Journal of Asian Economics 24 (2013) 147–157

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Journal of Asian Economics

Does financial system activity affect tax revenue in Malaysia? Bounds

testing and causality approach
Roshaiza Taha a,*, Sisira R.N. Colombage b, Svetlana Maslyuk b, Loganathan Nanthakumar a
a
Faculty of Management and Economics, Universiti Malaysia Terengganu, 21030 Kuala, Terengganu, Malaysia
b
School of Business and Economics Monash University Churchill, 3842 Victoria, Australia

A R T I C L E I N F O A B S T R A C T

Article history: We provide new empirical evidence on the relationship among direct tax revenue and
Received 17 April 2011 banking and non-banking activities in Malaysia’s financial system, utilising monthly data
Received in revised form 1 November 2012 for the period 1997–2008. The existence of the long run equilibrium relationship between
Accepted 1 November 2012 tax revenue and the financial system was investigated using the autoregressive
Available online 23 November 2012 distributive lag (ARDL) bounds testing approach to cointegration. We find a long-run
equilibrium relationship between the financial system and tax revenue in Malaysia. The
JEL classification: short-run dynamic relationship between direct tax revenue and financial system was
G15
investigated using the vector error correction model (VECM). The estimated ECTt1
H20
coefficient indicates a relatively fast speed of adjustment from short-run disequilibrium to
E62
long-run equilibrium. The Granger causality tests reveal unidirectional causality running
Keywords: from stock market towards direct tax revenue, indicating that an increase in stock market
Tax revenue activities is likely to improve the collection of direct tax revenue. Overall, we show that the
Banking sector impact of the financial system on direct tax revenue is more profound in the short run than
Bound testing in the long run.
Causality ß 2012 Elsevier Inc. All rights reserved.
Non-banking sector

1. Introduction

‘For a developing country such as Malaysia to progress well, the combination of a strong financial system and solid fiscal
policy is necessary to promote economic growth. Despite the importance of these measures and voluminous literature on the
topic, understanding of the relationship between the financial system and fiscal policy as well as their joint impact on economic
growth is far from complete. Although it is generally accepted that this relationship exists in developed countries (Akitoby &
Stratmann, 2008; Arin, Mamun, & Purushothman, 2009), studies do not agree on the direction of the causality or provide very
little insight into the particular fiscal policy tools that could help a government to achieve a desired financial market response
(Ardagna, 2009; Darrat, 1988, 1990; Laopodis, 2009). This is important because fiscal policy tools, especially taxation
arrangements, may have an impact on both the competitiveness of a country’s financial markets and banking and non-banking
institutions operating in those markets. Moreover, in developing countries this relationship needs to be investigated, and the
evidence of either no or negative causality between financial markets and taxation (e.g. a financial market does not contribute to
taxation revenue) should be used to raise additional questions as to why these findings have occurred.
In addition, the causal effect of specific financial variables on a taxation system seems to be an under-investigated area,
since previous studies have largely focused on a small portion of a financial system typically proxied by the stock market

* Corresponding author. Tel.: +60 142662154; fax: +60 96684238.

E-mail address: roshaiza@umt.edu.my (R. Taha).

1049-0078/$ – see front matter ß 2012 Elsevier Inc. All rights reserved.
http://dx.doi.org/10.1016/j.asieco.2012.11.001
148 R. Taha et al. / Journal of Asian Economics 24 (2013) 147–157

while neglecting the bonds market and banking sector activities. For instance, Bohn (1990), Demirguc-Kunt and Huizinga
(2001), Tavares and Valkanov (2001), and Ardagna (2009), focus on either banking or non-banking activities in the financial
system, but do not attempt to examine the impact of both types on tax revenue collection.
The main purpose of this paper is to examine the short-run and long-run linkages between taxation (direct tax revenue)
and the financial system (both banking and non-banking financial activities) in Malaysia as a developing country, utilizing
monthly data for the period 1997–2008. The existence of the long run equilibrium relationship between tax revenue and the
financial system was investigated using the autoregressive distributive lag (ARDL) bounds testing approach to cointegration,
which can be used regardless of whether the underlying variables are integrated of different orders or fractionally integrated.
The short-run dynamic relationship between direct tax revenue and financial system was investigated using the vector error
correction model (VECM).
This paper contributes to the literature on the relationship between taxation and the financial system in three ways. First,
it focuses on a wide range of financial variables that represent both banking and non-banking financial activities. Second, to
the best of our knowledge, this is the first paper to concurrently examine the relationship between tax and the financial
system in developing Asia with particular attention to Malaysia. Third, unlike previous studies which examined the role of
fiscal policy in Malaysia (e.g. the impact of tax rate changes on financial activities in that country), our aim is to investigate
the effect of the financial system on the direct tax revenue collection, given that for the past two decades direct tax revenue
has been the major contributor to government income in that country (Malaysia, 2008). Table 1 demonstrates that the share
of direct tax revenue in the total government revenue increased from 39% in 1980 to more than 50% in 2008.
The structure of this paper is as follows: Section 2 surveys the literature while Section 3 presents the data used in the
study and discusses the empirical methodology. The findings are presented in Section 4. The paper concludes with a brief
summary, followed by a discussion of the implications of our findings in Section 5.

