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Financial Agreement Bill 1994



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House: House of Representatives

Portfolio: Treasury

Commencement: On a day to be fixed by Proclamation, but if a day is not proclaimed within 12 months of the day on which the Act receives Royal Assent, then the Act is repealed on the first day after the end of that period.

Purpose

To amend the Financial Agreement Between the Commonwealth and the States 1927 to remove obsolete provisions of the 1927 Agreement, to include the Northern Territory and the ACT as members of the Loan Council and signatories to the Agreement, and to clarify and amend powers of the Council and of the States and Commonwealth under the Agreement.

Background

An important issue at the time of Federation was the question as to how the problem of existing State government debt would be dealt with under the Federal Constitution. It had been assumed at at least one of the various Conventions which discussed Federation that Australian government debt would be unified 1 . The unification of debt in this manner would allow regularisation of interest rates and where borrowing was centrally co-ordinated, would prevent competition between States for scarce loan funds. The need to co-ordinate borrowing was exacerbated by the large revenue loss to the States which would result from exclusive Commonwealth power over customs and excise duties 2 . This revenue loss would also give the States grounds to argue for general revenue distribution from the Commonwealth to make up the loss, as the Commonwealth would presumably be flush with excess funds.

The Constitution made little specific provision for dealing with the problem of general revenue distribution, and the question of State debt. Section 87 of the Constitution (the Braddon clause) provided that 75% of customs and excise revenue would be returned to the States in the first 10 years of Federation, while section 105 allowed the Commonwealth to take over pre-Federation debts of the States in proportion to their populations 3 .

After the expiry of the 10 years in the Braddon clause, the problem of State debt, and control of borrowing remained. The solution for the time being was a fixed per capita grant from the Commonwealth to the States, along with a proposal to reach some form of intergovernmental agreement on the borrowing question 4 . In 1909, a referendum was passed which amended section 105 of the Constitution to enable the Commonwealth to take over State debts incurred after Federation, as a precursor to some cooperative scheme 5 .

In 1923, the pressures of lingering war time debt on all governments led to the creation of a voluntary loan council, whose purpose was to coordinate State borrowing overseas and to further intergovernmental cooperation when borrowing overseas. This structure proved a useful base for the Financial Agreement reached between the Commonwealth and the States in 1927.

Financial Agreement Between the Commonwealth and the States 1927

The agreement set out procedures for borrowing by the States and Commonwealth, established the Australian Loan Council, set up sinking funds for the debt and provided for the Commonwealth to put to referendum a provision to amend the Constitution to give it specific power to make and enforce financial agreements with the States. The Agreement made no provision for the ACT or Northern Territory, who attended Loan Council meetings, but were effectively spoken for by the Commonwealth.

Clause 3 of Part I established the Australian Loan Council, which comprised a Minister from each State and a Minister of the Commonwealth appointed by the Prime Minister 6 . The borrowings of governments were coordinated through Clause 3 (g) which required each government to submit to the Council a program for borrowing in the next financial year. The program would then require approval of the Council under Clause 3 (h) and the Council could allocate borrowing across the Commonwealth and States as it saw fit. Clause 3 (m) gave the Commonwealth 2 votes and a casting vote in Council decisions, while each State member had 1 vote. Loans for defence and "temporary purposes" were specifically excluded under Clause 3 (g).

Clause 4 provided that the Commonwealth would undertake all borrowings on behalf of the States, unless the Council decided unanimously otherwise, and that as long as the Agreement were in force, no money was to be borrowed by the parties otherwise than in accordance with the Agreement.

Part III of the Agreement was contingent on the passing of the referendum mentioned above. Clause 3 established a sinking fund for each of the net public debts of the States which vested control over the funds in the National Debt Commission by virtue of Clause 3 (n). The National Debt Commission was established under the National Debt Sinking Fund Act 1923.

The Agreement was ratified by the Commonwealth under the Financial Agreement Act 1928 and was subsequently passed by all State Parliaments. In 1928, the proposed referendum was passed 7 and the new section 105A was inserted into the Constitution. This section not only gave the Commonwealth the power to make agreements with the States relating to their debts, but also gave it unprecedented power of enforcement of any such Agreement 8 . This power was used in 1932 to involuntarily assign State revenue to the Commonwealth when NSW defaulted on overseas loans. Its exercise was challenged in NSW v Commonwealth (Garnishee Case) (No.1) and held by majority to be valid.

Section 105A also allowed any Agreement under the section to be varied or rescinded by the parties, and the Agreement has been amended a number of times since its initial inception in 1927.

A major deficiency in the Agreement at the time of its inception was the fact that it did not cover borrowings by State instrumentalities or other entities partially or fully owned by the States. To prevent the States circumventing the Agreement by borrowing through these entities, a "Gentleman's Agreement" was arranged in 1936, although the Agreement had no legal force 9 . The "Gentleman's Agreement" was varied from time to time and purported to cover borrowings by semi-government or local government authorities. In a similar fashion to the Financial Agreement, the Gentleman's Agreement required the submission of borrowing programs by these entities to the Council for approval.

