III Public Finance: Sustainable Fiscal Adjustment
Author: Ms. Kristina Kostial and Victoria Summers
Language:
English
Keywords:
OP; Bangko Sentral ng Pilipinas; government; bank; Philippines; monetary policy; Philippine authorities; wage bill; expenditure responsibility; government financial institutions; local government unit; Business enterprises; Public sector; East Asia
Download PDF (4.4 MB)

Abstract

Since the early 1990s, there has been a significant improvement in the Philippines’ fiscal accounts. The consolidated public sector balance moved from deficits in the range of one-half of 1 percent of GNP to 2 percent of GNP at the beginning of the 1990s to a balanced position in 1996. This reflected not only a substantial reduction in the deficit of the monitored government-owned and -controlled corporations and a strong consolidation in the national government balance, but also an improvement in the position of other public sector entities. Since 1997, fiscal balances have moved back into higher deficits, as fiscal policy turned expansionary in support of domestic demand mainly by accommodating the revenue losses associated with the crisis-related slowdown of growth.

Since the early 1990s, there has been a significant improvement in the Philippines’ fiscal accounts. The consolidated public sector balance moved from deficits in the range of one-half of 1 percent of GNP to 2 percent of GNP at the beginning of the 1990s to a balanced position in 1996. This reflected not only a substantial reduction in the deficit of the monitored government-owned and -controlled corporations and a strong consolidation in the national government balance, but also an improvement in the position of other public sector entities. Since 1997, fiscal balances have moved back into higher deficits, as fiscal policy turned expansionary in support of domestic demand mainly by accommodating the revenue losses associated with the crisis-related slowdown of growth.

This section describes Philippine fiscal developments in recent years and outlines the reform agenda to ensure medium-term fiscal sustainability. It describes the evolution of the tax system and changes in the level and composition of government expenditures; and developments in public sector entities outside of the national government. It then analyzes the response of fiscal policy to the challenges posed by the Asian crisis, and evaluates the sustainability of Philippine fiscal policy. The last part presents the remaining reform agenda.

The performance of fiscal policy can be assessed along many interrelated dimensions. Tanzi, Chu, and Gupta (1999) provide general considerations that should guide such an evaluation:

  • Quality of the tax system. Does fiscal policy rest on a fair, efficient, and transparent system of taxation (ideally, a system of easily administered taxes, moderate tax rates, and a minimum number of exemptions)?

  • Level and composition of public expenditures. Are the aggregate level of expenditures and the composition of expenditures appropriate to the governments objectives with respect to growth and equity?1 How well has policy been geared toward curtailment of unproductive public expenditures?

  • Fiscal stance. How well has fiscal policy responded to changing economic circumstances, in particular to the sharp changes as a result of the Asian crisis?

  • Fiscal sustainability. Could current fiscal policies be maintained into the (indefinite) future without leading the government into insolvency?

Applying these considerations to the conduct of Philippine fiscal policy, the main conclusions of the section are the following:

  • Tax policy. Major lax reforms since 1986 have been beneficial in increasing the progressivity of taxes, lessening distortions, and simplifying the tax system. However, tax incentives continue to erode the tax base and administration remains weak, resulting in an inadequate revenue yield and weak buoyancy (positive cyclical response) of the tax system.

  • Expenditure policy. Continued weaknesses in the tax effort and substantial debt service payments have constrained policy choices, particularly by limiting much-needed outlays for infrastructure and social sectors (health and education). Some unproductive expenditures have been scaled down (for example, military expenditures), but others have not, including the cost of an overstaffed civil service and an inefficient intergovernmental transfer system.

  • Fiscal stance. Policymakers responded appropriately to the regional financial crisis by allowing fiscal deficits to widen in line with the slowing economy. However, faster progress with tax administration reform may have prevented the need for expenditure cuts in 1998. and allowed the provision of a larger expenditure stimulus.

  • Fiscal sustainability. Indicators of sustainability have improved considerably in recent years. Nevertheless, a review of prospective fiscal developments suggests that the fiscal situation remains vulnerable. Strong economic growth and continued progress in key fiscal reform areas are needed to keep government on a debt sustainable path over the medium-term.

Fiscal Developments During the 1990s

The consolidated public sector deficit declined sharply during 1990–96 (Figure 3.1). Although some of this improvement was due to nonrecurrent elements such as receipts from the privatization of government assets, the underlying consolidated public sector deficit (which excludes privatization receipts) also improved substantially. Three-fifths of the improvement in the underlying consolidated public sector deficit occurred in 1991. Since then, improvement has been less rapid, and has resulted largely from favorable interest rate developments and from lower expenditure rather than strengthened revenue effort. Fiscal deficits widened in 1997–98, mainly as a result of the slowdown in economic activity associated with the Asian crisis (Tables 3.1-3.8).

Figure 3.1.
Figure 3.1.

Public Sector Balance and National Government Balance

(In percent of GNP)

Sources: Philippine authorities; and IMF staff estimates.
Table 3.1.

