The deepening crisis:
the real score on deficits
and the public debtâ

In her state of the nation address before Congress last July, President Arroyo drew attention to the government’s worsening fiscal and debt problems, calling the deficit “our most urgent problem”. That was an accurate statement. The looming threat represented by an uncontrolled public debt is indeed the biggest economic challenge the country will have to confront immediately and for the remainder of this decade.

But, surely, now it has been placed on the national agenda and there is no getting around it, this can only mean the issue will be seriously addressed and resolved, right?

Apparently not. Recent events and discussions give ample reason to doubt whether the President’s message has been truly understood and internalized by the political elite and public alike – and hence whether the issue will be given its due importance. Though business people may wring their hands, bureaucrats may fret, and a polite audience may click their tongues, public debt and government deficits, it must be acknowledged, are of no immediate concern to the great majority of Filipinos.

This is precisely where risk and danger lurk. Because the issue is arcane and removed from people’s daily experience, it commands no great constituency; that many of the proposed solutions portend only collective sacrifice and pain means the only reaction they arouse is broad opposition and deep resentment. And because the issue is crucial but esoteric, well-known but unpopular, it is almost inevitable for some politicians, media, and public intellectuals to make political capital of the situation by pandering to public ignorance instead of relieving it.

The result is an understandable cognitive dissonance: the sound-bites and headlines giving a premium to “clever” solutions with a false assurance that there is indeed no crisis, or that a crisis can be staved off with no sacrifice, no pain, and no radical readjustments in people’s way of life. The quality of public debate on the issue stirs grave doubts whether the scale and consequences of “our most urgent problem” are indeed being fully appreciated.

Why it matters

The national government’s total debt stood at 3.36 trillion pesos as of the end of 2003, split almost equally between foreign and domestic liabilities. This was as large as 78 percent of gdp in 2003. The outstanding debt of the public sector as a whole (the consolidated public sector debt) was running at more than 130 percent of GDP (Chart 1). Both are on the uptrend.

Creditors are on edge over whether in the near future the government should default and they will be unable to get their money back; investors on the other hand would hesitate to invest in a country that seems headed inexorably for another crisis. The growing size of the debt and the deficit are undoubtedly the biggest reasons that investment and growth in this country have remained sluggish – fully seven years since the start of the Asian crisis.

The danger such numbers represent is obvious. The growing dependence on debt means that any sudden increase in global interest rates – which can no longer be ruled out – would cause huge difficulties in repayment, whether or not the government defaulted formally. This would result in a sharp cutback in subsequent credit, particularly from foreign lenders, and precipitate a crisis such as that Argentina or Turkey experienced. As the 1983-1984 crisis showed, the cutback in foreign lending would lead to a sharp peso depreciation, most likely aggravated by capital flight, severely contract trade as the price of imports rose, and correspondingly cause a deep recession and unemployment. The current uncertainty of the international climate, especially as it affects the country’s energy supplies and military spending regarding anti-terrorism, makes it prudent to be fiscally more conservative.

A crisis would not be averted even if government sought relief by reneging only on debt held by its own citizens (this might prove tempting, since Filipinos hold most of the government’s peso-denominated debt as well as a good chunk of dollar-denominated debt). Even that would also cause major difficulties and bankruptcies for the domestic banking system, which holds a large amount of government paper, and ruin millions of depositors. Such a systemic shock would entail a no less severe economic contraction, causing thousands of bankruptcies and throwing millions onto the streets.

At the moment, such scenarios are being fended off only by the fact that the country continues to earn more foreign exchange than it spends (thanks especially to overseas workers’ remittances). But this could just as easily change. Any large external shock, such as a sustained increase in world oil prices, or a sharp fall-off in workers’ remittances, or ironically, even rapid growth that caused the import bill to rise, would make the country increasingly vulnerable. While the economy is not yet on the brink at this time, it can probably afford at most three years to avert such a crisis – with possibly a year at most to convince financial markets it is doing something to reverse the situation.

Chart 1.Total national-government and public-sector debt

(1996-2003; as a percentage of current gdp)

Apart from what lenders and investors think, however, there is a more urgent and mundane reason for the government to focus on the deficit and the level of public debt. Unless it does so, it can make little progress on any of its promised programs. It is by now well known that almost 30 percent of annual spending is taken up by interest payments on past debt alone. Roughly half then goes simply to paying salaries and operating expenses. In 2003, capital outlays (which include the infrastructure budget) made up a little more than 6 percent of the budget, with amounts being slashed almost by half even in nominal terms.[1] All of this leaves very little to go around by way of government programs, causing a wide gap between reality and its ambitious plans and promises.

Debt and deficits – stylized facts

In principle, the public debt can be understood as the accumulated difference between what government spends and what it earns. It would be a great error, however, to focus only on the visible part of government spending and revenue, namely the national government’s budget deficit, and therefore attribute the causes of the problem entirely to that quarter. In fact, the two largest failures that have led to the present critical state of public finances are first, the failure of the tax structure and bureaucracy, and second, the inefficiency and lack of accountability on the part of public corporations. We tackle these in turn.

