Will a company tax cut really benefit everyone?

The government intends to introduce the company tax cuts in this year's budget. In 2015-16 companies with an annual turnover of less than $2 million paid a lower company tax rate than bigger companies - 28.5% versus the standard 30%. This financial year that will be lowered to 27.5% for companies turning over less than $10 million. Over the next 10 years the rate will be progressively lowered until it hits 25% for all companies regardless of turnover.

The big picture

The government argues we'll all end up winners from further cuts, as companies will have more money to invest and employ people. But since the cuts were announced, there has been conflicting research on just how much of a boost they would deliver.

In the week of the budget, Treasury released a working paper on the tax cut's long-term effects, though it stressed it had not specifically modelled the Coalition's planned cuts. The paper found cutting the company tax rate from 30% to 25% would add 1%-1.2% to gross domestic product (GDP), depending on how the cuts were financed. Gross national income (GNI), which many commentators regard as more important because it excludes money flowing out of the country to foreigners, would rise by a more modest 0.6%-0.8%, largely due to higher wages. It found households would be better off regardless of how the cuts were funded.

The dividend wrinkle

Wondering about that difference between the projected rise in GDP versus GNI? That's where the tax cuts have become contentious. Thanks to our dividend imputation system, local investors won't benefit in after-tax terms from a company tax cut as we will simply pay more personal income tax on our dividends.

Foreign investors, however, don't benefit from imputation and so will be the more immediate winners from the tax cuts (although profits taken out of Australia to countries with which we have a tax treaty could incur extra tax there). This has led to some claims that the proposed cuts are a "multibillion-dollar gift" to the US Treasury - probably not what the Coalition intended. However, Treasury says lower taxes would encourage foreign investment in Australia.

Franking credits and yield

More personally, share investors (and their super funds) will get less income, after tax, from their dividends unless company dividends increase to compensate.

Super funds pay only 15% tax on earnings and receive refunds on unused franking credits. The Australian Shareholders Association gives the example of a fund that invests $10,000 in 625 shares in XYZ Ltd. XYZ makes a $3-a-share profit and pays tax of 90c a share at the 30% rate. It pays a $1.20 fully franked dividend, keeping 40% of the profit for future investment.

For the super fund, that is a dividend yield of 7.5% on its $10,000 investment. But that $750 dividend comes with $321.43 worth of franking credits, taking the fund's taxable income to $1071.43. It pays $160.71 tax on that income, leaving it with another $160.71 in refundable franking credits to add to the $750 income already received. So its after-tax yield rises to 9.11%.

So what happens on a 25% tax rate? Assume the company maintains its $750 dividend. But at the lower tax rate, franking credits fall to $250. The fund's taxable income is $1000 and it pays $150 tax, and receives a refund of $100 from the excess franking credits. So its after-tax return on the dividend has fallen to 8.5%. Of course, if the company paid a higher dividend from its higher profit, the super fund could be as well off, or better off, but that depends on the company's dividend policy.

For individual investors, a lower company tax rate will mean reduced returns for those on lower tax rates and a higher tax bill for those whose personal tax rate is higher than the company rate.

Any theory that company tax cuts are good for the country relies on the so-called "trickle-down effect" - the notion that benefits provided to those at the top of the food chain get passed on.

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