Malcolm Turnbull has been left with a $2.9 billion hospital bill and no tax plan after a meeting with the premiers.
The prime minister wanted the state and territory leaders to sign on to a deal in which they would get control of a portion of income tax, but lose an equivalent amount in federal government grants.
If they need more money for services the states would have to raise the rate, rather than Canberra find the cash.
But the Council of Australian Governments meeting ended with Mr Turnbull ditching the plan in favour of an interim hospital deal and the states looking at taking a slice of the income tax pool.
For every dollar taken, the states would still lose a dollar in federal grants, making them think more carefully about how they spend the money.
There were no promises on schools funding beyond a commitment to conclude talks in early 2017.
Mr Turnbull and Treasurer Scott Morrison now have a month to come up with an alternative tax plan before the federal budget is delivered.
Shadow treasurer Chris Bowen says the prime minister had sold the income tax deal as "the most fundamental reform to the federation in generations".
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But the COAG meeting had ended in a "complete and utter shemozzle".
Mr Turnbull ended Tony Abbott's reign as prime minister in September 2015 arguing the country needed new economic leadership.
"This is economic leadership Malcolm Turnbull-style," Mr Bowen said.
