1.1 What is Horizontal Fiscal Equalisation and what is it intended to achieve?
If all sub-national governments in a country faced the same circumstances – that is, if they all had the same ability to raise revenue and faced the same service costs – then HFE would not be necessary. However, different sub-national governments typically have different costs and capacities to raise revenue for reasons that are beyond their control. The process to address these differences is known as Horizontal Fiscal Equalisation(or HFE).
In Australia, HFE is not referred to in the Constitution, defined in legislation or described in any agreement between governments. Rather, the definition has evolved over time, largely through the body that administers HFE in Australia – the Commonwealth Grants Commission (CGC). The current CGC definition of HFE is:
State governments should receive funding from the pool of goods and services tax revenue such that, after allowing for material factors affecting revenues and expenditures, each would have the fiscal capacity to provide services and the associated infrastructure at the same standard, if each made the same effort to raise revenue from its own sources and operated at the same level of efficiency.1
At a simpler level, the CGC describes horizontal fiscal equalisation as follows:
… equalisation aims to put all States on a level fiscal playing field.2
The range of concepts covered by the term Horizontal Fiscal Equalisation
In Australia, HFE is performed only by payments from the Commonwealth to the States (that is, no payments are made by one State to another), a situation largely driven by the high degree of Vertical Fiscal Imbalance (VFI) in Australia.3 The current source of funds to address HFE is the revenue from the goods and services tax (GST). With HFE being sought through GST payments to the States, thechallenge for the designers of the system (and now the Panel) has been how to make these payments ‘fairly’.
Fairness is an inherently subjective concept and there is a range of views on what is, or is not, ‘fair’. Because the various perceptions of fairness are critical to an evaluation of the current system of GST distribution, this concept is dealt with in more detail later in this Chapter.
For present purposes, it is sufficient to point out that some jurisdictions and commentators argue that the Commonwealth should simply give the States the same amount of revenue per citizen, referred to as an equal per capita (EPC) distribution.4 Both New South Wales and Victoria suggest that an EPC distribution of GST would be the most appropriate form, although both States acknowledge that additional payments would then need to be made by the Commonwealth to some States, or in relation to some issues.5
New South Wales says:
An alternative distribution model incorporating an equal per capita distribution of the GST pool to all states, with an additional, separately funded equalizing distribution to the recipient states would provide a simpler, more transparent, more stable system of HFE.6
Victoria considers that:
There is a strong case for transitioning to an EPC distribution of the GST pool over the longer-term … EPC shares would be simple to calculate, thus negating the need for a complex CGC architecture to calculate relativities. The system would also be devoid of the type of perverse incentives for inefficiency that exist under the current system.7
At the other end of the spectrum of opinion, some argue that States should receive an amount based on a precise and comprehensive measurement of their revenue raising capacity and their service delivery costs. This requires a form of equalisation that is broad and deep – broad in the scope of matters it encompasses and deep in terms of the level of detail considered on each.
The current system in Australia is closer to this ‘broad and deep’ notion of HFE than equalisation systems in other countries.8 However, it is not at the extreme end of the spectrum, due to practical data limitations and prior deliberate moves towards simplicity.9
Some State submissions can be seen as proposing a move further towards the ‘broad and deep’ end of the spectrum. For example, the Australian Capital Territory proposes subsidies paid by the Commonwealth to specific industries be included, thus broadening the scope of HFE.10
Similarly, Western Australia suggests that, if the existing equalisation framework is retained, a range of ‘gaps’ should be addressed, including, for example, servicing national parks.11 Inclusion of such costs would increase the depth of relevant individual assessments.12
In short, the concept of HFE has been and can be used to cover the entire spectrum of variations between an EPC distribution and a ‘broad and deep’ form of full equalisation.
Does HFE describe the mechanism or the objective?
As well as encompassing a range of concepts, the term HFE can be used to refer to both an objective and the mechanism used to achieve it. Henry Ergas and Jonathan Pincus make this point in their submission to the Review:
Horizontal fiscal equalisation refers both to a mechanism and to an objective. The mechanism is the process through which revenues collected by the Commonwealth from the Goods and Services Tax … are distributed to the States and Territories … The objective is that of securing particular outcomes captured by the term ‘equalisation’.13
In Australia, these two meanings of the term are often used interchangeably because there has been no practical reason to differentiate between them. However, the distinction between the use of the term to describe the mechanism and the objective may become important if additional goals are sought through the GST distribution mechanism in the future.