Gloria Macapagal-Arroyo

President of the Republic of the Philippines 2001 - 2010

Reforming the Tax System: Painful but Necessary and Beneficial

Perspective

The steady inflow of revenue is indispensable for any country that has a tremendous economic and social development agenda in front of it. Huge amounts of resources are necessary to underwrite industrial, agricultural, and services development alongside health., education, and livelihood programs for the people, not to mention the administration of government.

Gloria Macapagal-Arroyo assumed the Presidency under extraordinary circumstances. In the aftermath of the Second EDSA People Power Revolution, the newly installed President suddenly faced a task far more daunting than having to manage towards eventual stability the divergent forces who pushed for EDSA II. While the country was still reeling from the effects of the 1997 Asian financial crisis, widespread political uncertainties and weak global conditions took a toll on the country's fiscal standing. Thus, early into 2001, the Philippine economy was held back by an expanding budget deficit.

An academic economist herself, the President recognized that a government largely dependent on loans to finance its programs could never attain, much less sustain, long-term growth. Internally generated taxes and non-taxes are an unavoidable necessity. It thus became imperative that the deficit be reduced to more manageable levels. The economy needed a radical reform in its tax system, and no other person understood this better than the President herself.

What the President did to reform the tax system constitutes an epic story in itself. Mentioning only unavoidable bits of that story, this paper focuses on the impact of that reform program on the country's immediate fiscal position and long-run fiscal development and stability.

I. Defining the Problem and Its Consequences

A. The Budget Deficit

The failure of revenues to match expenditures over the years understandably gave rise to budget deficits. Already at a high level in the late 1990s, the deficit persisted into the third millennium. The Chart below shows the numbers. The deficit amounted to P134.2 billion in 2000, rose to P147.6 billion in 2001, and reached a peak of P210.7 billion in 2002. Therefrom it eased downward, declining to P200 billion in 2003 and P187 billion in 2004. By 2005, it was at P146.8 billion.

A budget deficit, even when unavoidable, must not be allowed to persist. It raises interest rates, thereby discouraging investment. It pushes prices upward, by competing with unearned funds for goods and services in the market, thereby prejudicing the public, especially the poor. In sum, it slows down development and generates instability.

B. The Consequences

1. Rising Debt

One inevitable consequence of a chronic fiscal deficit is of course an increasing public debt. A quick view of the National Government's debt profile five years before President Arroyo assumed office shows that the country's outstanding debt had continuously increased, with foreign debt exceeding domestic debt in 1997, the year the Asian financial crisis swept the region.

As the Chart above shows, the domestic debt rose from P725 billion in 1995 to P1,271 billion in 2001; while the foreign debt jumped from P601 billion in 1995 to P1,610 billion in 2001. An expanding national debt requires setting aside an increasing amount in the expenditure budget for interest and amortization payments. This service payment can become onerous if the debt balloons over time.

Declining Tax Effort

The failure of revenues to increase alongside the increase of the Gross Domestic Product can be seen in the so-called Tax Effort – the percentage of Taxes (and non-taxes) to the Gross Domestic Product. While the Tax Effort increased steadily from just 9.9 percent in 1993 to its peak of 13 percent in 1997, it traveled downward after that, to 10.7 percent in 2001.

C. Early Solutions

Improvements through the BIR

Early into her term, the President directed the BIR to go through a process of transformation to make the agency more taxpayer-focused. In compliance with this directive, the Voluntary Assessment Program and the Compromise Settlement Program were implemented in 2001 together with the expansion of the coverage and scope of the creditable withholding tax system. The Electronic Filing and Payment System (eFPS) also introduced the paperless filing and payment of tax returns, resulting to a 7.73 percent increase in collections.

In 2002, basic strategies were adopted to meet the high expectations in revenue collections. New systems such as the Reconciliation of Listings for Enforcement (RELIEF System) and the Voluntary Assessment and Abatement Program were introduced. The VAAP was offered to taxpayers with under-declared sales, receipts or income. The BIR also enhanced the security of tax payments through the use of electronic broadcasting systems and the expansion of the eFPS.

2. Amidst Adverse Surroundings, Positive Results

Despite the negative developments in the internal and external environments in 2003, the BIR managed to increase revenue collection by 7.97 percent due to the expansion of VAAP to cover other industries and the implementation of the BIR Text Raffle Program. The following year, BIR collections grew by 9.9 percent due to new administrative measures, which include the Tax Compliance Verification Drive (TCVD), the Business Intelligence Task Force (BITF), and the Centennial Taxpayers Recognition Program.

