Borrowing and the Burden of Debt

CHAPTER 6

BACKGROUND

The Government has acknowledged the existence of a debt problem.

A feature of the Victorian Government's economic and financial policies has been the greater reliance on borrowings than in other States, except Tasmania.  The appropriateness of this has come under increasing questioning, particularly since the down-grading in June 1990 by Moody's of the rating assigned to $A denominated debt guaranteed by the Victorian Government. ⁽¹⁾  This was the first such down-grading of $A denominated debt of an Australian State since World War II and, while the rating (Aa1) remained at a high level, the basis of the down-grading -- the high proportion of revenue going to meet debt servicing costs and the Government's "diminished capacity to address its economic and financial problems" -- highlighted the potential for high borrowing policies to result in political and economic instability.  Further emphasis has been given to this potential by the announcement in March-April 1991 by both Moody's and Australian Ratings that they were considering a possible further down-rating.  On that occasion Moody's identified a number of areas of concern, viz, continuing national economic slowdown, growing infrastructure needs, continually high budget deficits, political inertia, high level of contingent liabilities and potential for further weakening of Commonwealth assistance.

In his 1990-91 Budget Speech the Victorian Treasurer acknowledged that Victoria has a high level of debt and that the cost of servicing debt "has now reached a point where the policies of the past need fundamental change".  He also stated that in future the Government intended to make a stronger contribution to capital works from recurrent revenue.  The Treasurer attributed Victoria's high debt level to two main factors.  First, certain services, notably gas supply, provided from within Victoria's public sector, are a private sector responsibility in other States.  Second, Victoria has "always" operated on the basis of high borrowings and high debt because successive governments believed "it was fair that the cost of State infrastructures should be borne by future generations that derived the benefit".

A central feature of the Government's 1990-91 Budget was the implementation of a debt management strategy which envisaged a small estimated reduction in budget sector debt through an increase in the sale of government "business" assets ⁽²⁾ sufficient to more than meet the estimated (lower) budget deficit and the increase in debt resulting from the take-over of additional debts of Tricontinental.  The Treasurer also indicated that Victorian semi-government authorities would sharply reduce their net borrowings in 1990-91 and that Victoria would accordingly borrow less than the global borrowing limit set for its authorities by Loan Council.  For the Victorian public sector as a whole the budget estimates for 1990-91 suggested that, while there would be an increase in net debt (from $26.6 billion at June 1990 to $27.2 billion at June 1991), that would involve a reduction (of 0.7% points) in the proportion of debt to Victorian non-farm GDP, taking it down to just over 25% at June 1991.

The Budget also provided for a sharp cut back in estimated capital expenditure by the public sector in 1990-91 -- expenditure on fixed assets was estimated to fall by 16.4%.  This also appears to be a "fundamental change" compared with the previous policy of making the rate of capital investment responsive to the state of the economy and the economic cycle. ⁽³⁾

But the acknowledgement leaves a question mark.

Apart from accepting that economic and financial circumstances had changed, the acknowledgement by the Victorian Treasurer that "the policies of the past need fundamental change" was not accompanied by any explanation of why such a change had suddenly become necessary, or what particular level of debt servicing charges should be targeted.  The apparent continued support in the Budget Speech for the notion that it is "fair" for future generations to bear the cost of State infrastructure, and persistent assertions by The Age's chief economic writer that "borrowings by Victorians from Victorians" are no cause for concern, suggest that the underlying rationale for a policy of high public sector borrowings has not necessarily been discarded and that it may have some residual support.

This Chapter examines the issues against the background of trends in debt and debt servicing costs of Victoria and other States, and the purposes for which debt has been employed.  The examination covers the debt and other financial commitments of both the budget and non-budget sectors as both sectors are the ultimate responsibility of the State Government and each sector contributes to Victoria's overall debt problem.

What constitutes a debt problem?

There are no precise criteria or even rules of thumb which can be used to determine whether a State or even a country has a debt problem.  Much depends on economic and political circumstances and the purposes for which borrowings have been used. ⁽⁴⁾  Further, as indicated by the considerable range of ratings by credit rating agencies, there are degrees of debt problems.  The rating currently given to Victorian debt -- the second highest -- indicates that the State still has capacity to increase the burden of debt should it be judged appropriate to do so.  At the same time, the initial down-grading, and the recently emerged prospect of a further down-rating, are warning signals that the State's policies have become significantly more risky.  Moreover, it is important to note that major down-gradings sometimes come after a financial crisis has occurred.

What constitutes a "debt problem"?  At one end of the spectrum the most obvious answer is that a debt problem exists when there is an incapacity to service and/or repay outstanding borrowings;  a "problem" of that order would, however, be not a problem, but a crisis.  In the case of a State Government it is most unlikely that such a situation would ever arise in any absolute sense, given the assets held and the power to tax. ⁽⁵⁾  However, there is potential for serious economic and financial problems to emerge well before any possible question arises of suspension of payments.  Essentially, these problems arise from two main sources.

First, and most obvious, investors start to demand a higher rate of return for lending to a high debt State.  In Victoria's case, this has already occurred and the Auditor General has estimated that this is probably adding around $5 million per annum cumulatively to the cost of Victorian borrowings. ⁽⁶⁾ 

Second, and more important, there is likely to be an increasing reluctance by the "present generation" to bear the burden of increasing servicing costs either through higher taxes or through a lower level of ordinary services.  This increased reluctance becomes the more evident if past borrowings have been used for non-revenue earning purposes or for investments in enterprises which are earning poor returns and requiring increasing subsidies from general revenue.

Moreover, if comparisons with other States indicate that those States have used their borrowings more productively, this will likely add to dissatisfaction.  Thus, far from regarding it as "fair" to bear the cost of past borrowings, the present generation is likely increasingly to resent having to pay the costs of decisions in which they played no part, and the benefits of which they may well dispute.  This is likely in turn, to be reflected in increased political resistance to higher taxes or cuts in ordinary services, thereby making it more and more difficult for the Government to service the existing debt without taking decisions that would lead to its political overthrow.  The South American "solution" -- to expand the money supply and reduce the real cost of debt servicing by impoverishing its citizens in a different manner -- is not available to a State Government.

It is this potential for political instability, leading to an incapacity to make decisions needed to restore a State's finances, that goes to the heart of what constitutes a debt problem.  Once that political incapacity emerges there are inevitable flow through effects to the State economy as businesses and individuals also become more reluctant to take decisive action, particularly as regards longer term investment.  The emergence of such a situation can, in turn, increase the difficulty of servicing State debt as the growth in the State's economy and revenues slows.

The change in economic circumstances after the 1960's and 1970's made particularly inappropriate the pursuit by the State Government of high borrowing policies.  The shift from negative real interest rates in the 1960's and 1970's to high positive real rates in the 1980's not only raised the costs of borrowing but required greater attention to improving the return on capital expenditure.

Now, with the Australian economy in recession and the prospect of slower growth in the 1990's, the State is in a classic over-geared situation in which high debt servicing costs are accompanied by slower growth and, hence, a reduced capacity to meet them.

THE EXTENT OF DEBT AND ITS SERVICING

Victoria has the second highest per capita debt after Tasmania.

ABS figures of net debt for State public sectors, compiled on a basis comparable between States, are set out in Table 6.1 ⁽⁷⁾ which also includes our estimates for 1990-91.  ABS figures show that, at 30 June 1990, net public debt was $27.7 billion, which constituted over $6,400 per head.  At this level the Victorian public sector's net debt is the largest in Australia and only Tasmania has a higher per capita debt and a higher debt relative to State product.  Part of the reason for Victoria's high net debt is the fact that Victoria has a relatively low level of financial assets.  Thus at 30 June 1988 Victoria's gross financial assets were less than those of NSW, Queensland or South Australia.

It should be noted that the ABS estimate of net debt at 30 June 1990 is $1.1 billion higher than the estimate published in the Victorian Budget papers.  This appears to be due in part to the inclusion as debt by the ABS of operating leases which the State Government refuses to count as debt, presumably because it would mean acknowledging that they effectively involve avoidance of Loan Council global limits on borrowing.

