Turning Crisis into Opportunity

Carlito Anoñuevo, Jessica Reyes Cantos, Jenina Joy Chavez, Sylvia Estrada-Claudio, Alvin Firmeza, Margarita Gomez, Nepomuceno Malaluan, Hazel Jean Malapit, Cristina A. Morales, Rene Ofreneo, Rene R. Raya, and Filomeno S. Sta. Ana III

Several months have passed since the media first bannered the warning of the 11 faculty members of University of the Philippines School of Economics (UPSECON) about a looming economic catastrophe in the event that a worsening fiscal crisis is not arrested.

The good news is that everyone, from Gloria Macapagal-Arroyo (GMA) to
the man on the street, is aware of the gravity of the problem. The UPSECON paper has generated a dynamic public discussion and debate. GMA herself has acknowledged that there is a fiscal crisis.

But the bad news is that the administration has not yet acted decisively on the problem. Its actions to date are far from reassuring. The tax proposals that the administration has certified urgent are ill-conceived or half baked. Government has likewise resorted to cheap gimmicks (the donation to the Bayanihan fund turns out to be tax-deductible) and catchy but hollow slogans (on belt tightening, “live simply or simple leave”). Symbols have overwhelmed substance.

Identified priorities and even some proposed measures are wrong. For example, Congress has given priority to the tax amnesty bill. This bill, in fact, undermines tax reforms since an amnesty—which will be given for the nth time—will only encourage further tax evasion.

Further, what should be a non-controversial indexation to inflation of the excise tax on sin products is being mangled. The bill that the House approved practically defeats the very purpose of indexation. The tax increase is set at 20 percent, which does not compensate the losses from inflation in previous years. The rate increases by a mere 3 percent in 2005 and another 3 percent in 2006, again below the projected inflation rate for both years. The deal brokered by Malacañang during a meeting with the top executives of cigarette firms is even worse—a tax increase of 12 percent in 2005 and a nominal uniform increase of 40 centavos in 2006, to be followed by an insignificant 3 percent annual increase till 2010.

We have expected all along that vested interests would do everything to undermine the sin tax. In the early phase, as part of multiple tactics, some legislators captured by vested interests advocated a return to the ad valorem system, which is easily circumvented, in light of the weak state capacity to monitor underpricing. Other legislators, also serving the same vested interests, proposed to maintain different tiers in a specific tax regime, which complicates tax administration. Either way, government loses substantial revenues. On top of this, the imperative for government to be credible and accountable—an absolute pre-requisite so that the public can at least accept the forthcoming painful measures—has suffered a serious blow, given the series of exposes of scandal and corruption involving the military, the Cabinet and Congress. Against this backdrop of dissonance, incoherence, and backtracking, we need to consolidate the struggle for key fiscal reforms and firm up the principles behind such reforms.

We stress that revenues have to be increased at the soonest possible time through a combination of good tax administration and progressive, smart tax policy. We likewise stress that new taxes should be sensitive to progressivity and equity even as the total package should yield substantial and buoyant revenues. And we should also emphasize that the necessary adjustments should harmonize with efforts to restructure the Philippine economy in a progressive manner.

In this light, more important than quickly raising 80 billion pesos out of someone’s pocket, we must pay attention to whose pockets we are dipping into. From a moral standpoint, the poor, who certainly have the least to do with this fiscal mess, should not bear the brunt. The majority of the people have already sacrificed enough—religiously contributing to the government’s coffers through various indirect taxes and withheld income taxes.

And yet, because of the severity of the fiscal problem and the desire to avert the crisis within a narrow window of opportunity, one may be tempted to go for tax measures that easily raise the much-needed revenues but fail miserably in terms of equity. Some may even argue that this crisis situation is enough justification to tax the poor disproportionately—if only because they are the easiest to tax.

True, there is no “simple, clever, or painless solution to the impending crisis.” But even as we search for short-run solutions, government must never lose sight of its broader goals of equity and sustainable development. Government must see to it that its actions in the short run do not exacerbate inequities over the long run. Failure to do so will only create new social problems that will have to be addressed in the future.

