Federalism is a dead idea. So what now?

"Without fiscal sovereignty, state sovereignty is illusory," he said. "The sheer imbalance of the fiscal capacities of the states vis-a-vis the commonwealth invites a form of implicit fiscal bullying and tacit mendicancy."

For all his fine words about renovating the federation, Rudd has ignored one-half of the debate: the taxation and revenue side. Rudd's approach, epitomised by health, has been to gain more control over spending to match the commonwealth's taxing clout. But there are limits to this while the states retain constitutional control over large areas of government activity, including health and education, and with referendums to change the Constitution to give the federal government more powers unlikely to succeed.

Treasury head Ken Henry's review of the tax system canvasses reforms in state taxation. While the report has been sitting on the desk of Wayne Swan, who is fearful of what it may unleash, this area should be relatively uncontroversial.

In 2007-08, the states raised $53 billion in tax revenue and another $36bn through other means, including sales, dividend income and interest earnings, for a total of $89bn. But they spent $157bn. If the states were businesses they would have gone broke long ago.

Instead, they stay afloat by receiving money from Canberra, both through the GST revenue and grants for specific purposes.

According to the Organisation for Economic Co-operation and Development, the gap between state revenue and spending is larger in Australia than in any other developed federation except Belgium.

The states themselves think there is plenty wrong with this system. In a submission to the Henry tax review last year, the Council for the Australian Federation, representing the states, said the gap between state spending and revenue broke the nexus between government decisions on the level of services and the revenue raised to fund them and allowed governments to shift blame.

That is a polite way of saying that, if you are spending someone else's money, you are likely to be less careful, particularly if you can blame the commonwealth for not providing enough.

The submission added that the mismatch in funding created duplication and excess administration, and meant governments were less responsive to the needs of their communities.

Andrew Fraser put it more bluntly in a speech in January: "Say you were designing a kite; you wouldn't decide to put 80 per cent of the weight on one side and 20 per cent on another and expect it to fly. Say you were designing a nation; you wouldn't set about having one level of government gaining 80 per cent of the revenue because it wouldn't fly. And neither do we."

Fraser was exaggerating only slightly: on the latest figures, the $89bn the states raised was 26 per cent of total government revenue in Australia, whereas their spending is 41 per cent of the total.

Fraser proposed two years ago replacing the GST revenue the states receive with a share of income tax. The idea is that the states would set their own rate of income tax - something they would have to justify to their voters - and the commonwealth would collect it on their behalf.