The Evolution of Constitutional Federalism in Australia
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The Evolution of Constitutional Federalism in Australia
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The Evolution of Constitutional
Federalism in Australia: An Incomplete
Contracts Approach
Bhajan Grewal and Peter Sheehan*
CSES Working Paper No. 22
ISSN: 1322 5138
ISBN: 1 86272 644 2
November 2003
*Bhajan Grewal is Deputy Director and Peter Sheehan is Director at the
Centre for Strategic Economic Studies, Victoria University (Melbourne).
Centre for Strategic Economic Studies
Victoria University of Technology
PO Box 14428 Melbourne City MC VIC 8001 Australia
Telephone +613 9248 1340
Fax +613 9248 1350
Email: csesinfo@vu.edu.au
Website: http://www.cfses.com
CSES Working Paper No. 22 1
The Evolution of Constitutional Federalism in Australia: An
Incomplete Contracts Approach
AbstractAbstract
The interest in, and the appeal of, fiscal federalism and fiscal
decentralization have been increasing in recent years. At the same time many
mature federations continue to evolve towards greater centralization, as Australia
has evolved in the last one hundred years. The reasons for the evolution of fiscal
federalism towards greater centralization remain unclear, and the traditional
theories of fiscal federalism shed little light on the factors that might be important
in this process. This paper suggests that the insight yielded by the new institutional
economics – that the motivations and incentives of economic agents, and the options
available to them, are influenced in a fundamental sense by the incompleteness of
contracts – may throw considerable light on the evolution of federalism in Australia
over the past one hundred years.
1. Introduction: Australia’s Federal System One Hundred Years On1. Introduction: Australia’s Federal System One Hundred Years On
In Australia, the distribution of legislative powers between the Commonwealth and
the States is vastly different today from the original distribution enshrined in the
federal constitution adopted on 1 January 1901. Whereas in 1901, power over most
public sector functions was assigned exclusively to the States, it is now shared with
the Commonwealth, with the result that legislative competence of the
Commonwealth government has expanded significantly over the last century and
that of the States has declined.
Similar trends towards greater centralisation may be observed in other
federations, e.g. the USA, Canada (notwithstanding some significant reversals in
the trend in this country since the 1960s), Germany and India. In each of these
federations, the people originally chose a certain degree of fiscal and legislative
decentralisation, which could only be changed by them according to specified
procedures of constitutional amendment. In each case, however, the balance of
power has shifted to dilute the chosen degree of decentralisation, and the authority
of subnational governments has weakened over time.
Considered in this context of international empirical evidence, the long-term
stability of fiscal decentralisation appears to be in doubt. Yet, there currently exists
no clear explanation of why such a transformation of federalism should occur, what
particular forces drive this transformation, and whether the future course of the
evolution of federalism can be predicted or controlled. The purpose of this paper is
to seek preliminary answers to some of these questions.
Although a significant body of economics literature has been developed over
the past fifty years dealing with a wide range of issues that arise in a federalized
public sector, a review in the following section finds that the current literature
sheds little light on why federalism evolves towards greater centralisation.
Meanwhile, given the increasing interest in decentralisation, devolution and
The Evolution of Constitutional Federalism in Australia: An
Incomplete Contracts Approach
AbstractAbstract
The interest in, and the appeal of, fiscal federalism and fiscal
decentralization have been increasing in recent years. At the same time many
mature federations continue to evolve towards greater centralization, as Australia
has evolved in the last one hundred years. The reasons for the evolution of fiscal
federalism towards greater centralization remain unclear, and the traditional
theories of fiscal federalism shed little light on the factors that might be important
in this process. This paper suggests that the insight yielded by the new institutional
economics – that the motivations and incentives of economic agents, and the options
available to them, are influenced in a fundamental sense by the incompleteness of
contracts – may throw considerable light on the evolution of federalism in Australia
over the past one hundred years.
