Action 5.5 Tighten internal controls, reduce procurement corruption/fraud/waste/ delay, and strengthen whistleblower protection

1^ Another widely feared consequence of the crisis had been the possible decline in foreign remittances, which are particularly important for the Philippine economy. Though remittance inflows have not declined in 2008 and 2009, their growth has decelerated significantly and is projected to remain at more moderate rates than before.

2^ All GDP figures are measured in constant (2000) US Dollars as reported in the World Bank’s Development Data Platform.

3^ While economic growth is widely regarded as a necessary condition for poverty reduction, it is not sufficient. This was made most evident in 2003-2006, when poverty indicators in the Philippines failed to decline even though GDP growth had picked up significantly. This suggests that the benefits of growth during that period were not being widely shared. Rather, the increase in economic growth appears to have been accompanied by a significant deterioration in the distribution of income and consumption. This issue is addressed in a separate Discussion Note.

4^ A third way is by raising the ratio of workers to population, either through increased labor participation or reduced dependency ratios, but there are natural limitations to the potential growth impulse arising from this source.

5^ In this discussion, the reference to industrial activity serves as a proxy for non-traditional, technologically more advanced production. Although such production also includes technologically sophisticated agricultural and service sub-sectors, most of it has tended to be concentrated in the Industry sector. The focus on Industry, therefore, is entirely due to limitations in the classification of data, which is only readily available in the traditional Agriculture/Services/Industry disaggregation.

6^ Had sector productivity growth rates in the Philippines been as fast as in other East Asian countries (Technical Annex, Scenario C), overall annual output per worker would have grown 2 percentage points faster.

7^ A recent empirical study (Rodrik, 2009) finds that while economic growth is positively correlated both with the GDP-share of industry and the share of exports, the former relationship is stronger and more robust that the latter. Insofar as the post-crisis external environment is less accommodating of trade surpluses, this is good news for the growth prospects of newly industrializing economies. It does not, however, provide support for pursuing an inward-oriented industrialization strategy.

8^ The difference in total factor productivity growth happens to be very close to the growth foregone on account of the incomplete structural transformation in the Philippines; see Technical Annex. That is, had the Philippines been able to fully absorb the labor released by Agriculture into the Industry sector, it would have been able to close about one-third of the average growth gap vis-à-vis its three regional neighbors.

9^ The Krugman team found that the essential structure of the Philippine economy was characterized by a highly inefficient manufacturing sector sheltered behind high protective walls and using excessively capital-intensive techniques, where the rapidly growing labor force was being absorbed, not into industrial jobs, but into subsistence agriculture and marginal service-sector employment. Although the government was found to have done a reasonable job of maintaining macroeconomic stability, its limited revenue base constrained its ability to undertake socially necessary spending, especially on infrastructure, which was very low by regional standards.

10^ See World Bank 2005, 2007; and Asian Development Bank, 2007.

11^ These tax-eroding responses refer to the passage of tax eroding measures (such as VAT exemptions for senior citizens) as well as delays in the passage of fiscal measures that were needed to preserve the gains from earlier tax policy reforms (e.g., the Rationalization of Fiscal Incentives, Simplified Net Income Taxations Scheme, SNITS, and the Restructuring of Excise Taxes on Sin Products. Moreover, the falling taxation ratio also reflects administrative inefficiencies in BIR and BOC.

12^ This represents a deterioration since 2006, when the Philippines was ranked 88^th out of 125 countries.

13^ A similar argument also applies to the gross domestic savings rate. Currently averaging 15% of GDP, this rate is very modest compared to the 40% average observed in the East Asia & Pacific region as a whole or the 28% average for all lower middle-income countries worldwide. However, this rate is adequate enough to satisfy the current limited demand for investment funds in the Philippines, and so does not seem to constitute a constraint on higher domestic investment spending at this time.

14^ These three areas of intervention also received particular attention in the recent Growth Report (Commission on Growth and Development, 2008), which sought to identify the common characteristics shared by the 13 developing countries worldwide that have been able to sustain high growth rates over a period of at least 30 years. These high-flying economies were found to have the following in common: they (i) fully exploited the world economy (i.e., strong outward-orientation), (ii) maintained macroeconomic stability, (iii) mustered high rates of saving and investment, (iv) let markets allocate resources, and (v) had committed, credible and capable governments (i.e., good governance).

