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Australian Government - GST Distribution Review

1 The role and purpose of Horizontal Fiscal Equalisation

This Chapter explains the background and goals of the current system of fiscal equalisation, and introduces some key concepts that will be developed in later Chapters.

The Terms of Reference make it clear that this is not a review of whether the concept of Horizontal Fiscal Equalisation (HFE) should continue to apply, but rather, what form it should take. However, the wide range of meanings attributed to the term HFE makes it important to consider what HFE is, to examine how it is currently approached in Australia, and review how it has been thought about in Australia in the past.

In particular, this Chapter will:

  • describe what HFE is, and discuss the range of ideas the term can cover
  • briefly examine how other federations approach HFE
  • describe how the HFE system operates and has operated in Australia
  • explore the form of HFE needed in Australia today and in the future.

1.1 What is Horizontal Fiscal Equalisation and what is it intended to achieve?

If all sub-national governments in a country faced the same circumstances - that is, if they all had the same ability to raise revenue and faced the same service costs - then HFE would not be necessary. However, different sub-national governments typically have different costs and capacities to raise revenue for reasons that are beyond their control. The process to address these differences is known as Horizontal Fiscal Equalisation(or HFE).

In Australia, HFE is not referred to in the Constitution, defined in legislation or described in any agreement between governments. Rather, the definition has evolved over time, largely through the body that administers HFE in Australia - the Commonwealth Grants Commission (CGC). The current CGC definition of HFE is:

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.1

At a simpler level, the CGC describes horizontal fiscal equalisation as follows:

… equalisation aims to put all States on a level fiscal playing field.2

The range of concepts covered by the term Horizontal Fiscal Equalisation

In Australia, HFE is performed only by payments from the Commonwealth to the States (that is, no payments are made by one State to another), a situation largely driven by the high degree of Vertical Fiscal Imbalance (VFI) in Australia.3 The current source of funds to address HFE is the revenue from the goods and services tax (GST). With HFE being sought through GST payments to the States, thechallenge for the designers of the system (and now the Panel) has been how to make these payments 'fairly'.

Fairness is an inherently subjective concept and there is a range of views on what is, or is not, 'fair'. Because the various perceptions of fairness are critical to an evaluation of the current system of GST distribution, this concept is dealt with in more detail later in this Chapter.

For present purposes, it is sufficient to point out that some jurisdictions and commentators argue that the Commonwealth should simply give the States the same amount of revenue per citizen, referred to as an equal per capita (EPC) distribution.4 Both New South Wales and Victoria suggest that an EPC distribution of GST would be the most appropriate form, although both States acknowledge that additional payments would then need to be made by the Commonwealth to some States, or in relation to some issues.5

New South Wales says:

An alternative distribution model incorporating an equal per capita distribution of the GST pool to all states, with an additional, separately funded equalizing distribution to the recipient states would provide a simpler, more transparent, more stable system of HFE.6

Victoria considers that:

There is a strong case for transitioning to an EPC distribution of the GST pool over the longer-term … EPC shares would be simple to calculate, thus negating the need for a complex CGC architecture to calculate relativities. The system would also be devoid of the type of perverse incentives for inefficiency that exist under the current system.7

At the other end of the spectrum of opinion, some argue that States should receive an amount based on a precise and comprehensive measurement of their revenue raising capacity and their service delivery costs. This requires a form of equalisation that is broad and deep - broad in the scope of matters it encompasses and deep in terms of the level of detail considered on each.

The current system in Australia is closer to this 'broad and deep' notion of HFE than equalisation systems in other countries.8 However, it is not at the extreme end of the spectrum, due to practical data limitations and prior deliberate moves towards simplicity.9

Some State submissions can be seen as proposing a move further towards the 'broad and deep' end of the spectrum. For example, the Australian Capital Territory proposes subsidies paid by the Commonwealth to specific industries be included, thus broadening the scope of HFE.10

Similarly, Western Australia suggests that, if the existing equalisation framework is retained, a range of 'gaps' should be addressed, including, for example, servicing national parks.11 Inclusion of such costs would increase the depth of relevant individual assessments.12

In short, the concept of HFE has been and can be used to cover the entire spectrum of variations between an EPC distribution and a 'broad and deep' form of full equalisation.

Does HFE describe the mechanism or the objective?

As well as encompassing a range of concepts, the term HFE can be used to refer to both an objective and the mechanism used to achieve it. Henry Ergas and Jonathan Pincus make this point in their submission to the Review:

Horizontal fiscal equalisation refers both to a mechanism and to an objective. The mechanism is the process through which revenues collected by the Commonwealth from the Goods and Services Tax … are distributed to the States and Territories … The objective is that of securing particular outcomes captured by the term 'equalisation'.13

In Australia, these two meanings of the term are often used interchangeably because there has been no practical reason to differentiate between them. However, the distinction between the use of the term to describe the mechanism and the objective may become important if additional goals are sought through the GST distribution mechanism in the future.

Equalising States' capacity, not individual outcomes

While HFE encompasses a range of meanings, a feature common to many is the notion of equalising States' capacities, rather than actual outcomes.

In pursuing HFE, national governments seek to compensate for things outside States' control. The goal is therefore often said to be to give States the capacity to provide equal outcomes without reversing or overriding the States' own policy choices. The use of the word capacity in this way emphasises the freedom of States to choose how to spend their money, even if their choices ultimately produce unequal outcomes for various classes of citizens.

Practical constraints on HFE models

There are practical constraints on all HFE models.

Advocates of the EPC model often suggest that extra funding should be provided by the Commonwealth to the States.14 However, as explained in the Introduction, extra Commonwealth funding is not available and existing payments from the Commonwealth to the States (specific purpose payments and national partnership payments) are already fully committed. In any case, an approach that distributed GST on an EPC basis, but required 'equalisation' of other Commonwealth payments would merely shift the current criticisms of HFE to the form of equalisation used to determine States' shares of the other funding.

