Australia's Future Tax System

Final Report: Detailed Analysis

Chapter E: Enhancing social and market outcomes

E8. Rationalising other taxes

E8–1 Insurance taxes

The role of insurance

There are a range of insurance products which can be purchased, including home and contents insurance, motor vehicle insurance, income protection insurance, health insurance, public liability insurance and workers' compensation insurance (which is largely provided by governments). In 2008, gross insurance premiums paid in Australia to private sector general insurance providers were in the order of $31.6 billion, with assets of $92.7 billion held by these companies. In 2008, $25.8 billion was paid out to settle general insurance claims (APRA 2009).

Insurance allows people to pay a premium to cover a loss if a certain event occurs. By spreading risk among a group of people, insurance products make any particular loss by a member of that group manageable. The ability for people to manage risk appropriately is an important factor in their wellbeing. Further, by enabling transactions that would not have taken place if insurance were not available, insurance plays an important role in encouraging the most productive use of resources. For example, a doctor may not undertake important surgery if they are unable to gain insurance for that procedure and hence may undertake less important, and less risky, activities instead. In other words, access to insurance allows for greater opportunities and flexibility for people and businesses.

Insurance markets are more prone to market failure than many other markets. There are two main sources of this vulnerability. The first is 'adverse selection', where potential buyers of insurance have better information about the probability of loss than insurers. For example, in the health insurance market, people who purchase health insurance know more about their health problems than those providing insurance. In this case, people who know they have above-average risk will buy more insurance than people with below-average risk. Therefore, premiums set by insurers according to the average risk will not be sufficient to cover the claims that eventually arise. The second is moral hazard, where the presence of insurance cover shifts the preferences of insured people towards higher risk behaviour.

Insurance taxes in Australia

Insurance taxes in Australia are levied by the States. All States impose duties on general insurance premiums with the 2008–09 rates ranging from 7.5 per cent to 11 per cent. There are a number of concessions and exemptions: for example, workers' compensation insurance is not taxed in most States. The States also apply different rates for life insurance and term insurance. Some States impose taxes on specific insurance products or have specific tax arrangements for the insurance industry. NSW and the ACT, for instance, impose a levy on health insurance policies (known as the Ambulance Service Levy in the ACT). NSW, Victoria and Tasmania require insurance companies to make contributions to the funding of fire brigades, which are generally passed on to the cost of insurance premiums.

Details of insurance taxes in each State are listed in Table E8–1.

Table E8–1: Insurance taxes in each State, 2008–09

Tax NSW VIC QLD WA SA TAS ACT NT
General insurance 9% 10% 7.5% 10% 11% 8% 10% 10%
Life insurance $0–$2,000: $1.00
Over $2,000: $1.00 + 20c per $200 or part thereof in excess of $2,000
$200–$2,000: 12c per $200 or part.
Over $2,000: $1.20 + 24c per $200 or part above $2,000.
$0–$2,000: 0.05%
Over $2,000: $1.00 + 0.1% of balance.
na $1.50 per $100 or part thereof of net premiums of previous year (min $100). Up to $2,000: 10c per $200 or part.
Over $2,000: $1.00 + 20c per $200 or part in excess of $2,000.
$0–$2,000: $1.00
Over $2,000: $1.00 + 20c per $200 or part thereof in excess of $2,000.
10c per $100 or part thereof the sum insured.
Term/temporary insurance 5% of first year premium 5% of first year premium 5% of first year premium na na 5% of first year premium 5% of first year premium 5% of first year premium
Insurance protection tax (a) na na na na na na na
Health insurance levy $1.19 per individual per week; $2.38 per week per family na na na na na $1.79 per individual per week; $3.58 per week per family na
Fire services levy (b) (b) na na na (b) na na
Surcharge/levy on motor vehicle third party vehicle insurance na 10% 10 cents duty per policy. Levies and fees depend on vehicle class 10% $60 $6 per policy na na
  1. $69 million per annum to help meet claims against policies held with HIH in relation to CTP and home owner warranty schemes. $65 million per annum levied on general insurers registered with APRA, with the remainder contributed by a 1 per cent ad valorem tax on overseas general insurers and those domestic insurers not registered with APRA.
  2. Providers of certain insurance products are levied to help fund the provision of emergency services. In NSW 73.7 per cent of the cost of providing the NSW Fire Brigades and the Rural Fire Service is recovered from insurers, while in Victoria 75 per cent of the cost of providing the Melbourne Fire and Emergency Services and 77.5 per cent of the Country Fire Authority is recovered from insurers. Tasmania has a hybrid funding system for fire services, including an insurance fire levy paid by commercial property owners and levied on specified forms of commercial property insurance at various rates.

