Vertical fiscal imbalance
One of the challenges faced by governments in all federations is that
over time the financial costs of providing services tend to shift between the
different levels of government. Unless financial adjustments are made, the
constitutional responsibilities of one level of government can become
misaligned with the capacity of that government to raise revenues needed to
meet financial demands made upon it. If the misalignment becomes too
substantial it can have serious consequences for the way the federation
operates, with constitutional balances of power shifting often without formal
constitutional reform. This chapter examines this issue in the context of the
The difference between the shares of revenue collection and of
expenditure among various tiers of governments is called the 'vertical fiscal
gap' or, in Australia, vertical fiscal imbalance' (VFI). VFI can exist between
any two levels of government. In some countries, the VFI is most marked between
national and regional governments (for example in Australia, Canada and India) while
in others it can also be between national and local governments (for example in
Brazil, Germany and the United States). In theory, there could be a VFI in
which a lower tier of government collects more revenue than it expends, and
transfer funds to a national government. In practice this never occurs. It is
always the national government that gathers most revenue, and then transfers it
to the state and local levels.
It is a commonly held belief among political practitioners within
federations and academic theorists of government that excessive levels of VFI
are undesirable. Among other things it creates inefficiencies, undermines
accountability between different tiers of government, reduces fiscal
transparency and can result in the misallocation of resources. As a result most
federations have developed sometimes highly complex intergovernmental arrangements,
involving transfers of large amounts of revenue to one or other tier of
government in an effort to remedy the problem. The size and conditionality of
the transfers are almost always controversial and lead to significant criticism
of the system.
VFI within the Australian federal system
The Australian federal system is characterised by a significant level of
VFI. Twomey and Withers have argued that 'some VFI is not unusual in a
federation' but go on to note that 'its extent in Australia is the most extreme
of any federation in the industrial world.'
Data collated by the Organisation for Economic Co-operation and Development
(OECD) indicates the degree of VFI within the Australian federal system
compared with other federations.
Figure 4.1: The vertical fiscal imbalance: a comparison
with other federations in per cent of total sub-national revenue
In considering Australia's VFI, it should also be noted that the extent
of the VFI varies depending on the assessment of the Commonwealth's revenue
raising capacity. The OECD data notes that Australia's VFI increased with the
introduction of the Goods and Services Tax (the GST). This was also noted in
evidence to the committee.
Australia only has a large VFI if one treats the GST as Commonwealth revenue.
Although legally accurate, as all of the revenue is distributed to the states
and territories, including the GST when calculating the VFI is a distortion of
the fiscal reality. Nevertheless, Australia's VFI is significant and
The chart prepared by CAF demonstrates the disparity in the Australian
federal system between revenue raising capacity and expenses across the levels
Figure 4.2: Commonwealth, state and local government
revenue and expenses
Australia's high level of VFI is not a recent phenomenon; it has been a
characteristic of the federation for many decades and has led to the
development of an extensive range of mechanisms to try to address the problem.
Managing VFI within the Australian federation
As the Commonwealth raises more revenue than the states and territories,
these mechanisms all involve the Commonwealth transferring funds to the states
to assist them to meet their expenditure responsibilities. As explored in
chapter five, this is known as 'fiscal equalisation'. The different capacities
of the states and territories to raise revenue has meant that their expenditure
requirements are taken into account when allocating payments.
As Twomey and Withers have noted, while Australia has significant VFI balancing,
this is due to the fact that Australia 'also happens to have the highest level
of fiscal equalisation.'
Measures that have been introduced to attempt to improve the fiscal
imbalance between the tiers of government include GST distribution, Specific
Purpose Payments (SPPs), National Partnership Payments (NPPs) and general
Prior to the IGA on Federal Financial Relations, discussed below, the
Commonwealth provided financial assistance to the states and territories
primarily in two forms: general revenue assistance – mainly GST revenue
and Specific Purpose Payments (SPPs).
Data provided by the OECD indicates the measures that existed as of 31 July
Figure 4.3: Measures to address VFI in Australia as of 31
Commenting on these measures, the OECD concluded that:
[a] simpler system of inter-governmental transfers involving
so-called “specific-purpose payments” would contribute to a clearer
specification of spending responsibilities. The specific-purpose payments
should become less complex and inflexible. A first step would be to develop an
outcome/output performance and reporting framework for each SPP. This is an
ambitious task as outcome/output measures of service delivery are difficult to
clearly define, measure and enforce in a robust way. Nevertheless, such
frameworks could ultimately lead to a move towards the funding of such payments
on an outcome/output basis in certain areas.
