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Philippines: Selected Issues

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International Monetary Fund
Published Date:
May 2006
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II. Cyclically-Adjusted Balances and Fiscal Sustainability In The Philippines9

The public sector deficit and debt in the Philippines increased sharply following the Asian crisis and have yet to return to their pre-crisis levels. This chapter uses cyclical decomposition of fiscal balances to gauge the extent to which the Asian crisis contributed to the deterioration in the fiscal position. The analysis suggests that the worsening of the underlying fiscal balance began before the crisis as a result of policy choices that led to a loss in revenue and increases in unproductive spending. These policies were maintained for several years after the crisis, causing a further weakening in the fiscal position that appears to have been aggravated by problems with tax administration. More recently, the authorities have embarked on an ambitious fiscal reform agenda. The chapter uses recent findings on the characteristics of sustainable fiscal adjustments to identify the challenges facing policy makers in ensuring that current fiscal consolidation efforts prove successful.

A. Introduction

1. After improving in the first half of the 1990s, the Philippines’ fiscal fortunes quickly reversed following the Asian crisis. In the mid-1990s, tax revenues increased markedly, the nonfinancial public sector (NFPS) budget was near balance, and public debt appeared to be on a declining path. Then came the Asian crisis and tax revenues plunged, the NFPS deficit increased sharply, and public debt began to climb. While some of these developments can be attributed to the crisis itself, other factors, such as the proliferation of tax incentives and weaknesses in tax administration also appear to have contributed. Moreover, the Philippines’ fiscal position did not improve following the crisis, indicating a fiscal problem that was not purely cyclical. The authorities are well aware of the need to take decisive action and have already embarked on an ambitious fiscal reform program that should support the move to a sustainable fiscal position.

Figure 1.The Philippines: NFPS Deficit and Debt, 1993-2004

2. This chapter assesses the fiscal stance in the Philippines before and after the Asian crisis by examining developments in the cyclically-adjusted fiscal balance. The analysis suggests that the fiscal position began worsening prior to the Asian crisis and that the cyclically-adjusted primary balance has yet to recover (on average) to the pre-crisis levels exhibited in the early 1990s. The chapter investigates the reasons for the substantial worsening in the underlying fiscal position, as well as for its subsequent failure to improve.

3. The chapter also identifies reform strategies that are likely to increase the chances of current fiscal consolidation efforts being successful. Over the past three years, the Philippine authorities have made important advances in reducing the NFPS deficit and debt, most notably through the increase in the electricity tariffs and the passage of the Value Added Tax (VAT) reform. As a result, the NFPS deficit declined by about 3 percentage points of GDP over 2003–05 with public debt reduced by 11 percentage points of GDP during the same period. Over the longer term, it will be important to preserve these gains and to ensure that the fiscal consolidation effort is durable and successful.

4. Cross-country empirical evidence suggests that the composition of fiscal adjustment is critical for its success. In particular, sustainable fiscal consolidation episodes typically involve tackling the government wage bill, subsidies, and other sensitive transfers, while durable revenue reforms tend to focus on improving the overall efficiency of the tax system by expanding the tax base and increasing revenue productivity. The ongoing fiscal reform in the Philippines is a major step forward, but can be reinforced by more decisive actions in a number of areas, including by strengthening tax administration, containing the deficits of public enterprises, and broadening the tax base by rationalizing tax incentives.

B. Methodology

5. The chapter uses cyclical decomposition of fiscal balances to measure the true fiscal stance. The actual budgetary position of the government can be a misleading indicator of the thrust of fiscal policy, because of the presence of automatic stabilizers (e.g., unemployment and welfare benefits) which move in a countercyclical fashion even in the absence of any discretionary action by the government. Determining the true fiscal stance requires purging the fiscal balance from the effects of these automatic stabilizers. This can be achieved by decomposing the primary balance into the cyclically adjusted balance (CAB) that would prevail if the economy was operating at its full potential, and the cyclical component that reflects the impact of the cycle on the fiscal balance. The CAB thus permits measurement of the contribution made by the Asian crisis to the worsening of the fiscal position in the Philippines.

