Commonwealth of Australia

Determination of Shares in revenue (%)

Tax collection State/ All Base Rate and administration Federal province Local orders

Federal

user charges have become an important source of revenue for some local government bodies, but the capacity of local governments to raise user charges varies widely.

State governments are free to impose taxes, at whatever rates they choose, on all tax bases that are not reserved to other tiers of government by the Constitution or by subsequent legislative or judicial decisions. The principal tax bases available to state and territory governments include taxes on land and property, such as land tax and stamp duties; taxes on financial and capital transactions; taxes on activities and the use of goods, such as motor vehicle taxes; taxes on mining; and taxes on gambling and insurance. States and territories have established their own revenue offices and are responsible for administration and collection from their own tax bases as well as taxation policy.

In practice, there is little real tax competition among the states and territories. In part, this reflects a recognition of the futility of beggar-thy-neighbour policies, and, in part, it is influenced by the process of fiscal equalization, with its “all-state standard” approach to the assessment of revenue capacities. There is a view that state tax bases have been corrupted over the years and that states and territories have not optimized the revenue available from their own tax bases.

fiscal equity and efficiency concerns and intergovernmental fiscal transfers

Vertical Fiscal Imbalance

Table 5 indicates the extent of vertical fiscal imbalance across the three orders of government in Australia. The federal government raises about 80 percent of total public-sector revenue in Australia. This partly reflects the tax powers embedded in the Constitution and partly reflects subsequent history, legislation, and judicial decisions. But the federal government requires only about 61 percent of total public-sector expenditure to meet its own-purpose obligations.

State and territory governments, by contrast, raise about 17 percent of total public-sector revenue from their own revenue sources but require some 33 percent of total public-sector expenditure to meet their obligations. Local governments raise about 3 percent of total public-sector revenue and account for about 6 percent of total public-sector expenditure.

This mismatch between revenue-raising capacity and expenditure obligations produces a very large vertical fiscal imbalance across the two orders of government. Many consider the extent of vertical fiscal imbalance in Australia to be undesirably large and, in several important respects, to impose constraints on appropriate actions. It is sometimes said that it hampers reform and takes away motivation for fiscal reform on the part of the states and territories. A significant proportion of funding from the federal government to the states and territories comes with strings attached, and some see this as undermining the benefits of federation (i.e., undermining genuine subsidiarity, competitive federalism, and the states’ and territories’ ability to develop more efficient ways of funding and delivering services). It is also sometimes said that the large vertical fiscal imbalance has negative implications for the accountability of state and territory governments.

Most observers agree that a reduction in the extent of vertical fiscal imbalance in Australia would be desirable. Suggestions for how this might be achieved include allowing the states and territories to levy an income tax by piggybacking on the federal government (with the federal government making room by reducing its own tax rate) and reforming state tax bases, particularly in the area of land tax.

But it is generally agreed that, while the vertical fiscal imbalance in Australia is undesirably large, some degree of imbalance is desirable. Some degree of centralization of tax powers is considered essential in order to provide national fiscal capacity to undertake national objectives and priorities.

Fiscal Transfers and Horizontal Fiscal Equalization

The large vertical fiscal imbalance requires a process by which funds are transferred from the federal government to the states and territories to enable them to meet their expenditure needs. At the present time, these transfers total about $us48.6 billion a year, comprising both general purpose (or untied) transfers (just under $us30 billion) and specific-purpose transfers, which are tied to particular objectives (nearly $us20 billion, including nearly $us6 billion in health care grants).

Federal transfers are extremely significant to the states and territories. Total untied and tied grants currently comprise, on average, over 50 percent of state and territory budget revenues.⁶ Fiscal transfers to the states and territories are also a significant element in the federal budget. They represent about 25 percent of total federal government tax revenue – about 16 percent in the form of untied grants and 9 percent as spps.

Until 2001, the actual total amount of the untied transfers (the “pool”) was determined by the federal government (subject to certain guarantees) and paid to the states and territories under equalization arrangements as financial assistance grants. Since 2001, under the Intergovernmental Agreement (iga) accompanying major tax reform, all revenue collected under the newly introduced gst (a value-added tax) has been distributed to the states and territories as untied grants, replacing the financial assistance grants. These transfers continue to be untied, and the iga states that the distribution across the states and territories is to be based on the principle of horizontal fiscal equalization. Under the igs, the federal government agreed to cease applying wholesale sales tax, while the states agreed to remove a range of taxes such as financial institutions duty, stamp duty on marketable securities, and debits tax. Agreement has been reached to phase out a range of other state taxes over the next few years. Thus, the composition of the pool of fiscal transfers has changed, but the principles for its distribution to the states have not.

