Michael Keating. Tax Reform and Future Federal-State Relations

Dec 10, 2015

All informed opinion is that fiscal repair in Australia will require action on the revenue side as well as the expenditure side of the Budget. Accordingly at least some tax reform is essential and unavoidable.

In addition, reform of the taxation system and the future of federal- state relations are inevitably closely connected. First, possible changes to increase the GST revenue are central to many of the proposals to raise the necessary extra revenue and would represent a key element of tax reform more generally. Second, for very good reasons all the revenue from the GST is passed to the States, so changes to the GST not only require the agreement of the States, but these GST changes are likely to involve further changes in Federal-State relations.

Thus two meetings on Thursday and Friday of this week, the first of Treasurers and the second involving heads of Australian governments, loom as being particularly important for the future of federal-state relations and our economy. The focus will be on the options for improving all governments’ future fiscal positions, and while these meetings are unlikely to arrive at concrete decisions at this stage of the ‘reform’ process, they should set the direction for possible future reform.

In what follows I consider some of the issues that these meetings of Treasurers and Heads of Government will need to address.

What are the additional revenue options?

It is understood that at the request of the States, the Australian Treasury has been modelling various options to (i) increase the rate of the GST and/ or (ii) to broaden its coverage, and/or (iii) raise the Medicare Levy over time. As reported in the press, the maximum revenue raised could be as much as $45 billion annually or as little as $15 billion.

There is general agreement that the options to increase the revenue from the GST will only be adopted if adequate compensation is provided to the lower and middle income groups affected. This is, however, only one instance of the more general point that any assessment of these options for raising additional revenue cannot be divorced from what would be done with the very substantial revenue proceeds.

Who benefits from any additional revenue?

A critical problem in determining the purposes for which the additional revenue might be used is that under present laws all the extra revenue from changes to the GST would flow to the States, and the Commonwealth doesn’t benefit at all. Of course, the present assignment of the GST revenue to the States could be over-turned, but that would be a serious step backwards in federal-state relations. It would probably result in two levels of government sharing the same revenue source, and this would in turn most likely lead to a return to previous arguments over revenue shares, with the States being concerned that they were being short-changed by the Australian government. Essentially the accountability of which government was responsible for any poor performance would be further muddled by any shift in favour of revenue sharing.

Accordingly, if the States are to retain all the extra revenue from any increase in the GST, then other ways will have to be found for the Australian government to meet its own demands for extra revenue – particularly to:

  • meet its essential demands to finance the compensation packages,
  • contribute to the restoration of its own fiscal surplus, and
  • provide some scope for tax cuts at least sufficient to remove the impact of bracket creep which is leading to middle income earners moving into higher tax brackets.

A possible ‘reform’ package

In the series Fairness, Opportunity and Security I outlined a strategy that met these demands by the Australian government and the States to spend the extra revenue that could be expected from options to change the GST. The critical element was a large reduction in specific purpose payments to the States. In this way the States would have a net gain from their increase in GST revenue, but much of the increase in the GST revenue gain would be offset by the reduction in specific purpose payments from the Budget.

In principle, this reduction in specific purpose payments from the Australian Government to the states would reflect a rationalisation of the governments’ respective roles and responsibilities; the bigger the rationalisation, the bigger the reduction in the specific purpose payments. The States would no doubt welcome their increased autonomy, and it would be portrayed as a major reform of federal state relations, leading to less duplication and improved accountability. Nevertheless, another critical issue is how far the Australian government can withdraw from its present shared responsibilities with the States without jeopardising the achievement of objectives for which the Australian government is held accountable.

In particular, it will be difficult to make large reductions in these specific purpose payments without some withdrawal from school or hospital funding as in the current financial year schools and hospitals account for some $30 billion of the $50 billion total in tied grants from the Australian government to the States. However, can the Australian government afford to totally withdraw from schools policy when innovation, employment participation and the future growth of the economy are all influenced by the quality and quantity of education. Similarly, the Australian Government is directly responsible for funding the provision of medical services through Medicare, but if it were to withdraw from the funding of hospitals there would probably be less integration in the provision of health services when desirably there should be more. On the other hand, it would however be difficult to reduce the funding of specific purpose programs by a lot without reducing Australian government funding for education and health.

The Grattan Institute proposals

Earlier this week the Grattan Institute made an important contribution to this discussion when it released a new report proposing A GST Reform Package. This report provides a more solid base of quantitative information which allows us to get a better handle on the exact dimensions of the choice between tax reform and more devolution to the States on the one hand, and on the other hand, the retention of influence by the Australian Government that it might need to achieve its own objectives.

In brief the preferred option favoured by Grattan would increase the GST rate to 15 per cent, which is estimated to generate around an extra $27 billion in revenue. Grattan would then spend around 30 per cent of this extra revenue on welfare payments, and expects that this would leave most of the bottom 20 per cent of income earners better off. Second, Grattan would commit a further 30 per cent of additional revenue to income tax cuts which would allow the government to shave 2 to 2.5 per cent percentage points off the bottom two tax rates. Along with the higher welfare payments proposed, Grattan considers that tax cuts of this magnitude would fully offset the increase in GST for most low and middle income households – those earning up to $100,000 a year – while also providing some benefit for those further up the income distribution.

At first glance this seems like a very attractive package, noting that it could be further tinkered with, especially by adjusting the ways in which the extra GST revenue is raised. As previously foreshadowed, however, the problem is how does the Australian government get its hands on the funds necessary to increase the welfare payments and reduce the income tax as proposed, let alone meet its responsibilities for returning the Budget to surplus. Instead, the reality is that the States are expected to pocket all the extra $27 billion GST revenue which would be raised in this package.

Accordingly Grattan proposes that the Commonwealth reduce the amount of its tied grants to the States by $22 billion so that the States are only better off by around a net $5 billion. Whether that would be sufficient to buy the States support for this sort of package is a moot point, as $5 billion is well short of the $20 billion a year which has already been cut from their budgets for health and education. Furthermore, it would be almost impossible to cut $22 billion out of tied grants to the States without withdrawing from all tied grants other than for health and education, or alternatively making very deep cuts to the grants for health and/or education.

But leaving these two problems aside for the moment, a further issue is that the fiscal position of the Australian government is only improved by a net $22 billion under the Grattan proposals. Out of this $22 billion the Australian government would have to fund an increase in welfare payments ($8 billion) and cuts in tax rates ($8 billion) leaving only around $6 billion to improve its budget and meet any other commitments, including the more ambitious tax cuts which the government would no doubt prefer.


What this Grattan package demonstrates most clearly is first, that as always, the devil is in the detail. Second, tax reform to put the nation’s finances on a more sustainable footing is necessary, but equally it is not easy. In particular, this specific package by the Grattan Institute raises the question of whether the relatively small gains are worth the pain?

Ultimately the problem for the Australian government in relying heavily on the GST to raise extra revenue is that the proceeds only flow to the States. So if the Australian Government wants to get more of that extra revenue it has to cut its tied grants harder, but for the most part these are closely related to its own responsibilities and reflect its own priorities.


Michael Keating AC was formerly Secretary, Department of Finance and Secretary, Prime Minister and Cabinet. He was the joint editor of the policy series ‘Fairness, Opportunity and Security’ which was posted on this blog and published as a book by ATF.

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