history of federal–state fiscal relations in australia: a review of the methodologies used

The Australian Economic Review, vol. 45, no. 2, pp. 145–57

History of Federal–State Fiscal Relations in Australia:A Review of the Methodologies Used

Ross Williams∗

Abstract

Governments of the Australian states and ter-ritories differ in their fiscal capacity. For thelast 80 years, the Commonwealth Grants Com-mission (CGC) has provided advice on inter-state fiscal transfers. The CGC initially pro-vided advice only on the needs of ‘claimantstates’, with the Commonwealth governmentdirectly playing an important role in mitigat-ing horizontal (and vertical) fiscal imbalances.Since 1981, however, nearly all general rev-enue grants from the Commonwealth to thestates have been based on recommendationsof the CGC. The article is thematically basedand examines the range of methodologies thathave been used to allocate federal funds tothe states since federation and examines theireffectiveness.

∗ Melbourne Institute of Applied Economic and Social Re-search, The University of Melbourne, Victoria 3010 Aus-tralia; email <[email protected]>. This is a revisedversion of a paper prepared for the Victorian Department ofTreasury and Finance as part of the federal government’sgoods and services tax distribution review. The paper waspresented at the HFE Workshop, organised by the Victo-rian Department of Treasury and Finance and Departmentof Premier and Cabinet, on 6 September 2011 and at theAtax State Funding Forum, Canberra, from 12–13 Septem-ber 2011. I am indebted to participants at these conferencesfor suggestions and comments.

1. Introduction

The fiscal position of a state is heavily depen-dent on the total amount of revenue transferredfrom the Commonwealth to the states and itsdistribution between the states. In Australia, thetransfers currently represent around 50 per centof total state revenue. In turn, around 50 per centof the transfers (25 per cent of state revenue)are allocated in a manner designed to even outfiscal imbalances between the states, as recom-mended by the Commonwealth Grants Com-mission (CGC). Compared with an equal percapita allocation, the CGC redistributes around8 per cent of the goods and services tax (GST),or around 4 per cent of total federal payments,to the states.

The CGC was established to provide in-dependent advice on the needs of financiallyweaker states, the ‘claimant states’. However,until the early 1980s, the great bulk of fed-eral transfers to the states was allocated byformula (modified by one-off deals) and pay-ments for specific purposes, in which the CGCplayed no direct role. The formula included el-ements of horizontal fiscal equalisation (HFE).It follows that a historical evaluation of theCGC must be undertaken in the wider con-text of total Commonwealth–state financialrelations.

Since 1981, the CGC has evaluated the rel-ative fiscal needs of all the states and its rec-ommendations apply to virtually all of the gen-eral revenue grants to the states. Now playingsuch an important role, it is not surprising thatthere is no shortage of views on how the CGCmight carry out its mandate. It is hoped that byevaluating past practices in this article, debatecan become more focused, with some optionsdiscarded in the light of experience and otheroptions progressed further.

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146 The Australian Economic Review June 2012

Within the framework of broad changes infederal–state fiscal relations, the CGC has em-ployed a range of methodologies over thenearly eight decades of its existence. The dis-cussions accompanying each of its reports arewell documented and throw much light on cur-rent controversies. Issues that frequently oc-cur include: what standard of service provisionshould be used in determining allocations, effi-ciency versus equity, the effect of methodologyon state policies and the timing of payments.1

After a brief historical overview, this articlelooks at the history of federal–state fiscal rela-tions under thematic headings.

2. Main Historical Changes inFederal–State Fiscal Relations2

At federation, the Australian constitution lim-ited the responsibilities of the Commonwealthgovernment but gave it the important revenuesource of customs and excise duties, which hadformed around three-quarters of the colonies’revenues. The states, with extensive responsi-bilities in education, health and law and or-der, were therefore dependent on fiscal trans-fers from the federal government. For the firstdecade after federation, the Braddon clause inthe constitution required that the states receiveat least three-quarters of customs and exciseduties.

From 1910, the states were compensated onan equal per capita basis, fixed in nominalterms, with special grants made to the weakerstates: Western Australia from 1910, Tasma-nia from 1912 and South Australia from 1929.The CGC was established in 1933 to providean independent assessment of the need for spe-cial budgetary assistance to states in financialneed.

The 1927 Financial Agreement establishedthe Loan Council. The Commonwealth tookover state debts but the states were still respon-sible for the payment of interest; the equal percapita payments to the states were now directedto the payment of this interest. The paymentswere fixed in nominal terms for 58 years. Asinking fund for repayment of debt was estab-lished to which both the Commonwealth andstates contributed.

However, because the states retained incometax as a source of revenue, transfers from theCommonwealth were less important than sub-sequently. In 1933–34, for example, Common-wealth payments to the states were a little overone-third of revenue from state taxation (CGC1936, pp. 192, 227) and a lower percentageof total own-source state revenue. The verticalfiscal imbalance became severe following thetake-over of income tax by the federal govern-ment in 1942.

The large fiscal changes associated with fed-eration and with the Commonwealth’s take-over of income tax were in each case followedimmediately by years where the resultant verti-cal fiscal imbalance was met by compensationpayments, based on revenue that had been col-lected by each state under the lost taxes. Inboth cases, however, in allocating these reim-bursement grants, the compensation principleeventually gave way to measures of financialneeds: special assistance to weaker states from1910–11; a formula that allowed for populationdensity from 1947–48.

