Europe seems to face a pretty simple choice. Move to fiscal integration or break up the Euro zone. But what model of fiscal integration will work?
Clearly a highly integrated system dominated by a federal taxing and spending authority will not be accepted. But fiscal integration must have enough teeth to provide system-wide stability and to overcome economic differences between European states.
With this in mind, the Australian model of federation might be a good starting point. Remember that in 1901, federation brought together a group of states with very diverse economic backgrounds. For the past century, those states have found it beneficial to stay in the federation despite fluctuating economic fortunes.
Federation moved a significant amount (but not all) taxing power to the Commonwealth. For example Reinhardt and Steel (2006) note that:
Between 1915 and 1942, income taxes were levied at both the state and federal level, leading to complexity and inequitable taxation of income across states.
Chart 1 in their paper suggests that the share of tax raising was about 20-30% State/80-70% Federal in the first couple of decades of federation.
While the federal government raised most of the revenue, the states did most of the spending:
The Australian Constitution allocated the majority of expenditure responsibilities to the states (p.6).
The federal government could not discriminate between states or parts of states in how it taxed under the constitution. So there was a need for fiscal equalization.
It was not long after Federation that fiscal inequality between the states led to federal funding in support of fiscal equalisation. In 1910-11, Western Australia requested fiscal assistance to compensate for the loss of tariffs, which had been its primary revenue source. In 1911-12, Tasmania was also a recipient of federal government grants, and South Australia became a recipient in the 1920s. Over time, horizontal fiscal equalisation was formalised with an independent body recommending distribution of federal government grants based on fiscal need (p.7).
Fiscal equalization continues through the Commonwealth Grants Commission up to today – although the focus has shifted explicitly to the GST revenues in recent years.
Now, Australia’s fiscal equilization scheme is not perfect. When times are good out west (as now) the WA government complains that it is subsidizing the eastern states. When mining is in the doldrums, Victoria and NSW complain about subsidizing the west. Everyone complains about subsidizing Tasmania.
But this is how it should be. Fiscal equilization can only be stable if the funds flow in different directions at different times as the economic fortunes of regions change. (One colleague – who will remain nameless – did suggest to me that we just throw Tasmania out as they never seem to ‘transfer out’ funds. I think this is short sighted. After all, not all retired people like the sun so without Tasmania, where will they go?)
So a modified Australian model might help Europe. Of course, the devil is in the detail, but at least the Australian experience provides a moderate and workable template. And, for Europe, the alternative seems much worse.