Malaysia’s federated fiscal system gives the federal government comprehensive revenue-raising powers while heavily restricting states from taxing and borrowing. The federal government’s application of these powers further concentrates power in the centre, creating a large financial shortfall between what state governments need to meet their expenditure responsibilities and what they can raise on their own.  

Transfers of revenue from federal to state governments are meant to address financial gaps: both revenue and expenditure shortfalls for all states and to reflect differences in circumstances between the states. They should compensate for the legal limits on state revenue-raising powers, while at the same time provide extra support to states that have less ability to raise revenue and have higher economic development needs.  

Whether federal transfers in Malaysia perform an ‘equalisation’ function — allocating more funds to less developed states with lower revenue-raising capacity — has received little examination. Federal transfers are mostly designed around specific activities (or political and historical reasons) not fiscal capacity or need. Allocations between states in Malaysia have not been empirically assessed against equalisation objectives. 

This paper examines whether the distribution of federal transfers promotes equalisation. It empirically assesses the allocation of transfers per capita by state against various indicators of fiscal capacity and fiscal resources, including economic size, household incomes, and economic structure.

Key findings include:

• Malaysia’s intergovernmental transfers do little to reduce revenue-raising and economic disparities between states. The paper provides further evidence that Malaysia’s highly centralised fiscal system is not sufficiently targeted to allocate funds according to economic development needs.
• The structural mismatch between states’ expenditure responsibilities and their limited revenue-raising powersis most serious in Terengganu, Perlis, and Kelantan, where own-source revenue as a share of expenditure exceeds 50%. Perlis, Negeri Sembilan, Kedah, and Perak meanwhile exhibit the greatest dependence on fiscal transfers as a share of revenue at over 70%, while dependence is relatively low for Sabah and Sarawak.
• While transfers somewhat reduce disparities, the distribution of federal transfers is not systematically aligned with underlying fiscal capacity. States like Kelantan and Kedah receive significantly lower transfers than expected given their low fiscal capacity, whereas Sarawak receives significantly higher per capita transfers than its economic strength implies.
• Malaysia needs a more coherent and transparent needs-based transfers model that accounts for demographic pressures, economic development levels, and location-specific service delivery requirements. Continuing to ignore the need to improve data collections and advance evidence-based targeting of transfers will entrench and widen disadvantages between states, against the spirit of federation.