Philippines: Report for the July 2004 Post-Program Monitoring Discussions
Author: International Monetary Fund
Publication Date:
03 Oct 2004
eISBN:
9781451831320
Language:
English
Keywords:
ISCR; CR; government; policy; rate; authorities definition; economy; government balance; Philippine authorities; tariff hike; long-term debt; short-term debt; Global
Download PDF (569.4 KB)

This paper focuses on 2004 Post Program Monitoring Discussions for the Philippines. The authorities are formulating a significant package of tax measures. IMF staff argued that the bulk of the additional revenues should be saved, thereby front-loading the medium-term deficit reduction effort. Such a strategy would boost market confidence and exploit the likely greater potential to enact tax measures at the beginning of the new administration’s term. The authorities are now also considering the power sector reforms.

Abstract

This paper focuses on 2004 Post Program Monitoring Discussions for the Philippines. The authorities are formulating a significant package of tax measures. IMF staff argued that the bulk of the additional revenues should be saved, thereby front-loading the medium-term deficit reduction effort. Such a strategy would boost market confidence and exploit the likely greater potential to enact tax measures at the beginning of the new administration’s term. The authorities are now also considering the power sector reforms.

I. Introduction

1. President Arroyo has won the election and a new six-year term. Final results of the May 10 election showed President Arroyo with 40 percent of the votes, a three point margin over the runner-up. Her coalition also secured the Vice Presidential post and won majorities in both houses of Congress. President Arroyo announced a 10-point agenda in her inaugural speech which included various anti-poverty initiatives, combined with a promise to balance the budget. Further details about her economic plans were provided in the State of the Nation Address delivered on July 26 (Box 1).

2. Financial markets have shown recent stability, but await implementation of reforms. During the first quarter of 2004, markets were roiled by concerns about possible policy discontinuity after the election and that the new administration might be disinclined to implement long-overdue reforms. However, the exchange rate and sovereign bond spreads have been more stable since April, when victory by President Arroyo began to look likely. Financial markets have as yet shown little reaction to the President’s announcements about her economic plans, and appear to be on hold until concrete details emerge.

II. Recent Development

3. GDP growth has been robust, but inflation has risen largely due to adverse cost factors. The first quarter GDP outturn of 6.4 percent (y/y) was boosted by strong agriculture and a pre-election surge in consumption, and a more moderate growth rate of 4.9 percent is expected for 2004 as a whole. Despite the good growth performance, the unemployment rate rose to 13.7 percent in the second quarter, up from 12.2 percent a year ago. Although the Bangko Sentral ng Pilipinas (BSP) raised the liquidity reserve requirement by 2 percentage points to 10 percent in February, inflation has continued to rise, reaching 6.0 percent in July (y/y) on account of higher food, fuel and transportation prices.1 Average inflation was 4.3 percent during the first seven months of 2004, compared to 3.0 percent in 2003, but within the inflation target of 4–5 percent.

4. External developments have been generally positive. Exports grew by 8½ percent in the first half of 2004 (y/y), a significant improvement on the 2.9 percent increase recorded in 2003 (full year), and providing an offset to the higher oil import bill. Remittances have increased only modestly, by 2.6 percent (y/y) in the first half of 2004, partly due to developments in the Middle East where a large number of Philippine overseas workers are employed. Almost two thirds of planned 2004 public sector external commercial borrowing of $4 billion has been raised to date. The BSP intervened to support the peso in February and March, but has since rebuilt international reserves back to the end-2003 level, while unwinding over half of the $0.7 billion oversold nondeliverable forwards (NDF) position accumulated in the first quarter. As of end-June, adjusted gross reserves were $14.7 billion, or 113 percent of short-term debt by remaining maturity.

5. Fiscal performance has been broadly on track. Through June, the National Government deficit (authorities’ definition) was on course to meet the 2004 target of 4.2 percent of GDP, compared to 4.6 percent of GDP in 2003 (Table 2).2 By contrast, the nonfinancial public sector deficit is expected to remain at about 5¾ percent of GDP in 2004 due to increasing losses at the National Power Corporation (NPC) and shrinking cash surpluses at the public pension funds, while nonfinancial public sector debt is projected to remain at about 100 percent of GDP.3 Although the amount of government domestic borrowing in 2004 to date has been much the same as last year, domestic treasury bill rates have trended up in line with the pick-up in inflation.

Table 1.

Philippines: Selected Economic Indicators, 2000–05

article image
Sources: Philippine authorities; and Fund staff estimates and projections.

