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The Australian Labor Party’s proposal to deny a cash refund on excess franking credits from Australian shares has very similar effects to the destructive and self-defeating consequences of the federal government’s 2017 changes to the Age Pension asset test (see my other SuperGuide article Age Pension changes costs pensioners now and increases government costs in the long term).
Many retirees will suffer a significant loss in income, which they will have to cover by drawing down their capital; this will force them to become more reliant on the Age Pension, thus eroding much of the government’s savings. In this article, I’ll briefly illustrate the impact of the proposed abolition of the franking credits cash refund by examining the effect of the proposal on two friends, Janet and Steve.
To understand the Australian Labor Party (ALP) proposal, we first have to understand how dividend franking works. It’s a simple idea, which becomes very confusing because of the terminology and the way it is implemented. That confusion has clouded the judgement of many commentators, and provided a very handy smokescreen for those with a hidden agenda.
A dividend is simply a portion of a company’s profit, transferred to a shareholder. That part of the profit, assuming it is taxable in Australia, is taxed in the hands of the shareholder, not the company.
However, the money travels by different routes: 30% of it is taken directly by the Australian Tax Office before the shareholder gets the dividend, in essentially the same way as pay-as-you-go tax payments are taken out of an employee’s salary before the employee is paid; the other 70% goes straight from the company to the shareholder.
In the arcane language of income tax, the amount taken by the ATO is known as a franking credit, the money received by the shareholder directly from the company is the dividend, and the dividend plus the franking credit equal the gross dividend. The gross dividend is included in the shareholder’s taxable income, and the ATO accounts for the fact that it has already taken the franking credit when the sums are done at tax time. If the ATO has taken more than it should have, the excess is refunded – just as with employee’s income tax.
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Franking credits are taxpayers’ money, not special handouts
Many commentators would have you believe that the franking credit is a special handout from the government, but it’s not. It’s the taxpayers’ money and it’s included in their taxable income; the ATO just looks after it for a while.
The ALP’s proposal is to stop the refund of excess franking credits (i.e. credits in excess of tax payable). The ALP would never do this with PAYG payments, but never mind: it’s easy for them to pretend dividends are different.
In the case of a shareholder with a relatively low income who would ordinarily pay no tax, or a self-managed super fund in pension mode (which also pays no tax), the ALP would simply confiscate the entire 30% franking credit. This is an additional tax despite the ALP’s claims to the contrary – what else can you call it when the ATO keeps your money?
Under the ALP’s proposal an SMSF in accumulation mode which invests solely in shares paying fully-franked dividends will see its tax rate jump from 15% to 30% (of the gross dividend). So much for “concessional” tax rates. In fact, it wouldn’t matter if the account was in pension mode or accumulation mode: either way the shareholder would only receive $0.70 after tax for each $1.00 of gross dividend.
The ALP’s proposal will actually hurt anyone whose income tax obligation is less than the franking credits they receive.
A mother who owns some shares and has taken time away from the workforce to raise her kids will probably lose her franking credits.
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Various commentators (not SuperGuide’s commentators) have pointed out that investors can simply sell their shares and reinvest in property trusts, funds etc which don’t provide franking credits but give a high yield. Doubtless many will do so and there may be consequences – for share prices for example. But if everyone does this, the ALP’s savings will evaporate and the whole exercise will prove pointless.
The examples below explore what happens when people keep their shares.
The ALP’s proposal has long-term ramifications, which has received superficial treatment at best from most commentators up to date. We need to dig a bit deeper, so let’s consider Janet’s case.
Janet loses 30% of income due to loss of franking credits refund
Janet began retirement on 1 Jan 2018 at age 65 ½. She was single, owned her own house and started retirement with $560,000 invested in shares paying a fully franked gross dividend of 5%, but providing no capital growth. Janet had negligible other assets or income.
In the first year of her retirement, Janet’s taxable income consists of a $19,600 dividend plus an $8,400 franking credit making a total of $28,000; so she pays no tax under the present system. She initially had a little too much capital to receive a part Age Pension, although that changed the next year.
The Age Pension is usually indexed to wages growth which is usually a little higher than inflation. Janet’s shares exhibit no capital growth, so their real value (adjusted for inflation) falls with time. The net effect is that her Age Pension rises as she gets older.
Under the ALP’s proposal, Janet would lose the $8,400 franking credit because she pays no tax. This is a loss of 1.5% of her capital or 30% of her income (roughly similar to the initial effects of the January 2017 Age Pension changes on Susan illustrated in SuperGuide article Age Pension changes costs pensioners now and increases government costs in the long term ).
Janet has no choice but to sell some of her shares to compensate for the lost income, which causes her real capital to fall even further, and her Age Pension entitlement to rise faster than it would under the current rules.
Let’s skip forward 30 years to when Janet turns 95. Under the ALP’s proposal, if she sells enough shares each year to compensate for any loss of income (i.e. she makes her total income, including a part Age Pension, the same as it would have been if the current rules continued), the real value (in 2018 dollars) of her capital at age 95 will be $89,944 less than it would have been under the current system.