6. The CAB is defined as the difference between cyclically adjusted revenues and expenditures. Cyclically adjusted revenues and expenditures are estimated using the OECD approach. Cyclical factors are eliminated from revenues by estimating revenue levels when output is at its potential, assuming average elasticity for the period 1990–2004.10 It is assumed that given limited welfare benefits and in the absence of unemployment benefits in the Philippines, expenditure is largely independent of cyclical developments and therefore cyclically adjusted expenditures are equal to actual expenditures.11

7. The fiscal stance is then defined as the first difference in the CAB.12 The fiscal stance can be a useful measure of the impact of fiscal policy on aggregate demand and can be employed to determine whether the fiscal policy is procyclical or counter-cyclical. A positive correlation between the fiscal stance and the output gap in a particular period indicates that fiscal policy was procyclical during that period.

8. Procyclicality of fiscal policy may have important implications for macroeconomic stability and fiscal sustainability. A recent IMF study concludes that procyclical fiscal policy exacerbates economic fluctuations, with adverse consequences for savings, investment, economic growth, and welfare. It also suggests that a stronger procyclical bias in the upturn may result in a deteriorating fiscal position over time, since deficits and debt built up during bad times are in general not offset during good times.13

C. Findings

9. Analysis of the CAB indicates that the deterioration in the underlying fiscal position predates the Asian crisis. Developments in cyclically-adjusted revenues and expenditures suggest that fiscal policy was loosened from 1995, prior to the Asian crisis (Figure 2). Cyclically-adjusted revenues fell, despite the tax reforms undertaken in the early and mid-1990s (Box 1), while primary spending increased substantially. Fiscal policy was also procyclical during the crisis.

10. The decline in the cyclically adjusted revenues prior to crisis can be attributed to a number of factors. Although the fiscal reforms helped to substantially boost tax receipts in the first half of the 1990s, the increase in revenues may have fallen short of potential because a number of structural weaknesses were not addressed. In particular, the reforms failed to rein in extensive tax incentives and did not tackle weaknesses in tax administration.14 In addition, the operating receipts of the Government Owned and Controlled Corporations (GOCCs) declined following the privatization in 1994 of the oil refining and distribution company Petron—a subsidiary of the Philippine National Oil Company (PNOC).

Figure 2.The Philippines: Cyclically Adjusted Balance and Output Gaps, 1990-2004

(In percent of GDP)

Source: Philippine authorities; and Fund staff estimates.

11. Spending policy was stimulative on average in the first half of the 1990s, including in the years immediately preceding the crisis, when output was above potential. Budget allocations favored increases in statutory outlays—including government wages and transfers to the local governments—over spending on infrastructure and maintenance. Primary expenditure expanded by almost 2 percentage points of GDP during 1995–97, with personnel outlays increasing by over 1½ percentage points of GDP.

Box 1.Philippines: National Government Tax Revenue Developments in 1990–2004

Two distinct periods can be identified in the Philippines’ tax revenue performance over the period 1990–2004. Prior to the Asian crisis, tax revenues increased strongly, likely as a result of tax reforms undertaken in the late 1980s and mid-1990s. Following the crisis, however, tax revenues fell off sharply and have not yet recovered to their pre-crisis levels.

Despite the on-going trade liberalization, the NG tax ratio increased by almost 3 percentage points of GDP during 1990–97. Over two-thirds of the increase can be attributed to buoyant income tax collection, in particularly on corporate profits, and the remaining third to higher VAT receipts possibly on account of the expanding tax base. The on-going trade liberalization offset some of these gains, resulting in a loss of over ½ percent of GDP in the annual tax ratio over the eight-year period. The tax ratio peaked at 17 percent of GDP in 1997.

