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The prospects of comprehensive tax reform appear to be fading. The concurrent reviews of the Federation and tax systems have been consigned to the proverbial dust bin and it’s increasingly apparent that any proposal to increase the rate or broaden the base of the GST is off the table.

Yet amid slowing economic growth both here and abroad the need for tax reform remains as acute as ever. Not only is our current tax system inefficient, but there is mounting evidence that it will be unable to fund public services that Australian voters expect in a sustainable manner.

The states are perhaps more vulnerable than the Commonwealth in the looming fiscal squeeze given their lack of taxing capacity. Although New South Wales and Victoria are currently benefiting from a short term fiscal reprieve courtesy of their spectacular and equally unsustainable housing booms, the longer term outlook for all states remains especially bleak.

Not only is the GST revenue growth slowing, but the prospect of the Commonwealth freezing (in real terms) special purpose grants to the states after 2017 will result in Commonwealth funding to the states dropping from 28% of federal spending in 2001 to a projected 21% by 2024 – cost shifting on an unprecedented scale.

Clearly something will have to give.

As a result of the emerging of this ‘fend for yourself federalism’ state governments will need to develop efficient and sustainable strategies to fund key public services into the future.

Increasing the rate or broadening the base of the GST has been the most widely discussed response to this challenge. However, as has become increasingly apparent in recent days, the Turnbull government is reluctant to pursue this option so long as the ALP, most Premiers and the community sector remain opposed to increasing our reliance on the GST.

The personal income tax is Australia’s largest and most robust tax and could be used to fund state governments. Moreover, according to Treasury it’s almost as efficient in economic terms as the GST. From a political perspective, it’s more progressive than a GST and should be more palatable to those concerned about equity considerations.

In practical terms there are numerous precedents for income tax sharing in federal systems. Such arrangements exist in Canada, the United States and Germany. The fact that any new state income tax levies could be harmonised with the existing federal tax and administered by the ATO would minimise administrative and compliance costs.

Given these benefits, and the fact that the GST is in the too hard basket, allowing states and territories to access the personal income tax base could be a central element of a broader reform package.

Proposals to share the income tax base across the federation have real merit; however, there are a number of design issues which have to be carefully analysed.

The first question is whether the states and Commonwealth should enter into a simple revenue sharing agreement whereby the states get a fixed percentage of personal income tax revenue. While this would give the states access to a growth tax it would do little to improve political accountability.

A more ambitious model would involve granting the states the power to set their own income tax levy or surcharge on the federal income tax base. Such a regime would improve accountability and allow state governments to set state income tax levies based on local preferences and demand for services.

Despite improved accountability, allowing the states to set their own income tax rates has significant distributional implications which have hitherto been ignored in the Australian debate. Quite simply per capita revenue from any residency-based state income tax levy will vary considerably between states because both income and employment levels vary considerably across the federation.

The bottom line is that wealthier states would benefit more from such a regime compared to poorer jurisdictions.

Our analysis suggests that 3.2% income tax levy on income above $37,000 could raise $10 billion for the states and territories. However, the distribution of such a levy favours wealthier jurisdictions whereas poorer states would have to exert a greater tax effort to raise equivalent per capita revenue.

One way of representing the magnitude of these distributional consequences is by considering the income tax levy that different jurisdictions would have to impose to raise the same per capita revenue. For example, Western Australia would have to impose a levy of 2.1% to raise its per capita share of a $10 billion levy. In contrast this figure for poorer states such as Tasmania and South Australia would be 5.0% and 4.3% respectively.

What is clear is the design details of income tax sharing models need to be analysed and debated in the lead up to this year’s federal election. The future of our federation depends on it.

An earlier version of this blog was published in The Australian in June 2015.

The full paper was published in the most recent issue of Australian Tax Forum:

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