Chapter 2
Commonwealth-state and territory fiscal relations[1]
An historical overview
2.1
The Australian Constitution confers on the Commonwealth limited
exclusive powers, such as managing Australia's defence forces, and setting the
rates of customs and excise.[2]
The Constitution also provides for areas where the Commonwealth can exercise
powers concurrently with the state governments, although the Commonwealth does
hold legislative supremacy in the case of inconsistency. These powers include
taxation, social welfare, postal services and telecommunications, banking and
insurance and industrial disputes that extend over state borders.
2.2
The state governments have exclusive responsibility over all other
service areas, including housing and urban development, law and order, energy,
rail and road transport, and health care and education. Taxes on property
(immovable property and financial and capital transactions) and payroll taxes
account for a major share of total state tax revenue. The Commonwealth can be
involved in areas of state responsibility through the granting of financial
assistance on terms and conditions it deems appropriate, as, for instance, in
the health care and education areas.[3]
2.3
The Commonwealth controls some of the broadest tax bases, including
personal and corporate income taxes, and as previously noted, customs and
excises. It collects the revenue of the Goods and Services Tax (GST),
implemented in July 2000, but transfers it entirely to the states.
2.4
The dissolution of internal tariff barriers at the time of Federation
meant that the states lost a major source of revenue. Section 94 of the
Constitution was designed to guarantee the states' financial wellbeing by
empowering the Commonwealth Parliament to provide to the states all surplus
Commonwealth revenue. With the propensity of the Commonwealth Government in
recent years to proclaim large 'surpluses,' one wonders why the states are not
making a greater political call for 'surplus revenue of the Commonwealth' to be
returned to them, although over the years the Commonwealth has found ways of
ensuring that no true surpluses exist.
2.5
States can also be assisted through section 96, the key part of which
states:
...the Parliament may grant financial assistance to any State on
such terms and conditions as the Parliament thinks fit.
The reason behind the insertion of these words was the
desire to provide financial security for the states in the early years of the
Commonwealth whilst also providing a means of helping the poorer states if they
should require financial assistance. Section 94 becoming effectively redundant
in the first years after Federation as the Commonwealth found ways of ensuring
that no surplus existed. As an alternative, the Commonwealth began to use
section 96 to make annual payments to the states to assist in the delivery of
services to their communities. Such payments came to be referred to as
'general-purpose' grants, by which it was understood that the states were free
to spend the money as they saw fit.
2.6
The Commonwealth Parliament's Main Roads Development Bill 1923 granted
the states funding that could be used only on the development of main roads.
This was the Commonwealth’s first foray into the provision of funding subject
to conditions. Five decades later, the Whitlam Government's decision to use tied
grants to impose major policy change on the states signalled the beginning of a
trend that has seen successive governments follow suit.
2.7
By the start of the 21st Century, about four of every ten
dollars given by the Commonwealth to the states had conditions attached. A
large proportion of these grants pertained to policy areas that were not
included in the original constitutional powers granted to the Commonwealth,
such as health and education. Such a high level of conditionality became a
major feature of the Australian federal model.
Current arrangements
2.8
The current framework for Commonwealth-state financial relations is
heavily influenced by the Intergovernmental Agreement on the Reform of
Commonwealth‑State Financial Relations, which was negotiated between
the Commonwealth and states and territories in 1998 and 1999 primarily to
govern arrangements for the distribution of GST revenue.[4]
Amongst other things the agreement provides that:
- the states can spend GST-related payments as they wish;
- revenue from the GST will be distributed among the states on 'horizontal
fiscal equalisation principles', according to a formula implemented by the
Commonwealth Grants Commission;
- the Commonwealth would, for a transitional period, ensure that no
state is worse off under the new arrangements than under the old arrangements
through the provision of 'budget balancing assistance';[5]
and
- the states would abolish certain taxes[6]
by specified dates, and that retention of some duties by states come under
review in the future.[7]
2.9
The Committee notes that in April 2005, all states with the exception of
New South Wales and Western Australia submitted a proposal that commits
them to abolish, by no later than 1 July 2010, most of these duties.
