Comments on Review of the Grants Commission Arrangements  (2001+)
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A review of the Commonwealth Grants Commission arrangements for sharing Commonwealth taxation with the states is reportedly being arranged by three states (Bolt C. 'Three states lambaste tax share system', Financial Review, 30/9/01) 

The Case:  NSW, Victoria and Western Australia are particularly concerned about large financial transfers to Queensland through the Grants Commission. Queensland has now developed through the growth of mining and tourism industry, and can expect future prosperity. Despite this Queensland receives over $2bn pa more than its economy contributes to Commonwealth taxes and other revenues. This allows Queensland to pay huge subsidies to attract industry. And, due to 60 years of subsidies, Queensland has no debts. There appear to be uncertainties about the adequacy of Grants Commission's methods (Egan M, Brumby J and Ripper E. - Treasurers of NSW, Victoria and WA, 'Donor states carry an unfair burden', Financial Review, 30/11/01) 

Queensland's response: The Treasurers of NSW, Victoria and WA want to overturn a core principle of Australia's federal system - which is that no matter where people live they are entitled to equal access to government services. This principle involves  horizontal fiscal equalization. The donor states are being simplistic in promoting efficiency at the expense of equity. They are claiming that Queensland is being subsidized. However the Commonwealth sets taxes so that people in similar circumstances pay equally. It then provides GST and special purposes revenues to the states.   The fundamental flaw in the three Treasurers' analysis is that they ignore distributions other than GST. In 2001-02 Commonwealth GST payments were $30.6bn and Special Purpose Payments (SPP) were $15.1bn. Queensland gained $41m over its population share on GST payments, and $66m less than its population share of SPP's. And in Balanced Budget Assistance Queensland received $213m below its population share. Queensland supports the current Grants Commission process because (a) the Commission is independent expert body (b) process is open an consultative (c) Commission's judgments are backed by a high level of analytical rigor (d) all Treasurers review Commission's methods and (e) terms of reference are set in conjunction with other states (Mackenroth T. - Queensland Treasurer 'Queensland happy to stay horizontal', Financial Review, 5/12/01)

The Proposed Review: Two well-regarded economists, Ross Garnaut and Vince Fitzgerald, have been appointed to review the basis of Commonwealth-state funding. The system they have been asked to review reflects substantial changes in the financial structure of the federation since 1901 - most particularly Commonwealth domination of the national tax base and a state dependence on financial grants which is much higher than in other federations such as US, Canada and Germany. As states are responsible for most important service delivery, their dependence on Commonwealth funding is a critical issue. According to a background paper, this review will not explore the return of income tax powers to the states (considered a politically dead option) but how to get existing arrangements right. This is worth doing, because of the complexity of existing arrangements - and the conflicting objectives. Grants to the states can be for general or specific purposes, and amount to some $50bn pa (or which $30bn are for general purposes, and are 90% derived from the GST). Allocation of these grants are determined by the Commonwealth Grants Commission - to allow each state enough money to provide services at the same standard as other states. This requires redistributing tax revenues from NSW, Victoria and Western Australia - because others have less revenue raising capacity (eg because of smaller populations and economies, higher services costs or more school age children). The process of determining grants is very detailed, results in 2000 pages of annual documentation and involves specific assessments of state revenue and spending needs across many areas. Grants provided for general purposes do not need to be spent on any particular programs. The present system does not adequately reward / punish states for good and bad policies (according to Ross Garnaut). At a press conference, the economists were also critical of special purpose funding (eg for spending on hospitals with conditions attached). There are many such programs - which can have conflicting requirements and assessments applied. Also the Grants Commission effectively takes away specific purpose funding by reducing general purpose grants (Woods A. 'A better balance for the states', Australia, 18/12/01)

A web-site for the Review presents a Background Paper - which includes Terms of Reference and a discussion of the issues involved.

Review of Commonwealth State Funding 
- An outline of the Background Paper -  
(December 2001)

Message from the Committee: There is a need to review Australia's federal arrangements. In particular States are responsible for much service delivery, but the Commonwealth has most fiscal power which has led to both special and general purpose grants. The arrangements which have evolved are not always relevant today. When the GST was introduced it became the basis for a large pool of funds available to the states. The review of Commonwealth / State funding will consider efficiency (ie could more economic growth, income or employment be generated); equity; and simplicity / transparency.

