8 Australia

Teresa Ter-Minassian
Published Date:
September 1997
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Jon Craig

The Australian federation is distinguished by a large vertical imbalance between revenue and expenditure assignments at the national and subnational level. The central government raises about 70 percent of total public sector revenue but undertakes only about half of public sector expenditures. The resultant “vertical gap” at the state and local government level is filled by grants and loans from the center. The federation also allows state, territory, and local governments and their public enterprises to borrow on their own account, subject to guidelines set jointly with the central government.

While this relatively centralized fiscal system has acted to strengthen the capacity of the central government to implement required stabilization policies, fiscal developments at lower levels of government have occasionally complicated economic management. Some commentators have also argued that the Australian federal system has created disincentives to the introduction of essential structural reforms by subnational governments, as well as wasteful overlap and duplication of services. The Australian authorities have taken new initiatives to tackle these perceived weaknesses, including a medium-term fiscal framework designed to better coordinate fiscal policies and hence permit the public sector to make a contribution to national saving objectives. Although there has been an extensive debate recently about the equalization arrangements in the federation, reviews at the political level suggest that they will continue for the time being.

Structure of Government

The Australian federation was formed in 1901. It comprises the commonwealth government plus the six original colonial state governments and two self-governing mainland territories. There are also about 900 local government bodies.

The Constitution underpinning the federation defines relatively few exclusive powers for the central government, one of which is the power to levy customs and excise duty. However, it does prescribe a number of powers that the commonwealth can exercise concurrently with the states and in which its laws would prevail in the event of a conflict. These powers include defense, taxation, foreign affairs, social welfare benefits and pensions, post and communications, currency, and banking and insurance. Section 96 of the Constitution gives the commonwealth parliament power to make grants on terms and conditions as it sees fit, and the commonwealth has used this power to influence subnational expenditure patterns and administrative priorities and, partly through them, macroeconomic stabilization policy generally.

The six original colonial states, which joined together to construct the original Constitution, retained residual (exclusive) legislative responsibility for a number of service areas including law and order, education, health, housing and urban development, road and rail transport, provision of electricity, gas and water, and a number of industry functions. The Constitution gives no formal recognition to the role of local government, and this level of government falls under state legislative control.

In fiscal and other intergovernmental matters, the two mainland territories—the Northern Territory and the Australian Capital Territory—receive state-like treatment. However, these territories can only attain full statehood by a majority vote of the existing states.1

Current Arrangements

In addition to their general government activities, the national and subnational governments operate both nonfinancial and financial public enterprises. In the national accounts, the consolidated public sector is defined to include the general government sector plus the net operating surplus of nonfinancial enterprises; the operations of public financial enterprises are excluded.2

Expenditure Assignments

As Figure 1a shows, the consolidated commonwealth sector is responsible for just over half of the total public expenditure in Australia and the state government sector for the bulk of the remaining share.

Figure 1.Australia: Composition of Public Expenditure, 1992/93

(In percent)

Sources: Australian government budget papers (various issues); Australian Bureau of Statistics, “Government Financial Estimates” (various issues), ABS Catalogue No. 5501; and IMF staff estimates.

Social welfare and health spending dominates the commonwealth sector’s own expenditure budget. Defense also remains an important item, although it has declined relative to GDP over the last decade (see Figure 1b). Of course, the pattern of total spending is different, since the commonwealth also makes large grants to subnational governments for education, health, transport, housing, and social security (see next section).

State government own expenditures are closely aligned with the residual constitutional powers of this level of government—education, health services, housing and community amenities, law, order, and public safety, transport and communications, and social services (see Figure 1c).

Local governments have been given a significant role in the provision of transport services (mainly roads and public transit services), recreational and cultural facilities, and housing and community services such as the provision of local roads and parks (see Figure 1d). About 350 local councils operate nonfinancial public enterprises delivering services such as water, electricity distribution, and transport.

Tax Assignments

Figure 2a shows the dominant position of the commonwealth government sector in total public sector revenues.

Figure 2.Australia: Sources of Own Revenue, 1992/93

(In percent)

Sources: Australian government budget papers (various issues); Australian Bureau of Statistics, “Government Financial Estimates” (various issues), ABS Catalogue No. 5501; and IMF staff estimates.

