Sunday, 4 May 2014

Background briefing: Commission of Audit, Taxation

This is a background briefing prepared for the Australian Risk Policy Institute about taxation arrangements between the Australian States and Territories.  The Australian Risk Policy Institute is a non-political non-government institute.  This paper may be copied in its present form without further approval.

Canberra: Enlighten Festival, 2014 - Image thrown onto walls of the National Library
The Commission of Audit has identified a significant duplication of functions between the Commonwealth and states/local governments.

This duplication results from a single accident of history - the Australian taxation treatment of income tax.  

Denis James succinctly backgrounded this change in a 1997 paper:

Perhaps the greatest source of the current vertical fiscal imbalance was the takeover of personal income tax by the Commonwealth during World War 2. A number of the States had been levying small amounts of income tax even before Federation, although the main source of taxation revenue available to them at that time were duties of customs and excise. When the power to levy customs and excise became the exclusive preserve of the Commonwealth upon Federation, the States began to develop their income tax base. Even so, the Commonwealth began to compete for this base by commencing to levy income tax in 1915. Nevertheless, prior to World War 2, the States and the Commonwealth shared the income tax base in such a way that the States were reasonably fiscally self sufficient.

However, in 1942, the Treasurer appointed a Committee to consider the question of the Commonwealth becoming the sole income taxing authority for the duration of the War, and for reimbursement payments to be made, using section 96 powers, to the States upon their retirement from the income taxing field. At the time, the various States imposed their income taxes at very different levels. The Commonwealth wished to raise income taxes to finance the War, but found itself in a quandary. If it set its income tax at a uniformly high level, this would impose a serious burden on those inhabitants in States with high income tax. Imposing low Commonwealth tax would not yield sufficient revenue. The solution was for the Commonwealth to impose a uniform, high rate of tax and reimburse the States for the income tax that they would have forgone.

The Committee presented its report and recommended that, for the duration of the War and one year afterwards, the Commonwealth government should be the sole authority to impose taxes on income and that the States should be duly compensated. In May 1942, legislation was introduced in the Federal Parliament to give effect to this recommendation and a uniform income tax scheme came into operation on 1 July 1942.

At a Premiers' Conference in January 1946, the States were informed that the Commonwealth proposed to continue uniform taxation indefinitely. A formula approach was adopted to the distribution of tax reimbursement grants which continued to be provided on condition that the States made no attempt to re-enter the income taxing field. This left the States with little alternative other than to devise new forms of taxation. 

The central collection of income tax is not a feature of most other federal systems.  In the US, states and federal governments impose separate income taxes. 

The centralisation of income tax practice raises a couple of interesting policy issues.  

That the centralised income tax system is superior to the US system is adopted as an article of faith in Australia.  In fact, the US experience suggests that separate taxation assessment is no less effective than a centralised system (in part because state based income tax can be better integrated into property based taxation systems).  However, the mere imposition of different rates by states and commonwealth does not mean that a centralised system of collection could not be maintained, if this was seen as desirable.  Of course, the imposition of different rates would inevitably invite questions about which taxation rate you or your company was exposed to, and taxation avoidance.  Other federal states seem to have devised mechanisms to minimise these issues.

Under a return to pre-1942 arrangements, the Commonwealth would only impose income tax for federal purposes (eg, defence, international relations and federal regulatory schemes).  The States would set rates for income taxes for their own state responsibilities (eg, schools, roads and health). Under such arrangements, it is unclear what purpose a Commonwealth Departments (such as Health) and associated Commonwealth Ministers might serve.  The removal of central organising functions would probably necessitate the emergence of state-managed inter-state co-ordination capacity – as in other federal systems.

The clear advantage of such an arrangement is that it removes present confusion about which level of government is responsible for imposing and spending tax.  Local political choices have immediately recognisable taxation consequences.  While collapsing the existing arrangements would result in significant savings at Commonwealth level, a degree of interstate coordination capacity would need to be rebuilt.

Peter Quinton
Palerang  May 2014

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