2. Literature on the relationship between the financial system and tax revenue

Many empirical studies have documented the relationship between financial activities and fiscal policy, with most extant
literature suggesting that fiscal policy has a strong negative impact on the performance of financial system activities
(typically stock and bond markets) in a developed country (Ardagna, 2009; Laopodis, 2009). Darrat (1988, 1990) find a strong
relationship between fiscal policy and stock market returns, and advocates the existence of lags between fiscal measure
implementation and a respective change in the stock market returns; while Tavares and Valkanov (2001) claim that an
increase in taxes has an immediate statistically negative and significant effect on expected stock and bond returns. More
recently, and by using panel data for OECD countries from 1960 to 2002, Ardagna (2009) suggests that fiscal contractions
have a positive effect on the performance of the stock market, while fiscal expansions have a negative effect. Laopodis (2009)
also reports that fiscal policy can affect the stock market in a negative and significant manner.
While other studies find an inverse relationship between taxation and financial system activities, Bohn (1990) presents a
case for a positive relationship using tax revenue as a proxy of tax rate. Bohn emphasises that government intervention in
financial activities through optimal policy may provide a hedge against shocks to the budget. Therefore, the nature of the
relationship between the financial system and taxation might change due to government involvement in reducing the
impact of distortionary tax.
More recently, literature suggests that the nature of the relationship between fiscal and financial variables might depend
on the level of interaction with political institutions as well as approaches to investment (Akitoby & Stratmann, 2008) and
types of taxes (Arin & Koray, 2006; Arin et al., 2009). For example, using a panel of emerging economies, Akitoby and
Stratmann (2008) argue that interaction with political institutions matters because international investors prefer a taxation
approach that reduces investment risk. After estimating a vector auto-regression (VAR) model with total taxes and the
decomposition of tax in four groups (income tax, corporate tax, indirect tax and social security tax) for the Canadian
economy, Arin and Koray (2006) find that different taxes will have different effects. Arin et al. (2009) find that indirect tax
and labour tax have significant negative effects on excess market returns, but corporate taxes produce no significant
response. This is due to the ability of firms to switch the investment mode from debt to equity financing. In addition, the
magnitude of the effect of indirect taxes on stock returns is larger than the effect of labour tax.

Table 1
The components of the government revenue in Malaysia.

Year Direct tax Percentage of total revenue Indirect tax Percentage of total revenue Non-tax revenue Percentage of total revenue

1980 5495 39 6565 47 1675 12

1984 8445 41 8029 39 3790 18
1988 7509 34 7199 33 6623 30
1992 15,403 39 13,369 34 9603 24
1996 25,851 44 21,421 37 10,330 18
2000 29,156 47 18,017 29 14,093 23
2004 48,702 49 23,347 23 26,511 27
2008 82,138 51 30,760 19 45,911 29
Source: Compiled by authors based on data collected from Federal Government Revenue, Treasury Department Malaysia (http://www.treasury.gov.my).
 R. Taha et al. / Journal of Asian Economics 24 (2013) 147–157 149

Analysing the interactions between taxation and the financial market, Aarle, Garretsen, and Gobbin (2003) find that the
nature of such interactions varies in both the short run and in the long run. Therefore, an increase in taxation does not
necessarily cause a contraction in financial market performance, because different taxpayer groups could have varying
effects on macroeconomic activity. In addition, the relationship between taxation and banking activities is less clear.
Focusing on banking institutions, Demirguc-Kunt and Huizinga (2001) find support for the strong effect of taxation on
banking activities. Their results suggest that the relationship between taxes and banking activities is positive for domestic
banks and negative for foreign banks. Therefore, the ownership status of the bank is important in determining the nature of
the relationship. In their review of the impacts of taxation on international banking, Hung and Lee (2010) suggest that
taxation plays a pertinent role in the development of the banking system.
In summary, most previous studies show that financial markets are transmission channels for fiscal shocks, and that the
effect of fiscal policy on financial market may depend on the type of fiscal instrument used. Throughout the review of the
literature, we note that few researchers have empirically examined how financial system activities can contribute to tax
revenue collection. Taxation revenue is one of the main sources of government income; however, the empirical literature on the
subject reveals a lack of investigation and understanding of the interaction between the financial system and taxation. Since the
identification of which policy contributes most to the stimulus of the financial market of a developing country is not clear cut in
the literature, it is difficult for governments to develop policy which could encourage activity in the financial system that would,
in turn, also contribute to economic growth. Therefore, it is believed that understanding the factors that influence tax revenue
could help to facilitate more productive revenue collection in the future. To further this understanding, the following section of
this paper focuses on an empirical analysis of the impact of financial system activities on direct tax revenue in Malaysia.

3. Data

To examine the relationship between the financial system (banking and non-banking financial activities) and direct tax
revenue collection, we use the monthly data for direct tax (DT) revenue and banking and non-banking financial activities
from 1997 to 2008. This sample period was chosen due to data availability. The purpose of using monthly data is that its high
frequency allows the order dynamics to be studied (Tsay, 2010). In line with Arin and Koray (2006) and Arin et al. (2009), we
use direct tax revenue as a proxy of tax revenue to capture the relationship between taxation and financial systems. Based on
the statistics reported in the Federal Government Revenue, Treasury Department (Malaysia, 2008), direct tax revenue is the
major contributor to total tax revenue and total government revenue, with the average contribution from 1997 to 2008 of
66.39% and 49.62%, respectively. In this paper, banking financial system activities consist of commercial bank loans to the
private sector (CB), and investment bank loans to the private sector (IB). Therefore, our sample is able to capture both sides of
banking: investment and commercial and to study their impact on direct taxation revenue. The non-banking financial
system variables are represented by the Kuala Lumpur Composite Index (KLCI), which is used as a stock market proxy, and
outstanding private sector bonds (BM). These two variables were chosen because over the past two decades Malaysian
government has been supporting the development of the stock and bond markets through the usage of various tax
incentives. The data are obtained from three different sources: the Inland Revenue Board Malaysia (DT), DataStream (KLCI),

Table 2
Description of data.

