Economic Policy

superannuation taxes

Unrealised gains, unrealistic taxes

In the 2023-24 Budget,, Labor announced it wanted to do something about the generous taxation of superannuation earnings for those above a high balance.

The figure of $3 million was announced as part of this. The plan was to tax earnings of the part of your superannuation balance that exceeds the threshold at a higher rate than the lower rate.

Earnings on superannuation balances at or below $3 million are taxed at a rate of up to 15 per cent, as they are currently.

For the portion of an individual’s superannuation balance above $3 million, the bill introduces an additional tax of 15 percent, bringing the overall tax rate to a maximum of 30 percent on the relevant earnings. This is still concessional when compared to the top marginal tax rate.

In announcing the bill, Treasurer Chalmers was at pains to highlight that it would impact, on 2021-22 figures, around 80,000 people, or 0.5 per cent of people with a superannuation account. This point was made, presumably, to draw attention to how few actually feel the force of this bill.

The system changes

The current superannuation system taxes contributions and earnings at the fund level, with a general tax rate of 15% during the accumulation phase. However, the effective tax rate can be lower due to factors like franking credits and tax exemptions for earnings supporting retirement income streams. Once individuals reach age 60, most benefit payments from superannuation are not taxed.

The new “Better Targeted Superannuation Concessions” bill would introduce a new method, which applies directly to individuals rather than the superannuation fund. 

Individuals can choose to pay this tax by withdrawing money from their superannuation or using funds from outside the super system. The government designed this tax to cover as many people as possible within legal boundaries. 

Unrealism gains

The bill comes due

Much of the criticism of the bill has centred on the taxation of unrealised gains. Critics argue that taxing paper profits before they are actually realised through a sale creates potential liquidity problems, as investors may need to sell other assets to pay taxes on gains that exist only on paper. 

Why should we care about this?

You can’t pay tax, on land, with land

There’s a principle that you should tax capital gains when they’re realised, rather than when they’re made. The difference between ‘realised’ and ‘made’ is that, to be realised, you need to sell something, and have money from the sale. ‘Made’, on the other hand, means that your asset has gone up in value, but you’re yet to actually cash out.

The reason it’s a principle is because tax is a tool used by government to impact price. When things go in price, fewer people want it. When it goes down, more people want it. 

Tax increases the price of a good or service: the GST makes it more expensive to pay for certain things. Making something GST-exempt makes it cheaper than things that aren’t. 

Taxes work this way on cigarettes, for example. We want fewer people to smoke, so we increase the price via taxation. 

Taxes can be used to encourage things, by reducing the price of it, which is how concessional taxation of superannuation works. We’re trying to encourage people to put money into their superannuation, because it means they are less likely to require the age pension. That saves money later, which is why we do it now. Sooner or later, as superannuation matures, and more people retire with high balances, those concessions won’t be as necessary — they may even become redundant. 

(That, by the way, would be a great problem to have — everybody being so wealthy in retirement that they don’t need to be encouraged to put more into their retirement savings!)

The Henry Tax Review¹ from 2010 reported, in an even-handed consideration of the options, that:

Income taxes in general, and particularly for individuals, are based on the realisation principle. That is, income is recognised as taxable when it is realised through a taxable event, such as the sale of an asset, rather than as the change in value of assets or wealth over time…

Where unrealised gains accrue a taxpayer may not have the cash at hand to pay the tax liability, and borrowing against or selling down assets to meet the tax liability would not be costless. Volatility in asset prices combined with lags in tax liabilities falling due may exacerbate these concerns.

Treasury nonetheless tends to like the taxation of income on accrual, as it’s ‘made’, rather than realisation, as it’s ‘received’, because it’s considered more ‘efficient’ — which means it has the least distortion on the economy, for every dollar raised — and is harder to avoid. 

But is it always? There are academic debates around this. Sometimes, it would be. But it is not without cost, as the Henry Tax Review found. And a growing body of research² suggests it would be more distortionary, rather than less.

Goodbye, accrual world

The debate about taxing gains as they occur, rather than at the point of sale, comes down to some fundamental issues with how tax systems work in practice.

Liquidity, liquidity, go away

The core problem is the disconnect between paper wealth and actual cash. Under the current system, you pay tax when you sell an asset – that is, when you have the money from the sale to pay the tax bill. But taxing annual increases in value creates an immediate need for cash without a corresponding sale. A homeowner whose property value increases by $100,000 would need to find money for the tax bill, likely through borrowing or selling other assets. Both options come with their own costs and complications.

