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Philippines: Selected Issues

Author(s):
International Monetary Fund. Asia and Pacific Dept
Published Date:
November 2017
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The Case for Fiscal Responsibility Law1

A non-statutory ceiling on the national government deficit has helped maintain macro-fiscal stability, but in the medium term the Philippines would benefit from a fiscal responsibility law (FRL) enshrining explicit fiscal rules with countercyclical elements and an independent fiscal council to improve accountability and transparency.

A. Introduction

1. A rule-based fiscal framework can improve credibility by building adequate fiscal buffers and making the conduct of fiscal policy transparent. Following a long period of fiscal consolidation in the aftermath of the Asian financial crisis, the Philippines has regulated fiscal policy by a non-binding ceiling on the national government budget deficit since 2010. This approach has served the country well in terms of macro-fiscal stabilization, but the fiscal policy framework can be further strengthened in the coming years by adopting a rule-based approach designed to avoid procyclical policy, ensure sufficient fiscal buffers against tail risks, make the conduct of fiscal policy accountable, transparent and predictable, keep the cost of borrowing low, and thereby promote long-term debt sustainability. There is ample empirical evidence indicating that countries with well-designed, binding fiscal rules tend to have stronger fiscal performance and better access to sources of funding than those without fiscal rules (Debrun and others, 2008; Schaechter and others, 2012; IMF, 2013).

2. Fiscal rules with countercyclical features would provide more effective operational guidance, especially considering the forthcoming surge in public investment. The fiscal policy stance, as measured by the cyclically-adjusted primary balance, moved by 1.2 percentage points of potential GDP on a cumulative basis over the past two years, implying a significant fiscal impulse during a period of strong economic growth.2 Especially in view of the coming increase in government spending on development projects, the Philippines would benefit from a comprehensive FRL setting out explicit fiscal rules and an independent fiscal policy council as a mean to improve accountability and transparency in managing fiscal risks and public financial resources and to anchor fiscal policy decisions to a sustainable path for public finances.

B. International Experience with Fiscal Rules

3. More than 90 countries across the world are now operating under fiscal rules, compared with five in 1990. Many countries have put in place permanent constraints on key fiscal aggregates through numerical limits on budget deficits, debt, expenditures, or revenue (Figure 2). These fiscal rules are designed to guide fiscal policymaking and anchor debt sustainability (Koptis and Symansky, 1998). The optimal design of fiscal rules varies from one country to another, depending on policy objectives and institutional capabilities. In this context, FRLs have become popular as a legal framework to enhance credibility, predictability and transparency by combining numerical rules with procedural regulations. Thereby, contrary to stand-alone fiscal rules, FRLs aim to provide a comprehensive framework to govern fiscal policy in a single piece of legislation.

Figure 1.National Government Debt, Deficit and Fiscal Impulse

Figure 2.Fiscal Rules Around the World

4. While a single rule offers simplicity, FRLs use a combination of different fiscal rules to address specific aspects for fiscal policy. As every fiscal rule has advantages as well as weaknesses, it is a common practice across the world to bring together the key elements of various fiscal rules in a fiscal responsibility framework. About 80 percent of the countries implementing rule-based fiscal policy use a combination of two or more rules—aiming to provide a medium-term anchor for fiscal policy and one (or multiple) operational target(s) on key fiscal aggregates. For example, a budget balance rule combined with a debt rule would provide a link to debt sustainability, while guiding short-term operational decisions. However, an expenditure rule, accompanied by a combination of a budget balance rule and a debt rule, would provide more effective operational guidance for fiscal policymaking and anchor debt sustainability to an appropriate long-term target.

5. Comprehensive institutional coverage makes fiscal rules more transparent and accountable. In countries with a federal government (or large subnational governments), it is necessary to look beyond the central government to the fiscal positions of subnational entities. Furthermore, autonomous and semi-autonomous institutions, extra-budgetary funds, and state-owned enterprises (SOEs) may have extensive quasi-fiscal operations with a significant amount of contingent liabilities.3 Therefore, as the national government is often forced to cover the losses and obligations of subnational governments and other public-sector institutions, the coverage of fiscal rules needs be comprehensive to avoid the possibility of undermining the FRL through off-budget transactions. Similarly, it is not advisable to exclude public sector investment from the coverage of fiscal rules, as it would create an incentive for inefficient investments and opportunistic reclassification of current into capital expenditure.

