FEDERALISM IN RETREAT: THE ABANDONMENT OF TAX SHARING AND FISCAL EQUALISATION

by RUSSELL MATHEWS*

Introduction The development of tax sharing and fiscal equalisation arrangements

has been of major significance in shaping the fiscal systems of most of the world’s federal countries. It is perhaps not generally realised that Australia was a pioneer in formulating the concepts of tax sharing and fiscal equalisation and in working out institutional arrangements for their application.

The Commonwealth Constitution itself contained provisions governing the sharing of what was then the major revenue source available to State and Commonwealth governments-customs and excise duties- during the first 10 years of federation. Section 87 of the Constitution provided that, during this period (and thereafter until the Commonwealth Parliament determined otherwise), not more than one-quarter of the net revenue from customs and excise duties was to be retained by the Commonwealth, the balance being required to be distributed among the States.

The formal arrangements for fiscal equalisation followed the estab- lishment of the Commonwealth Grants Commission in 1933, when the Commission began to apply the principle of fiscal capacity equalisation which had been conceived several years earlier by the remarkable Australian economist L.F. Giblin, himself an original member of the Com- mission. This principle of fiscal capacity equalisation, as described in one of the early reports of the Commission, was based on the notion that each State should receive special financial assistance to the extent necessary to enable it “by reasonable effort to function at a standard not appreciably below that of other States”.’

Both the tax sharing provisions and the fiscal equalisation arrange- ments resolved major constitutional crises in Australia. The first crisis was one of vertical fiscal imbalance and nearly prevented federation from being achieved at all. It resulted from the fact that the Common- wealth would have to take over customs and excise duties, which before federation had accounted for about three-quarters of all colonial taxes,

* Professor Mathews is Director of the Centre for Research on Federal Financial Relations in the Australian National University.

1. Commonwealth Grants Commission, Third Report 1936, Government Printer, Canberra, 1936, p. 75.

16

while most of the expenditure functions would be left with the States. Tax sharing resolved the problem of vertical fiscal imbalance by ensuring that, a t least during a transition period, each level of government would have access to revenues on a basis that was cocsistent with the functions it was required to perform.z

The establishment of the Commonwealth Grants Commission was a direct result of a second constitutional crisis, which was one of horizontal fiscal imbalance. It resulted from the financial weakness of the three less populous States and led to two-thirds of the electors of Western Australia declaring themselves in favour of secession in a formal referendum conducted in that State in 1933. The work of the Grants Commission in establishing a systematic basis for fiscal equalisation resolved the problem of horizontal fiscal imbalance, by ensuring that all States would henceforth be able to provide comparable services to their citizens so long a s they imposed comparable taxes and charges.

Tax Sharing and Fiscal Equalisation in Australia and Other Countries Although the sharing of customs and excise duties ceased in Australia

as soon as the Constitution permitted, most of the world’s federations have adopted tax sharing arrangements in one form or another. The mechanisms available for tax sharing include: the relatively weak arrangement whereby taxes paid to one level of government are deducted from the revenue base used by another; a system of tax rebates whereby taxes paid to one government a re credited against those due to another; piggy-back arrangements whereby one government may add percentage surcharges to the taxes payable to another; and formal constitutional provision for the sharing of tax proceeds between different levels of government in specified proportions.

Although some of these variants have been adopted in Australia, tax sharing in this country has usually involved relatively weak arrange- ments for policy co-ordination and, until 1976 a t least, these extended only to relatively minor taxes. In other federations, on the other hand, there has not only been widespread use of tax credits and piggy-back arrangements [as in Canada) or of constitutional tax sharing provisions (as in West Germany, Austria, Switzerland, and India); the shared taxes have also tended to be the most important sources of revenue, including income taxes, value-added taxes, and other forms of consumption taxes. Only the USA has shown as little interest in tax sharing as Australia.

2. It should be noted, however, that section 87 of the Constitution, the scwalled Brsddon Clause, was itself a factor impeding federation until the opposition of New South Wales was overcome by limiting the compulsory operation of the Clause to 10 years and giving the Commonwealth power under section 96 of the Constitution to make grants to the States. The latter power was intended to deal with what the January 1899 Premiers’ Con- ference described as “any exceptional circumstances which may from time to time arise in the financial position of any of the States”. Tax sharing and provision for what later came to be described as fiscal equalisation were thus directly linked in the Constitution.

17

In the case of fiscal equalisation, on the other hand, as a result of the work of the Commonwealth Grants Commission, Australia h'as developed the most sophisticated arrangements of any federal country. The special grants recommended by the Commission for payment to the financially weaker States were designed from the start to compensate for both shortfalls in revenue-raising capacity and additional costs of providing comparable services. With minor exceptions, no other federation has made any provision at all for expenditure disabilities, while revenue equalisation has been limited or partial.

For example, West Germany is the federation with the most compre- hensive tax sharing system, one which combines elements of vertical (federal-state-local) and horizontal (state-state and local-local) fiscal adjustments. However, even in this system the States with the highest fiscal capacity (Hamburg and Bremen) receive one-third to one-quarter more in taxation revenues per capita than the State with the lowest fiscal capacity (Bavaria) after all the equalisation adjustments have been made: Bavaria and the other seven States all receive approximately equal amounts in per capita terms after the adjustments.

Canada is the federation with the most highly developed system of revenue equalisation, one based on Federal grants to the Provinces to equalise revenue-raising capacity for some 30 Provincial revenue sources. But the equalisation is partial in the sense that, while low- capacity Provinces are equalised up to the national average, Provinces with above-average capacity are not equalised down. Furthermore, one of the most important sources of Provincial revenues-resource revenue- is partly insulated from the equalisation process. Some other federations provide equalisation payments on the West German or Canadian models, but the extent of equalisation is often limited to the modest effect of equal per capita grants from the federal government to the States. That is to say, no allowance is made for either differences in revenue-raising capacity in respect of own-source revenues or differences in expenditure needs. The USA makes no effective provision for fiscal equalisation at all. The result is that in no federal country other than Australia, including West Germany and Canada, is it possible for States or Provinces with relatively low fiscal capacity to provide services at standards com- parable to those provided by States or Provinces with high fiscal capacity, unless they are able to impose very much higher taxes and charges.