Concepts of HFE at the other end of the spectrum, seeking a more comprehensive form of equalisation, also face problems. A complete and comprehensive form of equalisation would ideally seek to be contemporaneous, but the unavailability of timely data creates a constraint.15 A separate constraint, contained in both the Panel's Terms of Reference and the latest Intergovernmental Agreement, is that GST payments cannot be tied. This would constrain those models of HFE that seek to equalise outcomes for individuals.

1.2 HFE around the world

Many federations and some unitary nations perform some form of HFE.

While comparing the range of HFE approaches around the world can be useful, care is required before concluding that one country's approach is suitable for another, as a wide range of factors influences the chosen form of HFE. The political structures, the degree of VFI, and the historical and social circumstances of a nation all have a significant bearing on the form of HFE that is most appropriate for a particular country.

Nevertheless, to demonstrate the different approaches currently in use, brief summaries of HFE as applying in Canada and Germany are set out below.

Canada16

Canada's equalisation program aims to ensure that Provinces have sufficient revenue to provide reasonably comparable levels of public services at reasonably comparable levels of taxation (subsection 36(2) of the Constitution Act, 1982).

To this end, Canada equalises Provinces' revenue-raising capacity, but not their expenditure needs. Further, one of the main sources of revenue for some Provinces - mining revenue - is subject to a discount of fifty per cent. Provinces receive the greater of the amount they would receive by fully excluding natural resource revenue, or by excluding 50 per cent of natural resource revenue.

As in Australia, equalisation payments are untied funds (so Provinces are free to spend the funds as they choose) and there are no transfers between Provinces, with all HFE transfers coming from the national government to Provincial governments. However, unlike Australia, only Provinces with below average capacities receive equalisation payments, so that each Province is not 'equalised' to exactly the same capacity. Provinces with below average capacity are equalised 'up' to the average, but those with above average capacity neither receive payments nor are required to contribute.

Canada's external territories, however, have a separate program, with both their revenue raising capacities and expenditure needs recognised.

Germany

Germany mainly equalises for revenue, with only some small adjustments for expense needs (namely population dispersion and cross-border issues).

There are multiple sources of funds for equalisation in Germany.

First, the Federal Government provides poor Lander17 with an above average share of Value-Added Tax (VAT). VAT revenue is shared among all levels of government. The Landers' share has recently been around 45 per cent, although it has varied over time. This share is allocated among them on an equalising basis, with 75 per cent distributed EPC and the remaining 25 per cent paid to Lander with below average fiscal capacity.

Secondly, unlike Canada or Australia, there are direct transfers between sub-national Governments. Poor Lander receive adjustment payments funded by the wealthy Lander.

Thirdly, Lander whose financial capacities after the distribution of VAT and transfers between the sub-national governments are still marginally below the average receive supplementary grants from the federal government.18

Vertical Fiscal Imbalance (VFI)

A range of factors influences the form of HFE used in any particular country. One important factor is the level or degree of VFI — a high level of VFI can make it easier for a national government to pursue a more complete form of HFE, because it is less likely to require direct transfers between sub-national governments.19

By international standards, Australia exhibits a high degree of VFI. VFI can be measured in several ways, but is often measured as State Government own-source taxes or revenues as a proportion of State Government expenditure. By this measure, Australian States experience considerably higher levels of VFI than sub-national Governments in Canada and Germany. State Government own-source revenues are around 54 per cent of State Government expenditure in Australia compared to over 70 per cent in both Canada and Germany.20 However, such figures can hide differences in the way taxes are structured and collected. German Lander, for example, have limited discretion in setting the tax rates and defining the tax bases for some of their 'own source' taxes.21 Canadian Provinces and Australian States, by contrast, have power to set bases and rates for all their own taxes.

1.3 How does HFE apply in Australia?

How HFE has applied in Australia in the past

Before World War II, the system was less 'full' than now in several ways.

First, not all States were included in the equalisation system. 'Claiming' States were raised to a minimum standard, rather than all States being equalised to an average. Secondly, not all expenditure categories were assessed. Instead, the assessment was limited to health, education and law and order.

Part of the reason for this was practical. Less money was distributed from the Commonwealth to the States (the degree of VFI was considerably less before World War II) and data sets were harder to obtain.22

Reforms in the late 1970s led to the inclusion of all States (but not Territories) in the equalisation process. The Northern Territory and Australian Capital Territory were included in 1988-89 and 1993-94 respectively.

The idea that States should be equalised to the 'same' capacity was not formally introduced into the CGC's definition of HFE until the 1990s. Prior to that, the phrase 'not appreciably different from' had been adopted.

A more detailed history of HFE in Australia can be found in the CGC's publications: The Last 25 Years and Equality in Diversity.23

How HFE applies in Australia today

Australia currently adopts an approach that is closer to 'full' equalisation than any other country. Australia's approach to equalisation can be considered 'full' in two ways. First, it seeks to equalise States to materially the 'same' capacity — it does not merely seek to act, for example, as a safety net bringing weak States up to a minimum standard. Secondly, it is broad in scope (including revenues, expenses, and capital) and deep in detail (in each of its assessments).24

How the CGC calculates HFE payments

The CGC uses a total of States' actual revenue and expenses to construct an 'average' State budget, which includes the costs to provide the average level of services and the average revenue raised by State taxes. It then considers to what extent States may be able to raise more (or less) than the average level of revenue (for example due to property market activity), and what factors beyond a State's control (such as demographic and geographic features) may require it to spend more (or less) than the average to provide services. States with below average capacity to raise revenue, or facing above average costs to provide services, receive relatively more GST revenue, while States with above average capacity to raise revenue, or facing below average costs to provide services, receive relatively less GST revenue.

Figure 1.1 below shows each State's assessed revenue (that is, the revenue they would raise from their own sources if they applied the average policies), their assessed expenditure (that is, the funding they would need to provide the average level of services and infrastructure, given their demographic characteristics and population growth) and their Commonwealth payments (actual non-GST payments received from the Commonwealth). There is a 'gap' between the assessed expenditure and the total of the assessed own source revenue plus Commonwealth payments.

