Paul Keating once warned us never to get between a Premier and a bucket of money. This should apply more so when it’s 6 Premiers, all going after the same bucket. That, roughly speaking, is the predicament faced by the Productivity Commission (PC) in reviewing the distribution formula for Goods and Services Tax (GST) revenue to States and Territories and the 2018 reforms to that process.
In a zero-sum world, someone is going to end up unhappy, but the PC’s interim report provoked more than the usual provincial bickering. So much so that it’s hard to see a navigable way forward. The Prime Minister has ruled out a change to the post-2018 arrangements, and yet, conceptually, they have become impossible to defend. Either way, it’s hard to see a return to the traditional, pre-2018 system.
The question is not whether we can find an optimal solution, but how to take some basic steps in the right direction.
Traditional fiscal equalisation
The traditional formula for distributing Commonwealth grants to the states is complex in its particulars, but conceptually quite simple. It aims to ensure that all states and territories have the fiscal capacity to deliver roughly equivalent services to their people for a roughly equivalent tax burden.
The key is that not all states are equal in their underlying fiscal capacities. New South Wales and Victoria have property values which generate more stamp duty and land tax, and high-income industries which yield strong payroll tax per capita. Tasmania faces inherent costs in delivering equivalent services because of its older and more dispersed population. The Northern Territory faces very high costs because of its significant remote Indigenous communities.
And in the past 20 years, 2 states – Western Australia and Queensland – have begun to generate substantial royalty income from their distinctive mineral endowments.
The traditional Commonwealth Grants Commission (CGC) formula gives more money (per capita) to states with low innate fiscal capacity and less to those with high innate fiscal capacity.
The currency of the traditional system is a state’s ‘GST relativity’ – the ratio between what a state receives and what it would get under an equal per capita distribution.
Under the CGC’s traditional approach, NSW has a relativity of 0.89, meaning it receives around 89 per cent of its per capita share. Tasmania gets nearly twice as much as its per capita share and Northern Territory more than 5 times as much.
The WA problem
The problem in 2018 was that the surge of mining royalty income to WA – from high iron ore prices and increased production – had led to a dramatic fall in the state’s GST relativity. The CGC formula was suggesting that WA should get around 30 per cent of the state’s per capita share of GST revenue. No state had ever experienced such a low relativity.
In fairness, WA’s surge in royalty revenue was also unprecedented.
In essence, the China boom – a great economic blessing for Australia – pushed our system of fiscal equalisation to breaking point. The system had held together over decades during which the 2 largest states, Victoria and New South Wales, were the ‘donor states’ and the rest were net recipients (relative to a per capita share). That was a stable political equilibrium, not least because the large states’ relativities were generally between 0.8 and 1.
When a smaller, outlying state faced a relativity close to 0.3 (and heading rapidly south), the political equilibrium broke apart.
Conceptually and technically, it was (and remains) the right answer within the logic of the formula. Commentary then and now emphasised that the formula had it right: WA’s falling GST share was only commensurate with the scale of its royalty bounty. This was true. But arguably beside the point.
The impeccable logic of the formula had summoned a backlash that was ultimately existential for the equalisation system. I was a Deputy Secretary in federal Treasury at the time, and close to these deliberations. It truly was a wicked dilemma. Of course, there was the option to ‘just say no’ to WA. And WA’s intellectual case was always weak. But I doubt many national governments the world over would have lightly ignored such a rising tide of parochial sentiment in their most outlying state.
The challenge was to quell that sentiment with the least possible disruption to the basic system of equalisation. On that score, the PC interim report provides valuable evidence.
The deal
In one sense, there is no single 2018 WA GST deal. More a series of layered compromises which were added on as the package progressed from initial announcement to ultimate agreement with the states and territories. But the main aspects of the 2018 arrangements were:
A floor on WA’s GST relativity, initially at 0.7, rising to 0.75
Explicitly linking WA’s GST relativity with the fiscally stronger of New South Wales and Victoria (currently New South Wales)
Maintaining, in the background, calculations of what other states would have received under an unchanged formula, with the Commonwealth compensating them for the difference, under a no-worse-off guarantee.
The second element supersedes the first. WA’s relativity is effectively pegged to that of NSW at around 0.82 – well above the notional floor of 0.75.
There was arguably some precedent for top-up payments. In the early days of the GST, some states were left temporarily worse off, once they had abolished agreed state nuisance taxes. Those states received Budget Balancing Assistance – effectively a Commonwealth top-up – to ensure they were no worse off.
But 8 years on, the 2018 deal has some big problems. One is cost. The reforms were originally expected to cost the Commonwealth about $5 billion by 2024-25 but have ended up costing almost $23 billion. The iron ore price has stayed higher for longer, which increases the fiscal cost to the Commonwealth of the no-worse-off guarantee – effectively compensating states for the cost of keeping WA’s relativity higher than it would otherwise be.
Arguably, this fiscal cost to the Commonwealth is not the true economic cost. First, the money is really a transfer from one level of government to another. Second, a true notion of cost – in the economic sense – involves a comparison with a plausible alternative, or counter-factual. For the reasons already outlined, that counter-factual is not zero. The Federal Government was always going to do something about the WA situation.
Nonetheless, it is clear that the 2018 arrangements were designed to deal with a temporary shock (the fall in WA GST share due to surging royalties). Now they are being used to address something more like an ongoing structural feature of the Australian economy (still high prices and big increases in production volumes).