The Philippines: Composition of Tax Revenues, 1990-2004

(In percent of GDP)

Various tax reforms may have played a role in strengthening the revenue collection. The first reform was started under the Aquino administration in 1986 and included the introduction of the VAT in 1988, which replaced a multi-rate manufacturers’ tax, and changes in individual and corporate income tax. This reform was followed by the expansion of the VAT in 1994 to include services that were previously subject to percentage taxes and the introduction of a Comprehensive Tax Reform package (CTRP) in 1997. Under the CTRP, ad valorem taxes on tobacco products and alcoholic beverages were replaced with specific excises; and the taxation of petroleum products was revamped by a substantial reduction in import tariffs and the introduction of petroleum excises.

However, the revenue gains from these reforms were not sustained. National government tax revenues declined by over 4½ percentage points of GDP between 1997 and 2004. About one-third of the decline came as a result of the continuing trade liberalization and another third from lower excises that were not indexed to inflation. The remainder of the decline can be attributed to lower income tax collection (1 percent of GDP) and weaker indirect taxes, including the VAT (0.5 percent of GDP). The factors contributing to the decline in the tax ratio since the crisis are discussed in the text.

12. These revenue and expenditure trends persisted after the Asian crisis. From 1998 onward, cyclically-adjusted revenues generally follow the unadjusted revenue trend, reflecting relatively small cyclical fluctuations during 1999–2004 (Figure 1). After a brief improvement in 1998, cyclically-adjusted revenues continued on a declining path, closely tracking the sharp fall in national government (NG) tax collections. NFPS revenues were also affected by a decline in GOCC receipts which fell by 1½ percentage points of GDP between 1998 and 2004. Some of this decline came as a result of a moderation in the demand for electricity following the Asian crisis and unfavorable contracts between the National Power Corporation (NPC) and independent power producers (IPPs).15 However, the primary factor explaining the deterioration in NPC’s revenues was the government’s decision in 2002 to cap increases in electricity tariffs and a number of subsequent pro-consumer tariff decisions.16 Statutory expenditure outlays peaked at 15.4 percent of GDP in 2003, after increasing by 2.3 percentage points compared to the 1990 level. The share of statutory outlays in total NG expenditure went up by over 14 percentage points to 79 percent in 2003. This marked change in expenditure composition led to a less flexible budget, which has limited discretionary expenditure policy over the past few years to cuts in capital and maintenance spending (Figure 4).

Figure 3.The Philippines: National Government Tax Revenue and Statutory Outlays, 1990-2004

(Percent of GDP)

13. There could be several explanations for why the underlying fiscal position did not improve following the Asian crisis. First, as described above, fiscal policy was procyclical before and during the crisis and the stimulative expenditure policy continued into the early-2000s.17 Second, the revenue reforms that boosted NG tax revenues enjoyed only temporary success for the following reasons: (i) while the VAT tax base was expanded, important sectors, including energy, were left out of the base; (ii) the income tax base was eroded by a proliferation of tax incentives in rapidly expanding sectors of the economy, including electronics;18 (iii) the revenues lost from trade liberalization were not replaced; and (iv) specific excises were not indexed to inflation. Third, tax administration weaknesses persisted and were not addressed.19 And finally, the weak financial position of public enterprises, including the state power company (NPC), contributed to the decline in the NFPS revenues.

Figure 4.The Philippines: NG Expenditure Composition

(In percent of total expenditure; unless stated otherwise)

Source: The Philippine authorities; and Fund staff estimates.

D. Making Fiscal Consolidation a Success

14. Since taking office in mid-2004, the administration has made important progress in addressing the fiscal problem. To this end, the government has launched a comprehensive fiscal reform program. The cornerstone of this program and the measure with the highest revenue potential is the VAT reform that extends the VAT base to energy products and allows for an increase in the VAT rate from 10 to 12 percent in early 2006. The authorities plan to spend a portion of the revenue proceeds from the VAT reform on funding priority infrastructure projects and boosting social spending.

