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Distribution of GST to the states

Hands holding an empty bowl
On Wednesday 30 March 2011, the Government announced a review of how the goods and services tax (GST) revenue is distributed to the states. This post looks at how GST revenue is currently distributed using horizontal fiscal equalisation. This post also presents some of the criticisms of equalisation, the role of the Commonwealth Grants Commission (CGC) and the scope of the proposed review.

In order to introduce the GST, the Howard Government made an agreement with the states known as the ‘Intergovernmental Agreement on the Reform of Commonwealth-State Financial Relations’ in May 1999. Put simply, they agreed that the states would abolish or reduce certain taxes and the Commonwealth would in return provide all revenue from the GST to the states. Appendix B to the agreement set out the form in which GST payments would be distributed. In particular, the agreement determined that GST would be distributed according to horizontal fiscal equalisation (HFE) principles:
The pool of funding to be distributed according to HFE principles in a financial year will comprise GST revenue grants and health care grants as defined under an Australian Health Care Agreement between the Commonwealth and the States and Territories. A State or Territory’s share of the pool will be based on its population share, adjusted by a relativity factor which embodies per capita financial needs based on recommendations of the Commonwealth Grants Commission. The relativity factor for a State or Territory will be determined by the Commonwealth Treasurer after he has consulted with each State and Territory.
This was further reinforced with the 2008 Intergovernmental Agreement on Federal Financial Arrangements which states:
25. The Commonwealth will make GST payments to the States and Territories equivalent to the revenue received from the GST, subject to the arrangements in this Agreement. GST payments will be freely available for use by the States and Territories for any purpose.

26. The Commonwealth will distribute GST payments among the States and Territories in accordance with the principle of horizontal fiscal equalisation.
The Commonwealth Grants Commission (CGC) calculates the relativities used to determine how much revenue is delivered to each state, based on HFE principles.

Equalisation has been the objective of the CGC since its first report in 1934. In 1976, the Commonwealth and the states agreed that the fiscal capacities of the states should be made equal, and this responsibility was given to the CGC. According to the CGC, the principle of HFE is that:
State governments should receive funding from the pool of goods and services tax revenue such that, after allowing for material factors affecting revenues and expenditures, each would have the fiscal capacity to provide services and the associated infrastructure at the same standard, if each made the same effort to raise revenue from its own sources and operated at the same level of efficiency.
Equalisation is designed to equalise States' capacity to provide services, not their results. This is because the Commission’s recommendations relate to untied general revenue grants and each State is free to decide its own priorities.
Essentially HFE is employed because there is a horizontal fiscal imbalance between the states whereby states ‘have differing abilities to provide comparable levels of services through the imposition of comparable tax burdens, because of demographic and economic disparities between them’.

In practice, this means some states receive more GST revenue than others, both in dollar terms and on a per capita basis. GST revenue is not distributed based on how much revenue was sourced from each state.

Per capita relativity
The amount of GST revenue received by each state is determined by its ‘per capita relativity’ which the CGC reviews annually. A state’s per capita relativity is adjusted for:
  • the effect of its above or below average disabilities relating to the use and costs of providing services — expense needs
  • the effect of its above or below average investment needs
  • the effect of its above or below average revenue raising capacities — revenue needs
  • the effect of its above or below average net lending needs, and
  • its above or below average per capita revenue from Australian Government payments that are available to fund its expense requirements.
A relativity above one indicates a state requires more than its equal per capita share of GST revenue, and a relativity below one indicates a state requires less than its equal per capita share of GST revenue. A state’s share of the GST revenue is then calculated by combining its per capita relativity with its estimated population as at December.
The latest relativities recommended by the CGC for 2011–12 are as follows:

Table 1 Per capita relativities

  Relativities used
for 2010-11
Relativities recommended
for 2011-12
New South Wales 0.95205 0.95776
Victoria 0.93995 0.90476
Queensland 0.91322 0.92861
Western Australia 0.68298 0.71729
South Australia 1.28497 1.27070
Tasmania 1.62091 1.59942
Australian Capital Territory 1.15295 1.11647
Northern Territory 5.07383 5.35708

Source: Commission calculation.