2.10
Under the Intergovernmental Agreement, the States agreed to abolish a
range of inefficient indirect taxes that were impeding economic activity. The
States themselves nominated the taxes to be abolished.
2.11
By 1 July 2005, the States had abolished several taxes that were listed
in the Intergovernmental Agreement. This first tranche of abolished state taxes
included accommodation tax, financial institutions duty, quoted marketable
securities duty and debits tax.
2.12
The agreement also provided for further state taxes to be abolished once
GST revenues proved to be sufficient. In 2006, the Australian Government
reached agreement with all States on a schedule for the abolition of a second
tranche of taxes, including all but one of the remaining state taxes listed in
the Intergovernmental Agreement. This second tranche of inefficient state taxes
being abolished includes stamp duties on mortgages, leases, and credit and
rental arrangements. Notwithstanding that all States are already receiving
substantial revenue gains from the Australian Government's reforms, some of
these state taxes will not be abolished until as late as 2012–13.[8]
A timetable for the abolition of state taxes is included in Appendix 4.
2.13
The committee notes the States are still required to abolish the one
remaining tax, the stamp duty on conveyances of real non-residential property,
before all of their commitments under the Intergovernmental Agreement will have
been met. So far, no State has specified when it will abolish this tax.
2.14
The committee makes a recommendation (Recommendation 6) for the
Commonwealth Government to pursue this matter in chapter 8.
2.15
Since 1 July 2000 when the GST was introduced, the other main forms of
Commonwealth financial assistance to the states have been budget balancing
assistance, payments made under National Competition Policy, and Specific
Purpose Payments (SPPs).
Specific Purpose Payments
2.16
Under existing arrangements, SPPs–which can be for current or capital
purposes–take the forms of:
- payments 'to' the states that supplement state funding of areas
such as public hospitals, government schools and roads. In 2006–07, such
payments accounted for about three-quarters of SPPs by value;
- payments 'through' the states that the states pass on to targeted
recipients such as non-government schools and local governments. In 2006–07,
payments through the states accounted for 20 per cent of SPPs by value; and
- payments paid directly to local government for services such as
disability, children’s and other welfare services, or payments made under the
Roads to Recovery program. These payments account for about five
per cent of SPPs by value.
The rationale for Specific Purpose
Payments
2.17
Most SPPs are subject to conditions which, while not legally binding,
must be met by the states, and so are called 'tied' grants. According to an Organisation
for Economic Co-operation and Development (OECD) working paper,[9]
such 'conditionality' takes a variety of forms:
- general policy conditions that may be attached to the grant of
money (e.g. that the states provide free public hospital access for Medicare
patients in return for funding under the Health Care Agreements);
- expenditure conditions (e.g. SPPs for schools to be spent on
teacher salaries and curriculum development);
- input control requirements, in the forms of 'maintenance of
effort' and 'matching funding' arrangements, where the states are required to
maintain funding levels and/or match Commonwealth funding in a program area;
- performance and financial information reporting by the states;
and
- due recognition conditions, whereby the states are required to
acknowledge publicly the Commonwealth’s funding.
2.18
By contrast, general purpose ('untied') section 96 grants are not
subject to conditions. The main component of untied grants is the revenue from
the GST. The value of other untied grants is relatively small and includes, for
example, the compensation paid to the states for the revenue they have forgone
since the introduction of the national scheme for the regulation of companies
and securities.
2.19
Several reasons exist for the Commonwealth to provide SPP assistance to
the states. First, while a state may have a very narrow view of a particular
program that it is seeking to undertake, seeing it as relevant to its own
residents, it may not account for the benefit the activity might have for
residents of other states. This can lead to the allocation of insufficient
resources. The Commonwealth may seek to encourage adequate expenditure by means
of an SPP. Some argue that this is the only legitimate reason for the provision
of tied grants. An example of such grants is funding for interstate highways.[10]
2.20
A second reason for the use of SPPs is a desire to promote co-operative
arrangements between the Commonwealth and individual states to achieve national
standards in particular services. This is highlighted in circumstances where no
individual state could be expected to effectively deliver services or to
deliver services in accordance with national objectives.[11]
A well-known example was the standardisation of Australian railway gauges.