Figure 1.1 Revenue available to meet expenditure requirements, 2010-11

This figure illustrates each State's assessed revenue, their Commonwealth payments and their assessed expenditure. There is a gap or shortfall between the assessed expenditure and the total revenue. The Northern Territory has the largest gap, and Western Australia has the smallest gap.

Source: CGC, 2012 update

Note: Assessed expenditure is the sum of assessed expenses, assessed investment and assessed net lending.

As shown in figure 1.2, the GST payment fills the gap between the revenue available (from the Commonwealth and States' own sources) and expenditure requirements, thus producing the result that States have (materially) the same capacity to fund their separate needs.

Figure 1.2 GST requirement, 2010-11

This figure replicates figure 1.1, but illustrates that GST fills the gap between a State's expenditure requirements and its assessed revenue plus Commonwealth payments.

Source: CGC, 2012 update

Once the CGC has calculated how much GST a State requires to fill the 'gap', it then divides the requirement by the average GST per capita to produce a 'relativity'.

Figures 1.1 and 1.2 show that some States have higher assessed revenue or expenditure per capita than others. Some States have higher assessed revenue per capita because there are factors beyond these States' control that mean they have a greater capacity to raise revenue from their own sources. For example, if a State has particularly high land values, its capacity to raise revenue from land tax may be greater than the average.

Similarly, higher assessed expenditure arises because the CGC considers that there are factors beyond these States' control that lead to higher costs in providing the average level of services to their residents. One example of a factor is the proportion of older people in a State's population. As older people utilise hospital services more than the average, States with a higher than average proportion of older people may have above average hospital costs, contributing to a higher than average assessed expenditure.

Following from the fact that the CGC seeks to achieve materially the 'same' level of capacity for all States, the CGC assesses revenue capacity and expense needs wherever it observes that a difference between the States is material.

The CGC's assessment of revenue currently comprises 13 revenue assessments in eight categories:

  • mining, conveyances, payroll, insurance, motor vehicle, land, other and Commonwealth payments.

The assessed expenditure includes 93 expenditure assessments across 14 categories:

  • schools, post-secondary, admitted patients, community health, welfare and housing, communities, justice, road, transport, services to industry, other, depreciation, investment and net lending.

When making judgements about assessments, the CGC has reference to four key principles. These principles were developed by the CGC in their 2010 Methodology Review, having evolved from principles used in the past.

The principles (sometimes called 'pillars') indicate that equalisation should be implemented through methods that:

  • reflect what States collectively do
  • are policy neutral
  • are practical
  • are most appropriate to the application year.25

The principle that equalisation should reflect 'what States collectively do' means that, as far as practical, the CGC seeks to avoid making judgments about what States could or should do. The average budget is therefore based on the average range of services actually provided by States and the average range of taxes actually imposed by States.

The principle of policy neutrality means that the CGC seeks to ensure that policy differences between States do not affect the GST distribution, and that the GST distribution process does not provide the States with incentives to vary their policies.

The principle of practicality refers to the need to base assessments on sound and reliable data and methods. It includes the idea that materiality and reliability of assessments need to be considered.

Finally, the CGC seeks to recommend GST payments that are most appropriate to the application year — that is, the distribution should be contemporaneous (or 'up to date') and should reflect State circumstances in the year the funds are used.

Some States are strong supporters of these principles,26 while others argue that the CGC does not implement the principles effectively in practice.27 States' detailed concerns with the implementation of these principles, particularly in relation to policy neutrality, are discussed in later Chapters.

The goal of the current HFE process

As explained above, while the ultimate goal of the current system is a fair distribution of the GST amongst the States, there is considerable dispute about whether the outcomes of the current process achieve that.

While State submissions show broad agreement with the notion that HFE currently has equity as its main objective, various States have different views on whether this objective is being met.

The Northern Territory, Australian Capital Territory, Tasmania and South Australia all argue strongly for the maintenance of a robust system of (full) equalisation, on the grounds that this is essential if the system is to be 'equitable'.28

The Northern Territory says:

The promotion of equity and fairness has been a central objective of Australian governments, and are long standing tenets of Australian society … The distribution of GST revenue based on the principle of fiscal equalisation is only one policy measure underpinning all governments' objective of achieving equity for all Australians, but it is an integral component. Equalisation is intended to provide horizontal equity between states, which complements other government policies aimed at vertical equity.29

The Australian Capital Territory considers that:

HFE's key purpose is equity [and, i]n a federal system equity requires the equal treatment of equals or equal treatment for persons different in no relevant respect. This underlying principle of equitable treatment is an important value to all Australians.

Australia's equalisation system is world-leading. Its objective, to allow each State to provide comparable services and infrastructure to every Australian citizen no matter where they reside is an egalitarian and equity driven approach …

States should have the same fiscal capacity for services to their citizens irrespective of the varying policies. Such fiscal equity is fundamental to a civilised federation and is described as 'essential as a guide to the operations of a liberal democratic state, stemming from the same base as the principle of equality of individuals before the law'.30

The Tasmanian submission argues along similar lines:

Equity is at the heart of HFE. Principles relating to efficiency, simplicity and predictability/stability are important aspects of a sound equalisation process. However, any dilution (or lower weighting) of these principles does not result in HFE ceasing to function adequately. By contrast, if the principle of equity is down-graded, the equalisation process will fail to achieve its major aim.

HFE reflects the principle that Australians should have access to a similar standard of service, regardless of the jurisdiction in which they live. This is [sic] strong egalitarian principle has been widely held by the Australian community and been reflected in the CGC's approach, in one form or another, since its inception in the 1930s.31

South Australia says that:

HFE ensures that otherwise similar households and firms in an integrated national economy, within the Australian federation, are not treated as different class citizens and entities merely on account of the accidents of natural resource location and circumstances of fellow residents within state borders.32

While the four remaining States broadly agree that the main goal of the current system is equity, they generally would not consider that an equitable system necessarily requires absolute equality of treatment — in their views, fairness (equity) could be achieved through a less rigorous pursuit of equal outcomes.

