Highlights

We expect the budgetary performance of Australia's states and territories will continue to gradually recover following a deep slump during the COVID-19 pandemic.   Receipts from payroll taxes, transfer duties, land taxes, and other own-source revenues are strengthening. Meanwhile, the last vestiges of emergency COVID-19 business and household support programs were phased out over the past year. The states collectively returned to a modest operating surplus in fiscal 2022 (year ended June 30) following two years of operating deficit, and we expect it will remain in operating surplus going forward.

Even as pandemic-related spending normalizes, new borrowing will still be needed to finance historically large infrastructure programs.   We therefore expect the sectorwide gross debt burden to continue to rise to about 40 percentage points (of operating revenue) higher than pre-pandemic levels. States are investing heavily in public transport, education, health, and energy infrastructure. They are doing this mostly to accommodate strong population growth and address congestion, though some projects have also escalated dramatically in cost because of environmental challenges or rapid inflation in the price of inputs. Our analysis is based on nonfinancial public sector (NFPS) accounts, which include the activities of nonfinancial government enterprises.

Financial autonomy is a double-edged sword.   Australia's states and territories are not constrained by statutory or constitutional budget rules. They are free to set their own fiscal targets and principles, which are nonbinding and in many cases are quite relaxed, in our view. This autonomy bestows on Australia's subnational governments considerable flexibility to respond to exogenous shocks (such as the COVID-19 downturn) and invest in infrastructure. But it also permits a larger revenue-expenditure imbalance compared with peers in other developed markets.

Domestic fiscal trajectories have diverged, with a divide opening between commodities-driven and services-oriented states.   We expect Western Australia, the largest iron ore producer in the world, will outperform almost all national and international peers, thanks in part to strong mineral royalty revenues. At the other extreme is Victoria, Australia's second-most populous state, whose operating balance is yet to fully recover from lengthy COVID-19-related lockdowns and whose fiscal restraint is a little weaker than peers', in our view. Other states and territories will fall somewhere between these two extremes.

Intergovernmental relations are broadly supportive.   Australia's federal model features a high degree of vertical fiscal imbalance. This means states and territories are somewhat reliant on downstream transfers from the Commonwealth (central government). They are also constitutionally responsible for services in areas such as health and public transport, where costs are growing quickly. In December 2023, the Commonwealth agreed to extend the "no worse off" guarantee for goods-and-services tax (GST) grants by three years, to the end of fiscal 2030, providing greater certainty for states' medium-term budgeting. This ensures that no states are worse off following reforms to the GST distribution model enacted in 2018. Among rated states, Western Australia is the clear winner from the 2018 reforms.

Governance and transparency will remain institutional strengths.   Australia benefits from highly stable and predictable governance, with broad political consensus in favor of conservative macroeconomic policy. Each of the states and territories publishes a comprehensive annual budget, a midyear review, and an annual report. The public service is generally competent and independent of politics. State parliaments, auditors-general, budget offices, ombudsmen, and the media provide extensive checks and balances.

Trend: Stable

The trend is stable. We expect revenue-expenditure imbalances to generally narrow over the next few years as operating balances continue to recover post-pandemic. The system's predictability, transparency, and accountability are enduring strengths. We evaluate the Australian subnational institutional framework to be one of the strongest in the world and consider a change during the next few years to be unlikely.

Downside:   We could revise downward our institutional framework assessment if the sector's revenue-expenditure imbalance--as evident from trends in the operating balance and balance after capital accounts--does not improve in line with our expectations. This could arise, for example, from a significant withdrawal of central government support, or from a broader political shift by state government leaders away from the conservative fiscal policy consensus of the past few decades, leading to more rapid debt accumulation.

Predictability Of The Framework

Intergovernmental system is mature, with major reforms being rare

The Australian system benefits from highly stable and predictable governance. Reforms are typically incremental, and major reforms are generally undertaken only after a lengthy period of review.

Australia's constitution divides powers between the Commonwealth and state governments. The different tiers of government work together in an approach often described as "cooperative federalism."

