Malaysia’s highly centralised fiscal system continues to face a significant Vertical Fiscal Imbalance (VFI), where state governments shoulder heavy expenditure responsibilities while having limited revenue-raising powers. Such dependency shapes federal transfers as a vital tool to not only reduce vertical fiscal gap but also economic disparity between states.

This paper specifically evaluates the equalisation impact of Malaysia’s intergovernmental transfer system from 2019 to 2024 by comparing a state’s actual receipts against its underlying economic potential. To achieve this, the study measures a state’s potential through a combination of observed revenue, macroeconomic determinants, and a specialized fiscal capacity index.

Key findings include:

• Significant vertical fiscal imbalances persist across Malaysia, reflecting a structural mismatch within the federal system. This reliance on the centre is most acute in Terengganu, Perlis, and Kelantan, where the states finance over half of their budgets through federal transfers.
• Federal transfers are not systematically aligned with a state’s fiscal capacity. States like Kelantan and Kedah receive lower support than their economic profiles suggest they need, while Sarawak remain notable outliers due to special constitutional provisions.
• The current intergovernmental transfers have a limited impact on reducing states’ economic disparities, as the 20% narrowing of fiscal gaps is driven by broad-based distribution rather than targeted equalisation.

As Malaysia works to strengthen regional stability, structural reform of the fiscal transfer system is vital. The country requires a coherent, transparent, and needs-based model that accounts for demographic pressures and the specific costs of local service delivery. Failing to prioritise evidence-based targeting will further entrench regional disadvantages, a trajectory that runs contrary to the fundamental spirit of the federation.