Methods used by some schools include seating children whose parents have not paid in special rows, withholding academic reports and marking students as absent so that their government living allowance is stopped.
Tuition in state schools is supposed to be free. The report says each family with a child at a state school should be given a charter outlining what the child is to be taught and government policy on fees.
National standards for discipline - including abolishing corporal punishment in all government and private schools - plus an Australia-wide strategy for reducing truancy should also be adopted, the report says.
Prepared by the Australian Law Reform Commission and the Human Rights and Equal Opportunity Commission, the 770-page report was two years in the making. It was tabled in federal parliament last week.
The report is highly critical of Australia's courts, child protection service, police treatment of young people, and central and local education systems.
On the issue of corporal punishment, the two commissions say that children should have the same protection from assault as adults.
Legal and child protection systems have failed to protect children from neglect, abuse and exploitation, the report says. The rights, interests and needs of children are often ignored and many fall through gaps in the system.
"The majority (of young people) are regularly hassled and harassed by police when hanging around together in public places."
The report warns that the situation will only worsen unless urgent action is taken.