TABLE 6.1:
NET DEBT

	1983-84		1986-87		1989-90		1990-91(e)
	$bn	% GSP	$bn	% GSP	$bn	% GSP	$bn	% GSP
NSW	15.6	23.1	20.1	21.7	20.8	15.8	22.0	16.2
VIC	16.0	28.3	21.5	29.4	27.7	27.1	27.9	26.7
QLD	4.8	17.0	5.7	14.8	3.4	6.2	3.5	6.2
WA	5.1	29.5	6.4	25.0	7.8	21.3	8.5	22.5
SA	3.3	21.9	4.1	19.6	4.7	16.7	5.3	18.1
TAS	2.1	49.2	2.6	42.9	3.0	36.8	3.4	40.4
All States	46.0	24.8	60.4	23.5	67.4	18.7	70.6	19.0
All States excl Vic	31.0	23.3	38.9	21.2	39.8	15.3	42.7	15.9

Notes:

(i) Net debt figures for 1983-84 and 1990-91 (est) are derived by adjusting net debt figures published in ABS 5501.0, 28 March 1991 on the same basis as on page 5 of that publication.

(ii) Gross State Product figures are the author's estimates based on GDP figures in ABS No.5206.0, Dec Q 1990

Table 6.1 shows that, while the burden of Victorian debt (measured relative to GSP) has been falling since the recent peak reached in 1986-87, the reduction has been much less than in Queensland and NSW and significantly less than the average for all States excluding Victoria.  Moreover, reflecting the much slower than expected growth in even nominal GSP, the burden of debt is now likely to drop by no more than 0.4% points of GSP in 1990-91.  Since 1983-84, the Victorian public sector's net debt has increased by 8.3% per annum, the highest of any State and well above the average of 4.7% per annum for all States excluding Victoria.

Thus, while the annual increase in indebtedness has declined as a proportion of GDP since 1986-87, it has remained above the average for the States up to the current financial year.  Indeed, in three out of the last five years Victoria's increase in net debt has been greater than that for any other State, relative to GSP.  The very small increase in net indebtedness estimated for 1990-91 is primarily a reflection of the large provision for asset sales, which the ABS estimates put at around $2,000m but which appears to be an under-estimate (see below).

Victoria has easily the highest debt servicing burden.

As to the debt servicing burden (measured by taking the proportion of interest to total revenue), Table 6.2 shows that this has actually increased since 1986-87 and is significantly higher than in 1983-84.

The servicing of Victoria's net public sector debt now takes over 21 cents of every dollar received in revenue, more than double the average for all other States of over 10 cents per revenue dollar.  In fact, Victoria has easily the highest debt servicing burden, with even Tasmania having to pay "only" 19 cents per revenue dollar.  The net interest bill faced by the total Victorian public sector in 1990-91 is estimated at $3.4 billion, more than the total estimated outlays on health, social security and welfare combined, more than any other State and nearly $800 million more than for the much larger State of NSW.  If Victoria could reduce to NSW levels the proportion of revenue going on net interest, there would be a saving of about $1.4 billion.

These official figures do not tell the full story, however.  The debt management strategy announced in the Budget includes provision for "managed increases in the rate of growth of debt charges through the use of interest rate swaps and other instruments, effectively spreading interest costs over the next 5 or 6 years".

Moreover, the increased resort to "operating" leases (see below) has to an extent substituted lease payments for interest payments.  In short, even allowing for the reduction in interest rates, the estimated slight fall in the debt servicing burden in 1990-91 is almost certainly misleading.

Also relevant is the decision by the June 1990 Loan Council meeting for the States to take back the primary responsibility for debt raised by the Commonwealth on behalf of the States under the Financial Agreement.  This means that the volume of public debt issued in the name of Victoria will increase progressively and the cost of servicing that debt will be higher than otherwise.

From a longer term historical perspective, estimates of net public sector debt published by the Victorian Government suggest that there has been little change in the burden of net debt since the mid 1970's and that the present burden is much lower than in 1960. ⁽⁸⁾  While from one point of view that may be comforting, what it also suggests is that the strengthening of Victoria's net debt position between 1960 and the mid 70s (chiefly as a result of inflation reducing the real burden of the State's debt) has not been consolidated, and in recent years has been partly lost.  Moreover, estimates published of debt servicing costs ⁽⁹⁾ suggest that net interest payments now represent a higher proportion of non-farm GDP than in 1960 (about 3.0 compared with 2.5%) and almost double the proportion in the mid 1970's.  These estimates show that, as a proportion of public sector revenue, ⁽¹⁰⁾ there has also been a doubling in the burden of debt servicing costs since the mid 1970's.  The fact that the burden of net debt has hardly changed since the mid 1970's, while the burden of debt servicing costs has about doubled, primarily reflects the much higher interest rates experienced in the 1980's.

TABLE 6.2:
DEBT SERVICING COSTS (Net Interest Paid As % of Revenue)

	1983-84	1986-87	1989-90	1990-91(e)
NSW	11.5	12.1	12.3	12.4
VIC	17.4	20.0	21.6	21.4
QLD	7.9	5.6	5.4	6.2
WA	12.2	13.6	13.0	12.7
SA	11.1	11.3	12.8	12.6
TAS	15.7	17.1	17.2	18.6
All States	12.6	13.4	13.4	13.2
All States excl Vic	11.0	11.0	11.1	10.4

Source:  ABS 5501.0, 28 March, 1991.

Official debt figures do not tell the whole story.

The foregoing relates to trends in and comparisons of official published statistics of debt and debt servicing costs.  However, there is a range of other commitments given by the Victorian public sector which either constitute near debt or involve contingent liabilities.  Thus, in his report on the budget for the year ended June 1990, the Auditor General included as part of debt unfunded superannuation liabilities of $16.0 billion and estimated that, on that basis, indebtedness of the budget sector alone was $32.6 billion compared with the figure of $14.5 billion published in Budget Paper No.2.  The Auditor General also drew attention to additional financial commitments totalling $3.1 ⁽¹¹⁾ billion and contingent liabilities amounting to $48.8 billion, of which some $25.1 billion were in respect of guarantees to financial institutions.  Some of these guarantees (for example, those in respect of the Victorian Equity Trust) are almost certainly going to be called up.

It is a matter of concern that contingent liabilities in the form of guarantees about doubled in the three years to June 1990.  Of course, with the sale of the State Bank since then, that will about halve these liabilities.  Even so, guarantees other than in respect of the State Bank amounted to $23.3 billion at 30 June 1990, compared with only $8.1 billion at 30 June 1983.  The resort to such guarantees creates the potential for "moral hazard" problems to arise -- as indeed occurred in the case of the State Bank -- and it seems particularly anomalous that every policy of insurance by the SIO should carry such a guarantee.

However, putting contingent liabilities on one side, the following picture can be compiled for public sector indebtedness, defined broadly, as at 30 June 1990.  It should be noted that these estimates do not include anything for employee entitlements and other commitments that may have been entered into by the non-budget sector, ⁽¹²⁾ or for potential liabilities in respect of unfunded liabilities of the Workcare and Third Party Insurance schemes.  It is not clear why the Auditor General has excluded these commitments, which would have added another $3-4 billion to the figures.

TABLE 6.3:
VICTORIAN PUBLIC SECTOR INDEBTEDNESS, 30 JUNE, 1990

Budget Sector   Net Borrowings   Employee entitlements   Creditors and accrued interest   Other Financial Commitments (incl operating leases)   Victorian Equity Trust	15.0 16.9 0.7 3.1 0.7 36.4
Non-Budget Sector   Net Borrowings	12.1
Total	48.5
Per Capita	$11,175

The Victorian Treasurer has disputed the inclusion as debt of employee entitlements and has disagreed with the Auditor General's conclusion that operating leases are "simply another form of borrowing and should have been taken into account for Loan Council purposes and reported as borrowings in the Treasurer's statement".  However, the Tasmanian Government has acknowledged that these leases are tantamount to borrowing.  In its Budget Papers it is stated that "While the usage of leasing and similar arrangements has been less in Tasmania than other States, the financing costs involved are becoming a significant element in the State's overall indebtedness". ⁽¹³⁾  Indeed, Tasmania's annual leasing payments now take around 0.7% of public sector revenue and, while no comparable figures are published for Victoria, it would be surprising if annual leasing payments were not taking at least 1% of Victorian public sector revenue, that is, the servicing costs of all forms of borrowing by the Victorian public sector almost certainly account for more than 21.4% of revenue.

