Michael Keating. The Future of Federalism

May 20, 2015

Fairness, Opportunity and Security
Policy series edited by Michael Keating and John Menadue.

Six months ago Tony Abbott announced that he wanted to ‘create a more rational system of government for the nation that we have undoubtedly have become’. A worth aspiration, but what does it mean in reality?

Fundamentally there are two contending doctrines regarding the future of federal-state relations in Australia. One view is that we should be working towards a clearer separation of the respective roles and responsibilities of each of the two levels of Government. The other view is that the two levels of government inevitably have to share responsibilities, and that the best way forward must be a system of cooperative federalism based on better arrangements for sharing joint responsibilities in the future.

This article will examine each of these two contending viewpoints, and their respective implications for the future of our federal system of governance. The conclusion is that each viewpoint has its merits, and in the best traditions of Australian public policy pragmatism, an amalgam of the two based on the nature of the different responsibilities for each of the different functions is probably the best outcome.

Separate roles and responsibilities

There is considerable intellectual attraction in the philosophical proposition that our system of government should be arranged so that:

  • policies and service delivery are as far as practical the responsibility of the level of government closest to the people receiving those services, and
  • each level of government is sovereign in its own sphere, with minimum duplication between the Commonwealth and the States.

Of course this proposition is not new; indeed the champions of States’ rights insist that this is what the framers of the Constitution intended. Furthermore a clearer separation of roles and responsibilities, coupled with commensurate revenue raising capacity, should enhance democratic accountability. It should also help improve efficiency by reducing duplication and ending the blame game where the buck is passed back and forth between governments.

Liberal governments have traditionally been attracted to these ideas, although their actual policies have often led to increased power and intervention by the Commonwealth in areas such as schools, irrigation and roads. The most important transfers of power from the Commonwealth to the States have, however, been initiated by Liberal governments. First payroll tax was passed over to the States and more recently the GST was introduced with the States receiving all the proceeds.

Shared responsibilities but separate roles

Despite the intellectual attraction of each level of government having its own clearly identified separate roles and responsibilities, there are in fact good reasons why the national government has become increasingly involved in functions that were originally the responsibility of the States:

  1. The actual decision to federate was always intended to lead to the development of a national market, but a consequence of that, along with increasing globalisation, is that common standards and regulation is required across many fields including rail gauges, heavy transport, workplace relations, company law, competition policy, food standards and the recognition of qualifications.
  2. The responsibilities of governments have grown, with the Australian Government now having constitutional responsibility for income support, medical services, pharmaceuticals, and public health. In addition, it is the Australian Government that is expected to manage the macro-economy, ensure full-employment and price stability, and promote national development including population growth, employment participation, and productivity.
  3. These various national responsibilities are not self-contained, and they inter-relate with and can be affected by many other government functions.
  4. The national government must necessarily dominate taxation policy and revenue collection, especially where factors of production are highly mobile, and thus the vertical fiscal imbalance which is such a feature of the Australian federation is to at least some extent also inevitable.

For these reasons any reforms of our Federal system of government need to ensure that the capacity of the national government to meet the legitimate expectations regarding its responsibilities is maintained. In particular, it will be important to consider for each government function how strong is the national interest in this function, either because of the national government’s direct responsibilities or because of the implications for its other key responsibilities.

So while some rationalisation of responsibilities of some government functions may well be sensible, where the national interest is not critical, there are other functions where the national interest is strong. In this latter case, the government responsibilities for the functions should continue to be shared, and the reforms need to focus on better arrangements for sharing those responsibilities.

Rationalisation of roles and responsibilities to achieve greater separation

The Abbott Government is now looking at these issues afresh and expects to release a White Paper on Federalism later this year. A strategy for radical change in our federal system could involve a big cut to the total $50 billion for specific purpose program funding to the States, of which hospitals ($16.4 bn), schools ($16.4 bn), infrastructure ($6.8 bn) and skills and workforce development ($1.8 billion) account for 83 per cent of that total. This cut in State revenue could be balanced by a substantial increase in the GST so that the State budgets were no worse off, or even a little better off. The revenue saved by the Commonwealth from the specific purpose programs could be used to pay sufficient compensation to low and middle income households so that they would not be too disadvantaged by the increase in the GST. The remaining surplus from the specific purpose program savings (probably about two thirds of the original total savings) would then be available to finance Budget repair (if necessary), other expenditure priorities and/or income tax cuts.

