5 December 1996

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Implementation of competition policy in local government

John Quiggin


Department of Economics

James Cook University

Paper prepared for the Urban Local Government Association of Queensland.




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The application of the Hilmer reforms to local government will have direct and immediate effects on the lives of all Australians. Under the COAG agreements, State and local governments are required to implement competitive reforms in all areas of publicly provided services.

The principal competitive reform required is the application of a public benefit test to determine the most appropriate reform of organisational structure for government enterprises with annual turnover in excess of $5 million. The aim of this paper is to examine the main options for competitive reform as they apply to local government. Key conclusions are

Full cost pricing is primarily a requirement for greater transparency in pricing policy, rather than a requirement to change policies

The claim that the adoption of two-part tariff requires the abandonment of access charges based on land values has no basis in economic theory

In the absence of clear evidence one way or the other, no presumption should be made in favour of, or against, greater commercialisation

Community service obligations provide an effective method of ensuring that pricing policies for corporatised government business enterprises are socially acceptable, but are less satisfactory as a method of controlling the quality of service

In the application of the public benefit test, it is important to exclude cost savings if they are derived by transferring costs from one group in the community such as ratepayers to another group such as employees

Appropriate valuation methods differ depending on the purpose for which valuation is undertaken. The deprival method is not, in general, appropriate as a basis for pricing policy

Payments from state to local government under competition policy should be conditional on bona fide implementation of a public benefit test, not on a decision to adopt corporatisation

Corporate business enterprises owned by local governments should not be subject to company income tax


The implementation of competition policy in local government

1. Introduction

Since 1993, the term 'Hilmer and related reforms', or sometimes simply 'Hilmer', has been used to describe the present stage of microeconomic reform focusing primarily on the belief that competition should be the central element of microeconomic policy. The term arises from the report of an Independent Committee of Inquiry into National Competition Policy (Hilmer, Rayner and Taperell 1993, hereafter the Hilmer Report) but the reform program goes well beyond the specific recommendations of Hilmer and his colleagues.

The Hilmer Committee was appointed in 1992 to inquire into and advise on appropriate changes to legislation and other measures in relation to:

whether the scope of the Trade Practices Act 1974 should be expanded to deal with anti-competitive conduct of persons or enterprises in areas of business currently outside the scope of the Act;

alternative means for addressing market behaviour and structure currently outside the scope of the Trade Practices Act 1974; and

other matters directly related to the application of the principles of competition policy.

The Committee's Report was issued in 1993. Advocates of reform within policy circles used the Hilmer Report as the basis for a renewed push for public sector reform, centred around the Council of Australian Governments (COAG). By virtue of its reliance on inter-governmental negotiations and remoteness from open political debate, the COAG process permitted further extensions of the reform process to be presented as a fait accompli, embodied in the opaque legislation of the National Competition Policy Act. Popular disenchantment with reform was thereby sidestepped. In the process, the term 'Hilmer reforms' has come to be used as shorthand for the entire program of microeconomic reform, particularly as it affects the public sector and government business enterprises.

Despite the remote nature of the process that produced it, the application of the Hilmer reforms to local government will have direct and immediate effects on the lives of all Australians. Under the COAG agreements, State and local governments are required to implement competitive reforms in all areas of publicly provided services.

The principal competitive reform required is the application of a public benefit test to determine the most appropriate reform of organisational structure for government enterprises with annual turnover in excess of $5 million. The reforms to be examined are

Full cost pricing within a standard 'departmental structure'



Further reforms include requirements to offer third-party access to publicly owned facilities, the application of the Trade Practices Act to local government business enterprises and the requirement for oversight of pricing policies.

The aim of this paper is to examine the main options for competitive reform as they apply to local government and to consider a number of issues arising with the implementation of completive reform including the application of the public benefit test, the specification of community service objectives, the valuation of assets the status of payments conditional on the implementation of reform and the appropriateness of subjecting corporatised local government business enterprises to company income tax.

