Saturday, November 29, 2008

TAXING TIMES: Could Ken Henry be thinking really big?

It's crunch time at the Henry Tax Review.

The Prime Minister's hand-picked five-person team is in the final stages of preparing the consultation paper it will release in December setting out the lines of thought that have emerged from the hundreds of submissions it has received and consultations it has held since August.


After that it'll spend an entire year honing down those lines of thought, expanding those that will work work and discarding that that will not until it reports in December 2009.

The good news is that many of the ideas that will work are actually quite simple. The inquiry's Chair, Treasury Secretary Ken Henry scared us a bit earlier this month when he talked about the myriad ways in which Australia taxes fencing wire and our 125 different taxes - "more than there are northern hairy nosed wombats".

These good ideas may be simple, but they are also disturbingly big.

None bigger than destroying one of Labor's most important tax measures in order to axe the company tax rate.

Dividend imputation was pushed through the Labor caucus only by the force of the Treasurer Paul Keating more than 20 years ago. He sold the change by asking it to imagine two small shopkeepers - perhaps an Italian or Pakistani couple in a working class area, according to a recent biography. If the shopkeepers formed a company their profits would be taxed twice - once at the company tax rate and then again at the full personal tax rate when they was distributed as dividends...

"If that fair?" Keating is said to have asked, and then told caucus that if double taxation wasn't fair for small shopkeepers it wasn't fair for anyone.

So from 1987 almost alone in the world, Australia taxed the corporate profits received by Australians only once. If a company had already paid tax on the profits it was distributing, its Australian shareholders (but not its foreign ones) could get a credit to set against their income tax.

Much of the rest of the world followed Australia. The UK already had such a system, but has since abolished it as has Ireland. They found it complicated and not particularly appreciated.

Appreciation matters. Nick Gruen of Lateral Economics points to a study that finds Keating's gift to be so little appreciated by Australian shareholders that it is "unable to reject the hypothesis that companies with dividend imputation do not attract any share price premium".

Many companies simply don't bother. They'd rather minimize their tax, and they know that Australians are about as likely to invest in them without dividend imputation as with.

The shareholders they need to impress are the ones from overseas - the so-called "swing" shareholders with investments in every country in the world to choose between who can really move a share price. Yet they are excluded from dividend imputation.

What they get instead is a 30 per cent headline corporate tax rate. About standard or not, it looks unattractive compared to other countries' headline tax rates.

Our system of imputation prevents them from getting a tax cut - a massive cut that would bring the corporate tax rate down to 19 per cent.

That's what Dr Gruen reckons would be possible if dividend imputation was axed. It costs more than $20 billion a year.

And he says the cut in the company tax rate could be even bigger. If cutting the rate brings in more foreign investors as it is likely to, it'll make it cheaper for Australian firms to raise money, boosting their profits and possibly funding further cuts in the headline rate.

All this without costing the Treasury a thing.

Who's going to mind? Well the Australian shareholders enjoying imputation credits are likely to be upset. But less so if Doctor Gruen explains his thinking to them. He believes the tax cut would lift foreign direct investment in Australian companies by almost one-quarter. That's right, almost one-quarter. Its the sort of thing that happened when Ireland and Britain abolished their imputation schemes to fund corporate tax cuts. Ireland in particular was flooded with foreign capital.

What would this do to Australian share prices? Nick Gruen believes it'll push them high enough to compensate the Australians investors who will miss out on their imputation credits. They'll get higher share prices instead. And back a decade ago Australia halved its rate of capital gains tax, didn't it?

Well actually, it didn't. Australia halved only the headline rate of capital gains tax and recouped much of the loss by removing the inflation discount. But it was the headline rate that mattered. All manner of Australians began gearing up to invest. Which is partly Dr Gruen's point. Headline rates matter. Australia is denying itself a 19 per cent corporate tax rate and the flood of money it might bring for no particularly good reason.

It's also denying itself a much simpler tax system.

Gruen has persuaded the Committee for the Economic Development of Australia of the merits of the change and also the government's Innovation Review of which he was a member.

It found that switching from dividend imputation to a lower tax rate looked "extremely promising from the perspective of promoting entrepreneurialism, productivity, investment and economic growth".

It reported that the equity issues were "surprisingly mild for such a large change."

Who's left to object such an apparently good and simple idea? Two of the members of the Henry Review, Dr Ken Henry and Professor Greg Smith helped introduce dividend imputation while working on tax at the Treasury in the mid 1980's. But that's unlikely to matter much. If they were bright enough to recognise a good idea two decades ago, they'll be bright enough to assess whether there's a better one now.

The Tax Office likes dividend imputation as an "integrity measure". It keeps (some) companies honest in reporting profits. But many more don't bother with imputation.

And managed trusts. Many owe their livelihoods to offering mum and dad investors dividend imputation and its benefits. They began fighting such a change the day Ken Henry was asked to chair the Review.

10 comments:

Anonymous said...

Dr Henry is intelligent, but I hope his ability to convey with force the main point of a report/review has improved since his days as Secretary to Treasury (and RBA member?) in 2003.

It appears that either Dr. Henry did not convey the main point of the 2003 RBA (see point 22 below) strongly enough or the Liberals were ultra arrogant (my guess is the latter) and ignored the main point of the RBA report:

http://www.rba.gov.au/PublicationsAndResearch/SubmissionsToParliamentaryCommittees/productivity_commission_first_home_ownership.pdf

Even though this current tax review is chaired by Dr Henry, rather than PC, one can expect the mainstream media to latch onto the lesser findings and promote that which is essentially regressive for the tax system overall.

