Australia's Future Tax System

Architecture of Australia's tax and transfer system

10.6 Federal fiscal relations

The States raised around $49 billion in state taxes and $36 billion in other own‑source revenue in 2006‑07. These combined sources represented around 55 per cent of the States' total revenue in that year. The remainder consists of transfers from the Australian government (Chart 10.2).

Chart 10.2: Composition of state government revenue in 2006‑07

Chart 10.2: Composition of state government revenue in 2006-07

Source: ABS (2008a); Australian Government (2007c).

In addition to their own revenue sources, the States received around $40 billion in GST revenue from the Australian government. The GST is an Australian government tax, with all revenue provided to the States to compensate them for — among other things — the removal of a range of inefficient state taxes, the loss of revenue replacement payments (originally levied in place of franchise fees) and the loss of financial assistance grants. The Australian government distributes the GST to the States as an untied grant based on the principle of horizontal fiscal equalisation (HFE), which takes into account the relative revenue raising capacity and expenditure needs of each of the States (see Box 10.4).

The States also received $29 billion in specific purpose payments (SPPs) from the Australian government. These are payments provided to the States to deliver specific policy outcomes in areas that are administered by the States. These payments are currently the subject of a reform process being undertaken through COAG.

The proportion of total revenue that comes from Australian government grants (GST and SPPs) differs considerably between the States (Chart 10.3). For example, NSW, Victoria, Queensland, Western Australia and the ACT each received a little over 40 per cent of their total revenue in 2006‑07 from the Australian government. The Northern Territory received around 75 per cent of its revenue from the Australian government, reflecting its higher per capita share of GST revenue delivered through the HFE process.

Chart 10.3: Sources of revenue for state governments in 2006‑07

Chart 10.3: Sources of revenue for state governments in 2006-07

Source: ABS (2008a); Australian Government (2007c).

Expenditure responsibilities

The allocation of expenditure responsibilities between levels of government in Australia has been largely shaped by the Constitution and reflects, to some extent, the principle of subsidiarity — that is, that decisions should be taken as close as possible to the citizens by the lowest level of government possible. The States have, and will continue to have, significant expenditure responsibilities and this means that the States need sustainable sources of revenue to fund expenditure.

In the context of an ageing population, the Productivity Commission (2005) noted that, given current taxing powers and expenditure responsibilities, the States' taxation sources would be relatively stable but, due to increasing expenditure pressures, their fiscal positions would be heavily influenced by transfers from the Australian government.

Box 10.4: Horizontal fiscal equalisation

Under the principle of HFE used by the Commonwealth Grants Commission (CGC) to allocate GST revenue, state governments receive funding from GST revenue and unquarantined health care grants, such that if each made the same effort to raise revenue from its own sources and operated at the same level of efficiency, each would have the capacity to provide services at the same standard.

The aim is to distribute the GST pool so that all States have the same fiscal capacity to deliver services to their populations. This does not mean that the same level of services is actually provided (as that is a matter of policy for each State). The CGC only takes into account differences that are beyond the control of individual States in working out the needs of each state. Each State's share is calculated on the assumption that it and all the other States apply average policies and practices in delivering services and that they all make the same effort to raise revenue.

A State's allocation from the GST pool is calculated as an equal per capita share, adjusted for:

  • expense needs — the effect of its above or below average disabilities relating to the use and costs of government services;
  • revenue needs — the effect of its above or below average revenue raising capacities; and
  • SPP needs — its above or below average per capita revenue from SPPs that are available to fund its expenditure requirements.

Each of these adjustments can have a negative or positive effect. For example, the extra cost associated with providing health and education services to people in remote areas is a positive expense need, while relatively high property values (which can lead to relatively higher amounts of conveyance duty revenue) are a negative revenue need.

The per capita allocation (equalising requirement) for each State is expressed as a ratio of the national average per capita amount distributed in the relevant year. This produces the State's 'relativity'. The relativities are calculated for five assessment years and then averaged. For example, the per capita relativities recommended for use in 2008‑09 are the average of the annual relativities for the five assessment years from 2002‑03 to 2006‑07.

A relativity of less than one, indicates a State will have less than an equal per capita share of the GST pool; a relativity above one indicates it will have more than an equal per capita share. No State can have its relativity increased without at least one of the other States having its reduced.