The Case for Systematic Fiscal Equalisation and Tax Sharing While most federal countries thus have more highly developed systems

of tax sharing than Australia, none has gone nearly so far in applying the principle of fiscal equalisation. Before we examine recent developments in Australia, it remains to review the case for systematic fiscal equalisation and tax sharing and for establishing institutional arrange- ments in which the application of the two concepts may be effectively integrated.

18

The case for fiscal equalisation in a federation rests on the value judg- ment that it is desirable for the citizens in all member states to have access to services of comparable range and quality, so long as the taxes and charges they pay are also of comparable severity. If equalisation adjustments are to have this effect, the governments of the member states must be compensated for differences in their capacities to raise revenues and differences in their costs of providing services. However, the purpose of the equaIisation adjustments is to make the provision of comparable services possible under conditions of comparable tax severity. It is the fiscal capacity of the governments of member states which is equalised; this form of fiscal equalisation is therefore often described as fiscal capacity equalisation.

There is a strong case for regarding fiscal equalisation as a crucial element in a federal system of government. This is because, while the capacity of member states to provide services is equalised, this does not require uniformity in taxing and spending decisions by state govern- ments. Fiscal capacity equalisation thus makes it possible to reconcile fiscal equality as between governments with diversity in levels and patterns of revenue raising and spending. Federal and state governments together can therefore be more responsive to the preferences of regional groups of citizens than is possible in a unitary country. In a very real sense, fiscal capacity equalisation enables the governments of a federal country to achieve the same equality of service provision and financing as the central government of a unitary country, with an additional degree of freedom in responding to the diverse needs and preferences of citizens.

The case for tax sharing depends in a similar way on the opportunities it provides for reconciling the diverse constitutional responsibilities of federal and state governments, in a manner that preserves their fiscal autonomy and their accountability to electors, with an effective means of co-ordinating their taxation policies. The federal government needs to have control over taxation revenues to the extent necessary to enable it to make redistributive tax-expenditure transfers to improve vertical equity as between individuals, to carry out its responsibilities for economic management, and to undertake expenditures on services such as defence for which it is directly responsible.

Likewise, state governments need flexible and buoyant revenue sources, at least at the margin, to enable them to carry out their constitutional responsibilities, which are mainly concerned with the direct provision of goods and services.

The case for tax sharing is linked with the need for horizontal equity, defined as the comparable tax-expenditure treatment of governments on the one hand and of comparable individuals on the other. The taxation arrangements in a federal country therefore need to make provision for intergovernmental fiscal equalisation in a manner that is consistent with horizontal equity for individuals. One of the principal advantages of a tax sharing system between federal and state governments is that it can be

19

easily combined with a closed-ended system of fiscal equalisation, by providing for a distribution of part of the shared revenues among the several state governments on a basis that fully reflects their relative revenue-raising capacities and expenditure needs.

Finally, the co-ordination of taxation policies, through tax sharing arrangements involving uniform assessment and collection provisions, will facilitate tax administration and reduce compliance costs for taxpayers. By minimising the extent of intergovernmental tax com- petition, also, tax sharing will eliminate one of the most important avenues of tax avoidance and reduce the incentives for inefficient shifts in the pattern of productive activity.

All this suggests the desirability of a formal agreement for co- ordinating taxation policies and sharing revenues in a federal country such as Australia, at least in respect of one of the main revenue sources such as personal income taxes. The principal characteristics of such a system will be: uniform assessment and collection arrangements; the retention of a specified proportion of base collections by the federal government for its own purposes; the distribution of a specified proportion of base collections among state governments on a fiscal equalisation basis; the right of the federal government to impose non- shared percentage surcharges or grant rebates for economic manage- ment purposes; the right of individual state governments to impose percentage surcharges a t rates of their own choosing; and a binding requirement that the two levels of government will jointly determine the provisions governing the basic tax rate and the structure of the revenue base.

Tax Sharing in Australia: Prospectus and Performance In 1976, it seemed that a tax sharing system along these lines was to be

established in Australia, thereby bringing to an end the highly centralised fiscal arrangements which had operated since the introduction of uniform income tax in 1942 and the concomitant loss of State fiscal autonomy and responsibility. The new Liberal-National Country Party Government had indicated its intention to implement a new federalism policy designed to achieve "co-operation not conflict, partnership and not domination", and to redistribute powers among Commonwealth, State and local governments so as to provide a barrier against "centralist authoritarian control".

The key element in the design of the new federalism policy was to be a system of sharing personal income taxes with state governments. In particular, while uniform assessment and collection arrangements were to continue, tax sharing entitlements amounting in total to 39.87% of collections in the previous year3 were to replace the formula-determined financial assistance grants which the Commonwealth had been making to

3. In 1976177 and 1977/78, the States' share was 33.6% of collections in the current year.

20

the States under the uniform tax arrangements. Provision was made for special Commonwealth surcharges or rebates which would not affect the shared revenue base. Individual States were to be permitted to impose surcharges on [or grant rebates to) their own citizens if they so wished. In one of the 35 Points of Understanding between the two levels of govern- ment about how the new system was to operate, the Commonwealth gave “a firm assurance” that it would keep the States fully informed of tax changes and their effects on State entitlements; that it would consider, in consultation with the States, adjustments to offset the effects of Commonwealth budget changes on State entitlements; that it would join with the States in reviewing changes in the tax legislation affecting the States; and that longer-term changes in the structure of taxes would be kept under notice between the two levels of government.

