Horizontal fiscal equalisation and disincentive effects – by Jim Hancock

A number of submissions to the Productivity Commission’s Horizontal Fiscal Equalisation (HFE) Inquiry have argued that GST grants should be distributed between the States equal per capita. But conventional policy goals such as promoting efficiency, equity and productivity at the national level provide no support for this prescription.

NSW and WA have argued to the Inquiry that GST funds should be allocated on an equal per capita basis. Both of them rest their case on the (dubious) claim that HFE substantially undermines incentives for States to pursue desirable reforms to promote growth and productivity. A number of private submissions express similar views.

Whether or not disincentive effects are substantial is a central issue for the Productivity Commission to resolve. I am sceptical that they are large. But even if they are, it does not follow at all that an equal per capita distribution is the best remedy.

Disincentives to States’ reform and development efforts can be removed with any scheme that makes grants invariant to State decisions. There are many schemes that fit the bill, such as:
• choosing a set of relativities and fixing them for ever—for example we could adopt the current relativities for ever (in contrast to equal per capita which is equivalent to adopting relativities of 1.000 for every State);
• adopting a pre-determined trajectory of changing relativities, for instance a trajectory derived by extrapolating current trends; or
• using a state-contingent set of relativities with the state variable being some factor that is indisputably beyond the influence of any State—for instance relativities might adjust in light of global mineral prices which in most cases could be regarded as beyond the influence of any State.
In the economics jargon, all of these schemes are “lump sum”, in the sense that the grant received by a State is independent of any action that it takes. None of the arguments about distortions to State decisions under HFE have any traction with these arrangements.

It is apparent from the listing above that there is a large “family” of grant distribution schemes that avoid any adverse incentive effects for the States. But which one is “best” among them? The answer to that question depends on what objectives the policy maker pursues.

If the objective is to maximise growth and consumption levels, then achieving an efficient allocation of labour and capital is important. The national policy maker will want to ensure that labour and capital are allocated where their marginal productivities are highest. If this is to be achieved then it is important to neutralise fiscal differences between States. If there are fiscal windfalls to be had from locating in WA and fiscal disadvantages from locating in Tasmania, these need to be removed if efficient location decisions are to be achieved.

To illustrate the point, consider a boat builder making a location decision. It could locate in Tasmania, which has a relatively weak fiscal capacity because it has limited mining royalties. Or it could locate in Perth, and cash in on royalty streams that are generated from iron ore operations some 1,200km to the north. Even if the innate cost and productivity characteristics meant that Tasmania were a more efficient location for boat building, the decision could be tipped in favour of Perth because locating there would entitle the boat builder to a share in the spoils of mining activity far to the north whereas locating in Hobart would not.

A policy maker who is concerned about efficiency—that is, maximising the living standards of the Australian community broadly—will want a grant distribution that avoids distortions like these. Adopting the current relativities on a go-forward basis will support this goal more effectively than an equal per capita distribution. This is so because in the near term the current relativities can be expected to be more effective than equal per capita in offsetting the fiscal externalities that arise from differing State fiscal circumstances. As we go further ahead, State fiscal circumstances will change and the current relativities will become less accurate as an indicator of needs, but not necessarily worse than equal per capita. So locking in the current relativities dominates equal per capita on grounds of efficiency, productivity and Australia-wide living standards.

A policy maker who is concerned about equity will need to reflect on what is meant by “equity”. Competing concepts are “equal per capita” and “horizontal equity”. The superficially appealing “equal per capita” argument is that equitable treatment requires giving each State the same per capita amount of GST. The “horizontal equity” principle is that like individuals should receive like fiscal treatment regardless of their location decisions. So, for instance, horizontal equity would require that a two-income family with two children should receive a similar distributive transfer (positive or negative) regardless of whether it chose to live in Brisbane or Perth or Dubbo or Bairnsdale. But if the horizontal equity principle is pursued, then differences in the economic and demographic structure of the States will need offsetting adjustments via the grant distribution. For example, if one State has large mining royalties to support its residents and another does not, then the grant distribution will need to offset this.

What would these two competing equity principles mean for choosing a policy-invariant distribution? Clearly if the equity goal is to have an equal per capita distribution then an equal per capita distribution is the solution. But if horizontal equity is the goal, then HFE is what is required. And locking in current relativities will perform better than an equal per capita distribution, for essentially the same reasons put forward above in respect of location efficiency.

While locking in current relativities will perform better than equal per capita on the criterion of efficiency and horizontal equity, it may be possible to do better. We could for example use relativities that vary in line with some extraneous indicators such as mineral prices, but with the taxable base fixed at contemporary output levels or fixed on the basis of an assessment of deposits within each State, so as to avoid distortions to future mining development decisions.

On grounds of national efficiency, productivity and equity there is a strong argument that a scheme that locks in current relativities in perpetuity dominates an equal per capita distribution. I wonder though, how those who have argued to the Commission that disincentive effects to the States are important would feel about this scheme. When confronted with this effective solution to their asserted problem, rather than their own preferred solution of equal per capita, I suspect that they would not be satisfied.

WA and NSW might even argue that the failure to adjust the grant distribution to changing circumstances in the future is a problem: after all WA might not always enjoy strong mining royalties, should the GST distribution not adapt to this? But a distribution that adapts to changing State circumstances is exactly what we now have. It is called horizontal fiscal equalisation. Would WA and NSW prefer to abandon HFE if the solution to alleged disincentive effects is not on the self-serving terms that they promote?

There are strong grounds for the Productivity Commission to rule out an equal per capita distribution of GST revenues on the grounds identified above. It should acknowledge that locking in current relativities, perhaps with some allowance for factors absolutely beyond the influence of the States, is superior to an equal per capita distribution on both efficiency and equity grounds.

The Commission would then need to consider whether the distortions inherent in the current HFE system are really so bad that national economic goals would be better served using the current relativities in perpetuity without adjustment for changing State circumstances. My belief is that they are not, and that HFE should remain the principle for allocating Commonwealth funds between the Australian States. But the answer will depend on the Commission’s findings about the importance of disincentive effects.

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