Federalism: a bulldozer job

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When the Australian colonies federated in 1901 the new federal government raised only 13% of the total tax take of all Australian governments. By 1910, it had climbed to just 22% – with no federal income tax.

Two world wars changed all that — by the end of the century the proportions had reversed. In 1999 the Commonwealth raised 77% of all tax with the states and municipalities at 23%.

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Now, with the GST having commenced in 2000, the federal share is 82% with the states at 16% and local government at 2%.

This imbalance would not be a problem if the expenditure of the tiers of government did not differ so markedly from their revenues. Currently, the Commonwealth spends 54% of total public expenditure with the states’ share at 40% and local councils 6%.

The states therefore raise only 16% of all taxes but account for 40% of all spending. The result — they are heavily dependent on fiscal handouts from Canberra. State governments have political responsibility for providing schools, hospitals, public transport and police but not for most of the revenue required to fund them.

Everyone recognises that this “vertical fiscal imbalance” is a problem and it was hoped that the meeting earlier this month of the Council of Australian Governments (COAG) would initiate a solution.

COAG consists of the Prime Minister, the Premiers and Chief Ministers of the states and territories, and the President of the Local Government Association. At the end of the meeting the Premiers were all smiles and praised the PM — it seemed progress may have been made. Closer examination revealed some useful cooperation on the National Reform Agenda, a “third wave” of micro-economic reform which COAG agreed to last February. The meeting agreed to set up the COAG Reform Council to study the costs and benefits of the proposed reforms which are aimed at lifting productivity and workforce participation over the next 10 years. The new Council will recommend federal compensation to the states for the costs of implementing the reforms.

However, there was no agreement on any substantial alteration of the financial relationship of the three tiers of government.

The mounting evidence of the need for such alteration arises from several factors. First, the ageing of the population is identified by both state and federal governments as certain to increase government expenditure in future, particularly in the health area, where spending will rise strongly for additional reasons — the cost of new medical technology and the public’s rising expectations of the system.

The NSW government estimates that by 2044, in today’s dollars, the “ageing wave” will result in a shortfall of $23 billion in the state’s total revenue available for the required spending. Three quarters of the gap will be caused by health spending.

The second factor is that federal revenues have increased enormously in recent years resulting from the resources boom and 14 years of continuous economic growth. Ross Gittins, writing in the Sydney Morning Herald (Weekend 8-9 July 2006) has estimated that over the 5 years to 2008-9, federal tax will increase by a massive $24.6 billion per year on average. Commonwealth revenue is now at an all-time high of 25% of GDP.

Gittins contrasts that with an average increase over the last 5 years of only $1.25 billion per year in GST revenue, which goes to the states. Of course the states have other sources of revenue which are “tied” federal grants, which have not increased significantly, and their own taxes mainly payroll tax, stamp duties and land tax. The revenue from these taxes is volatile and to take NSW as an example, with the end of the property boom, stamp duty revenues have fallen, offsetting increases in payroll tax. The states are therefore not sharing in the huge revenues flowing to the federal government.

A third factor affecting New South Wales and Victoria, the two richest states, is the way in which the GST’s revenue is distributed. In 2000 when it was introduced, the states gave up several state taxes in return for the GST money. Previously those relinquished taxes went straight to each state’s Treasury. However, the GST, being a federal tax, now passes to the states through the Commonwealth Grants Commission filter which redistributes “untied” revenue under the principal of “horizontal fiscal equalisation” (“HFE”). This has the effect of giving the poorer states (and the territories) a greater share of the pool with the aim of equalising the capacity of each state to deliver services with the same revenue-raising effort.

Thanks to Bill Leak.

The effect of this redistribution is that in 2006-7, NSW will receive $380 million less in GST than estimated in 2000.

If the GST had been distributed on a per capita basis in the year to 30 June 2006, NSW would have received $2 billion more and Victoria $1.3 billion more. In contrast, Queensland and WA which are benefiting most from the resources boom, scored more than their per capita shares of GST — an extra $400 million and $100 million respectively.

The Iemma government has recently received a 180-page report entitled “Benchmarking Australia’s Intergovernmental Fiscal Arrangements” (www.treasury.nsw.gov.au/pubs/fin-bench-rep.pdf) from Professor Neil Warren which compares our creaking federal-state financial structure with similar federations around the world.

Warren concludes that the trend in other federations is to decentralise spending responsibilities and taxing powers – the reverse of the trend here. He points out that most other federations assign spending responsibilities in health and education to one tier of government only, avoiding the inefficiency and cost and blame-shifting found in Australia where responsibility in those areas is shared roughly equally between the federal and state tiers.

The report criticises our system on numerous other grounds including;

– Most other federations have recently reviewed and changed their federal financial arrangements or regularly do so. Australia has not done so comprehensively since Federation.

– Our state taxes are either too narrowly-based (payroll tax, land tax) or inefficient (stamp duties) and the land-based taxes have a volatile yield.

– The states have less fiscal autonomy than second-tier governments in most federations. This inhibits the influence of state parliaments and reduces the democratic basis and nature of state governments.

– The horizontal fiscal equalisation process in Australia is more complex and less transparent than in all other federations making it difficult to determine if it is effective.

– The HFE process, by attempting to equalise expenditures rather than just revenues, as in other federations, discourages infrastructure investment and structural adjustment because such policies would result in less federal revenue being received by the state implementing them.

– The introduction of the GST has increased the vertical fiscal imbalance between the Commonwealth and the states because it replaced state taxes with a growing federal tax.

Professor Warren recommends COAG as the agent of comprehensive change to the system and notes that changes need not disadvantage a particular state if transitional safety-net arrangements are implemented.

The case for reform seems overwhelming but the political will is absent — it is still too easy for the six subsidised smaller states and territories to take the money and blame the Commonwealth. The Howard government of course is happy to keep the states under the thumb, starving them of funds in its relentless right-wing quest to reduce public services and thereby try to force state Labor governments from power.

This is not a criticism of the “third wave” reform agenda COAG has agreed to. However, COAG, although a representative body, is not a democratic one. Nothing happens unless the federal government agrees. With the Howard government holding the purse strings of 80% of all revenue, it dominates COAG in addition to the federal Parliament. The state parliaments are therefore increasingly irrelevant particularly when compared to their role at federation.

The road to reform is a rocky one because of the need for federal parliamentary agreement to any change. The Howard government has already rejected the NSW Government’s suggestion that the whole responsibility for health be transferred to the Commonwealth. A parallel reform might be to transfer the whole of education to the states. There is no reason why the states could not run the universities and take over full responsibility for school funding. Obviously these proposals would require substantial change to federal-state funding arrangements but one solution might be the allocation of specific shares of federal taxes to the states, reviewable at regular intervals.

The factors discussed above probably ensure that change will occur eventually. Perhaps then COAG meetings will no longer be followed by a chorus-line of Premiers praising their despised political opponent in grateful acceptance of a few fiscal crumbs.

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