Final Report: Detailed Analysis
G2. State tax reform
Reforms to State taxes should be coordinated through intergovernmental agreements between the Australian government and the States to provide the States with revenue stability and to facilitate good policy outcomes.
The implementation of a number of recommendations related to State taxes would require cooperation between the Australian government and the States. Further, some recommendations related to Australian government taxes would also impact on State taxes; for example, the recommendations relating to company income tax (Section B1) and resource taxes (Section C1). Depending on when some of the recommendations are implemented, the States may also be subject to losses in revenue that could not easily be made up from other revenue sources. Funding from the Australian government may at times be necessary to ensure that the financial position of a State is not adversely affected.
It is also important that reforms are sequenced in a way that allows people to understand the reason for change and how they will be affected. In many circumstances, changes will occur not only to taxes but also to transfers and other types of expenditures. For example, the reforms to the road transport sector outlined in Section E3 would require action by all levels of government — both in the way taxes and user charges are levied, and how services are delivered. Similarly, there is a high level of interaction between reforms to housing assistance and reforms to taxes that impact on the housing market (including conveyance duty and land tax). The process of State tax reform should not be seen only as an exercise of replacing poorly performing taxes with more sustainable taxes. It should also be seen as a mechanism to deliver better policy outcomes across the federation.
One way to coordinate and implement reforms over time is through an intergovernmental agreement between the Australian government and all the States. Examples of such agreements include the agreements related to the implementation of National Competition Policy, the Intergovernmental Agreement on the Reform of Commonwealth-State Financial Relations, which accompanied the introduction of the GST, and the recent Intergovernmental Agreement on Federal Financial Relations. Although the objectives of each of these agreements were different, experience suggests that intergovernmental agreements tend to be more effective if they have the following characteristics:
- The objective of reforms is clearly outlined and agreed to by all parties.
- Reforms involve a commitment from all governments and the roles and responsibilities of each government are clearly defined.
- Timelines linked to outcomes are clearly agreed. To allow for flexibility, it is preferable for reforms to be undertaken by a specified date, rather than on a specified date. In some circumstances, reforms may be contingent on certain events occurring, for example, the availability of cost-effective technology for road user charging.
- Performance reporting by all jurisdictions is transparent and enhances public accountability.
- If provided, any incentives and penalties associated with reform are clear and binding so that good performance is rewarded and poor performance is penalised. Any rewards and penalties for all parties are based on an independent review of performance.
As noted in Section G2-1, reforms to taxes across the federation should provide a platform for improving the performance of governments more broadly. The existing institutions for federal financial relations, however, need to support reforms to State taxes. Key aspects of these institutional arrangements are horizontal fiscal equalisation and payments for specific purposes.
Horizontal fiscal equalisation
Horizontal fiscal equalisation (HFE) is designed to provide GST revenue to the States so that if each State made the same effort to raise revenue from its own sources and operated at the same level of efficiency, each State would have the capacity to provide services at the same level. Part of this process is to assess the revenue-raising capacities of each of the States.
A change in tax mix adopted by all States will change their relative revenue-raising capacities, therefore affecting the distribution of GST revenue. A change in tax mix might be revenue-neutral to the States in an aggregate sense, but an individual State might have one of their relatively stronger bases replaced with a relatively weaker base, such that revenue from their own taxes is lower. However, this loss in revenue could be made up through the HFE process, as the loss of their relatively stronger tax base means that their revenue needs are higher. In theory, if all States apply the same revenue-raising effort, no State would have a financial incentive to resist or favour a revenue-neutral reform of State tax base composition on the basis of the local strength or weakness of particular tax bases.
In practice, however, the States will be affected differently because they apply different policies to their existing tax bases and are likely to continue to do so in regard to tax bases they have access to in the future. The redistribution of GST revenue will not take into account the impact of changes to tax bases on a State where it does not apply the average policy. That is, if a State is raising more than the average revenue off a base that is abolished, HFE will not compensate for revenue lost above the average, just as if a State was making a below-average effort that State would not be penalised. This may cause difficulties for some States, particularly if the States do not have the same ability to raise marginal revenue from the new tax base as they did with the old one.
