The report has recommended not major overhaul.
It wants to keep the horizontal fiscal equalisation (HFE) system to determine how GST revenue is distributed.
But it says it needs to be adjusted to take into account the changing economic fortunes of states and territories.
The report says the GST distribution system is “beyond comprehension by the public, and poorly understood by most within government.”
A case in point is Western Australia which is now struggling with the downturn of the mining industry.
“In this instance, the three‑year assessment period and two‑year lag in the system resulted in declining GST relativities coinciding with falls in royalty revenue, thereby exacerbating the effects of the economic cycle on Western Australia’s budget,” the Productivity Commission report said.
“However, Western Australia’s experience has been an unprecedented outlier, exacerbated by earlier budget decisions of the WA Government. For states with less extreme changes in fiscal capacity, limited contemporaneity has been less problematic, and indeed other states preferred an emphasis on stability.”
Under the formula, Western Australia receives just 34.4c out of every dollar of GST revenue. The Northern Territory gets $4.66 for every dollar raised, Tasmania gets $1.805 South Australia is on $1.44), Queensland gets $1.188, New South Wales receives 87.7 cents and Victoria 93.2 cents.
The commission says equity should remain at the heart of the HFE but it should aim to provide states with the fiscal capacity to provide a reasonable level of services.
Rather than bringing everyone up to the fiscal standard of the strongest state, there should be a more practical objective of “reasonable equalisation”.
“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 says.
The Treasurer Scott Morrison said the changes need to be done 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 WA, we must similarly consider the potential impact on smaller recipient states like South Australia and Tasmania as we consider any transition plans,” Mr Morrison said in a statement.
The issue will be thrashed out at the Council of Federal Financial Relations later this month.