Income Taxation, Schools, Hospitals and Federalism

Dugald Monro

Professional Associate with the Institute of Governance and Policy Analysis, University of Canberra.

Recently Malcolm Turnbull floated allowing the States and Territories to raise their own income taxation while handing total funding responsibility for public schools and hospitals to them. The April 1 Council of Australian Governments meeting rejected the proposal and it was withdrawn. However it is worth examining as the idea of States collecting their own income seems to resurface from time to time. Turnbull’s proposal would have been a fundamental change to how federalism has operated in Australia since 1942. Prior to 1942 States did raise their own income tax, alongside Commonwealth income tax.  The Commonwealth took over all income tax collection during WW2 in order to maximise funding for the war effort. Since WW2 the Commonwealth has provided general revenue assistance to the States and Territories (which can be spent as the States and Territories wish), originally primarily from Commonwealth raised income taxation, but now primarily from the Commonwealth raised GST. The Commonwealth also expanded the Specific Purpose Grants made to the States and Territories. These must be spent on the specified purpose.

Malcolm Turnbull has supported his position by arguing that if  States and Territories had to raise their own revenue, it would force them to be careful and efficient in their expenditure. He has also said that it would end the blame game, where both the Commonwealth and the States and Territories blamed each other for the state of services provided. To deal with the latter point first, this seems unlikely. The States and Territories would be likely to blame the Commonwealth for any total increase in income taxation (Commonwealth and State/Territory combined), claiming that the Commonwealth’s actions forced this on them. In contrast, the Commonwealth would say it was purely the State or Territory’s responsibility.

The type of federation where each level of government is responsible for discrete areas, including both raising the money and all expenditure in the area, is known as co-ordinate federalism. One issue raised with co-ordinated expenditure is that of ‘spill overs’. These occur where the actions of one level of government in their sphere of responsibility impact on the actions of the other level of Government’s sphere of responsibility. Both public schools and hospitals would be potentially subject to ‘spill overs’ from Commonwealth action. Funding for private schools would remain a Commonwealth responsibility. But the level and nature of private school funding can change the demand for public schooling (and vice versa). The original argument in the early 1960s for government funding for private schools was that private schools reduced the demand for, and thus the cost of, public schools. Should, for example,  Commonwealth funding arrangements for private schools lower the availability of low fee charging private schools in certain areas, then increased demand for public schooling, and thus increased demands for funding, would be likely. With hospitals the rate of hospitalisation can be affected by decisions made by the Commonwealth on the health insurance system (Medicare). The Government has announced changes to funding within Medicare to provide packages for chronic disease sufferers. One aim of this is to reduce hospitalisation. This would reduce costs to the States. A joint press release from Malcolm Turnbull and Health Minister Sussan Ley (31/3/16) announcing the initiative stated that ‘the  Prime Minister will invite State  and Territory leaders to partner with the Commonwealth on these reforms’, thus recognising the interdependence of the Commonwealth and the States and Territories, a point not acknowledged by the proposal to hand responsibility for hospitals entirely to the States and Territories.

A variation on the idea of ‘co-ordinate federalism’ is ‘competitive federalism’. This not only wishes to separate spheres of responsibility between levels of government, but also argues that competition between governments over taxation and service provision is desirable. States and Territories could choose the levels of taxation to charge, and the level of services offered, in order to attract businesses and people to their State or Territory. Proponents see this as encouraging efficiency and allowing citizens to choose the levels of taxation and services they prefer. However it also raises the question as to whether ‘a race to the bottom’ might occur. By lowering both taxation and services, e.g. public hospital or schools, a State or Territory might attract people and businesses who wished to pay less tax and didn’t care about the services, possible because they can afford to buy them privately. Schooling is an example: those using private schools (funded by the Commonwealth) might prefer lower taxes and lower spending on State schools. Conversely a State or Territory that had higher taxation and services might attract those who desired the services, particularly those on lower incomes who would pay less additional tax. An example could be those who couldn’t afford private schools but wanted decent public schooling. The result could be unsustainable for the second State or Territory. In this situation people would not effectively be able to choose a higher rate of taxation and services as no State or Territory could afford to do so. Of course, the extent to which people or business would move as a result of different levels of taxation and service provision is unclear, but the possibility is there.

This brief account, drawing on federalism theory, suggests that a lot more work is required before any proposal such as the States and Territories levying their own income tax is put forward. What would be done about ‘spill overs’? Are we happy if service provision varies markedly in different States and Territories? Could a race to the bottom be avoided? It also points to the need for fundamental examination of the nature of our federal system rather than piecemeal reforms to meet a particular situation. 

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