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Taxation, the states, and redrawing our fiscal constitution

States must be able to lessen their reliance from the much larger Commonwealth. AndreaDanti/Shutterstock

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.

Curtin University’s Alan Fenna argues the Commonwealth must be prepared to relinquish its monopoly over personal and corporate income tax.

It is hard to believe today, but the Constitution assigns the States powers over taxation almost equal to those of the Commonwealth. One wouldn’t know this for the simple reason that for well over half a century now, the Commonwealth and the High Court have ensured that the States cannot exercise those powers.

The result is that Australian federalism is crippled by an extraordinarily high degree of ‘vertical fiscal imbalance’ (VFI). The Commonwealth has access to revenue far in excess of its needs and the States have service delivery responsibilities far in excess of their revenues. With money comes power, and with power comes endless interference.

In 1942, the Commonwealth used its “spending power” under s.96 to drive the States out of the income tax field. This was a cruel irony, given that s.96 was inserted to facilitate aid to the states. Meanwhile, the High Court has imposed an idiosyncratic interpretation of “excise” duties under s.90 that has made it impossible for the States to levy the kind of general sales taxes that their counterparts do in federations such as Canada or the United States.

The main direct and indirect tax bases are thus off limits to the states. They are left scrounging for revenue in economically inefficient or socially undesirable ways and going cap in hand to the Commonwealth. The Commonwealth has always responded by providing substantial “general revenue” grants to the States. Originally these were called “reimbursement grants” — implicitly acknowledging that the money was not really the Commonwealth’s. However, that terminology was eventually dropped and the arrangements were formalised in 1999 with the agreement to hypothecate the net revenue of the GST to the states.

At the same time, though, the Commonwealth developed a substantial appetite for conditional transfers. These are the “tied grants” that use the spending power to buy influence or control over extensive areas of State responsibility. Important reforms to the system of tied grants were implemented by the Rudd government in 2009; however, the underlying realities remained unaffected.

Many of the pathologies of Australian federalism can be traced back to this extreme degree of fiscal imbalance and the resulting dominance enjoyed by the Commonwealth. These include overlap and duplication; opportunistic intervention; excessive entanglement; one-size-fits-all programs and lack of policy diversity; blame shifting and obscured accountability; and the degree to which ‘cooperative federalism’ is a euphemism for Commonwealth hegemony.

Reforming Australia’s fiscal arrangements is thus the key to reforming Australian federalism.

The good news is that identifying a solution is not difficult. The first, and most obvious, measure is to broaden and deepen the GST — and reduce income tax take commensurately. The GST base could be broadened by removing the health and education exemptions, while the rate could easily be raised by at least 5%. This boost to the GST would provide two benefits simultaneously: increasing the general revenue flow to the states and reducing Australia’s excessive reliance on direct taxes. The second measure is to acknowledge that the income tax is not the exclusive privilege of the Commonwealth and legislate for a revenue-sharing arrangement. Under that arrangement the States would receive a set share of the personal and corporate income tax. These two taxes provide the great bulk of revenue in Australia.

The Abbott government’s National Commission of Audit recently likewise recommended restoring income tax access to the states, but they opted for base sharing rather than simple revenue sharing. Base sharing gives individual states the power to change rates and thus provides them with greater autonomy in the field. However, the postulated benefits of such a system would in all likelihood be outweighed by the counterproductive race to the bottom it would invite.

The bad news (though it’s hardly news) is that the obstacles to implementing such reforms are considerable — in no small part because the Commonwealth holds all the cards. However, the States are themselves partly to blame. In particular, they have failed to grasp recent opportunities to push for an increase in the GST, largely because of shortsighted and counterproductive opposition to the equalising way in which the GST revenues are distributed. Ultimately they have no control over the GST: it is a Commonwealth tax that can be altered at any point by the Commonwealth. However, it is hard to see the Commonwealth wearing the odium of raising the GST just to improve the position of the States.

The real challenge, though, is to get the Commonwealth to relinquish its monopoly on the personal and corporate income tax. This might seem as impossible as it is reasonable. However, if the prime minister is dinkum about his commitment to “clarify roles and responsibilities for States and Territories so that they are, as far as possible, sovereign in their own sphere’ and reduce ‘Commonwealth intervention”, then that is exactly what will happen.

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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