Australia's business lobbies are fond of complaining that company tax is too high at 30 per cent. Lower it, they argue, and the economy would become more dynamic and everyone would benefit. But it isn't that simple. The combination of Australia's dividend imputation system, or franking, and the compulsory superannuation scheme, means that for a very high number of investors in big public companies the effective tax rate is only 15 per cent.
Dividend imputation works like this. Say a company makes $100 in before-tax profits. It pays tax at $30, leaving profits of $70, which it pays out to investors as a fully franked dividend. When that is distributed to shareholders they get the benefit, so there is only one taxable income, not two. That means a tax free $70 to the shareholder.
The situation is different when the dividends go to super funds, which is the case for about half of public company dividends. Super funds pay a tax rate of 15 per cent, but get the credit for tax having been paid at 30 per cent (the company tax rate). That means they get the dividend, plus a refund ($15 in our example) from the tax office. So in effect, $85 goes to the super fund, tax free. Not-for-profits are in an even better position.
This means that a significant portion of dividends paid by Australian public companies have an effective tax rate of only 15 per cent. About $1.4 trillion is held in Australian superannuation funds, about the same level as the market capitalisation of the Australian stock market. These super funds have large holdings in Australian listed shares, so they receive the franking benefits when those companies pay dividends.
Of course, companies typically do not pay out all their profits in dividends. Usually the rate is somewhere between two thirds and three quarters (except for mining companies, for which the payout ratio is much lower). Nevertheless, the low rate of tax on profits when they are given out as dividends to shareholders has far reaching consequences for the value of our larger listed companies.
A common notional way of valuing a company's shares is to calculate the future value of dividends, after making adjustments for inflation and other factors. A