The price of everything…

Valuation presents another significant challenge. While publicly traded assets have clear market prices, many valuable things don’t. Small businesses, unique properties, art collections – all of these require complex valuations. This creates uncertainty for both taxpayers and tax authorities, and opens up opportunities for dispute.

You win some, you lose some

Market volatility compounds these problems. An asset’s value can swing dramatically year to year. Paying tax on a 30% increase in share value makes little sense if that gain disappears in next year’s market downturn. The taxpayer has paid real money on theoretical gains that never materialised into actual wealth.

Money doesn’t grow on trees

The administrative burden would be substantial. Both taxpayers and tax authorities would need to maintain detailed records of value changes across all assets, every year. This represents a significant increase in complexity compared to the current system of tracking actual sales.

Some propose hybrid approaches, such as applying annual taxation only to easily valued assets like public shares. However, this creates its own distortions. Investors might shift toward hard-to-value assets specifically to avoid annual taxation, making investment decisions based on tax treatment rather than economic merit.

All by ourselves

Perhaps this is why nobody in the developed world taxes on accrual. Every capital gains-taxing OECD country does so on realisation, not accrual³. Italy did try introduce an accrual system in 1998, but abandoned it after a couple of years due to implementation issues.

While taxing on realisation has its own imperfections, it aligns tax obligations with actual cash flows, so you’ve got money to pay your tax with. That’s a decent foundation to begin with, and you’d think a pretty important one.

This isn’t the solution, but we need a solution

You may well think from all of this that I’m in favour of leaving things the way they are. 

Yes, with respect to this bill, that’s true. But with respect to the system, that’s not. 

What’s super for?

Superannuation in Australia is primarily designed to help people save for a comfortable retirement. Along the way, it’s picked up a few barnacles. Here are a few key reasons for its purpose:

1. Retirement income: Obviously. Superannuation is a long-term savings plan that aims to provide you with something to live on when you stop work. For individuals, that’s supposed to be the goal.
2. To save the Age Pension money: The more you have saved in super, the less you’re able to receive in Age Pension. With young people today on an average salary likely to retire with around $1.5 million in today’s dollars⁴ in their super balance, that means super’s ensuring we’re gradually phasing out a universal Age Pension (and with that, we’re saving money).
3. Non-inflationary rewards for work: Back in the early days superannuation was part of the scheme to give workers more money without chasing inflation, making it worse. Instead of just boosting wages, which could lead to businesses raising prices to cover costs (and then workers wanting even more money, and so on), super was a way to say “Here’s extra, but you can’t touch it yet⁵.” It was deferred compensation, tucked away, not contributing to immediate spending pressure.
4. Investment growth: Part of the idea of superannuation is that it creates a big pool of capital in Australia that can be chasing investments domestically and abroad. It’s part of the benefit, for large public companies, that super funds have increasingly enormous amounts of money under management, because the ‘management’ bit means buying something with it. Big part of that is shares. And you’re not going to be investing all your retirement savings in speculative pineapple farms in Guatemala, are you? Certainly not when you’ve got a nice big healthy Big 4 bank available, that can’t fail, paying dividends like it’s going out of style.
5. Inheritance planning — sometimes: Let’s be honest, we all know someone who’s very excited about using a low-tax vehicle to collect wealth they’ll never need, and never be able to spend, so they can pass it along at a concessional tax rate. Super’s supposed to be for retirement, but with contribution caps being what they are (generous), and tax rates inside super being so low (15%, or even zero in pension phase), it’s become a tempting way to build a nice little inheritance nest egg. It wasn’t the main intention, but let’s not pretend it’s not happening.

Every year, superannuation grows in complexity

Exceptions beget exceptions, loopholes beget loopholes

Every year, there’s a new complaint about what kind of super law change or rule reform is occurring that breaks the trust of self-funded retirees, who want more than anything some certainty that, once planned, you don’t have to go back and re-plan your retirement savings.. It happens under the Liberals — remember Division 293? — and it happens under Labor⁶.