Fund definition. Excludes privatization receipts of the national government, and includes net deficit from restructuring the central bank.

Includes the national government, Central Bank-Board of Liquidators, 14 monitored government-owned enterprises, social security institutions, and local governments.

The sum of all nonfinancial public sector revenue net of intra-public sector payments. It is assumed that 80 percent of Bureau of Treasury revenue represents interest and dividends from other parts of the nonfinancial public sector. Privatization receipts are excluded.

Defined as difference between nonfinancial public sector revenue and balance.

Gross debt net of sinking fund and social security institutions’ holdings of national government securities. May include other debt held by other parts of the nonfinancial public sector. This issue is being reviewed by an STA mission.

Adjusted for the estimated effects of Y2K. For base money only, adjusted for changes in reserve requirements.

As of May 2004.

As of August 5, 2004.

Defined as external debt plus liabilities of foreign banks in the Philippines to their headquarters, branches and agencies, some external debt not registered with the central bank and private capital lease agreements.

Gross reserves less gold and securities pledged as collateral against short-term liabilities.

Reserves as a percent of short-term debt (including medium- and long-term debt due in the following year). Both reserves and debt were adjusted for pledged assets.

Table 2.

Philippines: National Government Cash Accounts, 2001–05

(In percent of GDP; unless otherwise noted)

article image
Sources: Philippine authorities; and Fund staff projections.

Excludes purchase of NPC securities.

Includes privatization receipts as revenue and excludes the operations of the Central Bank-Board of Liquidators (CB-BOL).

Excludes privatization receipts from revenue.

Excludes contingent/guaranteed debt, but includes onlent debt.

Nonfinancial public sector includes the national government, CB-BOL, 14 monitored government-owned enterprises, social security institutions, and local governments. Debt is gross and net of sinking fund and social security institutions’ holdings of national government securities. Other debts held by other parts of the nonfinancial public sector may, however, be included. This issue is being reviewed by an STA mis

Defined as the deficit, plus amortization of medium- and long-term debt, plus the stock of short-term debt at the end of the last period.

III. Outlook and Vulnerability

6. Near-term risks arise primarily from the large external financing requirement. One source of risk is that U.S. inflation or growth surprises on the upside, triggering a sharper than expected tightening by the Fed, with destabilizing effects on global financial markets. In this environment, risk aversion would rise, with more serious consequences for emerging markets such as the Philippines with weaker fundamentals. Even without such an event, the Philippines has already been put on notice by the ratings agencies that downgrades may follow should the new administration not proceed with bold implementation of reforms. Moreover, while the domestic economy has weathered the effects of higher oil prices to date, additional increases going forward could weaken growth and further increase inflation. By contrast, the Philippines appears less vulnerable to a possible hard landing in China, since exports to China are largely inputs for processing and re-export, and are thus not closely linked to the strength of Chinese domestic demand.

7. Over the medium term, the Philippines’ growth prospects rest squarely on the pace of reform. Strong implementation of reforms will improve the prospects for growth and hence poverty reduction (Table 5). In addition to reducing the deficit, fiscal measures will create room for increased public spending on infrastructure. Power sector reform will remove the specter of supply shortages over the medium-term. By contrast, should the new administration be unable to fully implement its reform agenda, financing requirements and hence vulnerabilities would remain high over the medium term, and growth is forecast to trend down to about 4 percent by the end of the decade (Table 6). Such growth would only be about 2 percent in per capita terms and would likely do little to improve the lives of the estimated 40 percent of the population with incomes below $2 a day.

Table 3.

Philippines: Balance of Payments, 1999-2005

(In billions of U.S. dollars)

article image
Sources: Philippine authorities; and Fund staff estimates and projections.

Gross reserves less gold and securities pledged as collateral against short term liabilities.

As a percent of short-term debt excluding pledged assets of the central bank.

Monitored external liabilities are defined as external debt plus liabilities of foreign banks in the Philippines to their headquarters, branches and agencies, some external debt not registered with the central bank and private capital lease agreements.

In percent of goods and non-factor services.

Defined as the current account deficit, plus amortization on medium- and long-term debt, plus short-term debt at the end of the previous period.

Table 4.

Philippines: Monetary Survey, 2000-2004

article image
Source: Philippine authorities and CEIC

The Central Bank-Board of Liquidators was established in 1993 to absorb the debts of the old central bank.

Adjusted for exchange rate valuation effects.

Table 5.

Philippines: Medium-Term Outlook, 2002–09

(Strong reform scenario)

article image
Sources: Philippine authorities; and Fund staff estimates and projections.