Fiscal equalisation arrangements were to be strengthened as an essential element of the new tax sharing system. The four less populous States were to remain eligible for special financial assistance through the Commonwealth Grants Commission, while anv income tax surcharges imposed by those four States were also to be subject to equalisation through the Grants Commission. But the per capita tax sharing relativities of all six States, which were based on the distribution of financial assistance grants in the last year of the old arrangements (1975/76), were to be the subject of periodical reviews by the Grants Commission. The first such review was to be completed by 30 June 1981, at the same time as the first major review of the tax sharing arrange- ments as a whole. The Commonwealth and State governments were to agree well in advance on the procedures which were to be followed for this general review.

The new arrangements also included: a guarantee that during the first four years of the tax sharing system no State’s entitlement would fall below the amount it would have received under the old financial assis- tance grants arrangements: an indication that there was to be reduced emphasis on specific purpose grants, with provision for absorption of such grants in tax sharing entitlements in appropriate cases; provision for local government tax sharing grants; an indication that the Premiers‘ Conference would have an enhanced co-ordinating role in fiscal arrange- ments: and the establishment of an Advisory Council for Intergovernment Relations as a means of improving intergovernmental co-operation.

After six years of the new arrangements, it is clear that they do not meet the requirements of an effective tax sharing system as specified above. Far from increasing State fiscal autonomy and responsibility, they have increased the degree of Commonwealth control over State finances and hence the centralisation of the Australian public finances considered as a whole. The Commonwealth has continued to make unilateral decisions about the shared revenue base and the structure of the income tax system, the general effect of which has been to reduce State entitlements except to the extent that guarantee provisions operated

21

during the years 1976/77 to 1980/81.‘ The major review of the tax sharing arrangements which was to be completed by 30 June 1981 merely took the form of an announcement by the Commonwealth that the arrangements were to be drastically changed and State entitlements reduced for the four years 1981182 to 1984185. As noted below, the Commonwealth also made unilateral decisions about the tax sharing relativities of the States following the Grants Commission’s 1981 review and a second review which the Commission was required to undertake by 31 May 1982, the net effect of which was to abandon fiscal equalisation altogether.

The Commonwealth had earlier not consulted the States about the effect on State entitlements of changes in the rate structure, the spasmodic introduction and withdrawal of personal income tax indexa- tion, and changes in health insurance arrangements. In 1981, the year in which the tax sharing arrangements generally were supposed to be reviewed, it made a series of unilateral decisions which effectively brought all pretence of joint consultation and policy co-ordination to an end. As part of a new system of health funding, the Commonwealth announced that the hospital cost sharing grants, community health grants, and school dental grants which it had been making to the States and the Northern Territory were to be replaced by so-called identified health grants, which would eventually be absorbed in the tax sharing grants. Because the hospital cost sharing agreements with South Australia and Tasmania were not due to expire until 30 June 1985, the identified health grants in those States were to replace only their community health and school dental grants in the first instance; those States continued to be eligible for hospital cost sharing grants under the old arrangements until their agreements expired. As part of the new health funding arrangements, the Commonwealth specified that all persons who could afford to pay for hospital services should do so from 1 September 1981, after which the identified health grants for the Northern Territory and the four States other than South Australia and Tasmania would be reduced by the estimated amounts of the revenue which could be collected on the basis of charges specified by the Commonwealth.

Further unilateral decisions affecting the States were made by the Commonwealth following the Review of Commonwealth Functions in 1981, when the Commonwealth decided to terminate a number of specific pur- pose programs and transfer full financial responsibility for those programs to the States. Although general purpose grants were increased in 1981/82 by amounts in lieu of the specific purpose grants which were terminated, and although a number of other special additions were made to general revenue grants in that year, the Commonwealth arbitrarily held the increase in the States’ tax sharing grants in 1981/82 to 9%

4. The guarantee which operated in 1980/81 was not related to the financial assistance grants arrangements as in the previous four years, but provided that no State would receive less in real terms in 1980/81 than in 1979/80.

22

without the special additions, and 11.4% with the additions. Under the old tax sharing legislation, the increase would have been 16.6%. Finally, the Commonwealth decided that, after 1981182, total Commonwealth tax collections in the previous year would replace personal income tax collections as the shared revenue base, the States’ proportion to be determined by relating the arbitrarily determined grants in 1981182 to total tax collections in 1980/81. This was a matter on which the States themselves had been divided.

In all these ways, the Commonwealth was exercising control over State revenues in a manner that was quite inconsistent with the professed objectives of the tax sharing arrangements. By this means and through its domination of the Australian Loan Council, the Commonwealth now effectively determined both the total level of funds available to the States each year and the distribution of those funds among the States. Signifi- cantly, the 1981 legislation referred to the general revenue grants as tax sharing grants rather than tax sharing entitlements. The decisions taken a t the June 1982 Premiers’ Conference underlined this control, when the Commonwealth effectively made deductions from the tax sharing funds to assist in meeting the Commonwealth’s own guarantees that no State would receive an increase in real terms of less than 2% in 1982183 and 1% in each of the next two years.

Although the States retained the right to impose personal income tax surcharges or grant rebates, this right could not be exercised. This was partly because the Commonwealth had never made tax room for the States by reducing its own rates, and partly because personal income taxes were already very high for those taxpayers-mainly wage and salary earners-who could not avoid or evade them. The effect of the Commonwealth’s tight control over grants and loan allocations, combined with a reluctance on the part of the States to adjust their own taxes and charges, has meant that the Commonwealth is now in a position to exercise the same kind of expenditure control over individual State governments as over its own departments and instrumentalities.

Apart from their failure to restore State fiscal responsibility and accountability, the tax sharing arrangements have operated in such a way as to inhibit the Commonwealth’s economic management and income distribution policies, despite the fact that these are areas in which a centralised financing system is supposed to have substantial advantages.

