Chalmers Was Right

Why the "controversial" tax was fine. Good even!

It’s all water under the bridge now, but for what it’s worth, I think the government’s original plans for superannuation reform were underrated by much of the commentariat.

Take a recent AFR article by Richard Holden — one of Australia’s sharpest economists — who, reflecting much of the prevailing mood, argued that taxing unrealised capital gains would create all sorts of distortions, discouraging investment, dampening capital accumulation, and edging Australia down a slippery slope towards Elizabeth Warren–style wealth taxes.

I think that criticism is vastly overdone.

Liquidity Tap

One of the main downsides of taxing unrealised gains is that people may lack the liquidity to pay the tax. And that’s certainly true if we levied the tax on elderly pensioners who have made large the paper gains on their Sydney properties but who live on a very modest income.

But for superannuation accounts that problem largely doesn’t exist. The vast majority of super funds — even self-managed superannuation funds (SMSFs) — hold highly diversified portfolios, much of which are in liquid assets such as shares and listed trusts. Indeed, statistics from the ATO confirm that less than 1 per cent of SMSFs are totally invested in a single non-residential asset - “the family farm” scenario so often cited by critics.

Other SMSFs fully invested in illiquid assets such as unlisted trusts make up a tiny sliver of these self-managed superfunds. Furthermore, it’s highly likely that for even this tiny sliver, the vast majority would not be exposed to the superannuation tax as only around 4% of all self-managed super funds that are 100% invested in a single asset having anything close to the $3 million dollar threshold. In other words, the liquidity constraint argument — the strongest case against taxing unrealised gains — doesn’t really apply in the context of superannuation because almost everyone has a highly diversified and liquid portfolio.

Two Wrongs Make a Right

What about the claim that the tax would it distort behaviour? Possibly. But one of the key motivations for introducing the tax is that it actually corrects an underlying distortion built into the current system.

Right now, superannuation accounts are taxed at 15% during the accumulation phase — that is, while you’re working and contributing — and at 0% once you hit retirement and enter the pension phase. The problem is that this setup creates a powerful incentive to defer realising capital gains until after retirement when they can be realised completely tax-free.

How does this work in practice? Imagine someone places their family farm inside a superannuation structure. During their working life, they run the farm in a way that minimises any distributions or dividends, avoiding even the modest 15% tax rate and instead accumulating more capital to boost the paper value of the farm. Then, upon entering retirement — when the tax rate drops to zero — they sell those assets and realise all those accumulated gains tax-free.

In the most extreme cases, this allows wealthy individuals to reduce their lifetime tax burden to practically zero by deferring income and gains until they reach the tax-free pension phase. It’s hard to think of a clearer distortion to economic behaviour — or a better example of how the existing rules unintentionally encourage tax arbitrage.

The new design will help solve this problem a bit with taxes on earnings only, but I suspect a new game will arise getting super funds to realise all gains before you hit a new threshold and to hold off realising capital gains until you dip back below one as you draw down your account.

Super Capital Accumulation

What about the argument that it would destroy the incentive to invest in capital would an additional tax on super discourage some investment or wealth generation at the margin? Sure. But if we take that argument to its logical extreme, we’d be forced to conclude that all taxes on super should be abolished — which is clearly not what anyone is proposing.

In reality superannuation is one of the least elastic forms of investment when it comes to tax rates. For one thing, most people can’t withdraw their super until they reach retirement age so even if tax rates were increased it would be impossible for the capital to leave the system. For another, a large share of contributions are compulsory so even the tap running into the super system is difficult to turn off. Finally even after the proposed reform, the tax treatment of super remains highly concessional compared to almost any investment outside the system.

Unless you plan to liquidate the family farm and spend those millions immediately, you’re still far better off keeping your money in the super system — where it enjoys preferential tax treatment — than pulling it out into the real world, where you’ll pay income tax like every other working schlub.

The Dark Matter Theory of Economic Reform

Finally, I’d cite what I call my dark matter theory of economic reform. If you find a Treasurer out there advocating for a piece of economic reform, there’s a good chance they’ve been presented with convincing evidence by the boffins at Treasury that it’s worth doing.

I’m not aware of any published research quantifying how common the “defer capital gains until pension mode” tax strategy actually is. But if anyone has both the data and the incentive to track it down, it’s Treasury. And if Treasury forms a strong view on something, that view tends to find its way to the Treasurer’s desk.

Given what we know — that the measure would have affected ~80,000 households yet was forecast to raise billions of dollars in additional revenue — my suspicion is that this form of tax arbitrage wasn’t merely theoretical. It was real and common enough among the wealthiest super holders for Treasury to want to close the loophole.

That’s speculative, of course, since we don’t have the hard data. But in the absence of such data, the simplest explanation is usually the right one: the reform existed because a genuine distortion existed — and the people best placed to see it were already looking right at it.

In the end, this was never about punishing success or creeping toward a wealth tax. It was about patching a hole in the hull of the ship before the rich started sailing off tax-free into the sunset.

If that counts as radical reform in Australia, then perhaps the truly radical thing these days is simply insisting that the rules apply equally to everyone — even the ones with very large supers and very good accountants.