A lost opportunity: When Turnbull and the states dropped the ball on a crucial economic reform

Published in the Australian Financial Review, June 6, 2018

On March 30, 2016, Prime Minister Malcolm Turnbull raised the prospect of a state income tax option to deal with the problematic federal issues around taxation. At the time he correctly pointed out that “this is very big fundamental reform to federalism … the most fundamental reform to the federation in generations”. He went on to say “this, we believe, is the only way that we can genuinely reform our federation. It will give the states real financial autonomy. He also noted that it would end “the depressing blame game where no one really knows who is responsible for what”.

Unfortunately this was rejected by an overwhelming majority of premiers and was dropped by the federal government. Personally, I believe that the collective premiers were directly acting against the best interests of their constituencies. These changes would solve a lot of the issues they have been grappling with for many years. For the sake of – in my view – short-term or partisan politics they let slip a golden opportunity.

In the United States they say that the states are the “laboratories of democracy”.

What of course they mean is that a federal system, made up of a separate national government and numerous regional (state) governments, provides the opportunity for experimentation that hopefully optimises the chance for the best mix of policies for that region’s population. .

That was the view of Alfred Deakin, Edmund Barton and Samuel Griffiths – Australia’s leading Federation fathers. I hazard a guess it is generally supported by most Australians, even if they don’t frame it in those intellectual terms but in the more pragmatic realisation that “Canberra” certainly doesn’t always know what is best for their town or region.

However, that doesn’t mean the federal system that we have today, nearly 120 years since it was set up, is ideal. Indeed it is far from ideal. It is in fact a sad mess. It has many “barnacles” on it, to use an expression of a former prime minister.

Shared taxes not more taxes

I have spent a lot of my career working on Commonwealth-state relations issues. I directly worked in that area of the Federal Treasury during the 1980s and then during the mid-1990s as a senior executive at the NSW Cabinet Office.

This area of policy can be enormously frustrating with distorted motivations being constantly apparent because of the poor state of financial arrangements. An income tax sharing agreement could make a substantial difference.

You don’t need to go far to hear from people that the health and education systems are in need of drastic reform. Premiers complain that they do not have enough money to run these systems and thus are forced to beg more and more assistance from the federal government, which results in greater federal intervention. That is not necessarily a good thing. The duplication is enormous and most Australians will have heard that the federal government amazingly employs 1868 education bureaucrats but does not own one school. There are almost countless examples across the portfolios where the federal government has its sticky hands involved in state decision-making because of the call on the Federal Budget. This is because the federal government raises more money than it directly spends and the states are in the opposite position.

However, don’t be misled by the siren song from some premiers and self-serving lobby groups that this would be fixed with more tax revenues, preferably by increasing the GST rate or expand its base or both. Raising the overall tax burden would not be in the national interest.

Doomed proposal

The basic problem that needs to be addressed is clearly stated in the government’s March 2015 discussion paper on taxation reform that notes that the states’ revenue base is inadequate to fund their spending growth responsibilities. Demand is outstripping supply. An income tax sharing agreement would help address this.

A brief history of income tax is relevant. Up until 1942 states levied income taxes. Then due to World War II’s funding demands it was mutually agreed to hand the tax to the federal government. After the emergency passed, it refused to hand it back.

That is until 1977 when Prime Minister Malcolm Fraser proposed a “New Federalism” policy and passed legislation to allow state income tax surcharges (or rebates for that matter) to help states meet their funding needs. Unfortunately, NSW Premier Neville Wran waged a short-sighted scare campaign on the issue alleging this would lead to “double taxation” and the option was never taken up.

Fourteen years later Prime Minister Bob Hawke was inching towards reintroducing such a policy when he lost a leadership ballot to Paul Keating in 1991. Hawke had set up a “Working Party on Tax Powers” that reported on October 4, 1991, and noted one option for reform was the introduction of a State Income Tax Surcharge. In response, all state and territory leaders at the time signed a communique on November 8, 1991, calling for its implementation. They sought a 6 per cent surcharge in a broadly revenue neutral package of reforms, whereby the federal government would reduce income tax and also payments to the states. So it was recommended by experts and was politically doable. However, the new Prime Minister Keating was personally against the proposal and it died there and then.

The idea resurfaced in February 2014 when the National Commission of Audit (NCA) recommended an income tax surcharge in its final report.

How the figures would stack up

Many so-called experts will complain that re-ordering the intergovernmental share of income tax revenue would do nothing to fix the relative balance between direct (e.g. income) taxes and indirect (e.g. GST) taxes.

There is truth to this. To make it clear, the income tax sharing option I believe should be debated is not designed to raise more total revenue but to substitute federal taxes with state taxes, thus not increasing the reliance on income taxes.

Helpfully, the NCA didn’t just raise the topic. It got the Treasury to do the economic modelling that shows how the figures would stack up.

Looking at the 2013-14 financial year the total transfer of funds (tied grants) from the federal government to the states, not including $51.2 billion in GST receipts, was $45.1 billion. The NCA notes that of this total $13.9 billion is for national health reform funding; specific education payments ($13.2 billion); payments for skills, disability and housing ($3.9 billion); and payments for 144 different National Partnership Agreements ($14.0 billion).

As an option they proposed that 10 percentage points of the tax bracket base between incomes of $37,000 and $80,000 be allocated to the states. Currently that tax bracket attracts a tax rate of 32.5 per cent. So a change would mean that for taxpayers in that bracket they would actually have a 22.5 per cent federal income tax and a 10 per cent NSW (insert other state names depending where you live) income tax.

The Treasury calculated that this 10 per cent state income tax would raise $25 billion. The NCA shows that this would allow the federal government to completely withdraw from all education funding, public housing projects and a large number of National Partnership Agreements.

The NCA also recommended a possible change to the distribution of GST revenues to states. For example today Western Australia complains that it only receives 4.2 per cent of GST total revenues which is only 10¢ in the dollar generated in that state. According to the NCA, the solution could be to largely scrap the existing Commonwealth Grants Commission formulas for dividing up the GST money between the states and substitute per capita grants based on population. However, they note to do this either means taking GST revenue off subsidised states like Tasmania and South Australia or by increasing the pool. The NCA argues for the latter. It did the requisite calculation and so as to ensure that the currently subsidised states are not worse off it proposes that with a federal government “top-up” of $4.9 billion on an annual basis (from non-GST tax revenues) this issue could be solved. The $4.9 billion would be divided between the subsidised states using the existing Commonwealth Grants Commission formulas.

Different strokes for different states

In summary, the end result of implementing a state income tax would be to address the states’ revenue problem, remove the federal government from a very large proportion of expenditure, and do it without increasing total revenues. That is a win-win proposition.

After the initial implementation you would allow states to vary their tax take. In a left-leaning state, where they seem to reward big spending governments, you might see the ALP raise the tax from 10 to 11 per cent. In NSW where a fiscally responsible Berejiklian government can deliver budget surpluses you might see a cut to 9 per cent if they thought it was sustainable.

In summary, I think there is very good case to be made for using income tax sharing as the basis of a long lasting reform of our Federation. I believe a future Federal government should return to this policy option and if states want a sustainable and secure growth tax they need to revisit their opposition to a state income tax.