ISSUES IN AUSTRALIAN FEDERALISM

ISSUES IN AUSTRALIAN FEDERALISM*

RUSSELL MATHEWS

1. INTRODUCTION It is appropriate that the subject of this paper should be Australian

federalism, because Professor Mills more than any other person determined the direction and shape of the Australian federal system during and after World War 11. It was very largely his influence that led, following the recommendations of the Committee on Uniform Taxation which he chaired,' to the introduction of uniform income taxation and the system of general revenue grants which dominated Commonwealth- State financial relations after 1942. It was Mills and his colleagues on the Grants Commission who changed the basis of special (equalisation) grants to the less affluent States in 1944, by developing new methods of calculating State taxable capacity and tax severity.2

Finally, it was Mills and his colleagues on the first Commonwealth Committee on Universities who worked out an institutional framework and a methodology for the assessment of specific purpose grants from the Commonwealth to the States, a development which was to change the whole basis of public sector decision-making.' It is difficult to imagine the structure of goverment and of the Australian economy which would have emerged in the absence of uniform taxation and the particular forms of equalisation grants and specific purpose grants which were adopted on the basis of Mills's recommendations.

As Chairman of the Committee on Uniform Taxation, the Com- monwealth Grants Commission and the Commonwealth Committee on Universities, Mills no doubt benefited from the advice and support of other members. In so far as uniform taxation was concerned, however, there is no doubt that it was his influence which was decisive. Long before the War, in 1928, he had argued, in his Presidential Address to Section G of the Australasian Association for the Advancement of Science,' in favour of a system of uniform Commonwealth taxes and -

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4.

The Tenth R. C. MiUs Memorial Lecture, University of Sydney, 18 October 1977. Commonwealth of Australia, Report of rhe Committee on Uniform lmurion, Commonwealth Government Printer, Canberra, 1942. Commonwealth Grants Commission, E/eventh Report 1944, Government Printer, Canberra, 1944. Commonwealth Committee on Universities, Interm Report 1950, Canberra, 1950 (mimeo.). The interim report was acted on by the Commonwealth Government and the Committee was dissolved before it proceeded to the preparation of a final report. "The Financial Relations of the Commonwealth and the Slates", The Economic Record, May 1928.

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grants to the States. This was just after the Prime Minister (S. M. Bruce) and the Commonwealth Treasurer Or. Earle Page) had sought to put an end to what they called “the vicious principle of one authority raising taxation for another authority to spend”. To this end, they had abolished the equal per capita payments of $2.50 per head which the Com monwealth had been making to the States since 191 0, and had convened the Premiers’ Comerences wnicn led to tne Financial Agreement and the establishment of the Australian Loan Council.

Mills had opposed the abolition of the per capita payments. He argued that considerations of equity, flexibility and uniformity suggested that the field of income tax should be left entirely to the Commonwealth, provided that the level of per capita payments to the States was also increased. In support of the proposition that revenue should be raised on the basis of taxable capacity and distributed on the basis of population, he quoted the following statement by L. F. Giblin: “The combination of Federal direct taxation, with per capita distribution to the States, makes an adjusting factor of the greatest nicety.’y5

Mills considered that one method of rectifying the lack of balance between government revenues and responsibilities, which he called the “maladjustment of financial means to political ends”, would be for the States to transfer to the Commonwealth powers over communications such as roads and railways. However, he suggested that a better solution would be to extend the system that had operated before the abolition of the per capita payments, by “handing over entirely to the Com- monwealth the two chief direct taxes, income and inheritance, on the understanding that payments should be made to the States to compensate for the resulting loss of revenue”.

Mills was at heart a unificationist, who believed that federalism was merely a stepping stone to unitary government. Nevertheless, he clearly recognised the need to reconcile national, State and local interests. The problem has not changed over the years. Indeed, the closing words of Mills’s Presidential Address in 1928, in which he quoted Professor Seligman’s views on the U.S.A.6 in support of his proposition that we are all Australians first and members of a State afterwards, could well serve as the text of this paper:

“We need in the . . . domain of fiscal and economic life the dis- appearance of the feeling of opposition between State and Nation, and the growth of a feeling of co-operation. Instead of thinking in terms ofsovereign States and Federal encroachments, we must learn, infinance as in economics, to speak more and more in terms of a co-operative effort which will preserve all that is best in local and sectional vigour, and yet at the same time bring our

5. ‘Federation and Finance”, The EEonomic Record, November 1926, p. 156. 6. Studiu in Public Finonce, Columbia University Press, New York, 1925, p. 179.

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institutions in line with the fundamentally changed conditions of a national life . . .” Attitudes to Federalism as a System of Government

The main issues in Australian federalism are thus much the same as in Mills’s time. Particular emphases may change, but the essential question is still the appropriate division of powers and responsibilities between the different levels of government, with special reference to expenditure responsibilities, taxation and borrowing arrangements, and the role of intergovernmental grants. But if the issues are the same, attitudes towards federalism as a system of government have certainly changed. In the 1920s and 1930s, federalism was still regarded as a somewhat un- satisfactory compromise between autonomous nation states and unitary government, or as a second-best solution to problems which would tend to disappear when a system of unitary government had been achieved. In evidence to the 1929 Royal Commission on the Constitution, Owen Dixon (who was later to become Chief Justice of the High Court) said:

“A federal form of government represents a compromise, and the theory upon which it rests as a political device includes the sup- position that it will serve during a period of transition, while people separately governed may find it possible to unite more closely under a less rigid constitution.”’

Giblin had presented a similar view in his 1926 Presidential Address to Section G of the Australasian Association for the Advancement of Science, although he placed a good deal of emphasis on “the conception of federation as a growing organism, regardless of the strict provision of the Constitution or the intentions of its founders”. Giblin said:

“Federation is not a definite form of Government but a compromise between the two principles of independence and nationality. Like all compromises, it is subject to continual adjustment in view of changing circumstances.”

Giblin pointed out that the national interest continually grows and that there is an inevitable tendency for federations to depart from the intentions of their founders. “The functions of the Federal Government of the United States”, he said, “were intended to be rigidly limited to what was ‘truly national in object and scope’; but they now include the in- struction of the housewife in the pickling of onions.”

In the intervening years, the Australian federal system has moved far along the road to Commonwealth financial domination, and yet federalism is probably more firmly established as the basis of govern-

7. Quoted by K . H. Baile “The Constitution of the Commonwealth, Economic Record, November 1929, p. 297. kofessor Bailey interpreted Dixon’s evidence to mean: “Federalism is only an interim solution at best . . . It isn t worth bothering about minor amendments. Leave the constitution alone until Australia is ready for a unitary system.’’

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ment than ever before. A superficial explanation of this seems to be the success which State governments have had in marshalling political opposition to the centralising policies of successive Commonwealth governments, but the real reason seems to be a changed attitude towards the notion of federalism itself.

Federalism is no longer regarded merely as a compromise solution, or an interim solution, or a second-best solution to the problems of government. Increasingly, the federal form is recognised as having positive advantages compared with loose associations of nation states on the one hand and highly centralised unitary governments on the other. Thus international groupings such as the European Communities, developing countries emerging from colonial status such as Papua New Guinea, and nations with long-established traditions of unitary government such as the United Kingdom are all groping towards some form of federal association. The reason for this is that federalism is now seen to be a means of facilitating decentralised decision-making within a unified planning and policy framework. Strengths and Weaknesses of Federalism

What are the positive advantages of federalism to a country such as Australia? First there are the benefits of decentralised decision-making, which flow from the greater opportunities which a federal system provides for governments to respond to diversity in the political, economic, social and cultural interests of the communities they represent. Decen- tralisation and responsiveness to diversity are inter-related aspects of democratic government, which must serve the will of the majority whilst somehow safeguarding the interests of minority groups and in- dividuals. Associated with these advantages of decentralised decision- making are the benefits of a unified planning and policy framework. These flow from the opportunities a federal system provides for putting into effect national policies directed to the efficient use of resources, economic stability in all its aspects, and greater social and economic equality .