As to the indebtedness in regard to unfunded superannuation liabilities, while it is common practice amongst the States not to count these liabilities as debt per se, there is no doubt that they represent a liability that will have to be met out of future Victorian government revenue.  Certainly, the substantial borrowings of the superannuation funds on behalf of the Government, in order to finance amounts the Government would otherwise have had to pay to superannuitants, ought to be included in the official debt figures. ⁽¹⁴⁾  Further, while it is true that most other States also have liabilities for unfunded superannuation schemes for Budget sector employees, ⁽¹⁵⁾ there is some evidence to suggest that the Victorian scheme may be more generous than in other States.  In particular, at 30 June 1990 NSW had a significantly lower net unfunded liability of $14 billion, ⁽¹⁶⁾ or $2413 per head of population compared to Victoria's $16 billion or $3,665 per head of population.  Grants Commission data on Victoria's superannuation payments from the budget shows that, over the five years to 1988-89, they increased by no less than 80%.

No information is available on Government physical assets.

In assessing Victoria's debt liability, account ought to be taken of the physical assets which have been created by the borrowings.  While no data is available, the value of such assets would undoubtedly exceed net Victorian public sector debt.  In this sense, therefore, the State Government itself can never be considered a candidate foi bankruptcy per se.  But well before bankruptcy is reached debt problems can and do arise in the sense referred to earlier.

THE USE OF BORROWINGS

Borrowings have been used to finance capital exenditure.

Some comfort can be taken from the fact that net borrowings ⁽¹⁷⁾ by the Victorian public sector have been equivalent to only some 50-60% of expenditure on fixed assets by the Victorian public sector.  In the current year, the Victorian Budget papers estimate that net borrowings will finance no more than around 30% of capital expenditure, reflecting the increased resort to proceeds of asset sales and the sharp reduction in estimated expenditure on fixed assets.

But more capital expenditure has been of a "social" kind.

But, while it is thus clear that borrowings have not been used to finance government consumption expenditure, that does not tell us anything about whether they have been productively employed.  A very broad indication can be obtained of the use of borrowings from the fact that net debt of the non-Budget sector (that is of statutory authorities), which makes up a little under half of the total state public sector net debt, was growing up to 1989-90 at a significantly slower rate of around 8% per annum compared with the 11% per annum growth in the Budget sector debt.  This doubtless partly reflects the reduction in major capital projects, primarily in the areas of electricity and gas, which together account for about three quarters of non-budget sector debt.  In the electricity area, capital spending slowed markedly following the installation of excess capacity in the early to mid 1980's on the basis of expectations of a major resources boom.  Moreover, although there now appears to be a need to increase spending, the SECV (which has been a major borrower) has recently announced its intention not to borrow for a period of several years in order to improve its debt/equity ratio and has proposed the partial privatisation of electricity generation.  Borrowings by bodies such as the SECV and Gas and Fuel might have been even lower but for the Government's policy of deliberately holding down their charges and requiring such bodies to pay hefty "dividends" to the Budget, thereby limiting the internal funds available to finance capital works.

And total capital expenditure has been cut back.

The slower growth in non-Budget sector debt raises a question as to whether the real decline in gross fixed capital expenditure in that sector in recent years reflects a reduction in need for infrastructure or whether it is more a reflection of Government "rationing" of borrowings for such purposes because of other perceived priorities.  More generally, the fact that Victoria is the only State in which the nominal level of capital outlays was lower in 1989-90 than in 1983-84, and the further very sharp cut in capital expenditure in the 1990-91 Budget, suggests that high debt levels are now constraining capital spending.

TABLE 6.4:
COMPOSITION OF VICTORIAN DEBT (NET)

	Budget Sector		Non-Budget Sector
	$Bn	% GSP	$Bn	% GSP
1982-83	6.9	14.1	7.1	14.5
1983-84	7.6	13.6	8.0	14.3
1984-85	8.5	13.8	9.1	14.7
1985-86	9.7	14.2	10.1	14.8
1986-87	10.8	14.9	10.6	14.7
1987-88	11.6	14.0	10.7	12.8
1988-89	12.7	13.8	11.5	12.5
1989-90	14.5	14.4	12.3	12.2

Source:  Victorian Budget Papers for debt figures.  GSP figures are the author's estimates.

This also, of course, raises an important question about the sustainability of the reduction in estimated net borrowings in 1990-91 once additional infrastructure spending becomes unavoidable and once there is a diminution in the supply of non-business assets capable of being sold.

Debt servicing costs of the budget sector have risen sharply.

What is clear is that an increasing proportion of net borrowings has been used to finance projects in the Budget sector, rather than the non-Budget sector.  This is of potential concern because the Budget sector comprises government activities that do not attract sufficient revenue to cover a significant proportion of costs and where there are few market tests as to the likely returns. ⁽¹⁸⁾  Thus, since 1986-87 the burden of net debt servicing costs of the budget sector have risen sharply from around 6% to 9% of revenue, about three times the NSW level.  The Queensland budget sector, by contrast, is actually a net earner of interest, that is, a net lender to the rest of the public sector.

While debt servicing costs of trading enterprises remain high.

Moreover, while the debt servicing ratio for the non-Budget sector of Victoria has been coming down in recent years, it remains at a very high level.  Almost 80 cents in every net revenue dollar of Victorian public trading enterprises is going to meet interest payments.  This is much higher than for Queensland (37%), NSW (62%), or WA (54%) and considerably higher than the average for the five States excluding Victoria.  Not surprisingly, this high debt servicing burden is reflected in the high losses of Victorian public trading enterprises, which are running at around $1 billion per annum or close to 1 % of Victoria's GSP.

THE OUTLOOK FOR DEBT

The Government budgeted for only a small debt increase in 1990-91.

At the time of the 1990-91 Budget the Government estimated that the net addition to Victoria's public sector debt in 1990-91 would be $574 million, which is broadly consistent with the estimate of $220m based on ABS estimates shown in Table 6.1 above.  The Victorian Government estimate assumed that, in addition to above-the-line asset sales of $711 million, there would be sales of "business" assets amounting to $2.6 billion and that the proceeds would be used to retire debt (including $1,700 million of bad debts of Tricontinental not taken over by the Government in 1989-90) and to help offset the estimated "deficit" ⁽¹⁹⁾ of $845 million.  Estimated proceeds from business asset sales included the $2.0 billion from the sale of the State Bank and (potentially) from the State Insurance Office, pine plantations and the State's interest in the Portland Smelter.

But the increase may be quite a bit larger.

However, there are serious doubts about whether the increase in public sector debt can be held to the Budget estimate.  Certainly, the projected "deficit" for 1990-91 seems likely to be significantly higher than $845 million and sales of "business" assets are unlikely to achieve the target of $2.6 billion.

It would not be surprising, in these circumstances, if the increase in net public sector debt were to reach say, $1,500 million or 1.4% of GSP.  While there are indications that the Government has been exploring "innovative" methods of borrowing, this would imply that the Government's target of borrowing "at least" $118 million less than its global borrowing limit of $1,137 million is unlikely to be fulfilled.  Indeed, the Government may need to seek a "special" increase in Victoria's global borrowing limit from the Commonwealth.

Beyond 1990-91 there mil be pressure to increase borrowings -- but the Commonwealth will seek to hold them down.