Clearly substantial savings in specific purpose programs will have to focus on the funding for the three big functions of hospitals, schools and infrastructure and the scope to hand back responsibility to the States for these functions, and/or to otherwise achieve savings. As noted that will require an assessment of how closely each program relates to other Commonwealth responsibilities, and its significance for meeting those other responsibilities.

Starting with hospitals, I consider that hospitals are so closely related to the Commonwealth’s responsibilities for medical services, that it would be counter-productive for the Commonwealth to withdraw totally from hospital funding. Health planning and delivery needs to be more closely integrated, not separated into different programs that are administered by different governments. In addition, the amount of hospital funding has already been reduced in the previous Budget, so it is assumed that no further savings are made in Commonwealth funding for hospitals.

Similarly in the article that I posted on fixing the Budget two days ago I suggested that the Commonwealth should make savings of at least $10 billion over the next four years by ceasing to fund uneconomic infrastructure that should not be built by any government. Further infrastructure savings for the Commonwealth alone could be achieved by handing the responsibility for funding back to the States for all infrastructure, other than nationally significant projects; at a rough guess these saving might amount to another $3.5 billion each year.

That leaves schools as the most significant function for potential rationalisation. Here the Commonwealth might consider totally withdrawing, thus saving $16.4 billion in 2015-16 and rising in future years. The justification would be that the Commonwealth has only limited influence now on school outcomes and schools are not all that closely related to Commonwealth responsibilities for tertiary education, which in turn are closely related to other Commonwealth responsibilities for the labour market.

Some rough ball park figuring suggests that if say the Australian Government:

  • Withdrew from funding state schools
  • limited its funding of infrastructure to nationally significant projects that would have an identifiable influence on the national economy,
  • withdrew its funding from many other smaller specific purpose programs

then perhaps as much as $20 billion per annum could be available for GST compensation, fiscal repair and tax cuts.

To fully compensate the States, however, they would probably demand around $25 billion in extra GST revenue, because of the $80 billion cuts in the last Budget to health and schools over the next decade. This $25 billion extra GST revenue could be achieved by:

  • some base broadening from the present 50 per cent of coverage of consumption to around a 75 per cent coverage
  • an increase in the tax rate from the present 10 per cent to 15 per cent, or
  • some combination of the two.

It would, however, be in the States’ interest to concentrate on base-broadening as GST revenue would then be more likely to rise faster in future.

After compensating middle and low income households for the additional cost impact of the increased GST, the Commonwealth would then have around $12 billion annually from the specific purpose program savings to finance a 7 per cent reduction in the income tax cut or meet other priorities; less than the 10 per cent income tax cuts introduced by Howard and Costello in 2001.

Clearly less ambitious packages involving less rationalisation of Federal-State responsibilities could be envisaged. That would mean less increase in GST and less reduction in income tax.

In particular, I think a better rationalisation of functions would be achieved if the Commonwealth took over sole responsibility for vocational education and training (VET), as a swap for withdrawing from funding State Schools. VET is closely related to Higher Education which is already largely funded by the Commonwealth. Indeed some institutions provide both forms of tertiary education, and they will need to become more closely integrated in the future.

In addition, VET should play a key role in improving skills that are vital to increasing employment participation and productivity, enhancing national development and reducing the inequality of incomes. For these reasons skills and workforce development are already primarily a Commonwealth responsibility, with VET providing one, albeit a critical means through which the Commonwealth realises these key responsibilities.

Such a swap of responsibilities of schools for VET between the Commonwealth and the States would halve the savings to the Commonwealth, meaning that the need to find additional GST revenue would be reduced by $7.5 billion from $25 billion under the first package to $17.5 billion under this alternative package. However, the savings to the Commonwealth Budget from specific purpose programs would also be reduced by $7.5 billion to just under $4.5 billion. Consequently the scope for tax cuts or meeting other expenditure priorities in this alternative package would be quite small. Indeed, it might even be non-existent if there was still a fiscal deficit because of insufficient savings from other Commonwealth expenditures or failure to sufficiently broaden the income tax base.

One other point to note is that if the reform packages outlined above fully realised, then the scope for income tax cuts identified in either package would result in tax cuts beyond those necessary to offset the impact of bracket creep. So in each case average income tax rates would actually be reduced, although not by much in the second package. Furthermore, if some of the compensation for the impact of the GST increase on low to middle income household budgets took the form of tax cuts, then this scope for reducing average income tax rates would be even bigger.

