Peter Swan

Last Tuesday, Treasury announced in its discussion paper that the Abbott government was considering amending or abolishing Australia’s tax imputation system.

Since 1987, Australian taxpayers have only been taxed once on corporate income, not the double taxation that investors in many other countries have had to put up with (New Zealand, Chile and Mexico remain the exceptions).

Our franking credit-based tax system has undoubtedly given Australia one of the best and fairest systems of corporate taxation in the world, despite our still very high tax rates.

New Zealand, for example, with the same system as ours has maximum tax rates at about 33%, compared with ours in excess of 47%.

In the same discussion paper, Treasury reports that $19 billion in franking credits is distributed annually to Australian shareholders, with another $10bn paid to companies for future distribution.

Annual dividends to the value of $44.33bn, with grossed up value of $63.33bn, precisely generates the reported franking credits of $19bn at the notional value of 42.86c per dollar of franked dividends.

If the relevant taxpayer is in the modest 37% marginal tax bracket ($80,000-$180,000), the incremental tax presently paid is $23.43bn on this income. Hence, for such taxpayers, the cost over and above franking is about $4.43bn.

If double taxation were reintroduced, the after corporate tax dividend income on which personal tax would be payable is $44.33bn, yielding $16.4bn in incremental tax revenue.

Thus, the total paid on dividend income rises from $23.43bn to $35.4bn ($16.4bn plus the $19bn of cancelled credits) which is an increase in the tax take of 51%. The effective marginal tax rate on dividend income rises from 37% to 56%, a staggering rise of 19 percentile points.

If a person were receiving $100,000 a year in franked dividends and 37% is their marginal tax rate, they would be paying $37,000 per year in personal tax, leaving a modest after-tax dividend income of $63,000.

After the change, personal tax is levied on the $70,000 of after-corporate-tax income, leaving only $44,100 in after-tax dividend income as the marginal tax rate is still 56%.

If the investor is in the 47% marginal tax bracket the devastation is even worse. Their present after-tax dividend income is $53,000 and with the loss of the corporate tax rebate of $30,000 on the gross income of $100,000, their after-tax income falls to only $37,100. The increase in tax is $15,900.

Since their total tax paid is $62,900, the effective marginal rate has risen from 47% to 63%, comparable to France with the world’s highest tax rate on distributions.

In present value terms at the average corporate return of 12.77% per annum, since July 2001 this $19bn annual loss to local shareholders amounts to a decline in value of $148.79bn for franking shares worth approximately $500bn, a potential massive hit to stock values.

The discussion paper points out, correctly, that imputation encourages Australian investors to invest more in Australian stocks and less in foreign stocks than they otherwise would in a world in which inefficient double taxation of dividends is universal.

Given that information is vital for successful investment and that most information is local, the home bias means that both Australian firm and investor returns are higher when more Australians invest locally. Imputation, like aspirin, brings many benefits.

The discussion paper is keen to bring about more foreign investment in Australia by lowering the corporate tax rate. Under imputation, Australian investors gain no benefit from any lowering and, in general, imputation does little to encourage foreign investment.

Here the discussion paper is quite schizophrenic – while wanting more corporate investment in Australia, it would like to remove imputation as this would lower Australian investment in ourselves.

If any tax savings were used to lower the corporate tax rate such that the overall level of investment were preserved, all it would achieve is a worsening of Australian tax efficiency while making most Australian investors worse off.

Unfortunately for all those advocating a massive tax grab of $19bn, revenue gains would soon prove illusory. Australian companies would soon shift their corporate activities and tax base to tax havens. Imputation provides a strong motive to pay tax locally.

When imputation was introduced in 1987, there was a sizeable increase in dividends distributed so as to harness imputation credits. This would soon be reversed if the tax grab lobbyists have their way. Companies with poor investment prospects would invest more in a wasteful fashion, weakening Australia’s investment performance.

Imputation means there is no tax benefit from taking on more debt. Reduced gearing that occurred with the introduction of imputation would be replaced by sizeable gearing-up.

If there is no, or limited, equity capital, there will be no or negligible dividends, but highly indebted companies become much more susceptible to collapse during recessions. Abolishing overtaxed dividends is perfectly legal, and we all pay the costs of corporate collapse.

That $19bn tax grab is soon converted into an additional $19bn in wasteful activities, while the entire corporate sector takes a significant hit from which recovery would be difficult indeed.

Peter Swan is a professor of finance at UNSW Business School. A version of this post appeared in The Australian. All figures are in Australian dollars.