The impact of abolishing franking credits

Putting aside arguments over the strengths and weaknesses of Australia's dividend imputation system, what would be the impact if it was abolished?

Putting aside arguments over the strengths and weaknesses of Australia's dividend imputation system, what would be the impact if it was abolished?

The franking system was implemented in the 1980s to prevent business profits being taxed twice: once at the company level and then again when shareholders receive dividends.  

By preventing shareholders from using franking credits to reduce their tax bill, the biggest impact of abolition would be an increase in the general level of taxation in Australia. The after-tax returns from capital investment would decline and there would be less incentive to invest. All things equal, this would result in smaller increases in productivity and a lower standard of living than would otherwise be the case. 

The impact on individual shareholders would vary: many of them prefer – and even rely on – dividend income and the attached franking credits whereas others are content to earn returns from capital gains. However, the additional tax burden would probably mean shareholders would generally be less likely to clamour for ever-increasing dividends, preferring companies reinvest profits or return them to shareholders via more tax-effective means such as share repurchases.

As a result, Australian stocks' high average dividend yield would likely decline closer to that of the US, where dividend income is already taxed twice.

From a company's point of view, the impact would also vary.

No doubt some managements would be further incentivised to hoard cash, arguing that the increased taxes borne by shareholders means they're better off allowing management to reinvest it on their behalf.

Yet if anything the opposite has been the case in Australia in recent times, with many companies reacting to Australian shareholders' desire for fully franked dividends by increasing their payout ratios beyond levels that are sustainable.

As we discussed in a recent article on Intelligent Investor Share Advisor, should Australia fall into recession, retailers such as Harvey Norman (ASX: HVN) and The Reject Shop (ASX: TRS) would have a hard time maintaining their current payout ratios. Heavily-indebted Santos (ASX: STO) and Origin (ASX: ORG) are also exposing their investors to risk by keeping their dividends too high.

Like with so many other investing topics, we agree with Warren Buffett's reasoning on this point: if a company can reinvest its free cash at higher rates of return than available to its shareholders, then it should do so. If not, then excess cash should be returned to shareholders rather than being hoarded or wasted on unprofitable investments.

It is worthwhile adding that Buffett defines 'free cash' as after the necessary capital investment in the business has been made, not before. His thoughts also align with the large amount of evidence showing management often wastes shareholders' funds when it embarks on expansionary binges.

Finally, companies renowned for their high level of fully franked dividends – such as the Commonwealth Bank (ASX: CBA), the other big banks or Telstra (ASX: TLS) – would lose the additional yield advantage that franking provides when compared to companies that pay partially franked or unfranked dividends. All things equal, A-REITs such as DEXUS (ASX: DXS) or Stockland (ASX: SGP) would probably become even more desired by investors chasing income. 

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