Why are we giving tax breaks for savings that are invested overseas?

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Last week saw the end of the UK tax year. Working in financial services, I inevitably received a flurry of messages from friends asking where to put last-minute ISA monies. I have few hard and fast rules in life, but mixing friendships and anything resembling financial advice is one of them. However there was one question that came up again and again in these messages. Why should I buy UK shares when US shares have performed better, and the underlying companies are more productive? Recent share price performance is indisputable. The US S&P 500 index has outperformed the UK FTSE 100 in thirteen out of the last fifteen years. And when it comes to US companies, they have grown profits by 220% since 2009. In the UK this has been just 56%. With the obvious point that past performance is no guarantee of future trends, this is compelling data. It is also the backdrop to a poorly developed debate on whether a UK tax system that incentivises retirement and personal savings should be agnostic to where those savings are invested.

The first thing to say is that individual savers – as well as pension fund managers as the custodians of retirement assets – should maximise risk-adjusted returns wherever they can be found in the world. It is not their job to support their home economy in a philanthropic or patriotic manner. There is a rich literature in the merits of avoiding a large home bias. However, the tax incentives that frame these savings decisions should have a wider set of aims. In particular, to maximise the UK economic impact of these decisions and how they support growth, wages, jobs and the tax revenues that support UK public services. This wider assessment is at the heart of the recent debate over a British ISA – whose intention was announced at last month’s Budget – and in mandating pension funds to report their UK-based asset holdings. Let’s unpack this debate in more detail.

Firstly, the impact of investment choices has a direct impact on the cost of capital for UK companies. Any decision to buy shares in a company lowers that company’s cost of capital. This makes it cheaper for that company to invest, grow and innovate. Some companies deserve that lower cost, and this is the virtuous alchemy of capitalism. Investment rewards efficiency by giving its agents additional resources to do more of it. For all the negative press that the financial services sector has received since the Global Financial Crisis of 2008, this remains the lodestar for a vibrant and socially useful financial sector.
But what if that idealistic process is broken, with self-reinforcing consequences? Purists would argue this can’t happen. But speak to any UK-listed company and this is exactly what is happening on UK stock markets. Investors have pulled out of UK shares for eighty of the last ninety-five months. This has led to the cost of capital being prohibitively high for many UK companies to scale, innovate, and grow. My own work estimates that this impact has put UK companies looking to raise equity at a 20% disadvantage to their global peers. Schroders, the investment manager, using a different methodology believes this was as high as 48% earlier this year. For an artificial intelligence or green energy company looking to grow here in the UK – almost certainly key enablers of future growth – that puts them at an immediate disadvantage relative to their global competitors.

The regular push back you hear is that the UK stock market does not contain enough innovative growth companies – but even adjusting for the fact that there is clearly no equivalent to Nvidia or Microsoft on the UK stock market, there is now a scarring effect from being listed in London. It was a major barrier to ARM relisting in the UK where this innovative, high growth microchip company would have become the fourth largest company on the UK stock market. The lack of pull factors for the fastest growing companies to come to the UK market has led to important intellectual property leaking out of the UK and choosing other international markets to raise capital. Over time, this becomes self-fulfilling as it disincentivises new companies to raise capital in the UK as benchmark valuations and suitable research have both been hollowed out.

So the necessary debate is whether growth is being stifled by a UK investor increasingly choosing to allocate their tax-break enhanced savings overseas? This is relevant given the tax breaks on ISAs and pensions sum to more than £50bn a year. Like any item of public spending, the full economic impact of these tax breaks is important to understand. Whether a UK tax break for savings should be the same whether it is used to invest in a UK growth company, or in a Silicon Valley giant is a huge policy question.

Other countries seem to know the answer. The UK is now a big international outlier in how it allocates to its home stock market. A recent report by the UK’s Capital Markets Industry Taskforce (CMIT) noted that UK pension funds are now underweight UK shares – with the largest funds allocating just 2.7% of their shareholdings to UK companies. Australia allocates 38% to its own companies, Japan 49%, the US 64%, and France 26%. These economies have noted the importance of a domestic savings base to support growth. In a 2023 report by KPMG for the Australian government, the analysis found that the AustralianSuper’s investment activities have “directly and indirectly boosted Gross National Income in FY2022 by approximately $640 (£320) for every worker in the economy”. Separate research by both the Centre for Policy Studies and the Bank of England has found the negative impact that Stamp Duty – levied uniquely on UK shares – has on growth, investment, and jobs. An admirable move towards a “global benchmarking” by the UK pensions industry has parallels to pursuing tariff-free trade. It is great for economic welfare if conducted synchronously, and multilaterally. But going alone in this way causes substantial and asymmetric economic harm. That appears to be the situation the UK savings industry has got itself into.
So, does the UK government and opposition have the inclination to change this? Increasingly, it seems so. Flatlining productivity, subdued investment, and the erosion of the corporate tax base are all causing alarm in Whitehall. Using the levers of public policy to redress savings incentives might just be key to getting economic growth back into the UK economy.

Published on The Times 08/04/2024

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