Renewing federalism: what are the solutions to Vertical Fiscal Imbalance?

The relationship between state-federal funding is a jigsaw puzzle. HoriaVarlan/Flickr , CC BY

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 Brian Galligan explains the reasons behind the vertical fiscal imbalance and the challenges of reforming state-federal funding relations.


Vertical fiscal imbalance (VFI) defines Australian fiscal federalism. VFI matters greatly because it distorts Australian federalism, causes unnecessary overlap and duplication, fosters fiscal irresponsibility, and blurs democratic accountability. So why do we persist with it, when the solutions are achievable through changing political and intergovernmental practice, and without constitutional amendment?

VFI sums up the skewed fiscal arrangements whereby the Commonwealth collects most taxation revenue, well in excess of its expenditure responsibilities and needs. It gives a large slice of this, $101 billion or 24.4% of its total revenue in 2014-15, to the states (and territories) in general and tied grants. Tied grants, where the Commonwealth sets the terms and conditions to suit its policy purposes, make up $46 billion of total grants, mainly for health and education, 32% and 31% of tied grants respectively.

The states are left with small and less efficient taxes, and depend on extensive Commonwealth grants for nearly half of their revenue. For example, in 2014-15 Victoria received $25 billion, equivalent to 47% of in its total revenue, from Commonwealth grants. Its own tax collection totalled $18 billion, with the main taxes being payroll $5.1 billion, land transfer $4.4 billion, gambling $1.8 billion, and motor vehicles $2.1 billion. Smaller states are more dependent — in 2014-15, South Australia received 51.5% of its total state revenue from grants, and Tasmania 61%.

No constitutional right

VFI has allowed Commonwealth governments to move into state policy areas such as hospitals and schools where they have no constitutional right. This is due to political advantage and opportunism, but also at times for good reasons of national interest. Good governance requires that constitutional roles be respected rather than subverted; and that governments’ responsibilities be matched with appropriate revenue sources. Both principles have been subverted through VFI.

Although it runs no hospitals or schools, the Commonwealth has massive health and education departments in Canberra. These jostle with state departments that actually run hospitals and schools in proposing policy additions and changes. This blurs responsibilities, causes policy dissonance, and diminishes public accountability.

Excessive Commonwealth encroachments are sustained by money, politics, and anti-federal presumptions about good governance. Commonwealth ministers and bureaucracies win kudos by expanding their domain; and stakeholders are drawn to money pots and Commonwealth blandishments. In addition, there has been a justifying discourse of Commonwealth-knows-best that favours action and intervention without critically assessing its effectiveness. In some instances to do with welfare and redistribution, or to break log jams in policy areas, national interest considerations are quite legitimate, but hardly justify the scale and duration of Commonwealth encroachments.

Blame game

States share the blame for sustaining VFI, being weak and complicit in allowing Commonwealth invasion of their policy domain. Most accept the maxim that “the only good tax is a Commonwealth tax”, championed by Queensland premier Joh Bjelke-Petersen in defeating an earlier move by the Malcolm Fraser government to allow states a small window into income tax. Despite periodic whinging, state premiers prefer grantsmanship to taking responsibility for raising their own revenue, preferring to spend “50 cent dollars” minted from the Commonwealth’s fiscal largesse.

They take the Commonwealth’s money, often disguise how it is spent, and readily shift the blame for their own policy failures to the Commonwealth.

The 2014 budget signalled something of a sea change in the Commonwealth’s approach to Australian federalism. The Abbott government announced massive cuts of $80 billion in funding for schools and hospitals from forward estimates. Defending this decision, government leaders including education minister Christopher Pyne insisted that because the Commonwealth did not run any schools or hospitals, it was the States’ responsibility to plug the gap.

Curiously, no one asked Pyne how he could justify his portfolio and huge department if indeed they ran no schools.

Perverse game

Nor could the states plug this massive shortfall without a corresponding realignment of fiscal federalism. This might occur in two ways: either the states get back into levying a portion of the income tax; or the rate and/or coverage of the GST is increased. Since all GST proceeds are distributed to the states, this would boost their revenues. The Commonwealth was passing the buck to the states to push for increasing the GST that would be electorally unpopular. Again we see the perverse games that VFI encourages.

The solutions to VFI are relatively straight forward. The Commonwealth retreats to its national purposes and leaves the states to manage their policy domains—in effect honouring the federal constitution. The Commonwealth uses section 96 tied grants sparingly for genuine purposes of assisting smaller states and for addressing genuine issues of national interest.

The states are given appropriate revenue capacity and made responsible for raising most of their own revenue. Subject to precise calculations being done, a first approximation might be giving the states the equivalent of half the $101 billion grant figure, including most of $46 billion tied grant component, as a proportionate share of income tax capacity.

A comparable federal country where provinces share income tax and have superior schools run by the provinces without any national department of education is Canada. Australia might follow suit with political leadership and better intergovernmental relations.

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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