State taxes means state reform

The possibility of state participation in income tax in one form or another promises to spice up this Friday’s COAG discussions. It won’t be for the first time. This idea has a history of periodically popping up in Commonwealth-state financial relations going back at least as far as 1971.

The fact that nothing has come of it says something about the obstacles it faces, not least of which has been the Commonwealth’s unwillingness to surrender monopoly control of income tax. This time, however, it seems to be the Prime Minister who’s raising the idea, and the states and territories (or at least some of them) raising the obstacles.

Whether there is merit in Malcolm Turnbull’s plan depends on the details and the strategic purpose. Is it just to channel more money to the states (either now or in the future), or is it to give the states more responsibility for raising the money they spend and therefore more incentive to spend wisely and efficiently?

At least some of the premiers — preferring like a long line of predecessors to spend money raised by someone else — see it as the former. They want the states to receive a fixed share of personal income tax revenue with the responsibility for raising it remaining with the Commonwealth.

To be fair to South Australian Premier Jay Weatherill, he is willing to give up some conditional (specific purpose) Commonwealth grants at the same time. Replacing conditional with unconditional grants based on income tax revenue would be a welcome step in itself, but it would do nothing to enhance state responsibility for raising revenue.

There are also a couple of premiers who want the Medicare levy to be increased and the extra revenue earmarked for state hospitals.

If revenue sharing is the premiers’ script for Friday, Turnbull should be prepared to resist it and table his own plan. Increasing state sharing of federal revenue would be the business-as-usual approach to Australian federalism that has seen state and territory accountability and clarity of roles diminish under the weight of ever-increasing dependence on the Commonwealth.

To be fair to the states, this outcome has not only been of their making. Government after government at the federal level has been only too eager to accept the expanded policy role in areas such as education and health that has come with an expanded role in funding. If Turnbull is willing to take a different direction, that would be a welcome demonstration of change as opposed to continuity.

State participation in income tax should only be developed as part of a broad reform of federalism that reduces states’ dependence on Commonwealth grants, strengthens individual state responsibility for funding their own expenses, and removes the Commonwealth from direct funding, policy or regulatory roles in areas of state responsibility. Such reform may need to be implemented in stages, but with the end goal kept clearly in sight.

In the field of income tax, enhancing the states’ responsibility for revenue raising means allowing them to impose their own rate of personal income tax. This could take various forms, but the important point is that after starting with a uniform rate each state should be free to vary its own rate independently of the others. Interstate tax competition is vital in delivering the benefits of a federal system. (For simplicity, the tax base should be the same as the Commonwealth’s, the ATO should administer the income tax for the states, and states should not get involved in company income tax.)

To avoid any increase in overall income tax at the commencement of this scheme, the Commonwealth would reduce its personal income tax by the same amount as the initial (uniform) state tax, and reduce its conditional grants to the states by an equivalent amount. At this point, the scheme is little different from revenue sharing, but the difference would come over time as states became free to vary their tax rate up or down. States may be tempted to go only one way — up — but interstate competition will help keep a lid on tax rates. They may also enjoy faster automatic revenue growth even without increasing their tax rate.

A state income tax isn’t the only reform of federalism that’s needed. There is little point in giving the states more individual responsibility for their own revenue without at the same time reviewing the system of horizontal fiscal equalisation. And states should be pressured to reform their existing payroll and land taxes and stamp duties.

Robert Carling is a Senior Fellow at the Centre for Independent Studies, and author of the research report Taming the Monster: Reforming Personal Income Tax, being released on April 6.