Source: CGC, Report on GST Revenue Sharing Relativities – 2011 update, p. 3

Relativities have changed significantly since the commencement of the GST. For example, Table 6-1 on page 74 of the latest CGC report shows that while WA currently has the lowest relativity of any state since 2000 (0.68298 in 2010-11), it had a per capita relativity greater than one between 2004–05 and 2006–07 (whereby it received more than its equal per capita share of GST revenue). The table also shows that NSW and Victoria have always had a per capita relativity below one, whereby they have received less than their equal per capita share of GST revenue.

Criticisms of equalisation
The distribution methods described above have led to some unrest among the states. There have been calls by some Premiers for a floor to be set on the minimum amount in the dollar returned to a state. However, this is contentious because, as the CGC notes:

No State can have its relativity increased without one or more of the other States having theirs reduced.
The CGC recognises that there are critics of equalisation in its report The Commonwealth Grants Commission: the past 25 years. Such critics maintain that equalisation can lead to a misallocation of resources between and within states, and that incentives for economic development and efficiency in state service provision are dulled. In particular, economic development could be reduced because if revenue raising capacities of a state are increased then they get less GST revenue, and if service provision becomes more efficient (and cheaper to provide) a state’s relativity would also get revised down. However, the CGC notes that in practice the drive for a state to improve conditions for residents and develop a strong economy, far outweighs its drive to receive optimal GST revenue.

Critics of HFE have advocated reducing the degree of equalisation. One possibly more palatable mechanism mentioned in the CGC’s report is that of ‘partial equalisation’ :
Partial equalisation could occur in several ways. The simplest would be to specify a target level of equalisation. For example, instead of the current aim of equalising all States to the average financial capacity, weaker States might have their fiscal capacity raised to say 80 per cent of the average. However, since the choice of the equalisation percentage requires judgment it would be a matter for governments.
Another possible option is that used by Canada whereby 50 per cent of revenue from natural resources is excluded from the calculation of revenue capacities. Other options include only assessing the revenue raising capacity of states, or removing funding for indigenous peoples from the calculation of relativities.

The CGC argues against a ‘state of origin’ approach, whereby revenue is returned to states based on where that revenue was generated:
Those who advocate a complete return of revenue to its State of origin are really advocating no equalisation, a position which runs counter to the revealed political compromise underpinning the Federation over the last century. It is also a situation that does not exist in many other federations ...
Such a method also encounters issues as GST generation and GST collection can occur across state borders.

In 2001, the Treasurers of NSW, Victoria and WA commissioned Ross Garnaut and Vince FitzGerald to undertake a review of Commonwealth-State funding. This report recommended that differing state needs be dealt with by negotiated specific purpose payments, and that the GST be allocated on an equal per capita basis. ‘The CGC would revert to the role for which it was established, and assess whether additional assistance was required by a State experiencing severe financial difficulty.’

The CGC regularly updates and reviews its methods of calculating relativities. A review was conducted in 2010 with the aim of achieving simpler, more transparent and more reliable assessments. For further reform to the CGC’s role in GST distribution, or the application of HFE principles, a new IGA would probably need to be agreed to by the Council of Australian Governments (COAG).

The review
The terms of reference of the review of GST distribution have indicated that equalisation will still be a principle behind future GST payments, and that the CGC will continue to make recommendations on the distribution of the GST. However, it highlights HFE as an area for review in light of growing challenges such as globalisation, climate change, population growth and technological change:
the Review will consider whether the distribution of the GST and the current form of horizontal fiscal equalisation will ensure that Australia is best placed to respond to these challenges and public confidence in the financial relationships within the Australian Federation is maintained.
The review will be conducted by Nick Greiner, John Brumby and Bruce Carter. An interim report will be provided by February 2012, with the final report due by September 2012.

Image source: http://economics.adelaide.edu.au/events/speakers/