By 1959, the formula adopted after WorldWar II was fully phased in. The reimburse-ment grants and supplementary grants werethen combined and called ‘financial assistancegrants’ (FAGs). The Commonwealth adjustedupwards the payments of grants to the weakerstates, thus reducing their need to seek assis-tance through the CGC.

From 1948 until 1981, the general revenuegrants to the states, as assessed by the federaltreasurer, included significant components ofHFE. Indeed, by the 1970s, the CGC had be-come a marginal player in federal–state fiscalrelations. Over the period 1972–73 to 1982–83,special grants to the claimant states were lessthan 1 per cent of Commonwealth payments tothe states (CGC 2008, p. 109, Table A-2).

The Fraser government of the mid-1970ssought a more rational basis for allocatingfunds to the states than the ‘method’ that hadgrown up in the post-war period. In 1978, theCGC was set the task of determining how allgeneral revenue payments to the states shouldbe made. The CGC reported in 1981 and thegeneral methodology enunciated therein wasbroadly accepted (CGC 1981b). From 1981,

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Williams: History of Federal–State Fiscal Relations in Australia 147

HFE was incorporated explicitly into the allo-cation of all general revenue payments to thestates. The CGC moved from being a periph-eral to a major player in federal–state fiscal re-lations. However, until the introduction of theGST in 2000, the total sum to be allocated tothe states still remained an item for negotiation.

The GST was introduced for the financialyear 2000–01, with proceeds distributed to thestates in lieu of FAGs, revenue replacementpayments and revenues from the abolished statetaxes. States were guaranteed a minimum pay-ment based on updates of previous arrange-ments. Agreement was reached that the GSTwould be allocated to the states on the basisof HFE, which was interpreted by the CGC tomean the methods it had been using to allocatethe FAGs. As stated in CGC (2008, p. 123):‘The reforms had no implications for the con-ceptual basis of the Commission’s work.’ How-ever, equalisation now was to apply to a largerpool of funds: 32 per cent larger in 2000–01than 1999–2000. For the first time, the pool ofgeneral revenue payments to the states was notsubject to federal government tinkering. Allo-cation to the states was now clearly a zero-sumgame.

3. Partial versus Full Horizontal FiscalEqualisation

The degree of horizontal equalisation has fourdimensions: the number of states explicitly in-cluded in the process, the extent to which allactivities undertaken by states are assessed inderiving fiscal transfers, the degree to whichstates are funded to enable them to provideequal services and the extent to which Com-monwealth payments for designated purposesare included in determinations of the CGC.

3.1 Standard and Claimant States

From its inception until 1981, the CGC evalu-ated the claims of the financially weaker statesfor assistance. The additional payments to theweaker states were financed from general Com-monwealth government revenue, thus easingvertical fiscal imbalances. In making its deter-minations, the CGC compared the fiscal perfor-

mance of the claimant states with those of thenon-claimant states. From 1933 until 1959–60,the claimant states were Western Australia, Tas-mania and South Australia, with the standardstates being New South Wales, Queensland andVictoria.

Under new arrangements first used in1960–61, New South Wales and Victoria be-came the standard states, largely on the practi-cal grounds that the other states could and didmove in and out of claimancy. The method en-sured larger grants than if other states had beenincluded in the standard and it failed to coverthe risk of making the claimant states better offthan any non-claimant state not included in thestandard.

Following the CGC’s 1981 report, the con-cept of claimant states was replaced by an eval-uation of the needs of all six states; the terri-tories were subsequently added in the 1980s.Initially, a six-state rotating standard was used,but in the 1993 review, this was simplified to anational average. With only eight states and ter-ritories, the all-state average can be affected bythe actions of one state. Because the CGC ap-plies this standard over many different and nar-row areas of public expenditure, even a smallstate can dominate the standard in some ar-eas. The current model in which a state’s GSTrevenue depends on the fiscal performance ofall states complicates revenue forecasting fora state, especially in the current period whenthere are quite large swings in economic per-formance across states and regions.

3.2 The Scope of Horizontal FiscalEqualisation

The scope of HFE in Australia has been drivenby the decision of the early CGC to base grantson the criterion of equalising budget balances,a decision influenced by the heavy debts thatstates incurred in the 1920s and the economicconditions of the early 1930s. L. F. Giblin wasthe most influential member of the three-personoriginal commission and his view was thatgrants should be based on an examination ofa state’s overall fiscal balance compared withother states. The choice of budget outcomesimplies that all items of state revenue and



expenditure must be evaluated. In contrast, fed-erations such as Germany and Canada confinethemselves to partial equalisation by restrictingcoverage to revenue-raising ability.

In the decade following its inception in1933, the CGC adopted a needs-based approachto horizontal fiscal imbalances. Modificationswere made to the published budget results toachieve uniformity of data across states andthen adjustments were made to the modifiedbudget results of the claimant states to allowfor any difference from the standard state aver-age in efforts to raise revenue and levels of ex-penditure. The recommended funding enableda claimant state to have the same per capitabudget deficit as the average of the standardstates. Head (1967, p. 496) argued that ‘thebudget-result component is not in fact an es-sential ingredient of a financial equalisationgrant’. Ignoring budget outcomes obviates thenecessity for debt charges to be included inthe determination. Head went on to state that,over time, large deficits will be financed by in-creased tax rates or reduced expenditure, whichcan be dealt with in an equalisation framework.Head (p. 497) noted that, in its 1963 report,the CGC reduced the grants to claimant statesby the amount of debt charges resulting fromlower taxes and higher expenditure than thestandard.

