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What is Horizontal Fiscal Equalisation (HFE)?

Horizontal Fiscal Equalisation (HFE) is the making of payments to State governments with the objective of equalising their fiscal capacities to provide public services. It is a feature of the financial arrangements in many federations that aims to reduce the inequalities in the fiscal capacities of sub-national governments arising from the differences in their geography, demography, natural endowments and economies. However the level of equalisation sought varies.

Full equalisation is the objective in Australia. That is, after HFE, each of the six States, the Australian Capital Territory and the Northern Territory (the States) would have the capacity to provide services and the associated infrastructure at the same standard, if each State made the same effort to raise revenue from its own sources and operated at the same level of efficiency. Currently the funds distributed to achieve HFE are the revenues raised from the Goods and Services Tax (GST).

The distribution of GST required to achieve HFE is decided by the Commonwealth Treasurer each year, on the basis of advice provided by the Commonwealth Grants Commission (CGC).

Achieving HFE does not mean that the States are directed how to raise revenue or how to spend their funds. GST revenue grants from the Commonwealth are untied and available for any purpose. Accordingly, HFE equalises fiscal capacity, not fiscal policies which remain for the States to decide for themselves. It does not:

• result in the same level of services or taxes in all States;
  
  
• direct that the States must achieve any specified level of service in any area; nor
  
  
• impose actual budget outcomes in accordance with the Commission's calculations.

Does fiscal equalisation aim to give the States the capacity to provide the same standard of services to every Australian?

No. Fiscal equalisation only aims to give the States the capacity to provide the same standard of services in comparable circumstances.

The Commission's calculations reflect what States do collectively. For example, States do not provide residents of rural and remote areas with the same access to services as people in the metropolitan areas. Fiscal equalisation is not intended to provide States with the capacity to achieve a standard of services they have not, on average, achieved.


Does the principle of HFE direct the States how to spend their GST revenue?

No. The GST paid to the States is untied revenue assistance and the States can spend it on any purpose they wish.

The Commission's calculations are based on how much States collectively have spent on each service, and on each population group. States are given the same overall capacity to implement the average policies of all States combined. However States are not forced to follow the average. They may spend more, or less, on any function according to their own assessment of priorities.

In areas where the Commonwealth wishes to influence the actual State spending, the Commonwealth will usually enter into a joint funding arrangement with the States – a specific purpose program.


Do Commonwealth payments to the States other than the GST impact on the Commission's recommendations on State GST shares?

Generally yes.

The objective of GST sharing is to equalise State fiscal capacities. State fiscal capacities are affected by Commonwealth payments where they provide States with budget support to deliver State services. Therefore, other than the GST, most Commonwealth payments to the States are taken into account  in the Commission's recommendations. Those that are not fall into two groups: those that don't provide budgetary support and those where the objective of a Commonwealth payment is in conflict with HFE. In the latter case, terms of reference to the Commission specify those payments which should not have an effect on the distribution of the GST.  (See Table 4-3, http://www.cgc.gov.au/__data/assets/pdf_file/0005/21758/2011_Update_final_report.pdf#page=59).

This approach is agreed by the Commonwealth, States and Territories in the Intergovernmental Agreement on Federal Financial Relations (IGA), and annual terms of reference provided to the Commission.


Under HFE is there any incentive for States to improve their service delivery efficiency?

Because the Commission achieves HFE by distributing GST revenue assuming all States operate at the average level of service delivery efficiency, rather than their actual level of efficiency, there is an incentive for each State to become more efficient. States with above average efficiency will receive more GST revenue than they need to deliver the average level of services and can use this at their discretion. Conversely States with below average efficiency will not receive enough and will either have to deliver below average levels of service or make up the shortfall within their own budgets.


Does HFE dampen incentives for State development?

HFE acts to remove differences between the States in the revenue capacities of their tax bases, and to the extent that State development is driven by a desire to build those bases, it acts to dampen, but not remove incentives for State development. Because of the way HFE is achieved, relying on historical data and averaging over three years, short term improvements to a State's tax base are retained by the State. In each year a State gains higher revenues if it has adopted policies which build its economy and tax base in that year.


Can States influence their grants?

The Commission has adopted principles which operate to limit the ability of individual States to influence their own grants, but which still capture the collective policies of the States on raising and spending revenue.

In practice, we calculate a State's fiscal position not on what it alone does, but what it would do if it followed the average policy of all the States. This limits the capacity of any one State to influence its grant to how its actions affect the average policy of all States, remembering that other States acting in isolation could adopt policies which affect the average in the other direction. In particular cases where a State could have a large role, for example Western Australia if iron ore royalties were considered in isolation, the Commission groups similar activities to reduce the influence of any one State.