The states and territories were attracted to the new tax arrangements (particularly the gst) because it offered them access to a substantial growth tax. In this regard, their aspirations have been met (although the states and territories have not all benefited equally under the new arrangements). The gst/hcg (health care grants) pool has grown from $us18.2 billion in 2000–01 to an anticipated $us35.7 billion in 2006–07. By way of comparison, the financial assistance grant pool, prior to the introduction of the new arrangements, was just over $us6 billion in 1981–82, and it was $us12.9 billion in 1993–94.

Horizontal Fiscal Equalization

Untied intergovernmental fiscal transfers in Australia are based on the principle of horizontal fiscal equalization, such that:

State (and territory) governments should receive funding from the pool of gst revenue such that, if each made the same effort to raise revenue from its own sources and operated at the same level of efficiency, each would have the capacity to provide services at the same standard.⁷

This principle is implemented under a comprehensive assessment of state and territory revenue-raising capacities and expenditure needs undertaken by the Commonwealth Grants Commission. Rather surprisingly, given the significance and very comprehensive nature of fiscal equalization in Australia, the principle of horizontal fiscal equalization is neither enshrined in the Constitution nor set out in legislation. The current definition has been developed by the Commonwealth Grants Commission, and, for all practical purposes, the basis upon which equalization is implemented has remained essentially unchanged since the mid-1970s.

The Australian states and territories differ in size, population, geography, history, demographics, level of development, and resource endowment. A dollar in the hands of one state cannot always be transformed into the same level of services in the hands of another. Giving all states and territories the same per capita amount would result in quite different levels of capacity for service delivery, even if they followed the same policies. Therefore, the transfer system focuses on distributing the pool so as to equalize the fiscal capacities of the states and territories.

The Three Pillars

“The current approach to fiscal equalization in Australia rests on three conceptual pillars – capacity equalization, policy neutrality, and internal standards.”⁸ Capacity equalization is particularly important because it establishes the fundamental objective of equalization. Equalization of the budget capacities of the state and territory governments is intended to provide them with the capacity to provide an equivalent range and standard of services to their constituents.

The Australian approach to equalization is not directed towards outcome equalization. The objective of funding distribution is not to provide equal access to public services for all citizens, irrespective of where they live. The states and territories themselves do not do this; people in rural and remote locations cannot gain access to the same range of services as do people in metropolitan areas. In the interest of policy neutrality, the Australian approach to equalization seeks to establish policy standards based on the average of the policies actually adopted by the states. This approach recognizes that policy choices influence all areas of taxing and spending and that an approach that sought to establish policy-free standards cannot be constructed.

For the use of internal standards, the financial benchmarks are the all-state average of revenue raised under the various tax heads, along with expenditure across the various recurrent functions of state and territory governments. External standards or standards (benchmarks) that reflect some concept of best practice are not applied. The assessment of differential per capita revenue capacities or expenditure needs is made only with regard to those influences judged to be beyond the control of individual states and territories.⁹ States and territories are not compensated for differences that result from policy choices. A state or territory that chooses to spend more than the average on a particular function does not receive additional funding. It still gets only its assessed need for that function, based on the standard and an assessment of its non-policy disabilities. A state that chooses a high taxation regime keeps the additional revenue it raises, and its grant share is not reduced. So there are no incentives or rewards to encourage “good policies,” and there are no penalties for “poor policies.” But equally, there is no compensation for states that choose, for example, to have higher than average levels of expenditure or to make a less than standard revenue-raising effort.

The end result of calculating disabilities across the range of expenditure and revenue categories is a measure that is referred to as the state or terri-tory’s relativity – that is, its overall financial need relative to that of the other states.

In order to avoid year-on-year volatility in the relativities and grant shares, the calculation of relativities is based on a moving five-year average (i.e., averaging the relativities for each year of a five-year period), using the latest available data. No attempt is made to anticipate relativities or grant shares based on forward projections. This means that the effect of changes in the relative fiscal circumstances of the states and territories is reflected in the relativities and grant shares only with a considerable lag.