In the early CGC reports, per capita expenseneeds of the claimant states for social services(education, health and law and order) were putat the national average. It was not until 1937that the CGC allowed for higher costs of pro-viding social services in the claimant statesarising from their smaller and more dispersedpopulations.3 Assessed allowances for ‘socialdensity’ were added to the standard expendi-ture on social services and increased in valueover time. Other expenses continued to be in-cluded at actual values per capita; that is, theclaimant states were fully compensated.

In the early years, when the states still leviedincome taxes, the CGC’s estimates of the tax-able capacity of a state were based predomi-nantly on federal personal and company taxesraised in each state and, to allow for the higherCommonwealth income tax threshold, an indexof real wages.

The methods used by the CGC to recom-mend special assistance continued to evolve inthe post-war period. Now that the states wereexcluded from levying income tax, the capac-ity to raise revenue was changed to an exam-ination of each major form of state taxation.The CGC calculated the amount the claimantstate could have raised if its rates and exemp-tions had been the same as the standard states.It then subtracted this from actual tax revenueto derive an assessment for revenue needs.

In its 1963 report, the CGC changed themethod of allowing for cost differences inmany of the social services, including school-ing and hospitals. It now applied unit costsin the standard states to the number of unitsin the claimant states. This was subsequentlybroadened to allow for some variation inunit costs, at the suggestion of the claimantstates, and to widen the multiplicand to eligiblepopulation.

In 1974, following suggestions by the federaltreasury, the CGC changed its presentation ofresults to what it called the ‘direct approach’.This placed much greater emphasis on the ad-ditional (or lesser) funding required to com-pensate a claimant state for differences, foreach revenue and expenditure category, fromthe standard. The new presentation downplayedthe role of state deficits. It also made it ex-plicit that the final grant payable was calculatedafter subtracting the extra per capita paymentthe claimant state received through Common-wealth FAGs compared with that received bythe standard states. The change in methodologywas algebraically equivalent to the old budget-balance method but it provided a framework tomove towards fuller fiscal capacity equalisationas data improved.

The 1977 report introduced the factor as-sessment method (CGC 1977), which remainsthe underlying method of implementing HFE.In this approach, on the expenditure side, theclaimant state’s percentage disabilities for eachcategory of expenditure were applied to the av-erage per capita expenditure in the standardstates. The disabilities to be considered in-cluded eligible population or units of use, scale,dispersion of population and the physical andeconomic environment. This was extended in



subsequent years to include urbanisation andsocio-demographic variables.

The move to a national average in 1981 ne-cessitated collecting all data from all states butthe range of revenues, expenditures and busi-ness undertakings included remained similarto that used in evaluating submissions fromclaimant states, being restricted to recurrenttransactions and business undertaking resultsthat had an impact on state budgets. Assess-ments became more detailed with better dataand additional modifications to remove the ef-fects of policy differences on business under-taking results. The methodology contained ves-tiges of the original budget model, in that eachstate was to be equalised to the level of thestandard (population-weighted six-state aver-age) budget result.

Health care grants replaced specific purposepayments (SPPs) for health in the 1982 review.Expenditure on roads was included for the firsttime in the 1993 review. Prior to then, they wereexcluded because of data problems, the diffi-culty of distinguishing between recurrent andcapital expenditure and the fact that much ofthe expenditure was financed by the Common-wealth government, which in part took accountof needs. Input costs in the form of wages andrent were introduced in 1993. The operatingcosts of capital were included through a depre-ciation variable in the 1999 review. In the earlyreports, some allowance was made for ‘main-tenance of capital equipment’ but, over time,the CGC had come to see its role as confined torecurrent needs, with the Loan Council lookingat capital needs.

The detailed analysis of public trading en-terprises (PTEs) was abandoned in 1999 andreplaced by community service obligations andconcessions towards the cost of using PTE ser-vices. In the late 1990s, the Commonwealthmade revenue replacement payments to off-setthe loss of state tax revenues following a HighCourt decision that invalidated state businessfranchise fees.

From 2001, the CGC moved to using datacalculated on an accrual basis. In the 2010 re-view, capital expenditure needs and net lendingwere introduced more directly by changing thefunding needs from that based on the operating

budget outcome to one based on the concept ofequalising financial net worth.

The rapid expansion of mining in the lastfew years and the proposed introduction at afederal level of a mineral resource rent tax hasdirected attention to the treatment of this rev-enue category by the CGC. Mining and otherroyalties have always posed difficulties for theCGC. The thirty-ninth report (CGC 1972, p. 83)noted that adjustments for mining royalties hadnot been made for many years (that is, actualrevenues were used) because the Commissionhad:

. . . experienced great difficulty in comparing therevenue-raising capacities of the states in thisfield, because of the variety of revenue bases,the variety of arrangements made between min-ing companies and individual state governmentsin connection with the provision of transport andother facilities . . . and uncertainty as to the levelof royalty which would be compatible with prof-itable operation in any particular case.

The inclusion of Queensland as a claimantstate in 1971–72 provided strong incentive forthe CGC to improve the treatment of miningrevenue. In 1974, the CGC moved from actualrevenue to revenue-raising ability based on thevalue of mineral output at the mine site and‘standard’ royalty rates which were constructedfor groups of commodities.

