As debate flares about what the objective of superannuation should be, everyone seems to agree on what it shouldn’t be: A taxpayer-subsidised inheritance scheme.

Yet that is exactly what super has become.

Tax breaks on superannuation mean less tax is paid on super savings than other forms of income.

Super tax breaks cost the budget up to $45 billion today, and could cost more than the age pension by as soon as 2036. Much of the boost to super balances from tax breaks is never spent.

By 2060, one-third of all withdrawals from super will be via bequests – up from one-fifth today.

The government’s plan to limit tax breaks on earnings on balances larger than $3 million is a good start. But the government should go further – the threshold should be lowered to $2 million.

Rein in tax breaks

Australians with more than $2 million in super should not benefit from generous tax breaks on earnings.

Only a tiny minority of Australians – about one in every 200 super fund members in 2019-20 – has accumulated more than $2 million in super.

Yet these accounts contain almost one in eight dollars in the super system, or almost as much as the accounts of the two-thirds of Australians who have less than $100,000 in super.

There is no reasonable rationale for generous tax breaks on balances between $2 million and $3 million. People with that much in super will have a very comfortable retirement without taxpayer support.

Dropping the cap to $2 million would save the budget a further $1 billion a year.

The earnings tax breaks on balances larger than $2 million can easily end up being more than poorer retirees get from the age pension. It’s unlikely much, if any, of this boost will get spent in retirement, which means earnings tax breaks just end up subsidising bequests to the children of well-off parents.

Unlike the government’s $3 million threshold, a $2 million threshold should be indexed in line with inflation right away.

Treasurer Jim Chalmers says super tax breaks may not be sustainable alongside the goal of budget repair. Photo: AAP

Manageable challenges

Levying a higher tax rate on the earnings of large balances is complicated by the fact existing super earnings taxes are levied at the level of the super fund, not the individual member account.

The government plan to levy a 15 per cent surcharge on the implied earnings of the super fund over the year (the change in account balance, net of contributions and withdrawals) is the best approach available.

It strikes the right balance between the need to apply the tax in line with the income earned (which would normally account for capital gains) and the need to limit the regulatory burden on super funds in order to administer the tax.

This approach will impose tax on unrealised capital gains on superannuation, with super fund members offered the choice of paying any tax liable on unrealised gains from within the fund, or from outside super.

The 2010 Henry Tax Review highlighted a number of benefits of shifting to taxing capital gains on an accrual basis, compared to taxing realised gains, including removing incentives to ‘lock in’ investments to hold onto untaxed capital gains while moving quickly to realise losses.

Taxing unrealised gains could create cash flow problems for some self-managed super fund (SMSF) members who hold illiquid assets, such as property, and will be required to pay tax before realising those gains.

But these problems shouldn’t be overstated, for three reasons.

First, about 85 per cent of accounts larger than $2 million are held by people over the age of 60 who are likely to be in draw-down phase and must already have enough cash on hand to pay out pensions each year in line with the ‘minimum draw-down’ rules.

Second, the tax does not have to be paid from super, and Australians with large super balances typically earn as much income from investments outside super.

Third, the first tax bills from the policy won’t be sent out until after 2026, which gives SMSF trustees plenty of time to update their investment strategies to be consistent with their new potential liquidity requirements.

Under superannuation law, SMSFs are also required to have an investment strategy, and that strategy must ensure the fund has sufficient liquidity to meet its obligations.

A $2 million threshold presents an opportunity to simplify the system. Super tax is notoriously complicated, and no aspect is more complicated than the transfer balance cap.

Yet a $2 million threshold would also allow the transfer balance cap – which governs the maximum amount new retirees can bring into the tax-free retirement phase – to be abolished.

A $2 million, inflation-indexed threshold would align with where the transfer balance cap, currently set at $1.7 million, should be by 2025, allowing it to be replaced.

Retirees could have all their savings in a single account and simply pay a higher rate on earnings above the $2 million threshold to reflect the fact that their initial tax rate is 0 per cent (probably about 23.5 per cent after accounting for franking credits and capital gains discounts).

It’s a long road back to making super tax breaks equitable and sustainable.

The Albanese government has taken the first sensible step, but there will need to be many more.

Brendan Coates is economic policy program director and Joey Moloney is a senior associate at Grattan Institute. They are the authors of Grattan’s new report, Super savings: Practical policies for fairer superannuation and a stronger budget