Cut leviathan's hunger for tax

Bookmark and Share Economics & Deregulation | Julie Novak
The Australian 15th January, 2013

The death last week of Nobel prize-winning economist James Buchanan captured newspaper headlines around the world, and for good reason.

Taught economics by some of the leading figures of the Chicago School, Buchanan later staked his own path of intellectual originality by suggesting that politicians, just like market participants, act in their own self-interest, and that institutional reform is central to improving the integrity of fiscal and monetary policymaking.

These features of Buchanan's work deserved the recognition they received over the past week, but his original, but somewhat unheralded work, on the economics of federal systems of government, is also relevant, especially for countries such as Australia.

A key feature of Buchanan's thought on federalism is his unflinching advocacy of fiscal decentralisation: that is, the assignment of taxing and expenditure functions to lower levels of government as much as practicable.

In his iconic book The Power to Tax, co-authored with Australian economist Geoffrey Brennan, Buchanan indicates that decentralisation erodes the natural tendencies of governments wanting to maximise their revenue collections at the expense of private-sector economic activity.

Federalism suppresses leviathan's revenue appetite because otherwise fiscally persecuted owners of capital and labour can relocate to lower-taxing jurisdictions, so long as free trade and migration within the federation is maintained.

Buchanan's essential prediction was that in a federal system, "total government intrusion into the economy should be smaller, ceteris paribus, the greater the extent to which taxes and expenditures are decentralised".

But to reinforce the compatibility of political action with the interests of the citizenry within a federal system, Buchanan also advocated that communities be permitted to secede from an existing federal country.

Writing in 1995, he said "secession, or the threat thereof, represents the only means through which the ultimate powers of the central government might be held in check".

Based on Buchanan's theory, one could speculate that the refusal to grant Western Australia secession in the 1930s subsequently reduced the threat to both federal and state governments that large numbers of people would seek to break away politically in response to high taxes and onerous regulations.

In addition to the idea of federalism as a political constraint mechanism, whether through mobility or secession, another major contribution by Buchanan concerns the question of fiscal equalisation.

One of Buchanan's earliest papers, published in 1950, shows how fiscal transfers between jurisdictions can be designed to internalise the fiscal externalities arising from the movement of labour in response to different taxing and spending levels presented by the state governments.

While this contribution on achieving fiscal equity within a federation remains influential, the 1950 paper was by no means Buchanan's final words on the matter.

Buchanan later recognised that a fiscal equalisation system could be adopted as a vehicle to enforce a high-taxing "fiscal cartel", within which the central government monopolises access to the major taxing bases and disburses excess revenues back to the states in the form of grants.

In effect, the risk is that fiscal equalisation could be used to suppress competitive federalism, thereby allowing all governments within the federal system to grow to a level beyond that otherwise preferred by citizens.

It is not unfair to claim that the modern Australian federal system, with its extreme degree of vertical fiscal imbalance, combined with the world's most complex fiscal equalisation process, reasonably approximates the fiscal cartel model depicted by Buchanan.

In a paper written in 2002, Buchanan defends the theoretical integrity of his original 1950 fiscal transfer scheme but poignantly observes that problems posed by political incentives and policy implementation must be explicitly accounted for when evaluating equalisation models.

The failure of governments and economists alike to sufficiently recognise these caveats represents a blind spot in the ongoing Australian debate about GST distribution between the states. Recently a number of prominent Australian political figures, such as former prime minister Bob Hawke and former Queensland premier Peter Beattie, have argued the case for abolishing the states altogether.

Such arguments are at the pointy end of the peculiar disconnect between Australian and international narratives, and indeed practices, concerning the acceptance of federalism as an organising principle for collective action.

Indeed, most other mature federations around the world put Australia in the shade when it comes to the decentralised nature of their fiscal and policy decision making.

The US may be falling in economic freedom rankings, thanks in no small part to its federal government, but competitive, low-taxing states such as Texas shine as beacons drawing in capital and labour, helping to maintain some semblance of American dynamism.

The Canadian provinces are similarly influential within a decentralised government structure where Ottawa largely keeps its hands off provincial affairs such as education, while Switzerland has maintained a system of vigorous tax competition, aiding its unrivalled position as a global financial centre.

Given our emaciated federalism, in which the federal government keeps the power of the purse and runs policy roughshod over the service-delivering states, calls to allocate at least the most important governmental functions to Canberra regrettably have widespread, albeit superficial, appeal.

But instead of surrendering everything of consequence to the likes of the Gillard government, Australia should take a leaf out of James Buchanan's book and decentralise, placing the centres of political powers and responsibilities as close to the people as possible.