The CGC in its forty-fourth report recog-nised that profitability was a better measure ofability to raise revenue, although it was able toestimate profitability for only one commodity,black coal (CGC 1977, pp. 52–4). The mea-sure used was value added less wages, capi-tal expenditure, transport costs and companytaxes.

From 2004, the CGC changed to output-based assessments, with the base being thevalue or volume of production according to theusual practice for each group of commodities.The CGC (2004, pp. 58–9) noted that, whileconceptually ‘the revenue base for royalties iseconomic rent because it reflects the underly-ing capacity of industry to pay’, in practice stateroyalties are levied on output. Data quality wasalso an important consideration in making the



change, although this might improve with theintroduction of the federal tax.

The concentration of particular minerals inone state adds to the difficulties of defining ameasure of ‘ability to raise revenue’. In the pre-1981 standard-state model, the problem arosemost acutely when a mineral was mined in aclaimant state but not in the standard states ofNew South Wales and Victoria. In the nationalaverage model, if one state dominates produc-tion of a particular commodity, its royalty ratesbecome the national standard unless commodi-ties are aggregated—which is usually done bythe CGC.

3.3 Less-than-Full Adjustment

The early determinations of the CGC aimedfor less-than-full HFE. From the second re-port onwards, the claimant states were to befunded not at the ‘normal’ standard achievedby the standard states but at a ‘minimum’ stan-dard. A penalty for claimancy was explicitlyintroduced, so that the allowance for social ser-vices was set from 6 to 10 per cent below thenational average and the standard severity oftaxation was set above the national average.These penalties also helped to ensure that aclaimant state could not be made better off thanthe weakest of the non-claimant states. In otherwords, to reach fiscal equality with the otherstates, the claimant states would have to makeabove-standard effort in revenue raising and/orprovide services more efficiently. This conceptwas articulated in the third report (CGC 1936,p. 75):

Special grants are justified when a State throughfinancial stress from any cause is unable effi-ciently to discharge its functions as a memberof the federation and should be determined by theamount of help found necessary to make it possi-ble for that State by reasonable effort to functionat a standard not appreciably below that of otherStates.

This principle of ‘not appreciably below’was enshrined in the Commonwealth GrantsCommission Act 1973 (Cwlth), under which,as amended at 1 February 2000, the CGC oper-ates. The 1936 report used the concept of ‘min-

imum’ rather than ‘relative’ needs. It arguedthat grants should not be paid to lift a state‘to the high standards of welfare of the mostprosperous states, but to a minimum standardwhich will enable it to carry on with reasonableefficiency’ (CGC 1936, p. 10).

In the first move to full equalisation, theneed for the claimant states to make an above-average effort in revenue raising and make aspecial effort to restrain expenditure lapsedin 1945. An attempt by the federal treasuryin 1958 to re-introduce these requirementswas unsuccessful. The methodological changesadopted by the CGC in 1974 largely completedthe move to relative rather than minimum fi-nancial needs.

The terms of reference for the 1981 reviewdefined HFE in a similar manner to the 1936definition: a state should be able to provide ser-vices not appreciably different from the stan-dards in other states. It was not until the 1999review that the phrase ‘not appreciably differ-ent’ was removed from the terms of reference,although the CGC had begun to use by its1993 report the expression ‘same standard ofservice’, without qualification (CGC 1993). Inpractice, the CGC had for some time been aim-ing for ‘full equalisation’, being uncomfortableabout the practical implementation of a stan-dard ‘not appreciably different’. The CGC inits 1981 report (p. 20) dated the switch from fi-nancial need to fiscal equalisaton as occurringin 1975:

In fact, as applied by the Commission before 1975,a claimant State’s financial need as interpreted bythe Commission fell somewhat short of full fis-cal equalisation. Until that time, the Commissionplaced some limitations on the amount of finan-cial assistance it was prepared to recommend, sothat the special grant received by a claimant Statewould not necessarily enable it to provide govern-ment services at standards comparable to those ofthe standard states.

3.4 Absolute versus Relative Payments

The current factor assessment method involvesexpressing disabilities for expenses in mul-tiplicative terms. This means that differenteffects are compounded. The CGC’s 1981



(pp. 101–2) report discussed the issue ofwhether disabilities should be compounded oradded. It favoured adding effects. It noted, forexample, that scale was not usually indepen-dent of dispersion. A separate but related pointis that, since 1981, general revenue paymentsto the states have been based on a series ofrelativities. This implies that the absolute val-ues of disabilities change with the importanceof the category and the size of the GST poolbeing allocated and indirectly with the changein expenditure on goods and services that aresubject to the GST. Prior to 1981, under theclaimant state model, all disabilities were ex-pressed as absolute dollars (or pounds). A pos-sible alternative to the current model wouldbe one where disabilities are calculated in ab-solute terms and updated between major re-views by an appropriate price index, such asthat for state government expenditures. Inter-estingly, in its 1936 report, the CGC stated that,while it was necessary for it to evaluate the rel-ative financial position of the various states,‘such relative position should not, however, bethe absolute basis of the grants’ (CGC 1936,p. 10).

Following the replacement of FAGs by theGST pool, there was a marked increase in thereal absolute amount of redistribution. Restrict-ing the pool to exclude health care grants, in1999–2000 the CGC redistributed nearly $2.5billion, in 2008–09 prices. By 2004–05, thefirst year in which all states received only theirGST entitlements, the redistributed amount wasnearly $4.0 billion in 2008–09 prices, an in-crease in real terms of around 60 per cent. Theredistribution has fallen back to around $3.5billion in recent years, about 40 per cent abovethe pre-GST levels.4

There is some evidence that the replacementof FAGs by the GST allocation benefited thosestates that derived relatively less revenue fromthe abolished financial transactions taxes. In2002–03, for example, New South Wales andVictoria would have received a smaller share ofthe GST pool than they did under the Guaran-teed Minimum Amount provisions which op-erated in that year and were based essentiallyon what states would have got if pre-GST ar-rangements had continued.

