Reforming goods and services tax is a bitter pill, but it could be one worth swallowing for Australia's debt-laden states. A tax hike could raise more than A$50 billion a year and vastly reduce the debt and borrowing needs of the states. Our three-scenario analysis shows this may, in turn, increase the potential for rating upgrades for up to five states.

If GST is left untouched, we forecast gross debt to reach 146% of operating revenues by 2026 from just 83% in 2019. Furthermore, we expect after capital account deficits will average about 10% of total revenues over the next two years. Deficits were just 3% in 2019.

The Case For GST Reform

Australian states have faced major hurdles since the start of the pandemic, enduring prolonged lockdowns and high inflation. Budgetary metrics have been persistently weak, particularly in non-commodity-driven states (see chart 1). This is contributing to ballooning debt across the sector, and led us to downgrade three states since December 2020.

GST has remained largely untouched since its introduction in 2000 and is a vital, but dwindling, revenue source for the states. It contributes about 20% of the sector's operating revenues.

The GST is a logical target for reform due to its broad base and efficiency relative to other key taxes. Economic orthodoxy accepts broad-based taxes such as land taxes and consumption taxes to be more efficient and less distortionary than stamp duties and corporate income taxes.

The past decade has involved much talk but little action on GST reform. In the past year alone, prominent figures that have joined the chorus for reform include Anne-Marie Gulde, IMF deputy director for Asia-Pacific, Ken Henry, former Treasury Secretary, and Matt Comyn, CEO of Commonwealth Bank of Australia.

A Political Hot Potato

The topic of raising GST is always politically sensitive, even when discussed in the context of broader reforms to Australia's tax system. The regressive nature of the tax raises questions about equity, which is especially prominent during a cost-of-living crisis.

Australia's GST rate lags many other countries. Australia had the third-lowest consumption tax rate at 10% among 38 OECD countries in 2022. The OECD average rate was 19.2%. While Australia is less reliant on consumption taxes than OECD peers, it has the second-highest reliance on income taxes.

In addition, the GST base has been eroding since its inception as the proportion of spending on GST-exempt items such as food, education and health has increased by about 15%, or 3 percentage points, over the past 20 years.

The Commonwealth's Parliamentary Budget Office previously forecast the taxable share to fall as low as 56%-58% of household consumption, down from 64% in 2000.

Chart 1

Three Scenarios For GST Reform

Increasing the base could raise an additional A$18 billion-A$54 billion annually.  For simplicity, our three-scenario analysis assumes reforms are implemented in full on July 1, 2024:

• Scenario 1: Removing GST exemptions from food, education, and financial services. This would raise an additional A$17.8 billion in fiscal 2025.
• Scenario 2: Increasing the GST rate to 15%. This would raise an additional A$30.5 billion in fiscal 2025.
• Scenario 3: Removing GST exemptions from food, education, and financial services and increasing the rate to 15%. This would raise an additional A$54.2 billion in fiscal 2025.

Australian Treasury modelling in 2022 suggested that the removal of the three largest GST-exemptions would add an additional A$16.1 billion in revenue in fiscal 2022, out of a total A$28.5 billion across all categories. Under these three scenarios, the national GST pool would increase by 19%-59% after accounting for a drop-off in demand from higher prices.

The Commonwealth collects GST revenue and distributes it directly to states and territories as grants.  This occurs under Australia's system of so-called horizontal fiscal equalization. The slice of the pie each state receives depends on their share of national population and the Commonwealth Grants Commission's (CGC) annual update of revenue-sharing relativities (see chart 2).

Chart 2

We assume each state's relativity is fixed according to the most recent update and that any external distributions such as the "no worse off guarantee" payments are unaffected. The no worse off guarantee requires the Commonwealth government to compensate states for shortfalls in their GST revenue share between the old and new distribution arrangements until fiscal 2030.

A larger GST pool would boost state operating revenues.  Under each scenario discussed above, we modelled the impact of a larger national GST pool on state finances with several simplifying assumptions:

• Reforms start in full on July 1, 2024.
• The GST base, including new taxable components, grows in line with latest Commonwealth budget estimates.
• Extra revenue is distributed in line with the latest CGC distribution and reported by states as operating revenue.
• Other taxes and government grants remain in line with current budget estimates. In other words, there is no offsetting tax relief such as lower income taxes.
• Expenditures are unchanged. Additional revenue lowers budgetary deficits, and any surplus goes toward paying back debt, and not toward higher spending.

