What Price a State Income Tax?

With pressure on the states (and territories) to raise more of their own income, what are the chances that a state income tax could be reintroduced?

At a broad theoretical level, it has some appeal. The states complain of “vertical fiscal imbalance”, a term that reflects that the states are committed to much more expenditure than revenue they raise, with the balance coming from the Commonwealth in the form of various grants.

The introduction of the GST was supposed to overcome this to some degree but recent events suggest that Commonwealth/state financial relationships are back where they were pre 2000.

History

Back in the day (at the time of Federation), the states levied their own income taxes and the Commonwealth raised most of its revenue by way of customs and excise duties. In 1942, the Commonwealth introduced such a high rate of income tax and gave itself priority for collection that it made it impossible for the states to continue to levy their own income tax.

This measure was a temporary one for the duration of the war, and the states were given compensation by way of what are now known as Commonwealth grants. These grants were to continue for 5 years after the cessation of the war.

A number of states (most notably South Australia) took their case to stop the Commonwealth to the High Court in 1942 in what was called “the first Uniform Tax Case”. They lost. This meant that the Commonwealth was allowed to raise income tax and take priority in collection even though it effectively meant the states could not also apply their own income tax.

In 1957, some states again took the Commonwealth to the High Court on a similar issue (boringly called the second Uniform Tax Case) and, unsurprisingly, lost.

These decisions do not mean that the states cannot apply their own income taxes; it seems that they are Constitutionally allowed to do so. What it means, I think, is that the Commonwealth calls the shots. If the Commonwealth wants to apply an income tax and take priority, it can.

But there does not seem to be anything to stop the Commonwealth from allowing the states to levy their own income taxes.

The Current Problem

Put simply, the states have limited capacity to raise revenue. They have inefficient taxes like (stamp) duty which raise a considerable chunk of their revenue. There is also the unpopular payroll tax (a tax on employment) and land tax. States have varying access to mining royalties and gambling taxes but the raising of royalties effectively reduces their access to Commonwealth grants.

The states want more certainty in their funding without having to negotiate constantly with the Commonwealth on how much they will get from the Grants Commission via complex formulae.

The Commonwealth is continuing to put pressure on the states to get rid of a plethora of small taxes as well as inefficient taxes like (stamp) duty. Consider the possibility of the Commonwealth giving a certain level of income tax responsibility to the states.

Exactly what this state income tax would look like is part of the detail to be determined. It could be on all taxpayers, an addition to the current income tax (although the current rate would presumably be reduced because the Commonwealth would have less expenditure to the states). This would seem to be the most efficient method but no modelling has been done on this to my knowledge. Perhaps it would be a business income tax only. This would need to be resolved. Those states seeking to encourage businesses could apply a lower rate, the trade off being that they raise less income.

The vertical fiscal imbalance would also be reduced with reliance on the Commonwealth being reduced.

This is a preliminary proposal, food for thought if you like. Sure, there is a lot of work to be done on such a proposal but why don’t we have a look at it?

Who would be against it? The states? Unlikely, as it would give them more control and certainty over their revenue collections? The Commonwealth? Surely not, if such an agreement resulted in the states getting rid of inefficient taxes. Taxpayers (read electors); probably, because we have become accustomed to not trusting politicians of any persuasion.

But maybe a bit of competition between the states on income tax rates would be a good thing.

Politics aside, would it improve our overall tax system??

I’d love to hear your thoughts. Is it worth investigating further?