The British way to tax concessions for share buying

26.9.2017 Media Coverage

Hafsteinn Hauksson, economist at GAMMA Capital Markets in London, writes in Vísbending's newest issue about how the British have tried to level the playing field for smaller investors by using tax free savings accounts.

In his book, Capital in the Twenty-First Century, Thomas Piketty points out that the concentration of wealth is generally much greater than the concentration of income from employment. He explains that this is due to the wealthy receiving more capital income than those who are not rich. Two recent research studies further explain the trend, one from Sweden¹ and the other from the US.²

These studies conclude that increased savings or access to improved investment opportunities is not a sufficient reason for growing inequality in both Sweden and the US. Instead it is the allocation of savings, which plays the dominant role.

The articles' authors find that both in Sweden and the US, those who are wealthier allocate a larger portion of their savings to investments bearing higher risk, such as in the share market, while the savings of those who have less, are mostly comprised of cash and housing. As the latter assets carry lower long-term interests, the savings of the wealthier group have a higher rate of return, giving rise to inequalities when measured by concentration of assets.

Visbendinghafsteinn2

[Picture, Disposable income, sum of percentiles, acc. 2015's tax return files. – Real estate / Vehicles / Deposits / Securities / Other assets. Source: Statistics Iceland]

As far as Icelandic data goes, it tells a similar tale.³ The assets of the decile with the least amount of assets are mostly comprised of cash, with the portion of real estate rising with growing wealth, but the only decile with notable securities in its portfolio is the one with the most assets. While the reasons for this will not be speculated upon here, it can be noted that the explanations seem not necessarily to be that the other nine deciles are lacking funds to invest, because families from and including the fourth decile file, on average file on their tax returns deposits from around one million ISK and upwards.

Increased taxation or more equal interest income opportunities?

Suggestions have been made, both in and out of Iceland, about ways to level the field and reduce inequalities. Most of them have in common: increased taxation on those who have more, with redistribution to those who have less. The problem with those suggestions is that they reduce risk incentives as well as fringe value creation, resulting in economic impracticalities when allocating production factors; while ideas relating to a fairer cake-cutting are commendable, they are of little help if they at the same time make for a smaller cake.

Suggestions to level the field by equalizing possibilities for savings returns have been less prominent. The British have chosen a simple solution to that end. All those domiciled in the UK can use tax-free savings accounts, Individual Savings Accounts (ISA). Banks and financial institutions manage the ISA-accounts, like any other deposit accounts. No tax is due from interest income, earnings or sales profit generated from the capital deposited, making taxation as simple as possible, with the added bonus of the arrangement being more easily understandable than i.e. the Icelandic rules about relative free interest income.

The British way: Tax-free savings accounts

Screen-Shot-2017-09-26-at-11.48.43It is very simple to apply for and start to use such an account for investment purposes. The user interface is similar to what people know from online banking and serves as a portal to a multitude of investment opportunities. Most financial institutions that offer such accounts in the UK make an effort to make them as accessible as possible, providing investors with good information and advice on investment opportunities. The accounts provide individuals with helpful information and make it simpler for them to start investing.

Individuals can deposit funds into the accounts up to a certain limit. The limit, now 20 thousand pounds, is up for review annually. The accounts make for a kind of personal allowance on capital income, which is proportionally more helpful for those at the less wealthy end of the investor spectrum — in the same way a personal tax allowance does for income from employment. From the start, just under 22 million, or third of the British population, has used these accounts to generate return on their savings. 90% of those using the accounts in Britain have a monthly income of 580 thousand ISK (ca. 4.250 pounds) or less.

Withdrawals from the accounts are not limited and they are always accessible. Therefore, the accounts are a good addition to pension fund savings where withdrawals are limited, allowing for other motives for saving and nearer in time than only saving money to use in old age. Still, the accounts encourage long term savings because the tax exemption grows with growing interests and enlarged capital.

The savings owners have many options when it comes to investing the funds deposited into the ISA-accounts, who do not favour any form of investment. The deposits can therefore be channelled in to traditional interest bearing savings accounts, to peer-to-peer lending and crowd-funding, to purchase of government bonds or corporate bonds, private equity and mutual fund certificates in securities funds. The accounts do not create incentives for undesirable risk (i.e. by favouring investment in shares of companies of a certain sort or in specific companies). Instead they let the savings owners themselves decide how they want to invest. By allowing fund investments they also offer risk diversification, domestic and international.

Conclusion

Tax-free savings accounts manage to hit several birds with one stone. They encourage savings and increase the diversity of investment options in the economy, without directing savings to specific channels at the cost of others. They create incentives for smaller investors to acquaint themselves with different investment possibilities and to evaluate the advantages of investing in securities, whether it be in a stock exchange or by investing in securities funds, and they promote enlightened discussion about individuals' finances. Lastly, they level the playing field for wealthy and less wealthy investors by making it easier for smaller investors to get returns from their savings and offer proportionally more relief for those with less capital.

- From Vísbending, Volume 35, Issue 34, 21 Sep 2017.

¹Bach, L. og Calvet, L. E. og Sodini, P. (2017) Rich Pickings? Risk, Return, and Skill in the Portfolios of the Wealthy. HEC Paris Research Paper No. FIN-2016-1126; Swedish House of Finance Research Paper No. 16-03.
²Wolff, E.N. (2014). HOUSEHOLD WEALTH TRENDS IN THE UNITED STATES, 1962-2013: WHAT HAPPENED OVER THE GREAT RECESSION? NBER Working Paper No. 20733.
³With the reservation that equity securities are registered at nominal value and real estate value is generally filed as equal to real estate assessment value, which can distort and lower the value of securities and real estate.