The commonwealth’s dominance flows from its control of the four major sources of national tax revenue—personal income tax, customs and excise duties, company income tax, and sales tax. Those arrangements flow, in turn, from the commonwealth’s constitutional responsibility for customs and excise and the transfer of the right to levy income tax to the commonwealth government during World War II. Almost 90 percent of commonwealth revenue comes from taxation (see Figure 2b), with company and personal income taxes contributing over 60 percent of total revenues, and taxes on goods and services a further 23 percent.3

Commonwealth grants and advances constitute about 40 percent of state government sector revenue (see Figure 2c). Tax revenues, which also constitute about 40 percent of total revenue, come from a number of diverse sources. Payroll taxes constitute the largest single source; the remaining tax bases are relatively small, comprising taxes on property—which include stamp duties and land taxes—and a number of indirect taxes—including so-called franchise fees that closely resemble the commonwealth’s excise duties, as well as taxes and fees on motor vehicles and gambling and insurance. The tax bases are similar in every state, although the tax rates and base definitions on similar items can vary substantially.

The net operating surplus of state nonfinancial public enterprises accounts for about 12 percent of state revenue. This share is greater than for the commonwealth, and reflects the broad scale of activities undertaken by the state enterprises.

Levies (rates) on residential property provide over half of local government revenue (see Figure 2d). Local governments also rely heavily on transfers from both the state and commonwealth governments, which together contribute close to 30 percent of their revenue. About 80 percent of the state sector payments to local government constitutes the passing on of funds received from the commonwealth. Local governments also raise significant revenues from the various enterprise services they provide (for example, garbage collection services and electricity distribution).

Grants and Advances

Composition of Grants and Advances

Given Australia’s considerable vertical imbalance, grants and advances from the center have played a relatively larger role than in similar federations, such as the United States and Canada. The estimated breakdown of these payments in 1997/98 is shown in Figure 3a. Almost all payments are now made in grant form. Over 50 percent of the payments are made in the form of specific purpose (functional) payments to the states, the bulk of which are used by the states themselves but some are simply passed “through” the states, which act as administrative agents, to other recipients (such as universities and local governments) (see Figure 3b). The remaining payments are general purpose payments, mostly in the form of revenue (current) grants to state or local governments. Payments to the subnational governments now total about 8 percent of GDP (Table 1).

Table 1.Australia: Commonwealth Payments to Subnational Government(In percent of GDP)
Total grants8.
Of which: current7.
Of which:
To states
General purpose3.
Of which: financial assistance grants3.
Specific purpose3.
To states1.
Through states1.
To local governments0.
Net advances−0.7−0.3−0.5−1.0
Total net payments6.

Figure 3.Australia: Grants to Subnational Governments

Sources: Australian Government budget papers(various issues); Australian Bureau of Statistics, “Government Financial estimates”(various issues), ABS Catalogue No. 5501; and IMF staff estimates.

Note: NSW = New South Wales; VIC = Victoria; QLD = Queensland; WA = Western Australia; SA = South Australia; TAS = Tasmania; ACT = Australian Capital Territory; and NT = Northern Territory.

General purpose payments to the states and to local governments are made for both recurrent and capital purposes, usually on an unconditional basis. The largest payment to the states is channeled through so-called financial assistance grants, which have generally been set by reference to formula. At present, financial assistance grants are set by reference to actual movements in consumer prices and population.

General purpose recurrent grants to local governments have been made since 1974/75. Grants are determined using a discretionary growth factor each year that tends to yield increases in payments similar in magnitude to those granted under financial assistance grants.

Commonwealth capital grants to the states now consist of relatively small urban development payments, which are distributed according to achievement of performance targets. The former system of capital grants made under the Loan Council arrangements (see below) was abolished in 1993–94. No general purpose capital payments are at present made directly to local governments.

Specific purpose payments cover a wide range of payments made by the commonwealth in pursuit of national policy objectives. They cover both recurrent and capital needs. Most specific purpose payments are subject to conditions on the related state expenditure. In general, these conditions fall into four categories:

• General program requirements, such as the requirement that states provide free public hospital treatment to Medicare patients (that is, those without private insurance) in return for grants made for hospitals.

• Requirements that the payment be spent for a specific purpose, or be passed on to other entities, including universities and nongovernment schools and to local governments.

• Agreements covering service provision and program delivery mechanisms.

• Detailed conditions on the operation of joint expenditure programs, including program or project approval, arrangements for matching contributions, and information requirements.

The main functional expenditures financed by specific purpose payments are education, health, and housing (see Figure 3c and Table 2).

