Turnbull's reform pitch – state access to income tax

Just when we thought the tax debate was winding down to minimalism, as least as far as the federal government was concerned, Malcolm Turnbull has decided to throw a curveball.

The government is preparing to discuss giving states and territories the ability to raise a share of income tax, in what would be the most radical move in federal-state financial relations since John Howard handed them the proceeds of the then new GST.

The idea is being run by the Prime Minister and his department, led by secretary Martin Parkinson.

The access to income tax is to be canvassed at this week’s Council of Australian Governments meeting, when the states are also set to be offered about $3 billion over three years to help with their health costs.

The income tax move can be seen as a carrot to placate premiers and chief ministers, who have been in constant protest over the Abbott government’s slashing of projected levels of spending in health and education and won’t be silenced with $3 billion.

On another view, if it was eventually implemented the income tax plan would be a “big idea” change that – depending on its scale – could make the Australian federation a whole lot more “federalist”.

The last time that allowing the states back into the income taxing field was contemplated was in the late stage of Bob Hawke’s prime ministership. Paul Keating, by then on the backbench between leadership challenges, strongly attacked this manifestation of “new federalism”. Nothing came of it.

Details of the Turnbull government’s thinking are sketchy. A possible model would have the Commonwealth income tax take reduced by a certain number of cents at each tax rate, leaving the room for states to fill the gap, or not, as they wished. The Commonwealth would correspondingly withdraw itself and its funding from some functional areas, leaving them to the states.

The Commission of Audit, set up by Tony Abbott and headed by Tony Shepherd, recommended a states' role in income tax in its 2014 report.

It said the Commonwealth should “reduce its personal income tax rate by an equivalent percentage point amount to a new State surcharge … and the States be provided with a capacity to periodically vary the surcharge they impose as a means of injecting further competition into the Federation”.

Options were also canvassed in a discussion paper on the federation the Abbott government issued last year.

These were “‘making room’ in the income tax base so that states and territories can raise their own rates; or sharing the income tax revenue collected by the Commonwealth”.

The discussion paper was part of the process for a promised white paper on “The Reform of the Federation” which the website says “will set out a clear, well-defined and timely policy platform”. This white paper has so far not appeared.

The arguments advanced for giving states power to play in the personal income tax area include that it would better align revenue raising and spending responsibilities, Commonwealth-state overlaps in functions would be reduced, the “blame game” would be harder to run, and the states - facing escalating costs in health and education particularly - would have a new growth tax.

The main argument against is that Australia could end up with a patchwork of both income tax and service levels, when a better model is national harmonisation. A related issue is whether it would be desirable for the federal government to vacate certain fields – for example health – where many would see a case for it to keep an oversight, even at the cost of some duplication.

The new tax model would also be complicated to implement, with one problem being how it would mesh with the fiscal equalisation undertaken by the Grants Commission, which aims to even out the differences between various states' revenue raising capacities and spending needs. Those critical of how the Grants Commission operates now dismiss that as a problem.

How much energy Turnbull is willing to invest in this exercise will depend to a large degree on the states' reactions.

It’s somewhat analogous to his challenge to the crossbenchers to strike a deal among themselves to pass his industrial legislation if they want to avoid a double dissolution.

The choice for the states would be to agree among themselves over the period ahead on the income tax plan or forgo a solution to their spending needs.

Just as he has shifted part of the political weight for a double dissolution, if it comes to that, to the Senate crossbench, so he is seeking a way to transfer the long term political burden of heath and education funding to the states.