Beyond 1990-91 there is a question as to the sustainability of such lesser increase in net debt as may be achieved in 1990-91.  Thus neither the existing high reliance on asset sales nor the very low level of capital expenditure in 1990-91 can be sustained;  the effects of the spreading of interest costs to future years will wear off;  and the possibility of an extended recession and/or a slow recovery from it will make for slow growth in State revenues and upward pressure on the public sector deficit.  Of course, the Commonwealth Government will be anxious to hold down the level of State authorities' borrowings in order to increase domestic saving and reduce the current account deficit.  Further, the move to allocating States' basic shares of Loan Council borrowing limits on an equal per capita basis will mean a reduction in Victoria's share of whatever overall global limit is set.

Victoria faces a serious debt problem.

All this adds up to the conclusion that, in the absence of measures to reduce recurrent spending and/or to privatise some statutory authorities, it will be difficult to repeat the (likely) reduction in 1990-91 in the ratio of net debt to GSP.  The reality is that the Victorian Government faces a serious debt problem.  Thus:-

1. While the burden of debt has fallen in recent years the reduction has been less than for other States and the relative burden remains high by interstate comparison.  Further, the published debt figures do not tell the full story, as other means have been found of financing capital spending which constitute quasi-borrowings;
2. The debt servicing burden is the highest among the States and has actually increased significantly since 1986-87.  Further, the published figure does not reveal the full extent of the burden, which probably involves the taking of over 22% of public sector revenue to meet interest or quasi-interest payments.  The re-assumption of responsibility for Financial Agreement debt, and the widening of interest margins from this and the credit rating down-grading, will add to servicing costs, although lower interest rates will provide some relief.  (However, real interest rates seem likely to remain high);
3. In addition to the official figures for public-sector debt, the Victorian Government has very considerably increased commitments of the public sector that constitute quasi-debt or contingent liabilities.  The extent of unfunded superannuation liabilities suggests a more generous superannuation scheme for Victorian public sector employees than for their NSW counterparts.  Even allowing for the reduction that will occur in contingent liabilities as a result of the sale of the State Bank, the increase in guarantees is of concern;
4. While borrowings have not been used to finance government consumption expenditure, there has been an increase in recent years in the proportion of borrowings used to finance Budget sector capital expenditure, which generally has much lower revenue earning potential.  Moreover, borrowings used to fund capital expenditure in the non-Budget sector have produced inadequate returns, reflected in the fact that interest payments continue to take 80% of every net revenue dollar and that losses are running at around $1 billion per annum;
5. While the 1990-91 Budget projects only a small increase in public sector debt and a fall in the relative burden, the much greater than expected deterioration in the Victorian economy and the likelihood of a higher public sector "deficit" means that any reduction in the relative debt burden is likely to be small in the current year.
6. Although the 1990-91 Budget is the first official acknowledgement that Victoria needs to effect a fundamental change in its high borrowing policies, the reliance on asset sales as the major vehicle for reducing the burden of debt fails to go to the heart of the problem and will be difficult to sustain.  The possibility of an extended period of slower growth in Victorian revenues will also make it difficult to sustain lower deficits (let alone reduce them further) and, hence, difficult to reduce borrowings for that purpose.  In addition, the current relatively low level of public fixed capital expenditure will not be sustainable and there will be mounting pressure either to increase borrowings for this purpose or to privatise.  Pressure to privatise is likely to be enhanced by the Commonwealth macro-economic policy objective of increasing domestic savings and, hence, maintaining a tight control on Loan Council global borrowing limits.

WHAT NEEDS TO BE DONE

Major changes in policies are needed.

The foregoing conclusions are based on there being little or no change in existing policies.  However, if policies along the lines proposed elsewhere in this Report were to be introduced to reduce recurrent outlays, improve the returns on public capital and/or to privatise substantial sections of that capital, there is no doubt that the debt problem could be brought under control.

The difficulty that now exists is that the implementation of such policies takes time and, because they will inevitably impinge on entrenched pressure groups, are likely to be subject to considerable opposition.  In our view, however, the problem is serious enough to warrant major changes in policies in the near term.  It will be argued, of course, that a recession is not the time to be cutting government spending and employment.  Arguments along such lines need to be balanced against the difficulties of reviving private sector activity in a sustained way without action along the lines indicated.  Moreover, the time to implement reforms is when the community most readily perceives that serious problems exist and can most readily identify their causes.

However in terms of possible objectives for bringing the debt problem under control, it is difficult to be specific either as to timing or as to ultimate objectives.  Certainly, the top priority should be to stop the further growth of public sector debt, which involves bringing public sector receipts and expenditures into balance.  The aim should be to do that without relying on proceeds of asset sales, that is, any such proceeds should be used to retire debt, and without increasing taxes.  The next step would then be to move into surplus so that, for a time, the public sector is contributing, in an on-going sense, to the reduction of debt.  The aim should be to gradually reduce budget sector debt, that is, the debt that largely represents "social" expenditure of a non-revenue earning nature.

We recognised, however, that, in view of generous redundancy provisions incorporated in wage awards, it may be difficult to bring the public sector into balance in the initial stages of any "reconstruction" program.  Accordingly, it may be necessary to borrow in order to pay off those who are made redundant in addition to voluntary redundancies through normal "wastage".  Such borrowings would, of course, be a good "investment" for the Victorian community and, provided they are limited to such purposes, would be well justified.

There also needs to be a change in the role of public sector borrowings and in the capacity of State Governments to undertake such borrowings.

More generally, there is a need to change the role of borrowing in financing State expenditure.  As a matter of policy, the Queensland Government has for some time financed non-revenue earning capital expenditure from budget revenues and the NSW Government has started to move in the same direction.  There have been similar indications from the Western Australian and Tasmanian Governments that they intend to adopt similar policies and, as noted, the Victorian Treasurer indicated in his Budget Speech that the Government intends to make a stronger contribution to capital works from recurrent revenue.

In our view, however, more needs to be done to prevent politicians succumbing to the strong temptation to resort to borrowings to finance expenditure that will result in short term electoral support, particularly from powerful interest groups in the community that are pursuing their own narrow interests.

The United States experience and practice is relevant.

The electorate of the States of the United States (US) has since the early 19th century adopted a wide variety of institutional restraints on the fiscal behaviour of their politicians.

The most widely used fiscal disciplinary tool (which all but one state employs in one form or another) is the requirement of a balanced budget.  In seven States, the requirement is solely statutory;  in 29, solely constitutional;  and in 13 States, the requirement is both constitutional and statutory.  In three States, the requirement stipulates only that the governor must submit a balanced budget but, in 25 States it requires that the State may not carry over a deficit into the next fiscal year.

There is also a wide variation in the stringency of these rcquirements across States.  By way of example, Art XVI Sec I of the California Constitution requires that the legislature shall not, in any manner, create a debt in excess of $300,000 without a vote of the people.

US balanced budget requirements have in Australia been generally perceived as restrictive but in reality to have little or no effect.  The experience of States of the US does not bear this out.  Indeed a recent major study of this experience found. ⁽²⁰⁾

"the presence of relatively stringent balanced budget requirements seems to be consistently and significantly associated with lower levels of deficits, lower levels of spending, debt and taxes".

and

"that it is safe to conclude on the basis of the findings reported here that balanced budget requirements generally have substantial effect.  It is not the case that these devices are only associated with tiny or trivial differences in state fiscal outcomes".

The Victorian Constitution should be amended to provide for a balanced budget.

It would be inappropriate to simply assume that what works in the US will work in Australia for there are significant institutional and political differences.  However, the success of the balanced budget requirements in the States of the US, as well as the poor fiscal performance of the Victorian and other Australian State Governments over the last decade and the weakness of other fiscal disciplines, strongly suggest the desirability of examining an amendment to the Victorian Constitution to require a balanced budget.  The precise form of such an amendment would require detailed examination and community debate.

We propose that the Government issue a Green Paper on the matter in the first instance.

---

ENDNOTES

1.  The down-grading by Moody's was followed by a down-grading to AA1 by Australian Ratings.

2.  In 1990-91 proceeds of $2,600 million from the sale of business assets are estimated to more than offset the deficit of $660 million (on the basis set out in Victorian Budget papers) plus Trico debts of $1,700 million on top of the $576 million already taken over by the State in 1989-90.  Proceeds of sales of "business" assets are distinguished in the Victorian Budget from proceeds of sales of "surplus" property and sales and leasebacks of property.  Proceeds from such latter sales are deducted from capital outlays above the line in the Victorian Budget whereas proceeds of sales of business assets are treated as available to help meet or offset the deficit but are not actually brought into the Budget per se.