2. Full cost pricing

The adoption of full cost pricing is the minimal level of reform considered acceptable under the agreement to implement competitive reform. Properly interpreted, full cost pricing is primarily a requirement for greater transparency in pricing policy, rather than a requirement to change policies. Local governments are still free to provide services to particular groups of consumers at any price they choose, provided that provision of services at subsidised prices is treated as a community service obligation (CSO) and explicitly funded out of general revenue. CSOs are a flexible instrument for the management of pricing policies, although they are much less satisfactory as a way of committing organisations to multiple service objectives. The distinguishing feature of full cost pricing as a reform strategy is that it is conducive to the maintenance of multiple objectives. This may be seen as a strength, since it permits flexible management by an elected government responsible to the residents served by the organisation. On the other hand, it may be seen as a weakness since it implies a lack of focus in the organisation, as compared to a corporatised or commercialised alternative. The latter view has predominated in the debate over competitive reform. The critical issue is whether organisational objectives can be specified clearly in advance or, alternatively, whether flexible adaptation to changing needs and circumstances is required.

Although it is unobjectionable in principle, several dangers arise with the implementation of full cost pricing reforms. The most important is that councils may be required to adopt economically unsound measures of the full cost price and may therefore be encouraged to set prices at this level rather than at a socially appropriate level

One difficulty is the possibility that some pricing policies may be regarded as unacceptable because the price charged to some users is too high. This problem is primarily associated with charges to business users of services such as water and electricity In effect, the imposition of competitive reform in this area removes an implicit taxation power previously held by local governments.

Many services provided by governments involve a substantial element of fixed or overhead cost. For such services, there is no unique measure of the full cost attributable to any individual user. In the absence of a requirement to cover total costs, standard economic analysis suggests that users should be charged an amount equal to short-run marginal cost. If there is a requirement to cover total costs this may be met either by raising prices above short-run marginal cost or by the use of a two-part tariff involving a combination of access and usage charges. Most attention, particularly in the case of water and sewerage services, has focused on the two-part tariff approach.

2.1 Two part tariffs

Under a two-part tariff, usages charges are normally set at short-run marginal costs, while fixed costs are recovered through access charges. Economic analysis provides only limited guidance on the allocation of fixed costs across consumers. Except in special cases, an upper bound is that no user should be charged more than 'stand-alone cost', that is, the cost of providing their own water and sewerage services independently of the public network. In practice, however, stand-alone cost is generally so high that this upper bound is not relevant.

Unfortunately, many advocates of two-part tariffs, notably including the Industry Commission have assumed that the access component of a two-part tariff must be equal for all users, or at least for all households and have therefore recommended the removal of fixed charges based on property values.

It must be emphasised that this recommendation has no basis in economic theory. The recommendation of fixed household access charges reflects either sloppy economic analysis or regressive preferences regarding income distribution. On the whole, it seems that the first factor is predominant. For reasons of simplicity, most theoretical discussions of two-part tariffs deal with the case when the access charge is uniform. It appears that many advocates of fixed household charges have taken this simplification to be an essential feature of a two-part tariff. On the other hand, the role of regressive distributional preferences should not be regarded. Such preferences clearly motivated the unsuccessful attempt by the Thatcher government to replace local government rates based on property values with an individual charge or 'poll tax'.

In the case of water pricing, considerations of horizontal and vertical equity suggest that access charges should be based on property values. The majority of water usage is related to gardens and the enhancement of asset values associated with access to water supply is likely to be related to land values rather than being uniform for all houses. Furthermore, a charge based on property values is less regressive than a fixed household access charge.

An important practical implication of the two-part tariff approach is that usage charges should vary according to the amount of spare capacity in the system. Immediately after the construction of a new dam, there will be considerable spare capacity and the marginal cost of provision will be low. By contrast, when capacity is fully used, the marginal cost of provision will be determined by the opportunity cost of water in alternative uses. This implies that prices should be increased until the point at which demand would justify the construction of a new dam. The use of the price mechanism in this fashion will encourage water conservation in periods when capacity is fully used and will therefore defer the need for construction of new dams.

