Comparing Fiscal Federalism in Canada and Australia

One interesting topic for a Canadian living in Australia is the manner in which fiscal and social responsibilities are divided between the levels of government.  Both countries are big, regionally diverse, and resource-rich (with all the pluses and minuses that entails).  As in Canada, Australian states are largely responsible for the big-ticket social programs: including health care, hospitals, and education.  The federal (or Commonwealth) level retains some direct social funding responsibilities, however.  For example, the Commonwealth government provides direct operating grants for schools (including, unfortunately, to the private schools that serve about one-third of Australian primary and secondary students).  The federal government also pays directly for Australia’s progressive pharmaceutical benefits scheme (which provides low-cost prescription drugs).

The revenue side of the equation, however, is much more centralized than in Canada.  The federal government retains full control over the biggest revenue levers.  Australia’s 10% GST is collected solely by the federal government, as are all personal and corporate income taxes.  Funds are then allocated to the states through large transfer payments to support the cost of state-delivered programs.  Federal cash transfers to the states average about 6% of GDP per year — almost twice as large as in Canada.

“Fiscal federalism” is thus more developed in Australia than in Canada.  There is more revenue-sharing throughout the country, than if each state were required to raise and spend its own tax revenues.  This contributes to a greater degree of regional equality in Australia; and the gap between richest and poorest states is significantly smaller than in Canada.  For example, per capita disposable income in resource-rich Western Australia (the richest state) is only 23 percent higher than in Tasmania (the poorest).  The comparable imbalance is more than twice as large in Canada: Alberta (highest) has a 56 percent advantage in per capita disposable income compared to Quebec (lowest).  If we considered the per capita value of public services as part of the overall consumption bundle, then the gap between Australian states would appear even smaller.

The Australian system also provides some built-in stabilization against the impact of regionally concentrated economic cycles — especially the periodic resources booms (and busts) which have dominated the economic trajectory of both countries in recent years.  Since the federal level of government collects a much larger share of total tax revenues, even a regionally concentrated resource boom will generate more spillover benefits to the rest of the country.  And at the same time, the inevitable bust will also be partly smoothed automatically by the operation of revenue-sharing mechanisms going the other way.

All this is the backdrop for a recent debate in Australia about whether more tax powers should be devolved to the state level.  This was the latest big idea on economic policy from Australia’s ruling Coalition government (an alliance of the conservative Liberal Party and the even-more-conservative rural-based National Party); they proposed to grant independent income tax powers to the states. The proposal was floated as a trial balloon, by an unpopular government struggling to define a compelling economic agenda in advance of a federal election later this year.  But the idea would clearly be a big step backward for the long-run conduct of fiscal policy in Australia.

Indeed, Canada’s experience with tax devolution provides an appropriate cautionary tale. Individual provinces in Canada set their own personal income, corporate, and sales tax rates. That hasn’t ended ongoing fiscal squabbles between the governments. But it has sparked a damaging competition to cut taxes that has undermined the revenue base for public services, exacerbated regional inequality, and contributed to growing debts.

After all, the devolution of income tax powers in Australia would naturally be accompanied by a devolution of funding responsibility for health care, hospitals, and schools. Coalition leaders argue that forcing state governments to raise the money they spend will enforce more accountability and efficiency in public service delivery. It’s also their response to demands from states for more revenues; the states are especially angry over an $80 billion Coalition cut from state transfers, announced in its austerity-focused 2014 budget. (That will sound familiar to Canadian readers, paralleling the former Harper government’s unilateral cut in CHT transfers.)  The Coalition’s retort is: “If you need the money so much, go out and raise it yourself.”

But that theory hasn’t exactly come true in Canada.  Canada’s ten provinces, with wide tax autonomy, reflect enormous variation in tax rates (and rules). Top marginal provincial income tax rates for 2015 ranged from 11.25 percent in Alberta, to over 25 percent in Quebec and New Brunswick. Provincial taxes, of course, are additive to those levied by the federal government (with its own top marginal federal income tax now rising to 33 percent). Each province sets its own rules regarding coverage, eligible deductions, and tax brackets, complicating inter-provincial commerce.