Relativities across Australia sum to one (i.e., the per capita relativities for each state and territory, when weighted for population share, will sum to one). The range for 2005–06 is from just under 0.9 for Victoria and New South Wales, to just over 4.3 for the Northern Territory.¹⁰ A relativity of less than one means that a state will receive less than an equal per capita share of the pool to be distributed; a relativity greater than one means that a state will receive more than an equal per capita share.

In 2004–05, the variation between the equalization distribution and an equal per capita distribution was about $us2.4 billion, equal to about

7.7 percent of the total pool of funds to be distributed.¹¹ New South Wales and Victoria received about $us195 per head less than their equal per capita share; all other states and territories received more, ranging from $us45 per head more than its equal per capita share for Western Australia to $us825 more for Tasmania and $us4,755 per head more for the Northern Territory (reflecting its very much greater expenditure disabilities). A little over two-thirds of the equalization distribution results from assessed differences in expenditure needs, and a little under one-third results from differences in assessed revenue capacities.

Western Australia (because of its access to royalties from natural resources) and New South Wales (because of its high asset values, particularly land and property values in Sydney) are assessed to have revenue-raising capacities above the all-state average, while Tasmania and South Australia have the weakest revenue-raising capacities. The Northern Territory has an assessed expenditure need that is more than twice the all-state average (reflecting the greater costs of service provision associated with its large area, generally inhospitable climate and terrain, small population, and the costs of delivering services to the relatively large indigenous population, particularly the large numbers living in small, scattered communities in remote locations). By contrast, Victoria has an assessed expenditure need below the all-state average, reflecting its relatively concentrated population and less demanding geographic and climatic conditions, allowing most services to be delivered at lower cost.

A major driver of the equalization redistribution are the assessments made to address the greater-than-average costs of providing services to indigenous Australians (which account for about one-third of the total redistribution). About two-thirds of the resulting total redistribution goes to support the assessed needs of the Northern Territory and Tasmania.

The comprehensive nature of equalization provides for an assessment of all circumstances and factors that affect the relative cost differences facing the states and territories in delivering standard services. These circumstances include the additional costs facing governments in meeting the requirements of large cities as well as those stemming from delivering services in rural and remote areas.

Australia’s equalization process is dynamic. The cycle of periodic reviews of methods and annual updates is designed to keep the relativities up to date in reflecting changes in the relative revenue-raising capacities of the states and territories and their use and cost of services over time. The relativities recently assessed for application in 2006–07 show a particularly clear trend, tracking the changes in the relative circumstances of the states and territories. Reflecting the strengthening of their fiscal positions (due to strong revenue growth from resource royalties and property markets), the relativities of Queensland and Western Australia have fallen, particularly over the last two years of the five-year assessment period. The relativities of New South Wales and Victoria have increased, reflecting the cooling of the property boom in these states and their lesser natural resource bases. The immediate impact of these changes on overall relativities and grant shares is dampened by the five-year averaging process. The proportion of the pool redistributed by equalization has shown a long-term decline between 1981–82 (nearly 12 percent) and 2006–07 (just under 7 percent).

Specific Purpose Payments

In addition to the untied pool of funds distributed under fiscal equalization arrangements, additional payments are made available by the federal government to the states and territories in specific areas. These are called specific purpose payments (spps). These payments are intended to support the implementation of particular national priorities. They are conditional payments, requiring the states to commit to undertake particular policies or programs, and sometimes requiring matching contributions by the states.

These payments currently constitute about 45 percent of total federal assistance to the states and territories. This proportion has varied from about 25 percent of total federal assistance in the early 1970s to just over 50 percent in the mid-1990s. These tied grants totalled $us14.6 billion in 2005– 06 (up from $us12.37 billion in 1998–99). They predominantly relate to areas that are the responsibility of the states and territories but that are also areas where the federal government wants the states and territories to support specific national objectives. The largest spps are in the areas of education, health, social security and welfare, transportation, and housing. spps for capital purposes totalled around $us2.25 billion in 2005–06.

The majority of spps are tied, meaning they are subject to conditions set by the federal government – conditions that are designed to ensure that national objectives are achieved. These conditions include general policy conditions, requirements that payments be expended for a designated purpose only, state maintenance of effort and matching funding arrangements, and reporting of financial and performance information.

The first-round distribution of these tied grants to states and territories is determined by the specific nature of the intergovernmental negotiations in each case. Some are determined on the basis of bilateral negotiations between the federal government and individual states or territories, while others are determined multilaterally between the federal government and all the states and territories together, typically in the context of the relevant Ministerial Forum of Federal and State/Territory Ministers.