3. Commercialisation

The term 'commercialisation' covers a range of competitive reform options, extending from pricing reforms of the type discussed above to full corporatisation. Hence, any assessment of commercialisation is, in large measure, an assessment of the entire reform process. In much of the discussion of the reform process, the desirability of extensive reform in the direction of increased commercialisation is taken for granted. This position is supported in part by general claims about the proved superiority of private sector business methods and in part by economic analysis such as that of the Industry Commission (1989, 1995a) which suggested that an extensive program of microeconomic reform could raise GDP by as much as 5.5 per cent. These estimates were criticised by Quiggin (1995), who concluded that the likely benefit was nearer to 0.5 per cent of GDP.

While the climate of opinion clearly favors extensive reform, there is very little evidence to show that the reform process as a whole has yielded, or will yield, substantial benefits. Claims concerning the benefits of reform in particular instances frequently do not stand up to close examination. For example, despite frequent claims to the contrary the real cost of air travel has not, on average, fallen since deregulation and the rate of price decline for telecommunications has been no more rapid since the competitive reforms of 1992 than for the postwar period as a whole (Quiggin 1996).

At the aggregate level, despite extensive microeconomic reform since 1986, there has been no acceleration in the rate of growth of total factor productivity for the economy as a whole. Countries such as the United Kingdom and New Zealand, which have undertaken similar reforms have had much the same experience. In both cases, the rate of economic growth since the implementation of reform in the early 1980s has lagged behind that of the OECD as a whole (OECD ...).

In the absence of clear evidence one way or the other, no presumption should be made in favour of, or against, greater commercialisation. The appropriate approach is to treat each area of activity on a case-by-case basis.

4. Corporatisation and community service obligations

The final competitive reform option involves the creation of a publicly owned corporation, either through special legislation or under general company law. There are a large number of technical issues that arise in the creation and governance of such a corporation, but these will not be addressed here. The main issue of concern is the tension between the corporate objective of profit maximisation and the desire of governments to pursue multiple objectives. Under corporatisation, such objectives must be pursed through the specification of community service obligations (CSOs). Such obligations must be explicitly costed and paid for by government through a transfer to the corporatised enterprise.

4.1 CSOs

The specification of CSOs tends to be a first step towards their elimination. In part this is a result of transparency. When the cost of CSOs is spelt out, it may become apparent that the benefits do not justify the costs. A less satisfactory reason for the vulnerability of CSOs is that CSOs appear as part of the budget sector, whereas the earnings of government business enterprises are 'off-budget'. Governments are typically much more concerned about on-budget than off-budget expenditures, even though the economic implications are identical.

A more fundamental difficulty with CSOs is the need for an exhaustive specification of the objectives of organisations which have historically been seen as serving the public interest in a generalised fashion. For example, the post office has long played an important role in the life of country towns, over and above the provision of standard letter services to country residents at a uniform rate. The closure or downgrading of the post office is often an important step in the decline and death of small towns. The CSO for Australia Post is specified as requiring the provision of standard letter services, but not the maintenance of a network of country post offices. This amounts in effect to a policy change; the result is to reduce the resources allocated to the objective of maintaining a decentralised population. This may well be a desirable change, but it is not explicitly chosen in the process of specifying CSOs. Thus, while the transparency argument applies in relation to the obligations retained by corporatised firms, it does not apply in relation to those objectives that are abandoned in the process of corporatisation.

4.2 Pricing obligations

CSOs are most satisfactory when applied to pricing policies. There is no significant difficulty in specifying a requirement that certain groups of users should be provided with services free of charge or at a price less than full costs. As observed above, where there is an element of fixed cost, technical difficulties arise in estimating the cost of providing a service to any given individuals and therefore to the payment a government should make to a corporatised enterprise to offset the cost of a CSO. However, at least in the case of wholly owned enterprise, exact specification of the cost of CSOs is not critically important, since it amounts to little more than the transfer of assets from one pocket to another.

4.3 Service obligations

CSOs are a less satisfactory instrument for imposing requirements relating to the nature of services to be provided. The basic problem is that such requirements may be hard to specify in the contractual terms required for a CSO. It is possible, for example, to require that garbage be collected twice a week, but more difficult to require that the garbage collection enterprise should respond sensitively to community concerns about noisy garbage trucks. There is little value in providing general injunctions of this kind to a corporatised enterprise. In the contest between the clear and unambiguous imperative to maximise profits, and vague instructions to pursue other objectives, profit-maximisation must win. Indeed, it is precisely this sharpening of focus that is desired under corporatisation.

