Horizontal Fiscal Equalisation – a Golden Handcuff

Vertical fiscal imbalance, fiscal equity and the Grants Commission

Australian Institute for Progress fellow John Fallon produced this paper on the financial arrangements between the Commonwealth Government and the States and Territories.  To download the paper, please click here.

Australia’s federal system is characterised by very high centralisation of revenue and decentralisation of expenditure – characterised by the term ‘vertical fiscal imbalance’. This imbalance requires transfer of substantial revenues from the  Commonwealth to the States and Territories in pursuit of a ‘fiscal equity objective’ where revenue transfers are made  to equalise or near equalise the fiscal capacities of the States and Territories to deliver certain government services to a specified standard.

Australia is at the extreme in terms of vertical fiscal imbalance, revenue centralisation and  fiscal equalisation for countries with federal structures.  The system of transfers is administered by the Commonwealth Grants Commission.   The system for distributing revenue to meet the fiscal equity objective has been subject to considerable criticism and review over many years. It is complex and opaque and has distortionary effects in terms of impacts on incentives for State and Territory governments to pursue economically efficient tax and economic development policies.

The Grants Commission’s objective has been recently changed by the Commonwealth so that ‘full equalisation’ of fiscal capacity will be changed to ‘reasonable equalisation’.  The recent changes will mean some less extreme outcomes in terms of revenue allocation and its effects but will still entail economic efficiency distortions in relation to incentives of State and Territory governments to develop efficient tax systems and pursue economic development that expands tax bases.  The system will also continue to be complex, opaque and costly to implement.

The system mainly creates distortions in relation to disincentives for the fiscally weaker States to pursue economic development and tax policies that expand their revenue raising capacity and this will continue despite the prospective changes. As an example the higher the potential tax capacity of a State, the less revenue it will receive from the Commonwealth because an average nation-wide tax rate is applied to the State’s potential tax base to assess its tax capacity.

For  the expenditure assessments, States still have an incentive to provide services as cost effectively as possible in relation to factors they can influence.  However, States have no incentive to ameliorate the structural disadvantages, for which the Grants Commission assumes a State has no control, and that are taken account of in calculating revenue transfers.

The fiscal equity objective is not well grounded in principles of distributive justice nor the concepts of horizontal and vertical equity that feature in the analysis of taxation policy.  It also reflects the pervasiveness of the pursuit of ‘equality’ with bureaucratic solutions in Australia that are at the expense of diversity and choice in a federal system.

The fiscal equity objective is specified at the level of a State or Territory and not focused on equity issues within the boundaries or for individuals.  There is also no commitment to ensure equal access to services within a State or region.

It also seems incongruous that the ACT should receive a per capita grant that is above the Australian average there while average disposable income is almost twice the Australian average.

An alternative approach that has been raised by some stakeholders is to redistribute GST on an equal per capita basis.   An equal per capita distribution would give primacy to economic efficiency effects.  This is because a State’s population share would be the sole determinant of the allocation of GST payments and not policies or performance with respect to revenue and service delivery capacity. An equal per capita allocation would also remove the need for administrative resources to determine allocations based on fiscal capacity assessments. Similar effects can be achieved by returning GST on a State-of-origin basis.

Such an option would also represent a move towards a more competitive form of federalism where States in effect compete with each other to provide residents with a preferred mix of public goods and taxation levels, consistent with the seminal theories of Tiebout and Buchanan in the public finance literature.  However, it is recognised that the existence of vertical fiscal imbalance itself creates separate governance issues because revenue raising responsibilities are not directly linked to expenditure responsibilities and this reduces the scope for and effectiveness of ‘competitive federalism’.  This issue could be addressed with tax reform that might be more likely if the GST was distributed on an equal per capita basis.

However, there would be a political need to address the problems of service delivery costs in the Northern Territory and to a lesser extent Tasmania.   The program of Specific Purpose Payments could be developed as an alternative to the current GST distribution arrangements to provide more targeted assistance to the Northern Territory in particular.