Consolidated Public Sector Balance

article image
Sources: Data provided by the Philippine authorities: and IMF staff estimates.

For 1998, includes outlays for an infrastructure project of the National Power Corporation, which is not shown In Table 3.7.

Table 3.2.

Operations of the National Government

(In billions of pesos)

article image
Sources: Data provided by the Philippine authorities; and IMF staff estimates.

Including domestic VAT.

Including VAT on imports.

Including travel tax.

Including transfer to the Oil Price Stabilization Fund and tax expenditures.

Table 3.3.

National Government Revenues and Grants

article image
Source; Data provided by the Philippine authorities.

Data on the components of excise duties are based on Bureau of Internal Revenue collections, which differ slightly from the records of the Treasury.

Foreign exchange tax and travel tax.

Including property taxes.

Including grants and Economic Support Fund and central bank restructuring.

Table 3.4.

National Government Expenditures and Net Lending

article image
Source: Data provided by the Philippine authorities.

Including Comprehensive Agriculture Reform Program land and acquisition and credit.

Table 3.5.

Operations of Social Security Institutions 1

(in billions of pesos)

article image
Source: Data provided by the Philippine authorities.

Social Security System and Government Service Insurance System, including Philippine Health Insurance Corporation starting in 1997.

By employees and employers.

National government’s contribution as employer, to the Government Service Insurance System,

Table 3.6.

Local Government’s Budgetary Operations

(In billions of pesos)

article image
Source: Data provided by the Philippine authorities

Preliminary actual.

Table 3.7.

Statement of Financial Operations of Major Monitored Public Corporations 1

(In billions of pesos)

article image
Source: Data provided by the Philippine authorities.

The Metro Manila Transit Corporation is included until its privatization in 1994.

Taken from corporations’ accounts; may differ from national government accounts.

Table 3.8.

Functional Classification of National Government Expenditures 1

article image
Source: Dm provided by the Philippine authorities.

Net of interest payments and net lending.

Derived by applying functional classification of obligation expenditures to cash disbursement.

The improvement in the consolidated public sector deficit has to a large extent been driven by improvements in the balance of the national government, which went from a large deficit to an almost balanced position in 1996 and 1997. Supported by strong gains in revenues at the beginning of the 1990s, the national government deficit narrowed from about 2 percent of GNP in 1991 to 0.3 percent of GNP and 0.1 percent of GNP in 1996 and 1997, respectively, while the expenditure ratio remained roughly the same. Since then, the national government deficit has widened due to the adverse impact of the Asian crisis mainly on the revenue side. An increase in tax revenues between 1991 and 1998 was more than offset by declines in nontax revenues (excluding privatization). At the same time, noninterest current expenditure increased by about 1.5 percent of GNP, due to a sharp increase in the wage bill and transfers to local government units. In contrast, operation and maintenance outlays and capital expenditures were compressed in an effort to limit the overall deficit.

Other public sector entities also improved their financial position in the 1990s, with aggregate deficits declining to below I percent of GNP since 1995. An important element in this regard was the decision of the government in 1996 to discontinue its intervention in the petroleum market via the Oil Price Stabilization Fund. However, in recent years, growing surpluses of the social security institutions, local government units, and government financial institutions have masked a deteriorating position of government-owned and -controlled corporations, in particular, the National Power Corporation.

Reflecting these developments, the public debt-to-GNP ratio declined until 1997, but has picked up since then. Total gross liabilities of the public sector,2 as a ratio to GNP. fell from about 110 percent in 1990 to about 90 percent in 1997. but increased to more than 100 percent in 1998. For the national government, the debt-to-GNP ratio fell from 70 percent in 1990 to 51 percent in 1996. before rising to about 60 percent in 1998. As a result of the still high level of outstanding debt, interest still constitutes a significant share of national government expenditure.

Despite the reforms of the 1990s, particularly tax reforms, a number of public sector issues remain to be addressed. In the national government budget, a stronger revenue effort is needed by improving tax administration and curbing fiscal incentives. On the expenditure side, the rapidly rising wage bill and allotments to local government units will need to be contained through civil service reform and a restructuring of intergovernmental fiscal relations. Outside the national government, the most pressing issue is the restructuring and privatization of the National Power Corporation.

Trends in National Government Revenues and Expenditures During the 1990s

There has been substantial consolidation in the national government fiscal accounts in the early 1990s, although part of it was reversed over the past two years. The main issues in the national government budget are weak tax administration, the wide range of tax incentives, intergovernmental fiscal relations, and civil service reform.

Revenues

Historically, tax collection in the Philippines has failed to harness its full potential. Although the revenue effort has been similar to that in Indonesia and Thailand, it has been lower than in Korea and Malaysia (Table 3.9). As discussed below, revenue generation has suffered from weak tax administration and the provision of Fiscal incentives. Because of low collections from direct taxes (mostly caused by under-performance of the enterprise profit tax due to the extensive use of tax holidays), the Philippines has had to rely more on indirect taxes, particularly import duties.

Table 3.9.

