Vertical fiscal imbalance (Australia)

 

I like to have a beer with Cameron – ‘Cam’. We drink in moderation, of course. A nice bloke: Cam’s my mate.

          The topic of conversation is usually footy, or movies, or things like that. I was over at his place one night a few years ago, reclining back in the lounge room with a drink, before we were going to head out with his wife for a meal at a Thai restaurant. The television was on, showing a story where the new government was talking about its spending priorities.

Cam didn’t hesitate to offer an opinion. According to him, governments should prioritise mostly health, schools, roads, transport, and more police – that kind of thing. He didn’t mention defence spending. Most people don’t, important though that is. Something else I occasionally hear is people from rural or regional areas saying that services or infrastructure needs to be improved outside of the capital cities.

In Australia, the federal government collects most revenue, even though the state governments do most of the spending on things that are most important to us. There are perverse incentives for the federal government to spend money on things that will get it re-elected.

Cam blamed the government for not spending enough on health and causing the hospitals crisis in Queensland. But what did he mean? Exactly who was he talking about when he said ‘the’ government?

Two questions. First, what do you think is important for governments to spend more money on? Second, where’s that money coming from?

In 2006 I had the pleasure of talking about this with Andrew Fraser, who later became the Treasurer in the Queensland State Government from 2007 to 2012. I met him in his office on about the tenth floor of the Executive Building in George Street, Brisbane. He was only 29 at the time, but I was even younger, 24. I think I just nodded most of the time that I was there. In person, Andrew was a nice guy. Slightly balding, and wearing glasses, he looked like a real public servant. But he was young, confident and intelligent.

Andrew suggested I do some research about taxing and spending systems in different countries around the world. I agreed, but in what I can only describe as extremely dumb, I never followed through with that opportunity.

Andrew waved at me a newly published book by David Hamill called The impact of the new tax system on Australian federalism.¹¹ Hamill was also a former Treasurer in the Queensland Government, from 1998 until 2001. After he retired in 2001 he was motivated to complete a PhD doctorate thesis on Australia’s tax system, which he converted into the book. In it, Hamill argues that since Australia federated in 1901, there has been a gradual tendency for more and more control over spending from the central (federal) government.

Academics call it vertical fiscal imbalance. It’s a sophisticated name that makes it sound more technical, like you have to be some sort of expert to understand it. You could also call it federal-state money shifting. In Australia’s constitution, the federal government has the sole right to raise money through income and company taxes. On the other hand, most of the spending and implementation of programs is carried out by the state government. So the states depend on the federal government to give them enough money, otherwise they won’t be able to deliver services and infrastructure projects or run government departments. But what if the federal government doesn’t give them enough money?

In early 2001, the federal Liberal/National party government looked like it was heading towards an election defeat later in that year. The Labor party opposition received good results in by-elections caused by two retiring members of parliament. The polls looked bad for the government, but the Prime Minister had a plan. Australians call it pork barrelling. In some countries it’s call a boondoggle. In simple language it’s a bribe, except that you’re being bribed by a politician with your own tax money. Over the course of the year, the government announced a series of new spending announcements that ran into billions of dollars. It also announced some changes to government policies to try to regain support, for example changing a position on the excise (tax) on petrol, which was a big political issue at the time, and reducing it by a massive 1.5 cents per litre. (!)

The most frequent government bribe that I remember from the Howard years was tax cuts. Cam remembers these well. It is one of the reasons why he voted for the coalition in the 2001 and 2004 elections. After about 2001 I think he kind of expected to get a tax cut every year. Many of us did.

In the 2001 budget the government introduced $5 billion in tax cuts. That was a big amount at the time for Australia, around 10 per cent of the government’s overall revenue, which was $153.5 billion.¹² They reduced the company tax rate from 34% to 30%.

Something else was new. The government announced a $300, one-off payment to all pensioners, to be paid in August that year, three months before the election. Does that look like a bribe to you? But who could argue against it? This type of thing seems almost normal in Australian politics now, but it wasn’t then. In 2009 the next government led by Kevin Rudd gave most taxpayers a $900 cheque, as a way to help prevent a recession. Cam did the obvious and used it to help buy a surround system for his lounge room. I’ve listened to it, and it sounds great. Money well spent. I put my money towards buying carpet for my house. Again, money well spent.