3.  In "Victorian Public Sector Debt", Information Paper No.2, Department of Management and Budget, December 1986, it was stated that "The present Government believes that the rate of capital investment or asset creation should also be responsive to the state of the economy and hence should vary over the economic cycle".

4.  For further discussion of the debt issue, see Debt:  What Should Be Done, by Richard J. Wood, October 1990

5.  There is also the likelihood that, in extremis, the Commonwealth Government would assist in some way.  Under the 1927 Financial Agreement, the Commonwealth assumed primary responsibility for all outstanding State debts and agreed to contribute towards the interest and sinking fund costs, which the States continued to pay to the Commonwealth.  However, it is questionable whether the Commonwealth would provide such extensive assistance in the event that only one State ran into debt problems.

6.  That is, $5 million in the first year, $10 million in the second year, and so on.

7.  To obtain an estimate of net debt, the ABS only deducts financial assets, which cover the financial claims of the non-financial public sector on other organisations and households and include shares and other forms of equity in companies listed on the stock exchange.  Other (fixed) assets are not offset against gross debt.  The ABS uses a "face value" definition of liabilities, i.e. the value to be repaid, or, in the case of securities, the nominal value shown on the security.  In the case of securities issued at a discount, this type of valuation is a little misleading because the face value includes a component of deferred interest payments.  For example, zero coupon bonds are normally sold at a deeply discounted rate.  Holders of these bonds are willing to hold them because of the lump sum they will receive at the maturity date.  Effectively, a proportion of this lump sum includes interest forgone over the life of the bond, thus not all of the face value of the bond represents debt outstanding.  (Equally, financing by this method means that true debt servicing costs are understated, because the interest accumulating is only scheduled to be paid when the debt matures.)  Excluded from the debt estimates are:  all liabilities of the financial public sector (i.e. State Banks, State Treasury Corporations etc);  equity;  contingent liabilities;  employee related liabilities such as superannuation and long service leave;  and, because of information shortages, short term trade credits.

8.  Chart 1.6, 1990-91 Budget Paper No.2.  This shows net debt at 60 percent of NFGDP in 1961-62, falling to around 27 percent in 1975-76.

9.  Media Release by Mr Roper of 18 May 1990, "Treasurer's Response to Moody's Statement".

10.  The definition of public sector revenue in Mr Roper's statement differs from that used in Table 5.

11.  Comprising $2.2 billion in respect of Trico and State Bank debts, $0.25 billion for guarantees of deposits with the Farrow group and $0.63 billion for operating lease arrangements.

12.  However, Victoria's statutory authorities mostly operate funded superannuation schemes.

13.  Tasmanian Budget Paper No.1, 1990-91, p 138.

14.  According to superannuation consultant, Mr Daryl Dixon, the Victorian Government had borrowed $1.3 billion as at 30 June 1990 from superannuation funds in order to fund lump-sum superannuation pay-outs.  Moreover, the Government pays a 6 percent real interest rate on such borrowings (Sunday Herald, 24 March 1991).

15.  Queensland operates a fully funded scheme for such employees, Tasmania has started to implement such a scheme and NSW is investigating it.

16.  Budget Paper No.2 1990-91 p.490.  Part of the reason for a lower per head liability in NSW would be relatively fewer Budget sector employees

17.  Net borrowings in this context includes net drawing on financial assets.

18.  A recent study published by EPAC suggested, for example, an excessive cost of capital works in Melbourne's outer suburbs to develop and service new blocks.  (See Infrastructure Costs On The Urban Fringe by Dr Robert Birrell).

19.  Defined for this purpose as Total Financing Transactions, less Increase in Provisions, for the public sector as a whole.

20.  Fiscal Discipline in the Federal System:  National Reform and the Experience of the States, ACIR, A-107, July 1987.

State Revenue

CHAPTER 5

COMMONWEALTH-STATE FINANCIAL RELATIONS

The reduction of the vertical imbalance between the Commonwealth and the States and an increase in State tax powers should not be a major near-term priority of the Victorian Government.

The most dominant and controversial aspect of State revenues is the high degree of reliance on grants from the Commonwealth Government.  In 1990-91 nearly 50% of Victoria's estimated general government revenue comes from the Commonwealth in the form of general and specific purpose grants.  This "vertical imbalance" between the State's own tax raising efforts and its spending is high in comparison with other federal jurisdictions.  Clearly, it reduces the link between expenditure and revenue decisions of the State Government and thereby diminishes its accountability.  However, while the significance of this imbalance may be acknowledged, the priority that should be given to reducing it by the Victorian Government is more questionable.  The view taken in this Report is that it is not a major factor affecting the efficiency of the State's spending and that the most important priority is to reduce the State's spending, debt and tax burden.

From the perspective of the Commonwealth Government and national economic requirements the reduction of the imbalance is also likely to command a relatively low priority.  The Victorian Government needs to take this into account in assessing its budgetary options.

There are four main reasons for this conclusion.

First, the national economic situation calls for economic policies that involve restraint in national spending and, as a key component of that, a reduction in the size of government.  While competition between the States in reducing taxes might produce this over time, the Commonwealth will likely take the view that the most effective way of achieving it in the near term would be through a continuation of the restraint imposed in recent years on its assistance to the States and on borrowings by State authorities.  Although initially the effects of this restraint were substantially offset by the rapid growth in State tax revenues arising from the "boom" in asset sales and prices (with the result that the burden of States' taxes has increased from 5 to 6% of GDP over the past 5-6 years), as the assets market declined, the restraint in Commonwealth assistance has forced all States to effect major reductions in their outlays.  In fact, States' outlays have been reduced by about 2.5 percentage points of GDP over the same period, which confirms that reductions in Commonwealth assistance have not simply been offset by increases in State's taxes, as is sometimes said.  Moreover, with the reduction in the States' own revenue base following the recession, and the likelihood that it will increase much more slowly when the economy recovers, the Commonwealth doubtless views favourably the fact that its policy of limiting assistance and borrowings is now pushing States such as Victoria not only into further expenditure restraint but into privatisation measures of various kinds.

In these circumstances the Commonwealth seems unlikely to give priority to giving the States' access a broader based tax.  It is relevant also in this context that one of the original rationales for an increase in States' tax powers derived from the argument that State Governments needed to have access to additional broad based taxes if they were to be able to expand the services which they supply to the community.  That was, indeed, the basis on which the Commonwealth transferred pay-roll tax to the States in 1971.  However, circumstances have changed dramatically since then and there is now growing acceptance of the need to reduce rather than expand the role of government, including State governments.

It is also relevant that the fact that States' access to broad based taxes is limited to the unpopular pay-roll tax acts as an inhibition on increases in States' tax rates.  This is particularly true in Victoria, where the burden of State taxes on businesses has become a major political issue.  Arguably, if the Victorian Government had had access to another broad based tax, it would have increased the rates of that tax ⁽¹⁾ rather than moved over the past two years to restrain expenditure and sell State assets.  The Commonwealth will be aware that, if the States had access to another broad based tax, a substantial amount of revenue could be raised by a small adjustment in the rate so that the increased burden would be widely spread and subject to minimal resistance.  Tax competition between States would thus likely be least effective in the case of an alternative broad based tax.

Second, the practical difficulties of the States accessing a broad based tax are not inconsiderable or free of controversy.  Unless clear benefits of a substantial nature are likely to be forthcoming, it would seem inappropriate therefore to divert State political and bureaucratic energies away from more important issues which are facing the State Government

The most popular option for an alternative broad based State tax is a consumption tax.  However, the Constitutional prohibition on State excises would make it difficult to arrange for the States to access such a tax on a basis that would give individual States effective decision-making powers, even assuming that the Commonwealth does eventually proceed with the establishment of such a tax. ⁽²⁾

The other main option -- a State income tax -- is already legally available to the States and successive Victorian Governments have tended to favour such a State tax. ⁽³⁾  It would certainly be practicable to move to a Canadian type arrangement where each Province effectively imposes a rate on top of the Federal rate, with the overall rate thus varying as between the Provinces.  The Commonwealth would then make a broadly offsetting reduction in its financial assistance grants to the States.  Further, the States could then use their access to the income tax field to substitute income tax for some of the more unpopular State taxes, such as pay-roll tax.