D. Subsequent Improvements

Following initial improvement efforts, the President saw the need to pursue additional measures that would not just improve collections but also revive some of the eternal verities among both collectors and taxpayers. Among the reform measures instituted were the 3Rs—Run After Tax Evaders (RATE), Run After the Smugglers (RATS), and Revenue Integrity Protection Service (RIPS).

1. The Revenue Integrity Protection Service (RIPS)

If the country was to improve its revenue collection effort, reform should start from within its ranks. Government should zero in on revenue officials who were not doing their jobs, and, worse, stealing taxpayer money. The Revenue Integrity Protection Service (RIPS), created in 2003 by virtue of Executive Order 259, was mandated to be the anti-corruption arm of the Department of Finance (DOF). It was tasked to investigate the lifestyle of the officials of the Bureau of Internal Revenue (BIR), the Bureau of Customs (BOC), and other revenue enforcement agencies so that appropriate cases may be filed in the Ombudsman against corrupt officials. As of mid-2009, 73 cases had been filed against 108 officials who failed the lifestyle check under RIPS.

2. Run After Tax Evaders (RATE)

While RIPS was charged with taking care of the issues against the tax collector, Run After Tax Evaders (RATE) was conceptualized in 2005 to enforce the criminal aspect of our tax laws against the taxpayers themselves. RATE investigates possible cases of tax evasion and assists the Prosecutor's office in the subsequent criminal prosecution. As of mid-2009, 121 cases had been filed against erring taxpayers.

3. Run After Smugglers (RATS)

As its name suggests, Run After Smugglers (RATS) is directed against the perennial problem of smuggling. The DOF joined hands with the Office of the Solicitor General to beef up the BOC's legal service by hiring new lawyers to prosecute customs-related cases. As of mid-2009, 78 criminal cases had been filed against 349 respondents involving illegal shipments worth P1.7 Billion. Also, since its inception, the Presidential Anti-Smuggling Group (PASG) had already apprehended about P637 million worth of smuggled goods.

4. The Lateral Attrition Law

With a boost from Congress, the Lateral Attrition Law (Republic Act No. 9335) was enacted to put a premium on the efficiency of revenue agencies. It establishes a system of rewards and incentives for revenue and customs officials and employees who reach their target revenue collections.

II. Pushing a Painful but Beneficial Reform Program

A. The Value Added Tax

Arguably the most significant legacy of President Arroyo in tax reform was her courageous sponsorship and implementation of the Reformed Value Added Tax Law (RVAT) in 2005. Against loud partisan opposition that succeeded in agitating some members of the population, the President proceeded to explain and implement the VAT Law.

All sales taxes are regressive in that they exact a higher proportion of expenditures on lower income groups than they do on higher income groups. The Value Added Tax is a sales tax. However, following persuasion and lobbying by the President, the VAT Law had allowed extensive exemptions on goods and services consumed directly by lower income groups, thus reducing its regressivity. At the same time, the VAT had clear advantages: It expanded the tax base; it minimized tax cheating; and it was easier to collect and more difficult to avoid than other sales taxes. Lastly, it improved the cash position of the Government beyond the simple increase in tax collection.

B. Immediate Impact

1. Surge in VAT Collections

The Chart above shows the sudden surge of VAT collections after the enactment and implementation of the RVAT Law in 2005. Ranging between P60 billion and P90 billion in the early 2000s, VAT collections jumped dramatically, by 60 percent from P87.9 billion in 2005 to P140.9 in 2006. Collections stayed at the P140 billion level until 2008, when they rose sharply to almost P170 billion in 2009.

2. Other Taxes

The VAT is only one of several taxes encompassed in total tax collections. The others are the income tax, the biggest of them all, which consists of corporate or business and individual income taxes; and excise and percentage taxes which include so-called "sin" taxes, applicable generally to imports, cigarettes, whiskeys, etc. Collections on these taxes also increased.

From 2000 to 2005 then to 2009: Income taxes increased from P202.6 billion to P323.4 billion then to P435.4 billion, while excise and percentage and other taxes increased from P74.8 billion to P132 billion then to P146 billion.