The possibility of more effective government under a federal system does not itself ensure that the benefits which have been identified will be automatically achieved. Many of the countries which became independent after World War I1 failed in their attempts to establish federations, usually because economic, political or cultural divisions were too great to be accommodated within any kind of national framework. Even Canada, one of the text-book federations, now finds its system under attack and Australia itself has not been immune from threats of secession.

The disadvantages or costs of federalism are associated with the same elements of decentralisation and responsiveness to diversity which have been identified above as strengths of a federal system.

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Political and administrative decisions are undoubtedly more difficult to make in a system of multi-level government than in a unitary system. This is not only because of the initial constitutional difficulty of allocating functions and powers but also because, within any constitutional framework, each unit of government in a federal system must have regard to the effects of its decisions on other governments. The interaction of decisions among the different levels and units of government adds another dimension to the complex processes of policy for- mulation and administration. Because of these difficulties, it has often been argued that federal government is likely to mean weak or inefficient government.

2. CONCEPTS OF FEDERALISM Although this problem of intergovernmental interaction has always

been recognised as a problem of federalism, it has been intensified during recent years by a changing conception of federal government and of the application of the federal principle. The Classical Concept of Federalism

In the classical view, the distinguishing characteristics of a federal system were the constitutional separation of powers, the independence and the equality of the federal government and the member states. In Wheare’s much quoted definition, the federal principle was “the method of dividing powers so that the general and regional governments are each, within a sphere, co-ordinate and independent”.*

The notions of separation of powers, independence and equality of governments had some meaning when applied to the federal constitu- tions that were established during the 18th and 19th centuries, because at that time the role of all governments was limited to a few separable functions and was in any case unobtrusive. Economic, social and physical relationships of all kinds were relatively uncomplicated. I t was therefore possible for all units of government to provide services directly to their constituents, without concerning themselves very much with the social and economic consequences of their actions or the external effects of those actions on other governments and jurisdictions.

Under these circumstances, it was possible to divide powers vertically between federal and state governments, allocating whole functions to one or other level. Thus defence, international relations and activities with interstate implications were typically made the responsibility of the federal government, while most other functions were reserved to the states. It is true that, with the exception of customs and excise duties, most taxing and borrowing powers were made concurrent, but this itself reflected the low aggregate level of taxation and the absence of tax com-

8. K. C. Wheare, Federd Governmenl. Oxford University Press, London, 1946, p. I 1

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petition between governments. By contrast, the 20th century has been marked by massive techno

logical change and ever-growing economic size and complexity, widen- ing social consciousness resulting in new perceptions of the role of government, greatly increased internal migration, and the development of great urban concentrations with their complicated service networks. These developments have resulted in a vast extension of the range and level of government services, a commingling of many functions, a recognition of the need for decentralised decision-making, and the by- passing of constitutional divisions by means of political agreements and financial adjustments.

As a result of these changes, a new concept of federal government has emerged. This recognises the need for a sharing of responsibilities between the different levels and units of government, in place of a rigid separation of powers. It emphasises the interdependence of governments rather than their independence, and is more concerned with what governments actually do than with their formal constitutional tat us.^ The application of the new principle results in a system of multi-level government, in which a balance must be struck between decentralised and centralised decision-making on the one hand and between the independence and the interdependence of governments on the other. Con- stitutional divisions, political forces and financial resources may all be expected to play a part in achieving that balance.lo The Interdependence of Governments

The interdependence of governments means that, for most functions, it is necessary for a horizontal division of powers and responsibilities to replace the vertical division of the classical federal system. Services such as transport, economic development, urban services, education, health and welfare services have national as well as state and local dimensions, and cannot be regarded as the sole responsibility of a single level of government if they are to be provided adequately, effectively and equitably.

Federal (i.e. national) governments are better qualified than state or local governments to make certain kinds of decisions in each of these fields, judged by such criteria as access to information sources, responsiveness to electorates, effects on economic stability and growth, cost effectiveness, capacity for contributing to economic equality and social justice, and the possibility of including all relevant costs and benefits in

9. Cf. A. H. Birch Federalism. Finance and Social Legislation, Oxford University Press, Oxford, 1955, p. 306; M. J. C. Vile, The Structure of Americun Federalism, Oxford University Press, Oxford, 1961, pp. 198-99; M. D. Reagan. The New Federalism, Oxford University Press. New York, p. 3.

10. Cf. M. J. C. Vile, "Federal Theory and the 'New Federalism',", paper presented to Canadian- European Workshop on Comparative Federalism, Queen's University (Kingston), August 1977 (rnirneo.), pp. 5-7.

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the decision calculus (thereby internalising what economists describe as the external or spillover effects of decisions). The tendency for taxes and other financial resources to become concentrated in the hands of federal governments has somewhat distorted the interpretation of what are really national interests. Nevertheless, on the basis of the same criteria State and local governments are better qualified to make certain kinds of decisions in the same functional fields.

In road transport, for example, it becomes necessary to distinguish between: national responsibilities (e.g., national highways; construction and design standards; uniform traffic codes; mobilisation of financial resources); State responsibilities (e.g., State highway networks; major responsibility for the integration of road and land use planning; major responsibility for road research, construction and maintenance; traffic control; and partial responsibility for road finance); and local responsibilities (e.g., local road networks; partial responsibility for the integration of road and land use planning; partial responsibility for road construction, maintenance and finance).

The interdependence of governments in relation to decision making has enormously complicated the legislative and administrative processes. Not only is it necessary to devise a basis on which responsibilities may be shared and priorities determined, but planning and operating decisions must be co-ordinated and linkages established so that the services provided by each level of government may be integrated in an inter- connected system. To the problem of allocating resources effectively among different funtional uses has been added the problem of deter- mining priorities between different levels or units of government.

Problems of Policy Co-ordination The principal problems of federalism as a system of government thus

result from the need to co-ordinate the decisions of interdependent governments. Of course, not all activities need to be co-ordinated and, in the interests of economy and efficiency, functions should be reserved for particular units of government wherever possible (for example, defence as a responsibility of the federal government). But the essential problem facing federal systems in the 20th century remains that of devising criteria, institutional machinery and procedures as a basis for responsibility sharing and policy co-ordination across the broad spectrum of public sector activity-expenditures, taxation, borrowing and intergovernmental grants arrangements. Where responsibilities are shared, an attempt must be made to avoid overlapping responsibilities and the wasteful duplication of activities on the one hand and divided responsibilities and gaps in the provision of services on the other.

The problem of achieving policy co-ordination is difficult enough, even if the different levels of government genuinely seek a solution to

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the problem in a spirit of co-operation. However, a greater danger has emerged in Australia during recent years, in that many politicians and public servants have found it rewarding to emphasise divisiveness rather than co-operation, or even to set about creating unnecessary conflicts, in order to gain electoral advantage or power. The federal system has itself been increasingly used as a political weapon, with battle-cries of central power and State rights replacing analysis and reason as the basis of government policy.

Federalism will not achieve its potential in Australia until electors (and those who influence public opinion) demonstrate that they under- stand that the other Australian governments which politicians attack are the representatives, not of hostile foreign powers, but of themselves collectively as Australians; and that each government must be judged on its own performance and its willingness to co-operate with other units of government, and not on the strength of its opposition to other governments. Intergovernmental Relationships and Issues

Relationships between governments in a federal system are governed by constitutional, political, economic, administrative and financial forces, and the balance of power among levels and units of government changes as the relative strength of each of these forces waxes and wanes. The major issues in Australian federalism, from the time of the federal conventions in the 1890s down to the present day, have been concerned with three broad groups of questions:

(a) the constitutional definition of the respective legislative powers of the Commonwealth and the States and the ways in which those powers are to be exercised;

(b) the balancing of economic relationships as they affect different States or sectional interests within States; and

(c) financial relationships between Commonwealth, State and local governments.

In each case, issues arise affecting vertical relationships between the different levels of government (for example, Commonwealth-State relations) on the one hand and horizontal relationships within particular levels of government (for example, relations between different State governments) on the other.