Nonfinancial public sector includes the national government, CB-BOL, 14 monitored government-owned enterprises, social security institutions, and local governments.

The sum of all nonfinancial public sector revenue net of intra-public sector payments. It is assumed that 80 percent of Bureau of Treasury revenue represents interest and dividends from other parts of the nonfinancial public sector. Privatization receipts are excluded.

Defined as difference between nonfinancial public sector revenue and primary balance.

Fund definition. Excludes privatization receipts of the national government, and includes net deficit from restructuring the central bank.

Gross debt net of sinking fund and social security institutions’ holdings of national government securities. May include other debt held by other parts of the nonfinancial public sector. This issue is being reviewed by an STA mission.

Gross reserves less gold and securities pledged as collateral against short-term liabilities.

Reserves as a percent of short-term debt (including medium and long-term debt due in the following year). Both reserves and debt were adjusted for gold-backed loans.

Defined as the current account deficit, plus amortization on medium- and long-term debt, plus short-term debt at the end of the previous period.

Defined as external debt plus liabilities of foreign banks in the Philippines to their headquarters, branches and agencies, some external debt not registered with the central bank and private capital lease agreements.

Table 6.

Philippines: Medium-Term Outlook, 2002–09

(Weak reform scenario)

article image
Sources: Philippine authorities; and Fund staff estimates and projections.

Nonfinancial public sector includes the national government, CB-BOL, 14 monitored government-owned enterprises, social security institutions, and local governments.

The sum of all nonfinancial public sector revenue net of intra-public sector payments. It is assumed that 80 percent of Bureau of Treasury revenue represents interest and dividends from other parts of the nonfinancial public sector. Privatization receipts are excluded.

Defined as difference between nonfinancial public sector revenue and primary balance.

Fund definition. Excludes privatization receipts of the national government, and includes net deficit from restructuring the central bank.

Gross debt net of sinking fund and social security institutions’ holdings of national government securities. May include other debt held by other parts of the nonfinancial public sector. This issue is being reviewed by an STA mission.

Gross reserves less gold and securities pledged as collateral against short-term liabilities.

Reserves as a percent of short-term debt (including medium and long-term debt due in the following year). Both reserves and debt were adjusted for gold-backed loans.

Defined as the current account deficit, plus amortization on medium- and long-term debt, plus short-term debt at the end of the previous period.

Defined as external debt plus liabilities of foreign banks in the Philippines to their headquarters, branches and agencies, some external debt not registered with the central bank and private capital lease agreements.

IV. Policy Discussions

8. The discussions focused on the conduct of macroeconomic policies and the reform imperatives for the new administration. Economic reforms have proceeded haltingly over the last few years, and staff emphasized that the election victory presented the government with a unique opening to jump start the reform process. Moreover, while the recent pickup in inflation bore watching, the relatively robust economic growth provided a conducive environment to undertaking reforms. Staff were encouraged by the efforts being made by the authorities to formulate a comprehensive economic package, including tax measures and raising power tariffs, but stressed that financial markets and potential investors were looking for early evidence of implementation. The quality of some of the proposed revenue measures also required scrutiny, while other measures had yet to be clearly specified and there was uncertainty about what they might entail.

9. The authorities viewed the current opportunity for reform in similar terms. The need to address fiscal and structural problems had long been recognized by the authorities and had been much-discussed with the Fund in recent years. However, critical economic reform bills had repeatedly been delayed by political resistance, perhaps reflecting a lack of a sense of urgency about the country’s economic problems. The election victory provided a new opportunity to work with Congress and dialogue was already underway with the legislators who were key to pushing through the necessary bills. Nonetheless, the authorities cautioned that it was unrealistic to expect quick passage of every reform bill that came before Congress. Indeed, by promulgating separate bills rather than an omnibus piece of legislation, they hoped to avoid opposition to a particular measure jeopardizing the entire reform package.

A. A. Monetary Policy

10. The key question facing the authorities was how much extra inflation to countenance on account of recent supply shocks. Based on current trends, staff projected average inflation to rise above the authorities’ 4–5 percent target range in 2005. While there were considerable uncertainties in the outlook, the breach of the target was likely to exceed the amount that could be justified by first-round effects of food and oil price shocks. This raised the question of whether monetary policy needed to be tightened and how best to signal to the public that second-round effects of supply shocks would not be accommodated.

