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Research Note no.1 2002-03
Horizontal Fiscal Equalisation
Richard Webb
Economics, Commerce and Industrial Relations Group
20 August 2002
Introduction
The Commonwealth distributes GST revenue
among the States(1) on the basis of the per capita relativities
that the Commonwealth Grants Commission (CGC) calculates.(2)
The calculations are based on the principle of horizontal fiscal equalisation
(HFE) (defined below).
New South Wales, Victoria and Western Australia
argue that HFE disadvantages them.(3) In November 2001, they
commissioned a Review
of CommonwealthState Funding to examine the methods
used to allocate Commonwealth grants among the States including the application
of HFE.(4) This Research Note explains what HFE is and canvasses
surrounding issues.
Definition
The CGC defines HFE as follows:
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 standards.(5)
Thus HFE seeks to ensure that each State
has the capacity to provide services at national average levels at average
levels of efficiency. HFE is grounded in the concept that citizens in
different States should have access to equal standards of government services.(6)
Spending Needs and Revenue
Capacity
The States have different capacities to
raise revenue and different spending 'needs'. For example, Western Australia
has a relatively large capacity to raise revenue from the mining industry
compared with Tasmania, and a State with a young population needs to spend
relatively more on primary education. To provide the States with equal
capacity to provide services, States with below average revenue-raising
capacity or above average spending needs receive a larger share of GST.
HFE thus redistributes resources from States with the capacity to provide
above-average services to the other States. Consequently, the amount of
GST a State receives differs from the amount it would receive if GST were
distributed on an equal per capita basis.
Policy Neutrality
When calculating spending needs and revenue-raising
capacity, the CGC takes account of factors that a State cannot control.
How a State raises revenue and spends it reflects policy choices. If the
distribution of GST were based on actual spending and revenue, a State
could (say) tax less to increase its share of GST revenue. The CGC therefore
seeks to make its assessments of revenue-raising capacity and spending
needs 'policy-neutral': a State receives a larger share of GST revenue
if it can demonstrate that it is unable to provide services at the national
average level for reasons that are beyond its control (disabilities).
The CGC also takes account of 'revenue raising effort', which compares
each State's actual revenue with its assessed capacity.
The CGC's assessment of spending needs
take account of Commonwealth specific purpose payments (SPPs) to the States
for functions such as education and health. The lower the SPP a State
receives (on a per capita basis) for a function, the higher the share
of GST revenue the State receives to bring it up to the national average.
HFE Issues(7)
Criticisms of HFE relate to the principle,
the CGC's assessments, and its consequences. For example, the NSW
Government Submission to the Review notes that
while HFE seeks to equalise States' fiscal capacity, this does not ensure
equitable treatment of individuals in similar circumstances. The counter
to this argument is that HFE does not seek this outcome. The submission
also questions to what extent it is possible to distinguish between policy
and non-policy factors.
By focusing on average levels of service
and delivery, critics argue that HFE does not provide an incentive to
improve efficiency. The Victorian
Government submission claims that States that
undertake reform to cut costs are penalised while inefficient States are
'compensated' for under-performance. There is, however, no consensus on
how to integrate incentives that reward efficiency into HFE assessments.
A criticism of the CGC's relativity calculations
is that they are based on questionable methodologies. The methodologies
are very complex. For example, to calculate disabilities, the CGC examines
each category of spending (health, education, etc.) and the factors that
influence demand for and the cost of providing each service. Clearly,
this is not an easy task, and the CGC sometimes lacks data needed to make
assessments. The CGC's inclusion of SPPs in its calculations is also contentious.
The CGC goes to considerable lengths to explain its methodologies and
undertakes a major review every five years. These reviews are open and
the States provide input to them.
Another criticism of the application of
HFE is that the scope of the services that the CGC's assessments cover
has extended too far. One argument is that assessments should be limited
to 'merit goods', that is, goods and services whose consumption is deemed
to be intrinsically desirable.(8) Law, order and public safety,
for example, might fall into this category. But limiting the scope to
merit goods would violate the concept of equality of capacity to provide
a wide range of services that underlies HFE.
Because the HFE redistributes resources
among the States, an issue is its economy-wide effects. For example, on
the one hand, it is argued that HFE improves resource allocation by encouraging
decentralisation and thus reducing the 'diseconomies' of large cities.
On the other hand, it has been argued that HFE discourages efficient location.
A study by the Centre
of Policy Studies for the Review found that:
a moveto an equal-per-capita basis
would be likely to increasewelfare by between $150 million and $250
million a year.(9)
This is a small proportion of GDP.
Vertical Fiscal Imbalance
The focus of HFE is on the distribution
of GST revenue among the States. Some of the tension surrounding this
might be eased if the States were less reliant on the Commonwealth for
revenuethe Commonwealth provides about half of total State revenueand
were able to raise more from their own sources. But the States have only
a narrow base on which to draw. In contrast, the States are responsible
for major areas of spending such as education and health.
Vertical fiscal imbalancethe imbalance
between the spending responsibilities of each tier of government and the
own-source revenue resources available to that tieris a feature of Australia's
federal system. The last major attempt the States made to gain access
to a large tax base was in the early 1990s, when they sought access to
income tax. With the failure of that attempt(10) the situation
is that the Commonwealth makes grants to the States conditional on them
not levying income tax.
Conclusions
With the States projected to receive almost
$30 billion of GST revenue in 200203, the principle and application of
HFE have important implications. But major change is unlikely. The States
seem likely to remain divided over the use of HFE with New South Wales,
Victoria and Western Australia seeking to have its application at least
modified, and the other States resisting change that would allow these
three States to receive a greater share of GST revenue. The Federal Treasurer
has said that the Government will not change existing GST distribution
arrangements unless the States reach consensus. And with no Commonwealth
government apparently willing to address the issue of vertical fiscal
imbalance, HFE's future seems assured.
- 'States' should be read as the States and Territories.
- Before the GST was introduced, the CGC calculated the
relativities used to distribute financial assistance grants.
- See, for example, Victoria 200102, Budget Paper No.
2, pp. 127135.
- The review has no particular status and the other States
do not endorse it. The review was to report by 31 May 2002 but the final
report has not yet been released.
- Commonwealth Grants Commission, Report on State
Revenue Sharing Relativities 2002 Update, p. 5.
- The HFE equity concept thus differs from the concept
of equitable treatment of individuals in like circumstances.
- For a more comprehensive discussion, see J. Hancock and
J. Smith, Financing
the Federation, South Australian Centre for
Economic Studies, September 2001.
- Marc Robinson, Submission
to the Review of CommonwealthState Funding.
- This finding is based on the concept of equitable treatment
of individuals in like circumstances, which differs from the equality
of capacity concept underlying HFE.
- Denis James, 'Federal and State Taxation: A Comparison
of the Australian, German and Canadian Systems', Current Issues Brief
no. 5, Department of the Parliamentary Library, 199798.
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