From Fiscal Redistribution to Devolution of Power: Lessons from Elsewhere and Possible Pathways Forward

Malaysia’s federal system remains one of the most centralised in the world, with nearly 95% of national tax revenue retained at the federal level. States are left dependent on discretionary transfers that are opaque, short-term, and rarely tied to performance. This not only restricts fiscal autonomy but also stifles innovation and undermines long-term planning. Many states now face rising financial stress, with debts collectively amounting to billions of Ringgit, while the reliance on annual allocations weakens both efficiency in resource use and efficacy in meeting the diverse needs of Malaysia’s states.

International examples from Federal nations highlight the benefits of a different approach. In India, independent Finance Commissions have created transparent, performance-linked transfer systems while the Inter-State Council provides a standing platform for negotiation. Mexico’s decentralisation reforms improved service delivery and democratic accountability, giving the National Conference of Governors a strong role in shaping national priorities. Brazil’s model, meanwhile, combines significant state-level tax powers with the coordinating role of the Nacional Council for Fiscal Policy (CONFAZ), ensuring local fiscal incentives are balanced with equity. Together, these cases illustrate the importance of subsidiarity, where responsibilities are devolved to the level of government best positioned to deliver effectively.

For Malaysia, and particularly for Penang, this report suggests reform requires movement on four fronts at once. First, greater transparency is needed—publishing funding formulas and allocations, linking transfers to Malaysia Plans, and embedding performance monitoring would build accountability and trust. Second, modernising tax instruments such as the Capitation Grant, THAP, and the Ecological Fiscal Transfer would ensure that transfers reflect real costs, address inequities, and create stronger incentives for growth. Third, states must be given more scope to raise their own revenues, whether through targeted levies, tourism and congestion charges, or new development finance mechanisms, enabling them to expand fiscal space and mobilise private investment. Finally, movement towards a more co-operative federalism would see federal ministries work in structured partnerships with states on areas such as education, health, digital inclusion, agriculture, climate resilience, and welfare, aligning national funding and building local delivery capacity to maximise both efficiency and efficacy.

Reform along these lines would shift the state-federal relationship from one based on dependency to one of partnership. For the federal government, this offers improved efficiency in resource use, stronger legitimacy, and more sustainable outcomes given the challenges we face. For states like Penang, it opens the space to pioneer innovation in climate-smart governance, digital transformation, and inclusive growth. By embedding subsidiarity and cooperation at the heart of fiscal federalism, Malaysia can move beyond the middle-income trap and build a federation that is more equitable, resilient, and responsive to its citizens.