In Cebr’s Top Ten for Twenty Four we argued ‘The outlook for bond and equity markets is the best for many years, though some of 2024’s gains have already been taken (in thin markets) during the last weeks of December 2023. Falling interest rates and steady growth are normally a great background for financial markets. And so far this year equities have backed this forecast up, with the FTSE 350 up 3.0% from the beginning of the year to 4 April.

However, this lags behind the performance seen elsewhere. The Eurostoxx 600 is up 6.7% in the year to 4 April, while the US Nasdaq is up 10.2%. While there are some compositional effects causing this divergence, such as the Nasdaq’s strong tech-focus, this nonetheless represents an underperformance for UK stocks.

This underperformance can not be explained by economic fundamentals, given that UK stocks look underpriced, especially compared to the US. While total earnings across FTSE constituents have grown by 61% in the past three years, market cap has fallen by 9% in that same period. The total Price to Earnings ratio sat at 16.5x as of 4 April, compared to 29.4 for Nasdaq.

Indeed, there are interlinked problems associated with the UK equity market. The first is that, uniquely in a mature economy, UK institutional investors shun UK quoted equites. UK pension and insurance funds now only own 4% of the UK equity market compared with 46% in 1997[1].

The second problem is that many UK companies are over leveraged. Leverage levels on a Bloomberg index of UK corporate bonds has risen from 2.6 times earnings in 2014 to 6.8 times earnings late last year[2]. In the past week the Bank of England financial stability committee has warned of the risks to financial stability from this level of leverage[3]. Much of the rise in leverage is associated with the growth of private equity.

The number of UK listed companies on the London Stock Exchange has fallen by 40% since 2008 while in 2023 the exchange raised only $972 million (compared with the Nasdaq raising $13 billion in the same year), the first time since 1995 that the London Stock Exchange failed to raise at least $1 billion. Meanwhile private equity in London raised $51 billion between 2018 and 2023 [4], raising $2.7 billion in 2023 for the months to August 4 [5]. This also compares with the £10.14 billion raised in London in venture capital during 2023 [6].

There were measures in the 6 March Budget including a plan for a UK ISA which probably should have helped, though the equity market didn’t react much to this on or anything around Budget Day and the view amongst commentators (which we share) is that the government’s plans are insufficient to deal with the scale of the problem.

Longer term, it makes sense to look at how the tax system biases UK corporate finance.

The most detailed study [7] of UK corporate finance and its interaction with the tax system, which was published at a time when the UK corporation tax rate was 6 percentage points lower than it is now, concluded:

‘We estimate that in the long run a one percentage point rise in the corporation tax rate would increase the leverage ratio of private companies by around 1 percentage point (our central estimates range from 0.76 to 1.40, depending on the instruments used). This result suggests that our sample firms are strongly responsive to changes in tax incentives for borrowing.’

The EU has gone so far as to propose a Debt Equity Bias Reduction Allowance [8] (DEBRA) creating a tax allowance at the individual investor level equal to the increase in the value of equity held to try to combat the adverse impact of corporate taxes on corporate finance.

Professor Michael Devereux, the leading UK expert on corporate taxation, has proposed an Allowance for Corporate Equity [9], which would have a similar effect to the EU’s DEBRA, in evidence to the House of Commons.

The EU has carried out some hypothetical calculations on the extent of the debt equity bias in the UK system and its implications for investment which shows convincingly how the tax system is biased against both retained earnings and the issue of new equity in favour of the issue of debt [10].

Although the tax system is unlikely to be the whole cause of growth of excess leverage in the UK and the decline in the role of quoted equities, a tax system that is biased against equity, which independent studies suggest is the case for the UK, has clearly contributed to the problem.

[1] Corporate Adviser

[2] Bloomberg

[3] Financial Times

[4] Statista

[5] Thomson Reuters

[6] Maddyness

[7] Devereux, Maffini & Xing, 2017

[8] European Commission

[9] UK Parliament

[10] The full results are in Section B1. This project lasted so long that the results, issued in 2020, related to the 2005 UK tax system. However, the recent rise in the Corporation Tax rate back to 25% has returned the system to something very similar to that in 2005.

For more information contact:

Christopher Breen, Head of Economic Insight 
Email: cbreen@cebr.com Phone: 020 7324 2866

Cebr is an independent London-based economic consultancy specialising in economic impact assessment, macroeconomic forecasting and thought leadership. For more information on this report, or if you are interested in commissioning research with Cebr, please contact us using our enquiries page.