News this week of Bill Shorten's plans for a Labor Government to stop access to franking credits for Australians who pay little or no tax will have a real impact. Two of AMP Capital's investment experts, Jeff Rogers and Dr Shane Oliver, use a case study to illustrate and explain the impact this could have.
News this week of Bill Shorten’s plans for a Labor Government to stop access to franking credits for Australians who pay little or no tax comes on top of ongoing debate around the merit of reducing the company tax rate for all Australian corporates.
Some are suggesting we get rid of the dividend imputation system entirely to fund deeper cuts in the company tax rate. The Labor Party has already flagged other proposals to raise the top marginal tax rate, restrict access to negative gearing and halve the capital gains tax discount.
The Labor Party’s proposal regarding dividend imputation could have a material impact on individuals’ income in retirement, something ipac CIO Jeff Rogers outlines in a case study below. The precise outcome would of course depend on whether the proposal is legislated, how it operates, and on exactly how a retiree holds their Australian shares.
Wrapped in vitriol
Anyone reading coverage on the topic this week will know it’s a complex issue which is also wrapped up in a fair dose of political vitriol.
The imputation tax system is a unique feature of the Australian system whereby company tax is essentially a withholding tax for Australian shareholders who effectively pay tax on underlying company earnings at their marginal rate , Rogers describes. This, he says, prevents the double taxation of dividends that would otherwise occur, first by the company at the corporate tax rate and second by the shareholder at their marginal rate.
Debates on franking credits and company tax are linked. In fact, because the current imputation system is unique to Australia, there is considerable disagreement around the economic impact of any reduction in the company tax rate, Rogers notes.
Rogers’ personal view is that only offshore shareholders would see material direct benefit from a reduced rate of company tax and that the imputation system as it stands today serves domestic corporates well and provides a great benefit to the growing group of Australian retirees.
Basically, it means that a larger proportion of our stock market’s return is delivered through dividend payments than in countries such as the US, Rogers highlights.
Shane Oliver, AMP Capital’s Chief Economist, agrees that the imputation system provides a great benefit to the growing group of Australian retirees and to the share market generally, but notes that Labor’s proposal does make some sense.
After all, Oliver notes, dividend imputation was meant to remove the double taxation of dividends rather than compensate people for tax already paid when they are not paying any tax on dividend income anyway.
But regardless of its original purpose, removal of dividend imputations for those who pay little or no tax will affect many self-funded retirees who have come to rely on it, particularly those less well-off retirees because they won’t have tax to offset it against, Oliver adds.
There are other knock on effects – both known and unknown – likely to cascade from the removal of the system Labor is proposing, some of these Oliver highlights further down in this article.
In practical terms, for retirees, dividends are tax-free and franking credits can be converted into cash, Rogers notes.The resulting cash flow provides a stable and growing source of post-retirement income that is well-aligned to retiree spending patterns, he says.
Rogers offers the following case study to show how a retiree under a dividend and non-dividend imputation system might be better or worse off.
By the numbers
This case study starts in late 2005 and follows a retiree who had the choice of investing their super fund balance in Australian shares or in the US share market. This 12-year period was chosen because it includes the global financial crisis and it starts at a time when the US dollar was at the same level as it is today, Rogers notes.
The annualised price return of the Australian market over this 12-year period was a disappointing 2.37 per cent per annum, while the US market delivered an annualised price return of 6.31 per cent in Australian dollars over that period. Advantage USA.
Of course, when you invest in shares you also receive the economic benefit of the dividends. Taking account of dividends, the Australian market delivered a total return of 6.99 per cent p.a. while the total return on US shares was 8.59 per cent p.a. The gap has narrowed.
Finally, for the purpose of this scenario, you need to account for the impact of tax on the retiree’s cash flow. As noted earlier, an Australian retiree can monetise the franking credits associated with their domestic shares. Taking this benefit into account, we estimate an after-tax return from the Australian market of 8.62 per cent p.a. By contrast, the withholding tax on dividends from US companies detracts from outcomes for the Australian retiree. Their after-tax return on US shares was approximately 8.25 per cent p.a. Advantage Australia!
But there is a more subtle structural effect at play here, Rogers notes. A retiree in pension mode must draw down on their retirement fund so the pattern of returns can have a meaningful impact on outcomes. When a retiree invests in Australian shares, more of their spending can be sourced from dividends and tax credits, which are reasonably stable. By contrast, if they invest in US equities, a greater proportion will be sourced from selling shares, which are inherently more volatile.
The impact is evident in the chart below which displays the balance remaining from the adoption of the two different investment strategies assuming the retiree started with $350,000 and was looking to spending $2,000 per month, increasing by 2 per cent each year.
The outcome where no financial value is assigned to franking credits is also displayed. Of course, company management would have allocated capital differently in such circumstances, so caution is required in interpreting this theoretical result.
Retirees worse off
With his years of analysis and modelling returns across asset classes and geographies, Rogers concludes that the dividend imputation system in Australia is a good system for these three main reasons:
First, there is evidence that Australian companies paying dividends with credits attached are less likely to seek to avoid tax.
Second, because Australian companies pay out a high proportion of their free cash flow in dividends, company management is forced to be particularly prudent in its internally-funded investment choices. If they want to make major investments they need to convince outside equity and debt holders of the efficacy of their plans.
More importantly, Rogers notes, Australian shares with high dividends and franking credits play an important role in improving retiree well-being as evidenced in the above case study.
The tax changes, if introduced, will also drive significant impacts on various asset classes with lots of cross currents, Oliver adds.
These impacts could relate to the fact that the proposed increase in top marginal tax rates under a Labor government will likely drive greater use of negative gearing across all assets classes to reduce taxable income, Oliver highlights. He also adds that the proposed changes to negative gearing will benefit new housing and other assets but would be very negative for existing housing.
Further, changes to dividend imputation as proposed would be negative for high dividend yielding highly franked shares but positive for other shares and other assets including housing as those affected re-allocate their investments reflecting a reduction in the relative attractiveness of shares with high franking credits (to the extent that they will no longer get access to the franking credits).
With all the analysis and tea-leaf reading aside, the fact remains though that the ALP still has to get elected and the next election may not come for another year or more.
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