On 26 March 2008, COAG agreed to a new microeconomic reform agenda for
Australia, 'with a particular focus on health, water, regulatory reform and the
broader productivity agenda'. As part of its reform agenda, COAG agreed,
on 29 November 2008, to a new framework for Commonwealth-State financial
relations, the terms of which were set out in the Intergovernmental Agreement
on Federal Financial Relations (the 'IGA on Federal Financial Relations').
The IGA on Federal Financial Relations recognises that 'the primacy of
state and territory responsibility in the delivery of services in these sectors
is implicit in the Constitution of the Commonwealth of Australia' but also
'that coordinated action is necessary to address many of the economic and
social challenges which confront the Australian community.
The aim was to:
Improve the quality and effectiveness of government services by
reducing Commonwealth prescriptions on service delivery by the States;
Provide states with increased flexibility in the way they deliver
services to the Australian people;
Provide a clearer specification of roles and responsibilities of
each level of government and an improved focus on accountability for better
outcomes and better service delivery;
Rationalise the number of payments to the states for Specific
Purpose Payments (SPPs), reducing the number of such payments from over 90 to
The IGA on Federal Financial Relations, which commenced on 1 January
2009, consolidated and simplified the forms in which the Commonwealth provides
payments to the states and territories. By it the Commonwealth could deliver
three types of financial support to states and territories:
Continued provision of 'general revenue assistance, including the
on-going provision of GST payments, to be used by the states and territories
for any purpose.' It was agreed that the distribution of
payments would continue to be made 'in accordance with the principle of horizontal
National Specific Purpose Payments (SPPs). The previous
arrangements for over 90 SPPs were replaced with five new national SPPs
corresponding with the five areas COAG identified as 'key service delivery
The Commonwealth agreed to increase the total appropriation for SPPs by $7.1
billion over five years. Each SPP is associated with a National Agreement that
contains the objectives, outcomes, outputs and performance indicators as well
as clarification of roles and responsibilities.
A new category of financial support, 'National Partnership'
payments. These are designed 'to support the delivery of specified outputs or
projects, to facilitate reforms or to reward those jurisdictions that deliver
on nationally significant reforms.'
These payments fall into three categories: project payments (to support
national objectives and help fund the delivery of specific projects);
facilitation payments (to help a state lift its standards of service delivery
in areas identified as national priorities); and reward payments (incentives to
encourage states to undertake reforms and attain performance benchmarks). There
has now been agreement to the first wave of these payments.
COAG agreed that '[a]ll intergovernmental financial transfers other than
for Commonwealth own purpose expenses will be subject to the IGA on Federal
Ms Mary Ann O'Loughlin, Executive Councillor and Head of Secretariat,
COAG Reform Council, advised that the IGA on Federal Financial Relations is
intended to rationalise the previous measures to address Australia's VFI:
The intergovernmental agreement is a set of significant
reforms of Australia’s federal financial relations. It governs all the policy
and financial relations between the Commonwealth and the states. It set up new
financial arrangements, national agreements and national partnerships between the
Commonwealth, state and territory governments. The national agreements replaced
the more prescriptive tied grant arrangements. The focus of the new agreements
is on agreed outcomes and performance indicators, milestones and benchmarks to
The Committee was informed that the IGA on Federal Financial Relations
provides for the new funding arrangements to be independently reviewed. The
COAG Reform Council is required to 'monitor, assess and publicly report on the
performance of governments in implementing nationally agreed reforms.' Ms
O'Loughlin advised that:
for the six national agreements...council undertakes a
comparatives analysis of government's performance against the agreed outcomes,
indicators and targets of the national agreements. For reward national
partnerships...the council is the independent assessor of whether the
predetermined milestones and benchmarks have been achieved before the
Commonwealth decides on incentive payments to reward reforms...
The committee was also advised that the Heads of Treasury Committee is
reviewing the National Agreements, National Partnerships and performance
framework, with particular reference to the availability of data. The Committee
is to report to COAG by the end of 2011.
Federal Financial Relations Act
The Federal Financial Relations Act 2009 was enacted to implement
the arrangements of the IGA on Federal Financial Relations, including
consolidating in one place the arrangements for Commonwealth payments to states
Previous arrangements for the distribution of GST revenue and appropriations
for health, infrastructure and offshore petroleum and greenhouse gas storage to
the states and territories were repealed.
Consistent with its object, the Federal Financial Relations Act made provision
for the calculation and distribution of GST revenue, SPPs and National
Partnership payments. It took effect on 1 April 2009.
