Three useful things to know about franking credits
Political point scoring has misrepresented a tax system designed to be fair
Australia's distinctive tax imputation and franking credits system became a political football during the 2019 federal election campaign.
According to Peter Swan, a professor of finance at UNSW Business School, the Opposition Labor Party erroneously tried to cast tax imputation as something designed by the haves to exploit the have-nots. The implication was that billions of dollars of taxpayers’ cash is distributed annually to the rich who receive a double-whammy benefit as they are either subject to a zero rate of personal tax, or close to zero.
Not true, says Swan, and the pitch was unconvincing with the electorate as well. But it highlighted that tax imputation and franking credits are not widely understood.
So, how does the system work, and why does Swan have 'skin in the game'?
The back story
“The origins of tax imputation go back a long way,” Swan says, “but its modern incarnation began with accountant and company director, Keith Campbell, who chaired the 1981 Financial System Inquiry, since named the Campbell committee in his honour.”
Swan was invited by that inquiry to submit seven research papers into ways of improving the efficiency of the tax system, with the bulk of his recommendations included in the final proposals.
“Far from aiming to benefit the rich, Campbell's aim was to make Australia’s tax system fairer and to encourage less well-off investors into ASX stocks which collectively have averaged some of the highest returns in the world – far in excess of bank deposits and government bonds that are traditionally favoured by relatively low-income investors,” Swan says.
Function and intention
“Suppose you earn a wage of $100, on which you would normally pay tax of $30, and also invest in a company that earns you $100 in income, on which it would pay company tax of $30 to the government as 30% is the company tax rate. The company pays the remaining $70 to you as a dividend,” explains Swan.
“Prior to the Hawke-Keating Labor government’s implementation of a simplified version of the Campbell committee proposals in 1987, you would have been forced to add that $70 to your wage income of $100 and, if not pushed into a higher income tax bracket, your tax would now be $51, a 70% increase.
“This increase is both unjust and unfair as well as discriminatory against productive investment as you have already contributed $30 in company tax as part of your tax contribution to society,” Swan says.
“What the Labor government did was rebate that $30 company tax paid on your behalf back to you as a ‘franking credit’ so that your personal tax was unaltered at $30, but in reality you earned $200 inclusive of company income on which you paid a total tax bill of $60 at your personal rate of 30%.
“However, if you had retired and were now subject to zero personal tax you would not have been as happy because you would not be able to make use of the $30 franking credit.”
In 2001, the Liberal Coalition government led by John Howard changed this by crediting back to investors in tax brackets below 30% the unused credit they received in the form of cash.
“This reform completed Campbell’s aim of eliminating double taxation of company and dividend income and thus removing a serious anomaly,” Swan says.
'The Coalition pitched to the electorate that it has provided corporate tax relief for small business'PETER SWAN
Two can play the imputation game
Swan notes that the Labor Party had always supported Howard's reform until the 2019 election campaign.
“[And] sadly, the Liberal Coalition government’s corporate tax policies, when led by Malcolm Turnbull, were far from blameless, either,” he says.
“Under that government’s Enterprise Tax Plan No. 2, the corporate tax rate was to be progressively reduced from 30% to 25% at an eventual cost to revenue of up to $13 billion per annum.”
A progressive reduction has been implemented for smaller, largely Australian-owned companies, but it has been abandoned for larger companies because it was successfully opposed by cross-benchers in the Senate.
“The Coalition pitched to the electorate that it has provided corporate tax relief for small business. This was not so, as the lower corporate tax payments for Australian-owned enterprises are precisely offset by smaller franking credit refunds to shareholders who are the small businesspeople,” says Swan.
He believes Australians dodged a bullet as a result of the failure of the tax cuts for large business, much of which is foreign owned.
Would these cuts have promoted more desirable foreign investment?
No, says Swan, because Australian investors use bank funds from abroad to invest in Australian stocks yielding franking credit benefits. This drives the return on investment in Australia to approximately the world rate, free of Australian corporate tax.
Swan's position has been outlined on BusinessThink in, Sorry Treasurer, but your corporate tax sums are not adding up, and will be further elaborated in Economic Record.