Australia's Future Tax System

Final Report: Detailed Analysis

Chapter G: Institutions, governance and administration

G2. State tax reform

G2–1 Principles for assigning tax responsibility in a federal system

The tax system spans the three levels of government in Australia — the Australian government, State governments and local governments. Individual governments separately administer their own taxes, but there is much interaction between the policy objectives and the administration of taxes levied by different governments.

Improving the structure of the tax system should begin with recognising that the wellbeing of the Australian people is affected by the taxes of the entire federation. A poorly performing tax affects people no matter which government is responsible for it. People also respond in their work and savings decisions to taxes as a whole, regardless of which level of government administers them. For example, the States' payroll taxes and the Australian government's personal income tax both affect the post-tax wages available to workers, which in turn impact on workforce participation decisions.

In this respect, recommendations for the design of a future system have been based, in the first instance, on the quality of particular taxes. The assignment of tax responsibility to a particular level of government is then a secondary, but important, consideration. The role of the States in the tax system and the implications of reform directions for State taxes are discussed in this section.

It is worth noting that many issues within the federation relate to governments' spending and other responsibilities and the way different levels of government deliver services. While these issues are largely beyond the Review's terms of reference, reforms to taxes across the federation can also provide a platform for future reforms that seek to improve the performance of governments more broadly.

The role of different levels of government in the tax system

For a number of reasons, including history, institutional arrangements and differences in the size and scope of their operations, the different levels of government in Australia raise tax revenue in different ways. Both the way that governments raise taxes and the proportion of tax revenue raised by each level of government have changed significantly since federation. They will inevitably change in the future as well, as each level of government will be affected by the drivers of change in different ways. Three of these drivers — increasing mobility of economic resources, demographic change and technology — are particularly relevant when considering the future roles of each level of government in the tax system.

  • Increasing mobility of productive resources, particularly the mobility of capital, will tend to favour tax systems with lighter taxation of mobile factors and fewer complex or unpredictable taxes levied on business. Factor mobility is generally higher within a country than between countries. This calls into question the capacity of sub-national governments to raise revenue from taxes that fall on highly mobile factors.
  • Demographic change will affect different tax bases and types of government expenditure in different ways. Given the current allocation of tax and expenditure responsibilities in Australia, governments will face fiscal pressures at different times. Population ageing means that taxes (and transfers) will need to be designed to encourage workforce participation and to not impede people moving around Australia to work where they are most productive.
  • Technological change will provide opportunities for governments at all levels to finance expenditures in different ways. For example, technology may allow roads to be more efficiently priced from direct charging (see Section E3 Road transport taxes).

Although Australia will retain its three levels of government, at least for the foreseeable future, there will likely be changes in their roles and responsibilities. It is therefore difficult to be definitive about tax assignment in the federation: as circumstances change, the ideal allocation of taxes to levels of government may also change. However, principles can be developed to help define the role of different levels of government in the tax system; that is, how much revenue they should raise and the type of taxes they should levy. Further, institutions can be set up to allow flexibility in these arrangements so that governments can adapt more easily to changing circumstances.

The amount of tax revenue for each level of government

Traditional fiscal federalism theory provides two benchmark models for how much taxing power should be available to each level of government in a federation. Musgrave (1959) and Oates (1972) argue that national governments are better placed to raise most taxes as sub-national taxation of potentially mobile factors tends to be distorting. Under this benchmark, the tax system in a federation would be largely centralised, even if sub-national governments have significant expenditure responsibilities. In contrast, Tiebout (1956) suggests a greater role for sub-national governments in the tax system. His view rests on the assumption that competition for mobile taxpayers ensures that each sub-national government will offer residents their preferred mix of taxes and government services.

In practice, these benchmarks are not found in a pure form. A comparison of federations reveals diversity in how much taxing power is given to sub-national governments relative to their expenditure responsibilities. As Bird and Smart (2009) note after comparing a number of developed federal countries, neither standard fiscal federalism theory nor the differing economic circumstances of different countries appears to offer a ready explanation for the substantial differences observable in the level and structure of State finances in different federations. They argue that this is because federations are largely a product of their history, rather than a desire to structure the tax system according to a particular model. In Australia's case, these historical factors include how the federation was set up (that is, the powers that the Constitution gave to different levels of government) and the way that Australian governments have responded to various crises, events and long-term pressures since federation.1

It is clear, however, that because of the practical difficulty of exactly matching revenue and expenditure at each level of government, all federations operate with some degree of 'vertical fiscal imbalance'. In the overwhelming majority of cases, it is the national government that collects more revenue than it spends. Usually this is due to the desire to have a more centrally coordinated tax system combined with decentralised provision of government services. Vertical fiscal imbalance has existed in Australia since federation, although the level has changed over time.2

More recent theory on fiscal federalism has focused less on benchmark models and more on the incentives and institutions that would best serve federal systems. In summarising the recent theory of fiscal federalism, Oates (2005) notes that the challenge for federations is:

one of determining the kinds of institutions that can accommodate fiscal decentralisation so as to realise the political advantages and economic gains from local control, while avoiding the potentially distorting and destabilizing effects that can result from soft budget constraints.

