the dividend patterns of the companies targeted were uneven, and again, the tax would be seen as unfair. Andersen, who had been engaged by Geoffrey Robinson to formulate the tax, finally proposed that it should address the under-pricing of the initial sale rather than the windfall profits that arose post-privatisation. This was a stronger rationale, and an easier concept to sell, politically.
The actual market capitalisation at privatisation was easily calculated as the share price at privatisation multiplied by total shares in issue. This was compared to a nominal market capitalisation calculated with the benefit of hindsight by applying a P/E ratio to the average earnings of the firm in the first four years since privatisation. The difference was regarded as the windfall element, and taxed at 40 per cent. The windfall tax was enormously successful for the UK, raising over five billion pounds, mainly from electricity and water companies. So could it provide a badly needed bonus for Minister for Finance, Charlie McCreevey this year?
Clearly, the yield from such a tax hinges on the choice of price/earnings (P/E) ratio, and the rate at which is applied. 40 per cent was chosen in the UK to link it to capital gains tax legislation. Following that logic, the appropriate rate for Ireland would be 20 per cent. The choice of P/E ratio is more problematic. In the UK, the tax was levied on many privatised firms, and an average ratio across all such firms was a meaningful and reasonably fair approach. In Ireland at the moment, only Greencore and Irish Life qualify as having been privatised by IPO before 1998. Greencore’s average P/E ratio over the first four years was 5.96. Irish Life’s was 22.67. For the purposes of this illustration, an average ratio of 14.31 is used, although arguably there are insufficient firms in the windfall tax net to make this equitable.
Greencore raised ?57,500,000 on flotation. Applying the P/E ratio of 14.31 to the average of the first four year’s earnings, and allowing for the fact that only 55 per cent of the company was sold off, the windfall tax that would be levied on the firm is 20 per cent of ?150,332,350, or E38,160,261. Applying a similar tax to Irish Life and Permanent would raise E35,255,070. This E73,415,331 would go a considerable way to plugging the gaps arising in this year’s figures. If the net could be widened to include private sales of state firms, such as Irish Steel, the overall take could be higher.
So what of the effect of this tax on the financial health of the taxpaying companies? Clearly, it would reduce shareholders’ funds, and take cash from the firm. One concern is that it could adversely affect ratios such as return on capital employed (ROCE), and trigger a loss of confidence in the firm. When the tax was applied in the UK, no such adverse market reaction was reported. Investors understood that the tax was indeed a once-off levy, not affecting future income streams. A more immediate worry is that if could affect the cash flow position of the firm, and irreparably damage liquidity.
The table below recalculates some of the key ratios from the 2001 accounts of both companies, as they would appear if the tax were levied in that year.
Clearly the tax would have had a punitive effect on Greencore, and would have directly impacted on its ability to pay a dividend in 2001. Irish Life and Permanent was in a healthier financial position, and while the tax would hit the ROCE, it is unlikely, based on UK experience, that this would be misinterpreted by the markets, and adversely affect the share price.
The windfall tax is not a perfect instrument to reclaim opportunities lost on privatisation. The most serious ethical deficiency is that it is ultimately borne by those investors holding shares in the privatised entity more than four years after privatisation, whereas the windfall gains of a low privatisation price accrued to the original buyers.
Secondly, it does not claw back all of the revenue lost, if applied at the capital gains tax rate of 20 per cent. Arguably, this is a limited criticism, as a 20 per cent rebate is clearly preferable to none. Thirdly, there is a risk that this unexpected tax could have a punitive effect on the key ratios of the firm. As can be seen above, the effect on the liquidity of the target firm is of particular concern.
Fourthly, on a conceptual basis, it can be seen as a tax on the very benefits of privatisation. Because it is assessed based on earnings in the first four years of private ownership, any new efficiencies will boost earnings, and result in a higher windfall tax liability.
Finally, and perhaps most significantly, by its nature a windfall tax is a once-off measure. If it were known to apply on an ongoing basis to all privatised firms it would be factored into the price investors are willing to pay, thereby reducing revenue to the government, and undermining the purpose of the tax. This could also create a moral hazard for managers in newly privatised firms, giving them an incentive to defer earnings from the first four years. These issues can only be avoided by imposing the tax once only, on whatever privatised firms are available to tax at a given time. This alone should discourage Charlie McCreevey from introducing the tax this year, however tempting it may seem. In future years, however, when ?ircom has been in private hands for more than four years, and if and when ICC, ACC, TSB, Aer Lingus, Aer Rianta and Coillte are in the firing line, an Irish windfall tax could provide a far more significant boost to the exchequer. |
Sheila Killian is a lecturer in corporate finance in the Department of Accounting and Finance at the University of Limerick.
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| Article appeared in the October 2002 issue.
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