3. Supporting Measures

The VAT rate was increased in 2007 from 10 percent to 12 percent, as allowed by the VAT law. This boosted VAT collections substantially. In addition, supportive measures were installed and implemented. These included: Enhance Voluntary Assessment Program (EVAP), which provided delinquent taxpayers the opportunity to voluntarily settle unpaid tax liabilities for all internal revenue taxes in the previous years; the Tax Mapping Program, which resulted in the rise of registered taxpayers; the RATE program which was expanded in 2006 to cover BIR regional offices; the "Premyo sa Resibo" raffle promo program, which benefited from a partnership with the Philippine Amusements and Gaming Corp. (PAGCOR), Philweb, and SMART Communications; the Tax Amnesty Act of 2007; and the Accounts Receivable, Abatement and Compromise Settlement program which generated additional revenues.

4. Lightening the Burden on the People

Amidst the single-minded concern for tax revenue enhancement measures, the life conditions of the people and business entities were never forgotten. Thus, tax-eroding measures were implemented, including the lowering of the corporate income tax from 35 to 30 percent, which took effect on January 2009, the increased exemption level of all taxpayers to P50,000, the exemption of minimum wage earners from the income tax, the granting to corporations of the option to avail of the Optional Standard Deduction (OSD), and, lastly, the replacement of the income tax and VAT of transmission operators with a 3 percent Franchise Tax. These measures not only gave assurance of support and understanding to the business sector; they also made contributions to the expansion of the national poverty eradication program.

5. Enhanced Tax Effort

Before the implementation of the reform program in 2005, the total national Government Tax Effort was on a decline. From 17 percent before the 1997 Asian financial crisis, the TE dipped to 12.4 percent. A year after implementation, the TE climbed up to 14.1 percent. Not even domestic strength, however, could reverse the adverse impact of the global financial meltdown and international economic recession on the Philippine economy. The TE dropped to 12.8 percent in 2009.

C. The VAT as Revenue Source: Long Term Significance

The use of VAT in boosting collections has tremendous longer-term fiscal significance. Since GDP is nothing more than the totality of the "value added" of all producing units in the economy, a 12 percent VAT applied on 75 percent of GDP, allowing 25 percent for exemptions to reduce the tax's regressivity, can yield an enormous amount of revenue. Such a way of proceeding, for instance, could have yielded to the Philippines in 2009, which had a 2009 GDP of P7.70 trillion, something like P578 billion in VAT collections – or more than three and a half times the amount actually collected. The VAT, in other words, has the potential of bearing an increasingly heavier share of the revenue side of the budget in coming years.

D. Strengthening Tax Administration

The strengthening of tax administration must never be ruled out in the search for ways for increasing revenues. As the Government had shown in the last few years through its implementation of various tax administration improvement measures, substantial revenue increases can be realized through this approach. But streamlining rules and procedures for payment and collection, identifying and punishing wrongdoers in the collection chain, and installing other corrective measures are not alone likely to enable government to meet targets. At some point in time, tax rates must be raised or new tax legislation passed. It is not a prospect to be welcomed. But as somebody has observed, only the medicine man can come up with a remedy that is painless.

E. Higher National Revenues

1. Non-Tax Sources

Tax collections are supplemented by non-tax revenue. Non-tax revenues consist mainly of earnings of the Government from its proprietary corporations such as the Bangko Sentral ng Pilipinas, the Landbank of the Philippines, and some Government-owned and –controlled corporations; and dividend earnings from private companies in which the Government held equity shares, as in San Miguel Corporation.

Non-tax revenues stood at P53.4 billion in 2000, reached P203.5 billion in 2007, only to decline in the next two years, to P153.6 billion in 2008 and P142.4 billion in 2009. The decline came in the wake of the global meltdown and recession that began in 2008 and forced local banking, manufacturing and exporting enterprises to cut back on production and employment in response to weakened demand from external markets.

2. Collections from GOCCs

Many of the Government-owned and -controlled corporations exact a toll on the budget, requiring heavy subsidies every year to support diverse programs. Some, however, operate at a "profit," not just to relieve pressure on the budget but to expand its capacity for enlarged public service programs.

Remittances from profit-making GOCCs helped improve the revenue picture. These remittances however followed a fractured pattern -- increasing one year, declining the next, going up again – in representation of the uncertainties of the markets in which they operated. GOCC remittances are shown in the chart below.