Table 2.Australia: Gross Specific Purpose Payments
(In millions of Australian dollars)
General public services252.00276.00293.00
Public order and safety124.00130.00131.00
Social security and welfare561.00894.00942.00
Housing and community amenities1,000.001,044.001,028.00
Recreation and culture28.0023.0027.00
Fuel and energy10.003.002.00
Agriculture, forestry, and fishing252.00140.00227.00
Mining, manufacturing, and construction15.0018.0022.00
Transport and communications1,885.001,059.00848.00
Other economic affairs100.0046.0039.00
Other purposes2,130.001,625.001,698.00
(Share of total specific purpose payments; in percent)
General public services1.471.651.72
Public order and safety0.720.780.77
Social security and welfare3.275.365.53
Housing and community amenities5.836.266.03
Recreation and culture0.160.140.16
Fuel and energy0.060.020.01
Agriculture, forestry, and fishing1.470.841.33
Mining, manufacturing, and construction0.090.110.13
Transport and communications10.986.354.98
Other economic affairs0.580.280.23
Other purposes12.419.749.96

Most specific purpose payments are indexed for inflation. A review by the Department of Finance in 1995 sought to simplify existing arrangements by developing four “cocktail” indices that combine standard wage and nonwage indices according to different weighting formulas. Each specific purpose payment will be assigned one of the cocktail indices.

The basis of allocation of specific purpose payments among the states varies. Some payments are influenced by historical patterns set when they were negotiated; others are based on the commonwealth’s perception of need (for example, hospital funds are distributed on a per capita basis, weighted according to age and sex), while others (such as public housing) are distributed on an equal per capita basis.

Equalization Arrangements

The concern to ensure horizontal equity among the states has long been a distinguishing feature of the Australian federation. This concern arose initially out of dissatisfaction by the states with the financial arrangements instituted after the federation was set up in 1901 and culminated in the establishment in 1933 of a permanent and independent authority—the Commonwealth Grants Commission (CGC)—to assess the claims of the states.

The assessment processes followed by the CGC have changed considerably in both scope and technique since its initial establishment. The present task of the CGC involves making assessments as to the allocation among the states of a large pool of general revenue grants estimated to amount to about 4.5 percent of GDP in 1995/96.

The CGC operates under terms of reference set by the commonwealth after consultation with states and territories. The CGC’s investigations aim to determine relative needs according to the principle “that each State should be given the capacity to provide the same standard of state-type services as the other states, if it makes the same effort to raise revenues from its own sources and conducts its affairs with the same operational level of efficiency.”

The assessment procedures followed by the CGC are very comprehensive. The assessment of the relative fiscal capacities of states and territories encompasses both revenue-raising capacities and expenditure needs. The assessments are carried out using a representative (or standard) budget that defines the revenue and expenditure items over which the measurement of equalization needs is to be made. National “financial and policy” standards are then calculated for the revenue and expenditure items in the representative budget and objective indicators are used to measure the relative revenue-raising capacities and expenditure needs of each state. The assessment process culminates in the recommendation of an index of relative needs (“relativities”) that, when weighted by estimated population in each region, provides a basis for allocating the general purpose grant.

The different allocation criteria used for distributing specific purpose payments (described above) can create difficulties for the CGC in assessing the distribution that should apply to general revenue grants. Since the CGC is charged with examining all sources of revenue for the states in its equalization exercises, including specific purpose payments from the commonwealth, any relative advantage or disadvantage to a particular state or territory conferred through specific purpose payments must be taken into account in the calculations. The most frequent methods used by the CGC have the effect of clawing back any advantage or disadvantage conferred by specific purpose payments.4 To resolve this potential conflict, the commonwealth has sometimes instructed the CGC to assess relativities on the assumption that existing specific purpose payment distribution patterns are maintained. For example, funds provided to South Australia under a recent financial assistance package (in the wake of large financial losses suffered by public financial institutions in that state) were excluded from the CGC’s assessment, to ensure that the benefit of this package was not fully clawed back through CGC assessment of a lower financial assistance grants allocation to that state.

The CGC undertakes a major review of the relativities every five years, with updates in intervening years. The recommendations by the CGC are usually—but not automatically—accepted by the commonwealth and state governments involved.

The extent of redistribution involved in the equalization process can be seen in Figure 3d, which shows the amount by which the recommended grants in 1995/96 exceed (or fall short of) those that would be paid if each state simply received an equal per capita grant.5 As can be seen, substantial funds are reallocated away from the larger states of New South Wales and Victoria with South Australia, Tasmania, and the Northern Territory being the largest beneficiaries.

General purpose grants to local governments are paid to each state on an equal per capita basis. Each state government maintains a separate grants commission to determine the allocation of these funds among their local governments. These commissions, which are entirely independent of the CGC, base their recommendations on equalization principles, subject to constraints set out in the commonwealth legislation (including a provision that all local authorities should share in the grant).


A distinctive feature of Australia’s federal fiscal arrangements is the Loan Council, a body for coordinating and controlling borrowing by all governments.6 Initially, the Loan Council operations covered only general government operations, specifying that all borrowing for this sector should be undertaken by the commonwealth government in its own name and then passed on to the states. However, the controls structure was extended, under the so-called Gentlemen’s Agreement in 1936, to cover limits on public enterprise borrowing.

