Focus on votes – given the next election is less than 11 months away, the budget on 6 March will inevitably contain measures designed to gain votes.
Investing in the UK – is central to economic growth, but we increasingly prioritise funding companies overseas. It is imperative to shift the agenda to UK growth and ensure that investment stays at home.
Recommendations for the Chancellor – the equity market is central to growth and prosperity in the UK. In this note, we discuss several measures to reverse the decline.
There is no magic money tree to fuel the UK equity market – it only comes from retail investors, wealth managers, pensions, share buybacks and overseas demand. If we do not incentivise increased investment, then we believe the slough of despond will continue.
Investing in the UK
Over the past 20 years, the UK has seen an exodus of investment from the UK market. Pensions have increasingly moved into fixed interest, alternatives and global funds, portfolio allocation by wealth managers has globalised, and retail investors have far more choice. As a result, the UK has become an orphan asset with the small & midcap space under severe pressure.
However, all is not lost. We believe there are plenty of levers to resuscitate the market, which would have a speedy and material impact to the benefit of all stakeholders. The budget next week is an initial opportunity to do this, and we expect additional measures to follow.
Here are some suggestions that we believe would have minimal impact on the initial tax take, but a major impact on the UK equity market, driving growth and higher tax in the future.
British ISA
- Introduce a £10k British ISA to start from the new tax year (April 2024), in addition to the existing £20k allowance.
- From April 2025, rebalance the £30k to an equal weighting between the British ISA and ‘Global’ ISA.
- Merge the Cash ISA and Stocks & Shares ISA to reduce complexity and increase flexibility.
- Make the British ISA exempt from IHT to ‘reward’ investing in the UK.
- Announcing the change in the budget would be nicely timed for the NatWest retail offer.
Naysayers often state that a British ISA would add complexity (since when has investing in your own country been complex?), that it would not make a difference (why not if it is attractive?), that investors should have freedom of choice (fine, but this is a tax break from the UK), or that it will take time to introduce (participants will move quickly to avoid competitive disadvantage).
The ISA allowance was last increased in April 2017 and so just pacing with inflation should have resulted in an increase to £26k.
Stamp duty
Stamp duty on shares raised £3.3bn in 2023. This tax has an impact on liquidity and valuation. We believe it should be removed altogether, particularly as the UK is at a competitive disadvantage to international markets (stamp duty is 0.5% in the UK, but zero in the US, Germany and Singapore).
We suspect the government would baulk at losing the full £3.3bn, even if it does improve economic growth and the long-term tax take. Unfortunately, in our view, the OBR is very good at recognising the short-term impact and generally poor at estimating the long-term benefit. Anyway, an easy measure would be to remove stamp duty from small & midcap shares (which even France excludes). This should cost a micro-fraction of the £3.3bn and give a vital boost to a crucial sector for the UK.
Pensions
The UK has one of the largest pools of pension assets in the world. Unfortunately, the performance track record is poor for a variety of reasons including risk aversion, tax position and companies’ desire to offload their schemes. Pension funds used to be the core investors in listed companies and, specifically, UK equities, but the latter has diminished from 44% in 1998 to 4% currently. This has been detrimental to pensioners’ incomes, companies’ cash flow, UK tax take and economic growth.
The good news is that many schemes are now back in surplus and we have an opportunity to change mentality and improve outcomes. Most important, we need to recognise that pensions do not exist in the ether and are crucial to the economy and to people who live in the UK. Most people want a combination of higher pensions and better public services, but neither of these are possible if pensions are run with too much emphasis on risk and an absence of investing in the UK.
Here are some high-level thoughts on how to change the agenda, many of which do not involve government spending.
- Mansion House Compact – broaden initiative to include listed small & midcap companies (AIM is included) and accelerate the timetable.
- Pension funds should clearly state their investments in the UK, including a split between listed shares, private investments, gilts and corporate bonds.
- Pension funds should report on their UK investments in terms of performance, contribution to economic growth and ESG targets.
- Pension funds should clearly state their purpose and reference their targets alongside their sponsor’s objectives.
- Companies with a pension scheme surplus should be encouraged to maintain the scheme rather than secure a buy-out. A proportion of the surplus could be apportioned to higher-growth assets and the company and pensioners could see benefits through greater access to the surplus (with sensible caveats applied).
