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Malaysia: Selected Issues

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International Monetary Fund
Published Date:
September 1999
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V. Fiscal Policy in Malaysia: Issues and Challenges Ahead1

A. Introduction

1. Over the past three decades, fiscal policy in Malaysia has been guided mainly by the medium-term objectives set out in the country’s five-year development plans. As a result, annual budget plans have generally reflected the priorities of the medium-term development plans.2 The size and composition of expenditure and revenue has been geared toward the attainment of these medium-term objectives, and short-term demand management has typically played a relatively minor role.

2. During the 1990s, however, demand management has played an increasingly more active role in the conduct of fiscal policy. Beginning in 1992, the authorities adopted a tighter fiscal stance, partly in an effort to slow down domestic demand and prevent an overheating of the economy arising from a surge in capital inflows. A modest easing of demand pressures in 1996 provided room for a more relaxed fiscal policy, but renewed demand pressures in 1997 necessitated tighter fiscal management. Up to that point, fiscal management was facilitated by the relatively smooth and predictable environment of strong and stable growth.

3. The severe financial crisis that has affected Malaysia and the region since 1997 has posed new challenges for fiscal policy. Since mid-1998, the Malaysian authorities have sought to stem the decline in output by adopting a policy strategy designed to revive economic activity. To this end, the stance of fiscal policy shifted from being contractionary to being expansionary during 1998, reflecting a number of measures taken over the course of the year that aimed to achieve a federal government deficit of over 2½ percent of GDP, compared with a surplus of about 2½ percent of GDP in 1997 (Table V.1).

Table V.1.Malaysia: Summary of Federal Government Operations, 1997-99 1/(In percent of GDP, unless otherwise indicated)
1997Budget 2/Prel.BudgetIMF est.
19981999
Federal government
Revenue24.019.820.417.918.5
Expenditure and net lending21.422.421.923.422.3
Overall balance2.6-2.6-1.5-5.5-3.8
Off-budget spending1.10.41.81.6
Overall balance (including off-budget spending) 3/-3.7-1.8-7.3-5.4
Memorandum items:
Fiscal impulse 4/5/-155.03.64.12.6
Structural impulse 6/-1.65.03.84.12.2
Adjusted structural impulse 7/
Federal government-1.34.62.90.9-0.1
Revenue impulse-2.43.32.8-0.2-0.8
Expenditure impulse1.11.20.11.10.7
Off-budget spending1.51.3
Adjusted structural impulse (including off-budget spending) 7/2.41.2
Sources: Information provided by the Malaysian authorities; and Fund staff estimates and projections.

Figures are presented in the IMF format.

Refers to revised budget plans announced in July 1998.

The figures exaggerate the overall balance because they do not net out federal government contributions to off-budget projects.

The fiscal impulse is a measure of the overall cyclical impact of the budget. It is calculated as the first difference of the fiscal stance. The fiscal stance is the gap between the actual federal government balance and the cyclically-neutral balance. The latter is calculated assuming that neutral revenue grows in line with actual GDP and that expenditure grows in line with potential GDP. The base year, in which actual and potential GDP are assumed to be equal, is 1993.

While the fiscal impulse measure shows indeed a sizeable positive contribution of the 1999 federal government budget on the growth of aggregate demand, it would nonetheless be inappropriate to use this measure to assess discretionary fiscal policy in 1999. The measure loses its precision when there are large swings in output or when the widening of the fiscal deficit reflects to a significant extent the impact of automatic stabilizers. First, fiscal impulse calculations rely on estimates of potential output. Such estimates become very unreliable in periods of sharp swings in output, such as in 1998–99. Second, by design, the fiscal impulse measure treats automatic stabilizers as discretionary fiscal policy. This reduces the reliability of the measure when large changes in output increase the contribution of automatic stabilizers–weak as they may be–on the budget, as it has been the case in 1998 and 1999.

Defined as the (negative) difference in the structural balance. The structural balance is the difference between a “full employment budget” and the fiscal stance. The structural impulse adjusts for the effects of automatic stabilizers, and is thus a measure of the effects of discretionary fiscal policy rather than the overall cyclical impact of the budget. However, the measure is subject to the same limitations as the fiscal impulse measure.

