Straya’s phantom menace tax

The Government’s proposal to tax unrealised gains in superannuation balances over $3 million might go down as one of the most economically reckless policy ideas in recent history.

This proposed tax seeks to impose additional tax at a rate of 15% on realised and unrealised superannuation earnings and gains, on the basis that the tax is applied to the proportion of the individual’s superannuation balance that exceeds $3 million in that income year.

And much like a shadowy force in a Star Wars prequel, the tax while targeting realised gains is also targeting something that hasn’t even happened yet, i.e., phantom gains that may never materialise.

In other words, the proposed tax will capture unrealised capital gains/losses (i.e. annual change in asset value even if nothing is sold) plus actual investment earnings (interest, dividends, etc.), minus personal contributions (to avoid taxing money just added), plus any withdrawals made (because if money is taken out, the super balance reduces for a reason other than poor investment performance).

While the Bill provides that negative earnings can be carried forward and offset against future Division 296 liabilities, it’s a false economy because you don’t get that back in cash, i.e., it’s an offset that might never get utilised.

And according to Treasury estimates, the proposed tax is projected to raise about $2.7 billion annually, and affect ~80,000 Australians.

While the intent may have been to simplify taxation across multiple super accounts, taxing a phantom gain before it’s realised undermines the very basis of long-term investing and fairness.

In short, it’s ill-conceived with enormous unintended consequences that could ripple across asset markets, investor confidence, and everyday Australian businesses.

Still, if these so-called Better targeted superannuation concessions are passed into reality, it will indirectly affect everyone in Straya and not just those with super balances >$3m. This note explains why.

Risk-taking gets punished

If you’re an investor choosing between conservative government bonds and high-growth investments like NASDAQ, Bitcoin, early-stage tech startups, venture capital or even property development, this tax punishes you for taking risk.

Imagine a scenario where you make a huge paper gain on a startup investment or tech stock, but then the market corrects, or the business fails. Under the current proposal, you’d still owe tax on the original paper gain, even if the asset is now worthless. This could force you to liquidate other positions just to cover a tax bill on something that you never actually received.

Here’s a worked example.

Year 1: assume serial startup investor Jim has a balance in super of $4 million and makes a $10 million unrealised gain in a startup investment. In that year he has no withdrawals and has made no contributions and has not earned any interest or dividends (this keeps our calculation purely about the unrealised gain).
Year 2: Let’s assume the startup collapses and the value of Jim’s super fund decreases back to say $3.5 million.

Here’s a summary of what I think happens to Jim’s fund.

What started to look like a win, turned into a barbeque, with a tax on that barbeque because despite the fleeting win on paper, Jim had to pay $1.07m in cash tax on a gain that never materialised because the company collapsed.

And while he might receive a $225,000 tax credit, it’s not cash, rather, it’s a future offset and not worth anything until and unless Jim has enough taxable earnings later on to offset it. If it turns out that he doesn’t, that credit sits there unused.

Maybe my math or interpretation isn’t perfect, but this sort of asymmetry turns risk-investment into a bad joke. Why take entrepreneurial risk if you know you’ll be penalised before realising success? The answer is that you won’t. You’ve just been disincentivised.

Thus, long-term capital will seek refuge in safer (less risky) or offshore environments because it almost always goes to where it’s treated best.

That’s a net loss for our entrepreneurship and job formation and leaves us more reliant on our natural resource endowment.

And it also fuels more demand for higher priced principal private residences, which enjoy a CGT free status. More heat in the property market and bigger, early inheritances for some? Is that what Mr Chalmers really wants?

Additionally, the ASX is anchored by superannuation money, both institutional and self-managed super funds (SMSFs). If super strategies shift toward low-volatility, low-growth assets to avoid tax complexity, the entire market could suffer. That includes the rank and file who are invested in industry super funds that are heavily invested in ASX (and offshore) companies.

In any event, less appetite for risk equals less innovation funding, fewer startups becoming successful businesses, fewer IPOs (already rare due to the current macro), and weaker innovation outcomes across all sectors.

This is not just bad for the 80,000 individuals, but laws dealing with unrealised gains could unmake Straya.

A familiar pain, taken to the limit

SMSF holders already understand the discomfort of paying quarterly instalments based on last year’s realised gains, indexed. Sometimes you're paying tax in advance of gains that haven’t been repeated or might not be.

But this new proposal is a very different beast. Chalmers wants only the wealthy to pay tax on something that might fall apart tomorrow. Hmmm?

So, let’s all try and imagine a country where we're forced to pay tax not on last year’s reality, but on what the value of a portfolio might be at the end of this year, even if it gets barbequed next year and you can’t use the credit.

Even if we didn’t sell a single thing. Even if we made no contributions. Even if a market crash wipes out our gains before EOFY. Even if we have to sell what’s left to pay the cash tax on our phantom gains that are about to be drilled by Chalmers death star laser. Even if it diminishes our retirement funds, instead of building them.

Would you agree to all of that? No, you would not. Nor should any government that’s got decent fiscal policy. And that probably explains it.

If you are caught in the net, would it change how you invest? Yes. Would you shift opportunities outside of super? Yes. Would you consider an even more expensive principal private residence that’s not subject to capital gains tax? Yes.

An inflationary policy? Yes.

On top of that, most wealthy funds have access to international capital markets and global wealth managers, so you can see where some money might be headed.