Under a 'soft budget constraint', a government can receive additional revenue without being accountable for how that revenue is raised. This can occur when a sub-national government is provided with additional grants from the national government, or when a national government withdraws grants to a sub-national government, to fill a revenue gap that, for example, has arisen due to poor fiscal planning. If a government is not accountable for the revenue it raises, it may not face the full cost of how it spends revenue and may have less incentive to be disciplined in how it spends that revenue.

A sub-national government could, in theory, face a hard budget constraint without raising any of its own revenue if there was a fixed agreement with the national government about the amount of revenue it received. In practice, such an arrangement would not be sustainable or desirable as it would deny sub-national governments flexibility to make spending decisions. A better way to ensure that sub-national governments face hard budget constraints, while allowing them the flexibility to change the amount of revenue they receive, is for sub-national governments to have access to taxes they can increase (or decrease) to finance spending decisions. Bird and Smart (2009) note that a government will face a hard budget constraint if it is able to increase or decrease spending only by increasing or decreasing its revenue in such a way that it is publicly responsible for the consequences of its actions. In other words, if a government chooses to spend extra money on a particular program, that government must raise the revenue required to fund that program rather than burden another level of government and it needs to be clear to people they are paying tax to fund the extra spending.

This does not necessarily mean, however, that sub-national governments have to fund all their spending from their own taxes. In a developed federation, it can be expected that there is some base level of goods and services that all sub-national governments will provide and that requires a commensurate amount of revenue. This revenue can be provided by the national government. Because of differences in preferences between jurisdictions, individual sub-national governments will want to provide different sets of goods and services. So that they can meet the preferences of their citizens, sub-national governments should have the capacity to raise tax revenue to fund significant marginal expenditure beyond the base level.

In applying this principle to the Australian federation, the question becomes how much of their own tax revenue State governments need in order to fund significant marginal expenditures. To a large degree, this is dependent on their expenditure responsibilities — both in terms of size (their total amount of expenditure) and nature (how different types of expenditure change over time). It is also a question that cannot be answered with a great deal of precision, as significant marginal expenditure is difficult to quantify. A general principle, however, is that as long as State governments have significant expenditure responsibilities, they should have access to significant and sustainable tax revenue. Furthermore, to enforce a hard budget constraint, they should also have some autonomy over (and responsibility for) the amount of revenue they raise.

Principle

The assignment of tax responsibility in a federation should take into account the revenue needs of each level of government. Each level of government should have access to tax revenue it can use to finance significant marginal expenditure decisions.

The type of taxes each level of government should levy

Because of differences in their size and their interaction with each other, different levels of government in a federation may have more or less capacity to raise revenue from a given tax on a sustainable basis. For example, it is unlikely that local governments in Australia could raise revenue sustainably from company income taxes as it would be relatively easy for businesses to move to a different local government area where they paid a lower amount of tax. All local governments would then have an incentive to keep lowering their taxes, either by lowering their tax rates or providing concessions to specific businesses. The likely end result is that they would not raise enough revenue to fund their expenditures.

Principles of tax assignment have been developed with the aim of ensuring that each level of government has access to a sustainable tax base while maintaining the coherence of the whole tax system. Principles developed by Musgrave (1983) suggest that if tax bases are highly mobile or distributed unequally across sub-national jurisdictions, they should be levied by national governments. Further, if taxes are used for redistribution or macroeconomic stabilisation, they should be levied by the national government, as it is better placed to coordinate these functions. These principles then suggest that appropriate tax bases for sub-national governments are ones that are immobile, are more equally distributed across jurisdictions and have limited inter-jurisdictional interaction.

The nature of a government's expenditure responsibilities may also be relevant to the question of tax assignment. For example, Warren (2006) includes in his benchmarks for tax assignment the principle that tax revenues should be able to expand in line with expenditure. That is, if a government has expenditure responsibilities that are expected to grow over time, then this expenditure should be financed from a tax base that is expected to grow.

While assignment rules are relevant to all federations, they will result in different outcomes in different federations. This is because federations are structured differently to begin with. There may be constitutional restrictions, as there are in Australia, on the taxes that different levels of government can levy. Further, the size of sub-national governments and the preferences of their citizens will influence the mobility of productive resources between them.

Principle

To the extent that there is a choice about the assignment of taxes in the federation, the Australian government should have control of taxes with more mobile tax bases and taxes used for redistribution and macroeconomic stabilisation. The States should have control of taxes on more immobile bases.

Own-source taxation is not the only way that sub-national governments can raise revenue autonomously. Autonomy is dependent on the extent to which governments can change the tax base and the tax rate. For tax bases that are more mobile between jurisdictions, the tax base may be more sustainable if it was uniform across all jurisdictions and not able to be changed by any individual government, as governments would not be placed under pressure to introduce tax exemptions or concessions. Revenue autonomy could still be achieved by allowing individual governments to change the rate of tax they apply to the uniform tax base.