One merit of the process of competitive reform is that it imposes on governments the need to seek, wherever possible, quantitative and qualitative measures of performance. Even if no structural reform is adopted, the use of such measures may provide information on areas of inadequate performance and incentives to achieve improvements.

4.4 Noncontractible obligations and the role of stakeholders

Where obligations are too general to be made the subject of contract, it is necessary to look for forms of governance in which stakeholders have an effective voice. There is some doubt over whether stakeholders other than shareholders and creditors have any voice in a corporate enterprise. The obligations of directors under company law do not appear to provide any scope for actions which harm the interests of shareholders and creditors, even if these actions yield a substantial benefit to other stakeholders. However, some work on the role of managers has suggested that there is in fact substantial scope to pursue socially desirable objectives, even at the expense of profit maximisation. On the whole, it would appear that reforms to the regulation of companies have diminished the freedom of managers in this respect.

If a corporatised government business enterprise is established under special legislation, there may be scope to influence its activities through a statement of corporate intent. Such a statement could, for instance, involve a requirement to adopt environmentally sustainable policies, or to take the interests of employees into account in decision-making. It remains to be seen whether such statements would have any force in practice.

5. The public benefit test

The central requirement of national competition policy is that policies that are regarded, prima facie, as anti-competitive, should be subject to a public benefit test. That is, it should be shown that such policies yield benefits sufficient to outweigh costs arising from the restrictions on competition that they impose.

5.1 Benefit-cost analysis and the public benefit test

The public benefit test may be interpreted in various ways. The framework most frequently used is that of benefit-cost analysis. The basic approach of benefit-cost analysis to the evaluation of a policy change is to estimate, in monetary terms, the impact of the change on all members of the community. The project is judged to be beneficial if the aggregate benefits exceed the aggregate costs.

The benefit-cost analysis approach encounters two main difficulties. First, some benefits and costs are hard to quantify in monetary terms. For example, there may be a loss of community pride and cohesion arising from having basic services provided by a large national or transnational contractor rather than by a local enterprise.

Second, standard benefit-cost analysis takes no account of income distribution. A project may be judged beneficial even though the costs are borne by poor people and the benefits received by wealthy people. This problem may be overcome by the use of weights reflecting social preferences concerning income distribution. Alternatively the 'efficiency' measure of public benefit generated by standard benefit-cost analysis may be supplemented by the use of equity criteria.

Both of these factors will be relevant in considering the application of the public benefit test to the implementation of competition policy. However, the most important issue in the evaluation of competitive reforms is the need to consider costs and benefits to all members of the community rather than considering narrow measures of budgetary savings. The correct use of benefit-cost analysis ensures that this need is met.

5.2 Efficiency improvements and transfers

The critical difference between benefit-cost analysis and the simple measures of budgetary savings that have dominated much discussion of CTC is derived from the distinction between efficiency improvements and transfers. An efficiency improvement arises if, in principle, the aggregate gains from a policy initiative are large enough to permit compensation to be paid to everyone made worse off by the initiative and still leave a net surplus. By contrast, a policy may generate a net reduction in the costs to government of providing a given service by transferring some of the cost burden to employees, consumers or other levels of government. In the benefit-cost analysis framework, such transfers cancel out, and result in no net benefit.

The need to take such transfers into account has often been neglected in assessments of the impact of competition policy. For example, the Industry Commission report The Growth and Revenue Implications of Hilmer and Related Reforms (Industry Commission 1995a) analysed the effects of a large-scale program of CTC. Following Domberger () and Rimmer (), the Industry Commission assumed that budgetary costs savings from CTC would average 20 per cent. It was estimated that the program of CTC considered in the study would yield a net public benefit equal to 1.7 per cent of GDP or between $7 billion and $8 billion.

