PUTTING TESSA IN THE DOCK

than at any time in at least the preceding 20 years. The 1980s was also a period of concern about declining private saving in many other industrialised coun- tries and coincided with worries over the ageing western populations and ability of social security sys- tems to cope with the pen- sions burden. Possibly in

245

free income. Contributions to PEPs are not tax deductible,

"The O f p E p but any income or capital gains accrued within a are tax free, and there is no tax

land 7ESSA1 investors Other 'lose

sumests on wi&&awah. -As give the Same t= treatment as a pEp for funds in designated

rather than comingfiorn bution -saving is out of

that t h e ~ o ~ o r t i o n O f

finds being substituted from other holdings schemes with annual cant+

taxed income but interest earned is tax-free and there is

new saving may be 1 urge"

f / !w- 1 T*k( )IN )lNl*

./

Putting TESSA JAMES BANKS

i n the dock ::::GE:Z:::~ rpsearrh at the Institute for Fixdl Studies

PEPs and TESSAs cost a lot but don't necessarily increase saving

1070-3535/96/040245 + 06 512.00/0 c 1996 THE DRYDEN PRESS

246 NEW ECONOMY

this might be the case is still a puzzle. Recent theories suggest that under-saving may be re- lated to individuals operating mental ac- counting processes or lacking self-control as opposed to saving ’optimally’ in the n d a s - sical sense. A similar, but related argument is that individuals might choose to rely on social security benefits rather than provide for themselves if not encouraged to save. Thus government expenditure on social security would be unnecessarily increased.

A third motive has been a desire to encour- age so-called popular capitalism. The sugges- tion is that economic performance will be en- hanced by increasing the number of individu- als with a direct stake in the performance of the economy. Finally, and the focus for most dis- cussion, greater saving is advocated as a way of improving economic performance. Insuffi- cient saving is said to put a brake on the level of the capital stock, and thus on the rate of economic growth. While the level of domestic saving is traditionally said to determine the return on investment and therefore the size of the capital stock in a closed economy, its role in a small increasingly open economy like the UK is far less clear.

Why tax incentives? One reason for using tax incentives to en- courage saving relates to the way in which different assets are currently treated by the tax system.

An ideal tax system would not distort indi- vidual choices between consumption today and consumption in the future, nor would it distort choices between saving in one way and saving in another. Decisions over asset- holdings should yield similar outcomes whether those decisions were based on pre- or post-tax rates of return.

This is still far from the case in the UK, but the inbduction of TESAs and PEPS has at least pmvided households with the opportunity of holding some of their savings in a form which is ~a~neut ra l lyby~etaxsys tem.Fun~held in PEPS and TEZSAs face a zero tax rate onintemt

accrued. By contrast, intwist payments from regular deposit accounts at the bank or build- ing society continue to suffer tax on the full nominal rate, and so the real rate of return is

moderate inflation. This is on top of the fact that the funds going into these accounts have already been sub~ed to income tax.

But the motivation for introducing TESSAS and PEPS was more than one of fiscalneutrality. Had this been the intention the most effective change, for most households, would have been to exempt interest income from tax on all bank and building society accounts, or to give a PEP- type tax treatment to all assets. Instead the mo- tivation seems to have been more complex, with popular capitalism ideas and extension of choice seeming to lie behind PEPS, while, in the case of =As, distributional motives and a desire to encourage saving for macroeconomic reasons were additional factors.

TESSAs and PEPS certainly succeeded in addressing some of the non-neutrality of the tax system, but was there anya priori reason to expect them to change the level of household saving? Standard economics suggests that to- tal saving will be affected when the marginal after-tax rate of return changes, but only to the extent that consumers are willing to substi- tute future for current consumption when in- terest rates change. However, a change in the interest rate will affect different households differently. An increase in the rate of return, for example, leads to at least two effects. The fact that current consumption is more expen- sive relative to the future means that consum- ers will lower their current consumption (in- creasing savings). But at the same time the increased return will make consumers better off in a lifetime sense and so they will want to consume more both now and in the future. So, whilst consumption in the future will unam- biguously rise when rates of return increase, the effect on current consumption, and hence saving, depends on the relative magnitude of the income and substitution effects. These ef- fects will be different sizes according to

substantially r e d u d - even in times of only

PUTTING TESSA IN THE DOCK 247

household tastes, income and expectations. Hence the average responsiveness of saving

to changes in the interest rate is essentially an empiricalissue,andresultsproducedfromsuch research are inconclusive. Another factor may be the number of available substitutes. If a re- form simply reduces the relative price of a pre- exishg product it seems likely that households will switch funds from a close substitute. On the other hand if the tax incentive can be combined with the introduction of a genuinely new prod- uct which would not previously have been available (a private pension plan is a good ex- ample) substitution frompreviousassets would seem much less likely.

