Australia's Future Tax System

Final Report: Detailed Analysis

Chapter G: Institutions, governance and administration

G2. State tax reform

G2–3 Reform directions for State taxes

The reform directions for individual State taxes or groups of State taxes are detailed in various parts of this Report. Table G2-1 provides a summary of these reform directions and references to the relevant sections of the Report.

Table G2-1: Reform directions for State taxes (including resource royalties)

State tax Reform direction Reference
Payroll tax Payroll tax should be replaced by a tax that better captures the value-add of labour. This could be a broad-based wages tax or, preferably, a cash flow tax. Section D3
Conveyance duty The removal of stamp duty should be achieved through a switch to more efficient taxes, such as those levied on broad bases (including consumption and land). Section C2
Land tax Land tax should be levied using an increasing marginal rate scale applying to the per-square-metre value of the land. The tax should be calculated per land holding, not on an entity's total holding. There should be no specific exemption for principal place of residence or primary production. Section C2
Insurance taxes All specific taxes on insurance products, including the fire services levy, should be abolished. Section E8
Motor vehicle taxes State taxes on motor vehicle use and ownership, including motor vehicle registration transfer (stamp) duty and taxi licence fees, should be replaced with efficient user charges where possible. Section E3
Gambling taxes Explore options for reducing conflicts in policy-making between regulation and revenue-raising. Section E7
Resource royalties Most existing output-based royalty and resource rent tax arrangements imposed on non-renewable resources should be replaced by a single rent-based tax. The Australian government and State governments should negotiate an appropriate allocation of the revenues and risks from the resource rent tax. Section C1

The long-term reform directions for State taxes would mean that the States rely less on transaction taxes and more on the efficient and immobile land tax base. The abolition of a number of taxes would contribute to a more coherent tax system across the federation.

Providing the States with better revenue sources

The States would need access to alternative sources of revenue to fund the abolition of a number of existing taxes. While the broadening of the land tax base is expected to yield additional revenue, it is envisaged that this reform would principally replace the revenue from conveyance duty.

Providing the States with more efficient and sustainable revenue sources is to some degree contingent on the reforms to consumption taxes, including payroll tax, outlined in Section D. Over time, revenue from a broad-based cash flow tax could provide a sustainable revenue base for the States to meet future cost pressures.

Different variations of consumption tax reform will have different implications for the role of the States. For example, the States currently levy their own payroll taxes, setting both the base and rate and could continue to set their own rates on a broad-based wages tax. In contrast, as a cash flow tax would be applied to business cash flows across Australia, to avoid significant complexity, and possible constitutional issues, the rate of the cash flow tax would need to be uniform across Australia.

Tax base sharing options

While the reforms to State taxes outlined above would provide the States with better revenue sources, the States would lose some discretion over how they raised their revenue (particularly if payroll tax was absorbed into a new cash flow tax). This calls into question whether the States would have sufficient revenue-raising autonomy — that is, whether they would have the capacity to raise revenue to finance significant marginal expenditure. How the States raise or receive revenue may also impact on how large cost pressures are over time. In Germany, for example, a reliance on intergovernmental grants in some German states have been linked to weakened fiscal discipline (Stehn & Fedelino 2009). If the States are not responsible for raising any of the revenue to fund increased spending, then there may be less incentive for them to provide services in more cost-effective ways.

While the States would have control over a reformed land tax, there may be some practical limitations on how this tax could be used to fund changes in expenditure. Although a reformed land tax base would be an appropriate revenue source for the States, the relative variability in land values may mean that changes in land tax rates may not always be a responsive mechanism for the States to use to fund expenditure decisions. Further, the revenue from the land tax may not be enough to allow States to have control over a significant amount of revenue (relative to their expenditure responsibilities).

If the States require further revenue-raising autonomy, then this could come through a tax base sharing arrangement. The Australian government currently raises significant amounts of revenue from two broad tax bases: the company tax base and the personal income tax base. It is possible that the States could share one of these bases, by applying a State-based surcharge.

While company tax has a broad base, as capital is highly mobile, it is expected that in the future the proportion of company tax revenue to total tax revenue will be lower than it is now (see Section B1 Company and other investment taxes). Further, as capital is mobile, States are likely to face pressure to reduce rates and they may be forced in to a 'race to the bottom' as they compete to maintain investment in their State. It is likely that these pressures are magnified (compared to international competition) in the case of States as the other characteristics that may attract investment (such as skilled labour and strong governance structures) are similar in each State. This would make the rate of the surcharge in each State a relatively more important factor in businesses' decisions about where to locate within Australia. At the same time, a State surcharge on company tax could not satisfactorily be integrated with the dividend imputation system.

The personal income tax base, which largely comprises the labour income of individuals, is less mobile between the States (as people move less freely than capital investment). Even where the personal income tax base includes some return to capital (for example, income from savings), the base is relatively immobile as the surcharge rate of tax would be based on where the person lives, not where the investment is undertaken.

