“The experience of war has impacted significantly upon the evolution of the Federal relationship between the Commonwealth and the States” – discuss by reference to the evolution of the current vertical fiscal imbalance between the Commonwealth and the States:

Introduction

This essay challenges the view that the experience of war has impacted significantly on the evolution of Australia’s federal relationship. The essay examines a defining feature of this relationship: the vertical fiscal imbalance (‘VFI’). It analyses the evolution of the VFI since Federation. It examines, in particular, expansions in the VFI that occurred during the First and Second World Wars. Despite their timing, the influence of Australia’s wartime experiences on these expansions should not be overstated. Two other factors - the centralising policies of Labor governments and the High Court’s approach to constitutional interpretation - had a greater impact on these developments. The essay concludes that attributing the VFI principally to Australia’s wartime history is both incorrect and unhelpful. Such an approach obscures not only the true origins of the VFI, but also the fact that that the VFI is likely to evolve into the future.  

Section 1: Introduction to the VFI

On 30 March 2016, Prime Minister Malcolm Turnbull introduced a bold proposal for reform of Australia’s Federation.[1] He suggested that states should levy their own income taxes.[2] This proposal was immediately withdrawn due to the opposition of state premiers.[3] Daniel Andrews, for example, was not interested in such ‘tax policy thought bubbles’.[4] Mike Baird firmly consigned the matter to the ‘longer term’.[5] This affair echoed Australia’s historical experiences; similar proposals by Prime Ministers Malcolm Fraser and Bob Hawke were received with little enthusiasm.[6]

These events highlight a defining characteristic of contemporary Australian federalism: entrenched VFI. The essence of the VFI is that the Commonwealth collects more revenue than it spends, while the states spend more revenue than they collect.[7] The states therefore depend on the Commonwealth to fund approximately 40% of their expenditure.[8] In 2014-15, the Commonwealth made 46% of this funding subject to conditions.[9] In this way, the Commonwealth exerts fiscal control over the states.  

VFI is observed in many federations.[10] However, the extent of Australia’s VFI is ‘extreme’.[11] This is controversial because VFI undermines accountability and transparency.[12] Furthermore, although VFI has some economic benefits[13] excessive VFI results in unnecessary duplication and distorts resource allocation.[14]

Section 2: The Evolution of the VFI

Federation 

Before 1901, the states’ primary revenue sources were customs and excise duties.[15] At Federation, the Commonwealth was granted exclusive power to impose such duties.[16] This facilitated free trade within the Commonwealth.[17] However, it also established a degree of VFI from the very beginning of the Federation.[18] Despite this, certain transitional provisions in the Constitution initially softened the effects of the VFI.[19] For example, the ‘Braddon Clause’ required the Commonwealth to return three quarters of its customs and excise revenue to the states for the first ten years of Federation.[20]

The Commonwealth was also granted the power to impose income taxation.[21] This power was to be concurrent rather than exclusive.[22] Nevertheless, it caused concern during the Convention Debates. For example, Sir Edmund Barton feared that Commonwealth income taxation could threaten states’ ‘solvency’ and thereby undermine the federal character of the Commonwealth.[23]

Despite this, the view emerged that because the Commonwealth was to have the power to defend Australia[24] it required the power to tax.[25] As Alfred Deakin explained, in wartime it could be ‘necessary to devote not only the last ship, but the last shilling’ to the defence of Australia.[26] However, the delegates agreed that the Commonwealth ‘would never impose direct taxation excepting in a case of great national urgency’.[27]

The Impact of the First World War

In the early years of Federation, the states recouped some of their lost customs and excise revenue by expanding their income taxes, stamp duties and probate taxes.[28] These developments constrained the VFI.[29] However, in 1915 during the First World War the Commonwealth introduced its own income tax to operate concurrently with the state regime.[30] This new Commonwealth tax was not merely - as envisaged by the framers - a temporary wartime measure. From the outset, the Commonwealth indicated that the tax was to be permanent.[31]

It is often suggested that Commonwealth income taxation was introduced to raise funds for the war effort.[32] However, the permanence of the tax suggests otherwise. As Chief Justice Robert French has notably observed, ‘deeper motives’ were at stake.[33] In the relevant Second Reading Speech, Attorney General Billy Hughes explained that the Commonwealth required additional revenue ‘to meet the great and growing liabilities of the War’.[34] However, he also noted that income taxation was ‘peculiarly appropriate to the circumstances of a moderate community’ as an ‘instrument of social reform’.[35] The Labor government of the day had a great interest in social reform. Prime Minister Andrew Fisher, for example, was an outspoken socialist who had pioneered welfare programs such as the introduction of Australia’s first national aged pension.[36] Consequently, the impact of the First World War on Commonwealth entry into the field of income taxation should not be overstated.

Developments between the Wars

During the inter-war period, it became apparent that the introduction of Commonwealth income taxation had caused the VFI to expand.[37] However, the states were ‘largely still self-financed’.[38]

During this period, the High Court in two landmark cases developed a new approach to constitutional interpretation. This peacetime development would later be instrumental in entrenching Australia’s VFI.

