Brain drain

The "real return" investment strategy

2007-12-25T19:33:00.000Z

I've written this description of my investment strategy for early retirement mainly to flesh out, clarify and summarise my thinking. Although I address an imaginary audience, I'm mainly talking to myself. Anyone who reads this should make up their own minds about its merits, and take responsibility for their own decisions if they allow themselves to be influenced by it.

Investment phases and early retirement

My "real return" strategy was intended to address the issue of how to safely achieve the maximum possible income from investment assets over a long retirement period.

In theory the fact that your early retirement savings only have to last as long as you live means you can count on withdrawing an element of capital each year. In practise the uncertainties of a long retirement period mean that I feel it is safer to divide your retirement into two phases, a coasting period where you try to maintain the value of your capital, and a run-down period when your life-expectancy is short enough that it is safe to start spending capital. In practise I'm unlikely to be certain that I want to use all my capital up on generating an income until my life expectancy has fallen to about 15 years, and if I do decide at that point there's nothing else I want to do with it, my income will be much higher in those years than the earlier ones. This isn't ideal. If spending throughout retirement is constant then ideally income should be as well. The marginal utility of money means that extra income in one year would have been worth more to me if it were spread equally between all the years. Unfortunately it seems unavoidable that being ready for contingencies does mean spending less than the maximum possible income, for the majority of a long retirement.

The "real return" investment strategy involves calculating how much income you can take during the coasting phase without your capital being eroded by withdrawals, charges, taxes or inflation. The real return tells you how much capital you need in the first place. The returns on investment are not treated as adjustable. It is outputs (spending) or inputs (initial capital) that are expected to adjust to the returns that are available.

In fact the real return strategy is a sensible strategy at any stage of life. It can be used in the accumulation phase, when one is still generating capital from working. A variation of it could also be used in the run-down phase, with the income taken being higher because the capital is no longer being preserved. In practise, with fifteen years to go, I'm most likely to just buy an increasing or inflation-linked annuity.

Once you've calculated the real return on different asset classes, the result also affects your asset allocation.

Before I get to the calculation, I need to visit some ideas that affect the strategy. The first couple will be familiar to anyone with any knowledge of investing, but some more interesting ones follow thereafter.
Diversification, asset classes and asset allocation

The idea of diversification is to hold different investments, so that when some do badly this is offset by others that do well. In the case of shares, splitting capital between as few as 15 companies that are all very different from each other is the bare minimum required for diversification. In practise, it is easier to invest in a fund, which will invest in a far wider spread of companies. Choosing a share tracker fund is an easy way to ensure we are as diversified as we can be, within the market the fund tracks.

An asset class is a group of investments that tend to be affected by the same factors, and therefore move up and down in value together. It is slightly subjective what we decide to label as asset classes, as there are always some factors that will cause any two investments to move in the same direction when they change. Some people divide shares into different asset classes, such as by country or region, or company size. Sometime a market sector is treated as an asset class. As shares of all kinds tend to move in the same direction during big stock-market booms and crashes, I prefer to regard shares as just one big asset class.

The other asset classes I recognise and use as a UK investor are cash deposits, bond funds and commercial property funds. Hedge funds and commodities are two asset classes I recognise, but don't regard as useful. I'm excluding residential property from consideration as an asset class on the assumption that the early retiree owns their own home outright, which in the UK in 2007 probably means having more money in one place than is strictly speaking a good idea.

The commercial property funds I have in mind are the unitised funds offered by insurance companies within pension and other investment products that they offer. Property unit trusts have unacceptably high charges. Property investment trusts do not have the very low volatility that is one of the best features of the asset class. They also have much higher charges than the cheapest funds available from insurance companies. Lastly, they use gearing, which I see as a negative factor. At the time of writing share prices of property investment trusts have just crashed by 40%, and they may therefore be a better temporary home for money invested in commercial property than unitised funds, but in the long term I will return to insurance company unitised pension funds for my property holdings.

One feature of unitised property funds that operate single-pricing is worth noting: when the managers switch the unit price between offer and bid bases, the fund value can fluctuate by 6% overnight. (Single pricing isn't such a big issue in share and bond funds, because the difference between the buying and selling prices of the underlying assets is much smaller.) Fortunately such switches are rare. I've noticed that Standard Life have adopted what I think is a clever strategy to stop people trying to trade against the switch. When their life fund switched to a bid basis for the first time in its 28 year existence, they closed it to inflows and started a new fund priced on an offer basis for anyone wanting to switch into property.

For the same reasons we diversify within asset classes, we need to consider diversifying among asset classes.

There is a formula based on finance theory for calculating the optimum mix of assets one should use. One problem with this is that it relies on parameters the estimates of which are so uncertain that the actual optimum portfolio could easily be very different from the one we calculate. Also, I read somewhere that "naive" asset allocation, consisting of simply allocating equal amounts to each asset class, is usually not much worse than the optimum allocation. I prefer naive allocation. It is easy to do, and means you will often have a big chunk of money in reserve to move into a different class after the latter has crashed. (The optimum mix formula will usually allocate a lot of money to one class and much smaller amounts to others.)
Market efficiency

Markets are efficient if whenever you come to trade the share price has already adjusted to all information that should affect it. This means that the share price is never expensive or cheap. The idea is quite logical; if there were any information anywhere in the world that would lead sensible people to believe a share price was wrong, they would buy or sell the share, and the price would adjust, and the process would continue until the price was right. As there are always thousands of highly-motivated people studying each share and buying or selling, the price should always be right.

A consequence of an efficient market is that there is no point in actively trading shares or paying someone to choose them for you. In an efficient market, any two diversified portfolios of shares will, with average luck, return the same as each other. By trading actively you increase your costs without increasing your returns. Similarly, anything you pay anyone who chooses shares or funds for you can only reduce your returns, as you will be paying a cost and receiving no benefit in terms of increased return. You must pay as little as possible to fund managers, financial advisors or full-service stockbrokers. It's important to remember the phrase "with average luck." Of course different portfolios may return different amounts. The point is that in an efficient market the differences are due to luck, not expertise. There's no way of knowing in advance which fund will return more, and therefore no reason to pay any fund manager more than the amount charged by the cheapest one.

Another consequence of market efficiency is that it is not worth spending time analysing or researching shares, since any information you come across will already be reflected in the share price when you come to trade.

There's an apparent paradox implicit in the idea of efficient markets. Markets can only be efficient if a substantial number of participants believe they aren't. If everyone believes markets are efficient, no-one will research shares, the share-prices will not correctly reflect the prospects of companies, and markets will become inefficient. If markets are inefficient, it pays to research them, so people will, and they will become efficient.

The investment classic that popularised the idea that markets are efficient is "A Random Walk Down Wall Street" by Burton Malkiel. I believe that when this book was first published, tracker funds didn't exist, and that they were invented to satisfy a demand created by this book. A cheap tracker fund is the ideal investment for a believer in efficient markets.

Market rationality

I read "A Random Walk Down Wall Street" for the second time shortly after the stock-market crash of 1987. Although 95% convinced by it that I should treat stock-markets as being efficient, I found its explanation of how the 1987 crash could be consistent with efficient markets theory difficult to swallow.

