Investment, the Corporate Tax Rate, and the Pricing of Franking Credits

Rarely, if ever, has it been shown anywhere that corporate income or related taxes are either fully priced or close to fully priced based entirely on stock market returns.

There is a very good reason for this lacuna due to perhaps the first law in economics, ‘the law of one price’. Heterogeneous traders in entirely different tax positions simultaneously trade the same security yielding a single price from which it is usually impossible to extract tax implications.

In fact, there have been several studies also published in The Economic Record, namely Lajbcygier and Wheatley (2012) and Siau, Sault and Warren (2015), suggesting that Australia’s almost unique franking credit rebates for corporate tax paid by companies on behalf of Australian shareholders are unpriced. If these studies were correct, it would follow logically that Australia’s cost of capital has been artificially inflated by our corporate tax rate and provide a case for reconsideration of our rate. (See, for example, Rimmer et al. (2014), Cao et al. (2015), Kouparitsas et al. (2016), Murphy (2016, 2018), Dixon and Nassios (2016) and Tran and Wende (2017).)

But, are franking credits fully priced or not?

For 2014-15, the Australian Tax Office (ATO) reported that franking credits paid out to Australian investors were worth 37.3 per cent of company tax revenue. Given expected company tax revenue in 2019-20 of $98.9 billion and an unchanged proportion, this would place a value on franking credits today of about $37 billion. It is important to know if these tax rebates are fully priced.

If they are fully priced, then the level of Australian corporate investment is unaffected by our grossed-up corporate tax rate of 42.86 per cent [(0.3/(1-0.3)] where 30 per cent is the headline rate. Australian companies would only pay the world tax-free cost of equity capital on Australian investment which is lower by the grossing-up rate. Australians investing offshore and not paying Australian corporate tax need to earn 42.86% more since they are not eligible for the tax rebate.

This creates a tax wedge, which is invisible in ordinary return data.

The Turnbull corporate tax cuts

The Turnbull Liberal-National Coalition Government (2015-2018) downplayed our tax imputation system (that my reports written for the Campbell Committee of Inquiry helped to introduce) when they suggested that the corporate tax rate was too high and needed to be reduced by 17 per cent.

If all corporate income were paid out to Australian investors, no Australian would pay even one cent in corporate tax as it would all be imputed into their personal income on which they pay personal tax. However, only about 70 per cent is immediately paid out as franked dividends and hence there is a present value cost due to payment delays which may not be all that high. Hence the corporate tax cut from 30 per cent to a phased-in rate of 25 per cent in 2021-22 (currently 27.5 per cent) for largely locally owned, small and medium enterprises with turnover up to $50 million will yield only a relatively small and perhaps negligible benefit to the recipient. While I believe that lower franking credit rebates should wash tax cuts out almost entirely for these smaller businesses, nonetheless Treasury has placed a surprisingly high cost of $1.8 billion on these cuts for 2019-20.

In effect, for all but foreign investors, the Australian corporate tax rate is zero or close to zero. Much to the chagrin of the Australian Labor Party (ALP) at the last election, shareholder retirees with a zero personal tax rate pay no tax on their corporate dividend income either due to franking rebates paid in cash. Nor should they as this is no more than a refund of tax paid on their behalf.

How can we identify the tax effects?

For the last 50 years, researchers have incorporated risk into cost of capital models by first using their data to compute Capital Asset Pricing Model (CAPM) beta values, or similar, and then on the second pass, estimating their model. (See, for example, Lajbcygier and Wheatley (2012) and Siau, Sault and Warren (2015).)

This double-dipping with the data induces all sorts of econometric biases and largely rules out finding tax effects since it is assumed that risk is unrelated to the tax regime. But, clearly both risk and the non-eligibility of Australian’s investing abroad for franking benefits can differentially affect returns between the two types of investment.

Hence, in my forthcoming Economic Record article, I interact the excess market return with indicator variables showing the type of investment to compare the risks associated with both domestic and overseas investment in a single cross-sectional regression covering my entire data period and free of double-dipping bias.

My findings

What I find is very surprising: the required return on Australian Security Exchange (ASX) stocks that never pay franked dividends is approximately 42.86 per cent higher than on stocks that normally pay franked dividends but do not always do so.