The treatment of spps under current equalization arrangements, however, is not well understood. Where an spp relates to a function of state/ territory expenditure for which needs are assessed by the Commonwealth Grants Commission, the services funded by the spp and the spp revenue available to the state/territory are included in the scope of the commis-sion’s assessments. Since the spp contributes to state/territory revenue, the effect of this treatment is that, other things being equal, a state/territory with a higher than equal per capita share of the spp than the commission’s corresponding assessment receives a lesser share of untied grants. This approach is taken with regard to all spps that are relevant to the scope of the equalization assessments, except those that are excluded by the terms of reference. In practice, very few spps are excluded.

The Commonwealth Grants Commission

The Commonwealth Grants Commission plays a central role in the fiscal equalization process in Australia. It is an independent body established under federal legislation, its purpose being to provide recommendations, in the form of relativities, that reflect the fiscal circumstances of the states and territories. This is to be the basis for fiscal transfers whose purpose is to achieve horizontal fiscal equalization in the Australian Federation. The commission responds to terms of reference from the federal government. By convention, the states and territories are consulted on these terms of reference. The commission does not initiate its own inquiries.

The commission exists under the administrative umbrella of the federal government, but its key stakeholders are understood to be the states and territories, and there is extensive consultation and interaction between the former and the latter. While the commission makes recommendations on state/territory relativities, consideration of these recommendations is undertaken by the Ministerial Council of Treasurers, with the formal decisions being made by the federal treasurer.

The commission does not determine the quantum of funds to be distributed (i.e., the size of the pool). Its recommendations relate only to the distribution of the pool among the states. Under the gst arrangements, the quantum of funds available in the pool is whatever is raised through the gst.

Fiscal Federalism beyond Equalization

Horizontal fiscal equalization, including the distribution of the gst pool (i.e., explicit equalization) and spps, is only one element of overall fiscal federalism in Australia. Substantial implicit equalization of individuals takes place through other transfers, such as social security and health care arrangements, and other federal own-purpose outlays. In terms of the total amount redistributed, this implicit equalization is larger than is explicit equalization.

National Competition Policy, designed to promote a more competitive domestic market, also provides a further source of transfers from the federal government to the states and territories. Under National Competition Policy, states and territories have committed to review legislation that restricts competition, to apply competitive neutrality to government business activities, and to introduce specific competitive reforms in electricity, gas, water, and road transport. Subject to the National Competition Council’s finding that states and territories are complying with these requirements, payments are made to them to compensate them for the costs of these reforms. In 2005–06, these payments totalled about $us600 million.

Issues in Fiscal Federalism

While there continues to be general agreement in Australia that the financially weaker states and territories should receive additional financial assistance, there is a growing political debate about both the existing principle of horizontal fiscal equalization and its implementation. Not surprisingly, as the size of the gst pool has increased, this debate has become more vigorous. Some, particularly in the more populous states, argue that the current concept of fiscal equalization is no longer appropriate because equalization distorts efficiency, drives mediocrity rather than efficiency, and is not consistent with the contemporary wider public policy framework in Australia.

The limited research on this issue does not clearly support a conclusion in either direction.¹² Equalization potentially imposes efficiency costs, but it also has economic as well as social benefits. Some commentators have also noted that it is not the primary purpose of equalization to promote efficiency for the sake of national production.

Equalization is also criticized because it does not do what most people would naturally assume that it does. It is natural to think of equalization in terms of equity for individuals or communities – people being treated equally in terms of access to and quality of services, irrespective of where they live. The approach to equalization in Australia is not designed to achieve equality of outcomes for individuals or communities; rather, its objective is to achieve equality in the financial capacity of state and territory governments to deliver services of a comparable standard.

Supporters of equalization argue that it is a necessary condition for interpersonal or intercommunity equity. They contend that, without the current equalization arrangements, the fiscal system would be even further away from treating individuals equally. Groups with particular interests are critical of the existing approach on the grounds that the states and territories are not obviously spending money in areas for which they “receive grants.” More widely, there are concerns about the level of detail and complexity associated with the current process of implementation of fiscal equalization, including the use of data and judgment. The Australian approach to equalization generates enormous requirements for comparable and consistent data across all states and territories at high levels of disaggregation. There are questions about the adequacy of some data and the way they are used, and whether, in these circumstances, a comprehensive and highly disaggregated approach can clearly be said to produce a stronger equalization outcome.

