Philippines Public Expenditure Management for Sustained and … · Report No. 14680-PH Philippines...

Report No. 14680-PH

PhilippinesPublic Expenditure Management for Sustainedand Equitable Growth(In Two Volumes) Volumne I

September 5,1995

Country Operations DivisionCountry Department IEast Asia & Pacific Region

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This report has been prepared by Hisan Shishido (task manager). Major contributors were:, Douglas Hartle,Jeffrey Hammer, David Steedman, Stephen Howes, John Arnold, Antoine Schwartz, Syed Husain, RosarioManasan, Pierre Markowski and Domenico Fanizza. Anjum Altaf, Shaikh Hossain, Renee Santiago, RenciePadernal, Benjamin Diokno, and Soniya Carvalho also contributed. Nam Pham prepared statistical appen-dix. Peer reviewers were Homi Kharas and Malcolm Holmes. Deep appreciation goes to Bob Killoran whohas patiently put this report together. Charu Vasil and Harry Travis provided editorial assistance.

PHILIPPINESPublic Expenditures Management for

Sustained and Equitable Growth

Table of ContentsPage No.

Executive Summary .......................................................... i

Introduction ......................................................... .I

1. A REVIEW OF FISCAI AGGREGATES ........................................................ 3

National Goverment ......................................................... 3

Consolidation of the Public Sector ......................................................... 9

Government Owned and Controlled Corporations ......................................................... 11

2. THE GOVERNMENT'S ROLE AND RESOURCE ALLOCATION ISSUES ........................................... 16

Introduction ..................................................... 16

Determinants and Effects of Aggregate Expenditure Pattems ............................... ...................... 16

Efficiency and the Role of the Public Sector in the Economy .................................. ................... 18

Equity in Public Expenditure ..................................................... 21

Omissions ..................................................... 25

Policy Recommendations on Sector Expenditure ..................................................... 26

TRANSPORT SECTOR ................................................. 26

POWER SECTOR ................................................. 28

WATER SUPPLY ................................................. 31

AGRICULTURE AND NATURAL RESOURCES ................ ................................. 32

EDUCATION ................................................. 35

HEALTH AND NUTRllION ................................................. 38

3. DEVOLUTION AND LOCAL GOVERNMENTS ................................................... 41

Background and Rationale ................................................... 41

Issues - Unintended and Intended Consequences of Devolution ................................................... 43

Principles for Improvements ................................................... 51

Policy Direction and Recommendations ................................................... 52

4. CIVIL SERVICE REFORM ................................................... 55

Introduction .................................................... 55

Background Analysis ................................................... 55

(a) Size, Salaries and Cost .................................................... 55

(b) Management Issues ................................................... 57

(c) Reform Initiatives .................................................... 59

Rationale and Objectives ................................................ 60

(a) Rationale ................................................ 60

(b) Objectives ................................................ 63

Strategic Issues ................................................ 63

(a) Political Commitment and Institutional Arrangements ................................................ 64

(b) Streamlining .................................................... 64

(c) Salary Strategies ................................................... 65

(d) Ways of Changing the Civil Service Size and Skills Mix ................................................... 66

(e) Personnel Management .................................................... 68

S. BUDGET PLANNING AND MANAGEMENT ................................................... 69

The Formal Budgetary Cycle .................................................... 69

Recent Budgetary Initiatives: Palliative or Cure? ................................................... 73

Issues .................................................... 74

Policy Recommendations ................................................... 75

ANNEX TO CHAPTER 5

RECOGNITION AND MANAGEMENT OF CONTINGENT AND OTHER LIABILITIES ........................ 82

Introduction ................... ................................................ 82

Definitions ............................................................... 83

Management and Control of Contingent Liabilities .............................................................. 83

(a) Objectives ......................................................... 83

(b) Budget and Expenditure Management Process . . ..................................................... 84

(c) Valuation ......................................................... 85

(d) Tuning of Expenditure Recognition .............................................................. 86

(e) Minimizing Losses .............................................................. . 86

Management and Control of Actuarially Determined Liabilities . ............................................................. 87

(a) Objectives ............................................................... 87

(b) Budget and Expenditure Management Process .............................................................. 87

Accountability ............................................................... 88

Conclusion ............................................................... 88

ATTACHMENT (Definitions) ............................................................... 90

LIST OF TABLES. CHARTS AND BOXES

CHAPTER l

TABLES

1-I Fiscal Aggregates 1980-94 (Percent of GNP) ........................ ......................................... 4

1-2 Trends in Public Expenditure in Asian Countries (As a Percentage of GDP) ............... .....................4

1-3 National Govermment O&M Spending by Selected Sector (% of GNP) .................... ........................7

1-4 Budgetary Inflexibilities -Mandated Expenditures (Percent of GNP) ...................... .......................8

1-5 Programmed and Actual Revenues and NG Investment (Billion) ...................................... ................ 9

1-6 Public Investment By Sector (% of GNP) ................................................................. 10

1-7 Consolidated Public Sector Deficit (billion peso, and % of GNP) ............................ 11......................... 1

1-8 Total Internal Cash Generation of Major GOCCs (In Million) ............................................. .............. 12

1-9 Net Income of Major GOCCs (Million) ..................................................................... 12

1-10 GOCC - National Government Financial Flows (Cash Basis) ......................................................... 14

1-11 NPC: Net Financial Flow with the National Government (In Million) . . 16

1-12 National Government Accounts - Medium Term Projections

(Percent of GNP) (Including CB-BOL) ......................................................................... 18

CHARTS

1-1 Public Expenditures 1976-1994 .......................................................................... 5

1-2 Mandated and Productive Expenditures ......................... ................................................ 7

CHAPTER 2

I&DLFs

2-1 Determiinants of Total Expenditure by Functional Category 1975-1993 ............................................ 17

CHARTS

2-1 Distribution of Taxes and Expenditure by Regional Income .............................................................. 22

2-2a Potential Incidence of Public Housing Program ......................................................................... 24

2-2b Substandard Housing by Regional Income ........................................................................ 24

CHAPTER3

TAfLE

3-1 Net Transfers to LGUs (Nominal million pesos) ........................................................................ 45

3-2 Consolidated Expenditures of National and Local Governments: Selected Items (% of GNP) ......... 45

3-3 Sectoral Allocation of National and Local Government Expenditures (% of GNP) .......................... 46

3-4 Expenditures by Sector, All Local Government Units: 1991, 1993 (% of GNP) ............................... 48

3-5 Collection Rates of Real Prperty Tax (percent) ........................................................................ 49

3-6 Total, Social and Health Expenditures Per Capita by LGUs 1991 and 1993, in nominal pesos ......... 50

BOXES

1 Civil Service Reform in Individual Agencies: the Case of the Central Bank ..................... ................... 59

2 An Audit of DECS ......................................................... 61

3 Competent Bureaucracies and Rapid Economic Growth ............................... .......................... 62

CURRZENCY EQ-UlIVALENr

(as of June 1995)

Currency Unit = Peso ()US$1 = 25.58

1 = US$0.039

FTISCAI, YEAR

January 1 - December 31

ABBREVIATIONS AND ACRONYMS

AA - Advice of Allotment DA - Department of AgricultureABM -Agency Budget Matrix DAR - Department of Agrarian ReformADB -Asian Development Bank DBM - Department of Budget and ManagementARB -Agrarian Reform Beneficiary DECS - Department of Education, Culture and SportsARC -Agrarian Reform Communities DILG - Department of Interior and LocalARF - Agrarian Reform Fund GovernmentARO - Allotment Release Order DOE - Department of EnergyATO - Air Transport Office DOF - Department of Finance

DOH - Department of HealthBESF - Budget of Expenditures and Sources of DOST-PCIERD - Department of Science and

Financing TechnologyBLT - Build, Lease and Transfer DOTC - Department of Transport andBOI - Bureau of Investments CommunicationBOT - Build-Operate-Transfer DPWH - Department of Public Works and HighwaysBSP - Bangko Sentral ng Pilipinas (Central Bank) DSWD - Department of Social Welfare andBWSA -Barangay Water Supply Association Development

CAG - Corporate Affairs Group (in Department of EMK - Effective Maintenance KilometerFinance) EO - Executive Order

CALABARZON - Cavite, Laguna, Batangas, Rizal, EPZ - Export Processing ZonesQuezon ERB -Energy Regulatory BoardCAR - Cordillera Autonomous Region ESC - Education Service ContractCARL - Comprehensive Agrarian Reform LawCARP - Comprehensive Agrarian Reform Program FAP - Foreign Assistecl ProjectsCB-BOL - Central Bank - Bureau of Liquidation FAPE - Fund For Assistance to Private EducationCCPAP - Coordinating Council of the Philippine

Assistance Program GAA - General Appropriations ActCOA - Commission On Audit GARO -General Allotment Release OrderCS - Civil Service GASTPE - Government Assistance to Students andCSC - Civil Service Commission Teachers in Private EducationCSPD - Consolidated Public Sector Deficit GDP - Gross Domestic Product

GFI - Government Financial Institutions

GNP - Gross National Product NEDA - National Economic and DevelopmentGOCC - Government Owned and Controlled Authority

Corporations NFA - National Food AuthorityGOP - Government of the Philippines NG - National GovernmentGPEP -Grains Productivity Enhancement Program NHA - National Housing AuthorityGSIS - Government Service Insurance System NIA - National Irrigation Administration

NIS - National Irrigation SystemHYV - High Yielding Variety NMYC - National Manpower and Youth Council

NPC - National Power CorporationIA - Irrigators Association NWRB - National Water Resource BoardIADP - Integrated Area Development ProjectICG - Internal Cash Generation O&M - Operation and MaintenanceIPP - Independent Power Producers ODA - Official Development AssistanceIRA - Internal Revenue Allotment OECF - Overseas Economic Cooperation FundISF - Irrigation Service Fee OPSF - Oil Price Stabilization Fund

KPA - Key Production Areas PAL - Philippine Air LinesPCGG - Presidential Commission For Good

LGU - Local Government Units GovernmentLPG - Liquefied Petroleum Gas PD - Presidential DecreeLRTA - Light Rail Transit Authority PDO - Port District OfficesLWUA - Local Water Utilities Administration PMO - Port Management Offices

PNOC - Philippine National Oil CompanyMIAA - Manila International Airport Authority PNR - Philippine National RailwaysMICT - Manila International Container Terminal PPA - Philippine Port AuthorityMMTC - Metro Manila Transit CorporationMOOE - Maintenance and Other Operating RA - Republic Act

ExpendituresMTADP - Medium Term Agricultural Development SARO - Special Allotment Release Order

Plan SEF - Special Education FundMTPIP - Medium Term Public Investment Program SSL2 - Salary Standardization Law IIMW - Megawatts SSS - Social Security SystemsMWSS - Metropolitan Waterworks and Sewerage SUC - State Universities and Colleges

System SWIP - Small Water Impounding Project

NAIA - Ninoy Aquino International Airport TFS - Tuition Fee SupplementsNALGU -National Assistance to Local GovernmentNCA - Notice of Cash Allocation VAT - Value Added TaxNCEE - National College Entrance ExaminationNCR - National Capital Region WD - Water DistrictNEA - National Electrification Administration WFP -Work and Financial PlanNEAT - National Educational Achievement Test

E X E C U T I V E S U M M A R Y

PHILIPPINES

Public Expenditure Management forSustained and Equitable Growth

This report discusses how Fiscal management remains The findings of this reportpublic expenditure management potentially precarious. Raising outline a framework for managingcan be further improved in the additional tax revenues has public expenditures in the Philip-Philippines, focusing on four become increasingly difficult pines to achieve sustained andareas: whereas past under-spending in equitable growth. While recom-

(i) the role of the public sector in infrastructure and social sectors mendations are discussed in morethe environment of the has enormously increased the detail below, this framework canexpanding private sector; expenditure needs in these sectors. be briefly summarized:

(ii) fiscal devolution and roles of Fiscal balance was restored in 1994 * Rationalize expenditures thatthe national and local govern- mostly because of higher have not sufficiently achievedments; privatization proceeds, lower objectives. Examples include

domestic interest NFA consumer subsidies and a(iii) building a rates and lower

civil service Thiere are thus urgenit needs to public investment good portion of spending onffiat can than anticipated. ~~~~~~state universities and colleges.that can einhaon)ce efficien)cy of fiscol than anticipated. Social safety nets need better

maginage nioi(igeftieiit by pTioeitiznng pigh targeting. Tax expenditures,changing maaeetblpirtzn ar, the high which amount to some 30Govern- expenditures anid inmproving privatization billion, need to be reviewedment role; budgetory maniugermientt proceeds, are based on clear priorities.and Udifficult to sustain.and) better There are thus # Improve budget procedures for

(iv) better There are thus better fiscal forecasting andbudgetary management that urgent needs to enhance efficiency control. It is vital that aidentifies and ensures funding of fiscal management by prioritiz- medium-term fiscal frameworkof priority activities, and ing expenditures and improving with improved projections ofincorporates contingent and budgetary management. The very fiscal aggregates be used as aactuarial liabilities within the nature of national government basis for budget planning, andfiscal framework. expenditure patterns is changing, that agreement with Congress

TIhe Government of the Philip- however, due to the evolving role be reached on this frameworkpines has been successfully of the public sector as the private so that agreed priorities can beimplementing liberalization sector role expands; and devolu- implemented. It is also criticalmeasures and increasing the role tion which is changing the relative that the cost of contingentof the private sector in the share of responsibilities between liabilities, particularly foreconomy. These efforts have, by the national and local govern- government guarantees, be1994, contributed to regaining ments. Improving public expendi- incorporated.macroeconomic balance and ture efficiency also requiresrestoring income growth based on examining who manages the * Strengthen fiscal devolutionprivate investments and exports. public sector (the quality of the t rough increasing autonomySustaining robust economic civil service) and how public gnac ntability foreoagrowth rates and addressing the resources are managed (budgetary governments. Local govern-country's development needs, processes) in addition to where ments need full autonomy Inhowever, will require significant resources go. need to be made accountablepublic as well as private invest- and face hard budget con-ment.