For example, Victoria argues that:

Over time, Australia's system of HFE has moved from one based on broad equity to one based on specific equality. These concepts are distinct. The goal of equity can be met without the provision of equal standards of service … equity is an important element of a strong and stable federation. However, it is arguable that the current system of HFE over-reaches in its quest for equality and thus, it is questionable if the system is successful in achieving its goals.33

New South Wales summarises the current system as one that:

… seeks to achieve full equalisation of state government fiscal capacities … This contrasts with the income tax/welfare system in Australia which aims only to moderate the income distribution of individuals.34

Western Australia says:

The current form of fiscal equalisation in Australia is too extreme. It is equivalent to a 100 per cent tax on any excess of one State's fiscal capacity over the average for all States. This would not be considered equitable or efficient in any other part of the national tax and transfer system. Nor is it seen in any other federation globally.35

Queensland considers that the aim of the GST distribution process is unclear, and argues that the Panel should seek to clarify it. Queensland quotes summaries of the aim of HFE mentioned in the CGC 2010 Review, the Commonwealth Budget papers and the issues paper of this Review, and argues that:

The intent of the three statements … is for all States to have the capacity to provide services to their residents. However, the statements differ in the suggested standard for these services. The Review's Terms of Reference do not refer to standards, the Commonwealth Grants Commission refers to 'the same standard', and the Australian Government refers to 'a comparable standard'. While the difference between the approaches of the Commonwealth Grants Commission and the Australian Government may appear to be a matter of semantics, in practice they seek quite different outcomes…

Additionally, in no area of Australian public policy does a desire for absolute equality of outcomes override all other considerations. Governments do not provide identical levels of services to every resident. The tax and transfer system does not equalise net incomes for all Australians. This is because other objectives — efficiency, fairness, simplicity — need to be taken into consideration to produce an optimal outcome.36

To resolve the differences identified, Queensland proposes that:

… this Review should seek to clarify the aim of the GST distribution process, and recommends the aim that is adopted be consistent with that specified by the Australian Government in 2011, and articulated in the Review's Terms of Reference (GST Distribution Review 2011, clause 3) and the Review Panel's Issues Paper (GST Distribution Review 2011a, p. 1). That is, the aim of the GST distribution process should be to provide the necessary budget support so that all States have the capacity to provide services at a comparable standard.37

1.4 Other criticisms of the current form of HFE

While the current HFE process exists primarily to balance out States' disparate capacities, some commentators consider that the current process creates other problems. Criticisms include that the current process:

  • is too unpredictable
  • is too complex
  • creates problems for the provision of nationally significant infrastructure
  • creates disincentives for reform or incentives for inefficient provision of services.

These criticisms, among others, are discussed in detail in later Chapters.38

However, even regarding the goal of horizontal equity, the current form of HFE has been criticised.

In their Review of Commonwealth-State Funding in 2002, Professor Ross Garnaut and Dr Vince FitzGerald concluded that:

The current system … fails to ensure equal treatment of people in similar fiscal positions (horizontal equity) … because it focuses on States rather than households or individuals, and because untied funds are not required to be spent on areas for which they are allocated …39

Likewise, Victoria argues that:

HFE should be designed to ensure that individuals have access to comparable government services, regardless of the state in which they reside.40

HFE, in this view, is a compromise which recognises the tension between horizontal equity and state autonomy. It can only ever secure a relatively narrow form of equity, in which differences in public sector treatment of residents should arise only from democratically supported decisions, not from fiscal capacity differences (Walsh 2011, p7). Further, studies have shown that HFE redistribution subsidies do little to reduce the inequity of income between rich and poor individuals and families; in other words, the HFE model has a negligible, or in some instances an adverse, effect on income equity.41

Victoria goes on to argue that Australia's circumstances have changed, that HFE has outlived its original intent, and that, nowadays:

HFE's role in securing interpersonal equity has largely disappeared … the income tax system, combined with social security and welfare transfers, is far more effective in moderating the income distribution of individuals and households than the HFE system.42

On the other hand, some argue that the focus on States' capacities (rather than individuals'or households') is a key element of the current system, providing residents of individual States with the ability to elect governments that provide a mixture of taxes and services preferred by residents of that State. For example, Tasmania says:

HFE is not about achieving equity between individuals. Any variations in actual service standards across jurisdictions reflect different preferences between jurisdictions rather than a failure of HFE to deliver equity.43

Western Australia also argues that the current form of HFE is failing to meet its objective of equity, but for different reasons to Garnaut and FitzGerald. Western Australia considers that its low relativity is 'manifestly unfair', arguing that:

Western Australia currently receives only 72 per cent of its population share of the GST pool, where population shares are broadly representative of the contribution each State's people make to the GST pool through their consumption. Having regard for the lags in the equalisation process and recent growth in mining revenues, it is projected that the 'return' to Western Australia will decline to about 33 per cent in 2014-15 … Notwithstanding the equalisation objective, such a low return to Western Australia is considered manifestly unfair, particularly after taking into account the large subsidy already provided by the State through the Commonwealth budget more generally, the effort that Western Australia has made to develop its natural resource endowment (and thereby to raise revenue from its own sources) and substantial shortcomings in the equalisation methodology.44

In addition, Western Australia argues that HFE fails to produce intergenerational equity:

HFE equalises mining endowments across States.

As a result, the resource State cannot retain its endowment (after conversion from minerals to cash in the form of royalties) for investment to secure its future (unlike other endowments). From a national perspective, the resource endowment, after redistribution across the nation, ends up largely supporting consumption rather than investment for future generations.

In this context, only the State with the resource has an incentive to use it to secure its future. The only equity justification for equalising any mining royalties is that State Governments are likely to use some of the royalties for consumption rather than development for the future, even if fully retained by the State.

If equalisation of royalties is reduced, non-resource States may receive smaller GST grants 'now', but more in the future than would have otherwise been the case — to the extent that the resource State has been able to invest royalties to help build a stronger economic base, including for when the minerals have been exhausted (with the fiscal returns from a stronger economic base being shared by all States).45

Is a low relativity inherently 'unfair'?

