The debate around franked dividends refuses to go away. Not long ago in an inquiry submission I signed off the following: “The decision to introduce dividend imputation has provided an unforeseen benefit for Australia, perhaps one that is still not fully appreciated by policymakers — it has made Australian companies manage their capital more efficiently. In turn, that makes them sounder investments.”
Yet this benefit appears to be in jeopardy still, because the debate about the value of dividend imputation has widened to a point where it is now a mainstream issue with contributions from economists and politicians alike.
Based on a range of work that goes back to 2015, we have accumulated a strong range of data to set the picture straight.
We seek to puncture the myths about franking credits in the hope that policymakers will possess the information they need when judging the effectiveness of a tax system that has served Australia well since 1987. Quite possibly, one of the foundations of the long period of economic stability we have enjoyed over this period has been the investment discipline the franking regime has promoted.
Myth 1: Franking is an anachronism; Australia should modernise its tax structure.
Reality: Franking’s primary benefits — avoiding double taxation, removing the incentive for high levels of corporate debt — remain valid. Dividend imputation was introduced to avoid the unfairness of taxing company profits twice.
Without franking, the interest expense deduction would be expected to have more influence in corporate funding. Since the introduction of franking, Australian companies have increased their gearing levels — in line with the secular decline in interest rates in the Western world
Myth 2: Franking is all about the tax refunds.
Reality: Franking’s most important influence has been on capital allocation in the economy.
Growth and innovation require that funds available for investment are channelled to the most promising opportunities. Franking facilitates this by automatically prompting companies that generate the most cash flow to pay it out, which allows shareholders to reinvest into the best opportunities. Without franking, this capital-recycling process would be diminished.
Myth 3: Australia has enjoyed long economic growth. Franking has played no part in this.
Reality: It is likely that franking has contributed to Australia’s lower economic volatility.
Franking constrains corporate reinvestment. If we assume that companies will fund their best projects first, their second-best projects second, etc, then constrained reinvestment should result in better outcomes.
Myth 4: If Australian companies have higher payout ratios, it must be at the expense of capex — but we need more investment now, not less.
Reality: Relative to US companies, Australian companies pay higher dividends and also invest more; the key difference is that Australian companies run their balance sheets more efficiently.
Myth 5: Franking promotes higher payouts, which reduces reinvestment and lowers future growth.
Reality: Higher payouts indicate higher future earnings growth — there is no income-growth trade-off.
Conventional wisdom holds that companies retain more earnings when growth opportunities are ample. Therefore, paying out large amounts of dividends signals a paucity of good growth opportunities. Academic analysis challenges this view. Arnott and Asness (2003) used 130 years of data to show that it is high-payout firms that generate the best earnings growth over time.
Myth 6: Franking turns the Australian market into a high-yield, low-price-return market.
Reality: Higher dividend-paying sharemarkets deliver higher price returns, even at the aggregate level.
Conventional wisdom assumes high-dividend stocks offer low growth potential. The perception is that companies that return much of their earnings to shareholders have less to invest than companies that retain profits. But again this is not supported by the data: over time, high-yielding markets have offered the highest total shareholder returns.
Myth 7: Abolishing franking would boost government revenue.
Reality: Franking creates integrity in the corporate tax base. Removing franking would give rise to behavioural changes that could erode the corporate tax base, leaving government finances — and retirees — worse off.
Australia is a first world nation, with first world community expectations for the services that its government will provide. As such, we can never compete with smaller or less developed nations that offer low or even zero company tax rates to attract corporates.
Myth 8: Franking disadvantages companies that earn significant overseas revenue.
Reality: These companies benefit from the positive side-effects of franking.
Relative to their direct peers listed on other markets, Australian companies with significant overseas revenue (“exporters”) show lower debt levels yet higher rates of asset growth. They have delivered higher cash flow return on investment and enjoy a lower cost of capital. As a result, they have achieved a higher income return than their international peers — and a higher price return, resulting in a higher total return.
Myth 9: Franking creates a risky market bias for retirees.
Reality: Franking does create a bias towards high-quality, well-managed, cash-generative equities: this will help keep self-funded retirees off the aged pension.
Super funds do show a bias towards domestic equities. But at the SMSF level, this is directed towards the more stable end of the equity market. Credit Suisse research shows that SMSFs own about 16 per cent of the local equity market. Advisers to these funds suggest that these investors want high-dividend yields from large companies they identify with and have a history of dividend growth.
Myth 10: Franking creates a home-market bias for retirees.
Reality: Franking results in well-managed, high-returning, lower-volatility companies that are justifiably attractive to domestic and international investors.
Myth 11: Franking makes Australian shares less attractive to overseas investors.
Reality: Corporate tax levels do not typically feature in investment decisions by foreign investors. Quality of operations and management are more significant; franking supports these.