Australia's Future Tax System

Architecture of Australia's tax and transfer system

4.3 Australian government and state revenue powers

One of the challenges accompanying federation was the creation of a two‑tier system of government that centralised control of some functions, while allowing each State sufficient autonomy to meet the social preferences of its constituency. The Australian Constitution specifically enumerates areas of legislative power to the Australian government, leaving the majority of expenditure responsibilities to the States as residual powers. Australian government powers were viewed as involving functions that the States were not able to conduct efficiently themselves, such as defence and foreign affairs.

In 1901 uniform Australian government tariff and excise duties replaced state customs and excise duties, in part, to secure free interstate trade and ensure adequate protection for Australian industry (Groenewegen 1985). They largely applied to the goods that had been taxed by the former colonies — tobacco products, beer and spirits and some basic food and clothing.

Although the States retained control of land and income taxes, at the time of federation customs and excise duties were by far the greatest source of tax revenue (Chart 4.4). The States were left with a shortfall of funding for their areas of expenditure responsibilities, whereas Australian government revenues exceeded the requirements of its limited role. To resolve this fiscal imbalance, the Constitution provided for a revenue sharing arrangement for the first 10 years following federation. The Australian government kept one quarter of customs and excise duty revenue with the remainder distributed to the States, along with any revenue that was surplus to Australian government needs.

Chart 4.4: Composition of Australian tax revenue

(1902‑03 to 2006‑07)

Chart 4.4: Composition of Australian tax revenue(1902‑03 to 2006‑07)

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

It was not long after federation that fiscal inequality between the States led to federal funding in support of fiscal equalisation. In 1910‑11 Western Australia requested fiscal assistance to compensate for the loss of tariffs, which had been its primary revenue source. In 1911‑12 Tasmania also received Australian government grants, and South Australia became a recipient in the 1920s. Over time, horizontal fiscal equalisation was formalised with an independent body recommending the distribution of Australian government grants based on fiscal need.

The Australian government introduced its own income tax in 1915 to raise funds for Australia's involvement in the First World War. The Second World War also saw fundamental changes to Australia's tax system. In 1942, the Australian government assumed control of income tax, as a war‑time measure, in exchange for government grants to the States. As a result the States' tax base was reduced until 1971 when the Australian government ceded control of payroll taxes to the States to supplement their tax base with a 'growth' tax. With the introduction of the GST in 2000, the States gained access to a further 'growth' tax, as a replacement for Australian Government Financial Assistance Grants and a range of inefficient indirect state taxes. Horizontal fiscal equalisation is applied through the distribution of the GST revenue to the States.

The role of the High Court and its interpretation of the Australian Constitution has been a significant contributor to determining the current distribution of taxing powers across levels of government. Both during and after the Second World War, the States unsuccessfully challenged, in the High Court, the means by which the Australian government, as a practical matter, excluded the States from the field of income tax. In a series of cases the High Court has considered the ability of the States to impose various kinds of indirect taxes (such as business franchise fees), in the context of the Australian government's exclusive power to impose duties of excise. The 'wide view' of excise duties adopted by the High Court in the late 1990s has meant that the power of the States to impose such taxes is severely limited.