1. Introduction: Australia’s Federal System One Hundred Years On1. Introduction: Australia’s Federal System One Hundred Years On
In Australia, the distribution of legislative powers between the Commonwealth and
the States is vastly different today from the original distribution enshrined in the
federal constitution adopted on 1 January 1901. Whereas in 1901, power over most
public sector functions was assigned exclusively to the States, it is now shared with
the Commonwealth, with the result that legislative competence of the
Commonwealth government has expanded significantly over the last century and
that of the States has declined.
Similar trends towards greater centralisation may be observed in other
federations, e.g. the USA, Canada (notwithstanding some significant reversals in
the trend in this country since the 1960s), Germany and India. In each of these
federations, the people originally chose a certain degree of fiscal and legislative
decentralisation, which could only be changed by them according to specified
procedures of constitutional amendment. In each case, however, the balance of
power has shifted to dilute the chosen degree of decentralisation, and the authority
of subnational governments has weakened over time.
Considered in this context of international empirical evidence, the long-term
stability of fiscal decentralisation appears to be in doubt. Yet, there currently exists
no clear explanation of why such a transformation of federalism should occur, what
particular forces drive this transformation, and whether the future course of the
evolution of federalism can be predicted or controlled. The purpose of this paper is
to seek preliminary answers to some of these questions.
Although a significant body of economics literature has been developed over
the past fifty years dealing with a wide range of issues that arise in a federalized
public sector, a review in the following section finds that the current literature
sheds little light on why federalism evolves towards greater centralisation.
Meanwhile, given the increasing interest in decentralisation, devolution and
CSES Working Paper No. 22 2
federalism around the world - not only in the wake of the demise of the Soviet
Union, but also recent fiscal developments in the East European countries and in
the European Union, the implementation of fiscal decentralisation in China, and of
fiscal devolution in Scotland and Wales – the questions raised above have become
ever more important and pressing. We propose in this paper an explanation of the
longer-term evolution of fiscal decentralisation with the aid of the concept of
incomplete contracts (2). We are not addressing here the question of whether
changes to federalism are desirable or undesirable. We are concerned solely with
explaining why and how the changes have occurred.
In Section 2, we provide evidence of the erosion of decentralization in the
course of the past one hundred years. The inability of the traditional economic
theories of fiscal federalism to offer meaningful explanations of the evolution of
federalism is discussed in Section 3. The concept of incomplete contracts is
introduced and its implications for the evolution of federalism are drawn in Section
4. In Section 5, a new interpretation of revenue sharing – a key institution of
federalism and one that has been particularly important in Australia – is developed
in the context of the theory of incomplete contracts. The proposition that Australia's
Constitution is an incomplete contract is considered in Section 6. The main driving
forces of the evolution of federalism in Australia are discussed in Section 7. Section
8 provides a summary of the main conclusions and their implications.
2. Australia: A Changing Federal System2. Australia: A Changing Federal System
The Constitution adopted in 1901 distributed legislative power over public
policies between the Commonwealth and the State governments in a highly
decentralized pattern. Only a limited number of substantive heads of power had
been assigned to the Commonwealth in Section 51; the remaining functions were
reserved for the States (3). In the event of a need for reassignment, the
Constitution could be amended in a manner prescribed in the Constitution
(Section 128), according to which a referendum for amendment must be
supported by not only a majority of voters but also by a majority of States. The
aim of this condition of double majority was to protect the interests of the voters
in the less populous States by ensuring that voters in only New South Wales and
Victoria could not by themselves alter the Constitution. But the Section 128
procedure for amendment has proved to be so difficult that during the past 100
years, the constitution has been amended on only eight occasions, although a
total of 42 Constitutional Amendment Bills have been presented to the people of
Australia on 18 referendum days. Indeed, in itself, Section 51 has proved to be
extremely stable and has been amended only twice during the past one hundred
years. In 1946, a new clause (xxiii A) was inserted to Section 51, empowering
Parliament to make laws with respect to the provision of maternity allowances,
widows' pensions, child endowment, unemployment, pharmaceutical, sickness
and hospital benefits, medical and dental services, benefits to students and
family allowances. The second amendment was made in 1967 but it did not affect
the balance of power of between the Commonwealth and the States (4).