Reflecting on the very comprehensive nature of equalization in Australia, some argue that horizontal fiscal equalization should be a safety net rather than a process requiring equalization of everything all the time. Some argue that the scope of equalization should be limited, for example, to the provision of “merit goods.” Others argue, in quite the opposite direction, that equalization should be extended to cover areas of state expenditure not currently differentially assessed.

A further criticism of the current approach involves using internal standards (i.e., what states do) rather than assessing needs and disabilities based on standards that reflect best practice in service delivery or revenue collection. This criticism reflects the importance of optimizing state and territory revenue-raising and expenditure policies and practices, particularly with respect to administrative efficiency. Proponents of this view often associate best practice standards with the principle of mutual obligation: states and territories that receive above average per capita grants should be accountable for the use of the additional funds.

The current approach to “policy neutrality” is also contentious, particularly given the range of adjustments that are made in the assessment process in order to reflect disabilities. The criticism is made that the current process attributes too much of the differences between states and territories regarding the costs of providing services or revenue raised to effects of disabilities, thus understating the effects of policy differences on different costs of service provision and revenue capacities.

Others strongly support the current approach, arguing that it reflects the broad and long-established political consensus concerning the objectives of equalization, which constitute an integral part of the fabric of the Federation. It has been the long-standing position of the Australian government, indeed of both major political parties in the federal arena, to support horizontal fiscal equalization as appropriate to the circumstances of the Australian Federation.

Recent Developments

Under the normal review cycle of fiscal equalization, comprehensive reviews of the methodology for determining relativities (and hence grant shares) are undertaken every five years. These have been limited to a review of the equalization methodology rather than of the principles and objectives of equalization. These reviews have not, therefore, provided a forum for those seeking to modify the principles of equalization in order to argue their case (to their increasing frustration).

In its 2004 report on state relativities, the Commonwealth Grants Commission made a number of observations about equalization and its imple-mentation.¹³ It expressed the view that it would be beneficial to review the equalization principles but noted that whether or not such a review was initiated was a matter for governments to decide. It recommended that, in the next review, states and territories agree to consider several matters relating to the implementation of equalization. These included the scope of equalization (whether the present approach, based on a comprehensive assessment of virtually all receipts and expenses in states’ operating statements, was appropriate and necessary), the size and trend of the redistributions, whether the process could be simplified (with a higher level of aggregation and fewer adjustments), and examination of the robustness and comparability of key data sets and likely future data availability.

For its 2010 review, the Commonwealth Grants Commission has been given terms of reference directing it to simplify its methods and to regularly report to the Ministerial Council of Treasurers on aspects of simplification. The Ministerial Council has not endorsed a more fundamental review of equalization, including its underlying principles and objectives.

Local Government

There are about 720 local government bodies in Australia, and they vary considerably in size and complexity. Populations vary from around 150 to nearly one million, while areas vary from two square kilometres to over 378,000 square kilometres. Functions also vary – for example, water supply and sewerage is a local government function in some states but not in others.

There are large differences in the range of services provided by councils in capital cities, metropolitan areas, regional centres, rural communities, and remote areas. There are also large differences both in how they raise revenue and in their capacity to do so. Services provided by local government bodies typically include engineering services (roads, bridges, drainage, etc.), community services (elderly care, childcare, fire prevention, etc.), environmental services (waste management and environmental protection), regulatory services (buildings, restaurants, and animals), and cultural services (libraries, art galleries, and museums).

Local government is the responsibility of the states and territories. They provide the legislative framework in which local government bodies operate, and they oversee their operations. As creatures of the states and territories, local government bodies are subject to regulation by state and territory governments and to legislation that may be amended by state/territory parliaments. A degree of autonomy for local government bodies is generally respected, but state and territory governments do have authority to intervene in local government fiscal matters (such as revenue decisions by councils) and, in some states, they have done so (e.g., by imposing rate capping). State governments also impinge on local government autonomy in areas such as local development and planning decisions. Local government functions have expanded over the last thirty years, and the composition of expenditure has changed markedly. Some of the larger changes over this period have been the following: a movement away from property-based services to human services; a decline in the relative importance of expenditure on roads; an increase in the relative importance of recreation and culture as well as housing and community amenities; and an expansion of education, health, welfare, and public safety services.

