Friday, May 21, 2010

Does Australia face a constitutional crisis?

I have watched the continuing machinations around the Rudd Government's proposed super mining tax with interest. Two important contributions are Treasury Secretary Ken Henry's post budget speech and a long and thoughtful speech by Ross Garnaut.

Ross Garnaut's speech refers in part to the impact of the tax on Commonwealth-State financial relations. A related issue is the doubts now raised about the constitutional validity of the tax. To my mind, we now have a potential constitutional crisis brewing of which the resource rent tax is only part. To understand this, we need to look at our present constitution.

Before going on, I should note my own position. I remain a supporter of a Federal system, but have always supported the idea of more states with greater flexibility in the re-distribution of powers between the centre and the states as needs change. I note my position only for reference. In this piece I am only concerned to scope the parameters of the emerging problem.  

Under our constitution, the Commonwealth has formal responsibility for certain activities, with the states responsible for the rest. In a formal sense, our structure has proved quite rigid. Long running attempts to subdivide existing states have so far been unsuccessful, while the Australian electorate has been resistant to any attempt to alter the constitution so far as Commonwealth-state powers are concerned.

While our formal structure has proved rigid, in practice the system has proved reasonably flexible if cumbersome. However, we may now be at a tipping point.

The functions that the states retain formal responsibility for include activities whose costs are growing quite rapidly. The states' tax base cannot support those functions.

At Federation, customs duties were seen as the main source of Commonwealth revenue, while the states relied on income tax. The effective transfer of income tax to the Commonwealth made the Commonwealth dominant financially.

Increasingly, state budgets came to depend upon Commonwealth payments. Increasingly, too, those payments came with strings. These were partially justified on public policy grounds, but increasingly reflected straight political arguments based on political dynamics at national level. State Governments were responsible to their voters, Commonwealth Governments to their voters, two very different dynamics.

The problems so created worked along two levels.

First, flexibility in state budgets was increasingly constrained, with the states retaining formal authority but without real responsibility. Secondly, to gain money, the states introduced new and extended existing taxes in those areas where they did retain power. These taxes were not only inadequate, but were also increasingly recognised as inefficient in national terms, distorting the operations of the economy.  

The introduction of the GST was intended to address what was called fiscal imbalance by giving the states access to a growth tax. It was also intended to replace a whole series of economically inefficient state taxes, thus enhancing national efficiency. From a state perspective, they gained revenue on one side, lost it on the other; the net effect was meant to be an enhancement in the states' revenue base.

The practical effects were a little different.

Since this was to be a state tax, you would think that each state would be given the GST revenue collected in that state. This did not happen. The distribution of GST revenue was treated in the same way as certain other payments to the states and allocated according to the principles laid down by the Commonwealth Grants Commission. This meant that the states gave up defined revenue sources, their taxes, for payments that were linked not so much to the GST collected in their state, but to total national collections and that varied from year to year.

The practical effect of this was that GST revenues did not give the states the degree of budget certainty that might have been expected, and also accentuated competition between the states. At the same time, first the Howard and then the Rudd Government continued the progressive extension of Commonwealth power into areas that were formally state domains.

In saying this, I am not saying that these extensions were necessarily wrong. I am concerned with the practical effects.

In a NSW context, I have suggested that the power of both the Treasury and Premier's & Cabinet has now become a serious drag upon that State's operating performance. However, I do understand the problems they face. Consider the position of a state treasury.

You are responsible to your minister who in turn is responsible to the Government and beyond that to Parliament and the people of the state. So you are dealing with a whole set of political and policy dynamics.

A significant proportion of your budget is fixed in terms of both revenues and activities because it comes tied in various ways from the Commonwealth. Here you have concerns along at least five dimensions:

  • in cashflow terms, you have to ensure that expenditure and Commonwealth payments match. This can be more easily said than done. One of the early criticisms of the school building program lay in a mismatch between receipts and spend. If expenditure is going to be greater than revenue at any point, you have to find cash from elsewhere to bridge the gap.
  • in performance terms, you have to ensure that the state and its agencies comply with funding terms. This adds state reporting requirements to the plethora of Commonwealth ones.
  • you have to take policy instability into account. Agreements can take time to negotiate and can vary greatly. In one small case that I was involved in in providing contact support to a state agency, I did nine cash flows over three months, including four in one month. All this was during a state budget round. I tried to set up the spread sheets so that I could create new ones by varying key assumptions, but policy fluidity invalidated the lot. Even when the agreement and any associated implementation plans are theoretically in place, they can be and are varied by unilateral Commonwealth decision.
  • you also have to take add-on costs into account. These come in all sorts of forms - matching spend; added overhead costs such as extra finance or other support staff; unseen program costs.
  • finally, you have to match spend to the assumptions and rules built into the Commonwealth support. The Commonwealth Auditor General's School Build report pointed to some of the problems that can arise her.

The higher the proportion of tied funds, the greater the real budget problems. In extreme cases, a significant proportion of the remaining discretionary funds is actually really committed because it is needed to manage problems created by Commonwealth funding mechanisms.

The resource rents tax may actually prove to be the straw that finally breaks the camel's back.

At a conceptual level, the Commonwealth argues that mining resources belong to the Australian people as a whole. It also argues, correctly, that existing state royalties are inefficient.

  The problem is that under the Australian constitution, mineral resources belong to the crown in right of the state in question. Putting this another way, WA resources belong not to all Australians, but to the people of WA. Further, mineral royalties are just about the only revenue growth area left to the states.

The Commonwealth could have handled the economic efficiency argument within the bounds of the existing constitution by saying that we will replace the existing royalty scheme with a new tax, but give the funds to the states on the basis of the tax collected in each state. Instead, it has grabbed for the golden egg, but attempted to accommodate the states by allowing for deductibility of existing royalty payments, in so doing putting a cap on the cash the states can get.

Leaving aside all the arguments for and against the tax in a general sense, I don't think that this is going to work. I have in mind WA in particular. It stood out against the Commonwealth on the GST. Now its recent state budget is centrally based on increases in WA mining royalties.

Even if some form of compromise can be found, it will still leave the general problem. At some point, the growing problems in Commonwealth-state financial problems will simply make the whole system unworkable.            

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