A far-reaching system of horizontal fiscal equalization seeks to give each state and territory similar financial capacity to deliver services to its residents. It works by the Commonwealth collecting GST revenue and redistributing it in the form of untied grants. In late 2018, the Commonwealth legislated a permanent relativity "floor" of 70 cents per person per dollar of GST, rising to 75 cents from fiscal 2025. This roughly means that, going forward, no state or territory will receive less than 70%-75% of its population share of the national pool. (Western Australia's relativity had previously plummeted as low as 30 cents per person per dollar of GST.) The 2018 changes also included some technical adjustments to ensure that the fiscal capacity of all states is raised to at least the equal of New South Wales or Victoria, whichever is higher.

In addition, the Commonwealth promised that no state or territory will receive less than it would have under the pre-2018 arrangements. To ensure this, it provides billions of dollars in "no worse off" guarantee payments, out of its own purse, over and above the ordinary GST entitlement. The transitional guarantee was originally to last until fiscal 2027, but in December 2023 the Commonwealth extended the guarantee by three years, to fiscal 2030. Some east-coast states complain that the 2018 reforms are doubly enriching Western Australia, which is also collecting higher royalties from elevated commodity prices and a strong U.S. dollar.

The announcement in December 2023 was packaged with other tweaks to intergovernmental cost-sharing. These included the Commonwealth agreeing to lift its contribution to state-run public hospitals to 45%, from under 40%, over 10 years. In exchange, the states will absorb more of the costs of disability services.

Recent changes to tied infrastructure grants should have a manageable impact. In November 2023, the Commonwealth axed state infrastructure grant funding for 50 "high risk" projects across the nation due to the possibility of cost blowouts or delays. The move will divert savings to existing projects, meaning there is little effect on the overall quantum of infrastructure grant funding and spending. The Commonwealth also expressed a preference to fund future projects on a 50:50 cost-sharing basis (rather than 80:20). This does not necessarily mean a reduction in overall federal funding, as we anticipate states will mostly reprioritize projects to remain within their overall capital expenditure envelopes.

States have some capacity to politically influence or oppose unwanted changes

We believe Australia's states and territories have some power to soften the negative consequences of reforms through intergovernmental forums. One example is their recent lobbying to extend the federal "no worse off" guarantee, which came as part of a broader suite of tweaks to health and disability funding. Substantive changes to federal-financial relations generally only occur after vigorous public debate.

Australia is one of the oldest federations in the world. All six states have their own constitutions. The Commonwealth government has no power to amend states' constitutions.

The states have equal representation in the Australian senate, the upper house of the bicameral federal parliament. There are 12 senators from each of the six states and two from each of the mainland territories. In theory, this design gives the smaller states strong powers to ensure that their interests are not dominated by those of more populous ones. In practice, senators tend to vote along party lines rather than geographic lines. However, senate committees serve as a watchdog over the executive branch of government.

Note that our institutional framework assessment applies to Australia's six states and its self-governing mainland territories (of which we rate one, Australian Capital Territory). The federal parliament gave the latter self-government in 1988. Although Australia's federal parliament can veto a territory law, in virtually all economic and fiscal matters we observe that the self-governing territories have equivalent powers and responsibilities to the six states, and hence we assess them as operating under the same framework.

Revenue/Expenditure Balance

Federation's vertical fiscal imbalance means state budgetary flexibility is only moderate

Subnational government operating revenues (the sum of own-source revenues and federal grants) are generally sufficient to cover recurrent spending responsibilities. In ordinary years, Australia's states and territories, on average, achieve modest operating surpluses of 5%-10% of operating revenues, but occasionally can incur individual operating deficits. The sectorwide subnational operating position tipped into deficit over fiscal years 2020 and 2021 because of the COVID-19 shock. Victoria's finances are particularly weak, posting an operating deficit on our measures of 17% of operating revenue in fiscal 2021.

