One of the great truisms of Australian politics is that federal/state relations are unavoidably bedevilled by "vertical fiscal imbalance", a phenomenon whereby the Commonwealth controls the great bulk of revenue-raising powers while the States bear the burden of providing many of the most expensive governmental functions and services, especially health and education.

The VFI truism is particularly potent in the current political era, given that the previous Rudd/Gillard government began the process of implementing sweeping needs-based funding reforms in the health and education sectors (the National Health Funding Pool and the Gonski education reforms).  Labor cunningly (or so they thought) left a "poison pill" for the incoming Abbott Coalition government by only funding those reforms for the first 4 years, leaving the "out years" beyond Forward Estimates unfunded (as the Charter of Budget Honesty permits). The Coalition was going to have to raise taxes or cut other spending in order to match Labor's promises over time.

Abbott outsmarted Labor in the run-up to the 2013 election by only promising to match Labor promises on health and education for those first 4 years.  The electorate (and a lazy media) largely failed to understand the sleight of hand and voted the Coalition into government on the erroneous assumption that health and education funding were safe.

But Abbott then outstmarted himself by making clear in his government's first budget that he would not be delivering the NHFP and Gonski funding beyond 2017.  That was the seemingly massive $80 billion funding cut to health and education referred to in media coverage about the 2014 Abbott/Hockey horror budget. The money was only ever notional and had never been funded by the Labor government, although obviously if delivered it would have made a huge positive difference to health and education.

However it would also have brought to full maturity the century-long process of Commonwealth takeover of State powers.  The States would have had sustainable funding for health and education delivered to them by the Commonwealth, but at the price of permanent Commonwealth dictation of the needs-based system for distribution and administration of that spending.  At least for believers in the virtues of federalism (like me), Abbott's abandonment of post-2017 NHFP and Gonski funding was a qualified blessing.  Of course it leaves a huge gap in forward spending on health and education, but I argue below that the States are in fact entirely capable of raising the necessary revenue themselves and should be expected to do so.

The popular (and to a significant extent expert) perception of State revenue-raising disability was first enunciated by Alfred Deakin who in 1902 said:

As the power of the purse in Great Britain established by degrees the authority of the Commons, it will ultimately establish in Australia the authority of the Commonwealth. The rights of self-government of the States have been fondly supposed to be safeguarded by the Constitution. It left them legally free, but financially bound to the chariot wheels of the Central Government. Their need will be its opportunity.