The second problem is that it leaves Australia’s equalisation system in an awkward no-man’s land. There is a strong case to be made for Australia’s traditional system of full equalisation. There is also a case which can be made (and some have) for something more partial, which would soften, but not eliminate, differences in fiscal capacity between states. Perhaps this could spur greater competition between states in some areas. The problem is that our post-2018 system effectively does neither. It simply equalises to 2 standards – one level for WA and one level for everyone else.
The third problem is mechanical. As the PC points out, by pegging WA’s relativity to that of NSW, all sorts of anomalies arise. A natural disaster in NSW, which temporarily hurts its fiscal capacity, would result in more money for WA. The system has always involved complex interactions, but this takes it to a new level.
What would a ‘solution’ look like?
It’s messy. Of course, there is one scenario in which the problem fixes itself. If the iron ore price fell dramatically towards early 2000s levels, then WA’s relativity would naturally rise, independent of the 0.75 floor or the NSW peg. Full equalisation could be restored, but other states would not win from this – their underlying relativities would fall, and so too the no-worse-off payments from the Commonwealth (if continued). The Commonwealth would win from reducing the no-worse-off payments but lose from the loss of company tax revenue from a lower iron ore price. Australians would be poorer.
Effectively this is the argument made by those who point out that the Federal Government has a natural hedge (tax revenue) against the no-worse-off payments: both are high when the iron ore price is high. A significantly lower iron ore price solves one problem at a big overall cost. We should be careful what we wish for.
Absent that scenario, we are back to square one: run the gauntlet of WA public opinion or come up with an alternative to address the biggest weaknesses in the 2018 deal.
The key point is that in the world of grown-up policy making, there is no perfect solution that solves for all these things. If we are to find a way forward, we must start with the acceptance that it will involve imperfect steps toward something a bit better than what we’ve currently got.
What follows is imprecise, and by no means a fully developed policy response. More a sketch of some contours.
First, it is probably time to break the nexus with the GST. Linking general grants to the states with the GST revenue was a key design feature of the 2000 tax reforms. It was a shrewd move that served multiple purposes at the time. One was to clearly define the amount of money being handed to the states, limiting the Commonwealth’s fiscal exposure. It gave then Treasurer Peter Costello a perfect response to any proposed change to the equalisation formula: come back to me when all States agree. They never could, given the fixed and well-defined sum that was being divided. A second feature was that it made amending the GST legislation (which requires state and territory assent) very hard, giving taxpayers greater assurance that the rate would not rise nor the base expand.
But today, the introduction of no-worse-off payments and other top-ups to the pool has effectively broken the GST link. The Commonwealth’s fiscal exposure is larger than just GST revenue and it is, in principle, open ended.
Moreover, the requirement to pass all GST revenue to the states has become a barrier to sensible discussion about GST reform, whether about the rate or the base.
In place of GST revenue, we could redefine the pool of Commonwealth grants on an expanded basis. One approach would be to add together the current GST revenue with the total of specific purpose (tied) grants to the states, roughly doubling the total. This number could be indexed to GDP growth each year and locked in as the guaranteed total amount that the Commonwealth will grant to the states.
This would largely replicate what tends to happen in practice but would provide greater certainty. It would take the financial sting out of Commonwealth-state negotiations over tied grants, since the total payments to states would be already determined.
In effect, it would effectively untie the money associated with existing agreements, which would be a significant step. In reality, much of what the Commonwealth thinks of as tied money, isn’t really. Formalising this means Commonwealth-state agreements could focus more on the substance of cooperative effort between governments, closer to the spirit of the 2008 reforms to inter-government relations.
Equalisation would be applied over the whole pool, as it effectively is now. But this would convey a more realistic account of how much each state receives relative to an equal per capita share. For example, WA already roughly gets its per capita share of tied grants. Even if we used the GST relativity applying to WA under the old system (0.24), the state would still receive more than 60 per cent of its per capita share of total Commonwealth grants.
For pragmatic purposes, if a floor is to be applied, it should really be based on a state’s share of this total aggregate pool of Commonwealth grants. This would be more logical and defensible than a numerical floor on a state’s share of GST revenue, which is but one component of total Commonwealth funding. It is also more defensible than pegging one state’s relativity to that of another.
The biggest question is whether such an arrangement could amount to a sustainable political equilibrium. Federal Governments will generally have a desire to tie state grants to specified uses or projects, and states will generally have a desire for more money. So there are gains from trade – and an incentive for the Commonwealth and individual states to make side deals outside this enlarged pool. Even if that happened, would we be worse off than we are today?
Can we fix it?
The PC interim report is a strong rebuttal of the post-2018 arrangements. It also usefully busts some of the bigger myths about fiscal equalisation (that it rewards poor performance, for example).
In the near term, WA will secure the continuation of the existing arrangements, because it has the political leverage to do so. But political leverage, like mining booms, doesn’t last forever. WA’s long-term interests might be better served by being part of a process to find workable improvements on the current system – a more sustainable, and conceptually defensible, set of arrangements for distributing Commonwealth grants.
Other states would need to show similar flexibility. Large states that have traditionally argued for an equal per capita distribution would do better to drop that position, which is politically infeasible and intellectually dubious, and defend the principle of fiscal equalisation. A narrow change is unlikely to work, because of the ‘6 Premiers (and 2 Chief Ministers), one bucket’ problem. So this could be a case where a bigger reform stands a better chance than a small one. But the history shows there is no clean way out; just imperfect options requiring pragmatism and some lateral thinking.
Michael Brennan is the CEO of the e61 Institute. He is an experienced economic policy professional, having been a former Chair of the Australian Productivity Commission and Deputy Secretary of the Australian Treasury. He has also worked as a Deputy Secretary in the Victorian Treasury, and as a consultant as well as an adviser to Federal and State Treasurers and Ministers for Finance.