ADDRESS

MENZIES RESEARCH LECTURE

STATE POLICY CONFERENCE

THE HILTON HOTEL

SYDNEY

FRIDAY, 1 JUNE 2007

In 2006-07, the States are collectively forecasting a fiscal deficit of around $4.9 billion and a cash deficit of around $7.9 billion.  The States are collectively forecast to remain in cash deficit over the forward estimates to 2009-10.  This constitutes a reversal of the surplus position that the States have been in since the beginning of the decade.  The States are borrowing to finance their deficits over the period to 2009-10 a cumulative sum of $58 billion, including borrowings by non-financial public corporations.

In contrast, the Australian Government is forecasting a fiscal surplus of $11.9 billion in 2006-07 and a cash surplus of $13.6 billion.  Underlying cash surpluses of between 1.0 and 1.2 per cent of GDP a year are projected across the forward estimate period.  These cumulative surpluses will total $50.7 billion from 2006-07 to 2009-10.

What the numbers show is that the Australian Government is contributing substantially to the pool of national savings.  As a net saver, it is not competing with the private sector for funds to invest in productive projects.  The Commonwealth is financing its investment from recurrent revenue and, after doing so, adding to savings.

Conversely the States are not funding investment from their revenues.  The States are borrowing – drawing down on savings rather than adding to them – and in this respect adding to pressure on monetary policy. 

In an interview with the Australian newspaper on 12 August 2006, the then outgoing Reserve Bank Governor, Mr Ian Macfarlane, said that the return of States to deficit spending was an issue that could affect monetary policy in future.

“I have been lucky – for most of my time, fiscal policy has consisted of small surpluses.

“So the movement in the government account has not been big enough to be important in the consideration of monetary policy.

“It might become an issue because the states are now part of the equation.”

The States point to the high levels of planned infrastructure spending as the reason for the recent deterioration in their budget bottom line.  While it is true that the States are expecting to significantly boost infrastructure spending in 2006-07 and 2007-08 compared to the levels of several years ago, the reason they cannot fund this investment from recurrent revenues is that expenses have grown strongly and run ahead of budget estimates. The windfall from the GST revenue and property taxes has been spent in recurrent expenditures.  It has not been allocated to investment.

Overall, State revenue (ex GST) has increased by an average of 7.1 per cent a year since 2000‑01.  Commonwealth-State financial reforms initiated by the Australian Government have played an important role in strengthening the financial position of the States.  As a result of the Intergovernmental Agreement on the Reform of Commonwealth‑State Financial Relations, the GST has provided the States with a stable, broad-based and growing source of revenue which they are free to spend according to their own budget priorities.  None of the States has shown an appetite for reducing tax.

The strong growth in State revenue has been matched by strong growth in expenditure.  Over the same period, expenditure has grown at an average of 6.2 per cent a year.  Employee expenses, which account for around 42 per cent State budgets, have grown by an average of almost 7.5 per cent over the last 5 years.  Despite the increases in expenditure, taxpayers continue to be dissatisfied with aspects of the services offered by the States.

A slow-down in the rate of growth in State revenue to only 2.7 per cent growth in 2006-07, combined with continued strong growth in expenses (forecast at 7.5 per cent this year), has been enough to put a big hole in State budgets.  This is why the States have insufficient operating surpluses to fund their planned infrastructure spending and are now engaged in debt financing.  Planned state infrastructure spending is also, to some extent, making up for under investment in infrastructure through the early part of the decade. 

Unfortunately the growth in revenue was not set aside to fund infrastructure.  It was spent on increasing recurrent expenditure.  Now that the States are attempting to catch up for past under investment they are forced to do so by borrowing.  During the longest economic expansion in Australian history, debt will be rising at the state level.

In contrast the Australian Government has been paying off and has now eliminated net debt.  It has been using revenue to fund its major infrastructure programmes.

AusLink is the Australian Government’s strategic long-term land transport policy. In the 2007-08 Budget, the Australian Government announced that it will increase funding under AusLink 1 by $695 million, bringing investment in land transport infrastructure to $15.8 billion over the five years to 2008-09.  Under a second AusLink national land transport plan, AusLink 2, the Australian  Government will invest $22.3 billion in road and rail infrastructure over five years from 2009-10.

The Australian Government has also introduced a number of key funding programmes to promote the sustainable use of water and invest in water infrastructure.  The $2 billion Australian Government Water Fund announced in 2004 primarily funds infrastructure projects that will improve Australia’s water management and efficiency.

