In common with most federal systems, a feature of the Australian federation is vertical fiscal imbalance. That is, the Commonwealth Government raises revenues in excess of its spending responsibilities, while State governments have insufficient revenue from their own sources to finance spending responsibilities. Chart 8.3.1 illustrates the level of vertical fiscal imbalance for the States and also shows how this imbalance has changed over time.
Chart 8.3.1: Vertical fiscal imbalance since Federation
Source: National Commission of Audit.
In Australia, vertical fiscal imbalance is observed in the significant gap between the revenue raised by the States and their expenses.
Chart 8.3.2 illustrates the level of vertical fiscal imbalance for the States in 2013-14.
Chart 8.3.2: State own-source revenue, State expenses and vertical fiscal imbalance, 2013-14
Source: 2013-14 State Budgets; Australian Government, 2013b.
To partially address vertical fiscal imbalance, the Commonwealth provides ongoing funding to the States to assist with the cost of their service delivery. Total Commonwealth funding to the States in 2013-14 represents around one quarter of the Commonwealth expenses and some 40 per cent of States revenue. Commonwealth funding consists of a mix of payment types, but payments are made explicitly across all key service delivery sectors.
Commonwealth payments to the States to address vertical fiscal imbalance (in 2013-14) consist of (Australian Government, 2013b):
- general revenue assistance (GST and other payments) of $51 billion per year, which is untied;
- National Specific Purpose Payments (NSPPs) of $31 billion per year, which are largely untied (the only requirement being that they be spent in the relevant sector); and
- National Partnership Payments (NPs) of $14 billion per year, which have varying degrees of conditionality attached, including meeting genuine accountability requirements.
While some level of vertical fiscal imbalance has been in place since the start of Federation, there are some significant issues which arise from the extent of vertical fiscal imbalance in Australia:
- the do not face the real costs of raising the revenue which they spend, which can make their service delivery less efficient; and
- there is a lack of accountability and associated blame-shifting between the Commonwealth and the States, as both parties are responsible for funding service delivery across a wide range of government functions.
A more efficient outcome would have the States able to match their expenditure more closely with their own revenues and become less dependent on the Commonwealth, while the Commonwealth matches its revenues more closely to its own needs.
A closer matching of revenue-raising capacity with expenditure responsibilities would make all levels of government more accountable and responsible for their actions, and hence lead to improvements in the efficiency of service delivery.
As the problem of vertical fiscal imbalance is an ongoing one, over the decades many different reviews and Commonwealth-State processes have explored this issue.
On 19 January 1970, the Premiers of all States signed a document entitled The Financial Relationships of the Commonwealth and the States. This document envisaged a scheme whereby the States should have access to income tax. At the subsequent Premiers’ Conference in February 1970, the Prime Minister rejected this proposal, citing a number of objections. These included macro-economic policy making considerations, the ‘equitable’ treatment of all Australians brought about by uniform taxation, the budgetary problems that would be faced by the States as income tax receipts fluctuated and the problems that would arise in the process of calculating equalisation grants by the Commonwealth Grants Commission (James, 1997).
When the Commonwealth attempted to allow the States to levy marginal income tax surcharges or rebates under the Income Tax (Arrangements With the States) Act 1978, the offer was declined (in part because the Commonwealth was not prepared to make room by lowering its rates) (James, 1997).
In 1991 the Working Party on Tax Powers to the Special Premiers Conference noted that addressing vertical fiscal imbalance 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’.
In 2000, the Commonwealth introduced the GST, with revenues hypothecated to the States.
In 2010, the review of Australia’s Future Tax System (the ‘Henry Tax Review’) noted that:
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.
There are a number of options that could be used for addressing the vertical fiscal imbalance between the Commonwealth and State governments including:
- introducing additional State taxes;
- adjusting the rate and/or base of GST;
- additional untied funding provided to the States; and
- providing the States with access to part of the Commonwealth’s personal income tax base.
The States’ own-source revenue could be increased to reduce the vertical fiscal imbalance and provide them with fiscal autonomy. This includes options such as broadening the base of existing State taxes.
An increase in the revenue collected by the GST could be achieved by increasing the rate of the GST or broadening the base of the GST to include goods and services that are currently not subject to GST.
Australia rates 29th lowest out of 33 OECD countries in terms of rate of value-added-tax levied. In the period since Australia introduced its GST in 2000, 20 OECD countries have increased their value-added-tax rate.
Australia also has a relatively narrow base of goods and services on which value-added-tax is applied compared to other OECD countries, rating 9th lowest from a comparison of 32 countries in 2011 (OECD, 2014).
The vertical fiscal imbalance could also be addressed by providing additional untied transfers to the States.
The Commonwealth provides a significant amount of funding through semi-tied and payments for specific purpose, contributing to the current level of vertical fiscal imbalance. One option for addressing some of the vertical fiscal imbalance is to provide more funding through untied general revenue assistance, rather than through tied or semi-tied payments.
The provision of greater levels of untied funding also offers major opportunities to reduce reporting requirements of the States.
A further option to increase State source income is a combined Commonwealth-State personal income tax, which could include providing the States with a designated share of personal income tax raised, or allowing the States to levy a State income tax surcharge (with the Commonwealth ‘making room’ so that overall income tax rate need not rise).
The Commonwealth raises some $180 billion per year from individuals and other withholding taxes.
There is no constitutional or legal limitation on the States imposing their own income taxes. However, there would be substantial administrative and compliance costs in each State and Territory levying its own income tax.
Giving the States access to the Commonwealth’s personal income tax base would provide them with another growing revenue source, but should not significantly affect compliance costs for Australian taxpayers. All income taxes would continue to be collected by the Australian Taxation Office.
Under such an approach, the Commonwealth would reduce its income tax rates and the States would then replace them with an income tax surcharge at the same rate, so that the overall personal income tax rate faced by individuals need not rise.
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.
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 replace a series of tied grant.
In the example above, the Commonwealth would take $25 billion out of the $45 billion in tied grants it currently provides to the States.
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 change would represent a material change in the current financial arrangements and that there would be legal, technical and administrative details to resolve. This should not, however, stand in the way of genuine reform.
A change in current arrangements to permit the States to levy an income surcharge would need to take account of the need for the Commonwealth to be able to continue to effect its broader macroeconomic and income distribution responsibilities recognising the role that income tax may play in this regard.
Such an arrangement would require an agreement between the Commonwealth and the States on future changes to personal income tax brackets and thresholds.
The Commission considers that this latter option of providing the States with access to the Commonwealth’s personal income tax base would be the best way forward to address the issue of vertical fiscal imbalance. By allowing for greater competition between the States, this option should lead to all States being more accountable for their own budgeting decisions.