15. Other measures will support the fiscal consolidation. Excise taxes on alcohol and tobacco products were increased by 30 percent on average at end-2004, although not fully indexed to inflation. The authorities are also actively pursuing a government rationalization program that should make the civil service leaner and more effective and improve government service delivery. Finally, significant progress has been made in containing the deficits of public enterprises, including by increasing electricity tariffs—a measure that has more than halved NPC’s deficit.

16. Considerable fiscal gains have already been achieved following the introduction of these reforms, but it will be important to lock in and build up on these gains. In this regard, findings from the recent literature on the link between the composition of fiscal adjustment and its sustainability can be used to identify possible strategies for making the ongoing fiscal consolidation effort a long-lasting success.

17. Recent empirical research finds that the composition of fiscal adjustment is crucial for its sustainability. In particular, sustainable fiscal consolidation episodes typically involve cutting unproductive expenditures, while durable revenue reforms tend to focus on broadening the tax base and increasing revenue productivity. Studies of fiscal adjustment episodes in OECD countries found that fiscal consolidations based on tax increases and cuts in capital spending tend to be shorter-lived than those that rely primarily on reducing outlays on transfers and the wage bill (Alesina and Perotti, 1995 and 1997). A more recent study of emerging market economies suggests that, in addition to cuts in wasteful spending, durable revenue mobilization and robust capital spending are also important components of a sustainable fiscal consolidation (Gupta, et al., 2003).

18. A simple intuitive explanation can be offered to support these results. Spending cuts in politically sensitive expenditure categories, such as wages, pensions, and subsidies, require strong political will and public backing, signaling a sound commitment to fiscal consolidation in countries that managed to successfully carry out these reforms. Similarly, durable reforms on the revenue side, such as introducing new taxes and expanding the base of existing taxes, usually require legislative amendments that are more difficult to reverse than administrative or executive orders, resulting in a longer lasting fiscal consolidation. In contrast, procyclical fiscal policies that encourage exuberant spending in good times may make it difficult to undo the deficits and debt built up during economic downturns.

19. The ongoing fiscal reforms in the Philippines are broadly in line with these findings. The reformed VAT bill should widen the revenue base by including previously exempt energy products and professional services in the tax net. The authorities are also attaching high priority to increasing productive spending on infrastructure, while reducing unproductive expenditure, including through civil service reform. Effective and timely implementation of these reforms is therefore key to the success of fiscal consolidation. However, to enhance the quality of fiscal consolidation and ensure its durability, these efforts would need to be supplemented by other high-quality reforms. These include:

  • Enhancing the revenue system by broadening the tax base, including through a meaningful rationalization of income tax incentives. While the VAT reform marks an important advance in this area, international comparison suggests that there is much upside potential to improving revenue performance in the Philippines (Box 2).
  • Ensuring that past revenue gains are not eroded over time, including by indexing excises to inflation and revising the level of excises in line with revenue needs and other public policy objectives.
  • Strengthening tax administration, including through improved taxpayer registration, audit strategies, return processing, and debt collection techniques.
  • Ensuring long-term sustainability of the pension system by conducting regular actuarial reviews and adjusting benefits and contributions in line with the long-term solvency of the system.
  • Rebalancing the composition of public spending away from statutory outlays to ensure adequate financing of infrastructure and maintenance spending. In this regard, the government’s decision to spend a share of the incremental revenue from the reformed VAT on infrastructure is a step in the right direction.

20. The deficits of the GOCCs also need to be contained to ensure that all subsectors of the public sector contribute to the adjustment effort. The recent progress made in reducing the large deficit of NPC will need to be solidified by ensuring full cost recovery and delivering successful privatization of the power sector over the medium term. Since high unchecked deficits of the GOCCs may undermine the NFPS fiscal consolidation strategy, it will be important to develop and enforce medium-term deficit targets for the GOCCs that would be aligned with the fiscal targets for the public sector as a whole.