- Pensions lost the ability to reclaim ACT under Gordon Brown’s changes. The impact was £5.4bn at the time (in 1999) given the scale of investment in equities. Restoring a tax credit for investing in UK-listed companies would both grow the UK economy and improve outcomes for pensioners.
The government can play a central role in re-shaping our attitudes to pensions and their ability to grow the UK economy, increase pensions and provide societal benefit.
Capital gains tax
Reward investors for investing long term in the UK. There is currently no differential between supporting overseas companies and supporting UK companies, when there is clearly a benefit from the latter for the UK. Here are some potential changes:
- A 10% tax band for basic rate taxpayers – reduce CGT to zero, based on holding a UK company for three years.
- A 20% tax band for higher rate taxpayers – reduce CGT to 10% based on holding a UK company for three years.
These measures would actually increase total CGT payments as it would improve the overall value of the UK market (nb a 10% increase = £250bn) and reduce the negative impact of crystallising a capital gain.
Bizarrely, the government has been actively reducing the tax-free allowance in recent years (from £12k in 2022/23, to £6k in 2023/24, to £1k in 2024/25). This has materially reduced the attraction of investing in shares (eg there is no CGT on gilts).
The concept of lower CGT for longer-term investments is well understood and appreciated in other markets. In the US, the rates of CGT for long-term capital (ie held for over one year) and are set materially lower than the UK (0% up to $60k, 15% up to $523k and 20% over $523k).
Dividend allowance
The government recently reduced the dividend allowance (from £2k in 2022/23 to £1k in 2023/24 and £0.5k in 2024/25) and increased the level of tax by 1.25%. The tax benefit is expected to be £810m by 2026, with 4.4m people affected. HMRC did not expect any impact on companies from this move, but clearly did not think about the overall impact on the equity market. The key driver for the change was to increase the tax take from smaller privately-owned companies that often distribute funds through dividends rather than income, given the favourable tax treatment. However, quoted companies were included in the change and the unintended consequence was to make equity dividends less attractive.
The Chancellor could reverse this by introducing a British ISA (whereby dividends are not taxable), or by introducing a dividend allowance specifically for investing in UK companies.
Why does this matter?
There has been long-term withdrawal of funds from UK equity markets that have gone into overseas assets or debt. Just in the past year, DB pension schemes have reduced exposure to UK equities from 9.9% to 7.6%. It is the same trend when looking at retail investments. The following chart shows retail holdings through Hargreaves Lansdown.
Figure 2: Hargreaves Lansdown trend in assets under administration (ex cash)
Source: Company accounts, Peel Hunt estimates
At first sight the blue segment at the bottom of the chart shows that the exposure to UK equities has increased recently. However, two other segments need to be included. The UK Equity Income Funds (green) has declined sharply since 2015, as has the UK Small & Mid-sized Companies Funds (in yellow). Combined, the UK allocation has dropped from c.52% in 2015 to c.32% in 2023.
A similar trend is also occurring in wealth management. This chart shows the allocation of assets at St James’s Place.
Figure 3: St James’s Place allocation to UK equities
Source: Company accounts, Peel Hunt estimates
This shows that the UK equity allocation has fallen from 30% in 2013 to 10% today. Despite the overall assets increasing fourfold over the past 10 years, the total amount invested in the UK is only marginally higher and has dropped over the past few years.
The exit of assets from UK equities, and specifically from the small & midcap sector, has meant that there has been a consistent trend of companies exiting the market and almost none joining. This reflects the low valuations and reduction in liquidity. Forty companies exited last year due to M&A, whilst nine transactions have already been announced so far this year.
This is having a direct impact on the health and scale of the small & midcap market. The following chart shows the decline in the number of companies and available market cap in the FTSE Smallcap.
Figure 4: Reduction in number of FTSE Smallcap companies
Source: Bloomberg
The pro-forma numbers assume that current transactions complete and if the current rate of decline is extrapolated, there will be no companies left by 2028.
All of this shows the importance of government intervention and highlights that incentivisation is required if we are to ensure a healthy UK equity market. The small & midcap sector is particularly vulnerable and if nothing is done, we will lose a core driver of economic growth and tax revenue.