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straints. Local government private sector competitively. This them. This distinction can betransfers can be improved by has been made possible through subtle in the social sectors. Publictaking into account equity technical development and provision of curative healthconsiderations and providing decomposing what used to be (which can be provided by theincentives to implement considered a natural monopoly private sector) increases theprojects that have high exter- into a number of contestable overall services in poorer regionsnalities (particularly in the activities. The most notable but not in the richer regions. Insocial or environmental areas). example is that the power sector the latter, public provision merelyMuch needs to be done to has been unbundled into genera- crowds out private services. Astrengthen local government tion, transmission, and distribu- careful review is needed not onlycapacity to carry out these tion. The Build-Operate-Transfer what services should be providedroles. (BOT) arrangements with private by the Government but also where

* Focus on improving civil power generators were instrumen- these services are provided forservice quality and efficiency. tal in overcoming the recent equity reasons. Similarly, theAs the role of the government power crisis. Other examples Government efforts to achievechanges, needs for the civil include toll roads, telecommunica- universal secondary education byservice change: from direct tion and water plants. Further- subsidizing those with no publicprovider of services to facilita- more, part of government services school access to go to privatetor for efficient private activi- such as road maintenance and schools has reduced the supply ofties. It is important that refuse collection can be contracted true private schools, and created agovernment be staffed by an out to the private sector. class of hybrid schools which callable and professional cadre The Government, however, is themselves private but are depen-that can carry out this role. aware that the private participa- dent on the government subsidies.Civil service reform that tion is not a panacea for the These subsidies have also divertedimproves inter alia incentives government's fiscal problem in all resources from important primaryfor higher level and profes- sectors. The private sector schools.sional staff - improving overall "cherry picks" - investing prima- RElArlIVE ROLES OFefficiency - is an important rily where returns are high and NATIONAL AND l.OCAlplank of overall fiscal reform. the pay-back period is short. They (G\VERNMEN rIS

maximize the financial returnTHE ROLE OF TH E rather than the return to the In 1992, the National Govern-GOVERNMENT society in general. This may ment started the process of

The public sector still has a increase the cost of services devolving major fiscal responsi-significant role to play despite the significantly. The Government's bilities for health, agriculturalexpanding role of the private regulatory oversight is thus extension, forest and watershedsector into areas previously important especially where management, rural infrastructureconsidered the monopoly of the private participants face limited and some welfare programs topublic sector. The simple ground (or no) competition; regulation of local government units (LGUs),rule is that the Government needs prices or service levels is required while increasing resource trans-to intervene either as a service It is also the responsibility of the fers. The objectives include: toprovider or regulator when an government that the privately improve local service delivery, andefficient market solution is un- provided portion of the service to reduce perception of politicallikely to exist if left to the private network (transport, power trans- alienation outside the Metrosector or when the equity impact mission, water supply) should be Manila through increased localis significant. effectively integrated in the autonomy.

Some services that used to be overall network. It is too early to judge the trueprovided only by the public sector Finally, public service provision consequences of devolution ascan now be provided by the needs to complement private data are limited, but a number of

activities and not to substitute for

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observations can still be made. * make LGUs accountable and areas, by allowing costFirst the allocation of transfers to harden the budget con- sharing with the nationalindividual LGUs is not based on straints within which they government.the LGUs' fiscal needs, fiscal must operate by removing CIVIll SERVICE , REFORMeffort, fiscal capacity or the uncertainties (both amountamount of devolved responsibili- and timing) on transfers to The ongoing evolution of theties. Thus there are winners and them, stopping NG funding of public sector due tolosers in terms of financial re- devolved activities, monitor- privatization and devolutionsources, without significant ing LGU borrowing, and provides a unique opportunitycorrelation to economic or social resisting pressures for national for carefully redefining its rolesattributes of individual LGUs. government bail-out of LGUs and priorities, and accordinglySecond because there is no in debt service difficulties. identifying ways to improveincentive for LGUs to raise more * strengthen LGU capacity for public sector management.revenues or implement activities fiscal planning and imple- The Government has seizedimportarnt for the nation as a mentation especially to ensure this opportunity and started awhole, local revenue efforts are that LGU budget systems are c ivil service reform processweakening and problems are coordinated with national called streamlining the bureau-occurring in implementing systems; there is a clear role g The goal of this exerciseprojects (both foreign assisted and for the national overnment in to improve efficiency of thelocally funded) whose benefits forovidingtechnical assistance central bureaucracy which, byspill over to more than one here f Goversrnent's own admission,jurisdiction. Third LGUs are suffers from "structural andspending larger amounts in the . develop a good statistical systemic dysfunction".social sectors, but spending on base for deriving the amount Objectives. dhere are five keyeconomic services (irrigation, of transfers to each LGU, objectives for civil serviceroads, etc.) appears to be suffer- especially in the area of reobjciem frcvl-evcing. The National Government's population.willingness to continue to fund While the current system of a) redefine the role of the publicthese devolved functions seems to income transfers is working - and sector and the civil servicebe a crucial reason for the LGUs' there would be some political followed by the restructuringreluctance to allocate their own difficulties in adjusting it - the and reorganization of depart-resources. Fourth. because Government may at some time ments and agencies;devolution makes fiscal monitor- wish to modify it. Two potential b) identify and reconfigure asing of the consolidated public improvements are highlighted required the civil service skillssector more difficult, the LGUs here: mix;need to confront strict budget * incorporate concerns about c) improve incentives to attractconstraints so that the overall equity and local resource and maintain desired skills;budget discipline be kept. Finally. mobilization in the allocation d) establish controls over the sizean early indication is that the mechanism of resource and cost of the public service;devolution may be increasing transfer by considering an andinequity; this needs to be moni- equalization grant based ontored and steps taken to deal with the tax base and revenue e) develop an integrated systemthe problems. efforts. for buanagng personnel

budgets, pOsitions andRecomumendations. Several . provide incentives for fund- individuals.

steps could be taken to improve ing critical activities for athe functioning of the existing small number of selected In order to implement effectivesystem: civil service reform, the Govern-

ment needs to design an inte-grated reform strategy thatincorporates all five objectives

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outlined above. The present costing of the various options, ing recruitment and wagereform effort falls short in estab- would help achieve and structures.lishing the desired skill profile, maintain the desired skills BUDGEIARY PROCESSESimproving incentives and install- mix, which will probablying a system of personnel manage- include a higher proportion of The budget processes are at leastment. These aspects are crucial, professional staff. Such a partly responsible for the inad-because the civil service is increas- reform would allow higher- equate coordination betweeningly expected to be a catalyst for level civil servants to be development planning and projectan economic transformation, and remunerated at rates more and program implementation; forthe composition and quality of the compatible with their private the selection of some low priorityfuture civil service should be sector counterparts. At lower projects over higher prioritysuited to this new role. levels, salaries are relatively projects; for inordinate delays in

Recommendations To achieve competitive with the private implementing high prioritythe objectives discussed above, the sector. A move away from the projects; and for a bias againstreform strategy must integrate the existing policy of concentrat- adequate maintenance of existingneeds for: clear definition of ing wage increases at lower facilities with a consequentpublic sector roles; identification levels would be highly decline in public services.of the skills mix and organiza- desirable. Issues There needs to be antional structure required for c) A combination of volunta overall agreement on the fiscalcarrying out the defined roles; retirement and targeted framework and national prioritiestransparent and fair implementa- retrenchment of surplus staff among members of the Congress,tion of restructuring and reorga- would complement the reform central departments of the Execu-nizing; appropriate incentives to of the incentive system in tive, and line departments be-achieve the desired skills mix; and achieving the desired skills cause, especially in a democracy,a reform in personnel manage- mix. This approach would be the budget process entails thement with a view to reinforcing far superior to reliance only reconciliation and compromises ofand sustaining these improve- on natural attrition. a multitude of conflicting inter-ments. While the Government is d) Personnel managemen ests. The central departmentsmaking efforts to form this reform, based on a review of (DBM, NEDA, DOF) usually takestrategy, the following actions the current allocation of a lead in preparing the budgetwould contribute to the success of management tasks among proposal. The Congress thenits implementation: mentral agencies, would imposes different priorities by

a) Strong political commitment significantly contribute to the adding activities of its own choicefrom the highest level of improved functioning of the (often in the areas of local roadsleadership is required, and the civil service. Management and irrigation, and state collegesOffice of the President needs would also benefit from an and universities). The Congressto take an increased lead in improved common human has to delete some other activitiesthis process. The existing resources data base and a because by constitution it cannotPresidential Committee system of objective perfor- increase the peso amount of theresponsible for the exercise mance evaluation. budget. The congressionaland its Technical Secretariat e) In the restructuring the public deletion often includes foreignmay be reinforced by the sector organization, it is assisted projects.addition of representatives important that the Govem- The Executive (DBM) oftenfrom CSC and advised by ment provide GOCCs and counters Congressional amend-outside experts as necessary. certain regulatory agencies ments by rationing cash in such a

b) A reform of the incentive with more autonomy regard- way as to favor the activities tosystem. based on a detailed which it accords highest priority.

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Revenue shortfalls relative to the are under no incentive to critically economic work should beestimates used in the budget are a assess their own proposals as carried out as objectively andgood reason to limit cash releases, NEDA will eventually assess reliably as the state of ourbut the threat of shortfalls (and them, but NEDA does not have understanding permits.not the actual shortfalls) is enough enough human resources for (b) The cost of contingentfor the Executive to introduce and assessing all of a variety of liabilities such as thosemaintain cash rationing during a projects in depth, in a short time. associated with the BOT-typefiscal year. Furthermore, con- Implementation delays frequently agreements needs to be takenflicts can often exist between the occur because the decision to into account as a real cost topriorities assigned to projects by proceed is often little more than a the budget when thesethe central agencies and the decision to begin the planning that liabilities are created (Annexpriorities favored by the line should have taken place earlier. to Chapter 5).departments. Because cash Recommendations A funda- (c) Based on the Fiscal Frame-releases are in essence fungible mental measure to ameliorate work, responsible centralbetween projects within a same these issues is to shift the conflict departments carry out devel-department/agency, the line resolution on the national priority opment programming. Thisagencies could also alter the from the "behind closed doors" activity will determine thespending priority thus subverting forum where cash rationing takes allocation of funds amongthe prionties established by the place, to Congressional debates major functional categories ofPresident about the appropriate size of the spending assisted by propos-

Cash rationing also has the public sector and the appropriate als from line departments andeffect of delaying implementation allocation of spending among the in accordance with the agreedof high priority projects because broad functional areas of national priority.line departments face great interest. This would shift theuncertainty concerning the flow of emphasis away from the limited (d) The Fiscal Framework andfunds that will be forthcoming. flow of funds to government in Development ProgranmmingGiven the uncertainty, some the short-term towards the should be the subject of a lointagencies try to safeguard their medium term economic ouflook Resolution of the Congress atmonth by month cash allocations and the policy options available to the beginnng of tde term offor the payment of wages and government. In so far as the every Congress and votedsalaries first before they start to "procedures" are concerned, prior to each tabling of thespend on more discretionary however, the medium-term fiscal President's Expenditurebudget items. framework recommended below Budget. Congress would be

Finally, there are technical may appear similar to the existing the two documents, afterproblems in project preparation- five-year development planning docume afterproject appraisals are often framework. The key difference is appropriate modification.jeopardized due to the insufficient how such procedures are imple- made by Congress must betrained staff in line departments mented. financed by reductions inwhose time is also demanded for (a) the National Government appropriations within thekeeping track of appropriations adopts a three-year Fiscal same functional category. Itand allotments. They need to Framework, which incorpo- should be understood thatprepare work plans in a hurry for rates annual (quarterly for the congressional and otherprojects added by the Congress. first year) projections of: fiscal changes that are inconsistentAllocation of responsibility for revenues based on existing with the approved Frameworkproject planning within the taxes, expenditures (current and the Program will beExecutive also poses problems. and capital), deficit, net loans vetoed. Departmental subver-The line departrnents, who and advances and net cash sion of the approved frame-originate these project proposals, requirements. Underlying

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E X 1 C U T I V E S U M M A R Y

work should also be disci- binding on development efficiently need to be identified,plined. programming. then privatized. Light rail transit,

(e) Once the Fiscal Framework . toll roads, some functions at ports,and Development Program- (g) There is a need for a comput- and airport management areming are in place and ap- erized accounting system among them. The Nationalproved, a department in defined in a manual, and 'Railway can also be considered forcharge of Budget Operations operating departments must privatization after its network isManagement (DBM), prepares be staffed with qualified shrunk and financial lossesbudget and implement it accountants capable of reduced.efficiently. Continued use of The same system should be Depending on the private sectorthe baseline budgeting is pre sied for lola res for transport service provisionrecommended. It should be pesrmi on lol dauton'of needs to be accompanied by thenoted that with the appropri- to introduction of more efficientdata-expenditures should atate Fiscal Framework in place, least be classified as proposed, pncing systems-involving thethere should be far less need appropriated authorized, reduction of cross-subsidies-to racon cash than earliert and committedad ual.The especially in the port and railwaythus complicated methods of committed and actual. The sub-sectors, and increased regula-allotment and cash releases computer system must be tion of safety and environmentalcan be largely abolished, robust with much backup and protechon. The Governmentexcept in large capital projects accessible to poorly trained needs to develop a regulatorywhere cash releases should be personnel. agency that is not involved incommensurate with the SECTOR RESOURCE provision of services. Finally,progress of the project prepa- ALLOCATION ISSUES appropriate staff down-sizing atration/implementation. In In the transport sector, the the center needs to be made asaddition, the department National Government is consider- responsibilities are devolved toshould: (i) establish rules for ing reducing its network to an local governments and the privateprocurement and personnel essential core that can be main- sector.management (with the Civil tained to a high standard. Eirst, In the power sector, reforms areService Commission); and (ii) small ports, airports and local already going on to "unbundle"conduct project monitoring to roads, need to be devolved to local the sector into generation, trans-evaluate the operational governments who would also mnission and distribution.perform-tance of other depart- review what is sustainable. Most Privatization of thermnal genera-ments. Management audits small roads are already under tion has started recently with theshould also be conducted by local jurisdiction, but the National power crisis, and is expected toan appropriate agency. Government is appropriately continue albeit at a slower rate.

