Taxing super and unintended consequences

Right now we’re feeling pretty confident about our 2013 fearless forecast that the Labor Government would increase taxes on super in order to fund the NDIS and other election year initiatives.

Not that we take any pleasure in that. We’d much rather be wrong. One of the brutal realities of the trench warfare of minority government has been that the strategic largely went out the window a long time ago. As the most strategic social policy of recent decades, super has always been at risk in this situation.

Treasury of course must be delighted. It has been waiting for years for the opportunity to wind back tax “expenditures” on super, and finally got a Government ready to listen to the siren song of revenues to fund new spending initiatives.

The entire concept of tax expenditures on super is faintly ridiculous. Such expenditures only exist because Australia has a highly progressive tax system, in which higher income earners pay a substantial proportion of total income tax. The 2% of taxpayers on the top marginal tax rate paid 24% of all personal income tax in 2009-10. Of course they are going to benefit from concessional taxes on super – consistent with retirement systems in the developed world. Indeed Australia’s system is less generous already than comparable nations.

The “cost” of tax expenditures assumes that super income streams currently taxed between zero and 15% (contributions, earnings and benefits) can be taxed at rates of up to 46.5%. But it’s hypothetical, and as the MRRT shows, estimates of what will be collected may be drastically off as people change their behavior.

So what are the tax possibilities, given that new taxes on end benefits appear to have been ruled out? The trick here is that it needs to raise enough money, and it needs to be administrable:

1. Our prime suspect remains changing contributions tax from a flat 15%, to marginal tax rates less 15%. There’s political cover as it was recommendation 18 of the Henry Report. It’s effectively a reintroduction of a complicated super surcharge. Funds hate it, but they can administer it. With nearly $80bn in employer contributions alone flowing into the system, an extra 5% tax yield gives you $4bn in new revenue.

2. Alternatively, the tax on earnings could be increased. Raising the rate from 15% to 20% (or perhaps 19% to match with the first marginal tax rate) would raise something in the order of $5bn, depending on actual returns. Very easy to administer, and members don’t see an explicit hit to their balance.

3. You could extend the 15% earnings tax to currently tax free pension divisions. This is attractive as pension divisions are starting to expend rapidly thanks to demography. It would hit SMSFs hardest, which have more assets in the pension phase. At face value, this might raise less revenue, but would also address tax minimization strategies based on the arbitrage between accumulation and pension divisions.

4. There have been suggestions of a higher earnings tax for members with a balance above a certain level – effectively a wealth tax. Perhaps politically attractive, but administering this one would be a nightmare, unless it was essentially an outright levy on large balances (ie similar to land tax).

The topic of tax benefits that high income earners get from super is an emotive one. It’s also less simple than it appears, and is fraught with unintended consequences. If higher income earners are effectively precluded from super via increased taxes, some of those consequences are likely to be:

Super will no longer be the simple, comprehensive retirement strategy that it should be. For anyone on the top marginal tax rate, a maximum annual contribution of $25,000 is unlikely to fund an adequate retirement, and ratcheting up taxes on super only makes this worse.

Expect greatly increased activity around tax minimization schemes. One of the unsung benefits of super has been much reduced incentives to engage in tax avoidance. Do we really want this to return, and the additional compliance measures that will have to be funded at the ATO?

Liquidity squeeze. Higher income earners account for a disproportionate percentage of super assets and cashflow. If they disengage from super, not only will the system growth rate slow, there will be a reduction of liquidity. The super system is cashflow positive, but it is more finely balanced than many realise. If the system goes cashflow negative, its ability to fund major investments in illiquid exposures such as infrastructure may be significant reduced. We have already seen examples of individual funds experiencing tighter liquidity via an older membership, and have noted a substantial drop in their appetite for illiquid assets.

Here’s hoping (but not particularly expecting) that common sense prevails.

Posted In: Trialogue