Taxpayers with lowest tax rate are hardest hit

Hi Jon,

It might please you to know that this Cuffelinks reader sent a letter to Chris Bowen in April 2018 using a similar example to yours to highlight the shortcomings of this proposal. However, rather than using Taxpayer A .. E, I used Bill (top taxpayer), Tanya, Penny and Chris (lowest income earner). I thought it was important to put the Shadow Treasurer as the low income earner so Mr Bowen could get a personal account of how much this policy initiative is the antithesis of ALP ethos. Needless to say, no reply from the Shadow Ministers office as yet. Might be time to invoke the Andy Dufresne strategy (Shawshank redemption) of a letter a week.

For the doubters, here is an example which illustrates the way company tax works.

Suppose I have written a phone app that I want to market at 50c a time. I choose a company structure to limit my liability if my app inadvertently causes a phone to explode.

I set up a small company and put in $10k of my money to fund it. I can do this either by giving a loan to the company or contributing capital to the company.

In the first year my company makes $1000 and has $500 in admin costs.

In the first scenario I treat the original capital as a loan to the company and they pay me interest at 5%, so I receive $500. This is a tax deduction to the company so their profit is now $0 so they pay no company tax. I pay tax at my normal rate on the $500.

In the second scenario I treat the original capital as equity and take my $500 as a director's fee. Again this is a tax deduction to the company so their profit is now $0 so they pay no company tax. I pay tax at my normal rate on the $500.

In the third scenario I treat the original capital as equity but take my $500 as a dividend. This is not a tax deduction to the company so their profit is $500 and they pay $150 company tax. I receive $350 as a cash dividend with a $150 franking credit. I pay tax at my normal rate on the $500. If my normal tax rate is zero, I receive the $150 as a cash refund so I get my full $500.

This is not a gift from the ATO of tax paid by other taxpayers. The refund arises only because of the way the capital of the company is structured (loan or equity) and the form in which I take the payment (interest, salary or dividend).

Under the proposed rules if my normal marginal tax rate is zero then I would get no refund if I take the $500 as a dividend. I would receive only $350 of my $500 profit. I would pay tax at 30% even though my marginal tax rate is zero.

Now let's take this a step further.

The differences in the payments above occur only because interest and wages are tax deductible for the company while dividends are not.

Suppose the proposed policy was extended to all types of income. This would be done by changing the rules so interest and wages were no longer a tax deduction for the company so they paid tax on this money.

The tax paid by the company on wages would be in place of the normal PAYG tax deducted by companies and sent to the ATO, so it would simplify working out wages.

All interest paid by companies (and banks) would have 30% already deducted and sent to the ATO and all salary and wage income would have 30% already deducted and sent to the ATO. This is how dividends are treated now so these would not change.

At the end of the year taxpayers would work out their tax owing and if it was more than the amount already remitted they would pay the extra. If it was less than the 30% already sent to the ATO there would be no cash refund. That would just be hard luck mate. You can't begrudge paying 30% of your income to fund schools, roads and hospitals now can you?

It would be interesting to see the swing in election results against a political party that proposed this.

But think about it – this is exactly what is being proposed for dividend income.

Jon has a compelling argument but I feel the issue is broader than this. ALP’s policy, is again piecemeal approach at fixing up perhaps an inefficiency.

Companies aren’t very efficient to transfer capital unlike trusts. Try transferring capital out of a company and facing a myriad of rules around Division 7A, deemed dividend and alike. Similar issues are not faced with transfer of capital from trusts. Insurance bonds are taxed differently. So we have different structures taxed differently and whether that is fair and efficient is arguable.

Let me pose a question. In a hypothetical situation, a controlled company pays tax and retains its earnings. With planning, dividends are pushed out within the tax free threshold, when the shareholder has no income, perhaps in retirement. I know this is a minority of situation but it illustrates the inefficiency and looseness of our tax system. Over multiple years, with distributions within the tax-free threshold, a company has the ability to effectively pay no tax, due to the low income of the shareholder. Is this efficient and fair?