15^ In regard to fiscal interventions, one Discussion Note discusses various options for improving tax policy and administration to secure a more stable basis for public finances, while another focuses on strengthening government institutions to manage fiscal risk and avoid fiscal crashes. On infrastructure development, two Discussion Notes discuss various options for improving infrastructure services in Transport and Energy, and another analyzes options for improving public financial management as an essential input for sound public investment. On governance, two Discussion Notes discuss options for improving competitiveness and governance reform.

16^ Particularly noteworthy in this regard are the very high minimum wage levels legislated in the Philippines. This may be preventing a more fluid transition of labor from agriculture to other higher-value activities, and contributing to the segmentation of the labor market into a formal and an informal sector. By raising labor costs in the formal sector, such segmentation would be encouraging more capital intensive production processes in that sector.

17^ One domestic barrier to competition that appears particularly onerous when coupled with a weak judiciary is the limitation on foreign ownership of Philippine assets to a maximum share of 40%. This minority ownership provision effectively bars many multinationals and banks from entering the Philippine market and competing. Another important barrier to competition is regulatory capture, which appears to prevail in various regulated activities. Though potentially open to all bidders, domestically-owned firms tend to be more adept at exploiting this option, being more familiar with the domestic political environment and legal terrain, and less constrained by sanctions on corrupt practices introduced by many governments in developed countries in the last decade.

18^ The shift in relative importance of these barriers to competition, away from import barriers toward domestic production barriers, may explain why many large domestically-owned companies have recently begun restructuring their businesses away from tradable, export-oriented activities into non-tradables; see World Bank Philippines Quarterly Update, October 2009, paragraph 16.

19^ Unlike export subsidies, industry-specific production subsidies are not prohibited under the WTO Agreement on Subsidies and Countervailing Measures (SCM). However, they are “actionable”; i.e., subject to challenge, either through a multilateral dispute settlement or through countervailing actions, in the event that they cause adverse effects to the interests of another member trading partner. For such a challenge to succeed, the complaining member must demonstrate the adverse trade effects arising from the subsidization, which involves a fact-intensive analysis and may be difficult to verify, especially, when the subsidies are also accompanied by an appreciated exchange rate.

20^ These marked differences in growth are discussed in the Discussion Note on “Restoring Faster Growth after the Crisis..

21^ The poverty gap, which measures how far households lie below the poverty line, also increased from 2000 to 2006; as did poverty severity, which takes into account the poverty gap, but places a higher weight on households that are further away from the poverty line.

22^ The global food price crisis in 2007 and, particularly, the global financial crisis that followed in 2008 are likely to have raised poverty levels further. World Bank simulations using a micro-macro general equilibrium model indicate that the poverty rate will be 0.9 and 1.5 percentage points higher in 2009 and 2010 as a result of the global crisis than it would have been in the absence of the crisis.

23^ A lower elasticity means that, compared to other countries, faster growth is needed to reduce poverty by the same amount. To appreciate this difference, note that it would take 20 years to cut the Philippine poverty rate in half with an annual per capita income growth rate of 2.5 percent and the growth elasticity of -1.3 estimated for the Philippines. The time to achieve this target would be reduced to 10 years with an annual growth rate of 5%, leaving everything else the same, or to 12 years if the growth elasticity were equal to the East Asian average of -2.3.

24^ Deaton, Angus (2005), “Measuring Poverty in a Growing World (or Measuring Growth in a Poor World)” Review of Economics and Statistics, Vol. LXXXVIII, No. 1, February, page 6.

25^ There may also be shortcomings in the quality of the Philippines National Accounts that have exacerbated the overestimation of GDP growth. See, e.g., Medalla, F. and K. Jandoc (2008), “Philippine GDP Growth after the Asian Financial Crisis: Resilient Economy or Weak Statistical System?”, University of the Philippines, School of Economics Discussion Paper No. 0802, May, together with the response by the National Statistical Coordination Board in http://www.nscb.gov.ph/announce/ForTheRecord/16Dec2009_PhilippineGDPEstimates.asp

26^ The dependency ratio, defined as the ratio of children under 15 and adults over 65 divided by the total working-age population, was calculated as 65 percent for the Philippines in 2005. The Philippine ratio exceeds the dependency ratios of Thailand (by 50%), Indonesia (by 27%) and Malaysia (by 16%).

