Tax-free savings scheme 'must die as benefits shrink

Things looked very different when Gordon Brown introduced the Individual Savings Account in 1999. The economy was booming, the stock market was enjoying one of its best-ever runs, and the wealthy and the middle classes were enjoying double-digit profits at the Treasury's expense as their tax-free Pep returns piled up year after year.

Isas would share out this largesse more equably, announced the Chancellor, with a tax-free product appealing more to those on low incomes and a little less generous to those already doing well.

When he said Isas would no longer receive the tax relief on share dividends that Peps had, nobody was too worried: after all, dividend income was dwarfed by rising share prices.

Six years later, share prices have plummeted to 1995 levels, and investors in equity-based Isas are seeing the tax advantages disappear.

Now influential think-tank the Institute of Public Policy Research has published a paper arguing that Isas have failed to persuade low earners to save, so they should be scrapped.

Is this right, or should Isas be replaced by something better? The IPPR's research shows that Isas are owned by people with pretty much the same income levels as those who had Peps. True, more young people own Isas, but otherwise not much has changed.

The think-tank argues that tax breaks are unlikely to attract people on low incomes because they don't pay much tax. A better way to get them to save, it suggests, might be to 'match' their savings with a contribution of public money.

The financial services industry, though, is generally dismissive of the premise that people on low incomes have the option to become significant savers. As Philippa Gee, investment strategist at financial adviser Torquil Clark, puts it: 'The Government should face up to reality: people on low incomes don't have a savings issue to address, they have a debt issue they need to sort out first. So many people have been building up debt through increasing their mortgage or other forms of credit, and they should think about clearing those debts before they think about saving.'

Yet for many of those who do have money to invest in Isas, the benefits will become pretty negligible from April 2004, when the Chancellor has threatened to remove the remaining 10 per cent tax credit on share dividends from Isa funds.

This means, in effect, that although investors won't pay tax on Isa income, money from shares will already have been taxed at the basic rate. If you are a basic rate taxpayer investing in an equity Isa, your only theoretical benefit will be exemption from Capital Gains Tax, which few people are liable for anyway.

There will still be a tax benefit for higher taxpayers and those with Isas invested in corporate bonds, other fixed interest securities, and cash. Yet, historically at least, shares have given the best returns.

Financial advisers, nevertheless, want Isas to stay. They say Gordon Brown should rescind his dividend credit cut, and make Isas simpler and more flexible.

Colin Jackson of Baronworth Investment Services says maxi- and mini-Isas are 'far too complicated', and hardly anybody has taken up the chance to invest ?1,000 in insurance products. 'I'd like to see an allowance of ?7,000 - or even ?10,000 - which the investor can put into whatever he or she wants: equities, bonds, cash, whatever,' Jackson says.

'Few people now want to invest in equities. Let them put the money into cash, then switch when the stock market picks up. That way the Government will still encourage people to save.'

The IPPR's alternative idea, that tax relief should be diverted to 'matched savings' is already being tested by the Government in the Savings Gateway scheme. In pilot areas, parents with a household income of less than ?15,000, or less than ?11,000 if they are childless, can save up to ?25 a month of their own money, which the state will match pound for pound.

Critics say this is open to abuse. 'Anybody who already has savings will simply divert them into the Savings Gateway without saving any new money,' says Carl Emmerson, of the rival think-tank, the Institute for Fiscal Studies.

'Anybody who has savings will divert that into the Savings Gateway, without saving anything new. And some people will increase their debts, and put it into the scheme to double their money.'

Emmerson says Isas should stay because they don't punish people with double taxation on money already plundered by income tax.

Gee at Torquil Clark adds: 'The public had a huge learning curve when Isas replaced Peps, and it would be a mistake to confuse savers when they should be receiving every encouragement.'