However, as indicated the Commonwealth is unlikely to favour a move by the States to access a broad based tax even in the near term and we believe that, for reasons discussed below, any such future move should be conditional on the States agreeing to constitutional restraints on State Governments increasing tax rates without specific reference to the electorate.  It might also be noted that, whether an increase in income tax to finance the reduction or elimination of (say) pay-roll tax would produce net benefits for the community as a whole is not completely clear.  While there is widespread acceptance of the view that pay-roll tax discourages employment, the issue is not clear-cut. ⁽⁴⁾  On the other hand, the disincentive effects on labour supply of increasing an income tax with a progressive rate scale are well documented.  Also, there could be adverse efficiency effects if States were to move away from a uniform basis of assessment, as some of the Canadian Provinces have done.

Third, a number of State taxes are levied in fields which are either already taxed by the Commonwealth for widely accepted reasons (such as alcohol, petrol and tobacco) or which would be taxed by a broad based consumption tax (services such as those involving transfers of real estate, shares and money).  Thus, while there may be room for improvement in the structure and rates of many State taxes, the fields of taxation to which they apply should not necessarily be regarded as inappropriate.  Even in the case of pay-roll tax, it needs to be noted that it is imposed at much higher rates in most overseas countries.  Against this background, there is room for doubt as to whether, even if the States were given access to a broad based tax, that would in practice lead to much reduction in the burden of taxation in most of the fields presently covered by State taxes.

Fourth, it should be noted that the States' reliance on Commonwealth grants for a substantial proportion of their revenues has not prevented tax competition between the States.  It is too rarely acknowledged that, as this Report brings out, there are quite substantial differences between States in the severity of taxes and in the level of services which they provide.  Further, the principles used by the Commonwealth Grants Commission in determining the distribution of the financial assistance grants do not inhibit such competition, that is, if (say) Victoria wishes to reduce its taxes that does not reduce its share of the grants.  The fact that there has not been more tax competition is more a reflection of the failure of State politicians to escape the clutches of the local pressure groups and to identify the benefits of smaller State governments for the State as a whole.  But, given that State taxes are 6 percent of GSP, the scope is there for any Victorian Government that wants the State to become more competitive.

Accordingly, this Report does not advocate that a major change in Commonwealth-State financial relationships, involving a reduction of the so-called vertical imbalance, and an increase in State tax powers, should be a policy priority of either the Victorian Government or the Commonwealth Government.  Rather, the focus should be on reducing the role of the State Government with a view to, inter alia, reducing the burden of State taxes.

The Commonwealth is likely to intensify the pressure on the States to undertake spending and other reforms

As noted, the national economic situation calls for economic policies that involve restraint in national spending and, as a key component of that, a reduction in the size of government and a return to net public sector saving.  To this end, we believe that the Commonwealth Government is likely to intensify the restraint on Commonwealth grants to the States, which has been eased somewhat since 1988-89, when total grants increased by only 1.5%.  The increases of 8.8% in 1989-90, and the estimated increase of 8.7% in the current financial year, ⁽⁵⁾ have provided substantial real growth at a time when real growth in national spending needed to be cut back.  Moreover, it is now evident that, contrary to the need for the public sector to be a substantial net saver, the public sector will be a net borrower in 1990-91 to the extent of some 2-3% of GDP.

Under those circumstances the Commonwealth seems likely to cut States' grants in real terms in 1991-92 and, hence, to abandon the real terms "guarantee" on the financial assistance grants, thereby exerting pressure on the Victorian Government to step up the pace of reform. ⁽⁶⁾  It would also be in the interests of the Victorian community if the Commonwealth were able to reduce any inclination for the Victorian and other State Governments to respond to their present "shortage" of funds by increasing State taxes, thereby adding to the difficulty of reducing the rate of increase in the C.P.I.

Adoption of a Federation Budget approach would assist in a more equitable sharing of the "burden" of restraining government spending and would also inhibit States from increasing taxes

The prospect of the States undertaking spending and efficiency reforms would be enhanced if the Commonwealth and the States were to adopt a Federation Budget approach to 1991-92.  The basic idea of such an approach would be for the Commonwealth and the States to each seek to agree at the annual Premiers Conference on objectives for spending, borrowing and taxes in the succeeding financial year and possibly beyond.  Thus, instead of the Premiers Conference discussing only one part of the Commonwealth and one part of the States' budgets, there would be a discussion and attempt to agree on the broad parameters of the budgets of all the governments.

Such an approach would allow the Commonwealth to press the States to give undertakings in regard to limiting increases in taxation.  The Commonwealth could indeed make its grants conditional on the States agreeing to specific limits on taxation.  For their part the States could press the Commonwealth to exercise the same restraint on its "own purpose" outlays as it was seeking to impose on the grants to the States. ⁽⁷⁾  In recent years this has been noticeably absent, with the Commonwealth passing most of the burden of expenditure restraint to the States.  Overall, a Federation Budget approach would be designed to have the States accept greater responsibility for national economic management and to take more account of national economic requirements in framing their own policies.

The Victorian Government should press the Commonwealth to reduce specific purpose grants and reduce duplication

The initiative for a Federation Budget would probably need to come from the Commonwealth Government.  But, although it would be designed to bring the States under closer Commonwealth control in terms of macro-economic policy, the Victorian Government could take advantage of such an approach to seek a reduction in Commonwealth involvement at the micro level.  Victoria and other States should in any event press the Commonwealth to reduce specific purpose grants in areas such as education, health and transport (with offsetting adjustments in general purpose grants) and, hence, reduce duplication between the Commonwealth and the States by passing back full responsibility to the States in a range of areas where Commonwealth politicians have judged it appropriate to intervene.  Such action would also give States more flexibility in determining their own spending priorities.  These are matters which will be taken up in the next Report.

Again, however, the home base should be the front line of attention for Victoria, especially having regard to the fact that in any Federation the central government is likely to insist that it is "vital" to have national, rather than differing regional, standards in some areas.  There may also be instances where central government action would produce "spill-over" benefits whose availability would inhibit action by any one State Government.

It is also relevant here that, although the Commonwealth "interferes" in many areas of State activity by providing specific purpose grants which are subject to conditions, around 50% of Commonwealth grants are for general purposes. ⁽⁸⁾  Accordingly, States have substantial scope to allocate resources as between different areas of their activity, and, at the margin, can determine the overall priority as between one area of activity and another.  For example, in the case of transport the States spend more than four times the amount they receive from the Commonwealth in specific purpose payments.  The Victorian Government may thus be regarded as substantially accountable to its electorate for determining the priority attached to one activity as against another. ⁽⁹⁾

VICTORIAN TAXES

There have been major additions to Victoria's tax regime

Contrary to the popular impression, there have been major additions to Victoria's taxing regime over the past twenty years.  Payroll tax was transferred to the States in 1971 and a tobacco franchise tax was introduced in most States in 1974.  Financial institutions duty was introduced in 1982/83 and in 1983 Victoria required certain public enterprises to pay an asset based "dividend" to replace a levy imposed on sales.  These "new" taxes accounted for over 40% of Victoria's total tax receipts in 1989/90.

The burden of Victorian taxation has increased

The new taxes have been exploited by Victoria and, while some of the additional revenue went to replace that lost from the abandonment of estate duty as a result of inter-state competition, there has been a general upward trend in the overall burden of State taxation.  Thus, between 1981-82 and 1990-91 (est) the overall burden of Victorian taxation (including "dividends" paid by public enterprises) has increased from 4.7% to an estimated 5.9% of GSP. ⁽¹⁰⁾

Moreover, while Commonwealth grants to Victoria have declined from 7.2% of GSP in 1986/87 to an estimated 6.4% of GSP in 1990-91, the latter figure is only slightly lower than when the present Labor Government came to office in 1982.