Of course, the household sector is not the only sector that saves. Recent research has acknowledged a link between individual sav- ing and government finances. Some commen- tators have claimed that even if relatively little extra private saving was raised through tax incentives the net effect on national saving may be large relative to the cost in foregone tax revenue. On top of this they have argued that aggregate government revenue may not necessarily fall because of increasing corporate tax revenues. Whether or not it is worth increasing private savings depends on whether it actually increases national savings and whether this in turn in- creases investment and growth. One also needs to consider whether the same money could have been

the following factors: 0 how much saving going into the new tax

favoured schemes is 'new' investment how much we lose in terms of tax revenue to get this saving. whether savings could have been in- creased in cheaper ways

In what follows, I focus on the scale and distri- bution of take-up of PEPS and TESSAS, which gives some clue to the first of these two factors. More work is currently underway at the DFS on the particular issue of how much saving under these schemes is completely new.

Lessons from abroad The UK is not the only corntry to have ex- perimented with tax incentives for saving.

The majority of the debate is centred on the US where there have been two major incen- tive schemes - the Individual Retirement Ac- count (IRA) and the 401(k) retirement savings scheme. Introduced in the mid-seventies, IRAs were long-term savings vehicles for in- dividuals without pension plans where taxes were deferred until the funds are withdrawn

""Initial Inland Revenue estimates for the tax

expenditure associated with PEPS in the first

year was less than E l million - the current estimate is €450 million

for 1995196 rising to €600 million in 1996197"

spent on something that was better for growth (eg, education & training). Here we focus on the household sector (Harding in this issue looks at the broader question).

The degree to which tax incentives for sav- ing are value for money, will depend on the reasons for their introduction. If they are in- troduced to encourage saving to promote in- vestment and growth, then their success or otherwise will depend to a certain extent on

(attheminimumageof 59).In 1981, eligibility was increased to all households and limits were increased. In one year contributions rose from $%n to $28bn and by 1986 IRA sav- ing represented about one fifth of personal saving. In the tax-reform act of 1986 high in- come tax payers with em- ployer-provided pensions were excluded from the

scheme and contributions immediately fell by 62 per cent. Since then they have remained low.

The 401(k) plan was introduced in 1977 but only took off in 1981. Much like a personal pension in the UK without the tax-free lump sum, no taxes are paid until funds are with- drawn and contributions are deducted from pay. Consequently plans are only available to employees of firms who choose to sponsor

248 NEW ECONOMY

such schemes. These employers may also sup- plement an employee’s 401(k) contributions if they choose.

The analysis of these schemes has become polarised. At one end of the spectnun the work of Poterba, Venti and Wise (1996) have

some idea of the expansion of the scheme since then, the current estimate is €450 million for 1995/96 rising to €600 million in 1996/97.

Official statistics show a startling growth in the number of PEPs. As the Chart (left) shows, take-up was initially low with only around

suggested that funds in the schemes have come almost entirely from new saving. At the other end of the scale, Engen, Gale and Sholtz (1994) claim that new saving ac- counts for almost nothing and that all funds were coming from the reshuf- fling of the assets of the previously wealthy. In the case of 401(k) plans these conflicting results were even found from analysing the same years of the same dataset. All commentators have their favoured estimates, but a view that one quarter of the funds invested in the plans would not have been saved otherwise would seem to be one which would not upset the majority.

Evidence from aggregate statistics One crude measure of the success of tax exempt schemes is government estimates of the tax foregone, often called the tax expenditure. For savings exemptions however, whilst these numbers provide some guide to the expected size of funds held the computations depend on assumptions about inflation, rate of return, mar@ tax rates and sources of funds coming into the accounts. This suggests the tax expen- diture estimates may bear little relation to any amount of tax actually forgone.

Initial Inland Revenue estimates for the tax expenditure associated with PEPs in their first year was less than one million pounds. As

200,000 plans being taken out in each year at the start of the scheme. At this time however, the rules were extremely re- strictive and the ad- ministrative charges on the funds were high, effectively dis- couraging investors. Over the next few Budgets, rules were sigruficantly relaxed and the number of plans held began to grow. The most dra-

matic change occured in 1993/4 when the number of plans taken out was 1.6 million - almost double that of the previous year. As of 1996, PEPs account for about €25 billion of personal wealth, f3 billion of which has been added in each year since 1993. This coincided with the most recent rule change where the proportion of a general PEP allowed to be held in a designated unit trust or investment trust was increased from 50 per cent to 100 per cent. As a result of the changes PEPs are now a very different vehicle to that which was in- troduced in 1986. Initially they were a small account designed for direct holdings of UK equity with a minimum holding time require- ment. Now there is no minimum time re- quirement, limits are substantially higher and it is possible to hold assets in much more di- versified ways within the plan.

Inland Revenue figures for TESSA hold- ings show that by the time the first schemes were rolled over in 1995 there were 4.5 million live TESSA accounts in the UK, implying that approximately one in six adults now owns a

PUTTING TESSA IN THE DOCK 249

TESSA. Stocks of wealth held are large (just over €28 billion) and the estimated tax expen- diture is around EQOO million per year. The

which contains information on TESSA hold- ings from 1991 onwards, and the Financial Research Survey (collected by National Opin-

experience of TESSAs, since their introduc- tion, has been one of more systematic growth than that of PEPs. The number of plans has risen smoothly from two to four and a half billion since the introduction, with about two-thirds of these plans being held in building socie- ties.

