Inside Story

State income tax: the idea that could one day fly

Abolished in 1942, revived but never implemented in the 1970s, this might have been the tax reform whose time had come, writes Tim Colebatch. But Malcolm Turnbull’s timing couldn’t be worse

Tim Colebatch 31 March 2016 1982 words

Prime minister Malcolm Turnbull might reach an agreement with state premiers including Mike Baird (centre) and Daniel Andrews (right) if the state income tax proposal revives after the election. David Moir/AAP Image

Conceptually, the Turnbull government’s proposal for the states to levy an income tax surcharge has a lot to recommend it. The hostile, knee-jerk reactions from some commentators reveal more about their political sympathies than their understanding of the issues – or the long history of this idea.

That doesn’t mean it will take off. To do that, it would need bipartisan support, yet it has been floated at the worst possible time. Of course Labor premiers won’t support it on the eve of a federal election. It isn’t going to happen.

The lesson of the past six months is clear: if we want tax reform to occur, it will need to be handled from the outset on a bipartisan – or tripartisan – basis, with a clear recognition of the goals it has to meet. Tax reforms are like referendums: without support from both sides of politics, there is no prospect of success.

The two big tax reforms of recent decades – the Hawke government’s reforms in 1985, and the Howard government’s GST in 1999 – became law only because of the support of the much-maligned Australian Democrats, a responsible centre party that held the balance of power in the Senate. We are unlikely to see another party like the Democrats again, so we will need to find a way of negotiating tax reform without them.

And if and when we do, a state income tax should be high on the list of options for change. It would be one of several, but in many respects it is better than the alternatives.

First, it would give the states better tax choices. It would be fairer than a GST. It would do less economic damage than payroll tax or stamp duties on property transfers, the two main taxes the states now control. And it would provide the states with a growth tax to match the increasing demands on government services.

Second, it would allow the states to raise the money to keep schools and hospitals going, after the Abbott government cut $80 billion from their future funding. There is a bizarre reluctance among most of the commentariat to grasp the seriousness of this issue for ordinary Australians, who rely on state-run schools and hospitals, and do not have the means to opt for private education or healthcare.

Somehow, the states are going to have to raise that extra revenue. We need to debate the best way of doing so, and a state income tax would be one of the best options.

Third, it would almost certainly be accompanied by reforms to federal–state relations to reduce the wasteful duplication of responsibilities between the two levels of government, which are ultimately paid for by taxpayers. It would streamline the process of government, and reduce its cost.

It’s to be hoped that the reform of federal and state responsibilities would be politically more sensitive and attuned to public sentiments than the prime minister’s bewildering suggestion on the ABC that the Commonwealth might end funding of government schools but continue funding non-government schools. That’s a policy strongly recommended for any party that is tired of being in government and would prefer a spell in opposition.

This is why the state income tax idea has been around for a long time, and keeps coming back. In 1976 Malcolm Fraser as prime minister unveiled a similar proposal, as stage two of his New Federalism policy, and parliament subsequently passed legislation to allow any state to impose an income tax surcharge.

As in the not-so-distant past – the states lost their income tax powers only in 1942 – there would be just one tax return, one agency collecting it, one set of rules defining the tax base, exemptions and so on. Each state would just decide which rate it wanted to add to the federal tax, and Canberra would collect it and pass it on.

Yet although the legislation sat on the books for twenty-one years, no state ever did levy a tax surcharge. Why not?

Former Victorian premier Dick Hamer, Fraser’s firmest ally at state level on this issue, claimed Fraser had welshed on an unwritten agreement that the federal government would pave the way by cutting its own income tax rates to “make room” for the states to impose theirs. Without that political cover, any state government imposing its own surcharge would be lifting taxes overall, and taking a huge political risk. Fraser denied there had ever been such an understanding, and blamed the states for preferring to spend federal money rather than raise their own.

The issue was revived in 1991 when NSW Liberal premier Nick Greiner and Queensland Labor premier Wayne Goss were partnering Labor prime minister Bob Hawke in wide-ranging reforms aimed, in part, at ending duplicate federal and state policy management. As part of that effort, they proposed a broadly similar scheme, in which part of the federal income tax would initially be earmarked as a states’ income tax, with the states able to vary the rate after three years.

But the same old parrot cries of “dual taxation” were heard loudly once Paul Keating, then on the backbench, seized on the issue in his ultimately successful campaign to unseat Hawke as PM. The plan died when Keating won. The Howard government then repealed Fraser’s legislation as part of its GST reforms.

