Breaking the dividend addiction

Australia has a dividend addiction, and it is hurting innovation and our economy.

It was never more clear that something is seriously wrong than earlier this year, when NAB announced that it would simultaneously pay a dividend and undertake a capital raising. That’s the equivalent of borrowing from a busker in order to throw him a (fully franked) coin.

I will return to this bizarre example later, but first a few statistics:

In Australia, ASX listed companies pay out, on average, 70% of their profits as dividends. Compare this to the US, where the S&P 500 average is about 30%. This difference is huge, and its impact cannot be overstated.

In order to illustrate the difference, I’ve invented two medium sized companies, both in the same industry and both earning $10 million per year:

Salty Paul’s Burgers Ltd is an Australian business and pays out $7 million in dividends to its shareholders, and invests the other $3 million.

Fat Joe’s Hotdog Co is American and pays out $3 million in dividends and invests the rest back into its business.

It’s no accident that Salty Paul’s pays out so much in dividends - most of its shareholders are retirees and super funds.

Think about it, if you were relying on the income, would you rather own shares in Salty Paul, who consistently puts a nice $30,000 deposit in your bank account every 6 months, or Fat Joe, whose dividend is lower and fluctuates.

Some might argue, “well one is just a growth stock and the other is a yield stock”, but this misses a key point: they are the same type of business, in the same industry. Salty Paul’s became a yield stock, not because of the inherent nature of the business, but because shareholders wanted a yield stock.

Australian businesses now largely exist to provide a steady, reliable income stream to investors. As a result, share prices (and therefore executive decisions) are unduly influenced by the size and reliability of dividends.

Of course every publicly listed company is owned by a range of shareholders with a range of objectives, but the insatiable appetite for dividends is a big factor across the ASX, as the numbers clearly show.

This situation leads to two economically disastrous outcomes: fewer jobs and stymied innovation.

As a startup founder, I am particularly concerned about the impact on innovation.

Innovation is usually a high risk, high reward investment. Whether it’s developing new products and services, experimenting with new business models, or adopting new technologies, there is often significant expense with no guarantee of a good return.

With the invention of new and disruptive technologies, businesses are often faced with a choice - do they take the risk as an early adopter in order to gain a competitive advantage and increase market share, or do they wait until the technology is proven elsewhere and then simply import it, sacrificing the potential upside in order to reduce their risk of a bad investment.

For a startup ecosystem to thrive, an economy needs a good number of early adopters to be the first customers. As many B2B startup founders here will tell you - this is absolutely not the case in Australia. In fact I think this is the main reason why startups go overseas. It’s not talent, investment, or regulation that make startups leave Australia, it’s a lack of customers hungry for a competitive advantage.

The simple reality is that with bigger dividends there are less funds retained for innovative investments. 

Salty Paul’s Burgers only has $3 million to invest, which it will probably use to open a couple of stores in new suburbs (a low risk investment). Fat Joe’s will also open a couple of stores for $3 million, but with $4 million left over, they can also afford to invest in a delivery app to engage customers and build market share.

There are many reasons why businesses like Fat Joe’s are better for society, I’ll name just a few:

1. The $4 million app investment provides income to the tech industry, which will in turn increase employment and capability in that industry
2. Fat Joe’s business delivers a better service to society (customer experience). This might not seem important for a fast food chain, but it’s a big deal for other industries like healthcare.
3. Next year, because of its increased market share, Fat Joe now has $13 million in earnings to invest even more in its business

Now you might be thinking, it’s all well and good to reduce dividends and increase investment, but what if there is nothing to invest in, what if we can’t put that money to good use?

I suspect this is the main defence used by executives and it is a bad one. There is always a good investment opportunity, there is just not a strong enough incentive to find one and back it. Compared to the pressure to maintain dividends - the pressure to innovate is small. The dividend is the safe and easy option and it's what the shareholders want.

Having now realised the objectively evil nature of high dividend payout ratios, it’s natural to ask, “how did we get here?” and “what do we do about it?”

How did we get here?

The first question hasn’t got a definitive answer, but I suspect it is primarily due to the interplay of two factors: super and franking credits. Our superannuation system incentivises retirees to live off income from assets accumulated over their lifetime. This is mostly a good thing, and those who invest in shares have two options for getting this income: dividends and selling shares (capital gains). 

Our franking credit system means dividends are practically tax free for most people (and retirees generally would get even more than the dividend due to a tax refund), while 50% of profits from selling shares are taxed (66% in the case of super funds).

The result is that shareholders who want income benefit more from dividends than capital gains. And, as we’ve already established, an increasing majority of shareholders want income. 

Another major factor is that shareholders don’t trust big businesses to spend their excess cash responsibly, due to a large number of botched attempts at global expansion in recent years. Rather than innovate, boards spend billions trying to replicate what they do in new geographies, and often fail dismally.

The pressure on big companies from their shareholders to pay dividends is so strong that we get the ludicrous situation of NAB, who simultaneously asked shareholders to give them cash, and paid those same investors a large dividend. I don’t blame NAB - it was in the interests of their shareholders so they could capitalise on the benefits of franking credits.

This is not a criticism of retirees, or investors who want dividends - they are simply acting in their own financial interests - this is a criticism of the system that makes dividends much more appealing than business growth as a means of achieving investment income.

So then, if super, franking credits and lack of C-suite imagination have caused this situation, what might we do about it?

A viable solution

I propose we adopt the following general principles:

1. Income gained through capital gains or franking credits should be tax neutral: there should be no advantage either way.
2. The R&D tax incentive should be widely expanded to include all forms of innovation.

I won't speculate about how best to bring about these changes, other than to say they absolutely can be achieved in a way that does not disrupt people’s financial plans for retirement. However, I will make a brief comment on the research and development (R&D) tax incentive.

As much as I support the government incentivising innovation, the R&D tax incentive is manifestly inadequate. The scheme has such a limited and restrictive definition of R&D that it excludes almost all meaningfully innovative activities in most industries. It literally requires that a scientific experiment be conducted, with a method, hypothesis and everything else we learned in high school chemistry, to qualify as R&D. It specifically excludes experiments that test ‘business’ hypotheses, for example 'testing' if there is sufficient demand for a new product or service to make it viable.

What this narrow view misses is basically 95% of all innovation. 5% of innovation is inventing a new technology, 95% is product/service development and commercialisation and is not covered by the R&D tax incentive. If we want to incentivise Australian businesses to invent and commercialise new technology, we need to incentivise the entire process, not just lab tests.

There is a trove of valuable R&D already being produced by universities, but no tax incentive for companies to take a risk in trying to commercialise them. What a waste.

Furthermore, many hugely impactful innovations do not involve new technology at all. They are entirely ‘business model innovations’: new products and services using existing technology. Why don’t we incentivise these types of investments?

By expanding the R&D tax incentive to become a broader innovation tax incentive, and reducing the relative advantages of dividends for shareholders, we would increase the attractiveness for businesses to spend their profits on innovation and business growth rather than dividends, share buybacks and risky overseas expansions. In turn we will likely see higher productivity, more jobs in high tech and emerging industries and a more diversified and globally competitive economy. It’s time to break the addiction!