Revenue Generation and Structure in the Asian-5

(In percent of GDP, 1990–96 average)

article image
Source: International Monetary Fund. Government finance Statistics Yearbook.

Philippine revenue policy has aimed at reducing the reliance on international trade taxes while bolstering domestic tax revenue. Mainly because of reductions in the effective import tariff, revenue of the Bureau of Customs has fallen from more than 5 percent of GNP in the early 1990s to 4 percent of GNP in 1997, and 3 percent of GNP in 1998. At the same time, major tax reforms have yielded an increase in the domestic tax collections by 3 percent of GNP over 1991–98.

Since 1986, tax reform has been an ongoing concern (Appendix 3.1 describes the tax system in the Philippines). The two major phases of tax reforms have been the 1986 tax reform package and a comprehensive set of reforms started in 1994 (including the Comprehensive Tax Reform Package of 1996–97). The 1986 reforms included changes in the individual and corporate income tax, the adoption of a VAT, and abolition of most export duties. Starting in 1994, the government embarked on a comprehensive set of reforms that included expansion of the VAT, rationalization of excise and oil product taxes, and major amendments to income tax legislation (Box 3.1.).

While these reforms have produced a more structurally sound tax system, the improvement in collections intended under the Comprehensive Tax Reform Package has not materialized to the extent expected. In particular, the VAT expansion has failed to yield the envisaged revenue gains, with the ratio of domestically collected VAT to GNP falling from 2.1 percent of GNP in 1994 to 1.7 percent of GNP in 1998. While part of this can be attributed to the recent slowdown in economic activity, it is likely that weak administration and failure to rein in tax incentives have also contributed.3

Rationalization of tax incentives is an important unfinished item of the reform agenda (Box 3.2). Despite the government’s original plans, the final Comprehensive Tax Reform Package legislation did not address the tax incentives problem. Key areas for reform include abolishing tax holidays, rationalizing the granting of incentives under the Investment Priorities Plan, limiting the use of tax credits (which are vulnerable to fraud), and reducing the number of specific laws that render tax administration difficult. Rationalization of incentives and phasing out of tax holidays could result in a substantial, but unquantifiable gain in revenues.4

Improving tax administration is also critical. In recent years, both the Bureau of Customs and the Bureau of Internal Revenue have made progress in modernizing their operational procedures—building new computer and information systems and restructuring their organizations. While customs administration improved notably, the Bureau of Internal Revenue remains plagued by major deficiencies, including corruption, lack of large taxpayer control, inadequate audit programs, and weak enforcement. The Bureau of Internal Revenue is currently in the process of reassessing its reform strategy.

Expenditures

In addition to the weak revenue effort, sizable interest and wage bills have constrained the Philippines’ room for maneuver on the expenditure side (Table 3.10). As a result, capital outlays in the Philippines have been substantially lower than in most other Asian countries. The broad composition of national government expenditures has remained unchanged in the 1990s, with current expenditures of about 16 percent of GNP, and capital expenditures of about 3 percent of GNP. While expenditures show hardly any cyclical response, the composition of current spending has changed markedly in recent years as lower outlays on interest, operations and maintenance, and subsidies were offset by higher allotments to local government units and a ballooning wage bill. The temporary hike in the interest bill in 1998 owing to the regional crisis was countered by restraints in capital outlays.

Table 3.10.

Expenditure Structure in the Asian-5

(In percent of GDP, 1990–96 average)

article image
Source: International Monetary Fund. Government Finance Statistics Yearbook.

Transfers to local government units have become a rapidly growing burden on the national government budget. The 1991 Local Government Code, which restructured intergovernmental finances (see below), requires the national government to transfer a specific proportion of domestic tax revenue to local government units.5 Due to its design, transfers to local government units tripled to almost 3 percent of GNP in 1998, and are expected to increase further in the coming years.

While civil service reform has been on the agenda for over a decade, actual progress has been slow. A program to “streamline the bureaucracy” was launched in 1994 to rationalize the compensation structure for the civil service while reducing personnel, so as to maintain the overall wage bill at the 1995 level of 5.6 percent of GNP. While substantial wage increases have been granted to all employees, the size of the civil service has not been sufficiently reduced nor have the wages of senior officials been increased adequately. As a result, the national government wage bill has increased by almost 2 percent of GNP since 1994 to 7.1 percent of GNP in 1998 (Figure 3.2).6

Figure 3.2.
Figure 3.2.

National Government Wage Bill and Public Sector Employment

Sources: Philippine Civil Service Commission; and IMF staff estimates.

Capital spending in the 1990s has been insufficient to greatly reduce the backlog of decades of underinvestment in infrastructure. Despite a relatively high road intensity compared with other East Asian countries, road standards and maintenance are inadequate, and only 20 percent of the road network is paved. Also ports and the rail system suffer from lack of maintenance, and supply of clean and safe water for urban as well as rural residents is insufficient. While the government has tried to encourage private sector participation through build-operate transfer arrangements, private sector involvement in infrastructure has been limited.