The Commonwealth’s stopgo policies on personal income tax indexa- tion have caused State tax sharing funds to fluctuate from year to year, not in accordance with economic conditions and financial needs so much as with decisions taken by the Commonwealth Government for political reasons. As one aspect of this, the role of personal income tax indexation has been turned on its head during recent years. In the Prime Minister’s own words, the case for tax indexation depends principally on the need to keep governments honest, by making them legislate for tax changes instead of relying on the interaction of inflation and a progressive rate

23

structure to provide automatic increases in tax yields. However, the present Governments has used tax indexation as an overt political device by twice promising before elections to introduce it and by abolishing it as soon as possible thereafter.

One consequence of this has been to increase the overall weight of income taxation in general and, because of the widespread opportunities for tax avoidance and evasion by other income recipients, the share of taxes paid by wage and salary earners and other low income groups in particular. As a result of the main burden of taxation being imposed on wage and salary earners, there is an inherent contradiction in the Commonwealth Government’s policies of controlling inflation through expenditure restraint, acceptance of high levels of unemployment, and resistance to wage pressures. This is partly because expenditure restraint would be unnecessary and unemployment could be alleviated if the Government were to take effective action to increase its revenue collections from non-wage-and-salary earners. But it is also attributable to the fact that the Government’s taxation policies lead directly to increased wage demands, the aspect of anti-inflation policy which is most difficult for the Government to control.

In addition to the inflationary consequences of concentrating taxation on wage and salary earners, the highly centralised taxation system has resulted in major distributional shifts in favour of the rich and to the disadvantage of low income groups generally. It is not an exaggeration to say that the combination of a voluntary income tax and a capital tax shelter which extends even to death duties, together with the absence of a broad-based consumption tax, has made Australia one of the world’s most charitable tax havens for the rich capitalist, and probably the only one in an economically advanced country.

While the Commonwealth Government’s tax sharing arrangements must bear a major share of the responsibility for this state of affairs, it is only fair to add that State governments have contributed, for example, by abolishing death duties, and that rationalisation of the taxation system has been impeded by the Labor Opposition. There seems to be a perverse conspiracy between government and opposition parties to throw the whole burden of taxation on to wage and salary earners, the former by opposing capital taxes of any kind and the latter by opposing broad-based indirect taxes. The only matter on which they seem to agree is in a naive belief that the disintegrating income tax system can be made to work by plugging tax avoidance and evasion loopholes.

The Reviews of State Tax Sharing Relativities The other major element in the tax sharing arrangements was the

requirement that the distribution of the States‘ total tax sharing

5. Liberal-National Party Coalition in office until 6 March 1983, when Australian Labor Party won government in general election.-Ed.

24

entitlement should be periodically reviewed, in the first instance by 30 June 1981. As noted above, the existing distribution had been derived from the per capita relativities of the old financial assistance grants. These were applied to State populations to derive adjusted population figures, which in turn determined the respective State shares. It will be seen from Table 1 that the per capita relativities which were specified in the 1976 tax sharing legislation, expressed a s a ratio of a Victorian figure of unity, ranged from 1.027 for New South Wales to 2.002 for Tasmania; this meant that for every $1 per head of population which Victoria received by way of tax sharing grants, New South Wales was entitled to $1.027 and Tasmania to $2.002.

These represented a substantial shift from the relativities which had been adopted in the Constitution as the basis of sharing customs and excise duties. Those relativities mainly reflected the respective contributions of the States to the total duties collected, although it was expected that eventually an equal per capita distribution would be adopted. The idea of an equal per capita distribution was later incor- porated in the general revenue grants which the Commonwealth made to the States from 1910111 to 1926/27. The tax reimbursement grants which the States received after the introduction of the uniform income tax legislation in 1942 initially reflected the actual collections of the States in the two preceding years when they had raised their own taxes. However, by 1957/58 the distribution had come to reflect population adjusted for differences in demographic structure and population density; it was very close to an equal per capita distribution. This was modified to the extent that the Commonwealth made special grants to three scwalled claimant States (South Australia, Western Australia, and Tasmania), on the recommendation of the Grants Commission, to compensate them for their lower revenue-raising capacity and higher costs of providing services relative to those of the other three States.

This position was changed in 1959, when financial assistance grants replaced the tax reimbursement grants and South Australia’s financial assistance grant was arbitrarily increased to enable it to withdraw from claimancy. This action set the pattern for subsequent years, as the distribution of the financial assistance grants began to depend on all kinds of ad hoc adjustments, often made for political reasons. This meant that the distribution came to reflect neither population nor the relative fiscal needs of the six States. On four occasions (including 1959), Commonwealth and State governments of the same political party (twice non-Labor and twice Labor) effected special financial deals which enabled the three less populous States to withdisw from claimancy (South Australia twice, Western Australia and Tasmania once each). When the Commonwealth began to make large specific purpose grants to the States on a basis that had no regard to their relative fiscal capacities or needs, especially in the education, health, and welfare fields, this further increased fiscal inequalities among the six States. As a result,

25

TABL

E 1

GR

AN

TS C

OM

MIS

SIO

N’S

REL

ATI

VIT

IES

AN

D N

EED

S A

SSES

SMEN

TS, 1

981

REPO

RT

Nee

ds p

er

Stat

e Ta

x Sh

arin

g St

ate

Shar

es o

f C

apita

R

elat

iviti

es

Tot

al E

ntitl

emen

ts

Ass

esse

d Needs

per

Cap

ita @

J A

risi

ng

Stan

- fr

om

dard

ised

Sp

ecifi

c D

efic

its

Gro

nts

Cap

lta

Ass

esse

d A

sses

sed

Bus

ines

s Pu

rpos

e pe

f by

Com

- by

Com

- Ex

pend

i- U

nder

- 19

76 A

ct

m’s

sion

(oJ

1976

Act

m

issi

on(a

J R

even

ue

ture

ta

king

T

otal

Ib

XeJ

M

VO YO

$

$ $

$

$ $

N

New

Sou

th W

ales

1.

0274

0 1.

048

30.6

45

32.4

34

-24.

39

-20.

79

-1.4

5 -4

6.63

-2.83

330.

56

Q,

Vic

tori

a 1.

0000

0 1.

000

22.6

86

23.5

40

-9.1

4 -3

9.34

-2

.75

-51.

