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Do franking credits matter?

Dividend imputation has been under scrutiny. The Tax Discussion Paper raises the notion that imputation does little to encourage investment in a small, open economy like Australia, where share prices and hence the cost of capital are set in international capital markets. Imputation is thus seen as a costly tax break for domestic shareholders with minimal associated benefits for the overall economy. The idea is that the removal of imputation could fund a reduction in the corporate tax rate, perhaps to as low as 20%, leading to a surge in foreign investment.

This line of argument has some merit: lowering the corporate tax rate should indeed attract additional foreign investment at the margin. However, this stance is somewhat narrow. To be fair, the Tax Discussion Paper is only airing a view for discussion, not making a policy recommendation. Nevertheless, it is worth asking what may be overlooked in adopting this line.

Mixed evidence on whether imputation is priced

The relationship between imputation and the return on investment required to satisfy the market (which might be called ‘cost of capital’) has been extensively examined in the finance literature. Unfortunately, there is no agreement.

One problem is that investors benefit from imputation to varying degrees. There are two theoretical approaches to solving this. The first involves identifying the ‘marginal investor’ – the last investor enticed to hold a stock, so that demand equals supply. The idea that share prices are determined in international capital markets implicitly assumes a marginal overseas investor who places no value on imputation credits. The second approach views share prices as reflecting some weighted average of investor demands. Here imputation credits would be partially priced, perhaps in accord with the 60-80% held by domestic investors.

Empirical analysis is no more enlightening. Four methods have been used to estimate the market value of imputation credits: analysing ex-dividend price drop-offs; comparing securities that differ in their dividend/imputation entitlements; examining if imputation credits are associated with lower market returns; and establishing whether stocks offering imputation credits trade on higher prices relative to fundamentals like earnings. Results are mixed. The majority of drop-off and comparative pricing studies find imputation to be partially priced, with a wide range of estimates. Meanwhile, footprints from imputation are hard to detect in returns and price levels. In any event, all empirical studies suffer from significant methodological issues.

Another issue is that the pricing of imputation might vary across stocks or time, perhaps due to differing marginal investors. Of particular relevance is the smaller, domestic company segment where investors are substantially local. In this case, it is reasonable to expect that imputation might be priced.

With the finance literature failing to arrive at a consensus, the assumption that imputation does not lower the cost of capital amounts to an extreme position along the spectrum. The possibility remains that imputation credits might be priced either partially, or in certain situations.

Imputation and behaviour

Of prime importance is how imputation influences behaviour, and whether these behaviours are beneficial or otherwise. This matters more than how imputation impacts ‘numbers’ like cost of capital estimates. Many decisions are not based on formal quantitative analysis; and imputation tends to be a second-order influence in any event. Analysis may be used to support decisions, but rarely drives them.

Recognition of the value of imputation credits has influence over behaviour in three notable areas, the first being the clearest and most important:

  • Payout policy – Imputation has encouraged higher company payouts: the divergence in the payout ratio for Australia versus the world post imputation is stark (see chart). Actions taken by companies to distribute imputation credits clearly indicate they recognise their value to certain shareholders, e.g. off-market buy-backs.

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  • Where taxes are paid – Imputation encourages paying Australian company tax at the margin (referred to as ‘integrity benefits’ in the Tax Discussion Paper). If the tax rate is roughly the same in Australia and overseas, why not pay locally and generate imputation credits?

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  • Portfolios – Australian investors may prefer domestic companies paying high, fully-franked yields, all other things being equal. This preference is more likely to manifest as a ‘tilt’, rather than a dominating factor. There are multiple reasons for home bias, or the historical favour for bank stocks, for instance.

GW Figure1 030715

GW Figure1 030715

Would removing imputation matter?

Whether and how removing imputation would make a difference depends on what else happens, especially any concurrent corporate tax rate reduction. For instance, this could dictate the tenor of share price reactions, as effects from loss of imputation are pitted against higher earnings. Rather than delve into a multitude of possibilities, I offer two substantial comments.

First, removing imputation would do away with a major driving force for higher payouts. Higher payouts have contributed to more disciplined use of capital, through reducing the ‘cash burning a hole in company’s pockets’, and creating more situations where justification is required to secure funding. This is a MAJOR benefit of the imputation system: a view also expressed by many fund managers. Hence dismantling imputation could be detrimental to both shareholders and the Australian economy through less efficient deployment of capital.