Even aside from concerns with intergenerational equity or the current methodology, Western Australia appears to argue that a low relativity is inherently unfair, using the analogy of personal income tax:

Australia's comprehensive equalisation is currently equivalent to a 100 per cent marginal tax rate on any above-average fiscal capacity … No one would ever consider a 100 per cent marginal tax rate on above-average personal or corporate income to be fair, particularly as above-average income has often been achieved through hard work and good choices.46

Further, Western Australia considers that its low relativity risks undermining confidence in the Federation, arguing that:

… fiscal equalisation is no longer the unifying force in the Australian federation that it was intended to be when the Commonwealth Grants Commission (CGC) was established in the 1930s — at which time States such as Western Australia demanded compensation for the costs they incurred from high external tariffs and other protectionist Commonwealth policies.

Instead fiscal equalisation is becoming a divisive influence, undermining public understanding and support for the Federal system. The wheel has turned full circle.47

[T]he subsidy now provided by Western Australia is becoming so extreme that equalisation (at least in its current form) is no longer supported by all participants.48

Western Australia concludes that:

… current and prospective equalisation outcomes are so extreme as to destroy any consensus on their acceptability …49

Others argue that Western Australia's low relativity is entirely appropriate given its strong revenue raising capacity. For example,Tasmania:

…strongly believes that variability in state relativities should not necessarily be of concern or warrant any particular attention. Rather, it is the direct correlation of state relativities to changes in state circumstances which matters. State relativities will fluctuate over time, and significantly so where relative state economic or demographic circumstances change. This should come as no surprise to states or HFE commentators … Structural change in the economy has contributed to increased trend divergence in state relativities as state fiscal capacities diverge. For example, the rise of China has created stronger global demand for Australia's mineral resources.

The value of mining production and associated investment has increased significantly, with investment in the mining sector projected to equal the combined total of investment of all other sectors by 2012. High mineral and other commodity prices have driven Australia's terms of trade to historic record high levels. As a result of this mining boom, iron ore exports from Western Australia and black coal exports from Queensland have grown dramatically in recent years. As revenues increase from state mining royalties, GST revenue to those states has, appropriately, decreased reflecting the fact that they have become more self-sufficient.50

The Australian Capital Territory and the Northern Territory make similar points.51 South Australia argues that the strong demand for Australia's mineral resources means that other industries and regions (such as South Australia) are facing increasing competitive pressure from an appreciating exchange rate. South Australia says that:

Any move away from full equalisation transfers would result in the South Australian economy being exposed to the adverse consequences of currency appreciation without receiving an appropriate sharing of the benefits of the terms of trade boom.52

For some, the relativity calculation is simply a function of statistics. The Australian Capital Territory makes this point by saying:

Western Australia's relativity of 0.68298 has no direct dollar value as it is merely a weighting which relates back to the Australian average (equal per capita) distribution of 1.00000.53

The Commonwealth Treasury submission suggests that, if all Commonwealth payments were considered in the calculation, Western Australia's relativity would be higher. Under this scenario, Western Australia's 2011-12 relativity would be 0.95, instead of the figure of 0.72 used by the CGC.54

Finally, the assertion that Western Australia's low relativity means that GST levied on consumption in Western Australia is effectively transferred to other States is disputed.

Australia Capital Territory makes this point in its submission:

It is not possible to calculate the actual GST contributed in each jurisdiction because the location of lodging tax returns is frequently different to the location at which the GST is collected. The mining industry is largely exempt from GST due to it exporting much of its product. On the other hand it is able to claim credit for GST paid on its significant capital investment. Therefore, the overall GST contributed by the Western Australian economy is likely to be lower than average.55

While it is not possible to trace GST collections to their source, just under a third of Western Australia's economy is comprised of an export industry (mining)56 which does not pay GST, but for which GST on inputs will be refunded. New South Wales and Victoria on the other hand, which have economies based more on domestic industries and host the head offices of many retailers, probably 'collect' more GST per capita than Western Australia.

Ultimately, the lowest Western Australia's relativity could go is to zero. A relativity of zero would mean that Western Australia's own source revenue was so strong it would not require a share of GST to achieve the average fiscal capacity — the other States would require all the GST to achieve the average. In this situation, despite receiving no GST, Western Australia would still have the capacity to provide at least the same standard of services to its citizens as the other States.

If measures were put in place to ensure that Western Australia continued to receive a share of the GST despite having a zero relativity, Western Australia would have a stronger fiscal capacity than the other States and would be able to provide a higher level of services to its citizens and/or levy lower taxes on businesses and households than the other States. Practically, this would mean that the Western Australian government could provide smaller class sizes in schools, more elective surgery procedures, more social housing, larger concessions to electricity consumers and better transport infrastructure than other States.

Adopting a longer term view provides a different perspective on a low or zero relativity. For example, comparing Western Australia's long-term (i.e. about 20-year) average relativity with that of Victoria, the State which has traditionally had the strongest fiscal capacity, Western Australia's average relativity would still be slightly above Victoria's (namely, 0.887 compared to 0.885).57

1.5 What form of GST distribution is right for Australia's future?

The ideal model for GST distribution

The key challenge for the Panel when considering the form of GST distribution is to ensure that the payments are distributed 'fairly'. However, the 'ideal' model would not only be 'fair', it would:

  • be seen to be fair
  • be easily understood (be simple and transparent)
  • allow States to plan their Budgets reasonably (be predictable)

and would not:

  • encourage bad policy
  • discourage good policy
  • cost more than it needs to
  • detract from public confidence in the Federation.

Currently, the distribution of the GST revenue is governed by the CGC definition of HFE as meaning equalising to materially the same capacities.58 All other aims (such as the pursuit of simplicity, predictability and policy neutrality) are subsidiary to achieving the paramount objective of equality.

The Panel has been asked to consider whether other goals should be pursued through the distribution of GST revenue. Such other goals include providing incentives for economic reform, incentives for the efficient provision of services and maintaining confidence in the Federation. While the recently added Terms of Reference59 will be discussed in detail in a second interim report, the Panel notes that it has been asked to consider whether and how State tax reform could be pursued alongside HFE.