(f) Organizationally, those who limiting further the national NPC is being spun off to subsid-establish the Fiscal Frame- highway that it would maintain to iaries based on regions or func-work and Development about 60 percent of the existing tions with a view to be sold toProgramming should work network. Road maintenance private interests. Distribution hasvery closely together-they should be carried out by private been largely private, but except forcould even be located in one contractors rather than through MERALCO, the sector compriseagency But should these two the force accounts. The National more than 130 small and finan-functions be divided into two Railway, which suffers from large cially weak distributors. Theagencies, it needs to be made financial losses, also needs to latter need to be consolidated intoclear that the financial con- reduce its size to a commuter rail about 15 large units that can sharestraints, which are dominated system around Manila. Second market risks with the generators.by macroeconomic consider- transport responsibilities that the For the time being, the highations, were absolutely private sector could provide more voltage transmission and hydro-

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E X E C LJ T l V [ S U M M A R Y

electric generation are recom- mance-dependent competitive of the poor to quality education.mended to remain largely in the allocation of resources. Cost-effectiveness also needs to be

public sector. The public sector Agriculture has suffered from improved. By doing so, the pubiic

also needs to focus its attention on slow growth recently, with serious sector spending would betterimproving the regulatory frame- implications for the already high, complement the private contribu-work, implementing fair and rural poverty incidence. A tion.transparent load dispatch system, coordinated approach to address It is recommended that, first,

and reforming pricing so that it this issue has been difficult measures to improve resource

incorporates time-of-day demand because major sector agencies availability in the sector bechanges and appropriate stand-by have employed different develop- introduced, and, second, the

and wheeling charges. ment strategies. Poor quality rural resources use need to be more cost

In the water sector, the objective infrastructure and feeble support effective and targeted. The

should be to rely increasingly on services have been serious impedi- measures to improve resource

cost reduction, demand manage- ments to rural growth; it is critical availability include: school

ment and increased efficiency in to boost rural productivity by construction and maintenance can

production and distribution. A improving rural transport and be devolved to local governments;

strategy that can introduce irrigation facilities, and agricul- State Universities and Colleges

incentives consistent with such an tural research and extension. should depend on full cost

objective is the commercialization Since many of these functions recovery and decentralizedand private sector participation have been devolved to local financial decisions; and budget

(PSP) initiative. Towards this end, governments, strengthening their management at the DECS be

the transitional steps are (i) rapid implementation capacity is of high rationalized so that resources are

introduction of PSP alternatives in priority. Improving infrastructure, ensured to reach schools rather

the large metropolitan centers together with removing uncertain- than lost at administration (as a

(Metro Manila, Metro Cebu, ties associated with the implemen- large segment of non-personnelDavao - the government is already tation of the Agrarian Reform, recurrent resources are). To

acting on this initiative); (ii) would promote private rural enhance cost effectiveness and

regrouping of smaller municipali- investments. Finally, protection of improve quality and equity of the

ties into regional service areas natural resources, especially sector services: the Government

large enough to yield necessary improved watershed manage- needs to move away from propor-

economies of scale in management, is a priority for sustainable tionality (equal per studentment, lower transaction costs and growth. expenditures in every province) to

attract private sector participation; Regarding the social sectors, the targeting resources towards the

(iii) setting up an independent public sector spends 2.7 percent of most disadvantaged areas to

regulatory body to undertake GNP on education, a sum that address the priority issues of

financial and other contract could be used more cost-effec- equity. The resources spent on

related regulation of private tively. The country as a whole achieving universal secondary

service operators; and (iv) in the spends a decent 6-7 percent of education by giving grants to

near future, making efforts to GNP, indicating large private students to go to private schools is

reduce excessively high non- presence in the sector as well as not reaching the poor; the rich use

revenue water in Metro Manila willingness to contribute to the resources to go to better

through increased maintenance education at the household level private schools for which they

and possibly a major network (in part due to the inadequate would have paid anyway and therehabilitation. For rural areas, a funding by the public sector). system provides perverse incen-

program of sequenced, demand- The effectiveness of the public tives for creating low-qualitydriven infrastructure investments sector contrbution should be private schools dependent largelv

are needed coordinated by the improved by focusing on quality on public subsidies. Rather thanpublic sector and based on perfor- of basic education and the access attempting to make this grant

available to the general public,

- - --. . ........... .- -------- -------- - -----


again, it should be targeted to thepoor and the per-student spend-ing be increased.

The health sector has beendevolved and it is too early tomake assessment on how spend-ing has been changed-the sectorthus is not reviewed here. It canbe noted, however, that thehealth sector expenditures beforethe devolution was particularlyprogressive favoring poorerregions. With the devolution theallocation is estimated to havebecome more regressive. Threeother issues can be noted here.First, the National Governmentstill has a role to play in morepreventive medicine nation-wide,given the extemalities involved.Second, public provision ofcurative health care, which ismore a private good than preven-tive care, is still important inpoorer regions while in richerregions such services merelycrowd out the private clinics.Third, the nutrition subsidythrough the general consumptionsubsidy of the National FoodAuthority is not targeted to thepoor and is a very expensivenutrition intervention. It isrecommended that the programbe phased out and more targetedand cost effective nutritionintervention programs put inplace.

Pp I,

PHILIPPINES: PUBLIC EXPENDITURE MANAGEMENT FORSUSTAINED AND EQUITABLE GROWTH

Introduction

The Philippines has at last enjoyed accelerating economic growth and macroeconomicstability in the last two years. GNP grew by 5 percent and inflation was contained at 7 percent in1994. Foreign capital inflows have increased severalfold reflecting strong investor confidence inthe country's policy stability. The events in Mexico early this year did not significantly affect thisconfidence. The Ramos Administration's growth-oriented program focusing on macroeconomicstabilization and further structural liberalization has finally, it is hoped, placed the economy onto asustainable growth path. The Administration's success in effectively solving the severe energycrisis of 1992 and 1993 has also boosted the image of the country.

Macroeconomic gaps have also narrowed. The national government (NG) deficit wasreduced from the average of 3.6 percent of GNP during 1986-88 to 1.4 percent in 1993 and then toa mere 0. 1 percent in 1994. Consolidated public sector deficit was the lowest ever recorded at 0.6percent of GNP in 1994. In the same year, overall balance of payments recorded a surplus due tostronig exports and foreign inflows.

To sustain this recent momentum, the Government of the Philippines (GOP) must stillmaintain investor confidence by tackling three issues: improve infrastructure services; address thehigh incidence of poverty; and still sustain sound fiscal management. This is a serious challenge.Significant investments are needed in physical infrastructure and human capital to off-set the pastunder-spending. Furthermore, high poverty incidence, which slows human capital developmentand often threatens political stability, needs to be addressed with increased vigor. Resourcerequirements in these areas are enormous. But, the Government faces significant opposition inraising additional tax revenues, and budget does not allow much flexibility as interest payments andwages are each running around 5-6 percent of GNP. Furthermore, recent fiscal improvementswere partly aided by higher privatization proceeds and lower domestic interest rates than expected.These are events which are unlikely to recur.

Tight budgets, difficulties in increasing revenues, and significant resource requirements forinfrastructure strengthening, and poverty alleviation with human capital development all point tothe urgent needs of the GOP to improve efficiency in allocating and managing its ownexpeniditures. This calls for prioritizing public expenditures so that only activities with higheco(nomic returns are funded (and implemented) and wasteful spending removed.

In prioritizing public expenditures, a number of issues should be examined. First, it iscrucial that the evolving role of the public sector vis-a-vis the private sector be carefully taken intoaccount. As a result of ongoing liberalization, the private sector is expanding its activities intoareas that used to be considered a public sector domain such as infrastructure and social services.With careful assessments of public sector roles, there will be opportunities to free up resources formore essential and so far under-funded services. Also, proper regulation will lower the cost to theeconomy of private provision of services in markets where competition is limited. Second, the

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GOP's etiorts to devolve major responsibilities to local government units (LGUs) need to be takeninto account in determining the roles of the NG and LGUs. Third, the civil service needs to bestrengthenied, with appropriate financial and other incentives, so that the Government with theemerging new roles and the priorities can be managed efficiently. Finally, the budget managementprocess can be improved to ensure timely implementation of priority activities.

Given this background, this report reviews the patterns and management of publicexpenditures, and makes recommendations for further improvemenus. The report is divided intotwo volumes. Volume I will focus on the expenditure management issues, specifically:

* review the overall fiscal patterns in the recent past and provide a medium-term fiscalframework (Chapter 1);

* discuss the role of the public sector in view of the expanding private activities and the need tocorrect market failures for efficiency enhancement and equity improvement (Chapter 11);

* examine how devolution is changing the spending pattern of the National Government and localgovernmnent units, and discuss how management of inter-government relationship can beimproved (Chapter 111);

- discuss how the public sector management can be improved in terms of both human resourcesand financial management. Given the evolving role of the Government, we will first discussthe desirable reforms of the civil service so that the civil servants in the future will be welladopted to managing the new public sector (Chapter IV); and

* discuss desirable changes in the way budgets are prepared and managed by the NationalGovernment (Chapter V). Chapter V also contains an annex that discusses how to managecontingent liabilities of the Government and how they should be incorporated in the overallfiscal framework.

Priority recommendations for improving management of major sector expenditures(transport. water, power, agriculture and natural resources, education and health) appear inChapter 11 in a summary form. Detailed discussions of sector issues appear in Volume 11.

1. A REVIEW OF FISCAL AGGREGATES

1. 1 This Chapter reviews aggregate fiscal figures for the National Government (NG)and the public enterprises called Government Owned and Controlled Corporation (GOCCs), toprovide a framework for discussions for the chapters that follow.

1.2 The analysis highlights four issues. First, since mid-1980s, the budget has becomeincreasingly inflexible because non-discretionary spending suppressed productive spending oninvestment and maintenance. Second, recent improvements in both NG and consolidated fiscalbalances are due primarily to high privatization proceeds, which may not recur in the future. Thiswas aided in 1994 by the low interest rates on treasury bills. Third, the aggregate financialperformance of the GOCC sector has not improved significantly since the start of the 1988 reform.But, while improvements in individual GOCC's financial performance remain important, thedirection of sector restructuring, for example, the role of the private sector, has come to dominatehow each GOCC should be reformed. Finally, future resource requirements are high because ofthe past under-investment in infrastructure and social sectors. The NG transfer to localgovernment units (LGUs) are also increasing substantially. Given these expenditure needs, fiscalmanagement will continue to be tight in the medium-term, and the Government needs to beselective and efficient in what it chooses to do.

National Government

1.3 The Government of the Philippines (GOP) has been an active participant in thecountry's development, as reflected by the growing share of public expenditures in GNP (Table 1-1, Chart 1-1). From 1976 to 1984, overall government spending was relatively stable, around 14to 15 percent of GNP. But starting with the trough in 1983-84, real spending has grown to anannual average of 19 percent of GNP during 1990-94. This represents an annual average nominalgrowth of 17 percent over the period of 1976-94. The average annual spending levels in thePhilippines are comparable to those of other Asian countries: public expenditure in neighboringAsian countries averaged about 22 percent of GDP during the 1980-90 period (Table 1-2). Ingeneral, public expenditures are positively associated with income per capita. Although there is noright level of spending for a country given its level of income, the GOP spending is below theamount predicted for its income level in 1992. In aggregate terms, therefore, it cannot be said thatthe GOP spending level obviously exceeds the appropriate amount. The key issues are how muchGOP spends relative to its revenues, and whether spending is efficient or not.

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TABLE 1-1: FISCAL AGGREGATES 1980-94 (PERCENT OF GNP)

1980-82 1983-85 1986-88 1989 1990 1991 1992 1993 1994

Total Revenues 13.1 12.0 14.3 16.7 16.7 17.4 17.5 17.1 19.9

otw Tax revenues 11.5 10.6 11.7 13.4 14.0 14.4 15.1 15.1 15.3

Curretit 9.9 9.3 13.1 15.6 16.4 15.5 15.5 14.7 16.6expenditures

Capital 6.7 4.8 4.7 3.2 3.7 4.0 3.9 3.8 3.4Expenditures

Infrastiuctuie etc. 2.9 1.4 1.2 1.4 1.2 1.4 2.2 1.7 2.4

NG Deficit -3.5 -2.0 -3.6 -2.1 -3.4 -2.1 -1.2 -1.4 -0.2

Source: DBM

TABLE 1-2: TRENDS IN PUBLIC EXPENDITURE IN ASIAN COUNTRIES (AS A PERCENTAGE OF GDP)

Country 1980 1985 1990 Couintryaverage(1[980s)

Bangladesih 11.7 11.8 13.2 12.4

India 18.7 20.7 17.4 19.8

Indonesia 23.7 19.6 19.0 20.7

Korea 21.5 18.5 16.8 18.4

Malaysia 32.3 32.3 29.3 30.2

Pakistan 22.7 23.5 23.2 23.4

Philippines 15.5 14.0 20.4 16.7

Sri Lanka 31.0 33.3 28.2 30.9

Thailand 19.8 19.6 15.5 17.9

Viet Nam NA NA 24.1 21.3

Asian average 20.8 21.5 22.4 22.6

Source. World Bank data base. Country Economic Reports.

1.4 Structure and Composition of Expenditures Two salient features underscore therecent trends in public expenditure pattern: (a) the share of current expenditure in total expenditure

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has increased since mid-1980s primarily driven by rising interest payments; and (b) capitalexpenditures and maintenance spending have been suppressed since mid-1980s. The structure ofexpenditures has evolved from the high public investment-cum-high deficit of the early 1980s to thelow investment-cum-low deficit today. The turning point was the financial crisis of 1983-85. Thestabilization efforts pushed down capital and maintenance spending while interest payments startedto rise due to the increased relative reliance on domestic financing of budget deficits. Wagepayments also increased gradually since 1983-85. GOP revenues increased significantly after the

tax reform introduced in 1986-88, from 13-14 percent of GNP to today's 18-19 percent . Butrecurrent expenditures rose faster due primarily to the continued rise in interest payments,shrinking public savings from 3 percent of GNP in early 1980s to 0.3 percent by 1990.Investments and maintenance outlays never recovered to the pre-crisis levels lest the fiscal gapsthreaten another financial crisis.

Chart 1-1

Public Expenditures 1976-1994

I .20-

15 I h er it apital

10150 ..... . . . . -: ntena n

0 0

Source: DBM

1 .5 Current expenditures have increased and become more inflexible because a greaterportion of the outlays is now mandated or non-discretionary. In the early 1980s, currentexpenditures were about 10 percent of GNP, and were equally divided between wages andoperations and maintenance. From the mid 1980s, they started to increase and are now about 15percent of GNP. This rise in current expenditure was driven most dramatically by an increase ininterest payments which increased from 1-2 percent of GNP to 6 percent of GNP by 1989-90 as theGovernment borrowed to finance a significant portion of budget deficit. The wage bill, which hadbeen compressed severely in the wake of the financial crisis, rebounded and increased to a levelhigher than the pre-crisis level by 1988 with the implementation of the first round of the Salary

See World Bank (1992, 1993) for description of the tax reform.

Standardization Act. Concurrently, during the 1980s, the number of personnel employed by thenational government also increased almost by 50 percent cumulatively (although the GOP managedto stabilize the size of the civil service during the 1990s). As a result, personnel expenditure rosefrom 3.8 percent of GNP in 1980 to near 6 percent in the early 1990s. Furthermore, the LocalGovernmenit Code of 1991 has mandated the NG to transfer an amount exceeding 10 percent of thetotal expenditures (2-3 percent of GNP) to the local government units (LGUs) from 1994, addingto the noni-discretionary portion of the NG spending.

1.6 These non-discretionary recurrent expenditures tend to crowd out morediscretionary expenditures, namely investment and maintenance outlays for existing capital stocksthat play a catalytic role for private investments. Table 1-4 indicates the amounts of theseintlexible or mandated as compared with the total revenues each year, and Chart 1-2 shows howmandated and non-discretionary expenditures (wages, interests and LGU transfers) have suppressedmore productive expenditures (investments and maintenance) from the mid-I 980s on.

1.7 Both public investments and maintenance outlays suffered unsustainable cuts.Capital expenditures by the NG have slipped from above 5 percent of GNP in the early 1980s toless thlan 3 percent in the late 1980s. Much of the decline was due to strict limits on the overallpublic sector deficit imposed by stabilization programs. The improved budgetary situation enabledsome restoration of capital expenditure, to a close to 4 percent of GNP in 1993 and 94, andprompted a rise in investments in infrastructure and in capital transfers to public bodies. Thesetransfers largely comprised outlays to GOCCs, local governments and contributions to theComiprehenisive Agriculture Reform Program (CARP). NG's own capital formation (primarilyroads, irrigation, agriculture, education, and health) has been only sliglhtly over I percent of GNPmlost of the years since the 1983/85 crisis. Furthermore, consolidated public investments (NG &GOCC) plummeted from 7-8 percent of GNP to about 3 percent between 1984 and 1989 (Table 1-6). As discussed later, these cuts in the productive expenditures have deteriorated infrastructurestocks and, as seen in the power crisis, led to an eventual breakdown of services, costing theeconlomily Imluch more than the nominal savings when cuts were made.

