Fiscal federalism

With federalism hotting up as an issue below the fold and here is Rory Robertson’s piece from the Oz on how the states have not had the revenue windfall that they’re supposed to have had from the GST. While I agree with Rory’s argument, one thing that should be mentioned is that while the states’ GST windfall has been modest, their housing stamp duty windfall was not.

Why Canberra’s rolling in cash
And it’s hard to know when enough is enough, writes Rory Robertson

RELATIVELY few outsiders these days devote much energy to looking at the complicated and time-consuming topic of federal and state finances and functions.

That’s left the public debate short on independent analysis and long on barrow-pushing. In analysing the federal budget in May, it occurred to me that there are at least four facts missing from the current debate on federalism.

First, the “massive revenue windfall” the states are said to have gained as a result of the shift to the GST is actually tiny in the general scheme of things. At $1.2 billion in 2005-06, or 0.1 per cent of GDP, it’s a rounding error in the federal budget.

Second, Canberra’s “tax take” as a share of GDP is at a multi-decade high on several measures (see chart). Probably it’s at an all-time high, in part reflecting its own massive revenue windfalls.

Third, Canberra’s earmarking of the GST as a “state tax” has not produced a profound shift in federal-state funding. Net transfers to the states have remained pretty steady as a share of GDP.

Finally, Canberra’s record-breaking immigration policy – a net intake of about a million new residents over the past decade – has put greater than usual pressure on state and local governments to manage and fund extra demand for things like housing, hospitals, schools, roads, police, public transport and other services.

With the COAG meeting just around the corner, tensions between Canberra and the states are running pretty high.

That’s hardly news: such tensions have existed since Federation in 1901.

As in many other relationships, federal-state squabbles mostly are about money.

The history here is important. Canberra took over the states’ income-taxing powers – now worth 18 per cent of GDP – during World War II, and didn’t give them back. In keeping these powers, Canberra became responsible for collecting a big chunk of tax for the states.

Indeed, since World War II Canberra has come to dominate overall tax collection. The ABS estimates that Canberra collected fully 82 per cent of all Australian taxes in 2004-05.

Meanwhile, the states – without income taxes – naturally do more spending than they do taxing.

Thus fiscal federalism for decades has involved Canberra each year collecting something like 5-7 per cent of GDP in worth of tax revenue for the states and delivering it to them in the form of “tied” and “untied” transfers.

These days, the first (stable) 4 per cent of GDP worth of transfers to the states comes via the GST as untied grants.

Canberra, of course, keeps a tight rein on total transfers to the states, by dictating each year the level of non-GST transfers, mainly specific purpose (tied) payments.

With the states dependent on Canberra for nearly half of their total revenue, their natural tendency is to claim they have been “short-changed”, while Canberra’s natural tendency is to claim it has delivered the states a “windfall”.

The states’ “GST windfall” of 0.1 per cent of GDP in 2005-06 seems to have taken the form one would expect when a (federal) government of one political stripe finds itself free to choose the size of total payments to (state) governments of another stripe. That is, it’s too small to make much difference, but not too small to be exaggerated.

Meanwhile, Canberra clearly is rolling in it.

Despite cutting taxes in his previous three budgets, Treasurer Costello in May announced another round of sizeable tax cuts (effective this week) and spending increases for 2006-07, alongside another chunky budget surplus.

Canberra’s recent revenue windfalls have been truly extraordinary.

Four budget updates since December 2004, for example, have delivered upgrades to four-year-rolling-revenue projections worth $123 billion in aggregate. This bonanza dwarfs even the $96 billion worth of net federal debt that accumulated over the 25 years to 1996.

For 2005-06 alone, the upside surprises in revenues over the past 18 months have totalled $25 billion. That’s around 2-1/2 per cent of GDP, or 20 times the states’ GST windfall.

With Canberra rolling in cash, many have wondered “where’s the money coming from?” The answer is fairly straightforward. Fifteen years of solid economic growth without recession mean economy-wide (taxable) income is elevated as never before.

But it’s not just the elevated level of GDP. The proportion of GDP collected as tax by Canberra also is at a multi-decade high, according to the ABS (see chart).

Indeed, the latest ABS data viewed alongside a century of history suggest Canberra’s tax-GDP ratio is at an all-time high.

That Costello has become the biggest-taxing Treasurer in living memory is a surprise, as he has cut taxes in each of his past four budgets. Indeed, no-one can remember the last time he increased taxes.

Actually, Canberra’s record “tax take” in partly an accident. Company tax revenues in particular have surged much more quickly than expected, jumping to an estimated 5.2 per cent of GDP in 2005-06. That compares with around 2-3 per cent of GDP in the 1980s.

Costello, of course, refuses to accept the highest-taxing Treasurer tag from the ABS, because its figures include the GST – worth a steady 4 per cent of GDP – which he has declared a “state tax”. But even when we leave the GST to one side and focus just on income tax, the new record remains intact.

