Taxing Federalism: The Australian Federation in its Second Century

Author: The Hon David Hamill served as Treasurer in the Beattie Government

1st July 2000 was arguably the most significant date in the recent history of the Australian federation. On this day, the Howard Government implemented its "New Tax System" (NTS) with its signature element, a broad-based consumption tax, the Goods and Services Tax (GST).

Tax reform had been the subject of considerable debate within Australia over a period of thirty years with a broad-based consumption tax being supported by various governments, oppositions, academics, economists and political commentators as a means of reducing Australia's heavy reliance upon direct taxation.

This debate had been pursued in official reports and tax summits. Furthermore, the 1993 federal election became a virtual referendum on the issue as the contending parties debated the merits of a GST and how it would impact upon Australian businesses and consumers.

Although the GST's political advocates lost the 1993 election, changes to Australia's tax system and the introduction of a broad based consumption tax remained on the political radar with organisations such as the Business Council of Australia continuing to advocate its cause.

While the New Tax System can be seen as the political outcome of this on-going tax reform agenda, its structure and the way in which the GST was placed at the centre of federal-state financial relations would not only have the well-canvassed implications for Australian businesses and consumers, but also usher in major changes to the structure of Australian federalism.

This paper will argue the following three propositions: 1.That the New Tax System is a product of a centralising dynamic embedded within the Australian federation; 2. That under the New Tax System, the States and Territories are experiencing the greatest challenge to their capacities as autonomous governmental entities within the Australian federation; and 3.Whereas Australia's conservative parties were the traditional advocates of federalism and opposed the traditional Labor preference for strong centralised government, the interventionism of the Howard Government has turned this political paradigm on its head as its approach to federal-state relations redefines Australian federalism. Federalism and Federations

Various commentators have observed that the influence of the central government within the Australian federation has expanded at the expense of the state governments over the course of the last one hundred years. However, this growth in the role of central government during the twentieth century was not unique to Australia.

Factors such as the emergence of national and international economies and the demands of world war contributed to the concentration of political and fiscal power in the hands of national governments around the world regardless of whether they were in unitary or federal states.

Furthermore, public support for the growth of the welfare state in "first world" countries in the post-World War II period also placed greater demands upon national governments as the costs and scope of increased social services provision was generally well beyond the financial capacity of local and regional governments.

Whilst Australia shared this experience, the history of the Australian federation suggests that there have also been factors specific to Australia that have played their part in enhancing the role of the Commonwealth Government at the expense of the States and Territories.

In order to assess the validity of that observation and understand how the Howard Government's New Tax System is impacting upon Australia's federation, it would first be helpful to establish exactly what we mean by the term "federation".

I suggest federations have four key characteristics that collectively set them apart from other systems of government in which functions are shared amongst different tiers of government. These characteristics are as follows:

  1. A constitutional sharing of legislative and fiscal power among national and sub-national governments;

    Federations are often the product of a federal bargain or covenant among the federating parties. This covenant is enshrined in a legally enforceable constitution that allocates the respective powers and responsibilities among the central and sub-national governments.
  2. Neither that distribution of constitutional powers among national and sub-national governments, nor the existence of those national and sub-national governments can be altered at the discretion of either the national government or a sub-national government acting alone or in concert with others;

    A critical feature of the constitutional arrangement of federation lies in the fact that the constitutional position and powers of the central government is not beholden to the sub-national governments or vice versa.

    The significance of this can be seen when one contrasts the constitutional position of an Australian State vis-à-vis the Commonwealth of Australia with that of local government vis-à-vis the States. Local government authorities are created and dissolved pursuant to legislation passed in State Parliaments, whereas the Commonwealth cannot abolish the States or amend their boundaries and the States cannot abolish the Commonwealth.
  3. Both the national and sub-national governments act directly on the citizens;

    This third characteristic is closely linked to the constitutional allocation of powers discussed above. The legislative and administrative actions of the national government and the sub-national governments impact directly upon the lives of the same public, as neither tier of government is merely the agent of the other. The public of the sub-national entity is also a part of the public of the national entity and the same people participate in the electoral process in respect of both tiers of government.
  4. A mechanism, usually judicial, exists to resolve constitutional disputes.