Tax base sharing of income tax operated in Australia before the Second World War, although there was little coordination between the two levels of government. In 1976, the Australian government introduced the possibility of the States levying a personal income tax surcharge to replace financial assistance grants. No State took up the option.5 A key reason for this was that the Australian government did not reduce its own tax rates to make room for the States (Carling 2007).

For a tax base sharing arrangement to work, therefore, it would be necessary for the Australian government to reduce its tax rates to allow room for the States. The revenue from tax base sharing that the States raised (and the Australian government gave up) should be offset by a reduction in grants from the Australian government or by the Australian government keeping a share of revenue from an existing revenue sharing arrangement. The revenue that the Australian government kept should be commensurate with the amount of revenue it gave up from the personal income tax base.

Administrative arrangements

While sharing of the personal income tax base appears to be constitutionally possible, there would be a number of administrative issues that would need to be considered, including the necessary State legislation. The administration and collection of the tax would need to allow for the revenue derived in each State to be returned to that State. It would also be necessary for taxpayers to be able to identify the Australian government and State government components of the tax that they pay, even though both would be administered centrally. This would allow people to link the additional tax they pay to the State government with the benefit that expenditure delivers in that State.

Key design elements of a tax base sharing arrangement are how much scope the States would have to change or influence the tax base and rate thresholds that applied in their State. As the personal income tax would continue to be centrally administered, the tax base should be uniform for all jurisdictions, and the Australian government would maintain policy control over changes in the tax base. One option could be that changes in the tax base would have to be agreed by the States — similar to the way the GST currently operates. However, this could compromise the flexibility that the Australian government needs to ensure that the tax base can remain coherent with changes in the economy and business practices. Further, as the Australian government would still raise the majority of revenue from personal income tax, it should maintain policy control of the tax base, and the States can be assured that the Australian government has the incentives that the tax base is managed appropriately.

In terms of setting the rate thresholds, as the Australian government is the appropriate level for determining distributional policies, one approach is for the Australian government to retain policy control of tax thresholds and the structure of the rate scale. While the structure of the personal income tax would be nationally uniform, the States could levy a flat rate surcharge on total income tax payable to the Australian government (with the surcharge payable based on the individual's place of residence). For example, if an individual's liability for Australian government personal income tax was $20,000, a State surcharge of 10 per cent would add $2,000 to the taxpayer's liability (which would be returned to the relevant State government).

Alternatively, the States could levy a tax rate (or rates) on the uniform tax base, potentially providing the States with more scope to change the structure of rates and thresholds. However, this could lead to a proliferation of marginal tax rate structures across the different States. Accordingly to ameliorate interaction with distributional policies and to limit complexity, it would be sensible under this approach to have some restrictions on the choices States had over rates and thresholds. A suitable approach may be the States being restricted to levying a flat rate of tax on income above the tax-free threshold.

If a personal income tax base sharing arrangement was desired, consideration would need to be given to how alternative approaches would impact on the complexity of the personal income tax structure and the administrative arrangements for returning revenue to the States. The personal income tax is also a key mechanism for the Australian government to influence workforce participation. The rate that States could levy in addition to the Australian government's personal income tax rates would need to be determined with careful consideration of participation objectives, particularly the relationship between the personal income tax and the transfer systems.

Finding

If the States required additional fiscal autonomy, they could raise revenue from sharing the personal income tax base. This could be done by the States levying a flat rate surcharge on income tax payable to the Australian government or a flat rate of tax on income above the tax-free threshold. The Australian government would need to reduce its rates of personal income tax and the States would receive lower revenue from grants or an existing revenue sharing arrangement. Any tax base sharing arrangement would need to be designed so that it was consistent with national objectives for redistribution and workforce participation and avoiding additional complexity.

Administration of State taxes

The reform directions suggest a reduced role for the States in the administration of taxes in the future. The abolition of a number of State taxes with the replacement revenue largely coming from centrally administered taxes would mean that the States could devote fewer resources to tax administration.

There is a possibility in the future that a single national body — the ATO or a successor organisation — could collect and administer all the taxes in the federation. This would reduce the costs of having separate administrations for each State and provide an opportunity to further reduce complexity in the overall tax system. However, if all State taxes were centrally administered, it would reduce the autonomy that States enjoy in raising their revenue. The States would need to decide if differences in taxes across the States are sufficient to warrant separate administrations. If in the future there were substantial convergence in the way States levied their taxes, the costs of maintaining separate administrations may outweigh the benefits.

Longer-term reforms to the administration of taxes and transfers and changes in the way that people interact with the tax and transfer system are also relevant to State taxes. For example, an online client account could be used by all levels of government to give people up-to-date personalised information, including information about liability for State taxes and charges (for more on the online client account, see Section G4 Client experience of the tax and transfer system).


5 The legislation allowing the States to impose a surcharge was repealed in 1989.