Between 1997 and 2003 the national government’s debt rose by P2.01 trillion, from P1.35 trillion to P3.36 trillion. Of this total increase (Table 1), 43 percent was due to deficits incurred by the national government during the same period. Nineteen percent was caused by exchange-rate changes: with half of the debt being foreign-currency denominated, the peso equivalent of the debt increases every time the peso depreciates. It is significant, however, that more than one third (37 percent) of the build-up in debt is due not to accumulated deficits but is to “non-budgetary accounts” and off-book items such as assumed liabilities and lending to corporations. These we discuss further below after examining the deficit blow-out.

Table 1. Accounting for the increase in debt 1997-2003

	Amount billion pesos	Percent distribution
Increase in the national government debt	2009.45	100.0
Due to national government deficits	855.69	42.6
Due to exchange-rate change	377.54	18.8
Due to non-budgetary accounts	320.55	16.0
Due to assumed liabilities and lending to corporations	428.10	21.3
Increase in cash	27.54	1.4

As is well known by now, national-government deficits have grown steadily over the past years (Chart 2). From near-balanced budgets in the middle and late 1990s, deficits surpassed 5 percent of gdp by 2002 before moderating slightly to 4.6 percent in 2003. By that time, of course, a good part of the problem was the rising share of debt service in the budget; in 2003 debt service took up 27 of the total budget.

Unlike the debt crisis experienced in the late 1980s, however, the increasing debt service today has not been precipitated by suddenly higher interest rates that the government must pay on its debt. (On the contrary, both domestic and foreign interest rates have been quite benign, a situation however that may not last very much longer.) This assertion is evident if one views the trends in the primary surplus. The government has more or less run surpluses net of debt service (primary surpluses running to almost 6 percent of gdp in 1994), but these disappeared noticeably from 1999. By the end of 2003, the primary surplus was down to 0.6 percent of gdp. Unlike 1983-1984, this time the problems were largely of the government’s own doing.

It is indisputable however that this deterioration was not due to any sudden spike in budgetary spending. Total spending has averaged 19 percent (Chart 3). Net of interest payments, national-government spending (i.e., primary spending) has in fact declined significantly since 1999, and is now at its lowest level in a decade. Large chunks of the national budget are already pre-empted by salaries, maintenance and operating expenses, and the internal revenue allotment to local governments, leaving little room for infrastructure spending and other development needs.

Chart 2. Primary and total surpluses and deficits

Chart 3. Primary spending and total spending

(1993-2003; as percentage of gdp)

Instead what is clear is that falling revenue- and tax-efforts have been the main reason for the worsening deficit picture since 1997. The tax-effort in particular fell from a high of 17 percent of gdp in 1997 to only 12.5 percent by 2003. That this occurred even during years of continuous, though moderate, economic growth strongly suggests that serious structural flaws have crept into the revenue system. It has been strongly suggested that much of this is due to rampant tax evasion abetted by a corrupt revenue bureaucracy. There is absolutely no dispute regarding this. On the other hand, it is also known that corruption and tax evasion are not new phenomena and have been age-old features of current tax administration. Unless one is prepared to state that corruption and evasion have drastically and autonomously worsened – evidence of which has not been presented – one would still be hard-pressed to explain the fall-off in tax effort since 1997. The point is not simply to show that evasion and corruption exist – for that is conceded – but that they have worsened and that this worsening is the sole or even major culprit in declining revenue effort.

Apart from worsening revenue administration, one must also consider that economic growth has been weaker. Moreover, the economy has had to contend with an inflexible and unresponsive tax structure, mortally weakened by the legislative failure to adjust specific taxes (e.g.. taxes on petroleum, beverage, and tobacco); the excessive grant of incentives and exemptions (e.g., from the boi and for special economic zones); the failure to provide for administrative rules to plug revenue leakages (e.g., failure to ensure that final taxes on loans and deposits withheld by banks are actually remitted to the government); and an unabashed surrender to lobbying, as illustrated by the vat exemptions given by Congress to doctors, lawyers (and law firms!), and even show-business. Finally, apart from administration, there is the problem of judicial failure in following through on tax evasion cases. Not only are large tax evaders unlikely to be charged; even those who are charged are likely to go scot-free.

In all this, therefore, there is blame enough to spread around – blame the executive for its failure to discipline the tax bureaucracy and rein in waste; blame the legislature for its failure to pass the laws that will adjust specific taxes to recover their real value and for caving in to powerful or populist lobbies; blame the judiciary for abetting tax evasion through its inaction and irresponsibility; and finally blame the taxpayers at large – better yet, the large taxpayers – for what the President has called “a culture” of tax avoidance and tax evasion.

Chart 4. Revenue- and tax-effort
(Revenues and taxes as percentages of gdp; 1995-2003)

The story behind non-budgetary accounts and assumed liabilities

Budget deficits have been the largest contributor to the growth of the government debt. But they are by no means the only major ones. It has already been mentioned that an equally sizeable amount (37 percent) of the debt-increase is due to “non-budgetary accounts” and assumed liabilities and lending to corporations.