    Notwithstanding the fact that the respective powers of the national and sub-national governments are set down out in a written constitution, the history of federations abounds with disputes between the tiers of government as to the extent of their constitutional powers vis-à-vis each other as well as actions brought by corporations and individuals challenging the validity of the legislation or administrative actions of national and sub-national governments. Federal constitutions generally provide for a judicial body to have the power to resolve these disputes. In the case of the United States of America, the Supreme Court performs this function, whereas in Australia, it is the role of the High Court.

Just as governmental powers are allocated across different levels of government in a federal Constitution, it is also important to recognise that in a federation, each national and sub-national government will have its own political, legislative, administrative, judicial, coercive and fiscal capabilities.

In other words, each enjoys a measure of state authority and state autonomy, i.e. each has its own capacity as a state.

The other characteristic that we should recognise about federations is that they are dynamic. Their constitutions and their institutions are being constantly shaped and reshaped through the interaction of their political, administrative, legislative, bureaucratic and judicial processes with social and economic factors both domestic and international.

Consequently, as their institutions and constitutions are reshaped through this interaction, so the capacity of each of the governmental entity relative to other government entities within the federation will be similarly reshaped, enlarged or diminished through these processes.

Whereas all federations are dynamic, some tending towards greater centralisation of power, other towards decentralisation, federations per se are neither centralising nor decentralising.

The nature of the dynamic within any federation will vary across time and depend on the nature of the interaction of the various institutions, political, bureaucratic and judicial players and within the context set by the broader social and economic issues mentioned previously.

So, what of Australia?

Australian Fiscal Federalism

In its 2002 report, The Federal Spending Power, the Quebec Commission on Fiscal Imbalance described the Australian federation as "perhaps the most centralized one in the world, to the point of reducing it to a unitary state".

This was certainly not the intention of the delegates to the Constitutional Conventions of the 1890s who sought to draft the Constitution in such a way as would limit the powers of the new central government and preserve as far as possible the independence of the States.

Yet I would argue that it was their actions that imbued the new federation with its centralising dynamic.

In fact, the very act of federation and the specific goal of an Australian customs union required the States to relinquish certain of their powers, such as the ability to impose customs and excise duties and transfer them to the new central government, which would have its own political, legislative and fiscal capacity to rival that of the States.

Whilst this new central government would also share a wide range of specific legislative powers with the States, it was significant that in these areas of concurrent jurisdiction, Commonwealth law would prevail over inconsistent State laws.

As the range of issues attracting the attention of the central government has broadened over time, the Commonwealth has expanded its activities into areas that had previously been the domain of the States.

The Commonwealth's growing fiscal domination of the federation coupled with its legislative capacity to override inconsistent State legislation in areas of concurrent jurisdiction has profoundly changed the respective roles and responsibilities of the States and the Commonwealth over the course of the last century in areas such as social services, education and environmental protection.

Whilst there are many facets to the story of Australian federalism, tonight I want to focus on just one i.e. how the fiscal capacity of the Commonwealth is impacting upon the federation and what role the Howard Government's New Tax System is playing in that story.

The fiscal capability of a state, i.e. its ability to raise revenue or access finance in sufficient quantities to discharge its responsibilities and resource its administrative and regulatory organs, is as fundamental to its capacity as a state as is its ability to exercise control over how, to what purpose and in what quantity these resources will be expended.

In Australia, the revenue raising capacity of the States has always been inadequate to meet their spending requirements. Indeed one could say that vertical fiscal imbalance has been a feature of the constitutional design of Australian fiscal federalism from the outset.