I define the term irrational market to mean one where share prices do not correctly reflect the prospects of companies, but it is impossible to predict when they will correct themselves. I replace the idea that markets are always efficient with the belief that they are always some mixture of efficient and irrational. In an irrational market, most of the practical rules of thumb that guide a believer in efficient markets still apply. There is still no way to get a higher return by predicting the future, whether directly by doing research, or indirectly by paying someone to choose shares for you.

It's something of a paradox that you can be absolutely certain that the stock-market is overvalued, and even though you are right, there is no sensible way to profit from this insight. You might consider buying a put option, however options have a time-cost built into their price, and (to quote a famous phrase attributed to Keynes) "the market can remain irrational much longer than you can remain solvent." If you try to profit by shorting shares, note that an overvalued market can become twice as overvalued, possibly bankrupting you, before the expected crash comes. On the other hand, you can use your belief that a market is overvalued to avoid investing in that market, and this is one strategy that differentiates someone who believes markets are sometimes irrational from someone who believes they are always efficient.
Sequence of returns

Uncertainty about the actual sequence of returns you might experience makes how much you can regularly take as income without prematurely running down your capital a much more difficult issue than it first appears. It's not good enough to take no more than the average amount your investments are expected to return. It makes a huge difference what order the good and bad years arrive in. Even if you get the expected average return, if you are unlucky and the worse-than-average years are disproportionately grouped at the beginning of the withdrawal period, you will eat into your capital and your portfolio will never recover from the dip. It is possible to take income at no more then the average annual rate your investments actually deliver, measured from your retirement date, and not only fail to preserve your capital, but actually spend it all. Some authors suggest on the basis of historical data that the maximum income a typical portfolio can safely support over a long period is 4% of the initial capital. A long period typically means 30 years or more. You are allowed to increase the income each year by the rate of inflation, so that it stays the same in real terms. Note that by safe they just mean you are highly unlikely to run your capital down to zero before the end of a 30 year period; your capital may still fall to near zero by the end.
Market valuation

During the late 1990s I strongly suspected the stock-market was overvalued. I'm talking about mainstream shares here; the dot-com bubble never came close to making any sense to me. Eventually I found intellectual justification for my instinct to stay out of shares. In March 2000, before the mainstream market crashed, "Valuing Wall Street" by Andrew Smithers and Stephen Wright was published. They said that stock-markets had a fair value that you could calculate, and this might differ from the current market value given by share prices. They advocated something called the "q" ratio as a measure of value. There is a second measure that also works, and gives the same answers, if calculated correctly. This is the cyclically-adjusted PE ratio of the market as a whole, called CAPE for short. Overvaluation of both is measured by comparing them to their historical averages. "q" is theoretically better, since there is a fundamental economic reason why it must remain constant on average over the long term. In the case of CAPE, its long-term average will only remain constant if the average return on shares remains constant. This return, known as Siegel's constant, looks as though it has stayed constant at about 6.75%, but there is no economic theory that explains why it should be at this level. As a result, it is always possible for market-valuation sceptics to argue that the long-term average value for CAPE might be changing over time. Having said that, Smithers and Wright prove that if CAPE is correctly calculated, it must give the same result as q. The charts in their book show that most of the time it does indicate the same level for the fair value of markets as q does. At the peak of the year 2000 stock-market bubble, the log of the ratio of q and CAPE to their historical averages peaked at about 1, a value that means the SP500 index was at 2.7 times fair value. The second highest peak was just before the 1929 crash. According to a chart at www.smithers.co.uk, the ratio then was 0.7, which means the index was at 2.0 times fair value. The biggest undervaluation was in about 1920, when the index was somewhere between 30% and 40% of fair value. The range of undervaluation I quote is because this was one of the infrequent periods when there was a noticeable divergence between the two measures. At the time of writing there has been another divergence. In June 2007, the date the chart was made up to, the SP500 was at 1520, q was saying the SP500 index was 29% overvalued and CAPE was saying it was 83% to expensive.

Smithers and Wright showed that in the long-term, by which they meant periods as long as 30 years, over or undervalued markets would correct themselves. This long time-scale is important, since it means their theory does not entirely contradict the idea that markets are unpredictable. Efficiency and irrationality still mean it is not possible to predict where markets will go over much shorter periods.

In early 2000 the high price of shares meant the long-term return was so low that taking all your money out of shares was the only sensible option.

Using the figures for June 2007 as an example, I can calculate the future return I expect on shares. First, I get the level of overvaluation indicated by q from www.smithers.co.uk. (I could take the equivalent figure for CAPE, or when they diverge, the average of the two, but I've decided that I trust q on its own the most.) The level of overvaluation is currently explicitly mentioned, but if it weren't I could derive it as follows. I get the latest value of the ratio of log q to its historical average, 0.25. (Actually for this example I cheated and calculated this from the stated level of overvaluation, if I'd read the value off the rather tiny chart I might have guessed it was closer to 0.20.) In Microsoft Excel I calculate the fair value of the SP500 index as 1520 / exp(0.25) = 1178, where 1520 is the level of the index at the end of June. The actual level of the index divided by fair value tells me how overvalued it is, 1520 / 1178 = 129%. 100% indicates fair value, so it is 29% above fair value. I divide Siegel's constant by this ratio to get an adjusted return. This gives me an expected return 6.75% / 129% = 5.2% for shares. (If I'm making the calculation a few months later, I can adjust the fair value by assuming it should have risen by (5.2%-1.5%) per year, where 1.5% is the dividend yield of the SP500.) Since I'm a UK investor, I then simply assume that the yield on the SP500 index is the best estimate of what I can expect from whatever UK fund I do invest in. This is a big assumption, but I don't have any alternative, as comparable data isn't available for other indices. In practise I have charted the SP500 and UK indices together, and there is a high degree of correlation. At the very least, I expect major bubbles and crashes to occur simultaneously in both, and if my method steers me in the right direction with respect to those, that's a huge advantage compared to investing in the dark.

While writing this, I've become aware of an academic paper on the web that not only agrees that markets can be valued using q and CAPE, but uses regression equations derived from historical data to predict the market over different time periods. The regression equations for shorter periods currently give far more pessimistic predictions than my method. The paper itself only contains regression equations for periods up to 20 years, however the site that referred me to it has its own version of the regression equations, and for periods of 30 years or more they give similar answers to my method. The reason the regression equations predict worse returns over the short term is that the historical data appears to show that there is momentum and feedback in the market, which in a bear market means bad years beget bad years. The equations collectively imply that when the market is overvalued, any correction is not likely to be spread evenly over a large number of future years, most of it is most like to come in the earlier years. The implication of this is that even if the long-term return is currently something like the 5.4% I've calculated for December 2007, and even if that were the highest return available on any asset class, I should still stay out of shares because the return over the next several years will probably be highly negative. A much better time to switch into shares will arrive, if I wait. Links to the paper and the site that referred me to it are at the bottom of this page.

Having made my own attempt to develop regression equations on the basis of historical data, I'm not convinced they are useful. Using recent stock-market history (in addition to valuations) did make a slight overall improvement to prediction accuracy, but for some reason that I failed to get to the bottom of, using these shorter-term predictions in a test of a real return strategy based on historical data actually seemed to deliver worse results than using long-term predictions based on valuations alone. I've decided to stick to my method outlined earlier in this section.
The real return approach to investing.
1. Decide how much income you need to generate. You need to leave room for things to go wrong, including the possibility that the following plan is flawed. My target figure is 133% of what I need to live comfortably, and double the minimum I need to pay my bills. I assume I'll usually only draw three-quarters of my target income each year, leaving the rest for contingencies.
  
