Smaller companies biggest winners

Two of the policy differences between the major political parties in the 2013 federal election are the Coalition’s commitments to a 1.5% cut in the corporate tax rate and to a more generous paid parental leave scheme than the Government’s.

The parental leave scheme will be funded, in part, by a 1.5% additional levy on the approximately 3,000 Australian companies with taxable incomes greater than $5 million.

The Coalition has also announced that the additional levy will not generate franking credits for the companies that are required to pay it. This raises the question of what is the likely effect of offsetting a 1.5% cut in company tax by a 1.5% additional levy on large business, and is the combination of the two good policy?

Under the Australian dividend imputation system, payments of company tax generate franking credits which can be attached to dividends. For domestic investors, franking credits have the effect of reducing the net amount of tax payable at the shareholder level on dividends. Investors such as superannuation funds, which are taxed at a lower average rate than the corporate rate, reduce their overall tax bill by offsetting excess franking credits against their other tax liabilities.

Individual self-funded retirees with average rates of tax below the corporate rate can actually receive refunds of excess franking credits. Thus, for domestic investors in listed companies, cutting the corporate tax rate should produce larger after-tax profits for companies, and hence larger dividends, but at same time will produce smaller franking credits.

The end result is that the domestic investor is in much the same position as before. They get a bigger dividend but a smaller franking credit, with the result that they pay more tax on the dividend. This effectively leaves them with the same after-tax dividend as they had previously.

How does the additional levy of 1.5% on large businesses affect shareholders in those companies? As the tax on those companies will be higher, dividends paid by them might be expected to be smaller. Here the question of whether or not the additional levy generates franking credits for those companies becomes important.

As the additional levy doesn’t generate franking credits, domestic shareholders (such as superannuation funds and self-funded retirees) in larger companies will be worse off. They will be receiving smaller dividends than investors in other companies but will not be receiving larger franking credits.

Many commentators favour reducing corporate tax rates generally to provide an incentive for foreign portfolio investment (for example, by foreign pension funds) in Australian companies. Australia does not allow most foreign investors franking credits on dividends paid to them, but refrains from levying dividend withholding tax on the portion of the dividend funded from profits that have generated franking credits.

This is of little use to foreign portfolio investors, which typically do not obtain credit in their home country for Australian corporate (as distinct from withholding) tax on the profits that funded dividends they receive. Hence, reducing the Australian corporate tax rate can provide real benefits for foreign portfolio investments.

However, the effect of the Coalition’s paid parental leave levy on the 3,000 largest companies will negate this benefit for foreign portfolio investors in these companies. As the largest companies are the ones most likely to have access to global financial markets, the likelihood is that the cut in the corporate tax rate will not increase the level of foreign portfolio investment very much, if at all.

So who will benefit from the 1.5% cut in the company tax rate? The answer seems to be owners of small companies who, with a lower corporate tax rate, will have an increased incentive to retain income rather than distribute it once their average tax rates exceed the corporate rate.

That does not seem to be a good policy outcome to me.

Professor Taylor is head of the Australian School of Business at the University of NSW.