One aspect of the tax policies which the Australian Labor Party (ALP) is taking to the 2019 Federal Election and which Labor Leader Bill Shorten mentioned in his Budget Reply speech has, with the exception the policy on electric cars, raised more opposition than most of the others put together. This is the proposal to eliminate refunds of franking credits on dividends for taxpayers who do not have a tax liability.
We examine this proposal in a two-part series. Part 1 points out how statements by Government members have misinterpreted data, and how the interaction of the refundability of franking credits with other aspects of the tax, transfer and superannuation systems produces inequitable results. Part 2 argues for a more targeted – and more politically palatable – approach than the ALP has proposed.
Misinterpretation of Treasury analysis by Government members
The Assistant Treasurer and, it seems several Government members across the country, cited Treasury analysis which showed that 84% of those claiming refunds of excess franking credits were on taxable incomes of less than $37,000 per year.
While the Treasury analysis is accurate (in fact it shows that 86% of individuals receiving franking credit refunds are on a taxable income of less than $37,000), the interpretations of it by Government members do not accurately reflect the likely impact of the ALP policy for several reasons. Many of these inaccuracies have already been pointed out by the ABC’s Fact Check; the points already made by Fact Check will only be summarised here.
Fact Check did find that excluding pensioners from the scope of those affected by the ALP policy did not make much difference to the percentage of those on taxable incomes less than $37,000 affected by the policy. The effect of taking 320,000 pensioners out of those affected merely meant than 83% of those affected were on taxable incomes less than $37,000, basically in line with statements by the Assistant Treasurer and others.
Nevertheless, Fact Check pointed out that the statement was misleading as: (a) it only took into account ‘taxable income’, not overall wealth or ‘income’, including exempt income derived by retirees over 60 from distributions; and (b) it failed to take into account the franking credit refunds claimed by super funds, where self-managed super funds accounted for 90% of refunds, and with those refunds being heavily skewed in favour of those funds with balances over $1 million.
While the comment by Fact Check is fair, a few additional comments are worth making.
1. Average refunds claimed per individual increase significantly as taxable income levels rise
The analysis by Treasury referred to the proportion of individuals affected by the policy who returned a taxable income of less than $37,000. Although the figure is correct, it should be pointed out that this only represented 59% of the dollar value of total refunds claimed. Once refunds received by pensioners are excluded, the dollar value of refunds affected falls to 58%.
In addition, the average refunds claimed per individual increase significantly as taxable income levels rise. For those on taxable incomes below $18,200, the average refund is $819 per annum or $15 per week. For those on taxable incomes between $18,201 and $37,000, the average refund is $2,222 per annum or $42 per week. For those on taxable income above $180,000, the average refund is $20,000 per annum or $384 per week.
2. Taxable income does not reflect all income, or the inequities in the current system
As far as the Income Tax Assessment Act 1997 (ITAA 1997) is concerned, income distributed to a retiree over 60 from a super fund in the pension phase is still income; it just isn’t taxable income, due to s301-10, which from 2007 has made such distributions non-assessable non-exempt income. This is where the ALP’s ‘Pensioner Guarantee’ assumes more relevance as it protects pensioners from the proposed changes.
For a retiree who has a taxable income of less than $37,000 to not be entitled to the age pension (possibly around 600,000 to 650,000 of them on Treasury figures), it is likely they would have failed the assets test for the age pension. For a single home owner, that would mean that the retiree has assets (other than their home) in excess of $567,000. For a couple, the limit is $853,000.
If we assume that a single retiree home owner over 60 has a balance of $570,000 in a super fund in the pension phase, then we get a more accurate picture of what the ‘income’ levels of the 600,000 to 650,000 affected people with taxable incomes less than $37,000 are.
Example: A single retiree with $570,000 super
Our retiree with the $570,000 super balance in the pension phase is required to draw down a 5% return each year. That is $28,500 tax free. The true income of the retiree is more like $37,000 + $28,500 = $65,500.
As the retiree would currently be receiving a refund of excess franking credits, the retiree would not be paying any tax at all. Under 2017-18 rates (assuming that the retiree was eligible for Senior Australians Tax Offset; SATO), the retiree would have had a tax liability of $1,711.32 on the $37,000 of taxable income; and, to obtain one cent of refunded franking credit, the retiree would have to have received $3,993.11 of franked dividends with $1,711.33 of franking credits attached.
Assuming a 5% return on investment, the retiree would need to own around $114,000 of shares in Australian companies paying franked dividends to receive a grossed up dividend of $5,704.44. The wealth of the retiree, excluding their home, therefore would at least be $570,000 (super fund balance) + $114,000 (share investment) = $684,000 and they would not be paying any tax at all. If some of the rest of the retiree’s taxable income of $37,000 came from other investments (such as rent or interest) then their assets could greater still.