Taxation powers are concentrated at the Commonwealth level while states and territories deliver most high-cost frontline public services, including in healthcare and primary and secondary education. This "vertical fiscal imbalance" in Australia is relatively severe compared with other federal countries, and it necessitates large downstream intergovernmental transfers. States and territories rely on the Commonwealth for around 39% of their operating revenue on an NFPS basis (see chart 1; sum of untied GST grants and other current grants).

Chart 1

The Commonwealth distributes the money it collects from GST to states and territories in the form of untied grants. The Commonwealth Grants Commission, an independent agency, determines the annual distribution of grants based on a formula that considers each jurisdiction's population and fiscal capacity. States and territories also receive tied grants from the Commonwealth that are earmarked for specific areas of service delivery and infrastructure. The Commonwealth can broadly set the terms and conditions of such grants.

States' own-source revenue bases are somewhat narrow. This is because the Australian constitution gives the Commonwealth government exclusive power over customs and excise duties. The Commonwealth is also the sole collector of personal income tax and company tax. Commodity-oriented states, most notably Western Australia and Queensland, derive a significant proportion of revenues from mineral royalties.

Some states have recently hiked taxes and fees. For instance, Victoria's latest budget implemented a "COVID Debt Levy" in the form of higher payroll and land taxes. New South Wales will lift coal royalty rates by 2.6 percentage points from mid-2024, while Queensland enacted a new progressive coal royalty regime in mid-2022 that contributed to it achieving a bumper operating surplus of 19% of operating revenue in fiscal 2023. Overall, however, we assess that the states' revenue autonomy can be hampered by interstate tax competition and control over only a limited number of taxation tools.

In October 2023, the High Court struck down electric vehicle levies (implemented by Victoria and proposed by some other states) after ruling that they are a form of excise tax, which states are prohibited from imposing under section 90 of the Australian constitution. This will punch a small hole in future state budgets. We are watching to see if this landmark judgment could have ramifications for other, far more important, state and territory taxes, such as stamp duties and motor vehicle registrations.

States and territories are responsible for substantial infrastructure delivery in areas such as roads and public transport, hospitals, schools, prisons, social housing, and utilities. They are often comfortable funding infrastructure through a mix of operating surpluses, co-contributions from the Commonwealth, and debt. This generally leads to after capital account deficits (see chart 2) financed through borrowing in capital markets.

Chart 2

We see major asset sales as unlikely in the near term. Over the past decade, some states and territories leased or privatized public assets (such as electricity networks, toll roads, ports, land title offices, motor vehicle registries, insurance businesses, and train and tram services) and reinvested the proceeds into new capital works. Asset sales have since become more politically contentious.

In our view, the states and territories possess only a moderate degree of budgetary flexibility. As noted above, they are relatively reliant on Commonwealth transfers. In addition, the fees and charges levied by government-owned enterprises, such as electricity and water utilities, are usually set by independent economic regulators. These account for about 14% of NFPS operating revenue (see chart 1). The biggest component of operating expenditure is public sector salaries (see chart 3), which can be hard to downsize. However, states and territories have substantial discretion to postpone or reprioritize infrastructure projects as needed.

Chart 3

We expect systemwide tax-supported debt, as a proportion of operating revenue, to climb by almost 40 percentage points between fiscal years 2020 and 2026 (see chart 4). Average interest expenses are likely to remain manageable, below or around 5% of operating revenue, despite a steep rise in bond yields over 2022-2023. Most state and territory government debt takes the form of fixed-rate, Australian-dollar bonds. Floating-rate or inflation-indexed bonds accounted for less than 13% of the face value of total long-term bonds on issue in fiscal 2022. Several states took advantage of low interest rates during the pandemic to extend the weighted-average tenor of their borrowing.

Chart 4

The COVID-19 pandemic dealt a substantial and lasting blow to subnational finances (see table 1). The states and territories rolled out an assertive countercyclical spending response, committing tens of billions of dollars to health and emergency economic support. Several reported moderate operating deficits and outsized after capital account deficits over fiscal years 2020-2022. State treasurers committed to "put the economy before the budget," and Reserve Bank of Australia officials urged them to contribute to the national stimulus effort (see "Credit FAQ: Why We Downgraded The Australian States Of New South Wales And Victoria," published Dec. 7, 2020).