The bias for a progressive fiscal policy should be applied to both taxation and spending. In practice, however, progressive taxes may be difficult to administer (e.g. high evasion rates for the highest income groups) or may yield insufficient revenues (e.g. taxes on luxury goods), justifying government’s reliance on indirect taxes. A less-than-progressive tax structure can be cured by having a progressive expenditure program in place to correct the inequities created by regressive tax policies.  Guided by this framework, we call for the following reforms: Protect spending for essential social and economic services that mostly benefit the poor and lay the basis for longer-term growth.

Even as the main strategy to address the fiscal crisis is to aggressively increase revenues, government must likewise consolidate its spending. But the fiscal deficit should not be used to justify an acrossthe-board reduction of government spending. Although there are many undesirable budgetary items that should be cut, government has likewise sacrificed spending for the most basic social and economicservices. For instance, we observe a significant decline in real per capita spending for health and education. On the contrary, despite the fiscal crisis, spending for essential services in real terms should be enhanced.

In short, austerity measures should be constrained by objectives that serve poverty reduction and give space to future growth. Push for the real indexation of the excise tax on tobacco and alcohol, and simplify the tax bracketing.

This tax measure has long been overdue. Special taxation of sin products is justified because its consumption negatively affects society through increased health risks. The revenues collected from sin taxes have been eroded by inflation over time, so that these products are grossly undertaxed relative to 1997 levels. It is for this reason that we reject the diluted House version of the bill as well as the worse compromise brokered by no less than Malacañang.

The lesson we draw from this fatal compromise is that the call for indexation becomes an empty shibboleth without crafting the specific and appropriate design of the tax. Indexation, in fact, is not enough. At present, there are a number of tiers for different products based on their value. Products classified as high-priced are taxed more than middle or low-priced categories. The more tiers we have, the more room we allow for misrepresentation of products and tax avoidance. A simplification of the tax brackets must accompany indexation in order to yield bigger revenues and promote horizontal equity.

· Put in place a targeted petroleum tax.

We propose a differential taxation on petroleum. A well-designed polluters’ tax can help alleviate traffic congestion and reduce urban pollution. Similar to the argument for sin taxes, specific taxes on petroleum have not been adjusted since 1997, and so it is also currently undertaxed.

To enhance its progressivity, the tax on petroleum can be targeted at the main consumers of gasoline—the car-owning middle classes and the rich. This proposal is similar to the United Kingdom’s colored diesel scheme, where the taxed red diesel is intended only for private vehicles, while the untaxed white diesel is intended for public transport vehicles. To ensure compliance, spot checks can be organized, and hefty penalties imposed on private vehicles with the wrong-colored fuel.

Still on the principle that polluters pay, the petroleum tax can be supplemented by a carbon tax, This means a tax is imposed on the carbon
content of power. Dirty power must be penalized through a bigger tax.
In this manner, we can promote the diversification of energy sources and encourage the use of renewable energy.

•    Impose an across-the-board import surcharge.

Perhaps, the single most immediate tax measure that government can implement is an across-the-board import surcharge. This measure does not require legislation—only administrative action—and adjustment is likely to be minimal for as long as the change is not too big.  An import surcharge is relatively easy to administer and promises to deliver huge revenues as well. Moreover, in her paper “Fiscal Reform Agenda: Getting Ready for the Bumpy Ride Ahead”, Rosario Manasan estimates this measure to yield 16 billion pesos in revenues for a 2 percent surcharge.  Even a 3 percent surcharge is reasonable.

What seems to have been underemphasized in public discussions is the role of the declining revenues from the Bureau of Customs (BOC) in the poor tax effort. BOC revenues fell from above 5 percent of GDP in the early to mid-1990s to only 2.4 percent in 2003 as a direct result of government’s aggressive trade liberalization policy, notwithstanding the fact that the import oil levy was transformed into an excise tax in 1997. In a similar vein, BOC’s share in total tax revenues in 1993, the year before tariffs were autonomously cut, was 35.61 percent and went down to 28.42 percent in 1996.  By 2003, this further declined to 20.09 percent.  Clearly, this drop in BOC revenues has contributed to the shortfall in government revenue. If we are consistent in using the argument that sectors currently undertaxed should be adjusted, we might as well include imports.

