By taxclubadmin 
Among federal nations, Australia is notable for its high degree of tax centralisation. The Commonwealth government raises more than 80% of all tax revenue and 100% of income tax revenue, much higher percentages than in comparable federal nations, like Canada and the United States. A common explanation is that state-level politicians prefer Commonwealth taxation because it spares states the unpopular task of levying taxes. The phrase, “the only good tax is a Commonwealth tax”, is often attributed to tax-shy state politicians.
In a recent article published in the American Journal of Comparative Law, “Federalism and Vertical Tax Competition”, I study “vertical tax competition” in the four oldest jurisdictions that grant concurrent constitutional jurisdiction over income taxation to the national and sub-national governments: Australia, Canada, Switzerland and the United States. Vertical tax competition is the competitive process in which governments at one level attempt to unilaterally increase their tax revenue at the expense of governments at a higher or lower level. This study makes two observations that suggest modifications to the traditional story that states prefer high levels of Commonwealth taxation.
The centralising tendency of vertical tax competition
The first is that vertical tax competition has a centralising tendency across federal nations. In all four jurisdictions, sub-national governments pioneered income taxes, but saw their income tax shares eroded by the extraordinary (military conflict) and the routine (the near constant rate-depressing tax competition that occurs between sub-national governments). Often these two factors combine. Most famously, in Australia and Canada, the national governments monopolised the income tax bases during the Second World War through “two-step offers”, in which the national government pledged to substantially increase its income tax rates across the country, but to provide compensatory cash transfers to only those sub-nations that repealed their own income taxes. This coercive manoeuvre is almost impossible to resist. Any sub-nation that refuses to repeal its income tax faces a ruinously high combined tax rate that will prompt the outmigration of mobile taxpayers to sub-nations that repeal their tax.
Successful state resistance to the centralisation of tax revenues
The second observation is that sub-nations have successfully resisted these centralising forces only in the rare instances when 1) constitutional rules expressly limit national tax shares or 2) the federation is multinational and contains one or more culturally-distinct sub-nations where voters have both strong preferences for sub-national taxation and substantial political power within the larger federation. Switzerland is an example of the first. The Swiss constitution caps national tax rates at 11.5% of personal income and 8.5% of corporate income, which preserves tax room for the Cantons. The Cantons currently raise almost 80% of income tax revenue. Canada is an example of the second. The Canadian government sought to maintain its income tax monopoly after the Second World War, but the government of Quebec won a high-stakes game of “chicken”. Quebec promised to reinstate its income tax and correctly wagered that its francophone residents would punish the federal, rather than provincial, government for the double taxation that would result. The federal government backed down in the face of electoral ruin.
These observations help explain the predicament Australian states face. Like other federations, the Commonwealth government has natural competitive advantages that give it an upper hand in vertical tax competition. And the states lack Swiss-style constitutional protections and Canadian-style sub-national identities. The comparison with Quebec is particularly apt. No Australian state can be assured of the support of voters if it chooses “to go it alone” and implement its own income tax.
Tax centralisation – a problem or solution? The two schools of thoughts in fiscal federalism
It is an open question whether this is a problem for Australia. There are two schools of thought in fiscal federalism. The classical view, popularised by Musgrave, is that tax centralisation is desirable because sub-national taxation is plagued by horizontal competition. A proponent of this view is likely to view unconstrained vertical tax competition positively, since it tends to result in low sub-national tax shares. A more recent view is that tax decentralisation mitigates a variety of political economy problems, including soft-budget constraints, fiscal illusion, and the loss of sub-national fiscal autonomy. A proponent of this view might judge vertical tax competition to be of greater concern. As evident in debates over the 2018 GST reforms in Australia, the wealthier states often find themselves in this latter camp, at least in part because they view Commonwealth taxation as a tool for redistributing locally-generated revenues to poorer states.
How should the law regulate vertical tax competition?
The choice between these competing normative perspectives matters for the legal regulation of vertical tax competition. There are a variety of options, ranging from rigid constitutional caps on tax rates, as in Switzerland, to flexible doctrinal rules that attempt to preserve a degree of sub-national fiscal autonomy.
A modest, but promising, doctrinal approach is the federal loyalty principle, which is most common in European jurisprudence. Federal loyalty requires that governments in a federal system make good faith efforts to respect the rights and interests of other governments when exercising their powers.[1] Swiss courts have held that the loyalty principle bars governments from using “trickery or abuse” in their dealings with one another; the Belgian Constitutional Court has held that governments must not exercise their powers in a manner that “alter[s] the equilibrium of the federal constitution as a whole”; and the South African Constitutional Court has explained that the loyalty principle “prevent[s] one sphere of government from using its powers in ways that would undermine other spheres of government, and prevent them from functioning effectively.”
Advantages of the federal loyalty principle
As a means of regulating vertical tax competition, the principle of federal loyalty has the advantage of being more flexible than other regulatory approaches. In emergencies, the principle probably permits competitive actions that completely exclude sub-national governments from the most important concurrently-assigned tax bases, like income. Complete exclusion increases the likelihood that the federation survives, so that sub-national autonomy can be preserved over the long term. In normal times, however, the principle probably bars complete exclusion, since exclusion changes the de facto architecture of a constitution in ways that materially diminish the fiscal and policy autonomy of sub-national governments. In essence, the loyalty principle has the attractive feature of barring extreme outcomes, except when extreme outcomes are necessary.
The federal loyalty principle may not satisfy enthusiastic proponents of the Musgravian view that sub-nations should be entirely excluded from the income tax base. But it does draw attention to the legal values, including sub-national autonomy, that underpin constitutional architecture. And it has the potential to lower the stakes in vertical tax competition, so that non-consensual exclusion from a tax base is off the table.
More broadly, there is no regulatory substitute for an attentive voting population that cares about fiscal federalism. Political supervision of fiscal federalism has a number of limitations, including the complexity of fiscal arrangements and the apparent disinterest of many voters. Nevertheless, as seen in Canada, careful political supervision by voters can alter the typical competitive outcomes and safeguard federal values.
[1] For surveys of the federal loyalty principle in different jurisdictions, see Jean-François Gaudreault-DesBiens, Cooperative Federalism in Search of a Normative Justification: Considering the Principle of Federal Loyalty, 23 Const. F. 1, 2–8 (2014); Francesco Palermo & Karl Kössler, Comparative Federalism: Constitutional Arrangements and Case Law 249–53 (2017).