27^ For example, the daily average wage in NCR is one-third higher than the national average and these differences are significant, even after accounting for differences in education attainment and labor market experience.

28^ Alternatively, the rising premiums could also be indicating the existence of skill mismatches (i.e., the skills supplied do not match those demanded by employers) or it could reflect an increase in the reservation wages of younger skilled workers.

29^ In a diagnostic of the Philippine economy carried out in the early 1990s, Paul Krugman et al (1992) had found that the Philippines was characterized by a highly inefficient manufacturing sector sheltered behind high protective walls and using excessively capital-intensive techniques. Though import barriers have come down since then, they are still significant for certain sectors, particularly in agriculture.

30^ The problem of regulatory capture appears to be associated mainly with shortcomings on the enforcement side, rather than in the regulatory framework itself.

31^ This pattern is reflected in the evolution real sector wages between 2000 and 2003: real daily wages over this period actually increased by 14% in agriculture over this 3-year period, albeit from a very low relative level, while only increased by 3% in manufacturing and declined by 5% in the services sector. The economy-wide average real wage declined by 1% over this period.

32^ The Philippines also stands out in terms of having among the most restrictive fixed-term contract regulations, as reported by ILO-LABORSTAT.

33^ These constraints and their elimination are addressed in Discussion Note No. 1.

34^ Investments in human capital development in effect seek to transform low-skill labor into the higher-skill labor that was already revealed to be most in demand in the leading industrial and services sectors.

35^ The policies recommended here are not designed to reverse the natural decline in agricultural employment observed in all countries as they develop. Rather, their intent is to eliminate sector distortions that accelerate the decline in agriculture employment, pushing workers prematurely into the low productivity informal sectors.

36^ Measures to improve governance, including the elimination of regulatory capture, are treated in a separate Discussion Note.

37^ Here, too, the prospects of climate change present important challenges for the tourism industry, in particular, considering the rising frequency of typhoons and its implications for coastal development.

38^ The government has already begun to expand the 4Ps program, from the pilot phase of 20,000 households in 2007 to one million households in December 2009.

39^ Various options for strengthening the social protection system in the Philippines, as well as the options for improving service delivery in health and education, are discussed in greater detail in separate Discussion Notes.

1^ The original reform plan was to accompany the tax rate reduction by an elimination of fiscal incentives to maintain revenues constant. The elimination of fiscal incentives did not take place, however, so revenues fell.

2^ The slowdown in economic activity and international trade flows on account of the global financial crisis of 2008-09 also contributed to the decline in tax revenues, but only to a minor extent, considering that projected CIT and PIT revenues only declined by roughly 0.3 percent of GDP between 2007 and 2009, while customs revenues remained more or less constant as a share of GDP.

1^ The remaining tax revenue is mainly made up of customs revenues and excise taxes.

2^ A similar result obtains if we assume that the Philippines is able to increase tax efficiency in the three tax categories shown in Table 2 to the East Asia & Pacific averages, while keeping rates unchanged. This would raise total revenues generated by these taxes by 77 percent (from 9.8 percent of GDP to 17.4 percent). However, to achieve the average level of tax efficiency attained in the other East Asian countries, it may be necessary to reduce some of the rates (to encourage better compliance), in which case the appropriate comparator would be the average tax intake in East Asia from these three taxes, which amounts to 14.9 percent of GDP. This would represent a 52 percent increase over the current tax intake in the Philippines.

3^ The difference in effective CIT tax rates between companies with and without incentives is the largest in the region. (Botman et al., 2008)

4^ Since the fiscal balance has been in deficit, the foregone revenue was financed through debt issuance.

5^ Due to concerns with undervaluation of excisable products, a 1996 tax reform led to a shift in excise taxation from an ad-valorem to specific (or unit) tax rates, but did not allow for automatic inflation adjustment of the rates.

6^ These figures are obtained by multiplying the second and third rows in Table 3.