1.8 O&M spending has also been reduced. It is included as budget item called MOOE--maintenance and other operating expenses. This item used to be as high as 5-6 percent of GNP.It has now fallen to less than 2 percent of GNP, below what is considered by many as the

minimum necessary . To make things worse, what is classified as MOOE in the governmentaccounts in various sectors includes many other expenditure items whichl often consist ofadminlistrative expenses unrelated to maintenance (education) or mostly wages for casual workers(roads), and not the cost of proper physical maintenance.

1.9 Table 1-3 is an attempt to derive "pure" O&M spending by subtracting from the totalMOOE debt service components, labor cost, and MIOOE spending in defense on an obligation

This is derived based on simple assumptions. If capital -output ratio is within the range of 4-5, and publicsector capital stock is 20 percent of the total , public sector capital stock can be estimated as about equal to thenational income. According to Heller (1979) the appropriate operation and maintenance varies between 30-50percent of ihc stock (health), to 8-10 percent ( roads) to I percent (buildings). 2 percent should be considered thebare iininiuiii if these figures are remotely robust.

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basis. From 1989-90, the O&M spending has declined by 0.4 percentage points of GNP, andconsidering that MOOE of the Agrarian Reform increased by 0.3 percent of GNP in 1994 alone,the outlays in remaining economic and social services appear to have declined more than half apercent of GNP since 1990. Particularly worrisome are the declines in O&M in education, whichhas not been devolved, and in transport for which the GOP expressed correctly that operation andmaintenance has the highest priority.

Chart 1-2

Mandated and Productive Expenditures

14

12 - .:

10~

Z 8

6

4

2

0(0 CD 0 (N -; o C

- CD -O co OD

r Mndated Productive

TABLE 1-3: NATIONAL GOVERNMENT O&M SPENDING BY SELECTED SECTOR (% OF GNP)

______ 1980 1983 1986 1989 1990 1991 1992 1993 1994

Pure O&M Spendn 2.251 .1 1.95 2.20~ 2.23 2.3 19 18 .2

Social Services 0.65 0.81 0.76 0.74 0 72 0 79 0.6-9 0. 59 0.5-3

40-2. 0.27 -0.27 -O.- -- -2-7

w Education 00.37 0.2 0.42 34 0.32 Health 0.27 0.33 0.26 0.30 0 29 0.32 O031 0.23 0.20

Econiomic Services 1 07 0.81 0.71, 0.89 0.95 0.701 0.66 0.59 0____3o/wAgrarian Reform 0.02 0.02 0.021 0.22 0.30 0.0 0.05 0.05 0.35