The system as it stood comprised 2 Agreements, the Financial Agreement whereby the States could borrow only through the Commonwealth, and the Gentleman's Agreement whereby State instrumentalities outside the Financial Agreement could borrow in their own right and issue debt.

During the mid 1980s, the States began to use a number of complex financing techniques to avoid Loan Council controls. In particular, the States established Central Borrowing Authorities (CBAs), which borrowed on behalf of all State government instrumentalities in each State. The CBAs borrowed on behalf of bodies outside of the Financial Agreement, and the States could effectively borrow de facto in their own right by borrowing from these CBAs. Indeed, borrowing indirectly through State CBAs became so prevalent that by 1987, the Commonwealth ceased borrowing on behalf of the States. It was clear that as Loan Council control diminished, sweeping reform to the system was needed.

In the 1984-85 Budget papers 10 , the Gentleman's agreement was formally abandoned in favour of a global approach. Under this regime, borrowing in all forms by Commonwealth and State semi-government and local authorities and Government owned companies would be subject to global numerical dollar limits 11 . The global limits excluded borrowings by government financial institutions and statutory marketing authorities. The global limits also again covered borrowings by electricity authorities which had previously been exempted on a trial basis in 1982-83.

By the latter part of the 1980s however, the States had become increasingly adroit at avoiding the global limits imposed under the new arrangements. The limits were often effectively bypassed by the use of complicated financing schemes involving entities whose status under the Agreement was unclear, and techniques such as long term leases of assets or sale and lease back methods 12 .

In 1990, the program was changed in a significant fashion. Restrictions on State authority overseas borrowing were removed, thereby giving the States more flexibility in the financing of debt and the distribution of global limits was to be phased towards an equal per capita basis over 5 years. These changes reflected the reality that the Financial Agreement and the Gentleman's Agreement had for all intents and purposes ceased to be of any effect. The States were more or less borrowing in their own name outside of the Financial Agreement 13 .

In 1992, the Loan Council resolved to move to a new monitoring and reporting system, and acknowledged that the global limits system had become less effective and was at the point of breakdown 14 . The Council acknowledged that the techniques mentioned above had:-

"...eroded the effectiveness of the Loan Council process by increasing the opportunities for the Loan Council to be circumvented and clouding the boundary lines which determine Loan Council coverage." 15

The reforms had 3 main purposes.

Firstly, the reforms would bring the Financial Agreement in to line with actual State borrowing practices. The Agreement was being consistently undermined by the use of complex financing schemes and the use of CBAs to borrow on behalf of the States. The new arrangements were to take account of these practices and would allow closer monitoring of each jurisdictions borrowing practices by other jurisdictions, without the need for Loan Council approval for borrowing.

Secondly, the distribution of global limits was done in an ad hoc fashion. Per capita requirements were considered to be poor indicators of a jurisdiction's overall debt position, its fiscal requirements, and ability to raise revenue and provide infrastructure and public services.

Thirdly, the reforms would recognise the fact that the States were already effectively borrowing in their own name. In this respect, the reforms would ensure that State borrowings were subject to outside market scrutiny by requiring the provision of detailed information concerning jurisdictional net debt positions to the Loan Council 16 .

The report indicated a change in Loan Council arrangements to implement a scheme based on a jurisdiction's overall net borrowing position, rather than global limits. Each government would submit to the Council its intended borrowing allocation (Loan Council Allocation or LCA) based on its net borrowing position. The Council would then assess the LCA on the basis of macroeconomic policy objectives and future fiscal outlook predictions for that jurisdiction. Important factors in this decision would include capital needs, infrastructure requirements and comparative fiscal circumstances 17 . If the LCA did not conform to these criteria, then the Council could ask the jurisdiction to provide adjustments to its request, or modify its fiscal strategy. The new arrangements would also deal with specific "memo" items, which were the sort of financing devices used by the States to circumvent the Agreement in the 1980s. These "memo" items included operating leases, finance leases and the degree of private sector involvement in public sector infrastructure. Overall, the Council stated that the new arrangements were intended to:-

"* facilitate financial market scrutiny of public sector finances via better reporting and so make jurisdictions accountable to markets;

* enhance the role of Loan Council as a forum for coordinating public sector borrowings in the light of a discussion of fiscal strategies;

* promote greater understanding of budgetary processes; and

* provide the basis for States and Territories assuming greater freedom and responsibility in determining their financing requirements consistent with their fiscal and debt position and overall macroeconomic constraints." 18

The new arrangements in relation to LCAs are currently in place although at its latest meeting in 1994 the Loan Council reconfirmed its commitment made in 1992-93 19 to:-

* abolish the restriction on the States borrowing in their own name;

* remove the Commonwealth's explicit power to borrow on behalf of the States;

* remove the need for future borrowing by the Commonwealth or the States to be approved under the Agreement; (although the Loan Council can still make resolutions)

* admit the ACT and Northern Territory as signatories to the Agreement; and

* replace the existing Agreement with the new arrangements.