7^ The consequence has been a declining tax-to-GDP ratio, an inequitably distributed tax burden, and lack of popular trust. Despite continued support from a large number of development partners, the only reforms to have been implemented relatively successfully so far are those relating to improved Information Technology (IT) systems.

1^ A review of market structure to assess the extent of competition in the sector may also be warranted.

2^ To reduce the regressiveness associated with increased excises on tobacco and alcohol—contrary to petroleum consumption, alcohol and tobacco consumption is higher, as a share of total spending, the poorer households are—a strengthening of (non price) efforts to reduce consumption of these products by the poor is warranted (e.g., education campaigns and increasing assistance to the poor to enable them to undergo cessation therapy.)

3^ This is because some foreign companies that are currently benefiting from tax incentives may be able to claim a foreign tax credit in their home country for any increase in their Philippine tax burden that results from the rationalization of incentives.

1^ See World Bank (2010), Philippines Discussion Note No. 2 on “Achieving Sustained Poverty Reduction.”

2^ Table 4 shows that private investment in the Philippines declined by roughly 5 percent of GDP between 1996-2000 and 2002-2008. This decline is even larger considering that the average investment over 1996-2000 was strongly influenced by the East Asian financial crisis of 1997-98, which led to a large drop of private investment. Before then, private investment had been on the order of 20 percent of GDP. Taking this as the point of reference, private investment has dropped by almost 8 percent of GDP.

3^ The differences in primary (or non-interest) central government spending are largely attributable to differences in interest payments on the public debt. While total interest payments averaged 1.9 percent of GDP in the four comparator East Asian countries during 2002-08, they averaged 5.1 percent in the Philippines.

4^ Total government spending on public infrastructure, health and education over 2002-2007 averaged 6.5 percent of GDP in the Philippines versus 12.4 percent in the four comparator counties in East Asia. These spending amounts translate into 49 percent of total non-interest government spending in the Philippines versus 57 percent in the comparator countries.

5 ^ The ICOR is calculated as the change in total capital stock (or net investment ratio) in year t, divided by the change in total GDP (or rate of real GDP growth) in year t+1. The idea behind this measure of efficiency is that a larger capital stock expands the production possibilities frontier, permitting faster growth. However, the change in the capital stock brought about through a given amount of investment spending may differ depending on the quality of the investment. Larger ICOR values, therefore, imply less efficient investment spending.

6^ This assessment of the efficiency of social expenditures in the Philippines is obtained from earlier research at the World Bank on the measurement of efficiency in public spending across countries. (Herrera, Santiago and Gaobo Pang (2005), “Efficiency of Public Spending in Developing Countries: An Efficiency Frontier Approach”, World Bank Working Paper, May.) This work involves the construction of empirically-derived world production possibilities frontiers, relating the amounts of public spending in particular sectors to various outcome indicators in each sector. In this context, efficiency is measured as the distance between a country’s actual combination of public spending and sector outcomes in each sector and an efficiency frontier. This distance to the frontier can be measured, alternatively, in terms of the amount of public spending made in generating a particular output, or in terms of the output generated for a particular level of public spending. In both cases, the index measuring efficiency is constructed in a way that countries on the frontier exhibit an index of 1.0 and less efficient countries exhibit an index that is between 0 and 1.

7^ The efficiency scores presented here may be exhibiting a number of biases. In particular, though efforts have been made to ensure consistency in the definition of public spending, some countries depend more on local government spending than others for the provision of certain public services, and these local expenditures are not always fully captured in the data. As a result, a country with relatively high levels of local government spending may come across as more efficient than another country with similar outcome indicators, but relatively higher levels of central government spending. Furthermore, there are numerous omitted variables other than public spending which influence outcome indicators and, therefore, bias the efficiency calculations. For example, countries that rely more on private education and health systems are likely to exhibit higher efficiency scores than countries that rely mostly on public provision of social services, since the efficiency calculations do not take into account the private resources used. Also, a sparsely populated country covering a large area is likely to have much higher unit costs for educating a child or treating a patient than more densely populated, largely urbanized countries, independent of the quality of government spending. Finally, it is also important to keep in mind that this note only addresses a limited set of “education or health outcomes" that may not be the most relevant ones and it does not address the distribution of outcomes.