The adjusted structural impulse improves upon the structural impulse by separating, to the extend possible, discretionary from nondiscretionary measures. The revenue impulse is based on estimates of the net revenue impact of new tax measures in the budget. The expenditure impulse is based on total expenditures after netting out interest payments.

Sources: Information provided by the Malaysian authorities; and Fund staff estimates and projections.

Figures are presented in the IMF format.

Refers to revised budget plans announced in July 1998.

The figures exaggerate the overall balance because they do not net out federal government contributions to off-budget projects.

The fiscal impulse is a measure of the overall cyclical impact of the budget. It is calculated as the first difference of the fiscal stance. The fiscal stance is the gap between the actual federal government balance and the cyclically-neutral balance. The latter is calculated assuming that neutral revenue grows in line with actual GDP and that expenditure grows in line with potential GDP. The base year, in which actual and potential GDP are assumed to be equal, is 1993.

While the fiscal impulse measure shows indeed a sizeable positive contribution of the 1999 federal government budget on the growth of aggregate demand, it would nonetheless be inappropriate to use this measure to assess discretionary fiscal policy in 1999. The measure loses its precision when there are large swings in output or when the widening of the fiscal deficit reflects to a significant extent the impact of automatic stabilizers. First, fiscal impulse calculations rely on estimates of potential output. Such estimates become very unreliable in periods of sharp swings in output, such as in 1998–99. Second, by design, the fiscal impulse measure treats automatic stabilizers as discretionary fiscal policy. This reduces the reliability of the measure when large changes in output increase the contribution of automatic stabilizers–weak as they may be–on the budget, as it has been the case in 1998 and 1999.

Defined as the (negative) difference in the structural balance. The structural balance is the difference between a “full employment budget” and the fiscal stance. The structural impulse adjusts for the effects of automatic stabilizers, and is thus a measure of the effects of discretionary fiscal policy rather than the overall cyclical impact of the budget. However, the measure is subject to the same limitations as the fiscal impulse measure.

The adjusted structural impulse improves upon the structural impulse by separating, to the extend possible, discretionary from nondiscretionary measures. The revenue impulse is based on estimates of the net revenue impact of new tax measures in the budget. The expenditure impulse is based on total expenditures after netting out interest payments.

4. Despite stepped up expenditures since 1998, the contribution of fiscal management to short-term policy objectives has been smaller than planned. The deficit of the federal government in 1998 was only 1½ percent of GDP—about half the target—reflecting higher-than-anticipated collection of direct taxes and delays in project implementation. The 1999 federal government budget targets a deficit of 5½ percent of GDP in an effort to provide a further stimulus. However, the actual stimulus could turn out to be smaller than planned, as a number of institutional and operational factors constrain the use of fiscal policy to pursue effectively the authorities’ stabilization objectives.

5. This chapter draws lessons from the recent experience and proposes a number of measures that would help to enhance the flexibility of fiscal management in the future. First, it analyzes factors that constrain the use of fiscal policy for stabilization purposes. Second, it discusses an agenda for fiscal reforms. The analysis points to the existence of rigidities in both the structure of public finances and the way fiscal management has been exercised as the principal reasons behind the relative ineffectiveness of stabilization efforts.

6. The remainder of the chapter is organized as follows. Section B puts fiscal policy in Malaysia in a broader perspective by presenting a brief description of the structure of the nonfinancial public sector. Section C discusses the main principles guiding the formulation and conduct of fiscal policy. Section D reviews recent developments in federal government finances against the background of the short-term objectives of fiscal policy. Section E evaluates the performance of fiscal policy in 1998–99, partly on the basis of summary quantitative indicators. Section F suggests an agenda for reform.

B. Structure of the Nonfinancial Public Sector

7. The Federation of Malaysia comprises the federal government, 13 state governments and two federal territories, and 148 local governments. The nonfinancial public sector covers the federal government, state and local governments, statutory bodies, and NFPEs.

8. The division of powers between the various layers of government is defined in the federal constitution. Malaysia’s federal arrangements give the federal government revenue-raising power over most important taxes, and the states expenditure responsibilities in a number of areas, including basic infrastructure (such as water supply), land and mines, and local governments.3 As a result, the federal government undertakes about three-fifths of general government expenditure but collects over four-fifths of general government revenue. Given this imbalance, the constitution provides for intergovernmental transfers (grants) to bridge the gap between states’ revenues and expenditures. In addition, the federal government provides loans—often on soft terms—to state governments to help them finance their development spending.

