This article first appeared in The Edge Malaysia Weekly on December 24, 2018 - December 30, 2018

THE expanding middle class expects better public services and the government would be in a better position to deliver them if it had broader income base. This is among the long-standing structural issues that experts say the new Pakatan Harapan government would need to address to have better fiscal flexibilities.

“Malaysia has recorded one of the steepest revenue [in proportion to GDP] declines over recent years. This limits the government’s scope to respond to future shocks and to provide the public services that Malaysia’s expanding middle class will increasingly expect from the state,” the World Bank said in its biannual Malaysia Economic Monitor released on Dec 18.

“Relative to international comparators, Malaysia is projected to record one of the lowest levels of fiscal revenue in proportion to GDP in 2019, well below the average for middle-income (27.5% of GDP) and advanced economies (36.2% of GDP),” it added.

According to the development bank, Malaysia’s general government revenue — which includes federal, state, local government and statutory bodies — “has declined steadily since reaching a peak of 25.8% in 2012” to an estimated 19.3% this year. The forecasted 18% for 2019 (excluding Petronas), which is almost a third lower than 2012’s, showed marked reduction across oil-based incomes and non-oil direct and indirect taxes over the last seven years.

The federal government’s portion alone fell from 21.4% in 2012 to 16.2% this year. Next year, it is projected to slide to 15.1%, excluding the RM30 billion special dividend from Petroliam Nasional Bhd (Petronas) that goes to fund the RM37 billion outstanding tax refunds the previous government owes to individuals and businesses.

“This will limit the scope of government intervention in [terms of] fiscal policy to respond in the event of economic shocks,” says World Bank’s country economist Shakira Teh Sharifuddin.

It is worth noting that global oil prices were well above US$100 a barrel and the ringgit was stronger versus the greenback in the “peak” year of 2012 used for comparison. The excess tax refunds of RM3.9 billion in 2018 and RM37 billion in 2019 also imply an overstatement of the previous federal government’s revenue.

Still, the concern here is that the government would be constrained in its capacity to sustain the provision of vital public services, as well as have limited capacity to facilitate redistribution through taxes and transfers.

In the near term, the government has said it plans to achieve fiscal consolidation through rigorous expenditure rationalisation. Government expenditure (excluding one-off tax refunds) is projected to decline to 18.1% of GDP in 2019 from 20.3% this year. Notwithstanding the planned spending rationalisation, the World Bank noted that “expenditure on civil service salaries and pensions has continued to dominate public spending”, with the share projected to increase further to 39.1% in 2019 from 36.9% in this year.

Low tax base a structural issue

When asked about the World Bank’s observation, economists point to long-standing structural issues of the relatively small tax base and the need to further diversify revenue sources.

“It is one of Malaysia’s structural problems, attributable to a lower tax base and high reliance on non-tax revenue from government-linked companies,” says Sunway University Business School economics professor Dr Yeah Kim Leng.

While federal government revenue in absolute terms had been inching up year on year, revenue buoyancy underwhelmed, notes Socio-economic Research Centre (SERC) executive director Lee Heng Guie.

“Revenue buoyancy, which is the responsiveness of tax revenue to GDP growth, declined from 2.1% in 2011 to just 0.5% in 2017,” Lee tells The Edge.

Between 2000 and 2009, federal revenue surpassed economic growth at a rate of 9.9% per annum. “But between 2010 and 2017, revenue grew at 4.1%, lagging behind GDP growth,” Lee says, noting how contribution from direct taxes had been on the decline, particularly petroleum income taxes with oil prices nowhere near their heyday prior to the plunge in late 2014.

Unlike indirect taxes — which include excise duties and consumption-based taxes such as the Sales and Services Tax (SST) — direct taxes are usually much more sensitive to economic performance, says Affin Hwang Capital chief economist and head of research Alan Tan.

Although the introduction of the Goods and Services Tax (GST) helped boost the government’s coffers between 2015 and 2017, it was not enough to stem the steady decline in revenue to GDP.
 

Measures to boost revenue buoyancy needed

The economists concur with the World Bank that Budget 2019’s measures and the establishment of a Tax Reform Committee are steps in the right direction.

“For instance, the government is looking into cross-border taxes and greater opportunities for indirect tax,” says SERC’s Lee, who also notes the need to broaden the scope of indirect taxes, such as the recently introduced SST.

“A good tax system should be fair and aim for an overall lower tax burden,” Lee says, pointing out that Malaysia’s tax burden of 14.3% is relatively high compared with other countries in the region, namely Singapore (14.2%), Hong Kong (13%), Taiwan (13%) and Indonesia (12%).

“Trying to lower the tax burden does not mean nobody will pay tax. But we don’t want to disincentivise employees or corporations by setting too high a [direct] tax rate,” he says.

The government can also consider boosting non-revenue income and receipts, such as dividends, apart from those currently received by Petronas, Lee says.

In its report, the World Bank recommended broadening the tax base, strengthening tax administration and compliance, as well as reducing unproductive tax deductions and incentives. 

“Some of these [deductions and incentives] are actually foregone tax revenues. Research shows that four out of five firms would come to Malaysia regardless of the incentives,” country economist Shakira shares.

Affin Hwang’s Tan, meanwhile, believes that there are enough measures in Budget 2019 to support economic growth and, as a result, federal income.

“As long as GDP growth holds above 4.5%, government revenue should remain substantial (enough to cover operating expenditure),” he says. Tan, who is keeping an eye on oil prices, expects GDP to grow 4.9% next year, thus continuing to support government revenue, of which 30.9% is projected to be oil-related (including Petronas’ special dividend). If the RM30 billion special Petronas dividend were excluded, oil-related revenue is expected to fall to 19.5% next year from 21.7% this year.

Another way to lessen the risks associated with declining government revenue is for the government to cut expenditure, particularly in the areas of civil service salaries and pension outlays, as well as untargeted subsidies, the World Bank says.

Yeah concurs, pointing to the need for effective government spending, especially development expenditure. “Over the next one to two years, the key imperative is to look at spending levels and spending efficiency,” he says.

Yet, the short-term fiscal consolidation efforts should not be seen as a solution to the declining revenue-to-GDP ratio, the World Bank says. “Raising adequate resources to finance the needs of Malaysia’s expanding middle class (including through the improved provision of basic public services, among others) will become an increasingly important priority.”

That said, economists reckon that the federal government can still build confidence if it maintains economic growth without relying heavily on federal expenditure.

“Lower government revenue is not necessarily a constraint to growth if the private sector can be catalysed (as the driving force),” Yeah says. “That could be more sustainable in the long run instead of needing to rely on government revenue.” 
 

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