The Labor Party is proposing a wide range of policy changes if it is elected on 18 May, and the consequences of most of them are uncertain.
Ironically, the heavy scrutiny on the franking credits policy may be leading to an incorrect remedy, while the subdued response to the proposal on capital gains tax ignores its potential significant implications.
This paper addresses two assumptions in the debate on these Labor policies:
- That pension members in large pooled funds (both industry and retail funds) will continue to receive the full benefit of their franking credits, especially when the fund has a large proportion of accumulation members.
- That the reduction in the capital gains tax discount from 50% to 25% is not worthy of much attention.
1. Trustees have yet to decide how to treat franking credits
Retirees who believe pooled retail and industry super funds are a safe haven for their franking credits may have to rethink that strategy. The argument goes that large funds with a high proportion of members in the accumulation phase pay tax on their super contributions and earnings, and this will always create a sufficient tax liability to fully absorb the franking credits allocated to the fund.
And at a whole fund level, that is true. But for those fund members in pension phase who are currently credited with an earnings rate that reflects their nil tax status, Labor’s policy now becomes an issue.
Under strict super fund rules that insist all fund members be treated without bias, it is possible that fund trustees may decide they should not have franking credits allocated to their accounts because they have no tax due if Labor’s policy is adopted.
The fund’s equitable treatment of members provision may require pension members’ earnings to be adjusted down to reflect the loss of the use of their franking credits.
Let’s look at some illustrative numbers
Consider a hypothetical industry fund of size $140 billion, with approximately two million members in the accumulation phase and about 200,000 in the pension phase. The average account balance across the whole fund is therefore about $64,000. Let’s also assume an average pension account balance of $200,000 and an average accumulation account balance of $50,000. That would imply a total pension phase account balance of $40 billion and a total accumulation balance of $100 billion.
Assume the same asset allocation mix for both pension and accumulation accounts of say 50% fixed interest and 50% Australian equities. Assume also a 5.0% fully franked dividend yield on equities and a fixed interest yield of 5.0%. We also assume the superannuation guarantee 9.5% of an average salary of $60,000 per member in super contributions going into the accumulation fund, uniformly across the year.
Sparing the maths details, these assumptions would yield for the pension accounts $429 million in franking credits, nil tax and an earning rate of 6.1%.
And for the accumulation accounts, $1,123 million in franking credits with total tax due $2,665 million, consisting of $955 million tax on earnings and $1,710 million contributions tax, yielding an earning rate of 5.2%. And the earning rate across the whole fund would be 5.4%.
Total franking credits across all accounts is $1,552 million, which is significantly less than total tax due in the fund, and are therefore fully absorbed.
Under the Labor policy, the pension members have no tax to offset against and would lose the value of their franking credits, meaning the earning rate across the pension accounts would fall to 5.0% from 6.1%. Applying the principle of equitable treatment, 5.0% is the rate that should be credited to the pension fund accounts. That represents a sizeable 18% loss of earnings.
The earnings rate across the whole fund would be unchanged at 5.4% because the accumulation accounts are able to realise full value of the pension accounts’ franking credits as well as their own. But it is currently uncertain how the benefit that would arise at the expense of the retirees’ loss, would be dealt with.
The potential outcome for pension phase members
Pension phase members may be disadvantaged if the principle of fairness is applied to the fund. It has been suggested that some funds could opt to maintain the status quo and declare earnings rates assuming the pension accounts notionally realised the full value of their franking credits. But that would mean that accumulation accounts would in effect be cross-subsidising retirees by absorbing the pension accounts’ franking credits on their behalf. That may be considered unfair by some trustees. And remember, their actions are under increased scrutiny since the Financial Services Royal Commission.
This may adversely impact hundreds of thousands of Australians who thought they were shielded from Labor’s new policy. Retirees thinking of abandoning their SMSFs for large pooled funds should think again and at least wait until the position is clarified.
[Register for our free weekly newsletter and access to our special investment ebooks.]
2. Labor’s capital gains tax change is the sleeping giant
Labor’s proposal on capital gains tax has escaped detailed scrutiny since its announcement, perhaps because it is a one-off event, and tends to be long term by nature. The electorate usually has a short-term focus.
Labor’s policy is that the discount on the taxation of gains realised on assets held for longer than a year will be reduced from 50% to 25%. It will apply to all assets purchased after 1 January 2020 while investments made prior to that date will be fully grandfathered.
In 1999, the Howard Government replaced indexation of the capital cost base for inflation with a 50% discount on the capital gain if the asset was held for longer than a year. The discount became a proxy allowance for inflation, and is generous for assets held for short periods in a low inflation environment.
Get set for a double- or triple-whammy
As well as the reduced discount, Labor intends to maintain current stepped marginal tax rates indefinitely, meaning the one-off nature of capital gains potentially pushes investors into higher tax bands than otherwise would be the case.
Consider a wage earner on $50,000 who buys a property after Labor’s capital gains tax policy takes effect. He sells the property in the 2024/25 year realising a gain of $200,000. After the 25% discount the taxable gain is $150,000, and total taxable income is $200,000. The investor has been pushed from a marginal rate of 32.5% to 47%. With additional tax payable due to the capital gain, of approximately $60,000.
Compare with the same capital gain under the Coalition tax regime. A 50% discount would apply to the gain reducing the taxable gain to $100,000. And with a 30% marginal tax rate spanning income from $45,000 to $200,000 under the Coalition from 2024/25, the investor’s marginal rate does not change from 30%. The extra tax in respect of the gain therefore being $30,000. Just half of that under Labor.
And a high marginal tax rate not only increases the tax take. It can also have a distortion effect on the market, in affecting an investor’s propensity to realise capital gains or not. For example, a high marginal rate incentivises investors to realise losses in a falling market, exacerbating that market. While in a rising market, the investor will not want to realise the gain pushing the market even higher.
When we think of capital gains tax, we often think of property, but let’s not forget that it will apply equally to share investments. And this time under Labor, it is a triple whammy when investing in income-producing, growth equities. Not only is a middle-income investor hit with the non-refundability of excess franking credits when the investment is in the income-producing stage, she will also suffer the reduced capital gains discount and possible higher marginal tax rate when she eventually realises the gains.
The problem with a capital gain is that it is realised at a point in time, and taxed wholly as a lump sum, even though it has sometimes accrued over lengthy periods. In the year that the gain is realised, the capital gain can dwarf other income. It can have a sledgehammer effect.
In an ideal world the gain would be spread out and the taxation would be on an accrual basis annually, against which investment expenses could be offset. And in the case of negatively-geared investments, tax losses would be reduced by the unrealised gains, reducing the burden on the budget and weakening the argument for Labor’s negative gearing policy.
Whereas in the past, taxing capital gains on an accrual basis may have been difficult, it should be easier today using property indices. In the case of publicly-listed shares, valuations are available in the market.
Perhaps the real reform of capital gains tax needs to be considered before jumping straight to an arbitrary change in the discount rate.
Tony Dillon is a recently-retired actuary, with no affiliation with any political party. This article is general information based on a current understanding of Labor’s proposals. It should be read in the context of other arguments in articles such as this and this, where executives from large funds advise they expect to refund excess franking credits.