The establishment of a Commonwealth of Australia with the express intention of erecting a national, uniform tariff to replace the individual tariffs and customs duties imposed by colonial governments represented a direct threat to the federating colonies' revenue bases. In fact, in the years immediately before federation, customs and excise duties constituted the lion's share of colonial revenue, comprising seventy-six per cent of all colonial and local government taxation.

Following the loss of their customs and excise revenue, the States sought to restore their fiscal capability by venturing into other areas of taxation, notably income tax. However, unlike the Commonwealth with its monopoly over levying customs and excise duties, the Constitution did not reserve a revenue base for the States.

With the exception of its exclusive power under s.90 to impose customs and excise duties, the Commonwealth's general power to impose taxation is concurrent with that of the States, subject only to the constraint that it cannot "discriminate between States or parts of States."

It did not take long for the Commonwealth to expand its revenue raising activities beyond customs and excise ands in 1910, the Fisher Government introduced Commonwealth Land Tax.

Spurred by its need to generate additional revenue to support its war effort, other Commonwealth incursions into what had been the States' revenue base followed with the introduction of Estate Duty in 1914, and Income Tax in 1915.

Whilst the Commonwealth has used its revenue-raising powers to enhance its fiscal capability, other provisions contained in the Constitution governing to the way in which the Commonwealth must deal with the funds it has raised have proved integral to the shape of Australian fiscal federalism and ultimately to the ability of the Commonwealth to achieve fiscal dominance over the States and Territories.

Although many of the provisions in Chapter IV of the Constitution were transitional in nature, others continue to be of vital importance to the conduct of federal state financial relations and by implication, to state capacity.

Key among these are those sections establishing the Commonwealth's power to appropriate funds, its power to provide financial assistance to the States subject to conditions, and its power to assume responsibility for the States' public debt

Concerned at the prospect of the Commonwealth using its fiscal power to intervene in areas that had traditionally been their responsibility, the States argued that the Commonwealth's appropriation power should only authorize funding in respect of those purposes for which the Constitution provided the Commonwealth with a specific legislative head of power. In their decision in the Pharmaceutical Benefits Case, a clear majority of High Court judges rejected this narrow view of Commonwealth power.

Thirty years later, the High Court in the Australian Assistance Plan Case adopted a similarly wide view of the Commonwealth's powers. In this case, the Victorian Government unsuccessfully challenged the Commonwealth's power to appropriate funds and allocate them directly to community organisations, bypassing the States.

It appears from these authorities that within the Australian federation, the dynamism extends to the scope of matters for which the Commonwealth may appropriate funds. These will vary over time according to what Australian society and the High Court sees as being within the role of a national government.

As the responsibilities of national governments have grown considerably in the period since World War II, the Court has authorised Commonwealth appropriations for a widening range of purposes, many impinging directly on areas of States' responsibility.

The Commonwealth has also used its powers under s.96, the power to provide financial assistance to the States on such conditions as it thinks fit, to enhance its fiscal dominance over the States. The Commonwealth's actions in this regard were dramatically reaffirmed in two landmark cases that effectively redefined the rules governing Australian fiscal federalism.

I refer to the Uniform Tax Cases, South Australia v Commonwealth (1942) and Uniform Tax Case and Victoria and New South Wales v Commonwealth (1957).

In the first of these cases, the High Court upheld the Commonwealth's requirement that States refrain from levying income tax in return for reimbursement grants pursuant to States Grants (Income Tax Reimbursement) Act. By this decision, the High Court confirmed the virtually untrammelled ability of the Commonwealth to impose conditions upon grants to the States even to the point that such conditions would effectively remove the States' capability to exercise their constitutional power to raise any taxes other than customs and excise duties.

This issue of tied grants or Specific Purpose Payments (SPPs) has vexed the States.

Whilst they have generally welcomed additional Commonwealth funding into areas for which they would otherwise be wholly responsible, the States have consistently criticised the rising ratio of tied money to untied money in total Commonwealth outlays to the States and the increasingly onerous conditions and administrative processes that the Commonwealth has attached to accessing the funds.

