Michael Keating. Rebalancing government in Australia. Part II

Nov 4, 2014

Taxation Reform and Vertical Fiscal Imbalance

Another third and final reason for national government pre-eminence over the States in our federal system is of course the national government’s domination of taxation, widely described as ‘vertical fiscal imbalance’ or VFI. Paul Keating called VFI the glue that holds our nation together, but for the States and the champions of States’ Rights, VFI is regularly trotted out as the root cause of centralism.

In the past the national government has passed payroll tax back to the States, and more recently the States now receive all the proceeds of the GST. It would, however, require very big further changes to taxation arrangements for the States ever to achieve full financial self-sufficiency.  While broadening the GST and/or increasing the rate would offer material assistance to the States, the revenue from the GST would need to increase by around 90 per cent in order to replace completely the revenue that the States presently receive from the Australian government though various specific purpose payments. Clearly such a 90 per cent increase in the GST is most unlikely. Indeed the scale of the change and its implications for the balance between indirect taxation and income taxes would have major implications for equity.

Consequently, in order for the States to become completely financially independent they would need to raise a substantial amount in their own names by way of the income tax. In principle this might be possible if the States and the Australian Government were able to agree an arrangement for the States to share in the proceeds of the national income tax. But do the States want to do this and would the Australian Government agree?

In fact in the past the Fraser Government offered the States the chance to levy a surcharge on top of the Commonwealth income tax, but none of them took up the opportunity. Apparently the States preferred to continue the arrangement whereby the Australian Government took the blame for the level of taxation, while they spent the proceeds, and were then able to cry poor and blame the Commonwealth whenever their service provision was considered deficient.

Equally for the Australian Government to exercise its responsibilities for national economic management and performance it would need to control the share of the income tax proceeds that the States received. This would need to be a fixed share, and not allowed to vary from year to year according to the preferences of the States; otherwise such variations could play havoc with the Australian Government’s macro-economic policy. But in that case it is questionable how much independence the States would really gain. Indeed the stage could then be set for a return to the traditional argy-bargy about how much general purpose funding the Commonwealth should make available. While at the same time the Australian Government would have lost any financial influence over the national objectives that specific purpose programs are presently meant to achieve.


While there is a case for broadening the GST and increasing the rate, with the proceeds to flow to the States, this in itself is unlikely to change significantly the nature of our federal-state financial relations. Instead substantial VFI will most likely remain, in which case we cannot really expect much change in the incentives and consequently the behaviour of either the Australian Government or the States.

Furthermore, the biggest problem facing all levels of Australian governments in recent years has not been so much the balance of revenue between the Australian Government and the States, but rather finding sufficient revenue to fund the services that Australians are demanding without recourse to continued borrowing. Thus in the last full year of the previous Labor Government (2012-13) the Australian general government sector payments represented 24.1 per cent of GDP; in fact a bit less than their long term average over the previous twelve years since 2000-01 of 24.5 per cent. While by comparison government revenue represented only 23.1 per cent of GDP in 2012-13 – quite a bit less than the average of 24.3 per cent over the previous twelve years. So it is reasonable to conclude that we have a revenue problem rather than an expenditure problem right now. Furthermore, this need for additional revenue may well increase further over the next decade or more because of the ageing of the population and increasing expectations such as have led to the demands for additional funding for the National Disability Insurance Scheme.

The reality is that tax reform inevitably uses up scarce political capital. In these circumstances the priority must be to restore the Australian Government’s access to revenue; for example by reducing and even removing many of the expensive tax concessions and plugging present loopholes. Restoring the integrity of the tax system in this way is much more important than a futile pursuit of a non-existent ‘big-bang’ solution to improve the operation of our federal system. Such an approach is almost certainly impractical and could never gain the necessary consensus. Instead incremental progress is much more likely and in practical terms probably the best way forward to an improved federal system for Australia.  This incremental approach will need to be based on a continuation of case-by-case discussions for the various programs and regulatory areas leading to the rationalisation of the respective roles and responsibilities of each level of government.

Although this approach to reform sometimes seems slow and tedious, past experience shows that it can achieve results. And the pace of reform can be speeded up by a Prime Minister who is prepared to make reform of the federation a priority and provide the necessary leadership, as was demonstrated by the cooperation achieved at the time of the Keating Government.

Finally we need to remember that, as Abbott himself concedes ‘The federation we have – with all its flaws – has spawned a vibrant democracy, a strong economy and a cohesive society that millions of migrants have chosen to join’. Not only is there no real possibility of radical change in our federal system, neither is there any need for it.


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