Welcome to the second entry in my occasional series, “Over There,” about personal finance topics in countries besides the United States. These posts aren’t meant as advice to people living in those countries, but rather as some kind of practical insight for American readers into how other countries deal with the the same issues we do: savings, insurance, education, retirement, taxes, and so on.
In today’s edition I want to cover the fascinating question of Australian “franking credits.”
Every question in tax policy has been answered differently in different times and places
To the extent that any state wants to collect taxes in order to finance government programs, it has to answer some basic questions:
- what should be taxed?
- what should the tax rates be, and how should they be structured?
- who should pay the tax?
- and who is responsible for reconciling taxes paid with taxes owed?
These questions can be and have been answered in an almost unlimited number of ways. For example, you may have heard anecdotally about early-modern “window taxes,” which levied a kind of wealth tax on homeowners based on the number of windows in their home.
Once you’ve decided that window taxes are a good way to raise revenue, you still have to answer the rest of the questions. For example, should the window tax be a flat tax on each window, starting with the first, or a progressive window tax, with the first few windows tax-free and each additional window incurring a larger and larger tax assessment? According to Wikipedia, Britain used the latter model, “a flat-rate house tax of 2 shillings per house…and a variable tax for the number of windows above ten windows in the house. Properties with between ten and twenty windows paid an extra four shillings…and those above twenty windows paid an extra eight shillings.”
Once you’ve settled on a progressive window tax, you still have to decide who should pay the tax. Should a tax assessor be employed to travel town-to-town and count windows each year, or should the builder of a house be required to add the house’s window tax assessment to the price?
And of course, the number of windows in a structure can change over time. When a house is made smaller by demolishing a wing or boarding up a window, does the owner have any opportunity to claim a refund of the window tax they’ve already paid? When an extension is added, how and when will they be assessed on the home’s increased window count?
Franking credits: an elegant solution to a universal problem
The taxation of private, for-profit companies has produced some of the most divergent answers to these fundamental questions. That’s for the simple reason that one one seems exactly sure what a corporation is. Is it purely a legal fiction created for the benefit of its shareholders? In that case, why shouldn’t shareholders have unlimited liability for the debts incurred and crimes committed by the corporation? Is it a distinct legal entity capable of committing crimes, exercising religion, and producing speech on its own behalf? In that case, shouldn’t the company pay taxes on its own profits like any other individual taxpayer?
In the United States, we’ve split all these differences by charging tax on corporate profits twice: once at the corporate level, and once at the individual level when those profits are returned to shareholders. That has the effect of creating a mildly progressive corporate income tax, with a floor: the corporation pays taxes on its profits at a more-or-less fixed rate of 21% on its corporate tax return, then distributions to shareholders are reported on each shareholder’s individual tax return and are taxed at between 0% and 39.6% depending on the duration of ownership and other income sources.
Australia solved the identical problem completely differently. When an Australian company decides to distribute dividends, it pays a flat 30% of the distribution in taxes to the government, which corresponds to the maximum individual dividend tax rate. That tax payment is then passed along to shareholders who receive dividends together with a co-called “franking credit,” which is fully refundable. A high-income taxpayer who owes taxes on dividends at the 30% rate simply applies his or her franking credit against the taxes owed, while a taxpayer who pays taxes at a lower marginal rate is able to claim the difference as a refund.
In effect, this means all shareholders pay taxes on corporate profits at their own marginal tax rates: when a low-income shareholder receives a $70 dividend they can claim a $30 franking credit refund, receiving the full $100 dividend at a 0% tax rate, while a high-income shareholder receiving the same $70 dividend will only be able to apply the $30 franking credit against their $30 in tax liability, paying an effective 30% tax.
Superannuation funds: a brief digression
Superannuation funds are Australia’s equivalent of the defined benefit, 401(k), 403(b), and IRA retirement arrangements used in the United States. Employers are required to make contributions, and employees are encouraged to make additional contributions, either through “concessional” (preferentially-taxed), or “non-concessional” (after-tax) contributions, roughly analogous to the way our 401(k) and IRA accounts feature both traditional and Roth contribution options.
From what I can tell, superannuation funds are an absolute wild west of high-fee, low-quality investment options, but since most contributions are made by employers (“free money”), Australians themselves don’t seem to be very aware or concerned that they’re being ripped off by their investment managers, and the funds contain a vast share of Australian retirement savings.
Superannuation funds and franking credits
The interaction of superannuation funds and franking credits recently became a moderately important political issue in Australia. The issue arises because it’s not immediately obvious how franking credits should be treated for superannuation account holders in retirement.
During the accumulation phase of an Australian worker’s life, the shares held in his concessional superannuation account are taxed at a flat 15%. Since corporate dividends are withheld at a 30% tax rate, each year the superannuation fund can claim a refundable franking credit of 15%.
But after so-called “preservation age” (“full retirement age” in the United States), income from the superannuation fund is tax-free, and under current Australian law, that entitles the account holder to a full refund of the corporation’s 30% dividend withholding, unless they have other sources of taxable income.
This creates the strange situation where corporations with a larger proportions of superannuation shareholders, and especially wealthy retiree shareholders without taxable income, pay lower taxes than corporations with larger proportions of taxable shareholders and retiree shareholders with other sources of taxable income.
Conclusion: should income in retirement be tax-free?
I’m struck by how often I see people making dramatic policy arguments anchored on sympathetic anecdotes without any underlying principle they’re able to articulate. This was made especially obvious when the mortgage interest and state and local tax deductions were limited in the Smash-and-Grab Tax Act of 2017: I am unable to find anyone able to explain why mortgage interest should be tax deductible, or why state and local taxes should be tax deductible, but plenty of people insisting they were being personally attacked and individually wronged by the limitations on the deductions, which of course only affected the small number of very wealthy individuals who itemized their deductions each year.
Similarly, when the Australian Labor (yes, that’s how they spell it) Party proposed limiting the refundability of franking credits for retirees, there was a vicious backlash by the tiny minority of Australian retirees using franking credits to supplement their tax-free retirement income, without even attempting to make a principled argument that Australian corporations ought to be able to distribute dividends tax-free to the wealthiest Australian retirees.
Ultimately, as their defeat in last week’s elections shows, whether the ALP is right or wrong on the question of franking credits will end up being less important than the question of whether they are able to convince their compatriots that it’s worth building a society that lasts more than one half-generation into the future. Needless to say, things are not looking good.