Investing for real: how to use tax releif to best effect

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There was an extraordinary piece of information in the Observer newspaper on Sunday. It was noted with regard to equity investors that:

Retail investors have voted with their feet. According to the Investment Management Association, more people have cashed in their Isa equities savings plans than taken out new ones in each year since 2004, despite tax breaks.

It is, of course, wholly rational behaviour. To all but the wilfully blind it was obvious that the stock market rise that started in 2004 was unsustainable. I predicted as such in 2003.

As the Observer also noted:

Data shows that retail investors accounted for £9.5bn in 2007, only marginally ahead of 2001, illustrating that the wider share ownership aspirations of Conservative politicians in the 1980s are a long way from being met.

In combination these two observations support a suspicion that I have held for a long time, which it is that people are not saving in the media offered to them because they either do not understand them or, more likely, they understand them very well and think they are too unpalatable, too risky and too removed from economic reality to meet their needs.

In that case why are we continuing to offer tax breaks for saving in the stock market when people cannot be persuaded that this is in their best interest? Shouldn't we accept the message that consumers are giving and promote alternative savings mechanisms instead which they might want to use?

What might those things being? Based purely on my own intuition, although that has been informed by discussion with a lot of people, what seems of most importance to most people that I meet are three things. Dependent upon age the highest priority is either health or education. The next most important issue is housing. Crime, immigration, transport and even the environment come somewhat lower on their list of priorities. Curiously, and I accept that this may just be a reflection of the people I know, the acquisition of material goods or the pursuit of consumption expenditure whilst important always seems peripheral to these fundamental concerns.

Right now we know that health and education and housing are not getting the attention that they deserve inside our economy. That is because people cannot invest in health and education because the only effective mechanism for their supply in which people have any confidence is the government and as a result there is no easy hypothecated way in which they can put their funds into the provision of these services to obtain the benefits they want.

Housing is a different issue. Far too many people have invested in housing, inappropriately and in uncoordinated fashion meaning there is a glut of two-bedroom rental property but a continuing shortage of necessary housing in many areas. The evidence has become painfully apparent that personal investment decisions do not meet society's needs in this area.

So what could be done? I suggest two very simple but almost certainly extremely effective changes. First of all ISAs should be withdrawn, not because they are not popular (the cash product still attracts significant funds) but because they represent an inappropriate and untargeted use of tax. They should be replaced by an equivalent fund that must, however, be invested in one of three things. They might be energy-efficiency funds, social housing funds designed to either build new social housing or to bring the existing stock up to an appropriate level of maintenance and environmental effectiveness, or health funds designed to provide the infrastructure the NHS needs a much lower cost than PFI always charges at present. This immediately provides funds for use by a central and local government at a time when this will be essential, means that the tax relief given provide a direct benefit to the government and means that people will understand that their investment is in a service from which they can benefit.

Second, pension funds need to be subject to an absolute limit on the maximum amount that can be invested in equity funds. Since almost no new share issues have taken place in the United Kingdom for many years (bar those associated with takeovers or the salvaging of near bankrupt entities) and in the USA the overall equity market is shrinking due to the repurchase of shares by companies this limit could be at a relatively modest level. A holding of little more than 30% in equities would seem appropriate. This would immediately take pressure off the market and reduce the volatility for the benefit of all participants. The funds not used in this way could then, as a matter of course, be invested in social funds of the sort described above through the People's Pension mechanism I mentioned here recently. These might well be structured as bonds to provide a secure secondary market to ensure liquidity. Due to existing uncertainty in the bond market for many corporate funds and the uncertainty surrounding many the insurance arrangements related to this market the backing of the government, which will be a necessary part of these fund arrangements, would ensure that they have a low yield but maximum security, which is a feature that any pension arrangement should prioritise.

Doing this would achieve three goals. Share price volatility will be reduced. Funds will be invested in real economic activity, which is essential at a time when economic activity is declining, especially in infrastructure development. Third, tax incentives for saving will be appropriately used to encourage long-term investment in long-term assets designed to provide safe, and secure long-term rewards at rates which are overall higher than those paid in equities, where, as the Observer also noted yesterday, the long-term rate of return is just 1%.

It's a triple whammy.