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Tax Reform Discussion and a State Income Tax

Tax Insights

This issue deserves some real consideration. Of course, the devil is in the detail (which we haven’t seen yet) but the concepts are worth looking at.

The idea of a State Income Tax does not appear out of nowhere, and it is worth looking briefly at the history of this issue.

Headline reads: “Government considering a State Income Tax”

With pressure on the States and Territories to raise more of their own income, what are the chances that a State Income Tax could be reintroduced?

At a broad theoretical level, it has some appeal. The States complain of “vertical fiscal imbalance”, a term that we know reflects that the States are committed to much more expenditure than revenue they raise, with the balance coming from the Commonwealth in the form of various grants.

The introduction of the GST was supposed to overcome this to some degree, but recent and continuing events suggest that Commonwealth/State financial relationships are back where they were pre 2000.

State Income Tax not dead, only resting?

The COAG Communique issued on 1 April 2016 from the 42nd COAG meeting in Canberra stated that there was not a consensus among States and Territories to support further consideration of the proposal to levy income tax on their own behalf.

However the leaders agreed to consider proposals to share personal income tax revenue with the States and Territories to:

  • provide them access to a broad revenue base that grows in line with the economy;
  • reduce the number of tied Commonwealth grants to the States and Territories, providing them with greater autonomy and reducing administrative burden; and
  • create flexibility for States and Territories to meet their ongoing expenditure needs.

COAG agreed with the work on broader opportunities for tax reform, including state tax reform, will be progressed by the Council on Federal Financial Relations, with a progress report to COAG at its next meeting.

History

Back in the day (at the time of Federation), the States levied their own income taxes and the Commonwealth raised most of its revenue by way of customs and excise duties. In 1942 during the Second World War, the Commonwealth introduced such a high rate of income tax and gave itself priority for collection that it made it impossible for the States to continue to levy their own income tax.

This measure was a temporary one for the duration of the war and the States were given compensation by way of what are now known as Commonwealth grants. These grants were to continue for five years after the cessation of the war.

Upset at the loss of their access to income tax, a number of States (most notably South Australia) took their case to stop the Commonwealth to the High Court in 1942 in what was called “the first Uniform Tax Case”. They lost. This meant that the Commonwealth was allowed to raise income tax and take priority in collection even though it effectively meant the States could not also apply their own income tax.

In 1957, some States again took the Commonwealth to the High Court on a similar issue and, unsurprisingly, lost.

These decisions do not mean that the States cannot apply their own income taxes; it seems that they are Constitutionally allowed to do so. What it seems to mean, is that the Commonwealth calls the shots. If the Commonwealth wants to apply an income tax and take priority, it can. But there does not seem to be anything to stop the Commonwealth from allowing the States to levy their own income taxes.

On 19 January 1970, the Premiers of all States signed a document entitled The Financial Relationships of the Commonwealth and the States. This document envisaged a scheme whereby the States should have access to income tax. At the subsequent Premiers’ Conference in February 1970, the Prime Minister, John Gorton, rejected this proposal, citing a number of objections. These included macro-economic policy making considerations, the “equitable” treatment of all Australians brought about by uniform taxation, the budgetary problems that would be faced by the States as income tax receipts fluctuated and the problems that would arise in the process of calculating equalisation grants by the Commonwealth Grants Commission

In 1976, as part of Malcolm Fraser’s “New Federalism” policy, income tax sharing arrangements with the States were introduced. As part of those arrangements, the Income Tax (Arrangements with the States) Act 1978 was passed which enabled the States to levy marginal income tax surcharges or rebates. The Act was repealed in 1988 and, during that ten year period, none of the States took up the opportunity to levy their own income tax. This may have been in part because the Commonwealth was not prepared to make room by lowering its rates.

In 1991, the Working Party on Tax Powers to the Special Premiers Conference noted that addressing vertical fiscal imbalance would “involve fundamental changes to the relationships between the various levels of government as well as the tax system of the nation. Changes of this nature have far-reaching effects on the community and, while that is no reason for avoiding change, it does argue for very careful consideration”.

In 2000, the Commonwealth introduced the GST, with revenues hypothecated to the States.

In 2010, the review of Australia’s Future Tax System (the “Henry Tax Review”) noted that:

“VFI may lead to accountability problems in regard to expenditure and taxation decisions made by governments. A closer matching of revenue and expenditure responsibilities at each level of government may increase the accountability of governments by making government financing more transparent.”