Contrary to the UPSECON 11’s claim that “international commitments prevent significant tariff adjustments,” we in fact have sizeable elbow room within which we can maneuver our tariff rates.  Our bound rates within the World Trade Organization (WTO), representing the maximum that we can raise tariff levels without violating our commitment to the WTO, are well above what we actually apply in practice.  With regard to vegetable imports, for example, applied tariffs are only 14 percent as against a bound rate or maximum allowable tariff of 40 percent; tariffs could be doubled and we would still be 12 percent below the bound rate.  On the whole, while our
average bound tariff rate for the agricultural sector is a little over 34 percent, our average applied tariff by the end of 2003 for the same sector was only 10.32 percent.  For non-agricultural products, the average bound tariff was 24.5 percent, while average applied rate was close to 2.9 percent.

It is likewise important to point out that practically all other tax measures being floated today will definitely have a dampening impact on effective demand. Such dampening of demand will likely lead to further increases in our already high unemployment.  Surely, with new taxes and fiscal pressures on investment climate, domestic industries and labor could very well use some additional degree, however small, of protection.

We acknowledge that an import surcharge, an indirect tax like the value-added tax (VAT), may also be regressive. However, unlike the VAT which covers all sectors, an import surcharge will only cover imported final and intermediate goods. Moreover, any inflationary effect that can reduce consumer welfare will improve the welfare of domestic producers, protecting jobs in the process.

In the end, the VAT, the import surcharge, and in fact any other tax measure will result in higher consumer prices. That is the tradeoff that we have to accept to avert a full-blown crisis.  An import surcharge, however, is unique in its potential to protect employment.

•    Limit industry coverage of Board of Investment’s
Investment Priorities Plan, and phase out special economic zones.

Too many and too generous fiscal incentives have resulted in hundreds of billions of pesos in foregone revenues.  In 2003, Department of Finance (DOF) estimates that foregone revenues arising from fiscal incentives amounted to 174 billion pesos.  Of this total amount, the Philippine Economic Zone Authority (PEZA) accounted for 157 billion pesos, by way of income tax holiday and tax and duty exemptions.

Ideally, incentives should be designed to attract investments that generate quality employment, transfer technology, have strong backward and forward linkages in the domestic economy, and cultivate future competitiveness. These incentives can be given to those industries that are technologically strategic to sustain Philippine growth and employment but by themselves will not attract investments without the incentives.
The regime of fiscal incentives in the Philippines, however, has been
biased for those industries and firms that are already high-growth
sectors and therefore do not need the incentives. (Smart and Globe, for
example, received generous tax perks for several years. Big food
manufacturing firms like Purefoods, San Miguel, Swift Foods and
Vitarich are exempted from certain import duties, thanks to a provision
in the Agricultural and Fisheries Modernization Act.)

With a hundred laws granting incentives, four incentive-giving bodies, and no solid, coherent industrial policy, it is no wonder that our uncoordinated regime of fiscal incentives has only served to attract footloose investment, with very little sunk costs and no linkages to the domestic economy.

An immediate measure government can undertake through administrative
action is to limit the industry categories in BOI’s Investment Priorities Plan.  We caution, however, against restricting fiscal incentives to current exports alone. One of the goals of fiscal incentives is to develop industries with a potential for future competitiveness. In rationalizing the industry priorities, we should be forward-looking and grant support for those sectors that have export potential in the medium- or long-term.  Rationalizing fiscal incentives, on the basis of an overarching industrial promotion strategy, will give us more “bang-for-the-buck,” more benefit per unit revenue forgone, than what we are enjoying today.

Government should likewise target special economic zones, which enjoy the biggest fiscal perks.  These special zones have no backward or forward links in the domestic economy.  They have only served as conduits for smuggling and corruption. But this action should be carefully phased and coupled with safety nets for workers, to minimize the adjustment from lost employment.

•    Broaden the value-added tax (VAT) base.