The current distribution of powers of legislative power is vastly different
from the original design, however, and has become highly centralized at the
Commonwealth level. For the most part, this increase in centralization has
occurred without formal alteration of the Constitution, i.e. without the express
approval of the majority of voters in majority of States, as originally required.
federalism around the world - not only in the wake of the demise of the Soviet
Union, but also recent fiscal developments in the East European countries and in
the European Union, the implementation of fiscal decentralisation in China, and of
fiscal devolution in Scotland and Wales – the questions raised above have become
ever more important and pressing. We propose in this paper an explanation of the
longer-term evolution of fiscal decentralisation with the aid of the concept of
incomplete contracts (2). We are not addressing here the question of whether
changes to federalism are desirable or undesirable. We are concerned solely with
explaining why and how the changes have occurred.
In Section 2, we provide evidence of the erosion of decentralization in the
course of the past one hundred years. The inability of the traditional economic
theories of fiscal federalism to offer meaningful explanations of the evolution of
federalism is discussed in Section 3. The concept of incomplete contracts is
introduced and its implications for the evolution of federalism are drawn in Section
4. In Section 5, a new interpretation of revenue sharing – a key institution of
federalism and one that has been particularly important in Australia – is developed
in the context of the theory of incomplete contracts. The proposition that Australia's
Constitution is an incomplete contract is considered in Section 6. The main driving
forces of the evolution of federalism in Australia are discussed in Section 7. Section
8 provides a summary of the main conclusions and their implications.
2. Australia: A Changing Federal System2. Australia: A Changing Federal System
The Constitution adopted in 1901 distributed legislative power over public
policies between the Commonwealth and the State governments in a highly
decentralized pattern. Only a limited number of substantive heads of power had
been assigned to the Commonwealth in Section 51; the remaining functions were
reserved for the States (3). In the event of a need for reassignment, the
Constitution could be amended in a manner prescribed in the Constitution
(Section 128), according to which a referendum for amendment must be
supported by not only a majority of voters but also by a majority of States. The
aim of this condition of double majority was to protect the interests of the voters
in the less populous States by ensuring that voters in only New South Wales and
Victoria could not by themselves alter the Constitution. But the Section 128
procedure for amendment has proved to be so difficult that during the past 100
years, the constitution has been amended on only eight occasions, although a
total of 42 Constitutional Amendment Bills have been presented to the people of
Australia on 18 referendum days. Indeed, in itself, Section 51 has proved to be
extremely stable and has been amended only twice during the past one hundred
years. In 1946, a new clause (xxiii A) was inserted to Section 51, empowering
Parliament to make laws with respect to the provision of maternity allowances,
widows' pensions, child endowment, unemployment, pharmaceutical, sickness
and hospital benefits, medical and dental services, benefits to students and
family allowances. The second amendment was made in 1967 but it did not affect
the balance of power of between the Commonwealth and the States (4).
The current distribution of powers of legislative power is vastly different
from the original design, however, and has become highly centralized at the
Commonwealth level. For the most part, this increase in centralization has
occurred without formal alteration of the Constitution, i.e. without the express
approval of the majority of voters in majority of States, as originally required.
CSES Working Paper No. 22 3
Fiscal centralization and decentralization are normally measured in
respect of the shares of subnational governments in national taxation revenues
and public expenditures (see, for example Bird, 1986, and Hunter and Shah,
1996). Information shown in Tables 1 to 3 in this section provides evidence of a
steep decline of fiscal decentralization in Australia, particularly after the Second
World War. Figures in Table 1 show that the share of total tax revenues collected
by the State and local governments (States herein after) from their own taxes has
fallen from 87 per cent at the time of the inauguration of the Constitution to 18
per cent in 2001-02. Given their expenditure responsibilities for community
services, the centralization of taxation revenue has made the States heavily
dependent on Commonwealth funding. Figures in Table 2 show that not only are
the States heavily dependent upon Commonwealth funding, which amounted to
nearly $52 billion in 2001-02, but more than 40 per cent of Commonwealth
payments to the States are currently in the form of specific purpose payments
(SPPs) that must be spent in accordance with conditions and directions imposed
by the Commonwealth. As shown in Table 3, the extensive role of specific purpose
payments has changed the nature of most of State functions into functions of
shared responsibility.