As a sphere of government in Australia, local government is small financially, and its relative importance has been declining. In 1961–62, local government was responsible for 8 percent of total government outlays, but by 1997–98 its share had declined to 5 percent. Local governments have limited revenue powers; the major source of revenue for local government in all states is taxes on properties (rates), which comprises about 50 percent of revenue on average. User charges are increasing in importance as a source of revenue, but the capacity of local government bodies to levy them varies considerably.

Historically, local government expenditures have exceeded the revenue available from their own sources. Prior to 1974, the states were the main source of additional financial assistance for local government. In 1974, the federal government introduced a program of untied financial assistance through the states (and, subsequently, the territories) to local government. The reasons cited involved making the third tier of government a genuine partner in the federal system and giving local government access to the na-tion’s finances. Subsequent federal governments have maintained and extended the program of financial assistance for local government. The level of financial assistance from the federal government (in the form of financial assistance grants) currently amounts to just over $us1.1 billion. On average, this equates to almost $us53.00 per capita, but reflecting the diversity of local government, the amount individual councils receive varies from about $us15.00 per capita to over $us5,250.00 per capita.

Federal transfers to local government are allocated to the states and territories on an equal per capita basis.¹⁴ Local government grants commissions are required to be established in each state and territory, and to allocate the funds received by the state to local government bodies within the jurisdiction on an equalization basis, subject to the qualification that every local government body in a state is entitled to receive an equal per capita allocation of 30 percent of the total state pool (to reflect the principle that all councils should share in the grant process).

Federal funding also includes a separate road pool, which is distributed to local councils on the basis of their relative need to maintain a local road network. This arrangement reflects the importance of local roads to local government. An inquiry to examine the interstate distribution of local road funding is currently being conducted.

Funding received by local government bodies under these financial assistance arrangements is untied, but it is expected to be applied in a manner that is consistent with the national principles set out in the legislation. Local government bodies also receive some financial assistance from the federal government in the form of spp. These totalled around $us330 million in 2005–06.

Since the introduction of the federal grants, local government revenue from all sources has grown on average by just over 10 percent per annum. The fastest-growing revenue source has been user charges (13 percent per annum). Federal assistance has increased at around 10.8 percent per annum and municipal rates at 9.4 percent. State assistance has grown more slowly, at 6.6 percent per annum. In total, financial assistance grants from the federal government to local government bodies contribute around 10 percent of local government revenue. (The figure is much higher in the Northern Territory, where there is less ratable land.)

State grants to local government have increased in absolute dollar terms but have declined in relative importance from about 15 percent of total local government revenue in 1974 to around 7 percent in recent years.

Financing Capital Investment

The assessment of state and territory needs for equalization transfers (and most spps) is based only on their need for recurrent budget assistance. (Since the equalization transfers are untied grants, states and territories may use these grants for capital purposes.) State, territory, and local governments are free to borrow to support capital investment, subject only to their ability to gain access to capital markets on acceptable terms.

Most states have modest borrowings, including foreign borrowings, which, typically, are undertaken through treasury corporations. All states have received credit ratings from the major credit ratings agencies, with most currently holding aaa ratings.

The previous Australian Loan Council arrangements, which restricted and regulated state borrowings, has been replaced by arrangements that operate on a voluntary basis and that emphasize the transparency of pub-lic-sector financing rather than adherence to strict borrowing limits. These arrangements are designed to enhance financial market scrutiny of public-sector borrowing and to facilitate informed judgments about each govern-ment’s financial performance.

Fiscal Federalism Dimensions of the Public Management Framework

Public-sector management is autonomous within all orders of government. Public-sector staffing and management responsibilities are separate and distinct in all governments (except for the very rare instance in which, when serious misadministration has occurred, a state government has appointed an administrator to replace a local government). Public servants in each jurisdiction are responsible to the relevant jurisdiction minister, and there is no involvement or interference in public-sector appointments or public-sector management generally from one tier of government to another. Each tier of government is free to determine its own size and the structure of public service.

The exercise of executive powers within the states and territories is completely autonomous. Constitutionally, it can be argued that the position of the territories is different from that of the states in that their status and operations can be overridden by the federal Parliament. In practice, however, the territories are treated as states, and this overriding has occurred only in the most exceptional circumstances.