The proposed hike in the VAT rate from 10 percent to 12 percent will be
disproportionately borne by poor consumers. Aside from being a regressive tax, this proposal is doubly unjust considering that the evasion rate is very high—estimated leakage for VAT ranges from 26 to 38 percent. The most tantalizing feature of this proposal to increase the VAT rate is its potential for huge revenues—even with substantial leakage.

From an efficiency perspective, the rate increase will only magnify the distortions in the present VAT, arising from the many exemptions. Increasing the VAT rate penalizes the formal sector and may further discourage the already-poor tax compliance. This will also serve to
further disadvantage legitimate businesses vis-a-vis smugglers and tax evaders, who already enjoy at least a 10 percent cost advantage, so that even the income tax collections from legitimate businesses may suffer.

Rather than increasing the rate, a more prudent move for government is to address the leakage problem in the VAT. This can be done by first eliminating many VAT exemptions to ensure that the tax is uniformly imposed across industries. This will also greatly improve the administration of the VAT, by widening the audit trail. In addition, we encourage the Bureau of Internal Revenue (BIR) to pursue its administrative reform measures to address leakage arising from misreporting. We likewise urge the public to demand receipts for all transactions.

•    Broaden the overall tax base.

There are many ways to gather information about tax evaders; some of
them do not even need legislation.  In fact, Commissioner Guillermo Parayno of the BIR has been able to widen the net through computerization, third-party information, intensive mapping, BIR on wheels, and the like.

Presumptive taxation is also worth exploring.  As a simple illustration, doctors with clinics at the Makati Medical Center or St. Luke’s Hospital or lawyers working at, say, the Firm or other Ayala offices, are presumed to have a high  average annual income and hence subject to  the top rate  on income tax.

Republic Act 9160 and RA 9194, respectively the Anti-Money Laundering
Act and the amendments thereto, could have provided the BIR with an
excellent tool for broadening the tax base.  Had tax evasion been
listed as an unlawful activity under RA 9160, thus becoming a predicate
crime for money laundering, the Anti-Money Laundering Council (AMLC)
would have then been given the responsibility and authority to look
into the bank accounts of offenders and would have given the BIR the
needed information on the actual amount of financial assets an offender
may be holding.  As the bill progressed through the House of Representatives and the Senate, its provisions were watered-down, and now we have an Act with very limited coverage.  Again, this is lost opportunity to clamp down on tax evasion.

•    Promote progressive taxation through increasing taxes on luxury goods and real property.

These measures will improve the overall progressivity of the tax structure. Increasing excise taxes on goods bought by the rich such as luxury vehicles, air travel, jewelry, high-end mobile phones, and the like deserves support, even as we acknowledge that by themselves they could not yield substantial revenues compared to other measures.  Not only luxury cars but all types of private motor vehicles should be subject to a higher excise tax.  After all, those who buy these vehicles belong to the upper classes.  A higher excise tax and an increase in registration fess of motor vehicles also serve to address
the problem of negative externalities, namely pollution and traffic. The real property tax is a tax on wealth and is therefore highly progressive. It is likewise a source of hefty revenues, In terms of the contractionary and inflationary effects common to many taxes, the real property tax is probably the least damaging because of its limited linkages to the rest of the economy. In fact, a simple revaluation of zoning values to current levels by the BIR effectively raises the property tax revenue, even without raising the actual tax rates. According to the BIR, many revenue districts are still using zoning
valuations based on 1997 and even 1995 property values, while the most
recent valuations used are from 2002.

Being a local tax, this measure does not directly relate to the national government’s fiscal position. However, it does provide a substantial resource base for local governments to pursue progressive spending on social services and infrastructure.  The increase in internally generated revenues by cities and municipalities also translates into freeing a portion of the central budget that is allocated to local government units (LGUs).

•    Reduce and reform pork barrel funds.

As part of burden sharing, the pork barrel funds have to be cut.  In the end, however, the reduction of pork may only be a realignment of funds, since the projects undertaken by legislators should have been identified anyway as national government projects. The gain from reducing pork is greater transparency in the spending, by making funds non-discretionary.

We recognize that the pork barrel funds can serve as an incentive for legislators to approve good laws, especially taking into consideration that critical revenue measures need Congress’s approval. But as part of reforming the budget, pork barrel funds must be used to finance projects that have a clear and direct link to poverty eradication and longer-term growth.