In April 2010, COAG – with the exception of WA – reached agreement on
the establishment of a National Health and Hospitals Network. It was agreed
From 1 July 2011, the Commonwealth will fund 60% of the efficient
price of all public hospital services delivered to public patients, 60% of
recurrent expenditure on research and training functions undertaken in public
hospitals, 60% of capital expenditure on a 'user cost of capital' basis where
possible, and (over time) up to 100% of the efficient price of 'primary health
care equivalent' outpatient services provided to the public.
The Commonwealth will also fund 100% of primary health care (e.g.
GP services) and aged care (other than in Victoria).
The Commonwealth will provide additional $5.4 billion from 1 July
2010 for health reforms and investment
From 2011-12 the Commonwealth will dedicate a portion of the
states' (excluding WA) GST revenue to health.
It was also agreed to make all necessary amendments to the IGA on
Federal Financial Relations and related Commonwealth legislation to reflect the
agreement on the National Health and Hospitals Network.
The effect of this agreement is that from 1 July 2011, significant
changes will be made to the Commonwealth's distribution of GST revenue and SPPs
amongst the states.
Concerns with the effect of VFI on Australia's federal system
Evidence to the committee highlights concerns with Australia's VFI. CAF
was critical of the extent of Australia's VFI, arguing that an excessive degree
of VFI is undesirable as it can:
weaken government accountability to the public by breaking the
nexus between a government’s decisions on the level of service provision and
the revenue raised to fund it. For every dollar spent by state governments,
less than 60 cents is raised directly for those purposes.
reduce transparency regarding who is responsible for which
government services, allowing governments to avoid responsibility by shifting
blame for funding and operational shortfalls to other spheres of government.
Health policy has been a prime example where different spheres of government
responsibility, for funding, operating and regulating across different areas of
the health care system, has resulted in public confusion and opportunity for
create inefficiencies, including through bureaucratic overlap,
duplication and excess and the cost of administering grants between
misallocate resources, including the inadequate or inappropriate
funding of services.
slow the responsiveness of governments to the needs of their
The Australian Chamber of Commerce and Industry was similarly critical
of the imbalance between the taxing and spending powers of the Commonwealth and
the states, arguing that several problems arise including:
Weakening of accountability: a separation between the two
authorities that raise and spend the revenue (the Commonwealth Government and
the State Government) leads to a weakening of accountability and inefficiencies
in the delivery of state services as State Governments do not bear the political
ill will of raising the taxes to pay for the services.
Reliance on inefficient taxes: the States are forced to rely on
inefficient taxes such as stamp duty and payroll tax in order to raise revenue
as their ability to impose more efficient taxes is restricted.
Limits incentive for states to cut taxes: the taxes that states
can impose are inefficient and regressive but their reduced revenue raising
capacity gives them very little incentive to reduce taxes.
This position was echoed by the NSW Business Chamber, which argued that:
Restrictions on the taxing powers of State and Territory
Governments mean that States are unable to take unilateral action to address
this issue. These restrictions on State powers mean that State Governments are
forced to rely on the few taxing powers they have for significant amounts of
revenue, even where it is commonly acknowledged that such taxes are inefficient
and volatile. This can hamper the process of State tax reform.
For the Government of Western Australia, 'the need for a new federal
fiscal framework is the most important and pressing element of "the reform
of relations" between the Commonwealth and States.'
A similar claim was advanced by the Pearce Division of the Liberal Party of
The fact that States lack the capacity to raise the funds
required to fulfil their spending responsibilities is problematic as it reduces
direct government accountability, with State governments not having to make the
difficult choices attached to balancing taxation and expenditure.
Further to this, it was the Pearce Division's belief that:
Reform of the financial relationship between the Commonwealth
and the States is necessary to strengthen the federation by ensuring that the
States have financial independence and the capacity to independently raise
sufficient revenue to fulfil their constitutional responsibilities.
It was put to the committee that the current mechanisms to address the
fiscal imbalance do not provide certainty to the states. Professor Galligan
argued that the Commonwealth continues to attempt to control the measures to
address VFI through use of 'accustomed carrots and sticks of intergovernmental
Referring to the negotiations around national health reforms, the Professor
stated that the Commonwealth had proposed allocating one-third of the GST to
fund the hospitals network; thereby moving away from the current model of
untied grants of GST revenues.
On this point Professor John Uhr commented that the VFI arrangements 'seemed to
be really cutting right into the whole small c Constitution of the GST.'
Professor Galligan articulated a view that seemed to summarise the
general spread of opinions on VFI given in the evidence to the committee:
Few perhaps prefer the status quo in Australian fiscal
federalism—for federalists it is too centralized,
but for centralists it is too complex and variegated from state to state.