9. The federal government’s main functions are undertaken through 14 key ministries—heading a number of operational units, called departments—and a number of statutory bodies. Central to the formulation and implementation of the government’s development policy is the Economic Planning Unit, the planning arm of the federal government. Each state, led by the chief minister, has its own constitution and legislature that legislates on matters not reserved for the federal government. Each state has its own planning unit. Nearly three-quarters of states’ own revenue is derived from nontax sources. Local governments have a narrow range of responsibilities, mainly in the provision of basic civic services. State governments can exercise a considerable degree of influence on local finances, including through control over state government transfers. In addition to these transfers, local governments finance their operations with federal government transfers, local tax and nontax revenue, and the sale of assets. Among these three layers of government, only the federal government can borrow from external sources.

10. Statutory bodies comprise any corporate body that is established by federal and state laws to carry out government tasks. There are 58 statutory bodies in the federal government. NFPEs are productive entities in which the government holds at least 50 percent of equity, either directly or indirectly through other public entities. Subsidiary companies of NFPEs are also classified as NFPEs.4 NFPEs operate on a commercial basis outside the federal government budget, and are principally involved in the sale of industrial and commercial goods and services. NFPEs are allowed to borrow from foreign sources; however, they enjoy no special privileges on domestic borrowing. Until the mid-1980s, NFPEs played a major role in the pursuit of government objectives. Following the privatization policy adopted in the mid-1980s and the emphasis on enhancing the role of the private sector, the remaining NFPEs have increasingly been operating along commercial principles.

11. The federal government is primarily responsible for implementing fiscal stabilization policies in Malaysia. States governments have a relatively narrowly-defined range of responsibilities, primarily in the provision of essential services, and a small and inelastic revenue base. Consequently, their ability to contribute to stabilization objectives is rather limited, as reflected in the relatively small share of their revenue and expenditure to total general government revenue and expenditure (Table V.2). With local governments and statutory bodies having an even smaller share, and with NFPEs operating largely on commercial principles, the federal government accounts for most of the impact of the public sector on the economy (Chart V.1).5

Table V.2.Malaysia: General Government Operations, 1990-99 1/2/(In percent of GDP)
Budget 3/Prel.Budget
199019951996199719981999
Total revenue and grants32.828.628.828.725.125.423.0
Of which:
Federal government25.023.423.724.019.820.417.9
State governments4.63.13.22.92.72.42.2
Total expenditure and net lending35.226.326.825.327.126.527.8
Total current expenditure 4/26.519.520.618.819.218.520.1
Of which:
Federal government19.115.216.314.814.914.315.7
State governments3.51.81.81.61.31.21.4
Total direct development expenditure 4/10.07.36.06.47.47.67.7
Of which:
Federal government5.64.33.43.84.64.95.5
State governments2.61.71.41.41.51.51.0
Net lending 5/-1.3-0.50.20.10.50.40.0
Overall balance-2.42.32.03.5-2.0-1.1-4.8
Financing2.4-2.3-2.0-3.52.01.14.8
External-0.8-0.9-0.9-0.60.70.7-0.1
Domestic (including change in assets)3.2-1.4-1.1-2.81.40.44.9
Source: Data provided by the Malaysian authorities.

Includes federal, state, and local governments, and the statutory bodies.

Figures are presented in the IMF format.

Refers to revised budget plans announced in July 1998.

Net of transfers.

Including adjustments for accounts payable.

Source: Data provided by the Malaysian authorities.

Includes federal, state, and local governments, and the statutory bodies.

Figures are presented in the IMF format.

Refers to revised budget plans announced in July 1998.

Net of transfers.

Including adjustments for accounts payable.

CHART V.1MALAYSIA: PUBLIC SECTOR ACCOUNTS, 1994–99 1/

(In percent of GDP)

Sources: Data provided by the Malaysian authorities; and Fund staff estimates.

1/ The consolidated public sector comprises the operations of the federal government, state and local governments, statutory bodies, and nonfinancial public enterprises (NFPEs).

