Opinion & Commentary
Fiscal federalism robs states of self-reliance
Commonwealth-state relations have recently focused on policy coordination under a National Reform Agenda in pursuit of improved productivity and labour force participation. This endeavour, though much needed, does not negate the case for further reform of Commonwealth-state financial relations. The Australian brand of fiscal federalism is continuing to impose economic costs and deny us the potential benefits of a federal structure, notwithstanding the GST-based reforms that have already taken place.
Those reforms, in brief summary, delivered the states 100 percent of the revenue from the new GST in return for giving up some of their decrepit, third world taxes and the old financial assistance grants from the Commonwealth. States’ finances are (or will be) better off as they reap more revenue growth with greater certainty and less volatility than under the old arrangements. The national economy is better off because a raft of inefficient, distorting financial transaction taxes are being scrapped in favour of a more-or-less efficient, broad-based consumption tax.
So far, so good. These are worthwhile benefits. But the GST reforms don’t really fix the long-standing basic flaws in Australia’s federal fiscal structure – and this is why the issue won’t go away.
First, the decentralized system that goes with federalism is supposed to benefit us by making government more responsive and adaptable, more efficient through policy experimentation and variety, and more competitive. But to reap these benefits we need clarity in the roles and responsibilities of the different levels of government, substantive roles for the sub-national levels and a high degree of financial and policy autonomy. Australian federalism lost its anchor to these ideals decades ago and the GST reforms have done nothing to restore it.
Claims that the states receive more revenue as a result of the GST miss the point that the essence of federalism isn’t more or less revenue, but autonomy and responsibility. The states do not – and constitutionally cannot – determine GST policy on their own. Meanwhile tied grants (specific purpose payments) from the Commonwealth to the states – half as large as the flow of GST revenue - are carrying the central government’s influence more widely and deeply into state service delivery. Responsibility and accountability are becoming more blurred and the old Commonwealth-state blame game is played as hard as ever.
Second, the states’ own tax systems remain deficient, relying on poorly designed payroll and land taxes and anachronistic stamp duties. Payroll and land tax are the only potentially efficient, broad-based taxes currently under state control. But they fall well short of their potential thanks to policies that have hollowed out their bases through high tax-free thresholds and a plethora of misguided exemptions and concessions.
Stamp duties on property transfers, insurance and motor vehicles will remain as important revenue sources even after the GST-related program of stamp duty repeal is completed in 2012. Contrary to popular belief, none of these (with the relatively minor exception of duty on business property transfers) was included in the list to be abolished in exchange for the GST, but their retention has more to do with the amount of revenue at stake ($14 billion annually) than their merits as taxes. In fact, they have little more to commend them than the taxes already on the GST chopping block.
What, then, should be done? All experience tells us that constitutional amendment is almost impossible to effect, but much can be done without it.
For a start, the Commonwealth should re-admit the states to the income tax base from which they have been excluded since 1942. This need not and should not mean increasing the overall burden of income tax provided the Commonwealth takes a large slice out of its existing income tax to make room. Nor need the compliance burden increase provided the ATO provides the administration for both the Commonwealth and the state income taxes, and the states use the same definition of taxable income as the Commonwealth. Giving the individual states policy control over their own income tax rates is the best way within existing constitutional constraints to restore the states’ fiscal autonomy, but the state tax would be best confined to personal income, not company income, with a single flat rate above the tax-free threshold.
Let’s say the Commonwealth cuts its personal income tax take by one-third, offset by a state personal income tax rate of around 10 percent (initially uniform but later subject to change by each state). This would leave a $40 billion hole in the federal budget and an equivalent gain to the states, which could be neutralized in two ways. First, the Commonwealth should retain 5 percentage points of the GST for its own purposes. Apart from being necessary for the budget arithmetic, this change would be desirable in its own right as it would do away with the current nonsensical situation whereby the level of government that holds the GST legislative pen has none of the direct revenue interest. Second, Commonwealth specific purpose payments to the states should be greatly scaled back following a thorough review of the roles and responsibilities of each tier of government.
To complete the package, the states should be required to reform their existing tax systems. Payroll tax and land tax are ripe for reform as broad-based, low-rate taxes. For example, payroll tax rates could be cut by one-third or more if tax-free thresholds were set much lower. State policies have now gone so far in the opposite direction that it is difficult to see this happening, but the states should at least scrap all remaining stamp duties, not just those they are already committed to phasing out. But it is fanciful to think the states could do this out of existing and projected GST revenue. An increase in the GST rate to 12.5 percent is needed. The increase in GST would largely offset the scrapping of stamp duties, but would leave a gap for the states to close from existing revenue sources or expenditure efficiencies.
This package could be tweaked in all manner of ways. The overall scheme is more important than the precise numbers. Its basic effect would be to make the tax system more benign in its economic effects and to restore the substance of federalism by making the states more self-reliant in carrying out a clear set of responsibilities.
Robert Carling is a Visiting Fellow at The Centre for Independent Studies. This article is based on his report State Taxation and Fiscal Federalism: A Blueprint for Further Reform, released by the Centre for Independent Studies.
