The two states say current policies are exacerbating the appalling levels of disadvantage in indigenous communities.

Their proposed overhaul has been put to a meeting of treasury heads in Melbourne as part of the Commonwealth Grant Commission's five-yearly review of commonwealth-state financial relations.

The two biggest states believe the higher costs faced by South Australia, Western Australia, Tasmania and especially the Northern Territory in servicing urban and remote Aboriginal communities should be taken out of the formula for redistributing the GST and dealt with directly between the commonwealth and the states affected.

Last week's meeting was called by the CGC to review "horizontal fiscal equalisation" -- the system for splitting GST money between the states based on their relative capacity to raise revenue and their relative "disabilities", or special needs.

Of the $39 billion raised by the GST in 2005-06, about $3.2billion was redistributed from NSW and Victoria to the other states, with indigenous needs accounting for more than a third of this.

"Indigenous funding is a clear area where HFE is not leading to better outcomes," NSW argued in its submission.

"Indigenous influences should be removed from the HFE framework. NSW believes that equalisation should only be applied to core state functions, such as health, education and law and order."

The two big states say levels of Aboriginal disadvantage demonstrate the system is not working.

Unlike special purpose payments, GST funding is not tied to particular projects. As a result, Victoria and NSW argue, money flowing to the Northern Territory and the other states is not being spent where it needs to be -- on Aboriginal welfare.

In fact, the weight carried by indigenous "disabilities" in the HFE formula could be seen as an obstacle to reform, it is argued, since any improvement in the statistics would lead to a decrease in funding.

As a result, the Victorian submission says, "poor government policy has contributed to the situation indigenous people currently find themselves in".

Victoria and NSW argue that the HFE formula is designed to bring services close to a common standard across the country, but is poorly equipped to assist communities where health, educational and other standards fall far below the average.

"Disadvantage that is so entrenched is something that GST-based funding is not designed to overcome," a senior NSW official said yesterday.

Apart from Victoria and NSW, none of the states or territories supports significant reform of HFE, which would be likely either to reduce their transfer payments or tie up their funding.

At present, Aborigines die 20 years earlier than other Australians, are 15 times more likely to be in jail and 10 times more likely to be murdered.

A Productivity Commission report in July last year found no significant improvement in these indicators had occurred over the previous two years.

And recent reports in The Australian have highlighted epidemic levels of child sexual abuse in Aboriginal communities.