Tax concessions on super need a rethink. These proposals would bring much needed reform

The federal government has proposed an additional tax of 15% on the earnings made on super balances of over A$3 million, the so-called Division 296 tax^[1]. This has set off a highly politicised debate that has often shed more heat than light.

Yet back in 2009, the wide-ranging Henry Review^[2] of the tax system cogently identified the three main problems with the super tax system and recommended reforms to fix them. The Henry Review recommendations, after some updating, are a better, more comprehensive solution than the controversial Division 296 tax.

The three problems are:

1. tax concessions for contributions are heavily skewed to high income earners

2. with an ageing population, it is unsustainable to keep the retirement phase tax-free

3. the system is so complex that most people do not fully understand it.

It is critical to properly address these problems with how super is taxed because Australians now have a massive $4.1 trillion in superannuation savings^[3].

Let us look at the main Henry Review recommendations and then see how the proposed Division 296 tax stacks up. Unlike some super tax systems, our system does not tax super pension payments, so the two key issues are how we tax contributions and earnings.

Tax concessions are skewed to high income earners

Employers pay workers in two ways.

First, they directly pay a cash salary that is taxed under a progressive income tax scale. The effective marginal tax rates, including the Medicare levy, rise in steps with income from 18% through to 32% (for the average wage earner), 39% and 47%.

Second, employers pay a contribution on workers’ behalf into their superannuation fund. From July 1, under the superannuation guarantee charge^[4] (SGC), this contribution will rise to 12% of cash salary. The contribution is taxed at a flat 15% when it is made into a fund, regardless of what income tax bracket the worker is in.

The way contributions are taxed is a massive concession for high income earners. They pay 47% tax on additional cash salary – but only 15% on their super contributions. In contrast, low income earners receive a tiny concession because the contributions tax rate of 15% is only just below their usual effective marginal tax rate of 18%.

The Henry Review recommended that instead, everyone should receive the same rate of tax concession as the average wage earner. This is how that idea would work today.

First, super contributions would be taxed in the hands of employees alongside their cash salary, rather than this tax being deducted by the super fund as is currently the case. Second, everyone would receive the same tax offset calculated as 17% of their contributions as their super tax concession.

One side effect of this Henry recommendation is that the average wage earner would now be paying the 15% contributions tax out of their own pocket, instead of the super fund paying this tax on the member’s behalf.

However, this loss of cash income can be avoided by tweaking the Henry recommendation.

Under my modified recommendation, the superannuation guarantee rate would be reduced to 10%, employers would be encouraged to fully pass on their savings from this by increasing wages by 1.8%, and the tax offset rate would be lifted to 20%. These policy settings would maintain both cash incomes and super balances for the average wage earner.

Pension mode should not be tax-free with an ageing population

In accumulation mode, the current system taxes fund earnings at 15%, with a lower effective rate of 10% on capital gains. However, after you retire and your account changes from accumulation mode to pension mode, the tax on earnings stops and your pension benefits are also tax-free.

The Henry Review recommended that earnings should continue to be taxed in pension mode in the same way as in accumulation mode. That way, retirees make a contribution to income tax revenue, which is important with an ageing population. A uniform earnings tax would also simplify what is an overly complex super tax system.

The Henry Review also recommended the earnings tax rate be reduced to 7.5% because long-term saving through superannuation is desirable. However, that proposal is probably unaffordable today because of the budget deficit.

The proposed change is just a patch-up job

The proposed Division 296 tax further complicates the tax system by introducing a third tax treatment for earnings, whereas the Henry Review simplifies the system with a uniform earnings tax. The complexities of Division 296 can be seen from the 304-page explanatory memorandum^[5].

The new tax also raises less revenue than the Henry Review recommendations yet we are experiencing a structural budget deficit. The new tax is more open to avoidance^[6] than the Henry recommendations. The new tax also does nothing to address the problem that tax concessions for contributions are heavily skewed to high income earners.

Taxing unrealised capital gains under the new tax may cause financial hardship for some retirees who are asset rich but income poor. The $3 million threshold for the new tax is not indexed^[7], unlike all of the other super tax system thresholds.

Overall, the proposed Division 296 tax is best seen as a rough attempt to counteract past policy errors that allowed excessive contributions into super.

The federal government should first address the main problems with the super tax system by implementing the Henry Review recommendations, suitably updated. Then, a considerably reworked Division 296 tax could potentially play a useful supporting role.

Read more: New taxes on super didn't get much attention in the election campaign. But they could be tricky to implement^[8]

References

1. ^{^} Division 296 tax (ministers.treasury.gov.au)
2. ^{^} Henry Review (treasury.gov.au)
3. ^{^} $4.1 trillion in superannuation savings (www.abs.gov.au)
4. ^{^} superannuation guarantee charge (www.ato.gov.au)
5. ^{^} explanatory memorandum (parlinfo.aph.gov.au)
6. ^{^} open to avoidance (www.afr.com)
7. ^{^} not indexed (www.sbs.com.au)
8. ^{^} New taxes on super didn't get much attention in the election campaign. But they could be tricky to implement (theconversation.com)