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What might the Tax White Paper say on imputation and CGT?

A tax question to Cuffelinks from Julie

I believe that the forthcoming Tax White Paper may address issues such as franking credits and capital gains discounting for taxation purposes.

Please can you tell me if you think these issues are under review?

I have heard that it is more than likely that franking credits will be abolished along with the 50% discount afforded to personal and business capital gains. These two items are of great interest to me and I was rather taken aback at the expectation these would be made redundant.

I have been reading your weekly newsletters since your inception. Fantastic!

Any thought on the eventuality of these two events and the response of the markets and various investments would be greatly appreciated.

Kind regards, Julie

The Financial System Inquiry noted many tax issues which need to be addressed by the forthcoming Tax White Paper. It was expected before the end of 2014, but its release has been delayed. If the current political malaise results in such a cautious policy approach that any controversies are avoided, then a wide range of issues that David Murray’s Inquiry wanted addressing will be left on hold indefinitely.

We asked Gordon Mackenzie, Senior Lecturer in taxation and business law at the Australian School of Business, University of New South Wales, for his personal opinion on Julie’s question.

Australia is the only developed country that still has a full dividend imputation system. In the more common and classic corporate tax system, the company pays tax and then the shareholder also pays tax on any distributions, which means:

  1. two lots of tax on the same corporate profits
  2. debt finance is cheaper as interest is tax deductible but distributions to shareholders are not
  3. there is an incentive not to distribute dividends because of the second tax.

I believe adverse changes to imputation credits on company dividends would be politically unwise as they are very popular among mum and dad investors and super funds. Traditionally, although the value of imputation credits is not included in equity valuations, they are greatly appreciated by retail investors, who chase them to improve their yield after tax. Change to capital gains tax is also unlikely to go ahead as most countries differentiate between regular income and capital gains.

Gordon referred us to his 12 December 2014 article from The Conversation (edited here slightly to avoid duplication) for a broader overview of current taxation issues.

David Murray’s Financial System Inquiry called for the removal of superannuation tax breaks but the government’s tax discussion paper is unlikely to advocate similar changes.

The FSI report recommends articulating the overarching purpose of the superannuation system so that future tax changes can be measured against the objective.

It says the purpose of superannuation is to “provide income in retirement to substitute or supplement the age pension”. This then prescribes, in theory at least, the tax breaks individuals can get from the system.

In this case, the maximum tax break an individual should get from superannuation would be roughly equal to the net present value of the age pension paid from age 65 to the median life expectancy.

The age pension is designed to keep people out of poverty after they leave the workforce. Yet how does the Inquiry’s definition of superannuation fit with financial planning theory which says that people need to aim for 70% of pre-retirement income to maintain their lifestyle?

It makes redundant any discussion about whether the current compulsory contribution limit of 9.25% provides an adequate retirement income. It also implies that superannuation should attract few tax breaks.

However, this raises the question of whether the tax system should be used to encourage saving, either through superannuation or outside it. There are four reasons why the tax system should not be used for this purpose.

The theory is don’t use taxes to incentivise saving

First, the tax revenue forgone through the concession is borne by all taxpayers, while only those using the concession benefit from it.

Second and third, tax benefits only go to the wealthy who have disposable income to save and who have access to information to maximise the benefits of saving, such as accountants and lawyers.

Finally, tax concessions don’t increase savings, they just move preferences to where people save. But the reality is that they are used.

The report observes that superannuation tax breaks distort behaviour and favour the wealthy. However, a number of its observations will be difficult for the government to implement.

The inquiry report endorses Ken Henry’s tax review recommendation to reduce the tax benefits of popular negative gearing investing as well as the over-taxation of income from deposits. It also advocates that income from large superannuation balances should attract more tax, however this has a whiff of retrospective tax about it.

Another suggestion that post-tax contributions should be further limited is also unlikely to be adopted by the government. Few people use these concessions and they benefit empty nesters who are selling down to enjoy a hipster inner city lifestyle rather than those trying to minimize their tax obligations.

The report says the system that taxes super earnings at 15% in the accumulation phase but not in the retirement phase, leads to asset allocation distortions, tax arbitrage and prevents funds offering “whole-of-life” financial products. However, it is doubtful whether any of these problems are tangible and important enough to warrant changing the system.

Finally, the report suggested removing the company share dividend imputation system and reviewing the capital gains tax discount. Interestingly, the report argues these incentives distort asset allocation yet both these measures were introduced with the intention of removing tax distortions. Imputation credits were introduced to lower the cost of capital towards equity rather than debt funding. The capital gains tax discount was introduced to prevent the over-taxation that potentially arises from capital gains all being taxed in one year at higher marginal tax rates.

Government unlikely to implement super tax changes

Should these tax observations be included in the tax issues paper? They seem to warrant considered discussion but with two overarching caveats.

First, superannuation is a very long-term savings vehicle and changes reduce confidence in the system.

Second, savings in the system are there based on the good faith continuance of existing tax laws. In the past 35 years there have been only minor changes that adversely affected existing superannuation account balances.

However, the chances of the government implementing these tax changes are slight.

Though Treasurer Joe Hockey backed the report’s recommendations to lower fees for super funds, it is unlikely that many of the report’s observations in terms of tax will go ahead.

Adverse changes to the superannuation system are off the table for the first term of this government apparently. If superannuation tax breaks are measured against the age pension, a significant proportion of the population will be adversely affected.

 

This article is reproduced from The Conversation. The comments are the views of Gordon Mackenzie and are not made in the context of any investor’s personal circumstances. Readers should obtain professional advice before acting on any investment decisions.

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