Michael Keating. The Turnbull Proposal for State Income Taxes

Prime Minister Turnbull says his proposal for the States to levy their own income tax ‘is the most fundamental reform to the Federation in generations’. Well maybe. It certainly would be a significant change, but reform? Furthermore, even if this proposal were ever implemented, it is hardly new. For example, the Fraser Government actually legislated to allow the States to raise their own income taxes, but none took up the opportunity.

In principal I agree that governments would be more accountable, and possibly more responsible, if they raised all or most of the revenue needed to fund their expenditures. Consequently, I accept that a move towards reducing the present degree of vertical fiscal imbalance and better match revenue and expenditure responsibilities should be seriously considered.

At this stage, however, Prime Minster Turnbull is only proposing to transfer 2 percentage points of the income tax rate to the States; effectively an annual transfer between the Commonwealth and the States of about $14 billion. This compares with the $8 billion a year that the Abbott Government took away in the notorious 2014 Budget, and if nothing else changed this extra $14 billion would be quite a carrot to induce the States to agree.

The Turnbull Government, however, is indicating that it is prepared to restore around $3 billion of these cuts to State payments, and so allowing the States to raise $14 billion in income tax revenue would leave the Australian Government Budget a net $9 billion down. Further savings would therefore be necessary, either from the Commonwealth’s own programs or from payments to the States. In this context it is not surprising that the Treasurer has floated the idea that another $6 billion could be clawed back by the Commonwealth ceasing its funding of State schools as part of the $14 billion package.

But apart from this fiscal problem, realistically much more would be needed to realise the Prime Minister’s vision of the States taking over full responsibility for a variety of functions and thus ending the ‘blame game’. Indeed, the $14 billion a year that has so far been floated would not even cover the cost of the Commonwealth contribution to hospitals as well as schools.

Most importantly, in this context, is that $14 billion is well short of the total of $50 billion paid each year to the States to cover all presently tied grants. For the States to be fully responsible for funding all their services would therefore require a far larger share of the income tax than has so far been mentioned, or alternatively allowing them much more freedom and capacity to increase income tax rates.

But until the States get the taxable capacity to raise all or most of this annual $50 billion does anyone seriously believe that this relatively small change to give them a 2 percentage point income tax rate would make the States much more accountable and responsible?

In my opinion there is some further scope to rationalise the respective roles and responsibilities of the Commonwealth and the States. For example, if Mr. Turnbull is fair dinkum why doesn’t he offer to return to the arrangements established by the Keating Government under which the Commonwealth was totally responsible for funding national highways, while the States and local government had total responsibility for all other roads. This arrangement was a sensible separation of responsibilities, but it fell foul of the pork-barrelling National Party, and so the Howard Government reversed it.

As both John Menadue and I have emphasised, however, for many joint government programs there are good reasons why we have adopted our present shared funding arrangements (see my earlier article on Federalism, reposted on 31 March, and John Menadue’s post on the same day).

Most importantly, in many cases the Australian Government has responsibilities that cannot be separated from those of the States. For example, education and training is vital for the future of innovation, productivity, employment participation, and economic growth, all of which are key Commonwealth responsibilities. While health necessarily involves both levels of government, as the Australian Government responsibilities for Medicare and aged care necessarily interact with the State Government responsibilities for hospital care.

Indeed, the Turnbull Government seems to be prepared to acknowledge that separating the roles and responsibilities of the two levels of government presents a particular problem. According to some media reports the Australian Government may not withdraw from health funding, but it could withdraw totally from having any responsibility for Schools. Certainly the Australian Government has less at stake in schools, where its intervention has never achieved a great deal in the past. But in that case, maybe the Australian Government should take over total funding responsibility for vocational education and training which is necessarily closely related to the needs of industry, and where most of the funding is increasingly being provided to both private and public providers using a competitive model.

Perhaps the most important Australian Government responsibility that would be compromised by the States setting their own tax rates would be the potential impact on fiscal policy. In the immediate future this is not expected to be a problem as the proposal envisages that the States would initially only be getting what would effectively be a share of the income tax, and the change would be revenue neutral. But once the States start setting their own income tax rates then this would compromise the necessary independence of the Australian Government to determine fiscal policy for the nation. Indeed, time is of the essence with fiscal policy and we cannot afford to have it run by some sort of Federal-State Committee. While on the other hand if governments set tax rates independently of one another, there is a risk that any time the Australian Government lowers its tax rates, then the States would seize the opportunity to take advantage of the extra taxation capacity available, and raise their own State income tax rates.

In addition, although the Australian Tax Office would continue to be responsible for administering the tax system, and each taxpayer would continue to file only a single return, there would be a number of administrative problems with the Prime Ministers’ proposal that would not be easy to resolve. Thus, unlike the GST revenue, which has a common tax rate and can therefore be distributed on a per capita basis, this per capita distribution makes no sense for income tax revenue if rates of taxation differ among States. Accordingly, companies are already demanding that the states should not have a share of company tax because of this sort of complication. Many individuals, however, also derive income in more than one state, and it still remains to be worked out how their income tax payments can be distributed between two or more States where the rates of taxation vary.

As John Menadue points out in his accompanying post, given its many problems and lack of clarity, this proposal by the Prime Minister is essentially a diversion from what is or should be the major concern of the Council of Australian Governments (COAG). The most critical challenge, which all Australian governments are facing, is first to repair the substantial Budget deficit, and in the longer-run to reconcile the demands for public services that are presently projected to run well ahead of likely government revenues.

What COAG should therefore be discussing is how to raise more revenue and/or reduce the demand for services or improve their efficiency. Personally, and as I have argued in other postings, I think it will prove to be impossible to meet reasonable demands for future services without at least some increase in overall taxation in the decades ahead (see, for example, my recent article posted 28 March).

In this regard the response by the Labor leader, Bill Shorten, to any suggestion that income tax might rise sometime in the future was most unhelpful. Mr. Shorten has already ensured that the possibility of raising the necessary extra revenue by increasing the GST was taken off the table, and now he seems to be intent on doing the same to any possible increase in the income tax in the decades ahead. One wonders how Labor could deliver its vision of society, and what it has supported, without increasing the overall tax take in the future – certainly Mr. Shorten has so far not told us.

By contrast, allowing the States to determine their own tax rates raises the risk that at worst the States may enter a new race to the bottom. This is what happened after payroll tax was handed over to them by the McMahon Government in 1971. The States have since dropped the payroll tax rate and increased the tax threshold and exemptions. Ostensibly this was in response to tax competition generated by a perceived need to attract new firms, but most of the changes did little to attract industry because they mainly helped small business which is not geographically mobile.

On the other hand, this time the Australian Government may force States to raise taxes by further squeezing their remaining tied grants. In that case the Australian Government would continue to solve its own fiscal problems by short-changing the States so that they are forced to raise taxes and thus take the blame for solving a problem of the Australian Government’s own making.

A better alternative would be to adopt the proposal by SA and NSW that the States all get a fixed share of the income tax. This hypothecated share of the income tax could then be increased if all governments agreed to raise the rates for this purpose. Furthermore, by thus achieving an agreed increase in the overall level of taxation nationally, it would help to resolve Australia’s most important longer-run fiscal problem.

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