Deakin has subsequently come to be seen as prescient, after the Commonwealth seized control of all income tax raising during the Second World War by using the defence and grants powers in the Australian Constitution. Later, High  Court interpretations of the Commonwealth's exclusive power over customs and excise duties (Constitution section 90) in Parton v Milk Board (1949) and then Ha v New South Wales (1997) held that the Commonwealth had a constitutionally entrenched monopoly over all taxes on the manufacture, distribution and sale of all goods (both primary and secondary products). Deakin's prophesy, it seemed, had been vindicated.  The States were indeed helpless mendicants of the Commonwealth, dependent on tied grants from the federal government which could dictate exactly how they they were required to spend federal grant money. But is it really true that the States are unable to raise enough revenue through their own powers to fund the services and facilities  they are expected to provide? I suggest the answer is emphatically in the negative. Australia's current Vertical Fiscal Imbalance flows almost entirely from a toxic political culture grounded in erroneous, exaggerated assumptions about alleged State constitutional incapacities. Deakin's chains and chariot wheels imagery is a convenient myth, allowing the States to evade their responsibilities and blame the Commonwealth for their own shortcomings.  The States are a bit like perpetual Gen Y adolescents, living at home free of charge with mum and dad until well into their thirties while complaining that the Olds are cramping their style. When we look at income tax, the constitutional reality is that this power is "concurrent" i.e. the States have just as much power as the Commonwealth to levy income taxes.  The Commonwealth could not in peace-time use the defence power to exclude the States.  It can still impose whatever conditions it likes on grants to the States, but the States wouldn't need Commonwealth grants if they chose to raise enough of their own revenue. In 1942 the most potent weapon deployed by the Commonwealth was that it raised federal income taxes to such high levels that it left no room for the States to levy their own income taxes without their own residents starving or going bankrupt.  The Commonwealth got away with that because of the wartime emergency situation.  In our contemporary globalised economy there is no way any federal government could or would raise income tax rates to a level that precluded States from raising their own income taxes if they wished. The real reasons why the States today don't choose to levy their own income taxes are purely pragmatic ones and have nothing to do with lack of power. The States prefer to let the Commonwealth incur the odium of tax collection, and despite current whingeing by WA they also privately accept that the modern Commonwealth Grants Commission system, which distributes revenue to the States on the basis of need, is a fair and efficient one that works very well.  It just wouldn't make sense to have a Commonwealth and eight separate state and territory income tax regimes. However, the fact that the States have the power to levy income tax gives them the ability, if they so choose, to demand a federal compact for equitable sharing of income tax receipts by threatening to levy their own income taxes if the Commonwealth won't come to the party. The picture is quite similar on the goods and services front.  John Howard rode to the States' rescue after Ha's Case in 1997 by implementing the Goods and Services Tax and pledging all its revenue to the States, again delivered by a needs-based formula administered by the Commonwealth Grants Commission.  But the States' constitutional disability under  Constitution section 90 exists only in relation to taxes on goods not services.  There are no constitutional impediments preventing the States from levying whatever taxes they like on the provision of services.  Moreover, in Australia's contemporary post-industrial society, services comprise more than 70% of GDP.  The proposition that the Commonwealth's exclusive power to levy excises somehow thwarts the States' fiscal independence is largely a myth. It is even more of a myth when we consider mineral resources.  It is certainly true that the States cannot levy taxes on the processing of minerals or their subsequent sale and distribution (because they would be excises).  However the States themselves own the minerals in the ground within their own borders.  They can and do impose royalties (i.e. taxes) on mining companies who wish to dig up and sell those minerals.  The problem during the minerals boom was that the States (especially the minerals-rich ones like WA and Queensland) irresponsibly chose not to increase those royalties so that their residents would gain a fair share of the huge windfall profits multinational mining companies were earning  from flogging the States' minerals to the Chinese.  That's why the Rudd/Gillard government eventually stepped in and sensibly if ineptly imposed its own Minerals Resource Rent Tax.  Much of that fiasco, which contributed mightily to Labor's loss of government, flowed from the fact that the States have been allowed to behave like naughty irresponsible teenagers for the last 70 years or so.  The States could raise mineral royalties rates tomorrow, and they certainly should do so as soon as minerals prices recover. In addition to all those massive and largely untapped sources of revenue for the States, they can also levy land taxes, payroll taxes, death duties and so on.  All are potentially lucrative revenue sources and the States are in no sense constrained from imposing them.  All are appropriate taxes that contribute to a well balanced fiscal system.  Why we don't have death duties, for example, is quite beyond my understanding.  Other favourite State revenue sources (e.g. stamp duty that has saved the Baird government's fiscal bacon during the recent Sydney Property Boom) are somewhat less desirable from an economic viewpoint. When examined carefully and globally, the States have adequate capacity to raise enough revenue to fully fund their own needs, or rather citizens' expectations as to what governments should provide.  Given that new PM Malcolm Turnbull and his Treasurer ScoMo are currently wrestling with the shape of a fair and economically responsible fiscal package to take to next year's election, Turnbull should overtly throw down the gauntlet to the States.  He should explain clearly to all Australians that the States and not the Commonwealth bear the constitutional responsibilities for health and education, and that they possess all the powers they need to raise the revenue necessary to discharge those responsibilities.  Turnbull should make clear that the Commonwealth will not be increasing the proportionate funding it already provides towards State functions and powers, and that it is up to the States to find the money they need and take full political responsibility for their decisions.  He should indicate that the Commonwealth will increase the GST rate or breadth of coverage if the States unanimously request this, but that the political responsibility for any such decision will be publicly borne by them.  He might even offer (rather more dangerously) to consider any proposition the States unanimously put forward for some sort of income tax-sharing regime. In other words, Turnbull should disavow the toxic myth of Deakin's Chariot Wheels and re-inscribe the system of fiscal federalism on which Australia's constitutional system is actually based.