While I don’t normally get into the topics of taxation or politics, today I’ll make an exception.
Since my own strategy for early retirement income is based on dividends, it naturally fits that I’d cover topics that affect this.
Recently, Bill Shorten announced the Labor Party wants to bring in some changes to franking credits.
There’s heaps of talk about what this means, in theory and practice. And there’s a wide range of possible outcomes, along with some likely unintended consequences.
Let’s take a look at the proposal, what the aim of it is, and what the outcome might be.
Franking Credits Today
As it stands, companies in Australia pay tax, and when they pay dividends, shareholders get a ‘credit’ for the tax that the company has paid on those earnings.
Then, the shareholder is liable for the difference between that tax the company has paid (30%) and their own personal tax rate. That sounds fair, right?
This makes sense, because as a shareholder, that’s (part of) your portion of the company’s earnings. After all, the shareholders are the real owners of the company.
So the same as any other asset, the earnings are taxed at whatever rate applies to the owner.
Shareholders on low incomes, with a tax rate below 30%, have some of the tax (franking credit) refunded, as their portion of the earnings has been taxed too highly.
And shareholders on higher tax brackets (above 30%), have to pay ‘top-up’ tax, as the earnings weren’t taxed high enough, in their situation.
Franking Credit Changes
The proposal is to keep the imputation system as is, but stop the refundable nature of the franking credits.
So anyone on a tax rate of less than 30%, receives no refund of the excess tax paid. And their portion of the company’s earnings have been taxed at 30%, despite those people (the end owner of the company) being on a lower personal tax rate.
Effectively, everyone on a lower tax rate than 30%, will be worse off as a result. They’ll receive lower income from their Aussie shares, and a lower after-tax return as a result.
This includes anyone working or retired, with Aussie shares to their name.
But for anyone on a tax bracket over 30%, the change will make no difference at all. They’ll continue to pay the ‘top-up’ tax and are able to fully utilise their franking credits.
While it might sound unfair, there’s a few reasons why Shorten is proposing this.
Super-Rich Super Funds
From the statements the Labor party has made, it’s very clear what their aim is.
The goal, is to raise more tax revenue.
Their weapon of choice, is franking credit changes.
And their target, is those with millions in super. Specifically, those in pension phase (retirement), who are generating massive investment income, and paying no tax.
Now, to be clear, they aren’t doing anything wrong. This is just the way the system is designed.
Because they’re on a tax rate of 0%, they get all their franking credits refunded. Their portion of the company’s earnings are untaxed, due to their personal tax rate of 0%.
So by cutting off franking refunds, Labor is hoping to raise billions in extra taxes. The taxes are to be spent on some noble causes, such as tax cuts for low/middle income earners, small business benefits and social programs.
But the problem is, everyone else is caught in their net. Despite them only wanting to catch the big fish, the little fish are caught in the net too.
The small shareholders who are self-funded or partially self-funded will be hurt the most.
Think about it this way…
Consider a self-funded retiree couple aged 70, invested in Aussie shares and receiving gross dividends of $35,000 per year (including franking credits). Their income will be cut to $24,500 – a 30% cut.
In that scenario, after the proposed franking credit changes, they’ll be back on the pension and the cost savings for the government are virtually eliminated.
There are many situations like this, where the small shareholder is missing out on critical income and will end up adding to the pension burden.
As a rule, the smaller the holder, the more important that income is.
Well, what about the big fish, who the policy is targeted at?
Swimming Around The Flags
For those with substantial assets in the zero-tax pension phase, there are many options, should the franking credit changes come in.
Does anyone believe they’ll just hang onto their Aussie fully franked shares, accepting the lower income and lower return? I don’t.
Instead, they have the option of dumping their Aussie shares, and investing in other assets.
Other choices include, any shares that are unfranked, where no company tax has been paid here in Oz. That includes infrastructure stocks, real estate investment trusts (REITs), utility stocks and even many managed funds.
Much of these investments operate as a ‘trust’ structure, meaning they simply pass through all their earnings to the end shareholders, without paying tax. And the shareholder is then taxed at their own personal tax rate, for the income and any capital gains distributed to them.
Also, the big fish can instead choose to invest in commercial property, residential property and overseas shares. Basically, anything other than Australian companies will still be tax-free.
Why? Because their tax rate is still 0%.
So much for catching the big fish!
The Result of Franking Credit Changes?
I’d estimate that the savings generated by the cancellation of refundable franking credits, to be somewhere between none, and not much.
Yes, that’s a figure pulled from my behind that won’t help balance the government’s budget. But most projections fail to consider behavioural changes from increases in taxes or policy changes.
Most people will simply change their approach to minimise the impact as best they can.
At the end of the day, it’s not all about minimising tax for the fun of it. More importantly, it’s about maximising returns.
