Proponents of the Australian Labor Party (ALP) policy assert that the original purpose of dividend imputation was only ever to remove the double taxation of corporate income distributed as dividends. However, that result could have been achieved more simply, but less equitably, by simply exempting dividends from taxation. This is the approach currently taken in Singapore and Malaysia. Allowing refundability of excess franking credits, as was done by the Howard Government in 2000, can be justified as promoting greater vertical and horizontal equity.
Despite the policy arguments in favour of refunding franking credits, as discussed in Part 1, there are situations where the interaction of refundability with other aspects of the tax, transfer and superannuation systems produces inequitable results. This includes:
- inequities associated with super funds with tax-exempt income receiving refunds of franking credits; and
- the interaction between the imputation system and the income tax exemption for distributions to super fund members over 60 in the pension phase.
A policy directed at resolving problems with these interactions would be a better targeted approach to problems in this area than the current ALP policy of abolishing cash refunds with exemptions for pensioners and other government allowance recipients on compassionate grounds (‘Pensioner Guarantee’).
1. Repeal s207-110(1)(b)(i) provision benefiting super funds
As discussed in Part 1, refunds of excess franking credits only really are possible when the fund has sufficient investments in Australian companies paying franked dividends, and to the extent its income is tax exempt current pension income. This suggests that a more targeted approach to reform in this area would be possible.
A simple and targeted solution would be to repeal ITAA 1997 s207-110(1)(b)(i) (the ITAA 1997 provision that allows super funds a franking credit tax offset for pension phase income that is tax exempt to them). This action would likely eliminate most of the franking credit refunds that are currently received by super funds without eliminating those relatively few refunds that might be received in the accumulation phase.
2. Exemption with progression for super fund earnings
Rather than eliminating cash refunds of excess franking credits for individuals, and carving out exemptions for pensioners on compassionate grounds, a better solution to the problems arising due to the interaction of the dividend imputation system with the exemption for super fund distributions to over 60s would be to fine tune the exemption.
Several countries around the world (for example, Belgium and Finland) in some circumstances use what is known as an ‘exemption with progression’ system in respect of the foreign income of their residents. Under this system, the foreign income is exempt from domestic tax but is taken into account in determining how the progressive rate scale will apply to the domestic income of the resident. A similar approach could be applied to the exemption for super fund earnings paid in the pension phase.
For example, for a retiree with $1.6 million invested in super fund which pays an allocated pension of $80,000 per annum, the $80,000 would still be tax free to the retiree. For purposes of applying the individual progressive rate scale, the next $1 of additional income that the retiree earnt would be taxed as if the retiree’s income was $80,001. This would mean that it would be taxed at a marginal rate of 32.5% plus 2% Medicare levy, and if all the retiree’s taxable income consisted of fully franked dividends, the retiree would still not be entitled to a refund of excess franking credits. They would be subject to the same amount of tax as retirees earning only, say, interest income. Thus, the fine tuning of the exemption would be consistent with horizontal equity. Under current rules, the retiree would not be eligible for the Senior Australians Tax Offset (SATO). Under the exemption with progression system proposed here, the retiree would not be eligible for SATO, but in 2018-2019 would be eligible for a low middle income tax offset of $270.
How would retirees be affected under our proposal?
Retirees who had taxable income of less than $18,200, or less than $37,000 but did not have non-assessable non-exempt income from super funds, would still receive refunds of excess franking credits under our proposal. It also protects those with a small super fund.
Say a retiree has $10,000 of tax-free super fund drawings. For the purposes of applying the progressive rate scale and relevant tax offsets (such as SATO), the next $1 of income that the retiree earnt would mean that the retiree’s total income would be regarded as $10,001. This would mean that the retiree would still pay not tax until the sum of the retiree’s tax-free drawings and the retiree’s other income equalled $18,200. SATO and other offsets, such as the low middle income tax offset, could also mean that the retiree would not have a net tax liability until the sum of the tax-free drawings and the retiree’s other income reached higher amounts.
How would this approach affect our example in Part 1 of a retiree with a super fund balance of $570,000 in the pension phase who draws down $28,500 per year tax free and has a taxable income of $37,000?
On 2017-2018 rates under an exemption with progression system, a tax rate of 32.5% plus 2% Medicare levy would apply to the additional income (namely, $37,000) that the retiree received. If SATO and various low income tax offsets were retained, the retiree would have a tax liability of $13,047. To obtain a refund of excess franking credits, the retiree would have to receive grossed up dividends of $43,490 and would need to hold around $870,000 worth of shares to receive that amount of dividends. In contrast, under the current system, the retiree would just need $3,993.11 of franked dividends with $1,711.33 of franking credits attached to receive refunds.
The end result of these more targeted proposals would be to eliminate most of the refunds of excess franking credits obtained by super funds. In addition, these proposals would mean that the dividend imputation system, the s301-10 ‘exemption’, the progressive rate scale and the tax offset system interacted in a manner which was more consistent with vertical and horizontal equity.
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 1, 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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