CHART 5.1
REVENUE, TAXES & GRANTS VICTORIA, 1981-1991
(as Percentage of Gross State Product)

Sources:

Australian Bureau of Statistics 5501.0, 28 March, 1991,
Australian Bureau of Statistics 5204.0,
Australian Bureau of Statistics 5220.0.

Notes:

⁽¹⁾ Taxation is defined here to include taxes, fees and fines plus "dividends" paid to the general government sector which are classified by the Australian Bureau of Statistics as property income.

⁽²⁾ Estimates for 1990-91 for tax revenue and GSP are the author's estimates and assume tax receipts are $407m less than the Budget estimate.

That is, comparing the present situation with that which existed when the Government assumed office, the increase in the burden of taxation has partly been to finance additional spending and only partly to replace "lost" Commonwealth grants.

Taxes on assets transfers and franchise taxes have increased in importance

As to the composition of Victoria's taxes, pay-roll tax now constitutes around 30% of total tax revenues and the rate of tax has been progressively lifted from 2.5% in 1971 to its present 7%.  However, the granting of extensive exemptions has not meant a commensurate increase in the over-all burden of payroll tax and there has in fact been a reduction since 1981-82 in the relative importance of the tax as a source of revenue.  The importance of taxes on transfers of assets (shares, money and property) has, by contrast, increased under the Labor Government, as has the relative importance of franchise taxes (on petrol, tobacco and alcohol).

TABLE 5.1:
COMPOSITION OF STATE TAXATION ⁽¹⁾

	1981/82	1990/91 (2)	Difference
Payroll	32.4	28.0	-4.4
Property Taxes	6.5	7.1	0.6
Land Taxes	5.4	6.2	0.8
Finance and capital	13.5	20.1	6.6
Stamp Duties	13.5	15.3	1.8
Financial Institutions Duty	0.0	4.8	4.8
Excise (3)	4.1	3.8	-0.3
Gambling	9.8	8.2	-1.6
Insurance	7.1	4.5	-2.6
Motor Vehicle (4)	11.9	7.0	-4.9
Franchise	8.5	12.1	3.6
Other	1.4	0.2	-1.2
Dividends (5)	0.0	4.8	4.8
Fees	0.8	2.7	1.9
Fines	1.3	1.5	0.2
TOTAL	100.0	100.0	0.0

Sources:  Australian Bureau of Statistics Taxation Revenue, 5506.0 April 1990 plus dividends reported as property income from Australian Bureau of Statitistics 5501.0, 28 March 1991

Notes:

⁽¹⁾ State taxation is defined herein to include taxes, fees and fines plus dividends paid to general government and classified by the ABS as property income.

⁽²⁾ Estimates for 1990-91 are the author's estimates based on data from Victorian Budget document No.4 1990-91.

⁽³⁾ Principally revenue from charges levied on statutory authorities and based on revenue.

⁽⁴⁾ Includes registration fees, stamp duty on registrations, drivers' licences and road transport and maintenance tax.

⁽⁵⁾ Property income paid to general government from State trading enterprises, which is primarily composed of dividends levied on asset values and not included by the ABS in taxes, fees and fines.

Although a high proportion of Victoria's taxes are paid by businesses in the first instance, the incidence is borne by individuals, including those who operate small businesses as sole proprietors or partnerships

Victorian taxes mostly fall in the first instance, on businesses, an estimated 75% being received from that quarter.  This "strategy" is doubtless partly designed to take advantage of the fact that, as State taxes are a deductible business expense, some 39% of the cost is borne by the Commonwealth and, hence, by payers of Commonwealth taxes.  In addition, the imposition of taxes on businesses rather than individuals allows the State Government to limit its unpopularity, particularly as there are extensive exemptions for small businesses.

However, any notion that the final incidence of State taxes is borne by business would be misleading.  Taxes levied on business inevitably end up by being either passed on to consumers or back to shareholders and operators of small businesses as sole proprietors or partnerships.  Either way it is the individual that bears the ultimate burden at the same time differences between States in rates of State Taxes do affect the competitiveness of business.

Victoria is a relatively high tax State

An inordinate amount of attention is paid by Victorian political parties and the media to the question of whether Victorian taxes are higher than those in N.S.W.  The reality is that both States impose taxes at rates which are higher than the average for the States -- and which should be lower.  On the definition of taxation used by the Commonwealth Grants Commission, Victoria's revenue from taxes is considerably higher than if its rates of taxation were imposed at the average rates for the States, and its taxes are also more severe than N.S.W.

TABLE 5.2:
STATE TAXES PER HEAD, 1989-90

	Actual $	Standard $	Difference $
New South Wales	1084	1081	+0.3
Victoria	1109	1029	+7.7
Queensland	705	912	-22.7
Western Australia	932	914	+2.0
South Australia	775	782	-0.9
Tasmania	824	684	+20.5

Source:  Commonwealth Grants Commission, 1991 Update.  Includes land revenue as well as receipts classified as taxes by the Commission.

Part of the debate about Victorian versus N.S.W. taxes arises from the fact that there are differences between the definition of taxes used by the Commonwealth Grants Commission and that used by the ABS.  The Commission includes as taxes all taxes that are used in financing States' current expenditure whereas the ABS purports to include all taxes and ABS figures show per capita tax collections in N.S.W. as being 7-10% higher than in Victoria.  However, the ABS does not count as a tax the "dividends" which the Victorian Government requires some public enterprises to pay and which were introduced in 1983 in lieu of the levy which was then imposed on sales of those enterprises and classified by the ABS as a tax.  Given this, and given that these "dividends" have often exceeded the profits earned by the enterprises, it appears that the Grants Commission's inclusion of them as a tax is the more realistic procedure for policy analysis and decision-making purposes. ⁽¹¹⁾

If these "dividends" are included in the otherwise more comprehensive ABS figures, the difference between Victorian and NSW per capita tax collections narrows markedly.  If allowance is also made for the fact that NSW has a higher taxable capacity (with the result that taxes imposed at the same rate in NSW will yield more per head than in Victoria), it appears that, overall, Victoria's tax severity may be fractionally lower than N.S.W.'s.  This appears to be the case even after the significant increases in tax rates in the 1990-91 Victorian Budget.

TABLE 5.3:
STATE TAXES PER HEAD

	ABS Estimate (1)		ABS Estimate (Adjusted) (2)
	1989-90	1990-91	1989-90	1990-91
New South Wales	1411	1486	1272	1340
Victoria	1309	1393	1239	1319

^(l) Based on Australian Bureau of Statistics estimates published in 5501.0, 28 March adjusted to include estimated "dividends" paid by public enterprises

⁽²⁾ Adjusted to allow for NSW higher taxable capacity on the basis of the Grants Commission's 1989-90 estimates of capacity to raise taxes and land revenue as published in their 1991 Update.  It is assumed that relative taxable capacity is unchanged in 1990-91.

TAX REFORM -- VICTORIA

A major objective should be to reduce the overall burden of Victoria's taxes

The most appropriate "reform" in Victoria's tax system would be to reduce the overall burden.  That would, in itself, reduce the concern that is expressed about the "inefficiency" of State taxes.

However, given the extent of Victoria's debt problem, we propose that priority should be given in the near term to stopping the further growth of Victorian public sector debt, which involves bringing public sector receipts and expenditure into balance.

A further step would then be to start reducing debt by moving into surplus while at the same time also starting to cut taxes, that is, the public sector should become for a period a net saver.  (This is discussed further in Chapter 6).  The move to public sector balance and then to surplus should be achieved not by increasing taxation but by a combination of cuts in current spending and a combination of improvements in the efficiency of public trading enterprises and, over time, their privatisation in whole or in part.

Changing the structure of Victoria's tax system

As already noted, under the present Government increased emphasis has been put on taxes which fall initially on businesses.  In addition, there has been an increase in the exemption levels so as to minimise the initial impact of taxes on small businesses and individuals, with a resultant narrowing of the tax base of a number of taxes.  This is especially true of pay-roll tax.