In its Draft Report on CTC (Industry Commission 1995b), the Commission examined the same issue taking into account the possibility that some budgetary cost savings were generated through reductions in wages and quality of services. In a simulation taking both factors into account, the estimated net benefit was reduced to 0.3 per cent of GDP or a little over $1 billion.

These estimated gains are based on the assumption that CTC is applied only in areas where, on average, the benefits are positive. That is, even though ex post some CTC exercises may prove not be worthwhile, it is assumed that the scope of CTC is limited to those areas where there is a reasonable ex ante expectation of positive net social benefits. In view of the redistributive and cost-shifting effects of CTC, this requires that budgetary cost savings should not merely be positive, but should outweigh any transfers/ If CTC were extended by fiat into areas where net social benefits were generally negative, the estimated gains would be dissipated. On the basis of these considerations, the Industry Commission (1995b) concluded that a program of compulsory competitive tendering is socially undesirable. Application of the public benefit test, taking account of transfers and cost-shifting is an essential element of the successful implementation of competition policy.

5.3 Wages and conditions

The simplest form of transfer arises if competitive reforms result in wage reductions, either because a corporatised government business enterprises can drive harder bargains with its workers, or because competitive tendering permits the replacement of public employees with workers receiving lower wages or worse conditions. If a reduction in costs is achieved through wage reductions, the benefit to ratepayers is exactly offset by the loss to wage-earners. Thus, there is no net public benefit.

5.4 Quality of service

There are a number of a priori reasons to expect the implementation of competitive reform of public sector service delivery to be associated with reductions in the quality of service. First, consider the incentives for governments faced with the reduce expenditure. It seems more politically attractive to implement reductions in service quality at the time of implementing competitive reforms rather than to make an explicit commitment to reduce service quality first, then to call for tenders for the provision of service at the reduced quality level.

Second, private contractors and corporatised government enterprises face incentives for are to provide the minimum service consistent with contractual obligations or statements of corporate purpose. Hence, if any services previously provided are not specified in the contract, or if there is room for interpretation regarding the quality of service required, it is reasonable to assume that the minimum quality will be provided.

An example may be given from the study of privatisation, a topic closely related to competitive reform. The conditions under which the newly privatised British Telecom (BT) was allowed a monopoly of local phone services in the United Kingdom did not include specification of the reliability of public telephone services. Since these services were unprofitable, the incentives facing BT were to permit the quality of service to decline, and the proportion of public phones in working order fell drastically. As a result, the regulating agency Oftel was forced to impose more detailed quality standards in this and other areas.

Two issues arise here. First, in applying the public benefit test, it seems appropriate to make some deduction to allow for a tendency, on average for quality to be reduced. Second, there are issues of transparency associated with the specification of service quality. If the quality of public services is to be reduced, this should be decided by a process of open public discussion rather than being covertly incorporated into a process of contracting out.

5.5 Work intensity

In many cases the main saving from competitive reforms arises from a smaller number of workers doing the same job. Prima facie, it seems reasonable to infer that cost savings arise primarily from increased work intensity. Since this increase in work intensity is not matched by an equivalent wage increase, it represents a transfer from workers to employers and should not be counted as a net gain. There is a tendency, criticised in Quiggin (1992), to regard output gains arising from increased effort as a free good. Such a view has no basis in mainstream economic theory, as was forcefully observed by Stigler (1976).

More detailed studies support the view that apparent efficiency gains from competitive reforms are actually due to increased work intensity. The main source of cost savings explicitly noted in studies of garbage collection by Domberger et al is the replacement of fixed 'task and finish' payments (sometimes for tasks which have become less onerous since the time rates were set) with piecework rates. Productivity gains from such changes in payment schedules will arise primarily from increased effort. Furthermore, the observation that tasks have become less onerous since rates were initially set implies that the new piecework rates will embody an effective reduction in wages in the absence of increased effort. Ganley and Grahl (1988) cite a number of cases of increases in working hours or reductions in working conditions associated with contracting out of garbage collection.

5.6 Employment effects

Competitive reforms have often been associated with job losses and reductions in employment. This outcome is most common in cases where increases work intensity and reductions in service quality are the primary sources of budgetary cost savings.