Accommodated by a reduction in the interest bill, national government expenditure has been reallocated toward social and general public services (Figure 3.3).7 However, this development reflects mainly an increase in the wage bill (as discussed above), and has not led to an improvement in the provision of basic education and health care services, as discussed in Section VII.

Figure 3.3.
Figure 3.3.

National Government Expenditure in a Functional Breakdown

(In percent of GNP)

Sources: Philippine authorities; and IMF staff estimates.

Military spending in the Philippines has been low during the 1990s, but could rise substantially in the future (Box 3.3).

Tax Reforms Since 1994

In 1994, the government launched a reform program designed to correct the long-standing problem of low tax collection by expanding the tax base. Much of this ambitious program has been realized with the important exception of tax incentive rationalization. However, despite intentions to raise the tax revenue ratio, particularly for consumption taxes, the reform has turned out broadly revenue neutral.

  • The first phase of the program was a reform of the VAT system, bringing a significant number of services, previously not taxed, into the system. This law was passed in 1994, though its implementation was delayed until 1996 as a result of a legal challenge to its constitutionality.1 The effect on revenue has been disappointing as the collection of VAT on domestic consumption fell from 2.1 percent of GNP in 1994 to 1.7 percent of GNP in 1998.

  • The second phase of the reform, referred to as the Comprehensive Tax Reform Package, covered income and excise taxes, rationalization of tax incentives, and statutory changes to tax administration.

Excise tax reform was enacted effective at the end of 1996. This legislation rationalized excise taxation on alcohol and tobacco products, in part by levying specific rather than ad valorem taxes to reduce tax evasion. As a result, excise lax revenue jumped by one-half of I percent of GNP to 2.5 percent of GNP in 1997; however, with the adverse effect of the Asian crisis on the sale of gasoline, excise tax revenue fell to 2.2 percent of GNP in 1998.

Also during 1996, oil product taxation was rationalized, with a substantial reduction in import tariffs, which was partly offset by the introduction of petroleum excises.

Income lax reform was passed in December 1997. Ultimately, the net revenue gain from the overall income tax package in the form enacted was small.

Major amendments to the individual income tax included changes in the rate structure, bringing the top marginal rate into line with the corporate tax rate (currently at 33 percent, but scheduled to be reduced to 32 percent in 2000 and thereafter), and increases in the level of personal exemptions, (The provisions of the individual tax reform, while structurally sound, were anticipated to result in a revenue reduction of approximately £8 billion annually; however, a wage increase offset this revenue loss such that revenues from the individual income tax increased slightly). The package included the reimposition through final withholding at a 6 percent rate, increasing to 10 percent by 2000.

Important structural improvements were made to the corporate income tax, including most notably a gradual rate reduction to 32 percent in 2000: the enactment of a fringe benefits tax: adoption of a net operating loss carry forward; disallowance of tax benefits of interest arbitrage; taxation of interest paid to residents from foreign currency deposit accounts; and the adoption of a corporate alternative minimum tax (although not in the preferred form of a tax on net assets, as originally proposed by the government, but rather as a tax on gross receipts less cost of goods sold).

The Comprehensive Tax Reform Package also included various provisions designed to increase administrative efficiency and reduce the scope for fraud and abuse.

1Notably, the expanded VAT included within its base value added in financial intermediation services. Such services are universally exempt in existing VAT systems because of measurement difficulties in the credit/invoice VAT. The implementation of this portion of the expanded VAT has been repeatedly postponed und has not yet come into effect.

Other Public Sector Entities

After large deficits in the 1980s, the fiscal position of other public sector entities improved substantially in the 1990s. Besides the national government, the consolidated public sector encompasses the following entities:

  • Local government units;8

  • Government-owned and -controlled corporations;

  • Oil Price Stabilization Fund—abolished in 1996;

  • Central Bank-Board of Liquidators:

  • The old Central Bank of the Philippines, replaced in 1993 by the Bangko Sentral ng Pilipinas;

  • Social security institutions; and

  • Government financial institutions.

Their consolidated balance (excluding the national government) has been in the range of small surpluses (in 1991 and 1996) and deficits below 1.5 percent of GNP. Future reform efforts need to focus on intergovernmental fiscal relationships and the financial position of government-owned and -controlled corporations, in particular the National Power Corporation.

Local Government Units

The 1991 Local Government Code reformed the governance structure in the Philippines by transferring more powers to local government units. Along with this reform, many former national government expenditure responsibilities (in the areas of agriculture, environment and natural resources, health, infrastructure and maintenance, and social welfare) were devolved to local government units, which have become the main provider of the social safety net. To finance the increased local government unit spending, the code has guaranteed transfers from the national government and granted fiscal autonomy to local government units, including local taxing powers and the right to borrow.

Tax Incentives

Philippine law includes a vast array of investment tax incentives of all types, granted by the Board of Investment, special economic zones, the Philippine Economic Zone Authority, and specific laws. Tentative estimates of the revenue loss due to these incentives point to an order of magnitude of at least 1 percent of GNP.

