The Australian government should give states control of a portion of the federal income tax and allow them to adjust the rate according to their needs.
Australia’s broken federation:
At the time of federation, in 1901, Australia’s state governments collected 87 percent of all government revenue.This allowed the states to have significant autonomy over their own affairs and promoted a healthy level of competition, with the federal government only taking responsibility for a few specific areas. Over the last 100 years, the federal government has gradually taken control of state responsibilities — a process that was accelerated when the federal government took control of income tax powers during WWII (While it is technically possible for states to introduce their own income taxes, they cannot do this without significantly disadvantaging themselves).
Today, the federal government collects around 81 percent of all tax revenue in Australia, and the states are largely dependent on the federal government for revenue, which provides them with 45 percent of their income. This problem is known as vertical fiscal imbalance.
Vertical fiscal imbalance has significantly reduced states autonomy and their ability to innovate and compete with each other, making them less efficient. Having one level of government responsible for service delivery and a different level of government responsible for collecting the revenue required, has made both levels of government less accountable to voters. The states are incentivized to make spending promises without having to collect the revenue to pay for them, and the federal government is incentivized to take-over state responsibilities. This is the cause of the so-called “blame game,” where each level of government blames the other for problems that occur.
Allowing states to control a portion of federal income tax would go a long way to increasing fiscal autonomy, and reducing the level of vertical fiscal imbalance. It would increase accountability for state governments. It would unleash competition, by allowing states to vary the rate of their income tax to best suit their needs. And it would encourage policy innovation, with states acting as laboratories of democracy — ultimately producing better outcomes for the Australian public.
How a new state income tax would work
In order to return a portion of income tax to state control, the federal government would need to withdraw from a certain amount of income tax, so it could be taken over by the states. In one option proposed by the National Commission of Audit in 2014, the federal government would lower the current personal income tax rate by 10 percentage points on incomes from $37,000 to $80,000 — changing the rate from 32.5 percent to 22.5 percent. A ‘state income tax surcharge’ would then be introduced, starting at a rate of 10 percent with the option for states to vary it in the future. This would grant the states control over a significant revenue source — estimated at about 25 billion per year — which they could use to further their policy priorities.
The state income tax surcharge could be collected in the same way as the rest of the federal income tax, avoiding administrative complications.
The benefits of state control over a portion of income tax
i. Accountability and efficiency
Allowing the states to control a portion of income tax would help to restore fiscal equivalence — the principle that each level of government should be responsible for raising the revenue that it spends.
This is essential to restoring accountability and ending the federal-state “blame game”. Politicians at the state level will no longer be able to blame their policy failures on a lack of federal funding. If they propose new spending initiatives, they will have to either raise the extra revenue directly — with all the potential electoral consequences — or find savings elsewhere in their budget. This is a far more transparent system than currently exists, making it easier for the public to hold their politicians to account.
This increased accountability will lead to greater efficiency at the state government level, as governments will be incentivized to use their resources in the best way possible. This is the direct opposite of the current system, which incentivizes state politicians to over promise and then complain to the federal government about their lack of funds.
ii. Increased competition
State control of a portion of income tax would unleash competition between the states.
With the ability to alter their rate of income tax — one of the most transparent taxes — states could compete with each other over the best mix of taxes and services. Some states may choose to reduce taxes and offer fewer services, while other may increase their share of income tax in order to provide a wider variety of services. Individuals and businesses would then be able to vote with their feet by moving to the jurisdiction that best suits their needs.
iii. Laboratories of democracy
The increased accountability and pressure from competition will encourage states to test and implement innovative policy solutions. Policies that prove to be a success can then be copied by other jurisdictions, while policy failures will be confined to individual states until they are repealed. This will lead to gradual improvement in government services, tax rates, regulations (and other areas) for all Australians.