Only a fraction of Australia's half-a-million self-managed superannuation funds pay any income tax, experts say, because of generous super concessions and franking credits that are undermining the federal budget.
Tax Office statistics show almost 300,000 self-managed superannuation funds eliminated or reduced their tax bills through exemptions on super and $2.5 billion in franking credits in 2011-12.
These are the most recent records available, although experts say the surge in dividend payments since then has further reduced the small amounts of tax paid by these funds, which are often the primary income of wealthy retirees.
At the time, 424,360 funds generated gross taxable income of $32.9 billion. About $15 billion of that was entirely exempt from income tax because the funds were in the pension phase, which doesn't incur income tax.
Self-managed funds contribute little to the tax system – because about half of the funds' assets are already in the pension phase, Tria Investment Partners principal Andrew Baker said. Also, most self-managed funds receive franked dividends, which cuts the tax bill of many other funds to zero.
"It's a problem isn't it?" Mr Baker said. "It's unlikely SMSFs are ever going to pay a substantial amount of tax as a segment."
The loss of revenue will rise because of an ageing population shifting assets into pension phase and the greater payment of dividends, he said.
Pressure is growing to focus on superannuation tax breaks in the Coalition's planned review of the taxation system. The government is desperate to find ways to reduce the budget deficit.
There have been frequent calls for the government to stop the concessions. The head of the Financial System Inquiry, David Murray, recently suggested Australia's dividend imputation system, which SMSFs are also capitalising on, needed to be looked at.
The roughly 1 million Australians with investments in self-managed super funds argue that having spent their careers paying income tax and following the rules they shouldn't be penalised for saving for retirement.
"Super funds, including SMSFs, are taxpayers, and franking credits should be available to all taxpayers," SMSF Professionals' Association of Australia's technical and professional standards director Graeme Colley said.
Experts say it would be better to tax the earnings of superannuation funds in pension phase at 15 per cent, rather than try to get rid of franking credits, which could see share prices plummet.
A fundamental change
Australia and New Zealand are now the only two developed countries that have full imputation of dividends.
Mr Baker said scrapping Australia's dividend imputation system, would involve "a fundamental change to the taxation system" that would be hard to implement. He said a better way to address the problem was a 15 per cent earnings tax for those in the pension stage. Another option was to copy the United States' minimum taxation rate, "that in short says everybody pays an amount of tax".
Ending franking credits could trigger a political backlash from investors and "would be reintroducing double taxation, so there are enormous problems with it", Mr Baker said.
"The UK did a similar thing 15 years ago, denying pension funds franking credits, and they got away with it . . . despite the protest." He said a tax rate on the pension phase would also stop gearing by SMSFs.
Tax Office data shows SMSFs have an interest expense bill of about $375 million a year, but Mr Baker said that's just the tip of the iceberg.
The data comes from SMSF tax returns, but it is common for SMSFs to achieve gearing outcomes by investing in private property trusts. He estimated the overall interest expense for the sector would be about $500 million annually.
Grattan Institute chief executive John Daley said any change to dividend imputation would have to be part of a package that also reduced the company tax rate and personal tax rates.
He said the difficulty with scrapping imputation was that it would "create incentives for companies to hoard capital rather than returning it to shareholders, which may reduce the efficiency of investment decisions".
Instead, the government should wind back superannuation tax breaks for the old and wealthy. "The easiest way to do this would be to tax the income and capital earnings of super funds in pension phase at 15 per cent," Mr Daley said. "These funds would then pay tax on earnings at the same rate as the super funds of those aged under 60."
He said there was no reason to grandfather this change.
"Anyone who is in pension phase can withdraw the entirety of their super fund tomorrow, and if they think they can find an investment on which they will pay less than 15 per cent tax, good luck to them," Mr Daley said.
"I'm guessing that there will be very few withdrawals."
'It ain't going to happen'
At the end of 2012, the average SMSF had $920,000 (typically funds are made up of more than one person: couples).
According to a 2012 ASX study, about 52 per cent of SMSFs directly hold Australian shares. Tax Office data shows of the $550 billion invested in SMSFs, $180 billion is directly invested in Australian-listed shares, which is already higher than the average of APRA-regulated funds.
Leading economist Saul Eslake said he was "undecided" about whether dividend imputation should be scrapped, although he had previously mentioned it is a costly tax break that the wealthy use to lower their marginal tax rates.
He said that like negative gearing, there are now so many who benefit from franking credits – SMSFs, investors and members of larger public or industry super funds – that "no matter what the intellectual merits of getting rid of it, it ain't going to happen for political reasons".
"Almost certainly, the benefits of franking credits are capitalised into the share prices of companies that have high franked dividend yields, so it seems almost inevitable that abolishing dividend imputation would cause share prices to fall, unless there were an equivalent reduction in the company tax rate," Mr Eslake said.
David Murray said in his review of the financial sector the imputation system – first introduced in 1987 and estimated to cost about $20 billion a year – had created a bias where individuals and super funds preferred shares and this had hindered the growth of the domestic corporate bond market.
PwC's submission to the Murray inquiry said "careful consideration should be given to whether there would be benefits to be obtained from modifications to the imputation system"