If workers who lose their jobs as a result of competitive reform are rapidly re-employed elsewhere, the process yields a net public benefit equal to the additional output produced in their new jobs. In many cases, however, workers remain unemployed for long periods or use redundancy payments to finance early retirement. The medium term economic impact of voluntary withdrawal from the labour force on a redundancy package is identical to that of an increase in unemployment. In these cases, there is no additional output and no net public benefit. The effective labour force available to the community is reduced, and this loss fully offsets the budgetary cost saving. Even where workers are re-employed, it is frequently in jobs requiring lower skills. The loss of skills associated with this process is equivalent to a shift in the effective supply of labour.

In the application of the public benefit test, some proportion of the unemployment generated by labour-shedding during the implementation of competition policy should be modelled as a medium term reduction in the labour force. Evidence reported by the Industry Commission (1995b) suggests that about 50 per cent of workers made redundant by microeconomic reform were still unemployed or not in the labour force after three years.

5.7 Workplace safety and related issues

Corporatised government business enterprises are subject to standard legal requirements regarding workplace health and safety. However, there is little incentive for a profit-maximising enterprise to exceed minimum standards, especially in a slack labour market. Hence, if existing practices provide a higher standard of safety than the legally required minimum, it is reasonable to expect some erosion of safety standards under corporatisation

5.8 Cost-shifting

Cost shifting between levels of government has been a common practice for many years, but the emphasis on cost minimisation associated with competitive tendering and contracting creates new incentives for cost shifting. An obvious way of minimising costs at one level of government is to make extensive use of services provided by another level of government on a free or subsidised basis.

Another source of cost shifting is tax evasion. The opportunities for evasion and avoidance are increased by contracting out. Public sector wage employees have less opportunities for evasion than any other group of income-earners. By contrast, contractors and their employees are in a very good position to evade taxes, especially if, like cleaners and garbage collectors, they work non-standard hours. The evidence reported in Tanzi (1982) indicates that evasion is insignificant among government employees and highest in the small business sector.

6. Valuation and rates of return

The valuation of publicly owned assets raises a number of complex issues. At least three different concepts of asset value are relevant

(i) replacement costs

(ii) opportunity cost

(iii) present value of future services

In discussion of competition policy, most attention has been focused on replacement cost, or on closely related concepts such as deprival value. However, replacement cost is not, in general, very important, except where it coincides with other measures such as opportunity cost. Particularly important issues arise in the case of assets that would not be replaced if they were lost (for example, many branch rail lines). Requiring a return on replacement costs for such assets will lead to their premature scrappage.

The asset value concept most relevant in determining appropriate pricing policy is opportunity cost. The opportunity cost of an asset may be either its market price, or the value of the services it would generate in an alternative use. If the revenue generated in the existing use does not provide an appropriate return on asset value in the sense of opportunity cost, then it would be better to sell the asset or divert it to other uses.

Finally, in considering the value that should be placed on an asset being considered for sale or transfer to a corporatised government business enterprises, it is necessary to consider the present value of future services the asset would generate. If this present value is less than (greater than) the sale price, sale of the asset is desirable (undesirable).

In general, it is desirable to conduct analysis in real terms. That is, a real rate of interest, in the range 4 to 6 per cent, should be used as the required rate of return and depreciation rates should take appropriate account of changes in nominal values. It is, however, logically possible, though very difficult in practice, to achieve the same outcome using nominal interest rates and nominal depreciation schedules.

7. Conditional payments

The 1995 meeting of the Council of Australian Governments (COAG) made agreements linking Commonwealth payments to the States to the implementation of National Competition Policy at the State level. The central objective of National Competition Policy, as it applies to the public sector, is to achieve the most efficient provision of publicly provided goods and services through reforms designed to ensure competitive neutrality and to minimise restrictions on competition. At the 1995 COAG meeting, State governments argued that the requirement to introduce competition in areas such as the electricity industry could lead to reductions in the profitability of State-owned enterprises and therefore in the flow of dividends to State governments. In addition, it was argued that under competition policy, the benefits of reform in State government business enterprises would flow primarily to consumers rather than taxpayers, and that, in view of the continuous pressure on State finances, some redistribution of the proceeds of reform was appropriate. The Commonwealth therefore agreed to make a payment to the States, conditional on the implementation of reforms to the satisfaction of the National Competition Council (NCC). These payments have been referred to as 'bonus' payments. However, as will be argued below, they are in fact only partial compensation for the steady erosion in the State share of the national revenue base.

