Malaysia’s Budget 2027: The Growing Divide in Federal-State Fiscal Transfers

Prime Minister Anwar Ibrahim has tabled the largest-ever federal budget at MYR510 billion, which is likely to be his final annual budget ahead of the 16th General Election (GE16). Despite fiscal challenges, this budget has provided substantial allocations to Sabah and Sarawak given their increased political weight. While these are beneficial to states, the process through which such decisions are reached ought to be more transparent, in order for fiscal transfers to be predictable and rules-based, rather than ad hoc and based on political calculations.  

The fiscal challenges mainly stem from the rapid increase in oil prices due to the Middle East crisis. The nation’s oil subsidy bill ballooned from the originally projected MYR15 billion to MYR40 billion in 2026. As a result, the country faces an increased fiscal deficit of 3.6 per cent in 2026 (the target is for a lower 3.3 per cent in 2027) and projected debt service charges for 2027 at 16.2 per cent of revenue, above an internal 15 per cent threshold. The projected debt-to-GDP ratio for 2027, while lower compared to the expected number for 2026, stands at 63.7 per cent, still above statutory targets of 60 per cent. As a result, the government is increasingly relying on funding from government-linked investment companies (GLICs), federal statutory bodies and public-private partnerships (PPPs). This amounts to MYR50.2 billion in 2027, up from MYR30 billion in 2026.

In terms of overall operating grants and transfers to states, Budget 2027 will see an increase to MYR12.63 billion in 2027, representing a significant increase of almost 17 per cent compared to 2026. In previous years, the allocations have consistently risen (see Table 1), but at a lower range of 5 to 10 per cent.

Table 1. Heftier Transfers

Year	2024 (Actual)	2025 (Actual)	2026 (Expected)	2027 (Projected)
Federal-State Fiscal Transfers	9.415b	10.3b	10.8b	12.63b

As with previous years, there is an emphasis on development expenditure given to the six underdeveloped states of Kedah, Kelantan, Perlis, Terengganu, Sabah and Sarawak. Specific projects were mentioned, including tackling floods and clean water in Kelantan, a sewage treatment plant and sewerage network in Terengganu and infrastructure development in Perlis. Other development projects include tackling flash floods in Selangor and Melaka, traffic congestion in Johor, and development along the East Coast Railway Link (ECRL) in Pahang.

Yet Prime Minister Anwar is caught between narrowed fiscal space and states’ demands for a bigger slice of the pie. Thus, his speech was explicit in addressing state expectations, saying that equity means “not every state getting the same, but every state getting what is fair and reasonable”.

In response, Terengganu Chief Minister Ahmad Samsuri Mokhtar from the federal opposition Parti Islam SeMalaysia (PAS) argued that if the government accepts the importance of a transparent and justice-based formula in fiscal relations with Sabah and Sarawak, the same principle should be considered for the peninsular states. In Parliament, he proposed a fiscal equalisation framework that more comprehensively takes into account each state’s spending needs, ability to generate its own revenue, infrastructure gaps and cost of development and delivering public services. These considered should be implemented alongside a “formula with a clear periodic review mechanism and open reporting”. An IDEAS report has shown that the federal-state transfer system is only partially rules-based, highly unpredictable and constrained by limited transparency.

Yet Prime Minister Anwar is caught between narrowed fiscal space and states’ demands for a bigger slice of the pie.

Indeed, the highest percentage increments in Budget 2027’s federal-state transfers come in the form of special grants to Sabah and Sarawak, under Article 112D of the Federal Constitution. The grants to the two states have been raised three times since 2022 (to MYR125.6 million in 2022, MYR300 million in 2023-2024 and MYR600 million in 2025). This will be more than doubled to MYR1.5 billion for each of the two states in 2026 and 2027 (the figures were confirmed by the Ministry of Finance at a public event on 19 October). The MYR 1.5 billion represents a MYR 900 million increase from the budget allocations for 2026. They will be paid out by the end of this year, likely in view of Sarawak’s imminent election around the same time.

Figure 1. Collective Importance of Sabah and Sarawak

This substantial raise is related to ongoing negotiations with Sabah and Sarawak on the Malaysia Agreement 1963 (MA63). A 2025 landmark ruling decided that the Sabah state government is entitled to 40 per cent of the net revenue it contributes to federal coffers. The federal government is disputing parts of the ruling in the Court of Appeal. Apart from the special grants, an additional allocation of MYR3.3 billion to road projects is being given to both states in this budget.

The motivation behind greater support for the two states is apparent. Sabah and Sarawak collectively contribute 56 out of 222 parliamentary seats, or 25.3 per cent. The two states are demanding that this be raised to one-third of the seats, and the federal government has agreed to do so. Their political significance in supporting the formation of any federal government is evident: the United Malays National Organisation and Barisan Nasional are unlikely to contest alongside Pakatan Harapan (PH) in GE16. As a result, PH will need representatives from Sabah and Sarawak to secure a strong parliamentary majority.

While Sabah and Sarawak captured the lion’s share of boosted allocation, the federal government also expanded revenue-generating channels for all other states. The second-highest percentage increase in federal-state transfers comes in the form of a new policy shift by the federal government to disburse 100 per cent of collected tourism tax revenue directly to state governments. While this was an initiative for 2026 announced early this year, this is a significant reform, where previously only 50 per cent of tourism tax was returned to states.

Finally, the Ecological Fiscal Transfer (EFT), which is a grant to support states’ efforts to conserve their forests and biodiversity, has expanded from MYR 250 million in 2025 and 2026 to MYR 270 million in Budget 2027. This represents an 8 per cent increase. Previously, the EFT grew from MYR 150 million in 2023 to MYR 200 million in 2024.

Figure 2. Push for Biodiversity

While these two policy measures are positive as states stand to gain financially, ultimately Budget 2027 highlights that Malaysia’s intergovernmental fiscal relations remain transactional and highly discretionary. While Borneo’s historical rights are duly being recognised, other states in Peninsular Malaysia continue to rely on subjective definitions of what is “fair and reasonable”. This dependence on the federal government on a project-by-project basis is unsustainable, while focusing on Sabah and Sarawak without a more transparent, rules-based fiscal equalisation formula for the rest of the states may signal political expediency over fairness. Establishing an objective fiscal framework, managed by an independent fiscal commission, should be a priority for Putrajaya, aligned with the spirit of federalism that lies at the very foundations of Malaysia.

2026/298