  There is a second good reason, in addition to allowing for contingincies, for taking an income well below the maximum. Happiness, to the extent it is determined by income, depends on keeping pace with the spending of your peer group. If income grows with inflation, and we use an accurate inflation rate, that only ensures we can continue to afford the things we know at the outset we are going to want to spend money on. It may not cover new things. A person retiring in Britain 30 years ago would not have budgeted for things we take for granted today, such as satellite television subscriptions, internet access and annual foreign holidays. Ideally, your income needs to rise in line with wage earnings, which generally increase at a higher rate than inflation.
2. Regard your capital as divided into pools. Money is in the same pool as other money if it can freely be moved to and back from the same place as the other money. For me, pools are defined by the tax system. Pension investments are one pool, tax-free individual savings accounts (ISAs) are another pool, investments held directly in non-tax-privileged accounts are a third. To give an example, money held in a fund in a Legal & General Stakeholder pension is in the same pool as money held directly in shares a Sippdeal account, because it is a legal requirement that pension funds can be transferred from one provider to another, on demand. On the other hand, investments held in an ISA are not in the same pool as investments held directly outside an ISA, because it is not possible to move more than £7000 per year into ISA accounts, and one would not want to move money out of an ISA unnecessarily, as it would permanently lose its tax-free status. It is however possible to move investments between ISA accounts with different providers without penalty, so all ISA investments are in the same pool as each other.
3. Estimate how much income different asset classes will support indefinitely.
  1. For cash subtract the rate of inflation from the expected interest yield to get the income yield. Treat any borrowings such as a mortgage as a negative cash holding that produces negative cash income.
  2. For bond funds, subtract the rate of inflation from the redemption yield to get the income yield.
  3. For shares, use the yield calculated as described in the section on market valuation.
  4. For property funds, use the net rental yield.
  Note that inflation is only subtracted in the case of cash and bonds. I broadly expect the capital value of "real assets" such as shares and property to keep pace with inflation. The "real return" I'm calculating is the amount that can be taken as income without the capital being depleted.
  
  Once you've calculated the overall return you expect on each asset class, calculate modified results separately for each pool, lowering these theoretical yields to take account of any taxes and fund management charges that will have to be paid on the actual investments in that pool.
  
  Here are examples of how I estimate the returns on different asset classes, in my pension pool, in December 2007. I could get a yield after inflation and charges of 5.5%-2.1%-0.4% = 3.0% from Legal and General's cash fund. The yield after inflation and charges for a bond ETF held in a Sippdeal account would be 6.4%-2.1%-0.2% = 4.1%. The yield of 5.2% in June 2007 for shares becomes 5.4% in December, when I adjust for changes since June. This is reduced to 5.0% by tracker fund charges. Data compiled by IPD and published from time to time in the newspapers gives the industry-average rental yield on commercial property, most recently 4.6%. As unitised funds have declined by about 15% since this was published, I adjust this by 15% to 5.3%. This gives the figure I would use for the unitised property fund that is available in a Legal and General Stakeholder pension, where tiered charging means that I would pay 0.4% if all my pension funds were held with them. This charge would reduce the yield on unitised property to 4.9%. However December 2007 falls in a highly unusual period for property, as property investment trusts are trading at huge discounts of between 30% and 50% to asset values. As a result, I am temporarily favouring investment trusts held in a Sippdeal account for property. The figure I use for the real return I expect from this variant of the property asset class is the rental yield, net of running and finance costs, which I calculate from the companies' latest accounts. The median yield for the funds I follow is currently 6.7%, compared to a median dividend yield of 8.8%. I'm not happy to take the dividend yield as the measure of income, as I can't know for certain that allowance has been made to prevent inflation and management charges eroding capital.
4. Within each pool, decide which asset classes you are going to use, then split money evenly between them. When first implementing the strategy, use all asset classes available within the pool that give a return within 0.25% of the most promising one. For example, when predicted returns are cash 3.0%, bonds 4.1%, property 6.7% and shares 5.0%, money would be invested entirely in property. As asset classes rise and fall from time to time you may have to switch completely into or out of any particular asset class. To prevent to frequent switching, add an unused asset class to the current mix only when it has the highest yield, but only eliminate one from the current mix when its yield falls more than 0.5% below the highest. Where a pool is invested in more than one asset class, buy whatever yields the most when adding funds or sell whatever yields the least when withdrawing money from the pool.
5. An alternative strategy would be to always split money evenly between the best two asset classes available in each pool. Frequent switching could be prevented by only allowing changes once a year. Maintain the even balance by shifting funds once a year, or by buying whatever you have least of when adding funds to the pool, or selling whatever you have most of when withdrawing money from the pool.
6. Take into account the costs of switching, especially capital gains tax where applicable, by having a rule that only allows a switch if the yield in cash (rather than percentage) terms from the whole portfolio would be higher after the switch, even though the capital may have reduced, for example by money set aside to pay any CGT liability the switch has caused.
7. The amount of capital you need to retire is the amount needed to generate the income you specified in the first step, given that the capital is invested and income calculated as described above.
After retirement, the maximum income you can take can be calculated at any time in the manner described above. In theory, if the yields you used for each asset class were always accurate estimates and never had to be adjusted downwards for any reason other than a rise in capital value, the income the portfolio produces would never fall. The income should rise slightly from year to year in line with the long-term rate of increase of company profits and property rental income. From time to time there could be a sudden permanent upwards jump in income, when an asset class crashes to become the new highest yielder, and you switch funds into it. Most of the time it wouldn't matter what happened to the value of your capital, as any reduction in capital values would be offset by an equivalent increase in the yield, leaving the amount of income you can take from the asset class unchanged. (This rosy scenario of never-falling income is only a broad-brush picture, in practise there are many things other than yield estimate miscalculations that could cause a drop in income yields without an offsetting rise in capital. The changing yield on cash is never offset by corresponding changes in capital. In a long recession share earnings and property rental yields might decline. The yield on bond or property funds might decline as a result of unfortunate trading by managers. Bond issuers may default at a greater rate than was anticipated in bond fund prices at the time of purchase.)

My real return strategy would wisely have required you to have far more capital if you were contemplating retiring in 2000 than it would have if you were doing so a few years later, after the stock-market decline.

I have looked at the effect of applying a variation of this strategy with just two asset classes, shares and "cash" (the long interest rate in Prof. Schillers data) over the period 1881-2007. Using hindsight, I tuned the actual withdrawal rate to be 87% of the predicted rate, the predicted rate being the forward-looking yield for the chosen asset class at any given time. This tuned withdrawal rate ensured capital at the end of the period exactly matched that at the start. In this strategy I assumed a 100% switch into the more promising asset class immediately it took the lead, with switching potentially on a monthly basis, and no switching costs. The adaptability of "real return" strategies is illustrated by the varying withdrawal rates I found. In July 1921, when the stock-market was at 41% of fair value, and inflation was -14.9%, this strategy suggested an annualised withdrawal rate of 17.8%. In October 2000, a couple of months after the market peaked at 294% of fair value, it suggested a withdrawal rate of just 2.03%. In both cases knowledge of what happened next makes these extreme withdrawal rates look justified.

