There's nothing unfair about dividend imputation -- it refunds tax that shouldn't have been paid

As election day approaches, dividend imputation is back in the news and the hot takes are running hot. Commentators are branding the system we’ve got a “tax dodge”, a “handout” and a “loophole”, and praising Labor’s proposal as economically sound.

But they’re wrong.

Australia, almost uniquely in the world, has for decades taxed profits in a special way. These profits are, in one way or another, owed to shareholders. In a normal tax system, profits are first taxed at the company level when they’re earned and then taxed at the personal level when they’re paid as dividends.

Dividend imputation eliminates the first stage.

For shares owned by Australians, the idea is to extinguish all taxes the company owes. To that end, Australian shareholders get a refund of the taxes paid by the company, known as “franking credits”. Labor says it has no beef with this idea. It set up Australia’s dividend imputation system in 1987.

Labor introduced dividend imputation

So what does it want to do now?

At the moment, Australian shareholders get back the taxes paid by the company no matter what. If they have a tax bill, then it’s reduced by the relevant amount; if they don’t have a tax bill, then they get a cheque in the mail instead.

John Howard reformed Labor’s system in the year 2000 on the recommendation of the Ralph Review of Business Taxation. Non-taxpayers as well as taxpayers would be eligible for refunds of company tax.

Labor wants to revert back to how things originally were. It wants to take away franking credits from anyone who, for any reason, doesn’t have a personal tax bill, whether rich or poor, young or old, in work or retired.

Many shareholders legitimately pay no tax

Reasons abound as to why you might own shares but pay no tax. And they need not have anything to do with being a tax dodger, a taker of handouts, or an exploiter of loopholes.

Imagine you own some Telstra shares, but take a year off to look after your children. When you work, the tax Telstra paid is refunded to you so no corporate tax is paid on those shares. But under Labor’s proposal when you take a year off, you would no longer be entitled to that refund. Telstra would only pay tax on your shares when you looked after your children.

To me, that’s nuts.

And if you think only the wealthy own shares, think again. There are thousands of Australians for whom those Telstra dividends pay the power bill.

So why is Labor proposing it?

Labor wants their money

In part because it wants the money – an estimated A$5 billion per year.

It’s hard to think of another reason. Getting a $100 cheque in the mail is equivalent to getting an extra $100 in your tax return.

Labor says it’s wrong to give tax refunds to people who don’t pay tax. But another way of looking at it is that they have paid tax – it’s just that the companies they own did it for them.

If you don’t like those without tax bills getting refunds then you ought to ask why it’s happening.

If you don’t like the answer – which might be that tax-free super is their only other source of income – you should look at fixing the root cause. But then you should leave the imputation system, which works as intended, alone.

And it’s prepared to abandon good tax design

The core principle of tax design is neutrality —- ensuring that taxes depend on behaviour as little as possible. The current system is neutral because shareholders get company tax back regardless of their tax status; Labor’s proposal would return company tax to some shareowners and not others.

The best way to target the rich is to design an income tax system that does it directly.

Reverting to the old, hobbled version of dividend imputation isn’t reform – it’s the opposite.

Read more: Words that matter. What’s a franking credit? What’s dividend imputation? And what's 'retiree tax'?

The only thing Labor’s proposal has going for it is the revenue it will raise. But that’s a low bar. The best policy isn’t the one that raises the most revenue, its the one that raises revenue at the lowest economic cost.

There are lots of ways to raise revenue. Many of them are coherent, principled, targeted, transparent, fair, and don’t distort economic activity. Work-related deductions, superannuation tax concessions, and the design of the income tax itself are better places to look.

Read more: It's hard to find out who Labor's dividend imputation policy will hit, but it is possible, and it isn't the poor