Inequity worsens with the progressive rate scale
Inequity is apparent here if the retiree is compared with someone who simply earns $65,500 as wages or salary (which is actually above average weekly earnings for all employees as at November 2018). At 2017-18 rates, the wage or salary earner would pay tax of $14,127 on $65,500 and would have an after tax income of $51,373, as compared with the retiree who would have an after tax ‘income’ of $65,500.
If you thought that this example showed up inequity in the current system, it actually gets worse because of the way the ‘exemption’ in s301-10 interacts with the progressive rate scale. Currently, the maximum balance for a superannuation fund in the pension phase is $1.6 million. For a retiree aged 65, a minimum of 5% has to be paid to the retiree and because of s301-10 that payment will be tax free to the retiree.
So our member would receive $80,000 from the super fund tax free, would also have received a grossed up dividend of $5,704.44, and would not pay any tax. The retiree’s ‘income’ would be $37,000 + $80,000 = $117,000, significantly above average full-time earnings, which stood at $83,454 at November 2018.
3. The role of refunds to self-managed super funds
While refunds to individuals are estimated to amount to $2.2 billion, refunds to super funds are approximately $2.8 billion, with $2.6 billion of these going to self-managed super funds (SMSFs).
Super funds in the accumulation phase are taxed at a rate of 15% on their earnings, including franked dividends. With the corporate rate being 30% and investment earnings being taxed at 15%, a super fund would need to have more than 50% of its investments in Australian companies paying franked dividends before it would be entitled to a refund of excess franking credits.
Typically, self-managed super funds invest around 30% of their overall portfolio in Australian shares. That level of investment in Australian shares will not get them a refund of franking credits. How then do SMSFs get so many refunds of excess franking credits?
This is how. Since 1989, super funds have been exempted on income they received and used to fund pensions paid in the retirement phase, yet they are entitled to a gross up and refundable tax offset for franking credits on dividends received. This treatment is unusual and can be considered inequitable as most other taxpayers receiving exempt income are not entitled to a gross up and tax offset for franking credits on dividends received.
(Admittedly, pooled superannuation trusts, life insurance companies and friendly societies are also entitled to franking credit tax offsets on certain exempt income and some tax-exempt institutions, such as charities and deductible gift recipients, are entitled to a gross up and tax offset).
A simple example can illustrate our point. Say a super fund had $70 of franked dividend income with $30 of franking credits attached, but had $200 of other investment income. When taxed on its investment earnings at a 15% rate, it would have an excess tax offset of $15 on its franked dividend income, which it would offset against the $30 of tax liability on its other investment income, making a net tax payable of $30 – $15 = $15.
If a super fund only had members in the pension phase, then for every 70c of net franked dividend income it received it would receive a refund of 30c.
Where a super fund had a mix of accumulation phase and pension phase investments, the effective overall tax rate on its investment income falls as the proportion of its investments is in the pension phase increases. Thus, as the proportion of super fund investments in Australian shares increases and as the proportion of super fund investments in the pension phase increases so too does the likelihood of super funds receiving a franking credit refund.
In the above example, if the super fund’s investments were doubled, but with half being in the pension phase and half being in the accumulation phase, the super fund would be entitled to franking credit refunds. The super fund would receive $140 of dividends with $60 of franking credits attached. The dividends would be grossed up to $200 by adding back the franking credits, and only $100 of the $200 would be taxable to the super fund. Tax would be assessed at the rate of 15%, making tax assessed of $15, but the super fund would be entitled to a tax offset of $30 because of the franking credits. The result would be that the super fund would be entitled to a tax refund of $15 – $30 = $15.
In light of these issues, we will consider in Part 2 how the ALP proposal can be better targeted, while still achieving equitable results.
Other articles in the Budget Forum 2019
The Instant Asset Write-off Will Lift Investment—but Is That What We Want?, by Steven Hamilton
Refundable Franking Credits: Why Reform Is Needed (and Why It Should Be Targeted) – Part 2, by John Taylor and Ann Kayis-Kumar
“All Without Increasing Taxes”? A Closer Look at Treasurer Frydenberg’s Refrain Repeated Eight Times in His Budget Speech, by John Taylor and Ann Kayis-Kumar
Tax Offsets and Equity in the Scheme for Taxing Resident Individuals, by Sonali Walpola and Yuan Ping
Forecasts and Deviations – the Challenge of Accountable Budget Forecasting, by Teck Chi Wong
Targeted Tax Relief Makes the Tax System Fairer but the Economy Poorer, by Steven Hamilton
A Simpler Tax System Should Spark Joy—Eliminating Tax Brackets Sadly Doesn’t, by Steven Hamilton
A Budget That Supports Indigenous Australians?, by Nicholas Biddle
Women in Economics 2019 Federal Budget Reflections, by Danielle Wood
Tax Progressivity in Australia: Things Aren’t as Simple as They Seem, by Chung Tran and Nabeeh Zakariyya
Coalition and Labor Voters Share Policy Priorities When They Are Informed About Inequality, by Chris Hoy
Future Budgets Are Going to Have to Spend More on Welfare, Which Is Fine. It’s Spending on Us, by Peter Whiteford
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