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Turnbull's State Income Tax Proposal Is A Stroke Of Foolishness

31/03/2016 12:38 PM AEDT | Updated 15/07/2016 12:51 PM AEST
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Initial reaction to Turnbull's proposal to allow some form of State income tax has ranged from it being considered as a stroke of genius, through to foolishness, even before the detail has been settled. And reaction has been further confused by inconsistencies between the Treasurer and the PM as to how it would work.

At its most basic level, it is simply a reclassification, replacing grants from the Commonwealth for things such as schools and hospitals, presently allocated on a more or less ad hoc basis, with a guaranteed share of income tax revenue.

This could be more attractive to the States as it would give them more direct access to a "growth tax", but would in no way guarantee that such funding would be adequate to meet the spiraling longer-term costs of health and education, with little increased "discipline" on their spending, or incentive for them to be more cost-conscious or efficient.

If the money runs out they will still "blame" the Commonwealth.

At a more sophisticated level, the attempt is to deal with what economists call "vertical fiscal imbalance" -- that is, the States do the bulk of the spending, without having the odium of having to raise the taxes to pay for it. It is argued that this would give them greater responsibility, impose more discipline, and remove their capacity to "blame" the Commonwealth.

This would mean that ultimately States could set their own rates of personal income tax, on some agreed basis. So, there would be no guarantee that the "total tax burden" would not increase, and there would also still be a need for "horizontal fiscal equalization" reflecting the reality of differential taxing capabilities between the States -- still some capacity for blaming.

Politically, it will be difficult to sell the idea of "another layer of tax", at the discretion of another layer of politicians, raising fears of an "American style" complicated, three-level tax system. With the distrust of politicians as great as it is, it will just look like yet another way to raise more tax.

As to eliminating the blame game, the essence is to make a once-and-for-all decision to allocate responsibilities for specific areas of government spending to just one level of government, with an absolute commitment to essentially close down the other level of government. For example, allocate education as a State responsibility, thereby being able to close the Federal Department of Education except for a national standards/curriculum responsibility, or have a single national Department of the Environment, closing State departments.

It was hoped the current Review of Federation would have made such recommendations. Then, against that background, consideration could be given to the most effective, fair and simple means of funding a reconstructed Federation, genuine tax reform.

Unfortunately, the Federation Review will fall well short of this ideal, and this tax proposal works to further fragment our Federation when, surely, we should focus on a national approach, to develop a national economy and social system, with a minimum of inconsistencies and impediments, rather than a confederation of independent, and competitive, States.

Just look at how the States, through competition, have neutered payroll tax, in principle one of the most effective taxes. Just imagine how competition with income tax rates may have significant labour market consequences with our mobile workforce.

Much progress has been made, across many policy and regulatory areas, to develop a national approach in recent years. This would be a significant backward step.

We might also learn from the current European/Euro difficulties. The longer-term success of the Euro, as a common currency, necessitates a unification of budgetary policies. This has been almost impossible for them to achieve, and the differences are now unsustainable, with weaker players, such as Greece, risking an exit.

Do we really want to risk the long-term stability of our common currency, the $A, as already significant differences between the States are accentuated? We will still need to channel significant grants to the weaker States that will not be able to fully fund their health and education bills, even with considerable taxing powers.

Handing back income tax powers to the States could also significantly constrain the Commonwealth Government's capacity to manage its income tax. For example, suppose the Commonwealth wants to hand back bracket creep. Is it going to have to gain the approval of State governments to vary tax brackets/rates?

Let's hope this proposal doesn't get up. While Turnbull may see some short-term political gain, it would have significant longer-term negative consequences for our national economy, and for the very fabric of our society.

Foolishness indeed!

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John Hewson is a Professor in the Crawford School, ANU, and a former Opposition Leader

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