Australia is believed to be the first federation to have introduced a formal system of horizontal fiscal equalisation (HFE) which was introduced in 1933 to compensate States which have a lower capacity to raise revenue. Many federations use fiscal equalisation to reduce the inequalities in the fiscal capacities of sub-national governments arising from the differences in their geography, demography, natural endowments and economies. However the level of equalisation sought varies. In Australia, the objective is full equalisation.
Full equalisation means that, after HFE, each of the six States, the Australian Capital Territory and the Northern Territory (the States) would have the capacity to provide services and the associated infrastructure at the same standard, if each State made the same effort to raise revenue from its own sources and operated at the same level of efficiency.
Currently the funds distributed to achieve HFE are the revenues raised from the Goods and Services Tax (GST), currently about AUD50bn a year. The distribution of GST required to achieve HFE is decided by the Federal Treasurer each year, on the basis of advice provided by the Commonwealth Grants Commission (CGC).
Achieving HFE does not mean that the States are directed how to raise revenue or how to spend their funds. GST revenue grants from the Commonwealth are untied and available for any purpose. Accordingly, HFE equalises fiscal capacity, not fiscal policies which remain for the States to decide for themselves. It does not result in the same level of services or taxes in all States, direct that the States must achieve any specified level of service in any area, nor impose actual budget outcomes in accordance with the Commission’s calculations.