Variables Abbreviation Description

Tax revenue (Karran, 1985; Bohn, DT Total direct tax revenue collected in Malaysia (includes taxes such as income tax
1990; Hsieh & Parker, 2007) on individuals and corporations, petroleum income tax, stamp duty and real
property gains tax)

Kuala Lumpur Composite Index
(Mun, Siong, & Thing, 2008)
KLCI Capitalisation-weighted stock market index that has been used as a benchmark
of the Malaysian stock market. This index is widely used by local and foreign
fund managers and investors as a
performance benchmark to measure the portfolios held in Malaysia. The index includes
companies belonging to the following industries: Consumer Products, Industrial Products,
Construction, Trading/Services, Finance, Property Plantation, Hotels, Mining, Property Trusts,
Close-End Fund, Technology, Infrastructure Project Companies (IPC), and Practice
Note 4 Condition (PN4)

Outstanding private sector bonds BM Private sector bonds contribute to 55% of the total outstanding bonds and
(Yusof, 1994; Singhand & Yusof, include mortgage
2002; Ibrahim & Wong, 2005) bonds, conventional bonds and Islamic bonds

Commercial bank loans to the CB The total value of credits granted by commercial banks to the private sector
private sector (King & Levine, excluding credit issued by the Central Bank of Malaysia
1993; Singhand & Yusof, 2002)

Investment bank loans to the private IB The total value of credits granted by investment banks to the private sector
sector (King & Levine, 1993; excluding credit issued by the Central Bank of Malaysia
Singhand & Yusof, 2002)
Source: Compiled by authors based on the official definitions of the variables from Inland Revenue Board (DT) and Central Bank of Malaysia (KLCI, BM, CB,
and IB).
150 R. Taha et al. / Journal of Asian Economics 24 (2013) 147–157

(a): Direct Tax Revenue (DT) (b): Stock Market (KLCI)

10.0 4.6

9.8 4.4

DT 9.6 4.2
KLCI

9.4 4.0

9.2 3.8
1998 2000 2002 2004 2006 2008 1998 2000 2002 2004 2006 2008
Year Year

(c): Outstanding Private Sector Bonds (BM) (d): Commercial Bank Loans to the Private Sector (CB)
5.8 5.9

5.8
5.6
5.7
5.4
5.6
BM

CB
5.2
5.5

5.0 5.4

4.8 5.3
1998 2000 2002 2004 2006 2008 1998 2000 2002 2004 2006 2008
Year Year

(e): Investment Bank Loans to the Private Sector (IB)

4.4

4.2

4.0
IB

3.8

3.6
1998 2000 2002 2004 2006 2008
Year

Fig. 1. Graphical representation of the variables (in natural log form).

Source: Author calculations based on data collected from monthly report of Inland Revenue Board Malaysia for DT, DataStream for KLCI and monthly
statistical bulletin published by the Central Bank of Malaysia for BM, CB and IB.

and the monthly statistical bulletin published by the Central Bank of Malaysia (BM, CB and IB). A description of the variables
is provided in Table 2.
Fig. 1 shows the data in natural log form. DT and KLCI appear to be very volatile. In 2000 there was a drastic increase in the
BM, which could be explained by the shift in policy from the Official Tax System to the Self-Assessment Tax System on
individual taxpayers, with the assessment year 2000 being the waiver year. In addition, this increase could have occurred
due to the recovery of the Malaysian economy from the 1997 crisis when investors were looking for an alternative
investment that was more secured as compared to an investment in the stock market.
Although IB was on a consistent downward trend throughout the study period, there was a sharp drop in 2007, which
could have been because of the investment banks’ exposure to the Global Financial Crisis (GFC). Note that although CB and IB
both consist of loans granted to the private sector, the patterns shown in Fig. 1 are markedly different. This is due to the
different roles played by commercial and investment banks in the economy. The immediate role of an investment bank
regardless of ownership (local or foreign) in Malaysia is to advise government and the private sector on privatisations and to
raise capital. As such, the operations of investment banks mainly relate to the provision of advisory management services
and conducting wholesale lending and deposit-taking activities. These functions complement the services offered by
commercial banks that focus on providing short-term credit for working capital and trade financing.
In addition, the Guidelines on Investment Banks Services by Central Bank of Malaysia clearly state that an investment
bank should focus only on providing assistance for investment activities, and that granting loans to customers should be
managed by a commercial bank. This policy implemented by the government has contributed to a downwards trend in
investment bank loans granted to the private sector. Commercial banks alternatively provide the normal banking services to
their customers, including accepting deposits, making loans and advances, discounting trade bills and bankers’ acceptances,
 R. Taha et al. / Journal of Asian Economics 24 (2013) 147–157 151

Table 3
Descriptive statistics.

Variable Mean Median Std. dev. Skewness Kurtosis Jarque–Bera ARCH LM

DT 9.55 9.56 0.17 0.26 2.51 3.12 (0.21) 19.02 (0.00)

KLCI 4.25 4.25 0.12 0.21 3.25 1.47 (0.48) 4.92 (0.03)
BM 5.34 5.45 0.33 0.50 1.66 16.83 (0.00) 34.20 (0.00)
CB 5.60 5.55 0.13 0.49 1.99 12.06 (0.00) 4.54 (0.10)
IB 4.09 4.12 0.20 0.46 2.40 7.32 (0.03) 0.67 (0.72)
Source: Author calculations.
Notes: Abbreviations are defined as follows: DT = direct tax revenue, KLCI = Kuala Lumpur Composite Index, BM = outstanding private sector bonds,
CB = commercial bank loans to the private sector and IB = investment bank loans to the private sector. DT, KLCI, BM, CB and IB are expressed in natural
logarithms and are calculated in local currency (Malaysia Ringgit). Jarque–Bera (JB) is the test for normality and ARCH LM is the test for the presence of ARCH
effects in errors. P-values are given in parenthesis.