Prospects for change are not promising, however. The Commonwealth was dealt the
superior hand by the constitution, and that superiority was embellished and
legitimated by the High Court.
Evidence before the committee indicates that the objectives of the IGA
on Federal Financial Relations may not be being fulfilled as well as was hoped.
Several submitters commented that, while the IGA was designed to rationalise
the proliferation of Special Purpose Payments, much of the complexity and
prescriptiveness of the old system appears to be returning via the 'back door'
of increased detail in the new National Agreements and National Partnerships.
The Tasmanian government observed:
It can be argued that only a few of the new NPs and IPs [Implementation
Plans sitting under National Partnership agreements] fully comply with the
new IGA principles. Rather than focusing on outcomes, many agreements remain
focussed on inputs – where and how the money is spent but without much regard
for what is actually achieved. In some cases, the agreements remain highly
prescriptive and continue the practice of Commonwealth micromanagement over
state service delivery.
The new framework has not yet fully realised its ambition of
reducing the administrative burden on Commonwealth and state departments. The
level of oversight and monitoring by the Commonwealth and the reporting
requirements placed on states is increasing costs and diverting resources away
from service delivery.
Dr Anne Twomey's assessment was more blunt:
[T]he new system of national partnership payments appears to
be a backdoor way for the Commonwealth to interfere again in areas of State
policy through the placement of conditions on payments. As time goes by, it is
likely that specific purpose payments will shrink, national partnership
payments will increase and we will be back to where we started with precisely
the same problems in terms of excessive administration costs, duplication,
waste and blame-shifting.
The Tasmanian government was also critical of the level of VFI in
Australia, but it did note that it was potentially 'more efficient for a
national government to raise certain revenues...compliance with a national tax
regime can be more efficient for businesses that operate in more than one
Options for reform
The reform of fiscal federalism is a particularly complex area of
governance, admitting of few easy solutions. The position put by the Business
Council of Australia summarises the situation well:
Ideally, each Government should raise the funds necessary to
fulfil its responsibilities. It is questionable, however, whether Australia’s
revenue raising system could be so radically adjusted given how far the
pendulum has swung in favour of the Commonwealth. Without adjustments, however,
it is likely that the States will become increasingly the service deliverers of
the Commonwealth’s policy agenda.
At their heart, all negotiations around fiscal reform appear to suffer
from the structural disadvantage by which states and local government are
always placed in an inferior bargaining position. Most options for reform
presented in submissions attempted to address the structural disadvantage
through a clearer reallocation of roles and responsibilities across the
different layers of government as well as providing states and territories with
a greater share of revenue over time to support their functions. Such an
approach assumes that it is actually possible to achieve a list of separate and
Whilst there is a growing number of people and organisations calling for
a reallocation of roles between the federal and state and territory governments,
it is less clear that any consensus could be achieved on reallocating those
roles. This is especially so in Australia which has 'a relatively high and
increasing degree of shared functions between different levels of government.'
Twomey and Withers propose a two-tier method for dealing with
There are two ways of dealing with a reallocation of
functions. The first is the higher level ‘clean lines approach, in which
defined subjects of jurisdiction are allocated to each level of government. For
example, the Commonwealth Government’s National Commission of Audit suggested
that States be responsible for preschool, primary and secondary education, with
Commonwealth funding of secondary education being through untied grants. The
Commission suggested that the Commonwealth take full responsibility for
vocational education and training and higher education.
Not all areas of government are susceptible to ‘clean lines’
divisions. There will always be a need for
areas of shared responsibility. This means
that a second approach needs to be taken to reallocation – not in relation to
responsibilities, but in relation to allocating roles in managing those shared
responsibilities. Better mechanisms for
co-operation are also needed to avoid ‘border issues’, to ensure the
coordination of government services and to avoid cost-shifting.
In their evidence, Twomey and Withers suggest that this reallocation
could be achieved through constitutional reform, but it was not essential.
Referred legislation could be an option.
Another model for reallocating roles was suggested in the submission
from the Northern Territory Statehood Steering Committee. It was argued that
the current push by the Statehood Committee for statehood represented a key
opportunity to raise the allocation of roles between the federal government and
the states. The Statehood Committee favours:
[a] process for clarifying the role through concerted policy
action at the Council of Australian Governments level rather than a more
abstract 'grand plan'. The principle that government is accessible and
accountable to those affected by its decisions should have a key role to play
in determining who is responsible for service delivery.
Not all commentators are as sanguine about the feasibility of
reallocating roles. As seen in chapter one, Professor Galligan believes that
coordinate federalism is an unsophisticated paradigm, one which is
inappropriate for modern Australia. In reality the Commonwealth and the states
or territories inextricably share roles and responsibilities.