Tax reform would boost operating surpluses under all scenarios.  The sector could see operating surpluses increase by between 3 and 10 percentage points, as a proportion of operating revenues. Although our base-case forecasts show all states returning to operating surpluses over the next two years, tax reform would hasten the improvement (see chart 3).

Chart 3

Under scenarios one and two, large infrastructure spending will keep after-capital account balances in the red.  Only significant GST reforms (i.e., broader base and a higher rate in scenario three) would shift sector-wide after-capital account deficits into structural surplus. After-capital account deficits as a proportion of total revenues would improve by 5-12 percentage points on average under the three scenarios (see chart 4).

• Victoria, which has the weakest fiscal outcomes, would remain in deficit under all scenarios.
• New South Wales, Queensland, Australian Capital Territory, and Tasmania, which all currently run double-digit deficits, would see deficits narrow under scenario one and two, and deliver surpluses under scenario three.
• South Australia, whose deficits are moderate, would see surpluses under all three scenarios.

Western Australia has been a clear outlier, with an average 1.3% surplus expected across fiscal years 2022-2026 (year ending June 30). The state has been a beneficiary of elevated commodity prices, driving up mining royalty receipts, and an agreement with the Commonwealth to institute a so-called relativity floor, which ensures it will receive at least 75 cents on the dollar for its per capita share of national GST collections from fiscal 2025 onward. Under all scenarios, Western Australia can cement after-capital account surpluses and comfortably pay down its debt.

Chart 4

Additional GST would deleverage the sector.  We forecast sector-wide debt to steadily increase over the next two years, driven by borrowings to fund large capital programs in New South Wales, Victoria, and Queensland. Higher GST collections would significantly deleverage the sector by increasing operating revenues and lowering borrowing needs. After only two years of higher collections, the sector-wide debt to operating revenue could improve by 10-40 percentage points depending on the scenario.

Chart 5

Up to five states face credit rating ramifications.  Under these three scenarios, we find that there could be upward pressure on up to five credit ratings. The additional revenue could improve the budgetary performance scores of all states, particularly those with weaker budgetary performance such as New South Wales and Victoria, and lead to lower debt assessments in others that are near the thresholds in our rating criteria. The table shows the range of potential rating effects for each state for scenarios one to three under the following assumptions:

• Budgetary performance improvements are sustained after fiscal 2025 and 2026.
• Debt burden reflects 2026 forecasts.
• No changes to economy, financial management, or liquidity. Though, in future years liquidity may potentially improve due to significantly lower budgetary deficits.

Table 1

Australian state credit ratings are among the highest of subnational governments globally, and range between 'AAA' (Western Australia) and 'AA' (Victoria). Since the start of the pandemic, we have downgraded three states: New South Wales and the Australian Capital Territory to 'AA+' from 'AAA', and Victoria to 'AA' from 'AAA'.

Tax Reform Could Fast-Track Post-Pandemic Fiscal Consolidation

With budget season imminent, states' measures to contain ballooning expenditures and record capital spend will draw increasing scrutiny. If left unchecked, a continued rise in debt could further weigh on state ratings. Sector-wide debt among Australian states is rising faster than for comparable peers (such as Canadian provinces and German states). Further growth could eventually become incompatible with our high institutional framework assessment (see "Australian States and Territories' Strong Fiscal Autonomy Is Double-Edged Sword," March 6, 2024).

Tax reform is a tantalizing but politically difficult lever for governments to pull to arrest the rapid growth in post-pandemic debt. Widespread tax reforms present clear benefits in Australia. Using GST hikes to replace inefficient taxes could boost efficiency, promote productivity, and consequently growth.

At a minimum, the GST reforms could rejuvenate state finances and cement a path to higher credit ratings across the sector.

Editor: Lex Hall

Related Research

• Australian States and Territories' Strong Fiscal Autonomy Is Double-Edged Sword, March 6, 2024