There’s an inherent conflict here between delivering certainty to retirees and delivering savings to the government. Because, after all, the point of this is to tax concessionally in the start of the scheme, to encourage people to put money into their retirement. But an ever-growing share of the population are expected to retire on over $1m in today’s dollars, because they’ve been working in an environment where superannuation has just been paid, all the time, at a higher rate than ever. They don’t need additional incentives to put money away, because there’s a good chance they might already be retiring with too much.

(Again, nice problem to have).

But here’s the rub: in trying to create a concessional environment, we’ve made super very attractive as a means to park money. But that cannot stay that way forever.

(Grand)father Time

Anytime a change is presented that might negatively impact people, it’s said that it should be grandfathered to avoid retrospective application. That’s generally a good idea, and one I support.

But the benefits of decisions made in the past are experienced in the future.

We don’t want a two-tier system, where entrants before a given year are locked in to permanent benefits, and anyone after an arbitrary cut-off date are locked out of those same benefits, even if they’re paying for those benefits via having to pay more in tax to compensate for the lost tax revenue from the generous concessions living on.

But we don’t want to change the rules willy-nilly, either, because certainty is important when you’re dealing with people’s retirements.

That’s why my preference would be to foreshadow changes years in advance, giving people long lead-times, but allow as well for changes to be made.

This complexity is further compounded by the interplay between superannuation and the Age Pension. The Age Pension is subject to income and assets tests, with superannuation balances falling under the assets test. This means substantial superannuation holdings can reduce or eliminate Age Pension eligibility. The mechanics of these means tests, with their intricate calculations and thresholds, are often difficult for individuals to grasp. 

The Age Pension, designed as a safety net for those with insufficient superannuation savings, is subject to means testing. This involves a comprehensive assessment of both income and assets, with an individual’s superannuation balance forming a significant component of the assets test.

The interaction between superannuation and the Age Pension introduces several layers of complexity, including:

• Deemed income: Rather than assessing the actual income — which is hard — generated by superannuation investments, the government applies “deeming” rules. This involves assuming a specific rate of return, regardless of actual investment performance. This deemed income is then factored into the Age Pension income test, potentially impacting eligibility and payment amounts.
• Asset Test taper rates: As an individual’s assessable assets (including superannuation) exceed certain thresholds, their Age Pension entitlement is progressively reduced. This reduction is governed by a “taper rate,” a specific formula that dictates the decrease in pension payments for each dollar of assets above the threshold. Understanding the precise impact of this taper rate is crucial for accurate retirement planning. There’s all sorts of exemptions that apply, or circumstances that might adjust things, but if it was as simple as using a calculator, it wouldn’t be an issue.
• Changes in relationship status: A change in relationship status, such as the death of a partner, can significantly alter Age Pension entitlements. The surviving partner’s assets and income are reassessed under the single person’s thresholds and rates, which can lead to a reduction in pension payments. Nasty.
• Income test complexities: Determining what constitutes assessable income for the Age Pension income test can be impossible. Various income streams, such as annuities, investment property rental income, and share dividends, are subject to specific rules and interpretations. Accurate assessment of these income sources is essential for ensuring correct Age Pension calculations.

The problem with complexities is that they reduce the actual certainty available to retirees who aren’t able to access paid advice. The system, well-designed, shouldn’t require paid advice to navigate.

This is why we need to clarify what the role of superannuation is, and what the role of superannuation is not.

This clarification should involve streamlining the administration of superannuation.

There are simplifications that can be made, and that will need to be made. This will result in winners and losers, like all changes. The system is generous, and Labor is right to identify that. It’s generous because it has to be, to get people to put money away.

But the generosity is becoming the hangover of an era when we needed incentives to put money away. These days, we don’t have a shortage of money going into superannuation. They are doing fine, thank you very much. These days, if anything, we might have too much.

And in this environment, it’s hard to justify endlessly maintaining generosity that’s a relic of a time when it was easy to justify.

But where Labor gets things wrong is that, if you’re going to make changes, make changes that make sense. Do it with long lead times. Explain the rationale. People are capable of understanding more than memes on social media. We can handle a serious conversation.

There’s a cost to letting this money go tax-free forever. It’s a cost that we can redirect elsewhere, to more pressing priorities, like making the Age Pension more generous, for those for whom super is failing to meet their basic retirement standards.

So, we’re going to have to make a change someday soon. I’m open to changes.

…so long as they don’t involve taxing unrealised gains.