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CURRENCY EQUIVALENTS

Average 1991 - US$1.0 = 26.7

Average 1990 - US$1.0 - 24.3

Average 1989 - US$1.0 = 21.7

Average 1988 - US$1.0 = 21.1

Average 1987 - US$1.0 = 20.6

Average 1986 - US$1.0 - 20.4

ACRONYMS AND ABBREVIATIONS

APT = Asset Privatization TrustBIR Bureau of Internal RevenueBOC Bureau of CustomsBOT - Build-Operate-TransferDBM = Department of Budget and ManagementDBP Development Bank of the PhilippinesDOF - Department of FinanceEO = Executive OrderEPZA - Export Processing Zone AuthorityETR 5 Effective Tax RateGC = Government-Owned or Controlled CorporationGCMCC = Government Corporate Monitoring and Coordinating CommitteeGSIS Government Service Insurance SystemGRT = Gross Receipts TaxICC = Investments Coordinating CommitteeLRTA Light Rail Transit AuthorityLWUA Local Water Utilities AdministratiorMTFP Medium Term Financial PlanMTPIP - Medium Term Public Investment ProgramMWSS Metropolitan Waterworks and Sewerage SystemNEDA = National Economic and Development AuthorityNEA - National Electrification AdministrationNFA = National Food AuthorityNHA National Housing AdministrationNIA = National Irrigation AdministrationNPC National Power CompanyNTRC x National Tax Research CenterOIC = Omnibus Investment CodeOPSP = Oil Price Stabilization FundPCE = Personal Consumer ExpenditurePNB - Philippine National BankPNOC Philippine National Oil CompanyPNR = Philippine National RailwaysPPA - Philippine Ports AuthoritySPPBS = Synchronized Planning Programming and Budget SystemTIN - Tax Identification NumberVAT = Value Added Tax

FOR OFFICIAL USE ONLY

PHILIPPINES

COUNTRY ECONOMIC REPORT

PUBLIC SECTOR RESOURCE MOBILIZATION AND EXPENDITURE MANAGEMENT

Table of Contents

EXECUTIVESUMMRY-2* f . o . . . . . . . . . . . . . . .

I. THE MACROECONOMIC CONTEXT . . . . . . . . . . . . . . . . . . . . . 1

A. Growth Experience since 1975 .... . . . . .. . ..... . 1B. Savings and Investment Behavior . . . . . . . . . . . . . . . . 9C. Implications for Development Strategy . . . . . . 22

II. PUBLIC RESOURCE MOBILIZATION . . . . . ............ . 24

A. Overview of Public Revenue System . . . . . . . . . . . . . . . 24B. Tax Intake and Tax Potential . . . . . . . . . . . . . . . . . 33C. Issues in Internal Revenue Collection . ..... . . . . . . . 38D. Internal Revenue Administration . . . ............ . 44E. Customs Administration . . . . . . . . . . . . . . . . . . . . 30F. Non-Tax Revenue Issues . . . . . . . . . . . . . . . . . . . . 55G. Enhancing Revenue Mobilization . . . . . . . . . . . . . . . . 56

7II. PUBLIC EXPENDITURE MANAGEMENT . . . . . . . . . . . . . . . . . . . 65

A. Budget Process Issu,s . . . . .. . .. . . . . . 65

B. Public Expenditure Patterns and Productivity . . . . . . . . . 69

C. Private Sector Role in Public Sector Projects . . . . . . . . . 79D. Government Corporations: Financial and Management Issues . . . 83

SelectedBibliography .... . 99

StatisticalAppendix .... .. . . . . . . . . . ....... . . . . 101

This report was prepared by a team consisting of Farrukh Iqbal (TaskManager), Jeffrey Balkind, Daniela Gressani and Delfin Go. It is based inpart on background reports prepared by A. Premchand, M. Woolley (IMF staff)and R. Manasan, M. Lamberte and E. de la Cruz (consultants). The help of the

National Tax Research Center is gratefully acknowledged.

This document has a restricted distribution and may be used by recipients only in the performanceof their official duties. Its contents rnay not otherwise be disclosed without World Bank authorization.

LIST OF TABLES, FIGURES & BOXES

CHAPTER I

TABLES Page

1.1 Key Macroeconomic Indicators . . . . . . . . . . . . . . . . . . . 21.2 External Finance Flows: 1970-89 . . . . . . . . . . . . . . . . . 31.3 External Environment: 1989-92 . . . . . . . . . . . . . . . . . . 51.4 Savings and Growth Rates . . . . . . . . . . . . . . . . . . . . 111.5 Comparative Savings and Growth Trends . . . . . . . . . . . . . . . 121.6 Selected Investment Data . . . . . . . . . . . . . . . . . . . . . 191.7 External Debt Outstanding, by Sector . . . . . . . . . . . 211.8 Debt and Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . 22

FIGURES

1.1 Real GDP Growth Rate . 2 .. . . 21.2 Ratio of Public Sector Deficit to GNP . . . . . . 71.3 Ratio of Current Account Balance to GNP . . . . . . . . . . . . . . 71.4 National Savings & Investment Rates . . . . . . . . . . . . . . . . 111.5 Public Sector Savings . . . . . . . . . . . . . . . . . . . . . . . 151.6 Public sector Investments . . . . . . . . . . . . . . . . . . . . . 151.7 Personal Savings and Real GDP . . . . . . . . . . . . . . . . . . 161.8 Net Foreign Investment Trends . . . . . . . . . . . . . . . . . . . 20

CHAPTER II

TABLES Page

2.1 Structure of National Government Revenues . . . . . . . . . . . . . 262.2 Revenue Importance of VAT . . . . . . . . . . . . . . . . . . . . . 292.3 Effective Tariff Rates: 1980-90 . . . ............. . 302.4 Buoyancy and Elasticity of Major Taxes . . . . . . . . . . . . . . 342.5 Tax Ratios in Comparative Perspective . . . . . . . . . . . . . . . 342.6 Potential Versus Actual Income Tax Collections . . . . . . . . . . 372.7 The Potential VAT Base in 1990 . . . . . . . . . . . . . . . . . . 372.8 Potential Versus Actual Number of Tax Filers . . . . . . . . . . . 392.9 Revenue Foregone from BOI Incentives . . . . . . . . . . . . . . . 422.10 Revenue Foregone from All Exemptions (1989) . . . . . . . . . . . . 432.11 BIR Accounts Receivable Collection Performance . . . . . . . . . . 462.12 Enforcement Through Warrant and Distraint Levies . . . . . . . . . 472.13 Workloads of Assessment Personnel . . . . . . . . . . . . . . . . . 492.14 Effectiveness of Tax Fraud Investigation . . . . . . . . . . . . . 502.15 Data on Seizure of Smuggled Goods . . . . . . . . . . . . . . . . . 512.16 Budget of the Customs Poline Administration . . . . . . . . . . . . 522.17 Import Inspection Performa.sce . . . . . . . . . . . . . . . . . . . 542.18 Data on Misdeclared Shipments . . . . . . . . . . . . . . . . . . . 542.19 Estimated Revenue Impact of Selected Measures . . . . . . . . . . . 632.20 Revenue Mobilization and other Objectives . . . . . . . . . . . . . 64

FIGURES

2.1 Structure of National Government Revenues . . . . . . . . . . . . . 272.2 Trends in Direct and Indirect Tax Shares . . . . . . .. . . . . . 272.3 Direct Taxes and Per Capita Income, 1989 . . . . . . . . . . . 332.4 Tax Ratios, 1976-1990 . . . . . . . . . . . . . . . . . . . . . . . 352.5 Gov't Revenue and Per Capita Income 1989 . . . . . . . . . . . . . 35

BOXES Page

2.1 Tax Reform Package of 1986 . . . . . . . . . . . . . . . . . . . . 252.2 Tax Measures Considered in 1991 . . . . . . . . . . . . . . . . . . 57

CHAPTER III

TABLES Page

3.1 National Govt. Expenditures, by Economic Classification,obligation Basis, (Percent of GNP) . . . . . . . . . . . 70

3.2 National Govt. Expenditures, by Sectoral Classification,obligation Basis, (Percent of GNP) . . . . . . . . . . . . . . . 70

3.3 Status of Private Power Projects . . . . . . I . . . . . . . . . . 843.4 The Major Subsidy Recipients . . . . . . . . . . . . . . . . . . . 893.5 The Major Equity Recipients . . . . . . . . . . . . . . . . . . . . 903.6 Results of Perfurmance Evaluation . . . . . . . . . . . . . . . . . 933.7 Collection Efficiency . ... . . ........ .94

FIGURES

3.1 Govt. Expenditures, by Economic Classification . . . . . . . . . . 723.2 Govt. Expenditures, by Sectoral Classification . . . . . . . . . . 723.3 Public Investments by Source (%GNP) . . . . ... 753.4 Public Investments by Source (million pesos) ...... . 753.5 Public Investments by Sector (Share of Total) . . . . . . . . . . . 763.6 Public Investments (Percent of GNP) ... ..... 763.7 Flow of Funds to GCs . . . . . . . . . . . . . . . . . . . . . . . 873.8 Govt Transfers to GCs . . . . . . . . . . . . . . . . . . . . . . . 883.9 GC Transfers to Government . . . . . . . . . . . . . . . . . . . . 883.10 Financial Performance of GCs . . . . . 96

BOXES

3.1 List of Monitored Corporations and Respective Mandates . . . . . . 86

3.2 Financial Crisis and Reform of the National PowerCorporation... . . . .... 98

EXECUTIVE SUMMARY

1. This report reviews recent macroeconomic trends and developments andsuggests that medium-tern development strategy in the Philippines should focuson fiscal adjustment, emphasizing non-de t sources of public finance on the onehand and judicious management of public expenditures on the other. Developinga non-debt base of public finance will require greater policy attention todomestic resource mobilization. Improving the management of public expenditureswill require better cost control and more realistic user charge policies forpublic services, as well as increasing the scope for private sector participationin public sector projects.

2. The report endorses the general direction of the government's currenteconomic stabilization program which gives high priority to fiscal adjustment.As far as the medium-term adjustment program is concerned, it urges that strongconsideration be given to the following three points. First, between revenuemobilization and expenditure reduction, Government should prefer the former sincethe latter is likely to be much more damaging to both short and long term growth.Second, Government should act on a broad front as far as revenue mobilization isconcerned: at present, it does not have the luxury of choosing between expandingthe base on which taxes are collected or improving the process of tax collection.Third, as far as public expenditure management is concerned, Government shouldpay special attention to improving the physical and financial performance ofpublic enterprises.

A. Background: The Adjustment Problem

3. The crux of the adjustment problem in the Philipines lies in certainstructural weaknesses of the external sector on the one hand and the domesticresource mobilization system on the other. The external sector is characterizedby high import dependence and a relatively slowly growing and narrowly basedexport structure. These aspects have condemned the Philippines to a history ofrecurrent balance of payments crises. Phases of economic recovery typicallyresult in high import growth but relatively lower export growth, thus leadinginexorably to payments problems.

4. It has proved difficult to resolve external payments crises by recourse tothe domestic resource mobilizatioii system since this has structural rigiditiesof its own. This system is characterized by low rates of public and privatesavings. On the public side, the tax system is unable to generate the volume ofresources needed to finance the desired level of expenditures partly because ofdeficiencies in design and structure and partly because of problems of taxadministration and collection. On the private side, savings are low partlybecause of income and demographic developments, partly because of the impact offoreign savings and partly because of shortcomings in the domestic financialsystem.

5. The scope for managing balance of payments crises has been narrowed inrecent years by certain developments pertaining to external and domestic

financing ability. On the external side, the availability of long termcommercial credit has been significantly curtailed since the onset of the debtcrisis in the early 1980s. Wnile official flows have increased somewhat, thishas not been enough to compensate for the decline in commercial flows; thePhilippines has experienced negative resource transfers in each of the last sevenyears. On the domestic side, Government has resorted increasingly to directborrowing. Excessive reliance on domestic debL issuance, however, is notdesirable because of the potential for driving interest rates up to damaginglevels. The domestic capital market is saturated with Government paper and hasrecently had difficulty in smoothly absorbing large amounts of domestic publicdebt.

6. The above points can be illustrated by referring to macroeconomicdevelopments during the 1980s. Several consecutive years of high growth financedby high external borrowing during 1975-82 led to a balance of payments problemin 1983-84. With the onset of a global debt crisis in 1982, further recourse toexternal borrowing was sharply curtailed. The subsequent adjustment processfeatured a deep recession over three years (1983-85) during which GNP fell at anaverage rate of 3.4%. Investment plunged from 272 of GNP in 1983 to around 14%in 1985.

7. The economy began to recover in 1986 and grew steadily over the next threeyears. Unfortunately, import growth was much stronger than export growth duringthis period (about 28% per annum compared to around 12% for exports) and abalance of payments crisis loomed again in 1990. Domestic policy slippagecontributed to the gathering crisis: the real exchange rate was allowed toappreciate, monetary control was relaxed, and fiscal deficit targets wereexceeded. With external financing still constrained, external debt servicingstill relatively large and domestic revenue performance still inadequate(although considerably improved), Government resorted to domestic borrowing tofinance growth. This, however, pushed up interest rates to very high levels,thus feeding the fiscal imbalance and propping up the exchange rate. A seriesof economic shocks during the year (drought, earthquake and Gulf conflict) mademacroeconomic management even more difficult. So did the worsening externalenvironment which saw the industrial countries slipping into slow growth andworld trade volumes declining.

8. The Government took corrective policy actions and formulated a newstabilization program at the end of 1990. Progress has been made in 1991 towardsachieving its goals. Fiscal imbalances have improved substantially and monetarygrowth has been gradually brought under control; as a result, inflation hasdecelerated to about 12 percent by end-1991, the current account deficit has beenreduced, and international reserves of the Central Bank have recoveredsubstantially. The cost of tight fiscal and monetary policy, however, has beenthe slowdown of growth, which is estimated below 1 percent in 1991.

The Tasks Ahead

9. In view of the foregoing, the tasks for both short-term and medium-termmacroeconomic management are clear. The short-term task is to continue with thestabilization program since the availability of development financing, from bothexternal and domestic sources, depends on a stable macroeconomic environment.

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The medium-term tesk is to develop further an adjustment program which will helpshake loose the structural constraints that have hobbled macroeconomic managementand hindered the achievement of sustained growth in the past.

10. Fiscal adjustment is central to both the stabilization and adjustmentobiectives. A key target of the ongoing stabilization program is the reductionof the fiscal deficit to 2.72 in 1992. The man.aer in which this is achieved willbe critical to structural adjustment. If it is achieved largely by cutbacks incapital outlays and without improvements in revenue mobilization, the countrywill achieve only temporary macroeconomic stability; political pressures andinfrastructure needs will revive expenditure growth and lead inexorably to arenewed fiscal crisis. The key to successful and sustainable medium-term fiscaladjustment lies in (a) the enhancement of domestic revenues and (b) the carefulmanagement of public expenditures so as to maintain growth momentum whilesimultaneously respecting fiscal constraints.

11. An adu'itional important consideration is the degree to which the privatesector can be harnessed in the pursuit of adjustment. This involves improvingthe environment for private savings and investment efforts. While this is notexplicitly considered in this report, its importance should not be under-emphasized. Private savings and investment are large components of aggregatesavings and investment and if they cannot be harnessed in support of thedevelopment effort, sustained high growth will remain out of reach. Toaccomplish this, it is important to maintain a credible macroeconomic policyregime, one that is consistent with stability objectives (especially fiscaladjustment) and one that is not subject to frequent reversal on politicalgrounds. A credible macroeconomic policy regime can catalyze and sustain growthin private savings and investment. Private savings will rise to the extent thatthe stability of policy and outcomes preserves capital value and discouragescapital flight. Private investment will rise as macro stability brings realinterest rate decline in its wake and provides a less volatile planningenvironment to the investor.

12. The stress on fiscal adjustment in this report should not be taken to meanthat measures to relax. the external constraint directly are not important. Theyare very important. Measures to promote market oriented exchange rates, low anduniform tariffs, minimal import restrictions, and institutional support forexport-oriented activities are a sine qua non for achieving high and sustainablegrowth. A number of key measures in these areas have been taken in 1991-92, butneed to be sustained to lay the foundation for long-term growth. Moreover.despite the pressures of an election year, the Executive and Legislature havecooperated in passing several important revenue measures, a promising test ofpolicy resolve which needs to be maintained.

B. Enhancing Domestic Revenues

13. The key question with respect to the public revenue system is whether ornot it generates sufficient funds to finance the desired development effort,given certain constraints on government's ability to borrow. In the case of thePhilippines, despite considerable improvement in recent years (the tax ratio rose

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from 10.3X during 1981-85 to 12.42 during 1986-1990), the system falls short inthree respects. First, it generates less than what is required to funddevelopment expenditures; this is shown by the fact that actual taxes collectedwere lower than the amounts targeted in each of the last five years. Second,Philippine tax effort lags that of its ASEAN neighbors and is less than what itsrelative development stage would lead one to expect. Third, the system generatesless revenue than would be expected from considerations of national income andtax parameters; mn other words, actual tax collections are far less thanpotential tax intake.

14. Tax Collections versus Tax Potential. Calculations performed in thisreport indicate that low collection relative to potential is a feature ofvirtually every major tax. For example, it is calculated that in 1988 only 532and 65Z of potential individual and corporate income taxes respectively werecaptured by the revenue system. VAT collections were short of potential by 50%in 1990. Significant tax evasion is reported for excise taxes also, althoughcurrent estimates are not available. Finally, it is reported that failure toprevent smuggling robs the national treasury of at least around 20% of potentialcollections from import duties. These estimates of tax potential are necessarilyimprecise but they provide a meaningful indication of the scale of the problem.

Revenue Collection: Structural Issues

15. Base Erosion through Exemptions. A considerable amount of revenue isforegone through exemptions awarded to government and private corporations.While some of these exemptions are justifiable (e.g. tax and duty drawbacks asa tool to promote exports) others may impose a fiscal cost well in excess ofactual benefits. For example, the evidence suggests that fiscal incentivesawarded through the Board of Investments are not particularly effective ininducing "incremental" investments and succeed only in providing a windfall gainto those who would have invested anyway because of other business considerations;in the meanwhile, such incentives accounted for a potential revenue loss ofaround 2.82 in 1989. Given current fiscal needs it is recommended that theincentive system, especially that covering private investment, be redesigned toreduce the number of eligible sectors or industries. Government has recentlyreduced the number of industries listed in the Investment Priority Program; thisis an encouraging initiative and should be intensified.

16. Base Erosion through Nonfiling of Tax Returns. Far fewer individuals andcorporations file tax returns than one might expect from general considerationsof income and employment growth and company formation in the country. Forexample, only about 28? of the potential number of individual income tax filersand 29Z of the potential number of corporate income tax filers actually filedreturns in 1989. Even if these ratios are doubled, to account for possibleliberalism in our calculations, the scope of the non-filing problem is still seento be very large. It is admittedly very difficult to address the non-filingproblem in an economy characterized by poor record-keeping and legal and fiscalimpediments to discovery and prosecution. Nevertheless, a start can be made bycomputerizing the tax monitoring system to catch drop-outs with greater ease.

17. Base Erosion through VAT Exemptions. When the VAT system was introducedin 1988, several categories of goods and services were exempted and a single rate

of OZ was adopted; This too has contributed to reducing the size of the baseon which taxes ~re raised in the Philippines. While a n4rrow base may have beensensible initially, in view of anticipated difficulties in introducing a newsystem, enough experience has been ined by now to justify the expansion of theVAT base. Among the categories of services that could be included in the VATbase are: hotels, caterers, common carriers, forest products, securities dealers,public utilities, communications, and entertainment. It should be noted thatrevenues would not necessarily be increased in all cases if the VAT rate of 10%is applieds for example, hotels currently charge a higher rate and there is nobenefit of input crediting. Nevertheless, a widening of the base would bejustified on rounds of tax neutralit' and easing of administration.

18. Underdeclaration of Incomes. Many of those who file do not report theirtaxable incomes accurately. This is particularly true of self.employedprofessionals and small businesses. The scope of the problem may be gauged fromthe results of a study ir which the presumptive income levels of doctors inManila were calculated from a survey of case loads, consulting hours and fees:it was foand that thege were from four to fifteen times higher than the averageincome reported by doctors in the tax files of the Bureau of Internal Revenue(BIR). In part, such underdeclaration is possible because of the 'egal inabilityof the BIR to detect cases of evasion through the financial records of taxfilers. The failure to catch such evasion, especially by the wealthy, involvesa large direct revenue loss, of course, but also has a corrosive effect on publicethics with regard to tax obligations.

19. Given the potential revenue payoff of more accurate declarations, it isrecommended that a presumptive income level system be introduced for certaincategories of hard-to-tax groups. It is clear that several legal andadministrative challenges will have to be surmounted before such a system can bewidely implemented. Concerned groups will lobby strongly against such a systemand initial assessments will be widely contested. On the administrative side,there is the difficulty of making sufficiently precise estimates and thenupdating them regularly. Neverth.eless, several countries (e.g. France, Turkey,Japan, Israel, Thailand) have adopte4 this system in one form or another; theirexperience suggests that the system is productive and that various anticipateddifficulties can be dealt with satisfactorily. For example, to obtain thecooperation of target taxpayer groups, their professional associations could beinvolved as partners in the process of estimating presumptive income levels andsetting procedures for revision and arbitration.

20. It is also recommended that the Bank Secrecy Law be amended to facilitatethe accquisition of financial records by the BIR. The amendments would have tobe made in such a way that a balance is struck between the authority's legitimateneed to know and the individual depositor's need for protection from abuse. Todevelop such amendments, guidance could be sought from the tax and bank laws ofother countries. Two considerations should be kept in mind. First, givenpresent levels of evasion, depositors should not be protected to a higher degreethan is normal for neighboring countries. Second, some concerns are likely tobe exaggerated. For example, relaxation of bank secrecy laws is unlikely tocreate great financial disruption. There usually is no alternative for the "big"tax evader to using banks since informal institutions are unlikely to provide anadequate degree of security and convenience. Concerns about runs on banks can

'vi. -

(also be met through othtir means, such as by providing liquidity to affected bankstht"Ough Cenqral Bankc mechanisms..

2iL. Overstatement of Deductions. There are several provisions in the tax codethat make ̀it easy for taxpayers to overstate allowqable deductions. For example,sp(rises often file separate returns with each claiming full deductions forchildren, effectively doubling the value of the deduction. Deductions forcertain business expenses, sv;ch as representation, promotion, and travel, arewidely abused. The problem here lies not in the allowance of deductions per sebut in the fact that they are not subject to reasonable ceilings. In thisregard, recent legislation (viz. the simplified net income tax scheme) to imposeiore rational ceilings on business deductions is to be welcomed.

Revenue Collection: Administration Issues

22. Internal revenue administrati^n has improved in recent years as evidencedby improvements in tax effort as well as in the cost of collection which declinedfrom 1.14 pesos for every 100 pesos collected in 1981-85 to an average of 0.83pesos in 1986r9O. Nevertheless, there is considerable room for improvement. Thekey problem areas relate to collection, audit and tax fraud investigation.

23. Problems in Collection. Collection is characterized by a rather largeoverhang of accounts receivable. The number of such accounts amounted to almost14% of the total number of income tax filers during 1986-90 while their valueamounted to almost 19% of total BIR collections. The severity of this problemcan be related to such causes as an inadequate taxpayer identification system,inadequate computerization of records, and weak enforcement follow-up. The firsttwo causes make it difficult to generate an accurete master list of taxpayers,monitor this list for drop-outs and delinquents, and update the record of,payments and adjustments. Manual tracking of accounts inevitably invites'disruption and delay, whether accidental or by design. Weak enforcement follow-up encourages fraud since the threat of penalty is effectively reduced. Lack ofpersonnel is typically cited as the chitf cause of weak enforcement. Often,however, the enforcement process cannot even be started because the defaultingtaxpayer cannot be located, a problem related both to a poor monitoring systemand lack of resources to investigate delinquencies.

24. The collection problem is being addressed by a change-over from the presentsystem of multiple account numbers for different tax transactions to a systemfeaturing a single tax identification number (TIN). This would help enhance dataprocessing and reduce tax evasion. Data processing would be facilitated sincefewer files would need to be opened, payments made could be easily recorded, andadjustments easily effected. Tax evasion would be discouraged to the extent thatdifferent transactions with BIR could be easily retrieved for cross-checkingpurposes. In addition, if the TIN were designed to identify spouses, this wouldhelp cut down on evasion through the practice of both spouses claiming fulldeductions for the same set of dependents. It should be noted that the fullvalue of a TIN system can only be derived if tax accounts are properlycomputerized. In addition, computerization would enable improved monitoring oftax account status and improved interaction with other government agencies thathave a revenue function.

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25. Problems in Audit. The quality of assessment and audit suffers from thelack of appropriate case screening criteria. At present, no attempt is made toseparate out cases which are likely to generate high post-audit adjustments fromthose whlich are unlikely to do so. Ae a result, workloads are heavy relative toavailable personnel and much of the assesement work consists of perfunctory deskreview. Experience shows that certain types of returns rarely involve fraud andmisdeclaration: for example, this is the case for returns filed by individualswho derive income purely from compensation and whose taxes are withheld atsource. Legislation has recently been pcssed making it possible to consider suchwithheld taxes final in nature. As 8t th, they need no longer be part of theauditable pool, a development that it --pected to reduce BIR's workload andimprove audit quality for the remaininL ,ases. It is recommended that casescreening criteria continue to be developed with ar. eye to the economics of taxadministration.

26. Problems in Tax rraud Investigatior. Tax fraud investigation in thePhilippines is characterized by slowness of pace and ineffectiveness of results.These characteristics are related in turn to a number of personnel motivationproblesa and to weak penalties In the law for tax fraud. Personnel motivationproblems arise from low pay and heavy workloads. The BIR has found it difficultto hire competent tax law"yers at its present pay scales as most such lawyers havea more lucrative alternative in -rivate practice. The number of legal personnelin BIR has declined from 142 in 1983 to only 88 in 1990; as a consequence, therehas been a sharp drop in the filing of civil and criminal tax cases.

27. Examiners are generally reluctant to get involved in tax fraudinvestigations because the process is a long drawn-out one with little prospectof a satisfactory outcome. Sometimes, such investigators are harassed andthreatened with lawsuits; in such cases they are personally liable for expensesand penalties if they lose the case. Furthermore, courts do not give highpriority to tax cases. And for cases that are heard and decided, the penaltiestypJ'ially awarded are considered unlikely to have a significant deterrent effect;civil penalties are light while criminal penalties are rarely imposed. In recentyears, the number of cases filed has been less than 0.1Z of the total number ofreturns.

28. Recently, 20 courts in selected major urban areas were asked to handletax cases on a priority basis; however, since these courts continued to handlenon-tax cases as well, they did not significantly ease the backlog of tax casesin the jurisdictions concerned. Legislation has recentlv been passed to set upa system of dedicated, specialized tax courts which would only hear tax cases.This is a step in the right direction. As far as penalties are concerned,common sense suggests that evasion should decrease in direct proportion tcanticipated penalties. Raising fines and applying jail terms more frequentlywould have a deterrent effect on tax fraud. Legislation has also been passedrecently to increase penalties for tax evasion; only experience will tell whetherthe enhanced penalties have a sufficient deterrence value, but this too is a stepin the right direction. What remains to be done now is to protect tax personnelfrom potential harassment. Thus it is recommended that legal protection be givento tax personnel against lawsuits for actions taken in their official capiytjin such cases, these personnel should also have access to public legal andfinancial support.

viii -

29. Customs Administration and Smuggliag. Underperformance with respect to thecollection of import duties is primarily related to inadequate surveillance andprevention of smuggling. Other problems, such as miodeclarLtion of dutiablevalue, are comparatively minor and are being adequately addressed by the pre-shipment, import inspection scheme; the incidence of misdeclaradion should befurther reduced by the recent decision to globalize this scheme.

30, The value of smuggling into the Philippines is high and seems to be rising.Indicative estimates prepared by the Economic Investigation and IntelligenceBureau show that smuggling averaged around $754 million during 1979-85 or about9? of average annual imports, and rose to $1.1 billion per year during 1986-90,or about 12Z of average annual imports. Apprehensions of smuggling attempts arefew and far between. The value of apprehended cargo is typically a smallfraction, around 4%, of the value of estimated smuggling.

31. Perhaps the most important cause of low apprehensions is the meagerness ofthe resources devoted to the prevention of smuggling. For example, customs waterpolice have only one operational patrol boat. Even this is used not for patrolduties but as a means of transport for customs officials to board ships for cargoinspection. The bureau does not even have its own stripping machines for cargoinspection; instead, it relies on private firms for this function, an aspect thatreduces the speed and flexibility with which the customs police can act. Thebudget of the customs police has decreased in nominal terms since 1986 and hasdeclined as a proportion of the overall customs budget in every one of the lastfive years.

32. Given the seriousness of the smuggling problem, it is recommended thatresources (both personnel and equipment) devoted to the anti-smuggling effort beconsiderabli increased; the recent award of a global import inspection contractto a private party should permit a reallocation of customs budget resources.

Privatization of State-Owned Assets

33. Government has been implementing a rationalization program during the pastfive years among whose key features is the privatization of state-owned assets.While revenue generation is not the dominant rationale for this program, it isan important consideration. From the point of view of revenue mobilization, theprogram has been a partial success. During the last five years, a sum of aroundP44 billion has been recorded as gross proceeds from privatization. Of this sum,however, only P14.5 billion has beern remitted to the national treasury so far.The remainder is accounted for mainly by amounts held in escrow pendingsettlement of legal issues, sales transactions awaiting completion via debt-equity or debt-asset swap schemes, and amounts payable in installments.

34. For the period 1992 and beyond, privatization is projected to gross P42billion of which Government's share is expected to be around P14 billion. Thebulk of the sales, an amount of P30 billion, is expected to occur in 1992; ofthis, Government's share is expected to be about P9 billion. Privatization gotoff to a good start in 1992 with the successful auction of Philippine Air Lines,a "big-ticket" item which drew a higher-than-expected bid. Among other suchitems slated for 1992 is the sale of a further batch of shares in the PhilippineNational Bank.

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35. The proceeds from privatization, both historical and projected, are smallrelative to total revenues. During 1987-90, .he cumulative remittances to thetreasury amounted to just around 1.5% of total revenues. Except in 1992, futurecontributions will be even less significant, partly because the proceeds willtaper off as the stock of privatizable assets shrinks and partly because totalrevenues (the denominator here) will increase through growth and inflation.Nevertheless, privatization should be encouraged for several reasons. First, ithas intrinsic merit in that it leads to a more efficient deployment of overallresources. Second, in an environment of severe fiscal constraint, additionalresources have a high marginal utility. Third, even if the direct revenue effectis limited, the indirect savings from disposing of non-performing assets andinefficiently managed public corporations can be quite substantial.

Revenue Mobilization Priorities

36. The foregoing has indicated that additional revenues might be derived fromimprovements both in the design and administration of the tax system. Givencurrent fiscal needs, the Philippines does not have the luxury of preferring oneset of improvements to the other- the "optimal" revenue strategy would combinenew taxesltax refinements with measures to improve tax collection. Action mustbe taken on all fronts. Recently, a number of important tax measures have beenlegislated. These include the imposition of more rational ceilings on businessdeductions, the simplification of the net income tax scheme, the restructuringof transfer taxes (on estates), the imposition of higher penalties for taxevasion and the setting up of specialized tax courts. In addition, a globalimport inspection scheme is due to be implemented soon. Among remainingmeasures, high priority should be given to the following on the grounds that theyare likely to "produce" sooner: (a) reduction of VAT exemptions; (b)restructuring of vehicle registration taxes; (c) computerization of revenueadministration; (d) introduction of a presumptive income level scheme; (e)enhancement of legal protection for tax personnel and (f) amendment of the BankSecrecy Law.

C. Improving Public Expenditure Management

37. While enhanced resource mobilization is a necessary condition forsustaining higher growth in the future, it is not a sufficient condition. It isimportant to go beyond raising resources to ensuring that they are used in anefficient manner and towards desirable ends. The experience of the Philippinesduring the 1970s provides a case in point. Public expenditures rosesubstantially during the 1970s, but they were not deployed in an efficientmanner. Higher public expenditures were associated with substantial growth inthe size of government, with an increase in subsidies for government services,and with a preference for large and expensive investments in sectors wherecomparative advantage was doubtful, to say the least. Consequently, theseexpenditures did not result in sustained growth and, to the extent that they werefinanced by external borrowing, did not generate the resources needed to meetdebt-service obligations. This contributed to the fiscal and economic crisis ofthe mid-1980s, a crisis whose ramifications affect budgetary priorities andeconomic performance even to this day.

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Patterns and Product4vity of Public Expenditures

38. Public Sector Investment. The relative decline of public investmentexpenditure is a prominent feature of the pattern of public expenditures inrecent years: total public sector investment, that is, including the investmentof public enterprises and local government units, declined sharply from anaverage of 6.4Z during 1975-85 to only 3.92 during 1986-90. Both the nationalgovernment and government corporations cut investment outlays as external flowsdeclined (relative to the 1970s). There was, in addition, a dramatic shift inthe sectoral composition of public investment: the share of the power sectordropped from 30Z of the total in 1975-85 to 19X in 1986-90 and that ofinfrastructure (roads, bridges, etc.) dropped from 66% to 53X. On the otherhand, the share of education almost quiadrupled (from 2.22 to 8.4%) while that ofhealth more than doubled (from 0.6Z to 1.8%). This shift was due to two factors:a reduction in the funds available to public enterprises (which are the majorinvestors in power and water etc.) and a commitment to social infrastructuredevelopment made by the Aquino Government.

39. Effect on Overall Productivity. The above-described changes in the sizeand composition of the public investment programs could have significantimplications for long-run growth in the Philippines. A proper assessment ofthese implications requires an understanding of the relationship between publicexpenditures and productivity growth. This relationship has long been thesubject of debate. Proponents argue that such expenditures are critical todevelopment in that they (a) make up for the lack of private capital andinitiative to develop infrastructure (b) compensate for market failure in certainareas (e.g. public goods provision) (c) exploit large positive externalities inthe social sectors and (d) stimulate private investment by raising aggregatedemand as well as by creating supportive and enabling infrastructure. Opponentsargue, however, that the evidence of market failure and lack of privateinitiative is weak and that public expenditures do not have a net stimulativeeffect for one or both of two reasons: they may depress overall productivitysince they are typically associated with less-efficient and non-competitive(public) enterprises and they may crowd out private investments by increasing thecost and/or decreasing the availability of credit to the private sector.

40. Judgements with regard to the productivity of public investment in thePhilippines must be based on cross-country experience since country-specificempirical analysis is hampered by lack of appropriate data and a commonly-accepted methodology. The tentative conclusions that might be drawn from cross-country evidence are (a) that pub,lic investment does increase productivity; (b)that operating and maintenance expenditures might be preferable to directlyproductive capital expenditures; a bias towards capital formation as opposed tocapital maintenance could be detrimental to growth; and (c) that the positivegrowth effects of human capital formation (via social sector spending) might begreater than those of physical capital formation. In light of this, the reductionin the size of the public investment program witnessed in recent years should bea cause for concern; cuttin the public investment program and not spendingenough on maintenance may only succeed in achieving short-run adjustment at theexpense of long run growth. On the other hand, the shift in the composition ofthe public investment Drogzam in favor of human capital formation could, underappropriate macroeconomic management, improve the returns to the program.

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41. Effect on Private Investment. Another channel by which public investmentis thought to affect national productivity is by way of its effect on privateinvestment. There are two considerations here, conveniently captured by theterms "crowding out" and "crowding in". Crowding out occurs when the effect offinancing public expenditures through borrowing is to raise the cost and/ordecrease the availability of credit to the private sector, thereby decreasingprivate investment. Crowding in can occur from the stimulative effect of publicexpenditures in one or both of two ways. There could be a demand-side effect ashigher government expenditures raise aggregate demand, subsequently leading toan increase in private investment. There could also be a supply-side effect aspublic investments relax key infrastructure constraints thereby enabling higherlevels of private investment.