This has been especially controversial where the administration of the grants programs has resulted in the Commonwealth duplicating existing State agencies by establishing parallel administrative structures and departments, which in turn constrain the administrative capability of their State counterparts.

Although there have been examples of States refusing to participate in programs which would have required them to match Commonwealth SPPs, they have generally acquiesced to the Commonwealth's demands and altered their spending and policy priorities accordingly.

The reasons for this capitulation are threefold.

  • Firstly, despite mounting a series of legal challenges to the way the central government has relied upon s.96 to impose conditions upon their access to SPPs, the States have been consistently rebuffed by the High Court repeatedly finding in favour of the Commonwealth.
  • Secondly, the States have generally lacked the political capability of sustaining their opposition to Commonwealth involvement in programs and projects funded in whole or part by SPPs, especially where there is public support for additional funds being spent in that area.
  • A third reason which explains the States' relative acquiescence to the Commonwealth's use of SPPs can be found in the significance those grants have in determining States' fiscal capability.

In the years immediately prior to the Second World War, SPPs mostly in the form of Road Grants comprised a little over one quarter of the funds provided to the States by the Commonwealth. It is relevant to recall that total Commonwealth payments to States and local government comprised fourteen per cent of the latters' revenue at that time.

In the period since the Second World War, successive federal governments armed with the additional fiscal clout derived from their monopoly of the income tax base, have expanded the range of programs associated with SPPs.

By the 1990s, SPPs comprised over fifty percent of the funds made available to the States by the Commonwealth.

Furthermore, with the bulk of these funds directed to key community service responsibilities of the States in health, education and welfare in addition to road construction and maintenance, the States had neither the fiscal capability to replace their reliance upon SPPs with an alternative source of funds, nor the political capability to endure the community backlash which would surely follow any reduction in community services resulting from their refusal to accept SPPs despite the conditions attached thereto.

I stated earlier that vertical fiscal imbalance was a feature of Australian fiscal federalism from the beginning. However, it has become more acute over time.

By the end of the First World War in 1918-19, the Commonwealth was raising seventy-three per cent of the total taxation levied by Australia's three tiers of government. Of total Commonwealth taxation revenue, its income taxes, which had been introduced only three years before comprised thirty-five per cent of Commonwealth tax collections.

As a result of the upsurge in Commonwealth revenue raising to service its war effort, by 1918-19 State and local government taxation comprised only 27% of total taxation however State income tax remained an important source of revenue, providing 50% of total State and local government taxation at that time.

Commonwealth efforts in revenue raising eased relative to that of the States in the interwar years such that by 1938-39, Commonwealth taxation comprised only fifty-four per cent of total Australian taxation.

Although the States and local governments were primarily responsible for raising their own revenue, vertical fiscal imbalance remained. Whereas State and local government taxation had risen to 46% of total taxation, State and local governments were responsible for 69% of total public sector outlays.

The introduction of uniform income taxation was a watershed for Australian fiscal federalism that dramatically enhanced the fiscal capability of the Commonwealth at the expense of the States.

By 1948-49, State and local government taxation had slumped to just 12% of total taxation and State and local governments now relied on the Commonwealth for 48% of their receipts.

69% of Commonwealth grants to the States were now untied Tax Reimbursement and Additional Revenue Assistance; 10% of Commonwealth grants to the States were special grants while 22% of Commonwealth grants to the States were specific purpose grants including roads and Financial Agreement Payments.

During the 1950s, 1960s and especially during the period of the Whitlam Government in the 1970s, the Commonwealth's use of SPPs increased significantly.

By 1993, SPPs totalled 53% of total Commonwealth funding to the States.

The Howard Government and its New Tax System

In this year's Queensland Budget Papers, the following statement appears with respect to Commonwealth SPPs to the States: negotiations continue to be problematic as the States are increasingly required to commit to the priorities of the Australian Government and meet strict input and accountability controls (Queensland Budget Papers 2004-05).

