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PC News - December 2017

Horizontal Fiscal Equalisation – distributing the GST revenue

Gears over cash money

A Commission draft report finds that the basic premise of horizontal fiscal equalisation (HFE) – fiscal equity in the Australian federation – has broad support. But the practice of HFE – the basis for distributing GST revenue to the States – has evolved over time and now embodies an undeliverable ideal, to give States the same fiscal capacity.

The system struggles with extreme circumstances and this is corroding confidence. There is also scope for the system to discourage desirable mineral and energy resources policies and State policy for major tax reform.

HFE has frequently been a point of contention among States, as each State has vied for a larger share of GST. But this friction has increased markedly in recent times as Western Australia’s share of the GST has fallen to an unprecedented low (figure 1).

Figure 1: Volatility and divergence in GST relativitiesa
State per capita relativities

  • Relativities since 1981. From 1981-82 until 1993-94, Victoria’s relativity was set at 1.0, with those of the other States fluctuating around this. New South Wales had a relativity slightly above 1.0 for most of this period, with the other States fluctuating between roughly 1.3 and 2.0. From the 1993-94 update, when the ACT was brought into the system and Victoria’s relativity was no longer fixed at 1.0, New South Wales, Victoria and the ACT were the three States with the strongest fiscal capacity and therefore the lowest relativities. The ACT’s relativity started to increase from the late 1990s, while the relativities of Western Australia, South Australia, and Tasmania were roughly constant (with Tasmania’s being the highest). After the onset of the mining boom in the mid-2000s, Western Australia’s relativity declined below 1.0, falling to reach a low of about 0.3 in 2015-16 and 2016-17. There was an increase in Queensland’s relativity after 2010-11, with its relativity exceeding 1.0 by 2012-13.

    a Ratio between a state’s actual GST share and the share it would receive under an equal per capita distribution (ie, a state’s share of GST divided by its share of the national population).

The practice of HFE in Australia

The Commonwealth Grants Commission (CGC) recommends a distribution of GST using a complex approach that covers all State government revenue and expenditure categories as well as payments they receive from the Commonwealth. Conceptually, the CGC’s formula does the following (figure 2):

  1. States with low fiscal capacities are raised to the average fiscal capacity of all States
  2. all States are raised to the capacity of the fiscally strongest (currently Western Australia)
  3. remaining GST revenue is distributed to all States on an equal per capita basis.

Figure 2: Schema of the conceptual stages of the HFE process

  • Fiscal capacity per capita

    This chart conceptualises HFE. Firstly, HFE bring states to the average: States with relatively low fiscal capacities are raised to the average fiscal capacity of all States. Secondly, it brings all states to the strongest: all States are raised to the capacity of the fiscally strongest States. Finally, the remainder if the GST pool is distributed as equal per capita.

How is the current system performing?

The current HFE system is functioning reasonably well in regard to:

  • equity: Australia’s HFE system achieves an almost complete degree of fiscal capacity equalisation – unique among OECD countries
  • an independent and transparent process: the CGC, as an expert agency independent from governments, is well placed to conduct the HFE distribution process
  • stability: HFE results in reasonably stable GST payments and a level of predictability for (most) States regarding budget outcomes.

However, there are deficiencies in a number of areas. These include:

  • equalisation is taken too far: equalising comprehensively and to the fiscally strongest State means that when there is an outlier, the redistribution task is considerable
  • policy neutrality: the potential for HFE to distort State policy is pronounced for major tax reforms and mineral resource policies. For example, Western Australia would lose about 88 per cent of the additional revenues to other States if it raised its iron ore royalties. Another example is if a State unilaterally cuts its rate of stamp duty on property in half, and replaces the lost revenue with a new broad based land tax. The potential GST effects of this reform are large – New South Wales and Victoria’s GST payments could be reduced by up to $1 billion per year.
  • simplicity and comprehensibility: full and precise equalisation has increased system complexity over time. This has led to the system being poorly understood by the public, and even by many within government.

In terms of overall national efficiency and growth, Australia’s HFE system has typically been found to have little direct effect. However, the current redistribution is historically high, which may be elevating any efficiency effects.

The Commission’s proposed reforms

A need for a revised objective

Equalising to the fiscally strongest State is not desirable or fair when that State is such an outlier, and when the pursuit of full equalisation may be resulting in broader (albeit in most instances small) costs to the economy. The Commission considers that HFE should aim for a different objective – a ‘reasonable’ level of fiscal capacity.

Like the current approach to HFE, the Commission’s proposed objective puts equity at the heart of HFE but it acknowledges that there is a trade-off between full and comprehensive equalisation on the one hand, and efficiency and simplicity on the other hand.

Are there preferable alternatives?

The Commission considered a number of methodology changes to address deficiencies in the current system. One option is to apply broad indicators to replace the assessment of the various revenue and expenditure categories. This offers greater prospects for balancing accuracy and simplicity and is being considered further for the final report. Other options raised by participants, such as relativity floors or discounts for particular revenue streams do not resolve HFE’s underlying deficiencies and likely have unintended consequences.

More fundamental changes were also considered that offer a departure from the CGC’s full equalisation principles (figure 3). This includes an equal per capita approach. While this approach would be extremely simple and would have no adverse effect on States’ incentives, it would fail to meet the core equity objective of HFE. Top up funding could also be provided to fiscally weaker States, but this would rely on Commonwealth Government funding, which has its own opportunity costs and is unlikely to be forthcoming in the current environment.

Figure 3: The equalisation task under alternative approachesa

  • Share of GST pool (per cent)

    This figure shows the redistribution away from equal per capita (expressed as a percentage on the GST pool) from 2000-01 to 2017-18. This is shown under the current system as well as what it would have looked like under three alternative systems: a 0.7 relativity floor, equalising to the average, and equalising to the second highest State.

    a The pool used for these calculations includes Health Care Grants in earlier periods.

Another option considered and proposed in the draft report is equalisation to less than the fiscally strongest State. This involves lifting States up to some agreed level of fiscal capacity and distributing the balance of the GST pool on an equal per capita basis. This approach could be used to bring States up to any level of fiscal capacity that is less than the strongest State, such as the average fiscal capacity or the fiscal capacity of the second strongest State. This approach addresses volatility introduced in the case of an extreme outlier State and would address some efficiency concerns.

The way forward

One thing that emerges from the assessment of different approaches is that none are perfect or universally supported by participants. All come at a cost, whether to equity, efficiency or simplicity, or some combination of these.

Equalisation to the average or the second strongest State still provides States with a high level of fiscal capacity, but not distorted by the extreme swings of one State.

Any material change to HFE in the current extreme environment will lead to significant redistributions of the GST. Timing and careful transition are paramount, especially to ensure the fiscally weaker States are not significantly disadvantaged.

Reforms to improve governance and accountability are also needed. Most importantly, there is a need for the Commonwealth Government to assume leadership and articulate a revised objective of HFE. The CGC should also take on a more prominent public communication and education role.

Ultimately though, reform to HFE will only go part of the way to improving outcomes within federal financial relations. There is a need to renew efforts to reform these relations more broadly. In the first instance, governments should work to a well-delineated division of responsibilities, particularly with respect to Indigenous policy. Genuinely reforming federal financial relations may then allow consideration of more fundamental reforms to HFE and afford a greater focus on the needs of the fiscally weaker states.

Horizontal Fiscal Equalisation

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