dealing in foreign exchange and providing business investment advisory services. To date, the role of the commercial banks
in promoting private investment and supporting economic development in Malaysia has become more prominent.
Summary statistics for the logged data are presented in Table 3. The statistics indicate that the average of all variables is
ranged 4.0–9.5. For all variables, a comparison of means and medians indicates that they are very close to each other over the
sample period. This shows that the data points are fairly close to each other and distributed somewhat evenly over the total
range. An examination of skewness indicates that for direct tax revenue and commercial bank loans to the private sector the
variables are positively skewed, meaning that most of the values are concentrated to the left of the mean, with extreme
values to the right.
KLCI, outstanding private sector bonds, and investment bank loans to the private sector, are negatively skewed. Kurtosis
values indicate that all variables are leptokurtic. The Jarque–Bera test for normality is not significant for direct tax and stock
market variables, meaning that the null hypothesis of normality cannot be rejected. The ARCH LM test also suggests the
presence of ARCH effects for all variables except for the CB and IB activities.

4. Methodology

The functional forms of this relationship assumed as follows:

ln DTt ¼ f ðln KLCLt ; ln BMt ; ln CBt ; ln IBt Þ (1)

This study uses the ARDL approach of Pesaran, Shin, and Smith (2001) to cointegration. The ARDL approach resolves the
common problems that arise when testing for cointegration using the two traditional methods, namely, the residual-based
cointegration test by Engle and Granger (1987) and Johansen’s (1988, 1991, 1995) maximum likelihood approach. The
problem with the Engle and Granger approach lies in its inability to pick out more than one cointegrating vector. Although
Johansen’s approach overcomes this problem associated with the Engle-Granger test, it tends to reject the null hypothesis of
no cointegration when, in fact, it does exist (Huang & Yang, 1996).
There are several advantages of the ARDL approach. First, the testing procedure is relatively simple. Second, it is
applicable irrespective of the order of integration of the variables, that is, whether the variables are I(0), I(1) or a combination
of both (Pesaran & Pesaran, 1997). However, in the case of the I(2) variable, this approach cannot be used since it will lead to
spurious results (Ahmad & Qayyum, 2008). Third, ARDL has superior small sample properties (Narayan, 2005a). Fourth,
because it is free of residual correlation, the ARDL approach is capable of avoiding the endogeneity problem (Pesaran, Shin, &
Smith, 1996). Finally, it can be used to estimate the long-run and short-run components of the model. One can derive the
error correction model (ECM) from the ARDL using simple linear transformation.
Before proceeding with ARDL, we test the variables for the order of integration. For this purpose, we employ the DF-GLS
unit root test of Elliott, Rothenberg, and Stock (1996). DF-GLS unit root test is more powerful compared to ADF stationary test
and is based on null hypothesis H0: b0 = 0 in the following regression:

DYtd ¼ b0 DYt1

d  d
þ b1 DYt1
 d
þ    þ b p1 DYt pþ1 þ mt (2)
where Ytd is the de-trended series and H0 of DF-GLS is that Yt has a random walk trend. The DF-GLS unit root test is performed
by estimating the intercept and trend utilizing using generalized least square technique. Because results of the unit root tests
are very sensitive to the existence of structural breaks in the series, we employ the Zivot and Andrews (1992) unit root test
(ZA test) that allows one-time endogenous structural break in the series. The ZA test allows estimating three models
depending on whether the break was in the mean (Model A, Eq. (3)), slope of the trend function (Model B, Eq. (4)), or both
(Model C, Eq. (4)): Xk
Dyt ¼ c þ ayt1 þ bt þ g DUt þ d j Dyt j þ et (3)
j¼1
X k
Dyt ¼ c þ ayt1 þ bt þ uDTt þ d j Dyt j þ et (4)
j¼1 Xk
Dyt ¼ c þ ayt1 þ bt þ uDUt þ g DTt þ d j Dyt j þ et (5)
j¼1
152 R. Taha et al. / Journal of Asian Economics 24 (2013) 147–157

where DUt is an indicator dummy variable for a mean shift occurring at a possible break-date (TB), and DTt is a corresponding
dummy variable for a shift in trend function. The null hypothesis in all three models is that yt contains a unit root with a
structural break or a = 0. Following the graphical behaviour of the series and the recommendations in ZA (1992), we estimate
models A and C.
The ARDL model used in this study can be expressed as follows:
p
X p
X p
X p
X p
X
Dln DTt ¼ a0 þ a1 Dln DTti þ a2 Dln KLCIti þ a3 Dln BMti þ a4 Dln CBti þ a5 Dln IBti
i¼1 i¼0 i¼0 i¼0 i¼0