The GST relativities are applied to estimated state populations in order to determine weighted shares of the GST pool. The final distribution of GST revenue is calculated by deducting the unquarantined health care grants, which are separately provided to the States, from each State's share of the GST pool. The calculations for the estimated distribution of the GST pool for 2008‑09 are shown in Table 10.1.

Table 10.1: Distribution of the GST pool 2008‑09

  Estimated 31 December population State revenue sharing relativities Adjusted population
(1) x (2)
Share of adjusted population
Share of GST pool
Unquarantined health care grants
GST payments
(5) — (6)
(1) (2) (3) (4) (5) (6) (7)
NSW 7,006,018 0.91060 6,379,680 29.7 16,171.3 3,083.6 13,087.7
VIC 5,328,012 0.92540 4,930,542 22.9 12,498.0 2,248.1 10,249.9
QLD 4,314,913 0.96508 4,164,236 19.4 10,555.6 1,811.0 8,744.6
WA 2,180,356 0.88288 1,924,993 8.9 4,879.5 934.6 3,944.9
SA 1,609,330 1.20856 1,944,972 9.0 4,930.2 760.5 4,169.7
TAS 499,914 1.52994 764,838 3.6 1,938.7 197.4 1,741.3
ACT 347,686 1.17205 407,505 1.9 1,033.0 118.6 914.4
NT 221,170 4.51835 999,323 4.6 2,533.1 105.6 2,427.5
Total 21,507,399   21,516,090 100.0 54,539.4 9,259.4 45,280.0

Source: Australian Government (2008b).

A change in tax mix adopted by all States will change the relative revenue raising capacities of the States, therefore affecting the assessment of revenue needs and ultimately 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 tax bases replaced with a relatively weaker base, such that revenue from their own taxes is lower. However, this loss in revenue would 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, in the presence of well functioning HFE, no state would have a financial incentive to resist or favour a revenue neutral reform of State tax base composition on account of the local strength or weakness of particular tax bases.

Perspectives on vertical fiscal imbalance

That the States' own revenue sources are insufficient to fund their expenditure responsibilities, while the Australian government's revenue sources are greater than is necessary to meet its expenditure responsibilities, results in what is called 'vertical fiscal imbalance' (VFI). The level of VFI can be measured as the revenue transferred from the Australian government to the States as a proportion of the States' total revenue. In 2006‑07, the Australian government transferred approximately $68 billion to the States in the form of GST revenue and SPPs, accounting for around 45 per cent of total state revenue.

VFI in Australia has developed primarily as a result of the States retaining many of their pre‑federation expenditure responsibilities and the Australian government assuming control of the main sources of taxation revenue. This reflects, in part, the comparative advantage in revenue raising and expenditure between levels of government in a federal system. Indeed, VFI is not unique to Australia — other countries with federal structures also exhibit VFI, although to varying degrees (Chart 10.4).

Chart 10.4: Vertical fiscal imbalance in selected OECD countries(a)

Chart 10.4: Vertical fiscal imbalance in selected OECD countries(a)

  1. VFI is defined as the ratio of federal payments to total sub‑national revenue. Data are for 2003, except Australia which uses data for 2005‑06.

Source: OECD (2006).

The level of VFI in Australia is not fixed and has fluctuated significantly since federation (Chart 10.5). The changing level of VFI has been driven mainly by changes in taxation responsibilities (as outlined briefly in Section 10.2 and in Section 4.3), rather than changes in expenditure responsibilities.

Chart 10.5: Vertical fiscal imbalance since federation

(Grants as a percentage of total state revenue)

Chart 10.5: Vertical fiscal imbalance since federation (Grants as a percentage of total state revenue)

Source: Mathews and Jay 1997; Australian Treasury estimates.

The introduction of the GST in 2000‑01 and the abolition of a number of state taxes resulted in an increase in measured VFI. However, focusing on measured VFI would conceal the impact that this reform had in the broader context of federal fiscal relations. That is, as all GST revenue is transferred to the States, this provides the States with an efficient and growing source of revenue to fund their expenditure responsibilities. The States reimburse the Australian government for the ATO's GST administration costs. Box 10.5 outlines the administration arrangements in relation to the GST base.

Box 10.5: Administration of the GST base

Clauses 32‑36 of the Intergovernmental Agreement on the Reform of Commonwealth‑State Financial Relations set out the administration arrangements applying to the GST. Any change to the rate or the base of the GST must be unanimously agreed by the Australian government and all the States. Purely administrative changes only require the majority support of the Australian government and the States.

