Renewing State Sovereignty

To see why the GST needs to be reformed, look no further than the comments made by state leaders during February’s Council of Australian Governments meeting. The Turnbull government’s offer to pay up to 45 per cent of public hospital funding and to cap annual growth in federal spending at 6.5 per cent per year was swiftly rejected by most state Labor leaders as an insufficient commitment.

Unfortunately this is standard practice in Australian politics. The state governments shamelessly request ever higher amounts of funding from Canberra, knowing they bear none of the political costs of overspending taxpayer money they do not collect. And when the funds are wasted by state governments, blame inevitably is placed on the federal government for ‘not doing enough’.

A significant factor in this dynamic is the Goods and Services Tax (GST). Introduced in 2000, the GST was intended to be a no strings attached way for the federal government to collect revenue for the benefit of the states. Instead, the endless blame-game has proven to be just that, while the neo-Marxist model of distributing GST revenue ‘from each according to his ability, to each according to his need’ has seen billions of dollars transferred from a few successful states such as Western Australia to subsidise underperforming Tasmania, South Australia and the Northern Territory.

The GST is in dire need of reform—and the solution is to end progressive redistribution of  funds between the states and restore fiscal autonomy.

The problem with the GST

Horizontal fiscal equalisation is the name given to the process the Commonwealth Grants Commission (CGC) uses to distribute the proceeds of the GST to the states. Essentially, the CGC attempts to address underlying fiscal differences between the state governments as calculated by an elaborate relativity formula, which develops a GST requirement. A state’s GST requirement is the difference between its assessed expenditure needs and the sum of its assessed own-source revenue capacity in addition to how much the state received from the Commonwealth in tied grant funding. The CGC’s calculations result in a ‘relativity’ figure for each state, which defines how much a state should receive in GST revenue relative to its share of the national population. For instance, in 2015/16, Western Australia’s relativity was calculated at 0.2999, meaning that the state was receiving only 30 cents compared to the dollar it would have received if GST revenue was distributed to every state equally
per capita.

In reality, these calculations are prone to substantial methodological and data problems. The CGC requires vast amounts of data to arrive at its calculations, but in many cases the data does not exist and the CGC must resort to best guess judgements. As Australian academic and former researcher at the Productivity Commission Jonathan Pincus noted over a decade ago:

the CGC research does not… reach the standards that would be expected of academic publications. It would not deserve a pass if it were submitted as a third-year undergraduate project in econometrics.

The use of old data (the three most recent years for which reliable data is available) may mean that changing economic circumstances are not reflected in the GST distribution determinations until years later. Further, a state’s share of the national population is also an inappropriate factor in the distribution of revenue, as it isn’t an indicator of how much a state contributes to the total GST pool.

States that are generating billions of dollars of GST revenue are seeing it transferred to other states on faulty premises. IPA research published in November 2017 reveals that over the life of the GST, the states of New South Wales, Victoria, and Western Australia, generated approximately $535 billion of the total GST pool, but in return only received $458 billion in GST revenue, while beneficiary states Tasmania and South Australia collected roughly $33 billion more than they contributed over that time.

In a gross perversion of Australia’s federal structure, the Northern Territory—a sole responsibility of the federal government—has received roughly $33 billion from the states since 2000/01, compared to the $8 billion it has generated.

The GST’s perverse incentives

Extensive and persistent fiscal redistribution under equalisation principles creates poor incentives for people and governments, suppressing migration of labour and capital and creating disincentives for economic reform at the state level.

A key rationale for horizontal fiscal equalisation is that it removes the incentives for fiscally induced migration between states, as otherwise a state with a high endowment of mineral resources would have a ‘fiscal advantage’ over other states, allowing it to offer lower taxes and a higher level of public services. However, it is not clear that the movement of labour and capital to such states should be deterred, because labour market mobility is an important but overlooked source of productivity gain. The current system creates inefficiencies, with factors of production encouraged to remain in high cost jurisdictions.

The second key incentive effect is that equalisation reduces the incentives for state governments to pursue pro-growth policy reform, since states bear the political costs of promoting contentious reforms, without receiving the benefits of such a change. Consider the example of a state that reduces barriers to gas exploration and production risks being labelled as anti-environment, but since the tax base is broadened, the GST relativity will be decreased thereby reducing its slice of the pie.

In the same way that people can be induced to remain in joblessness by way of financial dependence on the government, state governments can also fall into similar poverty traps. By effectively rewarding smaller jurisdictions to forego revenue from their own state, equalisation perversely makes those states more reliant on other jurisdictions.

STATE FISCAL AUTONOMY

These deep flaws are just a part of a larger institutional problem in Australian governance. One of the justifications for fiscal equalisation is that it compensates states for having lost the ability to levy taxes of their own, through a series of pro-Canberra High Court decisions. Indeed, the extent of Australia’s horizontal fiscal imbalance—the difference between a jurisdiction’s own-source revenue and their spending responsibilities—is among the worst in the world.

Following two High Court decisions in 1997 that deemed a range of state franchise and licence fees invalid, a centrally administered GST was offered as a replacement for the loss of state revenue. But the GST does not address the key problem of horizontal fiscal equalisation: autonomy. A state able to levy its own taxes can determine which rate applies in that jurisdiction (and whether there needs to be a tax at all). This enables jurisdictional competition, where different states compete with one another to introduce the best range of policies to attract business and individuals to operate in their jurisdiction.

The GST does not address the lack of state autonomy. The states now have little control over a major source of their revenue, substantially reducing the incentives for state governments to pursue pro-growth policies. since their revenue is primarily a factor of decisions made in other jurisdictions. The confusion from having one level of government collecting taxes and another responsible for service delivery fosters the endless blame game where governments fall short of their governmental responsibilities. This diminishes democratic accountability.

Changes to the GST calculation process—such as by distributing the GST equally per capita—would undoubtedly be an improvement, but would not address the underlying problem. The dominant jurisprudence of the High Court would suggest that the damaging decisions which debilitated the states will not be reversed, meaning the GST could not simply be decentralised. However, decentralised elements could nonetheless be introduced to enable the states to set the GST rate that applies in their jurisdiction and by allowing them to keep whatever revenue is generated within those borders.

One thing a state leader got partially right at February’s COAG meeting was when WA Premier McGowan tied the funding issue back to the GST:

It’s been very unfair on Western Australia for a very long time and states like South Australia ought to realise they’ve been so successful getting GST… they need to give something back.

Mr McGowan is certainly right that where state finances are concerned, it all comes back to the GST. However, the systemic problems cannot be resolved until we put an end to the federal imbalance and empower the states to take financial responsibility for themselves.

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