Since July 2000, when Commonwealth Government introduced the new
goods and service tax (GST), the States have been receiving all the GST revenue
(net of administrative costs to the Commonwealth) instead of general revenue
grants of the previous years. This arrangement came into effect as a part of the
Intergovernmental Agreement on the Reform of Commonwealth-State Financial
Reforms 1999, which followed the invalidation of State Business Franchise Fees
on tobacco, petroleum products and alcoholic beverages by the High Court on 5
August 1997 (see, Section 7 below for detail). Although this arrangement makes
the States feel more secure in respect of access to a broad-based and growing
source of revenue, Constitutionally and legally, GST is a Commonwealth tax (and
is treated as such by the Australian Bureau of Statistics) and for this reason, the
States are now more dependent on Commonwealth funding than they have ever
been in most of their peacetime history.
Table 1. Share of total taxation revenues by level of governmenTable 1. Share of total taxation revenues by level of governmen tt
Year State and local Commonwealth
1898-99 100 0
1901-02 87 13
1909-10 78 22
1918-19 27 73
1928-29 37 63
1938-39 41 59
1948-49 12 88
1958-59 17 83
1969-70 17 83
1979-80 20 80
1985-86 19 81
1989-90 22 78
1998-99 23 77
2001-02 18 82
Sources: Mathews and Jay (1997, reprint of 1972 edn), pp. 54, 58, 83, 100, 152, 194, 230,
282; Mathews and Grewal (1997); and ABS, various years, Cat. no. 5512.0.
Fiscal centralization and decentralization are normally measured in
respect of the shares of subnational governments in national taxation revenues
and public expenditures (see, for example Bird, 1986, and Hunter and Shah,
1996). Information shown in Tables 1 to 3 in this section provides evidence of a
steep decline of fiscal decentralization in Australia, particularly after the Second
World War. Figures in Table 1 show that the share of total tax revenues collected
by the State and local governments (States herein after) from their own taxes has
fallen from 87 per cent at the time of the inauguration of the Constitution to 18
per cent in 2001-02. Given their expenditure responsibilities for community
services, the centralization of taxation revenue has made the States heavily
dependent on Commonwealth funding. Figures in Table 2 show that not only are
the States heavily dependent upon Commonwealth funding, which amounted to
nearly $52 billion in 2001-02, but more than 40 per cent of Commonwealth
payments to the States are currently in the form of specific purpose payments
(SPPs) that must be spent in accordance with conditions and directions imposed
by the Commonwealth. As shown in Table 3, the extensive role of specific purpose
payments has changed the nature of most of State functions into functions of
shared responsibility.
Since July 2000, when Commonwealth Government introduced the new
goods and service tax (GST), the States have been receiving all the GST revenue
(net of administrative costs to the Commonwealth) instead of general revenue
grants of the previous years. This arrangement came into effect as a part of the
Intergovernmental Agreement on the Reform of Commonwealth-State Financial
Reforms 1999, which followed the invalidation of State Business Franchise Fees
on tobacco, petroleum products and alcoholic beverages by the High Court on 5
August 1997 (see, Section 7 below for detail). Although this arrangement makes
the States feel more secure in respect of access to a broad-based and growing
source of revenue, Constitutionally and legally, GST is a Commonwealth tax (and
is treated as such by the Australian Bureau of Statistics) and for this reason, the
States are now more dependent on Commonwealth funding than they have ever
been in most of their peacetime history.
Table 1. Share of total taxation revenues by level of governmenTable 1. Share of total taxation revenues by level of governmen tt
Year State and local Commonwealth
1898-99 100 0
1901-02 87 13
1909-10 78 22
1918-19 27 73
1928-29 37 63
1938-39 41 59
1948-49 12 88
1958-59 17 83
1969-70 17 83
1979-80 20 80
1985-86 19 81
1989-90 22 78
1998-99 23 77
2001-02 18 82
Sources: Mathews and Jay (1997, reprint of 1972 edn), pp. 54, 58, 83, 100, 152, 194, 230,
282; Mathews and Grewal (1997); and ABS, various years, Cat. no. 5512.0.