This statement betrays the fact that whilst SPPs may have reduced as a proportion of Commonwealth payments to the States under the Howard Government, they are still major a bone of contention in federal state financial relations.

However, the Howard Government has developed other means of coercing the budgetary priorities of State and Territory Governments than simply cajoling them with SPPs.

SPPs have often required matching funds from the States. However in a number of recently negotiated agreements in areas such as health and disability services, Commonwealth funding has been made conditional on States making a commitment to substantially larger real increases in their funding contributions over the life of the agreement.

As health and education generally comprise about half of the States' spending and as these service delivery areas are labour intensive and in the case of health services, already face escalating demand from an ageing population, the financial squeeze facing the States is all too apparent.

Furthermore, the Commonwealth mantra that all of the States' spending needs can be met from "free cash" from rapidly expanding GST revenue is somewhat hollow when much of this future revenue stream is already being locked up in Commonwealth-State funding agreements.

The fiscal position of the States has not been aided by the decisions of the High Court in respect of the financial powers of the Commonwealth.

Apart from a short period immediately following federation, decisions of the Court pertaining to fiscal federalism have generally favoured the national government over the States.

There are many cases that illustrate this point including the decision allowing the Commonwealth to circumvent the Constitutional provision giving the States access to its budget surpluses, or the uniform tax cases or those decisions preventing the States access to sales tax and other consumption based taxes.

All of these interactions by the High Court with the political processes of Australian fiscal federalism show the Court contributing greatly to the accretion of the Commonwealth Government's fiscal capability.

Indeed, through its interpretation of certain key sections of the Constitution in its role as Constitutional arbiter, the Court has reinforced the inherent centralising dynamic within the federation.

Fiscal capability within the Australian federation has been, and continues to be a critical contributor to state capacity and ultimately, to the distribution of political power within the federation. This observation is particularly relevant now with respect to the implications of the Net Tax System and the circumstances surrounding its introduction.

In order to retain some semblance of fiscal autonomy in the wake of having lost their direct access to income taxation, the States had expanded their revenue raising efforts by broadening the base for their stamp duty collections, introducing financial services taxes, increasing their reliance on gambling and gaming activities as a revenue source, and introducing business franchise and licensing fees on energy, tobacco and liquor.

However, the decision of the High Court of Australia in Ha and anor v State of New South Wales & ors; Walter Hammond & Associates v State of New South Wales & ors, triggered the opening of a window of opportunity for change which was exploited by the Commonwealth to achieve its long-held desire for a shift away from direct taxation in favour of a broad based consumption tax.

The Howard Government also took the opportunity to embed its tax reform proposals by placing them at the centre of federal state financial relations.

The High Court decision in Ha's Case was potentially devastating for the States as the loss of revenue from business franchise fees threatened their fiscal capability. Indeed, around $5 billion or 16% of State controlled revenue in 1997-98 was placed in jeopardy by the decision.

The rest is history.

The Commonwealth introduced temporary measures to replace the State revenue that could no longer be collected and channelled those funds, with conditions attached back to the States.

These arrangements, along with the payment of untied financial assistance grants ended with the introduction of the NTS and the GST in 2000.

The impact of the NTS on federal state finances was fairly straightforward.

The pool of GST funds, net of the cost its collection by the Australian Taxation Office would be distributed amongst the States and Territories subject to the recommendations of the Commonwealth Grants Commission.

Although the Commonwealth had initially intended that the States withdraw from collecting Stamp Duty in the Senate forced the Commonwealth to leave much of the States' Stamp Duty revenue in place as the exemption of fresh food from the GST significantly reduced its ability to offset the State revenue foregone.

Notwithstanding these changes, the introduction of GST was linked to the abolition of State Financial Institutions Duty and bed taxes, Stamp Duty on the trading of marketable securities and in 2005, Bank Accounts Debits Tax.

A review of Stamp Duty is also scheduled for next year.

