Eben Macdonald: The Government plans to tax savers – here’s what could go wrong

Eben Macdonald is an economics and finance writer who has contributed to The Cambridge Journal of Political Affairs, the IEA’s 1828 blog and Bright Blue. His research interests include economic history, currency economics and the behaviour of financial markets.

Rachel Reeves seems to be playing a game of musical chairs. Tracing through the relevant news articles from this month, one finds that the government’s been erratically unclear about if they’re going ahead with one obscure, wonkish policy idea – none other than Reeves’ proposal to reduce tax allowances on cash-based savings accounts (ISAs). The Chancellor’s rhetoric evades detail, but some reports suggest she wants to lower the current tax-exempt threshold of £20,000 to as low as £4,000.

Ambiguity aside, Reeves’ aims – if the proposal goes ahead – are perfectly obvious. By eliminating the tax incentives to hold cash, the Chancellor wants Brits to move their savings from low-risk, but low-yield cash ISAs to more profitable, but riskier, accounts which invest in stocks and shares. Currently, total ISA savings – both cash and stock-based – amount to over £700 billion, 59 per cent of which already resides in stocks. Nonetheless, she hopes to squeeze capital out of the remaining 41 per cent in cash holdings. This, the logic goes, will bolster the UK’s economic performance by shifting liquidity into equity markets, and ultimately highly efficient public companies reliant on the stock exchange.

For this proposal to work, and serve as a net benefit to the British economy, one must believe two things. Firstly, removing tax exemptions will genuinely discourage holding cash and coax savers into stock-based ISAs. This will probably work. Savers aren’t stupid: those who sit on cash do so because they’re risk-averse – by nesting their fortunes in bank deposits which yield consistent, even if low, interest, they display a preference for keeping money safe over a higher average return on investment. They’re well-aware of the opportunity to earn more if they shovelled their savings into stock-based ISAs, whose returns are monumentally higher. But they’re also familiar with the inherent volatility of the stocks and shares, meaning one day, those savings could be wiped out by a sudden market jolt.

Reeves’ policy, however, plans to open up the toolkit of behavioural economics. By scaling back the tax exemptions for cash deposits, the government will appropriate more of the already weak returns from cash ISAs. Apart from a few risk-averse diehards, this might well be enough for hundreds of thousands of savers to relinquish their prudent caution and opt for vastly higher returns instead, sheepdogging tonnes of capital into equity markets. If Labour executes Reeves’ suggestion, we can realistically expect billions of pounds to emigrate from cash- to stock-based ISAs.

The second notion, however, that this will bear positive implications for the UK vastly underestimates the macroeconomic benefits of cash holdings. The way the Chancellor probably sees it, cash ISAs are just heaps of immobile capital sitting there doing nothing, prevented from being put to better use only by neurotic, risk-obsessed savers. Draining all funds into stock ISAs, the policy implies, won’t come with any unintended consequences whatsoever. This is far from the case. Given they yield interest, one might be moved to contemplate that cash ISAs do invest in something. How, after all, would these accounts muster any returns if they’re as useless as Reeves insinuates? By picking leaves from Theresa May’s Magic Money Tree?

Cash ISAs reap returns by feeding liquid deposits into banks, and subsequently helping to finance predominantly mortgages. The Building Societies Association, whose members hold about 40 per cent of the nation’s cash ISAs, almost exclusively lend to property-buyers. These societies alone power around a quarter of all mortgage lending in the UK.

Rachel Reeves is perhaps right that her tax reforms will pump up equity markets by nudging savers in the right direction. But if this is the case, she must contend with another, more inconvenient reality; less money in cash ISAs will mean less available capital for mortgage loans, and ultimately higher interest rates. Economics, it must be said, is a game of trade offs. Some businesses will benefit from the pivot towards stock-based ISAs given they issue shares. Others will suffer from more expensive mortgage rates on their properties. Determining who wins the tug of war of political sympathy requires we comb through the exact numbers.

Doing so reveals Reeves’ policy to be highly misguided. It’s true that most UK businesses issue shares. But importantly, these are mostly issued privately, not on tradable, public forums like the stock market, which are the investment targets of the stock-based ISAs Reeves puts on a pedestal. To be clear, a mere 0.1 per cent of all companies offer shares publicly. These tax changes would therefore help a negligible fraction of businesses.

Far more UK firms, meanwhile, have reason to anguish over costlier mortgages. Data on the relative burden mortgages pose to businesses is admittedly scarce, but given that most own some form of property, mortgaged or not, it makes sense that around 54 per cent of them carry debt, including mortgage obligations. If you think these firms are safe from escalating rates because they’ve already locked in contracts, think again. As The Times reports, floating rates are a highly common borrowing strategy among SME firms, making them vulnerable to sudden rate hikes. A small increase in mortgage costs, triggered by Reeves’ policy, could then be devastating. According to estimates by NatWest, a 1 per cent increase in general interest rates would produce an extra 250 insolvencies per year, while almost 16 per cent of UK firms are at risk of ‘zombification’ (just able to avoid insolvency, but still paralysed by debt) by just a small increase in rates.

Since being elected, many of Labour’s most niche policies have failed to escape the public’s wrath; scaling back inheritance tax exemptions from farmers stands out as a rough example. So it’s understandable they seem hesitant to officially announce a measure which would inconvenience potentially millions across the country. Nevertheless, Reeves’ aim to promote investment into equity markets is indeed a noble one, an important facet of the UK economy – but arm-twisting savers into submission will simply backfire.