When Governments are chasing revenue, a piecemeal approach often produces distortions. It is high time that the country looked at the entire tax system to deal with the ageing tsunami and the trend of reduced working age people to support a growing number of people not working.

I have sent a proposal to Chris Bowen and cc'd my local Labor member, to make enquiries on my behalf if I received no answer after a month. Six weeks on still no response from either one.
I have some questions for those who support the Labor proposal.
1. Should people with higher incomes pay more tax? This is evident in the PAYG tax and this should be true for any other tax related proposal.
2. If I am to be taxed on money received, should I not have the opportunity to use any money spent in relation to obtain this income as a deduction - just like PAYG tax payers?
3. I am a SMSF retiree does this not mean I am in a superannuation scheme (albeit pension phase). How is it fair that I pay 30% tax on every dollar earned, when people with much much more than twice my superannuation balance (ie $1.6M) have transferred their balance above this amount, into the accumulation phase and pay only 15% tax on income earned? How is this fair? It seems that Labor has missed their mark and like many Governments are hurting the 'have nots'.
4. Since I am in the superannuation system should I not pay a maximum of 15% and should there not be a sliding scale so that those with more income pay more tax, just as it is in PAYG tax?
5. My superannuation balance is very unlikely to increase BUT costs are always rising and the % of money I have to take for my pension rises with age. My balance will decline and I really don't think the pension will afford me respite from rising costs. I thought superannuation was meant to keep people off the pension but by taking my franking credits I will have to go on the pension, perhaps very soon. Is this not a ridiculous scenario? Was this not a Labor idea from the Keating era?
6. I have paid tax my working life without the ability to use tax minimisation schemes (usually affordable only to the 'haves') and still pay tax in the form of GST but not Medicare. I cannot access any 'Government money' except through Medicare. If I paid tax equivalent to twice the Medicare levy would I still be classed as a burden on Australia's taxation system?
7. Can anyone really think or say that Labor's policy is well thought out, fair to all Australians and targets the wealthy members of our population.
Labor should target the tax minimisation schemes available only to the wealthy and limit their effect on the tax system. They probably won;t do that because they use the schemes and reap the benefits If you are going to do this Labor, then show some some spine and cut your superannuation benefits by 30% or is your superannuation balance lower than mine already??

At the risk of incurring the ire of Cuffelinks readers I have some thoughts. It was my understanding the initial objective of the franking system was to avoid double taxation. It was subsequently tweaked by Howard/Costello to allow for the refunding of credits to those on tax rates <30% i.e. retirees, as a sop to the grey vote during the mining boom when revenue could be splashed around.
It boils down to how your view franking credits. I can sympathise with retirees paying 0% who have come to view franking credits as income over the years but, again, this was not its original design. The example you use for Taxpayer A is therefore open to interpretation, depending on your vested interests. You say they have paid tax of $9,000 but my perspective is the company they invest in pays $9,000 in tax on its company profits at source. This seems quite reasonable given that it is how the majority of countries operate their tax system. This system, known as ‘dividend imputation’ is unusual and only 4 other countries in the world use it. Your interpretation that taxes on company profits are additional taxable income and a tax credit for shareholders is because that is how Howard/Costello chose to frame it to win votes. This suits your constituency but that doesn’t make it sacrosanct. Comparing tax on PAYG and investment income is also interesting one is tax on labour while the other on invested capital. These have always been considered two different sources of income with varying treatments.
Those who are truly on low income earners may not all escape unscathed. But Labor’s amendment to grandfather those on part pensions at least offers some concessions. What is fact is that the lion’s share of the $ value of franking credits go to those running SMSF’s with large balances, not Aussie battlers worried about whether they can use the heating come winter, as you seem to make out. It's a bit like the current negative gearing debate. Even though nurses and teachers use it, a disproportionate percentage of the $ value of the deductions go to the top 20% of earners who are more likely to be doctors and lawyers.
When it all boils down the system now needs reform because it saddles the country with huge imposts on the budget ($5bn p.a.) that are no longer affordable outside boom times. Add to this that many seniors already pay less tax than younger workers on same income due to all the other age-based tax breaks such as SAPTO, higher ML threshold, higher health insurance rebates etc. It’s time for some re-balancing…

The refunding of imputation credits saddles the budget with nothing, as it is not revenue the Government is entitled to retain. As for the tax treatment of labour versus invested capital, the latter is already addressed via the current capital gains tax rules. The current assessment of franked dividends against the individual recipient's overall tax liability simply ensures the same treatment of income flowing from company dividends as that afforded to, say, the rental income flowing from a property investment. Of course the change in value of that property, as with the capital value of the shares, is addressed under the CGT rules.

