Kudos for announcing it in advance but the Labor Party’s franking credit policy is deeply flawed

Labor is going to the election with a three-pronged approach to tax investors.

Firstly, they are planning to wind back negative gearing on property, other than new construction.

Secondly, they’re planning to lower the capital gains tax discount on long-term gains.

And thirdly, they’re planning to scrap the refund of franking credits in most circumstances.

Two reasonable people can hold intelligent, thoughtful but differing views on the first two.

The third, though, is both unfair and deeply flawed.

Before you fire off an e-mail to either abuse me or suggest I be knighted, let me explain.

I’m going to start with three premises that I think most people can agree on:

  • One, the tax system should be fair.
  • Two, you shouldn’t have to pay tax twice on dividend income.
  • Three — and thanks, Captain Obvious — the tax system, as it stands, is broken.

Now, before we go any further, please leave your political affiliations at the door.

I’ve bagged and praised both major parties for their different policies.

I’ll continue to do it but if you can’t put aside your team jersey and engage in a discussion of ideas, then there’s not much for you in what follows.

Bill Shorten’s policy on franking credits goes something like this:

“We’re happy for you to reduce your tax using franking credits, but we’re not going to give you a refund.”

Now, don’t get me wrong, I think the current situation — regarding the ability to pay exactly zero tax on certain income in retirement that might be up to $80,000 — is crackers.

But Shorten’s policy doesn’t fix that problem.

Here’s why. Consider three people, all of whom have Self Managed Super Funds in pension phase, and who — according to the current tax rules — pay zero per cent tax: Banking Betty, Rental Richard and Dividend Davina.

Banking Betty deposits $100,000 and earns $2000 each year in interest. Betty doesn’t pay any tax.

Rental Richard has a $100,000 property that pays him $2000 each year in rent. Richard doesn’t pay any tax.

Dividend Davina buys $100,000 worth of shares that earned a profit of $2000. The company paid tax of $600, so Davina gets $1400. Davina doesn’t pay any tax.

See the difference here? Because Davina’s investment is in the form of shares, she gets less than the other two.

Even though she’s not supposed to pay any tax, the company paid tax, so she gets less.

Under current rules, she’d get the $600 back, delivering on the government’s policy of a zero per cent tax rate, and equalising the return for each of the three investors.

Bill Shorten, in effect, is penalising investors for owning shares. Now, let’s address the elephant in the room.

Yes, because the company has already paid tax on that $2000, Davina does officially get a refund. And the optics of that are bad: it looks like somehow the taxpayer is subsidising Davina.

However, it’s all a question of cash flows and timing. The Australian Taxation Office just gives Davina back the money the company paid in tax.

And remember, a company is just a legal structure to organise your ownership interest in an asset.

Shares in a company aren’t all that different, in effect, to accounts at a bank. Your bank account is evidence that you have a claim to a share of the bank’s assets, even if you don’t know specifically which notes you deposited.

Imagine a scenario under which Banking Betty’s bank withholds 30 per cent of her interest and sends it to the government as tax. And where Rental Richard’s property manager is obligated to send 30 per cent of his rental income to the ATO.

Both of these investors would have to fill out a tax return and the ATO would send them a refund — because tax was paid on their income, even though the tax rate should have been zero per cent.

Would Bill Shorten stop Betty and Richard from getting their money back? I doubt it.

Essentially, because of the asset class they decide to invest in, our three protagonists are being treated differently. Sound fair to you? No, me neither.

Yes, the idea of a “refund” for someone who has paid no tax feels, somehow, deeply wrong. But it’s because tax was paid by the company, on behalf of a shareholder who shouldn’t be paying tax, so the ATO is essentially just righting that wrong.

Still with me? Still fuming that well-off people pay no tax? Me too.

Frankly, either income inside superannuation or distributions from super should be taxed, progressively, above a generous tax-free threshold. But neither party seems prepared to confront the elephant in the room.

Instead, Labor’s policy of penalising a subset of a subset of a population — either because of a poorly formed policy or rank political opportunism — is a terrible solution to a legitimate problem.

I’ve sought a response from both Bill Shorten and Chris Bowen but thus far to no effect.

Maybe it’s the elephant that dare not speak its name.

Scott Phillips is the Motley Fool’s chief investment officer. 

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