11. In view of current uncertainties, the authorities were holding interest rates steady. Staff argued that there was a case for monetary tightening given that world interest rates were rising, while the increases in indirect taxation and power prices being considered as part of the reform package would exert further upward pressure on inflation. In response, the authorities noted that the still considerable slack in the economy limited the potential for second-round effects of supply shocks, while food prices were expected to ease in the months ahead due to improved availability. Inflationary pressures would also be dampened were the peso to strengthen in response to sentiment-boosting reforms. The authorities agreed that possible second round effects might at some stage require monetary tightening, but for the time being had left monetary policy on hold. Nonetheless, staff urged the authorities to review the 2005 inflation forecast in the next few months once markets had reacted to the reform package, with a view to tightening monetary policy if necessary.

uA01fig03

Inflation developments and staff projections

(y/y percent change of the 4-qtr. moving average) 1/

Citation: IMF Staff Country Reports 2004, 317; 10.5089/9781451831320.002.A001

1/ The inflation target is based on annual average inflation. In this chart, the inflation rate in the fourth quarter (marked with a •) depicts the BSP’s performance against its inflation target.

12. There was considerable discussion about the inflation-targeting communication strategy. Consistent with the forward-looking nature of inflation targeting, staff recommended that the BSP announce ex ante how much of a breach of the 2005 inflation target it was willing to tolerate due to the recent supply shocks. The authorities responded that they had already informed the public that the upturn in inflation was due to special factors and was likely to be temporary. More generally, the BSP was cautious about publicizing precise quantitative estimates of inflation effects. This would be beyond the practice of most inflation-targeting central banks, and would likely be too technical for the informed layperson, who was the BSP’s target audience. Were the inflation target to be missed, the BSP’s preferred strategy was to invoke the specified escape clauses, and to explain deviations ex post.4 The authorities agreed, however, that should they announce an adjustment to the inflation target for 2005, an ex ante explanation to the public in quantitative terms would be warranted.

B. Fiscal Policy

13. With her election victory, President Arroyo has recommitted to balancing the budget. The precise commitment is not yet clear, but if this means eliminating the National Government deficit by 2009, as was her first administration’s objective, this would imply a fiscal adjustment of 4½ percentage points of GDP compared to the 2003 outturn. Other things equal, such an adjustment would reduce the nonfinancial public sector deficit from 5¾ percent of GDP in 2003 to 1¼ percent of GDP by 2009 (Table 5).5

14. While the authorities had yet to commit to annual deficit targets, staff argued that the deficit reduction should be front-loaded. In particular, reducing the deficit in linear fashion—by about ¾ percentage point of GDP each year during 2004-09—seemed insufficiently ambitious. For one, markets would be looking for strong initial evidence of the authorities’ ability to tackle the fiscal problem. Second, fiscal measures were likely to be easiest in the opening period of the new administration. These factors argued for a strong upfront reform effort, and to this end, staff advocated a reduction in the nonfinancial public sector deficit of 2½ percentage points of GDP by 2005. If achieved, such a reduction would make the 2009 deficit target easier to attain, as well as place the ratio of nonfinancial public sector debt to GDP on a clear downward path. By contrast, if the fiscal adjustment effort was to flag, as under the weak reform scenario shown in Table 6, debt would decline more slowly.

uA01fig04

Nonfinancial Public Sector Debt

(In percent of GDP)

Citation: IMF Staff Country Reports 2004, 317; 10.5089/9781451831320.002.A001

15. The authorities did not consider the upfront deficit adjustment recommended by staff to be politically feasible. In their view, three revenue measures—increasing alcohol and tobacco excises, increasing petroleum excises, and introducing a telecom franchise tax— had a reasonable chance of being passed by Congress over the next six months.6 Taken together these measures would imply additional revenue on a full year basis of roughly P 60 billion (1.2 percent of GDP). Moreover, in June, NPC had submitted a petition to the Energy Regulatory Commission (ERC) to increase the average generation tariff hike by P 1.87 per KwH, which, if granted in full, would generate additional public sector revenue of about P 70 billion in 2005 (1.4 percent of GDP). However, it was unclear whether so large a rate increase would be approved (see ¶ 22 below). Moreover, some of the additional public sector revenue would be spent to cover higher interest obligations and to restore the level of capital expenditure. Although the authorities had yet to commit to a particular 2005 target, these factors taken together suggested that a more realistic reduction in the nonfinancial public sector deficit compared to 2003 was about 1 percentage point of GDP.