42. Analysis for the Philippines suggests that public spending contributes tocrowding out through financial markets. The higher the demand for public credit,the higher are interest rates and the lower is the level of private investment.In the 1980s, these links have been even stronger since constrained foreignsavings meant that government had to satisfy more of its credit needs from thedomestic market pushing up interest rates in the bargain.

43. Investigation also suggests that government investment outlays have apositive direct effect on private investment whereas spending through governmentcorporations (GCs) has a negative effect. This cannot be neatly identified withInfrastructure and non-infrastructure investments since some GCs, such as thepower and water utilities, provide much-needed infrastructure services. It doesreflect the fact, however, that many GCs tend to compete with the private sectorin various business areas and may therefore crowd it out. This is a plausibledescription of GC behavior in the late 1970s and early 1980s, when many of themwere active in the manufacturing and mining sector and a few held monopolypositions in other sectors (e.g. coconut oil processing).

44. In any ctee, the mere provision of infrastructure may not be enough togenerate and sustain private investment; there typically needs to be a supportiveeconomic and political environment as well. This point can be illustrated fromthe experience of export processing zones in the Philippines. Starting in theearly 1970s, several export processing zones were established; they were providedwith basic infrastructure such as roads, water and power and benefitted as wellfrom fiscal incentives and the availability of imported inputs at world prices.However, on the whole, their performance has been disappointing in terms ofinvestment, employment and export growth, especially when compared to neighboringcountries. This is due in part to a poor choice of location for several of theEPZs set up in the Philippines and in part to a policy environment that hasgenerally supported import-substitution activities. A good example of thelocation problem is that of the Bataan EPZ, which is situated in a relativelyremote area (about 200km from Manila) and has never performed to potential.Despite the availability of good basic infrastructure within the Bataan EPZ inthe early years, it was unable to attract many investors. Over time, the lackof a growing revenue base led to cash shortages and inadequate expenditures onmaintenance which led in turn to a deterioration of the basic infrastructure: allin all, it has turned out to be a poor public infrastructure investment. On theother hand, a similar investment made in the Mactan EPZ has turned out wellprimarily because this site is well located, being cheek-by-jowl with Cebu.

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Private Sector Role in Public Investment

45. Three factors have led to increased discussion of a potential privatesector role in the provision of public investment in the Philippines. The firstis tbe continuing budget problem: there is not enough available to finance thedesirable level of infrastructure investment. Second, the e is a mountingawareness that public investment quality has been poor and that one way to guardagainst this would be to transfer part of the risk, and part of the reward, ofensuring quality to the private sector. Third, much international experience hasbeen gained with new mechanisms, such as the Build-Operate-Transfer (BOT) conceptand its many variants, for involving the private sector in public investmentactivitiest such experienri has reduced the uncertainty for both public andprivate parties contemplating such ventures and thereby reduced their resistanceto the idea.

46. The need for private participation is well illustrated by the example ofthe power sector in the Philippines. The National Power Corporation which Is thepublic entity entrusted with the task of generating power has been unable togenerate the necessary funds to meet planned investment schedules; it facescharges of inefficiency, mismanagement and corruption as well. The power plantsunder its management have technical and non-technical losses that are aboveindustry ste.ndards in Southeast Asia. Since 1989, there have been frequent poweroutages and it is estimated that output losses to industry on account of thisamount to around $1.1 million per day. The investment requirements to close thedemand-supply gap are overwhelming. During the period 1989-1999, it is estimatedthat 3,679 MWs of new capacity must be added; this would cost some $7.5 billion,of which $4.7 billion would be needed for new generating capacity alone. It isestimated that only 28% of this investment requirement can be sourceddomestically and 722 must come from foreign sources, in the form of loans and/orequity. Since NPC is not in a position to service its loans without budgetarysupport and since the pressures of the fiscal deficit indicate that even the 28%projected local public funding may not be available, it is imperative thatprivate financing be sought.

47. The Philippines has put in place a set of policies and guidelines tofacilitate private sector participation in a broad range of public infrastructureinvestments. An Executive Order (E0215) was enacted in 1987 to permit suchparticipation in power projects. One project has already been completed, one isunder negotiation, and three more are under evaluation. A total capacity of 1660MWs is to be developed under private contracts through 1995. In July 1990, anAct of Congress expanded the permitted scope of private participation to covermost infrastructure investments, including those in transport, communications,water supply, sewerage, education, health, and environmental management. Someimprovements have been brought about as well in the set of laws governing foreigninvestment; this should make it easier for foreigners to participate in publicinvestment projects. It is generally conceded that the political will, theexecutive enthusiasm and the appropriate legal framework are now in place. Whatis needed is experience with actual projects. With the benefit of suchexperience, guidelines and regulations can be fu-ther refined.

48. Some experience has already been gained. In 1989, NPC awarded a BOTcontract to Hopewell Holdings Ltd. under which the latter committed to install

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a 210MW gas turbine, operate it for 12 years, and then transfer the ownership toNPC. The installation was completed rapidly and the project is running smoothlyso far. The success of this project was due in part to the fact that Hopewellwas an experienced regional project developer able to offer a very attractivepackage to NPC. For its part, Government provided an adequate guarantee for thepurchase of power from the Hopewell project. Another proposed BOT project, thisone for a co-generation (steam and electricity) plant to be set up by CogentrixInc., did not fare as well. It was abandoned after protracted negotiationschiefly because of a failure to agree on an appropriate power purchase plan.Other critical factors were the lack of a clear process regarding environmentaland construction permits, lack of a strong local joint venture partner andfailure to secure financing. The Cogentrix example suggests that there needs tobe much learning-by-doing in this area, for both Government and the privatesector. Given the complexity of BOT projects and the lack of experience withforward contracts in infrastructure services, rapid and positive resolution ofdeals should not be routinely expected and such ventures should not be viewed asa panacea for the public infrastructure problem. In particular, such initiativesshould not distract attention from the need to improve the public sector'sability to provide the bulk of the infrastructure program.

Improving Public Enterprise Performance

49. Public enterprises are relevant to fiscal adjustment to the degree thatthey depend on the national government budget for their financing needs. If thisdependence can be reduced, the process of fiscal adjustment would be eased.There are two ways in which this is normally done. First, some governmentcorporations (GCs) can be privatized: this generates additional governmentrevenues and decreases future claims on the budget. The historical and potentialyield of the ongoing privatization program has already been noted in a previoussection. Second, for those enterprises that cannot be privatized, financialrestructuring can be undertaken so as to develop alternative sources of funds andmanagement improvements can be introduced so that costs are reduced, productivityis increased and lower claims are made on the budget as a consequence. ThePhilippines has attempted both financial and management restructuring for its GCsin recent years.

50. Financial Reform. Financial restructuring has taken the form of a sharpreduction in net budgetary transfers to GCs: net flows to GCs declined from ahigh of P33 billion in 1986 to P4 billion in 1990, or from 30% of expendituresto around 2Z. The decline was made up of a reduction in gross flows in the formof equity infusion and net lending as well as an increase in GC transfers to thenational government in the form of dividends, interest payments and the proceedsof privatization. Restructuring has also involved a change in the nature of thefinancial link with GCs, a change which made the size and cost of transfers moretransparent. Thus, subsidies have been preferred to equity or loans and, whenmade, loans have carried market interest rates. This approach has also beenapplied to tax exemptions. Most GCs (all but six) had their tax:exemptionsrevoked in 1986; since then, they have had to do without such privileges or applyto obtain relief from a Tax Expenditures Fund (TEF) set up in the budget. Thiseffectively limits the size of tax exemptions to the appropriation cover for theTEF and makes them transparent in the sense that they are subject to periodicreview by Congress.

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51. Such restructuring has contributed to greater financial autonomy which isreflected in declining dependence on funding from the government budget: theratio of government-sourced funds to total expenditures fell from 20Z to 72 overthe period 1986-90. There was also a rise, on average, in the volume of cashgenerated internally as well as an improvement in operating ratios from 1986 to1989 (but followed by a decline in 1990-91). It is generally believed that someGCs have managed themselves better once weaned from the public purse.

52. The above account of financial restructuring should be qualified by threeconsiderations. First, there was little attempt at generating internal cash bya market-oriented adjustment of user charges; indeed, user charges declined inreal terms over 1986-90. Second, there was a sharp cutback in the size of theoverall capital expenditure program of GCs, a cutback that also permitted slowergrowth in related current expenditures. A far better outcome of reduceddependence on the budget would have been an aggressive attempt to control costs,raise user charges in line with inflation, and preserve the investment progrm.Third, the trend in the direction of greater financial autonomy was upset in 1991on account of the deteriorating financial condition of the largest publiccorporation, the National Power Corporation. NPC was given financial support(loan plus equity) in the amount of almost 5 billion pesos, an amount equal toalmost 602 of the original budget for transfers to all GCs.

53. Management Reform. Management reform in the GCs has been attempted throughseveral means. First, the overall policy-making and monitoring body (the GCMCC)was reconstituted in 1987 with a clearer mandate. Second, technical assistancewas made available to GCs to formulate corporate plans, undertake computerizationof their accounting and management information systems, and carry out studies oftheir organizational needs and opportunities. Third, measures were adopted toincrease operational autonomy of GCs. Fourth, a performance evaluation andincentive system (PEIS) was introduced, initially for five GCs (in 1989) andsubsequently for another 23, with the goal being that of covering all eventually.

54. The results so far derived from the PEIS show that there remains much roomfor improvement of GC performance. Several GCs have consistently failed toachieve some targets. The general areas of concern and the main GCs affected areas follows (see inside cover for explanation of acronyms):

-Collection of receivables: NEA, NIA, LWUA and MWSS.-Operating Ratio: NHA, NFA.-Systems Loss: MWSS, NEA, NPC.-Profitability: NEA, NIA, LRTA, PNR, NFA

55. The experience with profitability merits special consideration. The netincome of GCs rose from P2.2 billion in 1985 to P6.3 billion in 1989, a handsome30X annual growth in nominal terms or 212 in real terms. However, this ismisleading to the extent that it includes government subsidies. Excluding thesubsidies, the net income picture is quite different. It shows a decline in bothnominal and real terms over the period 1985-90. Five of the 14 major GCsincurred consistent losses during this period: these are NIA, NEA, LRTA, PNR, andNFA. Since all but the NFA deal with the provision of basic services(irrigation, rural electricity, and transport), their poor financial performanceis a cause for concern. These are not services whose costs are hard to measure

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or price or whose beneficiaries are hard to separate into subsidy-deserving andnon-deserving groups. Poor financial Rerfomance for these GCs suggests thatthere has been inadequate reliance on cost-based user charges and insufficientcontrol over cost and productivity. These deficiencies point to correspondingsolutions, that is, better cost control and higher user charges. This conclusionis bolstered by the recent experience of the National Power Corporation, whichsuffered huge losses in 1991 due to failure to adjust user charges in a timelyfashion; NPC management stands Accused as well of having exercised poor controlover costs.

56. The question of control over costs and user charges is tied up with thedegree of operational autonomy that individual GCs have. The degree of autonomyvaries by category as well as by GC. There exist limits on the authority of GCsto make personnel, investment and financing decisions. For example, as far asthe ability to hire and fire personnel is concerned, all GCs are bound by civilservice rules and regulations; compensation levels are also governed by DBMguidelines. There is more flexibility on pricing decisions, although this variesby type of corporation. For example, most public utilities have to go throughpublic hearings before price adjustments can be made; they are also subject tolaws limiting rates of return on investment to 12%. The NPC and NFA, moreover,have to clear price adjustments with the Office of the President. NPC'sfinancial crisis in 1991 was due largely to the failure of oversight authoritiesto allow user charge increases requested by NPC management. Among the majorutilities, only the MWSS has full power to aujust rates without the approval ofhigher authorities. Since control over costs and user charges is shared betweenGCs and Government, responsibility must also be shared. Ultimately, Governmentmust make the appropriate political decisions that will truly rationalize publicsector operations and enable greater efficiency. Such decisions should not beconfined to cost control and iser charges only: government should consider takingadvantage of the fact that the services provided by some of the loss-making GCsare eminently privatizable.

57. In view of the foregoing, the following specific recommendations are made:

(a) the subsidy program should continue to be re-examined with a view todetermining desirable levels of subsidy for various activities and especially forfood and irrigation, the two highest subsidy receiving activities at present; thereview of the program should consider whether or not subsidies are in factreaching deserving beneficiaries and whether or not subsidy-delivery costs couldbe reduced through improvements in management and adjustment of user charges;

(b) the requirement for GCs to remit dividends to the NG should beimplemented with as few exemptions as possible; the 10% mandatory dividenddeclaration rate (percentage to net income) should be increased to 15%, which isthe average for firms listed on the stock exchange;

(c) GCs should be given more operational flexibility particularly withregard to the adjustment of user charges; at the very least, they should beallowed to automatically raise user charges in line with inflation; in general,power to adjust user charges should be vested in the governing boards of GCsrather than in the Office of the President;

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(d) GCs should also be given more autonomy in matters relating to personnelhiring and firing decisions; present restrictions on such powers limit theability of managers to improve manpower quality and reduce manpower costs and areinconsistent with the general objective of achieving a leaner but higher qualitybureaucracy; and

(e) systems to reward good performers and penalize poor performers amongOCs should be pursued, following on Executive Order 486 of November 8, 1991,which provides for the payment of bonuses and incentives to staff of well-performing corporations.

D. Combining Resource Mobilization with Efficiency

58. It has been argued in this report that a desirable development strategywould combine a shift towards non-debt sources of public finance and the use ofefficiency criteria to guide investment. Reconfiguring the sources of publicfinance will require further improvements in revenue effort. Emphasizinginvestment efficiency will require further exposing the economy to the disciplineof international competition through tariff reduction and a market determinedexchange rate. There is no inconsistency in the long run between theseobjectives or the effects of the measures required to achieve them. In the shortrun, however, there may be tradeoffs. For example, import duties are animportant source of revenues and tariff reductions will most likely decreaserevenue flows to the treasury. Similarly, exchange rate depreciation which maybe required to maintain international competitiveness will simultaneouslyincrease the foreign debt-service burden of the public sector, thereby increasingexpenditures. Given these possibilities, it is worthwhile exploring thequantitative dimensions of the tradeoffs between various measures that might beundertaken to promote domestic resource mobilization and economic efficiency.

59. Another, and recurrent, concern for the Philippines is the management ofthe current account deficit. Given a comparatively low level of investmentefficiency and a tight external financing constraint, such deficits quicklythreaten to produce balance of payments crises. Hence, it is important tcemaintain a stable and low current account deficit; at present, in the context ofthe IMF-supported stabilization program, the Philippines is in the process ofbringing down this deficit from the high and unsustainable level of 5.2Z of GNPreached in 1990. In achieving this objective, which translates into a reductionof foreign savings, domestic savings must be increased through fiscal adjustment.Policy formulation in this area requires knowledge of the quantitative linksbetween various fiscal adjustment measures and the current account objective.

60. Such quantitative links were examined with the aid of a computable generalequilibrium model of the Philippines. Four scenarios were simulated: (a) tariffreform as specified in Executive Order 470; (b) reduction of current accountdeficit by 1% of GDP; (c) an increase of 1Z in the investment rate and (d) acombination of selected efficiency increasing measures together with (a), (b) and(c). The efficiency measures comprise expansion of VAT coverage, eliminationof all subsidies prov'ded by Government, abolition of the special 5% import levy,and liberalization of investment and trade (leading to an increase in import and

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export elasticities). In each case, the model was used to calculate the requiredincrease in domestic taxes or decrease in government consumption using 1990 asthe reference year.

61. The results suggest that significant amounts of domestic revenues areneeded in order to achieve in a sustainable fashion the medium-term objectivesof greater efficiency, more growth, and a lower current account deficit, that is,the objectives implied by (a), (b) and (c) above. These objectives can beaccomplished by raising domestic taxes by 38Z which implies an increase in thetax ratio of around 192. Given that the typical rate of increase in tax revenuesin recent years has been around 22%, this suggests that special efforts arerequired to increase the elasticity and buoyancy of the tax system, that is, taxcollections must be increased through a combination of reforms affecting thedesign and administration of the tax system.

62. of coura-, a reduction of government expenditures would ease the revenueenhancement required. The results of the simulation exercises suggest that suchexpenditure reductions will have to be of similar magnitude to the revenueenhancements, that is, around 38% for the medium-term objectives case.Efficiency or productivity enhancing measures would also help. A simulationcombining selected expenditure reductions, revenue increases and productivityimprovements (scenario (d) above) suggests that the required revenue mobilizationcan be cut to 192 by such measures.

63. The key conclusions are, therefore, the following: (i) a significantincrease in revenues is required to meet the medium-term objectives of greaterefficiency, higher growth and lower external deficit; this cannot be met bynormal revenue increases associated with growth but must be obtained fromimprovements in tax collection; (ii) the required revenue effort can be moderatedby improvements in productivity and reductions in public expenditures which areobtainable from such measures as higher user charges and better cost control formost public enterprises.

I. THE MACROECONOMIC CONTEXT

1.1 This chapter provides the historical macroeconomic context forrelevant issues in domestic resource mobilization and management. It begins byreviewing, in Section A, the growth experience of the Philippine. in the lastfifteen years and analyzing, in Section B, the role of two key variables, savingsand investment, an. their public, private and foreign components. This providesthe basis for outlining, in Section C, the thrust of an appropriate macroeconomicmanagement strategy, a strategy that would be best placed to restore thePhilippines to a sustainable growth path after the roller-coaster ride of thelast fifteen years. Section C concludes with an overview of the organization ofthe report and the main issues dealt with in subsequent chapters.

A. Growth Experience since 1975

1.2 The chronicle of Philippine growth since 1975 is essentially one ofunsustainable expansion followed by inevitable contraction followed by anunsteady recovery (see Table 1.1 and Figure 1.1). The late 1970s were a boomperiod; real GNP growth averaged 6.1% during 1975-79. The first half of the 1980swas a bust period as the growth rate faltered to an average of 3.6? during 1980-82 and collapsed to -4.8% during 1983-85. The deep recession of the mid-1980seffectively set per capita income back to the levels reached in the late 1970s.Since then, the economy has recovered but in a wobbly fashion; real GNP grew by5.5Z during 1986-89 but then slid sharply during the next two years, to 4.2% in1990 and virtually 0% in 1991.

1.3 The Late 1970s. High growth in the late 1970s was surprising comingas it did in the face of deteriorating terms of trade brought on by high oilprices and falling commodity prices. It was made possible by a strategy thatemphasized finance rather than adjustment. Instead of adjusting to the oil priceand terms of trade developments by restructuring its economic base, thePhilippines ignored the new relative price signals and spent its way through amulti-year boom on the strength of foreign savings in the form of loans. Therewas a substantial inflow of such loans in this period and the external debt ofthe Philippines grew from $3.8 billion at the end of 1974 to $13.4 billion at theend of 1979. Much of the increment in external finance came from privatecommercial banks (see Table 1.2) which had become flush with 'petrodollar"deposits as a consequence of the sharp rise in the price of oil earlier in thedecade. The increase in external finance supported an increase in aggregateinvestment, which grew at an average of 11% over this period as compared to 7%during 1960-75. Much of the increase in investment took the form of governmentinvestment, as government embarked on an ambitious program of public sectorexpansion: public sector investment jumped from around 5% of GNP in 1975 to over11% in 1976 and averaged around 10% over the next four years.

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Table 1.1 Key Macroeconomic Indicators

1975-79 1980-82 1983-85 1986-89 1990 19911/

Real GNP Growth 6.1 3.6 -4.8 5.5 4.2 0.1Current Balance/GNP -5.0 -6.8 -5.0 -0.6 -6.8 -4.5Public SectorBalance/GNP/ -4.0 -5.3 -5.8 -3.7 -4.9 -2.5

Terms of Trade 141.9 112.0 105.6 120.9 109.2 n.a.Real Exchange Rate 101.8 90.0 101.8 92.8 86.8 98.8Inflation 10.2 13.8 27.8 6.0 12.7 17.7

/ Preliminary.

-! Comprises deficit of national government and 14 non-financialpublic enterprises only; consolidated deficit was 7.8Z of GDP in 1990.

Source: National Economic Development Authority and staff estimates.

Figure 1.1Real GDP Growth Rate

10--** -

4p

r 2:

e 0 L

n-2-

-4

75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91

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Table 1.2 External Finance Flows: 1970 -891/(Millions)

1970 1975 1980 1985 1987 1989

Total Debt. FlowsNet Flows 182 533 1619 1136 -161 1013Interest Payment 44 118 1491 1756 1849 2183Net Transfers 148 415 128 -620 -2011 -1169

Private FlowsNet Flows 7 175 799 532 -770 -419Interest Payment 15 33 231 473 747 1031Net Transfers 7 142 568 59 -1516 -1450

Memo: Commercial BanksNet Flows 101 126 771 536 -631 -247Interest Payments 29 30 372 518 765 1026Net Transfers 71 96 400 18 -1397 -1272

I/ Data refer to all debt except for 1)70 and 1975 which exclude short-termdebt.

Source: World Debt Tables, 1990-91

1.4 This aggressive strategy undoubtedly produced high growth, but it alsoweakened the economy in several respects. First, it was based on borrowed moneywhich had to be repaid; this reduced the room for maneuver available to economicmanagers who thereafter had to make policy decisions with debt-servicingobligations in mind. Second, much of the borrowed money was used to fund anexpansion of the public sector; this did not help in generating foreign exchangerevenues with which to meet debt-servicing obligations. Third, the easyavailability of credit encouraged excessive leveraging not only in the publicsector but also among private corporations. Fourth, this strategy was associatedwith an increase in investment in import-substitution activities supported by ahighly protectionist industrial and trade policy regime. Indeed, it caused anincrease in import-substitution activities to some extent by propping up thevalue of the peso. Fifth, it did not promote the country's competitiveness inthat the foreign finance flowed largely to the non-tradables sector (see Table1.8). Sixth, it initiated a weakening of the domestic savings effort andparticularly the personal savings effort, which began a decline from a level ofaround 11% in 1976 to virtually zero by 1983. All these developments renderedthe econom' more fragile, more unbalanced, and more vulnerable to shocks.

1.5 The Early 1980s. A series of shocks occurred during the early 1980swhich exposed the weaknesses of the growth strategy of the late 1970s. The

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shocks included, among externally generated events, the second oil price shock,an increase in world interest rates, a recession in the industrialized countries,and a sharp decline in the availability of foreign loans. These shocks wouldhave adversely affected growth performance in most countries but they had anexceptionally severe effect on the Philippines economy. Excessively leveragedfirms, both public and private, began to fail as interest rates rose and loansupply tightened. Even export oriented firms were hard hit as the industrializedcountries went into recession. A balance of payments crisis loomed as terms oftrade deteriorated further and as external funding began to dry up. Twoadditional events, a financial scandal in 1981 and the assassination of NinoyAquino in 1983, contributed to the mounting loss of confidence in the economy.Capital flight ensued, businesses defaulted on their debts, and banks failed.The net result was a faltering of growth during 1980-83 and a recession during1983-85. Ultimately, the economy adjusted to the various shocks in the only wayit could, through a deep recession.

1.6 The Late 1980s. The economy began a recovery in 1986, and thisgathered considerable steam during 1987-89 when real GNP grew at an average of6z. Recovery was assisted by several developments. First, the change ingovernment in 1986 restored private sector and foreign confidence in the economy.Second, larger flows of external finance resumed, although primarily frommultilateral institutions. Third, the new government introduced significantreforms such as rationalization of the public sector, deregulation of key partsof the agricultural sector, and restructuring of taxes and tax administration.Fourth, macroeconomic management was sound, distinguished by a prudent monetaryand fiscal stance and a responsible approach to external debt reduction. Fifth,the external environment improved in that oil prices and interest rates fellduring this period while the industrialized countries, the destination of thebulk of the Philippines' exports, enjoyed relatively higher growth than in theearly 1980s.

1.7 The recovery ran out of steam after 1989. During 1990, real GNP grewby around 4% while inflation increased to around 13%. During 1991, real GNP isexpected to grow by a meager O.'Z; the first three quarters have seen negativegrowth. Investment collapsed in 1990, growing by only 5.6%; it subsequentlydeclined by almost 17% in 1991. These developments were due in part to anextraordinary series of shocks that occurred over this period, including a coupattempt in December 1989, a prolonged drought in 1989-90, an earthquake in July1990, the Gulf crisis in 1990-91, and a major volcanic disaster in June 1991.

1.8 The external environment turned unfavorable in 1990 and 1991 (seeTable 1.3), thereby greasing the slide of the Philippine economy. Growth in theindustrial countries decelerated from 3.3% in 1989 to 2.6% in 1990 and furtherto 1.32 in 1991. World trading volume declined correspondingly, from 6.9t in1989, to 4.3% in 1990, and a meager 0.62 in 1991. Commodity price movements didnot help either: oil prices jumped by 28.2Z in 1990 before falling back by 16.4%in 1991 whereas the prices of non-fuel commodities, including some of thePhilippines' principal traditional exports, declined by 7.9% and 5.7X in 1990 and1991 respectively. About the only favorable trend was that in world interestrates; six-month LIBOR softened from a level of 9.3 in 1989 to 8.4 in 1990 andfurther to 6.6 in 1991. The overall external environment was thus clearlyunsupportive of high growth in the Philippines, and particularly so for export

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growth. Unfortunately, these external 4evelopments coincided with some domesticpolicy slippages.

Table 1.3: External Environment: 1989-92(Annual Percent Change, except as noted)

1989 1990 1991 1992(Actual) (Projections)

OutputWorld 3.3 2.2 0.9 2.8Industrial Countries 3.3 2.6 1.3 2.8U.S.A. 2.5 1.0 -0.3 3.0Developing Countries 3.2 1.0 -0.6 2.9

World Trade Volume 6.9 4.3 0.6 5.0

Commodity PricesOil 21.5 28.2 -16.4 1.0Non-Fuel -0.5 -7.9 -5.7 3.3

Interest Rates (level)6 Month LIBOR 9.3 8.4 6.6 7.0

Source: World Economic Outlook, October 1991, IMF.

1.9 On the domestic policy side, the real exchange rate was allowed toappreciate (in 1989-90), thereby contributing to a widening current accountdeficit. Public sector expenditures rose sharply, as both current and capitaloutlays were increased beyond planned levels, thereby contributing to an enlargedfiscal deficit. Monetary policy was insufficiently tight, thereby allowinginflation to rise beyond target levels. In 1990, the fiscal deficit rose to 5.2Zof GNP, the current account deficit increased to 5.8Z of GNP and inflation roseto 14X. By the time control was re-established over key macro balances, a lotof damage had been done. A line of credit provided by the IMF (the EFF of March1989) was canceled towards the end of 1990 as the program had gone significantlyoff-track, and negotiations for a new facility began. The Consultative Groupmeeting, scheduled for the summer of 1990 and necessary to build confidencethrough donor support, was postponed until a new agreement war reached with theIMF; the meeting ultimately took place in February 1991. The regular budgetprocess was suspended while these negotiations proceeded: the 1991 budget, dueto be passed in December 1990, was actually passed in June 1991. As a result,government expenditures were severely squeezed in the first two quarters anddisbursements were governed by cash on hand rather than by the size of theappropriation cover.

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1.10 In addition to exogenous shocks and policy slippages, macroeconomicperformance during 1990-91 was affected by structural features of the Philippineeconomy. The two most important structural constraints that were operative overthis period were the narrowness of the domestic capital market and the highimport-dependence of the economy. The capital market failed to smoothly absorbthe increase in domestic debt that was a key element of the recovery strategy.Domestic debt had to be increased for three reasons. First, because externalfinance, although flowing at higher levels than in the crisis years of 1983-85,was still limited: indeed resource transfers continued to be negative on a netbasis. Second, because the public revenue system, while improving as aconsequence of tax reforms introduced in 1986, was still yielding less thanrequired to cover expenditures. And, finally, because expenditures could not becut further from the already low levels reached in the crisis years; indeed, itmade sense to restore them in order to "pump-prime" the economy. Unfortunately,the domestic capital market proved too thin to support this strategy: as domesticdebt grew (from 192 of GDP in 1985 to around 22.4% in 1990) interest rates beganto climb; the Treasury Bill rate averaged around 10% in real terms during mostof 1990 and reached a high of 15Z in real terms (34Z in nominal terms) at onepoint. Such high rates were a signal that domestic borrowing needed to becurtailed. They complicated fiscal strategy since expenditures were risinglargely to meet higher interest payments. They changed lending and investmentpriorities in that banks increasingly sh:fted to holding T-bills rather thanmaking loans to business and businesses shifted to holding financial assetsrather than making physical investments.

1.11 The import dependence of the economy also prevented the consolidationof the recovery along a sustained high growth path. As incomes and investmentgrew during 1986-88, imports increased sharply and at more than twice the paceof export growth. Th large differential in these two growth rates, and theabsence of strong offs-tting trends in non-merchandise trade and transfers, ledto an increase in the current account deficit after 1986 which, indeed, had beena surplus year. While the size of the deficits was quite manageable during 1986-88, this was not the case thereafter and the balance of payments became a realconstraint on policy and performance. This behavior of imports in particular andthe current account balance in general has been true to type for the Philippines:high growth periods are associated with high rates of import growth which veryquickly lead to balance of payments difficulties which, in turn, are defused bymeasures to curtail imports. Usually, such measures are deflationary; sometimes,they produce a recession. Exports play a secondary role; typically, they havebeen unable to prevent balance of payments crises or prevent the recessionaryoutcome of remedial measures.

1.12 The Stabilization Program in 1991. The growing instability of theeconomy prompted a fresh stabilization effort towards the end of 1990. Whilenegotiations proceeded with the IMF, a special import levy of 92 was introducedas a temporary stabilization measure. Administrative measures were also takento curtail government expenditures. A new program was agreed to with the IMFby February 1991 under which a fresh set of macroeconomic targets and policies

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Figure 1.2Ratio of Public Sector Deficit to GNP

10

8

pe 8r

C0n 4t

2

76 76 77 78 79 80 81 82 83 84 86 88 87 es 8g 90

Figure 1.3Ratio of Current Account Balance to GNP

4

2-

0---

r

e 4

-8

-10 7 7 -80 - - -

76 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90

were adopted for an eighteen month period running to July 1992. The key targetsfor 1991 and 1992 were the following: the consolidated public sector deficit wasto decline to 3.7% and 2.52 of GNP; the current account deficit was to be trimmedto 4.5% and 3.92 of GNP; base money was to grow at a maximum of 10.9% and 12Zwhile broad money was to grow at not more than 10X and 12% over the respectiveyears. Given compliance with these targets, it was envisaged that inflationwould be reduced to under 102 and growth of real GNP would recover to 4% in 1992.

1.13 The above targets were to be achieved through conservative fiscal andmonetary policies. On the fiscal side, expenditures were to be cut selectivelyand subsidies arising from the operation of the Oil Price Stabilization Fund wereto be eliminated; furthermore, the internal cash generation ability of governmentcorporations, and in particular the National Power Corporation, was to beimproved by appropriate increases in user charges. At the same time, revenueswere to be raised through a combination of new taxes, refinements of existingtaxes and measures to improve tax collection. On the monetary side, reserverequirements and other monetary measures were to be implemented in a mannerconsistent with the base and broad money targets. The current account objectiveswere to be achieved through the maintenance of a flexible exchange rate regime.Longer term external and efficiency objectives were to be met through structuralreforms in trade and investment policies and through enhanced official andbilateral funding.

1.14 The stabilization program had a mixed experience in 1991. Whilecertain key targets were met, others were not; furthermore, the record ofadministrative and legislative achievement during 1991 was not such as to assurethe program's integrity in 1992 and beyond. Five areas of concern emerged.First, while the fiscal deficit declined, this occurred largely as a consequenceof steep cuts in capital outlays; this does not bode well for medium-term growthgiven the poor state of infrastructure in the Philippines and the dire need forits rehabilitation and expansion. On a more positive note, the reduction of thefiscal deficit contributed to a significant decline in interest rates. Ifinterest rates are maintained at low levels, this would provide an opportunityto increase capital outlays and thereby improve the quality of the fiscaladjustment effort.

1.15 Second, no significant revenue measures were legislated in 1991.Measures to introduce refinements in existing taxes and improve taxadministration languished in the legislature while the idea cf introducing newtaxes did not prosper at all. Meanwhile, the temporary import surcharge was cutfrom 9X to 52 leading to a further reduction in anticipated revenues.

1.16 Third, the overall fiscal program was compromised by the emergence ofa financial crisis in the largest public enterprise, the National PowerCorporation. This crisis diverted a significant amount of funds (about 5 billionpesos), originally set aside for other sectors and activities, to the NPC and itsexpenditure program. The most disturbing feature of this crisis was its originin a reluctance to pass on the true costs of producing electricity to theconsuming public through appropriate user charges.

1.17 Fourth, while the current account deficit target was met, this was duelargely to a sharp drop in imports arising from the temporary import levy and

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from a sluggish economy; a pick-up in the economy in 1992, perhaps due toelection related spending, may see a destabilizing rise in imports again. Abright spot was the modest growth of exports even in the face of a considerableslowdown in world trade. The decline in imports and a substantial increase innet foreign loan inflows (arising from previous reschedulings) led to a stronginternational reserves position and an appreciation of the peso. A persistenceof this condition raises the prospects of a balance of payments problem emergingonce again witn the next rebound of the economy.

1.18 Fifth, monetary targets were missed for most of 1991. Partly becauseof this, but also because of cost-push developments, the inflation rate did notdecline significantly in the first three quarters during which it ran at almosttwice the target level of 9Z.

1.19 Recent Developments. These concerns, and especially the lack ofprogress on the revenue front, prompted a re-examination of the stabilizationprogram towards the end of the year. Some of the above-noted problems have nowbeen resolved. Among important developments have been the following: somerevenue measures have been passed, the financial position of NPC has beenimproved through the passage of a substantial rate hike, provision has been madein the fiscal program for inclusion of extraordinary expenditures related to theMt. Pinatubo disaster, significant liberalization initiatives have beenundertaken irn the area of trade, foreign investment and foreign exchangeregulations, the inflation rate has come down to single digit levels, and tightermonetary management has been implemented. While some key revenue matters remainunresolved, the developments just noted provide a greater degree of assuranceabout the integrity of the stabilization program for 1992.

B. Savings and Investment Behavior

1.20 A simple but useful way to characterize the growth process is to focuson the links between savings, investment and growth. Growth depends oninvestment which, in turn, depends on the supply of savings. Both savings andinvestment can arise from three sources: public, private and foreign. While thischaracterization appears simple, depending as it does on just a few variables,their inter-relationships can be complex. For example, domestic and foreignsavings might substitute for each other. Or, public and private savings mightbe substitutes also; as more public savings are raised through the tax system,for instance, private savings might fall. Furthermore, public, private andforeign investments might also either substitute for each other or becomplementary depending on the content and context of the investment. Finally,there is the issue of investment efficiency. Higher investment levels need notlead to more growth if the investment is characterized by inefficiency and waste.

1.21 The behavior of these few macroeconomic variables, and the causes andconsequences of such behavior, go a long way towards explaining the pattern ofgrowth observed in the Philippines since 1975. This is not to suggest that theseare the only variables that matter, just that their interactions provide asimple, yet comprehensive, explanation for key aspects of the Philippine growthexperience.

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1.22 Savings-Investment Gap. An overview of the relevant data indicatesthat there was a large gap between national savings and aggregate investment inthe late 1970s and early 1980s that was filled by the inflow of foreign savings(see Table 1.4). A sharp increase in the inflow of foreign savings into thePhilippines can be detected in the mid-1970s when, in the space of just two yearsfrom 1973 to 1975, the ratio of such savings to GDP rose from -5.5% to 5.3% (seeFigure 1.4). The ratio stayed at around 5% through the rest of the decade androse to an average of 7.2% during 1982-83. Then it declined sharply, reaching -5.3% in 1986, and averaging about 0.5% since then to 1989 before rising onceagain to 5.12 in 1990. As already shown in the preceding section, this patternin the evolution of foreign. savings was a fundamental determinant ofmacroeconomic performance in the Philippines during the last fifteen years. Asforeign savings rose in the late 1970s, investment rose and income grew at a highrate. As foreign savings declined in the early 1980s, investment fell and incomegrowth decelerated into a full-blown recession. Since 1985, again with the helpof foreign savings, investment and income growth have recovered, although in anuneven and unsteady fashion. The cumulative effect of the reliance on foreignsavings has been an increase in the stock of external debt, from a level of $2.2billion in 1970 to $17.4 billion in 1980 and further to around $30.5 billion in1990.