Most important, cut the biggest pork barrel of them all—the President’s non-transparent huge discretionary funds. To deny this public demand will only erode whatever credibility the administration has left.

•    Link Internal Revenue Allotment (IRA) releases with counterpart local funds.

The proposal to cut IRA is a dangerous move, and could seriously undermine the delivery of basic social services. An across-the-board cut will adversely affect the ability of many local government units (LGUs), especially those with a small local tax base, to provide devolved social services.

The UPSECON 11 paper, estimates that about 35 billion pesos can be saved by reducing the IRA from 40 percent to 30 percent of the national government spending. There is already a de facto 5 percent reduction.  This is a result of the timing of IRA releases, which are done very late in the year so that LGUs no longer have time to use them.

On the other hand, it is also true that many LGUs are totally dependent on the IRA, not because of an inability to collect property and other local taxes, but rather because of an obstinate refusal to do so.  This is particularly true for cities and higher class municipalities (first to third class municipalities),  which have little excuse for their perennial dependence on IRA.  Addressing this problem then necessitates the creation of an incentive mechanism for LGUs, especially the higher class units that have the ability to raise their own revenues. The release of their IRA may be linked to a certain amount of counterpart funds.  To reiterate, we believe that the more prosperous LGUs can raise their own revenues through an increase in the real property tax.

In the medium-term,  a rationalization of the IRA has to include development concerns, apart from population, area and income, in the formula for allocation.

•    Arrest the bleeding of the National Power
Corporation (NPC) by junking populist policy and relentlessly pursuing
the renegotiation of  NPC contracts with independent power
producers (IPPs).

NPC is the single biggest contributor to the rise in the consolidated public sector deficit, and it accounts for a huge chunk of the debt stock assumed by the national government. In 2003 alone, NPC contributed a staggering 81.4 billion pesos of the total 105.3 billion pesos in government-owned and controlled corporation (GOCC) deficits.

At the heart of the NPC problem are the IPP contracts. When GMA’s popularity plunged on account of the high Power Purchase Agreement
(PPA) charges to cover the poorly-structured IPP contracts, she decided to cap the PPA to 40 centavos per kilowatt-hour. This decision translated to a loss for NPC of P0.85 per kilowatt-hour (kWh). The ballooning of NPC’s deficit from 21.7 billion pesos in 2002 to 81.4 billion pesos in 2003 is directly linked to this decision.

Further, the government had the opportunity to mitigate its losses when it undertook a review of the IPP contracts, pursuant to Section 68 of the Electric Power Industry Reform Act (EPIRA). Despite findings of serious financial, technical and legal issues on the IPPs, the renegotiation of the contracts did not yield substantial results. The Power Sector Assets and Liabilities Management Corporation (PSALM) estimates that the renegotiated terms yielded savings of 994 million US dollars in net present value.  Part of this, amounting to 383 US million dollars, is actually from the pre-termination of an IPP project. The estimated total savings translate to an average reduction 0.0908 centavos per kilowatt-hour on NPC’s  IPP obligation up to 2011, hardly making a dent in overcapacity and overprice payments to IPPs.

The insignificance of the said renegotiation was to be expected from a conservative framework. The review and renegotiation were conducted with the conclusive premise that the contracts were all entered into with the requisite regularity. Given this, government’s proposal to merely increase power rates cannot suffice, from a moral and political perspective.  Fairness requires that the review be reopened with the view to a more equitable sharing of the burden among consumers and the IPPs, and exacting accountability from responsible government officials.

•    End the financial hemorrhage of the Metropolitan Waterworks Sewerage System (MWSS).

Starting in 2001 when Maynilad stopped paying its concession fees, MWSS began to post deficits of 3.0 billion pesos, 2.6 billion pesos, 3.2
billion pesos, and 4.5 billion pesos for the years 2001, 2002, 2003,
and 2004, respectively. The concession fees are secured by a 120
million US dollars performance bond which MWSS has been unable to draw,
first because of Maynilad’s legal maneuvers to forestall the draw, and
now because of MWSS’s unexplainable failure to do so despite the
absence of any legal obstacle. There is in fact a standing resolution
by the MWSS board directing its administrator to draw on the bond on 30
July 2004 at the latest, but up to now remains unimplemented.