Should a small business owner running their business under a company structure pay a flat 30 percent on every dollar they ultimately receive in their hands because it was earnt through a company? Should a sole trader who has paid upfront PAYG tax throughout the tax year not have that tax reconciled against their total taxable income situation at EOFY, but rather have it retained by the ATO for no other reason than it has already been paid?

If a wealthy parent has gifted their young adult offspring an investment property worth a million dollars, should that fortunate young one pay not one cent of tax on up to $18200 of net rental earnings while a single dollar of fully franked dividend income in the hands of another person is taxed at a flat 30 percent before they see a cent of it? Funny that they have to declare both the dividend and the associated imputation credit in their tax return, but forfeit any recognition of the tax paid for no other reason than having a low income.

Labor's arbitrary grandfathering of particular sub-groups at a particular point in time are also indicative of a lack of conviction as to the righteousness of the proposed policy. Or perhaps that is just political expediency. It just happens to conveniently work very nicely for their Industry super fund benefactors. Either way, anyone with an iota of understanding of the dividend imputation system realises that the real issue lies with the marginal tax rates applied to different groups in society. This could be easily addressed while leaving the current plan's unwitting losers untouched, but would not the same easy sell, given that it does not as easily lend itself to obfuscation. The imputation system and its associated refunds are not widely understood, and is readily portrayed as a rort, when it is in fact one of the fairer elements of our tax system.

Consequently, the very class people who are supposedly represented by the Labor party wind up as the biggest losers, presumably because, to paraphrase another politician's faux pas, low income people don't own shares.

Above all, the very idea that company income should be taxed at a minimum flat 30 percent is largely neutralised by the fact that every higher income earner who receives a fully franked dividend, receives the full 30 percent back due to their effective marginal tax rate on that income being discounted by the 30 percent company tax already paid by the company. So in fact it is only the lowest and low income earners who pay the up to 30 percent flat tax on every dollar of dividend received.

In all my comprehensive reading and investigation of this issue I have not seen or been presented with a single sound or logical argument as to why Labor's proposal is a good idea. If enacted as proposed, it will simply serve to entrench further inequity in a society already uneasy about the growing divide between haves and have nots. Those who have the means will readily be able to adjust their arrangements to largely avoid the changes, when all that is really needed is for leaders of courage to initiate a frank and honest discussion about the long term sustainability of zero tax rates and SAPTO.

"Leaders of courage" being the problem.

Dane. Your taxable income and the tax you have to pay are NOT open to interpretation. Under present tax law, both the dividend and the franking credit are added to your taxable income which is then subject to your marginal tax rate.

As I have shown, unless you receive a tax credit for that pre-paid tax, you will be paying a minimum of 30% tax on those dividends, and not at your marginal tax rate. In effect you will be paying tax on income you never receive. This will impact on all taxpayers whose average tax rate is lower than 30%, but it only apples to dividends. This is in the name of fairness. In other words, if your average tax rate is lower than 30%, the only way we can ensure you pay tax on those dividends at your marginal rate is by giving you a cash refund. It puts Mr Shorten’s claim in a new light. He says those who don’t pay tax should not get a refund. In reality, it is only by providing a cash refund, that we ensure these taxpayers do not pay tax.

