Labor’s proposed new tax on superannuation balances in excess of $3m has rightly provoked a storm of criticism. But there has been less clarity about the nature of the problems it raises.
The tax itself is premised on a misconception: that superannuation is lightly taxed. In reality, superannuation is a form of very long-held savings, with significant restrictions on savers’ ability to make withdrawals before retirement age. A fund’s earnings are therefore repeatedly subject to tax, with each payment eating into the balance that will yield earnings in the future.
Those ongoing reductions create an ever-growing wedge between the amount that is actually in the fund and the amount that would have been in the fund had its earnings been allowed to compound tax-free.
That wedge, measured as the difference between the amount available on retirement and the amount that would have been available absent the taxes on earnings and on contributions, is the effective tax on superannuation. For example, if the actual balance on retirement is $100,000, and the tax-free balance would have been $200,000, taxes have cost the superannuant $1 for each dollar of retirement savings.
Measured in that way – as Professor Jonathan Pincus has in a recent paper – effective tax rates on superannuation will vary depending on the duration of the savings and on rates of return. It can nonetheless be shown that mandatory superannuation savings are taxed at about the same effective rate as the income taxes applying to middle-income earners, which, given that being forced to contribute imposes costs on savers, is scarcely concessional.
Meanwhile, voluntary contributions are taxed at effective rates well above the effective rates of income tax. If they remain attractive, it is because many other forms of saving are taxed even more heavily.
Moreover, effective tax rates on superannuation are greater yet when account is taken, as it should be, of the transfer payments those who have largely or entirely funded their own retirement forgo, most obviously the age pension and its associated benefits.
As a result, claims that the taxation of superannuation is highly concessional are sloppy at best, incorrect at worst. The case for increasing the tax rate on superannuation is consequently weak; that for subjecting unrealised capital gains to that higher tax rate is even weaker.
There are, it is true, some arguments for taxing unrealised capital gains. By far the strongest is that when gains are only taxed on realisation, the scope to defer the tax liability by holding on to assets creates a “lock-in” effect that makes asset markets less liquid and hence less efficient. And the higher the rate of capital gains tax, the greater are the lock-in effects and the harm they cause.
Clearly, taxing unrealised gains reduces the incentives to defer realisation and hence can make markets work better. But those benefits are more than offset by broader damage to economic efficiency.
In assessing that damage, it is useful to start from the fact that an efficient tax system – that is, a tax system that does not distort investment decisions – would treat capital gains and losses symmetrically. Such a system would not, in other words, change a fair bet, in which the upside and downside risks cancel out, into one not worth taking. Our current system for taxing capital gains does not respect that neutrality condition; the proposed change greatly aggravates the asymmetry, since net gains are taxed immediately (and at a high effective rate), while any credit for net losses is deferred, potentially indefinitely. Indeed, it is because the change heavily penalises gains, while preventing savers from easily withdrawing the funds that are taxed at the higher rate, that its projected revenues are so large.
The effect of that asymmetry in the treatment of gains and losses is to distort two sets of decisions: those of savers, who will shift their portfolios towards lower-risk classes; and those of firms, which, if they are to attract funding, must offer higher and more certain returns by avoiding high-risk investments. Moreover, the adverse impact will be greatest on investments that involve a small chance of extremely high returns along with a substantial chance of incurring losses.
Now, the efficiency of a market economy relies on the incentive investors have to hunt out projects that are likely to be especially profitable, while abandoning those that are not. Equally, an economy’s dynamism depends on the willingness of financial markets to underwrite investments that involve high risks but could yield high returns.
That the US high-technology industry blossomed after the Reagan tax reform, which drastically cut capital gains taxes and reduced the asymmetry in the treatment of capital gains and losses, is consequently no accident. Labor’s proposed changes do the exact opposite and will, as the volume of savings they affect rises, crimp investment not only in start-ups but also in risky mining ventures and in those parts of farming that are exposed to volatile world prices.
Nor do the distortions end there. As well as opting for relatively safe investments, savers will shift from less liquid to more liquid assets, for two reasons: so as to more readily meet their tax obligations; and because the market price of highly liquid assets is easier to determine, reducing the risk that they will be incorrectly overvalued by the ATO.
That effect will compound the bias against investments that are difficult to value because they are innovative or otherwise cutting-edge, further dampening our economy’s capacity to seize emerging opportunities.
Finally, there is no obvious reason for taxing unrealised capital gains in one savings instrument and not others. With Labor desperately seeking revenues, there must be a material likelihood that the approach will eventually be applied more broadly, increasing the damage it wreaks.
The many complex transitional issues the shift from taxing only on realisation to taxing unrealised gains creates for taxpayers – not least because of the need to find the funds required to pay the increased taxes – will add the immediate costs of financial stress and perceived unfairness on to that longer-term damage.
In short, this tax is poorly conceived and even more poorly executed. So fundamental a change warrants rigorous economic analysis; if any has been carried out, it is being kept tightly under wraps. Instead, the Treasurer, in seeking to justify it, has struggled to go beyond “soak the rich” rhetoric at its tawdriest.
Reading those statements, which are as confused as they are convoluted, it was hard not to be reminded of Richard, son of Nigel, who in AD1170 was both Bishop of London and a talented chancellor of the Exchequer. “The greatest skill of the Exchequer,” he wrote, “lies not in calculation, but in judgment.” That, unfortunately, is precisely what this proposal lacks.
Henry Ergas will give the Rule of Law Institute’s annual Robin Speed Memorial Lecture in Sydney on June 12.
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