Agriculture ____ 0.09& 0.10 0.091 0.15 0 19 __ 0211 0.18 01 01

~~~~~~~0r_ _ _ _- 01 012

Natural Resoe 0.1 1 0.1 0.08 0. 08 7 009 0.07 0.06 0.08Transp and Comm.lt 7 11 0.50 0.48 0.34 032 0.29 0.291 0.301 0.20Transp and Comm 0.71 | 0.50 048 0.341 03 .9 029 0 02

Source: DBM

I.10 Tax expenditures The tax expenditures, foregone revenues from various taxexemptionis and credits, are recently estimated to be about P 30 billion a year. BOI incentives (EO220 anid EO 226) amount to nearly a half of this, of which 50-60 percent (P 6-10 billion) areexemptionis of tariff and duty on imported capital equipments. In addition, special laws and otherEOs exemiipt many private and public bodies, including NPC, from various tax and tariff payments.

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The direct cost of these expenditures is the foregone revenues, but more indirect cost, i.e., creationof distortions, should not be ignored either. The GOP's Task Force on Tax and Tariff Reform haslooked into different costs of various exemptions. A continuous examination of costs and expectedgains of tax expenditures is needed so that the incentive structure will be rationalized andstreamlined. Furthermore, management of remaining incentives needs to be more transparent.

1.11 The budgetary release mechanism has been cited among factors that tended to slowthe implementation of public investments because these discretionary expenditures are subject tocurtailment even after the Congress has approved the budget. This happened especially whenrevenue shortfalls were foreseen (Table 1-5). (Improvements are being introduced in 1995, but itis too early to tell if there has been marked improvement--see Chapter 5.) The key issue is that theDepartment of Budget and Management (DBM) has released resources to line agencies only as

3revenues were collected to adhere to the overall deficit targets established under stabilizationprograms. This practice has increased uncertainty faced by the line agencies regarding the totalannual amount and the timing of resource availability. Such uncertainty has discouraged theagencies from spending resources on discretionary items for the first several months of the fiscalyear (fiscal year is January I-December 31) until agency managers are sure non-discretionary items(e.g., wages) can be fully paid. Given only the first three months of a fiscal year are the dryseason most suitable for construction work (i.e., the resources released during the rest of the fiscalyear could not be invested as productively ), this practice has made it very difficult to effectivelyimplement public investment or mnajor rehabilitation activities even when resources were available,ex post.

TABLE 1-4: BUDGETARY INFLEXIBILITIES--MANDATED EXPENDITURES (PERCENT OF GNP)

1988 1989 1990 1991 1992 1993 1994

Wages 5.2 5.6 5.8 5.7 5.4 5.3 5.6

Interests 5.8 6.0 6.6 5.9 5.8 5.1 5.3

LGU Transfers 0.4 0.4 0.4 0.5 1.2 1.8 2.2

Total Mandated 11.4 12.0 12.8 12.1 12.4 12.2 13.1

Revenues 14.3 16.7 16.7 17.4 17.5 17.1 18.9

Diff. bet. TotalMandated andRevenues 2.9 4.7 4.1 5.3 5.1 4.9 5.8

Source: DBM

3This has also had the side effect of making the DBM highly powerful; their fund release patterns, rather than the

intenlion of Congress or other executive departments, have determined the real budgets (see Chapter 5).

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TABLE 1-5: PROGRAMMED AND ACTUAL REVENUES AND NG INVESTMENT (P BILLION)

1988 1989 1990 1991 1992 [ 1993 1994

Programmed Revenues 122.4 145.0 179.5 206.4 278.9 284.2 319.2

Actual Revenues 112.9 152.4 180.9 220.8 253.1 260.3 325.6

Programmed NG 16.1 24.7 35.3 47.9 53.1 57.3 45.7Infrastructure and otherInvestment

Actual NG Infrastructure 15.2 20.9 29.1 37.6 46.1 40.2 42.4aild other Investment

Consolidation of the Public Sector

1 12 Consolidated Public Investment The behavior of consolidated public investments(Table 1-6) has mirrored that of the NG's investment, but its composition shifted reflecting thepriorities of each administration. It declined rapidly starting with the 1983/84 financial crisis from7.4 percenlt of GNP (1980-83 average) to 3.4 percent (1984-87 average), and started to increase toabove 4 percent of GNP only in the 1990s. In 1984, imnmediately after the start of the crisis, theMarcos administration reacted by reducing social investments from 0.53 percent to 0.22 percent ofGNP. The education sector took a particularly hard hit. Investments in the transport sector alsowere decimated, but the administration struggled to keep energy and power, and water sectorinvestment at as high a level as possible. The Aquino administration took a different strategy; itincreased social sector spending and road investments--but sharply curtailed investments in otherinfrastructure such as power, energy and water precipitating the start of the later infrastructurecrisis. The Ramos administration, which inherited the legacy of the Aquino administration-- weakinfrastructure and high poverty incidence together with a more liberalized policy environment--firstinvested lieavily in physical infrastructure (power and transport), and is nlow turning to address thesocial issues.

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TABLE 1-6: PUBLIC INVESTMENT BY SECTOR (% OF GNP)

Year 1980-83 1984-85 1986-88 1989-91 1992-93 1994

Administration and (Marcos) (Financial (Aquino, (Aquino, second (Ramos with (MostEvents Crisis) first half) half) power crisis) recent)

Public Adniinistiation 0.18 0.17 0.25 0.32 0.27 0.49

Social Investmenit 0.59 0.30 0.73 0.65 0.19 0.64

Education 0.16 0.12 0.25 0.31 0.12 0.33

Health 0.04 0.03 0.05 0.06 0.02 0.08

Othe rs 0.39 0.16 0.42 0.28 0.05 0.23

Economic Investment 6.60 3.45 1.93 3.76 4.31 4.86

Power/Energy 2.24 1.20 0.51 0.94 1.65 1.89

Water 0.34 0.26 0.11 0.18 0.13 0.08

Trspt/Co:nm 2.35 0.31 0.85 1.69 1.94 2.14

Others 1.67 1.68 0.46 0.95 0.59 0.75

Total 7.37 3.92 2.91 4.73 4.75 5.99

1.13 Consolidated Public Sector Deficit The GOP has also taken measures to maintain4

the consolidated public sector deficit (CPSD) at a sustainable level (Table 1-7). On average it hasbeeni 1-2 percentage points higher than the NG deficits (an average of 2.2 percent of GNP over1989-93, the 1994 figure is preliminary). There have been three institutions, beside the NG, thatsuffered significant deficits in the past: the Central Bank, the OPSF, and the National PowerCorporation (NPC) a public sector supplier of electric power. Among these, the GOP has recentlydealt with two major sources of deficit: the Central Bank; and the OPSF. The Central Banklosses were dealt with in 1993 by transferring poor quality liabilities into another entity CB-Bureauof Liquidation (CB-BOL), and by making sure that the new Central Bank (Bangko Sentral ngPilipinas-BSP) would have positive income and resources for independent monetary management.While this central bank restructuring did not substantially change the total consolidated deficit, ithas made possible more transparent deficit accounting and more efficient monetary managementby the new central bank, BSP. The OPSF deficit has been narrowed recently by timely adjustmentsof oil product prices, and there is a plan to make the oil price adjustments fully automatic

CPSD includes financial accounts of the NG, the Central Bank, the Oil Price Stabilization Fund (OPSF), theGovernment owned and controlled corporations (GOCCs), Government Financial Institutions (GFIs), and socialsecurity institutions.

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eliminating the need for the OPSF altogether. The remaining deficit center is the NPC. Given theserious needs for reliable power supply, the NPC should continue to invest, especially intransmlission activities, and the NPC may have to suffer deficits for the next five years.

1.14 The improved CPSD in 1994 is a combination of factors including increased taxefforts by the national government. But, again, what really turned the tide was the privatizationproceeds, which amounted to P 62 billion, that improved both NG and GOCC accounts. Adecline in the operation and maintenance spending during the 1990s has also contributed to thesmaller CPSD.

TABLE 1-7: CONSOLIDATED PUBLIC SECTOR DEFICIT (BILLION PESO, AND % OF GNP)

1987 1988 1989 1990 1991 1992 1993 1994

Total Public Sector -12.1 -25.9 -35.1 -54.3 -26.5 -27.0 -41.1 -10.4Balance

(percent of GNP) -1.8 -3.3 -3.8 -5.0 -2.1 -2.0 -2.7 -0.6

National Gov't -16.7 -23.2 -19.6 -37.1 -26.3 -15.9 -21.9 -1.8

GOCCs 0.2 2.9 -3.0 -16.4 -7.4 -12.3 -25.6 -13.;

OPSF -8.5 -1.5 10.1 5.4 -7.9 2.6

BSP/CB/CB-BO1. -10.7 -15.9 -20.9 -21.9 -21.2 -21.8 -16.0 0.3

GFIs 1.0 1.8 2.7 3.1 2.4 3.8 6.1 2.7

SSS/GSIS 5.4 4.4 8.3 10.0 8.2 8.6 11.6 0.4

Others/Adjustment 10.8 4.1 5.9 9.5 7.7 5.2 12.6 -1.6

Government Owned and Controlled Corporations.

1.15 During the 1970s, the GOP established a large number of GOCCs to, inter alia.improve provision of infrastructure services. The GOCC sector borrowed one fifth of domesticloanable funds and absorbed almost half of external loans to the country during 1975-84. Yet, thesector suffered from a number of inefficiency and its value added contributed a mere 1.8 percent ofGNP. By 1984, the GOCCs numbered more than 300, and required budgetary support thatneared a quarter of national government spending. Recognizing how serious the problem hadbecome, the GOP undertook a far-reaching sector reform during the 1980s throughprivatizing/liquidating more than 200 GOCCs, and strengthening performance of the remainingGOCCs. An oversight mechanism of GOCCs was also established within DOF. All performanceis now evaluated based on "contracts" between the GOCC and the NG. This section briefly reviewsperformance of the GOCCs from 1989, a year after the latest reform efforts started, to 1993, andexaminle if the benefits of the reform has been sustained. In addition, Volume 11 has detailed

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discussion on GOCCs in transport (PNR, LRTA and PPA); power (NPC): water sector (MWSSand LWUA); and agriculture (NIA and NFA).

TABLE 1-8: TOTAL INTERNAL CASH GENERATION OF MAJOR GOCCs

(IN P MILLION)

1989 1990 1991 1992 1993

All 14 GOCCs 7426 5493 9780 13102 11426

(Percent of GNP) (0.8) (0.5) (0.8) (0.9) (0.8)

Withlout NPC -18 2170 6550 2673 4321

(Percent of GNP) (0) (0.2) (0.5) (0.1 (0.3)

Source: Department of Finance (Corporate Affairs Group - CAG)

TABLE 1-9: NET INCOME OF MAJOR GOCCS (P MILLION)

1989 1990 1991 1992 1993

Export Processing Zone (EPZ) 3 3 65 46 63Authority

Local Water Utilities (LWUA) 24 41 30 157 117Administration

L-ight Rail Transit (LRTA) -350 -445 -585 -472 -370Authority

Metro Manila Transit (MMTC) 81 -275 -116 -47 -344Corp.

Metropolitan Waterworks (MWSS) 494 792 1069 1194 1072and Sewerage System

National Development (NDC) 722 -344 206 139 750Company

National Electrification (NEA) -630 -468 -335 -459 -332Administration

Nationial Food Authority (NFA) -1785 -1026 -2761 -3090 -1373

National Housing (NHA) 20 115 61 26 7Authority

National Irrigation (NIA) -39 -67 -31 -156 -37Administration

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Nationial Power (NPC) 1661 -65 -2930 4118 1565Co rpo ration

Philippine National Oil (PNOC) 1277 1714 2034 2500 3476Co.

Phlilippine National (PNR) -170 -284 -296 -285 -336Railway

Philippine Ports Authority (PPA) 381 358 194 396 418

Memoit): Nominal GNP 914,126 1,082.947 1,266,070 1.385,562 1,519,814

Source: Department of Finance (Corporate Affairs Group - CAG)

1.16 Financial performance of the 14 major GOCCs, listed in Tables 1-8 and 1-9,shows limited improvements during the early 1990s. Their internal cash generation (ICG) morethan doubled from 1990 to 1993 although a large portion of the ICG was generated by NPC,which enjoyed numerous implicit subsidies and tax exemptions; and to PNOC and NDC, whichbenefited from proceeds of privatization of their subsidiaries. Positive profits continue to beelusive for many GOCCs with no trend of improvement. Even those with net positive profits, the

6return on assets remained below 2 percent in all GOCCs but PNOC and MWSS . Theirperformanice was limited despite the fact that the market demand for services provided by GOCCshas been on the rise in recent years--demand for passenger and freight traffic, and for electricityand water connections, for example, have consistently shown an upward trend. There is thus anample evidence that the limited financial performance of GOCCs has been due to supply sideconstrainits.

1.17 The principal constraint faced by GOCCs is the inadequate financing forrehabilitationi and expanding capital stocks due to a number of reasons. First, to a large extent,they suffer from inability to adjust the low user charges for improved cost recovery; andinefficienit collection of existing user charges. For example, the Philippine National Railway(PNR), and Light Rail Transit Authority (LRTA) have not adjusted their fares since 1989 and1991. respectively, despite their persistent net loss position. The Philippine Ports Authority'starif'fs were frozen from 1985 till 1994, and National Irrigation Administration (NIA)'s irrigationfee lhas been constant since 1975 (note that part of the fee is in kind). NPC and MetropolitanWaterworks and Sewerage System (MWSS) have recently adjusted tariff rates, but they still havelarge annlual financing requirements. Second, collection rates are low: for Local Water UtilitiesAdminiistration (LWUA), it is 64 percent, and for NIA, 45 percent. Third, the problem iscompounded by large system losses due to poor network maintenance and pilferage: 58 percent ofwater MWSS produces no revenue, 43 percent for NIA and 20 percent for National Electrification

5Thcsc GOCCs receive most of the NG transfers, and are monitored by the Ministry of Finance.

MWSS appears to be under-spending on maintenance and their physical assets under-estimated. Thus, its actuallate of return may be lower.

- 14 -

Administration (NEA). Finally, poor levels of service also discourage users from paying user feescreating a vicious circle of poor service and poor funding.

1.18 Because of these problems, many GOCCs still have to depend on the NG resourcetransfers to them. The data on net flow of funds from NG to the major GOCCs appears to suggestthat it hias been reduced significantly during the last two years on accounts of increased taxpayments (Table 1-10 first row). But, it is misleading because improvemenits were due to theincrease in tax payments by NPC in 1992 and 1993. NPC's tax exemption status was confirmed bythe supreme court in August 1994, and NPC has requested refund of tax payments made beforethat date amounting to P 15 billion. NPC has already received P 8 billion in 1994. If thistransaction is taken into account (see below on NPC), the recent reduction in the net NG paymentsto GOCCs was small (Table 1-10, second row). Excluding NPC, the GOCC sector received fromthe NG, net, P 6.4 billion in 1989 and P 4.3 billion in 1993. This is a slow improvement.

TABLE 1-10: GOCC-NATIONAL GOVERNMENT FINANCIAL FLOWS (CASH BASIS)

1989 1990 1991 1992 1993

Net Flow (with NPC) -5341 -5273 -7711 457 -2058

Percent ot'GNP (0.6) (0.5) (0.6) (.03) (0.1)

Net Flow (without NPC) -6395 -4236 -4686 -2109 -4281

Percent of GNP (0.7) (0.4) (0.4) (0.2) (0.3)

From GOCC to NG(without NPC)

Tax payments 391 765 1338 980 1919

Interests 2918 1004 72 903 82

Dividends 80 197 130 219 629

Total (to NG) 3389 1906 1540 2102 2630

From NG to GOCCs(without NPC)

Equity 2078 2677 1544 200 1290

Net Lending 3461 1418 1450 1754 1681

Subsidies 4245 2047 3194 2257 3939

Total (from NG) 9784 6142 6188 4211 6911

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1. 19 To eliminate the vicious circle (poor services leading to poor user charge collection,and thus poor maintenance) and to establish a robust base for economic growth with improvedprovision of infrastructure services, many GOCCs have embarked upon ambitious investmentprograms. The 14 GOCCs trebled capital expenditures from P 12.7 billion in 1989 to P 40.5billion in 1993. NPC alone increased its investment from iP 6 billion to P 27 billion during thesame period to address the critical power shortages. If NPC is excluded, ICG in the aggregatefinanced 63 percent of the GOCCs' investmenit between 1989-1993. Domlestic borrowing finaliced33 percent and external borrowing the remaining 4 percent.

1.20 Many of these corporations will want to pursue ambitious investment programs toalleviate the infrastructure bottleneck as part of the modified Medium Term Development Plan.Projected capital expenditures are to the tune of P 20.3 billion for 1995 and e 32.5 billion for1996 excluding NPC. But, as discussed in Chapter 2 and in Volume 11 there is a need to examinethe role of the public sector and appropriate investment programs for each sector. For exam1ple,LWUA's role should depend on the desirable size of water supply schemes--whether they should bethe size of existing water districts in general or they should be regionalized to take advantage ofscale economies. If the GOP is to privatize MWSS, its investment programii needs appropriateadjustmients. The National Food Authority (NFA)'s generalized price subsidy has been ineffectivein alleviating poverty while being a heavy financial drain on the public sector. The GOP needs tocontilnue to phase out NFA's subsidized activities and divest the associated assets. Anotherexamlile of a GOCC needing a fundamental structural reform is the PNR which has suffered fromcontilnuous and significant losses despite repeated efforts to revitalize with donor assistance. Itshould probably slhrink its network to commuter rail around Manila and theni be privatized at anappropriate time. Finally, the National Housing Authority (NHA ) should einphasize housing forthe poor. and accordingly adjust its investment program.

1.21 NPC-NG Relationship NPC alone constitutes a major public finance issue; itsoperatinig deficit in 1994 was 1.2 percent of GDP despite direct and indirect support from the NG(Table 1-11, See Background Paper Section VI for details). NPC's finalicial situation will likelyremain precarious until 1998 when the deficit is projected to narrow to 0. I percent of GNP (due tothe decreased need for investment) even when rather optimistic revenue assumptions are employed.Three maiii reasons are at the roots of the NPC financial difficulties. First, the need to overcomeihe recenit power crisis caused a significant increase in investments and operating costs. Capitaloutlays reached 2 percent of GDP in 1994, more than twice as much as in 1989. Operating costalso increased because purchases of power from independent producers incr-eased substantiallylrom 1992. Second, despite the adoption of an automatic formula, prices have not beenl promliptlyadjusted to reflect changes in fuel costs and exchange rate movements resultilIg in increased NPCdeficits. Third, a number of investment projects which would yield returnis over a long temporalspan have been financed with loans with a much shorter term increasling slhort term financialdifficulties.

2. THE GOVERNMENT'S ROLE AND RESOURCE ALLOCATIONISSUES

Introduction

2. 1 Fiscal policy and public expenditure decisions are critical tools the Government hasin achieving the goal of higher income growth while maintaining social justice. This chapterreviews the GOP's role in resource allocation. In the first section of the Chapter, three generalpoints are made: (i) the expenditure level and pattern should be determined to achieve long termgoals of development and not be used as a short term counter-cyclical maneuver; (ii) the role of theGovernment, in the presence of the active private sector, should be carefully reviewed with therelative cost of private provision of public services in mind; and (iii) the Government couldproductively provide even private goods when the equity impact is significant. In the second half ofthe chapter, issues specific to major sectors are reviewed and recommendations for reforms and/orchanges in expenditure patterns are summarized. (The details of sector discussions appear inVolume 11.)

2.2 The key sector messages are as follows: (i) in the transport sub-sectors, the GOPneeds to continue to devolve parts of responsibilities to local governments and the private sectorwhile maintaining strong network planning and a regulatory framework; (ii) for utilities, the GOP'sfocus on privatizing "production"* of power and water is in the right direction, and the GOP canincrease efficiency further by taking advantage of scale economies through consolidatingdistribution systems; (iii) the GOP can focus on productivity increase in rural areas by investing inrural infrastructure and research. Also, the uncertainty regarding how and when the AgrarianReform will be completed has allegedly reduced private investment because of the ban on changingland use in the areas designated by the reform program. Reduction of this uncertainty will thuslikely contribute to increased private rural investment; and (iv) in social sectors, it is important thatthe poor get access to quality education and health services, and that the service provision be donein a more cost effective manner. In addition, strengthening technical and administrative capacity ofLGUs is of a highest priority, because many of these responsibilities have been devolved to them.

Determinants and Effects of Aggregate Expenditure Patterns

2.3 It is difficult to try to impute motives to the setting of priorities by decision makers;expenditure decisions are intensely political and the result of substantial compromise. Attempts,however, can be made to find some of the factors which go into the choices. Table 2-1 showsregression analyses of sectoral shares of budget on the rate of growth of tile previous year (tc seehow much expenditure changes as a result of good times versus retrenchment) and the debt servicetas a fraction of GDP) requirements of that year. These factors together are importantdeterminants of the overall budget envelope.

2.4 At this relatively aggregate level, spending on economic services (infrastructure,irrigation, etc.) represents a distinctly counter-cyclical maneuver as reflected in the negativecoefficient for growth. These expenditures tend to rise in bad times--the GOP intentionally "leans

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against the wind" by supporting the economic services as a way to speed up the resumption ofgrowth.