  Another hallmark of the previous Howard government was something called the Regional Grants Scheme, which was a fund for infrastructure, sporting facilities, and other projects in rural and regional areas. This was used to dramatic effect to provide a slush fund for electoral promises (bribes) designed to improve government support in regional and rural areas. But who could argue against it?

  Well, state governments can. Andrew Fraser found it frustrating. Although state governments can raise some revenue themselves, around half of their revenue comes from the federal government. The amount the states can raise themselves is limited, and affected by market fluctuations. Much of the money that does come from the federal government is given using ‘tied grants’. In other words, it comes with conditions, so the federal government has the power to dictate where and how the money is spent.

  Prime Minister Howard had a ready-made argument against claims from state government treasurers like Andrew Fraser that they were not receiving enough money. He argued that the new Goods and Services Tax system generated income that went freely to the states, without conditions, and the revenue from this tax was set to automatically grow as the economy grew. To Cam, this seems like a plausible argument, although admittedly it seems like the politicians are only arguing between themselves to score political points against each other.

While Howard’s argument about GST money going to state governments was true, it wasn't the whole truth. The states were still just as dependent as they ever were on the federal government for the total amount of money they would receive. If state governments received GST money, they still needed more funding than that from the federal government. The GST funding was topped up with various other forms of funding from the federal government. In down-to-Earth terms, the GST simply means that a bigger percentage of money goes directly to the state governments rather than going to the federal government first and then before it is allocated to the states. But the overall money received through federal taxes going to states isn’t really affected. Howard sure earned his reputation for being wiley.

  Roads funding in Australia is an interesting case study. All roads are divided up into federal government roads, state government roads and local council roads. Some roads are designated as national highways, or federal roads, which means that the federal government is responsible for providing funding to upgrade or maintain them. However, although the money comes from the federal government, it is usually the state government that is responsible for actually carrying out the upgrade or maintenance.

Add to this the number of road projects that are now ‘joint’ state and federal projects, where the state government might provide 50 per cent of the funding and the federal government provides 50 per cent. In other words the federal government provides 50 per cent of the funding, and gives other the money to the states who use that same money to provide the other 50 per cent. This isn't completely different to saying all the money comes from the federal government. The situation can also get much more complex than this.

It clouds the lines of accountability for the public. If a road hasn’t been maintained properly, which government is at fault? Should we blame Prime Minster Howard, or state treasurer Andrew Fraser? Or is it the fault of our local council mayor?

Similar funding complexity happens in other areas too. After natural disasters, the federal government provides funding to state governments and councils to repair damaged infrastructure and facilities. The federal government will provide 75% of the cost of repairs, with the other levels of government having to pay the rest. Of course, both levels of government try to take the credit. A local council will publicise the repairs that they have organised; the federal government will publicise the amount of money they have spent on rebuilding. Voters are none-the-wiser about the many different and complex ways the projects are funded and delivered.

This is an example of how local councils raise some money themselves, get some funds from the federal government, and get other funds 'from' the state government, which initially come from the federal government.

So here is the basis of the vertical fiscal imbalance, or cost-shifting, problem. Both federal and state governments need funds to carry out their programs and policies, but the federal government mostly controls the money.

In 2001 in Australia we saw an example of one of the problems with that. John Howard wanted his government to be re-elected at the election in late 2001, and he had money available to spend. It was his government that got to decide how much money to grant the states and how much money it could spend on its own promises to try to gain voter support.

There is a structural bias in this system, which means that the federal government has a lot to gain by restricting grants to state governments and using the funds to pork barrel or make big promises to the electorate. John Howard did it by promising to cut taxes, which had a measurable effect and helped his government win the 2001 election. But should he have offered a smaller tax cut and instead granted the surplus funds to the states to help them build needed infrastructure and deliver more services?

Interestingly, by the end of the Howard period of Liberal/National Party federal government in 2007, all eight of Australia’s state and territory governments were Labor. The federal government finished with a no-net-debt position, but all Australian states still had government, and most had high levels of debt. The Howard government decision to offer tax cuts and other election bribes most of the years it was in office came at the expense of sharing some of the money with the states to reduce their debt.

