Ode to an ISA

A "Brit ISA" would be a cyanide pill for British savers

The UK's ISA (Individual Savings Account) has some claim to being the most powerful savings vehicle in the world. For those not familiar with it, it is a savings account you pay in to with after-tax income, in which interest, dividends and capital gains are untaxed. Unlike America’s Roth IRA, you can take money out of it at any time, and the contribution limit is a generous £20,000 a year. You can keep the money in cash (and earn interest) or invest it in various different securities like stocks, bonds and funds. 

The ISA is basically the best thing about the UK's tax and savings regime, from my point of view. In a country that gives gigantic tax breaks to investment in one's house – with ruinous effects, since most people are invested in a single asset that shouldn't even really be a financial asset – it is one of the only places you can put your money as a normal person and watch it grow untouched. While extremely wealthy people can avoid tax on a grander scale, in economically wasteful ways, the ISA is available to everyone, and unlike most tax avoidance schemes, it is economically efficient to not have a tax penalty for forgoing consumption to create more output. It also allows you to avoid the hassle of calculating dividends and capital gains, which is a huge pain in the ass if you don’t have an accountant to do it for you.

Full disclosure: I've tried to live semi-frugally over the last decade or so of my life, and have put most of what I've saved into my ISA. My ISA is a big part of my financial planning for my future: I have pursued an unorthodox career path, and having a decent pot of money I can fall back on means I can take more chances without threatening my family's wellbeing.

The broader effects of the ISA are good too. Savings are good generally, since they make people more resilient when times are tough – we don't pay Universal Credit to people with more than £16,000 in savings, for example, because we reckon they can look after themselves until they run those down. And more investment is good, so avoiding taxing it means we get more of it.

This last point is an important part of the case for ISAs, including the fact that, in principle, UK ISA savers are probably making their savings available to British businesses to invest. That is one reason that capping ISAs, as was proposed last year, would be a mistake. So it may be easy to think that we can make ISAs even better for Britain by saying that you can only use them to invest in British firms.

That is what a collection of British investment funds have called for, and Bloomberg reports that the government is considering doing it in its budget next week. If the government does go ahead with this, I think it would be a pretty huge mistake, and one of the worst cases in recent times of corporate lobbying making people worse off. Here is a list of the companies lobbying for it. (Note that this post assumes the government plans to replace the ISA with a “Brit ISA”, as these companies have called for. It’s no big deal if they just create a new allowance on top of existing ones.)

First, understand what's at stake for people who use ISAs to save. Below is a chart showing total returns over the last ten years from investing in different funds that track the US stock market (the orange and yellow lines) versus funds that invest in the UK stock market (the red, white and green lines). This assumes that you re-invested any dividends that were paid out.

The total return from investing in the S&P 500, the most common US stock market index to invest in, was 227.9% over the past ten years. So in other words, if you had £10,000 and invested it back in 2014, you'd have about £32,790 today. 

The total return from investing in the best performing UK index, the FTSE 100, was 23.75% over that time – nearly ten times less than the S&P 500. So if you'd invested in that, you'd have £12,375: about £20,000 less than if you'd gone with the S&P 500. (You’d actually be poorer in real terms.)

So the first problem with the British ISA proposal is pretty straightforward. If the government had done this ten years ago, British savers would be much poorer today. A lot of people probably wouldn’t have bothered saving at all, if the only tax-free option was a real-terms loss in the anaemic FTSE 100.

The second problem relates to the importance of diversification. We should not expect that the next ten years will look like the last, and I am not telling you to invest in the S&P 500. For what it's worth, I am invested in an All-World fund, for maximum diversification across equities. The lesson above is not that we would all have been well-advised to pile into US equities in 2014 – we didn't know what the future would hold. The lesson is that being concentrated in a single country could have been fantastic, or it could have been – in this case, if that country was Britain – catastrophic. 

This goes doubly if you live in that country and it is a small market in global terms. In that case, somewhere between 90 and 99% of your life is already "invested" in that country already. Your salary, your current and future employers' prospects, your state pension, your future tax burden, and the wellbeing of all the public services you rely on are already unavoidably sunk into the UK’s fortunes, along with many other parts of your life.

If Britain does well in the future, as I dearly hope it will, anyone who lives here is already exposed to it well enough. If Britain does badly, however, anyone who lives here will be glad to have hedged by putting some of their liquid savings abroad. 

The third issue is that this doesn't solve any of the problems it's supposed to. The assumption here is that there are loads of UK companies that would grow rapidly if they only had more access to money. But if that's wrong, and returns are low for any other reason, then forcing more money in will do the exact opposite of what is hoped, and just drive returns down even more! It’s a matter of basic supply and demand: if you have more capital in the UK, then, other things being equal, the price of capital in the UK will fall.

Investment is low in Britain because opportunities for profit are scarce. This is because costs are high. There should be enormous amounts of productive investment in the creation of things like houses, railways, roads, airport runways, and energy generation – the high prices of these things is a strong signal of very high demand for more. But there isn't, because the costs of building those things are much higher than they ought to be, and in many cases infinitely high, because they're either incredibly difficult to get permission for, or they’re banned outright. So the cost of these investments is very high, and then the cost of other investments is high because the input costs of labour, transport, premises, and energy are all high as a result as well.

For a long time, we taxed investment returns from investment in physical capital like machinery and buildings more than we taxed spending on wages or pens and paper. That is another reason that investment has been low, and it's very good that we have begun to fix that. 

(There are lots of other reasons the UK isn't a great place to set up a high-growth company too – in my opinion, these reasons include: our interventionist competition authority and policy; a general preoccupation in politics with eliminating risk and harm over encouraging experimentation and progress; our high taxes on high earners; post-Brexit trade barriers with Europe; cultural factors that downplay the virtues of entrepreneurial risk-taking and overplay the virtue of fairness; and probably just the fact that America speaks English, so it’s easy to go there if you’ve got a lot of potential. Some of these, especially as they relate to corporate governance, have apparently been directly responsible for the UK stock market’s poor performance.)

I think a problem we have is an over-focus on the word "investment", and I am as guilty for this as anyone. Yes, investment in the UK is too low. It's good that everyone now agrees about this. But forcing more investment through schemes like this, without tackling the underlying reasons for low returns, is exactly the same as subsidising demand in the housing market instead of building more houses.

One striking thing highlighted by the Resolution Foundation is the finding that, in an accounting sense, UK returns are actually high compared to elsewhere. It might be easy to look at this and think that the problem is investors, not the investments themselves – until we remember the chart of returns at the top of this piece.

So what explains this apparent paradox? The answer is that the returns on investment shown in the Resolution Foundation chart don't factor in things that don't make it off the landing pad to begin with, for regulatory reasons. If you can only build the most profitable solar farm, because the costs of getting permission are so high, then returns on solar farm investments will inevitably look really good, even though we would be much richer if we could build more with a lower return. If we made the bottom 80% of the labour force unemployed, average wages of people in work would be sky-high, but it would not be a productive society overall.

So even though it's great that people want more investment, how we get it matters a great deal. We can try to lower costs for businesses by making it easier to build stuff, and see higher investment from domestic savers and foreign investors as a happy result of the UK being an easier place to build stuff and grow companies. Or we can listen to the British investment funds lobbying to ban people from investing overseas so they're forced, instead, to save their money with – guess who? – them. I’m with John: a windfall tax on the companies proposing this, and similarly naked rent-seeking measures, would give a much bigger boost to UK Plc.