The shadow Chancellor is wrong because less austerity would almost certainly have translated into a weaker pound, even higher inflation and higher borrowing costs – for home owners as well as HMG – which would have left us in a worse place than we are today. This is the realpolitik of the Coalition’s economic strategy and it was essentially what George Osborne needed to say today. He will be saying it a lot more.

Politicians do not dare to put it so bluntly (although Alistair Darling, to his credit, did) but the way out of a debt-induced crisis is always some form of ’workout’ and that needs time. Coalition policies have bought time. 

The rest is piffling – including helping aspiring home owners to get into a bind they would be better advised to avoid, amongst other measures we could similarly criticise as pointless or perverse.

The one thing we have consistently said to our clients from the moment the credit crunch hit is that it should, and probably will be, a long drawn out affair. Whereas companies can shift the make-up of their balance sheets very fast, households cannot – and indeed need to move slowly to avoid beggar-my-neighbour effects on other households. Actions by governments may in these circumstance have important validation effects (‘burden sharing’, for example) but they are relatively powerless to alter the course of market economies when driven by balance sheets. That causes me no concern, but I have more confidence in markets than I do governments.

Our clients, whatever the relative strength of their faith in markets and governments, should be glad that their Defined Outcome Portfolios assume that markets can stay hostile for a long time and that their exposures are tested, against personal time horizons, to survive that. Not to plan on this basis would be irresponsible, obviously.

Our Defined Outcome portfolios are managed to individually-customised applications of a quantitative model, designed at the asset allocation level to deliver goal-specific outcomes within explicit tolerance ranges at defined future dates. The allocation decisions follow from monthly computer runs of a unique model for every goal-based portfolio for every client. For the first time since the collapse of Lehman Brothers, we reran models midmonth, using Tuesday’s Tokyo close and Monday’s close for all other markets.

Several recent posts have focused on the attraction of Japanese equities. In this one, we focus on changes in exposure, rather than the allocations themselves, in the belief any investor, whatever their views, should change their exposures in response to such large price changes. As an explanation, we show below in full what we sent to clients on Monday, in advance of the changes. Though specific to our process, we think it is of interest to investors with different approaches.

Why we should follow the model

Our model is by design ‘contrarian’ but it is also blind to emotional influences on how it allocates capital (other than those emotions captured in the risk preferences for each portfolio goal). It is hard headed and also hard hearted.

The assumptions the model has been given about extreme short-term volatility in absolute and relative returns, from whatever source, allow for the kind of shock experienced in Japanese stocks. These assumptions are what keeps us out of equities for short-term liabilities.

The assumptions the model has been given about uncertainty in the long-term trend of real returns from any equity markets are also extremely prudent. In Japan’s case, the shortage of history (we only use data since the initial post-war reconstruction phase which we think ended in the mid-1950s) means that our trend projections allow for greater uncertainty than either the UK or US, which have over a century of data. But in fact there is widespread agreement amongst expert professionals that we ought not to expect any impact on the long-term trend of real returns from investing in Japan as a result of these tragic events.

The near-term impact on markets is likely to be explained by three factors:

1. The effects on measured activity – output, GDP, exports etc
2. Perceptions about the underlying valuation of Japanese equities
3. The effects on the mood of Japanese investors.

We should comment briefly on all three influences on the impact.

Counting the cost

While the destruction of national resources is always a loss, in economics the replacement of scrapped assets is counted as a gain. We can also anticipate that economic output will be temporarily lost due to power shortages. We do not yet know how public capital will be applied to making good personal loss, so that the neutral effects of reinvestment we should expect in the national accounts are not prevented by financial incapacity at the individual household level. Overall, however, the profile of activity will definitely change but not , over a decent interval, its eventual level. Temporary effects should not greatly alter the price investors are willing to pay for long-term profit and dividend streams for Japan’s businesses.

Market valuation

The market’s capacity to absorb such a shock ought therefore to be partly dependent on whether the valuation of share prices is thought to be particularly high or low at the time of the shock. Valuations are generally much less demanding than at the time of the Kobe earthquake in 1995, thanks to the combination of modest returns and gradual improvement in both profitability and profits in absolute. If we examine all incidents of major earthquake activity in industrial Japan since the start of the 20th century it is arguably the health of the banking system and the state of the property market (its main collateral) that has explained best the market impact. Both are infinitely healthier than in 1995.

