Professor John Piggott | CEPAR

Australia is lauded throughout the world for its retirement income structure. Although it is largely unappreciated at home, we are in an enviable position when compared to the implicit pension debt being racked up among our OECD counterparts. As a paradigm, it has everything going for it – income protection for the less well-off, cost containment, and mandatory minimal levels of mandatory self provision for those who can afford it.

But successive governments put the whole structure at risk by tinkering with super taxes.  No country has borne more capricious changes to the taxation of its private pensions than Australia.

It’s worth taking a step back from the current controversy to reflect on three questions. First, what should a pension tax system look like? Second, why should Australia’s pension tax system be subject to so many more changes than its counterparts elsewhere? And finally, why does it matter if Canberra fiddles?

Almost all countries offer tax concessions for pension saving. The implicit deal is, preserve your savings until you retire, and get a tax break.  The most common break is exempting the investment earnings of the pension fund. Then either contributions are deductible under the personal income tax, or benefits are tax-free.

On the whole, taxing benefits is the better way to go. This avoids complexities around employer deductions for pension contributions, and bad investment outcomes are cushioned through lower taxes, while investment outcomes above the norm pay some extra tax. The government shares the risk. The timing of tax collections is better too – tax revenues will increase when an expanding older population cohort is driving public expenditure up.

But whether contributions or benefits are taxed, as long as investment earnings are exempted, economic efficiency is well served. You have a system that closely aligns the tax treatment of super with the tax treatment meted out to the other major life-cycle asset – owner-occupied housing. This is a critically important aspect of the policy design.  In their roles as retirement saving vehicles, these two retirement assets should be treated similarly under the tax system. And by exempting earnings, the price distortion between consumption during working life and consumption during retirement is largely eliminated.

Australia’s super tax departs from both these standard paradigms. Instead, it separates superannuation taxes from personal income tax altogether. Contributions are income tax exempt, but taxable at a flat rate in the pension fund; earnings on those contributions are also taxed. And benefits used to be taxed as well, until the 2007 Better Super reforms exempted benefits paid to those over 60. The result is that there is no link with the progressivity inherent in the personal income tax.

Separating superannuation taxes from the personal income tax makes tinkering with pension taxes tempting for governments. Changes can be made without their showing up in a pay packet the next week.

This has happened several times since the Superannuation Guarantee was introduced, and it looks like it’s about to happen again. What is proposed may be a small step in the direction taken by the Henry Review on this issue, which accepted contributions taxes were here to stay, but recommended that the rebate be linked to the personal rate schedule. It also recommended a reduced earnings tax to help the power of compound interest generate more accumulations.

If that’s the direction of change, then it would be better to take the proposal in its entirety, rather than just apply it to the top 1%, as news reports suggest is likely. And this should be well thought out, converging to something stable, with discussion and consultation, not a last minute cash grab.

Not that the top 1% is taxed especially harshly in Australia. A somewhat higher marginal tax rate for the top 1%, say 49% above $250,000, maybe on a temporary basis, would be a better response.

So, why does the tinkering matter? Two important reasons. First, this is a whole-of-life issue, and long-term planning is part of it. Although some rules are bound to change with time, surprises are bad and should be avoided whenever possible. Once you get to a point where arbitrary policy surprises are expected, credibility in the system evaporates. The top 1% today, the top 5% tomorrow, who knows the day after?

People will likely reduce their non-mandatory contributions, saving will fall, eventual reliance on the age pension will be higher than it would otherwise have been, and most importantly, many people will have a less satisfying retirement.

Second, change increases administrative costs and charges. More records have to be kept, checked, and transferred when the worker changes funds. Australia’s pension costs are already on the high side. Through a full career, increasing charges by just a half percentage point can reduce the eventual accumulation by more than 10%. That impacts on everyone’s super outcomes, not just the top 1%.

Professor John Piggott is director of the ARC Centre of Excellence in Population Ageing Research at the University of NSW.

This article first appeared in the Australian Financial Review 30 April 2012.