Source: Institute of Public Affairs; Commonwealth Government Budget Papers 2017-18; Australian Bureau of Statistics cat. no. 5220.0.
HFE is a complex formula the Commonwealth Grants Commission (CGC) uses to distribute the GST pool to the states and territories. The CGC makes assessments based on the three most recent years for which reliable data is available about
- How much the states need to spend to provide the average national level of services and infrastructure
- How much revenue the states could raise by themselves under average national tax regimes.
As this reseach brief explains, the equalisation process suffers from significant data and methodological problems, creates damaging incentives for state governments, and compounds the central problem affecting state government finances – namely the near-complete loss of state fiscal autonomy.
Problem 1: HFE produces inequitable results
Attempting to ensure intergovernmental equity “does not necessarily translate into improved equity between citizens of different states, nor within a given jurisdiction.”3 Indeed, HFE may have inequitable effects by effectively transferring income from Australians in larger states to people with higher incomes in the two Territories. For instance, the Australian Capital Territory and the Northern Territory are net beneficiaries under GST equalisation while its residents have the highest and second highest weekly media income in the country ($998 and $871 for individuals respectively, compared to the national median weekly income of $662 in 2016).4
Problem 2: Flawed data and methodology
The calculations made by the CGC are complex and lack transparency. Dr Mikayla Novak explained in 2011 that the “CGC requires vast amounts of data to support its assessments which, in many cases, are not available or incomplete… The CGC frequently resorts to judgment – in other words, a best guess.”5
The reliance on guesswork undermines the credibility of the equalisation system. As academic Professor Jonathan Pincus noted in 2005, “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.”6
Additionally, 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.
Problem 3: Creates perverse incentives for state governments
The persistent fiscal redistribution under equalisation principles leads to the deeper consequence of creating or perverting damaging incentives for people and governments.
Equalisation suppresses labour and capital migration between the states
A key rationale for HFE is that it reduces naturally occurring labour and capital migration incentives that arise in a federal system. However, it is not clear that such incentives should be discouraged, as capital and labour migration is an important but overlooked source of productivity gain.7
Equalisation discourages state fiscal reform
Equalisation reduces the incentives for state governments to pursue pro-growth policy reform, since states bear the political costs of promoting contentious reforms, but do not fully receive the benefits of such changes. For example, a state that reduces barriers to gas exploration and production risk being labelled as anti-environmental, but the GST calculations will take into account a change in the state’s tax base, thereby reducing the state’s slice of the GST 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.8 By effectively rewarding smaller jurisdictions to forego revenue from their own state, equalisation perversely makes those states reliant on other jurisdictions. It is hardly a coincidence that it is Tasmania and South Australia that have consistently been the beneficiaries of equalisation.
Problem 4: Does not address underlying fiscal imbalances between the states and the Commonwealth
HFE attempts to address the phenomenon known as “vertical fiscal imbalance”. A key feature of a high vertical fiscal imbalance is centralised taxation and a lack of fiscal autonomy of state-level jurisdictions. These jurisdictions have little control over a major source of their own revenue and are unable to alter tax rules to suit their unique circumstances. As figure 3 shows, Australia has a remarkably high level of vertical fiscal imbalance compared to other comparable federations.
While HFE does potentially address some of the fiscal shortcomings of some states, it does not address the underlying problem that creates those shortcomings – the loss of autonomy.
Figure 3: Vertical fiscal imbalance in Australia and other comparable federations