(a) Engineers[39] (1920)

In Engineers the High Court overturned the reserved powers doctrine.[40] That doctrine had provided that the Commonwealth’s constitutional powers should be interpreted narrowly in order to ‘reserve’ the plenary power of the states.[41] This would, it was hoped, preserve the federal balance implied in the Constitution.[42] In Engineers the High Court held that the reserved powers doctrine, based as it was on the ‘spirit of the compact’, was too ‘vague’ to inform constitutional interpretation.[43] It was not the role of the Court to defend the federal balance.[44] The Court would therefore interpret the Constitution in its ‘ordinary and natural sense’.[45]  

(b) The Roads Case[46] (1926)                                                                             

Under section 96 of the Constitution, the Commonwealth can grant financial assistance to the states on ‘such terms and conditions as the Parliament thinks fit’.[47] In the Roads Case the High Court summarily dismissed a challenge to a grant made on arduous terms.[48] The case established that the High Court would uphold section 96 grants even if they undermined the federal balance; the grants power became ‘virtually unreviewable’.[49]

The Impact of the Second World War

(a) The Uniform Tax Scheme

In 1939, the Second World War broke out. The Commonwealth required additional revenue to fund the war effort.[50] The Commonwealth’s share of Australia’s income tax revenue therefore grew from 16 percent in 1938-9 to 44 percent in 1941-2.[51] However, the states remained active in the field of income taxation.[52] This constrained the Commonwealth’s ability to raise further revenue.[53] In 1942, the government established a Committee on Uniform Taxation to examine this problem.[54]

The Committee recommended that the Commonwealth abolish state income taxation.[55] This abolition was to be a temporary wartime measure.[56] This recommendation was well received in Cabinet.[57] Accordingly, Parliament enacted a scheme of four Acts to give effect to the Committee’s proposal: the ‘uniform tax scheme’.[58] First, under the Income Tax Act 1942 (Cth) the Commonwealth would impose extremely high levels of income tax.[59] Secondly, under the State Grants (Income Tax Reimbursement Act) 1942 (Cth) the Commonwealth would make significant section 96 grants to reward states that did not levy income tax.[60] Thirdly, under the Income Tax (War-Time Arrangements) Act 1942 (Cth) the Commonwealth would take charge of state tax departments’ resources for the duration of the War.[61] Fourthly, under the Income Tax Assessment Act 1942 (Cth) payment of Commonwealth income tax would take precedence over payment of state taxes.[62] This scheme made it virtually impossible for the states to impose income tax. In this way, it compounded Australia’s emerging VFI. 

The Committee was appointed just days after the bombing of Darwin.[63] The legislation was enacted in the very ‘crisis of war’ immediately after the Battle of Midway.[64] These wartime experiences undoubtedly contributed to public support for the scheme.[65] However, the ‘conventional’[66] view that the federal government was itself primarily motivated by the exigencies of war is overly simplistic.

Throughout 1942, critics accused the federal Labor government of political opportunism.[67] The government, they argued, was using the war to disguise its pursuit of a policy of centralisation unrelated to wartime objectives.[68] At that time – as in 1915 - the Labor Party supported centralisation on the basis that the Commonwealth was best positioned to engage in national social and economic reform.[69] The critics’ accusations were prescient. The government used revenue from the scheme to do far more than fund the war effort. By 1944 it had established Australia’s first Commonwealth child endowment scheme; widows’ pension; funeral benefit and sickness and invalid benefit.[70] As Gough Whitlam – himself a great supporter of uniform taxation - later emphasised, these developments leave no doubt that in implementing uniform taxation the government had a great deal ‘more in mind’ than the experience of war.[71]

(b) The First Uniform Tax Case

In June 1942 in the First Uniform Tax Case the states challenged the uniform tax scheme in the High Court.[72] The challenge was unsuccessful; the High Court upheld all four Acts. It is often suggested that Australia’s wartime experiences impacted the judgment.[73] This view is not entirely without substance. The majority held that the Arrangements Act was supported by the defence power.[74] Rich J, for example, noted that in wartime it is ‘notoriously essential’ that ‘the whole resources of the nation … should be marshalled and concentrated upon the war effort’.[75] The defence power is ‘elastic’;[76] the power is interpreted more broadly during a ‘raging’ war than in peacetime.[77] It is therefore possible that the Court would not have upheld the Arrangements Act had Australia not been at war. 

However, the Arrangements Act was the exception. The majority held that the three other Acts of the scheme – the Income Tax Act, the Grants Act and the Assessment Act - were supported by the taxation power, the incidental power and the grants power: not the defence power.[78] Far from being a product of the experience of war, this decision was a straightforward application of existing constitutional jurisprudence. The states submitted that the Acts were invalid because they would ‘impede, weaken or destroy’ their power to engage in an ‘essential activity of government’: taxation.[79] This submission had an ill ring. It was reminiscent of the reserved powers doctrine, if with an added gloss. Following Engineers, the Court therefore refused to entertain it.[80] Some judges acknowledged that as a ‘consequential effect’ the Acts would indeed ‘impede, weaken or destroy’ state activity and thereby affect the federal balance.[81] However, this consideration was irrelevant.[82]

There were dissenting views. Starke J, for example, argued that because the ‘maintenance of the states and their power’ was implied in the Constitution section 96 could not support the ‘crippling’ Grants Act.[83] However, following the Roads Case the majority firmly rejected this argument.[84] The Court therefore upheld the scheme in its entirety, entrenching the VFI.

