Productivity Commission Releases Draft Report Into GST & Horizontal Fiscal Equalisation

Monday 9 October 2017 @ 11.06 a.m. | Legal Research | Taxation

Today, the 9th of October 2017, the Productivity Commission (the Commission) released their draft report for the inquiry into Australia’s system of horizontal fiscal equalisation (HFE). The purpose of this report is to inquire into the distribution of GST revenue between the States and Territories of Australia, in particular with reference to HFE. In essence, the Commission is to consider the HFE system and whether it is in the best interests of national productivity. In addition, the Commission is to consider what the influence of HFE is on:

  • Productivity, efficiency and economic growth, including the movement of capital and labour across state borders;
  • The incentives for the States to undertake fiscal (expenditure and revenue) reforms that improve the operation of their own jurisdictions; and
  • The States’ abilities to prepare and deliver annual budgets.

Horizontal Fiscal Equalisation

Horizontal Fiscal Equalisation (HFE) is a well-established system of wealth distribution between the Commonwealth and States. Present since federation, the idea of HFE is to give States the same fiscal capacity as each other, that is, by bringing all States up to the fiscal capacity of the fiscally strongest State. This is achieved in Australia through the distribution of GST to the States and Territories on a basis of relativities, which are recommended by the independent Commonwealth Grants Commission (CGC). These relativities are in turn calculated by an assessment of each State’s fiscal capacity. The assessment includes, inter alia, an assessment of the State’s costs of providing government services as well as its capacity to raise revenue. The principles guiding the CGC’s methodology are:

  • Reflect what States collectively do;
  • Policy neutrality;
  • Practicality; and
  • Contemporaneity.

As such, the CGC currently recommends the distribution of GST according to the following formula:

“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.”

This in turn creates a system whereby:

  1. States with relatively low fiscal capacities are raised to the average fiscal capacity of all States
  2. All States are then raised to the capacity of the fiscally strongest
  3. Any remaining revenue from the GST pool is distributed to all States on an equal per capita (EPC) basis

The current argument against HFE in Australia is that as a system, it struggles with extreme circumstances. As such, it is argued that the HFE system disadvantages large tax reform, particularly in the areas of energy and resources, as it creates a major first-mover disadvantage for the State implementing costly or income-driven reform. Additionally, it is argued, that HFE is incomprehensible to the general public, as well as being poorly understood by members of the Australian government which decreases knowledge of, and trust in, the HFE system.

The Draft Report

Conducted by the Productivity Commission (the Commission), the draft report into HFE is the first report in relation to an independent inquiry, started in May 2017.The Commission itself is an independent research and advisory body for the Australian Government, guided by the Productivity Commission Act 1998, whose objective is to assist the government in making better policies in the long term interest of the Australian community. The Commission therefore aims to provide advice to the government which perpetuates the achievement of higher living standards for all members of the Australia community.

What the Commission found in conducting their inquiry is that the current method of HFE can provide a disincentive for State tax reform as large policy changes may often have a great impact on GST distribution. This was found to be the case because the incentive to alter GST income provides no individual incentive for States. Any gain seen for that state would then mostly be redistributed to the rest of the States as the first step in the equalisation process.

Another challenge that the Commission found in the current HFE system is that, as it stands, mining creates large problems for policy neutrality.

“Mineral and energy resources are very unevenly distributed across States. For example, over 98 per cent of all iron ore production is in Western Australia. […] Due to these outsized effects, some have argued that States have an incentive to under-tax mineral rents or extract rents through other means. Several participants strongly criticised the HFE system as a major disincentive to States developing their mineral and energy resources. Any State that developed contentious mining activity would bear the full political cost of the development, but only retain its population share of the royalties. And there are perennial concerns that the equalisation process does not fully account for industry development expenses, though this inquiry has not been presented with new or convincing evidence that changes are required.