3. CONSTITUTIONAL POWERS AND FUNCTIONS The Role of the Senate

During the constitutional conventions which led to federation, delegates were of course concerned with establishing the respective roles of the Commonwealth and the States in general. However, the delegates of the less populous colonies also sought to safeguard the interests of

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those colonies by providing for a Senate which would have virtually the same legislative powers as the House of Representatives and which would have equal representation from all States. Although conceived as a States’ House, the Senate never functioned as such because political forces soon led to voting along party rather than State lines. Even when there has been a suggestion that the Senate has acted to protect State interests, as in the events which led to the dismissal of the Whitlam government in 1975, the motivation has usually been strongly party political.

The convention delegates were conscious of the unusual powers which they gave to the Senate, but a strong Senate was an essential part of the federal compromise. It was pointed out by some delegates that there was a fundamental conflict between the principle of responsible government and the federal principle as the latter was applied in defin- ing the role of the Senate.” The fact that a head-on collision between these two principles was averted for three-quarters of a century was due simply to a self-denying ordinance by the Senate not to use its power to reject money bills. When the convention was broken in 1975, the political balance of the Commonwealth and its place in the federal system became inherently unstable. Although other arguments may be used to justify the existence of the Senate (such as its role as a house of review) there is no doubt that it has failed badly in the purpose for which it was intended. Moreover, unless a new constitutional agreement about its role can be reached, future conflicts between the Senate and the House of Representatives will threaten both responsible government and the effective operation of the federal system.

This is because the Australian Senate has only negative, disruptive, powers. It does not have the positive law-making or negotiating powers possessed by the U.S. Senate (which does not operate within a system of responsible government) or the West German Bundesrat (which is com- posed of Lander representatives who participate directly in the joint legislative process).

The Australian Senate is therefore in one sense too weak. But because it can reject legislation and even bring down a government with a majority in the House of Representatives, the Australian Senate is also too strong. Not only is it not constituted so as to facilitate the task of achieving the kind of policy co-ordination between the Commonwealth and the States which, it has been suggested above, is an essential requirement for effective Australian government. But also, especially when the Senate is controlled by parties in opposition to the government, it is

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1 1 . In the 1891 and the 1897 conventions, delegates thus asserted “Either responsible government will kill federation, or federation in the form in which we shall, I hope, be prepared to accept it. will kill responsible government” (J. Winthrop Hackett,in the 1891 Convention Debates, p. 280); and “[the Cabinet system of responsible government] w~ll either kill Federation or Federation will kill it” (Sir Richard Baker in the 1897 Convention Debates, p. 28).

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likely to make such co-ordination impossible by undermining the Commonwealth’s bargaining strength in negotiations with the States.

Just as the original Constitution was based on compromise, so constitutional amendments depend on some kind of consensus. The recent defeat of the simultaneous elections referendum proposal illustrates the difficulty of achieving important constitutional changes when electors in some States can be persuaded that their interests are likely to be adversely affected by the changes. This suggests that it will not be possible to curb the legislative powers of the Senate through consitutional amendment, and thereby to put an end to the instability of the Australian political system, unless some means is found of giving the Senate a more positive role. What is especially needed is a co-ordinating role in relation to joint Commonwealth-State programs and policies. One possibility would be to give Senate committees an intergovernmental rather than a functional orientation. But because the Senate cannot be held responsible or accountable for its actions in the same sense as the executive governments of the Commonwealth and the States, its co- ordinating role needs to be advisory in relation to both levels of government-that of an honest broker as it were. Changes in Constitutional Relationships

In so far as other constitutional changes are concerned, the activities of new institutions such as the Australian Constitutional Convention and the Advisory Council for Inter-government Relations may help with the task of reaching consensus on some issues and thereby ease the path of future referendums. Effective changes in constitutional relationships will no doubt also continue to result from judicial review (for example, with respect to taxing and spending powers), political bargaining (for example, with respect to railway operations) and financial arrangements (for example, with respect to specific purpose programs). Intergovernmental Agreements and Responsibility Sharing

A major consequence of the interdependence of governments and the commingling of functions in the modern federal system is that changes in the formal delineation of constitutional powers become less important than institutional arrangements and agreements between governments with respect to the sharing of powers. But if the allocation of functions, the sharing of responsibilities and the co-ordination of policies are to be effectively integrated into the process of government by means of intergovernmental agreements, several conditions must be met. To these, I now turn.

Criteria for the Allocation of Functions. Although any agreements will necessarily reflect the interplay of political forces and the policy priorities of the participating governments, they need to be negotiated and evaluated by reference to appropriate criteria for distinguishing between national, State and local responsibilities. As noted above, these

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criteria are concerned especially with which level or unit of government is best able, on the basis of such factors as access to information, financial resources, administrative capacity and political sensitivity, to inter- pret and respond to the community’s political, economic and social preferences.

Other things equal, where decisions taken by a unit of government affect adjoining jurisdictions within the same level of government (giving rise to what the economist calls external or spillover effects), the responsibility for the decisions should be transferred to a higher level of government, which will be able to take all the effects into account in making its decisions. This criterion suggests that it is the Com- monwealth government which must have the over-riding responsibility for macroeconomic fiscal, monetary, employment and international policies, for policies affecting the redistribution of incomes and wealth, and indeed for all economic and social policies the effects of which extend beyond the boundaries of any one State. Although some of this responsibility may be delegated, State and local governments must accept a subordinate role in relation to such policies.

Subject to this dominating qualification, decisions should be made by the level or unit of government which is closest to the people affected by the decisions. State and local governments should therefore have the main responsibility for decisions involving the allocation of resources within the public sector, including the development and operation of the economic infrastructure which is needed to provide essential services for the private sector, and the provision of detailed administrative, regulatory, community and social services.

Bargaining Strength. If intergovernmental agreements are to reflect fairly the interests of the communities which the governments represent, they should be based on co-operation rather than coercion. This means that the negotiating governments should not be inhibited by unequal bargaining strength.

In so far as the Commonwealth and States are concerned, there have been two kinds of bargaining inequalities, one favouring the Com- monwealth and the other the States. The Commonwealth’s monopoly of the major sources of tax revenue has given it a dominating financial advantage which has, however, been badly eroded during the last three or four years. The Commonwealth used its advantage to initiate numerous specific purpose grants programs in fields of traditional State responsibility, often without sufficient consultation with the States who had their own programs and who became responsible for administering the Commonwealth programs. There is little doubt that more effective policy co-ordination would have been achieved if the States had not been so dependent on Commonwealth financial support.

However, the States have usually had greater political bargaining

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strength, an advantage which has been achieved because of the remoteness of the Federal capital and the parochial bias of the news media. State-oriented newspapers and broadcasting media are invariably critical of the Commonwealth position in discussing Commonwealth- State relations and often treat unco-operative attitudes on the part of State politicians as a virtue rather than a vice.

Through its general responsibility for facilitating intergovernmental co-operation, the Advisory Council for Inter-government Relations may be able to improve the flow of information and advice about co- operation between governments, and in other ways help to balance the bargaining strength of the different levels of government. The council is likely to have a special responsibility in relation to local government, which remains completely subordinated to State governments.

Co-ordinating Machinery. Australia has been a pioneer in developing institutional arrangements to facilitate intergovernmental co-operation. Australian federal innovations include the Australian Loan Council, the Premier’s Conference, other ministerial conferences such as the Australian Agricultural Council, the Commonwealth Grants Com- mission, and the statutory advisory commissions (such as the Univer- sities Commission and the Commonwealth Bureau of Roads) which were established from time to time to advise on grant allocations under the growing number of specific purpose grants programs.

Some of these bodies have been more successful in co-ordinating policies than others. The conditions for success include clear and attainable objectives, the existence of a strong secretariat, constitutional or legislative authority, bi-partisan political support, effective liaison with relevant levels or units of government, independence from any one level or unit of government, the effective integration of financial decisions in the budgetary processes of the governments concerned and, more generally, some means of reconciling the operations of the co- ordinating body with the legislative and executive processes of government.”