1.23 The composition of foreign savings was different in different periods.Durinag the 1970s, a large proportion of the net flow originated in private loansources, such as commercial banks; for example, during 1975-79, about half of nettotal flows were from private sources and a quarter from commercial banks. Inthe next phase, private flows began to decline in relative terms as a series ofshocks battered the economy and confidence began to decline. Indeed, the onlyway to keep private flows up was to pay very high interest rates for very short-term money: the term structure of the Philippines external debt changed from onein which the snort-tenm debt averaged around 35% (in 1975-79) to one in whichshort maturities (mostly 90 day loans) accounted for 45% (in 1980-82). After1982, the declining economy accelerated the exodus of private lenders and, inturn, this exodus turned the economic decline into a free-fall.

1.24 During the 1980s, despite the deterioration of the economy, officialflows continued; indeed, they rose on average during the crisis years of 1983-85,compared to the pre-crisis years, and have risen steaeily since then. While thetrend in official flows was opposite that in private flows, this was not enoughto prevent a decline in net resource transfers once interest payments arefactored in: such transfers have been negative in every year since 1980,reflecting both the large increase in the Philippines' debt stock and the higheraverage level of world interest rates in the 1980s.

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Table 1.4: Savings and Growth RatesA'

Real GDP National Personal ForeignYear Growth Savings Rate Savings Rate Savings Rate

1970-74 5.1 23.2 8.3 -4.7

1975-79 6.5 25.2 8.9 4.6

1980-85 0.4 20.2 3.1 4.3

1986-90 4.2 16.5 3.4 0.4

Y Simple averages of ratios to GDP for all savings rates;note that data correspond to the 1972-based national accounts.

Source: National Income Accounts

Figure 1.4National Savings & Investment Rates

S0

25 pe 20,r

35____--0 - > -

0nt

10

6-

70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 858 87 88 89 90

-- Savings 1 Investment

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1.25 The above summary of trends in foreign savings has severalimplications fcr the design of a medium-term development strategy for thePhilippines. Future external financing is likely to consist primarily ofofficial flows. Some voluntary private commercial flows may also arise in thecontext of debt-rescheduling and debt-restructuring exercises, but th-se arelikely to be minor when viewed in the medium term perspective. As a result ofthis as well as a consequence of the debt-servicing profile on official loansaccumulated over the last two decades, the level of future external financing,measured as the ratio of net flows to GNP, is likely to be sharply lower than wasthe case in the late 1970s. Such flows will not support an investment programof dimensions similar to those observed in the 19708. This suggests severaloptions: the investment program could be kept small; more attention could be paidto investment efficiency so as to get a bigger bang from a smaller program;direct foreign investment could be encouraged; and, finally, alternative sourcesof financing, such as domestic borrowing or domestic revenue mobilization, couldbe harnessed.

Savings Trends

1.26 National Sav'-ngs. The pattern that dominates the behavior of nationalsavings over the period 1970-1990 is one of a high rate during the 1970s followedby a significantly lower rate during the 1980s. The national savings rateaveraged around 25Z in the 1970s and only around 182 in the 1980s. ThePhilippines went from being a high savings economy to being a low savingseconomy, especially in relation to its ASEAN neighbors. The pattern of savingsbehavior is highly correlated with that of real economic growth, suggesting thatit was the collapse of the growth rate and the decline in per capita incomelevels in the 1980s that led to the drop in the savings rate. For example, amajor break in the savings rate occurred in 1981, heralding the trend observedthrough the rest of the decade; this break closely follows a major break in thegrowth rate in 1980. This relationship is corroborated by the pattern of incomeand savings behavior in the Philippines relative to that in other ASEANcountries: the Philippines experienced the biggest drop in real GNP growth ratesas well as the biggest drop in national savings rates.

Table 1.5: Comparative Savings and Growth Trends

Saving Rates 1/ Growth Rates 2/1973-80 1980-87 1973-80 1980-87

Philippines 25.0 18.3 6.3 -0.6Malaysia 28.8 26.9 7.5 4.4Thailand 21.4 20.3 7.5 5.9Indonesia 28.2 26.3 7.2 5.1

1/ Refer to current ratios of gross national savings to GDP.2/ Refer to growth in real GDP.

Source: SAVEM Tables, May 1991, World Bank

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1.27 Econometric analysis confirms the importance of income growth to thegeneration of higher savings in the Philippines. It also reveals a negativerelationship between national and foreign savings (Lamberte, et.al., 1991). Thissuggests that the easy availability of foreign savings in the late 1970s weakenedthe domestic savings effort and that the resumption of higher aid flows in thelate 1980s may have a similar effect. To assess this result properly it isnecessary to clarify two issues. First, what is cause and what is effect? Doforeign savings actually lower domestic savings or is the statistical correlationsimply a reflection of the fact that foreign savings might come in when domesticsavings are low. In the case of the Philippines, the relevant evidence suggeststhat domestic "need" in the sense of low per capita income or low savings was notthe key determinant of foreign savings inflows. In the late 1970s, the periodof sharp growth in foreign savings inflows, national savings rates were high andwere supporting a reasonable level of economic growth. Furthermore, a largeproportion of the relevant inflows originated in private sources and was notdriven by the same motives as aid flows might. Indeed, these private flows mayhave been supply-driven in the sense that they represented an attempt bycommercial banks to place rising "petrodollar" deposits.

1.28 A second point that needs to be clarified is the mechanism by whichforeign finance might have depressed domestic savings. The most common intuitiveexplanation is that easy credit leads to a relaxation of the revenue-raisingeffort by the public sector while encouraging the undertaking of higherexpenditures. This would depress public sector savings. The evidence for sucha 'complacency effect" in the case of public savings is discussed below.

1.29 Public Savings. Public savings may be broken dorAn into the savingsof the national government and that of public enterprises. Government savingsrose through the 1970s and then began a gentle decline in the first half of the1980s which turned into a collapse in the second half. The explanation for thispattern lies in several developments. The rise in the 1970s reflected a strongrevenue effort brought about by changes in tax administration procedures:revenues fluctuated around 13.5% of GNP during 1975-80. The gentle decline inthe first half of the 1980s reflected a deterioration in the revenue effortbecause of the deterioration of the economy; this decline would have been sharperhad it not been for the fact that government expenditures were also cutsignificantly in this period. Finally, the collapse of government savings after1985 reflects essentially the impact of higher interest payments on currentexpenditures; the sharp rise in current expenditures that resulted from theassumption of the foreign debt liabilities of various public and private entitiesoffset even the effects of a much improved revenue effort over this period.

1.30 As far as national government savings are concerned, there does notseem to be a strong negative link between foreign savings and the nationalrevenue effort. When foreign savings inflows were high in the late 1970s andagain in the late 1980s, the revenue effort was high rather than low as might beexpected from the complacency theory (see Figure 2.4). Rather, the operativelink is between foreign savings and government expenditures: foreign savings wereused to finance higher levels of current and capital outlays rather than to relaxthe revenue drive.

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1.31 Public Enterprise Savings. Non-financial public enterprises appearto have operated more in keeping with the "complacency" hypothesis: theirsavings, while generally low, fluctuated with the availability of foreignfinance. When foreign finance was plentiful in the late 1970s, their savingshovered around 0%. As foreign finance became scarcer in the 1980s, savingsperformance improved; the savings rate rose from -0.8% in 1980 to 1.5% in 1988.Notwithstanding the above, the bulk of foreign finance was used to fund capitalexpenditures and not current expenditures. Financial public enterprises (i.e.,government financial institutions) were also affected by trends in externalfinance, but in their case, there was a substantial drop in savings in the crisisyears of 1984-87 as they were overwhelmed by a rising tide of loan defaults.

Personal Savings: Trends and Determinants

1.32 Savings and Income Growth. Personal savings rose through most of the1970s, from around 7% in 1970 to almost 11% in 1976; they then declined to 6.5Xby 1981 and further collapsed to virtually 02 by 1987 before staging a modest anduneven recovery thereafter.1 Effectively, the Philippines went from being arelatively high-savings country in the 1970s to a relatively low-savings countryin the 1980s, whether one looks at national savings or at personal savings.While slowly-evolving demographic factors, such as urbanization and changes inage structure, have played a role in shaping the long-run trend of the personalsavings rate, macroeconomic factors have been the dominant determinants in thelast 15 years. Among these factors was the collapse of income growth in the19808; the effect of this on the personal savings rate may be confirmed both byvisual inspection of trends (see Figure 1.7) and by rigorous statisticalanalysis. Clearly, then, the personal savings rate cannot be expected to recoverto the average level experienced in the early 1970s without a substantial andsustained recovery of income growth. On the other hand, sustained income growthis doubtful without a higher level of savings to fund the required investmenteffort. There is, in effect, a vicious cycle contained in the endogenousrelationship of income growth and savings. Breaking out of this cycle willrequire a consistent and credible macroeconomic policy regime sustained over anumber of years that will raise incomes while reassuring private savers thattheir financial savings will not be eroded by inflation and currencydepreciation. Without such a policy regime, income may not rise in a sustainedfashion, and over the period that it does rise it may not generate acorresponding increase in productive savings as private savers, anticipatinginflation and currency depreciation, will prefer to increase consumption and/or

l/ Personal rather than private savings are analyzed here because the latter,as defined in published National Income Accounts, comprise the savings of threedifferent types of savers, households and unincorporated businesses, publiccorporations and private corporations. Each of these groups has differentbehavioral propensities and is affected differently by government policymeasures. Accordingly, it is difficult to interpret the behavior of thecomposite variable defined as private savings. Personal savings refers only tothe savings of households and unincorporated businesses, a relatively uniformgroup as far as behavior is concerned.

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Figure 1.6Public Sector Savings

6

4 - _

po 2-rC

t 1

-2176 76 77 78 79 80 81 82 83 84 85 86 87 88 89

- National Government Nonfinancial PEs

Figure 1.6Public Sector Investments

10

e 6 _ _ _

n 4 t

76 76 77 78 79 80 81 82 83 84 86 86 87 88 89

X National Government ^ Nonfinancial PEs

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put their money in inflation hedges (such as property) or foreign bank accounts(i.e. engage in capital flight). The latter activities, while forms of savingfor the individual, are generally not considered to be supportive of domesticinvestment and growth; indeed capital flight is contractionary in its effects.

1.33 Effect of Foreign Savings. The income link, however, does not explainan important feature of the personal savings trend, this being the substantialdecline during 1976-80 when income growth was still high, This is betterexplained by reference to the effect of foreign savings and changing rural-urbanincome distribution. Foreign savings may stimulate or depress personal savingsdepending on the quality of the investment program financed through them and theincome expectations thereby generated.2 In the 1970s, foreign savings were usedto finance an ambitious public investment program of relatively poor quality.However, private savers were by and large unaware of this fact; they saw incomegrowth being sustained for several years and concluded that such growth was ofa permanent nature. Accordingly, they decreased their savings, that is, theyborrowed from expected higher future income to increase current consumption.This explains why the personal savings rate declined during 1976-81 even thoughincome growth was high. As the economy deteriorated in the 1980s, and theadverse consequences of the 1970s external borrowing strategy became clearer

Figure 1.7Personal Savings and Real GDP Growth

1 5

'p

n 0 _ X /t

-10 I . I I . . . . . . . .

70 71 72 73 74 75 76 77 78 79 80 81 8283 84 85 86 87 88 89 90

Real GDP Growth -4- Personal Savings

2/ Another link between foreign and domestic savings operates through financialmarkets. Large inflows of foreign savings may depress domestic personal savingsby depressing domestic interest rates. This link is unlikely to have beenquantitatively significant in the late 1970s because deposit interest rates wereinfluenced more by government decree than by market conditions in those years andthe interest elasticity of savings is generally low.

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income expectations related to foreign savings changed but again to the detrimentof personal savings; the decline of foreign savings in the 1980s was not met byan increase in personal savings in part because of the apprehension that fiscalconstraints thereby generated would continue to depress income growth anddestabilize the economy. In any case, the deceleration of income growth was theprimary influence over the personal savings rate over this period.

Investment Trends and Determinants

1.34 Aggregate Investment. Aggregate investment behaved similarly tonational savings. There was a sharp increase during the 1970s (see Figure 1.4),when investment rates climbed from around 21% in the early part of the decade toaround 30% in the latter part. This was followed by a sharp drop in the 1980s,to a low of 13% in 1986. The behavior of investment is related closely to theavailability of funds: investment rates were high in the 1970s as both domesticsavings and foreign savings (in the form of external finance) were high;investment rates collapsed during the 1980s as both external finance and nationalsavings declined sharply. Indeed, during much of the latter half of the 1980s,aggregate investment has been constrained by the level of national savings asforeign savings have been low or negative.

1.35 Components of Investment. The share of the private sector inaggregate investment declined steadily through the 1970s (from 93% in 1970 to 74%in 1979), with an especially sharp fall in 1975-1'176 (from 82% to 752); it stayedmore or less constant in the early 1980s (around 75Z) and has recently begun torise (from 752 in 1986 to 81% in 1989). This pattern is consistent with thestory told at various points above, that is that the role of the public sectorexpanded during the 1970s (fed by plentiful external financing) and declinedduring the 1980s (as external finance became scarcer); the more recent patternis related also to the public sector rationalization program implemented by theAquino Administration since 1986 which has sought to privatize several governmentcorporations and to force many others to rely to a greater degree on internallygenerated funds to sustain their investment programs.

1.36 Private Investment. Private investment followed trends in overallinvestment with one difference; it began to decline earlier, in 1975, whileoverall investment was still high, thus mimicking the relationship betweenpersonal and national savings.3 Private investment declined in importanceduring the 1970s as its share to total investment declined while publicinvestment grew rapidly both in level and share. This trend was reversed in therecovery following 1985.

31 The remarkable correspondence of the trends in private savings andinvestment (they both begin declining in 1975-76) suggests segmentation of thecredit market, that is, that private investment could only be funded from privatesources of credit. While this is a tempting hypothesis, it is not supported byevidence from credit distribution data. A more supportable hypothesis is onethat links private investment to public investment through a crowding outprocess.

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1.37 Trends in expected demand are usually the most important determinantof investment. If demand is expected to be strong and rising, investors arekeener to put in the capacity to meet this demand. On the other hand, if demandis weak and falling, investment is typically put off. Empirical analysisconfirms the importance of expected demand, as proxied by trends in GNP growth,to investment decisions in the Philippines. Thus, the sharp decline of theprivate investment rate in the first half of the 1980s and the recoverythereafter is consistent with the behavior of GNP over this period. However,this relationship, while important, does not yield a policy lever since incomegrowth is an outcome not an instrument, and since investment and income areendogenously related. Clearer policy implications may be obtained from someother determinants of investment, such as the relative price of capital, thenature of industrial relations and the characteristics of public investment.

1.38 Relative Price of Capital. The relative price of capital depends onthe price of investment goods relative to the price of output and the realinterest rate. The decline of private investment since the mid-1970s does notappear to have been caused by an increase of the relative price of investmentgoods but rather by an increase in the cost of borrowing. While the domesticprice of investment goods rose faster than the GDP deflator on average during thepost-war period, it actually declined between 1975 and 1980. In particular, theeffect of the large step devaluation of 1972 on the relative price of investmentgoods appears to have been exhausted by 1974. More recently, however, the largeincrease of the relative price of investment goods resulting from the exchangerate devaluations of 1983-84 reinforced the effect of the recession andcontributed substantially to the drop of the private investment rate in 1984-86.

1.39 Data on lending rates suggest a substantial increase in real rates inthe early 1980s and again in recent years; this has contributed to the risingrelative price of capital since the mid-1970s and to the consequent decline ofthe private investment rate. Indeed, the increase of the relative price ofcapital in recent years has probably been the most important deterrent to thefull recovery of private investment. This increase is related in turn to thehigh and rising public sector demand for credit in recent years.

1.40 Interest rate volatility has also increased in the 1980s in part dueto the increase in uncertaintZ caused by the 'debt overhang"; this is reflectedin volatility in inflation and exchange rates as well. Since investment is toa large extent irreversible, it is negative.y affected by volatility of keydeterminarsts such as interest rates. It is plausible to argue that the 'debtoverhang' has kept private investment from growing at a faster rate.

1.41 Crowding Out Effect. There is a large body of evidence indicatingthat both the level and the composition of public investment affect privateinvestment. There is evidence of this also in the Philippines. Althoughavailable data do not allow a clear distinction between infrastructure and non-infrastructure components of public investment until 1985, the assumption thatmost government investment has taken the form of infrastructure and that asubstantial part of public corporations investment has taken the form of otherproductive activities is thought to be accurate, at least until 1988, when the

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government started to privatize and restructure the public corporate sector.4Under this assumption, the government component of public investment -- i.e.infrastructure -- has provided a positive stimulus to private investmentthroughout the period, and in particular in 1975-1983, when it was substantiallyhigher than in the rest of the post-war period. On the other hand, the publiccorporations component of public investment -- i.e. non-infrastructure -- hasaffected private investment negatively, in particular in 1976-81, when itaveraged in excess of 5 per cent of GDP.

Table 1.6: Selected Investment Data

Real Gross Private SectorInvestment Rate a/ Share bl ICOR cl

(percent)

1970-74 22.2 88 4.2

1975-79 30.1 75 5.0

1980-85 24.7 75 8.4

1986-89 16.2 78 4.2

a/ Refers to simple averages of ratio of investment to GNPhb Refers to simple averages of ratio of private to total gross domestic fixed

capital formationc/ Simple averages of incremental capital output ratios.

1.42 Trends in Foreign Investment. Unlike other ASEAN countries,foreign investment has not been a sizeable component of private investment in thePhilippines. It did not exceed the level of 52 of private investment until thedebt conversion program was initiated in 1987, and even then did not exceed 8 percent. Meanwhile, over the last twenty years or so, foreign investment into theASEAN region increased dramatically, first towards Singapore and Malaysia andmore recently towards Thailand. Of the total inflows in the ASEAN region, thePhilippines' share was the lowest averaging only 4.5 percent during the periodunder study. In contrast the averages for Indonesia, Malaysia, Singapore andThailand were 15.4 percent, 30.3 percent, 40.0 percent and 9.8 percent,respectively.

4/ This should not be taken to imply that public corporations did not undertakeinfrastructure activities; among the largest public corporations, NPC and MWSShave carried out most of public infrastructure development in power generationand water and sanitation. Other corporations, as for instance PNOC and NSC, havehowever undertaken exclusively industrial activitiee.

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Figure 1.8Net Foreign Investment Trends

UWS Billion12

10 - _ _

8X

6 :

4

2

071 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90

M Indonesia E Malaysla a Singapore

e Thailand P Philippines

1.43 Foreign investment inflows in the Philippines appear to have respondedpositively to high income growth and competitiveness, as measured by the realexchange rate and the openness of trade policy. The important role played by thedomestic growth rate is consistent with the prevalent domestic orientation offoreign firms according to BOI approval data. The positive response of foreigninvestment to the adjustment in exchange rates in 1970 and in 1983-84 -- in thelatter case, anticipating the recovery of private investment -- and to importliberalization in 1981 was important as well to such flows. In addition,competitive real wages appear to have affected foreign investment.

1.44 The regulatory framework has also been of importance in shaping thedirection and size of foreign investment flows into the Philippine economy.Entry to majority-owned foreign firms is prohibited in several areas.5 Inaddition, until the .enactment of the new Foreign Investment Act in April 1991,entry in the unrestricted areas was subject to approval by the Board ofInvestments. According to the pre-1991 regulations, entry to majority-ownedforeign firms was to be allowed in export-oriented industries or in areas "notadequately exploited' by Filipino nationals, leaving substantial margins ofdiscretion to BOI -- and uncertainty to foreign investors. In addition, foreigninvestors need to register with the Central Bank in order to be able torepatriate earnings or equity at a later date. It is expected that the new

5/ The Constitution limits to 40 per cent foreign ownership of land, andenterprises active in the exploitation of national resources and the operationof public utilities. The Nationalization Laws further restrict foreign ownership--. between 0 and 40 per cent -- in sub-sectors of the following industries:banking, government contracts, shipping, construction, and trade. Entry offoreign-owned firms is prohibited in fishing, rice and corn farming, retailtrade, and mass media.

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Foreign Investment Act will reduce the procedural difficulties faced by foreigninvestors and thereby encourage a larger flow over the 1990s.

1.45 Investment Efficiency. Perhaps the most critical aspect of investmentin the Philippines is its efficiency. Developments in investment efficiency maybe gauged, albeit in a rough fashion, from the behavior of incremental capitaloutput ratios (ICORs). The data show that ICORs rose in the late 1970s, thenincreased dramatically through the mid-1980s, before declining sharply over theperiod 1988-90. The increase in the 1970s was a result of the public sectororientation of the investment push undertaken in the latter half of the decade;insulated from competitive pressures, such investment was not very efficient.The dramatic increase of the ICOR level in the 1980s was due to the collapse ofreal growth in the economy; the investment surge of the late 1970s failed toproduce a basis for sustained growth and, when external finance was reduced inthe mid-1980s, output growth collapsed. The decline in ICORs during 1988-90reflects the effect of rising capacity utilization; output increased withoutlarge increases in investment. As of 1990, however, the slack in capacityutilization appears to have been exhausted; higher ICORs, reflecting a moretypical level of investment efficiency for the Philippines, may be expected inthe future, unless reforms are undertaken to ensure that incremental investmentis of higher quality than before.

1.46 The sectoral allocation of external finance can also shed some lighton the issue of efficiency. Table 1.7 shows that external finance tended to gointo the non-traded goods sectors during the late 1970s but there was a shiftaway from these sectors after 1983: for example, from 1975-83, the share of non-traded goods sectors in the allocation of externally borrowed funds rose from 53Zto 812; thereafter, it declined to 432 in 1988. To the extent that the non-traded sectors are insulated from competition and display characteristics ofrelatively higher cost and lower efficiency as compared to the traded-goodssectors, one might conclude that investment efficiency was lower in the late1970s than in the late 1980s.

Table 1.7: External Debt Citstanding, by Sector(Percent)

1975 1977 1980 1983 1986 1988

Total, Economic Sectors 76.4 85.6 86.6 90.6 57.5 50.5Traded Goods Sectors 23.1 17.1 9.9 10.0 8.4 7.7Non-Traded Goods Sectors 53.3 68.5 76.6 80.6 49.1 42.8

Other Allocations 23.6 14.4 13.4 9.4 42.5 49.5

Total 100.0 100.00100.0 100.0 100.0 100.0

Source: Adapted from Lamberte et. al. (1991)

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1.47 Investment and Tax Generation. The conventional justification forexternal borrowing is based on high returns to domestic investment. In the caseof public borrowing, not only must the investments undertaken hasa a returnhigher than the cost of borrowing but they must be deployed in such a fashionthat these returns accrue to the national treasury in the form of tax revenues.The available data show that the sectoral allocation of borrowed funds was notconsistent with the objective of securing adequate flows of tax revenues:relatively undertaxed sectors obtained the bulk of the available externalfinance. For example, in 1979, over 60Z of outstanding external debt wasattributable to the agriculture, power and services (transport, water, trade,defense and public administration) sectors; these sectors are all relatively"undertaxedt in the sense that their contribution to tax revenues is less thantheir share in GDP (see Table 1.8). On the other hand, manufacturing is an"overtaxed" sector but it accounted for only 6.6% of the outstanding debt. Theallocation of borrowed funds changed over the 1980s in a manner more supportiveof revenue generation: by 1987, only about 37% of the outstanding debt could beattributed to the three "undertaxed" sectors noted earlier.

Table 1.8: Debt and Taxes

Sector Taxation Share of OutstandingIndex 1/ External Debt

1979 1987 1979 1987

Agriculture 0.3 0.4 2.9 3.2Manufacturing 1.8 1.3 6.6 4.5Power 2/ 0.5 0.5 28.4 14.2Services 3/ 0.7 0.5 28.7 16.4

1/ The index refers to the ratio of the sector's share in total taxes generatedto its share in GPP.

2/ Refers to electL:- .cy, gas and steam production.3/ Refers to transport, communications, water, sanitation, trade, defense and

public administration.

Source: Adapted from Lamberte et al. (1991)

C. Implications for Development Strategy

1.48 It is clear from the foregoing discussion that economic developmentstrategy for the future should target both stabilization and adjustment. Astabilization program is again underway with the support of the IMF. Someproblems in its implementation thrt have been identified here, such as thereconfiguration of electricity tariffs, have been resolved. Other problems, such

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as the legislation of permanent tax revenues to replace the special import levy,have not yet been resolved. The task for short-run management is clear: it isto continue with the existing stabilization program to meet the targets set forfiscal, monetar;' and external accounts.

1.49 The task for medium-term management is also clear: it is to pursue anadjustment program that will enable the economy to break away from the structuralconstraints that have repeatedly hobbled its performance. The discussion inpreceding sections has provided a sense of what some of these constraints are andhow they have operated. The lessons of the last fifteen years of macroeconomicexperience may usefully be summarized as follows:

(a) Growth financed through external debt is difficult to sustain.Servicing costs are exogenously determined and can rise rapidly whiledomestic policy flexibility is constrained by the need to finance thedebt. Export orientation is a must in order to generate the foreignexchange to service the debt. The combination of high foreignborrowing and a protected, import-substituting economy can bedisastrous. Moreover, foreign savings has tended to depress domesticsavings, especially personal savings.

(b) Growth financed through domestic debt is also difficult to sustain,primarily because the domestic capital market cannot smoothly absorblarge amounts of debt in its present state. Interest rates rise fastto levels that exceed the returns to be reasonably expected frompublic investment. A wider and deeper capital market is needed beforea domestic borrowing strategy can work.

(c) Ensuring investment efficiency is critical to a growth strategy,especially if it is financed by debt. Inefficient investments werethe nub of the economic crisis that hit the Philippines in the early1980s. Expensive money was spent unwisely; the expenditures did notgenerate the resources with which to pay back the debt.

1.50 These lessons suggest that the way forward for the Philippines liesin a development strategy that emphasizes non-debt sources of financing and thatseeks to improve the efficiency of investment, especially public investment. Theelements of such a strategy are reviewed in the rest of this report.

1.51 Chapter 2 provides a discussion of public sector resourcemobilization. The key elements of the tax system of the Philippines arehighlighted and problems of structure and administration are identified, leadingto recommendations for enhancing revenue collection. Chapter 3 provides adiscussion of public resource management on the premise that sustainable growthrequires not only a differently-configured public finance base but also a systemthat improves the returns from public expenditures. The elements of such asystem are investigated through an examination of such issues as the productivityof public investment, the potential role of the private sector in implementinga public investment program, and the scope for greater efficiency in thefinancing and management of public enterprises.

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II. PUBLIC RESOURCE MOBILIZATION

2.1 From the point of view of resource mobilization the key question withrespect to the public revenue system is whether or not it generates sufficientfunds to finance the desired development effort, given certain constraints onGovernment's ability to borrow. In the case of the Philippines the publicrevenue system does not generate adequate funds. This chapter explains why.

2.2 The structure of this chapter is as follows. The first sectionprovides, by way of introduction, an overview of the public revenue system,focussing on the principal taxes and their key characteristics. The secondsection provides evidence of the system's underperformance through a discussionof tax effort and of the gap between actual taxes collected and the tax potentialin the Philippines. The third and fourth sections investigate the causes of lowcollection of internal revenues, highlighting deficiencies in both structure andtax administration. The fifth section discusses problems in customsadministration. The sixth section diGeusses the revenue experience ofprivatization while the final section reviews proposals for enhancing revenuecollection.

A. Overview of Public Revenue Syste

2.3 An overview of the public revenue system might well start with areference to the Tax Reform Package (TRP) of 1986. The TRP comprised acomprehensive effort to improve the efficiency and equity of the tax systemwithout incurring losses in revenue. The TRP is widely regarded to have beensuccessful especially in improving efficiency and revenue productivity. Theaccompanying box provides details of the program and its achievements.

Structure of Taxes

2.4 Public revenues are raised from three main sources: internal revenues(55Z), trade taxes (25%) and non-tax revenues (20%). The chief sources ofinternal revenues are income, VAT and excise taxes. Import tariffs are the maintrade tax, export taxes having been abolished several years ago. Among non-taxsources of revenue, the two most important are miscellaneous fees and chargesand interest income from government deposits and advances.

2.5 In common with most developing countries, the Philippines raises thebulk of its public revenues from indirect taxes. In recent years (1986-90),indirect taxes have accounted for 682 of total tax revenues. This marks a shiftin tax structure from earlier years (1976-85) when the share of indirect taxeswas almost 5 percentage points higher (see Figures 2.1 and 2.2). This is largelydue to improvements in the design and collection of direct taxes following fromthe tax reforms of 1986. In particular, it appears that the imposition of afinal withholding tax on passive incomes from financial assets has improvedcollections. An additional factor behind the observed shift in tax structurecould be the secular, though modest, decline in nominal tariffs during the 1980s.

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BOX 2.1s TAX REFORM PACKAGE OF 1986

While tax reform has been a continuing activity In the Philippines, typically broughton by periodic flscal and economic crises, a major and notable attempt, generally referred toas the Tax Reform Package (TRP), was undertaken In July 1988 by the lncoming AquinoAdministratlon. This reform attempt was comprehensive In scope and aim: It covered a widerange of revenue sources and tax administration measures and sought to achieve lmprovwments Inthe revenue productivity, efficiency and equity of the tax system.

With respect to direct taxation, the TRP introduced the following major changoe:

a. Rationalization of basis for Income taxationb Increase In final tax on passive incomesce Elimination of double taxation of dividendsd. Abolition of surtax on corporate incomese Increase In personal exemptionsf Setting of a flat 8a% corporste Income tax rate

With respect to Indirect taxation, the TRP introduced the following major changes:

a. Introduction of a consumption-type VAT of 10%b. Simplification of tax rates applying to public utilitiesc. Conversion of some excise taxes from specific to ad valorem basisd. Abolition of export taxes, except on logse. Reduction of tariff ratesf. Withdrawal of tax exemptions for most government and private entities

With respect to tax administration, the TRP introduced the following major reforms:

a. Croation of VAT administration units within SIR systemb. Adoption of zonal valuation system for property tax mattersc. Grant of tax amnesties covering unpaid Income and property taxesd. Administrative settlement of delinquent accounts*. Setting of clearer guidelines for selection of audit cases

The TRP of 1988, and refinements thereafter, have improved the revenue productivity andefficiency of the tax system; this Is evident In the sharp improvement In tax revenue to GNPratios in recent years (from 10.26% in 1986 to 13.7% In 1990) and In the declining cost ofcollection for BIR (from 1.1% in 1986 to 0.8% in 1989). VAT has rapidly become a significantsource of revenues; moreover, it is yielding more than would have been expected from the taxesit replaced. While the grant of tax amnesties and the administrative settlement of delinquentaccounts brought in less than expected, the amount collected (around 8 billion pesos during1986-1990) was unprecedented; at the same time, these measures cleared a backlog of contestedcases and released personnel for other functions. As far aS equity is concerned, however, theImpact of the TRP has not been significant: by most accounts, the pattern of tax lncidence,which Is generally regressive, remains unchanged from 1985.

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Table 2.1: Structure of National Government Revenues (#)

Revenue Sourceo/Year 1976 1978 1980 1982 1984 1986 1988 1990

Direct Taxes 28.82 28.08 24.71 27.48 28.07 81.48 82.64 88.40

Income Taxes 24.89 24.44 28.26 24.39 26.69 28.94 80.28 81.85Individual 10.22 18.11 10.99 11.11 8.88 8.98 8.77 10.41Corporate 18.98 11.83 11.97 12.90 15.88 12.97 14.82 12.20Financal 1/f 0.83 1.93 6.48 7.16 9.26

Miceallaneous V 3.18 2.70 2.29 6.27 4.26 4.79 4.42 2.98

Ind;rect Taxes 78.68 78.92 75.29 72.62 71.98 88.62 67.88 88.60

Excise Taxes / 17.16 18.82 16.98 17.10 18.69 24.96 22.14 18.72Licence and

Business Taxes 4/ 18.79 21.75 24.88 22.82 17.82 18.50 19.49 20.51Imprt Duties S/ 27.90 26.64 24.65 24.77 27.01 19.71 19.42 21.:3

othre I/ 9.83 7.90 9.84 8.40 8.99 S.86 6.82 6.56f

1/ Includ, taxes on stock transactions, comnercial paper and bank deposits.2/ Include transfer taxes, real property taxes, motor vehicle and trovel taxes.8/ Include collections of the Bureau of Customs and tobacco Inspection fes./ Incl udo eo lectlons from Import trade, f I xed taxes, and selective percentage taxes (such as VAT).

Include documentary stamps, sale of confiscatod ;oods and other income of the Bureau of Customs./ Include export and premium duties, documentary stamp taxes, franchise taxes, forest charges, and

miscellansous Items.

Source: National Tax Research Center

The Principal Taxes

2.6 Individual Income Tax. While not the most productive single tax, thisis an important tax: collections from this source amounted to 10.4% of total taxrevenues in 1990. Among the notable characteristics of this tax are thefollowing:

(a) The top marginal rate is 35%; this is at the lower end of the rangeof rates observed in ASEAN countries. For example, Malaysila andThailand have top rates of 40% and 55% respectively. Only Singapore,at 33%, has a lower rate.

(b) Income derived from employment is treated the same, as far as taxrates and exemptions are concerned, as income derived from businessesand professions. However, the latter category enjoys the benefit ofdeductible business expenses, a benefit that is typically abusbd andthat results not only in a lower tax take for the authorities but alsoin some inequity in the burden of taxes between those who are employed(for wages and salaries) and those who are self-employed.

(c) Income derived from different sources is generally combined into one"global" figure for tax purposes, rather than being made subject todifferent "schedular" tax rates. One major exception to this rule is

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Figure 2.1Structure of National Government Revenues

Direct Taxes Direct Taxes

Indirect Taxes Indirect68%

1975-1985 1986-1990

Figure 2.2Trends in Direct and Indirect Tax Shares

60

per

ent

20 -- . - - .- - - - - - - - -

7677 7879 80 81828384 8686 87 8889 90

nDirect Taxes * Indirect Taxes

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the assessment of a final withholding tax of 20Z on passive income,derived from such sources as interest earnings.

2.7 Perhaps the most notable aspect of this tax, however, is how littleit generates relative to potential. For a variety of reasons, explored in moredetail in the next section, this tax is an underperformer: it brings in far lessthan would be expected from the general parameters of income and employmentgrowth in the Philippines.

2.8 Corporate Income Tax. This tax accounted for 12.22 of total taxcollections in 1990, a share which has -luctuated very little in the last fifteenyears. In 1986, the corporate tax was set at a uniform rate of 35Z for alltaxable income: before that, two rates (25% and 35Z) had applied to differentlevels. In terms of tax burden, the present rate compares favorably with otherASEAN countries; in fact, it lies at the lower end of the range for thesecountries. Until 1986, corporations were also subject to a 25Z surtax on netincome if they were found to be "improperly accumulating profits" by maintaininga low dividend payout policy. This surtax was abolished in the tax reformpackage of 1986; it had become redundant since the phasing out of the tax ondividends (done simultaneously via the TRP of 1986) removed a major impedimentto the distribution of dividends.

2.9 As with the individual income tax, perhaps the most notable aspect ofthis tax is its underperformance relative to potential. For a variety ofreasons, discussed in more detail in the n,jxt section, this tax also brings infar less than one might expect.