The potential for HFE to distort State policy is therefore pronounced for mineral and energy resources. While there is no direct evidence that GST effects have influenced specific policy decisions, the incentive effects are large and have the potential to undermine State policy neutrality over time. Yet there is no obvious and workable alternative for equalising mining revenue in a way that would not affect policy incentives. The current lack of policy neutrality may be an inevitable consequence of pursing full and comprehensive equalisation with the data available.”

In relation to the effect that HFE has on productivity and growth, the Commission found that the major concerns for these are the impact that HFE has in discouraging State revenue and reforms, as discussed above. As such, the Commission was unsure whether the HFE system in Australia has helped or hindered Australia’s productivity and growth.

The Commission summarised the current system as functioning reasonably well in relation to equity, independence and transparency of process and stability. However, the Commission outlined a number of deficiencies in a number of areas, in particular in: equalisation being taken too far; policy neutrality; and simplicity and comprehensibly.

“Overall, the current HFE system goes too far in the pursuit of equalisation and much beyond what other federations do. Arguably it also goes beyond what a unitary government would do, which is providing a level of services to all residents that is relatively consistent from one year to the next, and which is likely closer to the average across the nation. In contrast, equalising to the strongest State — particularly when the strongest State is so much stronger — has meant equalising to a benchmark that is relatively volatile.”

The Commission therefore recommended a revision to the objective of the HFE.

“The primary objective of the HFE system should be to provide the States with the fiscal capacity to allow them to supply services and the associated infrastructure of a reasonable standard. This objective should be pursued to the greatest extent possible, provided that:

  • it does not unduly influence the States’ own policies and choices beyond providing them with fiscal capacity;
  • it does not unduly hinder efficient movement of capital and people between States;
  • the process for determining the distribution of funds is transparent and based on reliable evidence.”

The Recommendations

In summary, the Commission made a number of draft findings and recommendations which are presented to aid in reforming the HFE system to be more in line with the best interests of national productivity and wellbeing. Some examples of these are:


The Commonwealth Government should clearly articulate the objective of HFE. This objective should aim for reasonable rather than full equalisation (as envisaged in draft finding 2.1). The objective should be established through a process led by the Commonwealth and involving consultation with the States, and should be reflected in the Intergovernmental Agreement on Federal Financial Relations. The objective should also be reflected in the terms of reference which the Commonwealth Government issues for the yearly update and five-yearly methodology review. The Commonwealth Grants Commission Act 1973 (Cwlth) should also be updated to reflect the adopted objective.


The Commonwealth Government should direct the CGC, through the terms of reference it receives, to consider approaches to assessment that deliver significant simplification and ‘good enough’ equalisation outcomes. The use of more highly aggregated assessments should receive detailed consideration as part of the current CGC process.


The Commonwealth needs to develop clear guidelines detailing the basis on which Commonwealth payments are to be quarantined from HFE by the Commonwealth Treasurer, so that they do not unnecessarily erode the efficacy of the CGC’s relativities. The guidelines should be based on the principle that quarantining of payments ought to occur only in exceptional circumstances.


The CGC — through its Chairperson and Commission members — should provide a strong neutral voice in the public discussion on the HFE system. The CGC should also enhance its formal interactions with the State and Commonwealth Governments. In particular, it could provide draft rulings to State Governments on the potential HFE implications of a policy change.


The CGC should make the data provided by the States publicly available on its website, along with the CGC’s calculations on these data. Where there are risks identified with this approach, mitigating steps should be identified and taken.


The Commonwealth and State Governments, through the Council on Federal Financial Relations, should develop a process that would work towards a longer term goal of reform to federal financial relations. In the first instance, it should assess how Commonwealth payments to the States — both general revenue assistance and payments for specific purposes — interact with each other today, given the significant reforms to payments for specific purposes that have occurred in recent years. The process should also work to a well-delineated division of responsibilities between the States and the Commonwealth, and establish clear lines and forms of accountability. Policies to address Indigenous disadvantage should be a priority in this regard.

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