The original arrangements continued with only small variations until 1984, when reforms were introduced directed to enable the states to take greater responsibility for their own borrowing. Under the new approach, states began borrowing to finance their budgets and became responsible for refinancing those securities and loans previously raised by the commonwealth on their behalf. In an attempt to retain control of subnational borrowing, global limits were placed on overall public sector borrowing, including the borrowing of public enterprises and local government authorities. Although initially successful, increased use of sophisticated financing techniques by the states (such as sale and leaseback arrangements) saw the intended controls circumvented to such an extent that the global limits approach was abolished in 1992/93.

In its place, the Loan Council has adopted procedures that seek to introduce transparent macroeconomic controls on the overall operations of the public sector. Under the new arrangements, the commonwealth and each state government will present to the Loan Council its net financing requirement for the coming financial year. These so-called Loan Council allocations cover the estimated general government balance and certain memorandum items.7 These proposals are considered by the Loan Council, taking into account each jurisdiction’s fiscal position and reasonable infrastructure needs, as well as the macroeconomic implications of the aggregate picture revealed by the Loan Council allocations. If an adjustment is required to meet national macroeconomic objectives, the nature of the adjustment and its allocation across governments will be negotiated within the Loan Council. If questions are raised about the fiscal strategy of any government, further justification for its financing request may be made, and the Loan Council can ask the government concerned to modify its strategy.

The new arrangements are accompanied by more stringent reporting requirements that enable up-to-date monitoring of net financing and debt. If a member becomes aware that it has exceeded, or is likely to exceed, a 3 percent tolerance level in either direction from its endorsed Loan Council allocation, it is obliged to provide an explanation to the Loan Council. This explanation will be made public. While the Loan Council would not be empowered to formally approve the change, it would have the opportunity to pursue any concerns raised by the change in the Loan Council allocation.

Since 1994/95 the arrangements incorporate two important innovations. First, the Loan Council allocations include allowance for public sector risk exposures to infrastructure projects with private sector involvement. Risk exposure calculations are undertaken for all projects with a life of ten years or longer that involve direct provision of services to a public sector entity or the underwriting by the public sector of services provided directly to consumers. The impact is calculated by applying a risk weight to the contingent liability that a project creates for a government. The risk weight is based on project gearing and volatility, and the length of the contract period over that the government faces penalty provisions.

Second, special adjustments are introduced for overfunding or underfunding by governments of the employer component of public sector superannuation scheme liabilities. Briefly, overfunding of the annual cost is to be treated as a form of saving and not as an addition to the Loan Council allocation, even though it may add to the measured deficit. By contrast, underfunding will be treated as a borrowing against Loan Council allocations. The adjustments involved will be handled through memorandum items in the Loan Council allocations calculations.

The initial experience with the new Loan Council allocation approach has been broadly satisfactory, and it appears that the publication of debt details has assisted greater market discipline on borrowing. Developments in borrowing and debt are discussed below.

Administrative Structures

Tax Administration

The commonwealth, state, and local government taxation systems are administered by separate entities. The Australian Taxation Office administers all the major taxes imposed by the commonwealth government, while the state and local governments maintain a number of smaller agencies to administer their taxes and fees. There is no legislative provision for exchange of information between authorities at different levels of government.

Budget Preparation and Implementation

The preparation and execution of budgets by the various levels of government are also conducted by separate agencies. At the commonwealth level, two agencies are involved, the Australian Treasury and the Ministry of Finance. The former has overall macroeconomic policy responsibilities, including the development of overall budget parameters, detailed intergovernment financial policies, and taxation policies, while the latter specializes in expenditure analysis and control.

Separate state treasuries administer state policies, and local governments also maintain their own systems for budget and financial management.

Although one might expect that Australia’s federal structure adds to the overall difficulty of formulating and implementing fiscal policies, particularly at the subnational level, several practical efforts have been made to alleviate these problems. First, the budget calendar is carefully arranged so that as many decisions as possible can be made in a sequential order. Thus, the Premiers’ Conference and Loan Council meetings between the commonwealth and the states normally take place about two months prior to the presentation of the commonwealth’s annual budget and up to six months before the state budgets are introduced. As a result, the resolution of most commonwealth and state financial issues is known well in advance of other budget issues, leaving ample time to make other fiscal adjustments as required. Second, the planning arrangements surrounding grants involve a degree of predictability for a large portion of the commonwealth payments to the states. This is particularly true for education and similar specific purpose payments that are formulated on a multiyear basis. The recent decision by the commonwealth to provide a real terms guarantee for financial assistance grants for the three years to 1996/97 has also improved the ability of state officials to forecast the resources available from the commonwealth for their budgets.