Under the legislation implementing National Competition Policy in Queensland, it is proposed that a proportion of this 'bonus' payments be distributed to local governments required to implement competitive reforms. As with the Commonwealth payment to the states, the distribution of 'bonus' funds to local governments in Queensland is conditional on the implementation of competitive reforms. However, an ambiguity has arisen as to whether eligibility for payments depends on the implementation of the competitive reform process including the public benefit test or on the adoption of particular reform options, particularly corporatisation, with or without a bona fide public benefit test. Discussion at the recent LGAQ conference suggested that the latter approach was favored.

In this section, it is argued that the appropriate criterion for receipt of 'bonus' payments is bona fide implementation of the public benefit test and that payments should not be conditional on the adoption of a particular mode of reform, such as corporatisation.

7.1 The status of the 'bonus' payments

The 'bonus' payments are a form of tied grant. In general, the offer of a tied grant, additional to normal entitlements may be regarded as beneficial to both the government offering the grant (since it would presumably not make the offer otherwise) and the government to which it is offered (since, if the conditions are excessively onerous, the grant may be declined).

However, the competition policy grant does not meet the requirement of additionality. The Commonwealth's main revenue sources, when properly indexed, grow in line with GDP. There are thus three main sources of growth in nominal revenue

The increase in the general price level;

The increase in population

The increase in real income per capita

A policy of allocating revenue proportionally between levels of governments would require transfers from the Commonwealth to the States to grow in line with GDP. This policy would ensure that the proportions of income allocated to Commonwealth-provided services, State-provided services and private consumption remained constant.

However the FAG formula offered by the Commonwealth implies that transfers grow only in line with prices and population, and therefore decline steadily relative to GDP. The 'bonus' payment offered conditionally on the implementation of competition policy represents only partial compensation for this decline. Hence the effect of imposing conditionality is, in effect, to tie part of the States' existing entitlement. This point is made even clearer by the fact that, as it now appears, even FAG payments are conditional on the implementation of competition policy.

The imposition of conditionality on the States effectively means that, not that they will gain an increased share of total revenue by implementing competition policy but that the continuing decline in their share of revenue will be made even more severe if they do not do so. The same point applies if conditionality is imposed by States on local government.

Since State and local governments are, effectively, to be punished for non-compliance rather than being rewarded for compliance, it is important that the concept of compliance should be interpreted in terms of the adoption of policies aimed at maximising public benefits rather than the acceptance of arbitrary preferences for particular organisational forms. The practice of tying grant funding to such preferences represents unwarranted interference by one level of government in the affairs of another.

7.2 The purpose of 'bonus' payments

As was argued above, the purpose of bonus payments was to ensure that State and local governments shared equitably in the presumed benefits of reform. The requirements for competitive pricing policies effectively removed from State and local governments a source of implicit tax and expenditure powers and the bonus payment is compensation for the loss of these reforms. The bonus payment, therefore, is designed to deal with the possibility that benefits of reform might flow to consumers at the expense of State and local governments. It is not designed to encourage governments to adopt 'reform' policies that would otherwise be economically unsound.

On this basis, the appropriate requirements for payment of the bonus to local governments should be

(i) the adoption of full cost pricing policies with CSOs made transparent

(ii) the adoption of the most efficient organisational form as determined by the public benefit test

The bonus payment should not be regarded as 'offsetting' the costs of moving to a particular reform option such as corporatisation. Assuming the public benefit test has been conducted correctly, such costs will be offset by efficiency gains and the resulting flow of

8. Taxation issues

The premise of competition policy, that public and private sector enterprises should compete on equal terms has been held, most notably by the Commonwealth Department of Finance, to imply that state and local government business enterprises should be subject to company income tax. If such enterprises are required to operate on the basis of a commercial debt-equity structure, and to achieve commercial rates of return to equity, a substantial proportion of total revenue will be paid to the Commonwealth in the form of company income tax. Although suggestions for the removal of the exemption of state and local government business enterprises from company income tax normally involve some form of compensatory payment from the Commonwealth, it would be naive to suppose that there would not be a net transfer away from state and local government to the Commonwealth.