Another option for reforming fiscal federalism, beyond that of
reallocating roles between layers of government, would be to consider more
holistic reform of the tax structure and tax levels. Twomey and Withers argue
[s]erious tax reform would recognise that Australia overtaxes
incomes and undertaxes spending compared to other OECD economies. Our overall
tax take is at the lower end of industrial economies as a share of GDP but is
strongly biased toward income tax sourcing. Both personal income taxes and
corporate income taxes represent higher shares of public revenue in Australia
than in most comparable countries.
Reform could extend further to revisiting horizontal fiscal
equalisation as well as vertical fiscal imbalance and the structure of
taxation. The pursuit of such equalisation in Australia exceeds the pattern in
all other comparable federations. As a consequence, it provides greater
disincentives for sub-national governments to seek and provide efficient
delivery of government services. At a minimum, more transparent and less
complex equalisation processes with improved incentives for efficiency could be
Other options for reform of the institutional arrangements include:
an expanded Federal Financial Relations Act 2009 subsuming
the existing Commonwealth Grants Commission and acting as a framework 'for
Commonwealth grants of financial assistance to the States, and for the
indexation of those grants' as well as defining the parameters for agreements;
a formal tax-sharing agreement between the Commonwealth and
States, based on proportion of Commonwealth tax revenue; and/or
states setting their own income taxes (though still collected by
the ATO); and
both the Commonwealth and states setting income taxes, to help
boost the proportion of revenue that is gathered directly by the states.
The committee notes that, by comparison with all other federations,
Australia has a high level of VFI. Over time, the VFI has severely undermined
the capacity of the states and territories to raise the revenue necessary to
undertake their assigned constitutional responsibilities. The committee also
notes that over many decades successive federal and states governments have
developed an extensive range of mechanisms to address the problem. These
mechanisms have certainly helped to manage Australia's high level of VFI but
the problem continues to be one of the most controversial in federal-state
The committee endorses the recent reforms to Special Purpose Payments,
reducing their total number from more than 90 to just five. However, the
committee notes the strong concerns expressed in evidence for the inquiry that
the new arrangements under the IGA on Federal Financial Relations are not
sufficiently meeting the objectives of reducing Commonwealth prescriptiveness
and increasing state flexibility regarding service delivery. The committee
cautions that the new arrangements must not become a new means for the
Commonwealth to attach overly prescriptive conditions on the payments, and
draws attention to the view of the OECD that measures to address VFI should
avoid complexity and inflexible arrangements.
While existing mechanisms have improved fiscal arrangements, ultimately,
however, they do not address the underlying fiscal imbalance itself. The
committee notes that as VFI is addressed through Commonwealth grants, states
are largely dependent on Commonwealth actions and policies. The committee notes,
by way of illustration, the Commonwealth's consideration of withholding
portions of the GST to fund national health reforms. This illustrates the
potential uncertainty for the states that can arise where states are to a
significant degree dependent on funding from the first tier of government.
A number of suggestions were put forward to address fiscal imbalance.
These included reallocating roles between the first and second tier of
Government. The committee considers that without radically reducing the states'
responsibilities, it is unclear that adjusting the role of the Commonwealth and
state governments would, on its own, address imbalances in revenue raising. Other
proposals included holistic reform of taxation structures and levels. The
recently announced review of GST distribution begins to address the issue
around equalisation referred to above. But clearly a broader debate needs to
occur in relation to taxation. The vertical fiscal imbalance in the Australia
federal system needs to be redressed. On the basis of the material presented to
the committee, the committee sees merit in a comprehensive assessment of the
IGA on Federal Financial Relation and taxation levels and structures, to
determine if measures can be taken to provide the states certainty regarding
their revenue raising and their capacity to meeting their responsibilities. As
noted, broader debate is required. The committee considers that the matter
should be referred to the Senate Committee which Recommendation XX of this
report will propose be created. The committee should draw on expert advice, for
example from the Productivity Commission, the COAG Reform Council and the
Commonwealth Grants Commission as required.
The committee recommends that the Joint Standing Committee proposed in
Recommendation 17 of this report inquire into the need for adjustments to the
IGA on Federal Financial Relations and to the level and structure of taxation
in Australia to provide the states certainty regarding revenue raising and
their capacity to meet their responsibilities. In considering this issue, the
committee should inquire into any related matters that the committee determines
are appropriate, including the roles of the state and federal governments, and
seek advice from the Productivity Commission, the COAG Reform Council and the
Commonwealth Grants Commission as required.
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