A Critical Need for Effective State-Federal Relations in Malaysia

EXECUTIVE SUMMARY

• In response to increasing calls for greater efficiency and equity in state-federal relations, structures, and processes, a Roundtable Discussion on State-Federal Relations was organised on 25 August, 2025, at the Penang Institute to discuss the present situation, and offer proposals for improvement to the situation.
• Prominent recommendations include the restoration of the State-Federal Parliamentary Special Select Committee (PSSC); reform of the current ‘national councils’ towards greater transparency and public accountability; and the establishment of an effective and transparent national platform for states to engage collectively with the federal government.
• Between states, state governments are urged to establish an inter-state body that serves as a platform for state governments to tackle matters of mutual concern.
• At all levels – federal, inter-state, as well as intra-state – initiatives should be undertaken to institutionalise and realise transparency, representative and participative democratic practices, performance-based legitimacy, and public accountability.

Introduction

This Issues highlights specific and concrete proposals and recommendations that have been floated by experts and policy-makers at the Roundtable Discussion on State-Federal Relations jointly-organised on 25 August, 2025, by the Penang State Select Committee (PSSC) on State-Federal Relations, and Penang Institute (PI). Co-chaired by PI executive director, Dato’ Dr. Ooi Kee Beng, and PSSC chairman YB Gooi Hsiao-Leung, the event saw two dozen former and current senior government officials, state legislators, and policy experts and practitioners sharing information and ideas on the prospects of bringing about greater equity, effectiveness, and efficiency in governance by improving on the opaque processes currently characterising state-federal relations in Malaysia.

The paper proceeds as follows: Section 1 lays out the proposals and recommendations for states to address with the federal government, or more correctly, with individual departments, ministries or other bodies of the federal government. The first part of this section pertains to suggestions on the ‘big-picture’. The second relates to the need for fiscal reforms, namely, to address the inefficiencies and inequities of the current system of collection and allocation of funds by the federal government to the states.

Section 2 is on particular actions and efforts that can be taken by state governments amongst themselves, i.e., aside from engagements at the federal level. These include raising awareness, organising, and mobilising states towards adopting a conscious and active position to enhance their side of state-federal relations. It also includes the need for capacity-building efforts to enable states to take on greater policy and fiscal responsibilities in tandem with their demands for greater fiscal capacity vis-à-vis the federal government. A third set of proposals and recommendations pertain to steps that individual states can take internally towards qualifying for, and realising, more equitable and efficient state-federal relations.

Section 3 concludes this paper by taking a step back from the concrete proposals and recommendations that have been floated to consider what principles, aims, goals, and values drive, or underlie, the calls for greater decentralisation and devolution of the Malaysian federal system. This Issues summarises these aspirations to be: greater transparency; participative and representative democracy; fairness; and public accountability.

State-To-Federal Engagement

National-level body for state-federal disputes

At the level of states’ engagement with the federal government, there is general consensus on the need for a national-level platform for comprehensive deliberations and decision-making over state-federal relations, powers, responsibilities, and functions. Existing platforms – such as the several national councils set up for discussions on specific areas such as finance, local governments, and land – have long been criticised for their lack of transparency, accountability, and effectiveness in redressing imbalances in federal-state relations. In addition, the roles of these councils and of those who sit in them as its members, and the substance and bases of their discussions and decisions, remain beyond the reach of even experts and policy-makers to understand. For example, what are the formulas for decisions on the collection or allocation of funds and other resources between the federal and state governments?

A necessary first step towards realising the proposed national state-federal body is the restoration of the Parliamentary Special Select Committee (PSSC) established in December 2018 but which became moot with the fall of the Pakatan Harapan government in February 2020. In this way, a review could be undertaken of the present ‘national councils’ – especially the National Financial Council – that embody much of what is wrong with current state-federal relations, and thereby reach a more optimal formulation of the proposed state-federal body.

How might transparency, accountability, and other goals, values, and principles be realised in the structure of the proposed body (i.e., its membership and leadership) and processes of deliberation? Larger and longer-term issues of state-federal relations can only be effectively addressed by such a national-level body which would comprehensively, systematically, and transparently deliberate on state-federal disputes.

