28/05/2014 - 15:01

No easy options on federal-state reform

28/05/2014 - 15:01

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The federal budget has triggered a serious bout of Commonwealth-state conflict.

No easy options on federal-state reform
NOT A FAN: Colin Barnett has been a strong critic of the current GST revenue distribution system. Photo: Attila Csaszar

The federal budget has triggered a serious bout of Commonwealth-state conflict.

The leaders of all states and territories except for Western Australia held an emergency meeting in Sydney recently to complain about a proposed $80 billion in cuts to federal education and health funding over the next 10 years, and to demand a meeting to discuss the implications.

It wasn’t just the cuts but the way they were announced – with no prior warning – that angered the premiers and chief ministers. With a Council of Australian Governments meeting having been held only weeks earlier, and with Liberal governments in power in Canberra and in most states, this fight was unexpected and has again raised questions about Australia’s federal system.

The underlying problem is the serious mismatch between responsibilities and revenues. The Commonwealth – through income and company tax as well as the GST – raises much more revenue than it needs to carry out its tasks, while the states and territories are in the reverse position; they have the main responsibility for delivering services but don’t raise enough revenue to fund them.

The result is that the states are very reliant on Commonwealth grants. About a quarter of Commonwealth revenue goes to the states in the form of tied and untied grants, while about half of state revenues comes from the Commonwealth, leaving them in a dependent position. We call this mismatch ‘vertical fiscal imbalance’ (VFI), and Australia has one of the most severe cases of it worldwide.

A key problem with VFI is that it leads to intrusive and expensive reporting and monitoring, as the states have to answer to the Commonwealth for how they spend their funds. This, in turn, stifles innovation and increases costs. In addition, overlap and duplication often occurs between the two levels of government.

Accountability and transparency suffer, as people don’t know which level of government does what, or who to blame when things go wrong. To make matters worse, the Commonwealth holds the whip-hand and can always renege on negotiated agreements with the states if it chooses to, as has occurred in this budget.

To rectify these issues there are three alternative directions along which federalism reform can travel – and each has its problems.

First, we can accept that there will always be overlap and duplication and that both Commonwealth and state governments will have an interest in policy areas such as health, education, housing, the environment and so on.

What is needed is for the two levels of government to work together to tackle joint problems. This was the attitude adopted initially by Kevin Rudd, who promised to ‘end the blame game’ and usher in a new period of ‘cooperative federalism’ overseen by regular meetings of COAG. While some progress was made, helped along in no small measure by big increases in Commonwealth grants to the states in the wake of the GFC, eventually the relationship turned sour. COAG was increasingly seen as overloaded and ineffectual, Mr Rudd threatened to take over health and hospitals, and Commonwealth funding increasingly came with strings attached.

The second approach is to recognise fiscal reality and give the Commonwealth more powers and responsibilities in relation to the states. Tony Abbott, in his 2009 book Battlelines, took this position, arguing for a constitutional referendum to effectively give the Commonwealth the right to intervene in, and ultimately take over, any policy area that it saw fit, in order to advance the national interest. Unsurprisingly, states do not agree with this proposition and the failures of Commonwealth policy and administration in the home insulation and Building the Education Revolution programs suggest there is good reason to suspect that Canberra does not always know best when it comes to service delivery. 

The third approach is to devolve more responsibility to the states, with the Commonwealth vacating the field, or at least reducing its presence by abolishing or drastically reducing its involvement in schools, hospitals, environmental and planning approvals etc. The National Commission of Audit advocated this position, as have others who wish to see a return to a more balanced federation.

Now prime minister, Mr Abbott has suggested as much with talk about the states needing to act like ‘adults’ and to become sovereign in their own fields of policy responsibility. The states themselves have on occasion advocated this.

To do so will require a larger and more certain revenue base for the states – preferably with the Commonwealth reducing its own share so that overall taxes don’t increase.

This brings us to the federal budget. The proposed cuts have put the coverage and level of GST back on the discussion table. But neither level of government wants to be seen as the one pushing for an increase, especially with Victoria, NSW and Queensland all holding elections over the coming year.

Meanwhile, WA expresses disinterest unless the distribution of GST revenues among the states is changed so that it gets a better deal. Unsurprisingly, the Commonwealth has said it is up to the states to come to an agreement before they will do anything.

An alternative suggested by the commission of audit is for the Commonwealth to lower its rates of income tax and provide room for the states to levy their own income taxes, with the resultant increase in untied state revenues being offset by a reduction in tied grants to the states. This would also allow competition between states over tax rates and make them politically responsible for the rate of tax.

A variant of this option would be for the states to receive a fixed share of federal income tax. The Commonwealth has not indicated any interest in this proposal yet and is unlikely to do so, as it implies a loss of control over fiscal policy as well as a reduction in revenue.

Finally, the Treasury Secretary Martin Parkinson has suggested the states look to reform their own existing revenue sources, such as land and payroll taxes, by broadening their base while lowering the tax rate. This could be an efficient (if politically difficult) path towards abolishing inefficient taxes such as stamp duty.

With all these options having their difficulties, the most likely outcome in the short term is for reform to be deferred until the release of two ‘white papers’ on federalism and tax, due to be completed towards the end of 2015. But with the federal election due less than a year after that, I suspect that the traditional approach of ‘muddling through’ rather than grand reform is the most likely outcome. 

John Phillimore is executive director at John Curtin Institute of Public Policy.

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