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[SYDNEY] Australia has launched a debate on tax reforms that could have the unintended effect of slashing demand for domestic equities in favour of bonds.
The government's Re:think discussion paper suggests Australia has the scope to increase its aggregate tax burden from 27 per cent of GDP, one of the lowest in the developed world, and questions the dividend imputation system, established in 1987, that gives refunds almost A$30 billion (US$22.8 billion) a year to shareholders.
Under imputation, company tax acts as a withholding tax on Australian shareholders in collecting some of the tax shareholders would pay when they receive dividends.
Local shareholders then receive a franking credit against their tax liabilities for the tax the company paid. Individuals, superannuation funds and charities are refunded any excess tax paid at the company level to the tune of around A$19 billion annually, with Australian companies claiming about A$10 billion worth of imputation credits.
As a result, Australian shareholders typically receive higher returns on local shares, compared with global equities and, subsequently, invest more of their savings in domestic shares rather than other investments, including foreign companies.
One problem with imputation is that, because it does not provide relief from underlying foreign corporate taxes, it creates a bias against Australian-owned companies investing in overseas firms or engaging in foreign business activities.
Franking credits also explain Australian investors' clear preference for equities over bonds.
Australia has the world's fourth-largest pension pool, with total assets of almost US$1.7 trillion last year, or 113 per cent of the country's GDP, according to the 2015 Towers Watson Global Pension Assets Study.
Just over half (51 per cent) of Australia's pension pool is invested in equities, the highest share among the seven largest national pension pools, while its bond allocation of just 15 per cent is less than half the international average of 31 per cent.
Australia's shallow domestic bond market would deepen if local investors shifted more of their savings into fixed-income products.
Philip Bayley, principal at ADCM Services, argued that the removal of franking credits would be "disastrous" for the local equity market, causing share prices to plunge and IPOs to cease.
He pointed out that dividend imputation was introduced in part to aid the development of the domestic equity market, which had resulted in the highest per capita equity ownership in the world, and allowed the very successful privatisations of the Commonwealth Bank of Australia, Qantas, Telstra and CSL, among others. Retail ownership of certain stocks can be as high as 40-50 per cent.
"If franking credits are removed, the market will go back to being the sleepy little sideshow that it once was. Australian companies will go offshore to raise equity - listing in London or New York - just as they go offshore to sell bonds now," Mr Bayley said.
He also predicted that their removal would kill the Additional Tier 1 capital (bank hybrid) market, as the cost of issuing these notes would soar 43 per cent, which would probably make it cheaper to issue common equity.
However, Mr Bayley doubted that the removal of franking credits alone would make a big difference to retail demand for bonds, especially if other investments continued to offer tax advantages.
"Investors would simply look for other tax-effective investment opportunities. If negative gearing is left unchanged, increased demand for investment properties and margin lending is a more likely outcome. If negative gearing is removed, then bonds would become relatively more attractive, all other things being equal," Mr Bayley said.
Negative gearing rules allow Australian property owners to claim tax deductions where their funding costs exceed rental income.
Mr Bayley pointed out that institutional demand could be more elastic and the removal of franking credits alone could lead to a reduced allocation to equities, as the returns from equities looked less attractive. "However, it is just as likely that the switch will be to international equities rather than domestic bonds," he said.
Any tax changes are a long way from becoming law. Re:think is a white paper, and a green paper is typically needed before legislation is drafted and can be passed by Parliament. This will not happen before the next federal election, due to be held on or before January 2017.