Mark LaMonica: Welcome to another episode of Investing Compass. Before we begin, a quick note that the information contained in this podcast is general in nature. It does not take into consideration your personal situation, circumstances or needs. 

Shani Jayamanne: It is very uncommon for government policy changes to have a clear, immediate and direct impact on an individual’s ability to consume and save. Especially for investors, we’ve seen many studies debunk the connection between economic growth and market performance.  

LaMonica: Today, we’re going to speak about stage three tax cuts. The stage three tax cuts are a hotly debated policy item, and it is a policy rarity in that it has an immediate impact on individuals and their capacity to consume and save. With stage 1 and 2 already completed, stage 3 focuses on high income earners. The cuts remove the 37% marginal tax rate, and it drops the 32.5% marginal tax rate to 30%. These tax cuts are proposed to be effective 1 July 2024.  

Jayamanne: In effect, this means that someone earnings $46,000 will pay the same tax rate as someone earning $200,000. It also means that high income earners will be receiving a significant bump to their take home earnings, with those currently in the highest marginal tax rate receiving the sweetest deal. 

LaMonica: For someone earning $150,000, that’s an increase of $3,974 per year. For someone earning $180,000, it’s an increase of $6,074 a year. For those earning $200,000, it’s an increase of $9,074 a year.  

Jayamanne: And just as a disclaimer – these amounts don’t include the Medicare levy, or the Medicare levy surcharge. 

LaMonica: You can see where this tax cut runs into some controversy. The argument to repeal this stage is that the removal of a tax bracket is increasing inequality in Australia.  

Jayamanne: The counter argument is that many Australians have experienced ‘bracket creep’ – when wage growth results in lower income workers creeping into higher brackets (plus, “everyone else has had a tax cut, where’s mine?”).  

LaMonica: The counter-counter argument to this is wage growth has stagnated. 

Jayamanne: Maybe we can take a lesson from the UK. In 1696, they introduced a window tax in an effort to make the tax system more progressive. The tax outlined that you would pay a surcharge based on how many windows that you had in your home.  

LaMonica: It was theorised that the poor would naturally have less windows and would be taxed less. Although this may have been true in rural areas, those in urban centres would be living in shared accommodation with way too much natural light for their tax bracket. 

Jayamanne: This of course led to creative forms of tax avoidance – boarding up windows and constructing houses that were practically unliveable with no natural light in some rooms.  

LaMonica: Maybe window taxes aren’t the answer –taxes will always be a balancing act between scalable policy that serves the majority, gathers enough revenue and pleases enough constituents to stay in government. Whichever side you sit on in this debate, it seems as though the Albanese Labor government will continue with the cuts.  

Jayamanne: Regardless of your political persuasions, as investors we must focus on the real outcomes of policy and what it will mean for you. If you’re a high-income earner, this means more cash. We like to think that our job is to help you navigate the current and future environment – market, tax, regulatory – all of it, within the confines of your circumstances. 

LaMonica: And for high income earners, the increase in cash flow associated with the stage three tax cuts seems to be a very possible reality. 

Jayamanne: It is easy for many of us when we receive a pay increase, if we come into a bonus, or we receive unexpected cashflow to allow for lifestyle creep to set in. Lifestyle creep occurs when your expenditures grow with your income. This isn’t always bad – I spend more money than 20-year-old Shani. I also don’t live in a share house and eat cheese toasties most nights for dinner (although occasionally, I do still indulge in my ‘student nachos’ – a horrifying meal of corn chips, salsa and melted cheese). It seems that as well as my quality of life, my culinary tastes have improved.  

LaMonica: We make money to live, and we want to live comfortably. The difference is the intention. Intentional spending gives us control over the outcomes of our money. When we have extra cashflow, intentional actions can mean the difference between spending it without much improvement to your life, and intentionally directing it on things you truly value.  

Jayamanne: Combine extra cashflow with time. It could mean a holiday sooner, paying off your mortgage earlier, or having enough of an emergency fund to provide peace of mind and prevent discomfort. 

LaMonica: We asked investment professionals from Morningstar what they’d do with the cash across three income levels. Surprisingly, none of them suggested more windows.  

Jayamanne: But maybe let’s start with us. Mark – what would you do with the extra money, at each of the levels – or just with extra cashflow in general? 