The Charts, show- ing the size of funds held in TESSAs and the steady rise in take- up, are illuminating. Although the number of plans changes smoothly over time the size of the ac- counts jumps sign& cantly in the first quar- ter of each year, par- ticularly in the first few years of the scheme. This seems to suggest funds were being moved into TESSAs from other ac- counts to take advan-

9lQl PlQl 93QI 94Ql 9SQl

SCiMYZlnbdRsVavla

tage of the tax exemption each time the maxi- mum holding limit increased - an effect which began to tail off as the scheme matured.

Evidence from household data Unfortunately there is very little information on the saving behaviour of UK households to tell us which types of household have bene- fitted from the tax advantages, and how much saving was 'new'. The only evidence comes from The Family Expenditure Survey

ion Polls) which has information on T E S SAs and PEPs as well as other assets, but only goes up until 1991 / 1992.

From this data we can see that in the early years of the scheme TESSA ownership was concentrated amongst high income, middle- aged well-educated households typically holding other forms of saving or financial as- set as well (Banks et al,

ner 1996). The higher Table

(on the next page) uses FES data for the entire duration of the scheme so far to show how the proportion of households in which at least one adult has a TESSA varies with the income of the house- hold. Only one per cent of the poorest quarter of households held a TESSA in the

1994; Banks and Tan-

first year of the scheme compared with 14 per cent of the richest quartile. But as the scheme has gone on there has been faster growth in ownership in the bottom half of the income distribution than in the top, wth the result that by 1994/5 the figure for the bottom quartile had risen to 4.5 per cent whereas the propor- tion of households in the top quartile with a TESSA had only risen by half to 21 per cent. So =As are now much more evenly distrib- uted across income groups than they were,

250 NEW ECONOMY

although still con- centrated very much in the top half of the income distribution.

The lower Table gives banded in- formation on the distribution of TESSA accounts by size in the FES data.The evidence suggests that in the first year most in- vestors pu t the maximum allowed - €3,000 - into a TESSA: over three quarters of TESSAs held in 1991 lie in the band, €2,000- 3,000. Similarly, a large proportion of TESSAs now lie in top band, nearly

The rich have more TESSAs Proponion ofhouseholds with a TESSA. by income band (%)

Income quanile 1 9 9 1 1992 199314 199415

POOfeSt 1.02 3.71 4.29 4.52 2nd Quartile 4.31 7.01 9.68 11.26 3rd Quamile 6.24 11.87 14.09 15.00 Richest 14.00 18.44 20.86 21.75

SaraxFESHasehdddm

Almost half of TESSA investors reach the maximum limit h a u n t held in rrssAr

1991 1992 199314 199415

f0-50 3.45 0.96 2.43 1.3 I 60-loo 1.59 0.48 0.14 0.79 f 100-250 1.33 1.77 1.43 0.66 €250-500 3.71 3.22 2.29 2.10 LSOO-IOOO 3.98 2.73 4.15 3.28 f1000.2000 10.08 8.20 8.01 6.03 €2000-3000 75.86 33.44 21.32 17.17 f3000.5000 - 49.20 19.74 20.18 f5000.9ooo - - 40.49 48.49 ALL 100.00 100.00 100.00 100.00

SaraxFESHcusahdddP

half of all TESSAs lie in the f3,000-5,000 band in 1992, over 40 per cent lie in the €5,000-9,000 band in 1993 and nearly half lie in this band in 1994/5. These figures understate the extent to which individuals invested the maximum possible in each year. Since the total number of TESSA holders grew each year, there will be in each year a proportion of new or more recent TESSA holders who are unable to in- vest the total cumulative maximum.

Over half of PEP holders in the FRS data owned direct equity (compared with 14 per cent of the sample as a whole) and one third held trusts or bonds (compared to 3.6 per cent of the whole sample). Not only are PEPs more concentrated towards the top of the income distribution than TESSAs, but many of the richer individuals may be taking out as many as one plan every year. The five million live PEPs may be held by as few as two million individuals. As with TESSAs however, the proportion of these investors who hold other

close substitutes which are essen- tially similar in all but the tax break means that the pro- portion of funds be- ing substituted from other trust or equity holdings rather than coming from new saving may be large.

Conclusions The perceived suc- cess or otherwise of tax incentives for saving depends very much on the initial reason for their in- troduction. TESSAs and PEFs have gen- erated the possibility for households to hold medium-term

savings in a way that is not penalised by the tax system. By 1995, stocks of savings in these assets had become quite large. In the sense that the tax system is more neutral than it was, the schemes have certainly been suc- cessful.

However, the degree to which the schemes have succeeded in encouraging new saving or new savers is still an open question. Both the aggregate data and what household level information there is, is con- sistent with the story that, initially, a large proportion of funds in the accounts may have come from other savings accounts rather than from individuals foregoing cur- rent consumption. This may well be less the case now than it was, although the macroe- conomic climate has changed and individu- als may have been saving more anyway, even in the absence of savings schemes