Superannuation tax reform: keep it simple, make it fairer

by John Daley

Published by The Australian, Thursday 3 December

Superannuation tax reform is in the air. Scott Morrison is now on board, declaring on Friday that the purpose of superannuation should not be to facilitate estate planning or allow millions to be squirrelled away tax-free in retirement. Yet the present system allows a lot of both.

The super debate has spawned any number of reform proposals. Everyone has a bright idea: lifetime caps; discounts relative to marginal tax rates; higher taxes based on earnings. It’s bewilderingly complicated.

And this is the core problem. If super were simpler, everyone would realise how unfair and expensive it was. If anyone suggested changes to income tax rates that had the same effect as the tax outcomes delivered by superannuation, it would be a short debate.

The complexity is a result of a system that doesn’t even have an agreed purpose.

This is a little surprising for a system that has assets of $2 trillion, annual administrative and management costs of $21 billion, and tax breaks that cost $25bn in lost budget revenue each year.

Ad hoc changes, without clear aims, have delivered a tangle of rules, limits and exceptions. Those who can afford good advisers usually find a way to use the system to substantially reduce their tax.

As the Financial System Inquiry suggested, the most plausible purpose for superannuation is that it should encourage savings to supplement and at most replace the age pension.

This implies that it should not be delivering big tax benefits to those unlikely to qualify for an age pension in the first place.

But our report for the Grattan Institute, Super Tax Targeting, shows more than half of the tax benefits of superannuation go to the top 20 per cent of income earners — people who are unlikely to qualify for an age pension.

The system is riddled with tax breaks that are particularly valuable to high-income earners on higher marginal rates.

Contributions to super are taxed at only 15 per cent. Earnings are taxed at only 15 per cent. And in retirement, earnings are tax-free. The top 10 per cent by income of over-60s drawing down on their super pay no tax on their average super earnings of $85,000 a year.

Super tax breaks still have their defenders, such as Henry Ergas on this page on Monday, who argued that it would be unfair to tax the super fund earnings of retirees at 15 per cent, even though workers already paid this much.

But Ergas neglects to mention that tax-free super earnings for retirees have their own costs.

Lower-income earners and younger people have to pay more in other taxes — now and in the future — to pay for the tax-free status of so many retirees.

Younger wage earners on $40,000 a year are paying far more tax than retirees do on much higher super incomes.

This is not just unfair. It is also inefficient. Our young worker earning $40,000 faces a marginal tax rate of 34.5 per cent.

The evidence that such tax rates affect choices to work is overwhelming, especially for sec­ondary income earners, particularly women.

And although Ergas is fixated on his idiosyncratic calculations of tax rates on savings, he has no answer to the evidence from overseas and Australia that high-income earners tend to save the same amount no matter how much tax they pay on their savings.

Even industry bodies agree that reform is needed. But the reforms they want could make the system even more complicated without making much real difference.

Suggestions by the Association of Superannuation Funds of Australia to change contribution tax breaks would almost certainly cost the budget money by enabling more tax planning. ASFA’s proposals for reform of earnings tax breaks would reduce the current costs of the system by a mere $200m a year.

So the various proposals for reform need to be compared carefully. How well do they limit tax breaks to levels that serve the purposes of the system? By how much would they improve budget bal­ances? What would be the administrative costs?

Our analysis of the competing proposals suggests three reforms would be most effective in targeting superannuation at its purpose.

Concessional contributions made from pre-tax income should be limited to $11,000 a year. This change would improve budget balances by $3.9bn a year.

Other options, such as levying higher taxes on contributions made by higher-income earners, would be less well targeted and more complex to administer.

Replacing the annual cap with a lifetime cap sounds attractive because it appears to allow people with broken work histories to catch up, but it would mainly ­turbocharge tax planning for wealthy older workers.

“Non-concessional contributions” made from post-tax income should be limited to $250,000 over a lifetime. Of the $33bn in post-tax contributions each year, around half are made by just 200,000 people who already have at least $500,000 in super.

Earnings in retirement are currently untaxed.

Taxing them at 15 per cent — like earnings before retirement — would improve budget balances by $2.7bn a year today, and by much more in future. While some have proposed a tax-free threshold or tax-free balances, this would add to administrative costs and further increase complexity.

A simple increase in the age pension would deliver more to lower-income retirees for the same budgetary cost as preserving a $20,000 tax-free threshold for superannuation (in addition to the $30,000 tax-free threshold for older income taxpayers).

The proposed reforms are fair. The changes to contributions taxes would be prospective.

The changes to earnings tax rates, like changes to income tax rates, would apply to future earnings of assets already acquired.

Low-income earners and younger people would pay less in other taxes if super tax breaks for the wealthy were wound back.

Those already retired would pay some tax on their superannuation savings, but they would pay much less than wage earners on similar incomes.

For a small proportion of women with higher incomes later in life, the changes would reduce catch-up contributions.

Yet the changes would reduce the tax breaks far more for a lot of rich old men.

We need to stop fiddling around the edges of superannuation. Decisive reform must simplify the system and reduce the wide gap between the purposes of the system and what it actually ­delivers.