Developments after the War

In January 1946, the federal government decided to maintain the ‘temporary’ uniform tax scheme indefinitely.[85] This decision was unrelated to the experience of war. Prime Minister Ben Chifley took great pride in the reform that the Labor government had undertaken since 1942.[86] He considered that even in wartime the government had ‘never lost faith in the ultimate victory’: expanding Australia’s social welfare system.[87] He therefore had no intention of losing the revenue required to maintain the government’s new programs. On the contrary, he was already planning a referendum to entrench them.[88] The VFI, having expanded during the War, therefore remained high.[89]

In 1957 in the Second Uniform Tax Case[90] the states returned to the High Court. They challenged the Grants Act and the Assessment Act.[91] This challenge was unsuccessful. The Court unanimously upheld the Grants Act:[92] the pivotal act of the scheme. The judgment is instructive. It confirms that Australia’s wartime experiences did not significantly impact the First Uniform Tax Case. Although Australia was no longer at war, in relation to the Grants Act the judges found it ‘impossible’ to distinguish the case at hand from its predecessor.[93] Once again, the states submitted that the principle ‘that the Commonwealth cannot prohibit or fetter or control the exercise by States of their constitutional powers’ should inform the interpretation of section 96.[94] Once again, the Court refused to entertain this submission.[95]

There were regrets. Dixon CJ suggested that the framers likely envisaged a narrower operation for section 96.[96] However, he considered that ‘the course of judicial decision has put any such limited interpretation … out of consideration’.[97] In wartime or peacetime, the High Court would not protect the states’ fiscal power. It would therefore allow the uniform tax scheme to continue in perpetuity.

Recent Developments

The VFI has endured since the Uniform Tax Cases.[98] Some federal governments have restricted state grants, worsening the VFI.[99] For example, the Keating government pursued fiscal centralisation to facilitate national social and economic reform.[100] The Howard government reduced state grants ostensibly to address the budget deficit.[101] None of these developments were informed by the experience of war.  

Section 3: The Future of the VFI

The VFI should not be dismissed as a product of Australia’s wartime experiences. Among other factors, the High Court’s approach to constitutional interpretation has had a greater impact on its evolution. Consequently, extreme VFI is not a fixed and immutable feature of Australian federalism. Should the High Court’s approach change, Australia’s federal relationship could evolve into something quite different.

The landmark case of Williams v Commonwealth No.1 (2012)[102] illustrates this point. In Williams the High Court held that the power of the Commonwealth government to contract was not unlimited.[103]  The Court’s approach was significant. In a ‘break from past practice’[104] - including the Uniform Tax Cases - the Court appeared to be willing to constrain the fiscal power of the Commonwealth in order to protect the federal balance. For example, French CJ considered that the fact that Commonwealth expenditure could ‘diminish the authority of the States in their fields of operation’ supported a restrictive interpretation of Commonwealth power.[105] The impact of this decision on the VFI is yet to be fully realised.[106] However, it certainly has the potential to alter Australia’s federal relationship, shifting the federal balance in favour of the states.[107]

Conclusion

During the First and Second World Wars, Australia’s VFI expanded. This suggests, prima facie, that the current VFI can be attributed principally to the experience of war. However, this proposition is incorrect. Both the centralising policies of Labor governments and the High Court’s approach to constitutional interpretation have had a more significant impact on the evolution of the VFI than Australia’s wartime experiences. Attributing Australia’s VFI to the experience of war is therefore unhelpful. It obscures the fact that the VFI is no immutable accident of history. It is a product of the choices made both by governments and by the High Court. Consequently, as the decision in Williams demonstrates, the VFI and indeed Australia’s federal relationship will continue to evolve into the future.

BIBLIOGRAPHY

A Articles/Books/Reports

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Chifley, Ben, cited in ‘Present Uniform Tax to Remain’, The Courier Mail (Brisbane) 23 January 1946

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Fenna, Alan, ‘Commonwealth Fiscal Power and Australian Federalism’ (2008) 31 (2) University of New South Wales Law Journal 553

Fisher, Rodney and Jacqueline McManus, ‘The Long and Winding Road: A Century of Centralisation in Australian Tax’ (Discussion Paper No 8, Australian Taxation Studies Program, July 2002)

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B Cases

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C Legislation

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Income Tax Act 1942 (Cth)

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DECLARATION

I declare that this essay is my own and unaided original work, except where I have acknowledged the work of others in accordance with the Australian Guide to Legal Citation. 

[1] Phillip Coorey, ‘Malcolm Turnbull says states should levy own income tax levels’, The Australian Financial Review (online), 30 March 2016 <http://www.afr.com/news/politics/election/malcolm-turnbull-says-states-s....