It seems the zero tax in retirement causes offence. In retirement mode, a super fund (industry, retail or SMSF) supporting a pension pays zero tax on income or capital gains earned by the fund. This has been the case since 1992 when super became universal and compulsory and has remained in place through the Costello super changes in 2007, the period when Mr Shorten was Minister for Superannuation in 2010, and the Morrison super changes in 2017. It reflects the fact that the money inside a super fund has already been taxed, both as contributions and on the earnings over a long period of time. It is now a social contract and is seen as compensation for compelling people to lock away their super savings for up to 40 years. As zero tax in super pension funds has been a feature of the retirement landscape for more than 25 years, it seems reasonable for people planning their retirement to believe that to be a permanent feature. For those already retired, changing it now, would be grossly unfair.

Fairness, like beauty, is in the eye of the beholder. By all means we should discuss fairness. We are all entitled to our own opinions. We are not entitled to our own facts.

Hi Jon,

I remember reading the following remark in the Cuffelinks back catalogue:

“People should understand that for Australian taxpayers, the company tax is broadly a withholding tax.” - Right Hon. P J Keating.

And withholding taxes by nature are tax credits not tax offsets.

Now if we were to accept Mr Keating broad view of the operation of dividend imputation then I am sure Taxpayer A in the above example would be well within his rights to ask a simple question of the current Shadow Treasurer: “why is Taxpayer E obtaining a full credit of her withholding tax and by the way what happened to the other 75% of company tax withheld from my dividend. Where is my tax credit?"

Dane, the original intent of imputation was not avoidance of 'double taxation'. That was how it was popularised, but the original conceptions were that it was about taxing income in the hands of the ultimate recipient and levying tax at that recipient's tax rate. It was about fairness of treatment for all tax payers, irrespective of whether they received income from a listed company structure, a sole trader business or wages.

In order to 'sell' the introduction of the scheme, it was said to avoid double taxation, but this was always only a political shorthand catchphrase, not something that tax people ever embraced. It was always inaccurate.

The fact that Paul Keating introduced a scheme that didn't go all the way to full integration of the company and personal tax regimes does not mean that this was the right way or the only way to implement the principle. In my view, he did the right thing by introducing imputation, but the wrong thing in not fully introducing it. Although Howard & Costello's motivation wasn't to fix that gap, their decision had that effect.

Nor does it matter two hoots what other countries do. Other countries index their marginal tax scales, but we don't. Does that mean we have to do so because someone else does it? No, the issue is what sort of principles do we want to implement in our tax policy.

And if you're going to have an imputation system at all, which credits back to all tax payers the tax that was pre-paid on earnings within listed company structures, then it is grossly unfair to exclude one portion of those tax payers. That this is the case is already conceded by the exemptions from the ALP's policy that are going to be granted - such as to non-tax paying charities and other not-for-profits, as well as recipients of the aged pension.

Which all simply points it towards a small subset of the community. If they should not be on a zero tax rate, then that's the policy that should be changed, not messing with a perfectly fair, workable tax system that will apply to many entities and individuals in any case!

But note, the 'lion's share' you refer to is an emotive argument that helps the debate very little. The fact is that zero tax rates apply to the income payments received by people with an SMSF up to $1.6 mn. Someone on that limit has to draw 4% as a 'pension' payment. That's $64k per annum. That's less than average weekly earnings! The insinuation that these people are rich and rorting the system is simply not true.

The social contract -including the compulsion to invest in super in the first place via the Super guarantee charge - means that this modest level of income should be tax free. Even if the income is earned in a pooling structure along with other investors known as shareholders.

Devils Advocate here. If all of Australian companies Dividends were fully franked and then all paid to shareholders who paid no tax, would that mean that our Government received no tax from all our companies? The tax having been refunded because everyone was in a tax free position? How would Australias economy survive?

Franco,

Firstly, it is unrealistic to think that every Australian companies will be in a position to pay fully franked dividends. In the modern global world that simply will not occur. To understand why, you need to understand how a company's franking account balance works. In addition, it is very rare that companies payout 100% of their earnings as dividends. The retained earnings base still attracts corporate tax that is not imputed to shareholders.

Secondly, the dividend imputation system has been around since 1987. How do you think the Australian economy has gone over the last 30 years. Not too shabby I would have thought.

