How super tax breaks should be reformed - Grattan Institute

As debate rages over the government’s plan to limit tax breaks for earnings on superannuation balances larger than $3m, a big question remains unanswered: why offer super tax breaks in the first place?

The answer tells us how they should be reformed.

These tax breaks mean less tax is paid on super savings than other forms of income. And they cost the budget a lot – up to $45bn a year, or 2 per cent of GDP – and soon they will cost more than the age pension.

Ultimately, super tax breaks mean that other taxes have to be higher to make up the forgone revenue, especially as the budget faces big spending pressures this next decade. And those other taxes, such as personal income tax, have big economic costs of their own.

Which is why super tax breaks should be offered only where they support a policy aim.

Three rationales are typically put forward.

First, many argue tax rates on the return from savings, especially long-term savings such as super, should be lower than taxes on income from working. The impact of taxes on savings compounds over time, so the impact on future consumption can be much larger than the headline rate of tax, the longer savings are held. It’s like compound interest, but in reverse.

Some go further and argue for an “expenditure tax treatment” for savings, where the return from saving, in the form of dividends, interest, or capital gains, is totally exempt from tax.

But tax breaks on both super contributions and earnings combine for a negative marginal effective tax rate for most income earners, compared to an expenditure tax benchmark where tax was paid on income when earned, and then both earnings and withdrawals were tax-free.

Past estimates by Treasury showed that Australia’s super tax breaks cost $11bn more in forgone tax revenue in 2013 (and would cost more today) than if Australia taxed super contributions at full marginal rates of personal income tax, but exempted earnings and withdrawals from tax.

There is no justification for taxing super more generously than an expenditure tax benchmark.

So, super savings should be taxed more, but still at a lower rate than wages.

Second, and relatedly, many argue super tax breaks are supposed to encourage additional savings, over and above compulsory contributions.

Yet the available evidence suggests that tax breaks for retirement savings have little impact on the total amount saved.

Instead, it’s compulsory super that lifts national saving.

As the 2020 Retirement Income Review concluded, “tax concessions appear to have a weak influence on overall savings behaviour”.

But people with higher incomes, and older savers, tend to switch their savings into whichever investment vehicle pays the least tax.

The implication is that we should move to harmonise the tax treatment of savings at the same rate, as ANU Tax and Transfer Policy Institute director Robert Breunig recently proposed. But making super tax breaks less generous is a necessary first step towards broader reforms to taxing savings.

Third, super tax breaks also arguably compensate people for being compelled to lock up their savings in super until retirement.

But low-income earners are more likely than higher-income earners to be hurt by forced saving via super. They are under more financial stress while working, and live shorter lives on average, so have less time in retirement to spend their super.

Therefore, the tax break offered on each dollar of super savings should be higher for lower-income earners than high-income earners. Unfortunately, Australia’s current system does the opposite.

So how should super tax breaks be reformed in line with these principles?

First, contributions tax breaks should be reformed to offer smaller tax breaks, per dollar contributed to super, for high-income earners.

The pre-tax contributions of people earning more than $220,000 a year should be taxed at 35 per cent, instead of the 30 per cent charged to those earning more than $250,000 currently, saving the budget $1.1bn a year.

Even still, most large pre-tax super contributions look like tax minimisation by wealthier, older Australians, rather than genuine retirement saving. So the cap on pre-tax super contributions should be lowered, from $27,500 to $20,000 a year, saving $1.6bn a year.

Second, super earnings in retirement – currently tax free – should be taxed at 15 per cent, the same as superannuation earnings before retirement. This would save the budget at least $5.3bn a year, and much more in future.

The top 10 per cent would pay an extra $7000 to $7500 a year on average, whereas the poorest half of all retirees would pay no more than an extra $200 each, and would stand to benefit much more from the increase in health and aged care spending these revenues could fund.

Taxing super earnings in retirement isn’t retrospective because it applies only to future earnings, which is no different to if we change the personal income tax rates applying to investment held outside of super.

Third, earnings on super accounts larger than $2m – rather than $3m as proposed by the Albanese government – should be taxed at 30 per cent. This would save about $3bn a year, compared to about $2bn a year under the government’s plan.

These three simple steps would make the taxation of superannuation fairer and support a stronger federal budget.

What’s not to like about that?

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