23

8.44

33

7.22

Q

ueen

slan

d 1.

3908

5 1.

487

17.9

50

19.9

12

8.87

52

.76

19.1

9 80.83

13.3

0 47

4.11

So

uth

Aus

tral

ia

1.52

676

1.31

9 11

.652

10

.445

72

.60

24.7

9 -1

9.73

77

.66

-6.6

1 45

1.04

W

este

rn A

ustr

alia

1.

6651

6 1.

284

12.1

44

9.71

6 -1

6.48

69

.25

19.3

1 72

.09

-28

.80

42

3.29

T

asm

ania

2.

0018

8 1.

549

4.92

3 3.

953

52.8

8 13

3.94

-5

2.86

13

3.95

-6

.90

507.

05

Six

Stat

es

100.

000

100.

000

331.

81(c

) 72

9.25

(c)

92.2

8(c)

51

3.33

(d)

133.

32(c

) 37

8.97

(c)

Not

es:

(a)

Ave

rage

of

year

s 19

77/7

8 to

197

9/80

. (b

) 19

7918

0.

(c)

Stan

dard

per

cap

ita a

mou

nt.

(d)

Stan

dard

def

icit.

(e

) Po

sitiv

e si

gn m

eans

spe

cifi

c pu

rpos

e gr

ants

wer

e be

low

sta

ndar

d ne

gativ

e si

gn m

eans

gra

nts

exce

eded

sta

ndar

d.

Sour

ce:

Com

mon

wea

lth G

rant

s C

omm

issi

on.

Rep

ort o

n St

ate

Tax

Shar

ing

Entit

lem

ents

198

1: V

olum

e I-

Mai

n R

epor

t, T

able

s 8-

3. 8

6. 8

-10,

AG

E. C

anbe

rra,

19

81.

whether a State sought special financial assistance through the Grants Commission began to depend on its relative share of other Commonwealth grants at least as much as on its relative financial needs. By 1976, when the Commonwealth Government’s new tax sharing legislation was adopted, only Queensland was a claimant State even though it was certainly not the State with the lowest fiscal capacity.

The review of tax sharing relativities was intended to establish a systematic basis for fiscal equalisation by means of the first comprehen- sive inquiry into the relative financial positions of all six States which has ever been undertaken in Australia. In the event, the review proved to be the most ambitious fiscal equalisation study which has ever been attempted in a federal country. The Commission’s reports, the sub- missions of the States and the Commonwealth Treasury, and the Com- mission’s working papers constitute a major reference source about the detailed working of the Australian public sector.

In view of the subsequent criticism by the three less populous States of the Commission’s findings, i t is perhaps necessary to point out that they themselves must have been in no real doubt that, as a result of a relatively favourable distribution of the tax sharing grants and, in some cases, specific purpose grants, they were in effect being over-equalised by 1976. Not only were they no longer seeking special financial assistance through the Grants Commission, but they successively opposed the idea of a relativities review at all, sought to have it carried out by a body other than the Grants Commission, attempted to modify the terms of reference to require the Commission to consider matters other than the fiscal equalisation principle in making its findings, and during the inquiry argued for departures from the application of the fiscal equalisation principle.

The terms of reference for the 1981 relativities review were adapted from the Commission’s own long-standing principle of fiscal equalisation. They required the Commission to advise on whether any change was desirable in the State per capita tax sharing relativities which had been specified in the 1976 legislation, on the basis of the principle that each State’s tax sharing entitlements should enable it to provide, without imposing taxes and charges at levels appreciably different from those of other States, government services at standards not appreciably different from those of other States.

In carrying out its task, the Commission had to resolve a large number of methodological issues, and a major part of the inquiry was concerned with the arguments of the States and the Commonwealth Treasury about these issues. The debate was carried on through a series of conferences and hearings, as well as in the written submissions of the States and the Commonwealth Treasury and the responses by other parties to those submissions. Detailed arguments about relative revenue and expenditure needs, in each of the categories distinguished by the Commission in standard budgets which it prepared for each State for the three years of

27

the review period (1977/78 to 1979/80), followed the same pattern, and were supported by wide-ranging inspections by the Commission in each of the States.

Subject to a number of minor qualifications which proved in the event to be not very significant, the distribution model adopted by the Commission was acceptable to all the States and the Commonwealth Treasury. It took the form of what was called a standardised deficit distribution model, whereby each State's per capita share of the total amount available depended on the excess of its standardised per capita expenditure over its standardised per capita revenue. A State's stan- dardised per capita expenditure was defined as the sum of standard per capita expenditure (a population-weighted six-State average) and its per capita expenditure needs, which were its differential costs of providing standard services. A State's standardised per capita revenue was defined as the standard per capita revenue less the State's revenue needs, defined as its differential revenue-raising capacity relative to standard. Expenditure and revenue needs could be positive or negative.

Again very approximately, a State's per capita share of the total State entitlements could be calculated in an alternative but equivalent manner, as the sum of an equal per capita share of the amount available plus the State's per capita revenue and expenditure needs.

Among the major methodological issues, many of which were strongly contested, were the choice of equalisation standard, the range of expenditures, revenues and business undertaking results to be included in the standard budget, the review period, the population measure, the treatment of specific purpose grants, the factors to be taken into account in assessing expenditure needs, the choice between a global and a tax-by- tax approach to the measurement of revenue needs, the method of assess- ing relative needs in relation to resource revenues, and a number of proposals for departures from fiscal equalisation, involving for example the treatment of the benefits which South Australia and Tasmania received when they transferred their railway systems to the Common- wealth in 1975.

The Commission found that a change in the State per capita relativities was desirable and presented assessments of relativities which it said would reflect the fiscal equalisation principle specified in its terms of reference. Contrary to public belief, the Commission made no recommen- dations in either the 1981 or the 1982 Reports. The results of the Commission's relativities and needs assessments are summarised and compared with the existing relativities in Table 1, from which it may be seen that, although the three less populous States were assessed as having very large positive needs, the application of the relativities assessments would have resulted in a significant redistribution from those three States to New South Wales, Victoria, and Queensland.

