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Tax and the financial planning process

A perfect tax system would not affect how people save and invest, but in practice, there are many ways that Australia’s tax system influences investor behaviour.



With the forthcoming Government White Paper on the Australian tax system and some comments that the Murray Inquiry made with respect to tax and the financial system, it is timely to have a look at where tax fits into financial planning.

An indicator of a good tax system overall, as the public finance economists love to say, is that tax should not impact on economic behaviour. Or, to put that another way, taxes should not ‘distort’ economic activity, which in the context of financial planning, means taxes should not ‘distort’ where individuals save because, after all, financial planning is just saving and investing.

All very well in theory. However, this is not the case in the real world and taxes can have a significant effect on how individuals save. In fact, the Murray Inquiry highlighted six different ways in which the Australian tax system distorts the way individuals save and it is these that will come under review with the Government White Paper.

So what are they and how do they affect the way a person saves?

  1. Tax affects asset selection by individuals. That is, tax impacts on which assets an individual (or SMSF) will hold. Probably the best example of this is Australian company shares that pay imputation credits. Investors will actively seek out this class of investment specifically to get the tax effect of dividend imputation.
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  2. Taxes affect asset allocation by individuals. That is, tax impacts how much a person will invest in or allocate their savings to each type or class of asset. Perhaps the outstanding example of this is the family home, which is tax exempt and is the asset class owned by the majority of Australians.
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  3. Tax affects how much individuals will borrow. The Henry Review noted that the Australian tax system of negative gearing actually incentivised people to ‘gear up’ for favourable tax advantages.
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  4. Tax affects asset location. In other words, tax affects where the assets are held. SMSFs are the best example, and they have become the preferred holding vehicle for many people’s wealth.
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  5. Tax affects whether individuals will invest directly or use a financial intermediary. The tax affects here can be subtle, such as the use of carry forward tax losses, which is not as effective in financial intermediaries when compared with investing directly. Some retail and industry superannuation funds do not handle the transition from accumulation to pension efficiently when compared with SMSFs.
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  6. The Australian tax system affects when to dispose of an asset. Individuals get a 50% tax discount and SMSFs get a one-third tax discount if they wait at least 12 months before disposing of the asset.

Although the theory is that the tax system should have no bearing on how people save and invest, these six differences will come under serious scrutiny by both Murray and the Government White Paper.

 

Gordon Mackenzie is a Senior Lecturer in taxation and business law at the Australian School of Business, University of New South Wales.

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