We include in our measure of tax-supported debt the net present value of leases. The introduction in 2019 of a new Australian Accounting Standards Board (AASB) standard, AASB 16-Leases, removed the distinction between operating leases and capital leases, resulting in an uptick in reported gross debt. In 2020, the states and territories also implemented a new accounting standard for "service concessions" (a type of public-private partnership), which may slightly inflate reported debt earlier in projects' lifecycles. We also adjust our measure of tax-supported debt for some states that have legislated debt retirement funds.

Sound political commitment to fiscal prudency, despite absence of binding rules

Australia's states and territories are not restricted by any statutory or constitutional rules on borrowing. They are largely autonomous, and the Commonwealth does not exert control over their financial performance.

Each state and territory government determines its own fiscal strategy, which is usually articulated in the annual budget or charter of fiscal responsibility. All have some form of self-imposed fiscal targets, which commonly revolve around a "golden rule" (i.e., delivering operating surpluses at general government level, on an accrual basis), managing growth in net debt, and closing unfunded pension liability gaps over time.

Several states have fiscal principles that call for net debt to be "stabilized" or "sustainable" in the medium term but are vague about timeframes for achieving this. Only New South Wales enshrines its fiscal targets in legislation, but there are no penalties for noncompliance. In 2021, Victoria's parliamentary budget office observed that fiscal targets and objectives often do not remain in place long enough to be useful.

We generally assess that there is solid political commitment to operating surpluses, or to restoring surpluses for those states that have tipped into operating deficit. However, budget repair discipline has waned a little, in our view. In the run-up to elections over 2022-2023, some states rolled out substantial new spending measures (see "Subnational Debt 2024: Australian States' Debt Rift Deepens," published Feb. 28, 2024).

Pension management is generally a strength in Australia compared to other systems. Most Australian workers have long transitioned to defined-contribution accumulation pension funds. Queensland has fully funded its legacy superannuation liabilities (i.e., defined-benefit pensions for civil servants), while other states generally aim to fully fund their legacy schemes by 2030-2040. Only Tasmania funds its superannuation liabilities on an emerging cost basis.

Track record of sovereign support during crises

There are no formalized bailout procedures for states and territories in Australia. However, the Commonwealth government demonstrated its willingness to provide extraordinary support by offering to guarantee state and territory debt, for a fee, during the financial crisis of 2009-2010 (see "Ratings On Commonwealth Of Australia, State Governments Unaffected By Temporary State Borrowing Guarantee," published March 25, 2009). This measure was effective in quickly alleviating capital market strains. The guarantee offer was voluntary and time-bound, and only two states chose to sign up. We think the Commonwealth would step in again, if needed, to provide support in a stress scenario.

The financial safety net for natural disasters is generous. The Commonwealth typically reimburses states and territories for 50%-75% of the costs of reinstating vital infrastructure, under the legislated Disaster Recovery Funding Arrangements (DRFA). The 50% reimbursement rate kicks in once disaster spending exceeds a threshold of just 0.225% of state revenues, and the 75% reimbursement rate activates at 1.75x the first threshold (or about 0.4% of state revenues).

In addition, when a state spends more on natural disasters than is funded by DRFA, its share of national GST grants will improve in future years under Australia's system of horizontal fiscal equalization (see "Bigger Flood And Fire Tests Lie Ahead For Australia," published Jan. 17, 2023).

Intergovernmental lending between the Commonwealth and lower tiers of government is small, and rare. In 2015, the Commonwealth provided a A$1 billion concessional loan to Australian Capital Territory to help fund a buyback and demolition scheme for homes affected by loose-fill asbestos. The loan has since been fully repaid.

Peer comparison

Among developed markets, the revenue-expenditure imbalance for Australian states and territories is relatively large (see chart 5). This imbalance--if it does not structurally narrow--presents the key downside risk to our institutional framework assessment.