These arrangements mean that the base and rate of the GST have been more stable than otherwise may have been the case. The rate of the GST has remained unchanged since introduction eight years ago. This compares to countries such as New Zealand and South Africa, which increased their rates of similar value added taxes within three years of introduction. Further, there have been no major changes to the GST base since its introduction, which again is unusual when compared to other countries such as South Africa (where products such as basic foods and paraffin have been made GST free) and France (where the entire value added tax system was revised).

The terms of reference for this review exclude examination of the rate and base of the GST.

As the Intergovernmental Agreement reforms illustrate, the measurement of VFI, and using it as a comparison across time, may not reflect what is occurring. Measurements of VFI may not accurately reflect the fiscal autonomy of the States because of the definition of the level of government that controls a particular tax base.

The same level of measured VFI can mask significant differences in the fiscal autonomy of the States because of the institutional arrangements governing grants from the Australian government. For example, an arrangement in which a State received 50 per cent of its revenue through Australian government grants that were 'untied' is markedly different to an arrangement in which a State received 50 per cent of its revenue through Australian government grants, but those grants had conditions attached to their receipt.

Although there are limitations to using measurements of VFI as a comparative tool, this does not diminish the importance of the costs and benefits stemming from the existence of VFI where it reflects a genuine mismatch between revenue raising powers and expenditure responsibilities, and is not just a measurement issue.

Costs of vertical fiscal imbalance

VFI may lead to accountability problems in regard to expenditure and taxation decisions made by governments. A closer matching of revenue and expenditure responsibilities at each level of government may increase the accountability of governments by making government financing more transparent. When a government does not have to raise the revenue it spends, this can create 'fiscal illusion'3, potentially leading to an over provision of services. This is because governments that receive grants might obtain a political benefit from providing services without the political cost of raising revenue.

These accountability problems with VFI may be alleviated if governments can, at the margin, raise their own revenue to fund their own discretionary expenditure. However, raising revenue at the margin may not address the risk of 'blame shifting'. Blame shifting can occur when citizens can hold either level of government accountable. The government that receives grants can blame any inadequacy in service provision on inadequate funding. This is particularly the case where the recipient government can convince its voters that its tax bases are not capable of raising enough revenue to deliver the service at the required level. Equally, the donor government can blame poor outcomes on either the administration or funding inadequacies of the recipient government.

Accountability can also be blurred where the recipient government's service provision is influenced by the government that provides the transfer. The conditions on service delivery may be different to the preferred option of the recipient government. Such an outcome may result in weakened accountability, as citizens hold the recipient government responsible for the services provided, even though it is unable to provide the service in its preferred way. Recognising the need to make roles and responsibilities clearer, COAG's reform agenda (as noted in Section 1.2) includes work on this front.

VFI may also distort the types of services provided. If the donor government chooses to spend the excess revenue it raises rather than transfer it to the recipient government, VFI may lead to an over‑provision of services in areas of responsibility of the donor government and under‑provision of recipient government services, relative to citizens' preferences.

Finally, the provision of grants may result in administration costs which might otherwise be avoided if each government were able to match its revenue and expenditure responsibilities. For example, resources are necessary to negotiate and monitor conditions on grant payments.

Benefits of vertical fiscal imbalance

By collecting relatively more revenue, a national government is likely to reduce the cost of taxation through economies of scale generally and, for those businesses that operate across sub‑national jurisdictions, lower compliance costs from having to deal with only one set of rules and one collection agency for any particular tax.

VFI also provides the national government with greater scope to create the opportunity for each citizen in the nation to receive the same overall standard of sub‑national government services. It has been argued that Australia's HFE process may provide a disincentive for States to undertake reforms, as some of the benefits of those reforms may be equalised away to other States, although it is questionable as to how relevant this argument is in practice (Garnaut and FitzGerald 2002).

The additional revenue available to a national government also provides it with scope to act in areas which may be the responsibility of sub‑national governments, but in which the existence of externalities or spillovers across borders can lead to sub‑national governments acting individually, rather than acting in the national interest. In Australia, the responsibilities in relation to water are an excellent example of this.

3 Fiscal illusion refers to the possibility that citizens may not appreciate the actual cost of the services they receive, due to the tax raised to fund the services not being fully visible to them. In relation to transfers, this illusion may occur if citizens do not link their payment of tax to one level of government with the provision of services by another level of government.