The Productivity Commission's draft report on the GST carve-up has backed the basic formula but recommends changes that will shock-proof the system.
The report affirms the use of the horizontal fiscal equalisation system to determine how GST revenue is distributed but recommends tweaking it to take into account the states' and territories' changing economic fortunes.
"The Turnbull government remains absolutely committed to HFE in determining how GST and other payments are made to the states and territories," Treasurer Scott Morrison said in a statement on Monday.
"However, the (commission) finds that the system goes too far, creating significant weaknesses."
The current system produces unforeseen and unfair outcomes, what the report describes as "unfair equity", as in the case of Western Australia. The state's share of GST has fallen to less than 30c in the dollar after the end of the mining boom.
The federal government has provided a $1.2 billion top up payment to WA, to stop its GST falling below 37c, but the commission says the use of such payments and setting a GST floor are not longer term solutions.
The report also says reliance on the system discourages the states and territories from reforming their tax systems, pursuing productivity or tapping their own mineral resources.
The report recommends resetting the HFE objective from "full" equalisation, currently interpreted as bringing everyone up to the fiscal standard of the strongest state, to a more practical objective of "reasonable equalisation".
"But we also need to do this in a way that gives all states and territories time to adjust," Mr Morrison said.
"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."
The report will be discussed by all the states' and territories' treasurers at the Council of Federal Financial Relations later this month.
The commission didn't make any recommendations on gas policy although Prime Minister Malcolm Turnbull has threatened to cut grants to states such as NSW that don't develop their gas resources.