The development of more effective institutional arrangements as a basis for intergovernmental policy co-ordination is one of the most urgent as well as one of the most difficult problems facing Australian governments. This again is a problem to which the Advisory Council for Inter-government Relations will be directing its attention.

The Role of Local Government A major constitutional question is concerned with the role of local

government. The distinguishing characteristics of Australian local

12. For a further discussion of this problem, see R. L. Mathews, “Philosophical, Political and Economic Conflicts in Australian Federalism”, Paper to 29th Annual Conference of the Institute of Public Administration of Canada, Victoria, B.C., 8 September 1977, pp. 16-19,

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government have been its lack of independence (deriving from the constitutional subordination of local authorities to the States), the small size of most authorities in terms of population served, and the restricted range of functions relative to those of local authorities in most other countries. Local governments in Australia have traditionally been concerned only with the provision of services to property. State governments themselves have provided major social and community services (in fields such as education, health and housing), while State instrumen- talities have provided major economic services (in fields such as transport, power, water supply and sewerage), both of which categories are the responsibility of local governments in many other Western countries.

Attempts by the Whitlam government to extend the role and improve the effectiveness of local government (“to make local government a genuine partner in the federation”) were only partly successful. The government’s proposed constitutional amendments (which would have given local government a voice on the Loan Council and authorised direct Commonwealth grants to local government) were unnecessary for the achievement of the government’s purpose and lacked the support of both the States and, with some exceptions, local government authorities themselves. The other main instrument used by the Commonwealth to improve the position of local government-the provision of financial assistance through the States by means of equalisation and specific purpose grants-was more effective. However, this too ran into opposition from State and local governments, partly because the principle of equalisation lacked universal support and partly because both State and local governments objected to the Commonwealth’s attempts to link the grants with the development of regional organisations.

The concept of equalisation was misunderstood by some State and local politicians and rejected by others, who set out to obtain Common- wealth general revenue grants for all local authorities-rich and poor alike-to the disadvantage of those with relatively low fiscal capacity. If there is any case for general revenue grants from the Commonwealth to all local authorities, it must rest on the proposition that there is a fundamental fiscal imbalance which makes it impossible for any local authorities, even those with the highest taxable capacities, to raise sufficient revenue from their own sources. The existence of such imbalance has not been dem0n~trated.l~ The tax effort of local government generally has fallen relative to that of other levels of government during recent years, and to the extent that there is a problem of local government finance& is a problem of unequal revenue-raising capacity and ex- cessive costs faced by some authorities in providing services.

~ ~~~~ ~ ~~~ ~~~~

13. Cf. P. D. Groenewegen, The Taxable Capacity of Local Government in New South Wales, Centre for Research on Federal Financial Relations, Distributed by ANU Press, Canberra. 1976.

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The changes in local government financial arrangements which were introduced by the present Commonwealth government involve: (a) the substitution of a fixed percentage of personal income tax collections (1.52 per cent) for the general revenue grants paid on the recommendation of the Commonwealth Grants Commission; (b) a change in the basis of distribution, whereby the Grants Commission’s longestablished principle of fiscal equalisation was replaced by a requirement that at least 30 per cent of the Commonwealth funds made available should be distributed on the basis of population“ and the remainder on an equalisation (or relative needs) basis; and (c) the establishment of six State Grants Commissions to recommend the distribution of grants within each of the States, leaving the Commonwealth Grants Commission with responsibility only for making periodic recommendations about the interstate distribution.

Judged by the criteria which have been established above, in particular those concerned with equality and efficiency, these changes must be viewed as a retrogression. Commonwealth taxpayers are being required to support wealthy ratepayers who are well able to finance their own local services, and to the extent that the population basis of distribution is used in a State there is a reduction in the funds available for equalisation purposes. Because the whole of a State’s allocation may now be distributed on a population basis, it is even possible that no account will be taken of differences in revenue-raising capacity or in expenditure needs. Furthermore, if financial assistance for local government is accepted as a national responsibility there is no justification for the creation of six new State Commissions to perform the tasks which were already being performed effectively by the Commonwealth Grants Commission. As well as causing the wasteful dismantling of an efficient organisation and the costly duplication of its activities in a number of unco-ordinated State agencies, the new structure will inevitably lead to continuing conflicts between Commonwealth and State priorities in relation to local government finance.l5

The Whitlam government’s aggressive advocacy of regionalism and the unnecessarily negative response of State and local governments have also left an undesirable legacy, in the form of hostility to the concept of regionalism which is so deep-seated as to make it unlikely that proposals for regionalisation will be judged on their merits for many years to come.

This is unfortunate, because the criteria referred to above suggest a

14. By agreement between the Commonwealth and the State concerned, certain other factors such as population density may be taken into account for the purpose of this allocation.

IS. See 1. Mc,Phail, “Financial Assistance to Local Government through State Grants Commissions and Spec~fic Purpose Programs”, Local Governmenf in Transifion, Centre for Research on Federal Financial Relations, Canberra (forthcoming), for a critical view of the new arrangements from the perspective of a State government.

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need for some form of regional organisation to facilitate the provision of certain types of services, the costs and benefits of which extend beyond the boundaries of individual local authorities without affecting the whole of a State. In particular, land use planning and the provision of most kinds of urban services need to be subject to some form of regional co-ordination, especially in metropolitan areas. The development of social and physical wastelands in Australia’s main cities during recent years, like the break of railway gauges in the 19th century, stands as one of the most visible monuments to the failure of Australian governments to coordinate their activities in the interests of the citizens they represent.

Numerous commissions and committees of inquiry have been appointed by State governments with a view to rationalising the structure of Australian local government. However, there has been little consensus on the part of the major political parties and local interests have usually strongly opposed reforms. In the face of this opposition, governments have usually not been prepared to implement the recommendations and most local authorities in Australia continue to be ill-equipped to perform a more effective role in the federal system.

It needs to be emphasised that larger units of local government are not necessarily justified by reference to the efficiency or economies of scale argument, whereby it is claimed that large councils can provide services to property more cheaply than small councils. By contracting out to adjoining councils or private contractors, small councils can sometimes provide services even more cheaply than large authorities.

There are two other reasons for insisting on a minimum size for local government units. The first is to facilitate the equalisation process by making all local government jurisdictions large enough to include areas with high taxable capacity (or ratable values) as well as areas with low taxable capacity, so that some subsidisation of the latter by the former may occur through the application of uniform rates of tax and standards of services. The second reason for larger local government units is to enable the role of local government to be expanded to provide services to people-in particular welfare services and community development-as well as services to property. The overhead and operating costs involved in appointing social welfare and community development officers are likely to be too high to be capable of being financed by very small councils, especially in poor communities where the services are most needed.I6

Although most of the recent initiatives in relation to local government

16. See R. F. Henderson and R. B. Lewis, “Changing Responsibilities of Local Government: Impli- cations of the Committee of Inquiry into Poverty”, Loco( Government in Trumirion, op. cit., and B. Manning, ”The Role of Local Governmen! in Community Development”, /oc. cit.. for a discussion of the role of local government in relation to welfare and community services.

15

have been undertaken by Commonwealth governments, in the last resort the performance of the local sector depends on actions by State governments and by local authorities themselves. The States need to be much more purposeful in improving the structure of local government. They also need to apply the same arguments for decentralised decision making which they use in resisting Commonwealth encroachment on their functions, and to show a much greater willingness to devolve responsibilities upon local government than they have been prepared to do in the past. For their part, local governments need to escape from the constraints imposed by their traditional reliance on services to property, to demand greater independence and flexibility under State legislation, to improve their management processes, and to demonstrate a greater sense of financial responsibility by substituting reasonable tax effort on their own part for their continuing clamour for increased Com- monwealth financial assistance.