2.21
Third, SPPs may provide a means of giving additional budget support to
enable the states to meet their expenditure responsibilities. Such grants may
take the form of cost-sharing arrangements between the Commonwealth and the
states. Grants which assist the states to meet their hospital running costs
illustrate this form of assistance. Typically this is related to the states
having an inadequate range of taxes with which to fund their responsibilities.
2.22
Fourth, at times, Commonwealth action may effectively amount to a
Commonwealth 'takeover' of a particular policy area as it seeks to achieve
economies of scale. The committee recalls that in 2006 the NSW and South
Australian Premiers actually argued in favour of yielding their
responsibilities for health to the Commonwealth Government.[12]
2.23
The use of SPPs means that today, a great many functions are shared
between the Commonwealth and the states to a much greater extent than would
have been envisaged by most of Australia’s Prime Ministers and Premiers since
Federation.
2.24
It must be noted, however, that sharing responsibilities creates
problems for Australian federalism, including inefficiencies derived from the
blurring of government responsibilities, wasteful duplication of effort, under-provision
of services, and a lack of effective policy co-ordination. Most notable,
however, is cost and blame-shifting among different levels of government.
2.25
Evidence was given that with shared responsibility, Commonwealth funding
enabled State Governments to avoid accountability for their actions, or lack of
action.
State and territory government
dependence on SPPs
2.26
The level of SPP funding is an ongoing issue between the Commonwealth
and the states. Paragraph 5(v) of the Intergovernmental Agreement on the Reform
of Commonwealth-State Financial Relations states:
The Commonwealth will continue to provide Specific Purpose Payments
(SPPs) to the States and Territories and has no intention of cutting aggregate
SPPs as part of the reform process set out in this Agreement, consistent with
the objective of the State and Territory Governments being financially better
off under the new arrangements.[13]
2.27
The reason for this provision is that the states were concerned that the
Commonwealth would reduce funding of SPPs following the introduction of the GST
and the Commonwealth's undertaking to provide all revenue from that tax to the
states. The states have interpreted the provision to mean that the level of
SPPs should be measured in real per capita terms using the consumer price index
to remove the effect of inflation.
Inputs and outcomes
2.28
As noted above, conditionality sometimes takes the form of so-called
input controls such as the states having to match Commonwealth funding. Generally
speaking, in recent years, input controls have been relatively benign. Short of
replacing SPPs with untied grants, another option that has been proposed is for
conditionality to focus on outcomes and results.[14]
2.29
Input controls may have the effect of:
- A focus on input controls may not place clients first,
particularly for SPPs providing services directly to individuals and groups
within the community;
- A focus on inputs distracts attention from meeting SPP objectives
and may not provide any indication of what is being achieved via the service
provision;
- Input controls limit incentives for service providers to improve
their efficiency, and prevent the redirection of efficiency savings into other
areas of expenditure; and
- Input controls do not allow service providers the flexibility to
move funds between program elements within SPPs to ensure that overall
objectives are achieved.
2.30
To address these concerns, it has been suggested that input controls
should be replaced by output controls – where State Governments receive funding
at least partly based on outcomes. However replacing input controls with output
controls does not necessarily mean improvements:
- It is much easier for States to meet input controls. For example,
it is much easier for a school to know in advance that they will meet a
requirement to have a flagpole than to meet a requirement for test results of a
particular standard. As a result, input controls provide more funding
certainty.
- It is easier to administer input controls and they have lower
compliance costs.
2.31
The committee makes a recommendation (Recommendation 8) relating to the
further consideration of the costs and benefits of input and output controls in
chapter 8.
Vertical fiscal imbalance
2.32
Vertical fiscal imbalance refers to the relationship between the
relative spending responsibilities of a tier of government and its capacity to
raise revenue. It is common to most, if not all, federal systems. In Australia,
the states have relatively large constitutionally-assigned spending
responsibilities but, in recent decades, relatively few own-revenue sources. The
reverse is true at the Commonwealth level.
