Market preserving federalism: implications for Malaysia

In the Malaysian federal system, the central government is in a dominant position and the states depend heavily on fiscal transfers from the centre to meet their budgetary needs. This model of fiscal federalism is widely regarded to have a negative impact on states‘ fiscal performance, in turn, affecting the overall performance of the economy. Having experienced three decades of rapid growth, Malaysian economic growth has been sluggish since the Asian financial crisis of 1997, and there is a widely shared view that the country needs a radical change in its economic development strategy in order to break out of the middle income trap. The National Economic Action Council of Malaysia has also been critical of the previous growth model for being inadequate for meeting this challenge, and the government‘s New Economic Model (NEM) aims at developing a system of governance that empowers the private sector for broad-based inclusive development. In this context, the aim of this thesis is to explore whether new insights gained from the latest model of federalism – the Market Preserving Federalism (MPF) – can be applied in Malaysia for reforming intergovernmental fiscal relations and for improving both national and regional economic growth potential. The concept of market preserving federalism (MPF) proposes a form of fiscal federalism with decentralised governance that functions on market-based principles, hard budget constraints, and fiscal accountability. The thesis investigates how the current model of fiscal decentralisation in Malaysia can be improved to support a market-based economy. Using econometric analysis of public finance data for two decades (1990-2009), the thesis evaluates the four critical attributes of Malaysian federalism, namely fiscal decentralisation, subnational competition, efficiency of public finances, and equity of outcomes by analysing the relationships between fiscal decentralisation and governmental incentives for revenue raising, public expenditure, and debt financing. In particular, the thesis analyses the nature of incentive structures generated by the current soft budget constraints faced by subnational governments and their effects on regional and national economic performance. Policy implications are drawn for reforming the current federal framework in order to foster business investment and inclusive economic development in Malaysia