I doubt I'd ever be brave enough to take the monthly equivalent of 17.8%. It's worth mentioning that the strategy very seldom recommended double-digit withdrawal rates. The median annualised withdrawal rate was 6.0%, and the average was 6.7%. It has not indicated a rate of 6% or higher since February 1991.
Summary
1. This method incorporates rules suggested by efficient markets theory by only considering asset classes as a whole in choosing where to invest. Within each asset class, efficient markets theory tells us we should simply choose the cheapest diversified fund.
2. It helps deal with market irrationality by taking into account market valuation. It is likely to take you out of an asset class during an extreme boom, and into it after an extreme crash.
3. It guides you on asset allocation by making you look at the return you can expect, and tells you how to do this in the difficult case of shares. It maximises returns by only spreading your investments between different asset classes when the differences in expected returns are not to large. The alternative allocation strategy of always using the best two asset classes gives you a more cautious option.
4. It helps deal with the sequence of returns problem during withdrawal by usually suggesting low incomes that are not to far from generally recommended safe levels, but improves on those by tuning the result to the current state of markets. In theory, it only allows you to withdraw the real income generated by the underlying assets, leaving the capital untouched. (The fact that market fluctuations cause the capital to vary in value shouldn't matter, as long as it continues to generate the same underlying income stream.)
5. It does not completely deal with the sequences of returns problem, or the possibility that real returns might fall after retirement. It is necessary to monitor and maintain your strategy, and possibly make adjustments to your spending if your retirement is going off-track.

Links
1. If you have any doubts that stockmarkets can be valued and long-term returns predicted, Valuing Wall Street is your new bible.
2. This paper includes regression equations to predict the SP500 index in 1, 5, 10 and 20 years time, based on current valuation levels. Note that the equations written on the charts for predicting one and ten year returns are wrong, you can derive the correct ones from the table "Exhibit 8".
3. The site Early Retirement Planning Insights gave me the link to that paper, and contains calculators based on its owners own versions of the regression equations
4. Somewhere on the web site of Smithers & Co you will find data or charts indicating current levels of valuation.
5. Firecalc

The most profound investment strategy of all time?

2006-09-12T09:35:00.000Z

Some time in the middle of the year 2000, I was sent an 86 page prospectus for a company about to be listed on the stock exchange, in which I was invited to invest. While perusing a section of small-print, a paragraph caught my eye that stopped me with a jolt. It suddenly revealed to me an investment strategy of awesome profundity. To understand the context in which this made such an impression, you need to be familiar with my previous reading on the subject of investment.

In one of the most famous investment books ever written, "A Random Walk Down Wall Street", the author set out the orthodox economist's view of financial markets. Markets are, for all practical purposes, efficient. This means that prices at all times reflect all information that might affect them. Tomorrow's price will be a random variation from today's price. Random (by definition) means unpredictable. There is no point studying a company to see if it's shares are expensive or cheap. Nor is there any point in studying charts of historical information. These can tell you nothing about future prices. It will do you no good to abstract the problem of choosing shares by instead trying to choose an "expert" such as a fund manager to choose shares for you. It makes no difference how much supposed expertise an investment analyst has, or what methods they use; it is in principle impossible for them to add any value towards the decision of whether or not to invest in a share. When you invest in a diversified portfolio of shares, it's your money at risk in the market that earns you your return, not the input of anyone involved in deciding the composition of the portfolio. If you pay a fund manager 1% a year to choose shares for you, you are simply reducing your expected return by that amount. A tracker fund with minimal charges is the only sensible way to invest in shares.

If I remember correctly, this book was first published at a time when no tracker funds existed. It helped create the demand that led to them being invented, in the mid-1970's.

When I re-read that book just after the 1987 stock-market crash, some doubts crept in. I was unable to believe that there was any rational reason why shares should overnight become worth 30% less than the previous day, when there was no news that could justify the change.

A consequence of the efficient-markets hypothesis is that, without the benefit of hindsight, there is never a right or wrong time to buy shares. The current price, whatever it is, is always fair value. As I watched mainstream stock-markets climbing in the late 1990's, I had the strong feeling that they were over-valued, that another crash could and would happen. I needed intellectual justification for my instinct to go against the efficient markets theory and get out of shares. It arrived in March 2000 in the form of another book by an economist, "Valuing Wall Street." This agreed that one couldn't make any useful judgments about the value of individual shares, nor judge where the stock-market as a whole would go in the short-term, say over five years, but showed how one could calculate whether the stock-market as a whole was under-valued or over-valued, and use that to draw useful conclusions about how it was likely to do over the subsequent 20 to 30 years. Those conclusions could justify a decision to be in or out of shares in the present. The author calculated that American stock markets needed to fall by two thirds to be fairly valued. Shortly after publication, a major crash was under way.

There is a scenario other than perfect market efficiency in which studying shares is pointless; when prices are the result of unpredictable irrationality by investors. I believe prices are sometimes efficient and sometimes unpredictably irrational. They are never inefficient, nor irrational in a way that allows anyone to predict where they will go next. To the advice of "A Random Walk Down Wall Street" that a tracker fund with minimal charges is the only sensible way to invest in shares, we can add a caveat from "Valuing Wall Street." Only invest in shares when they aren't over-valued.

Between reading these two books I read a lot about people who did spend their lives trying to do the impossible; out-perform the markets. In particular, I enjoyed "Market Wizards" and "New Market Wizards", collections of interviews with famous traders. These were people managing many millions of dollars, who had made returns of 20% to 30% a year, for a number of years. What I remember most from these and other books is the attitude of quasi-religious awe towards markets that was sometimes expressed. These star traders seemed to regard the market as a malignant metaphysical entity, an enemy trying to catch them out. One described the markets as a machine that held up a mirror to each trader, detecting whatever particular flaw existed in his character or personality, and using it to destroy him.

A quote along these lines is to be found in an amusing book, "A Fool and His Money." In it, a commodity trader is quoted telling the author, "When I first came down here I was Mr Big Ego. I had a law degree and here were all these ex-cops and truck drivers and people with 200-word vocabularies trading in the pits. I figured I'd make a killing, right? With this competition, how could you lose? Then I get the shit kicked out of me. Then I get the shit kicked out of me again. You know what I learned down here? Humility. Discipline. You come into this business with any sense of superiority, and you're dead. Sooner or later you find out who you are. That's what this game is about, finding out who you are. People say the market's this or the market's that, and they begin to think they can understand it. They discover they're wrong. They can't understand it. The market is ... the market is God."

In the same book, an expert estimates that 85% to 95% of people who invest in futures and options end up losing money.

The reason traders talk this way is obvious to economists; their mission is impossible, and any apparent success an illusion created by hindsight bias. For every trader who's had a run of good results making him interesting enough to be interviewed, there are thousands whose luck ran out more quickly, who have gone bust and left the industry.

For some readers, I now need to digress and explain financial spread-betting. An account with a British spread-betting company allows one to make trades equivalent to buying or selling short virtually any share, bond, currency, commodity, option or future traded on any financial market anywhere in the world, at close to market prices. Although the trades are described as bets, the companies are regulated by the same authority that regulates the derivatives industry, and in contrast to normal bets, winnings on spread-bets can be recovered from losers via legal action, if necessary. A spread-betting account is like a superior version of an account with a broker. The fact that trades are "bets" means customer's profits aren't taxed, but has little other significance. Spreads, the difference between buying and selling prices, are slightly wider than the in underlying markets, but there are other advantages that make spread-betting more attractive than trading via a broker. One way in which trading via a spread-betting company differs from trading via a broker is that the company acts as a market-maker, and takes the other side of all trades its customers wish to make.