Advanced councils in most States are already demonstrating the effective role which local government may play in the Australian public sector. As noted above, one of the major tasks of the Advisory Council for Inter-government Relations is concerned with the role of local government and its relationships with Commonwealth and State governments. The Australian Council of Local Government Associations and the State local government associations also have a responsibility in this regard. 4. ECONOMIC ISSUES

At the time of the federal conventions, the tariff question was the principal economic issue, and this affected relations between New South Wales and Victoria as well as Commonwealth-State and interstate relations generally. Later the federal economic problem became centred on the disabilities of the less populous and less affluent States. These com- plained that most of the economic advantages of federation accrued to protected industries in the industrialised States of New South Wales and Victoria, whilst their own industries usually had to compete in world markets under a federally-imposed cost disadvantage. The South Australian, Western Australian and Tasmanian governments also com- plained of budgetary difficulties resulting from inadequate revenue bases and high costs of providing services. Although ad hoc special financial assistance was given to Western Australia from 19 10- 1 1, Tasmania from 19 12- 13 and South Australia from 1929-30, dissatisfaction with the federal compact was so strong in these three States that secession movements developed during the early 1930s and in Western Australia a secession referendum submitted to electors by the State government was actually passed. Fiscal Equalisation as a Response to Economic Inequalities

The Commonwealth’s response was to establish the Commonwealth

16

Grants Commission as a quasi-judicial agency charged with reporting on the financial needs of any States which might claim special financial assistance under section 96 of the Constitution. The Commission considered arguments by the three States that the Constitution operated to their detriment, that they were adversely affected by Commonwealth policies, that they suffered from poverty of resources and economic inequalities, and that they needed financial support to balance their budgets.

The Commission rejected claims based on the working of the Con- stitution and the adverse effects of Commonwealth policies, which it said needed to be balanced against the benefits and were in any case im- measurable. It likewise rejected claims based on poverty of resources and economic differences, arguing that there was no disability if population was proportionate to resources and that nothing should be done to encourage uneconomic development. The Commission therefore adopted the principle of financial need as the basis for Commonwealth financial assistance, and defined a State’s financial need as “the amount of help found necessary to make it possible for that State by reasonable effort to function at a standard not appreciably below that of other States”.

The Commission’s methodology involved the systematic assessment of a claimant State’s financial needs, at first implicitly but more recently explicitly, by reference to differences between the claimant State and the standard States (now New South Wales and Victoria) in revenue-raising capacity and in the costs of providing comparable services. A claimant State’s revenue needs are now calculated by applying each of the standard State’s tax rates to the difference in the per capita revenue base of the claimant and the standard State, averaging the calculations and multiplying the result by the claimant State’s population. The claimant State’s expenditure needs may reflect either a higher number of units to be provided with services than the standard States (resulting, for example, from a higher proportion of school-age population to total population) or a higher unit cost of providing services (resulting, for example, from diseconomies of scale, dispersion of population, or climatic or other environmental factors). In the first case, the need is calculated as the product of the excess number of units and the average unit cost of providing the service in the standard States. In the second case, the need is calculated as the additional percentage cost of providing the service relative to the average per capita cost in the standard States. Both revenue needs and expenditure needs may be negative.”

17. The Grants Commission’s procedure may be described algebraically as follows:

17

It may be noted that the special grants paid by the Commonwealth on the recommendation of the Grants Commission are general revenue grants with no conditions attached; that is to say, they may be used for any purpose at the discretion of the claimant States. They are true equalisation grants, because they have the effect of equalising fiscal capacity to provide services, are independent of a claimant State's policies and do not require the claimant State to conform to standard revenue-raising or expenditure policies. In particular, a claimant State's eligibility for a special grant is not affected if its tax effort falls below that of the standard States; the State remains free to determine the severity and pattern of taxation as well as the level and distribution of services.

The concept of fiscal equalisation, which was originally developed by Professor L.F. Giblin during the 1920s and 1930s and applied by the original Grants Commission of which he was a member, is Australia's most significant contribution to the theory and practice of federalism. The importance of its key role in federalism can hardly be over- emphasised, because fiscal equalisation is the essential link between two of the principal objectives of federal government-diversity and equality. It is true that some federations-notably the United States of America-still make no provision for systematic fiscal equalisation. Moreover, it is often claimed that equality can only be achieved with centralisation and that there is therefore an essential conflict between equality and federalism.'*

But this is to confuse equality and uniformity. The systematic process of fiscal equalisation makes it possible for a claimant State to provide the same services as the standard States without having to impose higher taxes and charges, but does not oblige it to do so. In terms of equality, a federal system with a comprehensive system of fiscal equalisation is thus equivalent to a unitary system with an additional degree of freedom.

The special grants paid on the recommendation of the Grants Com- mission are directed to the equalisation of State budgets and not to more general objectives concerned, for example, with removing inequalities in State economies or personal incomes. The work of the Grants Com- mission has therefore diverted attention from what were originally con.

where G = equalisationgrant P = population R = revenuecoktions Y = revenuebase R = revenueeffort 1 E = expenditure 7 = additional percentage cnst of providing services relative to standard per capita

The subscripts i and s denote the individual government being subsidiscd and the standard govern ment (or governments) rspect~vely. 18. M. J. C. Vile, "Federal Theory and the 'New Federalism' ", op. cir., p. 10.

18

ceived of as economic issues to the more specific question of intergovernmental financial relations. This does not mean that the process of fiscal equalisation in Australia is wholly systematic or that it is concerned only with the equalisation of fiscal capacity. It also does not mean that all the economic issues in Australian federalism have been resolved.

To a large extent, arbitrary decisions by the Commonwealth government or ad hoc agreements between the Commonwealth and some or all States, involving changes in the distribution of financial assistance grants on the one hand and the payment of specific purpose grants on the other, have replaced the systematic and independent assessment of financial needs by the Grants Commission. The three States with the lowest fiscal capacity-South Australia, Western Australia and Tasmania-are thus not claimant States at present, presumably because they are receiving differential general revenue and other payments which more than compensate for the short-fall in their fiscal capacities. As a result of this over-compensation, inequalities among State fiscal capacities remain. However, an augmented Grants Commission will shortly begin the task of reviewing the interstate distribution of the States’ personal income tax sharing entitlements, a process which should help to restore fiscal equality among all six States.

Although specific purpose payments from the Commonwealth to the States are often directed to the provision of social or community services (such as education, health, urban services), many programs are concerned with economic services (such as transport, water supply, elec- tricity, industry assistance and development, and labour and employment). Although some specific purpose payments in both categories have equalisation objectives, the aim of many specific purpose programs is to equalise performance by reference to Commonwealth-determined standards of expenditure needs, rather than to equalise fiscal capacity. In other cases, there is no ostensible equalisation purpose; the distribution of payments made for purposes of assisting rural development thus often depends more on arbitrary political decisions than on the systematic assessment of relative needs or economic inequalities.

It is not generally recognised to what extent financial transfers from the Commonwealth to the States have changed the relative financial positions of the six States and, by implication, resulted in transfers from taxpayers in States with relatively high fiscal capacity to taxpayers in States with relatively low fiscal capacity. Table 1 shows that in 1974-75 the total grants received by Tasmania from the Commonwealth (excluding loans and advances) were estimated at $626 per head of population, compared with personal income tax paid by Tasmanians of only $489 per head of population. Whereas New South Wales and Victoria received in grants only about 60 per cent of the personal income taxes

19

paid by their citizens, Tasmania received 128 per cent and the other three States between 89 and 94 per cent.

The fact that such a substantial redistribution can take place indicates both the tolerance of the Australian federal system with respect to horizontal fiscal redistribution and the success which has been achieved in reconciling diversity and equality as objectives of public policy. Cer- tainly no other federal country makes such substantial transfers for the purpose of removing economic or financial inequalities, even though the Australian States are already much more homogeneous than the member states of other federations in terms of such indicators as production, personal income and consumption expenditure per head of population.

