Serious Money

May 28, 2010 7:50 pm

Will taxpayers end up in a jam tomorrow?

Tax is not like jam. We like the idea of jam today. But we much prefer tax tomorrow (or never). I’m sure the tea ladies at the Treasury know this. Let’s hope the chancellor does, too. Because if he increases capital gains tax (CGT) on private investors on June 22 – or even on April 6 next year – he could end up in a sticky situation.

It’s all to do with economics and taxpayer psychology. Several eminent academics have been cited this week in arguments against raising CGT from 18 per cent. Paul D. Evans of Ohio State University – author of the seminal Relationship Between Realised Capital Gains and Their Marginal Rate of Taxation, 1976-2004 – has apparently proved that taxpayers cash in fewer investments when tax rates are raised. A 1 percentage point reduction in the rate, however, leads to a 10.3 per cent rise in tax paid. Those fiscal experts at the Adam Smith Institute – who were behind the somewhat pithier Effect of Capital Gains Tax Rises on Revenues – concur that tax revenues can be lower under higher CGT rates. They say changes in investment behaviour occur to avoid tax. And Stuart Fowler – author of No Monkey Business: what investors need to know – has carried out a quantitative analysis of a doubling of CGT. He found that “the resulting downward pressure on the rewards makes risk taking irrational for taxable investors”.

But they could just as easily have read Lewis Carroll – author of Through The Looking Glass – and calibrated attitudes to tax from Alice’s attitude to jam: “I don’t want any today, at any rate.”

In short, raising the tax rate could simply result in investors deferring gains. So, the Treasury will not raise enough CGT to pay for tax reliefs elsewhere.

This, claim the critics, demonstrates the power of tax incentives.

But does it? Another submission to the Treasury this week suggested otherwise – and come up with a solution to the lack of investment in the UK.

It’s all to do with the psychology of behavioural finance. Several eminent academics and authors have been cited in a new paper from the insurance group Aegon. Thaler, de Meza, Irlenbusch and Reyniers – in Saving Britain: a White Paper on Rebuilding Britain’s Savings Culture – all conclude that the power of inertia is stronger than the power of tax breaks.

So, if anything, investors are more likely to defer gains because it’s easier than calculating complex CGT taper reliefs or indexation allowances.

As the paper puts it: “Previous policy interventions were guided by the principle that people are perfectly rational in their decision making. Interventions have been limited to ‘neutral’ market mechanisms – eg ‘matching’ incentives, taxation – when attempting to shape individual decisions. However, emerging evidence from the field of behavioural economics increasingly suggests these approaches are insufficient. People are often guided by habit or by inertia, generally hate making complicated choices, and often defer these indefinitely.”

In other words, many people would rather defer investing as well as paying tax. Jam today – or buying expensive jam making equipment today – is the national preference.

Aegon quotes the 2008 Wealth and Assets Survey, in which 39 per cent of respondents agreed with the statement: “I would rather enjoy a good standard of living today than save for retirement.” This might explain why the UK has the second lowest savings rate of any Organisation for Economic Co-operation and Development country over the past 20 years. We’re even worse than the Spanish – and they invented the concept of mañana.

But the power of inertia also provides an answer. In fact, the White Paper suggests several ways of boosting savings by “doing nothing”:

Save more tomorrow
In the book Nudge , Richard Thaler describes a charitable giving scheme that attracted more donors by starting them on very low sums, with a commitment to increase them later if they don’t opt out. Now US pension schemes have successfully adapted the principle – by only committing investors to higher contributions after a future pay review

Save back not cash back
If every payment point were also a savings point, behaviour would change, say the authors. They believe an option to add £5 to savings accounts at supermarket checkouts could become the norm

R ounding
In most transactions, people ignore the pence – so if all payments were rounded up to the nearest £1, small sums could be transferred to a savings account every day. “Make it painless, make it frictionless,” says Francis McGee of Aegon. “Can you save £50 a month? Most people say no. Can you save 20p? Most people say yes.”

It is already working. Lloyds TSB has an account called Save the Change. Sainsbury’s already offers Save Back. But if the Treasury backed a Save Back scheme, it might not have to spend £1.6bn a year on savings tax incentives – and we’d all have a lot more jam.
matthew.vincent@ft.com

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