HORIZONTAL FISCAL EQUALISATION

The general revenue assistance provided to the States by the Commonwealth is largely distributed on the basis of the horizontal fiscal equalisation (HFE) principles which are embodied in the per capita relativities recommended by the Commonwealth Grants Commission (CGC) - see Box 1. The objective of HFE is to improve equity for all Australian residents.

In its assessments, the CGC uses a complex methodology that takes account of differences in the per capita capacities of the States to raise revenues and differences in the per capita amounts required to be spent by the States in providing an average standard of government services. A State's actual per capita expenditure or revenue generally differs from the average of all States for two reasons:

influences that are beyond a State's control (referred to as 'disabilities') affect the cost at which it can provide services and its capacity for raising revenue; and
a State's policies, practices and operating efficiency differ from those of other States. [1]

HFE requires that only those factors beyond a State's control be taken into account in determining a State's relative needs and hence the distribution of Commonwealth general revenue grants. The CGC's recommendations seek to ensure that each State has the capacity to provide the average standard of State-type public services if it makes the same effort to raise revenue as the States on average and operates at an average level of efficiency.

Since 1990-91, the CGC's assessments have been based on data for the five financial years preceding the year in which the assessment is made. Accordingly, the review period for the per capita relativities to be applied in 1997-98 spans the years 1991-92 to 1995-96. The five year review period replaced a three year review period and aims to provide greater year-to-year stability in the distribution of FAGs among the States and hence provide a greater degree of certainty for the States in their forward planning. This was balanced against the greater contemporaneity of assessments with current circumstances that would be provided by a shorter review period.

By international standards, the extent of HFE in Australia is pronounced and the methodology is complex. The complexity of the CGC's processes has arisen in response to the requirements of the States and the Commonwealth over time for a comprehensive and rigorous approach to HFE. For its part, the CGC has sought to maximise the transparency of its methodology and to provide the opportunity for input and comment by the States and the Commonwealth.

Further information on HFE is provided in the CGC's 1997 Update report.

BOX 1: COMMONWEALTH GRANTS COMMISSION
The Commonwealth Grants Commission (CGC) is an independent statutory authority established by the Commonwealth Grants Commission Act 1973.
The CGC makes recommendations concerning the distribution of general revenue assistance to the States in response to terms of reference provided to it each year by the Commonwealth Government.
The Commonwealth's practice is to consult with the States concerning the CGC's terms of reference with a view to reinforcing the Commission's position as an independent arbiter in relation to horizontal fiscal equalisation.
The terms of reference define the general approach to be followed by the CGC as well as any specific conditions or limitations on the extent to which fiscal equalisation is to apply.
The CGC produces both annual updates and five-yearly reviews. Updates essentially revise the data upon which the CGC's assessments are based. The longer term reviews encompass changes to the Commission's methodology. The next review is scheduled for implementation in 1999.

Effects of Horizontal Fiscal Equalisation

The CGC first reported on relativities for the six States simultaneously in 1981. Prior to that time, the CGC's major task was to assess applications by 'claimant States' for special financial assistance from the Commonwealth under section 96 of the Constitution. The reviews of relativities were widened to include the Northern Territory in 1985 and the Australian Capital Territory in 1993.

The distribution of the pool of FAGs and HFGs in accordance with the CGC's per capita relativities means that New South Wales, Victoria, Western Australia and the Australian Capital Territory receive less than an equal per capita share, and the other States (particularly the Northern Territory and Tasmania) receive more. This reflects the CGC's assessment that the 'donor' States have greater relative revenue capacities and/or less significant expenditure disabilities than the other States.

Table 3 shows the amount of FAGs and HFGs received by each State under HFE relative to the amount that they would receive on the basis of an equal per capita distribution or a distribution based on personal income tax collections. The table shows that, in 1997-98, around $1,500 million (or 7.4 per cent) of the FAGs/HFGs pool is to be redistributed among the States as a result of the application of the CGC's relativities, compared with an equal per capita distribution.

Table 3: Impact of Horizontal Fiscal Equalisation on the Distribution of the Pool of Financial Assistance Grants and Hospital Funding Grants in 1997-98 ($million)(a)

(a) The pool consists of $16144.0 million in FAGs and $4102.9 million in HFGs - see Table 11 in Chapter III.