LaMonica: A tax cut of this magnitude is effectively the equivalent of a raise so I will be following the process I have gone through with each raise I’ve received in my career. I have always tried to be deliberate and structured with the way I’ve handled raises. When I was younger it occurred to me that a raise was both an opportunity but also a risk to my financial wellbeing. I saw many people simply let lifestyle creep take over as their salaries increased. There are always more ways to spend more money and ultimately after an initial period of pleasure that comes from increasing our spending it quickly becomes a new bare minimum or floor to our lifestyle and we devise new things to spend money on if only our salary would increase. Spending more also has other financial implications because it means that we should increase our emergency fund savings to match the increase in expenses and it becomes harder to save for retirement as we need a larger portfolio to support a more expensive lifestyle. 

As I got each raise and with this upcoming tax cut, I take the time to reassess my goals. Am I saving enough towards my goals and could increased saving bring down the required rate of return needed to achieve my goals? A lower required rate of return increases the likelihood that a goal is achieved. In my current situation I have two main goals that I’m trying to save towards. The first is retirement and in this case, I am comfortable that I am on track to achieve my goal and that my required rate of return is reasonable and does not need to be brought down further by increased savings. My next goal is to use investment accounts to fund travel through income generated from my holdings. My plan is to have a new account switch to paying out income to pay for travel every five years. In this case my next account which will raise my travel income by ~50% will kick in during 2024 when I turn 45. I do not believe that increasing my savings into this account is needed given the scale of the increase in income that is due to kick in at my 45th birthday. I am also comfortable that I’m on track with the account I plan to start spending at 50 and don’t believe that additional savings are needed. 

Overall, the biggest risk to my financial position is a large-scale rent increase. As a renter and given current rental conditions I believe that it is likely my rent will meaningfully increase when my lease expires in March of 2024. My plan is to save three quarters of the tax cut into my emergency fund which effectively “banks” the money which can then be redirected towards the rent increase that I’m expecting next year. That way I can ensure my lifestyle will not have to change given increases in what I pay for housing. While my emergency fund is adequate right now it never hurts to have more money in there. That will help with another risk to my financial position which is losing my job. As somebody who is only moderately competent at my job there is always a risk that I will lose it and given my age it is likely going to be a longer process to find a new job so I think a larger emergency fund will be the best use of the money.  

Shani – what about you? 

Jayamanne: I think something important to call out is although we’ve mentioned lump sum numbers per year, that’s not how it will practically be received. I can choose to save the surplus and invest it all at once, but I’ll be receiving a higher take home pay each paycheck, so I’ll put it to work as soon as I’ve received it. I’ve mentioned before that with every pay increase that I get, or every bonus that I get, I increase or add to my salary sacrifice contributions for super. So, I would use part of my increase to increase my salary sacrifice contributions. I also have 3 main financial goals outside of super, that I want to achieve before retirement.  

One of these goals is to help with certain costs for loved ones, and this is a goal that has about 10 to 15 years of runway left. It’s one of those goals where it is incredibly hard to define an amount because the costs are unknowable. As we all know, we’re all working with a finite amount of resources –so I think a couple of things that have shaped how I approach this goal is a very broad estimate of costs, and what I can afford to put away. It would bring me a lot more peace of mind to be able to put away a little more, so I’d direct part of my payment to that.   

So, in summary – two long term goals that will both give me peace of mind and where I can really put my money to work over a long-time horizon.  

LaMonica: Okay – let’s move onto a few other thoughts from investment professionals at Morningstar. Let’s start with Brian Han. Brian is a Director of Equity Research who covers telecoms, media and leisure. He’s actually also a comedian – anyone who has watched our Analyst Q&As will know that he is very switched on but can also illicit a few laughs at the same time. 

Jayamanne: Not an easy feat when it comes to investing. Brian’s advice was ‘don’t overthink it.’ He said’ Put all of it in a global equities or an emerging markets index fund and forget about it – don’t even try to time the market about when to get into the index fund, just do it! 

Then, leave the resilience and ingenuity of the human race and market economy to work their magic of compounding on that money. 

The chances are, in 10- or 20-years’ time, that money will amount to a great sum, without you having wasted a single minute or dollar being swayed by daily market noises emanating from fear and greed.’ 

LaMonica: But then he added ‘but if you do want to overthink it, how about this?’ 