CSES Working Paper No. 22 4
Table 2. Commonwealth payments to or for the States, selected yearsTable 2. Commonwealth payments to or for the States, selected years
Year Total payments
($m)
Conditional
payments ($m)
Conditional payments
as % of total payments
1918-19 12.9 0 0.0
1924-25 16 1 6.3
1929-30 25.2 6.2 24.6
1938-39 30.7 8.6 28.0
1945-46 100.4 6.4 6.4
1948-49 157 34 21.8
1958-59 582 141 24.2
1968-69 1620 424 26.2
1975-76 8555 4152 48.5
1978-79 10720 4485 41.8
1988-89 24745 11515 46.5
1994-95 30322 17041 56.2
1998-99 33673 16652 49.5
2001-02 51729 21020 40.6
Sources: Mathews and Jay (1997, reprint of 1972 edn, Tables 17, 23, 33, 46); Mathews
and Grewal (1997, Tables 4.1, 8.5, 12.1); and Commonwealth of Australia (1999, 2002).
Table 3. Government expenditure on selected purposes by level of governmeTable 3. Government expenditure on selected purposes by level of government, 2001nt, 2001-- 0202
Purpose All
governments
($m)
Commonwealth
Government
($m)
State and local
governments
($m)
Social security & welfare 74551 69080 7099
Health 44327 27613 24230
Education 37546 21507 27070
General public services 16243 9950 7536
Public debt transactions 15636 10535 5336
Transport & communications 14098 2647 13241
Defense 12017 12017 ---
Public order & safety 11535 1855 9777
Housing & community amenities 10011 2210 9287
Other economic affairs 8107 3895 4216
Recreation & culture 6535 2030 4550
Agriculture, forestry & fishing 3905 1691 2381
Fuel & energy 4105 3052 1073
Mining, manufacturing & constr. 2614 1686 929
Other 801 33625 853
Total 262032 203392 117578
Notes: 1. All figures are GFS expenses. Figures for the university sector have been added
into Commonwealth Government expenses.
2. Row totals do not add up due to intergovernmental transfers.
Source: Australian Bureau of Statistics, Government Finance Statistics 2001-02, Cat. No.
5512.0, June 2003.
Table 2. Commonwealth payments to or for the States, selected yearsTable 2. Commonwealth payments to or for the States, selected years
Year Total payments
($m)
Conditional
payments ($m)
Conditional payments
as % of total payments
1918-19 12.9 0 0.0
1924-25 16 1 6.3
1929-30 25.2 6.2 24.6
1938-39 30.7 8.6 28.0
1945-46 100.4 6.4 6.4
1948-49 157 34 21.8
1958-59 582 141 24.2
1968-69 1620 424 26.2
1975-76 8555 4152 48.5
1978-79 10720 4485 41.8
1988-89 24745 11515 46.5
1994-95 30322 17041 56.2
1998-99 33673 16652 49.5
2001-02 51729 21020 40.6
Sources: Mathews and Jay (1997, reprint of 1972 edn, Tables 17, 23, 33, 46); Mathews
and Grewal (1997, Tables 4.1, 8.5, 12.1); and Commonwealth of Australia (1999, 2002).
Table 3. Government expenditure on selected purposes by level of governmeTable 3. Government expenditure on selected purposes by level of government, 2001nt, 2001-- 0202
Purpose All
governments
($m)
Commonwealth
Government
($m)
State and local
governments
($m)
Social security & welfare 74551 69080 7099
Health 44327 27613 24230
Education 37546 21507 27070
General public services 16243 9950 7536
Public debt transactions 15636 10535 5336
Transport & communications 14098 2647 13241
Defense 12017 12017 ---
Public order & safety 11535 1855 9777
Housing & community amenities 10011 2210 9287
Other economic affairs 8107 3895 4216
Recreation & culture 6535 2030 4550
Agriculture, forestry & fishing 3905 1691 2381
Fuel & energy 4105 3052 1073
Mining, manufacturing & constr. 2614 1686 929
Other 801 33625 853
Total 262032 203392 117578
Notes: 1. All figures are GFS expenses. Figures for the university sector have been added
into Commonwealth Government expenses.
