Tax insights point to a simpler way

Taxes and death are often given equal billing in terms of certainty and popularity but when it comes to complexity our tax system seems to be a clear winner.

It is the cost of that complexity that the Australian Government is targeting with its review of the tax system being led by Treasury Secretary Ken Henry which prompted the public release of a major paper titled Architecture of Australia's tax and transfer system this week.

The size of the task facing Henry and the team is well illustrated by the report - all 336 pages of it - and it provides an interesting insight into our system of taxation and how the revenue is redistributed within our community.

If it feels like you are being taxed every time you turn around you may like to know we have a grand total of 125 taxes - 99 of them under the federal government's control, 25 from state governments and a solitary one by local government.

But 90% of the revenue is raised from just 10 taxes with income tax, GST and fuel taxes being the big ticket items.

The total tax take in 2006-07 was $262 billion but the good news is that when compared to the 29 countries in the Organisation for Economic Co-operation and Development (OECD) we are a relatively low taxing nation - eighth lowest in fact.
This report is not making recommendations - we will have to wait until the end of next year for that - rather setting the context and raising the issues the review will focus on.

But a key issue it raises in an investment context is the mix within the Australian tax system between taxes on labour income, capital income and consumption. For investors it will probably come as no surprise that Australia has one of the highest personal tax rates on capital gains.

What is perhaps not as well understood is that tax on savings and investment, according to the paper, represents about one-third of government total tax revenue. That puts us well up the OECD league tables - a top four position in fact - when it comes to taxing earnings from capital.

This raises an interesting issue particularly at a time when sharemarkets have suffered a pummelling for the past 12 months. Our tax system offers tax concessions on capital gains tax rates for growth assets held for more than 12 months and that undoubtedly influences the way portfolios are put together.

Investments in defensive assets like term deposits and fixed interest vehicles like bond funds are taxed at full marginal personal tax rates. The issue raised in this paper is whether that mechanism is really fair.

For example, the report gives the example of a taxpayer with $1,000 in a bank account earning 6 per cent interest and inflation eroding its value at 2.5 per cent.

Under a nominal income tax system the full $60 of interest earned is subject to tax,
but if the inflation component is excluded, only $35 is subject to tax.

There is no doubt our tax system is a powerful influence on how we invest and construct portfolios. Would people hold more fixed interest investments in their portfolio if the tax treatment was more attractive - almost certainly.

Market volatility over recent months has taught many investors the value of fixed interest as a diversifying, risk control component of their portfolio.

It is early days - and the tax review has a massive job ahead to simplify the way the tax system interacts with other arms of government like social security - but it is encouraging that the tax review is considering how these type of impacts are distorting savings and investments.