You will read or hear that the Japanese public sector could not be in a worse shape to deal with a disaster. This misses the point that governments never have money; only the private sector and foreign sector have money. Governments merely attach some of it, through taxation or borrowing. Japan is fortunate as an immensely wealthy and highly successful trading nation that it is not dependent on foreign creditors. In an era of low personal incomes growth and high risk aversion, the government’s financial deficit necessarily follows from the personal sector’s preference for high, liquid and low-risk holdings of financial assets and so has not made borrowing difficult.

Mood

If the economic impact of the tsunami is temporary and the valuation context is supportive, the market impact may mainly reflect its unpredictable effect on the mood of Japanese households and their instincts for how to manage their own balance sheets better in response to this sort of risk. We will see some national characteristics come to the fore in this crisis involving fortitude and discipline but we cannot assume either will extend to their risk tolerance.  They are likely to be glad they have been so risk averse to date but we cannot be sure they will not decide to be even more risk averse. If they are, the job of markets is to lower prices to tempt them back to risk taking.

Unlike 1995, markets look much more attractive to foreign investors and so their reaction could prove an important factor in determining the subsequent price action in Tokyo. Several major investment houses had said before the earthquake that they were bullish of Japan at current valuations and had been increasing exposure.  Amongst conventional valuation measures, yields are now higher than in the US and price to book values lower than either the US or UK. Earnings and cash flow multiples will be less useful for comparative purposes because of the short-term dislocations to sales.

The CGT rate increases to 28% from midnight tonight for investors with chargeable gains that, added to income, would take them into the higher rate band. Otherwise the rate remains at 18%. The Chancellor has set this rate in preference to a higher rate combined with relief for inflation or holding period, for simplicity’s sake.

Advisers and discretionary managers will not welcome the return to the old regime whereby the effective rate of tax on a realised gain is dependent on the investor’s income. For high earners this is not an issue but in some cases the effective rate will not be known at the point that realising a gain is being considered. Gains added to income may straddle the higher-rate threshold and be partly charged at 18% and partly at 28%. 

Wealthier investors will probably greet 28% as a lot better than they feared and the impact on forward-looking risk premiums that I discussed in my posts before the Budget is much less serious. But the fact remains that this is an effective rate of tax higher than most investors with control over the timing of their realisations have paid in the past, when indexation and taper relief were available. 

As a tax incurred at the point at which capital absolutely has to be converted to consumption, and cannot be further deferred, 28% without inflation relief is a high rate, considering the real returns at which private capital has accumulated over many years. But this stock of latent gains is essentially a captive that the Government can pluck at will.  If it can be deferred all the way to death, it will pluck it then, as part of the IHT bill. It is between these extreme cases that CGT is a discretionary tax.

The 18% rate was set at a level that did not significantly defer discretionary realisations but 28% will (and indeed should) cause deferral. The Chancellor suggested that Treasury advice was that setting the rate higher than 28% would reduce revenues. We believe the same will hold for the increase from 18% to 28% and that the additional projected revenues of £700-800m pa are heavily dependent on plucking the captive stock. 

Deferring realisations is not cost free. It usually conceals a great deal of inefficiencies in capital management, such as inappropriate risk levels and risk concentrations. Not being able to rebalance portfolios, changing strategic asset allocations, is likely over time to reduce returns, even if not by as much as if paying CGT. On the other hand, slowing down the turnover of individual holdings caused only by active managers’ selection preferences is likely to help returns.   

The industry will not want its portfolio activity hampered by externalities like CGT and we should expect more use of unitised investments, including unitising discretionary management portfolios, and a revival in the sales of investment bonds, even though the taxation of the ultimate gains is now broadly equal to deferred gains in an unwrapped unitised product. The problem with bond sales has always been that the profitability of the product made it very tempting to tell half truths about the tax position.

Amongst the captive victims of higher CGT rates are investors who chose lumpy holdings like property that cannot be disposed off gradually using annual allowances. This might be a welcome tilt away from the popular bias favouring bricks and mortar over financial assets. This is also, incidentally, the fastest growing area of tax collection from investigations, as HMRC trawl through Land Registry data.