Governments in a federation can coordinate in a number of different ways to raise tax revenue, including:

  • Individual governments may choose to apply a similar policy, or the same policy, as applies in other jurisdictions. For example, in recent years, a number of Australian States have harmonised most aspects of their payroll tax legislation.
  • Governments at one level may arrange for a higher level of government to undertake the collection and administration of a particular tax on their behalf (this would be easier if the tax base was uniform across the lower level of government).
  • Tax base sharing arrangements can involve two (or more) levels of government taxing the same base. Each jurisdiction can set its own rate and receive the revenue raised in, or derived from, that jurisdiction. Tax base sharing arrangements are used in a number of federations. For example, in Canada, all provinces (except for Quebec) have a base sharing agreement with the federal government for personal income tax that allows them to set their own rates and thresholds that apply in addition to the federal rates and thresholds. Tax collection agreements enable federal and provincial taxes to be administered centrally with the relevant revenues provided to provinces. Individuals need to file only one set of tax forms each year covering their federal and provincial tax.

To the extent that these arrangements provide the States with revenue from broader based taxes, they can also help the States avoid using less efficient and less equitable taxes.

Principle

Tax base sharing or centrally administered State taxes can provide the States with the capacity to raise revenue sustainably and with some autonomy.

Implementing the principles outlined above may come at the expense of other principles for the tax system as a whole. For example, if there is a tax that individual sub-national governments have full control over (that is, they can adjust the tax base and the tax rate) and they can raise tax revenue from this sustainably, the fact that the same tax is levied by different governments may create complexity for businesses that operate in different jurisdictions.

Taxes that are harmonised across jurisdictions and cannot be changed by an individual government may avoid this complexity. However, locking in the tax base may reduce the flexibility needed for policy to adjust to changing circumstances. For example, a change to the tax base may be necessary to ensure that a new type of good, service or transaction (which was not envisaged when the tax base was designed) is treated consistently. If institutional arrangements do not allow changes to be made easily, inconsistencies may accumulate and the efficiency of the tax may be impaired.

Principle

The assignment of tax responsibility should take into account how different arrangements affect the complexity of the tax system and its capacity to respond to changing circumstances.

Intergovernmental grants

If a government is to face a hard budget constraint, it must have access to taxes it has the autonomy to increase (or decrease) to finance its spending decisions. Sub-national governments are also likely to receive intergovernmental grants. It is important that these grants are provided in such a way that they maintain the need for sub-national governments to rely on their own taxes to finance their marginal expenditure decisions. If intergovernmental grants are excessive, then sub-national governments may use them as substitutes for raising their own tax revenue.

A particular issue associated with intergovernmental grants is the bailout problem. The national government may have a tendency to provide higher grants to sub-national governments facing difficult financial circumstances. While such grants provide a form of insurance, they can also create a moral hazard problem — that is, if governments know they will be bailed out, they have less incentive to exercise fiscal discipline (Inman 2003).

Intergovernmental grants will support a hard budget constraint if they are transparent; that is, if people can understand how much grant money is received and under what conditions. Grants should also not be subject to discretionary change in a way that allows sub-national governments to seek additional ad hoc funding.

These conditions are also relevant to ensure that the national government maintains a hard budget constraint. If a national government exercises poor fiscal planning, it may seek extra revenue through withholding previously agreed grants to sub-national governments. If intergovernmental grants cannot be subject to discretionary change, national governments could be restricted from withholding grants.

A revenue-sharing arrangement, under which sub-national governments share a fixed proportion of the revenue from a tax over which the national government has policy control, is consistent with these requirements. Such revenue effectively becomes 'infra-marginal'; that is, it has little bearing on sub-national governments' ability to deliver marginal services. Revenue-sharing arrangements can make clear exactly what sub-national governments are receiving. Further, because the revenue sub-national governments receive cannot exceed its share of what is being raised, if the share amount is adhered to the amount of revenue cannot be subject to grant seeking (or cutting) behaviour.

The revenue from a revenue-sharing arrangement could be distributed to sub-national governments in a number of ways. For some taxes it would be possible for revenue to be returned to the jurisdiction in which it was generated. This would provide sub-national governments with greater ownership over the revenue they receive. However, for other taxes, there are practical difficulties in determining the jurisdiction where the revenue was generated and distributing the revenue on a derivation basis is not possible. For example, for a business that operates in a number of jurisdictions, it may be difficult to determine where profits, and hence company income tax revenues, are generated. In such cases, alternatives for distributing revenue include allocating on the basis of population share or weighting revenue shares based on the relative fiscal capacities of sub-national governments.

Principle

To ensure that governments face a hard budget constraint, any intergovernmental grants should be transparent and not easily subject to discretionary changes.


1 The most notable example of this was during the Second World War when the Australian government assumed control of income tax (in exchange for grants to the States) to finance and coordinate the war effort.

2 See Chart 10.5 in the Australia's Future Tax System Architecture Paper.