When I opened an account with the spread-betting company whose prospectus I was reading at the start of this article, I was given a pamphlet explaining how to trade. Among other things, this tried to reassure me about dealing with them by telling me that they hedged their exposure to customer's trades in the underlying markets, and that it therefore made no difference to them whether I profited or lost from my trades. They made their money from the spread between buying and selling prices.

Taken in context, I believe that reassurance was honest. Nevertheless, it was the contradiction between that and what appeared in their prospectus that was electrifying. On page 13 in a paragraph entitled "Hedging", they explained that, within constraints set by available capital and prudence, they tried as far as possible not to hedge their exposure to customer bets by trading in the underlying markets. They gave as a reason that "The company operates on the assumption that clients are not able to outperform the market in the long run." This is a telling statement, especially given that some of their biggest customers are the traders who, when acting for their employers, set the pace in the underlying markets. The company's strategy is a kind of passive financial judo, which uses the customer's own actions to defeat them. The financial capital that allows the company to pursue this strategy can be thought of as the ultimate passive fund. If active traders under-perform trackers, then this mirror-image fund, you could call it an anti-active fund, must out-perform a tracker. The company aligns itself with the omniscient, omnipotent market, in opposition to the naive individuals who believe their characters, personalities and intelligence are sufficiently flawless to allow them to out-wit the collective intelligence of the rest of mankind.

A flat tax for the UK

2006-05-09T10:34:00.000Z

A number of articles have been written recently proposing a flat tax for the UK. This one suggests that national insurance be merged into general taxation, does not rely on extraneous spending cuts to lower the flat rate, and does not plan for a temporary gap between revenue and spending that is expected to be plugged by extra growth that tax reform will bring. It is intended to be an uncompromising application of the idea of the flat tax to the UK.

A method sometimes used to minimise proposed flat tax rates is to point to various reductions that can be made in government spending. This is only legitimate if these are a direct consequence of tax reform, and not extraneous savings. An example of an extraneous saving is a proposal to abolish the DTI. How to spend such savings is a political decision that should not be linked to tax restructuring. Assuming that a smaller state is desirable unnecessarily alienates the left. A flat tax is desirable for its simplicity, fairness and anti-avoidance benefits even if it does not shrink the size of the state, or cut the taxes of any particular group of taxpayers.

One of the arguments in favour of a flat tax is that by lowering marginal rates of tax it can produce extra economic growth. This means that a flat tax can be set below the level that you would expect to be needed if you assumed the economy was not going to be affected by the introduction of the tax. To the extent it is possible to estimate the growth dividend, it is reasonable to incorporate the change to the tax base into the calculations. These ought to be based on raising unchanged revenues from the changed economy, since it is outside the scope of tax reform to plan for permanent increases or decreases in revenue and spending. Having said that, incorporating the growth dividend into the calculations is neither easy nor uncontroversial, so in this proposal I do calculate possible rates for the proposed tax ignoring any such dividend.

Merging national insurance into income tax means I do need to deal in passing with the consequences for state pensions, even though this is a big subject I’d rather was outside the scope of this proposal.

What is a flat tax?

Many of my proposal’s key features are copied from the American flat tax proposal by Robert Hall and Alvin Rabushka.

Individuals have a personal allowance on which they do not pay tax.
They pay tax at a single flat rate on all income above the personal allowance.
Companies pay corporation tax at the flat rate on all their profits.
Dividend income is not taxed. The income in question has already been taxed at source via corporation tax.
Shares are exempt from Capital Gains Tax, as all the income shares entitle the holder to will already have been taxed via corporation tax.
Interest income is not taxed.
Interest paid is not a tax-deductible expense for businesses. This means that effectively these interest payments are taxed at source.
National insurance is abolished and the revenues replaced by increasing the flat rate by the necessary amount.
For individuals, the personal allowance is the only relief or allowance that affects the calculation of their tax bill.
Tax relief on personal pension contributions continues to be claimed at source by scheme organisers.
The entitlement to a 25% tax-free lump from pension savings is abolished for future contributions.
Pension funds can treat any investment income received as having been taxed at the flat rate, and reclaim the notional tax.

Abolishing allowances is done in the interest of simplicity. Allowances and credits we want to keep could be retained by moving them into the benefits system, where a little extra complexity will hardly be noticed, and where they are forced to compete with other benefits for their share of available resources.

We currently have a graduated tax system where taxpayers with higher incomes pay tax at a higher rate. It is sometimes said that a flat tax is less progressive. This need not be true. A flat tax with a personal allowance is just a graduated tax that has been restricted to only two bands. Take any graduated tax system, make the top rate the only rate, set the personal allowance so that the same total amount of tax is collected as before, and you have a flat tax that is similar in its progressiveness to the graduated tax it replaced.

Why would a flat tax be better?

The most obvious advantage is simplicity. Very few people would have to fill in a tax return. Income from employment, pensions, dividends, interest and from capital gains on shares is all automatically taxed correctly.

Another reason is fairness. At the moment some individuals have a tax burden far higher than others with precisely the same income. An example of this will be given in a moment.

A third reason is transparency. At the moment employees earning just £8,000 already face a marginal tax burden of 41%. They don't realise it, because some of the tax is labelled NI, and part of the burden of NI is further hidden by making employers responsible for paying it.

There are various costs that come with a complex tax system. There is the bureaucratic cost of complying with a more complex tax. There are economic costs that result from distorted incentives and high marginal rates. A more detailed account of the economic advantages of a flat tax can be found in Allister Heath's proposal. I don’t want to repeat here arguments that can be found in many other proposals.

The current system also has the disadvantage of avoidance. When rates of tax vary depending on characteristics of the sources and recipients of income, it creates incentives for taxpayers to try and legally avoid tax.

I want to focus in depth on just one example of a problem that could not have arisen under my flat tax. It’s not the only one I can think of, but it is a graphic example of what can go wrong when you have a complex tax system.

Consider the position of contractors, workers who work for a variety of clients on fixed term contracts. In particular, take as an example a worker who costs clients or agencies paying for his services £40,000 per year. I define the tax burden as that percentage of the £40,000 that goes to the state in the form of income tax and national insurance. Using 2005/2006 rates, if the worker is an employee the tax burden is 34%, if self-employed the tax burden is 26% and if trading via a company he owns the tax burden is 17%. The worker has a big incentive to avoid being taxed as an employee.

Whether a worker paid by a client is an employee or self-employed is a matter of law, not choice, so the tax burden cannot be lowered simply by having the client pay the worker fees gross and leaving him to account for tax as self-employed. Even if the worker is genuinely self-employed, because employment status is difficult to assess and the penalties for getting it wrong fall on the potential employer, companies will often avoid dealing directly with self-employed contractors.

On the other hand, it used to be that if the worker was paid via an agency, the agency was not the employer because they didn’t control what the worker did, and the client was not the employer because they had no contract with the worker. This meant that even people who were not genuinely self-employed could be taxed as such, if they were supplied by an agency. To counter this loophole, the Inland Revenue had to bring in legislation that caused agency workers who looked like employees to be taxed as though they were employees of the agency that was paying them. (This might be explained better by a legal expert.)