2.33
Even before the GST was introduced, Australia had a comparatively high degree
of vertical fiscal imbalance. It is surpassed by countries, for example, Belgium
and Mexico but exceeds other countries such as Canada, United States and Germany.[15]
The Commonwealth raises about 75 per cent of total general government
revenue but is responsible for about only 60 per cent of total expenditure on
government programs. In 2003–04, the Commonwealth raised about 78 per cent of
total government revenue and was responsible for about 65 per cent of total
government expenditure.
2.34
It can be argued that the advent of the GST and the abolition of some
state taxes have contributed to the rise in the degree of vertical fiscal
imbalance. Indeed, the states frequently complain that the shift in
revenue-raising power to the Commonwealth and their lack of own-source revenue
have increasingly led to a situation where the Commonwealth is virtually able
to dictate to the states the terms of SPPs.
2.35
On the other hand, it could be argued that the Commonwealth is, in
effect, merely acting as an agent who collects the GST on the states' behalf;
that this is tantamount to shifting some revenue-raising capacity back to the
states; and that this rolls back somewhat the vertical fiscal imbalance in the
states' favour.
2.36
The presence of vertical imbalance, with the states relying on transfers
from the Commonwealth, leads to design issues concerning the inter-governmental
transfer arrangements to bridge the vertical fiscal gap. Concerns include the
potential for: undermining accountability to taxpayers for expenditure
decisions; creating duplication and overlap in the provision of services;
constraining beneficial tax competition across jurisdictions; and weakening
incentives for tax and microeconomic reform. Increasing the states' revenue raising
capacity would be a step towards reducing the vertical fiscal gap.[16]
2.37
Many witnesses raised the question of the states resuming an incomes tax
ability with the Commonwealth vacating a certain percentage of the income tax
collections and allowing the states to impose their own level of top-up income
tax requirements. It was argued that this would increase the states'
accountability.
2.38
The Committee does not necessarily support the 'reform' of Income Tax Collections
by reducing the Commonwealth's collections with a corresponding reduction in
the payment of SPPs to the States and transferring to the States the ability to
raise their own income tax by adding a surcharge to the Commonwealth's base
income tax collections to fund what previously came to them as an SPP payment,
but believes there should be serious consideration of that proposition, to
address the States' concerns of vertical fiscal imbalance and to impose more
accountability on, and lessen blame shifting by, the States. The need for
States to impose their own income tax revenue would provide opportunities for
competitive taxation systems across the nation. Any such enquiry should
carefully assess benefits and costs and determine if the ability of the States
to impose their own income tax would be in the national interest.
2.39
Nevertheless the Committee does believe that this option needs to be
considered in detail by a specialised taskforce. Such an inquiry should
carefully assess benefits and costs and determine if the ability of the States
to impose their own income tax would be in the national interest. A specialised
taskforce should comprise leading economists and senior officials of the
Commonwealth's and each State/Territory's Treasury. The committee makes a
recommendation (Recommendation 7) in this regard in chapter 8.
Horizontal fiscal equalisation
2.40
Whereas vertical fiscal imbalance refers to the Commonwealth-state
relationship, horizontal equalisation refers to the relative distribution amongst
the states. Beginning in 2002–03, the states, in aggregate, have benefited
under the new arrangements in that the amount of GST payments they have
received has exceeded the amount they would have received under the old system.
However, these 'gains' have been distributed unequally, with Queensland gaining
the most (in dollar terms) principally at the expense of NSW but also Victoria.[17]
The main reason for the uneven distribution is the application of the
horizontal fiscal equalisation principle, on which the Commonwealth Grants
Commission bases its calculations of the relativities used to determine each
state's GST entitlement.
