Fiscal imbalance & the tax forum

Here in Australia, the Government's national tax forum opened this morning. The forum was one of the preconditions for support of the Gillard Government by country independent Rob Oakshott.

I haven't written on the forum to this point because I do not expect it to achieve very much in the short term. This post explains why.

Problems of Fiscal Imbalance in the Australian Federation

Economists use the term fiscal imbalance to describe situations where there is a divergence between expenditure responsibilities and revenue raising capacity at different levels of Government. The Australian states have major policy responsibilities, but their capacity to raise revenue is increasingly constrained. There is severe and growing fiscal imbalance between the states and commonwealth.

The introduction of the GST was meant to give the states an independent source of growth revenue. In return, the states were meant to remove taxes that created economic efficiencies. It hasn't worked that way. The nature of Commonwealth-State financial arrangements means that the actual allocation of GST money over time is unstable.

The states will not agree to anything that does not give them enhanced freedom to fulfil their constitutional responsibilities.

Commonwealth Policy Lock-in

The Australian Government has put itself into a policy-lock in that actually gives it no room to move outside the purely technical. Key points:

1. The actual revenue effects of any tax changes must be neutral from a Commonwealth perspective.
2. The states are expected to get rid of any economically inefficient taxes such as stamp duty and desirably pay roll tax.  
3. The Commonwealth will not agree to any increase in the GST, although both Rob Oakshott and Tony Windsor have indicated that they might support this. So there is no extra cash for the states here.
4. Proceeds from the proposes minerals resources rent tax have been allocated and locked in stone by the Commonwealth. This tax reduces the longer term tax take by the states (mineral royalties are one of the few present state tax growth areas) but offers them nothing in return.

The practical effect of the Commonwealth position is that the states are expected to absorb the pain with no prospect of gain. No rational government could be expected to accept this position.

Implications

Central to the Commonwealth's position is that it has the divine right to rule. Sadly for it, some might say sadly more broadly, Australia is a federation. Compromise is required.

I may be wrong, but I think that the Feds have got themselves so locked in that compromise is impossible. That's actually not a bad thing.

In some past posts I have explored the problems faced by the states in the context of the Australian constitution. I have suggested that WA in particular has become the flash point because it actually has real choices. It may well be in Australia's national interest for WA to force those choices. Otherwise, the system may just limp on.

If we really want to simplify the tax system, then the question of fiscal imbalance has to be addressed in a realistic way. WA may force that.

Postscript

So far the discussion at the Tax Forum has been reasonably predictable. The Australian has quite full coverage.

kvd asked me to amplify this point: "It may well be in Australia's national interest for WA to force those choices."

The problem of growing fiscal imbalance in the Australian Federation that I discussed above has been well recognised for some time, although I'm not sure that all the practical implications are as well recognised.

Operation of a Federal system in which one part raises money that is then spent by others requires discipline on both sides. That discipline is lacking.

In simple terms, the Commonwealth argues that because it is raising the money, it owes it to the Australian taxpayer to get value for money. Further, the Commonwealth Government is driven by its own electoral imperatives. For both reasons, the funds it provides are increasingly tied to very specific things.

The states are responsible to their voters in setting policy and delivering services within their areas of responsibility. In doing so, their capacity to act in any effective way has been increasingly constrained by their growing financial weakness.

COAG - the Council of Australian Governments - is meant to provide a vehicle for coordinated action across levels of Government. However, COAG has moved from a vehicle for cooperation and reform to a somewhat cumbersome device for asserting Commonwealth control. One side effect has been a decline in the effectiveness of COAG operations. 

The proposed mining resource rent tax provides an example of the problems in the current system. The Commonwealth took the view that this was a national tax and therefore under its control. It announced not just the tax, but also the way it proposed to spend the money. However, to maximise its own spend it had to limit state access to royalties, so the proposals actually represented a transfer of revenue from the states to the Commonwealth.

The Commonwealth did not seek to address this issue through cooperative discussions that took both sides into account, but instead attempted to impose its will by fiat. The result has been a something of a mess.

  In theory, it is open to the states as individual entities or in combination to reject Commonwealth funding offers. In practice, the financial weakness of the states has made it hard for any state to resist Commonwealth offers no matter how tied. In doing so, the states further weaken their financial positions and their real freedom of choice. Should a state wish to resist, the Commonwealth can and has threatened to withdraw other funding.

I said earlier that while the general problem of growing fiscal imbalance is well recognised, the practical problems are less well recognised. One example is the growing problems faced by all state treasuries in simply managing their state's financial position in circumstances where funding is tied to a multiplicity of agreements with an increasing proliferation of milestones and performance measures. This can lead to an increasing instability in cash flows that has to be managed by accessing those financial resources still under state control, affecting other state activities.      

There is, I think, growing recognition that the problem of fiscal imbalance needs to be addressed. However, the present practical  dynamics of the Australian Federal system make any effective action just too difficult. Some form of circuit breaker is required. 

Resource rich WA is in an unusual position because it has greater financial freedom. Further, the political dynamics within WA provide a political imperative for the state to assert its position. Should WA do so, it may force a broader review of Commonwealth-State financial relations.

In the absence of such a review, the current system is likely to limp on becoming progressively more complicated and less effective. Systemic problems within the current system are likely to force some changes in the longer term simply because of growing problems of complexity and inefficiency. To my mind, it would be better to address problems now.