The Turnbull government’s decision to follow the Fraser and Hawke governments in trying to resurrect a state income tax — last seen in Australia in World War II — will have a significant bearing on its political fortunes. Turnbull, consciously or not, this morning mimicked John Howard’s 1998 announcement of his decision to pursue a GST this morning when he declared he was embarking on a “journey” toward state income tax (Howard used “adventure”, about the GST; like Howard was, Turnbull is also trying to convey a sense of decisiveness in a first-term government that appears directionless). But while Howard faced an enormous challenge in convincing the electorate of the benefits of a GST, Turnbull faces a different kind of political challenge. Because under almost any scenario, under a state income tax South Australia and Tasmania get screwed.

There’s a strong economic logic behind a state income tax: it remedies that pernicious malady of the Australian federation, vertical fiscal imbalance, in which state and territory governments have significant spending responsibilities like health and education but rely on the primary tax revenue raiser, the federation, the Commonwealth, to allocate funding for them. This leads to brawls both among the states (over the distribution of GST revenue) and between the states and the Commonwealth — as has been going on since 2014, for instance, over the $80-odd billion in health and education funding that Tony Abbott and Joe Hockey cut that year.

It also appeals to economic purists because it would engender competitive tension between the states. Those states that can run their services more efficiently can reduce their income tax level, thereby attracting people away from other states. It would also put an end to that most annoying of political cliches, the “blame game”, in which the Commonwealth says it’s the states’ responsibility to run health and education and the states say they don’t get enough money to do so, and voters are caught in the middle. State and territory governments would have access to a tax revenue source to fund their services and could adjust it to provide better services if they wanted to, and allow voters to judge the results. Moreover, as Crikey pointed out last year, income taxes are actually forecast to rise more quickly than GST revenue, making income tax more of a “growth tax”.

All of that’s fine in theory, but there’s a basic design challenge. Assume Turnbull and first ministers agree to allocate a chunk of current income tax revenue to the states. How do allocate that chunk among the states? On population? On taxable income? On current tax paid? The allocation potentially varies significantly depending on which method you use, as two tax academics, Richard Eccleston and Neil Warren, pointed out in a paper in December. Because each state varies in terms not merely of population but of wealth and of distribution of taxpayers — some states have proportionally more high-income earners, or proportionally more low-income earners (or in the case of NSW, both of those) — slicing and dicing Commonwealth tax revenue requires some careful thought to avoid, if it’s possible, exactly the brawl that has been playing out over GST allocation for years now.

And if you go further and allow the states to increase their own chunk of income tax, how does that apply? Do they lift all tax rates by the same amount for every resident in that state (putting aside the potential for gaming where you live for tax purposes, which high-income earners would be able to do)? Do they hit only high-income earners? Or low- and middle-income earners? Do they make their system more or less progressive? The ACT, for example, has a very high proportion of high-income earners compared to other jurisdictions, so it would make a lot more money from a small increase in the top tax rate compared to other states.

For the bigger states, how you allocate revenue makes a difference. But for the smaller states, the stakes are much higher: under any proportional allocation of revenue, Tasmania and South Australia will lose out, badly. Because those states are smaller and poorer, any method of proportional allocation will leave them comparatively poorer. “In the case of South Australia and Tasmania, their lower incomes unsurprisingly result in revenue well below the national average from these state-based income taxes,” Eccleston and Warren conclude. It means that, in order to raise the same amount of income tax revenue, South Australia and Tasmanian would have to lift their income tax rates much higher than other states.

Needless to say, this would be a deterrent to people moving to those states. Alternatively, those states could cut their services, which would also be a deterrent. Either way, there would be a vicious circle established in which higher taxes or poorer services compared to bigger states would deter people and business from those states, which would further undermine their revenue.

Turnbull said this morning that, somehow, South Australia and Tasmania would be protected. But how? There would need to be some mechanism for non-proportionally reallocating revenue from other states to those states, as currently happens with the GST. But imagine Mike Baird or Daniel Andrews trying to pitch a 1% income tax rise to their voters but having to admit a portion of it would go not to NSW or Victorian services but to Tasmanian or South Australian services.

Whether South Australian Premier Jay Weatherill — who last November suggested a fixed allocation from existing income tax revenue, without any state capacity to vary income tax levels — has fully thought through the allocation issue isn’t clear. Once it does become clear, a state income tax might end up being a whole lot less palatable for some politicians. And a lot of voters.

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Peter Fray
Peter Fray
Editor-in-chief of Crikey
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