To sum up everything on the revenue side, Total National Revenues—taxes, non-taxes, and grants -- for the period 2000-2009 are as follows (in billion pesos)

III. Prioritizing Expenditures

A. Acknowledging Increased Needs

The President maintained a tight policy on the expenditure of hard-earned funds, but recognized more than anybody else the increased need for resources to underwrite diverse and urgent developmental requirements. All non-postponable and non-compressible requirements of national development were acknowledged and given their due allocation in the expenditure budget.

B. Reforming the Budget Process

1. The Medium Term Expenditure Framework

But first there was a need to improve the budgeting process. The first step taken in this direction was the formulation of the MTEF which was aimed to systematically map out the funding requirements of ongoing and alternative new projects on a three-year basis, determine uncommitted funds not needed for those projects, and use the funds instead to address more pressing long-term needs.

2. The Organizational Performance Indicator Framework

To ensure that all government programs had significant impact, the OPIF was created for the specific purpose of re-orienting the budgeting process from being input-based to being output-based. Performance indicators were introduced to measure outputs and link them to the higher development objectives of the Government.

3. Procurement Reform

Bolstered by the Government Procurement Reform Act of 2003, a stricter system was instituted for the procurement of civil works and other goods and services.The system called for greater accountability, lesser red tape, more competitive biddings, and greater participation by local contractors, all for the purpose of achieving maximum efficiency in the use of public funds.

4. The Rationalization Plan

Already in effect even before fiscal reform, a Rationalization Plan was put into effect for the purpose of minimizing redundancies and overlapping of functions in the government bureaucracy.

IV. The Expenditure Program, 2007-2009

A. Hitting the Trillion-Peso Level

Backed up by radically increased resources, the Budget Expenditure Program reached the trillion-peso level after the first year of fiscal reform, hitting exactly P1.15 trillion in 2006. Thereafter, expenditures climbed to P1.23 trillion in 2007 and P1.42 trillion in 2009. The numbers represent increases of 6 percent from 2007 to 2008 and 15.4 percent from 2008 to 2009.

Given the magnitude of the expenditure program, the Government's concern for stricter allocation of funds and more transparent decision-making becomes understandable. More funds can be lost through misallocation and opaqueness, if the budgeting process is not improved and the bureaucracy is not made aware of its heightened responsibility in the custody and use of the people's money.

B. Sectoral Allocations

The Budget Expenditure Program for 2007 – 2009 gave the highest allocation to Social Services, roughly 30 percent of total each year, second highest to Economic Services, roughly 25 percent of total each year, and third highest to Debt Service, some 23 percent of total each year. General Public Administration was allotted an average 17 percent annually and National Defense, at last place, was allotted an average 5 percent annually.

That social services was given the lion's share—per the table above--is not in question. Most citizens would approve of it, as it is also the President's major priority. But wasn't the economic services component on the miserly side, too small to sustain and administer the incredibly costly public works projects that economic development requires? Perhaps this was possible because the Government had the BOT program to fall back on. The BOT program mobilizes private sector resources to establish infrastructure, liberating the Government from the straitjacket of its limited budget, whether for capital expenditures or operating overhead.

Looking at the two pie charts above for national government expenditures in 2007 and 2009, what rattles Government critics is the large allocation for debt service (21-22% in both years). Debt service, like poverty alleviation, never fails to bring out the worst in these critics – the populist proclivity. Always denounced as a diminution of the amount that should go to – you said it – poverty alleviation, debt service is never presented as it really is : a recompense for all the benefits – new infrastructure, ability to smooth out sharp changes in the Government's cash flow, heightened capacity for accelerated growth – purchased with the debt, to be enjoyed by the nation's present generation and relished by future ones.

If we simply look at the trend for debt service over time, above, it certainly looks alarming in absolute terms. From Ps 174.8 BN at the start of the current administration in 2001, annual debt service nearly doubled to Ps 310 BN in 2006, dropped back down to below Ps 270 BN the following two years, then climbed right back to Ps 302.6 BN in 2009.

But absolute trends are only half the picture, and certainly misleading for analysis if taken in isolation. Below, it may be seen that the 21% share of debt service to the national budget in 2009, as depicted in the earlier pie chart, is actually the lowest it has been since the start of the current administration. From a previous low of 25.1% of the budget in 2002, the relative size of debt service went up every year until the need to borrow was alleviated by additional tax collections in the wake of EVAT and other fiscal reforms in the middle of the decade.