As such, the States will need to consider whether, and to what extent, such differences should be reflected in replacement taxes.
While GST revenue is currently used as the pool for implementing HFE, HFE could currently be achieved with a smaller pool of revenue. The amount of revenue needed to achieve HFE changes over time with changes in revenue-raising capacities, the costs of providing services, population shares and the way that other grants from the Australian government are distributed. Changes to tax and expenditure responsibilities would also affect the size of the pool that is needed to achieve HFE.
Payments for specific purposes
The Intergovernmental Agreement on Federal Financial Relations introduced significant reforms to payments for specific purposes from 1 January 2009. The new framework involves providing the States with National Specific Purpose Payments (National SPPs) for five key service delivery sectors (healthcare, schools, skills and workforce development, disability services and housing) and National Partnership payments designed to support the delivery of specified projects, to facilitate reforms or to reward States that deliver on nationally significant reforms.
While it is too early to assess the impact of the new arrangements, the reforms have generally improved the transparency of specific purpose payments. The National SPPs are provided as a contribution to the States' funding of key services, so the States can be seen as having the responsibility for funding marginal expenditure associated with the delivery of these services. Depending on the level and growth of these payments, they should be consistent with a hard budget constraint.
National Partnership payments can be a good mechanism to coordinate the delivery of national public goods; that is, goods and services the States are in the best position to deliver, but which produce benefits that extend beyond an individual State. If National Partnership payments are used too much for discretionary purposes, however, there is a risk that the payments will become more complex and will lead to the States will having softer budget constraints.
While changes to expenditure responsibilities are largely beyond the review's terms of reference, changes to the way that services are funded and provided across the federation are likely to be ongoing. As there is a strong relationship between the expenditure responsibilities of each level of government and the taxes and revenue sources that it needs, the assignment of taxes and revenues may need to change over time to reflect changes in expenditure responsibilities. The institutions in the federation will need to be flexible to respond to any significant changes.
A number of goods and services provided by governments are increasingly thought of in national terms. While the States provide health, education and community services, they often do this within a framework of national objectives and targets, often agreed through COAG. There is also an increasing desire to create national economic and regulatory frameworks to support the efficient and equitable provision of goods and services. These trends suggest that there may be pressure for the Australian government to assume greater responsibility for funding the provision of, or access to, a number of goods and services currently funded by the States. For example, the National Health and Hospitals Reform Commission (NHHRC) recommended that the Australian government assume some additional responsibility for the funding of health services, including public hospitals, public dental services and community health services (NHHRC 2009).
The appropriate response of tax and revenue assignment to significant changes in expenditure responsibilities will depend on the type and amount of expenditure involved. In general, the following approaches could be adopted:
- Changing the proportion of revenue for each level of government from a tax base sharing arrangement. For example, if one level of government takes over some expenditure, it can increase the rate of tax it levies on the uniform tax base, while the level of government that no longer has to fund the expenditure can reduce its rate of tax. This can be done so that the total tax burden does not change.
- Changing the shares of each level of government under a revenue-sharing agreement. The level of government undertaking more expenditure would receive a greater share of revenue.
- Changes to intergovernmental grants. If the Australian government undertakes more expenditure, it could keep some of the grants it currently provides to the States.
- Changes to taxes. One level of government could raise more in own-source taxes and the other level of government would raise less. The increase in revenue should come from a better (or, at least, no worse) tax than the tax being reduced.
A number of these options are currently possible and if personal income tax base sharing was introduced, then changing the proportion of revenue for each level of government from a tax base sharing arrangement would be an option in the future. If there were any changes to taxes and revenue to reflect changes in expenditure responsibilities, these changes should also be consistent with the principles outlined in this section.
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