This higher required return could conceivably be due to higher risk. But I suggest that it represents not a risk premium but, rather, it is compensation for the additional tax on outbound overseas investment. That additional tax is due to ineligibility for franking credit benefits that are in theory also worth 42.86 per cent to recipients of franked dividends because of the embedded tax relief.

As further confirmation of this tax-based interpretation, I find that stocks which normally provide franking benefits but sometimes fail to do so provide risk compensation of only about half this magnitude. The market clearly does not regard an occasional lapse in providing tax benefits as seriously as it views permanent cessation of tax benefits.

What benefit to the economy from a company tax cut?

The implications of these findings for the Australian economy are profound.

For the last decade, a whole series of computable general equilibrium models of Australia’s taxation system have been constructed on the untested assumption that franking credits are entirely unpriced (see links above).

If this were indeed the case, then investors in all the major Australian stocks that usually pay franking credits are seen as parasites who ‘double-dip’ by receiving both the hefty franking credit rebate plus the high grossed-up return required by Australians who invest off-shore and pay foreign company tax but not Australian company tax. Worse still, far too little investment takes place in the Australian economy because the high assumed tax wedge may drastically raise the required gross return on Australian investment leading to far too little investment.

My empirical findings call into question the conclusions drawn from this sophisticated model building, that have little econometric support other than guesses made about elasticity values.

Since there has been negligible change in the Australian corporate tax rate for decades, it is not possible to show statistically that lowering Australia’s corporate tax rate would induce an iota of new investment. My findings suggest that foreigners would not invest any more as a result of the now failed Turnbull plan to cut the tax rate from 30 per cent to 25 per cent for all companies, including companies with turnover in excess of $50 million per annum, at a cost to tax revenue of up to $13 billion annually. Note that the reduced tax rate for small, essentially Australian owned companies of 27.5 per cent has no cost to revenue as it is fully offset by reduced franking credits. Not only is it the case that only foreign shareholders benefit, but the apparent level of investment in Australia would appear to be already set at the world-efficient level due to the operation of the franking credit system.

Since my findings show that franking credits lower the cost of capital for franking firms by about 42.86 per cent, how is this possible without equity capital being supplied by foreigners? Since the arrival of the First Fleet, most capital has come from overseas, particularly England and the United States. There is insufficient scope for foreigners to sell their worthless (to them) franking entitlements to locals prior to the stock going ex-dividend and then repurchasing. Australia’s extensive international banking system provides the answer.

Domestic borrowings are ultimately funded by foreign debt capital, both personal and corporate. Both foreign-owned firms and firms with high foreign shareholding have a tax incentive to borrow offshore. Personal debt capital is then channelled into equity investment through Australia’s compulsory superannuation system and self-managed funds. Australia is basically a price taker in the global debt market that is not burdened by corporate taxes.

The election outcome would have been quite different if the corporate tax cuts were not abandoned

The Turnbull Government tried for years to get its corporate tax cuts past the crossbenchers in a hostile senate.

With few independent economists supporting the tax cuts and with evidence that I and others gave to the Senate Inquiry in favour of the status quo, the proposed legislation to pass on tax cuts to large companies failed.

No sooner was Scott Morrison elected the new leader by his party then the Coalition announced the abandonment of its corporate tax cuts for large enterprises that tend to have higher foreign ownership in favour of personal tax cuts that were far more electorally appealing.

Had the Coalition gone to the electorate at the last election on a promise of corporate tax cuts that could largely or only benefit foreign shareholders and would require the budget to be balanced by much higher personal taxes, the electoral outcome could have been quite different.

Dividend imputation is why we have almost 30 years of uninterrupted growth

My Record article concludes that one of the main reasons for Australia’s almost 30 years of uninterrupted growth has been our franking/tax imputation system. The payout rate for dividends is almost double the world average due entirely to imputation. As a result, investment funds get redirected from poorly performing companies to better performing companies.

Unlike the rest of the world, higher destabilising debt yields no tax benefits in Australia. Hence, Australian shares have earned the highest returns in the world with the lowest volatility/risk for many decades.

Finally, almost unique in the world, the level of investment is at the highest rate possible and is not distorted by our corporate tax system.

 

This forthcoming Economic Record article is currently available online.