All up, Canberra estimates that it collected a bit over 27 per cent of GDP worth of revenue in 2005-06, including about 2 per cent of GDP worth of non-tax revenue and 4 per cent of GDP worth of GST.

From that pile, it transferred a touch under 7 per cent of GDP to the states, leaving my new measure of Canberra’s “Own revenue” at 20.5 per cent of GDP in 2005-06.

Over the 2000s so far, Canberra’s “Own revenue” has averaged 20 per cent of GDP, up by 2 percentage points from its pre-GST average over the 1980s and 1990s.

It’s this 2-percentage-point jump in its “tax take” over the past decade that has allowed Canberra so easily to convert budget deficits averaging 1 per cent of GDP into surpluses of the same order, even with income tax cuts in the past four budgets.

Thus we have three of four easily assembled measures showing Canberra’s “tax take” at multi-decade highs.

Defying tradition and ABS methodology, Canberra now excludes from its published budget revenue and spending aggregates the bulk of the tax (the GST) it collects for – then transfers to – the states.

Canberra’s preferred measure of revenue-GDP thus shows not an uptrend but a small downshift! That’s because the wholesale sales tax and other taxes abolished in 2000 are counted but the replacement GST (worth 4 per cent of GDP) is ignored.

The declaration that the GST is a “state tax” happily ignores the fact that for decades Canberra has had responsibility for collecting and transferring 5-7 per cent of GDP worth of tax revenue to the states.

Earmarking the GST collected by Canberra as a “state tax” simply is a slightly different way of doing a stable 4 per cent of GDP worth of the same old thing.

As always, Canberra retains strict control over total transfers to the states, by controlling the level of specific purpose payments.

Contrary to the perception Canberra seems keen to promote, its total (net) payments to the states as a share of GDP are flat, not on an upward trend.

That is, after netting out the 1.4 per cent of GDP worth of compensation for the abolition of various state taxes, Canberra’s transfers to the states in 2005-06 match the 5.4 per cent of GDP recorded a decade ago.

Despite the 2 percentage points jump in Canberra’s tax-GDP ratio, there’s been no obvious top-up for the states. Presumably, that’s why the states’ attitude generally has been “Thanks for nothing (extra)”.

As far as I can see, the states’ main gain from Canberra’s GST-based funding arrangements seems to be increased financial flexibility via an increase in the ratio of untied to specific-purpose funding.

It thus remains unclear why Treasurer Costello reckons all this adds up to the states being given “the largest financial free kick since the Second World War”.

As noted above, any large immigration program brings with it a range of benefits (for example, increased output and taxes) and costs (for example, increased congestion and public spending). More working adults means more demands for housing, roads and public services.

With Australian immigration in 2006 set to exceed 100,000 new residents for a record eighth straight year (twice the run of the late-1980s), it’s clear that state and local governments are struggling with more than just – as many suspect – a simple lack of competence.

These four facts lead me to the simple question: How will we know when – to perform their current functions – Canberra has too much money and the states too little, or vice versa?

It’s a simple question, but one that to me seems tough to answer.

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Ken Parish
17 years ago

Fascinating figures. Strangely, it hadn’t even occurred to me that Costello was bullshitting about the supposed GST “windfall” to the States. I should observe, however, that the point Robertson makes about the imagined adverse effect of the Howard government’s high immigration program on State finances is almost certainly something of a furphy. The old Bureau of Immigration Research consistently found that migration programs skewed towards skilled and business streams produced small net positive economic outcomes from quite early after migrants’ arrival in Australia, whereas programs skewed towards refugee and humanitarian and family reunion streams showed very small net negative outcomes (with negative effects albeit small persisting for 10 years or so after arrival).

The Productivity Commission recently (April 2006) published a detailed study (PDF file) on the effects of migration. I’ve only skim read it, but its findigs appear essentially to duplicate those of the old BIR:

The greater emphasis on skilled immigration has contributed to improved labour market outcomes for immigrants. Consistent with previous Australian studies and research in other countries, the effect of increased skilled migration on average living standards is projected to be positive, but small. It is also likely that most of the benefits accrue to the immigrants themselves.

That doesn’t preclude the possibility (even probability) of a short run increase in the demand for state government services arising from a larger immigration program (even with a strong skew towards skills as the Howard government’s program certainly has), but any such effect is likely to be tiny and not a significant cause of any alleged state government fiscal hardship.

Cameron Riley
17 years ago

How will we know when – to perform their current functions – Canberra has too much money and the states too little, or vice versa?

That is a simple question, not a hard one. A government should only raise enough revenue to support itself and no more. The feds raise more than they need, and the states raise nearly 50% less than they need.

As these graphs show, the size of federal receipts, adjusted for inflation, have doubled in thirty years.