Board of Investment

As originally enacted in 1987, the Omnibus Investments Code provides a number of tax incentives for Board of Investment registered enterprises, including income tax holidays, customs duties exemptions, and export tax credits. Board of Investment registration may be given to firms in export-oriented industries, “catalytic industries” (that is, certain sectors of manufacture and agriculture/forestry), industries undergoing adjustment (for example, textiles), support activities (that is, infrastructure, telecommunications, transportation), and “mandatory inclusions” (for example, minerals, iron, and steel). The scope is broad—it is estimated that approximately one-third of all imports of capital equipment is by Board of Investment registered enterprises.

Investment priorities plan. Under the Omnibus Investment Code of 1987, an annual plan must be drawn up by the Board of Investment and approved by the president. This plan covers priority areas that receive tax and other incentives, and is viewed as a prime vehicle of industrial policy.

Income tax holidays. Board of Investment registered firms are eligible for income tax holidays lasting up to eight years. If tax holidays were to be abolished, this would most likely apply only to newly registered firms, as contracts with already registered firms would need to be grandfathered.

Tax credits. These are benefits designed to offset the adverse incentives of Board of investment duly exemptions for using imported capital equipment rather than domestically manufactured equipment. Board of In vestment enterprises are entitled to credits in the amount of the differential between the 3 percent minimum tariff (or the rate of zero, whichever applies) and the standard tariff rate that would have applied to domestic capital, which they purchase, had it been imported.

Special Economic Zones and Philippine Economic Zone Authority

Enterprises located in the former Clark and Subic bases (the “special economic zones”) are entitled to similar tax holidays and duty exemptions as those for the Board of Investment firms, but on a permanent basis. In addition, there are extremely broad provisions for retail duty-free shopping in these zones, extending not only to international travelers upon their return or departure from the Philippines, but to residents of the zones and even residents near the zones. The Philippine Economic Zone Authority (one of the monitored government-owned and -controlled corporations) administers numerous export processing zones that grant tax benefits to eligible firms; these zones have been multiplying rapidly.

Other Laws

Export Development Act of 1994. The Export Development Act allows for various incentives to encourage the growth of export industries.

Agriculture and Fisheries Modernization Act of 1997. This bill exempts from customs duty all imports (not just for capital) used for agriculture; implementing rules and regulations still need to be adopted, but—if interpreted liberally—the implementation of this bill could result in a revenue loss of up to 0.8 percent of GNP.

In addition to the above laws, there exist a plethora of special laws for certain industries (for example, the Iron and Steel Industry Act and Mining Act), many of which fall under the supervision of the Department of Trade and Industry.

Decentralization has more than doubled the size of local government unit budgets. Substantial transfers from the national government, but also improved internal revenue generation, have enabled local government units to increase their expenditures from 1.5 percent of GNP in 1990 to almost 4 percent of GNP in 1998, while running small surpluses in the range of 0.1–0.4 percent of GNP (Figure 3.4).

Figure 3.4.
Figure 3.4.

Local Government Units

(In percent of GNP)

Sources: Philippine authorities; and IMF staff estimates.

However, implementation of the Local Government Code has revealed some structural weaknesses.

  • While the code has empowered local government units with many new responsibilities, it has left the existing administrative structures largely intact. As a result, many local government units are not equipped with the necessary organization and implementation capacity to discharge the mandate they received. At the same time, transparency and monitoring of local government units is weak as there are no unified accounting and reporting rules.

  • The transfer arrangements are not providing incentives to local government units to increase their tax effort and have created an overdependence of some local government units on the allotments from the national government (some provinces and municipalities now get more than 95 percent of their income from the national government allotment). Also, local government unit revenue collection appears to be inefficient, with the costs of tax collections estimated to range from 30 percent of revenue collected to more than 100 percent.

  • Coordination between different levels of government is deficient, and some expenditure responsibilities have not yet been completely devolved, resulting in duplication or inadequate delivery of services. This shortcoming has been exacerbated by the distribution formula, which does not ensure a minimum quality of goods and services provided by local government units.9

  • While only few local government units have tapped capital markets so far, there is a risk of moral hazard from implicit guarantees from the national government.10

Government-Owned and -Controlled Corporations 11

After a short period of consolidation through the mid-1990s, government-owned and -controlled corporation balances have deteriorated in recent years. Privatization in 1994 and 1995 reduced the size of the government-owned and -controlled corporation sector by roughly 30 percent. Since then, a rise in current spending of the remaining government-owned and -controlled corporations has led to a gradual increase in the consolidated government-owned and -controlled corporations’ deficit (Figure 3.5), Principally responsible for this deterioration have been the National Power Corporation and the National Food Authority.

Figure 3.5.
Figure 3.5.

Government-Owned and -Controlled Corporations

(In percent of GNP)

Sources: Philippine authorities; and IMF staff estimates.

After major progress in the mid-1990s, privatization has leveled off in recent years. In 1986, the Committee on Privatization (to oversee the privatization program) and the Asset Privatization Trust (to deal with the marketing aspect of privatization) were created. After a slow start, the privatization process gained strong momentum in the mid-1990s with the sale of Petron and the National Steel Company. In light of the slow pace of privatization in recent years, the mandate of the privatization agencies has been extended until December 1999.