2.10 The Value Added Tax. The VAT was introduced in 1988 as a replacementfor a number of complex, cascading sales taxes and is considered to be aworthwhile innovation in the Philippine tax system. According to Manasan (1990),it has improved both the efficiency and equity of the tax system by reducingdifferences in tax rates across commodity and input types and increasing, albeitmodestly, the progressivity of sales taxes.1

2.11 From the standpoint of resource mobilization, the attractiveness ofVAT depends on three considerations: its importance as a source of revenue, theextent to which it has generated more revenues than the taxes it replaced, and

1/ Manasan (1990) examined the efficiency of the VAT by calculating effectivetax rates (ETRs) on the consumption of goods and services. Each ETR measured thedirect and indirect taxes passed en to each unit of consumption of a commodityor service from successive layers of taxes on outputs and inputs in theproduction and sales process. She found that, after the introduction of VAT, (a)the average ETR was more than halved (from 14.4% to 6.52); (b) the dispersion ofETRs was substantially reduced (from a range of 1.3Z-34.6Z to 0.4Z-13.3Z); and(c) the difference between the nominal and effective rate - a strict measure ofthe extent to which inputs are taxes - was more than halved (from 7.2% to 3.3%).Zanasan also examined the equity consequences of the introduction of VAT by meansof the Suits index, a summary measure of progressivity: this measure was foundto decline marginally.

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the extent to which it is approximating its potential yield. The first twocharacteristics are discussed below while the third is considered later.

2.12 Table 2.2 shows the revenue of VAT relative to other taxes of thenational government as a percent of GDP at market prices. In the first year ofimplementation, VAT revenue amounted to 1.6% of GDP. However, this representedcollections over a 9 month period only; full year collections would have amountedto about 2.12%. During the next two full years of implementation, 1989 and 1990,VAT revenue amounted to 2.07% and 2.28% of GDP, respectively. These figurescompare favorably with other sources of tax revenue reported in Table 2.2. Forexample, VAT collection was 57Z to 602 of the contribution of import duties(which amounted to 3.62 to 3.8% of GDP) and over 16% of the total tax effort(which stood at 12.4 to 14.12 of GDP).

2.13 The usefulness of VAT is partly a function of its revenue productivityrelative to the taxes it replaced. The revenue from the indirect taxes replacedby VAT was estimated by NTRC (1990) at P 15.8 billion in 1987, the year beforethe reform. This comprised about 2.24% of the GDP of the same year. Using thiscriterion, VAT revenue in 1989 failed to replace the revenue of the other taxesby approximately 7.6%. In 1990, however, it exceeded the neutrality benchmarkby 1.8%. Once administrative difficulties are resolved and the coverage of theVAT is increased, this tax will become one of the more stable and potent sourcesof revenue. As discussed in a later section, present collection is roughly halfof the potential intake from VAT.

Table 2.2: Revenue Importance of VAT(Percent of GDP)

1988 1989 1990

VAT 2.12 2.07 2.28Import Duties 2.86 3.63 3.77Other Indirect Taxes 3.46 3.01 3.61Direct Income 3.35 3.67 4.44

Total Tax Revenue 11.26 12.38 14.10

Source: Bureau of Internal Revenue

2.14 Excise Taxes. Excise taxes are an important source of revenue; theyhave typically been the single most important category of revenue after incometaxes. In 1990, excise taxes contributed around 19% of total tax revenues.While excises apply to numerous commodities, the bulk (around 90Z in 1990) of thetax take comes from only three product groups: alcohol, tobacco and petroleum.In various reform measures during the early 1980s, the form of most excise taxeswas changed from "specific" or per physical unit to "ad valorem" or per value.This resulted in a steady increase in the share of excise to total revenues, asexcise collections increased with economic growth and inflation. In 1990,

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however, the excise on petroleum products was changed back to a (lower) specifictax in a move designed to cushion the impact of rising oil prices; this resultedin a noticeable decline in the share of excise to total revenues.

2.15 Import Duties. In 1990, import duties contributed almost 22% of totaltax revenues. While they remain a significant source of revenue, their relativeimportance has declined substantially: during 1976-85, import duties averagedaround 262 of total revenues; this share fell to around 20X during 1986-90. Thisshift can be explained in part by the tariff reform program undertaken in the1980s, which has reduced average tariff rates, as well as by the operation of theBOI incentives program which has increased the scope of duty exemptions. Thisshift is also reflected in the behavior of effective tariff rates (total dutiescollected/total import value) which have declined steadily during the 1980s (seeTable 2.3).

Table 2.3: Effective Tariff Rates: 1980-90(Billion Pesos and percent)

Particulars 1980 1982 1984 1986 1988 1989 1990

TOTAL IMPORTS 48.1 64.1 99.7 98.7 137.2 225.2 290.1

Dutiable Imports 37.9 54.3 61.8 70.7 103.1 148.0 187.2

Non-Dutiable Imports 10.2 9.8 38.0 28.0 34.1 77.2 102.9

Total Duties Collected 11.5 12.5 19.1 17.7 25.0 38.4 46.8

Effeutive Tariff Rates(Total Duties Collected/TotalDutiable Imports) 30.3 23 30.9 25.1 24.3 25.9 25

Effective Tariff Rates(Total Duties Collected/Total Imports) 23.8 1.9.4 19.1 18 18.2 17.0 16.1

Source: Bureau of Customs

Evaluation of Philippines Tax Structure

2.16 One way to evaluate the Philippine tax system is to compare its keyfeatures to benchmarks provided in a recent World Bank paper entitled: Lessonsof Tax Reform. A comparison is provided below.

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World Bank Reference Philippines System

Taxes on Firms and Individuals

a. Personal income taxes should be a. Maximum individual tax rate is 35%;subject to maximum marginal rate of tax base, however, is small.50% and should be raised from widebases

b. Exemption levels should be high b. Exemption level of P12000 per(preferably twice per capita GDP) so married person (set in 1986) is low;as to exclude low income persons it is below per capita GDP as well as

below annual income derived from dailyminimum wage

c. System should feature gradually c. Marginal tax rate schedule forrising marginal individual income tax individuals is progressive, but notrates steeply so

d. Withholding taxes should be used d. Withholding taxes are applied tofor wage and interest incomes, and wage and interest incomes; however,presumptive taxation should be applied self-employed escape tax net easilyto hard-to-tax groups and presumptive taxation not used

e. Company income taxes should have e. Corporate income tax has unitarysingle statutory rate comparable to rate of 35%, which is identical toataximum personal income tax rate maximum personal income tax rate

f. Tax preferences should be limited f. Tax exemptions are relatively broadin coverage and duration to cases in scope and long in duration; theirwhere market imperfections cannot be justification in terms of marketaddressed more directly imperfections is weak

g. Deductions and exemptions should be g. While statutory variation is small,equal across sectors and assets deductions and exemptions vary greatly

across sectors in practice

h. Indexing provisions should be h. Indexing only done for personalgenerally applicable exemption levels

i. A 10-15% border withholding tax i. Profit remittances generally taxedshould be applied to repatriation of at 15.profit, dividend, etc.

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World Bank Reference Philippines System

Taxes on Goods and Services

a. Pr.mary source of revenue should be a. VAT is major, though not primary,a single-rate VAT (between 10 and 20Z) source; VAT rate is flat lOX withwith crediting provisions and zero crediting provisions and zero ratingrating of exports and goods consumed for exports and food and agriculturallargely by the poor products

b. Excise taxes (with simple and non- b. Excise revenue largely raised fromdiscriminatory rate structure) should alcohol, tobacco and petroleum; ratebe applied to luxury goods structure discriminates against

foreign producers

c. Level and variation of nominal c.Level and variation of nominaltariffs should be low; exports should tariffs have declined in 1980s and areget inputs at world prices. now relatively low; exports are

eligible for duty-drawbacks

d. Export taxes should be eliminated d. Export taxes were abolished in 1986

2.17 The above comparison suggests that the basic structure of thePhilippines tax system is sound; tax rates are not high and the number of bandsis not exces3ive. Furhermore, reliance on indirect as opposed to direct taxesis not out of line with comparable countries; as Figure 2.3 shows, thePhilippines is "normal" in terms of its relative reliance on direct taxes in thesense that it lies close to the regression line that best captures therelationship between the direct tax ratio and per capita GNP.

2.18 The we.aknesses of the Philippines tax system lie in the area ofcollection. Far less is collected than could be. This is so partly for reasonsof system design which allow relatively high degrees of tax avoidance and evasionand partly for reasons of tax administration which result in less being collectedthan is legally due to the tax authorities. These issues are examined in detailin later sections.

2.19 Another shortcoming of the Philippines tax system is itsregressiveness; richer people generally pay a smaller fraction of their incomesin taxes than poorer people. This characteristic is not explicitly discussed inthis report. Existing studies indicate that while direct taxes are progressive,the combined burden of direct and indirect taxes remains regressive. They alsoindicate horizontal inequity within the income tax structure as certain types ofincome, e.g. compensation income, bear a heavier burden. It should be noted thatthat highly inequitable tax systems tend to fail at revenue mobilization also,typically because they engender a high degree of cynicism and resentment amongtaxpayers. Often the source of inequity is not the structure of statutory ratesbut the failure to make richer people pay a "just" share of national taxesthrough lapses in tax enforcement. This breeds a debilitating public ethic inwhich it is not considered immoral to cheat on one's taxes because of thesystem's perceived unfairness.

- 33 -

Figure 2.3Direct Taxes and Per Capita Income, 19a9

80

D

e

t

R .a - ~ Phillpplneat 20

00 a 10 15 20 25.

GNP Per Capita (US$ 000)

B. Tax Intake and Tax Potential

Tax Ratios

2.20 Over the fifteen year period 1976-90, tax ratios in the Philippines(defined as the percentage ratio of tax revenues to GNP) have ranged from a lowof 9.8? to a high of 13.7%. In recent years, there has been a marked upwardtrend (see Figure 2.3) as tax ratios have risen from 10.3Z in 1985 to 13.72 in1990, the best ever achieved. The rising trend is also reflected in measures oftax elasticity and buoyancy: as Table 2.4 shows, these measures are much higherfor 1986-90 than for the ten year period before 1986. The achievements of recentyears stem from improvements in both the design and operation of the tax system.The Tax Reform Package of 1986 has clearly been successful in enabling the taxauthorities to lay claim to a rising share of national income in the process ofgrowth; this has been achieved, moreover, while keeping tax rates relatively low(e.g. 35Z top rate on income tax) and exemptions relatively generous.

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Table 2.4: Buoyancy and Elasticity of Major Taxes

Type of Tax 1976-1985 1986-1990Buoyancy Elasticity Buoyancy Elasticity

All Taxes 0.89 0.53 1.33 1.07

Individual income tax 0.62 0.54 1.58 1.22Corporate income tax 1.03 0.85 1.18 1.10Excise taxes 0.96 0.32 0.78 0.77License & business taxes 0.79 0.59 1.41 1.07Import Duties 0.86 0.50 1.52 1.37

Source: National Tax Research Centre

2.21 Despite this positive trend in recent years, the tax effort of thePhilippines falls short in two respects. It is lower than what is needed to funddevelopment expenditures, given borrowing constraints. It is also lower than theeffort demonstrated in neighboring countries. Figure 2.4 illustrates the firstpoint; it shows that actual tax intakes have consistently been below planned ortargeted levels in the last five years. Table 2.5 illustrates the second point;it shows that the Philippine has the smallest tax to GNP ratio (measured as anaverage over 1976-88) among ASEAN countries.

Table 2.5: Tax Ratios in Comparative Perspective

Country Average1976-1988

Indonesia 19.06Malaysia 22.13Singapore 17.03Thailand 13.73Philippines 11.12

Source: Key Indicators of Developing Asianand Pacific Countries, ADB

2.22 Aniother way to demonstrate the second point, that the Philippinesrevenue intake is below average, is shown in Figure 2.5 which plots revenue to

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Figure 2.4Tax Ratios, 1976-1990

14 -4 I'dp

e~~~~~~~~For 2.6

4 -

o I

76 77 78 79 80 81 82 83 84 85 86 87 88 89 90

Actual Tax Ratio -4 Target Ratio

Figure 2.6

4 0 - .... ..... ...

n 06101202

GNP Per Capita IUS$ 000)

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GNP ratios for thirty randomly chosen countries against their per capita GNPs for1980 and 1989. The Philippines lies below the regression line which bestcaptures the relationship between GNP and revenue intakes.

Tax Potential

2.23 The tax effort of the Philippines also falls short in a third respect;it generates less revenue than would be expected from considerations of nationalincome and tax parameters. This point can be demonstrated by making estimatesof tax potential for different types of taxes. Such calculations are made anddiscussed below for the following taxes: individual and corporate income, VAT,and import duties. It is best to note at the outset that the calculation of taxpotential is subject to much imprecision and methodological uncertainty.Different methods of calculating tax potential can result in widely-varyingestimates. Nevertheless, one can still derive useful information from the rangeand trend of estimates.

2.24 Income Tax Potential. Table 2.6 presents estimates of tax potentialfor various years for individual and corporate incomes. For individual incometaxes, the "gap" approach is used in which the estimate of tax potential isderived by applying statutory tax rates to an adjusted measure of personal incometaken from the national income accounts. Adjustments are necessary to reconciledifferences in the concept of income that is used in tax returns as opposed tothat used in national accounts. For corporations, the estimate of tax potentialis derived by applying the average amount of taxes paid per corporate tax filerto the total number of active registered stock corporations (adjusted by a factorof one-half to reflect the typical fraction of tax-exempt corporations). Theresults are notable. While there is variation from year to year, it appears thatthe revenue system generally captures about 50X of potential individual incometaxes and about 60? of potential corporate taxes; the rest is lost, either toavoidance or evasion. It is quite evident that the potential tax yield is muchhigher than the actual tax intake.2

2.25 VAT Potential. An estimate of VAT potential is made by firstcalculating the potential VAT base as the sum of all taxable final demandexpenditures. The most important element is the determination of the taxablepersonal consumer expenditure (PCE) by adjusting for unprocessed, agricultural,in-kind or home consumption, and other VAT-exempt consumption. Under the presentguidelines for the Philippines, 52? of PCE is taxable. For the year 1990, thistranslated to a VAT base of P 522.5 billion Ssee Table 2.7). The correspondingpotential revenue was P 52.2 billion or 4.62 of GDP at market prices. Relativeto this percentage, VAT collection was short by 55% and 50% in 1989 and 1990,respectively.

21 It might be emphasized that the calculations pertain to the years before1989. In recent years, tax collections have improved significantly; this may bedue in part to improvements in tax administration and a reduction in tax evasion.

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Table 2.6: Potential Versus Actual Income Tax Collections

Potential Tax Actual Tax Actual/Potential(Million Pesos) (Million Pesos) (Percent)

Individual Income Taxes

1984 10826 4476 411985 11015 5594 511987 7219 4681 651988 11805 6264 53

Corporate Income Taxes

1984 13311 8208 621985 11407 8441 741986 8673 4826 561987 13047 7518 581988 15083 9875 65

Sources: Manasan (1988) and Avila (1989).

Table 2.7: The Potential VAT Base in 1990

1. PCE in 1990 P 843.2 billionless 2. 10Z for overestimation 84.3equals 3. Adjusted PCE 758.9

4. Taxable PCE (= 522 of 13) 394.6

plus 5. Government consumption 104.5equals 6. Total taxable consumption 499.1

plus 7. Residential construction 38.0equals 8. Total domestic taxable

expenditure 537.1

plus 9. Tourist expenditure 11.2equals 10. Total taxable expenditure

at market prices 548.3

less 11. VAT revenue in 1990 25.8equals 12. Potential VAT Base 522.5

Source: For details of calculation see Version B in study done by IMF(Aguirre et al. 1987) in preparation for the VAT scheme.

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2.26 It may be argued that the potential VAT revenue as estimated in Table2.7 is on the high side. One problem is accounting for the exemption from VATof small establishments with sales of P 200,000 or less. Most of theseenterprises are small stores engaged in trading. If we assume that as much as70? of the gross value added in trade must be deducted from the first estimate,the adjusted tax base is P 365.8 billion and the corresponding revenue isequivalent to 3.2%3 of GDP. Against this more conservative potential, VATcollection was still short by 35? and 29% in 1989 and 1990, respectively. Thus,even conservative assumptions generate a relatively large VAT potential ascompared to present intake.

2.27 Moreover, the revenue potential of the VAT is affected by the levelof the tax rate and the coverage of the tax base. There is no reason to believethat these aspects of the VAT could not be improved. An idea of the potentialhere may be gained from an international comparison of VAT experiences. ThePhilippines performance (revenue as percent of GDP) is still substantially belowthe numbers of several countries like Chile (8.1?), Brazil (6.5Z), Korea (4.0?),Turkey (3.1?), Mexico (3.2?), and others. VAT collections in these countrieswere attained by different design features. Some countries have multiple tiersin their VAT rate - for example, Chile (6 rates), Colombia (6), Uruguay (2),Mexico (4), and Argentina (3). Several countries have an upper rate greater than10? - for example, Brazil (17), Uruguay (20), Mexico (20), Nicaragua (25), andColombia (35).

2.28 Potential Collection from Imports. There are several pieces ofevidence that suggest that the actual collection of import duties is belowpotential. Export-source data indicate that imports are understated in thePhilippines; clearly, many imports enter but are not recorded. Indicativeestimates prepared by the Economic Intelligence and Investigation Bureau (EIIB)show that smuggling averaged about 12? of the value of imports during 1986-89.This may be considered a conservative estimate. The prevalence of smuggling isalso indicated by occasional physical apprehension of smugglers; the general viewis that only a small fraction of the true smuggling is apprehended. The pricesof many imported goods in the local market are reported to be lower than whatthey should have been if the right amount of duties had been paid.

C. Issues in Internal Revenue Collection

2.29 Internal revenue collections are lower than their potential on accountof deficiencies in both the structure of the tax system and in the tax

3/ This is about 13? higher than the NTRC (1990) estimate. The VAT basecalculated in the NTRC study implied a potential revenue equal to 2.8? of GDP.This figure was arrived at from the production side by removing from total GDPthe value added from VAT-exempt economic activities. However, half of theremaining sectors, including mining and manufacturing, were excluded to representsmall establishments - a big subtraction. Also, no adjustments were made for theVAT-exempt value added of exports.

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administration system. This section provides a discussion of the majordeficiencies. For clarity in exposition, the discussion of structural issues isseparated into two parts, one dealing with the main sources of tax evasion andthe other focussing on tax base erosion due to exemptions provided to industriesand government corporations.

Structural Issues

2.30 The tax base in the Philippines is much smaller than it could be onaccount of several factors including a high degree of non-filing of tax returns,considerable underdeclaration of income, exaggeration of allowable deductions,and relatively generous tax exemptions provided to industries and governmentcorporations.

2.31 Non-Filing of Tax Returns. A major source of low tax collection isthe non-filing of tax returns by individuals and corporations. This can begauged by comparing the number of actual tax filers with the number of potentialfilers as done, for illustration, in Table 2.8 below. The potential number ofindividual tax filers is calculated as the product of the proportion ofindividuals with family income above P60,000 (obtained from Family Income andExpenditures Survey, 1988) and the number of people employed in the relevantyear. The product of these two numbers gives us a conservative estimate of thenumber of people with taxable incomes since P60,000 demarcates the top twodeciles of the income distribution. For corporations, the potential number offilers is assumed to be the number registered with the Securities and ExchangeCommission. The data clearly show that far fewer individuals and corporationsfile tax returns than would be expected from general parameters of income andemployment growth and corporate formation in the Philippines.

Table 2.8: Potential Versus Actual Number of Tax Filers

Year Potential Number Actual Number Ratio

Individual Income Tax Filers(millions)

1988 3.9 1.2 311989 3.9 1.4 36

Corporate Income Tax Filers(thousands)

1988 115.1 46.9 411989 124.1 40.4 33

Source: Staff Calculations

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2.32 Underdeclaration of Incomes. This is another major source of lowcollections, It is particularly problematic in the case of the self-employed,such as professionals and businessmen, whose true incomes are very difficult toassess. The scope of the problem may be gauged from the results of anexploratory study reported by Yoingco (1991) in which presumptive income levelswere calculated for doctors in Manila. The doctors were chosen from selectedmedical centers in Manila and a survey was made of their consultation hours, feesand patient traffic. The incomes thus calculated were between four to fifteentimes higher (ranging from P416000 to P1500000) than the average income (P92000)reported by doctors in their tax returns.

2.33 One reason why many are able to get away with undeclaration of incomesis the inability of the BIR to verify actual incomes through other evidence.This inability is rooted in two main causes: lack of computer facilities and lackof access to the filer's banking transactions. The lack of appropriate computerfacilities means that the BIR is unable to cross-check the records of othergovernment agencies with which the filer may have conducted transactions. Forexample, the records of the Bureau of Lands may show that a filer has severalproperties of which the BIR is unaware; rarely is the BIR able to link the incomeand wealth records of people, even for those with obvious wealth. Anotherexample would be the verification of business turnover and net income. Customstransactions might reveal that a business has much larger turnover than reportedto the BIR, but the BIR is rarely able to cross-check with the BOC for lack ofthe appropriate information network.

2.34 The lack of access to banking records is even more detrimental to theBIR's prosecution ability. This is particularly so with respect to casesinvolving the relatively wealthy who, because of the scale of their business andwealth, are most likely to use the organized financial system for their dealings.Under Republic Act 1405 (passed in 1955), bank deposits are guaranteed secrecy;they cannot be examined by the BIR or any other agency unless a case has beenfiled in court. The problem, however, is that typically a case cannot be filedunless there is sufficient supporting evidence, evidence that typically cannotbe obtained without access to bank records. The incentive to file cases againstwealthy persons is limited also by tta fact that they can file suit for damagesagainst BIR officers who then have to defend themselves at their own expense.The asymmetry of wealth, power and influence involved in such encounters leavesthe tax officer at great disadvantage and serves as a major deterrent to zealoustax investigations.

2.35 Overstatement of Deductions. There are several provisions in theindividual and corporate tax code that make it easy for the taxpayer to overstateallowable deductions and thus reduce taxable income. For example, a higherpersonal exemption allowances for "head of family" as opposed to "single" fileroften tempts taxpayers to report a false status to claim the higher allowance.Another example is the allowance of deductions for children which leads to claimsagainst fictitious offspring. These "pro-family" provisions have resulted inthere being more families and children according to tax records than there areaccording to marriage and birth registrations. A third example is the facilityof filing separate returns by married taxpayers. Typically, both spouses end upclaiming full deductions for all children; NTRC estimates that this aloneresulted in a revenue loss of 1.5 billion pesos in 1986-88.

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2.36 Deductions for business expenses are also thought to be widely abused,especially among individual business tax filers. One study (Manasan, 1988) foundthat claimed deduction rates tended to increase with income, a finding thatsupports the hypothesis of abuse since the normal expectation would have beenthat of constancy in deduction rates across income levels. Furthermore, in thecase of corporate income taxes, where the rate structure is less progressive andthere is no great advantage to minimizing incremental taxable income, no suchrelationship was found.

2.37 The problem lies not in the allowance of deductions per se but in thefact that reasonable ceilings are not in place, and in the practical difficultyof verifying the accuracy of claimed deductions. In a country and society inwhich receipts are typically neither demanded nor offered, it is hard to verifydeductions claimed for business representation, entertainment, travel andpromotion. Similarly, it is hard to assess the validity of deductions claimedfor expense-, related to depreciation, repair and maintenance of vehicles andequipment, which are used both for personal and business purposes.Consequently, it would be advisable to impose deduction ceilings in some casesand fixed ratios of deductions to income where ceilings may be difficult tojustify. It might be noted that the Tax Reform Package of 1986 envisaged suchceilings but these were not enacted due to resistance from the business sector.

Base Erosion through Exemptions

Investment Incentives

2.38 Fiscal incentives for investment have been a significant feature ofboth the tax system and industrial policy in the Philippines for several decades.The current structure of incentives was put into place in 1987 under the legalcover of the Omnibus Investment Code and provides a range of exemptions toeligible investments, including income tax holidays, waiver of taxes and dutieson imported capital equipment, tax credits on domestic capital equipment and taxcredits in general. Initiatives have been launched in recent years to replaceor supplement, as appropriate, some of these selective incentives with a systemof universal incentives featuring accelerated depreciation and net operating losscarry over privileges.

2.39 The rationale for the system of incentives presently on offer is tocompensate for market imperfections and to promote investment in general. Inrecent years. two criticisms have been levelled at this system. First, it isargued that fiscal incentives are not particularly effective in inducinginvestments. This argument is supported by evidence from other countries as wellas the Philippines. In the case of the Philippines, it is argued that a host ofother factors are more important in determining the level and composition ofinvestment. Such factors include political stability, law and order conditions,government regulations, market potential, macroeconomic policy, andinfrastructure quality.

2.40 Second, it is argued that the incentives impose a fiscal cost that maybe well in excess of the benefits generated and that a poor economy can illafford in any case. A. Yoingco, a former director of the NTRC, writes (seeYoingco, 1991) that incentives have "helped to decimate the productivity of the

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income tax system and have spawned avenues for tax evasion...we are giving awaya lot in exchange for nothing." Table 2.9 provides some data on the revenueforegone from the availment of the main incentives implemented by the 80I inrecent years. The numbers, which are conservatively estimated, range betweenfour and six billion pesos and average around 3% of total revenues. The two mostsignificant sources of foregone revenues are tax and duty exemptions on importedcapital equipment and general tax credits.

2.41 Another source of revenue loss is the exemption of taxes and dutieson imports brought into export processing zones. In 1989, this amounted toalmost P2.76 billion pesos; added to the revenue foregone from incentives availedof by BOI-approved investments, this implies a combined loss equivalent to about4.7Z of total revenues in 1989. Assuming that revenue losses from EPZA importsamount to about 22 of total revenues on averag? leads to an estimate of totalrevenue loss of around 5.5Z for a typical year. To be fair, however, it shouldbe noted that these estimates of revenue loss, especially for export processingzones, are on the high side because, without the incentives, imports and businessactivity would be lower.

Table 2.9: Revenue Foregone from BOI Incentives

Type of Incentive Revenue Foregone (Million Pesos)1988 1989 1990 1991 1/

Special Deductions 131 51 38 27Income Tax Holiday - 33 72 64Tax and Duty Exemptionson Imported Capital Equipment 1980 2640 3842 3167

Tax Credit on DomesticCapital Equipment 48 102 149 123

Tax Credits 1958 1261 1834 1513

Total Revenue Foregone 4117 4087 5935 4894

Total Revenue Collected(billion pesos) 112.9 153.5 179.5 230.8

Ratio of Revenue Foregoneto Revenue Collected(percent) 3.7 2.7 3.3 2.1

1/ Projected.

Source: Department of Finance

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Exemptions for Government Corporations

2.42 The system of tax and duty exemptions applicable to governmentcorporations has undergone several changes in the last decade or so. Upto mid-1984, GOCCs enjoyed an array of fiscal incentives to help them achieve prescribedsocial and economic development objectives. These incentives varied from totalexemption from the payment of all taxes, duties, fees, charges and assessmentsto exemptions from particular types of taxes such as real property tax. Thesevarious exemptions translated into an average revenue loss of around P6.4 billionor almost 15% of total revenue intake. Economic difficulties and the high fiscalcost of these exemptions prompted a re-examination of their rationale and theexemptions were withdrawn in mid-1984 in a rationalization move.

2.43 The rationalization attempt was half-hearted, however, and most GCswere able to recover their privileges either through discretionary Presidentialaction and through application to the Fiscal Incentives Review Board (FIRB).From mid-1984 to mid-1987, estimated revenues foregone on account of GCexemptions averaged P5.2 billion a year, or almost 8% of total revenues.

2.44 Another rationalization move was initiated in 1987. The fiscalprivileges of all GCs were once again withdrawn and their restoration was madesubject to clearer and more restrictive criteria. As a result, tax and dutyexemption privileges were restored for only six GCs and the revenue foregone onthis account now averages P2.76 billion per year or about 1.8X of totalrevenues.

Table 2.10: Revenue Foregone From All Exemptions (1989)

Source/Type Amount Ratio(Billion Pesos) (Z to GNP)

BOI-Approved Investments 4.1 2.7Export Processing Zones 2.8 1.8Government Corporations 2.8 1.8Others 13.0 8.5Total Revenue Foregone 22.7 14.8

Source: Department of Finance

4I To provide an avenue for relief for GCs that were severely affeqted by thewithdrawal of fiscal privileges, the government set up a Tax Expenditure Fund(TEF) to which GCs could apply for subsidies to cover eligible tax and dutyexpenditures. The TEF is funded by annual budgetary appropriations passed byCongress. The big advantage of shifting to this system of subsidies is that thetrue cost of fiscal privileges is made transparent and subject to legislativedebate. In addition, an automatic ceiling is imposed on the amount of fiscalleakage by the size of the appropriations cover.

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D. Internal Revenue Administration

2.45 This section evaluates the adequacy of the formal provisions on taxenforcement and the effectiveness of the tax machinery in implementing them. Itmay be useful to note at the outset that the performance of the BIR has improvedsignificantly in zecent years. This is evident not only in the rising trend oftax revenues to GDP noted in an earlier section, but also in data on thecollection efficiency of the BIR. For example, while it cost an average of P1.14pesos to collect P100 pesos during 1981-85, it only cost P0.83 pesos in 1986-90.Nevertheless, problems remain and improvements can be made. The principal issuesof administration are discussed below under three heads: collection; assessmentand audit; and tax fraud investigation.

Problems in Collection

2.46 Among the more significant problems in collection of internal revenuesare (a) deficiencies in payment and recording procedures and (b) existence ofsizable accounts receivable.

a. Payment and Recording Problem

2.47 The tax collection system of the Philippines features the use ofauthorized agent banks (AABs). Such banks are used as a measure of convenienceto taxpayers since bank branch networks are much more extensive than the BIRoffice network and since the postal system is unreliable.6 Taxpayers file taxreturns with BIR collection agents who then issue payment orders (POs) for theamount of taxes declared to be presented to an AAB. The MAB then issuescorresponding confirmation receipts (CRs) for the actual amounts declared andpaid via the POs. A reconciliation of POs and CRs is necessary to derive acurrent list of non-payment, deficient payment, or delinquent accounts. Suchreconciliation has proved to be a source of confusion and delay: it is notunusual to find cases of fully-paid accounts being pursued by the BIR becausethey have not been purged from the delinquent account list. As part of its taxadministration improvement program, the BIR plans to do away with the P0/CRsystem and to require instead that returns be filed and taxes paid directly toagent banks. Negotiations for loans and technical assistance to set up a fullyelectronic processing system are also being conducted (in part with the WorldBank).

5/ Even with the present system of filing through banks there is a problem of"hijacking" of returns. Returns are lost after being filed but before the BIRestablishes firm control over them; this typically occurs at the stage wherereturns are forwarded from regional offices to the district office forregistration. This is thought to be an outcome of collusion between BIRpersonnel and taxpayers. Computerization would offer a solution in that theregistration could be done at regional offices or wherever the first point ofentry into the system is located.

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b. Problem of Accounts Receivable

2,48 Data on the number and value of accounts receivable (see Table 2.11)indicate that the problem is serious along both dimensions. The number of suchaccounts amounted to almost 14% of the total number of income and capital gainstax filers (average over 1986-90); this ratio would be even higher if exemptreturns were removed from the denominator. The value of such accounts amountedto around 19% of BIR collections (on average over 1986-90). Furthermore,deficiencies in the monitoring system mean that it is difficult to tell whichaccounts have been delinquent for how long and what the status of enforcementaction is at any given point in time. The data also suggest, however, that some

improvement has occurred in the last five years. The ratio of such accounts tototal tax returns filed declined from 15.92 in 1986 to 11.92 in 1990, while theirvalue relative to total BIR collections declined from 24% to 10.2Z.6

2.49 The severity of the accounts receivable problem may be related tothree main causes. These are excessive centralization, an inadequate taxpayeridentification system, and weak enforcement follow-up on account of lack ofpersonnel.

2.50 Excessive centralization. Responsibility and control over delinquentaccounts greater than P20,000 in value rests with the central office of the BIR.In practice, this has meant that the central office handles the bulk of suchaccounts; in 1990, over 90% of all receivables were being handled by headquartersin Manila. It would appear that decentralization of control to regional anddistrict offices might improve the monitoring of such accounts since such officesare closer to the problem. A very simple problem often dogs the prosecution ofcases of delinquency: this is the lack of knowledge of the whereabouts of thedelinquent taxpayer. This problem could be partly mitigated if monitoring andfollow-up were made a district and regional office responsibility.

2.51 Inadequate taxpayer identification system. The Philippines lacks ataxpayer identification system that can generate an accurate master list oftaxpayers. At present, different account numbers are used for differentpurposes; for example, corporations use different numbers for internal revenueand customs transactions and individuals use different numbers for income andreal property tax transactions. It is also difficult to identify spouses anddependents from the existing account number system. The deficiencies of thepresent system can be judged from the following facts: (a) less than 202 ofincome and witthholding tax taxpayers currently use valid account numbers and(b) the master list has more than 11 million account numbers although only 2.5million entities file returns. The issue of accurate taxpayer identification is

6/ Accounts receivable may be classified in three categories: overdue, noticeand delinquent accounts. Overdue accounts are those for which no demand noticehas been issued. Notice accounts are those for notices have been issued butpayment not yet received. Delinquent accounts are those which remain unpaidafter 30 days from the date of issuance of a demand notice. Strictly speaking,data on accounts receivable may exaggerate the true delinquency problem. Inaddition, because of an inadequate recording system, deletions from the list ofaccounts receivable may not be properly recorded.

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being addressed through the introduction of a single taxpayer identificationnumber (TIN), similar to the social security number used in the United Statessystem. The TIN system is being implemented on a pilot project basis in onerevenue region in 1991 and will be extended to others soon.

Table 2.11: BIR Accounts Receivable Collection Performance(percent)

1986 1987 1988 1989 1990

Number

Accounts Collected to 8.3 16.2 8.8 13.0 6.8Accounts Outstanding

Accounts Collected to 15.9 15.8 12.9 12.9 11.9Total Income Tax Filers

Amount

Amounts Collected to 1.2 1.7 2.1 6.2 4.2Amounts Outstanding

Amounts Outstanding to 24.1 22.6 22.7 14.5 10.2Total BIR Collection

Amounts Collected to 0.3 0.4 0.5 0.9 0.4Tctal BIR Collection

Source: BIR Annual Reports. Also see notes to Table 6 in Statistical Appendix.

2.52 Weak enforcement follow-up. The high degree of delinquency in thepayment of taxes may also be partly attributed to the weak enforcement ofpenalties. The Philippines system requires the issuance of warrants of distraintand levy (WDL) to defaulting taxpayers following which property can be attachedand recovery obtained. Data on the implementation of WDLs in recent yearsindicate a high degree of non-enforcement: for example, during 1986-90, only 53Zof WDLs issued were actually closed (see Table 2.14). Lack of revenue seizureagents is almost always cited as the principal impediment to more effectivemanagement of delinquent accounts. Furthermore, it takes time and resources tosettle a case: a warrant has first to be served for a tax lien to be attached toproperty; notice of such lien has to be registered with the Office of theRegister of Deeds where the property is situated; seizure of the property has tobe effected; and sale thereof at public auction has to be made before the tax dueis recovered. A basic problem faced is that the process cannot even be startedin many cases because the defaulting taxpayer cannot be located.

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Table 2.12: Enforcement Through Warrant and Distraint Levies

Total WIL ClosedNumber of _

CY WDL Issued Number Ratio to TotalWDL Issued(Percent)

1986 17,464 12,746 731987 20,655 18,849 911988 19,929 6,696 341989 33,644 10,797 321990 16,827 8,535 51

108,513 57,623 53

Source: Bureau of Internal Revenue

2.53 A related issue pertains to the economics of prosecuting cases ofdefault. Under present law, the BIR is required to follow up on virtually allcases of default, resulting in the absurd situation where cases involving aslittle as P100 (about the daily minimum wage) are also filed and followed. In1990, as much as 93% of the number of accounts receivable involved amounts lessthan P20,000. Such enforcement is expensive. Moreover, the provision in the lawthat requires such prosecution was drafted over forty years ago and the triggeramount set then has by now become absurd because of inflation. While there isinsuff'cient data to make a detailed analysis of the costs and benefits ofprosecuting cases involving small amounts, it is generally agreed that the cost-effectiveness of BIR operations would be enhanced by setting the trigger defaultamount at a much higher level.

