The Productivity Commission (PC) has delivered its draft report on Horizontal Fiscal Equalisation to Treasurer, Scott Morrison. It highlights many shortcomings in the current system and recommends a complete overhaul.

Horizontal Fiscal Equalisation (HFE) is the term given to the sharing of GST revenues to the states to even out their fiscal capabilities. In practice it means the wealthy states like Western Australia subsidise poorer states like Tasmania.

This has led to many arguments and remains a serious point of issue in Commonwealth-State relations in Australia. The Productivity Commission report is not likely to make things any easier, at least in the short term.

The report, which can be downloaded here, does not beat around the bush. It is very clearly written and makes strong recommendations.

It says that while HFE has broad support, it is under significant strain and changes are needed. Its strongest recommendations are that the formula be simplified and made more transparent, and that distortions caused by such events as Western Australia’s mining boom be given less importance when assessing equalisation criteria.

“The practice of HFE has evolved over time, and now embodies an undeliverable ideal: to give states the same fiscal capacity,” says the report. “In other words, all states are brought up to the fiscal capacity of the fiscally strongest state (currently Western Australia).

“Notwithstanding anomalies, the current system of HFE has good points. It achieves an almost complete degree of equalisation — unique among OECD countries

“It has well‑established processes that involve consultation and regular methodology reviews. And HFE does not result in significant distortions to interstate migration or economic growth.”

But, says the report waxing lyrical, “the pure may be the enemy of the good.” It says the current HFE system is struggling with extreme circumstances, and this is corroding confidence in the system.

“Equalising comprehensively and to the fiscally strongest state means that the redistribution task is too great for any jurisdiction to bear; and is volatile at times of significant cyclical and structural change.

“There is scope for it to discourage desirable mineral and energy resources policies (royalties and development) and state policy for major tax reform (a costly first‑mover disadvantage).”

The system is beyond comprehension by the public, it says, and poorly understood by most within government. “This leads to a myriad of myths and confused accountability.”

The report says the Government should articulate a revised objective for HFE.” While equity should remain at the heart of HFE, it should aim to provide the states with the fiscal capacity to provide a reasonable level of services.

“Equalisation should no longer be to the highest state, but instead the average or the second highest state — still providing states a high level of fiscal capacity, but not distorted by the extreme swings of one state.”

The report points out that changes to the system will most likely lead to a significant redistribution of the GST. “Timing and careful transition are paramount, especially to ensure the fiscally weaker states are not significantly disadvantaged.”

It also recommends the Government should simplify the assessment process, even if it results in less precise equalisation.

“Reforming HFE will deliver benefits to the Australian community. But ultimately, greater benefits will only come from more fundamental reforms to Australia’s federal financial relations: namely, to spending and revenue raising responsibilities and accountabilities.”

That is the nub. It is not just about redistributing GST. It is about the wider issue of Commonwealth State relations, how revenue is raised, and who is responsible for expenditure. That is a much larger can of worms.

In any case, nothing will happen for a while. This is just a draft report, with written submissions invited until 10 November, and hearing held in Perth, Melbourne and Sydney later in November. The Productivity Commission intends to hand down its final report on 31 January 2018.