Divergent views on proposed franking credit overhaul
Australia could be staring down the barrel of skyrocketing corporate debt, a shrinking equity market, and the loss of innovation to non-listed environments if franking credits are scrapped, says Fidelity portfolio manager Kate Howitt.
Australia could be staring down the barrel of skyrocketing corporate debt, a shrinking equity market, and the loss of innovation to non-listed environments if franking credits are scrapped, says Fidelity portfolio manager Kate Howitt.
"I get very nervous when I hear rumblings about doing away with franking. And it all comes from treasury saying 'oh, there's revenue leakage to the federal government because of this'.
"[The removal of franking] would be a really short-sighted way of resetting a policy that has been really fundamental to some of the dynamism that we've managed to retain in our market," Howitt says.
She believes the removal of franking credits could lead to rising levels of debt among Australia's corporate class – a cause of serious concern if interest rates shift upwards.
Pointing to the US as an example, Howitt says major US companies looking to return value to shareholders have participated in mass share buy-backs, funded by low-interest debt.
This, Howitt says, is because if they return value to shareholders via dividends, the returns will get taxed at the corporate level, and then at the receipts level – "a dead-weight loss". This creates cause for concern when considered alongside the prospect of slowing growth and rising interest rates in the US.
"We're going to look back and say 'that wasn't the best way to go'," she says.
Kate Howitt partly attributes Australia's solid corporate balance sheets to franking credits
Laying off the buy-backs
Howitt believes Australian companies have retained decent balance sheets because they don't engage in big buy-backs.
"If you're sitting in the US and your company is making a lot of cash for the year, or you've got a balance sheet that you think you can gear up, the best way to return that value to shareholders is by doing a buyback.
"But in Australia, we have this wonderfully economic efficient regime of franking, incentivising companies to pay dividends to shareholders," she says.
US corporate debt reached a record US$6.3 trillion in June this year, according to S&P Global.
Howitt also warns of 'de-equitisation' – the shrinkage of equity markets via share buybacks – if franking is removed, leading to less opportunity for individual investors to purchase growth companies.
Referring to the US market again, she says the double taxation of dividends is encouraging US corporates to buy back their own shares. This in turn shrinks the equity market and forces smaller, innovative companies to turn to venture capitalists for funding.
"Innovation in the US is increasingly happening in an unlisted sphere, which of course is great if you're a sophisticated, high net worth individual who can do an allocation into VC," she says.
"But if you're more mainstream, just wanting to get your exposure to growth assets through listed equity markets, life is getting tougher. Today you're just getting these over-levered, older style companies who are gearing up their balance sheets, and less of the innovation coming through. The innovation is happening off-market."
According to Howitt, Australia has so far managed to avoid this dynamic partly because of franked dividends: "Investors keep getting cash back, which they can use to redeploy into smaller, more innovative and exciting growth companies".
Dividend imputation changes seem likely
Labor plans to implement its proposed changes to the dividend imputation scheme if it wins the election, expected by May next year.
Opposition Treasury spokesman Chris Bowen has defended the policy, saying cash refunds for excess imputation credits are costing the budget $6 billion a year — money he says is better spent on services, schools, education and paying down debt.
Labor has since exempted pensioners and grandfathered those SMSFs with at least one pensioner or cash-rebate recipient.
Some industry figures, including fixed income manager and Daintree Capital founding director Justin Tyler, have welcomed the policy. He told reporters in Sydney last week that "for us as bond investors, this is actually a good thing."
"What we hope is that we start to see a rotation on the part of Australian investors towards fixed income as an asset class," he says.
Tyler concedes many Australians who have staked their financial plans on the policy will be "negatively impacted."
Responding to concerns that franking credits have entrenched a home-market bias amongst Australian investors, Fidelity's Howitt is not convinced.
"If you go back and look at the performance of stock markets over a long period, Australia has been one of the very best performing markets.
"It's circular because we think if you go around and decompose that, the better performing stock markets, contrary to popular belief, are the ones where dividend yields are high, not where you get a lot of capital gains," she says.
Howitt suggests that while capital gains are a good thing for investors, they tend to be more transient, "whereas dividends are very steady, and high dividend paying markets promote capital discipline of corporates".
"If you're going to have a bias towards one particular market, Australia has been a good place to be."
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Emma Rapaport is a reporter with Morningstar Australia, based in Sydney.
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