C. Advantages of Fiscal Councils

6. Independent fiscal councils have become an important institution to promote a “culture of stability” and support the implementation of fiscal rules. The number of countries with fiscal councils increased to 38 as of end-2015 from 12 a decade earlier (Figure 3). Although most of established fiscal councils are in advanced economies, there is growing interest in emerging markets and developing countries—ranging from Chile to South Africa. While governments as elected representatives maintain discretion in setting fiscal priorities and selecting appropriate instruments, fiscal councils are established as a nonpartisan agency to promote sustainable public finances through greater accountability and transparency and a more-informed public debate. With a mandate to furnish unbiased macroeconomic and budgetary projections and evaluate ex ante and ex post compliance with fiscal rules, an independent fiscal council provides objective assessments of the appropriateness of fiscal policies and enhances the effectiveness of fiscal rules (Debrun, Hauner, and Kumar, 2009). Cross-country analyses and country-specific case studies suggest that well-designed and nonpartisan fiscal councils are effective in improving fiscal outcomes in advanced as well as emerging market economies (Hageman, 2011; IMF, 2013).

Figure 3.Fiscal Councils Across the World

7. The establishment of a fiscal council, however, does not by itself contribute to stronger fiscal performance. Using a sample of 58 advanced and developing countries over the period 1990-2011, Debrun and Kinda (2014) find that successful fiscal councils have unambiguous legal independence and adequate human resources to analyze fiscal measures and monitor adherence to numerical and procedural fiscal rules. Fiscal councils also have a mandate to analyze the efficiency of government expenditure in some counties (such as Korea and Slovenia) and to foster coordination among different spheres of the general government in other countries (such as Austria and Portugal).4 Hence, while the mandate and structures of independent fiscal policy councils depend on country-specific circumstances, there are key features shared by successful fiscal councils: (i) professionalism and political independence; (ii) exclusive focus on fiscal policy and debt sustainability; (iii) objectivity and transparency in fiscal policy analysis with unfettered access to information; and (iv) clearly defined institutional mandate.

D. Calibrating Fiscal Rules for the Philippines

8. With the objective of anchoring the government’s core fiscal operations, fiscal rules are designed to focus on the national government using unconsolidated data. In most countries, debt rules are set in gross rather than net terms. First, it is challenging to determine which government assets are truly liquid, especially in times of financial stress. Second, net debt may conceal the build-up of fiscal risks by masking important financing operations (such as bank recapitalization and loans to SOEs) that would be accounted for in gross debt. Third, the concept of net government debt is not as transparent as the definition of gross debt and far more difficult to communicate to the public. Although a broader coverage of fiscal activities—such as the nonfinancial public sector—would be more appropriate in assessing and adopting fiscal rules, limitations on the availability of detailed fiscal accounts across all layers of government do not allow calibration of fiscal rules at a broader level in the case of the Philippines. Besides the national government is responsible for the great majority of fiscal activities, with the rest of the public sector (particularly social security institutions and local governments) generating substantial primary surpluses.

9. The Philippines’ gross national government debt declined to 42 percent of GDP in 2016 from the peak of 74.4 percent in 2004. Gross debt consists of all government liabilities that are debt instruments, while net debt is calculated as gross debt minus financial assets corresponding to debt instruments, which are defined as a financial claim requiring payments of interest and/or principal at a date, or dates, in the future. In the Philippines, the Bond Sinking Fund (BSF) holds government debt amounting to 5.2 percent of GDP in 2016, hence lowering the national government’s debt stock from 42 percent of GDP on a gross basis to 36.8 percent of GDP in net terms (Figure 4). Furthermore, local governments and social security institutions run large surpluses and hold substantial amounts of national government debt. As a result, for the general government, including debt holdings of local governments and social security institutions, the consolidated net debt-to-GDP ratio amounted to 33.8 percent of GDP as of end-2016. On the other hand, including nonfinancial public enterprises, the consolidated nonfinancial public sector debt stock stood at 44.1 percent of GDP in 2016.