Nonetheless, the introduction of the National Fiscal Outlook program (see next section) has potential to significantly alter the budget preparation procedures followed by each of the participants within the federation, since it places emphasis on coordination of fiscal actions by the various governments within a macroeconomic framework.


Macroeconomic Management

Macroeconomic management is primarily the responsibility of the commonwealth government in Australia, but it is recognized that successful stabilization policy requires intergovernmental cooperation. Changes in the commonwealth’s own account taxes and spending, the level of grants paid to subnational governments, and changes in the access of subnational governments to borrowing are important means by which the commonwealth can seek to influence the overall stance of fiscal policy. However, the state and local governments still maintain a considerable degree of independence in budgetary decision making, flowing from their own substantial sources of revenue. Correct prediction of the likely response of these subnational governments to both economic developments and the commonwealth’s own policies is therefore very important in assessing the overall impact of public sector activity.

Although the various levels of government may be expected to work cooperatively over time to achieve satisfactory macroeconomic outcomes, the experiences of the late 1980s and early 1990s have served to demonstrate the difficulties of operating fiscal policy within the Australian federal structure.

With the exception of a brief downturn in 1985/86, the Australian economy experienced relatively rapid growth and falling unemployment in the period from 1982 to 1989. This necessitated a relatively restrictive fiscal policy, and the public sector requirement moved from an “underlying deficit” of 7 percent in 1983/84 to an overall surplus of almost 2 percent in 1988/89 (Figure 4a).8 Although this change was assisted by a marked reduction in state borrowing, the bulk of the adjustment fell on the commonwealth government sector (Figure 4b). While the commonwealth benefited from rapid growth in its revenues, substantial constraint on own account expenditures and grants to lower level governments was also required. However, during much of this period, subnational governments also experienced a strong growth in their own revenues partly because of robust employment growth (affecting payroll taxes) and a boom in asset prices affecting property and capital asset taxes. As a consequence, subnational expenditures, particularly recurrent expenditures, did not fall substantially relative to GDP during much of the period, notwithstanding the attempt by the commonwealth to restrain grants payments (see Figure 4c). In other words, it can be argued that stabilization efforts may have been less effective than they would otherwise have been because the impact of the cycle enabled subnational governments to sustain a more expansionary policy than might otherwise have been possible.

Figure 4.Australia: Nonfinancial Public Sector Operations

(In percent of GDP)

Sources: Australian government budget papers (various issues): Australian Bureau of Statistics, “Government Financial Estimates” (various issues), ABS Catalogue No. 5501; and IMF staff estimates.

After the downturn in 1989, opposite pressures came into effect. The collapse of the asset price boom had a particularly significant impact on subnational revenues, and some of the state governments sustained large losses in their overextended state-owned financial institutions. Recession-related demands on subnational expenditures were also substantial, and the ratio of expenditures to GDP rose slightly in the period to 1992. Although a number of subnational governments found themselves constrained by falling debt ratings, their deficits and debt levels rose initially with the total state underlying deficits pushing back up to almost 1 percent of GDP. Meanwhile, the commonwealth found its own revenue growth faltering and demand for its own expenditures, particularly on employment-related activities, rising. The commonwealth also found itself under pressure to assist states with their weakened budget positions. As a consequence of this dual pressure on its finances during the recession, the commonwealth underlying deficit blew out to close to 4 percent of GDP by 1993.

In the subsequent economic recovery, the states have brought about a significant turnaround in their fiscal situation by increasing their own source revenues (chiefly by raising taxes on existing tax bases but also by tapping new tax bases, such as gambling) and by curtailing expenditure growth (with significant reductions in numbers of public employees). They have also embarked on substantial privatization programs. Their underlying balances were in surplus by 1996, and with state debt continuing to fall. By contrast, efforts to stabilize the commonwealth financial position appeared to lag those of the subnational governments—with commonwealth own account expenditure and debt rising through the period to 1996. Overall general government debt rose substantially in the period to 1995 but has since stabilized (Figure 4d).

With Australia’s external debt at high levels, there is a continuing need to generate higher savings in the public sector which, in turn, requires improved cooperation and coordination of fiscal policies at the national level. A recognition of these needs led the commonwealth and the states to embark on joint forecasting and budget planning exercises in 1992. These forecasts were embodied in the preparation of a National Fiscal Outlook document that sought to define a medium-term framework for fiscal policy formulation. Subsequently, it has been successively updated and the published data for the 1997 exercise are shown in Table 3.