Faced with the same issues that deterred clients from dealing with self-employed workers, agencies ceased dealing with even the genuinely self-employed. Consequently the self-employed decided to set up one-person companies. By taking dividends net of corporation tax at the small companies rate they avoided NI altogether. They could do this even in circumstances where the law would have caused them to be taxed as employees had they been paid directly as individuals by a client or agency.

The Inland Revenue eventually addressed this loophole with the IR35 legislation, which says that when workers fail employment status tests applied to their relationship with the client, their company effectively has to spend 95% of the relevant fee income on remunerating them as employees.

Contract workers, as directors of their companies, are now responsible for determining employment status regarding their relationships with their clients. What makes someone akin to an employee is not explicitly defined in law, and it requires extensive knowledge of legal precedents and detailed consideration of many facets of the circumstances of every contract in order to make a decision. A separate decision has to be made for each contract – it is possible to be akin to self-employed with regard to one contract but akin to employed with respect to another.

Some contractors now devote a lot of their time to studying the legal issues, and carefully negotiating terms with employees and agents to ensure that their contracts and work circumstances are not indicative of employment. The tax incentive means they are highly motivated to do this. They can see their marginal tax burden fall from 47% to 19%, if they succeed.

As employment status is difficult to assess, contractors who assess themselves as not caught by IR35 cannot be certain their assessment will go unchallenged. There is always a considerable risk that if they are later investigated their inspector of taxes will draw the opposite conclusion from the same facts. At that point the contractor must consider employing an army of tax specialists to defend him from an unexpected tax bill of possibly many tens of thousands of pounds. (You might assume that if the Inland Revenue says a contractor fails the tests, they do. In fact, at the time of writing, the Professional Contractors Group web site gives a score of 1228 disputes won by the contractors and just 3 by the Inland Revenue.)

If a flat tax were introduced contractors would face exactly the same tax burden regardless of whether they were taxed as employees, self-employed or companies. Their employment status would cease to matter for tax purposes. Legislation that has evolved over decades to govern them could be binned. They would no longer spend time studying law. The uncertainty and expense of complying with IR35 would disappear. Tens of thousands of one-person companies would disappear. The overheads in terms of accounting fees and bureaucracy involved in running and taxing these companies would be eliminated.

Although there is now a degree of consistency surrounding employment status, so that, in theory at least, people who look like employees are taxed as such, the fact remains that there doesn’t appear to be any obvious reason why an employee should be taxed at a much higher rate than a self-employed person, who in turn is taxed at a much higher rate than someone with the same amount of investment income. The historical reason for these anomalies is the National Insurance system.

Why National Insurance should be abolished

If national insurance were insurance, there would be a strong correlation between payments made and benefits receivable. If there isn't, it's just a tax. The following quote from an article by John Hills at the Centre for Analysis of Social Exclusion at the LSE says it all.

"There is little link between contributions and benefits, either at the individual or the aggregate level, and the links that exist are incomprehensible to most. Contributions are not in reality earmarked, and there is no truly separate National Insurance Fund. If people are less unhappy about paying National Insurance than income tax, that is more a product of folk memory than of current reality."

NI has a more positive image than income tax in the public mind, so in addition to pointing out how it has evolved into effectively just a parallel income tax, it’s worth dispelling some other myths about it.

Myth 1. NI pays for the NHS.

The main thing NI pays for is state pensions. The NHS budget for 2005/2006 was over £80 billion, most of which was paid for out of general taxation. Only about £18 billion of the £85 billion collected in NI went to the NHS. NI is not the main source of funding for the NHS, and the NHS is not the main thing NI funds. In the same year NI paid about £52 billion in state pensions and £8 billion in incapacity benefits. NI also funds other relatively insignificant contributory benefits, of which the biggest are unemployment benefits and maternity pay. The way the NHS is funded and the fact that in the past the NI fund has been bailed out using general taxation is further evidence of how artificial the distinction between NI and tax is.

Myth 2. Employer’s NI doesn’t affect employees.

In the contractor example above, alert readers may have taken exception to my including employer's NI in the tax burden on employees, because it is the employer who pays it. Seen from an economic rather than a legal perspective though, gross salary agreed between employer and employee is just a nominal figure. What matters to an employer in deciding what a job is worth is the total cost of employment, including any taxes added on top of gross salary, and what matters to an employee is the net pay after any taxes. Market forces will determine these amounts. Gross salary for a new employee will be the nominal figure under the existing tax system that gives the outcome market forces require. The difference between the employer’s cost and the employee’s net pay is the tax burden on employment and in the long-term it makes no difference what proportions of the burden the different parties are legally responsible for. If a populist chancellor decided to decrease employees’ income taxes, but increase employers’ liabilities by a corresponding amount, in time nominal salaries would adjust so that employers and employees were in the same position as they would have been had no change been made.

NI should be abolished for the following reasons.

As a second personal income tax it doubles the administrative overheads.
It creates distortions as illustrated in the contractor example.
Its lack of transparency results in the public being deceived about levels of taxation.
It is unfair in that it can cause two people on the same income to be taxed at very different rates to each other.

Consequences of abolishing NI

What would happen to the contributory benefits NI pays for? Benefits other than pensions can be merged into the non-contributory benefits system, which is funded out of general taxation. Dealing with pensions is a bigger issue. With NI gone, employees will no longer be building up entitlements to state pensions. It is likely that the state will always feel obliged to assist old people who have not provided for themselves. Given that, it’s reasonable for the state to insist that those individuals who can afford to should mitigate the risk of being a future burden by contributing to a pension scheme during their working life. It’s been said that compulsory contributions would feel like a tax. This may be true, but unlike NI, compulsory contributions would produce benefits directly related to what each individual contributed, so would be much further from being a tax than NI is.

My proposals for pensions reform are as follows.

There should be no state pensions. There might be something called a state pension, but it would be a non-contributory social security benefit payable at the discretion of the government of the day with scope and generosity determined by that government. Like other non-contributory benefits, it would be funded out of general taxation. It would not be an entitlement that anyone could depend on in their retirement planning, as they would have no guarantee that it would still exist when they retired, or that they would be eligible for it if it did, or what level of benefits they might receive if it existed and they were eligible.
Personal and employer pension schemes would continue as before.
There should be a low-cost pension savings scheme similar to that suggested by the Turner report, but instead of just supplementing state pensions entitlement it would replace it as well. The right to opt-out suggested by Turner would only be allowed to those whose predicted pensions were already sufficient to keep them off benefits in retirement. The low-cost scheme would just be a default personal pension into which compulsory contributions were paid, if no other private or employer scheme were nominated instead. It would have access to a selection of funds with low management charges. Employees and employers could pay additional voluntary contributions into the low-cost scheme if they wished. Individuals would be free to transfer their pension funds between the low-cost scheme and other schemes.
The desire to provide pensions for certain categories of people who aren’t able to fund their own pensions, for example carers, could be met by the state making contributions on their behalf.

The Turner report suggests an improved state pension should be at the core of pensions provision, so you may wonder why I’m ruling this out. State pensions are similar to social security benefits in that their generosity is partially at the discretion of the government of the day, and people receive benefits that are not completely correlated to contributions they have paid. State pensions are similar to private pensions in that, unlike non-contributory benefits, they are an entitlement based on past scheme membership and therefore their existence, scope and generosity is not entirely at the discretion of the government of the day. Mixing the two components as the current system does introduces a lack of transparency. Transparency is a virtue; in other words we should be prejudiced in favour of it until a convincing case is made to abandon it in a particular situation. In the absence of a case, transparency can be introduced by separating the two components of state pensions. The component of state pensions that resembles private saving should be replaced by compulsory private saving. The component that resembles a non-contributory social security benefit should be replaced by one.