In the face of strong opposition to the Commission's assessments by the three less populous States and after a most cursory consideration of the

28

Commission’s Report a t a Premiers’ Conference in June 1981, decisions on the Commission’s findings were deferred for a year and the Commission was asked to present a further report by 31 May 1982 in the light of additional Commonwealth and State submissions and incorporating data for another year 1980/81. Meanwhile, the Commonwealth agreed to pro- vide additional grants amounting to $60 million in total to New South Wales, Victoria, and Queensland for 1981/82 as part of whatever total contribution the Commonwealth might subsequently make to facilitate adjustments to new relativities.

The terms of reference for the 1982 Review were delayed, muddled, and confusing. They were not received by the Commission until October 1981, by which time four of the 11 months available for the inquiry had already lapsed; the three additional members of the Commission, whose appointments had lapsed on 30 June 1981 a t the conclusion of the 1981 Review, were not reappointed until the end of January, four months before the Commission’s Report was due.

The terms of reference were muddled and confusing because of the decisions to combine a review of the distribution of the new identified health grants with the review of tax sharing relativities in a way that neither clearly integrated the two forms of grants nor clearly separated them: and to include the Northern Territory in the health grants relativities but not in the tax sharing relativities. In the letter transmitting the terms of reference, the Commission was also asked to consider the implications of underlying trends in the relative positions of the States; and to indicate the effects of using various alternative methods of assessing needs which the interested parties might propose, including the effect of adopting a different treatment of the budgetary gains made by South Australia and Tasmania when they transferred their railway systems.

The inclusion of the health grants in the inquiry posed a special problem for the Commission. This was partly because the effect of the new health arrangements on State finances, especially the new charges for hospital services, could not be determined by the time of the Report: and partly because it became necessary for the Commission to simulate, by means of a n artificial backcasting procedure, the financial positions of the States during the review period 1977178 to 1980181 on the basis of health funding arrangements which did not begin to operate until September 1981. There were other data problems associated with the inclusion of the year 1980/81 in the review, arising mainly from the fact that important demographic data from the 1981 Census were not avail- able before the Report was completed.

The 1982 Review itself followed much the same pattern as the 1981 Review and the Commission decided to adopt the same distribution model. Apart from the complications resulting from the new health funding arrangements and issues relating to the choice of review period and the treatment of trends and transient factors, the methodological issues

29

remained much the same as in the 1981 Review. The Commission eventually decided to adopt a four-year review period, taking the average of the results of the four years 1977/78 to 1980/81.

The principal assessments in the Commission’s 1982 Report are pre- sented in Table 2. This also shows the implied effects which the assessments would have had in 1981182 on the distribution of tax sharing and health grants among the six States, and the relativities determined at the June 1982 Premiers’ Conference. Table 3 shows the relative revenue efforts and service levels which were implied by the Commission’s assess- ments.

It will be seen that the 1982 assessments implied smaller gains for New South Wales and Victoria by comparison with the existing relativities and a larger gain for Queensland than had been implied by the 1981 assess- ments. They also implied lesser, unfavourable shifts for South Australia and Western Australia, while leaving Tasmania in much the same position. The main reasons for the changes as between the two sets of assessments were: first, changes in methodology and data affecting needs assessments, involving among other things the longer review period and new procedures for assessing revenue, expenditure, and business under- taking needs for some categories; the changes in the health funding arrangements: and revisions to State populations following the 1981 Census (these accounted for $42 million of the increase in Queensland’s assessed share and contributed substantially to the fall in the New South Wales and Victorian shares).

The Demise of Fiscal Equalisation: Post-Mortem In both the 1981 and 1982 Reports, the Commission recognised the

difficulties for State budgets which would result from the application of its assessments, and referred to a number of possible ways of moving from the existing tax sharing relativities to new relativities based on fiscal equalisation. However, it emphasised that the implementation of its assessments was a political matter which fell outside its terms of reference.

In the light of the strong criticism by some States of the Commission’s assessments, it is perhaps necessary to point out that the whole basis of the two Reviews was to establish relativities and not to determine the amounts of tax sharing funds which the States should receive collectively or individually. This also is a political decision. In particular, the Commission did not say or imply that funds should be taken away from some States and given to others. What could be inferred from the assessments was that, if the tax sharing grant received by, say, Tasmania was necessary for that State to perform its functions adequately, increased grants were necessary for the other States in varying propor- tions if they were to be able to provide comparable services without imposing higher taxes and charges. The figures in the last two columns in

30

TABL

E 2

GRA

NTS

CO

MM

ISSI

ON

’S A

SSES

SMEN

TS, 1982

REPO

RT, A

ND

PRE

MIE

RS’ C

ON

FERE

NCE

DEC

ISIO

NS

Tax

Shar

ing

in S

tate

Tax

R

elat

iviti

es

Shar

ing

and

Det

erm

ined

at 1982

Impl

ied

Cha

nges

Stat

e Sh

ares

of

Tax

Shar

ing

and

Stat

e Ta

x Sh

arin

g R

elat

iviti

es

Hea

lth G

rant

slcj

H

ealth

Gra

nts@

) Pr

emie

rs’ C

onfe

renc

e

Mod

ified

Co

m-

mis

sion

’s

Ass

umed

St

ate

1982

Effe

ctiv

e A

sses

sed

Ass

esse

d 1981

1982

Popu

la-

1981

1982

Ass

ess-

R

elat

iviti

es

Exis

ting

198l

(a)

19821b)

Exis

ting

Rev

iew

R

evie

w

tions

[dj

Rev

iew

R

evie

w

men

ts[e

j 1984/8slf)