The pursuit of other goals may allow more scope for the GST distribution process to emphasise the subsidiary aims of simplicity, efficiency and predictability. That is, by seeking to pursue tax reform or greater confidence in the Federation, it may also be easier to develop a form of distribution that is simple, predictable and creates no incentives for inefficiency.

Should 'full' HFE be the goal?

The Panel's consideration of the issues above has led it to examine whether 'full' HFE is still the most appropriate model, especially given the need to consider other goals.

As outlined earlier, the current form of HFE in Australia is widely considered to be a reasonably 'full' form of HFE. A less absolute (or 'partial') form of equalisation would allow for goals other than equity to be pursued, and might also allow for greater emphasis to be placed on the aims of simplicity, predictability and efficiency.

There are, of course, a wide variety of ways that partial equalisation could be pursued. The HFE system could be made more partial by not seeking to provide States with the 'same' capacity, but rather by seeking to equalise them to some other standard. Alternatively, a more partial form of equalisation could be pursued by narrowing the scope of the current assessments or pursuing individual assessments in less detail.

States' positions

States indicate a range of views on 'full' or 'partial' HFE.

As a general rule, the four States that currently receive less than their population share of GST (often referred to as 'donor' States) favour a more partial form of equalisation.

Victoria says:

Just as governments pursue only partial equalisation of budget capacities of private persons within jurisdictions, HFE's equity goals can be fulfilled by a system that acts as a 'safety net' to enable jurisdictions to provide an adequate (or minimum) level of services, as was the original rationale of the CGC's processes.

Partial equalisation of service standards is justified because of the inevitable trade-offs between the degree of equality pursued and the adverse incentive effects which can follow, reducing the level of efficiency achievable. A system which enables states to achieve identical service standards (rather than comparable standards or a minimum standard) can create efficiency costs without commensurate equity benefits.60

New South Wales favours a HFE definition that involves equalising to a 'comparable' standard, rather than the 'same' standard, arguing that:

An alternative definition of HFE is provided in the Commonwealth's Budget Paper No. 3:

Horizontal fiscal equalisation provides the necessary budget support so that all States have the capacity to provide services at a comparable standard, while ensuring that the interstate transfers are not so large that they would significantly distort economic behaviour and reduce productivity growth. (Budget Paper 3, p106)

New South Wales considers that this definition is much more suitable than the CGC's definition because it allows for the importance of efficiency effects and productivity growth. There is little in the current HFE system to ensure that the pursuit of equity is not at too great a cost to overall economic efficiency.61

While Western Australia does not explicitly seek a more partial form of equalisation (and argues that in some areas the CGC currently performs partial equalisation by failing to recognise some of its costs), the combination of some of its recommendations (such as a relativity floor and a limit to annual falls in GST relativities) places it on the 'partial' end of the spectrum.

Queensland specifically supports consideration of partial forms of equalisation:

…the aim of the GST distribution process should be to provide the necessary budget support so that all States have the capacity to provide services at a comparable standard.

Queensland believes consistent adoption of this aim would allow a wider consideration of approaches to GST distribution that provide the best outcome in terms of efficiency, equity, simplicity, predictability, and stability.

Queensland also believes that in recent years the application of the GST distribution process has been overly focused on the equalisation of total fiscal capacity, that is on full equalisation across the States. Queensland believes this is an overly narrow interpretation of the aim of the process and that it is possible to provide all States with the capacity to provide services without needing to equalise all revenues. Accordingly, Queensland supports exploration of 'partial' equalisation approaches in this Review as a means of achieving a better balance of the efficiency, equity, simplicity, predictability, and stability criteria.

In addition, Queensland believes there is an opportunity to consider whether 'a comparable standard' should be defined in terms of the average activity of States, as occurs currently, or whether an alternative definition may be appropriate.62

By contrast, States that currently receive more than their population share of GST (often referred to as 'recipient' States) favour the maintenance of a full form of equalisation.

Northern Territory says that:

Australia's form of equalisation is often described as 'full' or 'comprehensive'…[C]omprehensive equalisation is the only form of equalisation appropriate to Australia's needs due to the relative heterogeneity of states, in terms of population characteristics, geographic location, size and structure of economies and natural resource endowments, and the level of VFI between the Commonwealth and the states. These circumstances lead to significant disparity of expenditure needs and revenue capacities between Australian states.63

Full equalisation is based on the principle that persons living in comparable locations should expect similar access to government services. The concept of social citizenship at the national level should continue to be the primary objective of equalisation in Australia. A move away from full equalisation would imply that Australians living in similar regions of different states do not deserve the same access to government services.64

Tasmania believes the Review's Terms of Reference require full equalisation:

The Review Terms of Reference require full equalisation — that is, GST is to be distributed 'consistent with the principle that jurisdictions should have equal capacity to provide infrastructure and services to their citizens'. Tasmania asserts that this cannot be achieved with anything less than full equalisation.

Tasmania is strongly of the view that full equalisation is essential to achieving the current principle of HFE. Any form of partial equalisation (revenue or expenditure only or parts thereof) or proximate equalisation (less than 100 per cent of an agreed standard) would not result in states being provided with the same capacity to provide services and would result in greater regional disparities.65

South Australia argues along similar lines:

The current, comprehensive, system of fiscal equalisation in Australia is a fundamental strength of the Australian federation.

The terms of reference requires the Review to be guided by the principle that 'jurisdictions should have equal capacity to provide infrastructure and services to their citizens'.