Source: New South Wales Treasury (2009).

Insurance taxes have been a growing revenue source for the States, increasing from $2.0 billion in 1998–99 to $4.3 billion in 2007–08. This represents a (nominal) increase of 112 per cent, significantly higher than the increase in revenue from other State taxes in this period (46 per cent). There has not been a significant increase in the rates of insurance taxes over this period; in fact, some States have reduced the rate of their general insurance duty. This suggests that growth in revenue has been largely driven by increases in the value of insurance premiums.

Compared to other countries, taxes on insurance in Australia are relatively high. The International Comparison of Australia's Taxes (Australian Government 2006) found that of the nine other countries in the OECD–10 that were examined, two did not levy specific insurance taxes, five had rates between 2 and 5 per cent and the remaining two had rates that were still lower than that of the lowest taxing Australian State. Australia was the only country listed with double digit insurance tax rates (which apply in five States). In addition, of the OECD–10, only Australia, New Zealand and Japan applied a value-added tax (VAT) — in Australia's' case, the GST — to insurance contracts.

This finding is supported by the Insurance Council of Australia's October 2008 submission to the Review. Chart E8–1 (adapted from the submission) shows that from the selected group of sub-national and national governments, NSW and Victoria (which fund a high proportion of their fire services from contributions by insurance providers) have the highest level of specific taxes on insurance premiums. When the GST is included, the effective rate of tax on insurance is even higher.

Chart E8–1: International comparison of insurance taxes
(excluding VAT and GST)

Chart E8–1: International comparison of insurance taxes(excluding VAT and GST)

Source: Insurance Council of Australia submission, October 2008.

Insurance taxes can lead to under-insurance

A number of reports have found that insurance taxes can impose significant costs and are one of the least efficient taxes available to the States. For example, IPART (2008) concluded that insurance duty and fire services funding contributions are the least efficient State taxes. The Centre for International Economics (2009a) noted that the market for insurance is already subject to a number of substantial market failures that has resulted in under insurance and non-insurance, and taxes on insurance provide a further disincentive to insure. Freebairn (2009) notes that, given market failures in the insurance market can lead to under-insurance, if anything, insurance should be subsidised rather than taxed.

Insurance taxes reduce the return for any given cost of an insurance policy, meaning that people and businesses must pay more to achieve the same level of risk reduction. This can deter people and businesses from entering the insurance market or purchasing an adequate level of insurance. This reduces the size of the insurance market and hence the scope for insurers to pool risk, leading to an increase in the cost of insurance premiums beyond the first round impact of the tax.

The rates of non-insurance and under-insurance vary throughout Australia. While States with higher taxes on insurance do not always have higher rates of non-insurance and under-insurance, there are other reasons why differences in States may persist (such as differences in perceived levels of risk). Further, there is evidence that after Western Australia stopped basing its fire services levy on insurance, the level of non-insurance for both building and contents declined (Tooth & Barker 2007). Another study found that if the fire services levy, insurance duty and the insurance protection tax were removed, an additional 300,000 households across Australia would purchase contents insurance and an additional 69,000 households across Australia would purchase building insurance (Tooth 2007).

As well as being inefficient by leading to under-insurance or non-insurances, insurance taxes can also be inequitable. Rates of non-insurance (for building and content insurance) generally decline with higher incomes, and non-insurance can also be higher for certain demographic groups, such as retirees with mortgages and single parents (Tooth & Barker 2007). Because of their financial positions, people in these groups may be more vulnerable in the case of loss.