Problems in Assessment and Audit

2.54 The main problems related to the assessment and audit functions of theBIR arise with respect to (a) the degree of centralization of authority andresponsibility and (b) excessive workload.

a. Centralization of Responsibilities

2.55 The headquarters office is deeply involved in the actual examinationand Investigation of returns, especially for big taxpayers.7 This hasadvantages and disadvantages. Among the advantages is the fact that big casestypically involve complex business operations covering several regions. The

7/ BIR data show that in 1989 almost 82Z of the additional revenue fromassessments came from cases handled by the national office while 18Z came fromthose handled by regional offices.

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audit of such cases often requires examiners with special technical expertise whoare unlikely to be available in regional and district offices. Among thedisadvantages is the fact that such responsibilities take up valuable staff timeand other resources of the natinnal office, thereby affecting productivity inother mandated functions such as policy and review.

2.56 The centralization of the examination function is cited as motivationfor under-assessment by regional offices so as to maintain jurisdiction overcases. In some cases, the transmittal of the investigation reports aredeliberately delayed, leaving very little time for headquarters to conduct athorough review of the case. This has often led national investigators to issuearbitrary assessments to beat deadline.

b. Workload and Personnel Issues

2.57 The chief issue here can be seen as reflecting either an excessiveworkload for the existing staff or a serious personnel shortage for the existingwork requirements. For example, data on the complement of assessment personneland taxable returns filed in 1990 show that each assessment officer would havehandled 765 cases if a 100% audit policy were followed; in some revenue regions,the potential workload is as high as 1114 per officer. Of course, 100% auditsare not necessary and are not done in practice, but even a 10% audit policy,rather conservative for the Philippines, would require officers to handle 76.5cases on average, which is on the high side. Under present guidelines for auditselection, exanmirners performing field audits are supposed to take on not morethan 30 cases per year while examiners performing office audits are assigned amaximum of 90 cases. The general impression is that audit quality is poor.

2.58 One way to handle the caseload problem is to screen those cases thatare unlikely to generate significantly higher assessments after audit. Onecategory that would be a clear candidate is that of employed individuals whoderive income purely from compensation and whose taxes are withheld at source.If this category is removed from the potentially auditable pool, a 10% audit rulewould result in a workload of around 30 cases per officer (using 1989-90 data--see table 2.13). Another way to improve audit quality is to set up a largetaxpayers unit that would monitor such accounts intensively. Both of thesemeasures would provide a better solution than adding more assessment officers andexpanding t.de budget of the BIR.

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Table 2.13: Workloads of Assessment Personnel

Year Number of Number of Cases perCases Examiners Examiner

('000)

1986 1043 2641 391987 999 2564 391987 986 2711 361989 935 2838 331990 772 2933 26

Source: Bureau of Internal Revenue

Problems in Tax Fraud Investigation

2.59 Tax fraud investigation in the Philippines is characterized byslowness of pace and ineffectiveness of results. These characteristics arerelated in turn to a number of personnel motivation problems and to weakpenalties in law for tax fraud. Personnel motivation problems are reported toarise from low pay and excessive workloads. The BIR has found it difficult tohire competent tax lawyers at its present pay scales as most such lawyers havea much more lucrative alternative in private practice. The number of legalpersonnel in BIR has declined from 142 in 1983 to only 88 in 1990; there are someregional offices wlhich do not have any legal personnel. One consequence of thisappears to be a sharp fall-off in the filing of civil and criminal cases by theBIR in recent years (see Table 2.14).

2.60 Examiners are generally reluctant to get involved in tax fraudinvestigations because the process is a long drawn out one with little prospectof a satisfactory outcome. Sometimes, such investigators are harassed andthreatened. Often, they do not get the cooperation of other government agenciesin *:sjn",lishing their case. Typically, the courts do not give high priority totax cases. The civil and criminal penalties prescribed by law for tax fraud areconsidered too low to have a significant deterrent effect; civil penaltiesgenerally involve a 252 surcharge while crininal penalties limit imprisonment toa maximum of six years but typically to two years. Criminal penalties are rarelyimposed and tax fraud cases rarely go to court. In a typical year, the valueinvolved in tax fraud cases comes to only around 1.2? of total BIR collectionswhereas the number of cases filed is around 0.06% of the total number of taxfilers.

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Tablo 2.14: Effectiveness of Ton Fraud Investigation

Total Civil and CriminalTotal (Tax Fraud) Cases Ratios

fear --DIR

Textfilbrm Collection Number Amount Cases to Amount to(In Mill'ion) (Ml lon) Texfilore DIRCollectlon

1981. 2,701,482 18,827.20 974 271.80 0.04X 1.44X1982. 2,680,880 20,087.00 81o 309.00 0.03% 1.64X1998 2,792,742 21,462.70 1,078 84.00 0.04X 0.39%1984 2,929,976 32,088.00 150 412.11 0.005% 1.28X1986 2,832,748 41,858.20 1,887 379.40 0.08% 0.91%188 2,462,614 48,986.90 2,068 714.30 0.08X 1.62X1987 2,117,426 65,688.40 8,287 906.40 0.15X 1.66X1088 2,475,979 83,415.60 4,540 1,297.60 0.16X 2.06X1989 2,666,203 02,188.90 1,213 392.10 0.05% 0.48X1990 2,719,404 104,108.70 910 968.60 0.03X 0.92%

28,076,392 489,381.80 10,696 V,724.21 0.08X 1.17#

/ Refer to income and capital goins filers except in 1981 and 1082 for which no data availableon capital gains.

Source: Bureau of Internal Revenue

2.61 The above-noted problems have led to two notable initiatives in recentyears. First, the Supreme Court has designated special tex courts andprosecutors in some cities to speed up the handling of tax cases. Second,Congress is considering giving front line officials of the BIR higher salariesand incentives to enhance motivation and discourage corruption.

E. Customs Administration

2.62 Underperformance with respect to the collection of import duties isrelated tp a number of issues in customs administration. These are discussed inthis section under the following heads: surveillance and smuggling,classification and valuation, and examination and appraisal.

Surveillance and Smuggling

2.63 The smuggling of dutiable or banned imported goods can take severalforms including outright unrecorded entry, pilferage from customs custody and useof fake documents of duty payment. Smuggled goods are generally of the bannedor regulated category, or those subject to highi tariff rates such as textiles,electronics, food stuffs, and motor vehicle parts. The value of such smugglingis thought to be high: indicative estimates prepared by the Economic Intelligenceand Investigation Bureau (EIIB) showed that smuggling averaged $1.11 billion peryear during 1986-89, or about 12% of average annual imports. The extent ofsmuggling may have increased in recent years: EIIB estimates suggest that the

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value of smuggling averaged $754 million during 1979-85, or about 9Z of averageannual imports over the period.

2.64 Apprehensions of smuggling attempts are few and far between. Thevalue of apprehended cargo is typically a small fraction of the value of totalimports, typically less than 0.32, and about 4? or so of the estimated value ofsmuggling. While low, the value of apprehensions appears to be creeping ups itis reported that apprehensions rose from 2X of the total value of smuggled goodsin 1987 to 4? in 1989.

Table 2.15: Data on Seizure of Smuggled Goods

Number of Estimated Total Ratio toShipments Value of Imports TotalSeized Seized Goods Imports

(Million (MillionPesos) Pesos)

1987 104 129 98,697 0.13?1988 95 220 124,108 0.18Z1989 121 487 225,240 0.22Z1990 101 410 290,082 0.14?

Sources Intelligence Division, CIIS, Bureau of Customs.

2.65 Perhaps the roost important cause of low apprehensions is themeagerness of the resources devoted to the prevention and control of smuggling.For example, the customs police have only one operational patrol boat. Even thisis used not for patrol duties but as a means of transport for customs officialsto board ships for cargo inspection. The bureau does not even have its ownstripping machines for cargo inspection; instead, it relies on private firms forthis function, an aspect that reduces the speed and flexibility with which thecustoms police can act. The budget of the customs police has decreased Innominal terms since 1906, has declined as a proportion of the overall customobudget in every one of the last five years, and is now just over 112 of thecustoms budget (see Table 2.16). These resources are spent not on coasotalpatrolling but on maintenance of security within customs premises.

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Table 2.16: Budget of Customs Police Administration(Million pesos)

Year Customs CPA RatioBudget Budget (2)

1986 21.8 5.9 27.3

1987 24.8 3.9 15.6

1988 29.0 4.1 14.3

1989 36.1 4.5 12.4

1990 38.0 4.4 11.5

Source: Bureau of Customs

2.66 Another factor sometimes cited as contributing to a weak anti-smiuggling effort is the legal/administrative provision which allows the CustomsCommissioner to settle seizure cases directly without referring them to a courtof law. The merit of this provision is that it accelerates the collection ofrevenue and decreases administrative costs by expediting cargo releases and byavoiding court proceedings. The demerit is that it can be abused, and if it isroutinely abused it can weaken the enthusiasm of enforcement agents to pursuesmuggling cases.

2.67 Surveillance is also made more difficult by the poor condition of portfacilities. Dilapidated storage facilities contribute to the problem of cargopilferage. The modernization of these facilities is, however, dependent uponanother government agency, the Philippine Port Authority (PPA).

Classification and Valuation

2.68 Classification and valuation are the bases for computing customsduties, taxes, fees, charges and sundry imposts on imported goods. As such, itis imperative that the classification and valuation system be simple and clearthereby making it less subject to discretion and more resistant to manipulation.One recent chanige (in 1988) has improved the system in the Philippines. This wastEi adoption of the Harmonized System of classification; this system is used bymost of the country's trading partners and contains a clear-cut definition anddescription of goods, thereby lessening controversies in respect thereof. Amajor problem is the continued use of the hlome Consumption Value (tlCV) system ofvaluation rather than the Cost, Insurance and Freight (CIF) system. The CIP

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system is used by GATT members and is more transparent and less arbitrary thanthe HCV system.e

2.69 A further step taken to prevent misclassification and misdeclarationwas the hiring of the Societe Generale du Surveillance (SGS) to make inspectionsof cargoes destined for the Philippines from nine ports in East Asia.9 Anestimate of the extent of misdeclaration may be derived from the outcome of suchinspections. In a period of almost four years, SGS conducted a total of 212,181inspections; of these, 109,496 were dutiable shipments; of these, 69,002 werefound to require uplifting in declared values. Thus about 632 of the shipmentscontained problems of classification and valuation (see Table 2.19). However,in monetary terms, the problem is less sevcre: upliftments of dutiable valueamounted to only 1l.6Z of the total declared dutiable value while totaladditional duties payable to government amounted to about $125 million or lessthan 22 of total duties collected in this period. Part of the reason for this,of course, is the so-called 'honesty' effect: importers learn to provide accuratedeclarations once persuaded of the seriousness of the inspection process.

2.70 A similar impression, that the misdeclaration problem is minor inmonetary terms, is given by data on shipments not inspected by SGS bu'apprehended by the Bureau of Customs on account of misdeclaration. These datashow that, during 1988-90, the value of such shipments was typically less than0.4% of the value of total dutiable imports (see Table 2.20). This reinforcesthe impression that the real problem is not misdeclaration but physicalsmuggling; consequently, customs resources should be reallocated to emphasizeprevention of smuggling and away from classification and valuation functions.The globalization of the CISS should enable such a reorientation of customspriorities. 10

8/ An IMF report prepared in 1985 noted the following deficiencies in the HCVmethod used by the Philippines to assess dutiable values: it was arbitrary andin violation of GATT rules; it was administratively cumbersome; it discriminatedamong importers, penalizing those importing from neighboring countries; and itwas illogical in that it made valuation independent of such features of normalbusiness transactions as quantity discounts, discounts or premiums for paymentarrangements, commissions, and market fluctuations.

9/ The inspection scheme, formally called the Comprehensive Import SurveillanceScheme (CISS), was started in 1987 with coverage restricted to three countriesonly, Japan, tiong Kong and Taiwan. In 1989, it was expanded to cover six othercountries: South Korea, Singapore, Thailand, Malaysia, Indonesia, and Brunei.Macau was added to the list in 1990. In 1991, the CISS was made virtually globalas SGS was awarded a contract covering import inspection from almost 100 portsof slhipment.

101 Of course, other possibiliti6s exists the value of misdeclaration may be lowbecause of collusion between impo.ters and customs officials.

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Table 2.17: Import Inspection Performance(April 1987 - December 1990)

Number of inspections conducted 212181

Number of inspections of dutiable goods 109496

Number of dutiable shipments on whichincrease in dutiable value obtained 69002

Total Increase in Dutiable Value 361.4(million dollars)

Total Increase in Duties and Taxes 125.1(million dollars)

Source: Department of Finance

Table 2.18: Data on Misdeclared Shipments

Year Total Apprehended ShipmentsDutiableeImports Value Ratio to Total(Million) Dutiable Imports

1988 103.114 118.514 0.18?1989 148,013 582.922 0.39%1990 187,202 269.150 0.142

Source: Bureau of Customs

Examination and Appraisal

2.71 The examination and appraisal of imported goods may be conductedbefore or after each other depending on the filing of import entry and arrivalof goods. At present, examination and appraisal are undertaken by two separateofficials. The Examiner conducts physical examination of the imported goodswhile the Appraiser checks on the tariff classification and valuation based onthe doctunents subm-tted. The Appraiser may, if he deems necessary, make anocular re-inspection of the goods.

2.72 Given that it is difficult to make a proper assessment withoutactually seeing the cargo, it would appear that there is no good justification

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for splitting these two functions. It would be simpler and cheaper to combinethese functions. One concern, however, is that this would vest a lot of powerin a single officer and might make it easier for bribery to take place since onlyone person would need to be influenced. One way to reduce the bribery potentialwould be to rotate assessment officers at regular intervals; this would have theadditional benefit of enhancing their skills and experience across a wider rangeof locations and goods.

2.73 Presently there is no independent check on duty assessments afterpayments have been made. The practice of audit review which is a feature of thecollection of internal revenues might be adopted in the case of customs revenuesalso. Spot checks of documents and assessments after customs payments have beenmade could be undertaken as an additional deterrent to corruption.

F. Non-Tax Revenue Issues

2.74 Non-tax revenues have typically ranged from lOZ-15Z of total revenues.The principal non-tax revenue sources are interest income from loans andadvances, income from fees and charges for certain government services (e.g.forest charges), foreign grants, and proceeds from the sale of assets. In recentyears, the last-mentioned source has been the most significant component of non-tax revenues. Accordingly, this section dwells on the revenue implications ofthe government's privatization program.

Privatization of State-Owned Assets

2.75 Government has been implementing a rationalization program during thepast five years among whose key features is the privatization of state-ownedassets, Such assets fall into two categories: regular chartered publiccorporations and companies and properties (non-performing assets) acquired bygovernment as a result of the restructuring of several government financialinstitutions in the mid-1980s. The disposition authority over the relevantpublic corporations rests with a number of other government corporations whilethat for the non-performing assets rests with the Asset Privatization Trust(APT). From the point of view of resource mobilization, it is the dispositionof the latter group of assets that is more izportant since this results in directand immediate flow of revenues (net sales proceeds) to the national treasury.The sale of government corporations does not typically produce revenue for thenational goverrnent sinice the ownership rights rest with other governmentcorporations. However, such privatization helps the national treasury indirectlysince it typically improves the cash flow position of the disposing parentcorporation and enables it to declare a higher dividend to the nationalgovernment or seek reduced subsidies and other transfers from it.

2.76 Progress of ProRram. The rationalization program has been relativelysuccessful in disposing of non-performing assets but not in privatizing publicenterprises. By mid-1991, the APT had disposed of 230 out of the 399 accountsunder its management for a sum of P25.2 billion pesos. Compared to this, by end-1990, only 67 of the 123 government corporations approved for sale had been

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offered for sale and only 32 had actually been wholly or partially sold for atotal of P8.6 billion.

2.77 From the point of view of generating cash to meet current needs, theprogram has been a partial[5;0r6'succ&bsits inception, it was expected that theprogram would yield about P27.4 billion pesos from the sale of NPAs by end-1991.The sales value so far is P25.2 billion pesos. However, only P14.6 billion pesosof this sum has been remitted to the national treasury so far. The remainder isaccounted for mainly by amounts held in escrow pending settlement of legalissues, sales transactions awaiting completion via debt-equity or debt-asset swapschemes, and amounts payable in installments.

2.78 The program has been financially profitable for the nationalgovernment: the cost of privatizing NPAs has been negligible compared to theproceeds thereof. The national government provided APT a subsidy of P84.3million pesos during 1987-89, an amount equal to only 0.75% of the sales proceedsremitted to the Treasury in that period. Actual custodial expenses amounted toP295.5 million pesos during 1987-90, which was only 0.94% of the revenuesgenerated from the privatized assets.

2.79 Potential Revenues from Further Privatization. For the period 1992and beyond, privatization of NPAs is projected to gross P42 billion of whicharound P30 billion is expected in 1992 alone. Thus, the bulk of theprivatization is projected to occur by the end of 1992. From the total, thenational government is projected to receive proceeds of P14 billion, of whichP9.3 billion 13 expected in 1992.

2.80 Assessment. The proceeds from privatization, both historical andprojected, are small relative to total revenues. During 1987-90, the cumulativeremittances to the treasury amounted to just around 1.5 of total revenues.Future contributions will be even less significant, partly because the proceedswill taper off as the stock of privatisable assets shrinks and partly becausetotal revenues (the denominator here) will increase through growth and inflation.Nevertheless, privatization should be encouraged for several reasons. First, ithas intrinsic merit in that it leads to a more efficient deployment of overallresources. Second, in an environment of severe fiscal constraint, additionalresources have a hligh marginal utility. Third, even if the direct revenue effectis limited, the indirect savings from disposing of non-performing assets andinefficiently managed public corporations can be quite substantial. The game isworth the candle.

G. Enhancing Revenue Mobilization

2.81 The foregoing sections have reviewed and analyzed the main causes oflow tax collections in the Philippines. This section reviews some solutions thatmight be instrumental in Improving revenue mobili2ation. Some of these solutionsformed part of the Government's proposed tax reform program and were consideredin the legislature in 1991 (sea box 2.2). They are divided into two groups,those that would improve the design of the tax system and those that wouldImprove its administration.

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BOX 2.2: TAX REFORM PROPOSALS OF 1991

A sot of proposals was put forward by tho Administration for consideration by thePhilippine Congress.

The chief eloents of tho proposod tax reform packago were:

(a) Simplifiod Not Income Tax System: this aims to limit deductions on business expenses andreduce applicable tax rates; this Is expected to improve horizontal equity, lower taxratoe *nd generate a not rovonue guin.

(b) Restructuring of Transfor Taxes: high rates on gifts and transfers (of estates anddonations) are thought to have generated a high dogre of evasion and resultod in a verylow tax take; this proposal sooks to reduce tho highest applicable rate on estatetransfers from OOX to asx and tho number of brockots from sixteen to two.

(c) VAT Rofinements: one proposed refinement is to expand the VAT base by bringing suchproviously exompt sorvices as hotel, catering, and entertainment under VAT; anotherproposed refinoment Is to provide Incentives (in the form of a 4X shere of collectionsIn excos of target collections) to local governments to asslot In Improving collections;a third refinoment Is to Issue advanco tox credits to zoro-rated porsons or activitiesso as to roduco the number of refund claims.

(cd) Withholding Tax on Compensation Income: It io proposed that this tax be made a final one,to shift tho burden of adjustment of taxes duo end paid to employors and employoes, ondto absolve fixod-income senore of tho responsibility of filing tax returns; It isexpected that this would ease tax compliance, docreaso BIRs costs of collection, ondpermit e roallocation of BIR resources to the audit of more productivo casos.

(o) Mosures to Improvo Tax Administration: the chlf measuroes bing proposed are thocreation of special tax courts dodicated to speedy disposition of tax caoss, tho incressoof penaltioe for tax fraud, and tho creation of confidontial positions at the BIR endBBC; thoso positions would carry higher salarios and bonusoe but would not enjoy thoprotection of civil sorvice laws; It Is expected that the higher Income and lose socurotenure would discourage frontline examinors and asoossors from collusion with taxevaders.

In addition to the above, Govornment agroed with tho IMF on a fivo-point progrom toImprove tax administration. Tho program consists of meosures that can be lmploemntedrolativoly quickly and should doliver rosults soon enough to affect fiscal performance in 1992.Tho eloemnts of the program are:

(a) Introduction of a singlo Tax Idontification Number (TIN) to roplaco the existing arrayof tax accounts.

(b) Adoption of case screening criteria to distinguish between categorls likely to resultin high post-audit adjustments and those unlikely to do so.

(c) Collection of VAT on a monthly basis, Initially from large payers, to reduce collectionlags.

(d) Estabilshment of special unit to monitor filing and payment of taxes by large taxpayers.

(e) Reform of tax collection system to move away from current procedures involving paymentorders and confirmation receipts.

Improving Tax System Design

2.82 Presumptive Income Levels. It has been shown that non-filing andunderdeclaration result in significant loss of revenue and that it is difficultto verify the true incomes of self -employed professionals and businesses, the so-called Ohard-to-tax" groups. One way to attack underdeclaration is to estimate

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and apply presumptive income levels for different categories of professionals andbusinesses. Empirical evidence for the Philippines suggests that the degree ofunderdeclaration is high and there would be a large payoff to the adoption of aPIL system.

2.83 It is clear that several legal and administrative challenges will haveto be surmounted before such a system can be widely implemented. Concernedgroups will lobby strongly against such a system and initial assessments will bewidely contested. On the administrative side, there is the difficulty of makingsufficiently precise estimates and then updating them regularly, and further ofmanaging contested cases. Nevertheless, several countries (e.g. France, Turkey,Japan, Israel, Thailand) have adopted this system in one form or another; theirexperience suggests that the system is productive and that various anticipateddifficulties can be dealt with satisfactorily. For example, professionalassociations could be involved as partners in the process of estimating PILs andsetting procedures for revision and arbitration; this should result in a systemwhich has the sanction of the target taxpayer groups.

2.84 Business Deductions. It has been noted that the pattern of claimedbusiness deductions exhibits characteristics which suggest that this facility inthe tax law is being abused. This source of tax evasion could be controlled bysetting ceilings on allowable business deductions, especially on those that aremost open to abuse such as promotional, representational and travel expenses.Such ceilings were originally envisioned in the TRP of 1986 but were notintroduced in the face of opposition by business groups. At the time suchceilings were proposed in 1986 it was estimated that the net gain in revenuewould be around P200 million; on current levels of corporate income, the gaincould be three times larger.

2.85 VAT Coverage. When the VAT system was introduced in 1988, severalcategories of goods and services were exempted. While that may have been asensible decision at that time, in view of anticipated difficulties inintroducing a new system, enough experience has been gained by now to justify theexpansion of the VAT base. Among the categories of services that could beincluded in the VAT base are: hotels, caterers, common carriers, forest products,securities dealers, public utilities, communications, and entertainment. Itshould be noted that revenues would not necessarily be increased in all cases ifLhe VAT rate of 102 is applied: for example, hotels currently charge a higherrate and there is no benefit of input crediting. Nevertheless, a widening of thebase would be justified on grounds of tax neutrality and easing ofadministration.

2.86 Fiscal Incentives. The fiscal incentive system, featuring a varietyof tax waivers and credits to promote investment, is a notable source of revenuebase erosion. Unfortunately, the fact that at present investntent is perhaps moresensitive to other considerations, such as political stability and theavailability of infrastructure, renders the present system of incentivesineffective in terms of generating adequate levels and a desirable mix ofinvestment. Consequently, there is a case for drastically re-designing thesystem. For fiscal considerations, it would be useful for the redesigned systemto limit such incentives to a very small group of industries. Government hasbegun moving in this direction. The Investment Priorities Program list was

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reduced from 206 industries/sectors in 1990 to only 95 in 1991. If the processof pruning is continued in future years, this source of fiscal leakage will bereduced.

Improving Tax System Administration

2.87 Bank Secrecy Law. It has been argued that large scale tax evasion ismade possible mainly because of the legal inability of the BIR to detect casesof evasion through the financial records of tax filers. The failure to catchsuch evasion by "big fish" involves a large direct revenue loss, of course, butalso has a corrosive effect on public ethics with regard to tax obligations.Given this, it is imperative that the Bank Secrecy Law be amended in such a wayas to enable BIR to secure bank records without having to file a case in court.It should be made possible, for example, for the BIR to obtain bank records onceit starts a tax fraud investigation. Concerns about potential harassment oftaxpayers should be met in other ways, such as restricting access to only verysenior BIR officers. Concerns about runs on banks should also be met throughother means, such as providing liquidity to affected banks through Central Bankmechanisms. It should be noted, however, that concerns about financialdisruption that might be caused by the lifting of bank secrecy may beexaggerated; there usually is no alternative for the "big" tax evader to usingbanks since informal institutions are unlikely to be able to provide an adequatedegree of security and convenience.

2.88 Taxpayer Identification System. Data processing and taxpayeridentification is hampered by the existence of multiple account numbers fordifferent tax transactions with BIR. The BIR has already begun the process ofreplacing these multiple account numbers with a single tax identification number(TIN). This should help enhance data processing and reduce tax evasion. Dataprocessing would be facilitated since fewer files would need to be opened,payments made could be easily recorded, and adjustments easily effected. Taxevasion would be discouraged to the extent that different transactions with BIRcould be easily retrieved for cross-checking purposes. In addition, if the TINwere designed to identify spouses, this would help cut down on evasion throughthe practice of both spouses claiming full deductions for the same set ofdependents.

2.89 Computerization. It should be noted that the full value of a TINsystem can only be derived if tax accounts are properly computerized. Inaddition, computerization would enable improved monitoring of tax account statusand improved interaction with other government agencies that have a revenuefunction. Government is currently receiving technical assistance from variousinternational development agencies such as the World Bank, the InternationalMonetary Fund and the Asian Development Bank, in preparation for a taxcomputerization effort to start next year.

2.90 Expansion of Withholding Scheme. Legislation has been passed recentlyto enable the BIR to treat withholding on compensation income as final in nature.Withholding at source has generally proved to be a productive and reliable sourceof revenue, whether it be final withholding on passive earnings or tentativewithholding on compensation income. Experience has shown that the lattercategory of tax returns rarely involves fraud and seldom requires adjustments.

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Therefore, it is argued that the withholding from compensation income should bemade final for at least those cases where this is the sole source of income.Employers would be required to withhold an amount equal to the tax liability;should differences arise, they would be settled between employers and employeesdirectly through refunds or extra withholdings from the next year's salary. Thiswould cut down on the number of returns to be processed, examined, and acted uponby the BIR thereby releasing personnel and resources for more activeinvestigation of other returns. It is estimated that such a measure would reduceby 80X the number of returns to be filed and examined.

2.91 VAT Administration. Since VAT is a relatively new tax, there is roomfor improvement in its administration. Moreover, since VAT is a potent sourceof revenue, such improvements are likely to have a large payoff. The principalareas for improvement are: (a) Effort: VAT merits a larger administrative effortpossibly through an upgrading of the VAT division in the National Office to adistinct Service and the enlargement of VAT units in regional offices through thehiring of additional personnel; (b) Decentralization: All VAT processing, audit,and investigation functions should be delegated to the regional and districtoffices, leaving headquarters only the mandated roles of review and evaluation,and policy and program development; (c) Education: A VAT information programshould be continued so as to reach potential taxpayers who may not be filing outof sheer ignorance of the system and its requirements; (d; Monitoring: The listof VAT filers should be updated and verified periodically with a master list ofbusiness establishments in all revenue districts; (e) Cooperation: Thecooperation of local officials should be enlisted towards VAT collection byallocating a certain portion of VAT revenues to local governments; and(f) Collection: At least for the larger taxpayers, VAT should be collectedmonthly rather than quarterly, as is presently the case; the amounts involved arelarge and the interest income foregone from staggered collections is sizable.Monthly collections are quite feasible from large taxpayers and entail modestadministrative complications since large filers (i.e., those paying more thanP100,000 per quarter) form only 3% of VAT filers but account for almost 90Z ofVAT revenue.

2.92 Audit Case Selection. Another measure that has the potential forreducing workloads, increasing productivity and thereby reducing the cost ofcollection at BIR has to do with the selection of cases for audit andinvestigation. Under present law, the BIR is required to follow up on casesinvolving as little as P100 (about the daily minimum wage); in 1990, around 93Zof accounts receivable involved amounts less than P20,000 pesos. Following upon small cases is expensive. The criteria for selecting cases for audit andinvestigation should be adjusted so as to focus the resources of the BIR onrelatively larger cases with prospects of higher recoveries. It is counter-productive, from a revenue point of view, to spend more resources on thecollection process than might be reasonably expected as an outcome of theprocess. For small cases, only random audit and investigation should beconducted; this would keep collection expenditures low without removing thethreat of audit and prosecution from small taxpayers.

2.93 Courts and Penalties. It has been noted that the relevant BIRpersonnel are often discouraged from filing civil and criminal charges in casesof evasion because the court process is long and tedious and very seldom results

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in suitable penalties being awarded to the tax evader. In this light, it wouldbe useful to set up special tax courts and to increase the penalties applicableto tax evasion. Recently, 20 courts in selected major urban areas were taskedto handle tax cases on a priority basis; however, since these courts continue tohandle non-tax cases as well, they have not significantly eased the backlog oftax cases in the jurisdictions concerned. What is needed is a system ofdedicated, specialized tax courts which hear nothing but tax cases. As far aspenalties are concerned, common sense suggests that evasion should decrease indirect proportion to auticipated penalties. The problem in the Philippines isthat financial penalties are too low to be effective while the jail termsprescribed in the law are rarely applied. Raising fines and applying jail termsmore frequently would have a deterrent effect on tax fraud; administrative andjudicial discretion in this matter should be restricted so as to minimize thepossibility of "negotiated" settlements. Legislation has been passed recentlyto raise penalties for tax evasion and provide special courts for tax cases.These are clearly steps in the right direction.

2.94 Frontline Cadre. Corruption is a major element of tax evasion. Theroots of corruption may lie in all manner of socio-cultural considerations butthey also lie in such matters as low pay for tax and customs officers. Low paynot only discourages competent people from seeking a career in the BIR or BOC butalso encourages staff to increase their real incomes through collusion with taxevaders for a cut. One solution to this problem that is presently beingconsidered is to create a special cadre of frontline officers (examiners andassessors) tn the BIR and BOC who would be entitled to higher pay and specialbonuses but who would also be removed from the protection of civil service laws.It is thought that such a cadre would have iess incentive to be corrupt sincetheir pay would be higher but also because, if cases of corruption occur, theofficers concerned could be summnarily dismissed. In other words, the schemecontains both a carrot and a stick. Only experience will tell whether such ascheme will work and whether the carrot part or the stick part is the moreeffective element. Legislation was introduced in 1991 to implement such a schemebut it was not successful mainly because of concerns that it would give seniortax officers excessive discretion and set a bad precedent for the operation ofcivil service rules.

2.95 Control of Smuggling. It has been shown that smuggling is a far moreserious problem in the Philippines than misdeclaration of import value.Conservative estimates place the value of smuggling at 12Z of total imports.Given the archipelagic nature of the country it is admittedly difficult tocontrol smuggling; present efforts are, nevertheless, woefully inadequate.Resources (both personnel and equipment) devoted to the anti-smuggling effortneed to be considerably increased; the globalization of import inspections shouldpermit the necessary reallocation of customs budget resources. In addition,penalties for tax fraud via smuggling should be increased and court proceedingsexpedited.

Quantitative Aspects of Revenue Mobilization

2.96 Several of the measures discussed in the preceding section formed partof a legislative tax reform package advocated by Government and considered byCongress in 1991. Among the ones that were approved are: the simplified net

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income tax scheme including a rationalization of deductible expenses forbusinesses, increased penalties for tax evasion, creation of special tax courts,restructuring of transfer taxes on estates and donations, creation of a unit tomonitor taxes payable by large taxpayers, making the withholding tax oti incomederived solely from compensation final in nature, and restructuring of forestcharges. In addition, Philippine Air Lines was successfully auctioned, drawinga higher bid than anticipated. These developments helped to satisfy the IHF ofthe viability of the stabilization program for 1992. It is expected that theabove-noted measures will contribute to the generation of an additional 20billion pesos of revenue in 1992 and enable the government to maintain the publicsector deficit at 2.7Z of GNP and public expenditures at the level of about 18Zof GNP. This level of expenditures is expected to be consistent with a growthtarget of 2.5Z for 1992.

2.97 The medium term fiscal picture, however, leaves much to be desired.Among important measures that were not approved in the last legislative sessionwere: the extension of the VAT base, the rationalization of motor vehicle taxesand the approval of frontline "confidential" pGsitions at the BIR and BOC. Thefirst two of these measures were of the "hard" variety, that is, measures whoserevenue yield is relatively quick and predictable. The third measure isadmittedly "soft" but is estimated by BIR to have a high yield. To improve thefiscal picture in the medium run, these and other measures suggested in thisreport should be put on the legislative table again. Some of these measures areneeded to improve revenue flows but some have additional desirable features aswell of promoting neutrality and equity as well.

2.98 Revenue mobilization must also be evaluated in relation to otherdevelopment objectives, in particular, the objectives of achieving greatereconomic efficiency and of maintaining a sustainable current account deficit.In the long run, there is no inconsistency between these objectives and that ofraising more revenues. In the short run, however, some tradeoffs might arise.For example, greater economic efficiency often requires the reduction of importduties but these are typically important sources of revenue to the treasury.Similarly, exchange rate depreciation might be required to maintain internationalcompetitiveness and a low current account deficit, but this tends to increase theexternal debt service burden of the public sector, thereby increasing revenuerequirements. Policy formulation to achieve simulltaneously higher revenues andthe other objectives noted above requires knowledge of the quantitative linksbetween various revenue measures and other macro balances.

2.99 Such quantitative links were assessed for this report with the aid ofa computable general equilibrium model of the Philippines Four scenarios weresimulated: (a) tariff reform as specified in Executive Order 470; (b) redactionof current account deficit by 12 of GDP; (c) an increase of 1% in the investmentrate and (d) a combination of selected efficiency increasing measures togetherwith (a), (b) and (c). The efficiency measures comprise expansion of VATcoverage, elimination of all subsidies provided by Government, abolition of thespecial 5Z import levy, and liberalization of investment and trade (leading toan increase in import and export elasticities). In each case, the model was usedto calculate the required increase in domestic taxes or decrease in governmentconsumption using 1990 as the reference year. It -as assumed that prices andwages would be flexible enough to accommodate a real devaluation in each case;

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the maximum real devaluation implied under the first three scenarios was 3.62.It was also assumed that there would be no additional external financing.

Table 2.19: Estimated Revenue Impact of Selected Measures(Billion Pesos)

Annual Yield

Expansion of VAT Base and other Refinements 8.1

Creation of Confidential Positions 7.5

Simplification of Net Income Tax 2.7

Restructuring of Motor Vehicle Tax 2.6

Increased Penalties for Tax Evasion 3.2

Restructuring of Forest Charges 0.5

Continuation of 5Z Import Levy 4.2

Sources Congressional Planning and Budget Office

2.100 Table 2.20 below provides estimates of the adjustment in domestictaxes and tax ratio required under the various scenarios noted above. Thenumbers suggest that significant amounts of domestic revenues are needed in orderto implement the policies entailed by the objectives of greater efficiency, moregrowth, and a lower current account deficit, that is, a combination of (a),(b)and (c) above. These objectives can be accomplished by raising domestic taxesby 38Z which implies an increase in the tax ratio of around 19%. Given that thetypical rate of increase in tax revenues in recent years has been around 22Z,this suggests that special efforts are required to increase the elasticity andbuoyancy of the tax system, that is, tax collections must be increased througha combination of reforms affecting the design and administration of the taxsystem.