The Government of South Australia would strongly oppose any Review recommendations which were at odds with this principle. Proposals such as placing a 'floor' under relativities on some 'numerological' basis, or engaging in 'partial' equalisation (even if under the banner of 'simplification') would not be consistent with the terms of reference —they would clearly not deliver equal capacity …66

Similarly, partial equalisation would represent an arbitrary approach, requiring some form of national compact as to the acceptability or desirability of jurisdictions not having equal capacity to provide the same standard of all services (and which services should reflect an equal capacity principle and which should not). Even if such an agreement could be reached in relation to the equity shortfall involved, the outcome would be inefficient.67

The Australia Capital Territory strongly supports the current system of HFE68, saying:

Full equalisation is the only appropriate goal of HFE … Some States would argue that certain revenues or expenditures should be either left out of the scope of equalisation or included only in part … The selective exclusion of specific revenue or expenditures would not achieve equalisation. Such arguments effectively trade-off equity against other objectives.69

A new challenge

Recent additions to the Panel's Terms of Reference expand the Review's remit. The supplementary terms of reference are:

The Review should examine and make recommendations on possible changes to the form of equalisation to achieve the following objectives:

  1. ensure that HFE does not provide a disincentive to State tax reform,
  2. utilise HFE to provide incentives and disincentives to promote future State policy decisions which improve the efficiency of State taxes and mineral royalties, and
  3. examine the incentives for States to reduce Minerals Resource Rent Tax or Petroleum Resource Rent Tax revenue through increasing State mineral royalties.

In considering this issue, the Review will be guided by the following:

  1. the findings of the Australia's Future Tax System Review relating to existing State taxes and mineral royalties,
  2. the Minerals Resource Rent Tax and Petroleum Resource Rent Tax provide a more efficient approach to charging for Australia's non-renewable resources than mineral royalties, and
  3. State tax reform will not be financed by the Australian Government.

These new terms will be dealt with in a second interim report, following receipt of further submissions in response to the supplementary issues paper released on 22 December 2011.

1.6 Summary of the Panel's view on the role and purpose of HFE

The Terms of Reference contain guidance that the long standing practice of HFE has served Australia well, and submissions from the recipient States show strongly held views in support of the full equalisation goal of the current system. The Panel will therefore not recommend change lightly.

Nevertheless, judging by the disparity of views contained in submissions from experienced jurisdictions and commentators, the present arrangements are complex, opaque and therefore either not agreed, or not well understood. These circumstances result in criticisms that are linked to the issue of whether 'full' HFE should be the goal.

Furthermore, both international experience and Australia's own past practice show that something considerably less than pursuit of absolute equality between jurisdictions can result in a fair outcome and produce confidence in Federal financing arrangements.

The Panel's view on the proper role and purpose of the GST distribution

The Panel intends to investigate whether providing comparable capacities for States would be an approach more suitable to current challenges than providing materially the same capacities.

The Panel therefore invites submissions on how this concept might be accurately described and effectively implemented.


1 Commonwealth Grants Commission, Report on GST Revenue Sharing Relativities, 2010 Review, Vol 1, page 34.

2 Commonwealth Grants Commission, Report on GST Revenue Sharing Relativities, 2010 Review, Vol 1, page 22.

3 VFI refers to the imbalance of taxing powers and spending obligations between the central and the sub-national governments in a Federation. Where the sub-national governments raise less from taxes than they spend and the central government funds the difference, VFI is said to exist. For further discussion of VFI, see page 6.

4 The Northern Territory says that there are misinterpretations regarding the meaning of 'equal per capita' in that an equal per capita distribution is not the same as an equal payment per recipient distribution. For example, the amount of age pension payments to individuals is fixed across Australia, but this does not constitute an equal per capita distribution of pension payments in each state: see Northern Territory submission to the GST Distribution Review, October 2011, Appendix B, page 73.

5 It could be argued that an EPC distribution does not constitute HFE, as no assessment is made of the relative fiscal capacities of the recipients. On the other hand, it could also be argued that, as an EPC distribution does not consider the source of the revenue, it is an implicit form of HFE. However, as both States suggesting EPC in their submissions make reference to additional payments being required, the question of whether EPC alone constitutes HFE or not does not directly arise.

6 New South Wales submission to the GST Distribution Review, November 2011, page 47.

7 Victorian submission to the GST Distribution Review, October 2011, page 6.

8 See Western Australian submission to the GST Distribution Review, October 2011, page i; New South Wales submission to the GST Distribution Review, November 2011, page 6; Warren, N, Benchmarking Australia's intergovernmental fiscal arrangements, 2006, page 103; Boadway, R and Shah, A, Intergovernmental fiscal transfers: principles and practice, 2007, pages 36, 70 and 93.

9 See Northern Territory submission to the GST Distribution Review, October 2011, pages 38-39.

10 Australian Capital Territory submission to the GST Distribution Review, October 2011, page 8.

11 Western Australian submission to the GST Distribution Review, October 2011, pages 22, 54.

12 See also Queensland's point regarding costs of regional growth related to mining in Chapter 4 (section 4.2), the discussion of mining-related infrastructure costs in Chapter 6 (section 6.2), South Australia's statement that the lack of contemporaneity in the system should be addressed (South Australian submission to the GST Distribution Review, September 2011, page 3) and Victoria's point regarding cost pressures due to high migrant populations and urban congestion (Victorian submission to the GST Distribution Review, October 2011, page 18).

13 Submission from Henry Ergas and Jonathan Pincus to the GST Distribution Review, September 2011, page 2.

14 New South Wales submission to the GST Distribution Review, November 2011, page 48; Victorian submission to the GST Distribution Review, October 2011, page 6.

15 See Chapter 2.

16 Information sourced from Department of Finance Canada, Equalization program; and Expert Panel on Equalization and Territorial Formula Financing, 2006.

17 Lander is the term for Germany's sub-national Governments, and can be roughly translated into 'States' . Germany comprises 16 Lander (or States).

18 Stehn, S J, and Fedelino, A, Fiscal Incentives in the German Equalization System, 2009, page 6; Boadway, R, and Shah, A, Intergovernmental Transfers: Principles and Practice, 2007, page 147.

19 Walsh, Cliff., The Equity Case for Equalising Fiscal Capacities: Rationales, Value-Judgements, Compromises and their implications, A Discussion Paper prepared for the Department of Treasury and Finance, Government of Victoria, September 2011, page 25 – 28.

20 Warren, Neil, Benchmarking Australia's intergovernmental fiscal arrangements, final report to the New South Wales Government, 2006, page 56.

