Franking credits can raise Treasury just $10m. So why is the government talking about them again?

But the government is bothering, not just because companies have been raising capital to pay dividends, but because of broader economic implications. The Department of Industry, Innovation and Science has just published a timely report on the need to improve "innovation indicators", calling for a rethink of how we measure innovation - especially innovation related to intangible assets. Indeed, Australia does need to step up its innovation game.

There's no doubt the introduction of the imputation system behind franked dividends started with good intentions and helped attract investments in Australian companies, but some consequences were perhaps unpredictable. Let's unpack how it works at a very basic level, from a public company perspective and then from an investor perspective.

As a company that needs to attract capital in the share market, you need to play with the rules of the majority of investors. And if the large majority, whether super funds or retail investors, like dividends, then you need to find ways to regularly pay dividends.

So when you have to make a decision on how much to invest in research and development, or any other project with long-term benefits but short-term profit impact (and so dividend impact), what do you think you'll invest in? Anything that won't cost you too much today and will see financial returns in the next quarter or so.

To a large proportion of investors, franking credits are often worth more than capital gains. Why? Because we pay taxes on the capital gains but we get a tax credit on the franked dividends. Depending on your tax rate, not only do you have a tax benefit, but you can even get cash from the government because the company has paid taxes that you were not meant to pay!

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Given you don't need to hold shares for long to benefit from franking credits, if you have the choice between a company that pays fully franked dividends and a company that pays partially or non-franked dividends, you clearly end up with the first one. You are not rewarding good management in good industries - you are rewarding companies that are playing the franking credit game.

In fairness, it is true that the imputation system may not affect all types of innovation; only the ones that cost money. Two smart people in a room can come up with ideas that have a great impact on a company productivity without extraordinary expense.

But for innovation - including digital transformation - that does cost money and delivers benefits in the long term, the fact imputation credits discourage innovation is a serious concern. Unless you are a science-based company that has created a narrative for research and development investment, it might be tough to put aside funds to invest in innovation.

The bottom line is that companies in Australia tend to under-invest in innovation because they want to use that money to pay dividends, and franking credits are one of the big reasons why people love dividends. And let's not forget Australia is one of the very few countries in the world that uses an imputation system. As a result of that, our companies grow much less than foreign companies, with consequences for the entire economy and wealth of all Australians. People don't realise, or perhaps don't care, that they are giving up long-term wealth creation in their portfolio in exchange of short-term dividend gains.

This is true not just for innovation. As mentioned by David Gonski in his speech to the Committee for Economic Development of Australia in 2013 (see the collection "I Gave a Gonski"), if you pay considerable taxes in a jurisdiction overseas, you can't pass the benefits to the local shareholders. Again, in a dividend-driven market, the imputation system has consequences that ultimately impact long term growth.

Any change to the imputation system should be carefully examined - and any change that is retrospective, as originally suggested by the government, is probably not worth attention. But any revision should not be led by tax lawyers and accountants. We need to involve people who understand innovation and company growth in the digital and global age.