To sum up: the issue keeps coming back because there are good arguments for it. But it is very tricky to handle politically – which is why no one would introduce a serious proposal on the eve of a federal election. It won’t happen this time. But there are good reasons why it should happen next time.

Let’s look at some of the arguments raised against it.

Wouldn’t it mean double taxation, with Australia going from one income tax system to nine separate ones?

It is double taxation in the sense that both federal and state governments would be charging us income tax. But we already have that in other areas: the states apply land tax to our homes, or some of them, while the local council taxes the same home with municipal rates. No one regards that as an outrage.

As for nine separate tax systems, shadow treasurer Chris Bowen, who made the claim, knows it is phoney. Bowen has written a book on Australia’s former treasurers, and surely knows that that was not how the system worked when the states had income tax powers. There was only one income tax system then, and there would only be one in future.

Would it mean different tax rates in different states and territories?

Possibly. If it lasts long enough, then probably. The states levy their other main taxes at different rates: payroll tax, stamp duties on property sales, and land tax rates all differ between one state and another. In time, if they are free to change the rates, they will no doubt do so – either raising them to help meet a revenue crisis, or cutting them to try to win votes.

Wouldn’t that spell chaos for business?

Nope. States in the United States levy income tax at different rates. Strange to say, the American economy still works, quite well in fact. Business manages to function in Australia with different rates of state payroll tax. And note: business does not pay individual income tax. The only impact on nationwide businesses would be that their accounting systems would have to be adjusted; that’s easily fixed.

Wouldn’t people move interstate to avoid higher taxes?

Are you kidding? We are only talking surcharges here. Even if there were a difference of 1 per cent in the tax rates in New South Wales and Queensland (which is very unlikely), and your taxable income is $80,000, that’s an extra $800 you would be up for that year. The cost of selling your home, moving interstate and buying another one would be at least $40,000. And when you got there, you might find that the relative tax rates had changed, and you’d moved the wrong way.

Will it mean higher taxes?

Maybe. One hopes so, because the alternative is that Canberra will continue running deficits far into the future. Even after all those spending cuts in the 2014 budget, the Abbott government was spending $1.10 for every $1 it raised in revenue. Coalition and Labor governments have been doing that, or worse, for eight years now. If you don’t want that to continue, you have to make even deeper spending cuts, or raise taxes, or most likely both.

A report this week from the Committee for Economic Development of Australia warns that as expenditure rises with the ageing of the population, and as interest bills mount, the Commonwealth could remain stuck in deficit far into the future unless it bites the bullet and raises taxes – either directly, or by a sidestep in which the states raise taxes in return for losing Commonwealth grants.

Would the smaller states be disadvantaged?

Possibly, but only if there were a separate policy change to abandon the ideal of “horizontal fiscal equalisation,” under which the Grants Commission adjusts GST grants to the states to take account of their different capacities to raise revenue.

Certainly the states’ income tax capacities are very different; incomes in Sydney, Canberra, Melbourne and Perth are considerably higher than in South Australia and Tasmania, and hence a uniform state income tax of 2 per cent would raise very different amounts per head in different states. Tax expert Neil Warren, of the University of New South Wales, has estimated that the Australian Capital Territory would raise more than twice as much per head as Tasmania from an identical income tax rate.

But the Grants Commission routinely adjusts state GST entitlements to fully offset these differences. Just as Western Australia gets a low share of the GST because it raises so much from iron ore royalties, so the states and territories that would raise most from a state income tax would find their relative gains redistributed away when the commission calculates their next GST payment.

The Fraser government’s 1978 legislation made it clear that state income taxes would be included in the commission’s estimates of states’ entitlements. If the Turnbull government wanted the states to get different benefits, it would have to specifically direct the commission not to include state income taxes in its calculations. There is no sign that it plans to do that.

Wouldn’t it mean a “race to the bottom” in which states compete to cut tax rates, forcing them to cut services as well?

Only if state governments think they will win more political support from lower taxes than they would lose from lower services. It is no more likely than the opposite fear, that states will keep raising taxes so they can expand services.

The issue we are not facing up to is that the federal government is spending more than it earns, much more. This is not normal. This is not just a stage we are passing through. This is not something harmless, with no negative effects down the track. It is as dangerous in the long term as it would be if a family constantly spent more than it earned, year after year.

Eventually the debt collector calls. Your options become limited, painfully so, and stay limited for a long time. Your former lifestyle is now out of reach. As the CEDA report points out, this is not somewhere we want to go.

But all that depends on bringing a realistic approach to tax reform. That is no longer possible this side of the election. •