þ p1 ln DTt1 þ p2 ln KLCIt1 þ p3 ln BMt1 þ p4 ln CBt1 þ p5 ln IBt1 þ mt (6)

where D is the first difference operator and a is the short-run coefficients and s are the corresponding long run multipliers of
the underlying ARDL model. Where, mt is the white noise error term. The null hypothesis of no cointegration in Eq. (6) is H0:
p1 = p2 = p3 = p4 = p5 = 0 is tested against the alternative hypothesis Ha: p1 6¼ p2 6¼ p3 6¼ p4 6¼ p5 6¼ 0 by conducting an F-test
for the joint significance of the long-run coefficients and comparing the results with critical values in Narayan (2005b). If the
calculated F-statistic falls (above) below the lower (upper) bounds value, the null hypothesis cannot (can) be rejected. The
result is inconclusive if the F-statistic falls in between the upper and lower critical values.
To determine the direction of the causal relation between the series, we use the vector autoregression (VAR) shown in
Eq. (7):
2 3 2 32 32 3
Dln DTt a1 A11;i A12;i A13;i A14;i A15;i Dln DTti
6 7 6 76 76 7
6 Dln KLCIt 7 6 a2 76 A21;i A22;i A23;i A24;i A25;i 76 Dln KLCIti 7
6 7 6 76 76 7
6 Dln BMt 7 ¼ 6 a3 76 A31;i A32;i A33;i A34;i A35;i 76 Dln BMti 7
6 7 6 76 76 7
6 7 6 76 76 7
4 Dln CBt 5 4 a4 54 A41;i A42;i A43;i A44;i A45;i 54 Dln CBti 5
Dln IBt a5 A51;i A52;i A53;i A54;i A55;i Dln IBti
2 32 3 2 3 2 3 (7)
A11; p A12; p A13; p A14; p A15; p Dln DTt p p1 m1
6A 76 7 6 7 6 7
6 21; p A22; p A23; p A24; p A25; p 76 Dln KLCIt p 7 6 p2 7 6 m2 7
6 76 7 6 7 6 7
6 A
þ6 31; p A 32; p A33; p A 34; p A 76 7 6 7 6 7
35; p 76 Dln BMt p 7 þ 6 p3 7 þ 6 m3 7
6 76 7 6 7 6 7
A
4 41; p A 42; p A43; p A 44; p A45; p 54 Dln CBt p 5 4 p4 5 4 m 4 5
A51; p A52; p A53; p A54; p A55; p Dln IBt p p5 m5
where Granger causality test is performed as the test F-test for joint significance of ECTt1. The finding that A12,i 6¼ 0 will
imply that ln DT Granger causes ln KLC, while A21,i 6¼ 0 means a causal link from ln KLCI to ln DT.

5. Empirical results

5.1. Unit root tests results

The summary of the DF-GLS unit root test is given in Table 4 where the lag-length is chosen using the AIC. The results
reveal that all the variables are non-stationary in their level data, regardless of whether they are with or without trend. All
series were found to be stationary at the first difference at 1% significance level.
Tables 5 and 6 show tabulated results for ZA unit root tests for Model A and Model C. Results show that the unit root null
with a structural break cannot be rejected for most variables. But for BM and IB, at 5% critical value the unit root null can be
rejected in favour of a trend-stationary alternative with a one-time shift in November 2000 (Model A) and March 2008
(Model C) for both variables.
Non-stationarity of the series has a lot of policy implications as well as implications for modelling and forecasting the
series in future. The existence of a unit root in all variables under study suggests that shocks to the economic system, such as

Table 4
DF-GLS unit root test.

Variable Level 1st difference Overall decision I(d)

Test statistic AIC lag Test statistic AIC lag

ln DT 1.36 1 3.21*** 1 I(1)

ln KLCI 1.07 1 2.79*** 2 I(1)
ln BM 1.62 1 5.34*** 2 I(1)
ln CMB 3.05 1 4.18*** 2 I(1)
ln IB 1.10 0 10.77*** 0 I(1)
Source: Author calculations.
Notes: Abbreviations are defined as follows: DT = direct tax revenue, KLCI = Kuala Lumpur Composite Index, BM = outstanding private sector bonds,
CB = commercial bank loans to the private sector and IB = investment bank loans to the private sector. DT, KLCI, BM, CB and IB are expressed in natural
logarithms and are calculated in local currency (Malaysia Ringgit). D is the difference operator. DF-GLS test is based on the selection of the AIC. Critical
values for the DF-GLS test are based on Elliott et al. (1996, Table 1).
*** Significance at the 1% level.
 R. Taha et al. / Journal of Asian Economics 24 (2013) 147–157 153

Table 5
ZA unit root test results, Model A: break in intercept.

Variable Chosen lag order Dummy coefficient on intercept Minimum test statistic Estimated break Overall decision I(d)

ln DT 13 9.2760 (3.482) 3.4848 March, 2008 I(1)

ln GT 1 7.079255 (5.002) 5.0271 January, 2008 I(1)
ln KLCI 12 0.1201 (3.267) 4.8816 August, 1999 I(1)
ln CB 0 1.007 (4.136) 4.0856 August, 2004 I(1)
ln BM 9 9.0478 (16.890) 16.8305*** November, 2000 I(0)
ln IB 1 4.3282 (8.384) 8.4022*** March, 2008 I(0)
Source: Author calculations.
Notes: Abbreviations are defined as follows: DT = direct tax revenue, KLCI = Kuala Lumpur Composite Index, BM = outstanding private sector bonds,
CB = commercial bank loans to the private sector and IB = investment bank loans to the private sector. DT, KLCI, BM, CB and IB are expressed in natural
logarithms and are calculated in local currency (Malaysia Ringgit). (1) t-Statistics are given in parentheses; (2) critical values at 1%, 5% and 10% levels are
5.34, 4.8 and 4.58, respectively (Zivot & Andrews, 1992); and (3) the optimal lag length (k) is determined by the general to specific test and AIC.
*
Significance 10% level.
**
Significance at 5% level.
*** Significance at 1% level.

Table 6
ZA unit root test results, Model C: break in intercept and trend.