Second, imputation probably matters most for small, domestic companies, many of which are unlisted. In this sector, it is more likely that local investors who value imputation credits are the ones setting prices and providing the funding. Any adverse impacts from removing imputation may be concentrated in this (economically important) segment.

Imputation removes the double-taxation of corporate earnings, but only for resident shareholders. The concept of reintroducing double-taxation for domestic investors in order to fund a revenue-neutral switch that provides a net benefit to overseas investors doesn’t seem quite right. The notion that the outcome will be substantially greater foreign investment with limited losses elsewhere appears questionable, especially once the implications for domestically-focused companies and potential behavioural responses are taken into account.

 

Geoff Warren is Research Director at the Centre for International Finance and Regulation (CIFR). This article draws on a paper titled “Do Franking Credits Matter? Exploring the Financial Implications of Dividend Imputation”, written with Andrew Ainsworth and Graham Partington from the University of Sydney. The paper can be found at: http://www.cifr.edu.au/project/F004.aspx

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4 Comments

john rorke

July 06, 2015

This is an excellent summary of the issues. Proponents of abolition of franking credits should be asked a simple question - how do you justify taxing the same income twice just because it is earned in a company structure? This is entirely different from a further tax when the money is spent . A change in the law will result in a large restructuring of small business from companies to trusts which is not productive to the country.

The point about efficient use of capital is totally valid. Nor does a high payout prevent investment in growth. If you have a good business and a good story there are plenty of institutions looking for investment opportunities.

Any increased overseas investment resulting from abolition of credits is likely to be balanced by Australian investors placing more funds overseas as the benefit of credits is lost.

in summary the arguments for franking are sound in every respect .

Peter Knight

July 03, 2015

Franking is getting a hammering in the media lately and is another prime example of misguided commentary by people who should know better or merely by folk pushing their own vested interests. I say this, because anyone advocating the abolition of Franking Credits is really saying that they believe in double taxation! It should be remembered that companies can whenever they like, reduce or suspend dividends, either temporarily, or permanently, as they see fit, unlike most fixed interest securities; the majority of which have compulsory coupon payments. Companies can also reduce their payout ratios and thereby reduce the quantum of the dividend payment to their shareholders. All of these factors means that equity income streams are more volatile than fixed income payment streams. It also highlights the fact that shares are higher risk than just about any other investment. That is of course why the returns are greater over much longer time frames and can be extremely unpredictable and volatile over shorter periods of up to five years or so. Why would anyone with any financial acumen make the most risky investment asset class, even more risky by abolishing franking credits? Furthermore, just at the time when investors in retirement who are desperate for yield finally succumb to entering the stock market, they find the legislation changes and the expected yield from the shares that they have purchased, takes a 30% hit because franking credits have been abolished. Even with franking credits still in existence, the equity risk premium at time of writing is becoming quite stretched. Therefore, to do anything as stupid as to abolish franking credits would be tantamount to political suicide. As I said earlier, if you abolish franking credits you do so with the full knowledge that you are endorsing double taxation and therefore, you might as well tax everything twice just to be consistent! Just don’t expect to be re-elected-ever!

Ramani

July 03, 2015

Franking credits matter. They arose from the unfairness of double taxing shareholders, and after a while, unused franking credits have been eligible for a refund (akin to prepaid taxes on investor's behalf).

But those who predict the end of the world if they are removed are moved by losing the entrenched benefit rather than any pure principle. After all, double (even multiple) taxation is a fact of life. Post tax earnings spent attract GST, and we have become used to it.

If we want any evidence of how self-interest rather than principle drives the opposition, consider that small business shareholders paying 28.5% from 2015/16 will receive the current 30% tax credit! As life affords no free lunches, neither can the taxpayer 'refund' the 1.5% tax never paid. But I have not seen a whimper of protest against this statutory rort.

Franking credits have spawned the usual financial engineering deals (trafficking in them; the unjustifiable practice of share buy-backs treating part of the price as deemed dividends and paying some but not all shareholders; double dipping).

There is only one test: if the exchequer cannot afford it, franking credits cannot continue as at present. In the long term, Governments cannot spend what they do not have. Ask Greece.

Glen Cunningham

July 03, 2015

Imputation sure works for me as a SMSF investor - I see that every year in my refund cheque from the RBA.

When I was involved in the corporate sector in calculating the benefit to WACC we used McKinsey's analysis based on dividend drop off and applied around 70% of the benefit if I can recall. So yes it really does alter the cost of capital in the real world. It benefits both the corporate players and the fund manager investors - It is fair and logical and it should be kept.


 

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