What is fiscal equalisation?

As in other federal or decentralised unitary countries, there are inherent fiscal disparities between the Australian states arising from differences in service costs and revenue raising capacities beyond the control of governments. Absent any policy action, these differences would imply that Australian citizens face different state tax burdens, and levels of service provision, depending on where they choose to live. Such differences in the tax/service mix become more extreme as fiscal disparities between states increase.

Through the Inter-government Agreement (IGA), the states and commonwealth have agreed that the states should have ‘comparable’ fiscal capacities so that Australians face a similar tax burden, and level of service provision, regardless of their state of residence. This objective, derived from notions of equity and the need to support a national market for the movement of goods, services, people and capital, has underpinned inter-governmental relations in Australia since federation. It is not unique to Australia, and is a central principle in inter-governmental relations in many countries.

The objective is implemented in Australia by distributing the GST revenue pool to the states in such a way that seeks to ‘equalise’ state fiscal capacities, that is, to take account of differences in service costs and revenue raising capacities beyond state control in such a way that gives states comparable fiscal capacities. This process is known as horizontal fiscal equalisation (HFE). It is administered by the Commonwealth Grants Commission (CGC) which uses a formula to calculate differences in service costs and revenue raising capacities across states. The Commission then converts these measures into ‘relativities’ that are applied to the GST pool each year following recommendations to the treasurer.

As a result of applying HFE to the distribution of the GST pool, states with relatively strong fiscal capacities - perhaps because they have a comparatively strong revenue base – receive less funding per person from the GST pool relative to states with weak fiscal capacity. Conversely, states with relatively weak fiscal capacities – perhaps because they have a comparatively weak revenue base – receive more funding from the GST pool per person in order to achieve equalisation of fiscal capacities. However, after equalisation, states have comparable fiscal capacities consistent with the overarching objective behind HFE.

Federal Financial Relations

The fiscal equalisation system in Australia (Commonwealth-State financial relations) forms part of Federal Relations between the Commonwealth and the States.

The Intergovernmental Agreement on Federal Financial Relations (IGA) provides the overarching framework for fiscal equalisation in Australia.

The vertical fiscal imbalance is addressed by the Commonwealth's on-going financial support for the States' service delivery efforts, through general revenue assistance and specific purpose assistance.

The IGA provides for:

  • general revenue assistance, including the on-going provision of GST payments in accordance with the principle of HFE, to be used by the States for any purpose
  • National Payments for Specific Purposes to be spent in the key service delivery sectors
  • National Partnership Payments (NPPs) to support the delivery of specified outputs or projects, to facilitate reforms or to reward nationally significant reforms.

Schedule D of the IGA states that a State or Territory's share of GST payments will be basd on its adjusted population share. The calculation includes the Commonwealth Treasury's determination of the GST revenue sharing relativity for the State or Territory.

What is a relativity?

If States had the same economic, social and demographic features and Commonwealth payments were distributed uniformly among them, the Commission would recommend that the GST be distributed equally per person. Each State would be allocated the same (average) amount per resident.

However, some States are fiscally stronger than others — they have stronger tax bases, lower service delivery costs or receive above average Commonwealth payments. They need less GST revenue than other States if all States are to be fiscally equal.

That relative strength (or weakness) is measured by the State’s need for GST revenue, compared to the average and is summarised in its relativity. A stronger State might be assessed as needing only 90% of the average GST available on a per capita basis — its relativity would be 0.9. A weaker State might be assessed as needing 110% of the average, its relativity would be 1.1.

Some people have misinterpreted a relativity to be the proportion of the GST revenue raised in a State which is returned to that State. This would only be true if the GST collected per person were the same in every State, which given differences among the States is unlikely.

What is horizontal fiscal equalisation in practice?

The current operational definition of HFE that the commission has adopted is:

"State governments should receive funding from the pool of GST 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."

The current methods used by the Commission to determine State shares of the GST revenue are outlined in the 2015 Review. The history of the Commission's previous methods and decisions are outlined in the History page.

The pool of GST revenue

Funds available for the equalisation of fiscal capacities between the States and Territories are equivalent to the revenue received from the GST. While some States will receive shares larger than their population shares of the pool, others will accordingly receive a lower than population share.

Material factors

State fiscal capacities are affected by a wide variety of factors. The commission's recommendations take into account those factors which are outside the control of State governments.

A material factor is one whose influence on the Commission's calculation changes the GST distribution by more than a certain dollar amount per capita. That amount is determined by the Commission as part of its review of methodology.

Fiscal capacity

Fiscal capacity is a summary measure of the relative financial capacity of each State to provide general government services. Applying the same (average) set of policies to the varying circumstances of each State, it takes into account the resulting State expenses, revenues, assets and liabilities. Fiscal capacity is currently measured by reference to net financial assets per capita. States are said to have the same fiscal capacity, if after providing the same/average level of services and the associated infrastructure, and raising the same/average level of revenues, they can hold the same net financial assets per capita.

The same standard of services and the same effort to raise revenue at the same level of efficiency

The same standard of services (for example, for school or police services) and the same effort to raise revenue (for example, payroll tax rates and threshold) are defined as the average level of what States collectively do.

The level of service provided or the effort made to raise revenue is not distinguished from the efficiency with which the services are provided or the revenue raised. For example, we accept as the 'same' the expense per unit of target population, or revenue per dollar of revenue base. We are not concerned with whether a State achieves that rate through a low standard of service and an inefficient method of delivering the service or a high standard of service and an efficient method of delivering the service. We assume States operate at the 'same' level of efficiency.

Own source revenues

States' own source revenues include revenues raised by State governments other than grants from the Commonwealth government.

The average policies

The average polices are reflected in the practices of the States in the collection of revenue and the provision of services. These averages are usually weighted according to the size of the user or revenue bases in each State (for example, the average policy on school education is defined relative to the number of school-aged children).