~~

~~

YO YO

YO YO

$m

$m

Oh

%

N

ew S

outh

Wal

es

1.02740

1.048

1.018

31.709

33.361

32.207

35.851

+ 129.0

+38.9

1.018

1.018

2 V

icto

ria

1.00OOO

1.000

1.000

22.856

23.674

23.258

27.015

+63.9

+31.4

1.000

1.000

Que

ensl

and

1.39085

1.487

1.531

17.430

18.879

19.535

16.234

+ 113.1

+ 164.3

1.535

1.535

Sout

h A

ustr

alia

1.52676

1.319

1.402

11.197

10.116

10.554

9.020

-84.4

-50.2

1.455

1.474

Wes

tern

Aus

tral

ia

1.66516

1.284

1.368

12.110

10.145

10.631

8.964

- 153.4

- 115.4

1.373

1.494

Tas

man

ia

2.00188

1.549

1.589

4.699

3.825

3.815

2.916

-68.2

-69.0

1.646

1.901

Six

Stat

es

100.000

100.000

100.000

100.000

Not

es:

[a] A

vera

ge 1977/78 to

1979180.

[b]

Ave

rage

1977178 to

1980/81: a

ssum

es h

ealth

gra

nts

dist

ribu

ted

on b

asis

of 1981 A

ct.

[c)

Impl

ied 1981182.

(d) E

stim

ated

31

Dec

embe

r 1981.

[e)

Com

mis

sion

’s 1982

asse

ssm

ents

[as

in c

olum

n 3)

mod

ified

to

pres

erve

hos

pita

l co

st s

hari

ng b

enef

its f

or S

outh

Aus

tral

ia a

nd T

asm

ania

. (f

J R

elat

iviti

es im

plic

it in

1984/85 di

stri

butio

n on

bas

is o

f ph

asin

g in

of

mod

ified

rel

ativ

ities

ove

r th

ree

year

s su

bjec

t to

guar

ante

es,

and

assu

mpt

ions

th

at t

ax s

hari

ng g

rant

s w

ill i

ncre

ase

by 16%, 13.3%, a

nd 13.3% i

n ye

ers 1982183

to 1984/85: a

nd th

at i

nfla

tion

rate

s w

ill b

e 10.2%. 10.1%, a

nd

10.1%

resp

ectiv

ely.

So

urce

: C

omm

onw

ealth

Gra

nts

Com

mis

sion

, Rep

ort o

n St

ate

Tax

Shar

ing

and

Hea

lth G

rant

s 19

82: V

olum

e I-M

ain

Rep

ort,

Tab

les 74. 7-7, AG

PS. C

anbe

rra,

1982.

TAB

LE 3

IMPL

IED

STA

TE R

EVEN

UE

EFFO

RTS

AN

D S

ERV

ICE

LEV

ELS,

197

7/78

TO

198

0/81

(0]

per

cent

Imol

ied

Rev

enue

Eff

orts

fbl

Imol

ied

Serv

ices

Lev

elsf

cl

Law

, Ord

er

Tot

al

Bus

ines

s T

ax

Ter

rito

rial

T

otal

an

d Pu

blic

So

cial

O

ther

U

nder

- T

otal

R

even

ue

Rev

enue

fd)

Rev

enue

E

duca

tion

Hea

lth

Safe

ty

Serv

ices

E

xpen

ditu

re

taki

ngs

Exp

endi

ture

~~

New

Sou

th W

ales

10

4.6

106.

0 10

4.8

97.5

10

2.3

100.

6 99

.1

99.0

12

2.3

102.

0 V

icto

ria

107.

7 87

.9

104.

5 11

0.2

100.

2 86

.4

104.

4 10

8.6

98.7

10

4.3

Que

ensl

and

80.2

93

.1

82.4

82

.8

74.4

92

.5

80.6

94

.1

79.4

82

.6

Sout

h A

ustr

alia

98

.9

132.

2 10

1.9

110.

7 10

1.0

119.

2 11

0.0

90.4

86

.2

104.

4 W

este

rn A

ustr

alia

86

.2

111.

5 90

.9

93.4

13

2.6

104.

3 10

8.4

97.0

77

.0

102.

3 T

asm

ania

93

.8

92.5

93

.6

113.

7 10

5.4

154.

9 11

4.7

98.5

65

.9

108.

7

Six

Sta

tes

100.

0 10

0.0

100.

0 10

0.0

100.

0 10

0.0

100.

0 10

0.0

100.

0 10

0.0

Not

es:

(a)

The

se r

epre

sent

the

sim

ple

aver

age

of th

e fi

gure

s ca

lcul

ated

for

the

fou

r ye

ars

1977

178

to 1

9801

81.

(b)

Act

ual

reve

nue

as p

erce

ntag

e of

stan

dard

ised

rev

enue

. (c

) A

ctua

l ex

pend

itur

e as

per

cent

age

of st

anda

rdis

ed e

xpen

ditu

re.

(d)

Incl

udin

g in

tere

st e

arni

ngs.

So

urce

: C

omm

onw

ealth

Gra

nts

Com

mis

sion

. Rep

ort o

n St

ate

Taw

Sho

ring

and

Hea

lth G

rant

s 19

82: V

olum

e I-

Mai

n R

epor

t; V

olum

e 11

-App

endi

xes

and

Rep

orts

of

Con

sulta

nts,

AG

PS, C

anbe

rra,

198

2.

Table 2 suggest that, on the basis of the Commission's assessments of standardised revenues and expenditures for each State, New South Wales and Victoria were imposing higher levels of taxation than the other four States in 1980/81; and that Queensland was providing significantly lower levels of service than the other five States.

It follows that the question of tax sharing relativities or horizontal fiscal balance cannot be divorced from the question of vertical fiscal balance or the division of tax revenues between the Commonwealth and the States in general. One might therefore have expected a response from the Commonwealth which accepted a significant degree of financial responsibility for easing the transition from one set of relativities to another.