2.5 The effect of debt repayment is far and away most pronouniced in the share ofeconomic services, indicating a strong substitution between debt obligations and physicalinfrastructure. This corresponds to the observation above that there has been a long term decline ininfrastructure investment as a result of the debt crisis and high debt service obligation that ensued.Combining these results indicates that there is indeed substantial rebuildinig and new publicinvestments to be done to redress the legacy of the debt-ridden years. However, this should bedone according to a well planned strategy of providing public infrastructure and not be varied as acountercyclical tool.

2.6 In contrast, other expenditures (education, health, defense and publicadministration) tend to respond to transitory incomes, and increase in periods of faster growth.They can thus be considered more along the lines of consumption goods. Although the relationshipis weak for any one of the categories taken individually, together the relationship is quite strong.Interestingly, the share of expenditure going to social services did not fall with higher debtrepaymiienit. This is likely due to the change in regime which had a greater coinmitment to socialservices and the simultaneous increase in debt service payments. It is to the credit of thegovernmnent that such social sector spending were relatively protected from the need to repay loans.

TABLE 2-1: DETERMINANTS OF TOTAL EXPENDITURE BY FUNCTIONAL CATEGORY 1975-1993

Iiidepeindent variable Economic Services Social Services Derense Public Service

Growth of the Previous -.099* .032 .017 .031Year

(.049) (.028) (.022) (.019)

Debt payment as % of GDP -.242* .074* -..020 .079*

(.074) (.034) (.042) (.025)

{ R2 .62 .16 .56 .48

Autocorrelation .463 .045 .803 .229

(standard errors in parentheses, * = significant at 5 percent)

2.7 Using spending on economic services to stimulate short-termi growth in bad times,however, has not been productive. A statistical analysis indicates no correlation between shares ofexpenditures on economic and social services on the one hand and next year's economic growth onthe other. In fact, economic services had the weakest correlation with future growth. Thus, to theextent that one category of expenditure was favored relative to other parts of the budget as a meansto stimulate growth, not much came of it. While not a definitive analysis, there is no evidence tosupport a position other than using the government investment (and its rates of returns) andexpenditure programs to achieve their long-term goals and not to vary these targets for the sake ofshort term stabilization.

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2.8 In addition, to the extent that the social sectors are used both as a redistributivedevice and as a means of correcting market failures, there is no reason to compromise that missionfor macroeconomic goals. Indeed, regional public expenditures in education and healthi appear tosignificantly contribute to improved human capital and medium term growth of the region contraryto the limited significance of the aggregate figures. Both recurrent and capital expenditure oneducation increases significantly the share of students completing primary education, and healthexpenditures also contribute to reduction in infant mortality rates -- but this effect is limited to

poorer regions (see Background Paper Section VIII) suggesting that in richier regions publichealth expenditures are substitutes for private health care.

Efficiency and the Role of the Public Sector in the Economy

2.9 Tight budgets, expensive revenue collection, and a multiplicity of claims on thepublic purse, all make it essentia; that government activity demonstrate its ability to add tangibly tothe economy. Government furnishes goods and services ranging from pure public to pure private.In deciding where to cut and where to expand expenditures, it is crucial to determine which kindsof activities will substitute for private provision and which are truly additive. Within each sector itis possible to decompose budgets into three sorts of categories:

* those which are for pure "public" goods, that is, goods which cannot be provided by the privatesector. The principal reason .vould be that it would not be possible to refuse services to thosewho do not pay fees (within practical limits of the cost of exclusion). Tolls on local surfaceroads, for example, are impractical. In the most extreme example, it is impossible to excludeanyone from the benefits of national defense against foreign invasion. Here, the justification ofgovernment expenditure is completely clear and particular investmenlts onlly need to satisfy thesocial profitability rules in project evaluation.

* those in which the private sector can participate but not at desirable levels. They would need tobe subsidized (or taxed) or provided with a regulatory framework. The cost of the regulatoryneeds of the sector is but a small fraction of the provision itself. Electric power generation, forexample, needs the regulatory framework for selling into the national power grid (which can bepublic or, with more careful regulation still, privately owned and operated). However, theadministrative costs of monitoring and enforcing the contracts governinlg those sales aretrivially small compared to the welfare cost of raising the funds needed. The current trendtoward Build-Operate-Own (or Build-Operate-Transfer) schemes is a miajor recognition of thisoni the part of the government. Control of communicable disease is another such category -there will be private care for patients but it may come too slowly and with too little thoughit toprevention.

* those which are essentially private goods that are disproportionately conisumed by the poor.Providing them is a means of transferring resources to the poor in lieu of direct monetaryredistribution.

A similar analysis was carried out for infrastructure at a national level. The result is miixed probably reflectinglong geslation and lumpiness of investment.

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2.10 The GOP has done well in allowing private investors to take part in theinfrastructure and social areas. But, there is room for improvements. Many goods which areessentially private in nature are publicly provided. These goods are ones for which chargingappropriate user fees is possible and practicable and those who do not pay fees can be excludedfrom consuming them. Electric power generation is the best example of formerly public servicesthat can now be privately provided, and progress has been made in extending the scope of theprivate sector in other infrastructure areas. Other examples would include housing (which featurespromiiiently in the government's agenda for social reforms) and higher education. Further, there issubstantial variation in the extent to which these goods and services favors the poor. This opensthe possibility to specify more clearly the purpose of these budget items and to focus resourcesbetter on those expenditure categories which are better suited to the redistributive function.

2.11 In deciding on where to cut and where to expand public expenditures, it is crucial todetermine which kinds of activities will replace private provision and which truly add to the overallservice level. Each sector is characterized by activities with varying characteristics on thisdimension. Three clear examples may serve to illustrate.

2.12 Health. Expenditures by the Department of Health (and its local equivalents) runthe range from purely public goods to purely private. On the public end of the spectrum are suchactivities as pest control and certain forms of sanitation disposal. The government has no choicebut to provide them. If the government doesn't, no one will.

2.13 In a middle ground are services with high external effects. Infectious diseasecontrol is critical since people's own demand for services will not necessarily take into account thepossibility of infecting others. Services which combat consumer misinformation are also critical inhealth. The value of preventive care is frequently underestimated by the public and no privateprovider has much of an incentive to correct this misperception.

2.14 Finally there are services which are entirely private in nature (such as the treatmentof noni-comiimunicable disease). The public sector tends to provide this activity due mostly tomarket failures in insurance. However, much of the insurance problem could be handled throughbetter regulation.

2.15 It is essential that those activities which are public in nature are provided sufficientfunding and are not diluted by competing claims on resources which have less rationale forgovernmnent intervention. Results in the health section below (paras 2.85-91) indicate that differentkinds of public expenditure can have very different effects on the health status of the populationwith highl externality activities as well as subsidized treatmentfor the poor being the most effective.On the latter point there was significant progress during the 1980's. On the former, perhaps toolittle had been spent on preventive services. With devolution, the NG's role has been circumscribedsubstantially; interregional transfers in health per se are no longer feasible. As the general role ofthe NG in health care delivery has diminished, specific efforts should be bolstered in remainingareas which are of NG concern. Activities which cross jurisdictional boundaries such as infectiousdisease control should have the highest priority.

2. 16 Education. In 1989, the GOP decided to expand access of the public to secondaryeducation by subsidizing students with no access to public facilities to go to private secondary

- 20 -

schools. This is certainly a laudable goal but it may have been an expensive policy in relation tothe aggregate increases in educational attainment. The comparison should be with net increases inenrollment as a result of the policies implemented, rather than increases due to secular trends inincome and the simple passage of time. Since secondary education is more of a private good(students can be excluded if they don't pay fees) and there had been a substantial private sector insecondary education before the reforms, there is the distinct risk that added public expendituresimply shifted the burden of payment to the government from individuals.

2.17 Indeed, it appears that this measure increased (i) subsidization of those who wouldhave opted to go to private schools anyway, and at the same time, (ii) created a third type ofsecondary schools that are called private schools but dependent on this government subsidies andprovided low quality education services. It is difficult to see if this measure has contributed to theobjective of universal secondary school enrollment because of the difficulties in disentangling theeffects of price changes accompanying the reform from general secular trends. That the extensionof secondary education came at a higher cost to the public is a serious problem. This is not to saythat secondary education is a bad thing, only that it may come at the cost of reduced resources forprimary education. It is at lower levels of education that more genuine external effects aregenerated for the society. Further, primary education is one of the most consistent (acrossnumerous international studies) means of transferring income to the poor. There is still ways to goto achieve universal primary education. The added cost to DECS of having to handle secondaryeducation, by substantially replac;ng a functioning private sector, compromises the more criticalgoal.

2.18 In higher education, this argument is stronger still. The returns to a highereducation are almost exclusively private and are reflected in higher wages for the graduate. Thevibranicy of the private university sector indicates substantial substitution possibilities for publiclyprovided subsidies via the state universities and colleges. In relation to other countries in Asia, thecosts of higher education are much lower, precisely because of the competition in the private sector(Mingat and Tan).

2.19 The costs of higher education and the difficulty of borrowing against future earningsmay justify government interventions. But this should be in the form of loans (with full expectationof repayment) and not subsidies. The benefits, if any, of public subsidy would have to be on thegrounds of income distribution. The state university program has been one of the more extremeexamples where political influence, Congressional insertions, and supercession of DECS decisionshave outweighed technical considerations.

2.20 Power and Infrastructure. Again, investments and expenditures covered byDPWH and NPC span the range from almost pure public goods (surface roads where tolls areinfeasible) to services with large network externalities (power grid operation) to purely privategoods such as power generation and electricity use. After very rapid progress on privatization inthe power sector in response to shortages, subsequent actions have been much slower. Thesubsidies to NPC both explicit and implicit still distort private decisions. As pointed out in therecent report on private opportunities in power (World Bank, 1994), while there is an importantrole for the coordination of the electric power grid, generation and sale of electricity are essentiallyprivate activities. The costs borne (other than those caused by pollutioni) and the benefits receivedare fully excludable and rival. While some regulatory effort is necessary, the legitimate role of the

- 21 -

governm1ienit in raising investment funds and in supplying services at less than long run marginalcost is nil.

2.2 l The decision between building infrastructure and buying services should be keptactively in mind whenever infrastructure services are needed. Buying services can help obtain thedesired products, since investment plans will not be interrupted and civil servant wage obligationswill not overwhelm line agencies at the expense of needed operational expenditures. Similarly,contracting out services and making good on the contracts can assure that actual outputs areachieved as in road maintenance by protecting non-wage operational inputs form being squeezed byadjustments coming late in the year. The recent decision by Congress to reduce road maintenancethrough private contracts thus needs a review. Once the public's role In improving allocations isclear, there should be clearer mandates for following through on the obligation. Privatization,corporatization and purchases of goods/services rather than supplying through the civil service canall help.

2.22 Cost of private provision The private sector, however, does not provide a panaceafor the GOP. The private sector will make investments in physical infrastructure when and onlywhen it expects a high probability of earning an acceptable rate of return. In addition, most privateinvestors require a pay-back period of three to five years. These limit the types of investmentswhich can be made by the private sector. They may also create distortions because investmentswill be made to maximize financial return to the investor rather than to optimize the benefits to thecountry. It is particularly true when positive externalities are associated with the investment --forexamiiple, the private sector will find it hard to invest in a mass transit system that reducesconigestioni and air pollution.

2.23 Even when the private sector does decide to invest in infrastructure, the cost ofprivate capital should be evaluated carefully; it has higher cost of capital than when the governmentraises resources (because of additional risk incurred, high returns to competing investmentsavailable to them, and shorter maturity periods). Exceptions occur when the capital available to thegovernmetnt is limited by both insufficient fiscal revenues and limited access of the government tocapital markets. In such a case, the private sector access to funds may become truly additive togovernmi1enit investment. However, when governments do access capital markets through treasurybills and bond issues, it is essentially competing for the same sources of funds at the margin withthe private sector.

Equity in Public Expenditure.

2.24 It is difficult to determine with great accuracy who gets what from the public purse.Only relatively indirect methods are available to see to what extent the poor in the Philippinesbenefit more from public expendituie than do others. There are few surveys of national coveragewhich both identify the degree of use of public services and houselhold per capita income - the twoingredients necessary to pin down the distribution story. Here some inferences are made on thebasis of regional data - per capita subsidy costs and average regional income. While thisinformationi cannot determine whether poor people in poor regions receive their share ofexpenditure or if the benefits accrue to wealthier people within poor areas, some inferences can bemiade.

- 22 -

2.25 Ensuring that more of a particular spending reaches the poor relative to higherincome groups, however, may be too stringent a test for judging the redistributive capacity ofexpendliture. The real comparison is with the incidence of the marginal tax revenue needed to payfor the increased service. If the tax system is very progressive, meaninig that a large fraction ofexpenditure is funded by the relatively wealthy, then the system can support a number of activitieswhich, while not received more by poor than non-poor, are still net transfers due to their fundingmeclhaniisml .

Chart 2-1

Distribution of Taxes and Expenditure by Regional Income

3000

2500 -4--Tax

j -iSn : ; ; 7 | : t-- Roadsq 2000 -i--X Health

t Basic Ed

Sanitation

1000 Water

LU500

0 -a

1 3 5 7 9 11 13 15 17 19 21 23

Per Capita Regional Income

Lower Part of Chart Enlarged

4504 300

t) 300 -F 0 : i ealth

ot 250 6 _ ~ - = 5 : XBasic Ed2! 200 _ Sanitation

, 150 - - . . a :xS O -e--Water100

1 3 5 7 9 11 13 15 17 19 21 23

Per Capita Regional Income

2.26 The Philippines tax system is roughly proportional (i.e., everyone pays somethingquite close to 10 percent of their income in taxes) due to the reliance on itidirect taxes (which are

- 23 -

slightly regressive and contribute 70 percent of the total collections) modified by personal andbusiness taxes (which, while a smaller fraction of collections, are considerably more progressive,see World Bank 1993). Chart 2-1 compares the per capita tax payments with receipts of various

2expenditures per capita based on data for the 1980s and up to 1992 . In many of the expenditurecategories, absolute progressivity does not hold throughout the income distribution. But, lowerincome regions do receive more from the spending programs than they on average pay taxes tosupport these programs.

32.27 The clearest pro-poor programs are health and primary education (prior todevolution). The area which is least progressive (at least cross regionally) is public works (mostlyroads). Since much of infrastructure has characteristics of public goods. this may not be alarming.Its pattern is skewed largely by the concentration of DPWII activities in the National CapitalRegion. Public infrastructure with supports economic activity will naturally be more productive inthe more industrial parts of the country. While there is always a need to monitor the specificservices within the infrastructure aggregate to make sure opportunities for unbundling privatizableservices are taken, this becomes even more important when distributional issues are considered.The reduction of subsidy to privatizable infrastructure in urban areas will reduce the regressivetendency of expenditure evident in the data.

2.28 But, after the devolution started, both education and health expenditures allocation4

(GAA) lost their pro-poor patterns--richer regions received relatively more allocation(Background Paper Section VII and VIII). For health, positive correlation between the poverty andper capita sector expenditure by NG ends as early as 1992. The rate of decline in health resourceallocation is higher in poorer regions, while the NG expenditures have beeni protected from theeffect of devolution in richer regions. Regarding basic education, the regressive pattern emergesfrom 1994, and worsens in 1995. When 1994 data was examined by the level of education, alllevels of education have negative correlation with poverty incidence and that the primary educationspenidinig was unfortunately most regressive. As discussed below, these regressive NG spendingpatterns might very well be aggravated by devolution, because the IRA transfers to localgovernmenits were not implemented based on the income redistribution needs in mind (Chapter 3).

2.29 A major focus of the government's social priorities has been in the housing sector.Looking more closely at that sector reveals both opportunities and risks in addressing the needs ofpoor people through public subsidies. Charts 2-2 a and b shows two items taken from descriptionsof the National Housing Program. The first is the number of housing units "needed" by region.

Data is presented in regression form in order to facilitate comparison - that is, the curves represent estimatedexpenditures per capita based on the region's mean income.

Education results need to be interpreted with care. Spending per student is rather constant across regionsespecially at the primary level (see Chapter 10). The "per capita" progressivity may merely mean that thereare relatively more school age children in poorer regions. Also, it is found that the poor have limited accessto quality education (Chapter 10). That the NG spends more on poorer regions may not ensure that poorfamilies benefit from this spending pattern.

GAA is used partly because of difficulties to obtain detailed actual figures for recent years, and partly becauseGAA expresses "intention" of the government towards income distribution.

- 24 -

This is an estimate based on the number of substandard units and projected growth of housingdemand (from natural increase and from in-migration). The difference between the overall demandfor housinlg and that component of it which is due to actually substandard housing is quite strikingin terms of the income of the regions generating that demand. If housing policy could be directedspecifically to substandard units (without, of course, producing an incentive to keep housing unlitssubstandard!) rather than spread uniformly over the projected increase in housing units, the degreeto which the poor could benefit would rise substantially. In fact, the way in which the majority ofhousing subsidies is being administered - through the granting of mortgage subsidies - it is likelythat the amount of money flowing to the public through this channel is going primarily to the non-poor, and probably to higher income groups. No data cross-checked with household incomlle isavailable to confirm this, however.