Moves in these directions run contrary to the objective of transparency, that is, they minimise the impact on the community generally of tax increases by Government.  Any notion that by imposing taxes largely on "business" the community somehow avoids their impact would, of course, be misleading.

However, unless State Governments are given access to a new broad-based tax (which, as noted, seems unlikely), they are largely stuck with the existing State mix.  Further, any attempt to cut tax rates by broadening the base of existing taxes or introducing new taxes would likely be strongly opposed.

One possibility might be to shift the burden away from land tax to other forms of taxation.  The idea that land tax is a tax on "wealth" is misleading given that over half of the tax is paid by business (and that it is a deductible expense).  Moreover, the fact that the tax base is unrelated to the current state of the economy, and to any current capacity to pay, makes it a less suitable and less efficient vehicle of taxation.

The next Report will give further consideration to individual tax reforms.

TAX REFORM -- GENERAL

There is a need to constrain the capacity of politicians to increase taxes

The usual approach to consideration of taxation reform is to evaluate the most appropriate forms of tax and the most appropriate structure in terms of efficiency, equity and simplicity.  But, while there is certainly a need for such evaluations (and for appropriate changes to improve the efficiency of taxes), there is also a need to give consideration to measures that constrain the capacity of governments to increase taxes.  This need is best highlighted, perhaps, by the Victorian Government's action in the 1990-91 Budget in increasing taxes by 16% at a time of recession and without any attempt to seek the electorate's approval.

While it may be argued that those responsible for such actions will pay the price in due course, there is also a strong ease for instituting procedures both that encourage and allow the community to play a greater role before tax changes are made, and that also "force" State Governments to give consideration both to alternative courses of action and to wider implications.  This would become particularly important were the States to acquire a new broad-based tax, where the scope for increasing "taxation by stealth" would be enhanced. ⁽¹²⁾

There are a number of possible measures that would help

There is insufficient scope in this Report to explore this important issue in depth.  However, it is worth listing some of the possible ways in which greater discipline could be applied on our State politicians:-

1. Federation Budget -- as noted, this would involve State Governments to a greater extent in national economic management and focus their attention on the wider implications of tax increases;
2. Improvements in State Budget Information -- While there has been a significant improvement in recent years in the data and structure of the budget documents published by the Victorian (and other) Governments, there is a considerable need for further improvements in a number of areas in order to allow the informed comment and analysis that will help discipline State politicians.  In particular, there is a need to publish details of tax expenditures and comparisons of tax policies with those in other States.  More generally, three year forward estimates of both expenditure and revenues should be presented with each Budget (as is now done by the Commonwealth) and regular and timely monthly statements of revenues, expenditures and borrowings should be published on a national accounts basis.
3. Constitutional constraints -- one possibility would be to amend the Victorian Constitution to require that all increases in tax rates, and all proposals for new taxes, be submitted to a referendum.  This is effectively the situation in a number of American States and Swiss Cantons.  While it may sound too "radical" for Australia, it is an approach that should be further considered and debated, particularly if serious cosideration were to be given to a new broad based States' tax.  An alternative would be to allow citizen initiated referenda that would provide scope for a referendum to reject tax increases or to agree to them for a specific purpose.  Any such move would require safeguards to inhibit vexatious use by minority groups.
4. Earmarked Taxes -- a closer connection between the raising of taxes and their spending would be established if taxes were earmarked for particular purposes.  However, while this approach has theoretical attractions, there would be considerable practical difficulties in implementing it.

CONCLUSIONS

Our main conclusions on State revenues may be summarised as follows:-

• It is most unlikely to be a near term policy priority of the Commonwealth Government to seek to reduce the vertical imbalance between the Commonwealth and the States and to cede a major increase in State tax powers.  In these circumstances it should not be a priority of the Victorian Government either.
• The States should only be given access to a new broad based tax if they agree to some constitutional constraints on their capacity to increase State taxes.
• The Commonwealth is likely to intensify the pressure on the Victorian and other State Governments to reduce spending and improve public enterprise efficiency by tightening restraints on grants to the States.
• Adoption of a Federation Budget approach could help restrain State tax increases in response to such pressure and would assist in a more equitable sharing of the "burden" of restraining government spending.
• The burden of Victorian taxes has increased in recent years through greater utilisation of "new" taxes introduced over the past 20 years and by making business the focus of tax policy.
• Although a high proportion of Victoria's taxes is paid by businesses in the first instance, the ultimate incidence is borne by individuals.  Differences in State taxes can however, affect a State's competitiveness.
• Victoria is a relatively high tax State, as is N.S.W.  Overall there appears to be little between the two States in terms of severity of taxes.
• A major policy objective of the Victorian Government should be to reduce the burden of taxation.  However, in the near term the top priority should be to stop the further growth of public sector debt, which involves bringing public sector receipts and expenditures into balance.  A further step would then be to start reducing debt by moving into surplus while at the same time also starting to cut taxes.
• Unless State Governments are given access to a new broad based tax, they are largely "stuck" with the existing State tax mix.  Possible reforms would likely produce considerable resistance.
• The role of land tax should be reviewed given that it is not performing its supposed function as a "wealth" tax and that its incidence is often unrelated to current capacity to pay.
• Measures need to be taken to improve the community's awareness of State tax and budgetary issues, and their capacity to respond.  These include improvements in information about the budget and an examination of possible constitutional constraints on the capacity of politicians to increase taxes.

---

ENDNOTES

1.  Or, in the case of income tax, allowed the progressive rate scale to increase the effective rate.  Of course, the Victorian Government did sharply increase taxes in the 1990-91 Budget.  The suggestion here is that the overall increase in taxes in recent years would have been greater with a broad based tax.

2.  The present position of the Federal Labor Government is one of opposition to such a tax.  The Federal Opposition, however, has indicated an intention to introduce one.  It might be noted that Section 90 would not prevent the States levying a broad based consumption tax on the sale of services.

3.  It may be that one reason for this Victorian predilection, which tends not to be shared by other States, is the belief that, as the State with the second highest taxable capacity, Victoria would benefit.  However, this would only occur if there was some basic change in the equalisation arrangements, which is unlikely.

4.  Professor Geoffrey Brennan, an acknowledged world expert on taxation, has argued that payroll tax does not discriminate between labour and capital because "capital requires labour for its production and capital goods prices will tend to move in the same direction as gross-of-tax wages".  He has also argued that the States could well regard payroll tax as an alternative to a broad based consumption tax but with features that may have advantages over such a tax.  See "Issues in State Taxation", Edited by Cliff Walsh, Centre for Federal Financial Relations 1990.

5.  As per ABS 5501.0, 28 March 1991, Table 3

6.  As that guarantee was given last May subject to there being no substantive change in economic circumstances (which there clearly has been), the Commonwealth has a "let out".

7.  Commonwealth "own purpose" outlays are estimated in 1990-91 to take about the same proportion of GDP as they did when the Federal Labor Government took office in 1982-83.

8.  In addition, a substantial proportion of specific purpose payments are provided in block form and, as such, are de facto general purpose payments.

9.  The main exception is in tertiary education where the Commonwealth has the dominant role.  Commonwealth health policies also significantly constrain States' freedom to adjust their own health policies.

10.  The estimate for 1990-91 assumes that Victoria's tax receipts will be about $407 million less than estimated in the Budget and that GSP will increase by only 3.8 percent in nominal terms.

11.  Data presented in "Victorian Equity Trust:  Prospectus" Mclntosh, Hanson Hoare and Govett Ltd, 1988, shows that "dividends" paid by the State Electricity Commission of Victoria, Gas and Fuel Corporation, Melbourne Metropolitan Board of Works and Portland Smelter Unit Trust exceeded aggregate profits for these organisations during 1985/86 and it was stated that this is expected to continue through 1990-91.  The prospectus also shows that the SECV has been capitalising interest throughout the 1982-1987 period, which implies that it has been unable to meet its interest commitments.

12.  The key point here, of course, is that "small" increases in a broadly based tax will be widely spread and each increase in itself is unlikely to produce significant adverse reactions.