Revenue/Spending Imbalances
The Australian Constitution provided that both the Commonwealth and State Governments would be able to raise income taxes.
However, the Constitution granted exclusive authority for the Commonwealth to raise customs and excise duties.
In the period up to World War II, States raised most income taxes. During the Second World War, the Commonwealth used its expanded wartime powers to assume control over income taxation, agreeing to share its income tax revenues with States through grants while the war effort continued. The understanding was that the Commonwealth would return the income tax powers to States at the end of the war. However, the Commonwealth subsequently refused to do so.
The tax base of States has also been eroded with the High Court having adopted a progressively stricter interpretation of excise duties, considerably narrowing the range of taxes States are able to impose. This culminated in a 1997 High Court decision that led to the dismantling of State taxes on fuel, alcohol and tobacco and their replacement by Commonwealth taxes raised for the States.
The erosion of States’ tax powers has left States in the situation of relying on Commonwealth grants for a large proportion of the revenue they require to undertake their expenditure responsibilities.
The mismatch between revenue raising and expenditure responsibilities, with States unable to raise enough taxes to finance their functions, is known as “vertical fiscal imbalance” (VFI). As shown in the graph below, VFI is particularly high in Australia compared with other federations.
Vertical Fiscal imbalance
Own Source Revenue / Own Purpose Expenditure
Source: IMF Government Finance Statistics Yearbook (2005).
A degree of VFI ensures capacity for the central government to provide ‘equalisation’ grants to regional governments to help reduce differences in revenue generating capacity, and in the cost of delivering services.
However, unlike some other federations, the States’ dependence on grants from the Commonwealth goes well beyond what is necessary for equalisation purposes. While this provides a degree of financial security for the States against volatility in their own revenue bases, it is also recognised as having some serious downsides. In particular:
it reduces the accountability of governments to their electorates, because it is not clear which level of government is responsible when community expectations for services and infrastructure are not met;
it facilitates the attachment of conditions by the Commonwealth to a significant proportion of State funding, which if not consistent with overall community priorities can result in a misallocation of resources. Conditions are attached to around 40% of Commonwealth grants to the States;
it reduces incentives for States to put in place growth‑promoting policies and infrastructure, as the costs are borne by the State, while the tax benefits flow primarily to the Commonwealth (which retains the majority of the nation’s taxes) and other States (through the equity principles used to allocate Commonwealth grants among the States); and
The attached discussion paper on Revenue Sharing or Tax Base Sharing examines options for reducing VFI.