1. About the Review: Both general (GPP) and special (SPP) purpose grants will be considered - and the relationship between these and state / Commonwealth own outlays. The great financial significance of Commonwealth grants is outlined. NSW / Victoria and WA receive less than the per capita average of GST revenues.  NSW, Victoria, Queensland and ACT receive less than average share of SPPs. Also to be considered are budget balancing payments (arising from GST) and the Commonwealth's own spending.

2. How to participate

3. How the system grew: The Commonwealth have had greater taxing powers and the states had greater spending responsibilities. Special payments to assist states emerged early in the 20th century. A Grants Commission (CGC) was established in 1933. Commonwealth taxing powers were further increased as a wartime measure in 1942 when it assumed sole income tax responsibility (though states had previously raised 70% of income tax). From 1946 the CGC recommended distribution of tax receipts on the basis of each state's population characteristics (with WA and Tasmania free to apply for more). The Whitlam Government introduced many tied SPP's in the 1970s. The Fraser Government's policy of phasing these out came to little. In 1976 new tax sharing arrangements were introduced - and revenue assistance was determined by the CGC (with no distinction for 'claimant states'). Vertical fiscal imbalance increased greatly in 1997, when the GST was introduced, and many state taxes were abolished.  The CGC's role has shifted from just recommending assistance to claimant states - to dealing with large components of state funding generally. And the way it does this has changed. In 1936 its goal was to allow all states to function at a similar standard. In 1999 its goal was that "State Governments should receive funding from the Commonwealth such that if each made the same effort to raise revenue from its own sources and operated at the same level of efficiency, each would have the capacity to provide services at the same standard". The GST introduced a broad-based tax available to states - but there has been no change in either SPP or GPP arrangements.

4. The Existing Approach: Most GPPs are now from GST - which is allocated on the basis of horizontal fiscal equalisation. The impact of budget balancing assistance varies widely - eg Queensland gains little as it gave up little when the GST was introduced (having had no FID). The idea of horizontal fiscal equalisation is to give each state the same capacity to provide services if they make the same fiscal effort). A higher share of revenues is given to states with a lower capacity to raise their own revenues. It also provides compensation if their cost of providing services is higher. The aim of the CGC is to be policy neutral - to be based on factors outside state control. Many different factors influence assessments of relative expenditure requirements (list quoted) and relative revenue capacity (wages and salaries, land values, mining industry profits). Account is also taken of the differences in average service standards to different groups in different locations. Issues related to CGC process include: its complexity; the value judgements it embodies; and the effect on equity and efficiency (of service delivery and resource allocation). Policy neutrality aims to ensure that states can't influence grants through their policies. But states can influence their population's need for services, and the health of economies (and its capacity to provide taxation revenues).  There are unresolved complexities in policy neutrality (eg should states be compensated for higher costs of services, if in fact they don't provide them - and if they are not compensated would it not provide scope for grantsmanship).  Compensation for differences in SPPs also causes controversy.  There have been substantial changes in relative state shares of GPPs - with significant relative declines by WA and Queensland. SPP's are based on Section 96 of the Constitution. Issues related to this include: the great number of such programs; the provision of SPPs in areas where states have sole constitutional responsibility. The Commonwealth's own expenditures in various states vary significantly from the population share.   The Commonwealth receives considerably less in Queensland than the national per capita average of its own revenues (from companies and individuals).

5. Other Federations: discusses Germany, US and Canada

6. State Characteristics: compares budget balances, debts, revenues and expenditure. Queensland's position in terms of net debt is better than other states. Queensland also has a higher level of 'own source' revenue being income on investments.

The Commonwealth's Condition: Federal Government will not support changes to Commonwealth / State funding arrangements unless all states agree (Strutt S. and Allen L', Beattie Blocks plan to overhaul state funding', Financial Review, 1-2/12/01)
CPDS Comment on Review

CPDS Comments on the Grants Commission's Treatment of Queensland 

Introduction

The Queensland Treasurer has not answered the question being posed by the 'donor' states in the public debate that is outlined above. He spoke of the desirability of horizontal equalisation.  The 'donor' state are concerned (amongst other things) about the fact that, when funds are allocated by the Grants Commission on the basis of horizontal equity, Queensland receives significantly more funds from the Commonwealth than the revenues the latter obtains in Queensland - and that this is at their expense [1]. 

However the reason that NSW, Victoria and WA were publicly reported as giving for reviewing the Grants Commission arrangement may also need to be reconsidered. 