Howard often said of tax cuts, ‘I believe that once a government has paid for all its services and investments if there is money left over it should be returned back to voters as tax cuts.’ But were all services and needs paid for in that instance? Or did the states require more money from the federal government?

This little trick had an extra perverse benefit for the Howard Liberal government. It restricted funding to the states and then blamed the states for increasing state taxes, or not cutting state taxes. It painted the eight state and territory Labor governments as ‘high debt’ governments, and almost nobody thought to ask Howard whether he might be actually accountable for creating the problem. Howard used his own decisions to attack his political opponents, in a system that clearly makes it hard for voters to know who is responsible for policy failures. If there are shortages of funding for government hospitals, which are in theory managed by the states, should a voter blame the state government or the federal government (which has power to make more money available for hospitals)? Voters cannot easily be sure who is to blame, and both levels of government blame the other.

The federal government’s primary goal is to get itself re-elected. It will use money to buy itself as much credit as possible, to bribe voters as necessary. There is no incentive for the federal government to grant more money for hospitals or schools, or other areas which are, in theory, the responsibility of the state and territory governments.

This is a really perverse situation. In Australia since 1996, it has created a situation where state and territory governments, who are responsible for providing the biggest share of services such as hospitals, schools, transport and infrastructure, have found themselves in a situation where they have high levels of debt, and therefore are restricted in their ability to provide these services. Even though there has clearly been enough tax money available to avoid state governments having to go into debt, there has been an incentive for the federal government to ignore this responsibility, and instead try to spend money in a way that will get itself re-elected.

Queensland Treasurer Andrew Fraser was frustrated by the funding model. He raised it at meetings with other state and federal treasurers. As a government, the Queensland Labor Party made a decision to invest as much as they could in infrastructure, even though they thought the federal government weren’t providing as much money as was required. Bottleneck problems at ports, and the need to upgrade freight railway lines, as examples, convinced the state government to borrow money that they weren’t able to get from the federal government. Although, by 2007, the Australian federal government had no debt, the Australian state governments had debt. It’s a bit simple to blame the state governments for ‘mismanaging’ their budgets. The truth is, most state government funding comes from the federal government.

You could make the argument that the federal government uses its funds to its own electoral advantage and often doesn’t allocate enough money to the state governments. Perversely, it may even help them to make the state governments look bad, if they would want to do so.

When Sam talks in the media, she often blames the opposite level of government for not supplying enough money. To Cam, it looks like she is just trying to avoid blame and shift it to others. She is. State politicians often try to appeal to voters with local loyalties. But it’s hard to pin down which level of government is to blame. There is, however, a structural bias which favours the federal government and disfavours state governments. In a different way, you could say it disfavours taxpayers.

This situation is not unique to Australia, or even to federal systems of government. It applies in a variety of different situations in other countries where money is collected and controlled by one group of politicians with their own agendas, and is needed to be distributed to other politicians. These different politicians are often political opponents. As we all know, politicians have perverse incentives to take action and control money in a way that is most likely to help them or their allies get re-elected. There often is no incentive for politicians to distribute money based on need.

In Germany, the federal constitution makes certain taxes ‘shared’ revenue, and fixes the proportion that goes to the central and provincial governments. Something for Australia to consider, perhaps? Perhaps not for Australia’s constitution, but as a model that could be adopted through an intergovernmental agreement.

 

Key points: ·                In Australia, the federal government collects most of the taxes and keeps more of it than they should, rather than allocating more to state and local governments, who actually are responsible for delivering most services. ·                The GST tax system in Australia hasn’t given more overall funding to state governments. ·                Journalism feeds off the conflict between politicians at different levels of government who blame each other for all problems, making it difficult for voters to know who is really to blame.

Possible reforms: ·        An independent body, similar to the Australian Electoral Commission or an academic body, should publish and interpret easily understandable statistics about federal-state funding levels. ·        There should be a federal-state government intergovernmental agreement to guarantee the proportion of taxes that go to state governments as grants. The federal government should keep the ability to make ‘tied’ grants, but there should be a fixed minimum total amount of funding allocated to state governments. ·        Politicians should limit the amount of pork barrelling and excessive election promises when state governments are still in debt.