Table 1

COMMONWEALTH GRANTS TO STATES, PER CAPITA, 1974-75

s N.S .W. Vic. Q’ld S.A. W.A. Tas . To ta l

grants 155.4 151.7 218.2 255.3 253.0 348.2 187.4

capital grants 22. I 23.6 22.4 37.6 28.4 64.5 25.8

recurrent grants 86.8 95.2 79.8 98.6 102.5 107.2 91.1

capital grants 71.5 70.4 95.4 83.5 98.4 105.8 79.3

grants 335.8 340.8 415.8 475.0 482.3 625.7 383.5

income tax 561.61a) 556.3 469.8 503.2(b) 521.1 489.3 535.2

General revenue

General purpose

Specific purpose

Specific purpose

Total

Personal

Per cent Grants as percentage

of personal income tax 59.8 61.3 88.5 94.4 92.6 127.9 71.7

(a) Includes A.C.T. @J) Includes Northern Territory

Source: Payments to or for the States and Local Government Authorities 1976-77 and 1977-78, Budget Paper No. 7, Australian Government Publishing Service, Canberra, 1976 and 1977; Commonwealth Grants Commission. Forty-third Report 1976 on Special Asrirtance for Stores, Australian Government Publishing Service, Canberra, 1976.

Changing Economic Relationships Although economic differences between rich and poor States have

thus ceased to impose a major strain on the Australian federal system, some differences remain and economic relationships among the States are changing quite dramatically. The Tasmanian economy has thus been affected by transport problems to a greater extent than the other

20

States,Ig while a shift is taking place in the relative importance of different industries in the several States. In place of the two industrialised States and four States with rural-based economies which existed before World War 11, the Australian States may now be classified into two States with advanced industrial economies, the rate of growth of which is now tending to fall (New South Wales and Victoria); two States with rich resource bases, the pace of development of which is tending to accelerate (Queensland and Western Australia); and two States with more limited resource bases, the growth of which is also tending to slow down.

These changes may be expected to affect intergovernmental economic and financial relations in a number of ways. Tariff policy will remain an issue, but rapid increases which are taking place in mineral production and exports will have important interstate implications with respect to exchange rate policy, fiscal and monetary policies and even wage policy. The relatively uneven expansion of mining in the several States is already creating problems for the Australian Loan Council. By changing relative revenue-raising capacity among the States, also, it will eventually affect the pattern of interstate fiscal equalisation in Australia as well as raise the question of how revenues from royalties and mining taxation are to be distributed between the Commonwealth and States. 5. COMMONWEALTH-STATE FINANCIAL RELATIONSHIPS Federal Finance Criteria

Financial relations in a federal system are concerned with expenditure responsibilities (which have been considered above), taxation powers, borrowing and grants arrangements. General requirements for an effective system of fiscal federalism include:

(a) Vertical fiscal balance, defined as a situation where each level of government-Federal, State and local-can command the financial resources necessary for it to carry out its constitutional responsibilities. Because expenditure needs in relation to those responsibilities will inevitably change over time, vertical balance implies the existence of a flexible source of revenue for each level of government-in particular a flexible source of taxation.

(b) Horizontal fiscal balance, defined as a situation in which each unit within a particular level of government has the capacity to provide comparable standards of services to those of other units, provided it imposes comparable taxes and charges. As noted above, this implies the existence of a system of fiscal equalisation for State and local governments.

(c) The co-ordination of taxation arrangements in such a way as to ~~

19. See In uity into the Sfrucfure o/lndusfty and the Employrnenf Situation in Tasmania, Report, by Sir h e Callaghan, Australian Government Publishing Service, Canberra, 1977.

21

meet the general objectives of economic policy in relation to the allocation of resources, the level of economic activity and the distribution of incomes and wealth.

(d) The co-ordination of borrowing arrangements in accordance with the needs of the different levels and units of government and the requirements of economic policy generally.

(e) The co-ordination of intergovernment grants arrangements. This implies not only that fiscal equalisation grants will be made to the extent necessary to achieve horizontal fiscal balance. It also implies that, to the extent that vertical fiscal transfers are made from one level of government to another in the form of general revenue grants or specific purpose payments, the arrangements will be based on mutually acceptable agreements as opposed to coercion.

(f) The maintenance of a sufficient degree of financial independence on the part of each level and unit of government to establish financial responsibility for performance and political accountability. This implies that each government will balance its taxing decisions against its expenditure decisions, at least at the margin. As with other aspects of federalism policy, to the extent that this requirement clashes with the need for co-ordinated decision-making a balance must be sought between the conflicting objectives.

Financial Relations After World War I1 The distinguishing characteristics of Australian fiscal federalism after

World War I1 were Commonwealth financial domination combined with lack of State financial responsibility. These conditions resulted from: the uniform income tax arrangements and the reliance of the States on Commonwealth general revenue grants as a substitute for their own taxes; High Court decisions which made it difficult for the States to impose broad-based consumption taxes; Commonwealth control of the Loan Council; and a growth in specific purpose grants for Commonwealth-determined programs and policies in fields of State constitutional responsibility.

Both Labor and non-labor Commonwealth governments pursued policies which had the effect of increasing central power, but the centralising tendencies became more pronounced during the period of the Whitlam government, when political and financial issues combined to produce a bitter confrontation between the Commonwealth and State governments.

Throughout the post-war period, the States had objected to the loss of income tax powers and to the formula used to calculate tax reimburse- ment grants (later called financial assistance grants). They also com- plained about the increasing burden of State indebtedness, which resulted from the fact that the Commonwealth used its surplus taxation

22

revenue to make special loans to the States in support of their works programs. Largely because of these special loans, by the late 1960s the Commonwealth was in the unique position for a national government of being a net creditor in relation to all other sectors of the economy.

The States were also critical of the growing use of specific purpose grants, especially those which included matching or other revenue conditions, on the grounds that they imposed the Commonwealth’s spending priorities and made it difficult for them to respond to what they perceived as the needs of their communities. Between 1972-73 and 1975-76, specific purpose payments to the States more than quadrupled, rising from $932 million to $4,153 million. Finally, as we have seen above, the States objected to the Commonwealth’s proposals to strengthen the role of local government and develop new forms of regional organisation.

Although adjustments were made from time to time in taxation, grants, debt arrangements and expenditure functions, the fundamental fiscal disequilibrium remained. The foregoing principles of fiscal federalism-vertical balance, horizontal balance, policy co-ordination and fiscal responsibility-were simply not being applied in the Australian situation.

Although the States did take action to increase taxes under their own control throughout this period, they showed little interest in having income tax powers restored to them. Instead they concentrated on attempts to relate the level of financial assistance grants to income tax yields, which by the 1970s were increasing very rapidly indeed as a result of the interaction of the progressive rate structure and inflation. The States’ approach to fiscal federalism was thus based on maximising the level of Commonwealth grants rather than restoring State financial responsibility.

But although they were prepared to play a subordinate financial role, the States resorted increasingly to political action in an attempt to discredit the Commonwealth’s centralising policies. They were successful in mobilising popular support for State rights in a series of constitutional referendums, State elections and, eventually, the Commonwealth election of 1975.

Meanwhile, both the Whitlam government and the Liberal-National Country Party opposition were beginning to emphasise the need for a new approach to Australian federalism, one based on intergovernmental policy co-ordination. Constructive proposals to this end were made by the Prime Minister (E.G. Whitlam) and accepted by State Premiers a t the May 1975 Premiers’ Conference, but little progress had been made in implementing the proposals before the government was defeated. Meanwhile the opposition had announced that, if elected to office, it would introduce a new federalism policy based on intergovernmental

23

co-ordination of taxation and grants arrangements. Following the defeat of the Labor government in December 1975, the new Prime Minister (J.M. Fraser) convened a series of Premiers’ Conferences at which agreement was reached on a new system of fiscal federalism.

The New Federalism Policy Apart from the arrangements for local government financial

assistance (which have been discussed above) and the decision to establish an Advisory Council for Inter-government Relations, the new federalism policy is concerned chiefly with the substitution of personal income tax sharing arrangements for the financial assistance grants which had been paid under the uniform tax system.

