In her Mansion House speech a few days ago, the Chancellor appears to have squashed speculation that cash ISAs may be restricted or abolished. At the same time she called on the ISA industry to promote more risk-taking in order to achieve better returns and thereby increase investment in the UK economy. Unfortunately, her exhortation to ISA providers to encourage buying shares rather than cash deposits reinforces a widespread misconception: that buying shares in an ISA results in increased investment in the real economy.
So are ISAs little more than a tax avoidance scheme for the better off? In this article I should like briefly to examine the history, development and current size of ISAs, to analyse and question their justification, and suggest what changes should be made in the savings regime.
Origin, development and size of ISAs
Over the past nearly 40 years ISAs and their predecessors have become a fixed component of the UK’s economy. They started in a small way in 1986 when Personal Equity Plans (PEPs) were introduced in Nigel Lawson’s budget. They were joined in 1990 by Tax-Exempt Special Savings Accounts (TESSAs). In 1999 these were combined by Gordon Brown into the current Individual Savings Account (ISA), and their size and scope have been progressively increased over 25 years. The maximum annual amount that can be subscribed has increased from £7000 in 1999 to £20 000 in 2017. Income and capital gains from savings within the account are free of tax.
In 2024 it was calculated by Interactive Investor that someone who subscribed the full ISA allowance every 6 April since 1999 in the average global fund (having thus subscribed £306,560 in total) would have a portfolio worth £807 455 over 25 years of ISA - that is a tax-free capital gain of half a million pounds.
According to HMRC Annual Savings Statistics the total amount of savings held in ISAs in 2022/23 was £726 billion (equivalent to about 29% of the nation’s GDP). The cost to the Exchequer in income and capital gains tax foregone was £4.9 billions. So ISAs are a VERY BIG DEAL and understandably very popular with the 22.3 million taxpayers who benefit from them.
So it is with some trepidation that I dare to question or challenge them.
Justification for ISAs
So what is the rationale for these generous tax exemptions? There are two main justifications for ISAs:
To encourage people to save.
According to HMRC's Non-structural Tax Relief Statistics the objective of ISAs is “to encourage individuals to save over time by removing the tax liability for savings income.” This objective fits in well with the Margaret Thatcher analogy of the national economy and the thrifty housewife. But this is a false analogy. The national economy is obviously different from an individual household budget, and indeed there are times when it is in the national interest to encourage people to spend rather than save. That is why the Bank of England reduces interest rates during a recession (in order to stimulate borrowing and spending).
Moreover, why should the state subsidise people to do what is in their own interest? People save for a variety of personal reasons: for a deposit on a house, for their summer holiday, to top up their pension, for an emergency or a “rainy day” – or simply because they do not spend all their income. Why do they need an additional incentive?
To avoid double taxation – that is, being taxed twice on the same income or asset
The argument here is that, if somebody saves out of their net income after having paid income tax, it is unfair to tax them again on the interest they receive on those savings. But this argument is not wholly convincing, and is not applied consistently elsewhere. Everybody has to pay VAT out of their taxed income, but nobody suggests that we should be able to offset VAT against income tax. Moreover, there is already more favourable treatment of savings income, with additional personal allowances and lower initial tax rates.
Savings and investment
Reverting to Rachel Reeves’ Mansion House speech there appears to be confusion in her (or her speech writer’s) mind about the use of the word “investment” – for it has two distinct meanings: a popular meaning and a precise economic meaning.
The popular meaning of the word “invest” is given by the Oxford English Dictionary as to “expend (money, effort) in something from which a return or profit is expected, now esp. in the purchase of property, shares etc, for the sake of the interest, dividends or profits accruing from them.” Thus, savers “invest” in an ISA in the hope of receiving an income or making a capital gain.
The economist’s definition of “investment” is much narrower: “the creation of a capital asset, or the enhancement of an existing capital asset”. A “capital asset” is something that increases future productive capacity – for example, a new factory, or a fleet of new vehicles, machine tools or a new computer system. On this definition the buying and selling of existing shares, bonds and other purely financial assets does not constitute investment since it adds nothing to the nation’s ability to produce goods and services.
According to her CV the Chancellor is a trained economist and has worked for the Bank of England in that capacity, so she is presumably well aware of the above distinction. So it is disappointing that she did not have more to say about channelling savings into genuine investment (i.e. capital formation) rather than into speculating on the stock market.
How to reform ISAs
If, as I say above, the claimed justifications for ISAs (encouragement of saving, avoiding double taxation) do not withstand analysis, then ISAs are indeed little more than a glorified tax avoidance scheme for the better-off.
Given they they are probably politically untouchable, are there any ways in which ISAs can be modified or tweaked so that they genuinely contribute to much needed investment in the real economy but without giving a huge unnecessary subsidy to the prosperous middle classes?
It would be unthinkable to withdraw the tax benefits that have already accrued, but it would be possible to start phasing them out from next year (i.e. existing ISAs retain their tax-sheltered status but new ones are progressively restricted). The details would have to be worked out, but I make the following suggestions:
Existing ISAs are frozen, and initially their current tax-sheltered status continues – for now.
The amount that can be subscribed to a new ISA is reduced – say, from £20 000 to £15 000 (which is what it was in 2015) or less.
Income tax relief on new ISAs should be at the standard rate of income tax (20%). Thus higher rate taxpayers would pay 20% rather than 40% tax on income from dividends or interest. Since there is already an Annual Exempt Amount of £3000 for capital gains there is no need to allow any further relief within an ISA.
The range of products that can be purchased within a new ISA should be restricted to genuine investments that enable the creation of new or enhanced capital assets – such as Initial Public Offerings (IPOs), rights issues (if tied to new investment), new corporate bonds, funds for small and medium business loans including startups, and possibly municipal bonds if they are tied to specific capital projects (e.g. a new or replacement bridge or a new tramway system). This restriction would therefore exclude the purchase of existing shares and bonds.
Cash-only deposits would become ineligible for ISAs.
Eventually – say, after five years – consideration could be given to ending the tax-sheltered status of existing ISAs. One option would be to transfer them into pension schemes, so that the saver would retain the tax benefit of the ISA but would pay income tax when the pension scheme pays out.
I expect a tax accountant or pension expert can find flaws in the detail of the above suggestions, but I think the principle is right, and with good will a feasible programme could be worked out. Of course the banks, building societies and stockbrokers would whinge, and no doubt the Conservative Party and Nigel Farage (himself a former stockbroker) would oppose this challenge to their supporters’ privileges. But it should be welcomed by those who wish to boost genuine investment in the British economy. Above all it would partly redress the balance between those whose incomes barely cover their household needs – let alone an ISA - and those who benefit from this undeserved tax break.
© Robin Paice 2025
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