Unions NSW had argued the cap was so low that it effectively prevented third parties from being involved by-elections. Spending by by-election candidates is capped at $245,600.
The High Court ruled the $20,000 cap was invalid, after lawyers for NSW conceded it "impermissibly burdens the implied freedom of communication".
"Today the High Court has once again ruled that legislation aimed at silencing the government's critics is not valid," Unions NSW secretary Mark Morey said.
"Everyone in our democracy - from unions to community groups - should have the chance to have their voices heard.
"We are delighted with this result which upholds vital freedoms granted by our constitution."
The NSW concession came after the NSW Joint Standing Committee on Electoral Matters recommended parliament increase the expenditure cap to $198,750.
But that is yet to be legislated, so no cap is in place as of Wednesday.
The decision does not affect spending caps for candidates and third-party campaigners for the March state election.
NSW Premier Dominic Perrottet said he believed caps should be in place to restrict election spending and hoped for more public funding for campaigning to reduce the influence of third parties and lobbyists.
"I haven't been able to get advice about the decision today but I do believe caps are important," he told reporters.
"The advice I've received on public funding of elections is it's not as easy as I would have expected it to be, but I think that's what we need to move to."
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