When’s a Tax Cut Not a Tax Cut?

Christmas time, food and wine…and beer…and more food.

A constant carousel of catch ups, family events and — most importantly these days — making sure the respective sets of grandparents get enough grandchild time.

It’s a great time.

And throughout it all, conversations ranging from the mundane to the meaningful. Or sometimes after too much wine, the meaningless too!

Cryptocurrencies were a hot topic this festive season, of course.

And I was the go-to person for interested friends and relatives, the majority of whom had only recently discovered the world of bitcoin.

But I’m also fortunate to have relatives with skills in areas I’m no expert in either. A few of whom happen to be high flying accountants.

So, in turn, I don’t waste the opportunity to pepper them with questions on taxation matters, both personal and professional.

This Christmas season I particularly wanted to know about a topic I think will be a huge political football this year.

The issue of company tax cuts.

Donald Trump’s December 2017 company tax reforms have opened the taxation doors for conservative politicians the world over.

Treasurer Scott Morrison was quick to flag his intentions with regards to cutting company tax rates.

I asked my accountant brother in law what this would mean for investors here in Australia. What I found out surprised me.

The outcome was a lot less clear cut than I’d originally thought…

The company tax issue no one talks about

This is what I had presumed would happen…

The Turnbull government would cut company tax rates to, say, 25%. Shareholders would rejoice. Markets would go up.

After all, the companies you part own would now have to pay less tax.

Meaning you would personally make more profits, right?

Well it’s not as simple as that.

As my brother in law told me, the problem is it won’t work like this for most shareholders. And it’s all to do with franking credits.

Franking credits are a uniquely Australian solution to the problem of double taxation. That’s the problem that would occur if you had to pay tax on dividends, on top of the tax a company had already paid.

Instead, what happens is that dividends paid out by a company to you are taxed at your own personal tax rate, after you claim a credit for the 30% already taxed.

The net result is that many Australian investors and super funds pay little to no extra tax on dividends.

And if you don’t owe enough tax, you even get a refund of the tax paid by the company.

It’s a pretty sweet deal for Australian investors.

But here’s the thing. 

It’s only Australian investors that benefit.

Foreign shareholders don’t get the benefit of these franking credits, as they pay tax in their own country.

This means the only significant continuing purpose of company tax is to tax foreign shareholders.

Since the franking credit rate moves up or down with the rate of company tax, Australian shareholders have little or nothing to gain from a cut in the company tax rate.

Only foreign shareholders — present or prospective — would benefit.

This wasn’t the result I expected.

A tax cut with no benefit.

But, but, but…

Of course, you could argue that cutting tax for foreign investors will stimulate new investment into the country.

But politically it’s just not as compelling as a basic tax saving message.

And I’m not even sure in Australia’s case this will have much bearing on foreign investment flow.

After all, we have a natural advantage in industries like resources, tourism and agriculture. Rising economies like China and India need what we have, to a large extent regardless of taxation policies.

And other sectors, like financial services, are heavily protected and mostly domestically focussed.

New industries which could do with investment, like technology, currently make up a miniscule 1.3% of the Australian stock market.

But the argument of tax cuts stimulating investment falls down here, too.

After all, if we want to attract more investment into growth areas like technology and biotech, surely there’s a less expensive way than giving every foreign investor a tax cut on their mining stocks?

For you and I, this is an illusory tax cut. Pretty pointless, to be honest.

And in a time of budget deficits, expensive to boot.

This time it’s personal

I’m all for tax cuts, but personal tax cuts are what needs to be on the table. And the issue of fairness needs to be addressed too.

As the ‘Paradise Papers’ scandal revealed in 2017, the wealthier you are, the more options you have to reduce or avoid your tax liability. Especially in foreign bank accounts.

Society can’t function when the only people paying tax are honest middle-class workers.

This is the discussion our politicians need to have. A fair taxation system which treats all as equal. And rewards actual innovation, rather than entrenching crony capitalism.

Alas, I fear we’re in for six months of slogans followed by a pointless company tax cut.

But for you and me, it will be the tax cut that wasn’t a tax cut.

Ryan Dinse,
Editor, Money Morning

Ryan Dinse is an Editor at Money Morning.

He has worked in finance and investing for the past two decades as a financial planner, senior credit analyst, equity trader and fintech entrepreneur.

With an academic background in economics, he believes that the key to making good investments is investing appropriately at each stage of the economic cycle.

Different market conditions provide different opportunities. Ryan combines fundamental, technical and economic analysis with the goal of making sure you are in the right investments at the right time.

Ryan's premium publications include:

Money Morning Australia