Horizontal fiscal equalisation

Draft report

Released 09 / 10 / 2017

You were invited to examine the draft report and to make written submissions by 10 November 2017.

Please note: This draft report is for research purposes only. For final outcomes of this inquiry refer to the inquiry report.

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Supplementary material

This commissioned paper looks at how accountability for the provision of government services has been embedded in the institutional arrangements of the Federation of Australia.

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Key points
Contents

The basic premise of HFE — fiscal equity in the Australian federation — has broad support.
While the specific practice of HFE has always been debated, it is now under significant strain as Western Australia's share of the GST has fallen to an extreme low.
The practice of HFE has evolved over time, and now embodies an undeliverable ideal: to give States the same fiscal capacity. In other words, all States are brought up to the fiscal capacity of the fiscally strongest State (currently, as assessed by the CGC, Western Australia).
Notwithstanding anomalies, the current system of HFE has good points.
- It achieves an almost complete degree of 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.
And HFE does not result in significant distortions to interstate migration or economic growth.
But the pure may be the enemy of the good: the current HFE system struggles with extreme circumstances, and this is corroding confidence in the system.
- Equalising comprehensively and to the fiscally strongest State means that the redistribution task is too great for any jurisdiction to bear; and is volatile at times of significant cyclical and structural change.
- There is scope for it to discourage desirable mineral and energy resources policies (royalties and development) and State policy for major tax reform (a costly first-mover disadvantage).
- The system is beyond comprehension by the public, and poorly understood by most within government — lending itself to a myriad of myths and confused accountability.
The Australian Government should articulate a revised objective for HFE. While equity should remain at the heart of HFE, it should aim to provide States with the fiscal capacity to provide a reasonable level of services.
- Equalisation should no longer be to the highest state, but instead the average or the second highest State — still providing States a high level of fiscal capacity, but not distorted by the extreme swings of one State.
- By contrast, relativity floors or discounts for particular revenue streams do not resolve HFE’s deficiencies and must prove arbitrary, and likely have unintended consequences.
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.
The Commonwealth Treasurer should ask the CGC to recommend relativities consistent with a revised objective. The CGC should also be directed to pursue significant simplification of its assessment process, even if it results in slightly less — or less precise — equalisation.
The CGC should play a prominent public communication and education role — a much needed objective voice to inform the public dialogue about HFE.
Reforming 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 accountabilities.

Preliminaries: Cover, Copyright and publication detail, Opportunity for further comment, Terms of reference, Contents, Acknowledgments, Abbreviations and explanations, and Glossary
Overview - including key points
Draft recommendations and findings
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 Conduct of the inquiry
Chapter 2 What is the objective of HFE?
- 2.1 Why countries adopt systems of HFE
- 2.2 How does Australia’s HFE system work?
- 2.3 Concerns with the current HFE objective
- 2.4 A revised objective
Chapter 3 How does HFE work in Australia?
- 3.1 The evolution of HFE in Australia
- 3.2 Present day context for HFE in Australia
- 3.3 Calculation and methodology processes of the Commonwealth Grants Commission
- 3.4 To what extent does HFE achieve equalisation?
Chapter 4 Does HFE influence States’ incentives to undertake reforms?
- 4.1 State tax reform
- 4.2 Efficiency of service delivery
- 4.3 Mineral and energy resources
Chapter 5 How does HFE affect State budget management?
- 5.1 How does HFE affect State budget cycles?
- 5.2 How does the HFE system affect budget planning?
Chapter 6 Does HFE influence interstate migration and productivity?
- 6.1 HFE and efficient migration: what the theory says
- 6.2 Modelling the efficiency effects of HFE
- 6.3 Has HFE influenced migration decisions?
Chapter 7 Improving current arrangements
- 7.1 Treating outliers differently
- 7.2 Departing from what States collectively do
- 7.3 Summing up on changes in methodology
- 7.4 Treating quarantined Commonwealth payments differently
Chapter 8 Alternative approaches
- 8.1 Fiscal equalisation in OECD countries
- 8.2 Lessons for Australia from OECD experience
- 8.3 Alternative approaches to distributing GST revenue
Chapter 9 Scope for reform
- 9.1 What scope is there to improve current arrangements?
- 9.2 Improving institutional arrangements
- 9.3 Broader reforms to federal financial relations
Appendix A Public consultation
Appendix B Other Commonwealth payments
Appendix C Calculations and cameos
Appendix D Modelling the efficiency of HFE
References