The reasoning underlying the claim that state and local government business enterprises should be subject to company income tax is obsolete, since it fails to take account of the introduction of dividend imputation, and the abolition classical system of double taxation. Under dividend imputation, the company income tax is, in principle, abolished as a separate source of revenue. Company income tax is merely a convenient method of collecting the personal income taxes that would be paid by shareholders in any case. The payment of company income tax reduces the profits available for distribution to shareholders, but, under dividend imputation, this reduction is fully offset by the value of franking credits. From the viewpoint of shareholders in a company that pays out its entire post-tax profit in the form of franked dividends, it does not matter whether or not the company is liable for company income tax.

It is true that not all companies take full advantage of the benefits of dividend imputation, and that company income tax yields positive net revenue. However, the fact that not all companies make maximum use of the effective abolition of company tax is irrelevant. The requirement for competition on equal terms does not mean that public enterprises should be forced to emulate the bad decisions of private enterprises.

In fact, removal of the company tax exemption would place state and local government business enterprises at an effective disadvantage relative to their competitors in the private sector. Because state and local governments do not pay income tax, they can gain no benefit from dividend imputation. The point can be illustrated by considering the case of a local government enterprise initially exempt from company income tax. Suppose for simplicity that the ratepayers are a group of equal-sized unincorporated business owners and that they are considering the option of replacing the local government enterprise with an identical enterprise which they would jointly own as shareholders.

Under dividend imputation, the ratepayers would be indifferent between the two choices. Under the status quo, the profits of the enterprise would reduce their rates bills and increase their taxable income. Their tax liability would be equal to the income tax rate multiplied by their share of the profits. The privatisation option would yield exactly the same outcome. If however, the local government enterprise were subject to company income tax, the ratepayers would be subject to double taxation under public ownership. Hence, in place of the level playing field, there would be a bias in favour of the privately owned firm.

These problems could, in principle, be overcome by allowing local governments to claim dividend imputation credits in the form of cash payments from the Commonwealth. This would however be nothing more than a Byzantine method of restoring the status quo ante. Moreover, given the complexities of taxation law, there is the danger of unintended consequences. Such a procedure might open new opportunities for tax avoidance on the part of individuals or companies working in collaboration with state or local governments.

Even if a scheme for abolishing the company tax exemption could be designed to achieve a level playing field, the benefits would be outweighed by the effect on vertical fiscal imbalance. The fact that the Commonwealth is responsible for most revenue raising, but not for most final expenditure has created a long-standing bias in favor of lower taxes and against the public expenditure undertaken by state and local governments. A proposal in which the Commonwealth gained still more revenue and was required to make compensatory payments to state and local governments would simply exacerbate this problem. There can be no doubt that the ultimate effect would be to reduce the funds available to state and local governments and require reductions in services and increases in distortionary state and local taxes.




Industry Commission, (1995a), The growth and revenue implications of Hilmer and related reforms, AGPS, Canberra.

Industry Commission, (1995b), Draft Report on Competitive Tendering and Contracting by Public Sector Agencies, AGPS, Melbourne.

Quiggin, J. (1994), 'The fiscal gains from contracting out: Transfers or efficiency improvements?', Australian Economic Review September, 97-102.

Quiggin, J. (1996), 'Competitive tendering and contracting: An assessment of the Industry Commission Draft Report', paper presented at IIR Conference on Competitive tendering and contracting , Sydney.

Stigler, G. J. (1976), 'The Xistence of X-Efficiency', American Economic Review 66(1), 213-16.

Tanzi, V. (ed.) (1982), The underground economy in the United States and Abroad, Blackwell, Oxford.

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