24 January 2019
The chief economist for the government’s 2014 Financial System Inquiry has called for dividend franking credits to be overhauled, hitting out at the “significant economic distortion” created by excess credit refunds for investors who pay no tax.
Kevin Davis, a professor of finance at University of Melbourne who was a panel member on David Murray’s landmark financial system review, said dividend imputation was designed to prevent double taxation of corporate profits.
“It wasn’t meant to lead to zero taxation of corporate income which occurs when dividends are paid to investors on zero marginal tax rates and rebates paid,” Mr Davis told The Australian.
“That has created a significant economic distortion, and while removing the rebate may be painful for those who have structured their investments to maximise gains from this tax arbitrage, such a change is warranted,” he said.
The government has repeatedly attacked Labor’s proposal to end cash rebates for excess franking credits for shareholders who pay little or no income tax, which is expected to increase government revenue by $56 billion over a decade.
The cost to the budget of the scheme has dramatically increased since it was introduced by the Howard government, when the measure cost just $500 million a year. Since then, many investors and self-managed superannuation fund operators have shifted all their assets into equities to take advantage of the franking credit rebate.
According to research by University of Sydney senior lecturer Andrew Ainsworth, small retail “mum and dad” shareholders are most likely to “aggressively” buy and sell shares around dividend payment dates to receive franking credit refunds.
Dr Ainsworth, a former Reserve Bank analyst who specialises in researching dividends and the imputation tax system, has urged a parliamentary committee examining Labor’s planned franking credit ban to investigate short-term trading on the sharemarket.
Retail investors who engaged in short-term trading may be harming the federal budget by claiming refunds in breach of the so-called 45-day rule, Dr Ainsworth said.
Introduced in 1997, the rule requires shareholders to hold stock for 45 days around the ex-dividend day in an attempt to limit short-term trading. However, there is little evidence the laws are enforced.
“I believe it is important to know if the 45-day holding period rule is enforced, and how,” Dr Ainsworth said. “If this rule is not adequately enforced then rectifying this would be a more equitable way to address the impact of franking credits on the federal budget than the proposed policy under consideration by the committee.
“A focus on short-term trading and the impact it has on the federal budget is worthy of investigation. I would argue that this should receive attention ahead of policy changes that target long-term investors.”
Labor is under pressure to overhaul its franking credit ban following a series of public hearings where angry retirees and shareholders lined up to slam the opposition’s proposal. The House of Representatives economics committee will be holding a further series of hearings across marginal Queensland electorates later this month.
Dr Ainsworth’s research has found that individual investors increase share buying “aggressively” before dividend payment dates and ramp up selling after payment dates in order to take advantage of the imputation tax credit.
The franking credits allow investors to lower their personal tax liabilities. Shareholders who can’t access the 50 per cent capital gains tax discount, which applies to assets held for more than a year, will prefer buying stocks to gain the dividends rather than expecting stock prices to go up over the long term.
Dr Ainsworth has also found this type of trading had a “material price impact” on shares after the dividend payment date, suggesting the dividend imputation system was leading to distortions in the market pricing of shares.
According to an analysis of the proposal by the independent Parliamentary Budget Office, 53 per cent of excess franking credits claimed by self-managed super funds were to funds with more than $2.44m in assets. Funds with more than $1m claimed 82 per cent of the franking credits, worth $2.1bn a year.
Grattan Institute senior fellow Danielle Wood said it was a “far from perfect” proposal, but endorsed it as a way to improve the health of the budget amid an ageing population.