16. The authorities’ thinking on other revenue measures was still at a formative stage. Options included scaling back tax incentives and making further efforts to strengthen tax compliance. Repealing nonstandard VAT exemptions and zero-ratings was also an option,7 although the authorities were less inclined to raise the VAT rate itself. In addition, the authorities were considering the introduction of a gross income tax (GIT), which would involve a sharp reduction in deductions in exchange for a lower tax rate. Support for this reform arose from concerns that some current deductions, such as travel, representation and advertising, allowed too much scope for tax-official discretion, and were being widely abused. The form that the GIT might take was still being studied, but the intention was to sharply limit deductions, for example, to the direct costs of goods sold (Box 2). Concerns about poor compliance were also prompting calls for a tax amnesty so as to bring evaders into the tax net.

17. Staff raised doubts about the quality of some of these additional measures, particularly the GIT. While there was scope to simplify the corporate income tax by tightening loopholes and limiting tax official discretion, a GIT seemed ill-advised, particularly given the uncertainty attached to the likely revenue impact. Restricting deductions to a narrow definition like the costs of goods sold would discriminate against industries where costs of goods sold were a small part of business expenses. Equity across industries would require different tax rates, or even different tax bases, which would belie the objective of simplification. In any case, under a GIT, there would still be ample room for tax officials to exercise discretion in determining which deductions were permissible, and for taxpayers to disguise non-deductible costs as deductible ones. The authorities responded that if a GIT were to be introduced, its design would attempt to address some of these issues. Staff also urged the authorities to strongly resist proposals for new tax amnesties, which had been tried repeatedly in the Philippines, and as shown by international experience, were likely to do more harm to future compliance than they raised in initial revenue.

18. In the staff’s view, a higher VAT rate was an attractive revenue-raising option. At 10 percent, the VAT rate in the Philippines was not high by international standards, and there was widespread international evidence that raising the VAT rate would significantly increase tax revenues, even for a country with low VAT efficiency like the Philippines. However, the authorities expressed concern that a higher rate would only increase the tax burden on already honest tax payers. While they did not rule out raising the rate, they preferred to continue to concentrate their efforts on strengthening administration and improving VAT compliance.

19. The authorities explained their plans to rationalize expenditure, including through civil service reform. A plan was being formulated to eliminate redundant civil service positions in conjunction with a voluntary early retirement scheme, although it was too early to predict the effect on civil service employment. The reform would be facilitated by the establishment of a comprehensive personnel information system. Staff supported these plans, but argued that growth of the public sector wage bill could also be contained by tilting future wage increases to positions that were most understaffed and underpaid relative to the private sector. The authorities were also considering a proposal to tighten restrictions on the congressional allocations made to legislators to spend on preferred projects (currently amounting to about ½ percent of GDP), so that these funds were better focused in highpriority areas.

20. Reform of the public pension system was also important to ensuring fiscal sustainability. The Social Security System (SSS), the public pension fund for nongovernment employees, was facing a long-run actuarial deficit that was expected to deplete its assets by 2015. Staff therefore welcomed current attempts to extend the life of the fund by increasing contribution rates and cutting costs. The Government Service Insurance System (GSIS), the pension fund for government employees, was also facing long-run financial difficulties. Although it had recently run cash surpluses, asset management had been sub-optimal, with all assets invested domestically, including poorly-monitored loans to employees. Staff therefore supported the intention to professionalize asset management, but expressed concerns about GSIS’s current plans to expand its policy lending.

C. Power Sector

21. The new administration faces a large unfinished agenda of power sector reforms. The Electric Power Industry Reform Act (EPIRA) passed in 2001 contained an ambitious blue-print for power sector restructuring, but implementation has proved difficult. The privatization program has made little headway, while populist influences on tariff setting have created a perception of regulatory uncertainty and have left the NPC unable to cover costs (Box 3). Preliminary estimates suggest that without a significant tariff increase, NPC’s total deficit will amount to at least P 60 billion in 2004 (1.2 percent of GDP). Yet substantial investment in the power sector is necessary to avoid future shortages, and given the lengthy gestation periods for power plant construction, time is of the essence in getting the private sector involved. The new administration is attaching top priority to quickening the pace of power sector reform.