2.41
Questions have been raised regarding the appropriateness of the current
equalisation mechanism in terms of the equity it achieves against the potential
efficiency losses and the cost of institutional complexity it entails. Concerns
arise about the usefulness of extensive interstate fiscal equalisation given
the relatively low pre-equalisation disparities.[18]
There have, in recent years, been a number of calls to reform and to remove
horizontal fiscal equalisation, for example by the Victorian Employer's Chamber
of Commerce and Industry.[19]
Transitional and other assistance
2.42
The Commonwealth also provides compensation to the states for the
deferral of GST revenue resulting from its decision that small businesses and
non‑profit organisations, which voluntarily registered for the GST, could
pay and report GST on an annual, rather than monthly or quarterly, basis. Due
to an overpayment of this compensation to the states, the Commonwealth agreed
with the states to suspend the payments for 2006–07.[20]
2.43
In March 2008, the Council of Australian Governments announced a change
to the architecture of Commonwealth-state financial arrangements. This new financial
framework will result in a significant rationalisation of SPPs; consolidating
the nearly ninety existing SPPs into five or six new national agreements for
delivery of core government services. These are health, affordable housing,
early childhood and schools, vocational education and training, and disability
services. The reform is said to be finalised by the end of 2008, and the new framework
will commence from 1 January 2009 with the reform of payments for healthcare
to be implemented by 1 July 2009.[21]
2.44
The Australian National Audit Office (ANAO) has identified the
development and implementation of the new federal financial framework as a potential
audit topic in 2008–09.[22]
The committee would support the ANAO undertaking such an audit and accordingly makes
a recommendation (Recommendation 9) in chapter 8.
Reforming funding arrangements
2.45
Clarifying government roles and responsibilities has the potential to
improve public sector efficiency. Fragmentation of decision making and funding
arrangements, particularly in the areas of hospital services and old-age care,
creates incentives for cost and blame-shifting between different levels of government.
A collaborative approach between different levels of government to overcome some
of these problems, would help to develop better governance arrangements and
improve spending assignments. A less complex system of inter‑governmental
transfers would also contribute to a more effective specification of spending
responsibilities. Stronger revenue-raising capacity on the part of the states,
through a further improvement in the efficiency of the state tax system, would
raise the ability of state and local governments to meet expenditure
responsibilities and allow them to be better prepared for coping with
demographic change.[23]
2.46
However such reforms could come at significant cost. Collaboration
between governments could well mean a reduction in competitive pressures which
should be there to increase efficiency. Reduced complexity of payments to
states could mean fewer conditions, and therefore lesser accountability, on the
states and stronger revenue-raising capacity for the states could result overall
in higher taxation for Australians.
2.47
There is no straightforward solution to the question of dividing
responsibilities between jurisdictions. The
'subsidiarity' principle may, however, provide some guidance. This principle
holds that the central government should limit its activities to those which
lower levels of government cannot perform effectively. That is, responsibility
should rest, where possible, with the lowest level of government.
2.48
It is important to distinguish between responsibility for funding and
responsibility for service provision. Under SPPs, the states are responsible
for service provision. Funding, on the other hand, is sometimes shared between
the Commonwealth and the states and sometimes not. Reform proposals envisage
different combinations of responsibility for service delivery and funding.
2.49
It is interesting to note that the Business Council of Australia estimated
in 2006 that Australian taxpayers were $836 million a year worse off because of
higher spending by the Federal Government on areas of responsibility like
pharmaceuticals, general practitioners and aged care facilities than for
services that would have been more efficiently provided by public hospitals
which are the responsibilities of the states.[24]
The Business Council of Australia also calculated the cost of the
inefficiencies in the Federal system were $8.9 billion,[25]
including:
- a $2.8 billion cost of inefficient state taxes such as taxes on
insurance, land tax, stamp duty and commercial conveyances and other stamp
duties;[26]
- a $2.3 billion cost in inefficient state spending;[27]
- a $1.8 billion cost from duplicated spending or administration of
inefficient grants.[28]
2.50
An operator of an interstate train in Australia may have to deal with
six access regulators, seven rail safety regulators, with nine different prices
of legislation, three transport accident investigators, 15 pieces of
legislation covering occupational health and safety of rail operations and 75
pieces of legislation with powers over environmental management.
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