Figure 4.Layers of Government Debt

10. There is a large literature on the “safe” level of debt, but thresholds vary from one country to another and over time.5 Even if a debt threshold is estimated with reasonable accuracy, it should not be treated as a long-term anchor for the level of government debt, as it could result in unsustainable debt dynamics during adverse shocks. This calls for imposing a sufficient “safety margin” between the debt target and the “maximum limit” for government debt, beyond which sustainability would be questionable and the government may not be able to lower or stabilize the debt ratio through the regular conduct of fiscal policy (Ostry and others, 2010). In line with the commonly-used debt threshold for emerging markets and developing countries, the appropriate “maximum debt limit” for the Philippines is assumed to be 60 percent of GDP and a debt anchor is estimated to keep debt below this “maximum limit” with high probability even when adverse shocks occur. This is also consistent with recent empirical studies identifying the level of government debt beyond which it has a negative effect on economic growth, even taking into account the positive impact of public investment on growth (Checherita-Westphal, Hallett, and Rother, 2014; Fournier, 2016).

11. Projections of future government debt are subject to a plethora of policy uncertainties and exogenous shocks. First, there is policy uncertainty regarding the future development of taxation and government spending. Second, even if one assumes no changes in tax and expenditure policies, there is economic uncertainty, which must be taken into account. The growth rate of the economy, demographic changes as well as the interest rate at which the government can borrow determine the macro-financial environment that directly or indirectly affects the state of public finances. Since this economic environment is subject to exogenous shocks, assessing the optimal level of government debt requires an estimation of the joint probability distribution of economic fundamentals and the level of government debt.

12. The joint distribution of macroeconomic variables is estimated to perform multiple simulations. The “safe” level of gross debt-to-GDP ratio for the national government in the Philippines is then estimated using the stochastic simulation methodology proposed by Baum and others (2017). Each simulation generates a path for macroeconomic variables over the projection horizon, during which the variables are subject to shocks in each period.6 Subsequently, medium-term debt trajectories consistent with each simulated path of macroeconomic variables are attained from the system of simultaneous equations formed by the debt accumulation equation (i.e., government budget constraint) and a fiscal reaction function (FRF) estimated over the past in which the level of the primary balance responds to the level of government debt and realizations of macroeconomic variables.7 A debt anchor for the Philippines needs to be sufficiently low to protect the country against shocks, including natural disasters and contingent liabilities.8 Furthermore, given the low level of tax revenue mobilization (relative to peers and its own potential), the Philippines could also experience a greater sensitivity of macro-financial conditions to debt sustainability at higher levels of indebtedness.

13. Stochastic simulations indicate that the optimal debt anchor for the national government in the Philippines is 45 percent of GDP in gross terms. After setting the “maximum limit” on national government gross debt at 60 percent of GDP and given the country’s macroeconomic and fiscal performance over the period 1980-2016, the simulation analysis of future debt trajectories shows that national government gross debt must remain below 45 percent of GDP in the long term, which is equivalent to a general government net debt of about 35 percent of GDP. This “safety margin” of 15 percent of GDP—difference between the maximum debt limit of 60 percent of and the debt target of 45 percent—would ensure that the “maximum limit” is not breached with a probability of 5 percent over the medium-term horizon (Figure 5).9 In other words, we consider 45 percent of GDP as the “safe” level of gross debt that the national government can maintain without experiencing fiscal distress over the medium term.10 Therefore, since the current level of gross national government debt is just below the estimated debt anchor, the Philippines has some fiscal space to scale up public investments over the medium term, without endangering debt sustainability, as long as its pace consistent with tax revenue efforts and the economy’s absorption capacity to avoid the risk of overheating.

Figure 5.National Government Gross Debt Anchor Simulations

14. To provide operational guidance under the debt target, a structural budget balance rule is calibrated to maintain a countercyclical fiscal policy stance. While the overall budget balance is a commonly used indicator to assess the fiscal policy stance, it is a deficient measure as it includes factors beyond the control of policymakers. Even the primary balance excluding interest income and payments is still affected by macroeconomic developments. A structural indicator would provide a better assessment of the underlying (or permanent) fiscal position by removing cyclical factors, one-off revenues and expenditures, and potentially other temporary effects from the headline budget balance. Accordingly, the structural primary deficit target is derived to bring about a gradual convergence toward the debt target set at 45 percent of GDP. Calibrating the budget balance path over the economic cycle yields a cyclically-adjusted primary deficit target of 2 percent of potential GDP for the national government (Figure 6). If implemented in 2017, this would imply a fiscal loosening by about 1 percentage points of potential GDP relative to the policy stance in 2016, but it would be still consistent with the national government’s overall deficit target of 3 percent of GDP and keep the national government gross debt-to-GDP ratio below the proposed debt anchor.