Chart 2-2 a

Potential Incidence of Public Housing Program

20

X, 5 ... .

0~

10

0 5000 10000 15000 20000 25000 30000

Income per Capita of region

Chart 2-2 b

Substandard Housing by Regional Income I

7

6

5

:~4cn3

z~2

I0

8 8.5 9 95 10 10.5

Reglonal Income per capita (in logs)

- 25 -

2.30 Policy implications of distributional analysis. Government intervenes in theeconomy for reasons unrelated to helping the poor. However, expenditures which have little to dowith correcting market failures should have a beneficial distributional profile in order to justifypublic subsidies. There are two ways to affect the amount and the distributional characteristics ofthe subsidy: by manipulating the fee charged for services (such as water, electricity, universityeducation or health care) or by changing service characteristics and thereby alter the pattern of useof the service (e.g. location of facilities, comprehensiveness of network hook-ups). Thedistributional profile helps to determine the most effective way of improving delivery of services tothe poor. If the profile is not progressive: either poorer people get less than richer or, worse,poorer people get less than their contribution to revenues, and fees should be raised. The poor arenot hurt disproportionately and the subsidy is reduced. Extension of services to more of thepopulation will reach the poor and change the distributional profile over time. Having access tosafe water at a cost is better than having no access at all.

Omissions

2.31 Inappropriate public expenditures are easier to identify and fault than failures tospend money where it would do more good. Put another way, public expenditures designed toremedy private sector market imperfections can be evaluated, while complete market failures, as inthe case of public goods, may be more important but likely to be overlooked. Environmentalprotection and pollution abatement are two areas that warrant more attention.

2.32 Environmental protection will not be done adequately without public involvement.The main environmental issues have been reviewed in Bank and other documents. Thegovernmenit has been increasing the allocation to the Department of Environmiiient and NaturalResources at a faster rate of growth than the overall budget (39 percent versus 4 percent from 1992to 1994) and it is difficult to set specific numerical goals for this increase. However, the steadilyincreasing congestion and pollution of Metro Manila indicates substantial scope for strongerefforts. It is not necessary that such effort be more expensive. Much pollution abatement can beaccomplished with taxes, either on industrial effluents or on the use of automobiles in center city.Reliance on tax instruments are usually more efficient than other methods of pollution control suchas enforced standards (World Bank Discussion Paper #287) for two reasons. First, they allowindividual producers to find the best way of reducing pollution or otherwise paying for the coststhey impose. Second, by raising revenue instead of spending it, there will be substitution of anefficient tax for the distortionary taxes currently in place. The recent report, "PhilippinesPollution,,,,," recommends such a tax based solution along with a description of how best toimplement it.

2.33 Beyond the tax solution, alleviating congestion is likely to require real investments.Evaluating transit systems and infrastructure investments which change urbanl form and traffic flowshould be a high priority.

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Policy Recommendations on Sector Expenditure

2.34 Key recommendations for each of the major sector are summilarized below. More5

detailed examinations of sector expenditures appears in Volume II of this report. Crucial questionsthat need to be asked in deriving the recommendations are as following:

* Is the mix of sector spending appropriate for the economy'? Does it complement, supplement,or comipete with the current or possible role of the private sector? Is this NG spendingconsistent with the ongoing devolution process?

* Where there is redistributional intent, is the sector spending benefiting the poor more thanupper income groups?

* Are the expenditures achieving the outcome which were intended, or are they inefficient?

TRANSPORT SECTOR

2.35 Introduction Although the transport sector includes a diverse set of modes andnetworks, a common set of policies improve the efficiency of government expenditure in thesector. A key factor is to reduce the size of networks that the NG should build and maintain sothat the quality of services can be as high as possible. Specifically, the GOP needs to consider:

(i) agreeinig on appropriate division of responsibilities between the NG and LGUs;

(ii) enlarginig the scope for transferring transport services to the private sector;

(iii) imlproving network planning that takes into account LGU and private sector participation;

(iii) addressing the issue of pricing and regulation; and

(iv) down-sizing staff according to the reduced role of the government.

2.36 Devolution to Local Governments The first two concern improvements to thetransport network. In the case of the roads, railroads, ports and airport. this means a reduction inthe size of the network to be maintained by the central government to an essential core which thegovernmiiienlt can afford to maintain to an adequately high standard. First, decisions need to bemade as to which part of the network would be transferred to LGUs. Then LGUs would have tomake the same decision as to wlhat is sustainable. However, this transfer should also includetransfer of the source of revenues needed to miaintain the local network. This implies an explicittransfer of taxing and/or pricing authority. The local governments would then be faced withbalanicing the level of tax or price which the populace would accept with the size of the localnetwork which could be maintainied to an acceptable standard. In the case of roads, most of thenetwork imiaintenance work for non-national roads has already been devolved. Furthermore, the

Power sector and health sector are not discussed in Volume II because strategies ot these sectors have beendiscussed in recent World Bank reports (World Bank 1994a, World Bank 1994b).

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governmenit is considering to focus the maintenance work on the core artery network of about14,517 km out of the total national roads of 26,554 km. The devolution of smaller ports to localgovernments should reduce PPA's responsibilities while allowing local governments to make thechanges necessary to improve their performance.

2.37 Private Supply The second issue is to transfer selected responsibilities forproviding transport services to the private sector to take advantage of its demonstrated ability toconstruct and maintain infrastructure and to operate and maintain transport services. TheGovernment has already started doing this successfully in power. The government must firstexaminie its role as a provider of public infrastructure and essential services and then identify thosefunctions whiclh the private sector could perform more effectively. However, the GOP wouldcontinue to insure access to the infrastructure and optimal pricing of the services so as to maximizethe economic benefits derived from the network. The GOP should also insure that the individualservices and infrastructure provided by the private sector are effectively integrated with the rest ofthe network so as to maximize the efficiency of the network. For example, toll roads should bewell integrated as part of the highway network. Much more road maintenance needs to be carriedout by private contractors rather than through force accounts--a trend whiclh recently was reversedby Congress. In addition, the Philippine National Railway (PNR), which has been too small to takeadvantage of scale economies and has been making persistent losses, needs to be reformed. Onealternative is to convert it to a short-distance commuter rail linked witlh the rest of Manila's urbantransport and, possibly be privatized. Finally, the Government should continue to act as a providerof low-cost funds to finance the development of transport infrastructure. To do this, it shoulddiversify thie sources of funds, to include not only tax revenues, ODA and government loans butalso bonds which are either issued or guaranteed by the central government and public offerings ofcorporatized transport functions.

2.38 Network Planning A related issue is the improvement in network planning. In thecase the urban transit and roads, this means integrating the individual rail transit systems (LightRail Transit Systems and privatized and commuterized PNR), interfacing them with the existingtransit and public road transport systems and developing the urban roads as components of anetwork rather than individual links. In particular, the returns to the third LRT system would beenhanced significantly if it were to be effectively linked to first and second systems of LRT. In thecase of the ports, this means merging the ports located within a metropolitan area and including theprivate ports in the planning for additional capacity requirements. In the case of the air transport,this would mean establishing a system of municipal and private airports which would serve the

.iaeler markets and private aviation.

2.39 Pricing and Regulation The fourth issue is to introduce more efficient pricing oftransport services. The rationalization of pricing is especially important for the ports, railroad andairports because the present system has created an elaborate system of cross-subsidies favoringspecific markets by setting prices far below the users' willingness-to-pay. This system prevents thegovernment from applying basic financial management criteria such as equating costs with prices ormaintaininig a minimum level of surplus. The most effective way to control prices and their relatedcosts would be through greater reliance on market forces. The benefits of deregulation andincreased competition have been felt throughout the transport sector. The last vestiges of priceregulation (and regulation of the frequency of service) are being eliminated from the domestic

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shipping and have been partially removed from the air transport sector. The railroad and the portsector have not benefited from this autonomy with the result that they continue to provide a lowerquality at prices which do not cover the costs.

2.40 The phasing out of the government's role in economic regulation of the transportsector should be complemented by a strengthening of its regulation of safety and environmentalprotection. As the private sector involvement increases and the forces of competition encourage areduction in operating costs, it will become more important for the governmenit to insure that aimiiimluI standard of sal'ety is mzaintained and that the reduction in financial costs does not create agreater cost in terms of environimlental degradation. In order to avoid a conflict of interest, it willbe necessary to develop regulatory agencies which are not involved in providing transport services.This imiplies removing these responsibilities from the PPA, ATO, PNR. and perhaps, from theDOTC.

2.41 Staffing The final issue to be tackled is the downsizing of the government agenciesinvolved in transport. There are situations where there is obvious over-staffing not only throughthe in(discrimninate use of casual labor but also because of the failure to reduce the staff as theirresponsibilities have decreased. The amount of staff required will continue to decrease as theirresponsibilities are devolved to the local governments or transferred to the private sector. Forexamiple, DPWH's labor force should be smaller with the increased contract maintenance andsh.ould he miore professional so that better network planning can be made. Similarly, PPA is over-stafl'ed with administrative personnel. There is a need to reduce this layer of staffing, andconltract/casual workers as responsibilities are devolved to LGUs and the private sector. Forcountries such as Malaysia , Singapore and Thailand, this downsizing has been relatively easybecause tlheir rapidly expanding economies absorbed the excess labor. While the Philippines hasnot yet attained this level of growth, there is some scope for voluntary separations due to thecombination of low morale and expanding employment in the private sector. There is also somescope for the transfer of skilled personnel in situations where the private sector assumesresponsibility for the activities which they were involved in. There is the iminediate option foreliminating casual labor. Hlowever, a small percentage should be maintained since some of thecasual labor fill positions whicil are critical. For the remaining staff, the government must rely onattrition and early retirements but without stopping to recruit younger, more enthusiastic and bettereducated personnel to take on the changing responsibilities of the governillelit agencies.

POWER SECTOR

2.42 Introduction The Philippines has experienced a major crisis of electricity supply in1992-93, with blackouts averaginig seven hours per day being common in maniy regions across thecountry. Facing serious economilc losses, the GOP sought to supplemenit the capacity of theNational Power Corporation (NPC), the Philippines' monopoly supplier of electricity, with privatepower developimient. As a result, the crisis ended by early 1994, and it becamie clear that thegrowing involvemilenit of private power producers will result in a marked transformation of thepower genieration subsector fromnl nearly 100 percent public in 1991, to nearly 80 percent private by1998. Since the 100 percent of distribution utilities are already private, the private interest will havecomie to dominiiate the power sector.

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2.43 The Government's major power sector goal continues to be to meet all futurecapacity requirements in collaboration with private developers and private capital. Including long-deferred replacement of aging plants, capital requirements for generation during 1994-2000 areabout US$ 10 billion or more; for the same period, investments in transmission should exceed US$3billion. Neither the GOP nor the private sector, acting alone, can mobilize such amounts.Therefore, the GOP and the private sector must continue collaborating constructively for theforeseeable future.

2.44 Issues and Constraints To realize this collaboration, there is a need to bring ineffective competition and appropriate risk sharing between suppliers and distributors. In addition,there is a need to formulate appropriate roles of NPC, GOP agencies, and the private sector.Competitioin and risk sharing have been inhibited by captive relationships, franchise restrictions,and mloniopolies. NPC is suffering from over-worked equipment and lost public credibility onaccount of the recent power crisis. Yet, NPC is still the dominant supplier in the sector, purchasingfor resale more than 80 percent of planned private sector-produced electricity and assuming most ofthe inarket risk as well. The Government would prefer that NPC pass the rnarket risk to thedistributors (who are all private). but most are so weak and fragmented that few private powergenierators are yet inclined to deal with them directly.

2.45 Another constraint on NPC is that it should not serve as sponsor of the privatepower producers, developer of its own generation capacity, wholesaler of electricity, and alsosimultaneously act as (i) an impartial planner and operator of the transmission system and (ii)formulator of rules of dispatch. In the future, when supply is ample, multiple suppliers will needunliase(d access to the transmission system. Therefore, a separate transmission company,indepenident of any supplier, which a dispatch entity that is competent to establish fair andtransparenit rules, needs to be developed.

2.46 Proposed Sector Structure The GOP realizes that to achieve this goal, NPC needsto be restructured and Government agencies strengthened to capture the benefits expected to ensuefrom privatization. The distributors apart from MERALCO need to pursue market strengththrougLl consolidation. The desirable sector structure would include: largely private generationwith restructured and part privatized NPC; consolidated distribution utilities; and a backbonetransmission company which can be publicly owned at lirst.

2.47 NPC's generation facilities should be spun-off, as proposed by GOP, to wholly-owned subsidiary regional companies functioning as holding companies for existing plants anddevelopers of new state-sponsored thermal generation facilities. Alternatively, NPC could createeven mlore subsidiaries, based on functional or geographic considerations, to manage its generationfacilities. These subsidiaries' should enable them to follow commercial operating practices, andonce soundly operated, sell their shares to private interests. NPC will continue to have a vitalheadquarters function in the future. In the near term, it should establish a sound basis for spinningoff the transmission company and regional subsidiaries. Once the subsidiaries can obtain financingon their own merits, the parent will act more like a holding company; it will (i) assist thesubsidiaries with cash management, (ii) collect interest and dividends from the subsidiaries; and(iii) meet its remaining liabilities.

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2.48 Consolidation of 130 small distribution utilities into 15 or fewer continuous units isrecommenieiided because real competition among suppliers depends on the development of morecommiiercially-viable buyers. Such a consolidation can lead to needed efficiency reforms, and largerdistributioni utilities can then take appropriate market risks. The proposed consolidation, however,poses imaniy political problems; important entrenched interests are driving hard to maintain thestatus quo. Therefore, GOP needs to focus on an interim arrangement, whichi (i) progressivelyreduces the extent of market risk assumed by the Government; and (ii) provides appropriateincenltives for consolidation (including subtransmission networks of 69kV).

2.49 For its part, the public sector must focus on maintaining an enabling environment,within which the private sector can compete without undue constraints. The GOP's capacity tocreate and maintain a favorable climate for private sector-led growth also needs strengtheningthrouglh: (i) establishing clear policies and rules for independent power generation, which in turnrequires enhanced GOP (DOE) capacity for policy formulation and rule-making; and (ii) adjustingthe legal and regulatory framework.

2.50 The following three functions should remain at the national level: Power SystemnPlanning (this function should be shifted from NPC to Department of Energy (DOE) once thelatter has developed the necessary capacity); Hydroelectric Development; an(d BackboneTransmnission Svstemns and Dispatclh. The last, the backbone transmission system could still beregionlalized. However, responsibility for the system should be retained at the national level, so thatthe priority for interconnection will not be subordinated to regional concerns. The need to ensuresupplier-s unlrestrained access to the transmission system provides a compellinig rationale forcreatilng a transmission company that is distinctly separate from any supplier, including state enter-prises inivolved in power generation. For the same reason, this proposed new company should alsoowII anid operate all facilities for dispatch. The dispatch function must be executed fairly andefficienitly. The participation of the Government, NPC, the private power producers and distributorsin the fornulation of a dispatch entity and dispatch policy can be an outstanding opportunity toreachi long-termi consensus on those principles and enable a competitive environment for privatesector participation.

2.5 1 Reg,ulatory Framework . A major feature of the proposed sector structure isincreased relianice on effective competition as a regulator, although DOE, ERB and NEA willcontilule to be involved in regulation and monitoring. Because the recommlienided structureanticipates and supports direct contact between suppliers and distributors, it also has the importantadvantage of relying less on Government regulation than several alternative frameworks that wereconsidered. ERB would continiue regulating the distributors' tariffs since there would effectivelycontinue to be protected monopolies. To strengthen their capacity, ERB, DOE, and NEA wouldstill iieed to undergo a substantial institution building effort and staff strengtlhening due to theincreased size and technical complexity of the work load.

2.52 Implementilng a fair and transparent load dispatch systeml is the most importantresidual ut'ture roles in the power sector for the Government. Load dispatch should be linked toopel atioin of the transmission system; that linkage appears to have advantages in the Philippines,w here n(o precedent exists for collaborative pooling among competing suppliers. As substantialadditionis to capacity come on line, the dispatcher will determine the order with which plants are

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brouglht on line so as to minimize consumers' costs. However, provisions will be needed to honorNPC-executed PPAs that guarantee a high off-take for some relatively high cost electricity.