Variable Chosen lag order Dummy coefficient on intercept Dummy coefficient on trend Minimum test statistic Estimated break Overall decision I(d)

ln DT 13 20.2409 (2.062) 0.03024 (0.145) 3.9542 February, 2001 I(1)

ln GT 1 8.0102 (5.356) 0.0032 (2.678) 5.3766 April, 2007 I(1)
ln KLCI 12 0.8702 (2.501) 0.0614 (2.910) 5.2984 July, 1998 I(1)
ln CB 0 1.6400 (4.566) 0.0004 (3.170) 4.5365 August, 2004 I(1)
ln BM 9 9.1178 (17.399) 0.0098 (11.065) 17.3895*** November, 2000 I(0)
ln IB 1 2.9338 (5.895) 0.0029 (5.766) 5.9135*** March, 2008 I(0)
Source: Author calculations.
Notes: Abbreviations are defined as follows: DT = direct tax revenue, KLCI = Kuala Lumpur Composite Index, BM = outstanding private sector bonds,
CB = commercial bank loans to the private sector and IB = investment bank loans to the private sector. DT, KLCI, BM, CB and IB are expressed in natural
logarithms and are calculated in local currency (Malaysia Ringgit). (1) t-Statistics are given in parentheses; (2) critical values at 1%, 5% and 10% levels are
5.57, 5.08 and 4.82, respectively (Zivot & Andrews, 1992); and (3) The optimal lag length (k) is determined by the general to specific test and AIC.
*
Significance 10% level.
**
Significance at 5% level.
*** Significance at 1% level.

regulatory changes, are likely to have a permanent effect on these variables. The example is a regulatory change to BM in
early 2000 and the GFC that impacted the BM and IB, respectively. Also, since none of the variables is stationary, using past
values of these variables to forecast future values is not likely to be useful (Hendry & Juselius, 2000). Having determined the
order of integration, we proceed to ARDL.

5.2. Cointegration results

The F-test used to test for cointegration is sensitive to the number of lags used for each first differenced variable
(Bahmani-Oskooee & Brooks, 2003). To select the appropriate lag we use two approaches: a general-to-specific modelling
approach and the Akaike Information Criterion (AIC), which both choose the maximum lag order of 1. Following Pesaran and
Pesaran (1997), we first estimate an OLS regression and then conduct the joint significance F-test to determine the long-run
coefficients. The results are reported in Table 7 and show evidence of a long-run relationship when DT is the dependent
variable because the F-statistic value clearly exceeds the upper bounds critical values of 5.51 and 4.21 at 1% and 5% levels of
significance.
The null hypothesis of no cointegration among the variables cannot be accepted, implying that these variables are linked
into the long run equilibrium relationship, and the DT has long-run effects on KLCI, BM, CB and IB. The validity of Eq. (6) is
confirmed by employing several diagnostic tests including Breusch–Godfrey serial correlation Lagrange Multiplier (LM) test,
JB test for normality, heterokedasticity test, and the Ramsey RESET test for appropriateness of the functional form. The
Breusch–Godfrey LM test statistic confirmed that there is no serial correlation problem in the residuals, while the JB test
statistic confirmed the normality in the behaviour of the estimated residuals. No heterokedasticity was detected, and the
RESET test confirms the correct functional form.
154 R. Taha et al. / Journal of Asian Economics 24 (2013) 147–157

Table 7
Results of ARDL bounds test cointegration.

Dependent variable AIC lag order F-statistic Probability Decision

***
FlnDt(ln DTjln KLCI, ln BM, ln CB, ln IB) 1 26.94 0.00 Cointegrated

Diagnostic test statistics

Jarque–Bera normality test = 0.55 [0.76]

Serial correlation = 63.49 [0.00]
Heteroskedasticity test = 2.72 [0.10]
Ramsey RESET test = 0.11 [0.73]
Source: Author calculations.
Notes: Abbreviations are defined as follows: DT = direct tax revenue, KLCI = Kuala Lumpur Composite Index, BM = outstanding private sector bonds,
CB = commercial bank loans to the private sector and IB = investment bank loans to the private sector. DT, KLCI, BM, CB and IB are expressed in natural
logarithms and are calculated in local currency (Malaysia Ringgit). The critical values from Narayan (2005b) are 2.55–3.64, 3.01–4.21, and 4.09–5.51 for 10%,
5% and 1% significance level, respectively.
*** Significance at 1% level.

Table 8
VECM Granger causality test (joint F-test).

ln DTt ln KLCIt ln BMt ln CBt ln IBt ECTt1

ln DTt – 4.62 (0.03)** 0.28 (0.59) 0.10 (0.74) 1.41 (0.23) 0.64 [0.10]*
ln KLCIt 0.03 (0.84)  0.55 (0.45) 0.15 (0.69) 0.29 (0.58) 0.13 [0.05]**
ln BMt 2.26 (0.13) 0.08 (0.76)  0.24 (0.61) 0.04 (0.83) 0.02 [0.52]
ln CBt 0.59 (0.43) 0.18 (0.67) 0.10 (0.74)  0.08 (0.76) 0.02 [0.01]
ln IBt 0.42 (0.51) 0.27 (0.60) 0.26 (0.60) 0.26 (0.60)  0.06 [0.04]

Diagnostic test statistics:

Serial correlation = 0.72 [0.48], Heteroskedasticity test = 1.04 [0.41], JB = 0.99 [0.60]
Source: Author calculations.
Notes: Abbreviations are defined as follows: DT = direct tax revenue, KLCI = Kuala Lumpur Composite Index, BM = outstanding private sector bonds,
CB = commercial bank loans to the private sector and IB = investment bank loans to the private sector. DT, KLCI, BM, CB and IB are expressed in natural
logarithms and are calculated in local currency (Malaysia Ringgit). Values in (.) and [.] are p-values and standard errors, respectively.
* Significance 10% level.
** Significance at 5% level.
***
Significance at 1% level.