Table 3.Australia: National Fiscal Outlook; 1997 Version
1996/97 Estimated1997/98 Projected1998/99 projected1999/2000 Projected
(Percent change)
Economic assumptions
Real GDP3.503.503.503.50
Consumer prices1.501.752.502.50
(In percent of GDP)
Fiscal aggregates1
Commonwealth general government25.2024,7024.7024.90
States general government15.2014.4014.0013.60
Of which: commonwealth transfers8.207.907.707.40
Own source revenue7.006.506.306.20
Commonwealth general government27.025.3024.9024.40
States general government15.2014.3013.8013.40
Underlying balance 2
Commonwealth general government−1.80−0.60−0.200.50
States general government0.
Total general government1.700.500.000.80
Source: National Fiscal Outlook, report to the Premiers’ Conference, 1997.

Figures exclude asset sales and commonwealth advances to the states.

The underlying deficit is defined as expenditures (excluding net advances) less revenue. Net advances include new policy lending and net equity injections. Revenues from privatizations are thus excluded.

Source: National Fiscal Outlook, report to the Premiers’ Conference, 1997.

Figures exclude asset sales and commonwealth advances to the states.

The underlying deficit is defined as expenditures (excluding net advances) less revenue. Net advances include new policy lending and net equity injections. Revenues from privatizations are thus excluded.

Structural Reform

In addition to the need to boost national savings, the Australian authorities have recognized a need to implement a broad range of structural reforms to boost the nation’s productivity performance. The system of intergovernment finances has potential to influence success in a number of important structural issues.

Some of these structural issues stem directly from the large vertical imbalance within the federation. Commentators have identified five related problems flowing from this imbalance:

  • Reduced accountability by subnational governments to their electorates.

  • Duplication and overlap in provision of service.

  • Excessive conditionality on payments from the commonwealth.

  • Inhibition of taxation reform.

  • Slow implementation of microeconomic reforms.

The commonwealth government has made periodic efforts to tackle these issues. In the second half of the 1970s, the government legislated to give the states the right to impose their own personal income tax—which would have piggybacked on the commonwealth tax (as is done in Canada). However, the subnational governments failed to take up the offer with one premier remarking that “the only good tax is a commonwealth tax.” Subsequently, the commonwealth agreed to return a fixed share of the proceeds from personal tax, and later a (different) share of the proceeds of all taxes. None of these arrangements survived.

In 1990, the commonwealth launched a proposal for a “closer partnership” with the states that would address the narrowness of the subnational tax base, the conditionality of specific purpose payments, and questions of overlap and duplication.

Some limited progress was made, particularly on the last issue. However, the closer partnership foundered on the unwillingness of the commonwealth to cede any of its control over broader-based taxes or to provide longer-term guarantees to the subnational governments of a fixed share of commonwealth taxation. The need to retain control over macroeconomic policy was cited as the reason for this stance.

Many of the major problems identified in the closer partnership dialogue therefore remain.

Accountability of state governments does not appear to be as strong as in some other federations. In particular, there is a tendency to blame the commonwealth for failures in areas where states have primary service responsibility but funds are provided predominantly by the commonwealth.

State tax reform has been inhibited. State government reports—chaired by Collins (1988) and Nieuwenhuysen (1988)—and other commentators have suggested that state taxes tend to be regressive and to distort incentives.9 They are narrowly based, subject to variable rates on similar transactions, and involve high costs of compliance. There is also a lack of harmonization in both tax rates and bases across states. In past years, the commonwealth has transferred some taxes to the states—including the payroll tax (1971) and the bank account debit tax (1990/91)—however, these have not had a large impact on state revenue-raising capacity. States face both constitutional and practical restrictions on moving toward more neutral and broad-based systems. In particular, section 90 of the Constitution and associated High Court rulings have been taken as denying the states the capacity to impose taxes on “the manufacture, production, sale or purchase of goods” (Walsh, 1991).10 These legal restraints are seen as one reason why the states have not attempted to introduce a broadly based sales tax or attempted to impose sales taxes on the largely untaxed service sector in Australia. However, there is also a more general issue as to the practicability of states extending their sales tax bases while the commonwealth has occupied the predominant position in this field. Australia does not possess a broadly based VAT. However, there has been considerable discussion about the desirability of implementing such a tax at the national level, and this may have deterred the states and territories from efforts to extend their indirect taxes.

So long as the commonwealth holds national spending priorities that differ from those of the states, some conditionality cannot be avoided. However, some have argued that the conditions imposed in the past were often overly intrusive and sometimes interfered with the efficient provision of services. There has been some reduction in conditionality (there are few stringent “matching” requirements nowadays). However, some commentators have argued that the conditionality has simply become more sophisticated, not less intrusive. For example, influence can be exerted through a joint planning structure; new untied grants may come with requirements for bilateral negotiations about the purposes for which they will be used; and performance criteria (focusing on outputs) have been introduced for some programs in place of tied funds.

