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Renewing federalism: state budgets, VFI and a ‘hard budget’ constraint

Finding the balance in state-federal funding is harder than it should be. Image sourced from

The reform of Australia’s federation is under review. In this special series, we ask leading Australian academics to begin a debate on renewing federalism, from tax reform to the broader issues of democracy.

The University of Melbourne’s John Freebairn argues how hard budget constraints are a way to ensure state governments act responsibly in the way they fund services.

State (and territory) budgets depend on grants from the Commonwealth for about half of their revenue. This dependence on funds from the Commonwealth is referred to as vertical fiscal imbalance (VFI). For good reasons, some level of VFI seems inevitable.

If state budgets face a hard budget constraint, it is meant that when a state increases (or decreases) a major expenditure program, say another $500 million on health or education, it raises (or reduces) the required revenue from an increase (or decrease) of its own taxes.

Conditions supporting a “hard budget” constraint, combined with VFI, result in accountability of state budgets and good allocations of limited resources between the private and public sectors.

Unfortunately, Australian federal-financial relations are far from meeting a “hard budget” constraint.

Vertical Fiscal Imbalance (VFI)

Consideration of the better location of different taxes and of different public expenditure programs at the national or Commonwealth level versus at the decentralised or state level has resulted in VFI across different federal systems across the globe, including Australia.

Key areas of public expenditure at the federal level include defence, external affairs and social security outlays for redistribution to meet general society objectives of equity. The use of fiscal policy to manage the economy makes more sense at the national level.

On the other hand, there are strong arguments for having state governments responsible for the delivery of education, health, law and order, transport and other services. Often society preferences for the quantity and form of these services vary from state to state, as do circumstances affecting the relative costs of different supply options. Greater accountability for the quantity and quality of supply is likely with a decentralised supply strategy. Importantly, there is imperfect information about the relative merits of different supply options.

This state of imperfect knowledge favours competitive federalism and experimentation to find better supply and delivery options, rather than a one-size-fits-all centralised supply strategy, and often a lowest common denominator choice.

Turning to taxation to fund public expenditures, the larger revenue collecting taxes are better collected at the national level. This includes income taxes, broad based consumption taxes, and specific indirect taxes to internalise external costs with a national dimension, such as tobacco, alcohol and greenhouse gas emissions. These taxes affect decisions on the geographic location of businesses and people; different effective tax rates between the different states would involve significant distortions and efficiency costs.

Taxes better suited to the states involve geographically immobile tax bases, including land tax, special taxes on the economic rent of mining and other natural resources, and user fees for transport services and to internalise external costs of congestion.

Combining the more desired allocation of different expenditure programs and different taxes between the Commonwealth and the states, with current outlays and taxes, results in VFI well in excess of 50%, the present level.

Such a high level of VFI, if not matched by a hard budget constraint, can result in poor government decisions. If a particular state budget deficit easily can be financed by extra Commonwealth money on request, the cost to the particular state is spread across other states, resulting in excess government.

Particularly where there is some overlap of funding and programs, as for health and education in Australia, each level of government likes to blame the other level rather than take responsibility and be accountable to the voter. Also, scarce and valuable bureaucratic resources in both the Commonwealth and the states are wasted in blame-shifting and gaming, rather than in the delivery of better services.

Ingredients for a hard budget constraint

When state governments are responsible and accountable to their electorate for funding expenditure changes from their own taxes, a hard budget constraint, VFI approach would be consistent with good budget policy. A hard budget requires minimum overlap of federal and state spending programs and responsibility, that Commonwealth grants to the states are transparent and insensitive to individual state budget fiscal outcomes, and the states have access to their own broad based tax bases and the right to change tax rates to fund marginal changes in their expenditures.

Unfortunately, neither level of government is close to being able to achieve this - and the blame lies with both. Commonwealth encroachment almost since Federation in 2001 on education, health and other services provision has led to confusion, the lack of accountability, and the blame game on the quantity and quality of services provided.

For their part, the states have eroded their potential broad based taxes, including on land and payrolls. Various special exemptions mean these tax bases are about a half of their potential comprehensive base. In the case of land tax, the progressive rate schedule adds distortions, and is far less direct and effective in achieving distributional equity than the Commonwealth income tax base, which includes rent income.

Renewing Federalism is in partnership with the Australian National University’s Tax and Transfer Policy Institute at the Crawford School of Public Policy and with the University of Melbourne School of Government.

Our Renewing Federalism series will culminate in a symposium on October 2 at ANU. If you would like to attend the event, please see event details and RSVP here.

Read more in the series here

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