It's the economy, stupid!

Franking credit trouble

You read it in The Australian first - two weeks ago I indicated a problem with the Coalition’s paid parental leave (PPL) scheme. “The final complication is how this levy will interact with dividend imputation. This could very easily become an intergenerational transfer from self-funded retirees and superannuation funds to female employees in small business. I suspect the Coalition has not thought about that.”

Given comments in the media today I suspect they still haven’t given much thought to the issue. Watching television comperes trying to explain the problem has been amusing too.

The basic idea is this: company income tax is a withholding tax for Australian investors. Investors pay the company tax at their own marginal tax rate. Those investors in the 45 per cent tax bracket have to pay in the difference between the company rate of 30 per cent and their own rate. While those investors in the 19 per cent bracket get a tax credit for the difference between their rate of 19 per cent and the 30 per cent company rate. Depending on their tax affairs the government might even send them a cheque for the difference.

Reducing the company income tax may appear to have little effect on Australian investors as it leaves their overall tax burden unchanged. What it does do, however, is change the settling up at the end of the tax-year. Investors in high tax brackets will have to pay in a bit more than they did before, while investors in low tax brackets will get back a little less than they did before.

This remains true irrespective of the size of the dividend. Tony Abbott was saying today that under a Coalition government dividends will be higher because the economy will be run better. Perhaps. Even if that is were true, however, there is no magic pudding. The company tax being withheld will be reduced but the overall tax liability is unchanged. The difference being the PPL levy being paid for by investors.

To show the difference between Tony Abbott’s PPL and a tax cut generally I have an example. Consider five taxpayers, one in each of the tax brackets. I first show what happens at present. For every $1 of company profit 30c is paid in company tax, and 70c is paid in dividends (I’m assuming a 100 per cent payout ratio). I then calculate the differential between the personal income tax and the company income tax. The taxpayer then either has a credit if their tax rate is lower than the company rate or has to pay in if their personal tax rate is higher that the company rate. The last row of the first panel shows the overall effect. For every $1 of profit the taxpayer in the 0 per cent bracket has $1. For every $1 of profit the taxpayer in the 19 per cent bracket has 81c and so on.

Franking example.

In the second example I show what happens if the company tax rate is reduced to 28.5 per cent. The numbers change slightly, the differential changes with people paying in slightly less or more as the case may be, but the end result is unchanged. The amount of cash that investors have at the end of the day has not changed - that is because the profit is ultimately taxed at the investors marginal rate.

Now look at the third example - here I show a reduction in the company tax rate to 28.5 per cent and a 1.5 per cent levy. Now look what happens. For every $1 of profit the taxpayer in the 0 per cent bracket has 98.5c. For every $1 of profit the taxpayer in the 19 per cent bracket has 79.5c and so on.

That example works for every dollar of profit that is taxed and then paid out as a dividend. The levy here is partially paid for by investors - by self-funded retirees and superannuation funds.