More recently, the Government announced the $10 billion National Plan for Water Security.  The Plan includes: significant investment in water efficient technology and infrastructure; funding to address the over-allocation of Australia’s water resources; and reforms to the governance of the Murray-Darling Basin Commission to ensure that water is managed responsibly into the future.

On the telecommunications front, the Australian Government has provided targeted funding assistance of more than $1 billion (in the past decade) to bridge the gap in telecommunications services between metropolitan and non-metropolitan Australia.  In addition, in August 2005 the Government announced the biggest regional telecommunications programme in Australia’s history, including the $1.1 billion Connect Australia package and the $2 billion Communications Fund.

The Government has also been investing heavily in defence infrastructure and facilities.  The current Defence Capability Plan outlines $51 billion of new acquisitions over 10 years. In 2007-08, the Government’s commitment to defence will total $22 billion – an increase of 47 per cent in real terms since 1995-96. 

After under investing in infrastructure through the early part of the decade, States are generally forecasting significant increases in infrastructure spending.  Capital investment in 2005-06 was $23.2 billion, 50 percent higher than 2001-02 levels.  In aggregate, capital investment in the State public sector will be $124 billion between 2006-07 and 2009-10.  Around half is being financed by debt.

The public non-financial corporations of State Government hold the substantial stock of net debt, reflecting the investment in capital this sector requires in order to deliver services such as water, electricity and gas.  In total, net debt for the general government and public non-financial corporations sectors is expected to increase by $58 billion between June 2006 and June 2010.

Spending on productive and competitive infrastructure is a good thing.  Borrowing to fund it can be a responsible decision.  Funding it from revenue is even more responsible.

The catch up in State infrastructure spending comes at a time where there is already strong competition for human and capital resources from the private sector.  As a result this is putting more pressure on resources and bidding up prices.

For example, in Western Australia, where some projects have been delayed by six to twelve months, or even suspended, rises in costs in the construction industry and consumer demand have led to additional costs of $1.2 billion over five years for investment in electricity infrastructure in Western Australia. 

Pushing up the price of investment will generally mean that the provider will need a higher return.  This pushes up prices for business and consumers. 

In addition competing for savings, other things being equal, puts pressure on interest rates.  In the financial markets the Australian Government policy exerts downward influence on rates while State Government activity exerts upward influence. 

The Australian Government net debt was eliminated in 2005-06.  The net debt of the Australian Government’s corporations is expected to be eliminated in 2006-07.  The Government has also set aside money in a Future Fund to build savings to cover the costs of unfunded superannuation liabilities.  In the 2007-08 Budget, the Government announced the establishment of a Higher Education Endowment Fund, with an initial investment of $5 billion funded from the 2006-07 budget surplus.  This significant investment will contribute to the achievement of an Australian higher education sector of a first class standard.

And the Australian government has significantly cut tax.

Conversely the States collectively, will be building debt during this period when they have exceptionally strong revenue.

The States will receive GST revenue of $41.9 billion in 2007‑08, an increase of 5.8 per cent from 2006-07.  This includes a revenue windfall of $3.2 billion in 2007‑08 above what they would have received had the Australian Government not reformed the financial arrangements.

This annual revenue windfall will increase to $4.6 billion by 2010-11.  The growth in this windfall to the States is over and above the growth they would have received under the previous system.  To put this GST windfall in context, the amount the States would have received under the previous arrangements of now abolished taxes and financial assistance grants would have grown at 4.2 per cent, well above average annual CPI growth of 2.6 per cent over the same period.  However, GST growth has outperformed both of these by growing at an average of 7.0 per cent since July 2000. 

In return for receiving GST revenue, the States agreed to abolish a range of inefficient taxes that were impeding economic activity.  The States themselves nominated the taxes to be abolished. Some taxes were abolished immediately with others to be addressed after 2005 when the growth of GST receipts had become known and established.  It was expected that once GST revenue proved sufficient, the States would abolish these taxes.  The Australian Government has now secured timetables for the abolition of all but one of the state taxes listed for abolition in the Intergovernmental Agreement.  The abolition of these taxes is estimated to save taxpayers $5.0 billion in 2007-08, increasing over the forward years.

The GST applies to the sale of most goods and services in Australia. Its broad base makes it a relatively efficient tax because it does not affect decision making based on distorted prices.  This is in stark comparison to some of the other taxes that State governments collect, which are focused on a narrow field of economic activity and therefore have a proportionally greater impact in distorting decisions.  Here I point to stamp duties on property conveyances and stamp duties on insurance products.