22. The discussions revealed considerable agreement on the need for a substantial power tariff hike. NPC’s recent P 1.87 per KwH tariff petition would translate into an almost 20 percent increase in the average price paid by end-users in the Manila area. However, the authorities expressed concerns that so large an increase could result in a backlash from consumers. In this context, the authorities were investigating whether life-line tariffs, the discounted rate for minimum usage, could be better targeted to protect those on low incomes. A sharp tariff hike would also have an adverse effect on industrial competitiveness which would undermine efforts to attract FDI.8 Nevertheless, the authorities noted that the NPC tariff petition included a provision for time of use pricing, which would reduce the effect on industry. This would further be mitigated once a revision to the tariff structure under consideration is introduced to end the current situation of industry crosssubsidizing residential consumers. Staff recognized the constraints on too large a tariff increase, but noted that the need to reduce the public sector deficit implied that the less revenue raised from electricity consumers, the more revenue government would have to raise elsewhere.9

23. Privatization was also essential to encourage investment and minimize risks of supply shortages. The bill authorizing the franchise of the National Transmission Corporation (Transco) has languished in Congress since September 2002 and staff argued that its speedy passage would send a clear signal that the authorities welcomed private sector participation in the power sector. The authorities concurred, noting that the franchise bill would be refiled as soon as possible. Moreover, with the election over, there was renewed interest from foreign investors in Transco and bidding would shortly be reopened. The authorities also intended to privatize 70 percent of NPC’s generation assets by end-2005, with a number of small plants having already been sold. Staff welcomed these plans, but noted that reducing regulatory uncertainty would be essential for attracting investors to the power sector and avoiding future supply shortages.

D. Banking Sector

24. The quality of the assets in the banking system continued to be an important concern. Banks have high nonperforming assets (NPAs) and low profitability, while true capital adequacy is obscured by weaknesses in accounting practices, particularly with regard to the valuation of foreclosed assets (“real and other properties owned or acquired” or ROPOAs). There were also concerns that deficiencies in the way banks classify loans understate the level of distressed assets. Staff analysis indicated that once allowance was made for these factors, the banking system’s capital adequacy fell well short of regulatory requirements, and of providing the system with enough scope to buffer major shocks such as an abrupt rise in interest rates. Recapitalization of banks is urgent both to increase the resilience of the banking system and to enhance its ability to contribute to economic growth.10 The authorities broadly agreed with staff’s analysis, but pointed out that the weakness lay in particular banks.

25. Staff welcomed recent steps to strengthen the regulatory and supervisory framework, but argued that the NPA resolution strategy should be accompanied by greater pressure on banks to enhance the strength of their finances and adopt best accounting practices. Amendments made to the Philippine Deposit Insurance Corporation (PDIC) Charter in July had resulted in a number of enhancements to the bank resolution framework, such as allowing for the seamless take-over of banks under receivership. Regulations had also been issued to improve banks’ credit risk management, strengthen documentary requirements and compliance, and enhance investor protection through securities custodianship and registry requirements.11 By contrast, there had been little progress to date in resolving NPAs under the Special Purpose Vehicle (SPV) framework. The authorities were still hopeful that deals would take place before the framework expired in April 2005. However, staff argued that significant NPA sales were more likely if the BSP put pressure on banks to enhance valuation and provisioning of nonperforming assets, especially ROPOAs, while enforcing the adoption of international accounting standards so that the resulting losses become reflected in the banks’ financial statements. To revitalize the current strategy and allow supervisors to apply greater pressure, staff advocated a two-pronged approach, consisting of strengthening the legal powers of the BSP and PDIC and the implementation of a restructuring strategy (Box 4).

26. Lack of legal protection for supervisors has been a long-standing problem in the Philippines. At present, BSP and PDIC supervisors, rather than their institutions, are primarily liable for regulatory actions that are contested in court. The authorities had hoped to provide adequate legal protection to PDIC supervisors through the recent amendments, but this had not been passed by Congress. The next battleground would be amending the BSP Charter and the authorities were already trying to convince Congress that supervisors in the Philippines were inadequately protected compared with international best practice. There was also a need to grant supervisors a waiver from the deposit secrecy law. In addition, the BSP wanted the power to write down the shareholder capital of noncompliant banks as part of the prompt corrective action framework, and would attempt to convince legislators that this was another area where the Philippines lagged international best practice.

27. Legal amendments should be followed by the implementation of a restructuring strategy. The basis of such strategy would be a thorough diagnosis of the capital needs of individual banks that would lay the foundation for future enforcement actions. Staff argued that once the condition of the banking system was fully transparent, viable but undercapitalized banks should be required to present a rehabilitation plan. If such plans were deemed insufficient, the bank would need to be intervened. With losses imposed on existing owners, new investors could be attracted. Part of this strategy could be achieved through a continuation of the current policy in favor of mergers and consolidation. As a last resort, an incentive-based public recapitalization scheme with safeguards could be set up to encourage private capital injections.