Why not allow the state to run a pay-as-you-go contributory scheme that relates rewards to contributions? We’ve already been down this route. This is what the current system was supposed to be, before it was bodged, so we’ve already experienced the fundamental problem and its consequences. In trying to serve as trustees of a contributory scheme where different amounts are contributed on behalf of different individuals, while being accountable only to voters, many of whom are not contributors and all of whom have equal influence via the ballot box, the state has a conflict of interest that renders it unfit to act as trustee of a contributory scheme. If the state wants to give pensions to people that exceed what any contributions might actuarially entitle them to, it should do so openly through the social security system, rather than through hidden cross-subsidies in a complex scheme that members don’t understand. The revenue should be raised openly and fairly from general taxation.

Possible rates and allowances for a flat tax system

In calculating the rate a flat tax might be set at, I’ve used 2005/2006 data and assumed that individuals’ incomes would have been the same under the changed system. I’ve assumed that the new system needs to raise the same total amount of revenue as the existing system.

The reduction in personal income tax paid on dividend income has been calculated from HMRC table 2.6. Only the extra tax on dividends taxed at the higher rate is lost. The total higher rate tax paid is £5,180 million. Taking into account the amount that is paid by associated tax credits, the loss is £5,180 x (22.5% / 32.5%) = £3,586 million.

The same table also gives the loss in interest income, £133 + £2,010 + £1,880 = £4,023 million.

Table 14.4 shows that about two thirds (£11,853/£17,721) of capital gains arise from financial assets. I therefore assume that eliminating CGT on shares reduces the tax take by this proportion. Table 1.2 shows CGT raising £2,879 million in 2005/2006, so the loss is £1,993 million.

From a report by the government actuary I note that the flat tax will have to raise an extra £85,425 million to replace revenue raised by NI. In the same document I see that £48,511 million of this is raised from employers NI.

Table 3.3 tells me there are 29.2 million taxpayers.

I use £5,000 million as an estimate of the cost of re-introducing tax relief on dividend income for pension schemes.

Using table 2.6 I calculate the total taxes on earnings under the current system are £5,560+£71,000+£37,200 = £113,760 million.

Using table 2.6, the number of taxpayers and the personal allowance of £4,895, I calculate the tax base for earned income as £5,560/10%+£71,000/22%+£37,200/40%+(29,200,000*£0.004,895) = £614,261 million. (I presume that there are a negligible number of taxpayers who don’t have income of at least £4895 from employment, self-employment or pensions.)

I’ve assumed that employees’ taxable salaries are increased by the amount required to prevent employers deriving an immediate benefit from the abolition of employer’s NI. The tax base for earned income under the flat tax is therefore £614,261+£48,511 = £662,722 million.

Using the figures above, I calculate the revenue the flat tax has to replace as [taxes on earnings] + [amount raised by all NI] + [tax on dividends net of tax credits] + [tax on interest] + [CGT on shares] + [cost of pension dividend income tax relief] = £113,760+£85,425+£3,586+£4,023+£1,993+£5,000 = £213,787 million.

The following table shows, for a range of tax rates, the corresponding personal allowance that would result in the fixed revenue target being met. It also shows, for each combination of tax rate and personal allowance, the amount of tax that would be paid by taxpayers on half average income, average income and double average income.

Tax rate	Tax on all earnings	Corp. tax changes	Individual rev. target	Personal Allowance	Tax on £14,260	Tax on £28,520	Tax on £57,039
38%	£251,853	£16,350	£197,437	£4,904	£3,555	£8,974	£19,811
39%	£258,481	£18,050	£195,737	£5,510	£3,413	£8,974	£20,097
40%	£265,109	£19,750	£194,037	£6,085	£3,270	£8,974	£20,382
41%	£271,737	£21,450	£192,337	£6,632	£3,127	£8,974	£20,667
42%	£278,364	£23,150	£190,637	£7,153	£2,985	£8,974	£20,952
43%	£284,992	£24,850	£188,937	£7,650	£2,842	£8,974	£21,237
44%	£291,620	£26,550	£187,237	£8,124	£2,700	£8,974	£21,522
45%	£298,248	£28,250	£185,537	£8,578	£2,557	£8,974	£21,808
46%	£304,875	£29,950	£183,837	£9,011	£2,414	£8,974	£22,093
47%	£311,503	£31,650	£182,137	£9,426	£2,272	£8,974	£22,378
48%	£318,131	£33,350	£180,437	£9,824	£2,129	£8,974	£22,663
49%	£324,758	£35,050	£178,737	£10,206	£1,987	£8,974	£22,948
50%	£331,386	£36,750	£177,037	£10,572	£1,844	£8,974	£23,234

The second column of this table shows the effect of applying the flat rate to the entire £662,722 million tax base.

In the third column of the table I used a HM Treasury ready reckoner to calculate the gains in millions from changing corporation tax to a range of flat rates. The effect of changing the small companies rate is calculated as ([new rate]-19) x £250. The effect of changing the main rate is given by ([new rate]-30) x £1,450. The same site has versions of this document produced in different years, each forecasting a few years ahead. I’ve deliberately not used the nearest one for 2005/2006 because the nearest forecasts always give very different figures from longer range ones. I assume this is because for the nearest forecast they are taking into account the effect of the change being introduced part of the way through the year.

In the fourth column I calculate the revenue that needs to be raised from individuals after subtracting the increase in corporation tax revenues from the original figure of £213,787.

In the fifth column I calculate the personal allowance by subtracting col. 4 from col. 2 and dividing the result by the number of taxpayers.

The table of flat tax rates and allowances illustrates that for taxpayers on below average income, their tax bills decrease as the tax rate increases, because they gain more from the increase in personal allowances than they lose from the increased rate. The opposite is true for taxpayers on above average incomes.

Note that a rate of (say) 40% would represent a tax cut to higher-paid employees, who faced a marginal burden of up to 48% under the old system. On the other hand, it takes the tax burden on large companies from being lower than in most European countries to being higher. I wonder to what extent it is possible to increase tax rates on large companies from the current 30% level, before they decide to relocate their profits to a different jurisdiction.

Winners and Losers

How does the proposed system affect different classes of taxpayers? I’ve used the 2005/2006 tax regime and chosen a rate of 40% in the following calculations.

Net salary for all employees increases. There are different ways of handling the abolition of employer’s NI without handing a short-term tax-cut to employers. I’ve assumed that employers are required to pay an amount equivalent to employers NI under the old system towards their employees tax bill. This payment will be a benefit-in-kind to the employees and therefore part of their taxable salary. Note that the increase in net salaries may not translate into an increase in immediate spending power; the effect of any compulsory pension contributions out of salary has not been factored in. Since employees are no longer getting any state pension entitlement out of the taxes they pay, one cannot say for certain that all are better off.

