Australia's system of dividing Goods and Services Tax revenue between the states is broken "beyond comprehension by the public, and poorly understood by most within government", the Productivity Commission has declared in a landmark report.
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Although it has broad support, GST embodies an "undeliverable ideal": to bring all states up to the financial capacity of the strongest state, which at the moment is Western Australia.
"The pure may be the enemy of the good," the commission says.
"The current system struggles with extreme circumstances, and this is corroding confidence."
The commission's draft report on GST distribution, delivered to Treasurer Scott Morrison, recommends instead that the system bring all states up to the standard of the average or the second-highest state, in order to avoid extreme swings which at one point saw Western Australia get as little as 29 per cent of what it would have if the money was divided up on the basis of population.
It finds that the present system punishes states that attempt worthwhile tax reforms such as replacing stamp duty with land tax, or introducing a traffic congestion charge.
It also punishes states that allow contentious mining activities, giving them "the full political cost" of the approval, but only their population's share of the royalties.
The commission says NSW and Victoria, which have banned coal-seam gas exploration, will benefit from the coal-seam gas exploration and extraction allowed in Queensland and other states.
However, the commission rejects proposals to change the system by allowing each state to keep at least 50 per cent of any extra mining revenue (proposed by the Grants Commission) and setting a minimum GST distribution beyond which no state can fall (proposed by Western Australia).
"Mining revenue is a prime example of a source-based advantage - one a state benefits from by virtue of where its borders happen to be drawn - and should prima facie be included in the equalisation process," it says.
Allowing mining states to keep a guaranteed minimum proportion of their mining income could lead to calls for other carve outs.
The commission wants future GST distributions to merely bring the financially weaker states up to a "reasonable standard", rather than the "same standard".
It says the change would have to be phased in, beginning in 2020.
Mr Morrison agrees, saying any changes had to be introduced "in a way that gives all states and territories time to adjust".
"While we must continue to act to provide fairer treatment for states like Western Australia, we must similarly consider the potential impact on smaller recipient states like South Australia and Tasmania as we consider any transition plans," he said.
The commission will deliver a final report to the Treasurer in January.