Such accounts stem basically from the fact that the operations of the “government” are much larger than the activities involving regular branches and agencies. This much is already evident in the distinction between what is called “national government” debt and “public sector” debt. National- government debt at the end of 2003 was equivalent to 78 percent of GDP. Total public-sector debt, on the other hand, was more than 130 percent. The latter includes the former as well as the liabilities of government-owned or -controlled corporations, which are strictly speaking not obligations of the national government – or not yet, anyway.

In principle corporate entities like the National Power Corporation (npc), the Public Estates Authority (pea), gsis, and sss, although government-controlled, are supposed to pay their own way, borrowing on their own account whenever needed to serve their clients better, but in turn collecting fees or earning revenues to repay those liabilities. The servicing of such debts should not in principle show up in the national government’s budget.

Experience has shown, however, that the national government will frequently step in to assume the debts of such government corporations when these run into trouble and fail. The result: what ought to have been liabilities only of these corporations and the clients they serve become transformed into debts of the national government and of all Filipinos. The pattern is not new and has unfortunately persisted to this day. The huge debts inherited from the Marcos administration that are still a burden to today’s taxpayers consist largely of the debts of ostensibly self-financing projects that turned sour and of supposedly self-sustaining institutions that bellied up and needed to be rescued. These include the bailouts of the Central Bank, the dbp, the pnb, and the old npc (like the Bataan nuclear power plant). Most of these are classified as “non-budgetary accounts”. They have long been officially recognized as government debt, and magnitude and debt service are largely known in advance. In Table 1 the servicing of these debts accounted for P320 billion or 16 percent of the rise in debt in the period 1997-2003 alone.

On the other hand, the other off-budget item we have decided to call “assumed liabilities and net lending to corporations” (alnlc) in Table 1 is more difficult to assess. Unlike “non-budgetary accounts”, a large part of which is a legacy of the past, the size of alnlc is essentially indeterminate, since this must wait on future decisions regarding how much further government will assume the debt incurred by government corporations. Among the large new debts recently assumed by the national government have been those of the National Power Corporation and the Philippine Estates Authority. When, for example, npc recently sought to cover its running losses by borrowing abroad, there were no takers of its bonds; the national government instead bought the npc debt paper, then proceeded to borrow abroad on its own account then lent this on to the npc. Thus what should have been the debts of a single corporation became the liabilities of the entire government and became included in the debt-service budget right under the noses of Congress. Over the past five years alone (1999-2003) the national government took over P44.5 billion of npc debt. Other liabilities that may be in the pipeline for takeover and which could mysteriously make a surprise budgetary appearance include those of the sss, gsis, and the rsbs.

The alnlc make up more than one-fifth of the increase in total debt thus far. But another source of indeterminacy in the alnlc stems from the fact that a good part of them are “contingent liabilities”, whose magnitudes are variable, since whether and how much of them the government must pay depends on certain “triggers” being activated. When, for example, npc entered into purchased-power agreements with some private producers of electricity, it did so under “take-or-pay” clauses that committed the government to pay the generator a fixed amount, regardless of whether the npc sold all the electricity or not. In other cases, the ballooning of such liabilities is inflicted by the government on itself. For example the government, for political reasons, decided to reduce power-rate charges and light-rail fares to levels below the prices it contracted to pay. Until these prices change, therefore, the difference shows up as debt service in the budget.

A relevant question then becomes how much the national government is ultimately likely to owe and how much it should be prepared to pay from taxes and other revenues. Is it the large figure of P3.36 trillion or the even-larger figure[2] of P4.13 trillion? The answer is certainly “some figure between the two”. At this point, however, no one can tell exactly how much the final figure will be. Whether the debt-service payments of the national government are bigger or smaller will depend on (a) how well government-run corporations perform their operations and stay out of financial trouble; and (b) whether or not government decides to bail out failing corporations and assume their liabilities.

The problem of the ballooning government debt, therefore, cannot then be attributed solely to the “extravagance” of government budgets, or the inadequacy of its tax revenues. An equally important part of the story has been the dismal performance of government-run corporations and the equally disastrous policies of all previous administrations that have affected them. Both have played a major role in determining the size of the debt and the burden that taxpayers must bear to service it.

Even as one must agree with the note of urgency sounded by the administration on this problem, therefore, no one can justify an approach that entails all adjustment and pain falling only on the general taxpayer. One of the imbalances of the current system – which has been exploited by every President in the last four decades – is that the executive, acting without Congress, can decide whether and to what extent contingent and guaranteed liabilities of government corporations are to be assumed by the national government and passed on to the general public. To that extent, and because of automatic debt-appropriation, Congressional approval is reduced to a mere rubber stamp.