The Chancellor referred in his speech to a loss of revenue from people converting income into gains of £1b pa. I would like to know where this comes from. One large hole in the CGT net, the treatment of carried interest in private equity, remains in spite of the fact it was the source of the canard about ‘paying more tax than a cleaner’ that George Osborne could not resist bringing into his speech to support the Budget’s ‘progressive’ credentials.

The lifetime ‘entrepreneurs’ relief’ goes up from £2m to £5m. Considering entrepeneurial wealth creation is probaly less affected by tax rates on expected gains than portfolio investments,  but much more sensitive to risk sharing or subsidy in the event of losses, this is a curious incentive to pick out for special treatment.

People’s employment income is not generally sensitive to tax rates. High tax rates may, at the margin, act as a disincentive to work but when bills have to be paid we don’t have an opt out. When capital is employed, things are very different. We don’t have to make it work hard or expose it to risks and will only opt in to risk-taking activity if the return probabilities appear to make it worthwhile. The relevant returns are after all taxes. Theoretically this justifies a different tax regime for employment earnings and savings income. But in practice not keeping the income tax rates similar leaves too much scope for arbitrage by altering the source from, say, salary to dividend. This means the capital element of investment growth is the only candidate for different treatment.

If capital gains are taxed at the same rate as income, with no relief for holding period or general inflation, we can compare the after-tax returns on risky ventures with a risk-free rate of return to see what impact it might have on people’s choices about risk taking.  

The historical real rate of return, from both income and capital, earned by equity investments in the UK and other markets, before charges, is about 6% pa with deviations, even over long periods, of about half or twice this. At zero inflation, this is also the nominal return. The typical expenses of managed exposures to risky investments are about 1.5% pa so this brings the ‘captured’ growth to about 4.5% pa. At an equalised 40% tax rate on both income and gains, a realistic ‘pocketed’ return expectation for long holding periods is therefore 60% of this, or 2.7%.

If you had no particular view about the future, this historical rate would also be a reasonable estimate of the mean future rate, with a 50% chance of being exceeded. However, actual estimates will reflect investors’ beliefs about whether the past is representative. Survey evidence suggests (rightly or wrongly) the coming decade is expected to provide lower returns than historically. If the expected real gross return is 4%, instead of 6%, the pocketed return drops to 1.5% pa.

The alternative to risk taking is to hold some ’safe harbour’ asset. In any formal investment decision process where capital only ventures out of safe harbour because it is attracted by the range of possible returns from risky assets, a doubling of the tax wedge on gains means either some taxable risk assets are pulled back to safe harbour or the owner decides to increase their risk tolerance. There is always some level of indifference for any individual investor between accepting the certain return and gambling on the likely range of uncertain risky returns. That is what defines risk tolerance.

If investors’ viewed cash as the natural safe harbour asset, this is only safe in money terms and leaves them exposed, over long periods, to inflation. Not having a particular view about the future, a reasonable estimate of their real, after-inflation, cash return would be in line with historical averages which would be about 1%. This implies at zero inflation a mean risk premium after tax and charges of just 0.5% and a very substantial risk of falling short of the cash return.

In practice, investors increasingly do not view cash as their safe harbour, for the same reason that they view equities and property as at one and the same time risky investments, offering a risk premium for business and economic uncertainty, and inflation hedges, offering over long periods compensation for general inflation. The only asset safe in both nominal and real terms is an index linked gilt as it allows certainty in planning purchasing-power outcomes. The current level of index linked gilt yield, which is a real yield after inflation, is also about 1%. The true expected ‘pocketed’ risk premium for bearing both business and inflation risks in equities is therefore also about 0.5%.

The effect of a doubling of the tax wedge on expected risk premiums is sensitive to the actual level of inflation when there is no or incomplete indexation.

At 5% inflation, the 1.5% expected net return on risky assets becomes 7.5% gross and 4.5% net. Holding an index linked gilt, the nominal after-tax yield would be 5.4% because most of the return is in the form of CGT-free uplift to the redemption proceeds. With most of the possible return distribution below the risk free rate, very few personal levels of risk tolerance would justify moving out of safe harbour.

