December 2006
Political Predictions
The Economy

Walking on a knife’s edge

This analysis was solicited by i Report, the online magazine of the Philippine Center for Investigative Journalism, for its current series on political predictions. The views expressed in the essays included in this series do not necessarily reflect those of the PCIJ or any of its staff members.

MAKE NO mistake about it: The Arroyo government has focused its energies on improving its fiscal situation. But it is doing so primarily to address the concerns of international creditors and credit-rating agencies, as well as to survive the political challenges to Gloria Macapagal Arroyo’s presidency. And while it has been hailed by the creditor community as a “success,” the Arroyo administration’s fiscal policy now poses a major obstacle to economic growth, job creation, poverty reduction, and the attainment of the Millennium Development Goals (MDGs).

In 2005 the present administration was able to lower the fiscal deficit, both in absolute terms and as a proportion of the gross domestic product or GDP. In the first nine months of this year it reduced the deficit by P70 billion. That, however, was less than half the target deficit for the period.

A closer look at the fiscal balance also shows that the lower deficit was achieved primarily through spending cuts rather than improved revenue mobilization. Spending cuts accounted for 92 percent of the improvement in the January-to-September deficit vis-à-vis targets, while increased revenues contributed a meager eight percent. In fact, the Arroyo government failed to meet its tax targets in 2005 and this year. In 2005 it had to resort to a 10-percent cut in non-interest, non-IRA (Internal Revenue Allotment) spending to produce an “acceptable” deficit. This year, the spending cuts are deepening: 18 percent in the first nine months.

This pattern of fiscal management has certainly made the bottom line look good to creditors and credit rating agencies. But it is unsustainable. The weaknesses in the fiscal management by the Arroyo government will become more difficult to hide in the next three years, and may even erase the gains already made.

On the revenue side, efforts to raise tax revenues will fall short of expectations. For one, the Arroyo government does not have the credibility, the moral suasion, or the political will to compel big business and the elite to pay more taxes. This year, it failed to meet targeted increases in taxes paid by professionals such as doctors and lawyers. And it is halfhearted about removing tax holidays and other fiscal incentives for big business and investors who, studies show, would have invested anyway even without the incentives.

Subsequently, the government relies more and more on workers and ordinary consumers. Shifting the tax burden on those who have less and earn less is at the core of the Arroyo government’s tax strategy. Raising the value-added tax (VAT) rate from 10 percent to 12 percent may do the trick for one year — the tax effort (taxes as percent of GDP) improved from 13 percent in 2005 to 14 percent in the first nine months of this year. But to achieve a tax effort of 20 percent and higher in the coming years, the government must rely on a tax base with steady jobs and rising real incomes — two basic conditions missing today.

Wage and salary workers are the primary source of personal income-tax revenues, contributing nearly 90 percent of close to P100 billion in 2004. They form the “critical mass” as far as income taxes are concerned. But they are an endangered species under the Arroyo government. Of the employed, only about half are salaried employees — a narrow base from whom to draw income taxes. Job creation has been weak and a significant number of new jobs are found in the informal sector, where earnings are outside the income-tax net.

Ordinary consumers with shallow pockets and mounting personal debts make another cluster of unwitting taxpayers who form the government’s tax base. By the government’s own estimate, average family incomes in real terms fell by 10 percent between 2000 and 2003. A base that is as severely income-challenged as this cannot possibly contribute to a rapid rise in the tax effort.

ONE PIECE of the unsustainable tax puzzle merits attention: the reliance on debt for revenues. Every time the Bureau of Treasury sells government debt papers, the national government collects a tax on the interest it pays its lenders. In other words, whenever the government borrows in the domestic market, such borrowing boosts its tax revenues. The more it borrows the more taxes it earns.

The flipside is that the less the government borrows, the less it earns in taxes. From January to September 2006 it earned only P25 billion in taxes on Treasury bills, against an expected level of P32 billion. Bureau of Internal Revenue chief Jose Mario Buñag himself attributes his agency’s failure to meet its tax targets largely to the Treasury’s reduced borrowing.

Too, the lowering of interest rates has resulted in lower-than-planned taxes on interest earned from bank deposits. Of the government’s target of P22 billion for the first nine months of this year, only P14 billion was actually raised. To keep debt service within manageable limits, the Treasury’s practice has been to reject bids from banks vying to purchase its debt papers at high interest rates. Consequently, interest rates have been falling. The downside to this practice is that taxes collected on the interest earned from bank deposits are now less robust.

The nexus between borrowing and taxes runs deep — at times, with negative fiscal consequences.

This is what we have: a government that is relying on a stagnant salaried work force and on a largely unemployed and income-challenged consumer base for the bulk of its taxes. As the government borrows less, it also earns less in taxes. As it continues to keep interest rates on a downward trend it undermines its own ability to tax interest earned on savings deposited with banks.