In this connection, the President’s proposal to limit the number of corporations is laudable and a step in the right direction. What matters immediately, however, is not the absolute number of corporations: it is whether and how much this contributes to the national debt. Hence it matters to what extent the administration itself encourages, benefits from, and ultimately condones their irresponsibility and loss-making behavior. More important than limiting the number of corporations is a hard annual limit to how much of a subsidy and guaranty they can expect from hereon. The fact that at the moment, there are no practical limits is an onus on the presidency and an abdication of responsibility on the part of Congress.

Unsustainability: the simple arithmetic

This late in the day, staving off a full-blown fiscal crisis really boils down to attaining one goal, stopping the growth of the government debt as proportion of gdp. In other words, maintain it indefinitely at its current level of 78 percent, or lower. In the end, any combination of measures that falls short of accomplishing this goal cannot be regarded as serious.

As a little algebra will show (see Appendix), whether the size of the public debt relative to gdp can be kept constant or not will depend on the following factors: (a) the existing debt-gdp ratio; (b) the growth rate of output; (c) the rate of inflation; (d) the rate of currency depreciation; (e) the government’s primary surplus or deficit, i.e., the excess of revenue over spending, excluding interest payments; (f) domestic and foreign interest rates; and (g) the extent to which the government assumes the debts of failing corporations or services contingent liabilities, i.e., the non-budget and off-book items discussed earlier.

It is intuitive that rapid economic growth should reduce the size of any level of debt in relation to gdp. Higher inflation likewise lowers the value of pre-existing obligations. On the other hand, higher domestic interest rates increase debt-servicing payments, and to the extent a portion of the debt is payable in foreign currency, higher foreign interest rates and currency depreciation would also enlarge the debt service requirements. Finally, of course, a larger primary surplus would reduce the debt-gdp ratio to the extent it allowed one not only to service the existing debt but also to pay it down.[3]

One may directly verify that the goal of stabilizing the government debt-gdp ratio cannot be achieved without a radical change in observed trends. Historically, real output growth has hovered at only 4.2 percent annually; inflation and depreciation are respectively 5 percent and 4 percent annually. The average interest rate is about 10.5 percent, while the servicing of off-budget items is currently three percent of gdp. This configuration can be sustained only if the government runs a primary surplus equal to 4.0 percent of gdp. In the current state of things, however, the actual primary surplus is only 0.6 percent of gdp, a level at which the debt would grow indefinitely.

In practice, of course, the debt would stop growing simply because it would become so large at a certain point that the government’s creditors would refuse to lend any further – or the government itself may declare it is unable to service its debt – a default. Along the way they will have demanded increasingly higher interest rates, making it even harder to keep up payments.

This has already occurred in the case of the country’s foreign borrowings, with successive credit downgrades raising the cost of borrowing. Hence, the country is already paying a high price for fiscal deficit deterioration. By reducing the risks of sovereign incapacity through credible deficit reduction, it is possible to reduce the high interest rate premium costs of financing debt. It further helps to alleviate pessimistic economic expectations arising from large fiscal deficits.

False hopes

Arriving at an adequate response to the deepening crisis must entail first presenting real alternatives to the public and to the political leadership. Conversely, it is important to dispose of schemes that tend merely to raise unrealistic hopes and distract from serious solutions. Below are discussed some apparently inspired but ultimately unworkable, inadequate, or even plainly disastrous ideas.

1. Why the country cannot “outgrow” the problem

One of the first ideas that must be disposed of is that the economy can somehow “grow” itself out of a crisis-trajectory while keeping inflation and currency depreciation at levels no worse than today’s. The thread of plausibility on which this hangs is that – as a matter of simple arithmetic – higher economic growth of about 8 percent could make the existing size of debt more manageable in relation to gdp.

But this is no more than whistling in the dark. When has the economy ever demonstrated the ability to achieve, much less sustain, gdp growth of 7-8 percent annually? The answer, of course, is at no time in recent memory. Thus the idea merely begs the question. If the economy – under the same administration – was unable to grow at 8 percent when world oil prices and global interest rates were low and the country had better credit ratings, what is there to make us think it can do so in the future? It is sobering to note that the historical growth rate of the Philippine economy from the nineties to the present averages only slightly more than 4 percent even if only non-crisis years are included.

There is a finer point. Unless growth happened to be export-driven or accompanied by accelerating workers’ remittances (both unlikely under present circumstances), higher growth would cause rising imports and wipe out the current-account surplus. This would knock out one of the economy’s shaky props. For that would mean that, rather than inducing fellow-Filipinos to lend their dollars to the government, the government would have to accept the drastically higher interest rates demanded by foreigners. Interest payments would be pushed up, and the country pushed closer to a debt crisis.

2. Why simple spending cuts will not work

Similar to the previous one is the floated idea that the government should simply “live within its means” by cutting down waste. Indeed a striking proposal has been made by some to limit the increase in the government budget to no more than 5 percent per annum in absolute terms. The apparent rationality of this proposal evaporates, however, once it realised that inflation alone hovers at 4-5 percent per annum, so that the proponents are really arguing that total government spending should be frozen in real terms. With population increasing annually at 2.3 percent, this is tantamount to a reduction of government spending in real terms per Filipino. To see the inadequacy of this proposal, it should be noted that the annual education budget has difficulty today even keeping up with new pupils. The education budget was only 2.4 percent of gdp in 2003 (Table 2), down from 2.9 percent in 2001; it has by and large risen by less than inflation, so that its real value has in fact fallen. Absent some drastic change, these trends are bound to continue. The programmed increase in the budget in 2004 is obviously less than the expected rate of inflation and certainly the rate of growth of output.

Table 2. Shrinking education budgets

	Education budget (in billions of pesos)	As a proportion of gdp (percent)	Growth of budget (percent)	CPI Inflation (percent)
2001	97.5	2.9	--	4.4
2002	104.1	2.6	6.7	6.1
2003	104.5	2.4	0.3	3.1
2004	107.5	2.3*	2.9	5.5*

Sources: NEDA, BSP, DBM; *authors’ estimates

The fact is that many vital budget items such as education have already been frozen or are even shrinking in real terms. But simply because this has been done in the past does not mean it can – or should – continue. That budgets have been frozen is not a sign of strength – rather one of despair.

Let there be no mistake: there is every reason to look closely into the efficiency of public spending in order to eliminate waste and corruption. Raising the efficiency of government expenditure and investment implies that more results are achieved for the same amount of expenditure. But when the bulk of national-government spending is already pre-empted by debt service, the internal revenue allotment to local governments, salaries of teachers, police, and soldiers, not to mention maintenance and operations, it is difficult to find ways of reducing outlays that are sufficient to meet the demands of sustainable debt without provoking large dislocations and inviting social unrest.

3. Why reforming tax administration will not suffice

An attractive proposal is the often-repeated line that in fact “no new taxes are needed”; “all that is required is sound enforcement and tax administration”; “get rid of corruption, and you get rid of the deficit problem”. It is no surprise that this fallacy has spread and taken hold: it was the common theme propagated by both administration and opposition in the past electoral campaign, and both must now assume full responsibility for the deception they have foisted on the public.

The grain of truth in this suggestion is that – as already discussed – the efficiency of tax collection has indeed fallen off dramatically and is a major cause of the current budget deficits. It is also true that if the revenue effort were to be restored to 17-18 from the current 12 percent, the current trajectory of moderate growth, inflation, and depreciation might stand a chance of being sustained. The crucial consideration, however, is first, whether the time exists for such reforms in administration to play out before the fiscal time bomb explodes. It has taken all of five-to-six years for the revenue effort to reach its present dire levels. Can it possibly recover in a shorter period? Most likely not.

Again there should be no mistake. There is every reason to support reforms in revenue administration, and indeed, many (including some of the undersigned) have proposed altogether scrapping the current bir agency structure and replacing it with a performance-oriented agency such as the ill-fated irma. But even those who support this reform will admit that recovering the integrity of revenue administration is a project for the long-haul, and that indeed in the short run it may even lead to a drop in revenues as threatened incumbents and insiders attempt to hold the government revenues hostage.

Second, the limits of reforming tax-administration are in fact evident in the entirely modest nature of success even under the current bir leadership, arguably already one of the most determined. After the administration’s great hue and cry this last year over catching tax cheats and their abettors in the bir and Customs, after the much-vaunted “lifestyle checks” and charges against bureaucrats, the tax effort in 2003 was in fact no better than it was in 2002. All that was achieved – and this was a success in itself –was to halt the slide in revenue effort.

These considerations suggest that the best intentions notwithstanding, reforms in revenue administration cannot do the entire job of staving off the crisis, nor indeed do it in time. Corruption in revenue administration was simply not solely responsible for the drop in revenues. As already pointed out, important taxes (on petroleum, tobacco, and alcoholic beverages) have simply not been adjusted for inflation; tax breaks have been generously expanded; special groups have been unduly favored; and changing economic patterns of production and consumption have meant that new sectors are under-assessed. These reasons make it evident that apart from pursuing reforms in tax administration, a substantial change in the tax structure, particularly a topping-up or updating of existing taxes, as well as new taxes must form necessary components of the fiscal-rescue.

There is truth to the idea that part of the difficulty in revenue collection is created by the complexity of the tax system. A simpler set of rules would make compliance more transparent and collection less prone to discretion and corruption. It is probably in this spirit that the idea of shifting the system over to a gross income tax (git) has been suggested. We think, however, that the promised simplification may fail to materialize, and that the proposed measure may in fact do more harm.

There are two possibilities: a gross income tax would either enforce a “one-size-fits-all” approach, or it could avoid this by tailoring tax formulas to suit different types of firms and activities. In the former case, a git system could positively hurt firms whose real conditions fail to conform to those assumed in the formula. Unlike typical manufacturing firms, for example, a good part of costs of consulting and other service-sector firms could consist of training and travel costs. But such firms would be unable to deduct these costs as “cost of goods sold”, although these would be completely legitimate. Even firms that were starting up and promoting new products could find their marketing and advertising costs disallowed, putting them at a disadvantage against established competitors. Ultimately, one could not rule out the possibility that even firms that were actually losing money could end up paying taxes. In short, the measure would fail a test of equity by treating un-equals as if they were equal.

The proposed git could be designed to avoid the above difficulties. It could apply different procedures depending on the activity, e.g., use different tax schedules for manufacturing versus service firms, or use shifting definitions of what can and cannot be classified as “cost of goods sold”, or “cost of sales”. But then this would defeat the rationale for the git, which is its supposed simplicity. Moreover this would leave ample room for evasion through profit-shifting on the part of firms with multiple activities, as well as provide opportunities for discretionary behavior and corruption on the part of tax collectors. In short, gross-income tax could be effective by being unfair; or it could be made fair but defeat its own purpose by being ineffective. No magic bullet here.

4. Monetizing the deficits – down a slippery slope

Should opposition to any significant tax measures prove intractable, few new revenue measures are likely to be passed. Similarly, political resistance may prevent power rates, light-rail fares, expressway tolls, and the entire slew of fees and charges from being raised. As a result, the servicing of non-budget and off-book debts may continue to be a heavy burden.

In such circumstances, a clever and sophisticated proposal may ultimately be floated for the government to stave off crisis – with the central bank’s cooperation – by simply monetizing its deficits. Essentially government could use high-powered money (effectively “printing” money) to pay its domestic debts as well as to buy the foreign exchange needed to service its foreign debts.

One obvious result of course would be depreciation, possibly at double-digit rates, with inflation also likely to kick in at double digits. Here again there is a grain of plausibility in the idea. Double-digit inflation and peso depreciation could make the debt somewhat more tractable, since it would amount to increasing the size of nominal gdp relative to the debt. The government basically gains to the extent that it pays off the maturing part of its old debt stock using pesos with lower purchasing power. Domestic interest rates would of course rise with inflation and depreciation, but the government would need to pay such higher rates only on its new borrowings, which are less than the stock of its old debt, so that it could still come out ahead.

What could prove wrong with such an approach? First, the relief it provides is obviously inherently limited, since any further new borrowing would carry higher interest rates. And though inflation would temporarily solve the problem of servicing domestic debt, it would actually make the servicing of foreign debt – which is about half the total –more difficult and costly. The peso amounts needed to service the entire stock of foreign debt would balloon owing to the large depreciation. The same would hold for non-budget liabilities, since a large part of that is also denominated in foreign currency.

Second, monetizing the deficit requires some form of capital controls. Only in this way would the government be able source its foreign-exchange needs; otherwise the mere threat of a large depreciation and run-away inflation would lead to a massive capital flight and a rapid loss of reserves. The Philippines, however, has historically been unable to implement such controls effectively – not even under the Marcos regime, so that the possibility of massive capital flight cannot be fully discounted.

The ultimate objection, however, must be that this partial solution to the government’s problems will have been obtained unjustly at the cost of a rapid loss in living standards and heightened uncertainty for large parts of the population. The true incidence of an “inflation tax” is inherently unpredictable. The better-off may be forced to accept a sharp cut in wealth to the extent that they hold government and other debt, whose interest payments are now worth less in real terms. But ordinary people are likely to feel the brunt of sharply higher prices. Inflationary expectations are likely to be fanned by price- and wage-increases, with any adjustments being unlikely to meet with anyone’s full satisfaction. The prospect of capital flight and a rapid loss in reserves is a real one. All in all the potential for significant social unrest cannot be ignored.

The Philippine economy has little to brag about in terms of performance. But the little it has achieved thus far has allowed it to attain a modicum of stability in most macroeconomic variables: restrained inflation at single digits, modest currency depreciation, low interest rates, and sustained if unspectacular, growth in real output. It is precisely these hard-won achievements, however, that an aggressive deficit-monetization would brush aside. Hence, even as the government may buy somewhat more time with such measures, the true question is whether they do not also undercut the basis for any long-run recovery.

A burden shared

The preceding section will have demonstrated one point: there is no simple, clever, or painless solution to the impending crisis; those who say otherwise are being either naïve or disingenuous, or both. But even as any adequate solution will demand sacrifice, our concern is that sacrifice should be fairly apportioned. People will demand, and government should aim for, a solution that is not only effective but also just.

Raising new taxes or just maintaining the real value of existing ones, increasing service-tariffs, or cost-cutting will always be contentious and are bound to meet resistance. If government is to foster solidarity and understanding for the national predicament, therefore, it must take special pains to render a candid accounting – not the least to some of its own leaders and representatives – of how the economy came to this impasse in the first place. More importantly, government must state what actions it intends to take to forestall a recurrence of these difficulties in the future.

The measures proposed by government must be seen to result from a judicious weighing of alternatives, a coherent program, and to have been guided by economic principles and a concern for equitable burden sharing. Confidence and credibility will hardly be served when government floats “trial balloons” on revenue and cost-cutting measures that appear arbitrary and offhand, only for these to be withdrawn subsequently.

Finally, fairness requires that if sacrifice is to be borne by the people, the government would do well to begin with and to demand more of itself. In this the acupuncturist’s maxim may serve as guide: “A thousand needles on oneself before even a single one on the patient.”

What follows is offered in the spirit of beginning a constructive public discussion of alternatives. We set down what we regard as both a workable and fair approach to resolving the government’s fiscal predicament (summarized in Table 3). No omniscience is claimed, and others are welcome to dispute the tenor and the numbers of these suggestions. Considering the nation’s predicament and the need for urgent action, however, it is but fair to ask of them one thing: do better.

Hence:

1. Limit the burden of servicing off-budget liabilities to 1.5 percent of gdp through price-and fee-adjustments, cost-cutting, and management pay-cuts in government corporations.

We have already argued that it is wrong to put the brunt of all the adjustment on the national budget. The debt has not been entirely caused by runaway budgets in the first place. A good part of it is debt taken over from government corporations, especially npc. It stands to reason, then, that the burden imposed by those corporations must first be limited. Among others this implies that a ceiling must be set on the rate at which the national government assumes the debt of these corporations. The servicing of such assumed liabilities is currently equivalent to some 3 percent of gdp. In the next few years it would be reasonable to restrict this amount to no more than 1.5 percent of gdp. Doing this, however, means compelling these corporations to get back on sound financial footing. Among other things, serious and demonstrable efforts are required to cut out waste, gain control over the generous pay, perks, and corruption among executives and the rank and file of such corporations. For the most part, however, the most effective immediate action will entail decisions to allow increases in the prices or fees for specific services (notably power), or a curtailment in their quantities, all of which are changes to be borne by clients or customers. Indeed the first order of business is for the administration to turn its back on the past practice of politicized price-setting. A big part of npc losses, after all, was due to the capping of ppa charges to 40 centavos as a popular concession, even as the npc continued to pay at least P1.20 to its ipp suppliers.

The closest attention should be devoted to the npc, which is responsible for the biggest part of the consolidated public sector deficit and also accounts for a large part of the debt that is effectively absorbed by the national government. A crucial step in reducing the burden to taxpayers is the adjustment of power tariffs. (An increase of P1.50 per kilowatt-hour already represents a reduction of the burden equal to 1 percent of gdp.) Such a step is also indispensable in selling off the npc’s assets (now held by psalm), which is a necessary condition for the success of the epira. For even if the government should succeed in momentarily halting the rise in debt-service from government corporations, the problem of off-budget liabilities cannot be said to have been decisively solved until the privatization of npc has been completed.

2. Raise the national government’s primary surplus to control the size of the debt and to safeguard the basis for future growth.

The government needs to exert extraordinary efforts to sustain a larger primary surplus (that is, revenues less expenditures excluding debt service). If the aim is simply to put a stop to the growth of debt relative to gdp, then the primary surplus must rise to 2.5 percent of gdp, compared to the current 0.6 percent. This means raising additional revenues or cutting additional costs equivalent of about P81.7 billion annually.[4] Such a target for debt-maintenance is compatible with maintaining the current moderate levels of output growth, inflation, depreciation, and interest rates.[5] These figures of course presume that the burden of off-budget liabilities can be reduced in the manner already discussed.

Table 3. The current trajectory versus burden sharing

Scenario	Output growth %	Depreciation %	Inflation %	Off-budget*	Primary surplus*	Additional revenue requirements*	Comment
Current trajectory	4.2	4.0	5.0	3.0	0.6**		unsustainable; required primary surplus is 4%
Burden-sharing	4.2	4.0	5.0	1.5	2.5		required primary surplus for controlling debt
Target revenue be raised or costs to be cut						2.9
Of which: For additional primary surplus						1.9	In addition to existing primary surplus of 0.6
For future growth						1.0+	for vital social spending and possible debt-reduction

* as % of gdp; **actual primary surplus

It cannot be the sole purpose of government, however, simply to survive its fiscal trials. If the basis for future growth is not to be compromised, then a policy of simple debt maintenance cannot suffice, and the government must do more. A program that merely saved the government’s fiscal hide and imposed sacrifices on its people, yet gave them nothing in return would be the height of state arrogance.

At the very least, therefore – in addition to the reforms required to prevent a crisis recurring in the future – provisions must be made for an expansion of essential budgets and possibly pay down debt in the future. Budgets devoted to physical infrastructure and to education need particularly to be increased in the face of a growing population and so as not to fall far behind in competitiveness. A prudent program would provide for an increase in the annual gdp share of these essential budget items, say by an additional 1 to 1.5 percentage points (about P43-64 billion).

If this is taken into account, government needs to raise additional revenues or cut costs by that amount. The new measures must therefore raise a total of 2.9 percent of gdp, of which 1.9 percent is to achieve the minimum primary surplus of 2.5 percent needed for debt maintenance and 1 percent is to augment budgets of vital infrastructure and education. If further amounts are raised this may be used to retire debt. Again this allows for a maintenance of at least current growth rates of output and avoiding any permanent rise in inflation, depreciation, and interest rates. In 2003 figures, this would be equivalent to raising additional revenues or cutting costs equal to a minimum of about P125 billion annually.[6]

3. Raise revenues by closing off tax-loopholes, updating existing taxes, passing new revenue measures, and reallocating spending.

It is not difficult to determine consistent, abstract orders of magnitude for macroeconomic variables that yield stability. The real challenge to the government, however, is to find measures that not merely attain macroeconomic targets, but more importantly also find a degree of social tolerance, though obviously not acceptance and support, among an already embattled and suspicious citizenry. Needless to say, it would be easier for the public to accept that painful measures are indeed necessary, if the government, its leaders, and the economic elite were first to put themselves in the line of fire.

Our own suggested criteria for evaluating proposed revenue- or cost-cutting measures are as follows: (a) implement the full intent of existing laws ahead of new taxes; (b) distribute the burden of cost-adjustment and spending cuts throughout government; (c) consider only new taxes based on strict economic justification and ease of collection, in that order.

On this basis, we endorse the measures contained in Table 4, each of which is discussed in succeeding paragraphs. Taken together, these measures, which either reduce costs or raise revenues, could conservatively help raise the primary surplus to the required 2.5 percent of gdp, in line with earlier macroeconomic discussions, and assuming the current surplus level of 0.6 percent of gdp is preserved, as well as sustain vital spending.

a. Indexing existing specific taxes on tobacco and alcohol products. The indexation of specific taxes on alcoholic beverages and tobacco (the so-called “sin products”) is a long-delayed measure that has been on the administration’s agenda of priority legislation for at least the past two Congresses. This measure is not even a new tax at all, for it simply implements the intent of the comprehensive tax reform program (1997), which replaced the ad valorem taxes on these goods with specific excises, under the proviso that these specific peso amounts would be regularly updated. The failure to implement that proviso thus effectively means that the products in question – whose negative consumption externalities justify their being taxed extraordinarily in the first place – are currently undertaxed relative to the levels prevailing 1997.

To prevent a similar erosion of these taxes occurring in the future, an important change in the law should allow for their automatic and periodic indexing. No special intervention by Congress should thenceforth be required, and the law should allow the indexing to be carried out following a formula and utilizing data collected purely administratively by, say, the National Statistics Office. This, it will be recalled, was the provision struck out of the original comprehensive tax reform package.

The passage or non-passage of this measure is the first signal of the government’s (both the executive and the legislative) commitment to address the debt-and-deficit issue. Indeed it is fair to say that if this piece of legislation is not finally passed and signed before the end of this year, the entire government’s credibility with respect to the entire fiscal- and debt-problem will have been irretrievably lost.

b. Plugging tax leaks. In the same spirit of taking the intent of existing laws seriously, no new legislation is needed – merely new procedures and approaches – to generate significant revenues by a focusing on significant leakages in the implementation of certain provisions of the tax code. The Department of Finance and the National Tax Research Center in 2000 estimated that these measures could generate almost P25 billion, or about six-tenths of one percent of 2003 gdp.

Table 4. Possible immediate revenue- and cost-saving measures

Revenue measure	Additional take (bn pesos)	Contribution to revenue or cost-cutting (% of gdp)	Remarks
a. Indexation of specific taxes on tobacco and alcohol	14	0.33	a bill long pending in Congress
b. Closing off tax leaks plus additional BIR effort	12.4	0.3	half of the yield estimated by DOF (refer to Table 5)
c. P2-specific tax on petroleum	12	0.28	P2 per liter on approx. 6 mn liters (excluding fuel used for power)
d. Motor-vehicle fee increase and	2.0	0.05	a 50-percent fee increase (P1000 on ca. 2 million vehicles,
e. Eight-percent increase in excise on new vehicle registration	3.2	0.07	8 percent applied to ca. 80,000 new vehicles annually at average price of P500,000 per unit
f. Increase VAT rate from 10 to 12 percent and expand coverage	25	0.58	each percentage increase in VAT yields 0.3 percent of GDP
g. Reduce IRA to 30 percent	35.2	0.82	nominal amounts based on 2003 figures
h. Halve CDF allocations	10.7	0.25	P100 mn each from 24 Senators plus P35 mn each from 236 Representatives
i. other measures to be identified	10.3	0.24
Subtotal (new measures)	124.8	2.90
j.. Existing primary surplus	25.8	0.60
Total Higher primary surplus plus new measures	150.6	3.50
Memo: j. Servicing of off-budget items and assumed liabilities	65	1.50	assumed reduced from current level of 3 percent of gdp

*Reckoned on the basis of 2003 gdp of P4.3 trillion.

Table 5. Estimated yield from full implementation of existing tax laws

Type of tax/measure

Estimated yield (in P billions)