2.101 Of course, a reduction of government expenditures would ease therevenue enhan-ement required. So would measures that increase the productivityof the economy. This is done in the fourth simulation ncted above. Governmentexpenditures are reduced to the extent that all subsidies offered by the nationalgovernment are eliminated. Productivity is enhanced by liberalization ofinvestment and trade. In addition, this simulation features an increase in thecoverage of VAT to include most of the service sector (with an assumed collectionrate of 602 of the actual collection rate in manufacturing). These measures, in

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combination, reduzce the required domestic revenue effort by half; an increase ofonly 19Z is called for in this case.

Table 2.20: Revenue Mobilization and Other Objectives

Percent ChangeDomestic Taxes Tax/GDP

1. Reduction in Current 16.2 10.7Account Deficit by 1Z

2. Tariff Ref3rm: E0470 11.4 0.6

3. Investment Growth of 11.8 8.2Additional 5%

4. Total (1+2+3) 38.1 19.4

5. Total + Other Measures!/ 19.6 7.0

11 Other measures refer to: extending the -overage of VAT;eliminating subsidies, and liberalizing investment and trade.

Source: Staff Calculations

2.102 The key conclusions are, therefore, the following: (i) asignificant increase in revenues is required to meet the combined objectives ofgreater efficiezcy, higher growth and lower external deficit; this can not be metby normal revenue increases associated with growth but must be obtained fromimprovements in tax collection; (ii) the required revenue effort can be mV'eratedby improvements in productivity and reductions in government expenditures; thenext chapter considers how this might be done through reforms in the managementof public expenditures.

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III. PUBLIC EXPENDITURE MANAGEMENT

3.1 While enhanced resource mobilization is a necessary condition forsustaining higher growth in the future, it is not a sufficient condition. Itis important to go beyond raising resources to ensuring that they are used inan efficient manner and towards desirable ends. The recent economir historyof the Philippines provides a case in point. Public expenditures rosesubstantially during the 1970s, but they were not deployed in an efficientmanner. Higher public expenditures were associated with substantial growthin the size of government, with an increase in subsidies for governmentservices, and with a preference for large and expensive investments insectors where comparative advantage was doubtful, to say the least.Consequently, these expenditures did not result in sustained growth and, tothe extent that they were financed by external borrowing, did not generatethe resources needed to meet debt-service obligations. The result was afiscal and economic crisis in the mid-1980s, whose ramifications affectbudgetary priorities and economic performance even to this day.

3.2 If a similar outcome is to be avoided in the future, not only mustthe pattern of funding shift towards resources raised domestically but thesize and composition of expenditures must be guided to a greater extent bythe criterion of efficiency and cost-effectiveness. This necessitatesconsideration of issues related to the management of public expenditureswhich is accordingly the topic of this chapter. Since the central governmentand public enterprises account for the bulk of public expenditure, attentionis focussed primarily on these and local government issues are ignored.

3.3 The chapter is organized as follows. The first section providesa brief discussion of budget process issues mainly to see if grossinefficiencies arise in the transformation of development plans to annual andmedium term financial plans for public expenditures. The second sectionreviews recent trends in government expenditures and public investments andexamines the factors that determine the productivity of such expenditures inthe Philippines. Among these factors is a greater role for the privatesector in delivering infrastructure services; this is the subject of thethird section. The fourth section deals with public enterprises andconsiders issues related to their financial autonomy, operational efficiencyand financial performance.

A. Budget Process Issues

3.4 The budget process is important to the issue of public resourcemanagement in that it has the potential to change the content, increase thecost and delay the implementation of the public expenditure program. Theextent to which this occurs in the Philippines is discussed below through areview of three stages of the budget process: planning, approval andimplementation.

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3.5 Budget Planning. On the whole, the budget planning process in thePhilippines is sound. The process is a consultative one; the investmentpriorities of both central line ministries and local government units aresought and accommodated subject to fiscal constraints and national prioritiesexpressed in the Medium Term Public Investment Program (MTPIP). One measureof the overall soundness of the system is that public investment outlays hbvetended to follow MTPIP sectcral allocation patterns even when fiscalconstraints have prevented the attainment of matching levels of expenditures.Furthermore, recognizing that local government units are often incapable ofdrawing up plans and priorities, and also that some local investment programsmay be inconsistent in a regional context, the system provides for relevanttechnical assistance as well as consistency checks through RegionalDevelopment Councils. This process has irproved local capabilities in manyinstances. thereby providing a base on which further decentralization canrest.

3.6 One recent innovation has reduced frictions in the planning processas well as the time needed to put together a final plan. For the 1990budget, the Department of Budget and Management (DBH) prescribed ceilings tospending agencies and let them decide how to prune their submissions to fitunder these; the earlier practice had been for DBM and the spending agency toprune submissions jointly, a practice that was both eacromonious and time-consuming. The ability to choose their own priorities (subject to broadnational guidelines) has been welcomed by spending agencies and has speededup the budget submission process.

3.7 Nevertheless, there are two areas of concern. One is that thepresent planning process does not yield a Medium Term Financial Plan (MTFP)of sufficient accuracy to reliably guide medium term budget decisions. Thepresent MTFP is highly aggregative and tentative. Related to this concern isthe fact that, whereas capital expenditures are carefully planned, selectedand monitored, a similar degree of attention is not foeused on currentexpenditures which make up close to 80% of the budget. There tends to belittle analysis of the individual components of agency current expenditureprofiles as they relate to development objectives. In practice, this hasmeant a rather haphazard approach to budgeting for operations and maintenanceexpenditures. The MTFP could become a more useful document if it were lessaggregative and more detailed in its coverage of expenditure categories andif it contained simulations of multiple scenarios with respect to the keydeterminants of expenditure trends.

3.8 The other concern is that the syste- may be growing too complex.Many agencies are involved and there is always the risk of coming up withinconsistent plans, priorities and schedules. Rather than sort out theinconsistencies at a later stage, it may be better to improve coordinationearlier. Accordingly, Government has recently begun testing a coordinationexercise called the Synchronized Planning, Programming, and Budget System(SPPBS). The SPPBS is intended to improve coordination among the budget,planning and revenue agencies in particular so as tc ensure consistency ofbudget plans with development goals and available finance. Implementing theSPPBS will be a difficult exercise, but one worth pursuing as long as

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attention is not diverted from the pressing short-term problems that confrontpolicy makers.

3.9 Budget Approval. The budget approval process involves the reviewof the submitted budget by Congress. This process has revealed some tensionsin recent years. There was a serious delay of about six months in theapproval of the 1991 budget partly due to disagreement over expenditurepriorities but largely over revenue mobilization strategy with Congressobjecting to the tax increase measures proposed by the Government to meet theterms of a macroeconomic agreement worked out with the IMF.

3.10 One expenditure area over which differences have regularly arisenis external debt service. Congress has tried to set limits to this categoryin the budget whereas the Administration has argued that debt service fallsunder the cover of automatic appropriations and congressional authorizationis not required. Despite the fact that the Government's position wasaffirmed by the Supreme Court two years ago, attempts to set debt servicecaps persist. While this may not be a problem with procedures per se butmore a reflection of political sentiments on the part of some legislators, ithas the potential to disrupt the approval process.

3.11 Budget Implementation. The procedures for commitment and releaseof funds affect the efficiency with which public resources are managed. Ifthe procedures are cumbersome, program schedules can slip in critical waysand investment costs can rise. On the other hand, if procedures are too lax,funds could be spent for inappropriate purposes, again increasing overallprogram costs. The objectives of flexibility and control have to bebalanced. Three innovations of recent years merit comment. First, thevalidity of authorizations was extended by a year, in effect giving agenciestwo years to make authorized expenditures. Second, the common fund approachwas adopted whereby agencies were given the authority to shift funds fromslow-moving projects to fast-moving projects. Third, fast release procedureswere adopted whereby agencies were given cash to cover authorizedexpenditures even before Government had received disbursements from foreigncreditors. These innovations have provided greater flexibility to agenciesin managing projects. The last-mentioned measure has, however, created someproblems for macro managers in that agencies have less incentive to submitdocumentation required by foreign creditors on a timely basis and theTreasury is left with an unpredictable lag between outflows and inflows. Thishas contributed to cash management problems.

3.12 In recent years, two aspects of cash management have drawnattention. One aspect is that of cash float. This became a prominent issuein 1990, at a time of great fiscal stress, when it was discovered that thecash float involved in the transmittal of funds from the DBM to spendingagencies was averaging around 10 billion pesos. This was considered to beexcessive in relation to the true cash needs of the spending agencies and wasthought to be caused by high interest rates then carried by Governmentsecurities. These rates provided an incentive to depository banks to delaythe transmission of funds to spending agencies in order to benefit from thespread between the interest rate they paid to agencies on such deposits andthe return from investing in government securities. It is thought that some

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spending agencies also sought to improve their financial position by delayingtheir expenditure schedules and investing excess cash in T-bills. Oncedetected, the problem was speedily resolved. The number of depository bankswas reduced from 7 (including conmercial banks) to 3 (including onlygovernment owned banks) and the average float was cut from 10 billion tounder 4 billion pesos.

3.13 A second area of concern is that of the timeliness of cash releasesto spending agencies. Many agencies complain that project schedules aredisrupted and delayed by the failure of DBM to make cash releases on timedespite the existence of appropriate authorization for the relevantexpenditures. This problem has been especially acute in 1991 but appears tobe related more to policy than to process. A widening fiscal deficit in 1990led to a policy decision to limit expenditures to the availability ofrevenues on a monthly basis. Since anticipated revenue enhancement measuresdid not materialize, this led to a squeeze on cash releases to spendingagencies; spending has been determined effectively by cash on hand ratherthan appropriation cover. Assuming that fiscal constraints necessitatecontinuation of this approach, it is useful to consider how its adverseeffects might be controlled.

3.14 The main adverse effect of such a cash management approach is thatit reduces the usefulness of work plans submitted by the agencies. If cashreleases do not bear much resemblance to submitted plans over a couple ofyears, cynicism might creep into the process of formulating plans.Furthermore, contractors working on government projects would adjust theirown cost and schedule submissions to take into account the greateruncertainty characterizing anticipated reimbursements. Such responses wouldtend to delay project start-ups, lengthen implementation intervals, andincrease costs. Two steps might be taken to decrease the uncertaintyinvolved and thereby mitigate adverse consequences. First, a core set ofgovernmnt expenditures could be identified which will receive priority infinancing. in other words, funds rationing would be selective acrossagencies. In this way, once it is known which projects fall into the coreset, uncertainty with respect to their financial needs being fulfilled wouldbe reduced. Second, revenue intake should be smoothened across months tomeet anticipated expendicures through the use of borrowed funds. This can bedone by allowing weekly Treasury auction sizes to vary in accordance withweekly or monthly revenue needs rather than be set at pre-determined levels,consistent with annual needs, as is the case at present.

1/ The intention here is not to engage in micro-management of eachagency's spending but to have a pre-determined rule to allocate cuts acrossagencies; that is, not all agencies would receive the same across-the-boardpercentage cut. As far as intra-agency projects are concerned, it is best toleave "triagel decisions to the agency concerned since it usually has thebest information on individual project status and importance.

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B. Public Expenditure Patterns and Productivity

3.15 There are some very clear trends and patterns in the recentevolution of public expenditures. These are discussed below in two sections,one dealing with the national government budget2 and the other dealing withpublic sector investments, including the capital expenditures of the nationalgovernment as well as those of government owned and controlled corporations(GCs); the investment outlays of local government units are ignored as theyare a small fraction of the total. For ease of exposition, the discussion isframed in terms of a comparison of recent pattetns for the period 1986-90with those that prevailed over the period 1975-85.

Government Expenditure Patterns

3.16 Economic Categories. Viewed in terms of economic or functionalcategories, the recent pattern of national government expenditures showsseveral clear differences with the earlier period: (a) Total governmentexpenditures jumped as a proportion of GNP from 15.9Z to around 21Z. Thiswas due entirely to (b) an increase in current operating expenditures from10.9% to around 17Z; the share of capital expenditures declined from 52 to3.8?. The rise in current expenditures was due primarily to (c) a sharpincrease in interest payment obligations (from 1.22 to 6.1?) and an increasein personal services expenditures (from 3.82 to 5.3Z). The decline in theshare of capital expenditures was accompanied by (d) a fluctuating trend inoperating and maintenance expenditures which fell in the early part and rosein the latter part of the decade and by (e) a sharp fall in investmentoutlays from 2.12 to 0.8Z of GNP.

3.17 The sharp rise in interest payment obligations came about as aresult of two factors. First, the national government assumed (in 1985) theexternal debt liabilities of several government and private entities forwhich it had issued guarantees and which were in the process of beingrestructured in the wake of the financial and economic collapse of the mid-1980s. This assumption of liabilities transferred the debt serviceobligation to the national government, thereby resulting in a big increase inallocations for interest payments. Second, substantial depreciation of thepeso relative to the earlier period increased the magnitude of the external

2/ The budget of the national government is organized in two parts,current and capital expenditures. There are no special accounts that are notincluded in these two categories. Operations and maintenance expendituresare included in current expenditures. The practice of specifying adevelopment budget, listing all current and capital expenditures as have adevelopmental impact, is not followed in the Philippines.

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Table 3.1: NA71ONAL GOVERNMENT EXPENDITURES, BY ECONOMIC CLASSIFICATIONdOBLIGATION BASIS, (Percent of GNP)

........... ............................... .................

1975- 1986-1985 1990 1986 1987 1988 1989 1990

TOTAL 15.90 21.04 18.63 22.11 20.34 20.73 22.47

Current Operating Expenditures 10.88 17.21 12.59 18.14 17.53 17.72 18.49

Personal Services 3.83 5.34 4.64 4.48 5.30 5.41 6.23Maintenance and other

Operating Expenditures 7.05 11.87 7.95 13.66 12.23 12.31 12.26Interest Payments 1.22 6.07 3.52 9.98 5.57 5.73 5.68Transfers 1.13 1.12 1.00 0.84 1.02 1.14 1.41Loan Repayment 1.91 2.16 1.05 0.00 3.09 2.89 2.81Other MOE 2.78 2.52 2.38 2.83 2.55 2.55 2.36

Capital Outlay 5.02 3.83 6.04 3.97 2.81 3.01 3.99

Land, Land Improvements andStructure Outlays 1.51 1.08 0.49 1.07 0.91 1.11 1.51

Buildings & Structures 0.57 0.82 0.97 0.53 0.53 0.66 1.27Equipment 0.26 0.28 0.10 0.17 0.34 0.36 0.34Investment Outlay 2.13 0.81 2.03 0.67 0.29 0.58 0.81Loans Outlay 0.54 0.84 2.46 1.52 0.74 0.30 0.07

Table 3.2 NATIONAL GOVERNMENT EXPENDITURES, BY SECTORAL CLASSIFICATIONOBLIGATION BASIS, (Percent of GNP)

1975- 1986.1'985 1990 1986 1987 1988 1989 1990

TOTAL 15.90 21.04 18.63 22.11 20.34 20.73 22.47

Total Economic Services 6.42 4.83 6.73 4.74 4.02 4.31 4.88

Total Social Services 3.00 4.03 4.10 3.42 3.64 4.08 4.61Education 1.76 2.74 2.27 2.41 2.68 2.84 3.17Health 0.54 0.65 0.53 0.57 0.66 0.65 0.75Other Social Services 0.71 0.64 1.29 0.45 0.30 0.59 0.68

National Defense 1.67 1.32 1.25 1.24 1.50 1.34 1.26

Total Public Services 1.80 2.46 1.99 2.72 2.51 2.25 2.72

Debt Service 3.00 8.22 4.56 9.98 8.67 8.57 8.49

Unallocated 0.00 0.18 0.00 0.00 0.00 0.18 0.53

Net L.nding 0.49 0.68 2.45 1.09 0.60 0.17 0.04

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debt servicing obligation.: Recent years have seen positive developments,however, as declining international interest rates and successful debtrescheduling exercises have reduced interest payments from almost 10 of GNPin 1987 to around 5.7Z in 1990; in terms of shares of the annual budget,interest payments have declined from 45Z of the budget to around 25Z overthis period.

3.18 Interest payments, however, were not the only factor behind theincrease in current expenditures. Personal services expenditures also grewsharply as a result of numerous salary adjustments granted to governmentemployees by the Aquino Administration and some increase in the number ofemployees. The salary adjustments include a 10? across the board increase inJuly 1986, a 5? increase for career executive positions and a 302 increase ofrank and file employees in selected agencies in 1987, and increases impliedby the Salary Standardization Act which came into effect in 1990. As aresult, expenditures on this account have steadily risen from 4.6? in 1986 to6.2? of GNP in 1990 or from 20? of the annual budget to over 27?.

3.19 The increase in personal service expenditures must be viewed inperspective, however. Even with substantial growth in recent years, suchexpenditures are not out of line in comparison with neighboring countries.The Philippines spends a lower proportion of its budget dn wages and salariesfor government employees than Malaysia and Thailand. The bulk of recentincreases was due to the Salary Standardization Act and represented atransitional phase; now that the Act is in place, personnel expenditures areexpected to grow at a more normal rate. Furthermore, the public sector workforce remains a small proportion of the total labor force. The number ofpublic sector employees has only increased modestly, from 1.19 million in1986 to 1.25 million in 1990; within this, the size of the nationalgovernment employee roster increased from around 832,000 to around 845,000.Much of this increase occurred in field-level staff rather than centraloffice staff, in part due to the "nationalization" of local level teachers.

3.20 The sharp decline in investment outlays and the lack of anyincrease in maintenance expenditures is worrying in view of the clearinfrastructure and maintenance deficiencies in the country.4 These trendsalso suggest that the fiscal adjustment since the mid-1980s has been borne

a/ The prominent role of the larger interest payment obligation nowshouldered by the national government is reflected in two notable features ofrecent budgets: (a) government expenditures net of interest payments werevirtually the same (around 14.52 of GNP) during 1986-90 as during 1975-85 and(b) primary surpluses were generated in each of the last five years as non-interest expenditures were systematically lower than revenues.

4/ Even the "other MOE" category in Table 3.1 may not be adequatelydisaggregated to show trends in 'true" maintenance expenditures. However,sufficiently disaggregated data collected from the key infrastructureagencies and corporations confirm the impression that maintenanceexpenditures remain inadequate. Such expenditures have averaged about 12? ofcapital outlays in recent years.

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Fig 3.1 National Government Expenditureby Economic Classification

(percent of GNP)

PeraonalPersonal 6.3%

386%

Interest Payments1.2% Other Capital Othr-1990

Capitl 293.0%al~ neet Payments ivsmn

F19 3.2 Natlonal Government Enventment

Other Current investment6.8% ~~~~~2.1%

Other Current1975-1986Total * 15.9% 1986-1990

Total * 20.9%

Fig 3.2 National Government Expenditureby Sectoral Classification

(percent of G3NP)

Economic 0oia6.4% 4.0oEonomIc

48%

social Publi3.0% ~~~~~Other .. :...:..Oher

1.7%

Pubi1.8% ~Debt Service

3.0% Debt Service1975-1986 8.2%

Total a 15.9% 1988-1990Total a 20.9%

_ 73 -

primarily by these expenditure categories. Such a pattern of adjustment isnot unusual and reflects the politics of budget formulation in resource-constrained countries. It is alarming, however, to the extent that itessentially buys short-term adjustment at the expense of long-term growth; inso doing, such a strategy may sow the seeds of its own failure in thatforegone growth may constrain resource mobilization and thereby createadditional pressure on the fiscal balance.

3.21 Much of the decline in capital investment outlays occurred during1986-88 as the new government sought to bring the fiscal accounts undercontrol; in these three years, investment outlays plunged from a high of 2Zof GNP (or 11Z of the budget) to 0.32 of GNP (or 1.4% of the budget). Thisdramatic decline was partly reversed during 1988-90 as investment outlaysclimbed to 0.8Z of GNP (or 3.6Z of the budget).

3.22 Sectoral Categories. Several other trends become evident whennational government expenditures are viewed from a sectoral or functionalperspective. From this perspective, (a) economic service allocationscontracted from 6.4% during 1975-85 to 4.8% during 1986-90 while (b) socialservice allocations expanded from 3Z to 4% and public services rose from 1.8to 2.5%. The most notable trend was (c) the sharp increase in debt serviceallocations which rose from 3% to 8.2Z.

3.23 The relative contraction of allocations to overall economicservices was matched by declines in the shares of all but one sub-categorynamely, Agrarian Reform. The five-fold increase in the relative share ofthis sub-category from 0.08z of GNP to 0.42% reflected the AquinoAdministration's priorities: land reform via the Comprehensive AgrarianReform Program has been a major element in this administration's developmentstrategy.

3.24 Another major element of recent development strategy has been anemphasis on eduration. This is reflected in the increased relative share ofeducation expenditures from an average of 1.76% of GNP to 2.7Z. Indeed,education's share in the national budget increased to 14Z in 1990, making itthe second most important budget category next to debt service.

3.25 The reasons for the growth in the importance of debt service as abudget category have already been mentioned. It is the largest claimant onthe annual budget, having increased from around 19% during 1975-85 to 39Zduring 1986-90. In recent years, however, its share of the budget has beendeclining, from a high of 45% in 1987 to a low of 38% in 1990. Thisdeclining trend reflects external debt reschedulings and reductions (throughdebt-equity swaps etc.) and a softening of world interest rates.

Public Sector Investment

3.26 Analysis of overall public sector investment, that is, comprising thecombined capital outlays of the national government, public enterprises, andlocal government units, reveals three notable trends. First, there was a sharpdecline in public sector investment, from 6.4Z of GNP to around 3.9Z. Second,there was a shift in the relative importance of the national government and

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public enterprises to the overall program; the share of investment originatingin the national government rose from around 39% to around 53? while that ofpublic enterprises declined from around 59? to 43Z. Third, there was a changein the composition of public investment in that the share of socialinfrastructure rose relative to that of physical infrastructure.

3.27 The sharp decline in public investment took place in two stages: therewas a plunge during 1983-85 from 7.3Z to 4.3? followed by a more gradual declineto 3.2% in 1988. The dramatic plunge during 1983-85 was a response to a sharpreduction in resources brought about by the combination of a deep recession anda decline in external finance. Growth in the public investment program continuedto lag GNP growth in the first three years of the new government as thedisruption of the bureaucracy through changes in personnel and procedureshampered project implementation. Since 1988, however, spublic investment hasrisen steadily, reaching a level of 4.6? of GNP in 1990.

3.28 The national government became a relatively more important source ofinvestment spending than it used to be largely because, starting in 1986, itreduced the flow of equity and loans to government cJrporations thereby deprivingthem of their main source (other than foreign loanf,) of funds. Some governmentcorporations have since diversified their funding sources (by raising usercharges and cutting operational costs) and have begun rebuilding their investmentprograms. However, several including the largest government corporation andlargest investor, the National Power Corporation, remain heavily dependent onnational government and foreign funding for their investment programs: if suchfunding is not forthcoming, the investment program is cut.

3.29 The shift in sources of investment spending led to a shift in thesectoral composition of public investment. As one would expect, sectors such aspower and energy did not grow as much as sectors such as roads and transportationsince the former are dominated by government corporations and the latter bynational government agencies. In addition, national government spendingpriorities changed towards greater emphasis on social infrastructure; so sectorssuch as education, health and public administration grew relative to economicsectors such as agriculture and ransportation.

3.30 Some of these sectoral shifts were dramatic. The share of investmentin the power sector dropped from 30? of the total in 1975-85 to 19? in 1986-90while that of infrastructure (such as roads and bridges) dropped from 66? to 53?.On the other hand, the share of education almost quadrupled (from 2.2Z to 8.4?)while that of health tripled (from 0.6? to 1.8?).

3.31 The above-described changes in the size and composition of the publicexpenditures and investment programs could have significant implications forlong-run growth in the Philippines. A proper assessment of these implicationsrequires an understanding of the relationship between economic growth and publicexpenditures. This is elaborated in the next section.

6/ By some measures the ratio of public investment to GNP stood at 5Zin 1990; the source of the discrepancy is not clear.

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Fig. 3.3: Public Investments, by Source(Percent of GNP)

National Government2.3% National Government

2.2%

Local Gov'ts Local Gov'te0.3% 0.2%

Govt Corporations Govt Corporations3*4% 1.8% 19

1975-1985 1988-99Total - 6.0% Total - 4.0%

Fig. 3.4: Public Investments, by Source(Million pesos)

P million60

80 . -- _ _ - - - - - . __.._...._ =

40 _ --- _ .d. -.

s0 --- ;------- - ------------.- -------

20

10

76 76 77 78 79 80 81 82 83 64 85 86 87 88 89 90

= National Government 1 GCs EDi Local Governments

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Flg. 3.5: Public Investments, by Seotor(Share of Total)

Infrastructure64%s

Infrastructure

/ \llifl / | :I Othersii 111iliiii: 13%

M :2::::: Other Other Socialv~~~~~~Others OE11% 12%

Other Social Education'~cjuctio~~ Agriculture 8%

Agriculture 2%18-1917% 1986-1990

1975-1985

Fig. 3.6: Public Investments, by Sector(Percent of GNP)

.~~~~~~~~~~

07B 76 77 78 79 80 81 82 83 84 86 86 87 88 89 90

I Infrastructure E Agricuiture E3 Education

E Other Soclal Q Others

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The Prodctivity of Public Expenditures

3.32 The role of public expenditures in economic development has long beenthe subject of debate. Proponents argue that such expenditures are critical todevelopment in that they (a) make up for the lack of private capital andinitiative to develop infrastructure (b) compensate for market failure in certainareas (e.g. public goods provision) (c) exploit large positive externalities inthe social sectors and (d) stimulate private investment by raising aggregatedemand as well as by creating supportive and enabling infrastructure. Opponentsargue, however, that the evidence of market failure and lack of privateinitiative is weak and that public expenditures do not have a net stimulativeeffect for one or both of two reasons: they may depress overall productivitysince they are typically associated with less-efficient and non-competitiveenterprises and they may crowd out private investments by increasing the costand/or decreasing the availabiitty of credit to the private sector.

3.33 Recent empirical work has not provided a definitive resolution of thisdebate: while some issues have been clarified, others remain murky. For example,some studies have found that national productivity is strongly affected by therate of public investment (Aschauer, 1988,1989); indeed, public investment isfound to have an even stronger impact than private investment. Others find acorrelation between growth and public investment which is positive but notnecessarily very strong (Barro, 1989). Still others find that the relationshipdiffers by component of public expenditure. One recent study (Diamond, 1990)involving a cross-section of 38 developing countries found the following: (a)while aggregate public spending did not exert a significant influence on realgrowth, this was due to the offsetting effects of its components in that capitalspending did raise real growth but current spending did not; (b) furtherdisaggregation sv:ggested that capital expenditures on social services had abigger impact on growth than capital expenditures on infrastructure and (c)directly productive capital expenditures had a negative effect on growth.

3.34 Some tentative conclusions might be drawn from the above. It is clearthat the concepts of aggregate public spending and aggregate public investmentspending are not particularly useful. Even if uniform and non-conflictingresults had been obtained for such concepts, it would be difficult to use themas guides for policy. To do this, it is necessary to disaggregate and examinevarious components. In this regard, the Diamond results noted above imply thatoperating and maintenance expenditures might be preferable to directly productivecapital expenditures (on infrastructure) as far as short-run growth is concerned;a bias towards capital formation rather than capital maintenance could bedetrimental to growth. They also suggest that the positive growth effects ofcapital expenditures may come through human capital formation (via sopial sectorspending) rather than through the traditional channel of physical infrastructure(roads, power, etc.).

3.35 Empirical results for the Philippines from an analysis conducted alongthe lines of Aschauer (1989) suggest that public investment does lead to anincrease in productivity and that investment in infrastructure and economicsectors is more productive than investment in agriculture and social sectors.The effects are, however, quantitatively mtodest: a 12 increase in the ratio ofpublic investment to GDP raises labor productivity by only 0.04% and the same

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holds, upon disaggregation, for the effect of infrastructure investment. Giventhat the approach used here captures only the short-run effect of publicinvestments, the results generated should be viewed with caution. This is soespecially for the results on the productivity of social sector investments:these typically bear fruit in the long run and have often been shown to havereturns superior to those of many standard physical infrastructure investments.

Effec. of Public Investment on Private Investment

3.36 Another channel by which public investment affects nationalproductivity is by way of its effect on private investment. There are twoconsiderations here, conveniently captured by the terms 'crowding out." and"crowding in". Crowding out occurs when the effect of financing publicexpenditures through borrowing is to raise the cost andlor decrease theavailability of credit to the private sector, thereby decreasing privateinvestment. Crowding in can occur from the stimulative effect of publicexpenditures in one or both of two ways. There could be a demand-side effect ashigher government expenditures raise aggregate demand, subsequently leading toan increase in private investment. There could also be a supply-side effect aspublic investments relax key infrastructure constraints thereby enabling higherlevels of private investment.

3.37 These potential effects of public investment have been examined in anumber of empirical studies (see Blejer and Khan, 1984; Chibber and vanWijnbergen, 1988). The empirical consensus is that infrastructure investmentscrowd in private investment whereas non-infrastructure investments crowd it out.There is weak support also for the view that public spending crowds out privatespending through its financial market effects. We report below the results ofan exercise carried out to investigate such effects in the case of thePhilippines. The exercise had two parts, one dealing with private investment asa whole and the other focussing on foreign investment.

3.38 Our results suggest that public spending could contribute to crowdingout through financial markets. The higher the availability of credit to theprivate sector, the higher is private investment. From other sources it is alsofairly well established that higher public expenditures are associated with ahigher public demand for credit (given the relatively low yield public revenuesystem) which, by implication, results in there being less available for theprivate sector.

3.39 Our results also suggest that government investment outlays have apositive direct effect on private investment whereas spending through governmentcorporations (GCs) has a negative effect. This cannot be neatly identified withinfrastructure and non-infrastructure investments since some GCs, such as thepower and water utilities, provide much-needed infrastructure services. It doesreflect the fact, however, that many GCs tend to compete with the private sectorin various business areas and may therefore crowd it out. This is a plausibledescription of GC behavior in the late 1970s and early 1980s, when many of themwere active in the manufacturing and mining sector and a fe held monopolypositions in other sectors (e.g. coconut oil processing).

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3.40 In any case, the mere provision of infrastructure is seldom enough togenlerate and sustain private investment; there needs to be a supportive economicand political environment as well. This point can be illustrated from theexperience of export processing zones in the Philippines. Starting in the early1970s, several export processing zones were established; they were provided withbasic infrastructure such as roads, water and power and benefitted as well fromfiscal incentives and the availability of imported inputs at world prices.However, on the whole, their performance has been disappointing in terms ofinvestment, employment and export growth, especially when compared to neighboringcountries. This is due in part to a poor choice of location for several of theEPZs set up in the Philippines and in part to a policy environment that hasgenerally supported import-substitution activities. A good example of thelocation problem is that of th, Bataan EPZ, which is situated in a relativelyremote area (about 200km from Manila) and has never performed to potential.Despite the availability of good basic infrastructure within the Bataan EPZ inthe early years, it was unable to attract many investors. Over time, the lackof a growing revenue base led to cash shortages and inadequate expenditures onmaintenance which led in turn to a deterioration of the basic infrastructure: allin all, it has turned out to be a poor public infrastructure investment. On theother hand, a similar investment made in the Mactan EPZ has turned out wellprimarily because this site is well located, being cheek-by-jowl with Cebu.

C. Private Sector Role in Public Sector Projectse

The BOT Concept

3.41 In the past few years there has been much discussion of whether andhow the role of the private sector can be enhanced in the delivery of basicinfrastructure and services in developing countries, and the Philippines is agood case in point. As discussed above, the Philippine Government's budget hasbeen hard-pressed to finance a minimum level of public investment expenditures.In order to provide for the infrastructure needs of economic growth withouthaving always to rely on scarce public funds, governments have been turning tosuch arrangements as the Build-Operate and Transfer (BOT) Scheme. Under the BOTmodel, a private developer or contractor is awarded a concession to build, ownand operate a given plant for a fixed period (say 15-20 years), after which timethe firm transfers the project to the Government, which agrees to buy the plantat a pre-agreed price or formula (or it could even be free at that point intime). There are two variants of the BOT scheme, viz. the Build, Own, andOperate (BOO) arrangement, under which the foreign firm does not transfer theplant to the Government and instead continues to own and operate the plant inperpetuity; and the Build, Transfer and Operate (BTO) version, under which theforeign firm builds the plant, soon thereafte% transfers ownership to theGovernment, which in turn hands the plant back to the private firm for the latterto operate it on a concession basis for a given period. Although there are some

e/ This section draws on a recent Bank study entitled: 'PrivateInvestment in Power and Coal in Asia -- Selected Case Studies and Lessons,"Report No. 9884-ASIA, November 1991.

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differences between BOTs, BOOs, and BTOs -- primarily the ownership question --in this discussion the phrase BOT will be used generically to capture the othervariants as well.7

3.42 There are three primary advantages of BOT projects each of which wouldseem relevant for the Philippines: (i) such projects can supplementinfrastructure capacity without constituting a drain on scarce public investmentfunds. Thus, the BOT scheme can substitute for domestic resource mobilizationfor part of the public investment program; (ii) the bulk of the financingobligations, which consist of both equity and loan funds, shifts from theGovernment budget to the private sector. To the extent that the equity portionis substantial, the BOT arrangement is therefore also a means of increasing theflow of foreign investment funds; and (iii) where the project involvessubstantial operating eomplexities and/or risks, the BOT arrangement allows theGovernment to reduce its risks by passing these onto a qualified firm withinternational experience. Thus, given the size and complexity of most large-scale energy and transportation projects, if done on a BOT arrangement, theproject can thereby secure access to up-to-date technical expertise from abroadon a continuing basis. However, technical innovation or large size are notnecessary conditions of BOT projects. The Hopewell Navotas Gas Turbine project,is a good illustration of a successful, small BOT project.

3.43 There can also be disadvantages to BOT initiatives. They involvecomplex negotiations and axpenditure of time and resources by both parties. Thefew projects done so far in developing countries have not been "pure" BOTschemes; rather, the respective governments have been asked for substantialfinancial guarantees to cover the loan and foreign exchange risk for the privateparty. To the extent such guarantees are given, this dilutes a major advantageof the BOT concept for many developing country governments. Providing a loanguarantee increases external indebtedness and typically depletes the country'saccess to international credit, which is much the same as when a governmentborrows directly to fund its public investments. The merits of a BOT thereforerest firstly on the balance between the "costt of the guarantees provided byGovernment and the leveraging value (additional finance thereby secured) of theguarantees; and secondly on whether there are specific operational efficienciesto be obtained by having the project run by the private sector. The tradeoffsmust be carefully weighed, including the possibility that protracted negotiationsmight not lead to a concluded deal. Where adequate financial risk transfer isresisted by the private party, a better arrangement might be to have the privatecompany build the plant and then operate it on a concession basis.

7/ Although the BOT scheme has been extensively used in power projectsin the United States, it is fairly new in the developing countries, havingbeen applied recently in the Pakistan Hab River Power Project (project stillto be implemented) and four other projects which have been implemented: theChina Shajiao Power Project, the China An Tai Bao Coal Project, the IndonesiaBHP-Utah Coal Project, and the Philippines Navotas Power Project. There havealso been detailed discussions on proposed BOT projects in Turkey, severalLatin American countries, and in Eastern Europe.

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The Potential for BOT Projects in the Power Sector

3.44 In the late-1980s it was apparent that the National Power Corporation(NPC) would be unable to meet electricity demand and by 1987 power shortages andbrownouts became common. Clearly, NPC's investment program was insufficient tomeet a situation of growing power shortages. In July 1987 Executive Order No.215 was issued, which for the first time allowed private sector participation inthe generation and transmission of power. Under this executive order, NPC'sexclusive rights over power generation were withdrawn. In 1988 NPC issuednotification of bid offers for private generation projects and it received bidsto construct two power projects -- the Navotas Project and the Batangas PowerProject. Annex A reviews the project experience, which is summarized below.