V. Staff Appraisal

28. The election victory provides a chance to break from the past and to boldly implement reforms. Seizing the current opportunity for reforms will set the stage for higher growth, lower unemployment, and reduced poverty. In this light, staff welcomes the authorities’ current efforts to formulate a substantive package of reforms and looks forward to the announcement of a clear set of measures that removes uncertainties about the intended reforms. Moreover, given the past history of delays in implementing reforms, early endorsement by legislators of the administration’s reform package is of critical importance.

29. Although financial markets have shown recent stability, vulnerabilities remain sizeable. Economic growth has been relatively strong and the authorities deserve credit for skillfully managing the economic risks associated with the pre-election period. Nonetheless, unless fiscal policy is decisively restored to a sustainable path, the situation could quickly unravel, particularly given continued large external financing requirements which make the Philippines vulnerable to sudden changes in sentiment toward emerging markets. If reforms do not proceed at a brisk pace, there is the potential for downgrades from the credit rating agencies, which could limit market access and negatively affect the economy.

30. Monetary policy may need to be tightened in the period ahead. A breach of the 2005 inflation target is in prospect due to higher food and oil prices, combined with prospective hikes in indirect taxes and power tariffs. The global interest cycle has also turned. On the other hand, there is some slack in the economy, and the peso is currently not a source of inflationary pressure. The BSP should reassess its inflation forecast once markets have responded to the new fiscal package, and tighten monetary policy if inflation is expected to exceed that which can be attributed solely to the first round effects of the recent supply shocks.

31. The commitment to reducing the fiscal deficit is welcome, but adjustment should be front-loaded. Given the high and unsustainable level of public debt, the new administration has rightly committed to balancing the budget. To this end, the authorities are considering an ambitious fiscal package centered on tax measures, combined with a large NPC tariff increase. In the staff’s view, the bulk of these additional revenues should be saved, thereby front-loading fiscal adjustment. Reducing the deficit early on recognizes that tax measures will be easiest at the beginning of the new administration. Moreover, a large upfront adjustment will put public debt on a clearly sustainable path and create room for a recovery in private sector investment.

32. The nature and quality of the fiscal measures is critical. Staff fully supports current proposals to increase alcohol, tobacco, and petroleum excises and to repeal nonstandard VAT exemptions and zero-ratings. Staff would also urge the authorities to raise the VAT rate, which is low by international standards. In addition, recent efforts to strengthen tax administration have borne fruit and should be continued. However, the suggested introduction of GIT carries substantial revenue risks, and has the potential to introduce significant distortions, complicate tax administration, and still leave ample room for discretion by revenue officials. A better avenue for tax reform would be to scale back the extensive system of tax incentives, which is the largest source of complexity.

33. Over the medium term, other reforms are necessary to ensure fiscal sustainability. Staff welcomes current proposals to streamline the civil service, including through voluntary retirement, and underscores the critical importance of steps being taken to shore up the finances of the pension funds. Staff would, however, encourage the authorities to strongly resist proposals for new tax amnesties, given the potentially harmful effect on taxpayer compliance over time.

34. Important reforms are being proposed in the power sector, but again implementation will be key. Stemming NPC losses is a critical challenge for the new administration that will be difficult to meet without a sizable increase in generation tariffs. Adverse effects on industry will be mitigated by time of use pricing, while life-line tariffs should be carefully targeted to shield vulnerable consumers. The administration is appropriately giving priority to Congress passing the Transco franchise bill, which will be pivotal in promoting much needed investment. More generally, reducing regulatory uncertainty is essential for attracting investors and for the success of power sector reforms.

35. Priority should also be attached to financial sector reform. Asset quality problems in the banking system continue to be an important concern. At present, the system is fragile and ill-equipped to contribute to economic growth. To revitalize the system, the current strategy of inducing banks to offload NPAs on a voluntary basis needs to be accompanied by greater pressure from supervisors. Staff also urges the new administration and Congress to strengthen legal protection for BSP and PDIC supervisors. Legal amendments should be followed by the implementation of a restructuring strategy for the banking sector.

36. Further strengthening of statistics is necessary in the period ahead. Staff welcomes the authorities’ commitment to redress data shortcomings and encourages them to intensify efforts to implement the recommendations made in the data ROSC.

The New Administration’s Policies

In her inaugural speech on June 30, President Arroyo announced a 10-point plan to guide her second six-year term:

  • Create more than 6–10 million jobs, support 3 million entrepreneurs, and develop 1–2 million hectares of land for agribusiness.

  • Ensure that everyone of school age is in school in an uncrowded classroom and in surroundings conducive to learning.

  • Balance the budget.

  • Link the entire country via a network of transport and digital infrastructure.