The Problem

The main reason that the equalisation procedures which result in the Grant's Commission's 'generosity' to Queensland should be reviewed is not that its economy is now strongly developed so that it can afford to become a net contributor (because of growth of the mining and tourism industries that the donor states referred to). In point of fact, an examination of Queensland's budget suggests that it is facing growing difficulties (see CPDS Comments in About Queensland's Budget). 

Rather the main problem is that Queensland has not needed (financially) to take the development of its economy very seriously (and thus provides only a weak per-capita base for State and Commonwealth government taxes and charges). It could do this because it has been able to rely on receiving a share of national tax revenues which provide compensation for its own weak tax base. For this same reason Queensland receives payments from the Commonwealth that substantially exceed the taxes and charges the Commonwealth receives in Queensland.

How it works: The revenue which the Commonwealth receives in Queensland depends on the strength of the state's tax base. Gross state product per capita is a good proxy for this and has tended to be around 85%  of the national average in Queensland. Thus the Commonwealth's tax collections in Queensland are limited.

However Queensland's share of this national revenue is then equalized - and this equalization formula adds insult to injury by compensating Queensland for the revenue disadvantages that its weak tax base impose on state taxation.

Clearly the Grants Commission's procedures have not been 'policy neutral' and have resulted in significant economic inefficiencies.

Evidence

In the 1980s efforts (by the author and others) to develop a productive modern economy in Queensland were constantly frustrated because: 

  • preference was given to maximizing government's financial position. The latter was seen (strangely) as the main indicator of Queensland's 'economic' strength - so  the goal of having a 'strong state' focused on public finance rather than on the economy. At the same time;
  • Australia's highly distorted Commonwealth / State financial arrangements: 
    • provided a share of Commonwealth revenues on a 'needs' basis without regard for whether the state had a strong tax base; and
    • left only a narrow tax base to the states - in areas where revenues were apparently dependent more on economic 'turnover' than on economic value-added.

    This encouraged Queensland to favour industries with high economic 'turnover' - rather than those with high value-added which might have done more to strengthen Commonwealth tax receipts.  

In the 1990s political rhetoric has endorsed the real development of Queensland's economy - but for the reasons outlined above this has not needed to achieve practical productive capabilities (and in fact does not appear likely to do so). Queensland's Economic Strategy suggests why both traditional and recent strategies have not created a well developed economy.

Indicators of the lack of serious development of Queensland's economy are also outlined in Queensland's Economic Strategy which includes reference to:

  • a per-capita gross state product that is perpetually low relative to national averages;
    • [An aside: Queensland's low per-capita GSP MAY also partly reflect its branch office status - if earnings from branch offices in Queensland are credited to to their interstate head offices. Though how such earnings are counted in determining state product is unknown to this author. The review's Background Paper (Section 4.3) notes that (a) the Commonwealth receives much lower per capita revenue in Queensland than in some states and that (b) this "reflect the location of activities from which the revenues are derived (place of residence for personal income tax, location of gross operating surplus for company tax, location of production and sale respectively for petroleum production revenues and excise, and location of consumption of goods and services for GST)" - though whether this compensates for the 'branch office' phenomenon is also unclear].
  • the poor quality (low value-added) of industries that have been encouraged by a naive emphasis on growth rather than on development;
  • weaknesses in Queensland's institutional capability to develop its economy;
  • the lack of any real prospect that current populist programs will improve the situation.

Queensland's Financial Position

Moreover, it appears very likely that Queensland's financial position has deteriorated in recent years - so that any expectation that other states might now profit financially at Queensland's expense are uncertain (See About Queensland's Budgets).

The core problem seems to be that the weak tax base that has been created by defective economic strategies now makes it difficult to fund a rapidly-growing decentralised state at a reasonable standard. Furthermore any substantial increases in tax rates can be expected to require economic adjustments. Thus the review of the Grant's Commission arrangement might come to a different conclusion to that which the Treasurers of NSW, Victoria and WA reportedly suggested (see the Case above).   
Other Comments

Other CPDS Comments on the Proposed Review

In addition to the effect the Grants Commission rules have on the base a state's economy provides for Commonwealth taxes, the implications for Australia current account deficit might also be considered. Encouraging industries that involve large turnover but produce little domestic income not only produces a weak taxation base but must also have implications for Australia's at-times-restrictive current account deficit (as the latter reflects the difference between domestic expenditure and domestic income - see The Current Account Deficit Constraint, 1998).  

