Discussion paper

Dividend imputation and the Australian financial system: What have been the consequences?

21 Oct 2015

Dividend imputation was introduced in Australia in 1987. Despite many theoretical and empirical studies, there is little consensus on its effects on the cost of equity capital, share prices, or investment – due primarily to different views on the consequences of international integration on equity pricing. In contrast, there appears to be general agreement on the effects on corporate leverage and dividend policy, and asset allocation strategies of investors, even though many of these effects hinge upon how international integration affects the cost of equity capital. The objective of this paper is to outline these effects, drawing on and critically reviewing the existing literature to assess what conclusions can be drawn, and causes of disagreement, on imputation’s effects on the Australian Financial System.

It is concluded that imputation has provided significant benefits to the Australian economy through effects on corporate behaviour, particularly through inducing lower leverage and higher dividend payout rates, with positive implications for financial stability and market discipline of companies. Whether it has stimulated domestic physical investment is unclear – this depends upon what counterfactual tax system and rates are assumed and upon whether international integration has prevented any reduction in the cost of equity capital to Australian companies. It has had positive effects on the growth rate of the Australian equity market, relative to debt markets – reflecting both supply and demand influences. It only involves discriminatory favourable tax treatment of domestic equity investments relative to fixed interest investments (including bank deposits) if it is the case that international integration prevents any effect on the cost of equity for Australian firms. (Otherwise, an alternative classical tax system would lead to higher cash returns on equities). Shifting to a classical tax system with a company tax rate which generated equivalent government tax revenue would be likely to have distributional consequences which can be argued to be adverse to low tax-rate investors, and could have significant one-off stock price effects with consequences for capital gains and losses for investors.

Because of imputation, Australia’s overall (company plus investor) tax rate on company income distributed as dividends, is lower than that in many other Organisation for Economic Co-operation and Development (OECD) countries, despite an apparently high corporate tax rate.

On balance, the case for shifting away from an imputation system is not strong, given the beneficial effects it has on corporate financial policies.

This paper is one of three in Stage 3 of the Australian Centre for Financial Studies (ACFS) program: Funding Australia’s Future.  Initiated in 2012, this program aims to better understand the changing dynamics of the financial system and its impact on role in future economic growth.

The first stage of the project, completed in 2013, analysed the interaction between suppliers of funds, financial sector participants, and end users throughout the economy. 

The four papers from Stage 2 explored these issues further and provided valuable input to the Financial System Inquiry on how well Australia’s financial sector serves the economy (especially households and business), and how effectively it links the sources and uses of finance for the benefit of Australian society. 

This third and final stage of the project, launched in January 2015, explored three specific challenges to the financial sector highlighted by the Financial System Inquiry, Tax System Review and Intergenerational Report. While quite diverse, each of the topics in stage 3 has a bearing on important issues for the future of the financial system and its role in serving the economy. 

Stage Three was supported by a group of stakeholders comprising: Accenture, the Association of Superannuation Funds of Australia, Challenger Limited, IBM, Industry Super Australia, National Australia Bank, Self managed Super Fund Association and Vanguard Investments, as well as the Treasury.

A key objective of this project is to ensure the papers bring together a diverse range of insights and opinions from all areas of the Australian financial services sector, however in accordance with the ACFS Code of Research Conduct, the final outcomes are independent.

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