5.3. Granger causality results

Having established the existence of the long-run cointegration relationship between direct tax revenue and the financial
system, we then test for causality and estimate a short-run dynamic model for Eq. (7). Causality is investigated using the
Wald test by examining the joint significance of the lagged differences of the explanatory variables. Results in Table 8 suggest
a causal relationship between stock market and direct tax revenue in the short run.

40 1.2

30
1.0

20
0.8
10
0.6
0
0.4
-10
0.2
-20

-30 0.0

-40 -0.2
25 50 75 100 125 25 50 75 100 125

CUSUM 5% Significance CUSUM of Squares 5% Significance

Fig. 2. Plots of CUSUM and CUSUM square recursive residuals.

Source: Author calculations.
 R. Taha et al. / Journal of Asian Economics 24 (2013) 147–157 155

The stability of the coefficients in the regression equations is assessed through the cumulative sum (CUSUM) and
cumulative sum of squares (CUSUMSQ) tests of Brown, Durbin, and Evans (1975) that are applied to the model residuals. In
this test, the plots of the CUSUM test statistics against the model breakpoints should stay within the 5% significance level to
ensure the stability of the estimation (Baharumshah, Mohd, & Masih, 2009). The same condition also applies to the
CUSUMSQ plots, where corresponding statistic values are based on the squared recursive residuals. As can be seen in Fig. 2,
the plots of the CUSUM and CUSUMSQ statistics stay within the critical bounds, indicating the stability of the parameters of
the VECM model.
This analysis provides support for the view that financial system activities are crucial for direct tax revenue collection.
Results from this study are consistent with Taha, Colombage, and Maslyuk (2010), who analyse the relationship between tax
revenue and the financial system in Malaysia within a bivariate model. Taha et al. (2010) find that tax revenue collection is
driven by changes in the financial system activities, confirming the relative importance of financial market activities in the
Malaysian economy. However, our results fail to show a significant impact of the commercial bank proxies on tax revenue
collection. This might be due to a few abrupt slowdowns of local and global economic growth that took place during the
entire study period.

6. Conclusion and policy implications

The nexus between taxation and financial system has been widely discussed in the developed country context. However,
in recent years there has been a growing focus in the developing countries on the importance of implementing an effective
taxation policy framework to stimulate financial activities, which in turn could foster economic growth. It is suggested in the
literature that fiscal policy, especially tax policy, has a significant influence on investment decisions. Theoretically and
empirically, most of the literature (Ardagna, 2009; Arin et al., 2009; Laopodis, 2009; Tavares & Valkanov, 2001) reports the
negative relationship between tax policy and financial system. However, very few studies have examined the impact of
financial system activities on direct tax revenue collection in a developing country, and decomposed the financial system
into banking and non-banking activities. In this paper, we study both long-run and short-run relationships between direct
tax revenue and banking and non-banking financial sector activities in Malaysia from 1997 to 2008 using higher frequency
(monthly) data.
DF-GLS unit root tests reveal that all variables are non-stationary, meaning that shocks to direct tax revenue and our
proxies for banking and non-banking financial activities will have a permanent impact on these series. ZA (1992) unit root
test results for models A and C also suggest the existence of a unit root in all variables except for BM and IB. For these two
variables, the unit root null was rejected in favour of trend-stationary series with a one-time structural break in November
2000 (BM) and March 2008 (IB). This means that the impact of shocks on these variables, such as changes in the regulatory
structure or the Global Financial Crisis, will result in a temporary deviation from their long-term growth path. These findings
also have important policy implications for Malaysia. For instance, as suggested by Hendry and Juselius (2000), ‘‘variables
related to the levels of any variables with a stochastic trend will inherit that non-stationarity and transmit it to other
variables in turn.’’ Therefore, given the large extent to which direct taxation revenue, main stock market index, and
commercial bank loans are integrated into the real economy, if shocks to these variables are persistent, key macroeconomic
variables including GDP of which government revenue is a component are likely to inherit this persistence.
The mixture of I(1) and I(0) variables allows us to investigate the short-run and long-run relationships between the
financial system and tax revenue using the ARDL bounds-testing approach to cointegration. Results suggest that direct tax
revenue and banking and non-banking financial activities are bound together in the long-run, linear equilibrium
relationship. Following Stock and Watson (1993), this means that these variables share the same stochastic trend which is
composed of the accumulated individual shocks that cause a permanent random change of the conditional mean of the
series. While the variables might drift from this equilibrium relationship in the short run, in the long run they are bound
together. This suggests that both banking and non-banking financial activities play a vital role in direct tax revenue
collection. The diagnostic tests for serial correlation, heteroskedasticity, and normality in residuals also confirm the validity
of the model. Thus, it is important to undertake a financial liberalisation by removing repressionist policies to allow both
banking and non-banking sectors to better perform their function of mobilizing savings and allocating capital which, in turn,
results in achieving economic growth.
It is accepted in the literature that taxation policies (and in this case direct taxation policies) affect the competitiveness of
companies and the efficiency of the financial sector overall. Therefore, our finding that stock market has a significant positive
causal effect on direct tax revenue in the short-run run also has a significant policy implication. Equities issues are
considered to be the major source of funds in the corporate sector in Malaysia to fund various investment projects. Malaysia
has adopted a tax regime that minimises the cost of equity financing and bond financing by providing tax incentives for both
investors in the financial market, the issuers of financial securities, and financial intermediaries. Although such policies have
led to an increase in the size of the equity market in Malaysia – and in 2010 Malaysia’s equities market ranked the fifth fastest
growing market in Asia – stock market liquidity hinders productive investment that can lead to higher direct revenue
collection. Therefore, Malaysia can take steps to inject liquidity into the stock market by reducing transaction cost, fees and
charges of market participants, educating potential investors, and establishing an efficient trading system.
In addition, in 2008 Malaysia changed taxation of dividends paid to the shareholders by introducing a single tier tax
system (STS) that replaced the imputation tax system. The transitioning to this system will be completed in December 2013.
156 R. Taha et al. / Journal of Asian Economics 24 (2013) 147–157

