Introduction
A feature of Australia's federal system is that the
States have relatively large constitutionally-assigned spending responsibilities
but few own-revenue sources whilst the reverse is true at the Commonwealth
level. The difference between the relative revenue and spending responsibilities
of the Commonwealth and States is known as vertical fiscal imbalance
(VFI).
The merits of VFI have long been debated. The issue
became more prominent with the introduction of the GST. This was associated
with an increase in VFI since under the agreement that the States receive
all GST revenue, the States agreed to abolish or reduce some taxes.(1)
This Research Note canvasses some of the issues in the debate over VFI.
How big is VFI?
Australia has the greatest degree of VFI of any federal
country.(2) The Commonwealth's own-source revenueabout 75
per cent of total Commonwealth and State revenueexceeds its own-purpose
outlays of around 57 per cent of Commonwealth and State spending combined.(3)
The gap between State own-revenue and spending is
filled by Commonwealth grants in the forms of general purpose payments
and specific purpose payments (SPPs).(4)
In 200203, payments to the States are estimated to be equivalent to
more than 30 per cent of Commonwealth spending.(5)
Why VFI?
VFI is attributable to a number of interrelated factors.(6) First, the Commonwealth's financial
power has increased through time at the States' expense. A major factor
was the Commonwealth's taking control of income tax in 1942. Another
factor has been the High Court's increasingly broad interpretation of
'excise', a tax constitutionally reserved for the Commonwealth. For
example, in 1997, the Court ruled that State tobacco franchise fees
are an excise.
Second, the States are constitutionally responsible
for major areas of spending such as health and education. The Commonwealth
has used section 96 of the Constitutionwhich allows the Parliament
to grant financial assistance to any State on such terms and conditions
as it sees fitto extend its influence in the post-war period into areas
of State responsibility through SPPs.
Criticisms of VFI
Critics have argued that VFI reduces government accountability.
The underlying argument is that governments should be accountable for
both spending and how they raise revenue. This principle is undermined
when one tier of government raises revenue but another tier spends it.
An example is the GST: the States spend all GST revenue but the Commonwealth
imposes the GST.
A second criticism is that VFI forces the States
to rely on narrowly-based taxes for own-source revenue. A taxation principle
is that the tax basesuch as land or consumptionshould be as broad
as possible, that is, with minimal exemptions. The Commonwealth imposes
the main broadly-based taxesthe GST and personal income taxleaving
the States with only a few such taxes, namely payroll and land taxes,
and a number of narrowly-based taxes such as stamp duties.
Third, it is argued that the Commonwealth's financial
power diminishes the political power of the States. This argument holds
that the States are best placed to determine priorities in the areas
for which they are responsible. But the Commonwealth uses its financial
power to override State priorities, for example, by requiring the States
to spend more on a function than they would prefer.
A related argument is that VFI is likely to distort
the pattern of public spending away from State functions towards Commonwealth
functions, and therefore from areas such as economic infrastructure
and community services.
Fifth, it is argued that the negotiation of agreements
between the Commonwealth and the States involves unnecessary policy
duplication and waste of resources.
Arguments for VFI
Advocates of VFI (though not necessarily of current
arrangements) make the following claims.
First, the Commonwealth is best placed to determine
'national' interests as distinct from narrower State interests. An example
might be the restoration of the Murray Darling basin where the reconciliation
of divergent State interests is an issue.
Second, some argue that the Commonwealth should have
resources to help reduce cycles in the level of economic activity. Further,
the Commonwealth should be able to influence the allocation of resources
throughout the economy by its spending and revenue decisions.
A related argument is that the Commonwealth should
be responsible for meeting equity objectives through the taxation/welfare
system.
Fourth, the Commonwealth's access to revenue allows
it to pursue horizontal fiscal equalisation, that is, to ensure that
each State has the capacity to provide services at national average
levels at average levels of efficiency.(7)
Fifth, it has been argued that a centralised tax
administration is more efficient than a decentralised one. Further,
centralised administration reduces scope for 'tax competition' whereby
States match tax cuts in other States.
A sixth claim is that the alleged adverse effects
of VFI are overstated. One proponent of this view has put it in these
terms:
Although vertical fiscal imbalance has often been criticised,
it has not been demonstrated from a national interest point of view
that a pressing problem exists. The States do conduct substantial revenue
raising in their own right. This means that although on
average the States do not raise the full amount of every dollar
they spend, at the margin they must raise their own revenues
to fund their own discretionary spending programmes.(8)
VFI Issues
The debate over VFI raises the question of whether
there are principles that can help determine the assignment of spending
and taxing responsibilities to different tiers of government. It is
widely accepted that some degree of fiscal devolution is desirable to
allow local considerations to be taken into account in decisions. Further,
there are theories about the optimal assignment of spending and taxing
responsibilities to different tiers of government. For example, one
line of thought holds that lower tiers can play a useful role in resource
allocation decisions but that equity and stabilisation roles are best
left to national governments. But in Australia, as elsewhere, there
is little agreement on the degree of governmental centralisation and,
in practice, federations exhibit varying degrees
of VFI.
Conclusions
Major change that would alter the degree of VFI seems
unlikely. High Court decisions have precluded the States from imposing
broadly-based consumption taxes such as the GST.
Similarly, the States seem unlikely to gain access
to the personal income tax base. The Fraser Government legislated to
allow the States to impose income tax. But this failed partly because
the Government did not make 'tax room' by cutting personal tax rates.
The States would have had to impose a surcharge which none was willing
to do. The Hawke Government repealed the legislation that would have
allowed the States to impose a surcharge. The last major attempt the
States made to gain access to a large tax base was in the early 1990s,
when they sought access to income tax. With the failure of that attempt,
the situation remains that the Commonwealth makes grants to the States
conditional on them not levying income tax.(9)
Another option to reduce VFI would be for the Commonwealth
to take over some functions from the States. But this would face legal
and political hurdles.