Under Stage 1 of the arrangements, which came into force in 1976-77, the States receive 33.6 per cent of Commonwealth personal income tax collections net of special surcharges or rebates (the percentage being based on the relationship between financial assistance grants and tax collections in 1975-76). The initial distribution of the tax entitlements among the six States is based on the per capita relativities of the financial assistance grants in 1975-76, but provision has been made for the relativities to be reviewed periodically by an augmented Commonwealth Grants Commission. The four less populous States remain free to apply for special grants through .the Grants Commission; such grants are additional to tax sharing entitlements.

Under Stage 2 of the arrangments (which may operate from 1977-78), individual States are able to impose percentage surcharges or allow rebates of personal income tax, and thus vary taxes paid by their citizens to the benefit or cost of their own revenues. But there will continue to be a uniform basis of assessment and collection on the basis of Commonwealth laws; only percentage rates of tax may vary among States. In recognition of differences in State taxable capacity, provision is being made for equalisation of surcharges by means of supplementary grants assessed by the Grants Commission.

As another major element of the new federalism policy, it was intended that specific purpose payments to the States would be reduced by phasing out some programs and absorbing others into general purpose funds. In the event, most programs in the field of urban and regional development have been abolished or substantially reduced. Education programs have been retained under revised arrangements, but there has been a reduction in most programs in real terms and the Commonwealth is seeking some form of cost sharing arrangement with the States. Following major reviews of health and welfare programs during the last two years, it seems likely that there will be a consolidation of many individual grants into block grants, thereby giving the States greater discretion in spending.

24

Issues under the New Federalism Policy The tax sharing arrangements in the new federalism policy represent a

significant retreat from the Commonwealth’s income tax monopoly and a step towards vertical balance, co-ordination of taxation and grants arrangements, and the restoration of State financial responsibility. They retain most of the advantages of uniform taxation, including effective Commonwealth control over policies for economic management and income distribution, the convenience to taxpayers of a single system of assessment and collection, and the minimisation of wasteful intergovernmental tax competition. The equalisation provisions of the tax sharing arrangements have the potential for achieving horizontal financial balance, because the per capita relativities of the six States will now be subject to periodic review on a systematic basis by an independent body.

However, it is not yet clear whether the States will take advantage of the opportunities for greater financial autonomy which the new scheme will present. There have already been indications that the States will find it more expedient to argue about their percentage share and the revenue base than to impose their own surcharges. Most States have indicated that they have no intention of introducing income tax surcharges, and only two States (Victoria and Western Australia) seem likely to pass complementary legislation which would enable them to do so.

The new federalism policy has conceded to the States the three principal demands which they had made in opposition to the Whitlam government’s centralising policies-a fixed share of personal income tax collections, a switch from specific purpose grants, and State control over policies for local and regional government. It might therefore have been expected that the States would have reacted very favourably to the new arrangements. However, except for their initial response, which was no doubt based on an expectation that there would be a substantial increase in the general revenue funds flowing from the Commonwealth, the States have been highly critical of the arrangements.

Apart from hostility to the notion of income tax surcharges (which some Premiers have said would involve double taxation), the States have even attacked the three major changes which they themselves had sought. They have thus been critical of the use of personal income tax collections as the new revenue base and of the switch from specific purpose programs. Some States have also been reluctant to accept the cost of establishing State Grants Commissions to advise on the allocation of local government grants.

It is true that State revenues under the new arrangements have fallen well below their expectations. In 1976-77, the tax sharing entitlements of all States except Queensland fell short of the amounts which would have been received under the financial assistance grants arrangements, so that it was necessary to invoke the guarantee provisions of the tax

25

sharing arrangements whereby, for the first four years, all States were to receive payments at least equal to those which they would have ob- tained as financial assistance grants. In 1976-77, also, the aggregate amount of specific purpose payments fell by 2 per cent in absolute terms, at a time when the real value was being eroded even more steeply by the continuing high rate of inflation.

Nevertheless, it has become only too clear that the States’ response to the new arrangements is based on expediency rather than principle and that they continue to be more interested in maximising financial returns than in regaining a measure of financial autonomy and co-ordinating their policies with those of the Commonwealth.

For its part, the Commonwealth has tended to exploit its position by making unilateral decisions affecting the States without adequate consultation or regard for their interests. From the Commonwealth’s point of view, there are in any case difficulties in obtaining the agreement of all the States to major policy changes such as personal tax indexation (which was introduced in 1976-77) and the designation of the Medibank levy (which was also introduced in 1976-77) as a surcharge outside the revenue base. This is especially so if the States continue to concern themselves only with the effect of the changes on their own en ti tlements.

There are, however, technical or administrative as well as political problems impeding tax co-ordination. These include: (a) cash flow problems if a State’s actual tax entitlement falls short of its estimated entitlement (as happened for all States except Tasmania in 1976-77); (b) the difficulty of estimating tax entitlements as a result of changes during a year in estimates of population and tax collections; (c) the problem of obtaining information about the effects of Commonwealth budget policy on State entitlements in time for State budget decisions.

There is obviously a clash between the planning and budgeting requirements of the States and the Commonwealth’s need for budget security, but the general effect of the foregoing problems has been to increase State uncertainty about the revenues they may expect to receive in a given year.m To reduce some of these uncertainties, it has been proposed that entitlements in a given year be related to income tax collections in the preceding year, the percentage to be applied to the base being adjusted to offset the reduction in the revenue base.

A major weakness in the tax sharing arrangements, for which the Commonwealth and the States share responsibility, has been the failure of the Commonwealth to make tax room for State surcharges by reducing its own rates and making a simultaneous and equivalent reduction in 20. See R. D. Barnes, “The Implications of the New Federalism for State Budgets”, Aspecrs of rhe

New Federalism Policy, Oocasional Paper No. 7, Centre for Research on Federal Financial Relations, Canberra, 1977, for an elaboration of these problems.

26

the amount of State tax sharing entitlements. This would have forced the States to accept responsibility for imposing surcharges without necessarily increasing the total weight of income taxation. It would also have made it easier for the Commonwealth to counter State arguments about their percentage share and the revenue base, and it would have established a much closer link between State taxing and spending decisions than is possible under the present arrangements. It says much about the States’ continuing lack of financial responsibility that they have not sought tax room for themselves.

There will also be problems in achieving compatibility between the three kinds of equalisation arrangments for which provision has been made-the periodic review of per capita relativities of all six States, the continuing provision for claims for special financial assistance by the four less populous States, and the equalisation of surcharges. The possibility of conflicts between the first two forms of equalisation has been reduced by the recent decision that the review of relativities will be undertaken by an augmented Commonwealth Grants Commission, but some questions remain unanswered. For example, will special grants paid to the less populous States between the periodic reviews of relativities be absorbed in tax sharing entitlements at the time of the reviews, and if so on what basis? Guidelines which have been laid down for the review of relativities are generally consistent with the Grants Commission’s normal equalisation principles, but the review “is to include an examination of the existing relativities, of the factors which have influenced them and of any relevant changes which have occurred in the period since those relativities were established”.2’

However, it has also been decided that the criteria used for the equalisation of surcharges will differ from the Grants Commission’s equalisation principles, in that an equalisation grant for one of the less populous States imposing the surcharge will be based on that State’s rate of surcharge and not on a standard rate. This means that the State can influence the amount of its grant by varying its own policy. It also means that there will be financial incentives to all States to substitute income tax surcharges for existing forms of State taxation, although it is not yet clear how State governments will balance these financial advantages against the political disadvantages of increasing the effective level of income taxation.22

Other limitations or weaknesses of the new federalism policy include the following:

(a) There are no arrangements for more general co-ordination of tax

21. Poyrnents to or for the States and Local Government Authorities 1977-78, op. cif., p. 17. 22. For an explanation of this fpint and a general evaluation of the ualisation arrangements of the

new federahmglicy, see L. Mathews, “The Federal Year in%eview”, in the 1975 and 1976 Reports of the ntre for Research on Federal Financial Relations, Canberra, 1976 and 1977.