Even if we were more optimistic about the growth compared with historical rates, a 50% chance of achieving at least 6% translates into 5.7% net of tax with inflation at 5%, only fractionally above the 5.4% after tax ‘nominal’ return on index linked gilts. Still in safe harbour.

I do not think using equity return examples alters the position greatly where rented property would be the risky opportunity. The income element of total return is typically thought to be greater for property because net yields after expenses are higher than for most equity markets (although this is not necessarily the case in fact if the investor suffers periods without tenants). This ignores the reinvestment required to maintain a property at the ‘current market rent’. If this is built into expectations, the impact of a higher CGT rate should be broadly the same as in public equity markets.

My examples use current yields for risk free asets. The incentive for leaving safe harbour are in fact constantly changing, not least as a response to the yields themselves, in a feedback loop. In the current situation, marked by heavy deficit financing by governments, debt is likely to be quite expensive in both nominal and real terms. With borrowing rates artificially suppressed in countries adopting quantitative easing, this is not necessarily evident yet in debt markets and therefore in risk free yields. Competition for risk taking is likely to get tougher, not easier.

One solution to an increase in taxes and a reduction in after-tax risk premiums is that equity and property prices fall untill they are again competitive. Since this is not obviously a good solution for the economy generally or tax revenues in particular, it contributed to my belief that increasing the rate of CGT without reliefs was a rank outsider in my possible scenarios.

This explanation deliberately gives no credence to alternative theoretical possibilities, which are that the geared impact of the increase in unrelieved CGT on risk premiums is conveniently offset by an increase in the average taxable investor’s risk tolerance, or that their withdrawal from risk taking is conveniently substituted by ‘gross’ investors, such as pension funds.

You might think, reading this, that individual investors do not in real life gather and process information in this ordered, rational way. Of course this is true, and ever was. But the implication of the historical evidence of time-varying absolute and relative returns is that these returns are in fact constrined by collective, crowd behaviour in a way consistent with rational risk and return trade offs. The numbers are not just random and they matter.

They matter not least to politicians. It worries me that anyone thinks political leaders might be ignorant or casual about such fundamental assumptions about economic decision making. That it has brought people like John Redwood, a former Treasury minister, into open revolt is therefore a useful warning to a Coalition Cabinet that gives some appearance of treating important tax policies like bargaining chips. Like me, the media have also not really taken the risk of this worst-case scenario seriously enough to date. Let us all up the ante.

The devil in the detail

We do not know yet what changes will be agreed between the Conservatives and the Lib-Dems, only that they ‘agree to seek a detailed agreement on taxing non-business capital gains at rates similar or close to those applied to income’. The devil will be in the detail of that agreement. If the rate increases to close to 40% without relief for either time (taper relief as a function of the holding period) or inflation (indexation uplift of the cost base), the changes will be a bad backwards step in both principle and practice and will probably shrink rather than increase the tax the Government raises (which isn’t very much anyway). If the rate increases, but with reliefs based on time or inflation, the tax will be fairer in principle and more honest, to the extent the government does not then tax historical general inflation in capital values. But it will still be impractical and expensive to operate and will distort decision making. It will probably still reduce the tax take, for the same reason people believe in simpler, lower, flat taxes with no reliefs.

Guessing the detail

Look for the way in which the Emergency Budget on 22nd June deal with time and/or inflation.

• Indexation has more integrity than taper but taper is simpler to account for.
• The policy could revert to the position prior to 1998 and apply full RPI uplift to the cost base, starting at 1982 values.
• It could rebase the start level from 1982 to a date more recent (requiring ‘backward revaluation’ of assets – simple for listed securities, more expensive and arbitrary for property) and apply either indexation or taper relief from that new date.
• It could apply taper to the existing base costs, all the way back to 1982 if held for longer, so a much more gradual rate of taper than the regime post 1998 and one which bring the effective benefit more closely into line with the small size of the annual uplifts with indexation relief.
• It could give less weight to inflation and more to a politically-correct notion that gains realised after short holding periods are less worthy than gains after long holding periods, as was the case with the 1998 regime (no taper for three years).

How individuals view each option depends on their own vested interests, as a function of their known base costs and actual holding periods and their expected future gains and holding periods.