2/ Staff estimates. They exclude domestic debt of the NFPEs.

12. The measured size of the nonfinancial public sector in Malaysia understates the true impact of government on the economy owing to widespread use of off-budget activities, most notably in infrastructure projects.6 Following the drive for privatization of NFPEs undertaken between the mid-1980s and mid-1990s, the government’s approach has shifted from outright privatization of enterprises to privatization of projects. Privatized projects remain in most cases part of the government’s development plan, but the degree of government control over their financing and implementation is rather weak. Financing for these projects is provided to a significant extent from private sources on commercial principles, thereby imparting an element of financial discipline. A sizeable component of the government’s investment program is carried out off-budget (see Table V.1). While privatization of projects has transferred a major portion of expenditure—particularly for infrastructure—to the private sector, the costs to the government have not been eliminated; tax concessions, government participation, and the provision of loans at favorable terms have continued to impact public finances.

C. Principles Guiding the Formulation and Implementation of Fiscal Policy

13. Malaysia’s public finances operate on the distinction between operating (recurrent) and development (capital) budget. Against the backdrop of unsustainable fiscal expansion in the early 1980s, the principal objective of fiscal management in recent years has been the promotion of macroeconomic stability and growth. To this end, the availability of revenue determines the size of the operating budget, and the capacity to raise non-inflationary financing guides the size of the development budget. A strong culture of underestimating revenues has also served to reinforce prudence; the result has been a consistent record of more-favorable-than-planned overall balances (Chart V.2).

CHART V.2MALAYSIA: FEDERAL GOVERNMENT REVENUE, EXPENDITURE, AND OVERALL BALANCE 1990–98 1/

(In percent of GDP)

Source: Data provided by the Malaysian authorities.

1/ Data are in the authorities’ format.

14. Two main principles have guided budget formulation and the conduct of fiscal policy in recent years: the preservation of an operating surplus, and fiscal sustainability.

  • The authorities regard the preservation of an operating surplus as an essential mechanism for providing fiscal discipline, and have, to the extent possible, committed to adhering to the rule at all times. The rule serves the underlying objective that government development spending be financed partly by government savings. Coupled with the practice of underestimating revenues, the rule has helped the authorities to contain current spending.
  • Fiscal sustainability has become a principal consideration in the formulation of fiscal policy since the mid-1980s when adjustment efforts succeeded in putting the economy on a more favorable debt path. The authorities have since been more mindful of the implications of annual budgets for fiscal sustainability, and have refrained from unsustainable expansions in fiscal policy. While this principle does not translate to a strict operational rule, it nonetheless guides fiscal management in Malaysia.

15. Reflecting the disciplined application of these prudential principles in recent years, the authorities have managed to maintain tight budgetary control despite constraints imposed by the complex institutional framework. Notwithstanding the variety of objectives pursued by the federal government, the multiple layers of government, and the existence of off-budgetary operations which complicate fiscal management, the authorities had until recently been able to build up substantial head room from the prudent exercise of fiscal policy over the past several years. This achievement is attributable to a broad consensus on fiscal conservatism, and has limited fiscal deficits, financing requirements, and government debt (see Chart V.1).

D. Recent Developments in Federal Government Finances

16. Fiscal policy shifted from a contractionary to an expansionary stance during 1998. The federal government budget for 1998 aimed to increase the fiscal surplus to 3 percent of GDP from an anticipated surplus of 2 percent of GDP in 1997.7 Against the backdrop of a rapidly deteriorating external environment and much-weaker-than-anticipated economic activity, the government announced two mid-year policy packages designed to revive economic activity through spending on development projects, including infrastructure. The revised federal government budget aimed for a fiscal deficit of 2½ percent of GDP in 1998, compared with an actual surplus of over 2½ percent of GDP in the previous year.

17. Despite stepped up development expenditures during 1998, the boost to demand was smaller than planned. In the event, the federal government budget recorded a deficit of 1½ percent of GDP, reflecting higher-than-expected direct tax revenues and delays in project implementation. Two main factors accounted for the lower-than-planned fiscal deficit in 1998:

  • The relative lack of automatic stabilizers— in both the tax and expenditure systems—did not allow for a full fiscal response to the sharp fall in economic activity, as evidenced by continued growth in direct tax revenues in 1998.8
  • The reliance on infrastructure projects to kick-start the economy. Considerable lags in commencing spending on projects prevented the government from achieving its spending targets, both on- and off-budget.