Janet: Fully franked gross dividend 5%, but no capital growth
|Current rules||ALP proposal||Change|
|Real capital at age 95||$309,160||$219,216||-$89,944|
|Total real franking credits||$196,530||$0||-$196,530|
|Total real Age Pension payments||$429,917||$560,044||$130,127|
In 2018 dollars: The ALP’s proposal, with respect to Janet, would save the federal government franking credits worth $196,530, but this is at the expense of $130,127 in extra Age Pension payments, making the net savings to government of $66,403 which is substantially less than Janet’s $89,944 capital loss.
Let’s look at a slightly different scenario, for Steve.
Steve never pays tax due to loss of franking credits refund
Steve’s circumstances are identical to Janet’s except that he chose a different portfolio of shares, producing 5% capital growth plus a 5% fully franked dividend. Under the current rules, Steve’s income consists of dividends plus franking credits plus any part Age Pension he may be entitled to, less income tax which will apply if his shares and dividends grow sufficiently.
Steve: fully franked gross dividend 5%, and 5% capital growth
|Current rules||Labor proposal||Change|
|Real capital at age 95||$1,170,794||$509,852||-$660,942|
|Total real franking credits||$396,577||$0||-$396,577|
|Total tax paid||$146,452||$0||-$146,452|
|Total real Age Pension payments||$0||$58,358||$58,358|
Under the current rules (excess franking credits are still refunded), Steve’s dividend income increases as his shares grow in value, and after six years’ retirement he reaches the point where he does indeed begin paying income tax on the gross dividends. His tax payments total $146,452 (in 2018 dollars) by the time he reaches 95. He never receives any Age Pension. See tables ‘Steve’s capital’ and ‘Steve’s Age Pension’ below.
But under the ALP’s proposal, Steve loses all of his franking credits and is continually tapping into his capital to compensate. As a result, his capital (in real terms) remains almost constant through the first half of his retirement and falls thereafter. Thus he never receives a high enough income from his shares to pay tax, and after age 85 he starts receiving a part Age Pension. Effectively the federal government consumes all of the capital growth in Steve’s investments over 30 years – he loses more than he started with. This capital reduction dramatically erodes his financial resilience and ability to deal with life’s emergencies and unforeseen events. See tables below.
The ALP’s proposal gives the government a net saving of just $191,767 (in 2018 dollars) – only 30% of Steve’s lifetime real capital loss. It is a brutally inefficient way for the government to save money.
ALP’s proposal hits all types of Australians, and is unfair
In presenting its proposal, the ALP emphasised that it was designed to target the rich. But neither Janet nor Steve is rich, and they get hit hard. Furthermore, the process is inefficient in the sense that the federal government’s net gain is less than the retirees’ capital loss.
What the ALP wants to do to franking is every bit as destructive as what the current government did to the Age Pension by changing the asset test taper rate in 2017 (see SuperGuide article Age Pension changes costs pensioners now and increases government costs in the long term).
There is no fairness in the ALP’s proposal. There is not even a decent justification for it. The best the ALP has been able to do is to say:
- We “can’t afford” the cost of refunding franking credits. Why not say we can’t afford tax refunds of any kind, the logic is the same? And why not look for less destructive ways to deal with ballooning government expenditure?
- This proposal restores the system to the way Paul Keating originally set it up. Well, we could wind the clock back 30 years on all sorts of things, but that doesn’t mean we should.
And what’s with “the dog ate my homework”? Why are both major parties so reluctant to release details of their modelling behind the 2017 Age Pension changes and the ALP’s current proposal? Are they embarrassed?
I just wish that both major parties would stop attacking retirees, and focus more on making life better for all Australians, and less on confiscating our assets – it’s a profoundly lazy way to pretend to manage the economy.
To politicians of all persuasions: stop and think. One day you too will retire. What about your elderly relatives and friends? What about your own inheritance?
Important facts about the ALP’s proposed ban on cash refunds for excess franking credits
- Franking credits are exactly the same as PAYG tax collection, and any excess should always be refunded.
- The ALP has provided no logical and reasonable justification for confiscating franking credits.
- Confiscating franking credits forces retirees to draw down capital to maintain income.
- Dependence on the Age Pension is increased, negating much of the cash benefit for the government.
Technical note: Age Pension parameters are those which applied at 1 Jan 18; for future years, the full Age pension is assumed to indexed to wages, at 3%, while other parameters (thresholds etc) are indexed to CPI inflation at 2%. Income tax is calculated using current tax parameters, and includes the Medicare levy, the low income tax offset and the seniors and pensioners tax offset. For calculation of tax in future years, the income is first converted to 2018 dollars to calculate the tax and the result is re-inflated to the future year. All calculations are done with an annual time-step.
Nothing in this article should be construed as financial advice.
The author: Dr Jim Bonham is a retired scientist and manager. As a trustee of a self-managed super fund, he is deeply concerned about the continuing instability of the rules around superannuation and the Age Pension. If the ALP’s proposal ever goes ahead, he would lose franking credits from his SMSF and from his personal shareholding.
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