• On economic grounds, the danger is greatest from any option that treats as a public windfall CGT resulting from the more than doubling of the general price level from 1982.
• This bears hardest on real property, as the gains cannot be ‘worked out’ gradually using annual exemptions, unlike securities.
• Taper looks arbitrary and inefficient for new investment decisions.
• But if combined with a recent new base date taper may not be too harmful for old investments.

Watch too for changes to the annual ’small gains’ allowance. The Lib-Dems wanted to cut this from £10,100 to £1,000 – a clear demonstration of fantasy politics as it would massively increase the number of tax returns being filed each year in an HMRC already struggling. If the Conservatives don’t scotch this proposal they will deserve the derision it will attract from both left and right.

Guessing the effective date

What price principle? The rate of CGT is known at the point a decision is made to sell. It is chargeable at the rate effective at the point of sale. So if the Government were to make the regime changes retrospective to 6th April 2010 it would be an historic breach of principle. However, there must be some probability assigned to this scenario, enough to consider making sales in haste and certainly enough to warrant considering bringing forward sales that would be made for good reason anyway.

In practice most individuals will already have made the sales that ‘would be made anyway’, before 5th April 2010 and possibly even well before the election speculation included a possible increase in CGT rates. The flat rate of 18% was an effective rate lower than at almost any stage in the past, and (in the days of indexation) higher only than assets whose peak rates of growth were earned in the 1980s. Many of our clients were willing to pay tax at that rate but would have otherwise avoided the transactions had the tax charge been much higher. That is why we think around 20% is the optimal rate for revenue generation.

It is unusual for the rate of CGT or reliefs to change part way through the tax year, hence the most probable scenario could look like a change effective at the end of this year. But there is another reason for making it effective later. If the revenue effects are largely illusory or speculative, and this is really gesture politics, some hard benefit could be derived by incentivising the bringing forward of realisations into a one-off nine-month window.

What probability you assign to the changes being effective from 22nd June depends in large measure on your view of its practicality and cost for HMRC. Our own accountants think it leaves plenty of time for HMRC to adjust its own self-assessment software, at no great cost. However, this may depend partly on the new form of taper or indexation relief and, particularly, the need for new valuations if the base date changes. For decision making, note, this scenario makes little effective difference as it is only the chance of bagging the 18% rate in the current window that affects decisions about sale of assets prior to the Budget.

If it is left to year end, however, there is then every reason to assess the merit of bringing forward realisations, particularly of property holdings, into 2010/11. This is not just a tax exercise but a call to action to review the ‘capital efficiency’ of household balance sheets, given realistic risks and returns but also whether needs for liquidity and certainty dominate your financial planning. You do not need to wait for the Budget to do that. Just pick up the phone.

Implications for efficient investment

1. Tax management in portfolio management

• Tax matters. It is a cost of investing but often discretionary. Budget for it like all other costs.
• Only lazy clients let investment managers get away with saying they will ignore tax in their decision making.
• As a general rule, it is over-confidence about gross returns, whether by manager or customer, that leads to capital management that is wasteful of the tax budget. Watch for this. Humility in the face of market uncertainty is more likely to be associated with good tax housekeeping.

2. The importance of index linked gilts

• In the absence of proper indexation (not taper relief, which may or may not be as effective), it will be inefficient to receive ‘inflation compensation’ via increases in nominal capital values that are then chargeable to CGT. This has nothing to do with making sales in the course of efficient management of portfolios but rather a long-term view of the after-tax risk and reward of capital that at some point will be turned into consumption, such as to support spending or to make lifetime gifts.
• The higher the taxation of gains that are really only inflation compensation, the more efficient it is to hold index linked gilts as the hedging assets for future consumption. Most of the return will be inflation compensation and will be received tax free. If you are not already using horizon-matched index linked gilts to manage the uncertainty about long-term wealth or spending outcomes, you certainly should be now.

