Federal funds and fiscal capacity

Allocations to states are supposed to level the playing field, not widen the gap

WITH two state elections on the horizon and many different stakeholders making pronouncements about what should or should not happen in their respective states, issues surrounding state auto­nomy in our diverse federation continue to feature prominently in Malaysian public policy.

My colleagues at the Institute for Democracy and Economic Affairs (Ideas) have long been exploring the issues of decentralisation, from the various options that states have to generate ­revenue to ranking budget transparency across the 13 state governments.

The latter is a popular topic among state leaders themselves. They all want to do well, and yet there are no obvious correlations according to party, suggesting that good governance comes down to the qualities of individual leaders rather than strong party discipline.

In Policy Paper No 91, “Federal Transfers and Fiscal Capacity in Malaysia: Evidence on Equalisa­tion Across States”, authors Nor Nazirah Mohamed, Zheng Sheng Lew and Nurul Aqila Abdul Hadi describe how 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 supposed to address these financial gaps: both revenue and expenditure shortfalls for all states, and to reflect differences in circumstances between the states.

Indeed, these transfers should compensate for the legal limits on state revenue-raising powers while providing extra support to states that have less ability to raise revenue and higher economic development needs.

However, whether such transfers actually do perform this “equalisation” function – allocating more funds to less developed states with lower revenue-raising capacity – has received little ­scrutiny. Allocations between states in Malaysia have not been empirically assessed against equalisation objectives.

In the paper, the authors empirically assess 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.

Their four key findings are as follows:

First, that Malaysia’s intergovernmental transfers do little to reduce revenue-raising and economic disparities within states. Worse, the authors found that Malaysia’s highly centralised ­fiscal system is insufficiently ­targeted to allocate funds according to economic development needs.

Second, the structural mismatch between states’ expenditure responsibilities and their limited revenue-raising powers is most serious in Terengganu, Perlis and Kelantan, where own-source revenue as a share of expenditure exceeds 50%. Perlis, Negri Sembilan, Kedah and Perak exhibit the greatest dependence on fiscal transfers as a share of revenue at over 70%.

Third, the distribution of federal transfers is not systematically aligned with underlying fiscal capacity. For example, Kelantan and Kedah receive lower transfers than expected given their low fiscal capacity, whereas Sarawak receives significantly higher per capita transfers than its economic strength implies.

Fourth, 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, which is against the spirit of federation.

In sum, the authors’ work will reinforce what many Malaysians already think: that the Federal Government favours some states over others in an illogical and unfair way. In some cases, transfers are motivated by electoral incentives: if a state election is coming up, projects involving large investments may suddenly be announced.

I have observed this to be particularly true when a minister feels that their own constituency should receive extra benefits, even diverting projects that have already been approved by their predecessor.

It is not always so sinister: sometimes, experts passionately do believe that transfers to a particular state may have longer-term sustainable benefits for the country as a whole, especially if there are unique geographical factors.

This was perhaps already embedded in the thinking behind the legislation that created PETRONAS; but as we can see, that has made it far from immune from criticism and alternative ways of thinking about oil revenues.

Furthermore, it will be an inevitable consequence of state pride that leaders will want to show special care and attention to their ancestral homeland.

What we have to be wary about is when that state patriotism trumps all other considerations, leaving other states even further behind, damaging relationships between federal and state governments, and opening up the possibility to destroying the entire ­federation itself.

Tunku Zain Al-‘Abidin is founding president of the Institute for Democracy and Economic Affairs (Ideas). The views expressed here are the writer’s own.