Too much vested to do otherwise.

Good luck, Dr Henry.

Peter Martin said...

Thanks Anonymous.

I wouldn't hurt if you sent the Review a submission, reminding it of that submission.

It was indeed spot on, I think.

Kind regards,

Peter

djm said...

I see you got a bit of hate-mail from self-funded retirees who believe that are dependent on imputation credits. Do you plan on responding?

Letters said...

LETTERS TO THE EDITOR December 1, 2008

Beware the wrath of retirees robbed

WHAT an exquisite piece of timing ("Strong case to amputate imputation", BusinessDay, 29/11).

World sharemarkets are at their most volatile, with the Australian market spooked at the barest hint of bad news. Let's add to the uncertainty by ditching dividend imputation. This on the shaky premise that a lowered company tax rate will ensure overseas investors flood into our market.

Forget Australian investors, they don't understand the advantages of imputation anyway. Forget those companies whose shares are held by local retirees specifically looking for dividend income. Retirees can sell if they need money.

What planet are those propounding these changes actually living on? Perhaps one where the bulls are still gambolling.

I strongly suggest that the ever-expanding demographic of superannuation retirees often buys shares for income potential and does understand dividend imputation.

It's hardly rocket science: you as a part-owner of a company receive a tax credit for any Australian company tax paid on the profits you receive as dividends.

Ending double taxation was one of the great reforms of the Keating days. Of all times, this is, assuredly, not the time to "amputate".

People are not as stupid as implied and will be greatly disturbed at this proposal. Adding to uncertainty on top of uncertainty is the last thing that should be contemplated.

Robyn Murtagh, Kew

Price is much too high

AS A self-funded retiree, I was disturbed by "Strong case to amputate imputation". For me, the removal of dividend imputation credits would lead to an immediate and continuing 30per cent lower annual income.

Nick Gruen speculates that share prices may rise, which might compensate for a 30per cent annual loss of income. This is not credible. For instance, how can the current 50per cent share price fall, compensate for a 30per cent loss of income?

For those who have financially planned their retirement on the basis of receiving Australian share dividends and imputation credits, the possible removal of imputation would be a financial disaster from which they might never recover.

I would predict that, in cases where the existing increase in income from imputation is "so little appreciated", a 30per cent drop in income would become, very largely, unappreciated.

For retirees, it could be elevated to the level of a government-changing issue.

Peter O'Neill, Elsternwick

Weilding the wrong knife

PETER Martin needs to know that the thousands of self-funded retirees are wedded to their fully franked dividends and would seriously want to "amputate" any one messing with imputation credits.

A higher share price does not put bread on the table, and capital gains that have to be realised only decrease our base capital, because of the tax.

I would suggest the net result of loss of imputation credits would be that more retirees would end up on the state pension because their income would be seriously reduced. Most of us didn't have the option of investing our hard-earned into tax-free superannuation when we retired.

Who cares about overseas investors? Most have all sorts of cunning tax avoidance schemes in place, so they don't need any extra consideration.

Zona Severn, Mount Martha

Surely he jests?

PETER Martin's so called strong case to "amputate imputation" was either a tongue-in-cheek view designed to attract the ire of self-funded retirees and others or speculation, based on no proof or fact that such an action would bring a greater benefit to overseas investors. He misses vital points: retirees don't benefit from increased share prices so much as the relief provided by imputation, and such action could force many more on to the age pension.

The market has already been spooked enough without being subjected to further shocks.

Ralph Stone, Benalla

Peter Martin said...

Gee, These people must be wealthy retirees. You need to earn a lot of money to pay tax as a retiree.

Anonymous said...

Thanks Peter, I did make a submission to the Henry Tax Review and will take your good advice and send a reminder re the RBA.

The closest statement in my submission, re the findings of the RBA report, were:

“Housing unaffordability in Australia is no accident. It is the result of deliberate discrimination against home buyers with systemic tax advantage skewed heavily towards investors. Housing will not become affordable until the issue of tax discrimination is addressed.

Peripheral and connected to tax equity in housing are related elements:

1. negative impact of negative gearing and interest only loan,
2. high tax impost on savings,
3. personal tax threshold atrophy at base level,
4. IG2: planned blunder or the revenue versus costs fantasy.”

In hindsight I should have put my earlier post to this blog into the review – next time.

Cheers

Marek said...

Peter,

If they fall under the tax threshold they wouldn't they receive a tax refund on the imputation credit?

Wasn't sure about this but if pensioners hate it enough to write in about it it must be worth considering!

Peter Martin said...

Thanks Marek, You are right.

It's detailed here:

http://pmdivimp.notlong.com

"Resident individuals who don't need to lodge a tax return can apply to the ATO for a refund using the Refund of imputation credits application and instructions for individuals booklet.

Resident individuals who don't need to lodge a tax return and who want a faster refund, can apply by simply phoning 13 28 65.


They are used to the income - and won't trust modeling that suggests they will be better off.

Marek said...

I hate the idea of double taxing anything, but if it meant that the tax rate dropped to 19% then you would think that the dividend would rise (because of greater profits)and they would at least particularly make up for it. And as a bonus it would mean less misleading headlines about how much tax rich people pay!

What really gets me is how many different forms of income there are, why should someone who makes an income though property deals be taxed differently than someone who is a shop assistant? At the end of the day its all income and should be taxed as such.

Sydney Buyers Agent said...

Australia should be lucky, it is among the countries kept afloat (relatively) as compared to other countries hit by the global financial crisis.

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