Military Expenditures: Developments in the 1990s and Outlook

Military spending in the 1990s has been below the Asian average. Direct military spending has been cut by one-half in 1990–98 to about 1 percent of GNP in 1998, while military spending including outlays for health, education, social security, and housing has been about 1.5 percent of GNP.1 Currently, about 70 percent of the Department of National Defense’s budget is allocated to cover salaries, contributions to a pension fund, as well as direct pension benefits. While roughly 20 percent of the budget is used for operation and maintenance, capital outlays amount only to about 10 percent.

Military spending may increase substantially in the future. The implementation of the Armed Forces of the Philippines Modernization Act (enacted in 1995) will boost military spending as it appropriated an amount of £165 billion for the modernization of the Armed Forces of the Philippines over 15 years. The Armed Forces of the Philippines modernization will be financed through an extrabudgetary fund, which has been endowed with £30 billion from privatization receipts, but has not yet become operational.

Military Spending

(In percent of GDP)

article image
Sources: international Monetary Fund World Economic Outlook; and Philippine authorities.
1Data from other sources (U.S. Arms Control and Disarmament Agency, Stockholm international Peace Research Institute, and Institute for International Strategic Studies) indicate that military spending was in the range of 1.4–2.8 percent of GDP for 1992–96. The variance can be explained by different definitions employed to measure military spending. However, most sources report a declining trend in military spending.

Since the power crisis of the early 1990s, the National Power Corporation has been incurring sizable deficits. The National Power Corporation entered the 1990s in a fragile position as it had financed its 1980 expansions by extensive external borrowings (Box 3.4.). its position was further weakened by the power crisis at the beginning of the 1990s, Part of the government’s response involved the signing of contracts with Independent Power Producers that locked the National Power Corporation into power purchases on relatively expensive terms for the next decades. Bolstered by fast growing sales, the National Power Corporation’s position improved temporarily in the mid-1990s, but it has deteriorated sharply in recent years, reflecting depressed power sales as a result of the economic slowdown and delays in the implementation of tariff increases. Plans for reform of the power sector and privatization of the National Power Corporation have been held up by delays in passing enabling legislation (the Omnibus Electricity Bill).

The National Food Authority’s financial position has been somewhat volatile due to its principal mandate to stabilize the domestic market for rice.12 The National Food Authority was created 27 years ago, with a temporary mandate, until the agricultural sector develops sufficiently. To date, it continues to handle procurement, marketing, and distribution of grains, and its interventions have been costly at times. In addition to its regulatory and supervisory function, the National Food Authority is involved in providing a limited social safety net to the poorest 10percent of the population in some regions (by distributing vouchers to poor families, with the help of nongovernmental organizations, for buying fortified rice at a subsidized price). With support from the Asian Development Bank, the government intends to liberalize the grain market in the near future.

Oil Price Stabilization Fund

The government ceased to intervene in the oil market by deregulating the sector in 1996 and subsequently abolishing the Oil Price Stabilization Fund. The Oil Price Stabilization Fund was set up in 1984 to shield consumers from fluctuations in world oil prices and the exchange rate, but delays in price increases led to the accumulation of large deficits in the Oil Price Stabilization Fund. Since deregulation (completed in early 1998), prices for petroleum products are allowed to move freely, and the Oil Price Stabilization Fund has discontinued its operations.

The Central Bank

With the liquidation of the old central bank, a new central bank—Bangko Sentral ng Pilipinas—and a fund to liquidate the old central bank’s debt (Central Bank-Board of Liquidators) were created in 1993. The old central bank had been running deficits in the range of 1–2 percent of GNP. The Central Bank Board of Liquidators assumed the (entirely external) debt of the old central bank and—to service the principal and interest on its liabilities—was endowed with government securities for £220 billion and mandated to receive a certain share of Bangko Sentral ng Pilipinas’ profits. In 1994–98, the Central Bank-Board of Liquidators has had annual deficits of about 1 percent of GNP, and the Bangko Sentral ng Pilipinas has achieved moderate profits in most years.

Electricity Sector and National Power Corporation

The National Power Corporation is the largest government-owned and -controlled corporation in the Philippines, it is the only seller of electricity in the wholesale market and has a monopoly in transmission. Distribution is handled by the private sector.

Background

  • During the 1980s, the National Power Corporation’s substantial expansion was covered almost exclusively by external borrowings guaranteed by the national government (in part because electricity tariffs were not adjusted in a timely manner).

  • At the beginning of the 1990s, the Philippines faced severe shortages of electricity, brought on by neglect of maintenance and inadequate capital investment in the late 1980s. The power crisis was alleviated by large and expensive emergency investment projects in new capacity, financed by external borrowing (and some build-operate-transfer arrangements). In addition, the National Power Corporation signed contracts with Independent Power Producers, which locked the National Power Corporation into expensive power purchase agreements for the next several decades.