Figure 6.National Government Debt Anchor and Deficit Path

15. To bring stronger operational guidance and better manage aggregate demand, the structural primary balance rule should be linked to an expenditure rule. While a debt anchor and a structural primary balance rule are considered to be adequate, adopting an expenditure rule would provide additional macroeconomic stabilization properties in an emerging market economy with significant development needs. Assuming that there is no significant cyclical component to expenditure and automatic stabilizers operate only on the revenue side in the Philippines, we conclude that there is no difference between nominal expenditure and structural expenditure.11 Also, it is assumed that the structural tax ratio (computed as the ratio of cyclically-adjusted revenues to potential GDP) remains constant unless there is a significant change in tax policies. Under these assumptions, the optimal expenditure rule links the annual growth rate of total national government spending (excluding targeted social assistance) to nominal potential GDP growth.

E. Conclusion

16. The Philippines would benefit from a well-designed FRL ensuring fiscal rules designed for debt sustainability and countercyclical policy. There is no one-size-fits-all fiscal rule, but there are common threads in assessing the appropriateness of fiscal policy and how it should be optimized for aggregate demand management. While the national government’s non-binding ceiling on the overall budget deficit is helpful, it does not constitute an appropriate operational target to guide fiscal policy over the economic cycle, reduce spending volatility in the absence of a binding constraint on primary expenditures, and explicitly link the fiscal stance to the government’s intertemporal budget constraint. To this end, given the country’s adequate analytical capacity and policy track-record, the following combination of fiscal rules—based on the stochastic simulation exercise—is recommended to formulate policymaking with countercyclical properties and an explicit reference to long-term debt sustainability:

  • A gross debt target of 45 percent of GDP for the national government (which is equivalent to a general government net debt of about 35 percent of GDP);

  • A structural budget balance target defined as the cyclically-adjusted national government primary deficit of 2 percent of potential GDP;

  • An expenditure rule that limits the annual growth rate of total expenditures excluding targeted social assistance to nominal potential GDP growth; and

  • A limit on the stock of contingent liabilities, including PPPs, set at 10 percent of GDP for the general government.

17. Fiscal rules should have sufficient flexibility to respond to exogenous shocks, while being supported by explicit enforcement procedures and corrective mechanisms. The FRL needs to balance credibility and flexibility in responding to developments outside the direct control of policymakers. To this end, the Philippines should have well-defined escape clauses that allow for temporary deviations from the fiscal rules according to: (i) a limited number of pre-specified exceptional and unforeseeable exogenous events such as large-scale natural disasters and severe financial crises and deep economic recessions; (ii) clear guidelines on the interpretation and determination of such events; and (iii) an unambiguous transition path to compliance with the fiscal rules and the regime that applies during the convergence period.12

18. The FRL’s success in guiding policy and shaping public expectations depends on effective enforcement and correction mechanisms. The success of fiscal rules in guiding policymakers as well as shaping expectations in general depends on predetermined provisions for dealing with deviations from the fiscal rules. Empirical evidence indicates that fiscal rules with no effective enforcement mechanism result in worse fiscal outcomes than fiscal rules with well-defined enforcement directives (Debrun and others, 2008). To this end, the Philippines should introduce enforcement sanctions with reputational costs (i.e., public report to Congress) in case of deviations from the fiscal rules and a specific timetable to offset such deviations over a certain period of time. In this context, the establishment of an independent fiscal council is particularly important to provide unbiased macro-fiscal projections and evaluate compliance with fiscal rules. This would enhance transparency and accountability of fiscal operations and buttress credibility of the rule-based fiscal policy framework.

Box 1.Advantages and Disadvantages of Different Types of Fiscal Rules

Different fiscal rules trade off the extent of debt stabilization with the degree of countercyclical properties. Operational fiscal rules differ according to the type of budgetary aggregate that they seek to constrain, and have different advantages and drawbacks. Accordingly, the design of a rule-based fiscal policy framework should address the need for short-term economic stabilization and ensure fiscal sustainability over the long term.

