Non-financial corporations source funds internally from retained earnings and externally from lenders and from financial markets.
Corporations decide on a mix of debt and equity that minimises their cost of capital while maintaining a favourable credit rating. Financing decisions also reflect particular preferences for internal over external financing, the particular activities that corporates undertake, and the timing of any fund raising. Risk preferences matter as well. Corporates have to consider the risk that debt providers might not roll over debt when it matures or any triggers in debt contracts requiring early repayment. Depending on the nature of coupon payments on debt, corporates may need to consider the risk that interest rates might increase. Australia’s corporate tax regime also affects corporates’ choice of financing.
Given that access to different types of funding also matters, issues relating to the domestic corporate bond and equity markets are explored elsewhere in this chapter.
Tax treatment of corporate financing
In Australia, as is the case in tax systems across the world, debt costs are tax deductible. Equity-financed investments are subject to corporate tax, although Australia’s dividend imputation regime reduces, to some degree, the after-tax cost of equity.
Some submissions raise the need to review Australia’s dividend imputation regime. Submissions note the effect of imputation on investor and corporate behaviour, but they also recognise the potentially complex consequences of any changes to the corporate tax regime on such behaviour and the broader flow of funds. In its submission, PwC states:
[C]areful consideration should be given to whether there would be benefits to be obtained from modifications to the imputation system.30
In 1987, Australia introduced dividend imputation to remove the bias against domestic equity (because of the pre-existing double taxation of corporate earnings) and to increase investment. However, the case for retaining imputation is now less clear than it was in the past.
The dividend imputation system affects corporate funding decisions in two main ways: the amount of debt financing to seek, and the share of earnings to distribute to shareholders, which affects the amount of equity financing used.
By removing the double taxation of corporate earnings, the introduction of dividend imputation reduced the cost of equity and so contributed to the general decline in leverage among non-financial corporates. Relative to corporates in other jurisdictions, Australian corporates generally have lower leverage.31 In general, this makes Australia’s corporate sector more resilient to shocks and means that such shocks are less likely to have systemic implications. When reflecting on the lessons of the GFC, the International Monetary Fund (IMF) stated:
In most countries, the tax system is biased toward debt financing through deductibility of interest payments. This bias to higher leverage increases the vulnerability of the private sector to shocks, and should be eliminated.32
Corporates’ dividend policies are influenced by demand from shareholders for dividends and demand from domestic shareholders for the franking credits associated with imputation (as well as corporates’ capital funding and cash flow requirements). This encourages firms to pay a greater proportion of their earnings as dividends. Arguably, this subjects corporates to more market discipline by requiring them to raise more external funds (debt or equity) to fund new investment projects.
Australia’s Future Tax System Review argued that the benefits of dividend imputation, particularly in lowering the cost of capital, have declined as Australia’s economy has become more open. If, as some argue, global capital markets set the (risk-adjusted) cost of funding, dividend imputation acts as a subsidy to domestic equity holders but does not affect the cost of capital or the level of investment. The effect of dividend imputation is to increase private saving and reduce the use of foreign funding for investment.33
The degree to which dividend imputation may act as a subsidy to domestic equity, making equities relatively more attractive as a savings vehicle, may contribute to a number of characteristics of the broader financial system. These include:
- The propensity of domestic investors, particularly superannuation funds, to hold more domestic equity relative to foreign equity and other asset classes than otherwise would be the case, which encourages less diversified portfolios
- The lack of a deep, liquid domestic corporate bond market
- Low demand for annuities, which are largely supported by fixed-income securities, relative to a retirement income strategy based on high-yield domestic equity
30 PwC 2014, First round submission to the Financial System Inquiry, page 76.
31 Fan, J P H, Titman, S and Twite, G 2012, ‘An International Comparison of Capital Structure and Debt Maturity Choices’, Journal of Financial and Quantitative Analysis, issue 1,vol 47, University of Washington, Seattle, pages 23–56.
32 International Monetary Fund (IMF) 2009, Lessons of the Global Crisis for Macroeconomic Policy, 19 February, page 14.
33 Commonwealth of Australia 2009, Australia’s Future Tax System Review: Report to the Treasurer, Part Two — Detailed analysis, volume 1 of 2, Canberra, pages 191–98.