Main Problems in the 1990s

  • The National Power Corporation’s debt-to-equity ratio increased from 1.6 in 1993 to 4.2 in 1997, reflecting high operating expenses, increased financing charges, and currency depreciation,

  • The arrangements with Independent Power Producers are lucrative to the Independent Power Producers

  • and expensive for the National Power Corporation. For example, in the wake of the Asian crisis, power sales were depressed, but since the National Power Corporation has minimum off-take agreements with Independent Power Producers, it has had to buy power for which demand did not exist. The National Power Corporation’s room for increasing its tariffs is limited, as Philippine end-user tariffs are the highest in Asia outside Japan, reflecting not only the National Power Corporation’s costs, but also inefficiencies in the distribution sector that are mainly handled by rural electric cooperatives.1

Reforms

Plans for reform of the power sector and privatization of the National Power Corporation hinge on passage of the reform program of the Omnibus Power Restructuring Bill currently before congress. Under the reform program, the National Power Corporation’s monopoly in power generation would cease. The generating assets would be grouped into several generating companies that would be privatized, and power generation would be private sector-dominated. Open access transmission and distribution systems would be established to support competitive markets in electricity.

1While East Asian countries’ distribution losses were about 13 percent in 1992–95. Philippines’ distribution losses were higher by 3 percent. Moreover, the average collection efficiency of the distribution sector is only about 90 percent.

Social Security Institutions

Reflecting sizable increases in their membership while the number of beneficiaries has been lagging, the social security institutions have been running substantial surpluses.13 With the exception of 1994, when the social security institutions invested in shares of Meralco (the Manila Electric Company), the aggregated balance of the social security institutions has been in surplus. After a decline in the surplus in the mid-1990s owing to an increase in benefits, the surplus increased in 1998, reflecting, inter alia, an increase in membership and contribution rates.

However, the financial viability of the social security institutions system is a matter of concern at present levels of benefits and returns. The social security institutions’ capacity to pay may be undermined by sizable lending at below-market interest rates to their members and the government and in-house management that is not independent from political interference. This could result in a cut in future pension benefits or the need to raise membership contributions.

Government Financial Institutions

After taking action to improve their lending practices and financial controls in the 1980s, the government financial institutions have been producing profits. The government financial institutions comprise the Development Bank of the Philippines, Phii Guarantee (recently renamed TIDCORP), and the Land Bank. The aggregated balance of the government financial institutions has been in surplus, hovering about 0.3 percent of GNP in the 1990s. The Development Bank of the Philippines is slated for privatization.

Fiscal Response to the Asian Crisis, 1997–99

The overall fiscal response to the Asian crisis was broadly appropriate, although better tax administration might have prevented the need for expenditure cuts. With monetary policy geared toward stabilizing the peso, fiscal policy took up the task of supporting domestic demand (Box 3.5.). The extent of fiscal relaxation reflected the more modest economic slowdown compared with other crisis countries, as well as constraints imposed by the high level of public debt, and concerns over adverse market reaction to a higher deficit. In implementing fiscal policy, better tax collection would have helped shield critical expenditures from cuts, particularly on social priorities and infrastructure.

To examine further the policy response to the crisis, fiscal developments in 1997-98 are decomposed into those caused by economic elements and policy elements, respectively. The analysis decomposes changes in the fiscal balances into:

  • endogenous changes owing to economic elements, which are further broken down into three main components: growth and imports, exchange rate, and interest rate;

  • changes induced by policy measures, defined to include both active and passive discretionary policy measures;14 and

  • residual changes that cannot be accounted for by either of these elements.

The decomposition highlights the following developments (Table 3.11).

  • In 1997, the fiscal deficit widened slightly relative to the previous year, although economic elements worked in the direction of shrinking the deficit.

    Among the economic elements, a lower domestic interest bill was the dominant influence on the fiscal outcome.

    The major policy measures in 1997 were a substantial increase in the wage bill (by 0.9 percent of GNP) and somewhat higher capital expenditure, partly offset by the elimination of the transfer to the Oil Price Stabilization Fund.

  • In 1998, the fiscal deficit widened further by almost 2 percentage points of GNP (relative to 1997), with the widening of the deficit owing to changes in economic elements partially contained by policy measures.

Table 3.11.

Changes in National Government Fiscal Balances

(Relative to previous pear; in percent of GNP)

article image
Sources: Data provided by the Philippine authorities; and IMF staff estimates.

Including changes to maintain a constant expenditure/GNP ratio.

includes change in the effectiveness of tax administration and Central Bank-Board of Liquidators’ operations.

Three economic ingredients (income growth, interest rates, and change in the mix of dutiable imports) contributed to a widening of the fiscal balance. The predominant ingredient was the slowdown in growth and the change in the mix of imports, which affected tax revenues by more than 1.5 percent of GNP.

The policy measures were almost entirely on the expenditure side, as outlays were compressed to contain the effect of economic ingredients on the fiscal balance.