Gross salary	Net salary before	Taxable salary after	Net salary after	Net salary change
£4,987	£4,967	£5,000	£5,000	£33
£9,420	£8,177	£10,000	£8,434	£257
£13,853	£11,147	£15,000	£11,434	£287
£18,285	£14,116	£20,000	£14,434	£318
£22,718	£17,086	£25,000	£17,434	£348
£27,150	£20,056	£30,000	£20,434	£378
£31,583	£23,026	£35,000	£23,434	£408
£36,016	£26,321	£40,000	£26,434	£113
£40,448	£29,167	£45,000	£29,434	£267
£44,881	£31,782	£50,000	£32,434	£652

The self-employed are generally worse off.

Gross profits	Net profits before	Net profits after	Net profits change
£5,000	£4,981	£5,000	£19
£10,000	£8,719	£8,434	-£285
£15,000	£12,219	£11,434	-£785
£20,000	£15,719	£14,434	-£1,285
£25,000	£19,219	£17,434	-£1,785
£30,000	£22,719	£20,434	-£2,285
£35,000	£26,376	£23,434	-£2,942
£40,000	£29,739	£26,434	-£3,305
£45,000	£32,689	£29,434	-£3,255
£50,000	£35,639	£32,434	-£3,205

Pensioners lose the most. Note that I’ve assumed the standard personal allowance for the “before” calculation – pensioners entitled to various age allowances will lose slightly more than is shown here.

Gross income	Net income before	Net income after	Net income change
£5,000	£4,990	£5,000	£11
£10,000	£9,128	£8,434	-£694
£15,000	£13,028	£11,434	-£1,594
£20,000	£16,928	£14,434	-£2,494
£25,000	£20,828	£17,434	-£3,394
£30,000	£24,728	£20,434	-£4,294
£35,000	£28,628	£23,434	-£5,194
£40,000	£32,041	£26,434	-£5,607
£45,000	£35,041	£29,434	-£5,607
£50,000	£38,041	£32,434	-£5,607

Implementation

Here is a suggested route toward implementation, assuming we target a flat rate of 40%.

Initial changes - no net change in revenue.

Make dividends not taxable in the hands of recipients. (Cut of £3,586 million.)
Exempt shares from CGT. (Cut of £1,993 million.)
Make interest not taxable for recipients, and not tax-deductible as an expense for businesses. This only applies for loans where the terms of the loan were committed to after the change. (Cut of £4,023 million.)
Abolish the small companies rate of corporation tax and tax all companies at the main rate, 30%. (Increase of £2,750 million)
Increase basic rate to 24%. (Increase of £6,800 million.)
Abolish the starting rate band, adjust the start of the basic rate band to make this revenue-neutral.

Introduce compulsory pension contributions and other pension reforms

Providers are obliged to notify HMRC of individual’s fund sizes as at the end of each calendar year. (For final-salary schemes the usual pension rules for translating an entitlement into a lump sum are followed.)
HMRC calculate a pension income projection at age 75 based on a hypothetical scenario:
1. No future contributions
2. Taking benefits at the earliest possible age, 55.
3. Taking the maximum lump sum entitlement at the earliest opportunity and spending it on something other than producing an income.
4. Taking the maximum income allowable under drawdown rules between 55 and 75
5. Buying an RPI-linked annuity at 75 with no guarantee period and no survivor benefits.
6. Projected income from any state pension entitlement is added to calculate total projected pension at 75.
If the projection yields an annual income in today’s money that is less than a full-time worker on the national minimum wage would earn, compulsory pension contributions are required.
HMRC notify employers as to whether compulsory contributions apply. (Since they have all the data, HMRC may as well also make themselves useful by also sending an annual projection to the taxpayer, though probably based on a different scenario, such as retirement at state pension age.)
Compulsory contributions are a fixed percentage of salary above the personal allowance. Any contributions the employer may be making are deducted from the amount the employee is required to make. The employer has a right and a duty to deduct employee contributions from salary and pay them into a scheme. The employer can decide what scheme they get paid in to. For final salary schemes, increases in entitlement accrued as a result of extra service are used to calculate a notional employer contribution that is deemed to have been made.
Tax-free lump sums on future pension contributions are effectively abolished by freezing such entitlements at a level linked to fund values on the day of abolition. (For example, if someone has 100K in their pension on abolition date, their tax-free lump sum will be limited to what 25K would have been worth had it been invested in a fund on abolition date and sold on the day they request their lump sum, assuming the notional fund had given an annual return of 6% plus inflation.)
Allow pension funds to reclaim notional tax at the flat rate on any interest and dividends they receive. Increase basic rate by 2% to pay for this.

Abolish NI, and with effect from the same date

Increase the rate of tax on self-employed profits in basic rate band from 26% to 34%.
Increase the rate of Corporation tax to 34%.
Increase the rate of tax on employment income in the basic rate band from 26% to 40%.
Require employers to pay an amount equivalent to employers NI towards their employees tax bill. This “benefit-in-kind” is then part of the employee’s taxable income.
Make any changes needed with regard to contributory benefits (other than pensions) being replaced by non-contributory equivalents.
Since entitlements to state pensions will cease to accrue, and if compulsory pensions were introduced at an earlier date, increase the percentage of salary required as compulsory contributions.

Make revenue-neutral annual changes of one or two percent to all rates over several years until they've converged on the same flat rate. The amount employers contribute to employee tax bills should gradually be eliminated.

Is 40% too high a rate?

40% sounds like a very high marginal rate, even though it is only what is needed to fund current levels of spending.

In fact for employees, the rate represents a cut in their burden. Employees who are currently higher-rate tax-payers currently have a marginal burden of up to 48%, so those who believe a growth dividend should result from cutting marginal rates do have a significant cut to monitor, to see if their expectations are confirmed.

Is it fair that pensioners who paid high employee rates of tax in the past, and expected to pay pensioner rates of half those marginal rates in retirement, now see tax on the component of their income that falls into the basic rate band being doubled over a relatively short period? If we invert the question, asking if it is fair for employees to shoulder the burden alone, we can see that it isn't. After NI abolition, employees will not be accruing extra state pension entitlement in exchange for shouldering the ongoing liabilities of the state pension scheme. This residual burden is akin to the burden of non-contributory benefits, for those who must shoulder it. It is therefore right that it be funded out of general taxation, as this is the way non-contributory benefits are usually funded. More generally, there is no logical reason why a pensioner should pay different amounts of tax to an employee with the same income. Lastly, even if there were reasons to favour pensioners, I would argue that if they are to receive a better deal from the state than other sets of individuals, it is the job of the benefits system rather than the tax system to give it to them. This allows such benefits to be seen in their proper context, where they can be judged against alternative uses of the same money.

It is interesting to note that social spending is £327 billion, according to the treasury budget summary for 2005. This is more than the sum total raised by income tax, NI and Corporation tax. State social spending is theoretically optional, in the sense that (leaving political acceptability aside) it is easily possible to imagine a future in which it does not exist. On the other hand, it will probably always be true that social spending could be doubled and yet still fall short of delivering what a substantial proportion of voters want. If we arbitrarily assume other taxes are fixed, then the level of a flat tax could be anything from 0% up to whatever maximises the tax take, depending on what level of spending we choose to support. If we view income taxes as optional and benefiting all UK residents more or less equally, and notice that HMRC table 2.4 shows that half of all income tax comes from the 10% with the highest incomes, we might conclude that it's time for the British to start being nice to the rich. They're paying for the rest of us.

Brain drain

The "real return" investment strategy

Investment phases and early retirement

Diversification, asset classes and asset allocation

Market efficiency

Market rationality

Sequence of returns

Market valuation

The real return approach to investing.

Summary

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