The new Agreement, to be implemented by the Bill, retains the Loan Council but limits its powers to the making of resolutions only.

Main Provisions

Clause 4 approves the new Agreement, which is set out in the Schedule to the Bill.

Clause 6 establishes the Debt Retirement Reserve Trust Account (DRRTA), whose purpose is for the receipt and payment of monies under the 1994 Financial Agreement.

Clause 7 establishes a separate account for each State and the Northern Territory in the Debt Retirement Reserve Trust Account, which replaces the National Debt Sinking Fund accounts to be abolished by the National Debt Sinking Fund Repeal Bill 1994.

The Schedule to the Bill contains the 1994 Financial Agreement. Recital C provides that the 1994 Agreement intends to make provisions different from those in the 1927 Agreement, including removing the power of the Commonwealth to borrow on behalf of the States and allowing the States to borrow in their own names. Clause 1 (1) states that the Agreement is not binding on any party unless it is either signed with prior authority of the party's Parliament, or after signing it is approved by the Parliament of the party. Clause 4 sets up the Loan Council, sets down rules and procedures for voting and provides for membership and meetings. Clause 4 (9) gives the Council power to make resolutions in relation to borrowings, raisings and other financial arrangements of public sector entities. These resolutions are not final and binding on the signatories to the Agreement. Clause 5 sets out interest payment obligations of the Commonwealth and the States. Clause 15 obliges the Commonwealth to keep separate accounts for all the States and the Northern Territory in respect of debt, interest and sinking funds, or contributions for the purposes of the DRRTA. Clause 16 rescinds the original Agreement, subject to the retaining of certain provisions relating to administration of debt which are transitory, until the new accounts are established.

Comment

The Financial Agreement Bill 1994 represents an important reform which leaves control of State borrowing, legally, as a matter for the States. The Agreement proposed under the Bill gives no power to the Loan Council to make binding determinations on borrowing on signatories, although it can still make resolutions. The States will therefore be responsible to their electorates and international financial market scrutiny for their borrowing practices. The provision of detailed information concerning State borrowings should lead to a more accountable and transparent means of determining State debt positions and strategies. Ultimately, control over State borrowings is achieved by the Commonwealth by the need for the States to provide information concerning debt strategy and the threat of withdrawal of Commonwealth grants if loan conditions are not complied with. This threat has already been used on previous occasions 20 . Given the dubious legal status of the existing Agreement 21 , the ability to avoid obligations and the unenforceability of the old agreements, the new position represents an acknowledgment of the failures of the previous arrangements. In reality, it is the economic, rather than the legal power of the Commonwealth which enables it to decide on the degree of control it wishes to maintain over State borrowings. The new Agreement sets up a structure which explicitly recognises this fact.

Endnotes

1 Much of the information on the history of the Financial Agreement is obtained from Saunders, C, "Government Borrowing in Australia", Melbourne University Law Review, Vol 17, No. 2, 1989, p 187-218.

2 Constitution, section 90.

3 Saunders, ibid p 189.

4 Ibid, p 191.

5 Constitution Alteration (State Debts) 1909.

6 The references to clause numbers in this paragraph refer to the clause numbers in the original Agreement in the Financial Agreement Act 1928.

7 Constitution Alteration (State Debts) 1928.

8 Section 105A (5) provides that:-

"Every such Agreement and any such variation thereof shall be binding upon the Commonwealth and the states parties thereto notwithstanding anything contained in this Constitution or the Constitution of the several States or in law of the Parliament of the Commonwealth or of any State."

9 Ibid, p 204.

10 Commonwealth Budget Paper No. 7, 1984-85, Payments to or for the States, the Northern Territory and Local Government Authorities.

11 Ibid, p 31.

12 For a comprehensive overview of the situation, see D.James, "The Australian Loan Council (2nd Edition)", Background Paper No. 29 of 1993, Dept of Parliamentary Library, at p 8-10.

13 See James, ibid.

14 "Future Arrangements for Loan Council Monitoring and Reporting", Loan Council, 5 July 1993, p 1.

15 Ibid.

16 See generally, James, ibid.

17 Loan Council Report, 5 July 1993, ibid, p 2.

18 Ibid, p 3.

19 Commonwealth Budget Paper No. 4, 1992-93, Commonwealth Financial Relations with Other Levels of Government, p 62

20 James, ibid, p 21.

21 Saunders, ibid p 210.

Marco Bini Ph. 06 277 2476

Bills Digest Service 11 April 1994

Parliamentary Research Service

This Digest does not have any official legal status. Other sources should be consulted to determine the subsequent official status of the Bill.

Except to the extent of the uses permitted under the Copyright Act 1968, no part of this publication may be reproduced or transmitted in any form or by any means, including information storage and retrieval systems, without the prior written consent of the Parliamentary Library, other than by Members of the Australian Parliament in the course of their official duties.

Published by the Department of the Parliamentary Library, 1994.