In February 1995, the Australian National Audit Office (ANAO) completed a critical review of the administration of specific purpose payments. The ANAO recommended the introduction of the following:

  • Measures to strengthen incentives for greater efficiency of programs, including the identification, measurement, and sharing of potential savings in projects.

  • In programs where there is a matching requirement, a more detailed specification of the commonwealth’s requirements in order to assist states to promote more precise program performance measures.

As noted, there has been progress in the identification and rectification of possible areas of overlap and duplication in the provision of public services. The Council of Australian Government (an intergovernmental body) undertook a major review of arrangements involving areas of shared responsibility, and this has led to some clarification of the roles and responsibilities of commonwealth and subnational governments. For example, the commonwealth withdrew from funding of arterial roads in 1993 and decided it would henceforth restrict its funding to national highways. The amount formerly paid for arterial roads through specific purpose payments was added to the general assistance payments.

The focus of recent intergovernment reform debate has moved to the impact of present taxation and grant arrangements on the incentive of the states to introduce structural reform. This debate has stemmed from the observation that structural reform undertaken by subnational governments should act to boost national production and welfare, but the rewards may flow predominantly to the commonwealth owing to its control over the main taxation instruments. Unless the commonwealth agrees to pass on a portion of any increased revenue generated from higher national output in the form of grants, the states’ incentive to participate in such reforms may be diminished (Walsh, 1991).

Two aspects have received particular attention. First, the commonwealth and the states agreed to implement a National Competition Policy recommended by an independent commission headed by Professor Hilmer. The so-called Hilmer report made recommendations to address six major concerns: extension of the existing anticompetitive conduct legislation to cover the unincorporated sector and state government business activities; a review of unjustified regulatory restrictions on competition by governments; development of a set of principles to govern the operation of public monopolies, including proposals mandating separation of regulatory and business functions where competition is introduced into a market previously supplied by a public monopoly; establishing a legally based “access regime” for essential infrastructure facilities that cannot be duplicated economically; restraints on monopoly pricing; and fostering “competitive neutrality” between government and private businesses.

The implementation of these reforms was made difficult by actual and perceived differences in the costs and benefits of reform. While the national, and each subnational, government stood to gain from greater efficiency, some state governments also faced the loss of monopoly rents. Accordingly, in return for agreement by state governments to a clear timetable for reform, in 1994/95 the commonwealth agreed to provide phased compensation payments to the states, conditional on their making satisfactory progress on the agreed reforms.

The reforms are expected to have a substantial impact in five areas of public sector activity, several of which are predominantly under the control of subnational governments: electricity, natural gas, water, telecommunications, and air, sea, rail, and road transportation.

There has also been the question of the consistent taxation treatment of public trading enterprises at different levels of government and the budgetary impact of subsequent action to privatize such enterprises. Historically, publicly owned trading enterprises at both the commonwealth and state level have been exempt from the commonwealth’s wholesale sales taxes. The state level enterprises have also been exempt from commonwealth corporate income tax. However, such corporations were widely expected to make higher dividend contributions to the budget to compensate for their preferred treatment. Action to privatize such enterprises therefore had the effect of bringing them within the commonwealth’s tax net with direct implications for state revenues via both lost dividend revenue and a reduced sale price.

At the 1994 Premiers’ Conference, it was agreed that states will collect tax equivalent payments directly from their wholly owned trading enterprises, while the commonwealth will continue to collect tax from partially privatized state level enterprises and will comprehensively apply the company income tax and wholesale sales tax to its own trading enterprises. Key elements of the agreement are:

  • The commonwealth will amend tax legislation to ensure that wholly owned state level enterprises will be exempt from the company income tax and the wholesale sales tax.

  • The states will impose a tax equivalent payment on their wholly owned state level enterprises that is uniform among states and matches the commonwealth’s tax system.

  • Compensation will be provided on a case-by-case basis to ensure that neither the commonwealth nor the states are disadvantaged by the arrangements.

It has been estimated that the amendments to commonwealth legislation will impose a cost of at least $A 680 million a year (about 1.5 percent of GDP) to the commonwealth budget.

These decisions on taxation of public enterprises follow earlier decisions to allow states to impose payroll and other tax and charges on commonwealth public enterprises and should have the desirable effect of creating a more level playing field for competition between public and private enterprises.

In addition to these vertical balance issues, there has been a renewed focus on horizontal balance issues. There are two elements to this debate.

First, notwithstanding considerable simplification efforts by the CGC itself, the assessment measures used in the calculation of per capita relativities have come under sharper scrutiny. In particular, there is debate about the appropriateness of methods of assessing location-specific disabilities, such as dispersion factors, administrative scale factors, urbanization factors, and the possible use of global rather than tax-by-tax assessments of revenue capacity.