State revenue from stamp duties on conveyances has grown strongly as the property market has risen during a long period of economic growth.  In total, the States collected nearly $11 billion in revenue from stamp duty on conveyances in 2005‑06, compared with $5.3 billion in 2000-01. 

Property taxes such as stamp duties and land taxes represented 33 per cent of States’ own-source tax revenue in 2005-06, up from 23 per cent in 2000-01.

Australians are paying a higher rate of stamp duty on the median house price.  States have not moved stamp duty thresholds in line with inflation let alone moved them in excess of inflation.  Had the States indexed thresholds to inflation from 1996-97, stamp duty on the median house would be 4 per cent or almost $450 lower in Brisbane, 7 per cent or around $1,300 lower in Sydney, and 24 per cent or almost $4,900 lower in Perth.

Rates and thresholds for established home owners have not changed in New South Wales since 1986, except in 2004 when a “premium property tax” was introduced for houses valued over $3 million, and stamp duty rates in Queensland increased from 1 July 2006 for houses valued at over $500,000.

State taxes on insurance significantly add to the cost of insuring.  For example, in Victoria the added taxes and charges can be as much as 70 per cent of the price of the risk premium.  This clearly results in distorted market outcomes.  It also results in poor policy outcomes as lower income earners risk significant long-term problems through under‑insurance.  The taxes on insurance fall heavily on those who can least afford to bear the risk.

Despite the States’ growing revenue sources, from GST and state taxes, the Australian Government has faced ongoing pressure to expand its role in areas of traditional State responsibility, partly in response to deficiencies in service delivery.

For example, the States have always been responsible for preschools.  In 2005-06, the States spent around $0.6 billion on preschools.  The Australian Government has taken responsibility for funding child care and in 2005-06 spent around $2.1 billion on child care.  Following changes in the recent Budget, in 2007-08 the Government will spend nearly $3 billion.

Recently some state governments have demanded the Australian Government spend more on early childhood education, despite this being a traditional area of state responsibility.  Victoria has called on the Australian Government to commit some $250 million over four years.  It apparently does not occur to the Government that since it completely controls this area it could increase funding and improve outcomes itself.  This is an example of what is becoming quite a common feature of State Governments – the demand that the Commonwealth fix areas of state responsibility.  

States and territories have traditional responsibility for the funding of vocational education and training.  One of the ways they traditionally discharged this was through technical schools at the secondary level.  However political correctness in the 1980s led many State Governments to close such schools. 

The Australian government has had to step in to remedy this terrible policy failure.

From 2005 the Australian Government has provided funding for 25 Australian Technical Colleges at a cost of $468 million over five years.  In the 2007-08 Budget we announced an additional 3 Australian Technical Colleges at a cost of $84 million over five years.  Having vacated the field none of the States shows any sign of re-establishing new technical schools.  The area has largely passed from State to Commonwealth funding.

Although in general States will demand independence from Canberra control, in practice the demands for Commonwealth intervention is usually led by the States themselves – either avoiding responsibility for some policy failure or attempting to obtain increased finance. The Commonwealth has increasingly widened its sphere of engagement in areas like education, health, environment and water.

The traffic is all one way.  I cannot think of a single area of service where the States have taken responsibility from the Commonwealth. We are therefore seeing one way traffic on areas of respective responsibility – increased for the Commonwealth, diminished for the States.

In the past the explanation for this traffic was usually financial – that the States did not have access to a growth tax and therefore could not maintain all their services.  But all that changed with the GST – a growth tax that grows in line with the production of goods and services.

It was my hope when putting these arrangements into place that this would provide a secure source of revenue which State Governments would use to take full management and responsibility for areas of State jurisdiction.

The financial arrangements changed dramatically.  Unfortunately the accountability for State administration has not changed much at all.  As I have shown the revenue growth has been eaten up by recurrent expenditure and not investment. The underinvestment which is now being rectified to some degeree is being funded through debt.

The answer is not to lower expectations of State Governments but to restore them. In my view the electorate is ready to support a State Government which will take responsibility for service delivery and prudently manage financial resources to that end.

In a speech in Shepparton in 2003 I said:

“Federalism is failing Australia.” 

Unless we restructure and improve it the current arrangements will continue to hinder our economic performance.

In a world of cut-throat competition this is a recipe for slippage which we cannot afford.

I commend the Menzies Centre for their examination of this theme of federalism and the States.

It is important and timely and represents a real contribution to the national debate on federal state issues.

Address Menzies Research Lecture – Slideshow [.pps, 36KB]