How franking credit refunds provide a key tax safety net

Labor’s proposal to remove franking credit refunds has generated significant debate regarding whether Australia’s franking credit system is fair. Unfortunately, franking credits are a complex topic and one that is easily misunderstood.

As a result, the debate frequently confuses the fairness of franking credits with the fairness of a flat tax rate in superannuation.

Protecting low income earners

One of the most misunderstood features of franking credits is how they protect those with modest means. For example, consider those who earn under $18,200 and are therefore beneath the tax-free threshold – their expectation will typically be that they should be paying no tax. If franking credits refunds didn’t exist, they would instead find themselves paying 30% tax on any income they receive as dividends (i.e. the 30% company tax rate that is applied to dividends), as shown in Figure 1.

Figure 1: Effective tax rate for dividend income outside super by income level

In this regard, franking credit refunds can be viewed not as a tax loophole but rather a safety net for people with low income, to help reduce tax paid. Without it, dividends are taxed at a rate of 30 per cent for people below the tax-free threshold, or twice for some higher earners. An important point here is that although lower income people may not be paying the tax themselves, that doesn’t mean the tax isn’t being paid on their behalf.

Impact of flat super tax rate

Critics of the current franking credits system point out that franking credit refunds go disproportionately to the wealthiest individuals, with 82 per cent of tax refunds claimed by SMSFs going to the top 30 per cent of funds¹.

But attributing these refunds to franking credits is a case of mistaken identity. It is the flat tax rate in superannuation that drives this.

In superannuation, regardless of income, everyone pays the same tax rate of either 15 per cent or zero, depending on whether the person is retired or not. So regardless of the size of a person’s super balance, the tax rate will always be below the corporate tax rate of 30 per cent.

This means there is no limit to franking credit refunds within superannuation. In contrast to this, outside superannuation where progressive income tax rates apply, franking credit refunds decrease with wealth (see Figure 2).

Figure 2: Franking credit refunds – inside vs outside super

If it wasn’t for the flat tax rate in superannuation, franking credit refunds would go disproportionately to people on low and middle-incomes. The appropriateness of interaction of the current superannuation tax rates and the franking credit system is a fertile area for debate.

The cost of franking credits in perspective

Withdrawing franking credit refunds would remove a safety net outside of superannuation for people on low incomes and would only reduce superannuation tax concessions by a small amount. The Parliamentary Budget Office has estimated that removing franking credit refunds would raise $5.2 billion in 2020-21², which equates to some 13% of the $40.6 billion cost of superannuation tax concessions in 2017-18³. Without doubt, this would be a contentious way to reduce tax concessions and warrants careful consideration.

Australia has a progressive tax system, which is designed such that people with higher incomes pay more tax. Removing franking credit refunds would move the country from a progressive tax rate on dividends to a flat tax of 30 per cent for most people. Most economists favour progressive tax systems and this would be put at risk were franking credit refunds withdrawn.

¹ Parliamentary Budget Office, Dividend imputation credit refunds – further information, 19 November 2018.
² Parliamentary Budget Office, Dividend imputation credit refunds, 4 May 2018.
³ Treasury of Australia, Tax Expenditures Statement 2017, January 2018.