There is more scope for intervention by states and territories in the activities of local governments than in the activities of the federal government. However, while intervention does occur, it is on an exceptional rather than a routine basis and is associated only with instances of serious mismanagement. In some states, the state government has legislated to require local government amalgamations or to impose ceilings on the rate increases that local governments can introduce from year to year. However, at a practical level, the federal government has made considerable use of its fiscal strength to achieve particular objectives. Corruption is not seen as a serious issue in any order of government in Australia. There are comprehensive and rigorous requirements for audits of all agencies, and there is parliamentary oversight for all governments. All states and territories have established ombudsmen commissions and a range of review and appeal mechanisms.

the way forward

The structure of intergovernmental financial arrangements in Australia is well established and comprehensive. It reflects both the constitutional structure of the Australian Federation and the results of political and judicial decisions taken over the years since Federation. Significantly, it also reflects the strongly egalitarian outlook in Australia expressed in the notion of equitable treatment of all citizens. The arrangements focus on federal, state, and territorial governments, with local government occupying a very minor role.

Fiscal federalism in Australia is characterized by a high level of vertical fiscal imbalance between the federal and subnational governments. The extent of vertical fiscal imbalance is larger in Australia than it is in most federations. A unique feature of Australian taxation is that tax bases are available almost exclusively to one order of government, with the federal government having access to the major tax bases.

Most commentators consider the extent of vertical fiscal imbalance in Australia to be undesirably large, imposing constraints on desirable reforms within the states and territories. Notwithstanding this, some degree of vertical imbalance is generally seen as desirable. Some degree of centralization of tax powers provides national fiscal capacity to undertake national objectives and priorities. When the federal government announced a benchmark study of Australia’s taxation structure, there was no suggestion that the extent of vertical fiscal imbalance was a matter for review (or even of any concern).

The high degree of vertical fiscal imbalance places considerable focus on the process for transferring funding to the states and territories. In Australia, this is done under the principle of horizontal fiscal equalization, which aims to provide state and territory governments with equal fiscal capacity to provide services to their constituents. This process, which is undertaken through a comprehensive assessment of the relative revenue-raising capacities and expenditure needs of state and territory governments, has in the past generally had a high level of acceptance. However, within the context of budget constraints, and as the circumstances of the states change and the scale of these transfers increases, a number of stakeholders are now questioning this process.

The increasing criticism of horizontal fiscal equalization, particularly from the “donor” states, is directed at both its principle and its implementation. As an issue of principle, it is said that equalization presents an impediment to efficiency. There are clearly trade-offs between equalization and a strict notion of efficiency, but the limited research on this question in the Australian context does not clearly support an argument in either direction. There are also increasing calls to limit the redistribution to only the weakest states or territories rather than to seek equalization across all.

Many people in the larger states have also begun to argue that gst revenue should be distributed on a derivation basis – that is, that it should be returned to the jurisdiction in which it was generated. If implemented, this would lead to massive changes in its distribution and would clearly leave the states and territories in unequal fiscal circumstances. The larger, donor states argue that, under the current approach, the size of the redistribution away from them is becoming unsustainable.

An issue of principle is that the existing equalization processes are not well understood, and there are common misconceptions – in particular, that it seeks to achieve interpersonal or intercommunity equity. It is clearly not a good thing that such an important element of the architecture of the Federation is not well understood.

Criticisms of the implementation of equalization in Australia focus primarily on its complexity. The methodology, which seeks to establish non-policy differences across states and territories over the range of their revenues and expenditures, is extremely comprehensive. Criticisms note its use of data and reliance on judgment. Most commentators agree that, for some assessments, data are used in a manner that contravenes appropriate levels of confidence. The current implementation of equalization is also criticized for using internal standards (i.e., what states do) rather than best-practice standards to determine appropriate benchmarks for revenue capacity and expenditure need. Not surprisingly, the smaller, recipient states are generally supportive of the current approach to equalization.

There has been reluctance to review the principles underlying horizontal fiscal equalization in Australia. Many see it as an essential element of the Federation and one that has served it well. Because it regards the gst as a state/territory tax, the federal government has consistently indicated that such a review would only be considered with the unanimous support of the states and territories.

In contrast with other federations, such as Canada, where there is lively debate over federalism, the limited wider interest in these issues in Australia, including the lack of academic interest in and research on fiscal federalism, means there is very little empirical evidence regarding the implications of equalization for the Federation.

