The impact of lower company tax on the share market
Despite intensive lobbying by the business sector, the government still faces major obstacles to cutting the large company tax rate to 25 per cent. Large corporations such as Rio Tinto warn leaving the company tax rate at 30 per cent would inevitably lead to moving more of their operations overseas where lower tax rates apply, such as the new rate of 21 per cent in the United States.
While more attention is paid to the potential benefits of making Australia a more attractive investment destination, the impact of a lower company tax rate on the Australian share market is also an important issue. Our market received a substantial boost in 1987 when then-Treasurer Paul Keating introduced the imputation credit system of company tax.
By granting resident investors a full credit for all company tax paid on dividends received by them, imputation effectively reduced the company tax rate (which was as high as 49 per cent at one stage) to zero but only for residents and only when profits were distributed. Prior to 1987, shareholders paid full personal income tax rates on dividends paid out of profits that had already been subject to company tax.
This tax change boosted residents' demand for shares and encouraged companies to increase dividend payouts, adding to the attractions of owning listed shares. Imputation credits are now less valuable at the current 30 per cent tax rate and their value would fall further if the company tax were reduced to 25 per cent.
But even at a 25 per cent tax rate, imputation credits would substantially improve the returns for low rate taxpayers. Superannuation and pension funds would continue to receive tax advantages from owning dividendpaying shares. Personal taxpayers, however would, because of their higher marginal tax rates, face additional tax bills on franked dividends they receive.
Unless lowering company tax rates boosted company profits before tax is payable, owning shares paying franked dividends would be less attractive to individual shareholders. Lowering the company tax rate would, however, benefit overseas investors not eligible for imputation credits because of the lift to after-tax profits because of lower tax bills.
Overall, a lower company tax rate may not be good news for existing resident shareholders unless it lifts company pre-tax profits. There is, however, one bonus for existing shareholders resulting from speculation about a lower company tax rate.
Because a lower tax rate will reduce the value of imputation credits, companies are encouraged to distribute existing franking credits as soon as possible to maximise the benefits to resident shareholders. This is the reason many Australian companies pay out (and are likely to continue to do so) a high percentage of their profits as franked dividends.