Further considerations for this national body on state-federal relations include the need to:

• Structure and formulate the body in such a way that member-states (or states’ demands) are tackled seriously by the federal government.
• Institutionally and legally ensure that deliberations and decisions are carried out systematically and transparently, and lead to concrete measures and policies that fulfil the purposes for which the disputes or issues were raised.
• Ensure that all formulas or bases for decisions such as on federal allocation and collection of funds to and from states are transparent to all, and subject to regular review and reform.

Fiscal Reform

The PSSC Roundtable discussed also the often-heard demands by states for fiscal reform, both in terms of the federal government’s collection of taxes from the states, as well as its allocation of funds to the states. At their most fundamental, the questions reflect the need for understanding what and how things work in the ‘black box’ of state-federal relations. As expressed by former Penang state secretary and current CEO of the Penang Infrastructure Corporation, Dato’ Seri Farizan Darus, the questions boil down to four:

• How much does the Federal Government collect from the states?
• How much does it allocate to states?
• What is the ratio of federal collections from states to federal allocations to states?
• How much do states understand what they should receive from the federal government?

Answers to those questions should serve as the beginning of subsequent deliberations and negotiations between state and federal governments.

In terms of proposals for how collection and disbursement of monies might be carried out, a common one being that taxes such as the sales and service tax (SST) be shared by federal and state, Think City technical director Stuart MacDonald suggested that states could float a ‘baseline’ approach: anything more than ‘x’ amount of monies collected as taxes within a state, for example, could be retained with that state for its use. The inverse of this baseline proposal to reform federal allocations and spending in the states might possibly take the form of stipulating that residual amounts of state revenue growth beyond a certain threshold (e.g., state revenue growth surpassing ‘x’ percentage from the previous year) be retained/returned within the state that had experienced that growth.

The larger concerns with current federal decisions and practices relating to collection and allocation vis-à-vis states, however, pertain to the fact that they go against agreed good practices and principles of planning and policy-making. Rather than multi-year allocations based on transparent and consistent formulations and reasonable and predictable outcomes, states are subject to uncertainty and, arguably, arbitrary federal dispersals on a yearly basis, sometimes in response to states’ applications, sometimes despite state applications, but at all times subject to the will and largess of those who hold the federal purse. The current practice lends towards inefficiency and dependency.

As for specific types of allocations, MacDonald pointed to the disjuncture between the constitutionally-stipulated per capita grants as currently decided on and disbursed indiscriminately by the federal government, on the one hand, and the needs and conditions of the receiving states, on the other. For this reason, MacDonald proposed that capitation grants be weighted instead, for the specific circumstances and characteristics of the states and their population, such as age, cost of living, and cost of service delivery.

Similarly, the TAHAP (Economic Development, Infrastructure, and Quality of Life) grants have been roundly criticised as woefully inadequate and effectively favouring larger, richer states and effectively penalising smaller, poorer states.

The newly-introduced Ecological Fiscal Transfer (EFT) grants have been greeted as a welcome introduction to the Malaysian system of transfers. But even the practice of EFTs has been criticised for systemic uncertainty, lack of transparency, and disjuncture from efforts to address climate change as well as to fulfil demands of accountability and public confidence.

Examples of good practice with regards to state-federal fiscal arrangements and relations can be readily found around the world, such as Australia’s Horizontal Fiscal Equalisation (HFE), Germany’s Länderfinanzausgleich systems, South Africa’s weighted population and poverty indexing, and India’s Finance Commission. In these and other examples, representatives of central governments in federal systems sit in bodies together with officials and public finance experts serving the states (alternatively called ‘regions’, ‘provinces’, or ‘territories’) to deliberate and decide on state-federal financial flows.

Summarising the proposals, World Bank economist Deisigan Shammugam said federal-to-state fiscal transfers should reflect or embody clear and transparent rules; serve to deepen fiscal decentralisation; increase or enhance federal-state collaboration to improve public service delivery; and reduce uncertainty while promoting long-term and continuity of policy-making.

Finally, states should undertake exercises in policy realism by working out the practicalities and concrete consequences of devolved and state-federal sharing of responsibilities and funding. They should assess their capacity and capability to take on functions and powers that currently are federal but might be more effectively exercised at the state level.

In this way, considered greater state involvement might possibly take place in technical and vocational training and education (TVET), preventive health, health promotion, disease prevention, community wellbeing, social welfare, digital technology, development and promotion of halal industries, agriculture and food security, tackling environment and climate change challenges, and social welfare. If successful, state administration might, for example, bring about greater tailor-made and localised education; outcome or delivery-driven and needs-based social welfare; and greater green urban infrastructure, climate adaptation, and renewable energy practices.

