Maybe the government really should have another look at Australia’s still relatively unique system of dividend imputation. Why haven’t other countries, apart from New Zealand and Malta, followed suit?
Well, Australia’s non-mining capital stock peaked in 1987 and has been declining ever since. It’s now the lowest on record as a percentage of GDP.
In 1987, dividend imputation was introduced to remove the double taxation of dividends -- one of the many great reforms during the Hawke/Keating era.
Coincidence? Definitely not. Dividend imputation lowered the cost of equity for Australian companies and resulted in a structural decline in gearing, but it has also resulted in sustained pressure on companies to increase their dividend payout ratios and not retain earnings.
The result is chronic under-investment by companies outside the mining industry, and especially in manufacturing.
Last week the chief executive of the Australian Industry Group, Innes Willox, exhorted Australia’s manufacturers to invest in technology and supply chains. The future of the industry, he said, depends on it.
There were good reasons to remove the double taxation of dividends. Before Paul Keating introduced imputation, corporate funding was biased towards debt and corporate gearing was such that Australian companies were vulnerable to financial shocks. But in removing that distortion, the government introduced another one.
The Financial System Inquiry has now raised the question of whether dividend imputation should be revisited.
In a submission to the FSI, Pricewaterhouse Coopers wrote: “In the context of the overriding importance of ensuring Australia’s sound fiscal position, and recognising the need to find new sources of investment to sustain Australia’s growth, as well as the need to remove investment bias in the tax system, we believe that careful consideration should be given to whether there would be benefits to be obtained from modifications to the imputation system.”
Indeed, there may be a case for distorting the tax system the other way -- in favour of retained earnings.
The FSI’s interim report raised other distortions caused by dividend imputation: Australian investors hold more domestic equities and have less diversified portfolios, the lack of a deep liquid corporate bond market and low demand for annuities.
The use of equities, especially bank shares, as income-producing assets by investors is clearly a distortion and has led to Australians generally having much riskier portfolios than they should.
Bank stocks have had a wonderful run in the past two years but there is good reason to think the next few years won’t be as good, with rising interest rates and unemployment crimping profits and, perhaps dividends.
But the most important and damaging distortion is arguably the lack of retained earnings in Australia.
Even the mining companies are now responding to the pressure to increase their dividends.
Some of the businesses that require the greatest level of capital expenditure in order to keep up -- banks, Telstra, manufacturers -- also have the highest payout ratios because chief executives are typically paid bonuses on total shareholder return (that is, share price plus dividends and in this country both of those things are determined by the dividend).
In the US, where dividends are still taxed twice, payout ratios are lower and retained earnings much higher.
Investors argue, with plenty of justification, that if companies keep their earnings instead of paying them out as dividends, they just waste the money.
Before 1987 there were far too many wasteful takeovers by CEOs looking to simply to build their empires.
But perhaps it has now gone too far the other way. Australian firms with wonderful cash flows that could be used to grow the business (and the nation) are forced to disgorge the lot to shareholders so they can waste it instead.