The rich people they’re trying to target, will simply invest in other assets where they can still earn plenty of investment income and not pay tax. Since their tax rate is 0%, it’s no drama to sell or switch investments, to earn a higher return.
Basically, the franking credit changes would (somewhat) discourage investment in Australian companies. And it puts a minimum tax on company earnings and dividends of 30%.
If those earnings come from an investment property or wages, those earnings are taxed at the individuals own tax rate, whether it’s 0% or 48%. So why not their shares?
It just seems like a lazy, blanket approach to take, that will have minimal benefits, while hurting the wrong people.
It appears the problem is not with franking credits and refunds. But the problem is the 0% tax rate on rich retirees. And I agree, that’s overly generous, and not sustainable.
So, if the goal is to increase tax revenue from the wealthier retirees, then why not target it specifically?
The government could do this by having progressive tax rates in Super. The more you’ve got, the higher your tax rate. This would probably have a much bigger impact, while doing the least amount of damage.
Importantly, none of the small holders will be affected, which isn’t their target.
While it’s currently being debated, the franking credit changes may even affect Super Funds, due to their 15% tax rate.
I’ve seen different opinions on this. But if true, the result is a lower after-tax return for Super Funds investing in Aussie shares. And this is sad, because it will cause more capital to be invested in assets other than Australian companies.
Also, a lower return on Super Funds while we’re working, means a lower balance on retirement. Therefore, we end up with more people reliant on the government for support. Further reducing any benefit to the government budget.
Let’s pretend for a minute. Assume nobody changed their investment strategy after the changes. Here’s the outcome for two retiree couples who are invested in Aussie fully-franked shares…
Retirees A, generate $400k of gross dividends from their shares in pension phase, and pay zero tax. After the changes, their income drops by 30%, to $280k.
Retirees B, generate $40k of gross dividends from their shares in pension phase, and pay zero tax. After the changes, their income drops by 30%, to $28k.
Who is more affected?
Obviously, it’s an equal loss in percentage terms. But in reality, Retirees B will now likely need to go on the pension, while the richer couple is probably doing just fine.
So in practice, it affects the less well-off, more than the rich.
Again, the problem is clearly with the 0% tax rate on huge retirement balances, not specifically with franking credits.
All Earnings Should Be Equal
Currently, the tax system is quite fair across all assets.
With the refundable franking credits in place, it puts shares in Australian companies on a level-playing field with other Aussie investments like direct property, commercial property, infrastructure and others I mentioned above.
Because the earnings from these assets all flow through to the end owner, before being taxed. But receiving earnings from the company, after being taxed, wouldn’t be fair, compared to the other assets.
To take away the refunds for people in tax brackets under 30%, means only middle and high-tax payers get to fully utilise their franking credits. But clearly, it’s the most valuable to the lowest income earners.
I’m not sure that fits with Labor’s ‘equality’ mantra.
But what if the big companies end up owned by super funds and tax-free individuals?
This is a fair argument. We certainly don’t want this to happen, because the government will lose increasing amounts of revenue.
But the solution is probably not to remove the refundable nature of franking credits. Remember, that evens out the playing field for all tax rates, when compared with other sources of earnings.
There are media stories of some people getting franking refunds of hundreds of thousands of dollars. But the truth is, this will be in the minority.
And with the recent limits on tax-free super balances, this is already phasing out to some extent. These super-rich retirees will be paying at least 15% tax on most of their earnings.
As I see it, the problem is the low tax rates. With these franking credit changes, they will just alter people’s investment decisions, while raising little, if any, extra revenue.
If tax rates are higher for those holders, then whatever they invest in, there’ll be a genuine improvement in tax revenue.
At the end of the day, I think the franking system is fairer since becoming refundable. It allows people of all incomes to fully utilise the benefits, not just high income earners.
Already, it appears that Bill Shorten is watering down the policy, after backlash from genuine low income earners, caught up in the proposal.
The underlying problem is clearly that some high earners are making extremely large amounts of investment income and not having to pay tax. The solution then, is to change the tax rates.
Having progressive taxes inside super, just like outside super, is probably the fairest way to go about it. And it’ll ensure that genuine low income earners, and lower wealth retirees pay less tax, than those better off.
By retaining the system as it stands today (and fixing tax rates), it avoids the higher-wealth retirees simply changing their investment strategy, to generate a strong income in other assets, and still pay no tax. And it avoids any capital flowing away from Australian companies, to other types of investments.
While I don’t agree with the proposal of franking credit changes, I do agree with people earning hundreds of thousands in income from their investments, having to pay at least some tax!
But don’t just take it from me, I’m biased by my own self-interest of course!
Anyway, that’s how I see it. And at least it makes politics interesting for a while!
What do you think about the proposed franking credit changes?