  • Provide power and water to all barangays (neighborhoods).

  • Decongest Metro Manila.

  • Develop the Subic-Clark corridor into the most competitive international service and logistic center in the region.

  • Computerize the electoral process.

  • Bring peace to Mindanao.

  • Reconcile the divisive issues generated by EDSA I, II, and III (the popular revolts that overthrew President Marcos, President Estrada and almost President Arroyo herself, respectively).

More details of the administration’s policies were revealed in the State of the Nation Address (SONA) delivered by President Arroyo at the opening of the new session of Congress on July 26, 2004, and in policy speeches preceding the SONA. Key elements include:

  • The recognition that the most urgent problem facing the country was the chronic budget deficit which had led to a squeeze on infrastructure investment and programs necessary for societal peace.

  • Key fiscal priorities included expanding revenues, spending more on infrastructure and social programs, and finding budgetary savings.

  • The administration was proposing 8 legislative revenue measures aimed at raising P 80 billion (1.6 percent of GDP), including: (i) a gross income tax system; (ii) some as yet unspecified changes to the VAT; (iii) a telecom franchise tax; (iv) indexation of excises on alcohol and tobacco products; (v) indexation of excises on petroleum products; (vi) rationalization of fiscal incentives; (vii) introduction of a targeted tax amnesty; and (viii) the creation of a performance driven framework for revenue agencies.

  • The government expected to raise another P 20 billion through administrative measures such as increasing efficiency and cutting costs, increasing specific charges and fees, raising duties on petroleum products, and increasing profit transfers from government corporations.

  • The need for cheap power in the near term could best be achieved by privatization of electricity assets and the President reiterated as a priority that Congress pass the much-delayed Transco franchise bill so as to facilitate the sale of the national electricity grid.

  • Government agencies needed to be re-engineered to reduce waste and corruption. Already 80 offices under the Office of the President had been abolished and another 30 would soon be abolished. Congress was urged to pass a law on government reengineering with “silver parachutes” to facilitate the needed reduction in staffing levels.

  • Other key priorities included spending on critical social needs such as health, clean water and education. The President also stressed the need to advance land reform and renewed her call for Congress to pass the “farmland as collateral” bill.

Revenue Raising Options

While gross income taxation (GIT) proposals in various forms have circulated in the Philippines for over a decade, it is still unclear what form the new administration’s GIT proposal will take. However, the most common previous proposals have been to alter business income taxes so that only the direct costs of production would be deductible. For example, overhead expenses such as advertising costs and wages for administrative personnel might not be deductible. The tax base and/or tax rate might also vary across industries to reflect differing cost structures. GIT proponents claim that the elimination of many deductions will simplify the tax system, reduce opportunities for discretion among corrupt tax officials, allow for a reduction in business income tax rates, and increase revenue.

However, GIT proposals are unlikely to be simpler or reduce corruption, since there will still be many opportunities to debate the deductibility of expenses. A GIT system would also likely be more distortionary, since it would have widely differential effects on different sectors. Moreover, attempts to address this deficiency through differing rates and/or bases would undermine the original rationale for the GIT – simplicity and ease of administration. If the number of excluded deductions is sufficiently large, the GIT may also be ruled under some counties’ tax law as a turnover tax rather than as an income tax. As a result, multinationals (potentially including U.S. companies) would be unable to offset GIT payments against their home country income tax liability, which could negatively affect foreign direct investment.

Several factors argue for an increase in the VAT rate. In particular, the VAT has important efficiency and administrative advantages over other revenue sources, and it is moderately progressive in the Philippines due to exemptions for most agricultural goods and small traders. At 10 percent, the current Philippine VAT rate is low. For example, the average standard rate is 14 percent in Latin America and 20 percent in Eastern Europe. Although the average rate in Asia is only 11 percent, other countries in the region either have access to substantial oil revenue (Indonesia and Vietnam) or have a much lower debt service burden than the Philippines. A higher VAT rate has also proven to be a reliable revenue-raiser (see table), even in countries with low initial efficiency ratios (such as the Philippines where the efficiency ratio is 0.31).

Opponents of a VAT rate increase in the Philippines argue that it will put honest taxpayers at a further disadvantage, given the significant evasion of the VAT. There is evidence of VAT evasion in the Philippines, including the low efficiency ratio. However, it is not clear that tax evasion would be any greater for the VAT than for other available revenue enhancers.

Changes in VAT Rates and Revenue: Experience with Single Rate VATs in Asia and Latin America

article image
Sources: Fund staff documents and estimates.