Illustration by Michael Mucci.

Illustration: Michael Mucci

At this week's COAG meeting, state and territory treasurers will present a plan giving them a portion of the federal government's income tax receipts in exchange for phasing out stamp duties. The aim is to get rid of an inefficient tax and give states and territories more financial security.

A more ambitious plan would use this basic idea to start a national conversation about the most serious problem with Australia's federation: the vertical fiscal imbalance.

State governments only raise 16 per cent of the total tax take but have 40 per cent of the spending responsibilities. Meanwhile, the federal government raises 80 per cent of Australia's total tax.

Getting money from the federal government to the states involves double-handling, duplication and arguments over priorities, spending and policy. Responsibility and accountability become hazy due to the lack of clear ownership.

In practice everyone has a finger in most pies with huge overlaps between tiers of government. Federal and state governments have departments of health, education, environment, transport and housing, to name a few, even though the constitution is clear these are state matters.

When Australia's founding fathers wrote the constitution, they envisaged a system of co-ordinate federalism, where the federal and state governments would operate almost entirely independently of each other. Each tier would have its own areas of responsibility with its own tax revenue to carry out those responsibilities.

But over time a vertical fiscal imbalance arose as states lost their ability to raise sufficient revenue, at the expense of the federal government's ability to raise ever more.

High Court decisions have killed some state taxes by determining they were excises and fall in the federal jurisdiction. In 1942 (and re-confirmed in 1957) the High Court effectively removed the ability of the states to levy income taxes.

Australia's vertical fiscal imbalance is now one of the largest in the developed world and makes co-ordinate federalism impossible. Instead Australia has a system optimistically termed co-operative federalism. In theory, the federal and state governments work together on issues, through mechanisms such as COAG and grant arrangements.

But the federal government has the whip hand. Section 96 of the constitution says ''the Parliament may grant financial assistance to any State on such terms and conditions as the Parliament thinks fit'' meaning the federal government can involve itself in almost any area of policy whether it is theoretically responsible for it or not.

And involve itself it does. According to the OECD, aside from the GST, well over 80 per cent of federal government grants to the states are tied, that is, have strings attached. This is why COAG and ministerial forums often degenerate into the states demanding money with few or no conditions and the federal government demanding reform or detailed reporting in exchange for cash.

The state treasurers' plan to be presented on Friday could be emboldened to kick-start a discussion to sort out the mess that is the current system.

When the federal government introduced the GST in 2000, the states scrapped inefficient taxes in exchange for GST revenue. Critically GST revenue is handed over without policy or spending conditions.

States could be given a far greater proportion of income tax revenue in this way, as general purpose grants. The states would not necessarily get more money, but what they do get would not have conditions attached. The federal government would become simply a collection agent, as is the case with the GST.

This would return decisions over priorities, policies and spending to the individual states, reinvigorating alleged inter-state competition as a driver of innovation and progress.

Alternatively, the constitutional arrangements could be turned on their head. The federal government could take over most policy-making and spending decisions, only giving money to the states as service delivery agents.

This would involve massive constitutional upheaval, but may be a better long-term answer because it would allow the federal government to harmonise policy and allocate resources in the most efficient way for competing in an increasingly globalised world.

These are radically different propositions for fixing the problem and people in Australia, led by politicians and the media, need to decide how the system should work. The only thing people agree on at the moment is that the is a mess and it is unclear who is in charge.

Dr Joff Lelliott is state director of the political think tank The Australian Fabians (Queensland) and teaches Australian politics part-time at the University of Queensland.

joff@lelliott.net