01 May 2015
By Alex Sanchez and Michael Potter

A federation fit for purpose

Significant debate is ongoing about collecting the GST and distributing it to the States. The West Australian Premier, Colin Barnett, was apparently ‘furious’ over the GST split provided to WA, with the state getting less than 30 cents in the dollar of GST revenue. The other states retorted that Western Australia signed up to the current system, and should therefore live with the consequences. And the commonwealth, like a parent turning away as the kids squabble, utters that it’s the responsibility of the states themselves to agree. Meanwhile, the federal government is proposing to apply GST to online services such as Netflix and clamp down on GST avoidance through the cash economy, and others are contemplating an increase in the GST rate.

However, the fixation by commentators and policy makers on how much GST is collected and how it is distributed tax revenue means that the bigger question, what taxes should the States collect, is overlooked.

The starting point is that the Federal Government raises much more tax revenue than it needs, while the States raise much less. So the Fedstop up State Budgets by distributing revenue (the GST) to the States. It is this distribution formula that WA is complaining about, a more vehement version of similar complaints recently by other large States (NSW and Victoria).

The issues get worse. Despite being sold the GST as a growth tax, GST revenue is growing more slowly than expected. A lot of this structural (growth in the consumption of GST exempt goods such as health) while some it cyclical (we are saving more and spending less). Whatever the case, the largest states, WA in particular, are hit by a double whammy: GST growing slowly, and then being distributed to other States.

But for all the sound and motion on this issue, theneed for State tax reform as a means of fixing State budgets and growing their economies is sadly missed. While reform of the GST and its distribution are important, these are not themost urgent or most beneficial reforms. The largest benefits, in fact, will come from reforms to State taxes, particularly stamp duty, land taxes, insurance taxes and payroll taxes. This should be the first order priority for the Federal and State governments. Distribution issues should be secondary. As they say – a rising tide lifts all boats.

A recent analysis by the Treasury makes the opportunities clear. In simple terms, stamp duties are the worst tax; and taxes on land are the best. Stamp duties are worse than taxes on companies; and land taxes are better than the GST. There are similar results in many other studies, including modelling conducted for the Henry tax review by KPMG Econtech.

It should therefore be pretty clear that a big cut to stamp duties, paid for by an increase in land tax, will provide considerable upside to the economy. Using a higher GST to pay for a lower tax on companies is also beneficial of course, but nowhere near as beneficial as using land tax to pay for a cut to stamp duty.

It is somewhat mystifying why this reform option is always missed in all the huffing and puffing over the GST and company tax. Perhaps it is because stamp duty is paid by only a small number of people, while there are many more paying company tax and GST? Or possibly because it would mean a tax that is paid infrequently (stamp duty) is replaced with a tax paid frequently (land tax). But if you took this view of the world, then why was the Wholesale Sales Tax replaced by the GST?

In any case, the politics of this reform is not as toxic as some might think. The ACT Government has forged a path with implementing this tax switch, and there should be useful lessons from this reform for other States. Indeed, the ACT took such a tax reform package to an election, and notwithstanding some opposition, was re-elected. Political commentators may need to have another think about just how “hard” reform actually is, after the examples of both NSW and the ACT. Both these governments have demonstrated that hard reforms stand up to strident opposition.

Although land tax offers both an efficient and equitable source of revenue, it is unlikely that State governments would accept replacement of all their grants and taxes with asubstantial increase in land tax. There are a number of other tax options worth exploring, particularly to substitute for grants from the Federal Government. The State Governments should fully explore these options before they retreat to crying poor or pathetically complaining about inadequate Federal Government funding.

Firstly, State governments could make better use of their payroll taxes. The States have made this tax fairly inefficient, mainly because they provide high exemption thresholds. Only larger businesses now pay payroll tax. As economists will often tell you, a broader payroll tax at a lower rate wouldbe fairly similar in its economic incidence to a GST.

So reform of payroll tax and GST could substitute for each other. Payroll tax could be replaced by a broader GST (or vice versa). There are arguments for and against each tax - for example, payroll taxes magnify any inefficiencies in the labour market, particularly if wages can’t adapt to the tax, while GST exemptions create distortions which aren’t usually mirrored in payroll taxes. Whatever the case, there is scope for new thinking. There could also be substantial simplification from the Commonwealth collecting payroll tax through the BAS system. The States could nominate their own payroll rate (the tax base would be agreed between the States) and the Commonwealth would merely return all tax collected to the relevant State and independently of the Grants Commission process.

But another option is for the Federal Government to cut income taxes and State governments to levy a replacement income tax surcharge (given the economic costs of income taxes, overall increases in these taxes shouldn’t be on the agenda). This proposal was given some consideration in the early 90s and has recently been resuscitated by Dr Peter Hendy, formerly of ACCI and now a Federal MP. Irrespective of whether it is income tax surcharges or reform of payroll taxes, the task for the Commonwealth and the States is to make better use of tax bases beyond the GST and to use the available administrative arrangements to ease into that change.

There are other things the States could do such asmake better use of user charging. In particular, better road user charging would bring a multitude of benefits including reducing congestion, encouraging public transport use and reducing the need for it to be subsidised, improving signals for road investment, encouraging teleworking, encouraging more efficient use of land and reducing adverse environmental impacts. Technology could also be applied to the pricing of parking spaces and transit lanes. The States can give a jolt to productivity through structural reforms in markets (potato marketing boards, anyone?) and retail trading hours. And of course, the States could alleviate their revenue requirements by operating their budgets more efficiently or better still, removing themselves entirely from services available in private markets.

What all these solutions share in common is that they offer superior benefits to merely increasing GST revenue. They are a hand up not a hand out. And if States care about their own sovereignty (which frankly all Premiers should), then the importantly reduce the dependence of State governments on the Federal Government.

Now that would be a plan.