18. The 1999 budget aims to revive economic activity by providing a strong fiscal stimulus. The budget provides for a widening of the federal government deficit from 1½ percent of GDP in 1998 to 5½ percent of GDP in 1999, implying a fiscal impulse of 4 percent of GDP. In addition, the stimulus will be supplemented by significant increases in off-budget spending (see Table V.1).

E. Assessing the Stance of Fiscal Policy in 1998–99

19. The widening of the budget deficit in 1999 is not necessarily an indication of a more proactive fiscal policy, without considering discretionary policy measures. Part of the increase in the budget deficit is discretionary, and part of it reflects primarily a decline in direct tax revenues.9 Excluding the effect of direct tax collections, the increase in the federal government deficit in 1999 would have been much smaller than in the budget. In fact, it is argued below that only a small part of the increase in the budget deficit reflects discretionary policy measures.10

20. Excluding off-budget spending, it appears that the 1999 budget is not as proactive as intended.11 Discretionary tax measures have in fact been contractionary. The new tax measures included in the budget are expected to mobilize RM 0.5 billion (¼ percent of GDP) in additional net revenue. With discretionary revenue measures making a small negative contribution to fiscal stimulus, the discretionary stimulus is to come mainly from discretionary expenditure increases.

21. Expenditure measures in the budget provide for a modest stimulus of just over 1 percent of GDP.12 When the budget was formulated in 1998, total expenditures were targeted to decline by 1½ percent over the anticipated outturn. With expenditures falling short of the target in 1998, spending plans for 1999 now appear more expansionary. Nonetheless, the increase in non-interest expenditures in 1999 remains relatively small (5 percent over the 1997 outturn). Considering revenues and expenditures together, the discretionary measures in the 1999 budget seem to provide for a small stimulus of about 1 percent of GDP.

22. The budget outturn in 1999 is likely to involve a lower-than-planned fiscal deficit, implying that discretionary fiscal policy will be broadly neutral in its impact on aggregate demand. Despite efforts to step-up project implementation, it is likely that development spending will fall short of budget targets, implying virtually no discretionary stimulus; indeed, development spending in the first quarter of 1999 was 29 percent below its level in the same quarter of 1998. Moreover, tax revenue projections in the budget—especially for direct tax revenues—appear to be conservative.

23. The bulk of the discretionary fiscal stimulus is designed to come from off-budget spending. Spending on off-budget projects is targeted to accelerate from RM 1 billion in 1998 to over RM 5 billion in 1999, implying a net contribution to aggregate demand growth of around 1½ percent of GDP. However, difficulties in project identification, implementation, and financing could put obstacles in the way of delivering the planned stimulus.

F. Agenda for Reform

24. Prudent fiscal policies during the 1990s have enabled the authorities to create substantial head room in terms of debt dynamics. While fiscal prudence may have served the authorities well during most of the 1990s when output growth was maintained at high and relatively stable rates, the recent severe downturn has pointed to a number of rigidities in fiscal management.

25. Looking forward, the effectiveness of fiscal policy could be enhanced by strengthening the role of the budget as an automatic stabilizer, and by formulating and implementing the budget more flexibly. Measures could include the following:

  • Addressing short-term demand problems by relying on fiscal measures that could have a more immediate impact on the economy. Infrastructure projects enhance the country’s growth potential and have high multiplier effects; indeed they have been an integral part of Malaysia’s development strategy. However, there are faster and more effective means available to deliver a required fiscal stimulus. First, operating expenditures have a more immediate impact on aggregate demand. For example, transfers to state and local governments are effective means of providing stimulus, since state and local governments are usually in a better position to identify and start small spending programs. Second, expansion of development spending programs that are already in place could have an immediate effect. For example, expanding the scope of ongoing small-scale spending programs—such as small rural and housing projects—and providing additional funds for the social sectors would involve reasonably short lags.
  • Exercising fiscal policy more flexibly in times of crisis. The head room created in the past was not fully exhausted over the past year. Adherence to rigid implementation rules—such as the requirement that revenues cover operating expenditures—in times of severe economic crisis may in fact be destabilizing, since strict application of the rule implies cuts in operating expenditures during economic downturns. The authorities could aim to balance the operating budget over the course of the economic cycle instead of each year.
  • Building more automatic stabilizers in Malaysia’s budget, on both the revenue and expenditure sides. On the revenue side, the introduction of the VAT could help, provided that it is broad-based and replaces existing taxes that have widespread exemptions.13 Further efforts could include steps to reduce tax exemptions and expand the base of the tax system. On the expenditure side, strengthening Malaysia’s social safety net would not only provide a larger cushion for the most vulnerable segments of the population, but should also increase the stabilizing role of the budget. For instance, the bulk of Malaysia’s safety net structure has not been responsive to changes in economic activity because it is based mostly on social rather than economic criteria.
  • Integrating off-budget activities into the authorities’ overall budgetary planning to improve the transparency and effectiveness of fiscal operations. This would also make clearer the financing implications, as many of these projects compete with the government for financing while, at the same time, the government may be co-financing the projects. The provision of financing to off-budget activities based largely on commercial principles serves as a good prudential measure. However, it diminishes the effectiveness of fiscal policy, since control over major policy initiatives is largely in the hands of the private sector. This is particularly important in the current circumstances when the thrust of the discretionary fiscal stimulus has been planned to come from off-budget spending.
References

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1

This chapter was prepared by Dimitri Tzanninis (ext. 34114) who is available to answer questions.

2

The early 1980s were a notable exception, as demand management became the principal task of fiscal policy. The authorities sought by adopting expansionary fiscal policies to insulate the economy from what was perceived as temporary adverse developments in the external environment. In mid-1982, when it become evident that the deterioration in the external environment was permanent and that the domestic and external imbalances were becoming unsustainable, the authorities embarked on a course of fiscal consolidation.

3

The main taxes assigned to the federal government include taxes on corporate and personal income, excise and customs duties, and petroleum taxes. The main revenue sources assigned to the states include agricultural and urban land, mining, forestry, drainage, and irrigation.

4

The number of NFPEs declined from 56 in the mid-1980s to 28 currently, reflecting company restructuring and partial or full privatization.

5

Nonetheless, the federal government is relatively small in relation to GDP, even though it pursues a wide range of objectives. The objectives have generally been met by shifting the composition of expenditure, rather than increasing the overall size.

6

A broader coverage of the public sector to include off-budget activities would better capture the true impact of government operations on the economy. However, information on off-budget activities is limited.

7

Developments in federal government finances are discussed in detail in Chapter II of the accompanying Recent Economic Developments.

8

Income tax due (both for individuals and corporations) is based on income generated during the preceding year. With strong growth in 1997, direct tax collections rose by about 5 percent in 1998.

9

Direct tax collections are projected to decline by about RM 10 billion (3¼ percent of GDP) in 1999, reflecting the fact that tax collections will be based on income generated in 1998.

10

Changes in the budget balance tend to be poor indicators of the cyclical impact of fiscal policy, because certain revenue and expenditure categories are affected by cyclical conditions; thus it is not always clear whether such changes are the cause or the result of economic fluctuations.

11

The assessment is based on the identifiable discretionary measures in the budget. However, it is difficult to measure the exact fiscal stimulus in 1999, given that the part of the planned stimulus relating to infrastructure projects will carry over into 2000 and beyond. The task is further complicated by the pattern exhibited by direct tax revenues in 1998–99 owing to their dependence on the previous year’s income. This pattern distorts the operation of automatic stabilizers on the revenue side and further complicates assessment.

12

In assessing the impact of discretionary measures, the Fund staff traditionally relies on quantitative indicators that attempt to separate the impact of the economic cycle on the budget from the impact of discretionary policies. Such indicators include the structural impulse, which aims to capture the contribution of discretionary fiscal policy on the growth of aggregate demand. Calculations of the stimulus arising from discretionary measures are based on an adjusted structural impulse, which is described in Table V.1 and its footnotes.

13

The announced shift in the tax assessment year for the income tax from the previous year to the current year beginning in 2000 will also enhance the role of the budget as an automatic stabilizer.

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