Second, there has been a debate about the impact of equalization payments on economic efficiency. On the one hand, some authors (for example, Swan and Garvey, 1992) have suggested that such payments lower potential GDP growth (by discouraging labor from moving from locations where its marginal product is low to places where it is high and diverting funds from more “efficient uses” in those states with higher fiscal capacities), while others (such as Petchey and Walsh, 1993) support such payments on the grounds that they avoid “publicly induced migrational inefficiency.” This debate (which finds a counterpart in Canadian literature) remains unresolved.11

The focus has been on the CGC’s analysis of locational disabilities (including factors such as measures of population dispersion) that tend to lead to higher assessed needs for less populous, more far-flung states and territories within Australia.

Although the debate remains unresolved, it has been pointed out that both the commonwealth and the states tend to practice equalization within their own borders (as, indeed, do most unitary states) because they do not levy higher taxes in higher cost areas or provide lesser services in remote areas. If equalization between states was reduced or abolished, therefore, the impact would be felt statewide and not just in remote areas. In other words, there would be an incentive to move not simply from remote areas to cities but also from smaller state cities to the already large metropolitan areas of Sydney and Melbourne.

Of course, even if it can be demonstrated that there is some trade-off between equalization and efficiency that would not necessarily put an end to the matter since judgments would have to be made as to whether the efficiency cost was a worthwhile sacrifice for a more harmonious federation with open economic space permitting unrestricted competition and development.

The debate over the desirability and sustainability of equalization culminated in the creation of a Heads of Treasury working party in 1992 to examine the adequacy of the current scope and methodology of equalization as well as the principles upon which it is based. The report of the working party, which was presented to the 1994 Premiers’ Conference, made a number of recommendations for methodological change. However, it appears that there will be no immediate change to the use of the equalization approach in the distribution of financial assistance grants, and the commonwealth has subsequently strongly endorsed the present role of the CGC.


The operation of economic policy within the Australian federation is circumscribed by constitutional requirements and historical conventions. Although finances are relatively centralized, with a large vertical imbalance favoring the central government, the need to take account of the reactions of state and local governments to commonwealth policies adds to the difficulty of implementing stabilization policies. Moreover, the state and local governments retain considerable influence over structural reforms in a number of key activities. While the commonwealth has the financial power to exert considerable influence on the behavior of subnational governments if it chooses to use it, recent efforts have been directed to achieving better cooperation and coordination of policy through efforts to involve subnational governments in the attainment of important national goals. Meanwhile, despite an active debate on the methodology and economic costs of equalization, the Australian federation seems likely to continue its longstanding emphasis on horizontal fiscal balance.

For convenience, in the remainder of this chapter, the term “states” will be used to encompass the activities of the both the original colonial states and the mainland territories.

In any event, privatization and other factors have significantly diminished the role of public financial enterprises in Australia in recent years.

Unlike most industrial countries, Australia does not have a value-added tax (VAT).

That is, a state receiving a higher share of an “included” specific purpose payment than the CGC considers appropriate to satisfy its needs will be assessed a commensurately lower share of the general revenue distribution pool.

That is, if the allocation to each state varied directly with the population of the state.

The Loan Council had its origins in the need to coordinate government borrowing in the wake of the debt incurred during World War II, It was initially established on a voluntary basis in 1923 and was given formal status in legislation passed by the commonwealth and the states, in successive stages, from 1927 to 1929, and an amendment to the federal Constitution sanctioned by a referendum in 1928. The Council comprises one representative of the commonwealth—the prime minister or a nominee—and one representative of each state—the state premier or a nominee.

Memorandum items are used to adjust the statistical definitions of deficit and surplus used by the Australian Bureau of Statistics to include some items—such as operating leases or government’s risk-weighted exposure to infrastructure projects with private sector involvement—that may have the characteristics of public borrowing but are not included in the formal definition. It has also been agreed that some items should be excluded such as funding of public sector superannuation schemes in excess of expected costs of benefits and borrowing by statutory marketing authorities.

The “underlying budget” balance concept used in Australia excludes net advances and hence, the bulk of privatization revenues.

By way of example, Albon (1991) suggests that state taxes have discriminated against housing construction and, within that market, against rental housing in particular. However, Brennan commenting on Albon in the same volume notes that these distortions must be examined in the context of those introduced by commonwealth taxation policies (such as absence of capital gains tax on owner-occupied homes and use of deductible borrowing to achieve high gearing on rental property) that may tend to operate in the opposite direction.

This issue was tested again in the courts in 1993 and the rulings made again confirmed the supremacy of the commonwealth on this issue.

See, for example, Boadway and Hobson (1993).


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