Table 1: Non-Interest Spending
Sources of basic data: Bureau of Treasury (BTr) and Bangko Sentral ng Pilipinas (BSP)

2001 531,977 5.2 (1.6)
2002 589,395 10.8 7.0
2003 594,470 0.9 (2.6)
2004 617,783 3.9 (2.1)
2005 640,479 3.7 (3.9)
January-September 2005 458,900
January-September 2006 486,500 6.0 (0.8)

With lower-than-expected “dagdag” or earnings in tax revenues, the Arroyo government has been resorting to spending cuts — “bawas” — to convince creditors, credit rating agencies, and international fund managers that it is serious in putting its fiscal house in order. As the table above shows, national government spending, other than interest payments, has been declining in real terms every year under the Arroyo administration, except in 2002. It fell slightly in the first nine months of this year.

OFFICIALS OF the Arroyo government are beginning to recognize that underspending is a serious problem. In a conference of Philippine business last October, Finance Secretary Margarito B. Teves said, “It would simply be a Pyrrhic victory if we rely solely on the revenue side.” Socioeconomic Planning Secretary Romulo L. Neri has also acknowledged that too much fiscal discipline may be harmful to the economy; according to a recent Businessworld report, Neri assures the public that the Arroyo government would spend more in the last quarter of this year.

“Catch-up spending” may again appease international creditors and credit rating agencies, but it cannot address a serious backlog in basic infrastructure and needed social spending. Ordinary citizens know all too well the impact on their lives of a government that prioritizes debt spending over their needs: Agrarian reform is far from complete. Beneficiaries can hardly count on government support to make their land viable. Children have to cope with crowded and dilapidated classrooms (if not an outright shortage), not enough schoolbooks (the content of which has also been questioned), and deteriorating quality of teachers (many of whom, the more experienced among them, have gone abroad to work). Poor families have to turn to the local padron, charity, or lender in order to access health services. Many of them still do not have safe water at home.

On top of these, new pressures on fiscal resources are emerging as global warming and climate change unleash “super typhoons” and other extreme weather disturbances. Combine these with other “givens” — an abundance of active volcanoes throughout the country, substandard safety practices of the shipping industry, a growing illegal trade in toxic waste from neighboring countries, and man-made disasters. What the national government ends up with is one emergency relief operation after another.

The infrastructure requirements to prepare government at all levels to respond swiftly and effectively to disasters are huge. These would include, among others, geohazard mapping at a scale that enables municipalities to plan and prepare accordingly, establishing an effective early-warning system at the barangay level, land-use planning, capacity building for disaster prevention and response, and resettlement (including sustainable livelihood development) of families living in disaster-prone areas. Add to this the cost of rescue operations, emergency aid and relief, repair and rehabilitation of damaged infrastructure, and so on. Setting aside a calamity fund, while helpful, is far from sufficient.

THERE IS this widely held notion that reducing the fiscal deficit can work wonders by promoting investor confidence in the Philippine economy, in turn bringing all sorts of good things to the country. Dismissed as a crank idea in earlier times, this notion has returned with a vengeance to become a central article of faith among policy makers. The negative impact on the real economy, however, has become increasingly painful and clear in recent years — and will become even more so in the next three years.

The Arroyo government correctly points out that the economy has been growing nearly six years — the longest period it has done so without slipping into a crisis. But the GDP growth, averaging at 4.6 percent from 2001 to September 2006, is mediocre, if not stagnant. In fact, by the third quarter of this year economic growth failed to meet the planned target for the quarter. GDP grew by a mere 4.8 percent, against a level of nearly six percent in the first and second quarters.

The biggest single factor that explains why growth has been mediocre is declining investment spending. Official estimates show that real spending on capital formation as a percent of GDP has fallen from 20 percent in 2003 to 18 percent in 2005. In the first nine months of this year, investment spending dipped further to 17.7 percent of GDP.

This is not surprising given the Arroyo administration’s fiscal-management policy. There is little if no economic stimulus from the public sector simply because it has been cutting its spending. Without infrastructure spending and without private investor spending the economy’s productive capacity cannot expand. The stimulus to growth has for the longest period been consumer spending financed by remittances of overseas Filipinos. But even consumer spending has been weakening.

With investment spending virtually absent, government spending in the doldrums, and consumers hesitant to spend of late, export markets are the last remaining hope to fuel the country’s economic growth. Unfortunately, even here the prognosis is not good. The bulk of Philippine exports are semiconductors that depend on robust global demand. But most experts expect the U.S. economy — ergo, the global economy — to weaken in the coming years. The exodus of Filipinos for overseas jobs and the reliance on remittances from relatives abroad will probably be the only factors preventing a wholesale economic collapse.

DESPITE SUSTAINED if moderate growth in the last seven years, the crisis in the labor market triggered by the 1998 recession continues to worsen, manifesting itself early on in record-high open unemployment rates and of late in surging underemployment. If recent trends are anything to go by, the crisis in the labor market is likely to worsen in the next three years. Particularly worrisome is the decline in investments as this means less job-generating spending in the short run and shrinking productive capacity, which will hurt future employment creation.