While governments have consistently been unable to agree that the principles of horizontal fiscal equalization should be reconsidered, they have recently agreed to review aspects of its implementation. This review is to be conducted by the Commonwealth Grants Commission as part of its next major review of methodology. The terms of reference given to the commission direct it to simplify its assessments, with particular and early focus on such elements as the materiality of assessments (i.e., whether a particular assessment has a material impact on the relativities and grant shares), the reliability of assessment methods, the scope for more aggregated assessments, and the use of data. It is not clear where these debates will lead in the years ahead. On the basis of current trends, there will be four “donor” states in the next few years, signalling, at the political level, a potential shift in the balance of opinion regarding equalization principles and objectives. The two largest states, while expressing continuing support for the broad principles of equalization, are already arguing vigorously for a new approach that would reduce the extent to which they “subsidize” the smaller states. The federal government has begun to express strong views that the states and territories have not used the increased grants that have resulted from the introduction of the gst to effectively improve service delivery. It seems likely that the Council of Australian Governments will have the issue of fiscal federalism on its agenda in the coming days. It is too early to say where this might lead.

notes

1 The functions of the federal government are set out in Sections 51–52 of the Australian Constitution, while Chapter 5 of the Constitution outlines the broad functions of the states.

2 In 1995, a range of initiatives were agreed by all Australian governments designed to enable and encourage competition in the interests of the well-being of all Australians and the long-term sustainability of Australian industry. These initiatives were collectively termed National Competition Policy. The principal elements of National Competition Policy were the introduction of competitive neutrality to enable privately owned businesses to compete with government enterprises on an equal footing; the development of a national access regime to enable competing businesses to use nationally significant infrastructure; and specific reforms in the gas, electricity, water, and road transport industries.

3 Following the bombing of Darwin during the Second World War, uniform income taxation legislation was enacted by the federal government, beginning on 1 July 1942, to enable the Commonwealth to meet expenditure needs during the war. The intention was that the Commonwealth would continue collecting income tax until one year after the end of the war. This legislation remains in force.

4 The Inter-governmental Agreement on Reform of Commonwealth-State Financial Relations came into force on 1 July 1999. Among other things, it introduced a goods and services tax. The Commonwealth and the states also agreed to the abolition of a range of taxes. The goods and services tax was to be collected by the federal government at a uniform rate. The agreement provided that the revenue raised by the goods and services tax would be transferred to the states and territories under horizontal fiscal equalization principles.

5 A Second Statement on the Conduct of Monetary Policy was issued by the federal treasurer and the governor of the Reserve Bank of Australia in July 2003. It set out the agreement between the treasurer and the governor on their respective roles and responsibilities in the operation of monetary policy in Australia. The statement confirmed the independence of the bank and the objectives of monetary policy, including medium-term price stability.

6 The relative importance of federal transfers to the states and territories varies. At the upper end, federal transfers constitute about 85 percent of total government revenue in the Northern Territory, while at the lower end the figure is about 45 percent in New South Wales.

7 Commonwealth Grants Commission, Report on State Revenue Sharing Relativities, 2004 Review (Canberra, February 2004), 4.

8 Ibid., 5.

9 The Commonwealth Grants Commission terms these influences “disabilities.” The nature of disabilities, and how they are assessed, is provided in each review or update report of the commission. For example, see Commonwealth Grants Commission, Report on State Revenue Sharing Relativities 2004, Review (Canberra, February 2004), 7.

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10 Commonwealth Grants Commission, Report on State Revenue Sharing Relativities, 2006 Update (Canberra, February 2006), 19.

11 Commonwealth Grants Commission, Report on State Revenue Sharing Relativities 2004 (Canberra, February 2004), 21. Over subsequent Updates, the proportion of the gst pool redistributed has decreased, and for 2006–07 it is anticipated that it will be less than 7 percent.

12 Modelling undertaken for the Review of Commonwealth-State Funding, commissioned by the states of New South Wales, Victoria, and Western Australia, found that replacing the Commonwealth Grants Commission’s recommended allocations to the states and territories with an equal per capita grant distribution would increase national welfare by usD$126 million. See R. Garnaut and V. Fitzgerald, Review of Commonwealth-State Funding Final Report August 2002 (Melbourne), 143. Using different assumptions, the same model found a welfare gain from horizontal fiscal equalization on the order of us$106 million. See Mark Picton and Peter B. Dixon, Issues Involving Modelling by cops of the Efficiency Effects of Commonwealth State Funding: Report to Queensland Treasury (Melbourne, Centre of Policy Studies, Monash University, March 2003).

13 Commonwealth Grants Commission, Report on State Revenue Sharing Relativities 2004 Review (Canberra, February 2004), chap. 7.

14 The basis of these transfers and their purposes are set out in the Commonwealth Local Government (Financial Assistance) Act, 1995.