The pensions industry has said it will suffer in the short-term from changes in the tax treatment of dividends announced in Wednesday's budget.

As well as hurting pension funds, the new measures will hit private investors with substantial dividend holdings, including those who opt for scrip dividends or shares instead of a cash payment. Such scrip dividends were previously treated as investments but will now be taxed as income.

The abolition of tax credits attaching to dividends paid by companies will cost the 200,000 members of Irish occupational pension schemes about £25 million, the Irish Association of Pension Funds (IAPF) has said.

"Pension scheme members will have to increase contributions by £25 million or suffer a £25 million reduction in benefits as a result of this unexpected move," IAPF chairman, Mr Paul O'Faherty said.

Coyle Hamilton described the changes as "most unwelcome" for pension funds and said they were surprising in view of the previous government's concern about low pensions coverage.

The Minister for Finance said in the Budget that a reduced tax credit would apply to dividend payments made to shareholders on or after December 3rd, 1997.

The credit is being reduced from around one quarter to just under one eighth of the dividend and will be cut to zero from April 6th, 1999.

This means that investors receiving a dividend from a company paying the standard rate of corporation tax will see their effective tax bill rise from around 35 per cent to 41 per cent next year, accountants say. And, from April 1999, their dividend income will have no tax credit attached and will be subject to the higher rate of income taxation, which will be 46 per cent from next April.

Many in the investment community believe Mr McCreevy should have phased out the tax credits in tandem with reductions in the rate of corporation tax rather than opting for a "Big Bang" approach.

Mr McCreevy cut corporation tax to 32 per cent from 36 per cent in the budget but the IAPF said corporation tax would have to fall to 19 per cent before the tax credit elimination would have a neutral impact on pensions.

The Irish Association of Investment Managers (IAIM) and the Institute of Taxation have already expressed their concern about the changes and their implications for Ireland's life and pensions business as well as wider investment decisions in Irish equities.

They are concerned that the move will drive investment overseas by making it more attractive for pension funds and others to invest abroad. But Coyle Hamilton notes that the Irish investment community has always been creative and will respond by providing new investment opportunities for pension schemes.

Companies may also respond by changing their dividend strategy to better accommodate investors by using share buy-backs or other more tax effective ways of returning value to shareholders while some firms may increase their dividends to compensate for the loss of investor income. The reduction in corporation tax should boost profits, providing some scope for them to do this.