The deepening jobs crisis today stands as the single biggest failure of the Arroyo administration. Despite sustained growth, unemployment has hovered at near record levels since 2001. A change in the official definition of unemployment may have obscured the bad situation. Nonetheless, the jobs deficit is clear to anyone who cares to see it. The employment-to-population ratio at 59 percent in 2006, after eight successive years of growth and counting, is even slightly lower than its level in 1998, a recession year. That is, only six out of 10 Filipinos of working age can find employment. Every year, over half a million Filipinos become of working age, with no prospects at all of finding gainful employment, let alone quality employment.

A new dimension to the sustained crisis in the labor market is surging underemployment. Since April 2005, underemployment has been rising rapidly as the bulk of new job creation has come from agriculture and informal services. Total underemployment went up from nine percent in 2004 to 12 percent in 2005 and 14 percent in the first half of 2006. In particular, visible underemployment, the proportion of part-time workers wanting additional work hours, has hit a 20-year high.

Rising underemployment is important because it may indicate growing poverty incidence. Underemployed workers carry a high risk of becoming poor with incomes insufficient to carry themselves and their families above the poverty threshold. Poor families are likely to be found among the underemployed more than among the unemployed simply because they cannot afford to be unemployed. This fact shows up in the regional data: Regions with high underemployment rates (rather than unemployment rates) tend to have high poverty incidence while regions with low underemployment report low poverty rates.

The worsening jobs deficit can be traced to low and poor-quality growth. Current GDP growth rates are simply not enough to generate enough jobs to absorb a fast-growing working-age population. Differences in growth forecast in the order of half a percentage point are minor and inconsequential. The economy must significantly raise its growth rate to be able to create adequate employment and quickly bring down joblessness.

WITH THE 2015 deadline for the Millennium Development Goals less than a decade away, the next five years will set the stage for success or failure in meeting these. Beyond this, there would be little time to put in place the policies and programs necessary to achieve these goals.

Government spending is crucial to fulfilling the MDGs since most of these involve the provision of public goods, including education, health services, water and sanitation, and so on. Poverty reduction hinges on economic growth that favors the poor as well as the provision of income support for the poorest and those who have no access to the benefits of growth.

It really should not take much for the Philippines to achieve the MDGs, says Rosario Manasan of the Philippine Institute for Development Studies (PIDS) in a recent study. Manasan estimates the additional annual government spending required in five MDG-related areas — poverty reduction, education, health and nutrition, and water and sanitation — would be 1.1 percent of GDP in 2007-2015.

This figure is small compared to the reduction in the fiscal deficit by three percent of GDP, from five percent in 2001 to two percent in 2005. Since the reduction in the deficit was achieved largely through spending cuts, there is little room for reallocating expenditures. Accommodating the necessary MDG-spending necessarily leads to a higher fiscal deficit. This throws into sharp relief the folly of a fiscal policy focused on cutting down the deficit at all cost.

No one questions the fact that by taming the fiscal deficit, the Arroyo administration removed the immediate risk of financial crisis posed by a ballooning public debt. The imposition of new tax measures has also arrested the decline in the tax effort. But significant downside risks remain on the revenue side as weak job creation and declining household incomes undermine tax revenues. Lower borrowing requirement by the government as a result of the smaller deficit also implies lower tax earnings from interest payments to lenders.

Success in the fiscal sector has been achieved at a steep price. A closer look at the fiscal balance shows that the lower deficit was achieved primarily through deep spending cuts in critical economic and social services. Furthermore, the tight fiscal policy, which aims to eliminate the deficit by 2008 or 2010 at the latest, has begun to hurt growth and job creation.

Contrary to claims that reducing the deficit will promote growth by restoring investor confidence, the record for the last six quarters show that investment spending in the real economy has been compromised. Declining investment spending presents cause for alarm in view of its negative effect on future growth and job creation. Without a strong recovery in investments, the Philippine economy will, at best, continue to grow at the moderate rate of four to five percent. At this pace, there is no getting out of the current doldrums, let alone catching up with our neighbors. In particular, the crisis in the labor market characterized by near-record levels of open unemployment and underemployment will continue to worsen. The effects of the deepening jobs crisis on poverty and welfare are all too obvious.

President Arroyo’s economic managers are walking on a knife’s edge. On the one hand, continuing to pursue a tight fiscal policy creates pressures on the real economy in terms of depressed demand, weak job creation, rising joblessness, and growing poverty. On the other hand, relaxing its fiscal stance to accommodate much-needed public spending runs the risk of displeasing the country’s creditors. An alternative strategy calls for broader goals and a more flexible approach than the present administration has shown itself capable of imagining.

Maitet Diokno-Pascual is chair of the Board of Trustees of the Institute for Popular Democracy (IPD). Clarence Pascual is senior researcher at the Labor Education and Research Network (LEARN).