Reforming federalism: Issues and objectives.

This loss of fiscal independence has theoretical as well as policy and financial implications. Firstly, the centralisation of fiscal control implicit in the IGA runs contrary to the federalist ideal and the associated principle of financial subsidiarity, or the notion that taxing and spending decisions should be devolved to the level of government closest to citizens (Bird and Ebel 2006). Whilst there are ongoing debates about the relative political and economic merits of fiscal decentralisation (discussed below), it is clear that the IGA has reduced the potential for such devolution and inter-State variation in tax systems and rates.

The growing centralisation in Australian federalism under the IGA has also had a number of political and economic consequences. Arguably, the political authority of State governments has increasingly been constrained in key policy arenas such as education, health and water management, where they either require direct funding and/or cooperation from the Commonwealth. This has both eroded political accountability in Australia’s federal system and has forced State governments to accede to Commonwealth demands in areas where States have traditionally had jurisdiction (for example, National Water Initiative; Mersey Hospital takeover).

Given that this paper is fundamentally concerned with intergovernmental financial relations it is important to briefly sketch established arguments concerning whether taxing powers should be centralised or devolved, and the related debate as to whether taxing powers and spending obligations ought to be aligned; the so-called vertical fiscal balance in a federal system.

Arguments for fiscal decentralisation

First and foremost is the idea that decentralisation will promote tax competition between States, acting as a constraint on revenue growth and providing incentives to improve the efficiency of State taxation. The so-called Tiebout hypothesis is popular with those on the right with an interest in constraining the size of the state while being criticised by those on the left who hold a more sanguine view of the state’s ability to provide public goods (Tiebout 1956). A related argument concerns the potential for innovation and interstate policy learning in a federal system. Thirdly, it is claimed that fiscal decentralisation can provide scope for State governments to tailor tax levels and the structure of State tax systems to meet specific regional needs.

Arguments for fiscal centralisation

There are also a number of arguments for fiscal centralisation. As national economies are exposed to increasing competitive pressures and commerce is increasingly conducted on a national and international scale, there have been growing calls for greater regulatory harmonisation (BCA 2007; Rudd 2007). In the tax arena it is argued that a national tax system reduces compliance costs for businesses operating across State boundaries as well as for consumers and employees who purchase goods and services or work interstate. Harmonisation also eliminates the potential for tax-related distortions caused when taxpayers try to exploit arbitrages between States. On the administrative front, there are also clear economies of scale when tax administration is managed by a national agency such as the ATO on a uniform national tax base.

Vertical fiscal balance and financial accountability

Another important theme in debates on fiscal federalism concerns the constitutional attribution of taxing powers and spending responsibilities in a federal system. Australia currently has the highest VFI of any federal state in the OECD (Twomey and Withers 2007: 37). There exists a consensus that the delivery of public services is both more efficient and transparent when there is a balance of taxing and spending powers within a federation (Mathews and Grewal 1997; Fitzgerald 1998; World Bank 2000:117; Row and Duhs 2001: 61–3; for a summary, see Dollery 2002).[5] Yet while most commentators regard Australia’s VFI as problematic, there is much less consensus about how it should be resolved.

Federalists argue that the VFI should be addressed by increasing the States’ fiscal capacity through expanding their own-source tax base. At the very least it is argued that States need access to an earmarked percentage of national taxes under a regime which grants the States some control over the amount of revenue raised and how it is spent (Warren 2006: Ch. 2). In contrast, centralists argue that the most efficient strategy to address a VFI is for the national government to assume responsibility for the provision of services equivalent to its financial resources.

In between the two ends of this spectrum there are a number of intermediate positions. The most interesting compromises in this respect are funding models which feature a national tax base and centralised administration while preserving the budgetary and governance capacities of sub-national government. For example, in both Germany and Canada, sub-national governments share significant tax bases (such as personal income tax) with national governments (Braund 2003). In practice this involves regional governments setting a surcharge on national taxes which is collected by the central government on their behalf. The goal here is to enhance the efficiency of the national tax system while preserving key aspects of the federalist ideal.

Another option of direct relevance to the Australian debate is for the national government, given its superior budgetary capacity, to assume financial responsibility for key services hitherto managed by the States, but under a governance model which promotes local management and control. The final section of this paper assesses the financial implication of one such transfer; a Commonwealth takeover of public hospitals.

[5] Dollery (2002) points out that Groenewegen has long argued that high levels of fiscal centralisation in a federal system tend to decrease administrative and compliance costs (Groenewegen 1990).