3.5 Commonwealth Payments for DesignatedPurposes

When the Commonwealth government pro-vides funds to a state in an area that is a statefunction, the CGC has treated most of thesepayments as reducing the need for general rev-enue assistance to the state. In some instances,however, the Commonwealth government hasdirected the CGC to quarantine the payments sothat they do not reduce payments to the states.

The methodology of including both the ex-penditure and revenue from many SPPs wascodified in the early 1970s as these forms ofpayments increased in importance. The datalags involved in CGC determinations meansthat the federal government’s intent is metimmediately, whereas the reductions in stategeneral revenue occur several years later. Theadvantage of this treatment of SPPs is that itoff-sets federal government decisions that donot meet strict economic criteria; on the otherhand, the treatment might be thought counterto national policy in areas such as the provisionof infrastructure.

The 2008 Intergovernmental Agreement onFederal Financial Relations provided for threetypes of designated payments to the states: na-tional SPPs, national partnership project pay-ments (NPPPs) and national partnership and fa-cilitation and reward payments. The third cate-gory was not to affect the GST distribution. Thedistribution of SPPs is moving to an equal percapita payment, with the exception of healthgrants. As before, the CGC makes a case-by-case determination of SPPs and NPPPs, al-though the majority is deemed to reduce theneed for GST funds. Capital grants are includedif they are for state purposes. Although the fis-cal performance of PTEs is currently outsidethe scope of CGC determinations, capital grantsto PTEs affect net financial worth and thus therelativities.

4. Interactions between Vertical andHorizontal Transfers

There are a number of examples where at-tempts to deal with horizontal fiscal inequal-ity has impacted on vertical fiscal imbalanceand vice versa. Until 1981, special assistance



to states, of itself, increased the total amounttransferred from the federal government to thestates. In several periods prior to this, someclaimant states were able to trade-off specialassistance for increased general revenue grants.From 1948 until 1957–58, the federal treasuryallocated general revenue grants to the statesusing a formula that included demographic andpopulation density measures similar to thoseused by the CGC to deal with horizontal fiscalinequalities. In another example, the Common-wealth government’s SPPs to the states affectCGC determinations.

Vertical fiscal imbalance increased markedlyin 1942 with the introduction of federal uniformincome tax and the abolition of state incometaxes. The states were reimbursed on the ba-sis of the average income tax collections in theyears 1939–40 and 1940–41. Initially, the newarrangements provided for any state to seekadditional funding if it felt that the reimburse-ment payments were insufficient to meet itsrevenue requirements. The CGC was empow-ered to consider such requests and make recom-mendations to the treasurer. The claimant stateswere thus in a position to apply to the CGC forboth reimbursement grants and special assis-tance. The difficulties inherent in this dual rolelead to a revision of the uniform tax scheme in1946, whereby the CGC was no longer requiredto provide advice on the sufficiency of the reim-bursement grants. Any state seeking additionalassistance as a consequence of the uniform tax-ation arrangements now had to apply directlyto the federal treasury. This led to numerousdeals between states and the Commonwealthand a growth in supplementary payments. TheCGC continued to examine claims for specialassistance.

From 1948–49, the aggregate reimbursementgrants were updated on the basis of populationincreases and average wages. The total amountwas allocated between states on the basis ofan adjusted population which incorporated thenumber of school-aged children and the per-centages of the population living in areas of lowpopulation density.5 The new methodology wasphased in over a 10 year period. Supplemen-tary payments continued to be made. As a con-sequence of the incorporation of expense dif-

ferences into the re-imbursement grants, overthe period 1945–46 to 1957–58, total generalrevenue grants to the three claimant states in-creased from 17.6 per cent of total general rev-enue payments to the states to 20.7 per cent, butspecial grants fell from 11.3 per cent to 10.1 percent.

When the formula for allocating reimburse-ment grants became fully operational, Victoriaand New South Wales expressed great dissatis-faction with the distribution of funds. As a re-sult of this pressure, in 1959 the reimbursementgrants and supplementary grants were com-bined and labelled as FAGs. Claimant stateswere reduced to two: Tasmania and WesternAustralia. The first allocation of FAGs to thestates in 1959–60 was based, with adjustments,on their total general revenue grants from theCommonwealth in 1958–59. Adjustments forchanges in population density and numberof school children were dropped, effectivelyfrozen at 1957–58 levels. The Commonwealth,concerned with the growth in special grants, in-creased the general revenue grants to the previ-ous claimant states. For example, in 1959–60,the per capita FAG to Western Australia was1.65 times that of Victoria, whereas in 1958–59the relativity under the income tax reimburse-ment scheme was only 1.16. Together with thenew relativities, a more generous method ofupdating the amounts was introduced whichincluded an annual ‘betterment factor’ in ad-dition to a state’s population growth and theincrease in average wages.