21 Stehn, S J, and Fedelino, A, Fiscal Incentives in the German Equalization System, 2009, pages 6-7; Boadway, R, and Shah, A, Intergovernmental Transfers: Principles and Practice, 2007, page 147; Commonwealth Grants Commission, The Commonwealth Grants Commission: The Last 25 Years, 2008, page 96 and Bundesministerium der Finanzen, The Federal Financial Equalisation System in Germany, page 4.

22 Walsh, Cliff, Fiscal Capacity Equalisation: An exploration and critique of the equity rationale, A Discussion Paper prepared for the Department of Treasury and Finance, Government of Victoria, December 2011, page 74 (see also attachment B and section 7 (starting at page 85)).

23 Commonwealth Grants Commission, 1995, Equality in Diversity: History of the Commonwealth Grants Commission, Second Edition, Australian Government Publishing Service; Commonwealth Grants Commission, The Commonwealth Grants Commission: The Last 25 Years, 2008.

24 References suggesting that Australia's current form of HFE is 'full' (or seeks to be 'full') include: Commonwealth Treasury submission to GST Distribution Review, October 2011, page 9; Northern Territory submission to the GST Distribution Review, October 2011, page 14; Queensland submission to the GST Distribution Review, October 2011, page 3; Tasmanian submission to the GST Distribution Review, October 2011, page 15; New South Wales submission to the GST Distribution Review, November 2011, page 10; Victorian submission to the GST Distribution Review, October 2011, page 2, 23; Australian Capital Territory submission to the GST Distribution Review, October 2011, page 9.

25 Commonwealth Grants Commission, Report on GST Revenue Sharing Relativities, 2010 Review, Vol 1, pages 35-37 and for further information on materiality, see also page 39.

26 Australian Capital Territory submission to the GST Distribution Review, October 2011, page 2.

27 New South Wales submission to the GST Distribution Review, November 2011, page 13.

28 Some States also argue for HFE by way of analogy with the situation in a unitary government or the actions of the current Federal Government (see Appendix B, and Attachment A to the South Australia submission to the GST Distribution Review, September 2011, pages 6, 18-19; Australian Capital Territory submission to the GST Distribution Review, October 2011, pages 0, 4).

29 Northern Territory submission to the GST Distribution Review, October 2011, pages 36, 37.

30 Australian Capital Territory submission to the GST Distribution Review, October 2011, page 4.

31 Tasmanian submission to the GST Distribution Review, October 2011, page 17.

32 South Australian submission to the GST Distribution Review, September 2011, page 5.

33 Victorian submission to the GST Distribution Review, October 2011, pages 13, 14.

34 New South Wales submission to the GST Distribution Review, November 2011, page 10.

35 Western Australian submission to the GST Distribution Review, October 2011, page i.

36 Queensland submission to the GST Distribution Review, October 2011, page 2-3.

37 Queensland submission to the GST Distribution Review, October 2011, page 3.

38 See Chapter 2 for a discussion of criticisms relating to HFE's unpredictability, Chapter 3 for criticisms relating to the complexity of the system, Chapter 4 for criticisms relating to disincentives for reform and incentives for inefficient provision of services and Chapter 5 for criticisms relating to infrastructure payments.

39 Garnaut, R, and FitzGerald, V, Review of Commonwealth-State Funding, Final Report, August 2002, page 123.

40 Victorian submission to the GST Distribution Review, October 2011, page 13.

41 Victorian submission to the GST Distribution Review, October 2011, page 14.

42 Victorian submission to the GST Distribution Review, October 2011, page 21.

43 Tasmanian submission to the GST Distribution Review, October 2011, page 17, 18; see also Australia Capital Territory submission to the GST Distribution Review, October 2011, page 2.

44 Western Australian submission to the GST Distribution Review, October 2011, pages 10, 11.

45 Western Australian submission to the GST Distribution Review, October 2011, pages 14-15.

46 Western Australian submission to the GST Distribution Review, October 2011, page 12.

47 Western Australian submission to the GST Distribution Review, October 2011, page i.

48 Western Australian submission to the GST Distribution Review, October 2011, page 11.

49 Western Australian submission to the GST Distribution Review, October 2011, page 23.

50 Tasmanian submission to the GST Distribution Review, October 2011, page 5-6.

51 Australian Capital Territory submission to the GST Distribution Review, October 2011, page 0; Northern Territory submission to the GST Distribution Review, October 2011, page 16-18.

52 South Australian submission to the GST Distribution Review, September 2011, page 7.

53 Australian Capital Territory submission to the GST Distribution Review, October 2011, page 8.

54 Commonwealth Treasury submission to the GST Distribution Review, October 2011, page 13.

55 Australian Capital Territory submission to the GST Distribution Review, October 2011, page 8.

56 'Mining activity accounted for 27.5% of GSP in 2009-10', from p1 of Western Australia Economic Profile – August 2011, produced by the Department of State Development, Western Australia State Government.

57 The long-term average covers 22 years from 1993-94 to 2014-15. It does not cover the period up to 1993-94 when Western Australia was consistently a 'claimant' or 'recipient' State.

58 See sections 1.1 and 1.3 for a discussion of how the GST is distributed in Australia today.

59 See the Supplementary Issues Paper which sets out some background information relating to the additional Terms of Reference.

60 Victorian submission to the GST Distribution Review, October 2011, page 13.

61 New South Wales submission to the GST Distribution Review, November 2011, page 12.

62 Queensland submission to the GST Distribution Review, October 2011, page 3.

63 Northern Territory submission to the GST Distribution Review, October 2011, page 37.

64 Northern Territory submission to the GST Distribution Review, October 2011, page 39.

65 Tasmanian submission to the GST Distribution Review, October 2011, page 15, 16.

66 South Australian submission to the GST Distribution Review, September 2011, page 2.

67 South Australian submission to the GST Distribution Review, September 2011, page 7.

68 Australia Capital Territory submission to the GST Distribution Review, October 2011, page 1.

69 Australia Capital Territory submission to the GST Distribution Review, October 2011, page 9.