(b) 1997 relativities as recommended by the CGC - see Table 4 below.

(d) Based on each State's contribution to total net tax paid by individuals for 1994-95, as shown in Table P15 of Australian Taxation Office, Taxation Statistics 1994-95.

Table 4 shows the per capita relativities used to distribute the combined pool of FAGs and HFGs since 1993.

Western Australia and Queensland have experienced the largest declines in per capita relativities, reflecting relatively strong economic growth in those States which has contributed to an increase in their assessed fiscal capacities.
- In its 1997 Update report, the CGC for the first time assessed Western Australia as having above average fiscal capacity, reflected in a per capita relativity of less than one.
The per capita relativities of the remaining States (except for South Australia) have increased, particularly those of Victoria and Tasmania.

Table 4: Commonwealth Grants Commission Relativities, 1993 to 1997

(a) Supplementary relativities calculated by the CGC to take into account the Medicare Agreements and Commonwealth policy in respect of State stamp duty exemptions for corporate reconstructions.

(b) The 1996 Update relativities as amended by the CGC's subsequent alternative calculation of 29 May 1996 relating to the treatment of Section 130 payments to Western Australia by deduction.

The estimated State distribution of general revenue assistance on a per capita basis for 1997-98 is shown in Chart 6. It indicates that New South Wales, Victoria and Western Australia receive less than average per capita payments while the Northern Territory receives five times the national average and Tasmania and South Australia also benefit from above average per capita payments.

Chart 6: General Revenue Assistance, 1997-98

Source: Table 6 of this Budget Paper.

Fiscal Equalisation and Specific Purpose Payments

In determining per capita relativities for the distribution of general revenue assistance, the CGC takes account of the interstate distribution of most current SPPs. Within the CGC's methodology there are four approaches to dealing with SPPs.

Inclusion is used for SPPs which are considered to go towards meeting the CGC's assessment of State expenditure needs (for example, SPPs for funding government schools). In essence, this assumes that the provision of funding through SPPs is no different in effect from the provision of general revenue assistance.
Absorption is a variant of the inclusion approach with the main difference being that SPPs treated by this method are added to the pool of FAGs and the CGC's recommended per capita relativities are determined with regard to the combined pool in that year. Unquarantined HFGs are treated in this manner.
Deduction is used where an SPP is considered to finance expenditure in addition to that which the States would otherwise have undertaken or where an SPP is distributed in accordance with the CGC's assessment of State needs. Under this approach, only the State-funded portion of expenditure is included in the CGC's assessments. A number of health SPPs - including the incentives package and bonus pool payments in the Medicare Agreements - are treated by deduction. The deduction approach seeks to quarantine the distribution of FAGs from the interstate distribution of SPPs.
Exclusion is used for SPPs which are directed to areas in which the Commonwealth has largely accepted financial responsibility (for example, most SPPs 'through' the States) or which are outside the scope of the CGC's assessment. Under this method all expenditure in the particular area is excluded from the assessments.

The distribution of SPPs treated by inclusion or absorption (about three-quarters of current SPPs 'to' the States) affects the distribution of FAGs. In general, while the effect of the inclusion method on the overall distribution of funding depends on a number of factors, a State receiving a higher (lower) share of an 'included' SPP than the CGC considers appropriate to satisfy its relative 'needs' in the area will be assessed as requiring a commensurately lower (higher) share of the FAGs/HFGs pool. Concerns have been expressed that this may in some instances result in the Commonwealth's policy objectives with respect to SPPs being overridden.

The Commonwealth attempts to balance the objectives of SPPs with the objectives of fiscal equalisation. Accordingly, the Commonwealth has sometimes instructed the CGC to treat certain SPPs in a different way from how the CGC may otherwise have treated them. For example, the financial assistance provided under the South Australian Assistance Package is excluded from the CGC's assessments to ensure that the benefit of the assistance is not redistributed to the other States by a change in the distribution of FAGs.

In any event, it is not necessarily the case that the Commonwealth's policy objectives will be forgone where an SPP's distribution may be overridden over time in a financial sense. The objective of an SPP may be achieved by the fulfilment of the related conditions which the Commonwealth has agreed with the State receiving the payment.