8^ Another indicator that is sometimes used in cross-country comparisons to measure public sector efficiency refers to the size of public employment. Inefficient governments are often characterized by having a large public workforce as an employment generating measure. However, the Philippines does not stand out in terms of either the size of the public sector workforce (≈ 8% of total labor force) or the size of the national government wage bill (5% of GDP), both of which are similar to the ratios observed in the other comparator countries.

9^ The gap in public investment identified here is similar in magnitude to the shortfall in public infrastructure investment identified in the World Bank’s (2005) infrastructure report on the Philippines. That report had called for a gradual increase in infrastructure investments from 2.8 percent of GDP (in 2008) to at least 5 percent of GDP. Similarly, the gap of 1.6 percent of GDP in public education spending shown in Table 5 is close to the 2% of GDP shortfall in education spending identified in the forthcoming World Bank (2010) public expenditure review on basic education. The World Bank is currently also working on a health sector assessment that seeks to provide a detailed actuarial analysis of the benefits package that should be provided by the Government to achieve better outcomes as well as the costs of mitigating supply side constraints to achieve these goals. Unfortunately, the findings from that analysis are not yet available for comparative purposes.

10^ The proposed increase in public investment already would constitute an important step toward improving the investment climate, considering that the last Investment Climate Assessment (carried out in 2005) identified the deficit in public infrastructure as one of the top 3 investment climate constraints.

11^ In fact, the tax effort fell to 12.8 percent of GDP in 2009, or well below the targeted 14 percent, making the task of raising enough fiscal revenues to support the higher spending target even more difficult.

12^ The fiscal savings obtainable by eliminating these subsidies and transfers would not accrue to the central government, but to the non-financial public sector as a whole.

13^ This estimate is calculated by netting out the cost of rice subsidization through NFA (estimated to be between 0.6 percent and 1 percent of GDP) from the total budget transfers to GOCCs in 2008. In addition, however, it is important to stress that budgetary transfers to the GOCCs only represent a small part of the public support they receive, which includes periodic recapitalizations and the financing of current deficits by issuing debts that are assumed by the national government. The GOCCs also generally operate in a much more favorable environment than private sector companies (e.g., most have tax exemptions and easy access to credit), which has a fiscal cost that usually does not appear in the government budget. See World Bank (2010), “Philippines Development Report 2009.”

14^ For specific details on this measure, see World Bank (2010), Philippines Discussion Notes No. 11 (Health) and No. 12 (Basic Education).

15^ For details, see World Bank (2010), Philippines Discussion Note No. 6 (Competitiveness).

16^ For details, see World Bank (2010), Philippines Discussion Note No. 23 (Public Financial Management).

17^ This amount is calculated as a residual. Specific policy options for raising tax revenues are discussed in World Bank (2010), Philippines Discussion Note No 3 (Tax Policy and Administration).

1^ World Bank, 2009, “Fiscal Risks: Assessment and Recommendations” chapter 2 of the 2009 Philippines Development Report. The assessment is based entirely on publicly available information though the World Bank can update the assessment based on existing non-public information.

2^ In particular, (i) a 1 percentage point reduction of GDP growth increases the overall fiscal deficit by P14.7 billion; (ii) a 1 percentage point increase in the inflation rate reduces the overall fiscal deficit by P4.5 billion; (iii) a 100 basis points increase in the 91 T-bill rate increases the overall fiscal deficit by P9.6 billion; and a 1 peso depreciation of the peso/US dollar exchange rate increases the overall fiscal deficit by P1 billion.

3^ Over the past five years, tax revenues were systematically (and significantly) over-estimated compared to the budget. In contrast, non-tax revenues were regularly under-estimated. On the expenditure side, up until 2008, actual spending has been systematically below budgeted amounts. The under-spending mostly arose on personnel services, maintenance and operations expenditures, and (very significantly) interest payments.

4^ These include the President, the Bangko Sentral ng Pilipinas (BSP; the central bank), the Department of Finance (DOF) (at least six agencies), the National Economic Development Authority (NEDA), the Commission on Audit (CoA), and less directly, the Department of Budget Management (DBM).