Likewise, it may be seen below that debt service to GDP, after climbing to a high of 24.7% in 2005, also dropped to a recent low only 19% in 2008. It worsened somewhat, going up to 21.1% in 2009, as the global recession weakened GDP to only 1% growth in that year—very low, but still positive.

What about national defense, isn't the allocation microscopic? It is difficult not to argue for an increase in the allocation. The threats to peace and order are not imaginary. Various groups are devoting themselves to the overthrow of our government, some even to the fragmentation of our nation. A case can be made that until a comprehensive peace settlement is signed and perfected with all dissident groups, we must protect ourselves, and we will have to pay—for modern equipment, adequate training, and so forth--in order to protect ourselves properly.

C. Intra-Sectoral Allocations

Of social services, the highest allocation, approximately 50 percent of total, went to education, the President's highest priority, next highest to social security and welfare, and third to health – collectively a reflection of the President's commitment to poverty alleviation.

Of economic services, infrastructure (consisting of communications, roads, transport, water resources development, flood control, and power and energy) was allocated the biggest chunk, some 11 percent of total each year, followed by local government units, who received some 6 percent of total each year, and thirdly by agriculture and agrarian reform, with some 4.5 percent of total each year.

D. Direct Assistance to the People

One of the most welcome innovations to assistance administration introduced by the Government was the use of the Direct Approach in the identification of recipient families and the delivery of the assistance to them. At the heart of this approach was the President's Katas ng VAT program. The Direct Approach enabled the Government to support critical social services and safety nets for the people and provide direct financial assistance to them, specially the most vulnerable groups, without leaking out a part of the benefits through the nooks and crannies of the bureaucratic channels or directing the benefits to unintended groups.

IV. A Zero Budget Deficit: Almost, Not Quite

The fiscal reform program was accompanied by a Deficit-Closing Schedule. In anticipation of heightened revenues and moderated expenditures, this Schedule envisioned a steadily declining deficit in the years ahead, one that came down to zero in 2010.

As it turned out, reality was better than imagination. By 2006, one year after the VAT program, the deficit which stood at P146.8 billion in 2005, was down to P64.8 billion. In 2007, it was farther down to P12.4 billion, successfully eliminating the budgetary gap for all practical purposes.

But even the best conceived plans can be laid to waste by Man himself if not by Nature. This time, the two combined. The global financial meltdown and the real economic recession that each began in 2008 were conjoined by home-grown Ondoy and Pepeng, the most devastating typhoons of the last one and a half generations, in 2009. A huge stimulus package, not to mention various emergency employment-saving programs, had to be set aside and implemented for the mitigation of adverse impacts

Result: a reversal of direction for the budget deficit. Instead of proceeding downward, it turned up, increasing to P68.1 billion in 2008 and to P298.5 billion in 2009.

The deficit can go beyond P300 billion in 2010, truly an unpalatable possibility. But, to be candid about it, it is not anything that cannot be solved in three years by a clear-minded government.

V. The Past is Prologue

The President has often called her stand on her reforms as "stubborn," one that was unmindful of the strong criticisms by her political opponents. In hindsight, it was this stubbornness that has been enabling the country to weather the merciless storms that have been buffeting the world economy in the last three years.

With the support of public service oriented legislators who also put their political future on the line identifying with a measure whose significance had been deliberately twisted by Government critics, the fiscal reform program strengthened the fiscal system in the immediate term and laid down a basis for the sustenance of growth in the long-term.

The reform program introduced an innovation on the expenditure side of the budget as well. This is the little-noticed and least-understood Direct Assistance Program, better known as the Katas ng VAT Program. By avoiding the nooks and crannies of the bureaucracy that had a way of swallowing up truckloads of relief commodities, the KATAS program extended the assistance to the beneficiaries directly, thereby assuring itself that the assistance remained whole and undiminished and did not leak out to any unintended beneficiary.

Leaving Behind Strong Economic Fundamentals

As the Arroyo administration draws to a close, the P1.54 Trillion National Budget for 2010 caps the promises made nine years ago. The President sees this budget as the realization of a dream she saw when she took her sacred oath before the crowds of EDSA II. Nine years hence, the economic fundamentals have been well guarded and preserved against distractions and controversy.

The country now stands on solid ground despite the effects of the global crisis. After putting to rest the boom-and-bust story that used to characterize the Philippine economy, the next administration can take off with revved up machinery. It is upon this strong economy and stable fiscal position that the next administration can plan to start off towards an even better future for the country.