Thirdly, not everyone is in pension mode at one time. About 16% of the population are aged 65+ (up from about 12% two decades ago). The largest segment of the population (66%) is still those in the 15 - 64 age bracket traditionally called "working age population". This percentage has not changed markedly since the 1996 Census.

Rest assured that there are plenty of working age taxpayers that will continue to contribute to Government revenue and keep it in line with CPI. The trend over the last twenty years is to cut back on government expenditures that traditionally found their way into the hands of the retired population.

Franco
The present imputation system ensures that Australian shareholders always pay tax on their dividends at their marginal tax rate. It also ensures that foreign investors, who do not have access to franking credits, always pay the company tax rate (30%) on their Australian dividends. Foreign investors represent over a third of the market. If the company tax rate was zero, Australian shareholders would still pay tax on their dividends at their marginal rate, but foreign investors would pay no tax in Australia.

In this way, dividend income from shares for Australian taxpayers is treated the same way as all other sources of income, while also ensuring that the ATO has first bite of the revenue before some of it disappears overseas. The system may be complicated but at least it is fair. It is the cash refund of the excess pre-paid tax that makes it fair by ensuring that each taxpayer pays tax on their dividends at their marginal rate.

If the marginal tax rate of some taxpayers is too low, let's address that so that all are treated equally. But this Labor proposal discriminates against self-funded retirees in favour of age pensioners, it discriminates against SMSFs in favour of industry funds and it discriminates against Australian equities in favour of other asset classes.

Yes, Franco, that would be a dire situation. But not because of the imputation system! It would be dire because it would mean that no one who earned taxable income owned shares. This could be because all medium to high income earners had abandoned the share market, which would push up the cost of capital for our companies enormously. Or it could be because Australian income levels had fallen so low that we were all at the zero tax rate. Or it could mean that we'd stopped having children and stopped immigration so that we'd all retired and were paying no tax. GDP would have collapsed and we'd all be in a dire situation.
But none of that would be because we had an imputation system.
You're not being a Devil's Advocate, you're argument is simply nonsense.

So many here seem to have missed a few important points.
The first issue is that companies in which you own shares are NOT YOU and you've made a deliberate choice to invest via a company usually because the whole point of companies is to limit liabilities - or in other words, to limit responsibility. So how you think that you can/should do that as well as gain all the benefits of direct ownership is perhaps a rather interesting example of deluded self-interest. The company pays the tax and Paul Keating (just ask him, he'll tell) saw that there was a potential for double taxation AND an opportunity to bring Mums and Dads into a broader share ownership culture (just ask him - he'll tell you) so he led the world in "tax reform"...but that was then cynically abused a decade later, when...
The Howard/Costello trick was used as a vote winner at a time when that government's popularity was fading and it worked a treat. Always back the horse in the race named "Self-Interest" - you know it will be trying! Who said that?
I think the charts above are a wonderful example of miss-direction of the highest order and could be used in economics lectures and even statistics lectures to show how to muddle an issue in an apparently scientific manner. The "average" tax rate is a nonsense and you all know it. Marginal tax rates are what matter and the only reality in this exercise. You can't have a lower marginal tax rate than 19% and you CAN get all your franking credits back until you have exhausted all at 19% at which point you have a tax rate of NIL. And still you want MORE??
How dare people treat others like idiots and then pretend it's anything BUT self-interest. Frankly, my dear I don't give a damn if you don't like it, because it's obvious that this country needs to raise MORE tax revenue, not LESS and often it's those who are complaining loudest who should and can pay more but who scream like blue murder if they ever have to, while most of us shut up and pay because we know that better roads, schools, hospitals, policing, fire-fighting, nursing etc etc depend upon us as a nation being able to afford it without resorting to charity, so-called philanthropy (by wealthy who do everything possible to pay least tax, so they can make grand jestures - spelling intentional.
Those of you/us who pay their fair share of tax and also donate to worthy causes - good on you! You can join the vast majority of lowest incomes who do the same and who generally don't claim a tax deduction, because they think that would be disingenuous. :)

In response to Phil Carman, all I'll say is that thank goodness the Campbell Inquiry, then Keating and then Howard/Costello thought that 30% of your earnings was way too much to pay for the 'benefits' of being in a limited liability company structure. They abandoned that ultra expensive classic taxation system that confused one set of arrangements (limiting liability) with another (the incidence of taxation) and we ended up with a very effective, fair imputation system.

