Source: Plato

Figure 2. The after-tax value of one dollar of taxable income including franking.

Source: Plato

Figure 2 highlights that the current franking system puts taxes on corporate profits, and unfranked income held directly or via trusts on an equal footing. It also highlights the lower effective tax rate on capital gains.

Post ALP changes

We re-draw Figures 1 and 2 post the ALP tax changes in Figures 3 and 4. We increase the top marginal tax rate by 2% and reduce the CGT discount by 50% for individuals, and factor in the impact of eliminating refundable franking credits. Note, we only show the CGT impact for new investments (refer our later discussion) and for superannuation taxed at 15%, we assume the superannuation fund has sufficient tax payable (tax on contributions and tax on other income) to offset or use up all the franking credits.

Figure 3. The after-tax value of one dollar of pre-tax income under the ALP tax proposals

Source: Plato

The impact of franking changes creates two classes of tax-exempt investors – those who still receive franking credit refunds such as charities and Centrelink pensioners, and those that can’t. In this case, a dollar of fully franked dividend is only worth $1 for pension phase SMSF, not $1.43, a substantial difference. Similarly, for someone on the 19% marginal tax rate, a fully franked dividend is only worth $1, versus the $1.13 in Figure 1. For investors on higher tax rates, the value of fully franked dividends remains the same (other than for the highest marginal tax rate individual due to the 2c tax rate increase).

In Figure 4 you can clearly see the loss in value of fully franked income versus other forms of income for tax exempt investors who can’t claim franking credit refunds. To further highlight the changes, in Figure 5 we plot the differences between the current situation in Figure 2 with the ALP proposal in Figure 4. Figure 5 also clearly highlights the impact of not refunding franking to low tax investors (0% and 19%) tax rates, as well as the increase in the capital gains tax rate. The 30% loss in value on fully franked dividends for tax exempt investors who can’t utilise franking is by far the largest tax change, dwarfing the increases in taxes for the highest marginal taxed individual.

Figure 4. The after-tax value of one dollar of taxable income including franking under the ALP proposals.

Source: Plato

Figure 5. Estimated differences in the after-tax value of one dollar of taxable income including franking credits under the ALP proposed tax changes versus current position.

Source: Plato

Tax on Trust Income

Under the ALP proposal a Labor government would introduce a standard minimum 30% tax rate from 1 July 2019 for discretionary trust distributions to mature beneficiaries aged over 18. We have attempted to model this for different individual tax rates, and for comparison purposes, show the after-tax values for franked dividend income and other direct unfranked income (for example interest or rental income) earned by individuals in Figure 6. Figure 6 clearly highlights that low tax rate individuals would be better off investing directly rather than via a trust or company structure. The effective tax rate for low tax investors (0% and 19% tax rates) rises to 30% on both franked dividends and trust distributions.

Figure 6. The estimated after-tax value of franked income, trust distributions and other income for individuals under the ALP proposals.

Source: Plato

To consider the impact of the change, Figure 7 plots the current tax paid with estimated tax under the ALP proposal, for an individual receiving only taxable discretionary trust income. For simplicity purposes we have excluded the Medicare Levy. Whilst in percentage terms the biggest loss is for incomes up to $18200 per annum, the maximum dollar loss is for someone with a $37,000 taxable income.

Figure 7. The impact on ALP trust income proposal – all income from discretionary trust.

Source: Plato estimates excluding Medicare Levy

Negative Gearing and Capital Gains Tax

For negative gearing we have taken a slightly different approach. In Figure 8 we look at the effective tax rates on capital gains revenue and interest deductions under the current situation compared to the ALP proposal. Since the negative gearing and capital gains tax arrangements are grandfathered, the current situation will remain for assets already held. It should also be noted that Labor propose to continue to allow negative gearing of new housing, so the deductibility of interest remains the same for new housing as the current situation.

Currently under the negative gearing regime, interest is deductible at the investors marginal tax rate, so for a taxpayer on a 37% tax rate (39% including Medicare Levy) the current after-tax value of income paid is $0.61. I pay $1 of interest and save 39 cents in tax. On the other hand, the current tax rate on long-term capital gains is half the full marginal rate (19.5%) so the after-tax value of any long-term capital gains is essentially $0.805 – I receive $1 and pay 19.5 cents in tax. Under the ALP proposal, interest expenses are not allowed as a tax deduction at the individual’s marginal tax rate (e.g., no negative gearing), rather they are carried forward to offset future capital gains. With CGT effectively increasing to 75% of marginal rates, the new effective CGT for this investor is 29.25%, so both revenue and expenses are worth $0.7075 after tax. However, it is actually worse than this, because we haven’t taken account of the time value of money in Figure 8. Currently you pay interest each year and can deduct interest charges from negative gearing against income each year. Under the ALP proposal, whilst you continue to have to pay the negatively geared interest each year, you can only carryforward the interest expense to offset against the capital gain when realised. So the interest tax deduction will be in future dollars.

Figure 8. Changes to the after-tax value of capital gains and interest deductibility (negative gearing).

Source: Plato estimates excluding Medicare Levy

Figure 8 also highlights that there will be significant incentives for investors to hold onto grandfathered assets, assets bought before 1 January 2020.

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