One big problem, however, with any package rationalising Commonwealth-State responsibilities along these lines is that the Abbott Government has said it will not act on the GST without unanimous support, and indeed it cannot act without the agreement of all the States and Territories, plus the Senate. Maybe this agreement would be forthcoming after an election if the Government based its election campaign around this sort of reform package. I also consider that Labor should support at least the rationalisation of responsibilities by swapping its funding for State schools for a take-over of VET. The fact that this would involve an increase in the GST does not seem to me to be an argument against this rationalisation, as it would lead to more efficient government programs and help put State finances on a firmer footing. 

A better sharing of Commonwealth-State joint responsibilities

Even a radical rationalisation of Commonwealth-State responsibilities is likely to leave the Commonwealth and the States sharing some responsibilities. But how best to share these joint responsibilities has been a long running problem, so we also need to consider how these programs can be better designed and managed to achieve better results.

Historically the Commonwealth and the States have focussed on the inputs for shared programs, often based on an agreement about how much each would provide in funding. A better way forward is to reach agreement on the outputs and outcomes to be achieved, and then determine consequent funding. The actual delivery of those services, however, should usually be the sole responsibility of the States, or some other provider where the market is opened up to choice (for example, as is happening for vocational education and training in an increasing number of States). The idea is that the Commonwealth will focus on what needs to be achieved, but the States would then have considerable discretion as to how these output and outcome targets will be achieved, having regard to their own local circumstances. In effect there is a purchaser-provider relationship between the Commonwealth and the States for the delivery of services, although in this case the provider works as a joint partner in planning and funding the services.

Increasingly other providers are, however, entering what is effectively a managed market for publicly funded services, often with better results. Indeed the Australian Government is increasingly by-passing the States in seeking partners for the delivery of government services. Where the Government contracts with multiple accredited providers, this allows for more variety of service provision so that people are then able to choose the provider which is best able to meet their personal needs. Indeed this would be the model, if as proposed above the Commonwealth took over sole funding responsibility for VET. The Commonwealth would then continue the present practice of allowing trainees to select their provider from an accredited list, which would include TAFE providers, and the Commonwealth would then directly pay the provider.

Experience so far suggests that there can be problems of quality control with this purchaser-provider model of service delivery. Tighter regulation may be necessary, but governments can also use the power of their purse to ensure improvements in quality over time, by only accrediting those providers who continue to meet standards and/or who have achieved the best outcome results. This approach and the competition now being experienced may also lead to the State providers improving the quality of their services too, and consequently less pressure on the Commonwealth to intervene in the actual delivery of services.

Where the Commonwealth and the States continue to share responsibilities for planning and funding the services, a more informed way of achieving agreement on the outcomes and outputs to be achieved is proposed by John Menadue in an accompanying article. In brief, Menadue proposes a Joint Commonwealth/State Health Commission in any State that is willing to agree, which would pool all funding sources. Such a joint approach to future planning and funding seems to offer the best chance of achieving the necessary focus on each individual patient’s multiple health issues through the full integration of all health services and their funding. This is particularly important in an area like health where consumer sovereignty cannot be assumed, unlike many other public services where it is more reasonable to assume that after clients have received professional advice they are the best judge of what they want.

Nevertheless, while these ideas for sharing responsibilities better seem to offer a path towards a more cooperative system of Federalism, they are not without their own problems. First progress is inevitably slow as the future arrangements for each service needs to be considered on its merits. Second there is an unresolved issue as to what sanctions might be available where a State fails to meet the agreed output/outcome targets, especially if that reflects under-funding by the State.


An interesting question is whether any government will be prepared to embark on a radical reform of Federal-State relations by withdrawing a large amount of funding for specific purposes, and increasing the GST instead, even if that did offer the best chance, or even the only chance of funding significant future income tax cuts.

The package of reforms for Federal-State relations proposed here would involve some rationalisation of responsibilities that are currently shared, and the net loss of funding to the States would have to be financed by some increase in the GST. However where, as is almost certain, some functions continue to be shared then it will be necessary to continue the reforms started by the Hawke-Keating Government, and further developed by the Rudd Government in favour of new and better ways to share joint responsibilities. But assuming that this alternative approach involves only a modest withdrawal from funding specific purpose programs, there would be little or no scope for income tax cuts beyond those necessary to offset the impact of bracket creep.

Furthermore, even a radical rationalisation of responsibilities would still leave the States being significantly dependent financially on the Commonwealth, although less so the more specific purpose payments are cut and the GST increased. But so long as the States continue to be significantly dependent financially then their claims to sovereignty are compromised, and some continued sharing of responsibilities will continue.

Dr Michael Keating AC was formerly Secretary of the Department of Finance, and Secretary of the Department of Prime Minister and Cabinet.

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