In short, the States were required to remove taxes over which they had control and accept revenue from a tax over which they had no control, further eroding their fiscal autonomy.

As well, as eroding the fiscal autonomy of the States, the NTS has also exacerbated the level of vertical fiscal imbalance within the federation.

In 1999-00, the Commonwealth collected 77.8% of total Australian taxation, the States 19.2% and local government 3.2%.

Just two years later, the Commonwealth's share of total taxes paid by Australians had risen to 81.7% whilst State tax collections had fallen to 15.1% of the total and local government's share remained static at 3.1%.

In 1999-2000, the States received 37% of their revenue from the Commonwealth.

In 2004-05, it is expected that the States will receive 49% of their revenue from the Commonwealth while the proportion of State revenue sourced from State taxes is estimated to be 32%, down from 40% in 1999-2000.

But what of the future?
Whither Federalism?

The conservative parties have traditionally cast themselves as the vocal defenders of federalism in words if not in deeds.

While Menzies presided over a steady expansion of Commonwealth activities in the 1950s and 1960s, the Howard Government has brought Commonwealth interventionism into the traditional areas of State responsibility in areas such as education to new levels. Witness the linking of Commonwealth funding for schools to the presence of flagpoles or the election commitment to fund technical colleges, in direct competition with the State run TAFE system.

Furthermore, the Commonwealth has not been backward in using its fiscal dominance of the States to enforce its policy preferences.

This occurred when Treasurer Costello threatened States with a loss of Revenue Replacement Payments if they did not maintain reduced licensing fees with respect to low alcohol beer.

In the case of Queensland, the threat was also extended to the State's share of GST revenue should it act to remove its fuel subsidy scheme.

If there is any doubt that the Commonwealth had the constitutional teeth to put these threats into effect, one has only to read the judgements in the Uniform Tax cases to learn how the Commonwealth could use s.96 for this purpose.

In many respects the GST revenue is the ultimate SPP and that the Commonwealth is likely to mandate the States' relinquishing other parts of their own source revenue base in return for their continued participation in the distribution of the ever-increasing GST revenue pool.

Who knows, with a Senate majority from July 2005, the stage may be set for the Howard Government to amend the existing GST legislation to allow the Commonwealth to unilaterally reset the GST base and rate in order to implement the its original tax reform proposals or the Hewson GST of 15%, which came with the additional objective of abolishing State Payroll tax and Stamp Duty.

The Australian Federation is moving into uncharted waters.

There has been only one short period since 1910 and the emergence of the modern system of party politics in Australia that the same parties have controlled government in all the states and the Commonwealth simultaneously.

That was in a short period in 1969-1970.

However, there were some variations to the theme with the Country Party being the senior coalition partner in Queensland and the Liberals being a minority government in Tasmania supported by the short-lived Centre Party of one from the cross benches.

Notably however, the Federal Coalition Government did not enjoy senate majority.

Now we are facing a unique scenario where there are ALP governments in all states and territories and a Coalition Government that will have control of both houses of the Federal Parliament.

In this scenario, there is no conservative State government able to argue the case for the States within coalition party circles and constrain an increasingly strident Commonwealth Government bent on redrawing the lines of governmental responsibility within the Australian federation.

This certainly is an interesting twist to Australian federal state relations.

Future of federalism lies in States and Commonwealth having the capacity to fulfil their responsibilities.

The danger for Australian federalism is that this is not so.

Should the Howard Government continue along its current interventionist path and seek to further enhance the Commonwealth fiscal dominance of the States, then the latter will be reduced to mere agents of the Commonwealth, deprived of any fiscal or real administrative or legislative capability in areas of major public spending such as education and health.

In other words the States became a shadow of their former selves with limited independent sources of revenue and a very limited scope of authority restricted to areas of domestic civil law and its enforcement.

It is a taxing time for Australian federalism and without constitutional reform to restore some independent fiscal capability to the States; their future looks very bleak indeed.

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