Time for a state income tax? Federation paper's bold look forward

By David Donaldson

February 9, 2015

The final issues paper in the lead-up to the Reform of the Federation White Paper — focusing on federal financial relations — raises the prospect of the states being given a greater share of revenue through changes to the tax system.

The document, released last week, puts the amelioration of the vertical fiscal imbalance (VFI) — the phenomenon of the Commonwealth collecting much of the revenue the states spend — on the agenda, arguing that Australia’s Commonwealth-state funding arrangements, in which the federal government holds most of the power, have the potential to turn co-operative federalism into “coercive federalism”:

“Many commentators consider the extent of VFI in Australia to be undesirably large and, in several important respects, leads to the imposition of constraints on the autonomy (or sovereignty) of States and Territories.”

A high level of VFI leaves states and territories reliant on the federal government to make provision for funding functions controlled by state governments, meaning that if the Commonwealth decides to cut grants to the states — as the Abbott government did in 2013 — states have little ability to replace that funding. This undermines accountability and transparency by giving the jobs of providing money and delivering services with different levels of government, as the issues paper points out:

“A high degree of VFI arguably increases the risk of blame shifting between levels of governments. The sub-national government can blame inadequacies in service provision on inadequate funding from the national government. Equally, the national government can blame poor outcomes on inadequacies in administration or implementation by the sub-national government, thus justifying further intervention in the sub-national government’s business and exacerbating the risk of overlap.”

Australia has one of the highest rates of vertical fiscal imbalance of any federation in the world, with around 45% of state and territory funding coming from Commonwealth grants. Excluding the goods and services tax, which the Commonwealth collects but is not tied to funding specific programs, the rest of the Commonwealth grants to the states — mostly specific purpose grants — comprise 21.5% of state and territory revenue.

The International Monetary Fund argues “giving sufficient revenue autonomy to subnational governments is a critical condition for the success of expenditure containment efforts”. By making the states reliant on their own sources of revenue, rather than being able to simply ask the federal government for more money, the states are then given great incentive to spend wisely.

vfi countries

The issues paper argues the reduced certainty for state budgets engendered by relying upon the feds “is not conducive to good policy”. In addition, the larger the Commonwealth-state grants system is, the more bureaucracy is required in negotiation and monitoring — something that may be reduced if revenue and expenditure responsibilities were better aligned.

There are a couple of main options for reducing VFI, according to the issues paper:

  • Changes to spending responsibilities (with the Commonwealth increasing its spending responsibilities to more closely match its revenue);
  • Expansion of existing state and territory taxes or charges, or sharing of the Commonwealth tax base (such as income tax), together with commensurate reductions in Commonwealth taxes so there is no net increase in the tax burden; or
  • Some combination of the above.

In the absence of changes to the overall level of VFI, “it may still be possible to shift the balance between specific purpose grants and general revenue assistance, and to consider how far that could go to addressing concerns around efficiency and accountability”. While increasing the GST, for example, would not technically fix the gap, it would give states greater control over expenditure.

Although the states maintain the ability to levy income tax under the constitution, this power was ceded to the Commonwealth in World War II in return for general revenue assistance. But the growing gap between what the states collect and spend has led to calls to revisit these arrangements.

The share of Commonwealth money tied to particular programs has increased in recent years, making funding to the states less flexible. Overall Commonwealth grants have remained reasonably constant as a proportion of total Commonwealth spending over the decade to 2013-13, but specific purpose grants grew by 64.8%. General revenue revenue assistance (mostly comprised of the GST) increased by 14.4% over this period.

Different jurisdictions are better at funding themselves than others, though all suffer from VFI. Thanks in large part to mining royalties, Western Australia receives only 29.6% of its revenue from Commonwealth grants — the least of any state or territory — while the Northern Territory sits at 72.2% — the highest.

vfi sectors

The 2013 National Commission of Audit report recommended hypothecating a certain percentage of the personal income tax to the states and allowing the states the ability to vary the rate “as a means of injecting further competition into the federation”.

A paper from the Committee for the Economic Development of Australia last year also argued the government should consider giving a fixed proportion of the income tax to the states for the purpose of funding education, giving the states proper control in the running of public schools.

Former Victorian premier Steve Bracks has previously told The Mandarin he is against raising the GST, but thinks giving the states a part of the income tax “would help them deliver services better”.

Prime Minister Tony Abbott stated last year he believed in “better harmonising revenue and spending responsibilities”. The federation white paper, according to Abbott, is meant to make each level of government “sovereign in its own sphere”:

“To address ‘vertical fiscal imbalance’ we could either adjust the states spending responsibilities down to match their revenues, or we could adjust their revenues up. The first approach involves the current spending responsibilities being redistributed so that the Commonwealth would take on more responsibility and the states would deal with less.

“That would not necessarily mean the Commonwealth taking over responsibility for delivery of functions currently carried out by state and territory governments. Nor does it imply a ‘one-size-fits-all approach’ to service delivery. It could lead to a situation where funding for such services was delivered through an individual entitlement supplied through a market — along the lines of the NDIS.

“Alternatively, the Commonwealth could stop funding programmes in areas of state responsibility and stop using its financial power to influence how the states deliver services. The Commonwealth would be ready to work with states on a range of tax reforms that could permanently improve the states’ tax base — including changes to the indirect tax base with compensating reductions in income tax.”

The tax and federation white papers will be “closely aligned”, according to the issues paper, given the overlap on issues such as the vertical fiscal imbalance.

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