  • Debt rules, such as a ceiling on the debt-to-GDP ratio or a debt brake mechanism, safeguard fiscal solvency by linking the fiscal stance to debt sustainability over the medium term. However, debt rules are not typically effective as operational fiscal rules, as policy changes impact debt dynamics with a lag beyond the annual budget horizon, and do not have desirable countercyclical properties to stabilize macroeconomic fluctuations.

  • Budget balance rules, such as a ceiling on the overall budget deficit, are relatively easy to monitor and implement and can support debt sustainability. However, if specified in nominal terms, budget balance rules do not have stabilization properties and tend to lead to procyclical fiscal policy. Structural budget balance rules (such as the cyclically-adjusted budget balance), on the other hand, account for economic shocks and allow automatic stabilizers to operate. While these features augment the stabilization role of fiscal policy, inherent uncertainties in estimating the output gap make structural balance rules difficult to monitor and communicate.

  • Expenditure rules, such as a ceiling on nominal expenditure growth or as a percent of GDP, are operationally simple and provide clear guidance on how to adjust the fiscal stance over time.1/ While expenditure rules provide economic stabilization properties, they require a reliable medium-term budget framework to avoid the built-up of large deficits and deterioration in the net asset position due to persistently lower revenue generation.

  • Revenue rules, such as a floor or ceiling on revenues, seeks to increase revenue collection or avert an excessive tax burden. Revenue rules have no direct link to debt sustainability and would result in a procyclical fiscal policy, if there is no accompanying rule on expenditure growth or a ceiling on the general government budget deficit.

1/ Some countries adopt “golden rules” excluding investment spending, but this tends to complicate the implementation of fiscal rules and weaken fiscal sustainability, as it creates an incentive for inefficient investments and opportunistic reclassification of current into capital expenditure, and leads to higher current spending associated with maintenance of a higher level of public capital stock (Caseres and Ruiz-Arranz, 2010; IMF, 2014).
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Prepared by Serhan Cevik and based on a forthcoming working paper (“Economic Cycles and Fiscal Waves: The Case for Fiscal Responsibility Law in the Philippines”).

Fiscal impulse is measured as the change in the cyclically-adjusted primary balance as a share of potential GDP.

A contingent liability is an obligation that does not arise unless a particular event occurs. Some contingent liabilities are explicitly recorded as legal claims and guarantee agreements, while others are implicit, such as the government’s implicit support to SOEs and PPPs. Some contingent liabilities are quantifiable (i.e., litigation claims), while others are not quantifiable until they turn into actual liabilities.

IMF (2013) provides a detailed assessment of examples of fiscal council mandates.

Eberthardt and Presbitero (2015) and IMF (2016) provide comprehensive surveys of empirical and theoretical research in this area.

Macroeconomic shocks are drawn from symmetric normal distributions, although the empirical evidence suggest that shocks can be skewed to the downside (Escolano and Gaspar, 2016). The impact of shocks on debt paths, however, depends on the initial level of debt. For example, an adverse shock to growth and/or interest rates will increase debt by more when the initial debt level is higher.

The results remain broadly in line with the fiscal response estimated by the FRF for a panel of 26 large emerging market economies including the Philippines.

According to a recent IMF study, a country is likely to experience the realization of large contingent liabilities every twenty years and the average fiscal cost of contingent liabilities is around 10 percent of GDP. Accordingly, this exercise assumes a realization of contingent liabilities amounting to 7 percent of GDP over the medium term.

Fan charts show capture uncertainty surrounding the baseline projection from the 5th to 95th percentile of the distribution, with each shade of color representing a 5 percent level of likelihood.

This would also provide a reasonable cushion against natural disasters. The fiscal cost of natural disasters in the Philippines amounted to 0.6 percent of GDP on average and as much as 4.6 percent of GDP over the period 1960-2015.

This is consistent with empirical evidence showing that revenues are far more sensitive than expenditure to the economic cycle (Price, Dang, and Guillemette, 2014)

Budina, Kinda, Schaechter, and Weber (2012) provide a detailed account of escape clauses across all countries with a rule-based fiscal policy framework.

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