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A case for retaining franking credits when taxpayers earn low incomes

February 9, 2019 - 21:28 -- Admin

The Labor Party policy for not refunding
franking credits when an individual pays no income tax is poor policy.

Consider two arguments that have been used
to defend this stance but which seem irrelevant.  First, the argument that any tax involves
gainers and losers and that this is just an instance of that situation.  That is a weak argument since it could be
used to justify any tax.  For example
exempting all individuals who earn more than $50,000 income from paying income tax
but taxing everyone else benefits people earning more than $50,000 but harms
those losing less. But no one would sensibly advocate such a regressive tax even
though it is justified on the basis that one group lose while another gain.  Second, is the argument that many people with
huge wealth may get benefits from substantial franking benefits even though
they are wealthy because they are income-poor. 
That would sensibly be an argument for taxing their wealth rather than
for restricting imputation benefits that relate to their income.

As background there have been many discussions
about the case for abolishing the corporate tax altogether.  Corporate profits can be held as retained
earnings or distributed as dividends. 
Since dividends are taxed in the hands of shareholders and because retained
earnings will eventually be paid out as higher dividends on the resulting
capital investment or enjoyed as capital gains, both of which are taxed, why
tax profits within the firm?   Most
economists reject this line of argument because capital gains are generally
taxed at concessionary rates and, in any event, deferring the tax liability on
dividends by only incurring taxes in the future provides a source of tax evasion
within firms – tax liability can be postponed almost indefinitely.  So let us agree that we should tax corporate
earnings, if only to capture the tax benefits that would otherwise be lost by
firms channeling profits into retained earnings.

Dividends themselves, however, are only
income and there seems little reason to tax them in a different way than other
income. Hence we would not want to double tax dividends (once in the firm and
once when the shareholder receives them as income) and hence the case for
dividend imputation.  The basic idea is
that the corporation is appointed as a tax collection agent for the
government.  It collects a withholding
tax for dividend earners equal to the corporate tax rate, often 30%.  If firms pay this tax rate then shareholders
are only required to pay as tax the difference between their marginal tax rate (MRT)
and the 30% company rate. If a shareholder’s MRT is 45% they must then pay 15%
tax on their dividends since 30% has already been paid by the firm as a
withholding tax.

What happens if an individual’s MRT is
zero? This is the current issue of controversy. In Australia this is the case
when individuals earn taxable incomes less than $18,200.  Then the firm has withheld tax that the
individual is not obliged to pay for reasons of progressivity – they earn so
little income. The sensible policy is to return to that individual the tax wrongly
extracted by the corporation.  Indeed if
it is not returned then the income tax schedule becomes regressive in this
range of income. Those earning $18,200 or less get no imputation benefit while
those above $18,200 get a benefit.  A
progressive tax system with a minimum positive level of income at which tax
cuts in must provide negative taxes over this range – money accruing to the individual
from the government – if progressivity is to prevail.

At this stage of the argument supporters of
the Labor reforms become angry and claim that many people who get this return
of wrongly extracted tax are very wealthy and it isn’t fair that the
progressive income tax law applies to them. 
But that issue has been addressed in paragraph 1. If people believe that
wealth is excessive then tax wealth or tax superannuation.  (I do not support such moves but if the
argument is that wealth is socially excessive that is what you should do).  The difficulty with wrongly targeting income
taxes, when wealth is your concern, is that you create byproduct injustices.  Many in the community have relatively small
shareholdings of fully or partially franked shares.  For example, the Commonwealth Bank of
Australia reveals in its 2018 Annual Report that it had 809,805 shareholders
in total of whom 591,209 owned less than 1,000 shares.  They are small shareholders.  This story would be the same in many of our
large public companies – BHP, Telstra, Westpac, NAB and the various licensed
investment companies – that tend to pay close to fully-franked dividends. All
would have claimed imputation benefits and yet, many of these people would be
retirees earning modest or close to zero incomes. It is wrong to lump half a
million shareholders into the “very rich” basket.  Some are wealthy but many are not and
mistakenly targeting imputation credits rather than wealth obscures this.

Indeed, as mentioned, abandoning the return of this wrongly
extracted withheld tax is a reversion to a regressive income tax since while
more income rich asset owners get the withholding tax recognized as tax paid
those on low incomes do not.

Independent of these arguments are arguments over the lack of fairness of this move.  Since 1987, when this policy was introduced, equities that were sold in companies with fully or partially franked dividends have been sold on an “effective yield” (or “grossed up” yield) basis – the dividend paid was quoted and the effective yield calculated as the nominal dividend plus the franking credit that would be rebated.  For a fully franked share the effective yield was 100/70* nominal yield – the 70 reflecting the fact that a tax imputation benefit of 30% would accrue along with the nominal yield.    This determined the price that would be paid for securities in equity markets.  The price of a security yielding franked dividends would increase to reflect the prepayment of company tax by the firm.  Thus shareholders who purchased such shares after 1987 paid for this tax benefit in markets – it was not given away.  Changing the law to obliterate this benefit means that shareholders on incomes of less than $18,200 have paid too much for such securities.  One can justify such moves by the “some lose some gain” argument cited in paragraph 1 but this is a lousy case for the proposed change.  It is rather recognition of the adverse effects of the change with the weak counterargument that, never-mind, some recipients of these wrongly deducted taxes within firms will gain a benefit.