Regarding special purpose payments from the Commonwealth it is noted that:

  • a review of special purpose grants which the author undertook for the Queensland Coordinator General's Department in the mid 1970s (at the time that the level of these programs was being significantly increased) suggested that senior management in Queensland agencies were then being forced to expend a lot of time in seeking to obtain funds for (say) 10% of their budgets - and consequently were significantly constrained in effectively planning and managing their overall operations. Presumably this difficulty (which was serious because of states' responsibility for most public service delivery) has reduced to at least some extent over the years as these programs became routine;
  • while special purpose grants are a way of achieving goals of national significance, they may create administrative and political friction in intergovernmental relations because Australia's constitution does not include other arrangements which promote Commonwealth / State cooperation. In particular it might be that a Federal system such as that in Germany might improve the situation - ie where the Federal upper House is a true 'state's house' - ie members are appointed directly by state governments. Thus: 
    • the Federal Government is unable to move far away from policy options acceptable to the states, so cooperation rather than confrontation apparently characterises Federal / State relations; and 
    • governments opposing constructive changes which have general national support are subjected to considerable political pressure. 

    Any study of German practices, needs to take account of the implications of its Roman (as compared with British) legal tradition.

More generally, it can be noted that the high level of state financial dependence on the Commonwealth tends to give a higher than desirable level of internal policy influence to state financial authorities - and this was presumably one of the reasons for Queensland's primary emphasis on state financial goals in the 1970s and 1980s - and the resulting lack of real interest in developing a productive modern economy (as discussed above). 

2/11/01 (and revised subsequently)
Comments on Outcome

OUTCOME OF THE REVIEW

The final report of the review, Commonwealth State Relations for the 21st Century, is available on the Review website.

Media reports on the proposal stress the disunity amongst states which the proposals have produced - and the Commonwealth's desire to avoid taking any leadership role.

A push by NSW, Victoria and WA to gain a bigger share of federal funding has outraged smaller states. Change advocates suggested that current arrangements were costing $280m annually in economic inefficiencies. A cooperative federalism model was proposed to simplify special purpose payments, and to deliver a fairer distribution of $29bn GST revenues. Victoria, NSW and WA believe they are subsidizing other states $3bn pa. SA Premier (Mike Rann) accused bigger states of seeking to shirk their responsibilities. Tasmanian Treasurer (David Crean) suggested this was an attempt to overturn the principle of equity that had long underpinned federal state relationships. Queensland's Treasurer said that NSW, Victoria and WA had got what they paid for, and that Federal Treasurer had indicated that the issue would not be allowed to be discussed at next years meeting. The Prime Minister said states should decide amongst themselves how to divide federal funds (Lewis S, Emerson S and Plan T 'Fair go proposal has states brawling', Australian,  31/8/02)

A report to be released by NSW, Victoria and WA claims that horizontal fiscal equalization costs the economy hundreds of millions of $ pa. It says the system lacks transparency and accountability and does little to promote regional equity - and is a disincentive to states in promoting economic growth. The GST was supposed to give states more revenue - but largest states claim disadvantage through having to cross subsidize others. Report suggests new formula for sharing out $32bn GST and streamlining of $21bn special purpose funding. Proposed new model would guarantee no state received less than at present. NSW GST formula involves paying states to ensure meeting cost of minimum level of government services. Special purpose grants would be combined into a smaller number of general programs (Davis M and Drummond M 'Big states scrap over $50bn taxes', Financial Review, 30/8/02)

A possible solution to this particular political impasse may be to consider whether the Review was asked the wrong question - ie how to better organize federal financial relationships. The Review was asked this question because its architects believed that there had to be something wrong with Grants Commission methods if other states had to provide large fiscal transfers to Queensland which was perceived to be an economic success story. 

However Grants Commission arrangements were only a part of the problem. The main problem (as outlined above) was the defective economic strategies that Queensland adopted which resulted in a weak tax base and a need for large fiscal subsidies from other states. 

The issue that gave rise to the Review might have been better addressed directly, rather than indirectly through questions of Grants Commission arrangements.

Furthermore there are many deficiencies in federal-state relationships that have nothing to do with horizontal fiscal equalization which risk being buried if this is seen as the major point of contention.

An aside: An interesting email observation by the Hon Dr David Crean, Treasurer of Tasmania, on 28/10/02 was that the core problem lies in the vertical imbalances in Australia's federal financial system [Clearly if those vertical fiscal imbalances were eliminated, then the Commonwealth would not have to try to achieve horizontal equalization, and states would directly gain the benefits (or costs) of the effect which their economic strategies have on their state's tax bases).