Dividends that are paid by the companies using the STS are not taxable. Such measures related to dividend taxation as the
direct taxation of income earned by shareholders should lead to further development of the stock market in Malaysia.
The significant results reported for stock market activities highlight the importance of these activities in Malaysia.
However, there is no evidence of a significant relationship between tax revenue and investment bank loans to the private
sector. This can be explained by the decrease in both volume and value of investment bank loans to the private sector over
the sample period. This is partly due to the changing role of investment banks from offering loans to expanding off-balance
sheet activities while providing advisory services to their customers. At the same time, it can also be explained by the
government’s decision to grant tax exemptions on the profit gained by investment banks, which has led to a reduction in the
tax revenue obtained from this source.
In addition, no significant results were found regarding the impact of both commercial bank loans to the private sector
and the private bond market on the direct tax revenue. This finding is surprising because over the last decade Malaysian bond
market grew on average 10.8% and is at present the largest in ASEAN and the third largest in Asia with well-established
infrastructure facilities (Securities Commission, 2011). Similar to the equities, there are substantial direct tax incentives for
institutional and individual investors, including stamp duty exemption on investing and trading of Islamic financial
certificates or well known as ‘sukuk’ (Ibrahim & Wong, 2005). This finding could be due to the use of aggregate direct tax
revenue as the proxy for taxation. In further analysis it would be worthwhile to decompose direct tax revenue according to
its source (individuals, corporations, petroleum, stamp duty, and real property gains tax), as different tax groups have
different and offsetting effects on the economy. As indicated by Arin et al. (2009), the use of disaggregated data is more
accurate since different tax changes produce different financial responses. In addition, this finding could refer to foreign
investor preference for equity financing (e.g. the importance of equities as compared to debt in the Anglo Saxon financial
system) as compared to debt financing. For example, the US Securities and Exchange Commission named the Malaysian
Securities Exchange, Bursa Malaysia, as a designated offshore securities market (Yee & Tan, 2009).
As mentioned earlier, we could not find evidence that domestic credit to the private sector (CB) has a substantial causal
impact on direct tax revenue. This can be explained by the financial deregulation that has occurred in the recent years, as well
as access to the international capital markets which has reduced the value of bank loans as a source of finance to Malaysian
private sector organisations. In fact, the beginning of the sample corresponds to the Asian Financial Crisis, during which
many commercial banks in Malaysia suffered from very high rates of non-performing loans due to over-exposure to equity-
based financing (Bank Negara Malaysia, 1999). The crisis severely affected the health of the banking sector, as reflected in the
deterioration in capitalisation and asset quality (Sufian, 2006; Zhang, 2009). To strengthen the resilience of the banking
sector, Bank Negara undertook a merger program (completed in 2001), the result of which was the establishment of ten
major banking groups that control 80% of the domestic market for private sector deposits and loans (Sufian, 2006). In
addition, government created new regulatory institutions such as the asset management company and the Corporate Debt
Restructuring Committee (CDRC). Although these measures were successful and led to a gradual increase in domestic credit
to private sector, the contribution of income from loans to taxation was relatively small and only increased once the reforms
gained success.
In summary, results from this study contribute to a deeper knowledge of the financial system and direct tax revenue
nexus in Malaysia. Over the past two decades, not all financial system variables have played a pivotal role in the direct tax
revenue collection, which in turn might have been used by government to stimulate economic growth. The Malaysian
government did try to boost investment activities by offering new incentives for domestic and foreign residents, ensuring a
productive workforce, and providing political stability that would support economic development and progress (Malaysia,
2008). Most of these incentives are in the form of tax ease for investment activities, which could positively influence direct
revenue collection. However, in doing so, the government needs to establish whether giving such incentives in the future will
continue to provide high tax income to the economy. Our results show that, over the past two decades, tax incentives for
equity might have been more important for the overall development of the stock market and direct revenue collection than
the bond market, which also has quite a generous system of tax incentives.
The results of this study suggest several directions for future research. For instance, as suggested by Arin et al. (2009),
future analysis could utilize disaggregated fiscal variables (e.g. various components of taxes and spending), and therefore
provide a deeper picture of the relationship between tax revenue and financial system activities. This is because the strength
of the relationship might vary depending on the type of direct taxes or government spending used. In addition, a cross-
sectional analysis could be useful for comparison purposes in order to see how Malaysia performed as compared to other
countries. Finally, while our empirical findings support the pivotal role of the financial system in contributing to higher
government revenue, analysis that captures the transmission of taxing and spending shocks to the financial system would be
of great interest. Another extension of this study would be to focus on the size of banking and non-banking institutions in the
financial system, particularly from 2001 when the main wave of mergers in banking sector was completed. This will provide
a deeper understanding of the role of banking (in particular, the size of financial institutions) in the relationship between
direct tax revenue and the financial system in Malaysia.

Acknowledgements

We thank the editor and anonymous referees for their insightful comments that significantly improved the manuscript.
We are thankful to the participants of the 3rd International Journal of Arts and Sciences Conference for their valuable
 R. Taha et al. / Journal of Asian Economics 24 (2013) 147–157 157

comments and suggestions on earlier versions of this paper. We are also grateful to the Department of Statistics and the
Inland Revenue Board Malaysia for providing data.

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