5^ The resiliency of public debt increased since 2003 through: a sharp decrease in the debt level and an increase in the share of public debt denominated in domestic currency. Nonetheless, the debt-to-GDP ratio of the public sector remains high and, since 2008, started increasing again.

6^ No government unit is responsible for undertaking comprehensive, exhaustive and timely assessments of PPP projects. Large PPPs are currently in power, water and transport. Fiscal risks include risks related to right-of-way, political/regulatory risk, changes in laws, currency convertibility, and events of termination. A typical Independent Power Producer (IPP) contract, however, would also pass fuel supply and market risks to government. Exchange rate risk also arises when contractual payments are denominated in foreign currency.

7^ These include the non-adjustment of tariffs despite contractual, formula-based, obligations to automatically do so; they have triggered financial penalties and legal recourse against the state.

1^ Indeed, a fiscal risk statement provides a very clear view of whether true fiscal consolidation is taking place or whether consolidation is taking place at the expense of, say, an accumulation of contingent liabilities or an undue accumulation of risk in the public debt structure so as to reduce (in the short-term) the cost of servicing debt.

2^ A typical debt management strategy seeks to ensure that the government’s payments and financing needs are met at the lowest feasible cost subject to an acceptable level of risk. The adoption of such formal strategies is becoming common practice in the region recently (e.g., Indonesia and Thailand in 2005). Thailand’s debt structure is an extreme example as it is almost all domestically issued, with fixed rates. Indonesia also consolidated its external loans and domestic securities directorates into one Directorate General for Public Debt in 2006. This DG Debt is expected to: (i) favor domestic over foreign currency borrowing so as to lower foreign exchange risk (and foster the development of the domestic bond market); (ii) increase the share of fixed rate debt to reduce interest rate risk, (iii) lengthen maturities to reduce refinancing risk; and (iv) rely mostly on concessional external financing (to the extent possible) to reduce external borrowing costs.

3^ Though it should be noted that central PPP units by themselves are not sufficient to improve fiscal risks (evidence does not seem to suggest that countries that have central PPP units have fared better than those that do not; indeed some of the successful countries in tendering PPPs in Latin America do not have central units).

4^ A strong legal and institutional framework for project selection, approvals and contract negotiations is needed to comprehend fiscal risks involved in PPPs. The implementing agencies responsible for identifying and selecting BOT projects for ICC approval have limited technical, legal and financial capabilities to negotiate and write BOT (Build-Operate-Transfer) contracts that minimize fiscal cost and risks.

1^ To address these questions it is useful to begin by considering that greater competition can be achieved, both, by facilitating the entry of products and services from abroad, and by facilitating the entry of new firms to produce goods and services domestically. The former entails the removal of barriers to trade, while the latter entails the removal of barriers to the entry and exit of firms. The reduction of import tariffs and elimination of non-tariff barriers that inhibit the flow of goods and services across borders often constitute the first line of attack in promoting greater competition. These measures generally work well in generating greater competition when the products in question are so-called ‘tradables’. However, when these products involve ‘non-tradables’ or their sale depends on non-tradable inputs (such as local distribution channels and other services), then the elimination of trade barriers may only have a limited impact in promoting greater competition. In this case, the best line of attack is to facilitate the entry of new firms into the market, especially through the attraction of foreign investment. This requires, in turn, the removal of barriers to market entry and improvements in the investment climate.

2^ The TTRI is a measure of the average height of import tariff barriers, weighted by import shares and import demand elasticities. Similarly, the MA-TTRI measures the average tariff barrier facing Philippine exports among its trading partners. The Tariff TRI measure does not take into account other non-tariff barriers to trade and trade preferences. More comprehensive measures of trade barriers that incorporate these non-tariff barriers portray the Philippines as a less open economy, more comparable to the average economy in the East Asia & Pacific region and among the lower-middle-income group. The available data on non-tariff barriers, however, only dates as far as 2001 and so questions arise in regard to its accuracy.

3^ The World Bank’s Doing Business indicators rank economies based on 10 indicators of business regulations that track the time and cost needed by domestic companies to meet business regulations such as starting and operating a business, trading across borders, paying taxes, or closing a business.

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