3. A boost for ’bond wrappers’

• One reason why higher rates of CGT, even in the presence of time or inflation relief, are likely to reduce the tax revenue raised is because people like us will use offshore bonds as a holding vehicle for the assets we think we need to rebalance from time to time as part of efficient capital management.
• Bonds defer the tax on realisation although they also provide scope for reducing the overall tax rate if realised when the policyholder’s income tax rate is lower then the CGT rate, or if death occurs before gains have been taken and the policy has been ‘written in trust’ to beenfit the next generation.
• Except when the realisation of gains is unavoidable to to convert a stock of capital to a stream of spending money, or to make gifts, making sales to ‘rebalance’ a portfolio is an option, not a necessity. In any case, good professional management will minimise the frequency of transactions, and their attendant frictional costs, such as by opting out of active management and adopting ‘horizon matching’ when allocating assets.
• ISAs and SIPPs may provide capacity enough for the rebalancing stock of assets that would otherwise be within the CGT regime but where this capacity is restricted, for any reason, a low-cost bond wrapper is a good alternative holding vehicle.
• Watch out for commisison-driven sales of expensive investment bonds. The increase in CGT rates provides one last hurrah for IFAs promoting these expensive products before the Retail Distribution Review crunches the excessive margins. If you are paying a fee for advice there is no reason why the right wrapper should not be very cheap (and a flat rate).

4. Offshore funds

• Ironically, narrowing the gap between income tax and CGT effective rates will reduce the current regime’s heavy penalty on unregulated, unauthorised funds, with both gains and losses currently subject to income tax.
• Regardless of the tax change, however, the market in the UK for alternative investent strategies will mainly be shaped by the legislation coming from Europe that will allow hedge-fund like strategies in ‘passportable’ fund structures. This is something to monitor, not act on now.

5. Investment properties vs securities

• High effective CGT rates penalise against property and in favour of securities or funds investing in public-market securities. This is because holdings can be subdivided and realised in tranches, maximising allowances in the form of realised losses (themselves generated from partial sales to create the contingent asset of a loss carry forward) and the annual exempt amount.
• Buy-to-let property is the obvious candidate for review for possible replacement if a window is created in the Budget up to year end. Let property is an investment strategy where we see one of the greatest gaps between perception and reality so a review is a good idea anyway.

6. Home ownership

• As our recent paper on the economics of home ownership explains, owner-occupied (as opposed to investment) property relies for most of its benefit on the enjoyment of the asset as a form of ’consumption’. If financed by debt, actual financial gains depend on the cumulative real cost of the debt over the life of the loan. If the opportunity cost in the form of financial asset returns is higher, actual financial wealth is reduced below that resulting from renting property. Real financial gain is never to be taken for granted, least of all in today’s post-credit crisis world. I fear that higher CGT rates will be used to trump these economic arguments and validate a largely partial and emotive bias to property on the grounds the main residence is free of CGT.

7. Business assets

• The one-paragraph coalition statement makes a clear distinction between the regime for business and for non-business assets. But we have no basis for speculating about the detail in respect of business assets and see no actions that can be taken in any event between now and the Budget.
• We should not confuse the private equity industry, whose business model was dominated by the leveraged buy-out or buy-in, with entrepreneurship in general. The industry will be lobbying hard to ensure the changes do not hurt the ‘carried interest’ of partners but this is not obviously of any economic consequence. The economics of private equity have been upended by the credit crisis which has undermined the theories of capital efficiency, leverage and value added that private equity built on. Until these are replaced with a different and more robust basis of assessment, we cannot even begin to think about the role of tax incentives on enterprise in the future.
• But there is a more important debate to be had about the appropriate sharing of risk between business creators and intellectual property developers on the one hand (whom we need much more than private equity owners) and the tax payers on the other. This should not be policy made (or unmade) in haste.

8. Trusts

• There seems no obvious reason to expect changes to the existing regime which gives only half the annual allowance.
• A higher rate will return us to the penal regime applicable to stored-up gains in offshore trusts with UK beneficiaries.
• It would be nice to think both the parties to the coalition share the view that trusts are not just or primarily about tax mitigation and that the excessive tax burden indiscriminately imposed on trusts will be reformed at some point.

9. The Tax Reform Bill of 20..

• This goes for tax reform generally. The credit crisis probably put paid to any realistic chance of an incoming government reforming the tax code to reduce inefficiencies in decison making, cut the need for and cost of advice and increase the after-cost revenues collected by flatter taxes: lower rates across a broader base with fewer allowances and reliefs. It might reduce the fees from our financial planning activity but we will celebrate nonetheless. Meanwhile, we dream on.