3.45 The Navotas gas turbine project, which was successfully completed inMarch 1991, involved the installation of a 210 MW gas turbine generationcapacity, which was procured and installed on a BOT basis by Hopewell HoldingsLtd., based on a similar project that it had done in Shajiao, China. Under theproject arrangements, Hopewell is to operate the project for 12 years, afterwhich it will transfer the project to NPC. The Cogentrix Batangas project wasplanned to be about the same size -- 220 MW cogeneration capacity, consisting offour 55 MW. steam turbines, which were to obtain their steam from eight coalboilers. However, the project never went ahead. Hopewell's successfulexperience was in marked contrast to that of Cogentrix, and it is useful toexamine why that was the case.

3.46 Critical factors in the success of Hopewell's Navotas project includeits experience in implementing a similar project in China, an adequate financingpackage, and the fact that it was able to come to an agreement with NPC forpurcb-?se of the power generated. Also, an innovation in the agreement providesthat fuel input will be supplied by NPC under given efficiency parameters, whichavoids the need to have fuel pricing indexation arrangements.

3.47 In contrast, the history of the Batangas Cogeneration Project presentssome valuable insights into the potential pitfalls of BOT projects if theirarrangements cannot be worked out satisfactorily. Discussions were drawn out andmixed signals and poor coordination at the government decision-making levelplayed a key role in the sponsors' failure to proceed. There was no lack of lawsand regulations governing private power generation. However, the inability ofCogentrix and NPC to come to an agreement on the purchase of power was the singlemost important reason why that initiative failed. There were also difficultiesregarding the time it would take to obtain environmental and construction permitsand Cogentrix lacked a strong local joint venture partner.

Future Directions

3.48 Although groTith in demand for electricity fell from 9.4 percent in1987 to under 5 percent in 1990, demand is still outpacing the ability of NPC toconstruct new power plants. Outages of thermal power plants is exacerbating thesituation of severe shortages and blackouts, especially in Luzon and Mindanao.The output losses to industry on account of inadequate power are estimated toamount to about $1.1 million dollars per day. During the period 1990-1999, itis estimated that the Philippines will need to add about 3,700 Mws of new

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capacity costing some $7.5 billion ($4.7 billion of which is needed for newgenerating capacity). It is estimated that no more than a third of theseinvestment requirements will be sourced domestically and 72 percent will have tocome from foreign equity investment (such as BOT sponsors) and from foreign loansto the Government and NPC. Since NPC is already burdened with debt and has togenerate from its own resource. about 30 percent of its capital expenditures, andsince the pressures of the fiscal deficit indicate that much of this desired $7.5billion of energy generation and transmission investment will have to come fromforeign sources of finance, the decision to assign a larger role to the privatesector in the generation of energy is a welcome and necessary step.

3.49 In August 1990 NPC awarded to Hopewell Holdings Limited (Hong Kong)the right to develop a 700 Mky coal-fired BOT power plant in San Juan Batangas onLuzon island. NPC had issued a request for proposals for the coal-fired projectin November 1989, and prequalified fourteen firms for bidding. When ready(start-up schedul'd for January 1994), this project would be the second privatepower plant comp.'eted under E.O. 215.

3.50 Government also appro,ed in 1990 a proposal to build on a BOT basisa 440 MW geothermal project in Tongonan, Leyte. The plant, designated as arenewable resource production facility under E.O. 215, is expected to come online in late 1997. It will serve the Metro Manila load center on Luzon, via anunderwater transmission line. The project was originally included in the NPCexpansion plan, and has been accorded "preferred pioneer status", entitling itto tax benefits and 100 percent foreign ownership. A series of mini-hydro plantswith a total combined capacity of 11.5 MW have also been approved. These smallprojects will supply electric power to industrial users, cooperatives, andservice utilities in the localities where they are to be built.

3.51 Table 3.3 summarizes the major BOT projects in the power sector thatare under accreditation, including their stattus and planned completion dates.Even if only a half of the BOT projects are built, it would add a total of 830VW of generation capacity in the country, which would amount to about 20 percentof the total estimated increase in generation capacity that is required over theperiod 1991-1999. Such an increase in generation would amount to about anincrease of 30 percent over NPC's current generation capacity. This wouldrepresent a very sizeable expansion indeed, especially if it is to be providedentirely by the private sector using external sources of finance with no drainon the Government budget. Should the BOT scheme be successful in delivering thefour projects listed in the table (all of which are larger than theHopewell/Navotas project), it would represent a dramatic change in thearrangements regarding the actual financing of infrastructure programs in thecountry and it would represent a major achievement in the quest to attractforeign investment into the economy.

3.52 It is not intended that BOT be restricted to the power sector. InJuly 1990, an Act of Congress formally permitted BOT ventures in a broad rangeof public infrastructure investments, including those in transport,communications, water supply, sewerage, health, and environmental management.The fact that the first few BOT projects were in power is not an indication thatthere are no reasonable prospects in these other sectors. On the contrary, portoperations, airport services, shipping, warehousing are all illustrations of

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where the private sector on a BOT basis (i.e. with 100 percent foreign ownershipand 100 percent private risk) could offer a viable product or service, in an areawhere the public sector or the domestic private sector is not able to deliver aproduct/service of acceptable quality or standard. It may be that concessionarrangements or service contracts will prove over time to be an easier andquicker method to pursue, especially in the case of where there are linearprogramming-type activities to manage, such as the mass movement of freight goodsand passenger traffic. Foreign firms that are experienced in running ferryoperations for inter-island shipping, or handling containerized packing for goodstransferred at road-rail-port depots would be suitable candidates for solicitingBOT proposals.

D. Government Corporations: Financial and Management Issues

3.53 To the extent that Government Corporations (GCs) continue to receivesupport from the Government in the form of subsidies, loans, grants or equityinfusions, their economic and financial performance affects directly themanagement of public resources. Three issues are important to achieving greaterefficiency in public enterprises: privatization, financial autonomy, andmanagement improvements. The first issue relates largely to resourcemobilization in that the sale of Government assets contributes to non-taxrevenues; this issue was discussed in Chapter 2. In this section the publicenterprise sector is analyzed, recognizing that the net flow of budgetaryresources to public enterprises is in part determined by the productivity andefficiency of such enterprises.

3.54 Policy Framework. The ecunomic reform program of the AquinoAdministration attached high priority to rationalization of the public sector.This became a matter of some urgency because the public enterprise sector hadcome to represent a large financial drain by the mid-1980s. For example, by 1984budgetary contributions to GCs had increased so substantially that they accountedfor 22.5 percent of the total budget, up from a share of less than 8 percent tenyears earlier. Clearly, a situation of government corporations draining awaynearly one-quarter of the budget was unsustainable. It was vital to wean publiccorporations away from fiscal dependence. To do this required making themfinancially and managerially independent and accountable for their own decisions.

Table 3.3: Status of Private Power Projects(as of September 1990)

Project Sponsor Type Capacity Fuel Status Start-up(MW)

Navotas Gas Turbine Hopewell Holdings Ltd. BOT 200 Diesel Completed 1115191(Hongkong)

San Juan, Batangas Hopewell Holdings Ltd. BOT 700 Coal Awarded July 1995Coal-Fired Power (Hongkong) 1990, afterPlant int'tnl bidding.

co C o n t r a c tI ~~~~~~~~~~~~~negotiation

ongoing

Tongonan, Leyte a. Design power/Mitsui BOT 440 Steam Under Evaluation 1997Geothermal Power (New Zealand/Japan)Plant b. ORMAT Inc. (USA) BOT Steam Under Evaluation 1997

Limay, Bataan a. International Power BOT 300 Bunker C Under Negotiation 1993Combined Cycle Gas Company (USA)Turbine Power Plant b. Asea Brown Boveri BOT

(Switzerland)c. General Electricl BOT

Mitsui (USA/Japan)

Batangas Coal-Fired IPCO (Singapore) BOT 220 Coal Under Evaluation 1994Cogeneration PowerPlant

Total 1660

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3.55 The public enterprise reform program was launched with the followirf' policycommitments: (i) there would be minimal government intervention in the runni:.g of theGCs; (ii) there would be a drastic reduction of support and special privileges for GCs;and (iMi) greater flexibility and autonomy for GCs would be encouraged as aprerequisite for accountability in performance. These commitments underpinned thefollowing rolicy objectivess (i) there would be a larger role for the private sectorin the economy, especially in manufacturing activities; (ii) the fiscal deficit wouldbe reduced; and (iii) improved effectiveness of the GCs would be sought by insulatingthem from political interference. There was broad-based support for the GC reformprogram, both domestically and from the donor community.

Financial Autonomy

3.56 The reforms affected th,e Government's financial links with GCs in afundamental manner. The specific steps taken to encourage financial autonomy included:the removal of tax exemptions, imposition of restrictions on the issuance of Governmentguarantees for GC borrowings, imposition of interest on Treasury advances, curtailmentof subsidy grants, and tighter enforcement of payment of dividends from those GCsmaking profits. As part of these measures. a Tax Expenditure Fund was set up in theNG budget to cover tax exemptions.

3.57 The above measures and the emphasis on productivity improvements at theentity level led to a reduction of GC dependence on the budget. The net flow of fundsfrom the NG to the GCs, which had grown from 1.6 percent of GNP to 5.6 percent betweenthe period 1976-86, declined to 1.5 percent in 1987 and dropped further to around 0.3percent in 1988-89. This decline was made possible in large part by the assumption ofexternal debt service liabilities of GCs by the national government; however, evenafter adjusting for assumed debt service, there is a decline in net flows to GCssuggesting that there has been a mearingful reduction in dependence on the budget (seeFigure 3.7). This is reflected also in the trends of most individual transfercategories: equity infusions and net lending declined in nominal peso terms as well asrelative to GNP (see Figure 3.8).

3.58 There was also a marked increase in transfers from GCs to the nationalgovernment. The bulk of such reverse transfers was made up of interest payments, thegovernment's share in the income of the Philippine Amusement and Gaming Corporation(PAGCOR) and dividend payments by some GCs (see Figure 3.9). The overall picture ofimprovement should be qualified by two considerations. First, subsidy flows did notdecline, although they were directed at more deserving entities. Second, aggregatetransfer trends are heavily influenced by transfers to the National Power Corporation,the largest public corporation, so much so that preliminary data suggest that, in 1991,transfers to it alone exceeded the reduction in transfers to all other GCs combined.The financial position of NPC deteriorated sharply in 1991 because of delays inadjusting user charges, which resulted in the NG having to provide around P5 billionof transfers (in loans and equity) to NPC. This represented about 50 percent of totalbudget support to 14 GCs.

3.59 Subsidies. Subsidy contributions to GCs are recorded as having risen inthe period after 1986. This reflects a decision to make transfers more transparent.Transparency was accomplished in two ways, by including tax exemptions in the subsidy

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BOX 3.1: LIST OF 14 MONITORED GCS AND RESPECTIVE MANDATES

GC MANDATE

EPZA Export Processing Zone AuthoritOperation and management of export processing zones

LWUA Local Water Utilities AdministrationWater supply and waste water disposal outside Metro-Manila

LRTA Light Rail Transit AuthorityConstruction, operation and maintenance or lease of LRT systems

MMTC Metro Manilh Transit CorporationOperation of bus transport services

MWSS Metropolitan Waterworks and Sewerage SystemsWater supply and waste disposal in metropolitan areas

NDC National Development CorporationHolding company for developmental investments

NEA National Electrification AdministrationFinancial intermediary and procurement agent for electric cooperatives

NFA National Food AuthorityPromotion of local grains industry

NHA National Housing AdministrationProvision and maintenance of adequate housing

NIA National Irrigation AdministrationDevelopment and maintenance of irrigation systems

NPC National Power CorporationGeneration and transmission of bulk power

PNOC Philippine National Oil CompanyTransporting, refining and marketing crude oil and petro products, anddevelopment of indigenous energy resources

PNR Philippine National RailwaysOperation and maintenance of railways

Source: Department of Finance

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Figure 3.7Flow of Funds to Government Corporations

6

er

0 4e

t

32-

p I~~~~~~~~I I

76 77 78 79 80 81 82 83 84 85 86 87 88 89 90

- Net Flows 4 Less Debt Service

figures and by preferring subsidies to other forms of transfers whenever justifiable,such as when Government impo7es on a corporation a pricing policy that results infinancial losses. Between 1988 and 1989 there was a sharp jump in the level ofsubsidies, mainly to agencies carrying out some of the Government's socially-orientedprograms, e.g. the National Food Authority (NFA), the National IrrigationAdministration (NIA), the National Electrification Administration (NEA), the NationalHousing Administration (NHA) and the Land Bank. Table 3.4 below shows the major GCsubsidy recip.-ents for the two periods 1980-85 and 1986-90. Of significance is thatthe subsidy to the Fertilizer and Pesticide Authority (FPA) was virtually eliminated,in keeping with policy reforms supported by a World Bank adjustment loan in 1984.Subsidies to the five other GCs mentioned above increased significantly and accountedfor 58 percent of total subsidies to GCs in the 1986-90 period, compared to only 6.8percent of total subsidies in the preceding period. The two largest recipients ofsubsidies were the National Food Authority and the National Irrigation Administration.

8/ Subsidy figures after 1986 include tax exemptions granted tovarious GCs. As such, they are not directly comparable to figures before1986. Thus, it is difficult to say whether subsidies have actually risenover time.

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Figure 3.8Gov't Transfers to Gov't Corporatlons

p _0r

76 77 - 8 --------- 384868 8 8 9

0n

t~~~~~~~~~Egr 3.

0

N O _

I

076 77 78 79 80 81 82 83 84 85 86 87 88 89 90

Subsidy Equity ED Net Lending

Figure 3.9Gov't Corporatlon Transfers to Gov't

0.5

P 0.4 ------.--erc

O 0.3 - -----nt

ID 0.2 -- - - .- .

I

GN 0.1 .P

76 77 78 79 80 81 82 83 84 85 86 87 88 89 90

MDividends M Share In PAGCOR ED Interest

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Table 3.4 The Major Subsidy Recipients(in million Pesos)

1980-85 Z of 1986-90 Z ofTotal Total

Fertilizer and Pesticide Authority 1,504 27.0 15 0.1National Kidney Foundation 353 6.3 0 0.0Philippine Crop Insurance Corporati3n 198 3.6 144 1.3Philippine Coconut Authority 171 3.1 250 2.2National Food Authority 166 3.0 2,603 23.3National Housing Authority 159 2.9 604 5.4National Irrigation Admin'stration 49 0.9 2,227 19.9Land Bank 0 0.0 570 5.1National Electrification Administration 0 0.0 480 4.3Others 2,968 53.4 3,888 39.2

TOTAL 5,568 100.0 11,161 100.0

Source: DOF-Bureau of the Treasury

3.60 Equity Contributions. The other major form of NG financial transfers to GCsis equity infusion. In the mid-1970s such equity contributions were around 1.5 percentof GNP, but by 1982 they had climbed to 3.1 percent. In 1985 they stood at 2.6 percentof GNP and then started declining and were only 0.2 percent in 1989. Three featuresof trends and patterns in equity transfers are worth mentioning. First, much of itwent to government financial institutions. The Development Bank of the Philippines(DBP) was given a large share of total equity transfers through 1985, largely to staveoff its bankruptcy from the accumulation of bad loans; in 1986-87, however, theinevitable could no longer be postponed and DBP was rehabilitated via the transfer ofits external liabilities to the national government and a fresh infusion of equity.The Philippine National Bank alco experienced a similar bail out and equity transferin 1986-87. Regarding NPC, in addition to the P555 million equity contributionmentioned in para. 3.57, the NG converted P1.96 billion of previous advances intoadditional equity of the corporation.

3.61 Second, equity transfers to the National Power Corporation have undergonelarge fluctuations. In the first half of the 1980s, NPC received a large chunk oftotal equity transfers, in part no doubt to support its massive investment in theBataan Nuclear Power Plant. The Aquino Administration sharply reduced equity transfersto NPC during 1986-90, this time reflecting the overell cutback in infrastructureinvestment. In 1991, however, NPC was given an equit, infusion of P2.5 billion whichwas around 612 of the total equity transfer program for 1991 and considerably more thanthe amount provided in the previous five years. This demonstrates the extent of thedeterioration that occurred in NPC in 1991. The need to prop up NPC's finances was a

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direct result of the failure to adjust its user charges. Since NPC is the largestpublic corporation, variations in its financial performance have substantialconsequences for the public sector deficit. This points to the need to have timelyadjustments of electricity tariffs in the future, both to keep the enterprise viableand to preserve overall fiscal health.

Table 3.5: The Major Equity Recipients(in million Pesos)

1980-85 % of 1986-90 Z ofTotal Total

Development Bank of the Philippinec 14,848 28.6 3,691 17.8National Power Corporation 8,593 16.6 952 4.6National Irrigation Admn 3,315 6.4 2,000 9.7Philippine National Bank 3,050 5.9 3,750 18.1National Food Authority 386 0.7 1,567 7.6National Development Co. 4,265 8.2 216 1.0Philguarantee 1,550 3.0 1,480 7.2Others 15,901 30.6 7,023 34.0

Total 51,908 100.0 20,679 100.0

Source: DOF-Bureau of the Treasury

3.62 Third, aside from the above NPC infusion, the overall decline in equitycontributions that occurred between 1980-85 and 1986-90 led to a slowdown of fixedinvestment by the GCs.9 Starved for capital, and operating under a policy frameworkthat strongly discouraged investment on the part of those GCs that competed with theprivate sector (as in the case of PASAR and PHILPHOS) the restrictions on equityinfusion put an effective brake on expansion of the GCs. To the extent that GCsembarked on investments in the 3'86-90 period, the entities were encouraged to fundtheir expansion/ modernization requirements from funds other than NG equity. Netlending to the GCs also declined mainly because the NG started to charge marketinterest rates on any advances extended to the GCs and also because in some cases theadvances were converted into equity.

3.63 Tax Exemptlons. For a long time GCs had been given tax exemptions in lieuof equity contributions. In the late 1970s these tax exemptions grew to besubstantial, amounting to as much as 4.3 percent of GNP in 1978. The exemptions werebroad-based applying to import taxes, income taxes, withholding taxes on interest, realestate taxes, and sales taxes. In late 1984 the exemptions were cut back and amounted

9/ It might be noted that the investment program of GCs was alsoaffected by a cash squeeze produced by declining access to external loans andincreasing debt service obligations.

91 -

to 1.8 percent of GNP and 1.0 percent in 1985. In 1986 the new government withdrew allexemptions, but the Fiscal Incentive Review Board (FIRB) -- whose function it was todetermine the list cf GCs that could still be eligible to receive tax exemptions --granted exemptions to six GCs -- the APT, PITC, the Duty Free Philippines, NPC, thePrivate Debt Restructuring and Payment Corporation and the FPA. The exemptionsamounted to 0.4 percent of GNP in 1986. As for the rest of the GCs, they could claimrelief through the Tax Expenditure Fund by means of an explicit and transparent budgetappropriation. Also, GCs were charged fees for some services previously rendered free,such as the imposition in 1987 of fees for any guarantees provided by the Departmentof Finance on GC borrowings.

3.64 The issue of tax exemptions illustrates another problem with regard to theoperation and viability of public corporations. If tax exemptions were not provided,user charges would have to be raised. This is particularly true for NPC whichpresently accounts for the bulk of tax exemptions among GCs. The fiscal drain of a GCmust be seen not only in terms of transfers such as subsidies and equity but also interms of revenue foregone by the Government through providing tax exemptions. Indeed,to the extent that such exemptions allow the charging of lower rates they contributenot only to fiscal stress at the macro level but also to distortions at the microlevel, distortions which provide misleading signals to guide the investment programand the search for efficiency among GCs.

3.65 Dividend Payment Responsibilities. Before 1986, dividend payment1 oresponsibilities were loosely enforced. While enforcement efforts have improved sincethen, the results have not been exceptional. Of the 33 GCs from which dividends wereexpected, onl six paid any dividends in 1990. While non-payment was mostly due to theincurrinig of losses, other causes were also important. Among these was a specialexemption given to those GCs (primarily the GFIs) who invested surplus cash in TreasuryBills. Other reasons for non-paymient of dividends involved delays and lags caused byauditing. The situation improved in 1991 as the number of remitters rose to 14.

Management Issues

3.66 Public sector management notions have undergone a radical transformation inmany developing countries in the past decade. From a situation in which productivityand cost considerations used to be largely ignored in the provision of many publicservices, the emphasis has shifted to privatizing public enterprises where feasible andstriving for cost-efficient commercially-oriented operations where the service, for avariety of reasons, is likely to remain in public hands. Productivity measures andperformance targets for public enterprises are being successfully implemented inseveral countries. The Pailippines began to experiment with a productivity-orientedapproach several years ago under the auspices of a Bank adjustment loan (the GovernmentCorporation Reform Loan). This approach involves the development of multi-yearcorporate plans and the setting of annual productivity targets. In the past three yearsthe Performance Evaluation and Incentive System (PEIS) has been implemented in 5 large

10/ E0399 requires each profit-making GC to remit dividends equal to102 of its net earnings. Prior to 1986, the requirement was a more modest5%. E0399 does not apply to those GCs (such as NPC, NEA, MWSS) whose charterprovides for other rules on the distribution of profits. It also does notapply to GSIS and SSS.

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public enterprises (NPC, MWSS, NIA, PPA, NHA) in 1989, twelve more in 1990 and another17 more in 1991 for a total of 34 GCs. In addition, management reforms have beenimplemented in an effort to insulate GCs from political intervention, instill operatingpractices akin to those of the private sector, and improve corporate viability undera difficult macroeconomic situation.

3.67 A key institutional issue is whether the current policy framework isconsistent with the goal of "corporatization" of the public enterprise sector --defined as the ability of a public corporation to operate as a company, irrespectiveof whether or not it is to be privatized. Under the GC reform program, it wasenvisaged that some of the more efficient GCs needed to be able to grow and consolidatetheir operations before they could be sold as healthy, viable companies, and the onesthat were not in such a condition would need to be revamped or upgraded in order tobring them to vendible status. The Government Corporate Monitoring and CoordinationCommittee (GCMCC) was reconstituted with a mandate to oversee this process and toimplement the PEIS in the GCs designated to be retained in the public sector(responsibility for upgrading and monitoring of GCs designated to be privatized is leftto the disposition entity). The GCMCC also has a key role in the institutional follow-up of the GC reform process and specifically in the review of financial autonomy,operational efficiency/productivity questions, and related financial and personnelissues. The GCMCC is also involved in *disseminating the experience under the PEISprogram.

3.68 Experience with PEIS. The PEIS was formally begun in 1989. The GCMCCmanaged the evaluation prcgram, which was based on well-accepted systems of publicenterprise monitoring that had been developed in the late 1970s and early 1980s inother countries. The PEIS involved adoption of common performance criteria (return onassets, operating ratios, debt service ratio, current ratio), which were used in thecase of 15 GCs and specialized criteria (billing efficiency ratios NPC and MWSS,farebox ratios for PNR and LRTA), which were used in the case of 16 GCs. Refinementswere made to the system, such as the introduction of weights in 1990 -- financial orprofitability indicators were given a 40 percent weigbt. As stated above, the GCMCCstarted with modest coverage and was expanded in 1990-91. For 1992, ten more GCs willbe included. Results are shown below for the five pilot GCs with whom the program wasstarted; results for several others are available from Government.

3.69 Despite the modest targets, the GCs showed only a 43.2 percent success rate(number of performance criteria attained divided by the total number of criteria) in1989 and 35 percent in 1990. The corporations with the highest attainment ratios werethe Philippine Ports Authority (PPA) and Metropolitan Waterworks & Sewerage (MWSS),both of which attained nine out of the seventeen targets in 1989, whereas the NationalIrrigation Administration (NIA) attained only two out of 14 targets. The PEIS hasseveral weak points: first, some indicators are more important than others fordifferent corporations, e.g. collection indicators in the case of NHA and NIA, andbilling efficiency in the case of NPC and MWSS; second, it is quite difficult todevelop an adequate weighting system; and, third, performance may be affected byfactors outside management control, such as natural disasters, or limitations inoperational autonomy. It is useful, therefore, to supplement the impressions providedby the overall success rate measure with other, more specific, measures of operationalefficiency. Two measures are discussed below, collection efficiency and financialperformance.

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Table 3.6: Results of Performance Evaluation

No. ofPerformance Not Success

Government Corp. Year Criteria AtZained Attained Rate

National Power Corp. 1989 10 4 6 40.0O1990 10 5 5 50.OZ

Metropolitan Wate- S&S 1989 9 6 3 66.7Z1990 8 3 5 37.5Z

National Irrig. Admin. 1939 8 0 8 0.0%1990 6 2 4 33.3Z

Philippine Ports Auth. 1989 9 6 3 66.721990 8 3 5 37.5Z

National Housing Auth. 1989 8 3 5 37.5%1990 8 1 7 12.5Z

Total/Average 1989 44 19 25 43.221990 40 14 26 35.OZ

Source: Department of Finance - GCMCC

3.70 Operational EfficiencY. A key aspect of the viability of any publiccorporation is its operational efficiency. While there are several different ways tomeasure this for different corporations, depending on the type of goods and servicesthey provide, a useful and commonly-applicable measure is that of collectionefficiency, which refers essentially to performance with respect to collection ofaccounts receivable. Table 3.7 provides some data on this for a number of GCs in thePhilippines. 1wo aspects are worth noting. First, there is great variation incollection efficiency. Some GCs, such as NPC and MWSS, are excellent at collectingwhereas others, such as NEA, NHMFC, and NIA are very poor at collecting; as a result,the laggard companies build up arrears which they are also very ineffective inclearing. Second, the collection performance of NPC has a great influence on theaverage; given its preponderant size among GCs, weighted averages of performance aretypically dominated by the performance of NPC.

Table 3.7: Collection Efficiency

1985 1986 1987 1988 1989 1990 Average

NPC 95.0X 81.0Z 89.7t 87.2? 81.22 84.0% 87.2Z

LWUA - Current Accts 54.02 57.0% 58.02 39.1? 47.8? 43.22 49.8?Arrears 53.0? 47.0? 43.0? 2.9? 7.3Z 0.82 26.5Z

NIA - Current Accts 39.72 40.3Z 41.5? 39.4? 41.7% 51.02 42.3?Arrears 5.4Z 4.4? 3.3? 2.5Z 2.8Z 50.0? 11.2Z

MWSS 98.9% 93.7Z 75.5? 87.8? 83.32 71.02 84.7Z

NEA - Current Accts 22.5% 20.3% 23.52 17.82 17.8Z 20.5Z 21.42Arrears 15.2? 13.8? 20.9? 10.12 15.0? 16.2Z

NHA 64.0? 15.OZ 47.0? 11.0? 48.02 56.0? 39.8Z

HIGC - Current Aects n.a. n.a. n.a. 54.6? 72.5? 83.62 70.2%Arrears n.a. n.a. n.a. 38.02 41.02 73.4? 50.8Z

NHMFC Current Accts n.a. n.a. 52.1% 38.8? 38.92 73.6?1/ 52.9?Arrears n.a. n.a. n.a. 19.2% 12.0Z 12.02 14.4Z

EPZA 89.0X 82.OZ 84.0% 57.52 89.5% 77.8% 69.1?

Non-Weighted Averagel/ 65.9Z 52.8Z 57.7? 47.0? 56.22 63.02 57.52Weighted Average2/ 91.82 78.9? 85.0? 78.32 86.22 80.1Z 83.OZ

1/ Excluding arrears2/ Weight based on 1987 receipts

Source: Aquino, T. et al., Public Sector Resource Mobilization, andDepartment of Finance.

3.71 Financial Performance of GCs. The extent of improvement in the financialperformance of GCs in recent years depends on how government subsidies are treated.Gross of subsidies, the operating ratio (receipts divided by expenditures) of the 14major non-financial GCs shows clear improvement between 1985 and 1989; there was adecline in 1990 but this still left the ratio above its 1985 level. Net of subsidies,there is a similar picture of improvement luring 1985-89 but the decline in 1990brought the operating ratio back to its 1985 level. The importance of subsidies iseven greater when financial performance is viewed in terms of net income figures. Inthis case, financial performance clearly deteriorated as net income declined from 2.2billion pesos in 1985 to 1.8 in 1989 (net of subsidies). The chief reason for thedecline appears to be the failure to raise internal cash generation fast enough and

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substantially enough to cope with changing market conditions. User charges actuallydeclined in real terms over this period. Note that several GCs benefited from thegeneral decline in oil prices and interest rates over this period but were still unableto improve net income without a subsidy from Government. This suggests that muchgreater attention must be paid in the future to improvements in management ofgovernment corporations with a view to reducing costs and improving productivity.

3.72 Operational Autonomy. Measures to improve operational autonomy involvedgiving more flexibility on matters affecting personnel, procurement, investmentdecision controls, and negotiations with creditors. However, on the freedom to adjustuser charges, some of the GCs are able to set their tariffs (e.g.MWSS), whereas others(NPC, NEA) do not have delegated powers. NPC and NEA have to obtain the approval ofthe Energy Regulatory Board for any rate adjustments, while other boards have the lastsay on user charges or rates on output/products in their sector. The transport ratesof the Metro Manila Transit Corporation (MMTC) are subject to the same restrictions asthe private sector transport companies. The NFA is another case of an entity havingno power to adjust prices without approval of the National Government.

3.73 Other GCs, however, do have flexibility to adjust their rates. The financialinstitutions can adjust interest rates on lending and are not subject to any statecontrols. GCs, however, cannot seek external borrowings without government permission,because given the debt crisis that ensued in 1984, it is not possible to borrow in theabsence of government guarantees. Permission to borrow from abroad has to be given byNEDA. NEDA's clearance involves assessment of the relative priorities and desirabilityof the project. Government policy is to try and refrain from providing guarantees andfor private sector projects and to allow the multilateral institutions to securesovereign guarantees for public corporate loans. On personnel matters the GCs arelimited by the civil service coverage and by the regulations of the Department ofBudget and Management (DBM). Given the power of the unions, the ability of managersin the Government corporations to 'hire and fire" does not truly exist. Aside from theshallow depth of the capital markets, this factor may be the dominant reason why theprivatization of the big-ticket items has been slow to get off the ground, as the largecorporations do not feel that they are in a position to implement wide-scale staffcutbacks. The ab!lity to send employees overseas for training is limited given thepressing financial position of many GCs. Where training grants are available, whichare managed by NEDA, the possibilities are greater for matching training opportunitiesabroad with the needs to upgrade the skill mix of public sector employees. Theforegoing points regarding operational flexibility and the previous discussion offinancial performance suggests that the issue of operational autonomy, especially withregard to setting prices (user charges) and making personnel decisions (cost control),needs to be re-examined by policy-making authorities.

3.74 Some Conclusions. Three main conclusions may be drawn from the GC reformprocess so far. First, despite some improvements, government corporations remainsignificantly dependent on the national government; this is quite important to theirprofitability outcomes. Second, the financial and management performance of GCs hasbeen weak in recent years, primarily in the areas of pricing (user charges) and costcontrol. It is important to stress the importance of cost control since consumers aremore likely to accept higher user charges if they perceive clear improvements inoperational efficiency. Third, the problems of critical entities, such as NPC, need tobe distinguished from those of corporations in need of improvement but whoseperformance is considered not likely to jeopardize macroeconomic stability. This is

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Fig. 3.10: Financial Performance of %Cs

a) Operating Ratio (%)2

1.6 <

1.5 ----------- - - _ _

1 1

1 ------------------------------- ~~~~~~~~~~_ __ .__ _ __ _. ___

0.5 __

1985 1988 1987 1988 1989 1990

Gross -4- Net of Subsidy

8b) Net Income (billion pesos)

6

4

24 - ------ --- - - -- ___ _ _

-211986 1986 1987 1988 1989

-* Gross 5 Net of Subsidy

- 97 -

not the case with NPC, as the Government's cash infusion in May 1991 into thatcorporation amounted to nearly one-fifth of the projected national government deficitfor 1991. With this in mind, a more detailed discussion of NPC is provided in Box 3.1.

Selected Recommendations

3.75 Given the above analysis, the following recommendations are pertinent:

(a) the NG should continue to review its resource allocation system to find outwhether specific high-subsidy programs in food and irrigation should bemaintained. The cost of the non-revenue earning social services providedby such GCs should be weighed against budget priorities. Subsidies shouldnot be used to pay the costs arising from poor corporate performance and thelack of adjustment of user charges; recent initiatives to privatize thetrading operations of the NFA are a step in the right direction;

(b) the requirement for GCs to remit dividends to the NG should be strictlyimplemented. After many years of depending on NG funding, GCs should sharetheir earnings with the shareholders. The 10% mandatory dividenddeclaration rate (percentage to net income) should be increased to 1SZ,which is the average for firms iisted on the stock exchange;

(c) GCs should be given more operational flexibility particularly with regardto the adjustment of user charges. The decline in the real level of usercharges should be reversed;

(d) the PEIS should continue to be refined. Trends in key capacity indicators,such as the frequency of power brownouts in the case of NPC and the degreeof congestion at fare broths during rush hours in the case of the LRTAshould be monitored closely;

(e) systems to reward good performers and penalize poor performers should bepursued in line with Executive Order 486 which provides for the payment ofbonuses and incentives to GC staff in accordance with performance;

(f) ways to allow GC managers more autonomy with respect to hiring,compensation, and financing decisions should be studied; the objectiveshould be to improve the flexibility with which GC managers can respond tochanging economic conditions;

(g) the principle of public accountability should be infused in the corporateplan formulation and performance evaluation process. Thle GCs concernedshould be encouraged to conduct public hearings to discuss corporate plansand present annual reports so that interested and affected sectors canparticipate in the discussions and contribute to recommendations based onthe corporate plans.

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BOX 3.2: FINANCIAL CRISIS AND REFORM OF THE NATIONAL POWER CORPORATION

NPC'e Financial Problems. As In all countries with significant Inflation, the rate of roturnfor public ut17tltis in Philippines Is based on Its rovaluod fixod ausets. Partly because ofdifferences of vliws on th, valuation pproach and the preliminary results, the assets wore notrevalued during 1987-90. This mad it difficlt to obtain an accurate assessment of NPC'sfinancial performanco until mid-1991, when an aeset appralsal value was approved by NPC'a Board.Based on this appralsal, NPC's rat of return has ben bolow the 8K covenanted under the WorldBank's Energy Sector and Bacon Manito Projocto (Loans 8168-PH and 2969-PH), and was OX In 1988, 6XIn 1989 and 2.7X In 1990. This is much lower than the 7.9X roported In the Audit Reports for 1989-90 and it prompted the Bank to review the situation.

NPC's debt service ratio has b"en about 0.9 and 1.0 (compared with a minimum 1.3 covenanted).The deterioration In financial performance in 1990 resulted In a current ratio of below 1.0, angative return on Its net worth (down from 5X In 1989), or Its total assts (down from 1K In 1989)ond not losses of P66 million. Moreover, although NPC's Audit Reports show a positive Internalcash genoration, this was due to debt rescheduling, and during the laost four years more than 20OXof the capital expenditures was financod by loans. This was clearly unsustainable.

NPC's financial crisis resulted from: (a) Insufficient tariff adjustments In previous years,whose financial Impact wao not obvious due to the dolays In revalulng the fixed asosts and Improperaccounting of the cash flow; (b) the accumulation of debt service aft r 1991 (due to prevlous debtreacheduling); (c) a substantial increas- in oil prices In 1990-91; (d) lower Increases In powersales (3-3.6X In 1990-91 compared with 5K in 1989); and (o) a 25 percent devaluation of the pesovie-a-vis the dollar In 1990.

Tariff Probl-ms In 1991. A tariff Increase of PO.17/KWh was approved by NPC$s Board forImplementation from March 1991, but after 8 months of appeals to the Supreme Court (because ofcomplaints that NPC's rate of return exceeded 10X) and lengthy public hearings by the EnergyRegulatory Board, no decision has been taken to approve or deny the tariff Increase. Because ofthis delay, tho Increase In powor tariffs would have coincided with a 34X reduction In oil prices,that although already factored in the requested tariff was difficult to explain to the public atthat time. On top of financial problom,, there are roported Irregularities and Inefficiencieswithin NPC that damages Its credibility and Its ability to bring about the tariff Increases. Underthese conditions the tariff review became more political than technical. Slnce tariffs wore notIncreased In 1991, all of NPC*s financlol indicators worsened, including its rate of return (1X),Its *slf-financing ratio (-34K), and Its debt service ratio (0.5). NPC would end the year with anegative not income of almost P4,000 million. To allow NPC to pay its operating costs and debtservice, the Government had to provide P7 billion (about f270 million) of financing to NPC In May199l.