27

policies, involving for example estate and gift duties and a broad-based consumption tax. Two of the major reforms recommended by the Taxa- tion Review Committee (the Asprey Committee) involve, first, the substitution of a national estate and gift duty for the existing Com- monwealth and State taxes (with a sharing of the resulting revenues) and, second, the introduction of a value-added tax in place of the existing Commonwealth wholesale sales tax and possibly the State pay-roll taxes.” Certainly there is a need to rationalise both forms of taxation in Australia.

The Asprey Committee’s proposal for uniform estate and gift duties was based especially on “the complexity of separate Commonwealth and State taxes and the considerable costs in administration and compliance”. Further reasons for co-ordinating tax policy in these fields include the equitable and consistent treatment of taxpayers in different States, and the need to discourage action by individual States to seek special advantages for themselves by abolishing duties altogether and thus creating tax havens.*‘

There are also strong grounds for a joint approach to the taxation of goods and services in Australia. The introduction of a broad-based consumption tax, such as a general retail sales tax or a consumption-type value-added tax, would enable the burden of income taxation to be reduced and bring the Australian tax structure more into line with that of other Western countries. A broad-based tax could also replace some of the existing inefficient and discriminatory taxes, including the Com- monwealth sales tax, State pay-roll taxes and many other low-yielding, inefficient and irritating taxes which the States now impose on specific forms of business turnover.25

(b) No machinery has been established whereby mutually acceptable agreements can be reached on the implementation of specific purpose grants programs, especially where cost-sharing or matching arrangements are involved.

The proposal for the absorption of specific purpose grants in general purpose funds (or even block grants) raises difficult problems, because the distribution of existing specific purpose grants is quite different from the distribution of tax entitlementsM and it may be expected that expen-

23. Tuxolion Review Commitlee Full Repor131 Jonuory 1975, Australian Government Publishing Service, Canberra, 1975, Chapters 24 and 27.

24. See B. L. Johns and W. J . Sheehan, “Dcath and Gift Taxes in Australia”, Stole ond Locol Two- tion. op. cit.. Chapter 16, for a proposal for uniform duties based on Commonwealth assessment and collection and the payment to the States of all revenues except those collected in the Tem- tones.

25. For a discussion of a pxsible tax sharing arrangement in relation to a broad-based consum tion tax, see R. L. Mathews, “Business Activity Taxes and State Financial Responsibility”, in f;. L. Mathews (ed.), Stute ond Locol Taution, ANU Press, Canberra, 1977 (forthcoming), Chapter 12. See also P. D. Groenewegen, loc. cit., Chapter 18, for more general proposals for the co- ordination of taxation policies.

26. See analysis by W. R. Lane quoted by R. Else-Mitchell, “Equalisation Aspects of the New Federal- ism”, Aspects of the New Federulim Policy, op. cit.. p. 19.

28

diture needs in relation to specific purpose programs will continue to differ from relative differences in fiscal capacity generally. This problem has arisen in another form in Grants Commission inquiries; a major issue for the Grants Commission has been the appropriate treatment of specific purpose grants, such as schools grants and grants towards the operating costs of hospitals, which are based on needs or equalisation criteria that differ from the fiscal capacity equalisation principles adopted by the Comrnissi~n.~~

(c) The new federalism policy has, if anything, had an adverse effect on vertical financial balance in relation to State loan programs and it has done nothing to restore horizontal financial balance. Because capital outlays represent one of the few areas in the Commonwealth budget where there is some spending flexibility, loan programs and capital grants have fallen in real terms and relative to recurrent outlays during the last few years, thereby introducing a major distortion into the resource allocation process in the public sector.

Because changes in the allocation of the loan program among the seven governments in effect require a unanimous decision of the Loan Council, allocations have tended to reflect past allocations rather than current needs. This has been a major weakness in the Loan Council arrangements, although there has been some flexibility during recent years and States have in any case sometimes been able to circumvent the constraints on borrowing imposed by the Loan Council arrangements, for example by obtaining security deposits from mining companies to finance mineral railway projects and repaying the loans through freight earnings, leasing assets or purchasing them under instalment arrangements, and raising loans through semi-government or local authorities to finance expenditures that are normally met from State loan funds.**

Despite the problems which have been mentioned, the co-ordination of intergovernmental borrowing in Australia has been one of the major successes of Australian federalism. Doubts that have been raised in recent years about the future of the Loan Council seem to have been resolved by recent amendments to the Financial Agreement, which among other things imply that all governments accept the general arrangements for the coordination of borrowing and debt management.

The recent weakening of the Commonwealth’s financial position has raised a number of issues, including the opportunity which the States now have, through the Loan Council, “to comment on and decide the 27. See Commonwealth Grants Commission, Forty-second Reporf 1975 on S ial Assisfanee for

States, Australian Government Publishing Service, Canberra, 1975, pp. Sf%. for a discussion of this problem; also B. S. Grewal, Fiscal Equalisation, the Grants Cornmimion and the Schools Commission, Occasional Paper No. 5 , Centre for Research on Federal Financial Relations, Canberra, 1976.

28. See Grants Comn+$on, Forty-fin1 Report I974 on Special Assisrrrncefor States, Australian Government Publlshing Service, Canberra, 1974, p. 86.

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terms on which the Commonwealth will finance its Budget deficit”,’9 and the increase in borrowing by Commonwealth semi-government authorities which were previously funded through the Commonwealth’s Budget.

Other current issues affecting the Loan Council include the extended use of leasing arrangements and proposals by some States to finance development infrastructure by means of overseas borrowing.w These developments may be regarded as attempts to improve the flexibility of the Loan Council arrangements and to overcome some of the limitations discussed above, but if taken outside the Loan Council framework they could threaten the effectiveness of the co-ordination which has been achieved.

6. CONCLUSION It is not generally recognised that, during recent years, there has been

a dramatic shift in the balance of power in the Australian federal system, from the Commonwealth to the States. There have been three factors responsible for this. The first is constitutional, and stems from the in- herent instability in the Commonwealth government that has resulted from the power of the Senate to refuse supply to a government with a majority in the House of Representatives. The second is political, and stems from the success which State governments have achieved during recent years in mobilising support for so-called State rights. The third is financial, and results from a major change in the relative budgetary position of the Commonwealth and States.

Ironically, the shift in financial balance in favour of the States has resulted largely from a development which the States originally resisted as a threat to their own fiscal autonomy, namely the dramatic increase in specific purpose payments which occurred between 1972-73 and 1975-76. Whereas, during most of the period after World War 11, the Commonwealth was using its revenue surpluses to finance special loans to the States, the position has now been reversed; the Commonwealth is forced to borrow to finance revenue deficits incurred for the purpose of making specifice purpose grants to the States. There has thus been a change in the relative debt position of the Commonwealth and the States, while the Commonwealth has locked itself into a very difficult budgetary situation indeed. This shift in financial balance helps to ex- plain the Commonwealth government’s recent attempts to induce the States to accept greater responsibility for financing their own programs, for example by reducing the range and scale of specific purpose grants.31 29. A. R. G. Prowse and E. A. Mony, The Financial Agreement and the Future of the Loan

Council, Occasional Paper No. 4, Centre for Research on Federal Financial Relations, Canberra, 1976, p. 5.

30. fbid., pp. 5 , 7. 31. For an ana~ysls of the shift in federal financial balance, see W. R. C. Jay in ‘The Federal Year in

Review”, 1976 Report and Review of Fiscal Federalism in Australia, op. cit., pp. 30-35.

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The change in federal balance provides Australian governments with both an opportunity and a challenge to improve the effectiveness of decision making in the public sector. On the one hand, it offers and in- centive to the different governments to reconcile the conflicting needs of centralisation and decentralisation, of independence and interdependence, within the Australian federal system. On the other hand, it provides a challenge to the different levels and units of government to submerge their sectional interests in the interests of Australian government considered as an integrated system; in other words to follow the advice quoted by Professor Mills in his Presidential Address nearly 50 years ago, by acting “in terms of a co-operative effort which will preserve all that is best in local and sectional vigour” whilst meeting “the fundamentally changed conditions of a national life . . .”

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ISSUES IN AUSTRALIAN FEDERALISM