Fiscal Sustainability and Medium-Term Outlook

As a minimum policy requirement, fiscal policy should not lead to a situation in which the public debt-to-GNP ratio is increasing continuously. Historical data can be analyzed to determine whether Philippine fiscal policies so far have been sustainable. A medium-term projection can be used to take into account prospective developments that could have a significant bearing on the future sustainability of fiscal policies.

Although there are risks to fiscal sustainability, historical indicators and the medium-term outlook both suggest “sustainable” public debt dynamics. Historical indicators point to a substantial improvement in the national government position.15 While some developments pose a threat to fiscal sustainability (for example, the system of intergovernmental fiscal finances and the recent increase in the wage bill), the medium-term fiscal outlook appears sustainable provided the government follows through with reforms.

Key indicators of sustainability—fiscal balances and debt-to-GNP ratios—have improved in recent years. However, with a shift to more expansionary fiscal policies in response to the Asian crisis, there has been some deterioration in 1998.

  • Overall balances. The reduction in the consolidated public sector deficit as well as in the national government budget deficit in the 1990s have resulted in an improvement in fiscal sustainability during the 1990s (see section on fiscal developments). In response to the Asian crisis, however, both the national government as well as the consolidated balance deteriorated significantly.

  • Sustainable primary deficit. The national government budget has registered primary surpluses throughout the 1990s. Moreover, after a period of unsustainable fiscal policies at the time of the debt crisis in the 1980s, the national government’s primary balance has been more contractionary than a “sustainable primary balance,” with the exception of the crisis year 1998. In Figure 3.6, fiscal sustainability fs is measured by comparing the actual primary deficit pds 16

Figure 3.6.
Figure 3.6.

Sustainability of National Government Primary Balances

(In percent of GNP)

Sources: Philippine authorities; and IMF staff estimates.Note: Negative indicates sustainable policies; positive indicates unsustainable policies.1 Sharp peaks in 1985 and 1998 reflect substantial increases in the debt stock.
f⁢s=p⁢da−p⁢ds=p⁢da−(g−r)⁢d⁢ -(g−r*−c)⁢d*,(1)

where g is real domestic growth, r real domestic and foreign interest rates, c the rate of real exchange rate depreciation, and d the domestic and foreign debt ratios to GNP.17 A positive sign indicates that the primary deficit exceeds the sustainable level, resulting in an increase in the debt-to-GNP ratio, while a negative sign implies a decline in the ratio.18

Fiscal Stance, 1997–99

Following several years of fiscal consolidation, 1997–98 witnessed a shift to a more expansionary fiscal policy.

  • Although the fiscal program for 1997 had envisaged a further deficit reduction, a sizable revenue shortfall resulted in a widening of the deficit, implying a fiscal stimulus of 0.6 percent of GNP. The revenue shortfall reflected mainly administrative slippages in revenue collection, as economic growth was not seriously affected by the regional crisis until 1998; delays in implementing the Comprehensive Tax Reform Package also played a role.

  • While the initial program for 1998 aimed at returning gradually to the earlier consolidation path by reversing the policy slippages in 1997, it was modified to accommodate a significant increase in the fiscal deficit to take into account the effects of lower growth and somewhat higher social spending. As a result, fiscal policy imparted a stimulus of 1.2 percent of GNP, reflecting a sharp fall in revenues that was only partly offset by expenditure restraint.

The original program for 1999 had foreseen a return to fiscal consolidation assuming the recovery was well established by then. As prospects for recovery remained uncertain, however, the government decided not to withdraw fiscal stimulus, while medium-term considerations prevented provision of additional stimulus. Thus, the fiscal program was revised to keep a broadly unchanged fiscal stance, with a further fall in revenue offset by expenditure savings.

Fiscal Balances

(In percent of GNP)

article image
Sources: Philippine authorities: and IMF staff estimates.Note: A caveat needs to be added to this kind of analysis. The analysis is based on the assumption of recurrent cycles around potential output, contrasting the actual fiscal balance with a measure of the cyclically adjusted balance or neutral balance. However, when there are large adjustments including possibly persistent changes in economic conditions (for example, in the exchange rate) and structural changes in the economy, the assumption of a recovery back toward the original equilibrium may be less valid.

Consolidated public sector minus privatization receipts of the national government and government-owned and -controlled corporations.

includes the net deficit of the Central Bank Board of Liquidators and excludes privatization receipts.

The primary balance is defined as the national government balance excluding interest payments.

Describes a fiscal policy that is neither procyclical nor countercyclical (neutral revenue is defined as the revenue ratio in the base year 1991. when actual output is assumed to have been equal to potential, multiplied by actual GNP; neutral expenditure is the expenditure ratio in the base year, multiplied by potential GNP in the current year).

Defined as the difference between the actual and the neutral fiscal balance. A positive fiscal stance represents an expansionary fiscal policy relative to the base year, while a negative fiscal stance represents a contractionary fiscal policy relative to the base year.

Defined as the change in the fiscal stance between succeeding years. Positive fiscal impulse stems either from a revenue impulse, a situation in which actual revenues grow more slowly than neutral revenues, or one in which actual expenditures grow more rapidly than neutral expenditures, or both.