Payments to the states were reduced throughoff-set arrangements following the transfer ofpayroll tax to the states in 1971 and the Com-monwealth take-over of funding for universi-ties in 1974. From 1970, the Commonwealthprovided the states with substantial capitalgrants and assistance with debt charges. Withthe increased general assistance to states andcontinuing further ad hoc adjustments by theCommonwealth, special grants became less im-portant, with the smaller states choosing tomove in and out of claimant status. The CGChad become a relatively minor player in the al-location of general revenue grants to the states.

In the early 1970s, commentators were argu-ing for a more systematic approach to HFE.



Under a 1976 agreement, the amount dis-tributed to the states in aggregate was fixedas a share of federal government personal in-come tax collections (changed in 1982–83 toall Commonwealth tax revenue). The aggre-gate payment was allocated to the states onthe basis of 1975–76 relativities, pending a re-view of relativities by the CGC. The CGC re-ported in 1981 and recommended large changesto the distribution of general revenue grants toNew South Wales, Victoria and Queensland.The recommended changes were delayed but amodified version was phased in over the nextfew years. Now, for the first time, the CGC’smethodology was used to allocate most gen-eral revenue grants to the states, although one-off deals with individual states continued. In1985–86, the tax-sharing grants were replacedby FAGs that were indexed. It was not until2000, with the introduction of the GST, thattotal general revenue funding to the states wasfree of political decision.

Tying general revenue payments to the GSTwas seen by the states and Commonwealth asproviding a growth tax to the states. In prac-tice, the exemptions from the GST have meantthat the revenue from it is growing at a slowerrate than personal consumption expenditure.The income elasticity of demand for the GST-exempt health and education sectors is rela-tively high and the high Australian dollar hasencouraged growth in international travel andpurchases of goods from overseas.

The fact that the GST is levied by the Com-monwealth government but the proceeds areused to finance state government activity weak-ens the connection between state revenues andexpenses and acts as a strong disincentive toraising the rate or expanding the base. The po-litical incentives for the Commonwealth gov-ernment are to freeze the GST parameters andmeet the resultant increase in federal–state fis-cal imbalances by taking over state governmentfunctions.

5. Timing Issues

Recommendations of the CGC for a financialyear necessarily involve using data that are atleast 2 years old, unless budget forecasts are

used. The lags mean that, without adjustment,the recommended payments may not reflectconditions in the payment year. In the 1930s,the review used the audited figures for the fi-nancial year 2 years before the year of the pay-ment. Since 1981, mixes of 3 and 5 year aver-ages have been used.

The CGC dealt with timing issues from earlyon. If a state economy was deteriorating, duefor example to a drought, its grant would beincreased by an advance which would be takeninto account when the year of payment becamethe year of review. If the state economy wasbuoyant, some of the grant would be deferred.In 1949, this was formalised by dividing specialassistance grants into two parts: the comple-tion grant and the advance grant. The methodenabled differences between ex ante allocationsof funds and needs to be corrected when the fulldata became available. The ex post differential(the completion grant) could be either positiveor negative. The total grant for the year of pay-ment was thus the advance grant for the yearplus the completion grant for 2 years earlier. Apractical problem with the method was the needto make some estimate of the overall budgetposition of the standard states in the paymentyear. The system was abandoned in the early1980s. Vestiges of advance grants appeared in2000–01 when budgeting balancing assistanceassociated with the introduction of the GST waspartly paid in the form of an interest-free loanto states.

In the 1982 and 1985 reviews, the CGC wasasked to consider trends in making its determi-nations. In its 1985 report, it concluded that ithad found that ‘movements were more in thenature of irregular cycles rather than manifesta-tions of a consistent trend’ (CGC 1985, p. 162).In an effort to provide more up-to-date results,annual updates for the period between reviewsbegan in 1989.

In its 2010 report, the CGC moved to theuse of a 3 year average of past data; that is,data from 4 to 2 years before the payment yearwas used (CGC 2010). A shorter data periodensures that the data are more contemporane-ous and should therefore help to off-set fluc-tuations in state government own-source rev-enue. A shorter data period is likely, however, to



increase the variability in GST payments to thestates.

Relating payments to the level of personalconsumption expenditure through the GST im-parts a pro-cyclical bias to the transfers. Thiscould be neutralised by directing part of thepool in good times to a stabilisation fund thatcould be drawn upon in economic downturns.

6. Efficiency and Grant Design Effects

The CGC has always been aware of the pos-sible effects of its methodology on decision-making by states. On the expense side, forexample, there may be a tendency for statesto increase expenditure on activities that arefavourably treated in CGC determinations. Toillustrate, in the CGC’s determinations up un-til the 1970s, significant areas of expenses byclaimant states were not adjusted but includedat actual values. This had the expected result ofencouraging claimant states to expand expen-ditures in the unadjusted areas at a faster ratethan was occurring in the standard states. TheCommonwealth treasury produced evidence ofthis phenomenon in 1966, but it had also beendocumented earlier with respect to expenses in-curred outside the social services area where nopenalties were applied (see CGC 1995, pp. 46,96–7).