Other considerations

One of the attractions of insurance taxes is that they are relatively simple to administer. To calculate the general insurance tax, the rate is simply multiplied by the value of the premium. However, not all insurance taxes are this simple. For the fire services levy, the process for determining the appropriate recovery on each insurance product can be complex for insurance companies. In its October 2008 submission, the Insurance Council of Australia argued this complexity comes from insurers being required to provide their contribution to the levy in advance (thereby leaving insurers with the task of forecasting the market when applying the tax to premiums). Further, fluctuations in both the market mix (that is, across classes of business) and premium levels result in insurance companies bearing all of the collection risk. They conclude that under or over collection is an inevitable feature of this system.

By encouraging under-insurance or non-insurance, insurance taxes may also lead to an increase in government expenditure in the event of a disaster. For example, after the 2003 Canberra bushfires the ACT Government provided an additional $5,000 to each affected household that did not have contents insurance, in addition to the $5,000 provided to all whose homes were destroyed. To the extent that the public or governments have previously intervened to provide significant financial support in such circumstances, there can be a moral hazard as people may be less inclined to be insured if they believe they are likely to be compensated by others (including governments) in the case of loss (Victorian Government 2009). However, evidence from the United States suggests that individuals and communities may not base their insurance decisions on such expectation and in fact, in direct contrast to the moral hazard expectation, after the 2009 Victorian bushfires the industry experienced a strong uptake of insurance (Victorian Bushfires Royal Commission 2009).

That the fire services levy is applied to insurance premiums in an ad valorem manner results in, all else being equal, those properties with a higher fire risk paying a higher fire services levy (as their insurance premiums would be higher to cover their fire risk). Partially funding the fire services in such a way could be considered fair as it means that those people more likely to need fire services contribute more to their funding, while some government funding contributes to the public benefit of fire services.

However, as noted above, the higher tax on insurance generally leads to a reduction in the number of people insured and will spread the burden of funding such service over less people than desirable. The levy also does not tax motor vehicles, despite that motor vehicle owners, in Victoria, receive around 15 per cent of the benefits of fire services (Victorian Government 2009). Funding fire services in this way also means that people with little fire risk but either higher other risks (which will not call on fire services) or higher value assets contribute more to fire services which they are relatively less likely to use.

Additionally, the uninsured do not contribute to the funding of these services. While there may be mechanisms, such as in Victoria, to recover the cost of fire services provided to the uninsured, in practice it is businesses, rather than individuals, which are charged in Victoria (Victorian Government 2009). Further, those under-insuring face no such charges. Because cost recovery is somewhat limited, and the fact that fewer people insure due to the levy, those insured are likely to bear a higher burden for funding fire services. While consistently applying cost recovery may be seen as more equitable, it would present a risk that the non-insured would not call the fire brigade to avoid the charge, which increases the risk of damage to other properties. This highlights the public good characteristics of fire services.

Findings

Australia has high taxes on insurance, both in comparison to other countries and to the way that other products and industries are taxed. Specific taxes on insurance add to the cost of insurance premiums and can lead to under-insurance or non-insurance.

Low-income earners are more likely than high-income earners to abandon insurance in response to higher premiums. The result is that they bear more risk themselves, although they are less well-placed to do so than people with higher incomes.

Reform directions — abolish specific taxes on insurance

Recommendation 79:

All specific taxes on insurance products, including the fire services levy, should be abolished. Insurance products should be treated like most other services consumed within Australia and be subject to only one broad-based tax on consumption.

There is little justification for levying specific taxes on insurance products. Rather than correcting a market failure, insurance taxes can add to existing problems in the insurance market. The revenue from insurance taxes should be replaced by revenue from a more efficient and equitable tax.

If governments wish to provide incentives for people to consider the fire risks when deciding where to live, other mechanisms — such as a risk adjusted charge on property — may be more appropriate. However, it is not necessary that these charges should be set to exactly match the costs of providing fire services. In fact, it may be undesirable particularly where the cost of providing fire services varies significantly from year to year.