The Current Problem

Put simply, the States have limited capacity to raise revenue. They have inefficient taxes like (stamp) duty which raise a considerable chunk of their revenue. There is also the unpopular payroll tax (a tax on employment) and land tax. States have varying access to mining royalties and gambling taxes but the raising of royalties effectively reduces their access to Commonwealth grants.

While some level of vertical fiscal imbalance has been in place since the start of Federation, there are some significant issues which arise from the current extent of vertical fiscal imbalance in Australia:

  • the States do not face the real costs of raising the revenue which they spend, which can make their service delivery less efficient; and
  • there is a lack of accountability and associated blame-shifting between the Commonwealth and the States, as both parties are responsible for funding service delivery across a wide range of government functions.

So in spite of many variations on revenue sharing over a long period, vertical fiscal imbalance continues to get worse. In his paper “Vertical Fiscal Imbalance in Australia: A Problem for Tax Structure not for Revenue Sharing” Bhajan Grewal (Professorial Fellow, Victoria Institute of Strategic Economic Studies) makes the following observations.

The current system of revenue sharing has produced a situation in which :

  1. the Commonwealth Government appears to believe that the centralisation of economic and fiscal decisions is necessary for the achievement of national economic objectives, and the Commonwealth grants to States are an indispensable instrument of centralisation;
  2. the Commonwealth has on occasions used the blunt instrument of Commonwealth grants to starve the States financially in order to achieve their agreement on specific issues;
  3. the States have shown, except on a few occasions when the tax powers were pursued with unanimous support, generally a preference for Commonwealth grants, and have been opposed mainly to conditions attached to specific purpose grants:
  4. the States have often been content with blaming the Commonwealth for not giving them enough funds, instead of going seriously for additional tax powers; and
  5.  the institutions of fiscal federalism largely waste their time and effort on the determination of the level, the distribution and the composition of Commonwealth grants, instead of playing a constructive role in policy development and co-ordination.

Although this was written in 1995, many of these observations still seem valid. I do note, however, that the States are playing a more constructive, if largely individual, role in tax policy development.

The States say that they want more certainty in their funding without having to negotiate constantly with the Commonwealth on how much they will get from the Grants Commission via complex formulae.

The Commonwealth is continuing to put pressure on the States to get rid of a plethora of small taxes as well as inefficient taxes like (stamp) duty. We are now considering the possibility of the Commonwealth giving a certain level of income tax responsibility to the States.

Exactly what this State income tax would look like is part of the detail to be determined. It could be on all taxpayers, an addition to the current income tax (although the current rate would presumably be reduced because the Commonwealth would have less expenditure to the States). This would seem to be the most efficient method but no modelling has been done on this to my knowledge. Perhaps it would be a business income tax only. This would need to be resolved. Those States seeking to encourage businesses could apply a lower rate, the tradeoff being that they raise less income.

The vertical fiscal imbalance would also be overcome to some extent with reliance on the Commonwealth being reduced. Presumably efficiencies would arise as there would be a significant reduction in the blame-shifting game.

Political opportunists will come up with catchy slogans as to why it won’t work, and people smarter than me will have arguments against the proposal. Some of these are addressed.

It won’t be revenue neutral. My comment: If it makes the tax and allocation system more efficient, it will hopefully save money. Not withstanding that, there is currently big demand on revenue which can only be resolved by cutting expenditure, increasing revenue or a combination of both. The current system does not lend itself to revenue neutrality.

It will disadvantage the smaller States. My comment: I haven’t seen the economic modelling on this but have no problem in accepting this. If each State and Territory is free to levy its own income tax rates (within parameters presumably), smaller States may find it difficult to compete with larger States. Perhaps some form of compensation could be built in to any model.

It is double taxation. My comment: This is just scaremongering. While technically income may be taxed “twice”, it is just a substitute for the current rates. So instead of income being currently taxed at, say 35 cents in the dollar, the new rate would be (say) 20 cents in the dollar for the Commonwealth and (say) 15 cents in the dollar for the State. How is that double taxation?

It would produce nine different tax regimes. My comment: We have not seen and detail about the proposal, but all models to date have simply used the existing Income Tax Assessment Acts, with the tax being separately allocated. Also, don’t forget that we currently have separate State Duty Acts, Payroll Tax Acts and Land Tax Acts. Hopefully some or all of those will go in the transition.

So What?

The proposed State Income tax will be difficult to sell to electors who traditionally do not trust politicians of any persuasion, State or Federal. But surely it is worth considering, especially as more details come out.

If it makes States and Territories more responsible for raising the money they spend, and adds efficiencies to the system, then surely it will be a good thing. Will everybody be better off? Probably not, but if it is for the greater good and compensation is put in place to minimise the downside, it is worth serious consideration.

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