Dividend imputation and the Australian financial system: What have been the consequences?

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This paper was produced under the Funding Australia’s Future project which aims to better understand the changing dynamics of the financial system and its impact on future economic growth. The research from Stage Three explores specific challenges to the financial sector highlighted by the Financial System Inquiry, Tax System Review and Intergenerational Report. 

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Dividend imputation was introduced in Australia in 1987. Despite many theoretical and empirical studies, there is little consensus on its effects on the cost of equity capital, share prices, or investment – due primarily to different views on the consequences of international integration on equity pricing. In contrast, there appears to be general agreement on the effects on corporate leverage and dividend policy, and asset allocation strategies of investors, even though many of these effects hinge upon how international integration affects the cost of equity capital. The objective of this paper is to outline these effects, drawing on and critically reviewing the existing literature to assess what conclusions can be drawn, and causes of disagreement, on imputation’s effects on the Australian Financial System.

It is concluded that imputation has provided significant benefits to the Australian economy through effects on corporate behaviour, particularly through inducing lower leverage and higher dividend payout rates, with positive implications for financial stability and market discipline of companies. Whether it has stimulated domestic physical investment is unclear – this depends upon what counterfactual tax system and rates are assumed and upon whether international integration has prevented any reduction in the cost of equity capital to Australian companies. It has had positive effects on the growth rate of the Australian equity market, relative to debt markets – reflecting both supply and demand influences. It only involves discriminatory favourable tax treatment of domestic equity investments relative to fixed interest investments (including bank deposits) if it is the case that international integration prevents any effect on the cost of equity for Australian firms. (Otherwise, an alternative classical tax system would lead to higher cash returns on equities). Shifting to a classical tax system with a company tax rate which generated equivalent government tax revenue would be likely to have distributional consequences which can be argued to be adverse to low tax-rate investors, and could have significant one-off stock price effects with consequences for capital gains and losses for investors.

Because of imputation, Australia’s overall (company plus investor) tax rate on company income distributed as dividends, is lower than that in many other Organisation for Economic Co-operation and Development (OECD) countries, despite an apparently high corporate tax rate.

On balance, the case for shifting away from an imputation system is not strong, given the beneficial effects it has on corporate financial policies.

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The Australian Centre for Financial Studies (ACFS) initiated the Funding Australia’s Future project in late 2012 to undertake a stocktake of the Australian financial system, and its role and challenges in facilitating future economic growth within the wider economy.

In an economy that has enjoyed 21 years of consecutive economic growth and shown a resilience through the Global Financial Crisis (GFC) which is the envy of many nations, the financial sector has played a strong and pivotal role. The past decade, however, has been one of significant change. The impact of the GFC and the subsequent wave of global re-regulation have had a profound effect on patterns of financing, financial sector structure, and attitudes towards financial sector regulation. Identifying the extent to which these changes are transitory or likely to be more permanent is crucial to understanding how financing patterns and the financial sector will develop over the next decade or so.

The Funding Australia’s Future project is in three stages, the third of which explores key challenges to the Australian financial system, highlighted by the Financial System Inquiry, Tax System Review and Intergenerational Report.