Presumably because of its obsession with the need for expenditure restraint, this was not to be. As though to emphasise the fact noted above, that co-operation has been abandoned in favour of centralised Common- wealth control, the Commonwealth responded to the Commission's 1982 Report by making a unilateral announcement about the decisions which were to be taken. The Commonwealth's proposals, which seemed to be non-negotiable, were not handed to the States until the first morning of the June 1982 Premiers' Conference, and it is doubtful whether their implications could be fully grasped without much more information than was made public during and after the Conference. At a time when there is mounting pressure for governments to become more accountable for their actions, it must be a matter of regret that so little information is provided about Premiers' Conference and Loan Council decisions, which have a greater financial impact on the lives of all Australian citizens than almost any other single event.

The Press Release by the Treasurer after the Conference stated that the Conference had accepted the Commonwealth's proposals. It was said in the Press Release that, under these proposals, the Commission's relativities would be phased in over the three years 1982183 to 1984185, subject to a modification to the assessed relativities to enable South Australia and Tasmania to retain the full benefit of their hospital cost sharing grants. The phasing in was to be accompanied by a guarantee that each State's tax sharing grant would be increased by 2% in real terms in 1982183 and by 1% in real terms in each of the next two years. However, the guarantee was to be funded not by the Commonwealth but by the States themselves, by effectively setting aside $149 million from the tax sharing pool. Of this amount, $70 million represented the escalated value of the additional grants of $60 million made to New South Wales, Victoria, and Queensland in 1981/82, which themselves had been financed from an arbitrary reduction in the growth of the tax sharing grants in that year; while $79 million represented the value of the benefits of the South Australian and Tasmanian railway transfers. As a result of these guarantees, the States assessed as needing additional grants were

33

themselves required to assist the States assessed as being over-equalised, while the Commonwealth made no additional financial contribution of its own.

The statement that the Commission’s relativities will be phased in over three years was not correct. Even on the Commonwealth Treasurer’s own figures, as a result of the guarantee arrangements there will be very little real movement towards the Commission’s assessed relativities by 1984/85. In Tasmania’s case, for example, its tax sharing relativity to Victoria will have proceeded only from the existing figure of 1.98592 to 1.9010, when the modified Commission’s relativity is 1.646 (see Table 2). But in any case, the extent to which phasing-in occurs is dependent on the assumptions which the Commonwealth has made about the rate of growth of tax collections (which it can control after 1982/83, when it is estimated to be 16%) relative to the increase in the Consumer Price Index (CPI). If the CPI were to increase by, say, 14% in 1982/83, for example, even New South Wales and Victoria could be subject to the guarantee and there would be no change in their relativities to the three less populous States. If the increases in tax collections in 1983/84 and 1984185 were to be less than 1% above the increases in the CPI in those years, the same result would occur. There is no indication in the Press Release whether the Commonwealth will fund the guarantee if this should be necessary, and it must be remembered that the Commonwealth can unilaterally determine the rate of increase in tax collections.

Although the original Commonwealth proposal to the Premiers’ Con- ference asked for views from the Premiers about whether there should be further relativities reviews along lines indicated by the Commission, there was no reference to this in the Treasurer’s post-Conference Press Release. Indeed, if the Commonwealth’s commitment to a further major review were to be as weak as its response to the 1981 and 1982 Reviews, there would seem to be little point in undertaking such a project. A condition of the Commonwealth’s proposal, which was said to be accepted by the Premiers’ Conference, was that no special grants will be paid during the phasing-in period. It therefore seems that not only is fiscal equalisation a lost cause in relation to the distribution of the tax sharing grants, but that it is being abandoned in its traditional form in Australia except insofar a s the Grants Commission still has a role to play in relation to the Northern Territory, the Australian Capital Territory, and local government. As of this moment, there is no effective provision for fiscal equalisation among the States for the first time for 50 years.

Conclusion There are several puzzling aspects about the response of the different

governments to the Commission’s Reports. In the case of the Commonwealth, one wonders why it initiated two such comprehensive, costly, time-consuming, and exhaustive inquiries, which it must have done

34

in full knowledge of the political difficulties of implementing changes in relativities, if it were not prepared to carry the process through to its logical conclusion.

In the case of South Australia, Western Australia, and Tasmania, one wonders why they concentrated their attacks on the Commission itself instead of joining with the other States in seeking additional Common- wealth funds to ease the transition. While they might understandably have been disappointed with the Commission’s assessments, they should have been in no reasonable doubt that shifts in relativities were indicated by the data. While a different body of Commissioners working with a different staff might well have formed different judgments and made different assessments, any such changes would almost certainly involve swings and roundabouts. All six States could point to Commission decisions which adversely affected their relative positions to a significant degree. Despite the uncertainties and data limitations, one of the principal lessons to emerge from the two Reviews was that the effect of the Commission’s judgments on its needs assessments tended to be over- shadowed by the extreme volatility of some of the underlying revenue and expenditure bases and disability factors. This volatility depended, in turn, not only on a State’s own fiscal capacity and fiscal performance but also on what was happening in other States. It was, above all, a matter of relativities.

In the case of New South Wales, Victoria, and Queensland, there are two puzzles. First, why did they not join with the other States in pressing for a vertical as well as a horizontal financial adjustment, as suggested above? Second, why did they accept the Commonwealth’s proposals when, by rejecting them, they would have been free under existing legislation to apply for special grants through the Grants Commission, the cost of which would be borne not by the other States but by the Common- wealth itself? On recent trends, South Australia might also have been better off if it had left its options open in this respect.

A possible answer to all these puzzles is that the several governments may have seen short-term political advantages in the positions they adopted. If this is indeed the reason for what appears to have been the abandonment of fiscal equalisation in Australia, the principal losers are the federal system itself, the democratic process, and the people of all States. The level of financial assistance received by all States should be based on the systematic evaluation of their revenue and expenditure needs, and not on whether there is a political affinity between Common- wealth and State governments. Tax sharing and fiscal equalisation are capable of making an important contribution to the goals of economic efficiency, diversity and responsiveness in government, and distribu- tional equity, and should not be sacrificed on the altar of short-term political expediency.

35