Opinion Pieces

State Gap is Holding us Back

Renovating our federation is an essential reform, yet we have barely fired the starter’s gun in the public debate.

The public discussion in the first quarter of 2015 has yielded a broad consensus that Australia needs tax reform and we now have a reasonable shot at succeeding.

We now need a similar consensus that Australia’s federation requires radical surgery. To get us in the mood, the Government should swiftly issue the green paper of the Federation White Paper process.

Our federation – the states and territories glued together along ancient colonial songlines into one country – still often feels and behaves like a collection of separate colonies. Failed attempts at reform have left us with deadweight costs, a lack of accountability and are an increasing drag on our global competitiveness.

A serious package of federation reform must be proposed to the electorate by both major parties. Doing nothing on the federation would be vandalism.

The tax and federation processes are intertwined because we can’t achieve substantial change without reforming commonwealth-state relations.

So with only 15 months until the next election, we need to ensure the federation debate is comprehensible. As a start, let’s drop insider language such as vertical imbalances and horizontal equalisation.

The central problem facing the federation is funding. This is not about the distribution of the money between the states. Rather it is how we fund the states’ obligations when the Commonwealth raises most of the money.

The problem is the states currently spend $230 billion yet only raise $130 billion

In insider language, this vertical fiscal imbalance, or let’s call it the “state gap” in Australia is twice that of the Canadian and U.S. federations, creating two problems: inefficiency and a lack of accountability.

Federation funding has been kicked around since 1942 when the High Court held that only the Commonwealth could raise income taxes. Fraser and Hawke spent much of their time in power taking about “New Federalism": but little was achieved.  

In practical terms the “state gap” means that states are forced to raise their own revenue to supplement federal grants.

A further wrinkle, and this is where tax reform comes in, is that many state taxes are inefficient taxes.

A normal tax reduces growth. An inefficient tax destroys economic activity.

Inefficient state transaction taxes are a drag on the economy of $12 billion per annum and lead to perverse outcomes such as discouraging people from starting a new business or taking out insurance.

The South Australian threat during the recent Council of Australian Government meetings to reinstate duties abolished under the GST arrangements is terrifying.

We simply can not afford these costs as we strive to compete with our nimble, lean trading opponents in the Asian region.

Just as important is accountability of government. It undermines democracy if people are unable to genuinely distinguish between levels of government.

While the states clearly have responsibility for service delivery such as health and education, the Commonwealth is responsible for co-funding. This is where the buck passing started. It has never stopped.

In practical terms it means that parents do not know who to hold to account if teaching standards at school are substandard or the emergency waiting lines are too long in the hospital.

The federation white paper has asked whether we should reduce the gap and if so, how should that happen?

Of course we should.

The three options for reducing the state gap have typically included: allowing the states to raise more revenue, guaranteeing the states a certain level of income tax (canvassed in the Fraser years) or dividing the core responsibilities of health and education between the Commonwealth and states (Rudd proposed taking over the health system).

In a nation of 23 million people, allowing states to duplicate national systems such as income taxation seems unviable but the other options deserve deep consideration.

The federation is overdue for renovation. Serious reform proposals must be taken to the 2016 election. To have any chance of success, we have to start a comprehensible public conversation now.


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