In the 1930s, the CGC made judgementsabout the worth of state government activitiesand excluded expenditure on wasteful projects.In its first months of operation, the chairman,Sir Frederic Eggleston, set out the factors thatthe CGC might consider. Apart from inher-ent geographical and economic disabilities, theCGC would look at capital expenditure on non-productive assets, government policies aimedat settling unsuitable land, administrative ef-ficiency and the extent to which expendituregenerated general benefits to the community.These were not idle threats. In the first report,the grants to South Australia were reduced onaccount of losses incurred in wheat settlement,irrigation schemes and railway rehabilitation(CGC 1934). The Western Australian grant wassimilarly reduced for losses on settlements. Thesecond report sternly warned that ‘if the diffi-culties of a state were predominantly due to

its own fault in the past, a somewhat more se-vere standard could be imposed’ (CGC 1935,para. 120). The penalty for past mistakes wasexpressed in the assessment through a reduc-tion in assessed revenue. In the 1935 hearings,Eggleston stated that the Commission wouldexpect a claimant state to ‘indicate its pol-icy for the future and whether assistance fromthe Commonwealth will enable a constructiveand permanent solution of its problems’ (CGC1995, p. 24). The Commissioner’s view wasthat the system of special grants should pro-vide ‘ample stimulus to a state to try to escapefrom its position of financial inferiority’ (CGC1935, para. 119).

A limited attempt to allow for efficiency wasmentioned in the 1982 report (CGC 1982, p.20):

Where policy or efficiency differences were iden-tified by the Commission, policy or efficiencymodifications were made to the expenditure ofthe State being assessed, with a view to measur-ing the cost which that State would have incurredif its policies and operating efficiency had beenthe same as those of the State being used as astandard.

Efficiency considerations formed a signifi-cant component of the 1988 review, in whichthe terms of reference included ‘whether inits view, application of the principle of fis-cal equalisation has any significant conse-quences for the efficient allocation of re-sources across Australia’ (CGC 1988, p. xxi).In this report, a distinction was drawn onthe expense side between location-specificdisabilities and individual-specific disabilities.Location-specific disabilities include the costof providing services in areas of low popula-tion density and the congestion costs of urbanareas. The CGC has, over the years, found lo-cation costs to be much more difficult to mea-sure than the individual-specific costs arisingfrom population characteristics. A similar dis-tinction was made by the CGC in its third re-port. It allowed that a state may provide reliefto persons affected by federal policies or lim-ited natural resources but ‘such relief must not. . . take away the incentive to change to more



profitable forms of production’ nor ‘the incen-tive to move to better natural resources’ (CGC1936, p. 84).

It was argued by New South Wales andVictoria in the 1988 review that allowing forlocation-specific factors encouraged an ineffi-cient allocation of resources both within a stateand between states. In their view, the locationof people and industries should be left to themarket and regional areas should not be sub-sidised. Individual-specific disabilities, on theother hand, such as an above-average percent-age of school children or extra need for socialwelfare payments because of the presence ofmany low income households, are less distor-tionary and mimic the expenditure that a uni-tary national government might undertake. TheCGC recognised that HFE has efficiency effectsbut concluded that they were not large. TheCGC went on to state that any conflict betweenequalisation and efficiency was the responsi-bility of government (CGC 1988, pp. 147–8).

The CGC was asked to further look at effi-ciency effects in an issues report (CGC 1990a,1990b). A consultancy paper prepared by theInstitute of Applied Economic and Social Re-search, using a computable general equilibriummodel, found the efficiency costs to be rela-tively small. In its 1993 report (p. 70), the CGCexpressed a view on how the issue of efficiencymight be dealt with:

If they wished to do so, governments could givegreater weight to efficiency in the equalisationprocess by instructing the Commission accord-ingly in future terms of reference. Alternatively. . . the equalisation result could be modified byefficiency considerations when governments weredeciding upon the actual grants to the States.

The CGC takes as its revenue categories thetaxes actually collected by states, or more pre-cisely, the types of taxes levied in a majorityof states. The tax base and rates for each taxare taken as those actually used, or where theydiffer, the national average. Apart from its firstdecade, the CGC has eschewed general mea-sures of taxable capacity such as household in-come. Moreover, it has tried to replicate thetax schedules used by the states and incorpo-

rates thresholds and progressivity. This detailedapproach to ‘what states do’ complicates as-sessment. This seems to have been endemic inthe area of stamp duty on conveyances. In the1990 update and 1993 review, the CGC wres-tled with exemptions granted by some statesfor stamp duty on the transactions involvedin corporate reconstructions. In the 2010 re-view, adjustments had to be made for the treat-ment of duty on land-rich transactions for listedcompanies.

States by their revenue and expense policiescan influence the national standard to their ad-vantage. This applies to the actions of the largestates of New South Wales and Victoria but alsoto small states that are important in individualcategories. On the other hand, for minerals thatare concentrated in one or two states, the use ofnational averages has the effect of distributingthe revenue across all states.

Under the current national-average model,there is an incentive for states to impose low(high) tax rates where its taxable capacity ishigh (low). Thus, for a state with a relativelylarge number of small firms, its grant is in-creased if it uses a high threshold before pay-roll tax is levied. In addition, a state’s grantwill increase if its relative fiscal capacity (taxbase) declines when it raises tax rates. Dahlbyand Warren (2003, p. 444) examined these in-centive effects and concluded that ‘the director “first round” impact of the equalisation sys-tem on the fiscal decisions of the state govern-ments is potentially significant for a number oftaxes but especially for land taxes’. New SouthWales, in particular, has over the years arguedfor a broader interpretation of ‘what states do’through the use of global measures of revenue-raising ability.