In addition to immediately drawing on the performance bond for the full
amount, the MWSS should now seriously consider other remedies available
to it outside of participating in Maynilad’s rehabilitation case in order to stop its financial hemorrhage. We refer specifically to the right of MWSS under the Concession Agreement to initiate Early Termination Procedures.

We doubt that its reliance on the rehabilitation proceeding can produce a result favorable to government. Aside from unduly delaying the resolution of MWSS woes, the proceeding in the past has only resulted in a compromise agreement, the infamous Amendment No. 2, which is a shameless bailout of Maynilad’s sponsors and grossly disadvantageous to government. The substitute rehabilitation plan to  replace Amendment No. 2, submitted before the rehabilitation court, may be less shameless, but a bailout nonetheless.

Such display of accommodation of vested interests undermines the credibility of the GMA administration in leading a policy regime of fiscal recovery.

The reforms that we have explained above are far from complete.  They have likewise been articulated many times before.  This time, however, all these measures assume greater urgency.

In the very near term, government can easily implement several measures through administrative action: the import surcharge, the limiting of
sectors in BOI’s Investment Priority Plan, and the immediate drawing of
the Maynilad performance bond amounting to 120 million US dollars.
Together, these measures can yield roughly 30 billion pesos in revenues.

Other priority measures that Congress should support include the reduction of the pork barrel funds, the genuine indexation of sin taxes, the targeted petroleum tax, the removal of VAT exemptions, and the increased taxes on luxury goods. Medium- to long-term reforms include the continuation of tax administration reforms, the phase-out of special economic zones, the linking of IRA releases to counterpart funds, and the review and renegotiation of NPC contracts with IPPs.

The resources that will have to be raised, either from increased revenues or expenditure cuts, are indeed enormous. Let us not be lulled into a false sense of security by a piecemeal approach to fiscal reforms. In truth, there is really no magic number that has to be absolutely reached.  What is more important is for government to show its earnestness by immediately acting on the critical revenue measures.  Government has failed the initial test for allowing
Congress to approve a diluted version of the excise tax on sin products.

Now more than ever, we need from our policy-makers sound tax laws that will correct the structural problems in our tax system. We need from our policy-makers a realistic budget that reflects a progressive expenditure program, focusing on basic social services and infrastructure.

In many cases, invoking urgency has become synonymous with quick-fix solutions, and setting aside fairness for later. A practical tradeoff, some might call it. After all, if the crisis is not averted, it is the poor who will suffer the most.  We reject this reasoning, for quick fixes result in worse economic and political consequences. The great paradox is that while government desperately needs widespread public support to push for new taxes, government cannot win the public without being credible and being accountable.

How can the President convince the people to pay additional taxes when
she contributed to the making of this fiscal crisis? How can government
be credible in asking for new taxes, when it has been irresponsible in
using taxpayers’ money?

The recent expose about massive, high-level military corruption has further weakened government’s over-all credibility.  Of course, the perception is true that the scale of corruption in the military is no different from that of the rest of government.  The policy and institutional reforms must therefore tackle the bull by its horns.  A less-than-ideal but practical approach is, to reform corruption itself, as it were, making it tame and predictable.

The result of the 2004 national elections may have given the administration a legal prop, but  as the surveys show, the administration still lacks the political legitimacy and credibility amidst the popular perception that GMA won through cheating.  It would be counterproductive to revive old debates between the warring parties. At this point, we have no choice but accept that the current administration must take on the responsibility of solving the crisis.

The GMA administration is at a crossroads. Solving the current crisis depends on its capacity to build its legitimacy among the people.  Conversely, the regime’s survival depends on whether it can solve the crisis.  It has no choice but to take the steps necessary to gain political and social legitimacy.  This requires that it turn its back on the politics of corruption, patronage and subservience to the demands of the powerful.

In the end, taxation becomes both a moral and political question. Only
when government truly and sincerely acts on behalf of the people will
it earn its legitimacy and credibility—its very reason for being.

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