(AMP Capital)
15 December 2017

Tax policy is in the news again. The federal government wants to reduce the corporate tax rate to 25 per cent for all companies and has signalled a desire to cut personal tax to offset the impact of bracket creep.

The government has yet to announce how it will fund these initiatives. With changes to GST apparently off the table, some commentators have identified the dividend imputation system as a way of generating $11 billion of annual savings, which could be used for tax cuts. It is seen in some quarters (although not the government or the opposition) as low hanging fruit.

A well-timed report from the Tax and Transfer Policy Institute at The Crawford School at the Australian National University found that getting rid of full imputation could fund the company tax cut and offer social benefits to boot.

Under the imputation system, company tax is essentially a withholding tax for Australian shareholders who effectively pay tax on underlying company earnings at their marginal rate. This 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.

This is a unique feature of our system, and it’s mainly for this reason that there is disagreement around the economic impact of any reduction in the company tax rate. Personally, I think only offshore shareholders would see material direct benefit from a reduced rate of company tax.

Our imputation system should not be considered for the chopping board. It serves domestic corporates well and provides a great benefit to the growing group of Australian retirees. It means that a larger proportion of our stock market’s return is delivered through dividend payments than in countries such as the US. This is a very good thing for 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 they 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, Australian shares with high dividends and franking credits play an important role in improving retiree well-being. In pension mode, dividends are tax-free and franking credits can be converted into cash. The resulting cash flow provides a stable and growing source of post-retirement income that is well-aligned to retiree spending patterns. The following case study draws out this argument.

Late in 2005, a retiree had the choice of investing their super fund balance in Australian shares or in the US share market. I selected this 12-year period because it includes the global financial crisis and it starts at a time when the US dollar was at a same level as today.

Some facts. 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, 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. 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% 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.

The dividend imputation system has helped improve retiree well-being by supporting better capital allocation by Australian corporates who then return high tax-advantaged cash flows to shareholders. An unwind of this system would reduce retirement balances, lead to lower dividend payout ratios, increase the risk of poor corporate capital allocation, and produce inferior retirement outcomes.

Important note: 
While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided.