Political institutions and tax policy-making in the Philippines

Posted: April 18, 2010 in Cory Aquino, Fiscal incentives, Fiscal policy, FVR, Legislatures, LGUs, Philippine politics, Political institutions, Presidents, Taxation, Value-added tax (VAT)

In this blog entry, we continue sharing parts of the draft book on political institutions and policy making in the country.  To sharpen the discussion, we focus our attention on tax policy-making with emphasis on tax measures adopted during the presidency of Fidel Ramos.

I believe this discussion is timely given recent warnings that the incoming president will be saddled with fiscal deficits and need to raise revenues by way of raising value-added-tax (VAT) rates and rationalization of current fiscal incentives.

The examination of tax policies is a good way of seeing the policy making process of a country in action.  Taxation touches almost every aspect of the economy and society and taxation is the area of public policy where the most interests are at stake.  For one, a number of public policy decisions (such as public spending and borrowing) and private economic behavior (such as spending and investments) are related to taxation.

Raising adequate tax revenues to finance government programs and support public policy thrusts is one of the key failures of the Philippine state since the colonial period.  During the American colonial period, the efforts of the American-dominated Philippine Commission (which operated as a quasi-executive branch) to raise greater revenues were consistently opposed by the legislative assembly (composed largely of a Filipino elite that acquired land via Spanish land grants and the sale of church lands during the American occupation) (Golay 1984).

In fact, the political dominance of landowners in the legislature helps explain why the real property tax system was not even codified until 1973 (Montes 1991).  In addition, legislators had continually sought tax concessions for constituents and supporters.  Golay (1961) concluded that reliance on tax incentives was the reason why tax revenues did not increase (as a percentage share of the GDP) between 1950 and 1959 despite increasing rates of import duties on American goods.  In his study of the pre-martial law legislature, Stauffer (1970) noted that Congress consistently held back efforts to tax the export industries.  While the martial law government of Ferdinand Marcos adopted tax reforms that increased the tax burden of the wealthier classes, it also granted vast tax exemption privileges to cronies and front-men (Eaton 2002).

Notwithstanding the chronic fiscal crises and crushing debt burden inherited from the Marcos period, legislators were still reluctant to enact tax reform measures after the return to democracy in 1986. However, they were  yet were not immune to tax particularism.  In fact, the most common type of tax bills passed between 1987 and 1994 was designed to grant tax exemptions (Eaton 2002).  President Corazon Aquino (1986-1992) was thus forced to respond to the fiscal bind by relying on domestic borrowing, which allowed her to avoid the politically difficult decisions involved in either repudiating the Marcosian foreign debt or in pursuing tax reform.

Prior to the re-establishment of Congress in 1987, she enacted a limited tax measure which imposed a 10% value-added tax (VAT) on manufactured goods but excluded a wide range of services, including those provided by professionals and financial institutions.

The Ramos presidency (1992-1998) faced a harsher fiscal situation compared to the preceding Aquino government.  On top of the foreign debt service burden, Ramos had to contend with the loss of millions of dollars in official aid from the United States following the abrogation of the Military Bases Agreement and the subsequent withdrawal of American military forces from the country in 1991.  With the passage of the Local Government Code in 1991, his government also had to deal with the increased and automatic claim of local government units (LGUs) on national revenues.  He also had to honor international treaty commitments to lower tariffs.

The need to raise revenues is also demanded by his “Philippines 2000” program, a plan to transform the sick Philippine economy into the latest Asian newly industrializing economy by his term’s end.  It was regarded by many observers as the first strategic top-down project for social and economic restructuring since the Marcosian “New Society” program associated with martial law.

On his election to the presidency in May 1992 on a narrow mandate, Ramos faced an economic crisis characterized by nearly zero economic growth, falling average incomes, and daily power outages of up to 8 hours (De Dios 1993).  At 15% of gross national product (GNP), tax revenues in the Philippines were the lowest in Southeast Asia.  In contrast, In­donesia, Thailand and Malaysia had better tax efforts at 19.8%, 19% and 17.5% of GNP, respectively.  Similarly, the level of tax evasion (more than 50% of potential tax revenues are uncollected) in the country clearly reflected the weakness of Philippine tax administration (Manasan 1994).

As a first step, Ramos proposed the broadening of the narrow VAT base and asked Congress to include telecommunications, cargo transport, hotels and restaurants, books, newspapers, broadcasting, and the lease/sale of real estate.  By buying off congressional opposition to the measure through accelerated releases of pork barrel allocations, an expanded VAT law (Republic Act 7716) was enacted in 1994.  However, the new law’s implementation in July 1994 was suspended when the Supreme Court ruled it violated the Constitution.

After the 1995 mid-term elections, legislators from the House of Representatives resumed their offensive against expanded VAT coverage.  The outcome of this new tax policy process was the improved VAT or IVAT law (Republic Act 8241), which took effect on 1 January 1997.  The new law was a setback for Ramos as legislators reneged on an executive-legislative deal to limit exemptions.

Instead of expanding VAT coverage, RA 8241 expanded the list of industries and economic activities exempted from VAT, leading to foregone revenues estimated at US$20 million (Eaton 2002).  In effect, Ramos used up government funds and substantial political capital to end up with a tax law not entirely up to his liking in terms of revenue productivity, economic neutrality, and equity.

  1. bongmendoza says:

    Reblogged this on bong mendoza's blog.

  2. Bong, please add the ff. comment to my earlier statement: Since the formal adoption of Inflation Targeting as the monetary policy framework in 2002, BSP had become independent. As such, the government (elite) could no longer print money to finance the budget deficit. Since raising revenues is problematic (how can the elite tax itself?), government spending has been financed by borrowing, both domestic and foreign.

    • bongmendoza says:

      Dan, you should know that I am a drop-out from the UPSE grad school. I will do my best to comment on your remarks on taxation and spending. I also believed that the elites are not undifferentiated. When a tax bill is passed, certain elite factions are taxed and the monies are made available for the disposal of other elite factions. Generally, the division will be between revenue producing elites and spending elites. The spending elites, aka politicians, need the monies to raise their political profiles and get elected. Of course, given the inadequacy of public revenue, government spending has to be financed by borrowing, which eventually have to be financed by taxes, new borrowing, and other sources.

      Futhermore, the BSP may be formally independent. However, I think the personalistic culture does not disappear immediately. There might be residual influences of the Palace on the BSP.

  3. Bong, I am Dan Villanueva, residing in VA, USA. For details about me, check out my personal webpage below. I am a U.P. alumnus (Econ), way back in the mid-60s. As to your comment, “The question remains whether growth can be sustained for a longer period (to make significant dents on the country’s poverty rate) while political institutions remain unchanged”, I think the answer is NO. I’ve been reading the book, Why Nations Fail, by Acemoglu and Robinson (Crown, 2012), whose main argument is that only inclusive political institutions (that will foster inclusive economic institutions), away from both extractive political and economic institutions, can lead to sustainable economic growth with declining poverty. I think that A&R are correct. What I am perplexed about is the case of Singapore. With one political party, it has achieved enviable economic growth with almost every Singaporean free from poverty. A&R argue for a government that transitions into a multi-group in power (workers, professionals, small business operators, etc)–e.g., Brazil under Lula–and away from a few elites (with vast land holdings and conglomerates, and political power, either in the three branches of government or via political connections). Can you comment on the Singapore case? Finally, how can the Philippines replicate the Brazilian institutional change?

    • bongmendoza says:

      Hi Dan, thanks for your remarks. Acemoglu or Robinson visited the country about a month ago and preached to the converted. The ground for NIE was prepared earlier by Douglass North and John Nye from George Mason. My comments were actually rhetorical; I also do not believe that growth can be sustained without changing political institutions. I don’t have an explanation for Singapore myself but I will cite the arguments of the Southeast Asianists Doner, Ritchie & Slater (R. Doner, B. Ritchie and D. Slater. 2005. ‘Systemic Vulnerability and the Origins of Developmental States: Northeast and Southeast Asia in Comparative Perspective.’ International Organization 59(2): 327-361). The trio argued that like Taiwan and South Korea, Singapore faced an existential threat after leaving Malaysia. It had to consolidate its internal political base through patronage and other material rewards. But where will these resources come from? It did not have natural resources to speak. It was a small island without any hinterland. The way to go was to go up the value-added chain–manufacturing and services. Singapore parlayed its excellent location to advantage. The People’s Action Party (PAP) imposed social and labor discipline in exchange for patronage (housing) and performance. You know too that a high value-added economy requires more elaborate institutions and coordination mechanisms.

      I do not know much about Brazil and will just offer a few remarks. North and his colleagues, in Violence and Social Orders, also problematised the transition from limited (quite akin to A&R’s extractive) economies to open (akin to A&R’s inclusive) economies. In a summary article, Noel de Dios argued that economic and political institutions are mutually reinforcing, so that “limited-access order” societies like the Philippines may find it difficult to move forward by means of social and political institutions that seek to enforce impersonal rules, meritocracy, and democratic processes – i.e., institutions that presuppose societies with highly developed economies, contestable markets, and pervasive social organisations based on objective secular interests beyond kinship. The country’s failure to bring the actions of its elites to heel under the rule of law; its difficulties in forming enduring social organisations that go beyond
      personal ties and kinship; and its erratic record in controlling violence, particularly from the military – all point to the distance Philippine society needs to traverse before it can create the conditions to escape underdevelopment.

      De Dios opines that a radical change institutions will not do more harm than good. He suggests that It may be more prudent to inquire instead into the possibilities for incremental change under the present institutional set-up that could bring the country closer to threshold conditions. The three broad directions in which this might occur are as follows: (a) greater adherence to constitutional processes; (b) a reduction of presidential prerogatives within the present constitution; and (c) a rebuilding civil society and the spread of political education and organisation.

  4. […] Political institutions and tax policy-making in the Philippines April 2010 2 comments 3 […]

  5. Nonoy Oplas says:

    Bong, the Philippines’ income taxation policy in the 70s was socialist, about 70 % top marginal rate. Maybe Marcos later realized that socialism via high income taxes won’t work, so brought down income taxes to about 40 %. The rate later lowered to 32% in the 90s.

    • bongmendoza says:

      Mahirap naman talagang mangolekta ng income tax kung napakataas ng marginal rate. A punitive rate will induce tax evasion or encourage corruption amongst tax collection agents. There’s a great incentive to talk to them so tax assessment could be lowered.

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