7. Concluding Remarks

The CGC remains one of the few buffer insti-tutions in Australia that provides independentadvice on the allocation of government funds.Such bodies have disappeared in other areas,most noticeably in education. The advantagesof independent advisory bodies is that theyoperate at arms-length from day-to-day politi-cal decision-making, they build up expertise in



concepts, in institutional knowledge and in dataand they retain a long corporate memory. Allthis means that new tasks required of them startfrom a solid base. In both 1933 and 1978, thefederal government turned to the CGC whenthe ad hoc approach to federal–state financewas causing much dissatisfaction. Similarly, in2000, the federal government decided that theallocation of all GST revenue was to be made onthe basis of recommendations from the CGC.The downside of buffer institutions is that theycan become too narrow in their focus and donot consult widely enough—but this can alsobe true of government departments.

Intergovernmental relations in a federationnecessarily involve political decision-making.It is for this reason that the CGC can only oper-ate under terms of reference which are given toit by the Commonwealth government after con-sultation with the states. It is also why the CGCcan only make recommendations. The CGC hasfrequently in its reports mentioned that, in theend, it is up to government to make decisionson major issues, such as the trade-off betweenefficiency and equity, how recommendationsshould be implemented and the role of the CGCin overall federal–state fiscal relations.

February 2012

Endnotes

1. For previous discussions of the issues, see CGC (1990a,1990b), Garnaut and FitzGerald (2002a, 2002b) andWilliams (2005).

2. The CGC has documented its history in CGC (1981a,1995, 2008). See also Commonwealth Government(1975–1976).

3. The 1937 review was undertaken by a new group ofcommissioners. G. L. Wood and G. L. Creasey replacedGiblin and Sir Wallace Sanford. Eggleston remained aschairman.

4. Data taken from the Commonwealth Government’s(various years) Budget Paper No. 3 for the year after thedata year to minimise revisions; nominal sums deflated bychain price index for general government (state and local)consumption expenditure.

5. The adjusted population was calculated as (1 + d) ×(population + 4 × no. of children aged 5–15 years), wherethe population density factor d = (0.75 × d1 + 0.5 × d2

+ 0.25 × d3), d1 = proportion of state population living

in areas with a population density of less than one personper square mile, d2 = density of 1–<2 and d3 = density of2–<3. Indigenous persons were excluded from the popu-lation count.

References

Commonwealth Government (various years),Australia’s Federal Relations, Budget Pa-per No. 3, CanPrint Communications,Canberra.

Commonwealth Government 1975–1976, His-torical Appendixes, Budget Paper No. 7.

Commonwealth Grants Commission 1934, Re-port on the Applications Made in 1933 by theStates of South Australia, Western Australia,and Tasmania, for Financial Assistance fromthe Commonwealth under Section 96 of theConstitution, L. F. Johnston, Canberra.

Commonwealth Grants Commission 1935,Second Report, 1935.

Commonwealth Grants Commission 1936,Third Report, 1936.

Commonwealth Grants Commission 1972,Thirty-Ninth Report and Special Report,1972.

Commonwealth Grants Commission 1977,Forty-Fourth Report 1977 on Special Assis-tance for States, AGPS, Canberra.

Commonwealth Grants Commission 1981a,‘History of general revenue assistance by theCommonwealth to the states’, Appendix A,in Report on State Tax Sharing Entitlements1981, vol. 11, AGPS, Canberra.

Commonwealth Grants Commission 1981b,Report on State Tax Sharing Entitlements1981, Main Report, AGPS, Canberra.

Commonwealth Grants Commission 1982, Re-port on Tax Sharing Entitlements 1982,AGPS, Canberra.

Commonwealth Grants Commission 1985, Re-port on Tax Sharing Relativities 1985,AGPS, Canberra.

Commonwealth Grants Commission 1988, Re-port on General Grant Sharing Relativities,1988, vol. 1, Main Report, AGPS, Canberra.

Commonwealth Grants Commission 1990a,Report on Issues in Fiscal Equalisation, vol.1, Main Report, AGPS, Canberra.

Commonwealth Grants Commission 1990b,Report on Issues in Fiscal Equalisation,



vol. II, Appendixes and Consultant’s Report,AGPS, Canberra.

Commonwealth Grants Commission 1993, Re-port on General Revenue Grant Relativities1993, vol. 1, Main Report, AGPS, Canberra.

Commonwealth Grants Commission 1995,Equality in Diversity, History of the Com-monwealth Grants Commission, 2nd edn,AGPS, Canberra.

Commonwealth Grants Commission 2004, Re-port on State Revenue Sharing Relativi-ties, 2004 Review, CanPrint Communica-tions, Canberra.

Commonwealth Grants Commission 2008, TheCommonwealth Grants Commission: TheLast 25 Years, CGC, Canberra.

Commonwealth Grants Commission 2010, Re-port on GST Revenue Sharing Relativities,2010 Review, vol. 1, Main Report, CanPrintCommunications, Canberra.

Dahlby, B. and Warren, N. 2003, ‘Fiscal in-centive effects of the Australian equalisa-tion system’, Economic Record, vol. 79, pp.434–45.

Garnaut, R. and FitzGerald, V. 2002a, ‘Is-sues in Commonwealth–state funding’, Aus-tralian Economic Review, vol. 35, pp. 290–300.

Garnaut, R. and FitzGerald, V. 2002b, Reviewof Commonwealth–State Funding, FinalReport.

Head, J. G. 1967, ‘Financial equality in afederation: A study of the CommonwealthGrants Commission in Australia’, Finan-zarchiv, vol. 26, pp. 470–513.

Williams, R. 2005, ‘Federal–state financialrelations in Australia: The role of theCommonwealth Grants Commission’, Aus-tralian Economic Review, vol. 38, pp. 108–18.


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