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Horizontal Fiscal Equalisation

Inquiry report

This report was sent to Government on 15 May 2018 and publicly released on 5 July 2018.

The report assesses the influence of the current system of Horizontal Fiscal Equalisation (HFE) on productivity, efficiency and economic growth; the incentives for the States to undertake reforms that improve the operation of their jurisdictions; and on the States’ abilities to prepare and deliver annual budgets. It makes recommendations to improve the system, including its governance arrangements.

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  • Key points
  • Report roadmap
  • Contents summary
  • The basic premise of Horizontal Fiscal Equalisation — fiscal equality in the Australian federation — has broad support from all levels of government.
  • The current practice of HFE seeks to give all States the same fiscal capacity to deliver public services. To do this, all States are brought up to the fiscal capacity of the fiscally strongest State (currently, as assessed by the Commonwealth Grants Commission (CGC), Western Australia).
  • This approach to HFE is under intense scrutiny at present as Western Australia’s share of the GST has fallen to a record low. Even so, the current system of HFE has strengths.
    • It compensates States for their structural disadvantages and achieves an almost complete degree of fiscal equalisation — unique among OECD countries.
    • The independent and expert CGC is well placed to recommend GST relativities. It has well-established processes that involve consultation and regular methodology reviews.
  • But the current approach also has significant weaknesses. Reform and development opportunities are likely being missed at the expense of community wellbeing over time.
    • There is much scope for the system to discourage State policy for major tax reform and desirable mineral and energy policies (royalties and development).
    • Full fiscal equalisation does not systematically allow States to retain the dividends of their policy efforts. This raises concerns about the fairness of equalisation outcomes and corrodes public confidence in the system.
    • The system is very poorly understood by the public and indeed by most within government — lending itself to a myriad of myths and confused accountability.
  • While equity should remain at the heart of HFE, there is a need for a better balance between equity and efficiency.
    • The Commonwealth Government should set a revised objective for HFE to provide States with the fiscal capacity to deliver a reasonable standard of services. Changing the objective is an essential precursor to further improvements to the HFE system.
  • Governance reforms are also needed. This includes the CGC playing a more prominent communication role to inform the public discourse on HFE.
  • The CGC should be directed (without delay) to pursue more simple and policy-neutral assessments, and increase its materiality thresholds, in line with achieving a reasonable standard of equalisation. Other ‘in-system’ changes proposed by others, such as mining discounts, do not resolve HFE’s deficiencies and pose too much of a risk to fiscal equality.
  • In-system and governance changes will improve HFE but can only go so far. Additional efficiency gains are only in prospect from an alternative equalisation benchmark, which many would regard as a fairer outcome.
    • Amongst a number of options designed to equalise to a reasonable standard, equalisation to the average of all States (rather than to the strongest State) is judged to provide a better balance between fiscal equality, fairness and efficiency.
  • Changing the benchmark in the current fiscal environment will lead to a material redistribution of the GST. This change is likely to prove manageable for all States if phased. Transition should be funded by the beneficiary States and by hastening slowly, such that no State sees a reduction in its GST from one year to the next of more than 2 per cent of its overall revenue.
  • The transition paths outlined in this report would soften any year-on-year impact, to less than 1 per cent of State revenue.
  • Improving HFE will deliver benefits to the Australian community. But ultimately, greater benefits will only come from more fundamental reforms to Australia’s federal financial relations: namely, to spending and revenue raising responsibilities and ensuing accountabilities.

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  • Cover, Copyright and publication detail, Letter of transmittal, Terms of reference, Inquiry timeline, Acknowledgments, Abbreviations and explanations
  • Overview
  • Findings and recommendations
  • Chapter 1 About this inquiry
    • 1.1 Background to the inquiry
    • 1.2 What has the Commission been asked to do?
    • 1.3 The Productivity Commission’s approach
    • 1.4 What is the evidence base?
    • 1.5 Scope of the inquiry
    • 1.6 Consultation in the course of the inquiry
  • Chapter 2 How does HFE work in Australia?
    • 2.1 The evolution of HFE in Australia
    • 2.2 Present day context for HFE in Australia
    • 2.3 Calculation of the GST distribution
    • 2.4 The size of the equalisation task
  • Chapter 3 Does HFE influence States’ incentives to undertake reforms?
    • 3.1 State tax reform
    • 3.2 Efficiency of service delivery
    • 3.3 Mineral and energy resources
    • 3.4 Broader distortions across the HFE system
  • Chapter 4 How does HFE affect State budget management?
    • 4.1 How does HFE affect State budget cycles?
    • 4.2 How does the HFE system affect budget planning?
  • Chapter 5 Does HFE influence interstate migration?
    • 5.1 HFE and efficient migration: what the theory says
    • 5.2 Modelling HFE’s impact on migration
    • 5.3 Has HFE influenced migration decisions?
  • Chapter 6 Summing up the need for change
    • 6.1 The interpretation of equity is incomplete
    • 6.2 Efficiency is being compromised
    • 6.3 Transparency and accountability are lacking
    • 6.4 A revised objective for HFE is needed
    • 6.5 Improving HFE governance arrangements
  • Chapter 7 Are there better ways to assess fiscal capacity?
    • 7.1 Applying benchmark costs
    • 7.2 Using a single broad indicator
    • 7.3 Streamlining revenue and expenditure assessments
    • 7.4 Discounting entire revenue categories
    • 7.5 Targeted interventions for future policy changes
    • 7.6 Summing up
  • Chapter 8 Is there a preferred alternative benchmark for fiscal equalisation?
    • 8.1 Equal per capita and variants
    • 8.2 A relativity floor
    • 8.3 Alternative equalisation benchmarks
    • 8.4 How do the alternative benchmarks stack up?
  • Chapter 9 The way ahead
    • 9.1 Transitioning to a new equalisation benchmark
    • 9.2 Choosing an appropriate transition period
    • 9.3 Broader reforms to federal financial relations
  • Appendix A Public Consultation
  • Appendix B Other Commonwealth payments
    • B.1 Types of payments for specific purposes
    • B.2 Treatment of payments for specific purposes in the GST distribution
  • Appendix C Calculations and cameos
    • C.1 Alternative approaches to equalising States’ fiscal capacities
    • C.2 Adjustments to the current HFE system
    • C.3 Average rate effects
    • C.4 Cameos
  • Appendix D Modelling the efficiency of HFE
    • D.1 Studies that model the efficiency effects of HFE
    • D.2 Limitations of the modelling
  • Appendix E Fiscal equalisation in OECD countries
    • E.1 Features of fiscal equalisation
    • E.2 Lessons from international experience
  • Appendix F Transition analysis
    • F.1 Transition options and principles
    • F.2 Assessment methodology, inputs and assumptions
    • F.3 Transition results
    • F.A Annex: Alternative scenarios for future GST payments
  • References

Printed copies

Printed copies of this report can be purchased from Canprint Communications.

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