6.2 Addressing vertical fiscal imbalance

The Commission strongly considers the time has come for there to be a closer matching of revenue-raising capacity of the States with their expenditure responsibilities.

Options to reduce vertical fiscal imbalance have been examined in Australia over many decades.

In 1991, the Working Party on Tax Powers to the Special Premiers Conference noted that it is a basic tenet of a democratic system that the success with which governments perform their roles depends a great deal on the extent to which they are accountable to the community.

This Working Party put forward a number of options which worked to increase the fiscal autonomy of the States.

At the time, it was noted that the options under consideration would involve:

fundamental changes to the relationships between the various levels of government as well as the tax system of the nation. Changes of this nature have far-reaching effects on the community and, while that is no reason for avoiding change, it does argue for very careful consideration.

The Commission endorses the sentiment of the Working Party’s observations. It considers that the most realistic option for addressing the current vertical fiscal imbalance would be to increase State and Territory revenue capacities by providing them with access to the Commonwealth’s personal income tax base.

The Commission supports an arrangement whereby the Commonwealth would lower its personal income tax rates to allow room for the States to levy their own income tax surcharge.

The impact of lower revenue collections for the Commonwealth would be offset through an equivalent reduction in the payment of other Commonwealth financial assistance to the States. In other words, the financial implication would simply be a substitution of a new untied source of revenue to the States (through the personal income tax system) to replace a series of tied grants.

By way of illustration, the Commonwealth could permit States to access the personal tax base directly by reducing the current personal income rate of 32.5 per cent (which applies on incomes from $37,000 to $80,000) by 10 percentage points to 22.5 per cent.

A 10 percentage point ‘State income tax surcharge’ could be introduced to bring the overall rate back to 32.5 per cent. This 10 percentage point State surcharge would be hypothecated to the States providing them, in this example, with an estimated additional revenue source of around $25 billion per year.

To offset this, the Commonwealth would take $25 billion out of the $45 billion in tied grants it currently provides to the States. Included in the $25 billion, for example, could be the tied grants currently provided for schools and the tied grants paid through the various National Partnership Agreements.

It would also be possible to extend the income tax sharing arrangement by allowing the States to periodically adjust the surcharge rate (either up or down by several percentage points). This has the potential to inject further competitive tension within the Federation as States would have the autonomy to set rates and compete amongst themselves.

The Commission recognises that such a reform would represent a material change in the current financial arrangements and that there would be legal, technical and administrative details to resolve. However, there is no general legal limitation on State parliaments imposing income tax.

The opportunity for States to do so was in fact provided by the Commonwealth in the 1970s but States did not take up the offer (in part because the Commonwealth was not prepared to make room by lowering its rates).

A change in current arrangements to permit the States to levy an income surcharge would have to take account of the Commonwealth’s requirement to implement its broader macroeconomic and income distribution responsibilities.

Such an arrangement may, therefore, require an agreement between the Commonwealth and the States on future changes to personal income tax brackets and thresholds.

Other options for reducing the current level of vertical fiscal imbalance also exist, including the prospects for the States to extract more revenue from their existing tax bases, changing arrangements for the GST, or through the Commonwealth simply providing a greater proportion of existing financial assistance in the form of untied grants.

To the extent that these options do not promote greater competitive federalism, they are not supported.

Nonetheless the Commission sees merit in re-examining the base and rate of the GST as part of broader tax reform. To the extent that the overall tax burden should not increase, any changes to the GST should be offset by the elimination of other inefficient State taxes, including stamp duties and insurance taxes. Such reform would not improve vertical fiscal imbalance, but would lead to a more efficient tax system and improve Australia’s overall growth prospects.

Recommendation 8: Reforming the Federation – addressing vertical fiscal imbalance

A closer matching of the revenue-raising capacity of States and Territories and their expenditure responsibilities would make them more responsible in their own sphere. The Commission recommends that:

  1. the degree of vertical fiscal imbalance in the Federation be substantially reduced. This should be achieved by providing the States with access to the Commonwealth's personal income tax base;
  2. to facilitate this proposal, the Commonwealth should make room and reduce its personal income tax rate by an equivalent percentage point amount to a new State surcharge to ensure that taxes do not rise overall. Revenue raised would be hypothecated to the States; and
  3. the States be provided with a capacity to periodically vary the surcharge they impose as a means of injecting further competition into the Federation.