21. Procyclical fiscal policies should be avoided, whenever feasible. Such policies may unfortunately become inevitable during economic downturns due to the need to preserve the sustainability of public finances—especially in countries like the Philippines that face serious vulnerabilities stemming from the high debt burden and large gross financing requirement. In addition, sharp spending increases in good times can exacerbate economic volatility and damage fiscal sustainability over the longer run and therefore should be avoided. In this regard, the cautious spending stance in recent years bodes well for making the adjustment more durable, although expenditure composition can be improved, as discussed above.

Box 2.Philippines: International Comparison of Revenues and Expenditures

Comparison of the Philippine revenue performance to its peer group—countries with similar levels of economic development—suggests that much upside potential for revenue collection still exists.1 The Philippines has the second lowest tax ratio in the group, following Mexico, and the lowest among its Asian peers (Figure 5). While most Asian countries experienced a drop in tax ratios in the aftermath of the Asian crisis, the revenue decline was the steepest in the Philippines (Table 1). Moreover, the Philippines is the only Asian country in the group where revenues did not recover in the years following the crisis. The Philippines has the lowest VAT collection among its peers, though this may change with the VAT reform. Income tax collection is about average, while excises compare poorly to other countries, possibly as a result of failure to index them to inflation.

Table 1.The Philippines and Comparator Countries Tax Revenues, 1990-2003(In percent of GDP)
19931994199519961997199819992000200120022003Average
Philippines 2/15.616.016.316.917.015.614.513.713.512.512.514.9
South Africa 1/25.026.027.026.726.026.325.826.226.1
Malaysia19.420.119.619.519.816.814.214.318.818.817.618.1
Thailand 1/17.517.817.115.314.414.514.915.616.716.0
Bolivia 1/15.816.115.416.816.516.1
Colombia 2/10.810.09.710.110.810.610.611.213.311.913.711.1
Peru11.612.412.713.113.313.212.512.212.412.012.912.6
Indonesia14.415.915.014.216.015.016.313.215.0
Sri Lanka 2/17.517.217.817.016.014.515.014.514.614.015.8
Mexico11.310.710.710.811.210.210.811.710.9
Uruguay19.419.016.917.418.519.317.516.717.518.0
Unweighted average 3/14.915.015.016.116.515.815.415.216.316.417.314.5
Sources: Government Finance Statistics (IMF); International Financial Statistics (IMF); and World Economic Outlook (IMF).

General Government.

Budgetary Central Government.

For each revenue classification, only countries for which data are available are included in the calculation.

Sources: Government Finance Statistics (IMF); International Financial Statistics (IMF); and World Economic Outlook (IMF).

General Government.

Budgetary Central Government.

For each revenue classification, only countries for which data are available are included in the calculation.

Comparison with the peer group generally confirms the Philippines’ bias toward statutory outlays in expenditure composition. While the civil service wage bill appears average in the comparator group, it is the highest among the peer Asian countries (Figure 6). At the same time, capital spending in the Philippines is one of the lowest in the peer group. The Philippines has the lowest primary spending among its comparators, suggesting that the policy focus should be on improving the composition of spending, rather than on compressing it further (Table 2).

Table 2.Primary Expenditure in the Philippines and Comparator Countries, 1990-2003(In percent of GDP)
19931994199519961997199819992000200120022003Average
Philippines 2/13.813.914.415.016.115.416.115.314.915.114.114.9
Bolivia 1/24.624.322.923.325.227.727.427.129.330.729.626.5
Colombia 2/21.322.025.128.027.328.029.928.329.330.329.527.2
Malaysia19.819.619.119.618.719.320.021.126.426.026.121.4
Uruguay27.329.029.127.527.829.031.530.030.929.125.628.8
South Africa 1/25.825.124.624.023.222.622.021.221.621.923.323.2
Mexico19.820.718.118.719.518.618.319.019.320.421.119.4
Ecuador 2/22.218.419.820.619.420.519.119.920.021.620.720.2
Sri Lanka 2/21.220.623.621.319.519.518.619.919.717.216.219.8
Thailand 1/16.516.015.017.419.317.816.916.116.416.315.616.7
Indonesia13.713.111.811.515.113.713.418.015.412.814.913.9
Peru12.414.015.215.014.815.215.915.715.214.714.814.8
Unweighted average 3/20.420.320.420.620.921.121.221.522.121.921.621.1
Sources: Government Finance Statistics (IMF); International Financial Statistics (IMF); and World Economic Outlook (IMF).

