Federalism and the corporate governance analogy

Not only is a growing proportion of the funds going to the states now earmarked by the Commonwealth for purposes that fit its policy priorities, but its overall funding has effectively been shrunk, contrary to the Federal Government’s claims that its post-GST revenue-sharing arrangements have been a bonanza for the states.

Howard’s implementation of the GST as a supposedly “state tax” went some way towards repairing the shattered fiscal imbalance in one sense, but it remains completely under federal control and subject to alteration or removal at its whim. Although GST is a so-called “growth” tax, it isn’t growing anywhere near as fast as GDP, partly because it doesn’t capture revenue from the export sector of the economy but also because health and education are removed from the GST revenue base. Hence state budgets come under ever-increasing pressure and progressively fall behind as a proportion of GDP, while the Commonwealth’s share of revenue rises inexorably because of its control of corporate and personal income tax.

However, even vertical fiscal imbalance has its upside. It has facilitated the uniquely Australian institution of the Commonwealth Grants Commission with its poorly understood, regionally egalitarian and nation-building mission. The Grants Commission helps to ensure that smaller states are able to deliver comparable service levels to the mega-states of NSW and Victoria, a highly desirable outcome that would be much more difficult to achieve in the absence of a predominant national government revenue-raising role. In pure economic efficiency terms as well, it makes much more sense to have a single national income tax and GST system rather than separate ones for each of the eight states and territories and the Commonwealth. What is required is a system that restores a workable sovereign role for the states while maintaining predominantly unitary national tax collection.

A federal reform agenda

The election of a Rudd Labor government provides a unique opportunity for fundamental reform of Australian federalism. Tackling vertical fiscal imbalance must be a critical part of any such reform package, but we also need to redesign and sharpen the functional policy/management division between Commonwealth and states. The SMH article by Steve Burrell mentioned earlier also reports a proposal by Glenn Withers for repairing vertical fiscal imbalance:

SPPs [Special Purpose Payments] should be abolished and replaced with an equivalent share of income tax to be given to the states to spend as they see fit.

“A crucial first step … would be folding all specific-purpose payments into a general-purpose payment and keeping them as a fixed share of GDP … pending a constitutional convention which would review state tax powers,” he argued.

The only problem with solutions like this is realpolitik: no Commonwealth government is likely to surrender control of the federal purse-strings without receiving a compensating advantage from the states. At the moment, the Commonwealth mostly exercises policy oversight over the states through using tied grants or SPPs under Constitution section 96. Providing the states with a guaranteed untied share of revenue sufficient for their needs, as Withers proposes, would largely destroy the Commonwealth’s policy leverage over the states.

However, as I argued above, it actually makes sense in governance terms to have policy centrally co-ordinated via a co-operative federal structure like COAG, with day-to-day management and operational control vested in states and local governments able to understand and respond to local circumstances, needs and wishes.

In order to persuade the Rudd federal government to agree to permanently restoring vertical fiscal balance (as Withers proposes), the states will need to agree to refer powers to the Commonwealth under Constitution section 51(xxxvii). It isn't generally understood that our Constitution already contains the machinery necessary to redesign the federal balance of powers. The Commonwealth should logically have general power over the incorporation of companies (it controls them once they’re incorporated anyway); river flows in the Murray-Darling basin; and (subject to some safeguards) industrial relations. The states should also agree to refer policy but not operational control over health, education, transport activities directly affecting exports, and climate change, subject to COAG's co-ordinating role.

The major advantage the states would gain by agreeing to make these sorts of wide-ranging referrals of their constitutional powers to the Commonwealth would be that they would agree to do so only at the price of effectively entrenching a reciprocal Commonwealth guarantee to restore vertical fiscal balance. The states would refer these powers only for so long as the Commonwealth kept its promise of maintaining the states’ reasonable fiscal requirements as defined in the referral enactments, with that funding to be delivered in accordance with the recommendations of an independent and apolitical Commonwealth Grants Commission (to maintain equity in service provision between smaller and larger states).

Hence the states collectively would have a veto against overweening exercises of Commonwealth power. On the other hand, the Commonwealth would still possess the ultimate threat of pulling the pin on the entire arrangement and reverting to its current reliance on coercive section 96 grants if the states proved unduly obstructive in COAG.

Commonwealth threats to the states’ grant funding under our existing federal arrangements have been critical to the successful achievement of consensus on several key instances of “co-operative” federalism, notably the gun buyback scheme in the wake of the Port Arthur massacre, and less overtly in achieving national numeracy and literacy testing and agreement-in-principle on a national secondary education curriculum. The existence of some tension or ultimate threat/power residing in the Commonwealth may well be necessary to avoid permanent gridlock, inertia or a tendency of the states to relegate critically important but politically contentious issues to the “too hard” basket. However, at least with this proposal the Commonwealth is constrained by the fact that the states have a countervailing power to threaten to withdraw their referrals of power.

The states can refer powers under section 51(xxxvii) subject to conditions. In R v Public Vehicles Licensing Appeal Tribunal (Tas); Ex parte Australian National Airways Pty Ltd, a relatively rare unanimous High Court decision and one of the few dealing with section 51(xxxvii), the Court observed:

There is no reason to suppose that the words “matters referred” cannot cover matters referred for a time which is specified or which may depend on a future event even if that event involves the will of the State Governor-in-Council and consists in the fixing of a date by proclamation.

The states have in fact adopted this suggestion, most notably in their referral to the Commonwealth of powers to enact anti-terrorism legislation including so-called “control orders”. None of the Justices who considered the question in the recent High Court decision in (Jihad Jack) Thomas v Mowbray doubted that a referral in tightly limited terms was constitutionally valid. A flexible system of federal division of powers, whereby the states make strategic use of the referral provisions of the Constitution as a counterbalance to federal fiscal dominance, has significant advantages over any rigid constitutionalised division of powers.

Sadly, these ideas are likely to prove too utopian for our political practitioners. Nevertheless, they’re eminently feasible in legal and constitutional terms and would truly make Australia a world’s best practice model of federal governance, a worthwhile objective in a political environment mostly characterised by electorally driven, unadventurous “me-too-ism”.