Spend half of the money on time-tested books on investments, business-building, psychology, philosophy, and biographies of eminent (or exposes of dubious) historical characters in any field. And every time you finish one of these books and think you’ve learnt a lesson or two from it, spend a small portion of the rest of the money on stuff you really enjoy as a reward. The chances are, by the time you finished all the books, you would be much wiser, having profited from the experiences of all those who went before you – and got to have some treats along the way as a bonus. Whichever option you choose, the magic of compounding will benefit you greatly over the long term, whether in money or in wisdom. 

Jayamanne: Love it, Brian. If we asked people to listen to Investing Compass and then invest a portion of their money after it, we’d have a rally on SJ. 

LaMonica: I think you are grossly overestimating how many people listen to Investing Compass, Shani. Okay – one more from the stock pickers. Mathew Hodge who runs our equity research department in Australia. His answer was ‘it depends’. 

Jayamanne: That’s a very good answer for a podcast with a general advice disclaimer. 

LaMonica: It is, Shani. He said though, in practice just adding it to the mortgage is not a bad habit. Even if it’s just some portion of the benefit.  

If disciplined, investing the difference is likely to be a better strategy longer-term so long as the returns are superior to the savings on interest from the mortgage. That’s not a high bar in terms of return expectations in the long run, but the challenge there is staying the course. So, it becomes about discipline and psychology rather than any special investor insight. And if it’s possible to set up an automated rule to make automated deposits to a selected fund, ETF or other investment, then that would seem an appropriate approach. 

Jayamanne: A very Morningstar answer.  

LaMonica: We’ll do a one more – from Graham Hand, who runs Firstlinks, and is an Editorial Director at Morningstar. 

Jayamanne: He has said a question to anybody on “Where would you put the extra funds and why?” requires a personal context. We are all different. He pointed out he is 65 years old, he has worked in senior roles in financial markets for 45 years, he placed the maximum allowed into superannuation each year, he has not had a mortgage since the 1980s and his kids left home long ago (but he still has a dog). He says ‘You don’t need a compound interest calculator to realise he is more focused on the new tax on superannuation balances over $3 million than the Stage 3 tax cuts.  

He goes to say he appreciates the sentiment of eliminating bracket creep in the personal tax system, but the Government could better target ways to spend the money. There is a strong case to modify the changes before they come into effect, leaving the larger tax breaks for lower income levels. 

LaMonica: And then he follows by explaining where he would put his marginal investment dollars. He says ‘My portfolio includes growth assets in Australian equities, global equities, infrastructure, property and alternatives. But he has increased his allocation to cash and floating rate bonds in the last year or two to protect capital in the face of considerable uncertainty. Rising interest rates means an investment such as a hybrid with a major Australian bank is paying a floating rate currently around 7%, which is more than he expect from equities this year. He is cautious because of the impact of higher rates on consumers and companies, earnings declines in a US recession, war and geopolitical conflict and sustained inflation. So given his defensive attitude, lower taxes will lead to more invested in cash or bonds for the rest of 2023 and well into 2024, as central banks and markets struggle to resolve the excess liquidity of recent years. 

Jayamanne: These are all great answers, but they have a recurring theme. They are based on the personal circumstances and preferences of the responders. We know that this podcast might not seem like it is for everyone and that we’ve aimed this at high income earners. Practically though, this advice goes for any investor that’s able to find a surplus in their budget and wants to put it to work.  

LaMonica: I think it’s also important to acknowledge that for a lot of people, the recent past has meant that costs have skyrocketed. Inflation has impacted almost everything – from food, entertainment, leisure, travel. It costs more to do almost everything. 

Jayamanne: This has resulted in a lot of people cutting back and reducing spending. Sometimes, this is a good thing. If you’ve experienced lifestyle creep, this can bring you back a couple of squares and allow the stage 3 tax cut to pump into your investments. For others, this has meant severely cutting back on their quality of life. Unfortunately, the research shows that for these people they are mostly in the camps of having already received their tax cuts in stage 1 and 2. 

LaMonica: We’re not here to say that investing is the be all and end all. Investing is a means to an end, and you shouldn’t feel guilty about spending money that you’ve earned. Again – we want to come back to intention. Intentional spending, saving and investing is the key to ensuring the right balance. Understanding that forgoing cash today means that you may have more in the future. Understanding that sometimes you need that money today. Regardless – ensure there is intent behind your decisions.