The first part of this paper develops a theoretical model of fiscal equalisation and uses the model to derive an optimal equalisation formula that has general applicability for federations. If vertical equity is achieved by the central government and horizontal equity by interstate migration, the role of fiscal equalisation is to support an efficient distribution of different labour types across states. The theoretical model draws on Boadway and Flatters (1982) and Albouy (2012), with some Australian-oriented extensions. The resulting optimal formula implies that full equalisation should be applied for the fixed costs of state government and for source-based taxes on natural resources, land and capital. However, equalisation should only correct for difference in fiscal capacities arising from state demographic mixes when applied to the variable costs of state government, residence-based taxes on labour and consumption taxes. Simplifying assumptions of the model are discussed. The second part of this paper applies the optimal equalisation approach to Australia, using the Commonwealth Grants Commission (CGC) assessment for 2017/18 as a base. The effects on consumer welfare of moving from the current Australian full equalisation system to optimal equalisation, partial equalisation or no equalisation are estimated, along with the associated impacts on state populations.