General Government.

Budgetary Central Government.

For each expenditure classification, only countries for which data are available are included in the calculation.

Sources: Government Finance Statistics (IMF); International Financial Statistics (IMF); and World Economic Outlook (IMF).

General Government.

Budgetary Central Government.

For each expenditure classification, only countries for which data are available are included in the calculation.

1 Comparator group includes Bolivia (BOL), Colombia (COL), Ecuador (ECU), Indonesia (IDN), Malaysia (MYS), Mexico (MEX), Peru (PER), South Africa (ZAR), Sri Lanka (LKA), Thailand (THA), and Uruguay (URU).

Figure 5.Tax Revenues in the Philippines and Comparator Countries 1/

(In percent of GDP)

Sources: Government Finance Statistics (IMF); International Financial Statistics (IMF); and World Economic Outlook (IMF).

1/ 2003 or latest available year. Data may differ from other tables and charts presented in this paper due to the difference in sources used. VAT data for the Philippines do not include taxes collected at the border.

Figure 6.Expenditures in the Philippines and Comparator Countries 1/

(In percent of GDP)

Sources: Government Finance Statistics (IMF); International Financial Statistics (IMF); World Economic Outlook (IMF); CEIC Database; EMED Database and FAD databases (IMF)

1/ 2003 or latest available year. Data may differ from other tables and charts presented in this paper due to the difference in data sources.

22. A durable fiscal adjustment supported by high-quality measures can bring important benefits in the form of higher investment and growth. Empirical research, including recent studies by the IMF, shows that growth and unemployment respond more favorably to longer lasting, better-quality, fiscal adjustment.20 Fiscal reforms perceived as durable lend credibility to government policies and signal that the adjustment effort is sustainable, thereby boosting market confidence and increasing private investment.

23. Sustainable fiscal consolidation in the Philippines can bring a number of tangible benefits. It would create a more stable and favorable investment environment, attracting higher private capital inflows. Moreover, lower deficits would reduce risk premia and interest payments creating room in the budget for productive expenditure, including on infrastructure, while smaller statutory outlays would improve the ability of fiscal policy to react to economic cycle.

References

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9

Prepared by Daria Zakharova (dzakharova@imf.org).

10

Potential output is calculated by de-trending time-series data of real GDP, using the Hodrick-Prescott (HP) filter. Sensitivity analysis shows that the results are generally robust with respect to elasticity assumptions.

11

The formula used to calculate the CAB in year t is: CAB=Rt(Yt/pYt)αEt, where R is actual revenue; Yp is potential output; Y is actual output; α is the average elasticity of revenue with respect to Yp/Y for the period 1990–2004; and E is the actual expenditure.

12

A negative number implies a reduction in the CAB.

13

For further details on causes and consequences of procyclicality in fiscal policy see FAD 2005.

14

For the discussion of the drawbacks of the fiscal reforms undertaken in the early and mid-1990s, see Kostial and Summers (1999).

15

See also Manasan (2004) for an analysis of GOCC financial performance since the Asian crisis.

16

For more information on the causes behind the weak financial performance of NPC see Box 3 in IMF (2004).

17

Fiscal policy was on average procyclical during 1990-2004, with output gaps positively correlated with the fiscal stance in 9 out of 14 years.

18

For a description of tax incentives in the Philippines, see Chalk (2001).

19

For an analysis of revenue trends in the Philippines since the Asian crisis, see Inchauste (2002).

20

For a review of the existing literature on expansionary fiscal contractions, see Hemming et al. (2002).

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