2. Row totals do not add up due to intergovernmental transfers.
Source: Australian Bureau of Statistics, Government Finance Statistics 2001-02, Cat. No.
5512.0, June 2003.
CSES Working Paper No. 22 5
The historical ascendancy of centralization in Australia is sketched in Table 4,
through an outline of the major landmarks – intergovernmental events or High
Court decisions – that led to the erosion of the States' Constitutional authority. It
is clear that a significant measure of the Constitutional degree of
decentralization has been lost during the first hundred years after Federation.
Table 4. Major changes in the constitutional division of powers, selected landmarksTable 4. Major changes in the constitutional division of powers, selected landmarks
Year Selected events Impact on
decentralisation
1908 The States lost their Constitutional right to at least 75% of
the Commonwealth surplus revenue under Section 94
Greater
dependence of
States on
Commonwealth
1920 New legal doctrine established by the High Court in the
Engineers’ case, favouring Commonwealth government
Expansion of
Commonwealth
powers
1923 The power of Section 96 begins to unravel when road grants
are introduced
Expansion of
Commonwealth
powers
1927 The Financial Agreement sets up Australian Loan Council,
which would diminish States’ borrowing powers
Expansion of
Commonwealth
powers
1942 Commonwealth gains exclusive power over income taxation Greater
dependence of
States on
Commonwealth
1951 States cannot raise sufficient borrowings and become
dependent on Commonwealth Special Loans
Greater
dependence of
States on
Commonwealth
1969 State receipts duty declared invalid by the High Court Loss of States’
independent
revenue sources
1970 The High Court rules that the States cannot levy a tax on
any stage of sales of a product
Loss of States’
independent
revenue sources
1971 Transfer of Commonwealth Payroll tax to the States, with
corresponding reduction in tax sharing grants
States gain
independent
source of revenue
1973 Commonwealth specific purpose grants mushroom under
Whitlam administration
Expansion of
Commonwealth
powers
1974 Commonwealth takes over financing of tertiary education
from the States
Expansion of
Commonwealth
powers
The historical ascendancy of centralization in Australia is sketched in Table 4,
through an outline of the major landmarks – intergovernmental events or High
Court decisions – that led to the erosion of the States' Constitutional authority. It
is clear that a significant measure of the Constitutional degree of
decentralization has been lost during the first hundred years after Federation.
Table 4. Major changes in the constitutional division of powers, selected landmarksTable 4. Major changes in the constitutional division of powers, selected landmarks
Year Selected events Impact on
decentralisation
1908 The States lost their Constitutional right to at least 75% of
the Commonwealth surplus revenue under Section 94
Greater
dependence of
States on
Commonwealth
1920 New legal doctrine established by the High Court in the
Engineers’ case, favouring Commonwealth government
Expansion of
Commonwealth
powers
1923 The power of Section 96 begins to unravel when road grants
are introduced
Expansion of
Commonwealth
powers
1927 The Financial Agreement sets up Australian Loan Council,
which would diminish States’ borrowing powers
Expansion of
Commonwealth
powers
1942 Commonwealth gains exclusive power over income taxation Greater
dependence of
States on
Commonwealth
1951 States cannot raise sufficient borrowings and become
dependent on Commonwealth Special Loans
Greater
dependence of
States on
Commonwealth
1969 State receipts duty declared invalid by the High Court Loss of States’
independent
revenue sources
1970 The High Court rules that the States cannot levy a tax on
any stage of sales of a product
Loss of States’
independent
revenue sources
1971 Transfer of Commonwealth Payroll tax to the States, with
corresponding reduction in tax sharing grants
States gain
independent
source of revenue
1973 Commonwealth specific purpose grants mushroom under
Whitlam administration
Expansion of
Commonwealth
powers
1974 Commonwealth takes over financing of tertiary education
from the States
Expansion of
Commonwealth
powers
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