Comment: Removal of franking credits could be disastrous for both our equity and debt capital market

On Monday the government released its taxation white paper, the latest in a long line of taxation reviews. However, in this paper it appears that little has been left unconsidered - no sacred cows have been left undisturbed.
 
Franking credits, negative gearing, superannuation concessions and GST are all reviewed and questioned. The benefits of franking credits and whether they distort asset allocation in the financial system towards equities was briefly considered by the Financial System Inquiry but largely left to be explored in this white paper.
 
The FSI noted that franking credits only benefit local investors who can extract a higher return on investment than would otherwise be achieved. The white paper takes a similar view and asks whether the dividend imputation system continues to serve Australia well as our economy becomes more open.

Proponents for the development of the domestic corporate bond market have long argued that franking credits do create an equity bias among investors. If income from bonds were to receive a similar favourable tax treatment and be tax exempt, there would be a lot more investor interest in bonds and asset allocations would be adjusted accordingly.

But the white paper is not about reducing the government's tax take. It is about finding ways to increase it. So would the removal of franking credits be beneficial to the development of the corporate bond market?
 
If franking credits were removed in isolation of any other changes, it is doubtful that it would make a big difference to the demand for bonds, at least among retail investors. Retail investors are not big investors in bonds, and would simply look for other tax effective investment opportunities.

If negative gearing was left unchanged, increased demand for investment properties and margin lending would be a more likely outcome. If negative gearing was removed, bonds should become relatively more attractive, all other things being equal.

From the 1960s to the early '80s, debentures were very popular but this demand was also driven in part by a highly regulated and insular financial system that no longer exists. All other things are unlikely to remain equal, and the institutional investor response to such a change would impact retail demand for bonds and supply.

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 look less attractive. However, it is just as likely that the switch would be to international equities rather than domestic bonds.
 
As has been noted by the FSI and in the white paper, we have a much more open economy now. International equities would likely be perceived as offering better opportunities for capital growth and therefore more attractive returns overall.
 
Indeed, it is likely that the removal of franking credits would be disastrous for the local equity market - share prices would plunge and IPOs would cease. Australian companies would find it much harder to raise capital, as the focus of institutional investors switched to international markets.
 
What is being forgotten here are the benefits the dividend imputation system has brought to the domestic equity market. While it was introduced to reduce the inequity of double taxation of company profits, it was also introduced to reduce the reliance of local companies on debt funding, which among other things led to reduced taxable earnings.

It is this latter objective that led to the highest per capita equity ownership in the world and allowed the very successful privatisations of the Commonwealth Bank, Qantas, Telstra, CSL and more. We developed a sophisticated and deep and liquid equity capital market, here in Australia.

If franking credits are removed the market would go back to being the sleepy little sideshow that it was rapidly becoming. The increasing internationalisation of the economy would see to this.

If this competitive advantage of the local market is removed, Australian companies would increasingly go offshore to raise equity - listing in London or New York - just as they go offshore to sell bonds now. A merger between the ASX and SGX would suddenly look like a good idea but is doubtful that SGX would be interested anymore.

The removal of franking credits would probably be just as disastrous for the domestic corporate bond market. As institutional investors developed their expertise in dealing in international equity markets, so would they develop their skills and processes for dealing in international bond markets.

Moreover, the removal of dividend imputation would kill the additional tier one capital (bank hybrid) market stone dead. While dividends on hybrids are paid with a discounted cash component, topped up with franking credits, the absence of franking credits would require a cash payment 43 per cent greater than that currently paid.

Such a change is likely to make it cheaper for banks to issue real equity instead. It would certainly give them greater flexibility.

But then again, equity would be a whole lot more expensive without franking credits driving local demand.

With institutional demand for both equity and debt shifting to international markets, domestic capital markets would decline and investment opportunities would diminish. This would almost certainly ensure the demise of Self-Managed Superannuation Funds and put more money and power back in the hands of the institutions that would invest the funds offshore and thereby perpetuate the change.

So is the removal of franking credits likely to happen?

This is a white paper. In the normal course of events it would be followed by a green paper and then legislation would be drafted and subsequently passed by parliament.

But that won't happen in the current parliamentary term and beyond that we may well have a new government.