This is the kind of incentive distortion that risks gutting super’s original purpose, which was to encourage long-term, risk-adjusted investment to self-fund retirement and in the process, to build the national wealth.

Australia should be very cautious before crossing from reality into unreality, or the dark side.

The wealth effect and demand get crushed

As already alluded to, the first casualty of this policy would be the wealth effect.

Wealth effect is the natural increase in consumer confidence and spending that comes when people feel wealthier on paper. Remove that and you instantly put pressure on discretionary spending.

It’s like a fast and furious interest rate hike that intentionally destroys demand.

Still saying it won’t affect you? Well, if you’re in tourism, hospitality (cafés, restaurants), luxury goods, auto sales, home renovations, private education, wealth management, or lifestyle assets, and similar industries, brace for impact.

These sectors benefit directly from cashed-up retirees and financially secure investors.

Undermine super (because if this change gets through more will come) and you undermine confidence, spending and business formation.

But you’ll definitely keep administrators and liquidators in the sort of caviar they’ve already become accustomed to. And banks paying stuff all on deposits will also thank you.

Introduce this phantom tax and 80,000 normally big spending Aussies will be reviewing their purchasing behaviour, and the negative wealth effect will result in less consumption in these and other industries, lower productivity, lower government tax revenues and an increase in the unemployment rate.

Surely this is counter to the purpose of Keating’s vision splendid?

Property prices climb, but not for the right reasons

As faith in super as a tax-efficient retirement vehicle erodes, investors will reallocate, most likely into property.

That means more money flowing into already-hot markets with a shortage of construction workers and still-expensive building materials.

Next, prices will increase and push home ownership further out for first-home buyers. You’ll see some dizzying purchases at the higher end of the scale as affected people front run this perverse tax.

And we’ll then see less productivity/capital formation in the economy overall, given the size of the housing industry and its support sectors.

The wealth effect giveth… and Chalmers wanteth to taketh

What we are seeing is a tax that will incentivise a dangerous mismatch between tax obligations and liquidity, like in the Sweden experiment mentioned in the next section.

If markets rise, super balances swell, and a tax is triggered, even if the portfolio is made up of illiquid assets. That forces asset sales to pay tax on something that may never be realised.

And if the market turns? You’re taxed on the rise, but the fall is yours to carry as per the worked example above.

That’s hardly equitable, nor nation building, and hard to implement, and enforce. But it might help wallpaper over the cracks of falling tax collections from falling entrepreneurship, productivity and GDP, due to an ageing population.

But wait, Wilson Asset Management has a better way

Thankfully, there’s a way out that doesn’t require a tax on phantom wealth.

In their recent submission, Wilson Asset Management (WAM) proposes a practical fix. Their executive summary outlines the issue clearly:

“This paper contends that such a tax is economically unsound, brings with it unintended consequences, and is detrimental to Australia's long-term prosperity. By applying core economic principles—including deadweight loss, Laffer Curve dynamics, and wealth effects—we demonstrate that taxing unrealised gains in superannuation is likely to generate significant economic inefficiencies, discourage investment, and ultimately undermine the retirement security of Australians.”

Hear hear!

In particular, section 5.5.1 of the WAM submission provides some examples and cites Norway’s experience with taxing unrealised gains. It led to a brain and wealth drain, and a net tax revenue loss of US$448 million, compared with an expected gain of just US$146 million. Sweden suffered similarly, facing unexpected liquidity mismatches after capital flight followed its wealth tax.

Importantly, WAM believes the Government’s original intention wasn’t to tax unrealised gains, but simply to make tax calculation easier for individuals with multiple superannuation accounts over $3 million.

Here’s what they recommend:

“In reality, the majority of individuals with a balance of this size only have one fund or could easily rearrange their superannuation affairs by the time the legislation commences so that they have only one fund. If an individual only has one fund, the taxation of realised earnings could be easily calculated on balances over $3 million, therefore removing the requirement to tax unrealised gains. We propose that taxpayers who have only one superannuation interest should be able to elect to have this additional tax applied to that one fund, and as a result, only pay tax on actual realised taxable earnings.”

Well, it’s simple and fair. And it preserves the integrity of the system.

WAM reiterates what happens if the tax becomes a reality:

“By applying core economic principles, including deadweight loss, Laffer Curve dynamics, and wealth effects, we demonstrate that taxing unrealised gains in superannuation is likely to generate significant economic inefficiencies, discourage investment, and ultimately undermine the retirement security of Australians.”

The wrong fight, the right fix

Taxing unrealised gains is being spun as a fairness measure, but it’s out of step with global norms and fundamentally flawed because it:

Disincentivises risk and innovation.
Distorts investment behaviour, causes liquidity mismatches and capital flight.
Pumps up property prices while depressing risk asset prices.
Barbeques capital formation from risk taking by pricing out risk.
Triggers spending contractions, particularly in sectors still recovering from COVID lockdowns.
Undermines super as a retirement tool.

If Canberra listens to WAM and others, a clear and rational fix is already on the table. Without it, Australia risks fighting the wrong enemy, its own prosperity.

We go from the lucky country to the lazy country, without passing go and without collecting our $200… because the Government’s already got it.

The Force may be with Canberra, but at the moment it’s definitely not the right shade. Let’s hope an alternative door in the force opens.

See you in the market.

Mike