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Pensions to the fore

As we come to the end of the tax year, the financial services industry has been sending out literature. The timing tells us, of course, that Isas are one of the Government&#39s tax-favoured forms of saving. There are others – most important, pensions.

There is a very real question as to why the state feels it should encourage saving through different kinds of vehicles. The Government has outlined three reasons for helping people to save – for independence throughout their lives, for security if things go wrong and for comfort in old age.

The first of these objectives is a little nebulous but appears to be about helping people to deal with key turning points in their lives such as having children or learning.

The other two objectives are, however, straightforward and there would be wide agreement that the state should help individuals provide for their old age and deal with emergencies.

It is worth noting one objective which is not in this list – helping people accumulate assets to pass on as an inheritance.

This helps explain why the Government is quite rightly against significant changes to the annuity regime designed to help people pass on their pension pots to their heirs, which is precisely not the reason why pensions are tax-favoured.

The question is, how do the different forms of tax-favoured savings vehicles meet these Government objectives?

The tax-favoured status of pensions is the easiest to understand. By definition, pensions are the main route by which people secure a comfortable old age and their tax-favoured status is vital in persuading people to lock away their savings for up to 40 years or more.

Rainy day money has to be in very liquid form. Cash Isas are an appropriate form for sheltering some funds to deal with emergencies. The proposed asset-based welfare vehicles such as the child trust fund are des-igned to help secure independence through life.

Which of the Government&#39s objectives do equity-based Isas meet? They are clearly not appropriate for emergency use, as all equity-based saving should be held for at least five years.

Equity-based Isas also create real incentive problems for people thinking about locking away income for up to 40 years in their pension. Why should one do so when putting income into an Isa attracts somewhat similar tax treatment as saving in a pension, albeit on the basis of income not being tax-free on the way in but tax-free on the way out?

Equity-based Isas appear to complicate the choices facing savers. They exist largely because the Labour Government did not have the courage when it came into office in 1997 simply to end Peps – which largely benefited the already comfortable.

There is, however, a pot-ential scandal brewing for the Labour Government. From 2004, the advantages of investing in an equity-based Isa will be zero for a basic-rate taxpayer due to the little noticed abolition of the 10 per cent tax credit on dividend income.

It will become a vehicle solely of benefit for higher-rate taxpayers (and a tiny minority of basic-rate taxpayers who are wealthy enough to pay capital gains tax).

This will make the continuation of equity-based Isas very difficult for a Labour Government to justify on the basis of its own principles. They will be of benefit solely to the few, not the many.

Cash-based Isas have benefited a higher proportion of people on modest incomes. But the current regime is building up into something that looks excessively generous.

The rule of thumb used by financial advisers is that someone should have the equivalent of three months&#39 gross salary in an easily accessible account. For someone on average full-time earnings of just over £20,000, this would mean around £5,000-6,000.

However, someone who had used all their Isa all-owances to the maximum could now have £9,000 in a cash Isa (plus the same again if they had reinvested their Tessa) not counting accumulated interest.

A courageous left of centre Government would:

Keep pensions as the most tax-favoured form of saving.

Keep cash-based Isas but impose a maximum limit that made it clear that they were designed to be a modest rainy day pot “for the many”.

Abolish equity-based Isas altogether after 2004.

The tax system would be made more progressive by abolishing equity Isas and financial planning would be dramatically simplified by making pensions the only tax-favoured form of equity-based saving.

A left of centre Government could enact this policy and improve the coherence of the savings environment and at the same time be acting on its principles.

Peter Robinson is chief economist at the Institute for Public Policy Research

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