NPC s Reform Pro ram. A comprehensive Reform Program has now been agreed with the Government,which Incluaos (a) corporate improvements (an Immedlate Program and a Managoment Audit); (b)promotion of private sector participation In electricity generation and partial privatizatlon ofNPC; and (c) several financial actions, which would be satisfactory. Particularly critical is theproposed tariff increase that needs to be Implemented In January 1992 (about PO.24/kWh), which*hould: (a) ensure at least a OX rate of return on revalued assets In 1992; and (b) provide astisfactory cash position to NPC, without the need for further Governmont contributions.

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SELECTED BIBLIOGRAPHY

Aguirre, C. et. al.: A VAT for the Philippines, International MonetaryFund, Fiscal Affairs Department, 1987.

Aechauer, D.: Public Investment and Productivitv Growth in the Group ofSeven, Economic Perspectives, Federal Reserve Bank of Chicago, 1989.

Avila, A.: Measurement of Tax Evasion, National Tax Research CentreStaff Papers, 1989.

Barro, R.: Economic Growth in a Cross-Section of Countries, WorkingPaper No. 3120, National Bureau of Economic Growth, Cambridge, Mass. 1989

Bureau of Internal Revenue: Annual Reports, various years.

CowiConsult: Re-assement Study of EPZs and Industrial Estates, Reportprepared for Dept. of Trade and Industry, Republic of the Philippines, 1991.

Centre for Research and Communications Selected Papers on Tax Reform inthe Philippines, 1990.

De la Cruz, E. and G. Beltran: Issues in Government CorporationPerformance, Mi:ieo, World Bank, 1991.

Diamond J.: Government Expenditure and Growth, Finance and Development,Washington DC, December 1990.

Lamberte, M.: Private Financial Savings and Direct Foreign Investment,Mimeo, World Bank, 1991.

Lamberte, M., et.al.: External Financing, Structural Adjustment andDevelopment, Mimeo, Philippine Institute for Development Studies, 1991.

Manasan, R.: Tax Evasion in the Philippinea, Journal of PhilippineDevelopment, Volume XV, No. 2, 1988.

Manasan, R.: An Assessment of Fiscal Policy in the Philippines, WorkingPaper Series No. 90-06, Philippine Institute for Development Studies, 1990.

Muten, L. et.al.: The Tax and Customs System of the Philippines,International Monetary Fund, Fiscal Affairs Department, 1985.

National Tax Research Centre: Annual Reporta, various years.

National Tax Reeearch Centre: A Study on Tax Administration andCompliance in the Philippines, November 1986.

National Tax Research Centre: Assessment of Tax Reforms, 1986-89, 1989.

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National Tax Research Centre: An Aeessment of the Value Added TaxSYstem of the Philippines, October 1990,

Societe Generale de Survellancet Comprehensive Import SuPervisionService for the Philippines, Manila, 1990.

World Bank: Leasons of Tax Reform, Board Paper, 1991.

Yoingco, A.: Taxation in the PhilippineB: Foretellin2 of Things to Come#Asian-Pacifio Tax Investment Research Centre, Bulletin, February 1991.

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STATISTICAL APPENDIX

List of Tables

PageNo.

1. Savings and Growth Rates . . . . . . . . . . . . . . . . . . 1022. Public Sector Savings and Investments Rates . . . . . . . . 1033. Selected Investment Data . . . . . . . . . . . . . . . . . 1044. National Tax Effort: 1976-90 . . . . . .. , . . . . . 1055. Establishing PILs for Doctors . . . . . . . . . . . . . . . . 106

6. Internal Revenuet Accounts Receivable . . . . . . . . . . . 107

7. Workloade of Assessment and Collection Personnel . . . . . . 1088. Budget of the Customs Police Administration . . . . . . . . 109

9. SGA: Value of Inspection Advice Notices . . . . . . . . . . . . 11010. National Government Expenditures, by Economic Classitication . . 11111. National Government Expenditures, by Sectoral Classification . . 11212. Composition of Public Sector Investment (% Distribution) . . . . 11313. Composition of Public Sector Investment (% to GNP) . . . . . . . 11314. Public Sector Investment: (% Distribution) .. . .. . . 11415. Public Sector Investment (% to GNP) . . . . . . . . . . 11416. Net Flow of Funds between NG and GCs, 1976-90 . . . . . . . . . 11517. NG flows to GCs by Categories, 1976-90 . . . . . . . . . . . . . 11518. The Major Subsidy Recipie.ts .................. . 11619. The Major Equity Recipients .... . .- ... . 11720. Operating Ratios of Major Non-Financial GCs . . . . . . . . . . 11821. Net Income Major Non-Financial GCs . . .. .... .... 11822. Return on Assets Selected GCe s.. .11923. National Government Revenues by Source . . . . . . . . . . . . . 120

- 102 -

STATISTICAL APPENDIX

Table 1s Savings and Growth Rates 1/

Real GDP National PersonalForeign

Year Growth Savings Rate Savings RateSavings Rate

1970 4.7 20.9 6.9 0.31971 3.6 20.8 7.2 0.11972 4.7 21.1 8.1 -0.51973 7.8 27.0 9.8 -5.51974 4.8 26.0 9.7 0.91975 7.3 24.2 8.4 5.31976 7.7 25.2 10.8 5.81977 6.0 25.5 10.5 3.31978 5.3 24.6 8.4 4.31979 6.1 26.6 6.5 4.51980 7.9 25.7 6.0 5.01981 1.0 25.5 6.5 5.11982 2.9 21.0 3.2 7.31983 0.9 19.7 0.9 7.01984 -6.1 14.3 0.9 2.71985 -4.4 15.0 1.1 -1.11986 1.4 18.2 2.4 -5.31987 4.5 16.0 0.1 0.11988 6.2 18.0 6.0 0.71989 5.4 17.5 6.3 1.11990 3.3 13.0 2.3 5.2

Source: National Income Accounts, 1972 base.

1/ Refers to ratios to GDP

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Table 2: Public Sector Savings and Investmonts Rates 1/

Savings InvestmentoNG PE NFPE 3/ NG 2/ PS NFPE

1975 1.9 0.9 0.2 3.1 4.3 2.01976 1.? 1.0 0.2 3.4 12.8 7.71977 1.5 1.1 0.2 3.3 7.2 5.01978 2.7 0.7 -0.1 4.0 5.3 4.21979 4.1 0.8 -0.1 4.2 7.3 4.61980 3.9 0.8 -0.8 5.1 4.7 4.61981 3.1 1.1 0.3 7.1 8.8 5.91982 2.2 1.2 0.5 6.4 5.9 4.31983 2.9 1.1 0.4 4.8 5.2 3.21984 2.6 0.3 0.7 4.4 5.9 3.51985 2.3 -3.3 0.7 4.1 2.7 i.11986 2.0 -3.6 0.1 7.1 1.5 1.01987 0.5 -3.1 0.9 3.4 -0.6 1.21988 -0.1 0.2 1.0 2.7 1.1 1.11989 1.0 -0.5 0.0 3.1 1.9 1.8

Source: Adapted from Lamberte, et al., (1991), Table 4.5.1.

1/ NG - National Government; PE - Public Enterpr' £a2 includingfinancial institutions; NFPE - Non-Financial PublicEnterprises

2/ Includes own investments (infrastructure and other capitaloutlays) and investment transfers to PEs (equity and netlending).

3/ Savings ;or 1985-1988 include those of 14 major corporationsonly.

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Table 3: Selected Investment Data

Real Gross Private SectorInvestment Rate 1/ Share 2/ ICOR

(percent)

1970 21.5 93 5.91971 21.1 92 3.51972 19.7 87 3.91973 21.6 86 2.51974 26.9 84 5.11975 29.8 82 541976 31.4 75 4.61977 29.0 72 4.91978 29.0 71 5.31979 31.1 74 4.81980 30.1 75 6.51981 30.7 71 9.21982 28.8 74 15.51983 27.1 76 24.71984 17.4 74 -2.41985 14.3 78 -3.11986 13.2 75 7.21987 16.2 76 2.91988 17.4 79 2.91989 18.0 81 3.61990 18.2 -- --

Source: Adapted from Lamberte et al. (1991).

1/ Refers to ratio of investment to GNP

2/ Refers to ratio of private to total gross domestic fixed capitalformation

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Table 4: National Tax Ratios: 1976-90

Actual Tax PlanYear Effort Targets

1976 11.41 n.a.1977 11.29 n.a.1978 12.00 n.a.1979 12.46 n.a.1980 11.66 11.501981 10.53 10.331982 9.82 9.701983 10.62 9.601984 10.11 9.951985 10.25 8.661986 10.87 11.001987 12.38 12.501988 11.12 13.801989 12.94 14.001990 13.71 14.30

1976-1980 11.811981-1985 10.261986-1990 12.40

Source: National Tax Research Centre

Table 5: ESTABLISHING PILs FOR DOCTORS

Indicators Cardiology Allergology EENT Gastro- Oncology General Orthopedic Plastic|_________________ ___________ enterology Surgery Surgery Surgery

Average fee per P100 P200 P150 P150 P150 P100 P100 P100consultation

Clinic hours 7 5 4 4 4 4 2 4

Location

Number of 20 19 13 10 15 5 8 15Clients per day

Clinic days per 208 312 312 312 312 260 312 208year

Number ofSurgeriesperformed perweek

Minor 1 1 2 3 2 3

oH Major 1 1 1 1 1

Average fee persurgery

Minor P 500 P 560 P 360 P 300 p 750 p 4,000

Major P 6,600 P 4,000 P 4,600 P 10,000 P 10,000

Gross income per P416,000 P592,800 P896,400 P497,120 P928,720 P416,000 P769,600 P1,456,000year

*From P416,000 P592,800 P811,200 P468,000 P702,000 P130,000 P249,600 P 312,000consultation

*From surgery . _ P 85,200 P 29,120 P226,720 P286,000 P520,000 P1,144,000

Source: A. Yoingco (1991).

107 -

Table 6: Int rnnl Revenue-: Accounts Rocoivablo

PARTICULARS 1988 1987 1988 1989 1990

A. Number

1. Total Number ofIncome Tax FliersIn year 24177,426 2,185,190 2,476,979 2,684,745 2,719,404

2. Number of Outstanding/Accounts Receivables(A/R) as of 346,252 337,216 319,469 380,807 322,808

S. Number of AccountsCollected in year 28,687 64,826 28,199 42,878 21,867

4. Ratio of 3 to 2 8.28X 18.20X 8.83X 12.98X 0.77XS. Ratlo of A/R to

Total Incom TaxFilers 16.86X 16.83X 12.90X 12.88X 11.87X

8. Amount (In P/ Million)

1. Total 1IR Collectionin year 48,986.0 58,683.5 63,415.5 82,188.9 104,108.0

2. Outstanding A/Ras of 11,801.1 13,281.3 14,388.9 11,898.4 10,617.7

3. A/R Collected in year 137.3 230.2 305.6 732.1 447.44. Ratio of Collection

O to 2 1.21X 1.74X 2.13X 6.165 4.21XC. Ratio of Outstanding

A/R to Total SIRCollection 24.05X 22.64X 22.88x 14.47X 10.20X

D. Ratio of Amount ofA/R Collected toTotal SIR Collection 0.29X 0.39% 0.48K 0.89X 0.43X

Sourcoe: BIR Annual Reports 1986 to 1990 and Collection Service, SIR.

Note:

1. No date available on tho number and amount of A/R arising within each year, collections byages of accounts, and write-offc, If any.

2. Data on the number and amount of A/R ore on a cumulative basis as of end of each your. Thesedota cannot be related to the number of income taxfilrs and/or to total SIR collections onan annual baois for purposes of establishing levels/degr-e of performanco. The ratios shouldin no case be taken as the correct levols/degroes of performance on an annual basis. Theyare et beat used only to establish trend(s).

Table 7: Workloads of Assessment and Collection Personnel

Income Taxfilers: Average Workload(Net of Individ- Number of Cases Examiner

CY duals with Purely Assessment Number ofCompensation Personnel 1002 Audit 10 Coverage Accounts Personnel DelinquentIncome (1) 1 (2) (3) * 10 (5) 1 (6)

(1) (2) (3) (4) (5) (6) (7)

1983 1,174,733 2,606 451 45 -- 2,770 --1984 1,290,333 2,679 482 48 -- 2,888 --1985 1,082,740 2,775 390 39 -- 2,973 --

1 1986 1,042,901 2,641 395 39 -- 2,696 --00 1987 998,887 2,564 390 39 2,902 --

1988 985,913 2,711 364 36 319,459 3,397 941989 934,790 2,838 329 33 330,307 3,428 961990 772,492 2,993 263 26 322,803 3,512 91

Source: BIR Management Division and Annual Reports

Note: Taxfilers include individuals, partnerships and Corporations.

Table 8: Budget of the Customs Police Administration

Year (P100) Amount Increase Ratio to Amount Increase Amount Increase(P100) (Decrease) BOC Budget (P100) (Decrease) (P100) (Decrease)

1986 218,742 59,706 27.30Z1987 248,139 38,583 (35.382) 15.55Z 30,962 7,6211988 289,986 41.399 7.292 14.282 32,756 5.79X 8,643 13.4121989 361,969 44,843 8.312 12.392 35,528 8.46Z 9,315 7.7821990 380,268 43,599 2.77Z 11.47% 34,037 (4.97Z) 9,562 2.652

Source: General Appropriations Act, 1986-1990.

- 110 -

Table 9: SOA: Value of Inspection Advice Notices(April 1, 1987 - Docember 31, 1990)

INDONESIA, KOREA,JAPAN, TAIWAN AND MALAYSIA, SINGAPORE,

PARTICULARS TOTAL HONGKONG VALUE OF MACAU, THAIL AND ANDIMPORTS BRUNEI VALUE OF IMPORTS

(4/1/87 to 12/31/90) (10/1/89 to 12/31/90)

Number of Orders (IAN's) procoesedby SaS Manila Lialson Office 165,203 146,126 20,078

Total invoice of all IAN'slssued 9,768,608,899.14 8,601,718,847.31 1,268,850,061.83

Number of inspection conducted 212,181 180,888 21,293

Total Involce value of all CRF'sIssued 8,192,9B6,009.62 7,128,970,634.23 1,068,994,685.29

Number of inspections ofdutiable goods 109,498 95,378 14,117

Number of dutiablo shipments onwhich an uplift In dutiablevalue was obtained 89,002 59,839.00 9,163

Total Uplift In dutiable value 361,411,447.87 30,3868,9186.8 S5,044,631.29

Total increase In duties andtaxes payable to Government 2,765,279,338.28 2,284,896,870.29 467,696,946.21

Source: SOS Three Year and Nine Month Performance Report.

- ill -

Table 10: National Government Expenditures, by Economic Claussfication,Obligation Basis, (Fiscal ond Nonflscal, 1976-90)

(Percent of GNP)

1976- 1975- 1988- 1986- 1987-1986 1982 1985 1990 1990 1986 1987 1988 1989 1990

Total 15.90 16.61 18.22 20.95 21.84 18.683 22.11 20.84 20.78 22.8

Current O ratinaExpsnditursi 10.88 10.14 11.72 17.18 17.90 12.69 18.14 17.68 17.72 18.87

Personal Servicos 8.88 4.06 8.58 5.31 5.43 4.64 4.48 6.80 5.41 6.19Maintenance and Other

Operating Expenditures 7.05 6.08 8.14 11.82 12.47 7.95 18.68 12.28 12.31 12.18

Interest Payments 1.22 0.86 1.63 6.05 8.47 3.62 9.98 5.67 5.78 5.64Transfers to: 1.18 1.32 0.982 1.11 1.13 1.00 0.84 1.02 1.14 1.40

Local govt. 0.68 0.88 0.64 0.46 0.43 0.6 0.26 0.56 0.89 0.48All govt. corp. 0.18 0.22 0.12 0.23 0.27 0.0 0.21 0.287 0.37 0.22Finan. govt. corps. 0.01 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00Nonfinan. govt. corps.0.17 0.22 0.11 0.00 0.00 0.00 0.00 0.00 0.00 0.00

Others 0.33 0.47 0.16 0.43 0.43 0.41 0.37 0.18 0.38 0.70

Loan Ropayment andSinking Fund Contrib. 1.91 0.68 3.31 2.16 2.34 1.05 0.00 8.09 2.89 2.79

Othor MOE 2.78 3.23 2.27 2.51 2.58 2.38 2.83 2.65 2.55 2.34

capital Outlay 6.02 6.47 4.61 8.81 3.44 6.04 3.97 2.81 3.01 3.97

Land, Land Improvementsand Structure Outlays 1.51 1.98 0.98 1.07 1.17 0.49 1.07 0.91 1.11 1.50

Buildings and Structures 0.67 0.72 0.40 0.81 0.79 0.97 0.63 0.53 0.68 1.26Equipment 0.28 0.26 0.28 0.28 0.31 0.10 0.17 0.84 0.36 0.34Investment Outlay 2.18 2.21 2.04 0.80 0.60 2.03 0.67 0.29 0.68 0.80

Local government 0.00 0.00 0.00 0.11 0.13 0.00 0.00 0.00 0.22 0.23All govt. corps. 2.05 2.17 1.92 0.59 0.36 2.00 0.68 0.26 0.28 0.29Financial govt. corps. 1.10 0.80 1.43 0.00 0.00 0.00 0.00 0.00 0.00 0.00Nonfinan. govt. corps. 0.96 1.36 0.48 0.46 0.19 2.00 0.68 0.26 0.00 0.00Others 0.08 0.06 0.12 0.10 0.12 0.02 0.01 0.03 0.08 0.27

Loans Outlay 0.64 0.31 0.81 0.84 0.67 2.46 1.52 0.74 0.30 0.07

Local government 0.00 0.00 0.00 0.02 0.02 0.00 0.03 0.08 0.01 0.02All govt. corps. 0.49 0.26 0.76 0.68 0.88 2.4 1.09 0.60 0.17 -0.04

Financals govt. corps. 0.04 0.01 0.07 0.00 0.00 0.00 0.00 0.00 0.00 0.00Nonfinancial govt. corps. 0.46 0.25 0.69 0.54 0.21 2.45 1.09 0.00 0.00 0.00Others 0.05 0.04 0.06 0.14 0.17 0.00 0.40 0.12 0.18 0.09

- 112 -

Table 11: National Govornment Expenditures, by Sectoral Claselficatlon,Obligation Basis, (Fiscal and Nonflscal, 1976-90)

(Percent of GNP)

1975- 1976- 1988- 1988- 1987-1985 1982 1985 1990 1990 1986 1987 1988 1989 1990

Grand Total 15.90 15.81 18.22 20.96 21.84 18.63 22.11 20.34 20.71 22.12

Total Economic Servlccs 6.42 7.12 5.62 4.81 4.48 8.73 4.74 4.02 4.81 4.80

Agriculture 0.74 0.82 0.85 0.69 0.65 0.24 1.27 0.66 0.58 0.41Agrarian Reform 0.08 0.10 0.06 0.42 0.48 0.08 0.17 0.20 0.61 0.86Natural Resources 0.84 0.29 1.08 0.29 0.31 0.19 0.21 0.28 0.88 0.41Industry 0.26 0.94 0.16 0.18 0.16 0.05 0.89 0.10 0.09 0.08Trade 0.04 0.06 0.08 0.01 0.01 0.00 0.00 0.01 0.01 0.01Tourism 0.08 0.04 0.02 0.02 0.03 0.00 0.02 0.08 0.03 0.02Power A Energy 0.81 1.18 0.44 0.08 0.09 0.02 0.19 0.02 0.08 0.09Water Resources Dovelopment 0.18 0.19 0.11 0.04 0.05 0.00 0.08 0.06 0.04 0.08Transportation A Communication2.71 8.64 1.68 2.27 2.87 1.67 2.14 2.14 2.48 2.59Other Economic Services 0.97 0.63 1.48 0.96 0.85 4.60 0.26 0.89 0.18 0.31

Total Social Services 3.00 3.28 2.71 4.01 8.99 4.10 8.42 8.64 4.08 4.63

Education 1.76 1.90 1.009 2.73 2.80 2.27 2.41 2.88 2.83 3.12Health 0.64 0.68 0.49 0.65 0.87 0.68 0.67 0.68 0.66 0.74Social Services, Labor AEmployment 0.20 0.24 0.16 0.18 0.16 0.10 0.10 0.11 0.18 0.26

Housing A Coo. Development 0.48 0.61 0.44 0.43 0.81 1.11 0.32 0.18 0.33 0.40Other Social Sorvices 0.03 0.08 0.03 0.05 0.05 0,02 0.02 0.08 0.12 0.08

Natlonal Defense 1.87 2.07 1.22 1.31 1.32 1.26 1.24 1.60 1.34 1.24

Total Pubilc Services 1.80 1.86 1.75 2.46 2.53 1.99 2.72 2.61 2.24 2.B8

Public Administration 1.11 1.1 1.02 1.84 1.97 1.09 2.14 1.78 1.80 2.16Peace and Ordor 0.50 0.50 0.61 0.58 0.67 0.86 0.69 0.76 0.44 0.53Othors 0.20 0.18 0.22 0.04 0.00 0.25 0.00 0.00 0.00 0.00

Debt S*rvice 3.00 1.80 4.92 8.18 8.80 4.68 9.98 8.87 8.57 8.35

Unallocated 0.00 0.00 0.00 0.18 0.21 0.00 0.00 0.00 C.18 0.52

Not Lending 0.49 0.28 0.78 0.68 0.38 2.46 1.09 0.80 0.17 -0.14

- 113 -

Table 12: Composition of Public Sector Invostmnt(Percent Distribution)

Totol Infra- Other TotalAdmin/ Educa- social Agri- Trans- struc- economicDefen. tion Health s*rvices culture Power Water tation ture services

1976-82 4.2 2.1 .7 7.6 10.3 80.3 8.4 34.2 87.9 88.2

1983-85 4.6 3.2 .5 8.6 80.6 80.3 6.0 18.8 56.1 80.8

1988-90 7.8 8.4 1.8 20.1 13.6 19.1 8.8 30.0 63.0 72.0

1988 0.7 6.6 1.0 a4.7 16.1 26.9 6.8 17.11 48.8 64.1

1987 7.9 8.6 1.45 17.7 1.3 28.6 4.7 29.99 68.3 74.3

1988 14.1 9.46 2.4 18.2 16.1 15.8 3.9 84.4 4.1 69.7

1990 6.8 9.6 1.96 19.0 16.0 18.9 2.1 33.1 49.1 74.7

Table 13: Composition of Public Sector Investment(Percent to GNP)

Total Infra- TotalAdmin/ Educe- social Agri- Transpor- struc- economicDefense tion Health services culture Power Water tation ture services

1976-82 0.30 0.16 .05 0.65 0.75 2.22 0.25 2.61 4.98 8.47

1983-86 0.20 0.14 .02 0.36 1.30 1.29 0.26 0.80 2.84 3.69

1988-90 0.30 0.33 .07 0.80 0.64 0.76 0.15 1.20 2.10 2.87

1988 0.03 .198 .04 1.26 .57 .9 .21 .8 1.8 2.3

1987 0.26 .31 .06 0.65 .37 .86 .17 1.1 2.1 2.7

1988 0.47 .80 .08 .61 .48 .6 .12 1.1 1.7 2.2

1989 0.84 .84 .08 .79 .49 .99 .19 1.4 2.6 8.3

1990 0.24 .44 .09 .87 .69 .8 .10 1.6 2.8 3.4

- 114 -

Table 14: Public Sector Investment(Percent Distribution)

National 1/ Local 3/government GOCC 2/ governmentinvestment investment investment Total

1975-82 40.06 58.75 3.96 100.01983-85 37.86 61.04 4.22 100.01986 36.24 62.63 4.45 100.01987 48.71 49.18 4.84 100.01988 56.,0 41.07 6.64 100.01989 54.92 42.41 6.29 100.01990 66.92 31.29 5.20 100.0

1/ National government investment on own account from DBM obligation basisdata.

2.3/ GOCC and Local government investment from National Income Accounts.

Table 15: Public Sector Investment(Percent to GNP)

National 1/ Local 3/government GOCC 2/ governmentinvestment investment investment Total

1975-82 2.94 4.31 0.29 7.331983-85 1.66 2.54 0.23 4.251986 2.17 1.59 0.22 3.851987 1.55 1.93 0.16 3.651988 1.78 1.31 0.21 3.181989 2.13 1.64 0.24 3.881990 3.07 1.43 0.24 4.58

1/ National government investment on own account from DBM obligation basisdata.

2,31 GOCC and Local government investment from National Income Accounts.

- 115 -

Table 18: Not Flow of Funds Between NO and QCC, 197B-90-7Million Pesos unless otherwise indk'ated)

1976 1980 1986 1988 1967 1986 1989 1990

NET FLOWS TO NO (2,178) (6,746) (16,228) (33,143) (9,884) (1,885) (2,0489 (4,066)X of ONP -1.62X -2.41X -2.9GX -6.64X -1.46% -0.28x -0.a0o -0.36WX of NO Expenditur.s -10.83! -16.42% -20.28W -80.17X -8.03X -1.39X -1.88W -1.87X

NET FLOWS TO NO NET OF APTREMITTANCES (2,173) (S,740) (16,223) (83,143) (10,673) (7,284) (6,514) (7 5368)X of 0* -1.62W -2.41X -2.96X -6.04X -1.82X -0.869 -0.68W1 -0.67XK of NO Expendituroo -10.83K -16.42X -20.26K -30.17X -8.90X -6.85W -8.79X -3.47x

NET FLOWS TO NO LESS ASSUMEDDEST SERVICE (2,178) (6,746) (16,223) (33,143) (32,287) (25,922) (26,790) (32,653)X of GW -1.62W -2.41X -2.98X -6.64X -4.89X -3.16X -2.79W -2.88XX of NG Exponditures -10.83W -16.42X -20.26X -30.17X -26.93X -19.05X -16.68W -16.05X

Sourcos: Bureau of the TroasuryNational Economic & Dovelopment Authority

Table 17: NO Flows to GCs by Categories, 1978-90(VM11 ion Pesos unless otherwise lndicated)

1976 1980 1985 1988 1987 1988 1989 1990

NO Flows to CC. 2,226 5,819 17,041 33,613 13,328 9,270 11,784 12,330Subsidy 280 822 1,009 1,720 1,835 2,082 5,675 8,687Equity 1,846 4,622 14,853 12,836 4,414 1,823 2,107 4,484oet Lending 100 676 1,879 16,148 7,077 5,416 4,082 (791)Capital Transfersto PN8/DBP 0 0 0 4,409 0 0 0 0

NO Flows from OCs 63 73 818 470 3,692 7,385 8,916 8,265Dividends 53 73 112 90 36 608 165 1,748Sharo In PACCOR Income 0 0 706 a80 1,006 1,203 1,813 1,966Interest on Advances

to COCCi 0 0 0 0 1,610 276 2,66 1,082Gain on Sale of PN8 Stocks 0 0 0 0 0 0 808 0Sale of Asonts (APT) 0 0 0 0 1,039 5,399 3,688 3,478

Other NO OutflowsAssumed Liabilities 0 0 0 0 22,653 24,037 23,942 28,589Interost Paymnts(Domestic Debt) 0 0 0 0 6,648 8,47a 6,218 8,653

Interest Payments(External Debt) 0 0 0 0 6,826 6,691 7,132 7,348

Principal Payments(Domoestic Debt) 0 0 0 0 8,095 6,158 5,005 5,067

Principal Paymnts(External Debt) 0 0 0 0 2,388 4,716 5,687 9,608

Sources: Bureau of the TroasuryNational Economic A Development Authority

- 116

Table 18: The Major Subsidy Recipients(in million Pesos)

1980-85 1986-90

Fertilizer and Pesticide Authority 1,504 15National Kidney Foundation 353 0Phi. Crop Insurance Corp 198 144Philippine Coconut Authority 171 250National Food Authority 166 2,603National Housing Authority 159 604Phil. National Oil Co. 154 0NACIDA 138 90Philippine Heart Center 134 83Cultural Center of the Philippines 93 0National Irrigation Admn. 49 2,227Land Bank 0 570National Electrification Admn. 0 480Philippine National Railways 28 424Metro Manila Transit Corp. 0 221Phil. Convention & Visitors Corp. 0 168National Kidney Institute 60 86Asset Privatization Trust 0 84Lung Center of the Philippines 66 81Others 2,295 3,031

TOTAL 5,667 11,162

Source: DOF-Bureau of the Treasury

- 117 -

Table 19: The Major Equity Recipients(in million Pesos)

1980-85 1986-90

Development Bank of the Philippines 14,848 3,691National Power Corp. 8,593 952National Irrigation Admn 3,315 2,000Philippine National Bank 3,050 3,750Phil. National Oil Company 793 1,211Metropolitan Waterworks & Sewerage 2,034 451National Food Authority 386 1,567National Development Co. 4,265 216National Electrification Admn. 1,091 1,027Light Rail Transit Authority 1,058 995Local Waterworks Utilities Admn. 502 505Philguarantee 1,550 1,480Others 10,423 2,834

Total 51,908 20.680

Source: DOF-Bureau of the Treasury

- 118 -

Table 20: Operating Ratios of Major Non-Financial GCs

Operating Operating Operating Operating RatioReceipts Receipts Expenditure

Year Gross of Net of Gross of Net ofSubsidy Subsidy Subsidy Subsidy

1985 50,669 50,619 39,619 1.28 1.281986 34,638 34,523 27,079 1.28 1.271987 44,910 44,158 31,096 1.44 1.421988 48,240 46,595 35,237 1.37 1.321989 53,479 48,933 32,695 1.64 1.501990 71,159 68,963 53,928 1.32 1.28

Total/Average 303,095 293,805 219,654 1.38 1.34

Source: Department of Finance--GCMCC

Table 21: Net IncomeMajor Non-Financial GCs

(in billion pesos,

Gross Netof of

Year Subsidy Subsidy

1985 2.2 2.21986 0.4 0.31987 (0.8) (1.6)1988 3.9 2.31989 6.3 1.81990 N.A. N.A.

TOTAL 12.0 5.0

Source: Department of Finance

- 119 -

Table 22: Return on Assets Selected GCs(in percent)

GC 1986 1989

LRTA (0.02) 0.02LWUA 0.98 0.84MWSS 12.0 10.0NDC 4.8 5.2NPC 7.44 7.47PNR (0.22) (0.03)PNOC 6.58 10.91PPA 12.2 9.74

Non-WeightedAverage 5.5 5.52

Source: GCMCC

Notes:

a. Net income over total assets, at cost or revalued.

b. Criterion does not apply to MMTC, DPZA, NEA, NFA, NHA andNIA because of their chronic deficits.

- 120 -

Table 23: National Government Revenues by Source, 1985 - 1989(P Billion)

1985 1986 1987 1988 1989

Tax Revenues 61.1 65.5 85.9 90.3 123.1

BIR 42.6 46.8 58.6 63.7 82.6Domestic based 41.0 46.4 58.3 63.2 82.1Net Income 18.6 19.1 21.8 27.9 37.6Excise Taxes 13.5 16.4 22.6 20.2 24.9Sales Tax, VAT & Licenses 7.6 9.2 12.1 11.6 15.7Other Domestic Taxes 1.3 1.7 1.8 3.5 3.9

International Trade 1.6 0.4 0.3 0.5 0.5Travel Tax 1.4 0.3 0.3 0.5 0.5Others 0.2 0.1 0.0 0.0 0.0

Bureau of Customs 16.8 17.5 26.0 25.0 38.4Import Duties 15.8 16.9 26.0 25.0 35.1VAT on Imports 0.0 0.0 0.0 0.0 3.3Export Taxes 1.0 0.6 0.0 0.0 0.0

Other Offices 1.7 1.2 1.3 1.6 2.1Motor Vehicle Tax 1.0 1.0 1.1 1.3 1.5Real Property Tax 0.1 0.1 0.2 0.3 0.5Special Oil Import 0.5 0.0 0.0 0.0 0.0Others 0.1 0.1 0.0 0.0 0.1

Non-Tax Revenues 7.7 13.8 17.3 22.6 30.4

Collection from other Off1ces6.5 7.4 8.3 10.0 13.5Foreign Grants 0.1 0.2 1.4 1.4 1.3ESP 1.1 6.2 3.1 0.2 4.8PCGG u-.1ection 0.0 0.0 0.2 3.0 0.5APT Collections 0.0 0.0 1.0 3.0 1.5Interest Income from CB 0.0 0.0 1.8 4.7 6.1Interest on Adv. to Corp. 0.0 0.0 1.5 0.3 2.7

Total Revenues 68.8 79.3 103.2 112.9 153.5

Source: Bureau of Treasury

MAP SECTION

IBRD 22431w wr , ..._ n ._ -1146" tf4

CLASSIFICATION OF PROVINCESBY GEOGRAPHICAL REGIONS

I ILOCOS VI WESTERN VISAYAS PHILIPPINES20" 1 IIocos Norte 3 Aklan 20'2 ilocos Sur 39 Caplz3 La Union 40 Antique SATAN ES4 PoptsOinOn 41 llollo cl

CORDILLERA ADMINIStRATIVE 42 Negros Occidental 'REGION (CAR) 43 Ouimanas rvneCptl5 Abra VI) CENTRAL VISAVAS ' Provlnce Capitals6 KalingaApayao 44 Cebu7 MOuntain PrOvince 45 Negros Orlental Natlonal Capital8 Iftipo 46 B3ohol f9 Baenuat 47 Siquijor (o - - Province Boundaries

11 CAGAYANVALLEY Vill EASTERN VISAYAS10 Bat nes 4et Northern i6 - Region BoundarIes11 Cagayan 49 Western Smenar Igo BoundarieI 2 Isabela so Enitern SemenarT aa nerainlB udre1 3 Nueva Vlzcayt 5 1 Leyte Tb Internatonal undares1 4 uirino .52 Southern Leyte i 2 o nl

III CENTRAL LUZON 53 Billran1 s Nueva Ecija IX WESTERN MINDANAO liran1 fT tnlC 54 Zamboanga del Norte J3 9 6 vE /1 7 Zunbaleres ss Zemboonga del Sur San Prne 6Igo: 1 .rro , 01 a PamPnnp 56 Oariilan L o4o -,19 Batlen s7 Sulu / 13 14 MILES o e 0 150 SCo1 20 ouincen Sia Tawitawi AAlse ¾'

1" NATIONAL CAPITAL X NORTHERN MINDANAO 4 151REGION (NCR) 59 Suulpao del NoneaiaIV SOUTHERN TAGALOG 60 Cemiguln ;O ier

21 Aurora 61 Agusan del None 16 an 2)22 Quezon 62 MisnimlO Oriental U Z C) N23 Rtria 63 Mluami Ocidental J1 724 Cacihe 64 Bukidnon g 1 0 I I rIlE SE25 LBauna 65 Agusan del Sur 8 MA 23/).E26 7atnduu XI SOUTHERN MINDANAO27 MimnduroqrenJ 66 Surlgao del Sunro' a 26 Mlnoro Onenial 67 OaLvao Orietntal -29 Mlndoro Occidental 68 Davao del Norte r 32 V30 Romblon 69) Davao del Sur -_ .uoCATANDUANES31 Palawan 70 South Cotebato .

V BICOL XII CENTRALMINDANAO * *'**\ 9 n32 Camrineu Norte 71 Lanunao del Norte r.33 CiumanneesSun 72 Lanao del Sur'34 Cantanduanes 73 North Cotabato MmuA35 Albay 74 Maguindanao IV 2936 Sorsogon 75 Sullan Kudarat <737 Masbate mlND6oI4O30

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JUNE 1990