It’s not just that individuals pay tax  to two different levels of government. (Australians are aghast that Canadians have to submit two forms each year, to separately determine what they owe to the federal and provincial governments.) More damaging are the long-run fiscal and social mechanisms set in motion by interprovincial tax disharmony.  Provinces enjoying stronger economic conditions can reduce their tax rates, yet still meet revenue targets. This sparks a destructive race-to-the-bottom in tax rates that undermines government revenues across the country.

The worst example of this occurred during the resource boom of the 2000s. Oil-rich Alberta adopted a low flat-tax applying to all taxpayers (no matter how wealthy). This heightened demands on other provinces (felt most acutely in neighbouring British Columbia and Saskatchewan, but across Canada too) to reduce their own taxes in tandem. Well-off Canadians (especially those with significant business or investment income) can easily establish multiple residences, allowing them to pay their tax in lower-rate provinces. So the threat of relocation (whether real, or just for tax purposes) reinforces the race to the bottom.  Just one example: the threat by Canada’s big banks to nominally relocate their head offices to Alberta was a significant factor in the Ontario government’s 2010 decision to cut its own corporate income tax rate.

Regional inequalities are clearly exacerbated under the Canadian system.  Consider New Brunswick, a poorer eastern province, with a population of just 750,000. Its top marginal income tax rate is now more than twice as high as Alberta’s (and New Brunswickers also pay more GST: Alberta has no provincial GST, while New Brunswickers pay 8 percent, in both cases on top of a 5 percent federal levy). This makes it all the harder to retain young people, attract investment, and catch up to the rest of the country. Underfunded provincial schools obviously don’t help the province’s recovery, either.

By undermining fiscal capacity, interprovincial tax competition has also contributed to the escalation of provincial debt. Some provinces (like New Brunswick) now owe over 40 percent of their GDP in provincial debt (on top of their share of federal debt, another 33 percent of GDP). Alberta and other higher-income provinces have virtually no debt. Yet indebted provinces pay higher interest rates than Ottawa, generating many billions of dollars of avoidable debt service charges. It would be more efficient and less expensive for both revenues and debts to be managed centrally, in order to minimize both tax competition and interest rates.

The Australian government’s most unbelievable claim is that tax devolution would end fiscal squabbles between the governments. That was the theory in Canada in 1977, when the federal government transferred 13.5 percentage points of income tax room to the provinces, to fund provincially-delivered health and education programs. Forty years later, however, the squabbling is louder than ever. The provinces cannot hope to single-handedly fund public services from their own revenues (especially given the destructive effects of tax competition). So Ottawa still transfers $65 billion per year to the provinces (one-quarter of all federal spending). And debates over those transfers are as intense as ever — such as current provincial fury over the unilateral Harper reduction in federal health transfers (a problem which the new Liberal government has yet to address).

Federalism is a messy business. And that’s probably how it should be: the whole idea is to ensure a healthy balance between national and regional interests. Australia’s current system clearly promotes more efficiency in revenue collection, greater revenue-sharing between regions, and less of a race-to-the-bottom tax competition.  The Coalition’s hope that a one-time tax transfer to lower governments would somehow fix all problems of funding, revenue-sharing, and accountability is pure fantasy.

As it turns out, Coalition leaders abandoned the idea even more suddenly than they embraced it.  After all of one day of meetings with reluctant state Premiers, Prime Minister Turnbull quickly dumped what only days earlier he had described as a transformative change in Australian governance.  Now the Coalition is using the whole escapade as political cover, claiming that the states’ refusal to agree to raising their own income taxes disqualifies them from complaining about federal cutbacks.  Scott Morrison, the government’s Treasurer, says the whole gambit was merely intended to “call the states’ bluff.” (He reportedly was not even aware of the devolution plan, until the Prime Minister was announcing it, reinforcing the atmosphere of chaos currently enveloping the Coalition government.)

For Canadians, meanwhile, it is interesting to consider the strengths of a more centralized fiscal system like Australia’s.  The idea of removing provincial autonomy over income and sales taxes in Canada, replacing own-source revenues with larger transfers from the federal level, is far-fetched at present, and would require much study and debate.  But Australia’s experience certainly confirms the virtues of centralizing revenue collection, limiting interprovincial tax competition, and expanding inter-regional transfers.