Chart 5

On a global basis, Australia's subnational debt is midrange. The consolidated debt burden of Australia's states and territories (relative to operating revenue) is lower than that of Canadian provinces, and comparable to German states. A key difference between Australian states and Canadian provinces, on one hand, and many European regions on the other, is that the former are not bound by external fiscal rules. This bestows on them more flexibility to invest and maintain sizable after capital account deficits (see "Subnational Debt 2024: Fiscal Policy Differences Influence Borrowing In Developed Markets," published March 5, 2024).

Transparency And Accountability

Clearly defined roles and responsibilities

The Australian system generally ensures a clear delineation between elected ministers and the public service. The roles and responsibilities of each are defined by legislation. Budgets are scrutinized by parliamentary committees through regular "estimates" hearings. Officials at treasury departments publish independent budget updates prior to each state or territory election.

High degree of public disclosure

The states have adopted a uniform presentation standard, with both cash and accrual accounting. Annual reports and budgets are presented for multiple perimeters of government, including the core government ("general government"), the nonfinancial public sector, and the total state or territory, inclusive of publicly owned corporations. The latter also publish their own annual reports.

All states and territories prepare financial reports in accordance with Australian accounting standards and interpretations as issued by AASB. Since Jan. 1, 2005, these include the Australian equivalents to International Financial Reporting Standards.

Several states have stepped up their reporting on environmental, social, and governance risks, and some states have issued green or sustainability bonds, which require independent evaluation of use of proceeds.

Information is comprehensive and reliable

Transparency is a key strength of Australia's subnational institutional framework. The budgeting process is highly formalized. State and territory governments prepare annual budgets that contain detailed, four-year forecasts, known as "forward estimates," on a cash and accrual basis. Each state and territory publishes at least a comprehensive annual budget, a midyear review, and an annual report.

Several states and territories release quarterly or monthly financial updates at general government level. Some states have independent parliamentary budget offices; one produces long-term "intergenerational reports." Actuarial investigations of public superannuation liabilities are conducted on a regular basis. Most government agencies are subject to freedom-of-information laws. Every state and territory has some form of independent integrity or anticorruption commission, though their powers and capacities vary.

Each state or territory's auditor-general is responsible for auditing its annual financial statements and evaluating the performance and delivery of government programs. Auditors-general are statutory officers of parliament, and they certify whether accounts are true and fair. Annual reports are released in a timely fashion, generally within three to four months of fiscal year-end, though we have observed slippage for some states over the past few years.

Related Criteria

• Criteria | Governments | International Public Finance: Methodology For Rating Local And Regional Governments Outside Of The U.S., July 15, 2019

Related Research

• Subnational Debt 2024: Fiscal Policy Differences Influence Borrowing In Developed Markets, March 5, 2024
• Subnational Debt 2024: Australian States' Debt Rift Deepens, Feb. 28, 2024
• New South Wales, Feb. 12, 2024
• Western Australia (State of), Feb. 5, 2024
• State of Victoria, Jan. 30, 2024
• State of Queensland, Jan. 17, 2024
• Sector And Industry Variables: Institutional Framework Assessments For Local And Regional Governments Outside Of The U.S., Dec. 16, 2023
• Economic Research: Australia Can Avoid A Hard Landing, Dec. 7, 2023
• Tasmania (State of), Oct. 9, 2023
• Australian Capital Territory Rating Lowered To 'AA+' On Protracted Fiscal Recovery; Outlook Stable, Sept. 8, 2023
• South Australia Outlook Revised To Stable From Negative On Improving Operating Balance; 'AA+/A-1+' Ratings Affirmed, Aug. 17, 2023
• Bigger Flood And Fire Tests Lie Ahead For Australia, Jan. 17, 2023
• Credit FAQ: Why We Downgraded The Australian States Of New South Wales And Victoria, Dec. 7, 2020
• Ratings On Commonwealth Of Australia, State Governments Unaffected By Temporary State Borrowing Guarantee, March 25, 2009

Table 1

Editor: Kenneth Chung

Digital Design: Halie Mustow