In all the talk about refundable franking credits, it is easy to overlook the fact that a franking credit is additional income as well as a tax credit. The purpose of Australia’s franking system is to transfer all of the company profit to the shareholders as additional income where it is then taxed at shareholders’ marginal tax rates. But the shareholders only receive the dividends as money in the bank, which are paid out of the company’s after-tax income. Therefore, the shareholder also needs to include the company tax portion, withheld by the Tax Office, as well as the dividend in their taxable income. The portion withheld by the ATO then becomes a tax credit that can be set against the taxpayer’s own tax liability.
It’s not only a high income impact
At present if that tax credit exceeds their tax liability, taxpayers are entitled to a cash refund, just like a PAYG taxpayer who finds their employer has paid too much tax on their behalf. Under Labor’s proposal, franking credits will not be abolished, but excess tax credits will be withheld. The effect is that taxpayers with the lowest income tax rates are hardest hit. It’s not “excessive tax concessions for high income superannuation accounts” as Labor claims.
Company tax is a constant 30% regardless of the amount of profit being taxed. When that company profit is transferred to the shareholder for tax purposes, it is both additional income and a tax credit to account for the company tax already paid. The franking credit therefore represents 30% of the total income that a taxpayer derives from Australian shares.
Income taxes are progressive. This generates excess franking credits (and therefore tax refunds) on all low and middle incomes:
|Taxable income||Tax on this income|
|0 – $18,200||Nil|
|$18,201 – $37,000||19c for $1 over $18,200|
|$37,001 – $90,000||$3,572 plus 32.5c for each $1 over $37,000|
|$90,001 – $180,000||$20,797 plus 37c for each $1 over $90,000|
|$180,000 and over||$54,097 plus 45c for each $1 over $180,000|
As income rises, not only do taxpayers pay more tax, but they pay an increasing proportion of their income in tax. For example, from the above table the tax on an income of $37,000 is $3,572. The marginal tax rate on each additional dollar over $18,200 is 19%, but as a proportion of the total, the tax is only 9.65%. This is the average tax rate. The tax on $90,000 is $20,797. The marginal tax rate on each additional dollar over $37,000 is 32.5%, but as a proportion of the total, the tax is 22.1%. A taxpayer earning $90,000 pays proportionally more tax than someone earning $37,000.
If we were to revert to the situation that existed before 1987 when there were no franking credits, and there were no tax refunds, tax on dividends would then be identical to the tax on bank interest.
|Average tax rate||2.53%||9.12%||15.25%||20.42%||28.07%|
If we fast-forward to today and assume that all of our example taxpayers’ income is derived from franked dividends, the following table illustrates how the constant rate of company tax interacts with the rising proportion of tax as incomes rise. For simplicity, the tax payable has ignored the Medicare levy, which increases the tax, and tax offsets which reduce it.
|Average tax rate||7.47%||15.59%||20.42%||24.50%||31.55%|
In the table above, it is clear that the franking credit is a constant 30% of the taxable income. It also shows that the franking credit exceeds the tax liability on all incomes where the 30% company tax rate exceeds the average income tax rate. That excess tax credit is presently refunded as cash.
If the franking credit is additional income for one taxpayer, it must be additional income for all taxpayers. If it is not additional income, we would be using Table 1 and everyone would be much worse off, precisely because it would be a return to double taxation.
Effective minimum tax rate becomes 30%
The franking credit is income that is additional to the dividend. Taxpayer ‘A’ has a taxable income of $30,000 and pays $2,242 in tax. With the tax credit of $9,000, they are entitled to a cash refund of $6,758. Under Labor’s proposal, that excess tax credit will be withheld. Without the refund of the excess tax credit, Taxpayer ‘A’ has a taxable income of $30,000 and an after-tax income of $21,000. They have paid $9,000 tax on that taxable income compared to a PAYG taxpayer who pays $2,242 on the same taxable income. Without the cash refund, the effective minimum tax on those dividends is 30%, regardless of the marginal tax rate.
Clearly the cash refund does not depend on whether or not you pay tax, as Mr Shorten claims, but on the difference between the franking credit and your own tax liability. Without the cash refund, the after-tax incomes of many low and middle taxpayers are reduced. For low incomes that reduction in after-tax income is proportionally very large because the difference between their average tax rate and the constant company rate is also large. For higher incomes the reduction in after-tax income from this proposal becomes proportionally smaller because the difference between the constant franking credit rate and the average tax rate also becomes smaller.
High income earners pay enough tax to use the franking credit
That difference between the two rates disappears completely when the average income tax rate is equal to the company tax rate of 30%. But the average income tax rate does not reach 30% until incomes are very high. The above table shows that only taxpayer ‘E’, with the highest income, will not experience any reduction in after-tax income as a result of Labor’s proposal and will continue to be able to fully utilise their franking credits to pay their tax liability.
All taxpayers with dividend incomes below $140,000 will lose some of that tax credit refund, and those on the lowest incomes lose the most proportionally. This proposal has the effect of hitting taxpayers on the lowest tax rates the hardest, unless they belong to one of the exempt groups.
The ignorance around the fact that taxes on company profits are both additional taxable income and a tax credit for shareholders allows Labor to pretend that company profits are somehow separated from the shareholders who are responsible for the tax payable on that profit. Labor’s proposal focuses only on the tax credit, which may or may not be refunded, while ignoring the fact that shareholders also have a higher taxable income (and tax liability) due to those dividends and company taxes. To complete the fiction, Labor likes to pretend that franking credits are a gift from the ATO through a loophole unavailable to less sophisticated investors.
Under Labor’s proposal, the effective minimum tax rate on dividends (and only dividends) will be 30% regardless of a taxpayer’s marginal tax rate for all ‘non-exempt’ Australian shareholders. Although retirees tend to have lower marginal tax rates, the impact of this proposal is certainly not limited to retirees.
Jon Kalkman is a Director of the Australian Investors Association. This article is for general information only and does not consider the circumstances of any investor.
See also: Data analysis by SuperConcepts, Poorer retirees to be hardest hit by ALP franking credit changes. It argues: “A 20-year projection of different income levels confirms that lower earning retirees will be hit hardest by the ALP’s proposed removal of franking credit refunds. Data analysis by SuperConcepts confirms that retirees with an account-based pension receiving a minimum pension amount of $45,000 per annum at age 65, will find themselves 15% worse off in retirement savings after 20 years.”