Fiscal Sustainability of Malaysian State Governments under a Centralized Fiscal Federalism System: Evidence from Second-Generation Panel Data Analysis

Abstract

This study examines the fiscal sustainability of Malaysian state governments within a highly centralized system. Using annual data from 13 states between 2004 and 2023, we analyze whether state expenditures are structurally supported by their own revenues and federal transfers. Methodologically, we apply second-generation panel econometric tests to handle cross-sectional dependency. The diagnostics show that all fiscal variables are stationary at levels, meaning standard panel cointegration tests are not appropriate for this empirical setting. The empirical results show that own-source revenues do not provide sufficient support for long-run fiscal sustainability at the state level. However, when federal transfers are included, the long-run fiscal synchronization parameters improve significantly. This partial adjustment indicates weak fiscal sustainability, suggesting that federal transfers play a critical stabilizing role in supporting state fiscal adjustment. State-level analysis also reveals high heterogeneity: developed states with stronger economic and revenue bases demonstrate greater fiscal resilience, while fiscally weaker states remain more dependent on federal transfers. From a policy perspective, these findings highlight the need for a more transparent and rules-based fiscal transfer framework.