This week’s announcement by the Prime Minister about a possible change in income taxation might have come as a surprise to many people. As it was pointed out by many economists, journalists and the opposition leader, the current income taxation structure, where the Federal Government collects all income tax and doles it out to the States has been in place since 1942.

The challenge facing the States is that they do not have enough funding for health and education. The Prime Minister has suggested that this new splitting of income tax will address the problem and States will be able to fund their schools and hospitals with their share of income tax.

So we thought it might be time to have a look at the structure of the Federation under our Constitution and the evolution of our taxation system. Perhaps then we can better judge this week’s announcement.

First things first – before Federation

Before we Federated in 1901, the country we call Australia was made of up of six British colonies. Each of these colonies had their own taxation systems, their own militaries, their own voting systems etc. By the second half of the nineteenth century there were discussions about Federating and the colonies joining together. One of the most famous speeches about Federation was from Henry Parkes in Tenterfield in 1889:

The great question which we have to consider is, whether the time has not now arisen for the creation on this Australian continent of an Australian government and an Australian Parliament.

Parkes’ speech went on to discuss the need for a Federal army and the need for a nationwide uniform gauge railway line. But he also brought up the need to:

Devise the Constitution which will be necessary for bringing into existence a Federal Government with a Federal Parliament for the conduct of this great national undertaking.

He then goes on to say:

The Government and Parliament of New South Wales would be just as effective as now in all local matters, and so would the Parliament of Queensland. All great questions will be dealt with in a broad manner just as the Congress deals with the national affairs of the United States and as the Parliament of the Dominion of Canada deals with similar questions.

So Henry Parkes indicated that the States would still look after local matters while the new Federal Government would take care of broad national affairs.

Are health and education a local matter for the States? Or do we see these services as a national affair?

At Federation

Quick and Garran described taxation in 1901 in the Commentaries on the Constitution of the Commonwealth of Australia and wrote:

Taxation may be now defined as any exaction of money or revenue, by the authority of a State, from its subjects or citizens and others within its jurisdiction, for the purpose of defraying the cost of government, promoting the common welfare, and defending it against aggression from without.

And taxation power was given to the Federal parliament through Section 51ii of the Constitution:

51 Legislative powers of the Parliament
The Parliament shall, subject to this Constitution, have power to make laws for the peace, order, and good government of the Commonwealth with respect to:
(ii)  taxation; but so as not to discriminate between States or parts of States;

But the States also retained taxation power.

After Federation

At Federation or soon after, each of the States levied income tax from their populations, while the Federal Government obtained income from customs and import duties. It wasn’t until 1916 that the Federal Government introduced income tax in order to raise revenue to fund Australia’s involvement in WWI. In 1923 all States except WA came to an agreement that joint income tax returns would record both State and Federal taxes and the States would collect the tax and then hand the Federal Government their portion. The system was complex and the amount of tax paid by people in each State was different.

As a war time measure in 1942, the Federal Government suspended all agreements with the States for the imposition and collection of income tax and took over the role. In return for this revenue power the Federal Government agreed to give some of the proceeds back to the States which is in the form of funding grants as outlined in Section 96 of the Constitution:

Section 96 Financial assistance to States 
During a period of ten years after the establishment of the Commonwealth and thereafter until the Parliament otherwise provides, the Parliament may grant financial assistance to any State on such terms and conditions as the Parliament thinks fit. 

Thus the agreement made in 1942 meant that if a State did collect their own income tax, they would forfeit their Federal funding grants. And as stipulated in section 96, the funding grants are given to the States with terms and conditions, meaning they have to be spent in the way the Federal Government specifies. The system has remained this way since and has been endorsed by the High Court.

Would we be untying a complicated knot?

Perhaps. Since Federation we have seen more power given to the Federal Government by the States. The suggested taxation changes would seek to reverse this. The States would be given back the power to collect additional revenue for themselves which won’t be tied up with the terms and conditions of Federal funding grants.

But, by doing this we might be tying a new complicated knot. At the moment we have one income tax system. If the States also collected income tax, we might be adding further complexity to the system. However, this type of taxation is common in other countries, including the US, Canada, Switzerland and Germany.

The system of Federation in the US allows the Federal Government, States and even some Local Governments to levy income tax. So the States (and Local Governments) have the option of competing with each other by levying different levels of income, company, consumption and other taxes. While you’re in your working phase of life you might want to live somewhere that has the lowest income tax rates. If you’re a business owner you might want to set up your business in a State that has the lowest company tax rate and once you retire you might want to go and live in a State that has the lowest consumption tax rate as you spend your nest egg. This might work well in a country with 50 States. But how will it work in a country with six States and two Territories?

We have seen this type of competition in Australia in the 1970’s and 80’s and it was a race to the bottom with taxation in the States. Queensland Premier Joh Bjelke-Petersen was the first to cut death duties and the other States quickly followed. Why would this time be any different? Would we see the States trying to outdo each other on tax cuts, ensuring that the services that we need such as health and education were reduced?

Then there is the fairness issue. How will the States with smaller populations and lower income levels be able to collect enough revenue to run their schools and hospitals to the standard that is expected? The Prime Minister has signalled that these States won’t be disadvantaged. Presumably because they will continue to receive grants. Which does make the new system seem somewhat pointless. It doesn’t matter if a State can’t collect enough revenue, because the Feds will pick up the tab anyway.

Ordinary Australians will need to be convinced that these potential changes would actually improve anything. What’s the point of shaking up the Federation if the outcome for schools and hospitals is the same or perhaps even worse?

And then there is another thought - why share income tax this way? Why don’t the Federal and State Government split company tax? States could then encourage businesses to set up in their State with competitive company tax rates.

Last week the most well-known republican in Australia, our Prime Minister, used the Royal Prerogative to force the Senate to return early and this week he’s looking at shaking up the Federation through taxation. Could this be part of significant Constitutional change program?

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