This discussion is not about 'self-interest' and it's not about tax revenue in total. It's about sound tax policy. If we need more revenue, then raise the rates of tax on a broad range of tax payers, rather than changing good policy for one rife with exemptions and a lack of fairness.

Thank you Jon. This article needs to be distributed to every sitting politician, and widely across the finance and investment industry. If this policy goes ahead it will have presumably unintended consequences that will entrench yet another inequity in perpetuity. All coming from the party which pitches itself as the champion of the poor and low income earners. Aimed to gain favour with the very people who would suffer from it the most, though almost certainly don't realise it.

It befuddles me that there has not been a lot more fuss about these aspects of the proposal from industry professionals.

While I can accept the possibility that Labor have genuinely made an error here, the outcome is tantamount to theft. I am certainly no legal boffin, but if this goes ahead, I fail to see how there would not be some basis for a legal challenge.

Yet I have seen a number of ordinarily well informed industry commentators coming out in defence of a policy which is one of the most overtly wonky proposals I have seen in decades of following this kind of thing.

It truly boggles the mind.

Following on from oPau above, the excess credit carrying on in perpetuity much like a capital loss etc. Which I assume was his context

Another fiction from the Labor Party is that their policy of taking our franking credit refunds will encourage Australian investors to "diversify" by investing in international shares.

There are two problems with this.

Firstly by diversifying into international shares we would be taking on a currency risk that does not apply to Australian shares. If the Australian Dollar strengthens we could see our gains wiped out or even worse we could fall into a loss.

Secondly, there are a large number of large, mid-cap and small cap companies on the Australian stock market that invest and sell internationally (Think BHP, RIO, URB, QBE CYB, COH etc.) so we don't need the Labor Party to tell us that we need to diversify internationally. We are ALREADY diversified internationally if we hold a diversified portfolio of Australian shares.

John, while I agree with the sentiment of your comment I also don't think the arguments you've used are helpful. All investors should be globally diversified for optimal risk and return outcomes.

1) On currency risk, professional asset allocators believe that currency plays a diversifying role and thus reduces portfolio risk. Your comment turns only one scenario (a rising AUD) into the be-all and end-all. Even a rising AUD can be good, if it's happening when global shares are outperforming the local market; and of course, the AUD can fall, which it tends to do just when portfolios need the cushioning impact of currency gains. So going into foreign currency is not an argument against global share investing.

2) Half true. Those Australian companies are still listed in AUD and their market beta is linked to the local market. They aren't truly a form of global diversification in the sense of getting exposure to the different cyclicality of many different markets.

I think the better argument on this is to pick up the other article that Graham Hand has written about how Australian SMSF's actually are already reasonably well invested in global shares - around 12-15% I think he said. Therefore, we don't need the gratuitous advice of the ALP to encourage us to do more.

A couple of numerical slips with regard to the marginal tax rates but a very informative argument.

I believe the paragraph should have read:

As income rises, not only do taxpayers pay more tax, but they pay an increasing proportion of their income in tax. For example, from the above table the tax on an income of $37,000 is $3,572. The marginal tax rate on each additional dollar is ***32.5%***, but as a proportion of the total, the tax is only 9.65%. This is the average tax rate. The tax on $90,000 is $20,797. The marginal tax rate on each additional dollar is ***37%***, but as a proportion of the total, the tax is 22.1%. A taxpayer earning $90,000 pays proportionally more tax than someone earning $37,000.

Thanks Stephen, I can see the confusion in the numbers. I have added clarification to the above text. As taxable income of $37,000 fits just within the second tax bracket the percentage is correct. Amended as: <em>The marginal tax rate on each additional dollar <strong>over $18,200</strong> is 19%, but as a proportion of the total, the tax is only 9.65%.</em>

Under Labor's proposal the excess tax credit will be withheld, but does it carry over to offset against a capital gain that I may make in the next financial year?