While the 2021-2022 Covid-19 pandemic made obvious the structural cracks and weaknesses and inequalities of Malaysia’s social, health, and welfare system, the crisis also showed the positive contributions that greater state involvement and participation can bring to the table.

State-To-State Engagement

As the second tier of governance, states are urged to mobilise and organise with whole-of-state-and-society effort and deliberation towards a systematic, collective, and comprehensive formulation of steps and demands to realise fair, effective, and efficient state-federal relations. This includes the formation of a national-level inter-state body that engages on state-federal issues with the federal government, whether this means peninsular states coming together with Sabah and Sarawak as separate entities, or as a Malaysia-wide body of states.

The immediate question that arises is: what are the common denominators on which states will agree? However such a question is tackled and answered, every state party deciding to be part of such a project should be incentivised and motivated to (i) systematically bring about greater decentralisation and (ii) normalise decentralisation norms and policies.

In view of pending state elections – Sabah in 2025, Sarawak and Melaka in 2026 – and the 16th General Election slated before February 2028, all quarters should bear in mind that decentralisation is in the interests of the efficiency of state as well as federal-level governance and that they should work together for a more collaborative and cooperative federalism. No ruling party knows whether they will be in the federal or state government, or at all, or for how long, and this should incentivize them to be as impartial as possible in the discussions.

Internal state reflexivity

The point above overlaps and implicates the next, which is that an inter-state body aimed at bringing about greater efficiency and equity in state-federal relations necessarily involves each state taking decisive and systematic steps internally to assess its own capacity and capabilities and taking on more responsibilities in tandem with demanding more autonomy and resources from the federal government.

This includes each state taking efforts to measure its own performance before demanding functions and powers currently held by the federal government. As things stand, there are very limited measures to monitor state policy outcomes, and very limited examples of states prioritizing public accountability and transparency.

University of Nottingham-Malaysia’s Associate Professor Dr. Tricia Yeoh pointed out that the Government Service Efficiency Commitment Act 2025, passed in March 2025, provides the opportunity for states to prove they can, and should, take on greater rights and responsibilities.

In tandem with the greater fiscal, administrative, and policy autonomy, there is much room for states to build local capacity in anticipation of greater devolution of powers, functions, and responsibilities. States should already be formulating and developing, for example, their own paths towards policy autonomy and devolution as administrators and implementers of hitherto-federal policies. Among the possible avenues to raise revenues for this include such ideas as imposing ‘(traffic) congestion tax’, e-hailing surcharges, ‘vacant property tax’, and ‘land value tax’.

But how do we ensure tax-spending is delivering effective development outcomes for the state and the rakyat?

Part and parcel of this last point is the need to think through the question. As Think City managing director Dato’ Hamdan Abdul Majeed put it, ‘What works best at what level?’ Is it only about breaking down federal government functions and powers into smaller – regional, state, or district, for example – or are there functions and powers currently at or under the level of the states that should be scaled up to higher or larger dimensions?

Conclusion

Taking a step back, policy-makers who wish to see greater policy and fiscal decentralisation and devolution will find it productive to reflect and explore the motivations and intentions of those at the federal level. What might incentivise policy-makers and politicians with the federal ‘mindset’ to act for greater centralisation rather than in the other direction? Adopting such a stance might yield, for example, questions that may discomfort certain quarters but require answers. Are states ready, in the first place, to take on greater fiscal and other policy responsibilities? Unless states are ready to take on such questions, it would seem unlikely that those sitting in the inner circuits of responsibility and command of resources would surrender federal powers, functions, or responsibilities to any significant degree to the states.

As many of the participants at the Roundtable expressed, greater legitimacy, transparency, participative as well as representative democracy, and a sense of fairness and justice should not only be demanded but practised by all parties at all levels. Recounting political parties’ pledges to bring about local government elections during and previous to the 15th General Elections, veteran social activist and former academic Francis Loh said the endgame of all the talk about decentralisation and devolution is greater and deeper democracy, transparency, and equity.

Towards these ends, states should build up and normalise or mainstream decentralisation and devolution policies in their engagements with the larger public. More important is the exercise, reflection, and realisation of such aims and goals by those very quarters demanding their fulfilment by other parties.