2.53 Pricing Reform. Higher voltage power tariffs should by structured to reflect costsby: (i) unbundling fixed and variable costs within tariffs, and (ii) introducillg time-of-daydifferentials, at least for high and medium voltage consumers. Tariffs also need to explicitlyinclude costs of stand-by capacity. Moreover, at the wholesale level, power pricing in different re-gions should reflect the true costs of generation and transmission. Current ihter-regional cross-subsidies have served as a substantial disincentive to private power producers interested in locatingplants in the Visayas or Mindanao. Finally, separation of transmission costs and development ofwheeling charges as part of the tariff for energy can be developed and later applied to the bulktransfer of electricity between buyers and sellers. In order to encourage private power producers tosite their plants at favorable locations without losing the flexibility to identify the best possibleselling arrangements, an acceptable framework for wheeling charges over the transmission andsubtransmission systems is needed.

2.54 Taxation Taxation of fuels for power generations needs to be rationalized. Toenable all suppliers of electricity to pay the same amount for fuels while shouldering the fuel supplyrisks for themselves, fuel tax exemptions should either be extended to the private power producersor be eliminated altogether, which would require 10-15 percent increase in retail electricity prices.Given this tariff increase comes without concomitant improvements in service, and that there wouldnot be loss of existing tax revenues, the exemptions for now should be expanided to the IPPs. Thispolicy, however, needs to be reviewed as the sector reforms are implemented.

WATER SUPPLY

2.55 Introduction. Inadequate maintenance of water supply infrastructure and sustainedunder-investment in sewerage and sanitation have contributed to water shortages and environmentaldegradation. As public health concerns become prominent, fundamental reform of the sector and anew strategy for achieving it become more pressing. Decentralization, private sector participation,and integrated water resource management--including integration of water supply and sanitation--would constitute the defining elements in shaping the new strategy.

2.56 Maior Issues Water supply is comprised of approximately 500 Water Districts(WDs). 1000 municipal supply schemes and 4,000 Barangay pipes water supply schemes (servingperi-urban areas), all independently managed and operated. These are supported and fundedthrouglh different public sector institutions--MWSS for the Manila Metropolitan Area; LWUA inother urbani areas; and DPWH for rural areas. Most of these schemes are small, financiallyunviable, and without economic incentives or the force of effective regulation to control leakageand costs, and maintain quality service. Many supply schemes and their customers are caught in aviscous circle of attempted recovery of excessive costs through higher tariffs following andprecedinig yet further private tapping of alternative (ground water) sources.

2.57 There are two GOCCs in charge of water supply, LWUA and MWSS. MWSS hasbeen unable to reduce non-revenue water to acceptable levels over many years while LWUA hashad problems recovering loans from WDs and has limited capacity to support all the WDs under itsjurisdiction. The current pattern of incremental expansion of coverage based on internal resources

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of Water Districts or small loans from LWUA often leads to sub-optimally engineered systemsbased on small diameter pipes extending out in a "spider" formation. To avoid high sunk costs,sector improvement plans should be based on network investments compatible with appropriatemaster plans. Furthermore, while incremental investments is supply have made it possible for thequantity of water supplied to increase, minimal investment in infrastructure for waste waterdisposal leaves only 10 percent of the population in Metro Manila and 2 percent outside connectedto sewer service. and the price is beginning to be paid in increasing pollution of water resources,recourse to more distant and costly sources of raw water and higher morbidity rates due towaterborne diseases.

2.58 Recommendations for Future Policy Changes Improving sector performance willdepend on cost reduction, demand management and increased efficiency in production anddistributioll, all elements of commercialization and the private sector participation (PSP)initiative. The PSP strategy includes: (i) rapid introduction of GOP-supported PSP alternatives inthe large mletropolitan centers (privatization of MWSS, and systems in Metro Cebu and Davao)with contracts tailored to their specific circumstances; (ii) consolidation of administration of smallerschemes into regional service areas, with scale economies in management and the potential toattract private sector participation in due course; (iii)credible regulation of private serviceoperotors, and (iv) improved maintenance or major network rehabilitation in Metro Manila in orderto sharply reduce distribution losses, prior to or as part of privatization of MWSS. For rural areas,a programii of sequenced, demand-driven infrastructure investments is needed. This should becoordiniated by the public sector, with resources allocated competitively on the basis ofpertormanice.

AGRICULTURE AND NATURAL RESOURCES

2.59 Background Agriculture accounts for almost one-fourtlh (22 percent) of the GDPand almiiost half (45 percent) of the labor force. But, the health of the sector has been uneven. Afterstrong growth of over 5 percent p.a. during the 1970s, growth was negative during the economiccrisis of 1982-85. During the second half of the 1980s, the sector recovered and grew by 3 percenta year. only. Recent growth declined again to 0.9 percent. Several factors account for theslowdowni in sector growth after the 1970s. These include: an overall downward trend ininternlationial commliodity prices affecting the Philippines' traditional export crops, continuousdeterioration of intersectoral terms of trade, macro-econom-nic constraints, and a series of naturalcalamities. Uneven growth and the uncertainty associated the Government's principle rural povertyinitiative, the Comprehensive Agrarian Reform Program (CARP), has led to under-investment in

the sector, which, in turn, resulted in weak infrastructure, and feeble support services . With othersectors unable to absorb a growing labor force, poverty is now concentrated in rural areas, where itis estimated at over 50 percent. Rural poverty, in turn, has led to many political and socialproblems, and had an adverse impact on natural resource management and the environment.

6

The public sector spending in agriculture and natural resources have been about 5-9 percent of the totalgovernment spending , i.e., the share of resources the Philippine agricultural sector receives from the NG ismIucI less than the GNP share the sector produces. The ratio of these shares is 0.27 for the Philippines asopposed to 0.6 for Thailand. and 0.4 for Indonesia.

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2.60 The Government is challenged to address simultaneously rural poverty, thecontinuiug depletion and degradation of natural resources and the environment, and ruralinfrastructure and support services. While increased spending during the 1980s on natural resourceand environimental management was appropriate and effective, other responses to rural problemshave not been so. Most CARP expenditures have been for landowners' compensation; pricesupports were not targeted on the poor; and irrigation, rural infrastructure, and support serviceshave been left wanting.

2.61 The sector's problems were compounded by devolution to LGUs of agriculturalextenision, rural infrastructure, (including communal irrigation and tertiary roads), and someenvironimental protection and natural resource management. Either because of the implementationcapacity constraint of the LGUs or because of the LGU's' own preference, some of these activities,suclh as communal irrigation and integrated social forestry, have been almost at a standstill sincedevolution in 1992.

Existing Investment Plans

2.62 Level of Public Investment Recent average annual public expenditures onagriculture, including agrarian reform of about P 20 billion are insufficient to maintain growth,reduce poverty and manage natural resources and the rural environment. Public underfundingfollows a decline of 58 percent in lending for agriculture by the banking system over 1981-92. Toreverse this trend, the Medium-Term Public Investment Plan (MTPIP) for 1993-98 projects a levelof P 67 billion (excluding the Agrarian Reform Fund (ARF), which is outside the regular budget),rouLglly doubling of the sector's share in total public investment from about 5.6 percent in 1993 to10.1 percent in 1998.

2.63 Composition of Investment Annual budgets of some P 4 billion each for theDepartment of Environment and Natural Resources (DENR) and the National IrrigationAdminlistration (NIA) for the remaining years of the MTPIP (1995-98) represent an appropriatedoubling of 1994 allocations. Furthermore, the proposed phasing out of expenditures by theNational Food Authority (NFA) on interventions in the grains market (price support) is a welcomechange in Government policy. On the other hand, the ARP, which is outside the MTPIP, willcontinue to command a disproportionate share of total proposed rural expenditures. A huge amount(63 billion) is projected for landowners' compensation by 1998, without assurance of reinvestmentby the landowners in those rural areas. Similar imbalances are projected elsewhere. For example,the Department of Agrarian Reform (DAR) projects P 20 billion for support services andinfrastructure for one million beneficiary families over 1994-98. Yet, during the same period, theDENR must make do with only P 15.6 million for capital outlays under the MTPIP to benefit fourmillioni families living in the uplands, and also sustain responsibilities for bio-diversityconservation, forest protection and management, reforestation, watershed protection, and pollutioncontrol.

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Recommendations

2.64 For the rural sector to contribute more to the economic growth and to alleviate itspoverty, the Government must work specifically on: (i) enhancing rural productivity throughinvestilng in rural infrastructure and research; (ii) increasing private investment in rural areas by,amonig otlhers, reducing uncertainties associated with the Agrarian Reform; and (iii) protectingenvironmiiienit and natural resources. Also in pursuing these objectives, it needs to (iv) increasecoordilnation of development strategies among sector agencies, and strengtheni institutional capacityof implementing agencies.

2.65 Enhancini? Rural Productivity The public sector needs to invest more on ruralinfrastructure and in research and extension. These have high externalities and could be powerfulin raising rural productivity--be it of agriculture or non-agriculture--infrastructure by loweringtransport cost of inputs and outputs or increasing availability of irrigated water, and research andextensioni hy improving yields or introducing new crops that have high market potentials and valueadded. Given that many of these have been devolved to LGUs, the NG needs to consider providingselected LGUs with technical assistance in preparing and implementing infrastructure programs andextensionl services. In addition, it is urgently needed to develop a framework that allows costsharing between NG and LGUs of devolved functions with high externalities (see Chapter 4) andthat incorporates LGUs into foreign assisted projects. The NG also needs to lead in demand -driveni agricul,ural research and dissemination of research results in collaboration with the privatesector. TIhe GOP need to make sure that the extension services carried out by LGUs are linkedwith the research activities.

2.66 Increasing Private Rural Investments Private investment increases with higherproductivity and higher policy stability. It is thus important to implement measures discussedabove to raise rural productivity, in particular, improving rural infrastructure. In addition, privateinvestors require stable policy environment in which entrepreneurs can respond flexibly to marketforces. In this regard, the vivacity of private investors has been dampened by the uncertaintiesassociated with the future of the Comprehensive Agrarian Reform Program (CARP) especially as,unce land is designated by CARP, its conversion of use is difficult until land redistribution iscompilete. To make things worse for investors, the CARP has been moving slowly and increasingftuLre uLicertainties due mostly to: its high cost; limited impact on the poor without adequate ruralinfrastructure; and political opposition from existing land owners. Only about a quarter of thetargeted 10.3 million ha over 1987-98 has been distributed, and the deficit for the next four years isprojected to by over e 70 billion--resources that can also be well spent on rural infrastructure.

2.67 It is thus critical that the Government reduce these uncertainties. The DAR isalrea(dy considering, innovative policy changes that would be required in continuing the reformeftorts with reduced uncertainties. These changes include: "recalibration of targets"; imposition ofa progressive agricultural land tax; allowing either direct selling or volunitary land transfer betweenlandowilers and farmers without the intervention of the Government; and transforming the ARFinto a revolving fund.

2.68 Environm1ental and Natural Resource Protection In the environment and naturalresource imaniagenient, watershed management deserves more emphasis. Both institutional changes

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and increased investments are necessary in this area. Given the extent of watershed degradation inthe country, it is recommended that a long-term, programmatic approach be developed, with thecontribution of external financiers, to watershed rehabilitation and protection clearly planned andmonitored. The GOP also needs to address the absence of a national-level body to plan,coordinate and monitor a comprehensive and integrated approach to waterslhed managemelnt

2.69 Coordination of Development Strategy. In order to achieve greater efficiency inresource allocation to agriculture, there is a need to integrate three distinct development approachescurrently being followed: the DAs growth strategy based on comparative advantage being under itsMedium-Term Agricultural Development Plan (MTADP) --- essentially a top-down approach whichpicks "winners" for rice, corn, commercial crops, livestock, and fisheries, in "key production areas(KPAs)"; the DAR's bottom-up approach, involving participation by the local communities andNGOs, primarily focused on poverty alleviation, represented by the Agrarian Reform Community(ARC) concept; and another bottom-up, participatory approach of the DENR, primarily focused onsustainable natural resource management. In mid-1994, the DA and DAR reached an agreementthat when the KPAs and ARCs existed in the same area, the ARCs will serve as the main conduitfor tlle DA's program. A similar agreement is needed among DA, DAR, DENR and localgoverninenits regarding their respective jurisdiction. Further, the MTADP itself needs significantadjustments since some of its physical and financial targets are unrealistic. IN addition, theweaknesses in national water resources planning and allocation needs to be addressed throughstrengtlheniing the National Water Resources Board.

EDUCATION

2.70 Constitutionally, education commands the highest priority in the allocation ofCentral Government resources. Indeed, net of debt service and IRA, education absorbs close to 30percent of available GOP resources, a very high proportion by international standards, but less than3 percent of GNP. So, despite the effort of the GOP, public education in the Philippines is under-financed because total budget resources are limited, the burden of national debt is large; and thecentral government has devolved responsibilities and resources to LGUs.

2.71 Due to increasing demand and unmet financing requirements, the public educationsystem is responding in two ways which are incompatible with quality education. First,student/teacher ratios are increasing, and essential non-salary operating expenses are beingdeferred. Under-financing has particularly affected public secondary education. Second,inadequate NG resources has stimulated rapidly increasing education finaiicing from LGUs andprivate sources. The share of public education financed from local sources has risen rapidly from2 percent in 1990 to 8 percent of the total. Nevertheless, substantial variation in local resourcesamong regions and population groups portents growing inequity in public education among thosesame regions and population groups.

2.72 The bulk of LGU financing goes for MOOE (43 percent), but also includespersonniel expenditure (25 percent). Private education financing takes two forms. Private schools,accounting for substantial share of total post-elementary student enrollment (33 and 79 percent atsecondary and tertiary level respectively), are the more visible form. The other is the parentalcontribution, in the form of user fees (miscellaneous school fees, contributions to the PTA, the costof bvoks and other school materials, and transportation). All in all, total commitment of national

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resources for education is estimated to be close to 7 percent of GNP. Despite this non trivialnational investment, considerable progress still needs to be made in improving both the quality ofthe education system and its relevance for national development.

Equity

2.73 There are large disparities between and within regions in elementary sch0oolenrollment and retention, and these differences are associated with poverty and the quality ofschooling. Generally, the poor liave more limited access to quality education and are less likely torenmain enrolled to completion. Overall, two of three children entering first grade complete theelementary cycle. But there is near universal completion in the affluent areas, and over 70 percentnoni-comiipletion in the poorest provinces in Mindanao and the Visayas. Surveys among out-of-school children confirm the strong incidence of economic factors on school participation,particularly among post-elementary age groups. Also, even within the public schools the quality ofpublic education is comparatively lower in the poorest areas, where salaries are lower, facilitiespoorer, and school management weaker. These differentials are exacerbated with fiscaldecentralization and devolution, as LGUs serving higher income families can more readily provideextra support to public schools. As a result, there is a danger that the education quality gap betweenrich and poor areas will increase, further widening existing regional disparities in schoolcomipletioni rates and learning outcomes.

2.74 Present criteria and procedures underlying DECS' regional budget appropriationsare based on a nominally equal amount per student and do not aim at counterbalancing theregressive impact of fiscal decentralizationi on local public education finalicinig, not to speak ofredressinig disparities in public elenientary education of longer standing. In fact, there is no DECSstrategy for actively targeting resources towards the most pressing needs, the most disadvantagedareas or population groups. The issue is essentially political. There appears to be great reluctanceon the part of the national and local legislature to face the implications of the country'sconsiderable geographical, cultural and social diversity, and accept discriminatory use of nationalresour-ces tor the sake of addressing priority regional needs. As a result, DECS is largely deprivedol the authority and control required for effective social targeting.

2.75 Attempts to social targeting has instead promoted the Government to subsidizelower incomile youth to attend private secondary-schools and colleges throughi the DECS' GASTPEprogram (Government Assistance to Students and Teachers in Private Education). The programchianiniels tuition fee supplemenits (TFS) for students, and funds educational service contracting(ESC3 with private schools. Althougih innovative in design, and with close to fifty percentparticipationi of private secondary students, the program has a major flaw. For a given budgetallocation. the GASTPE programii maxinizes the number of beneficiaries by setting the benefits perbeneficiary at a level which is substantially below the actual cost of private schools. As a result: (i)TFS studenits are required to pay the difference between subsidy and actual cost, which eliminates alarge segimient of the target population; and (ii) thie better private schools, unable to collect their fulloperatiilg cost from ESC benetficiaries, are withdrawing from the schemie. The ESC scheme, in itspresenit forin, thus fosters the emiiergence of a third tier secondary schoolinig system: private, butlow cost/(quality for the subsidized students from lower income groups.

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Cost-effectiveness

2.76 Opportunities for cost savings in the operation of the public elementary educationsystemn are not apparent. Effectiveness can be improved by reducing grade repeaters and drop-outs.However, this will require substantial initial investment in quality improvements, which might befunded by reducing the cost to the national budget of the rather inefficient State Universities andColleges and improving the effectiveness of budgetary processes in DECS. the expendituremonitoring system. In improving cost effectiveness, it is important to protect the MOOE, non-salary recurrenit expenditures which cover educational materials and textbooks.

Governmiienit strategy

2.77 The Government intends to address quality and equity of basic education in theimnmlediate future by (i) increasing the length of the elementary cycle from five to six years; and (ii)focusing on the 19 Priority Provinces, with an integrated basic education component asrecoimmilended for the Presidential Task Force for the Fight against Poverty. It is to be hoped,however, that this strategy will not lead to neglect of poverty-related education priorities in non-selected provinces, or foster uniform approaclhes to widely different regional needs and

7circuLmstances. /

Main Recommendations

2.78 The following recommendations reflect two basic objectives. First, within thepnrevailing inter-sectoral allocation of the national budget, more resources ought to be madeavailable to DECS, so as to enable that department to fulfill its increasingly demanding mandate.Secondly, given national priorities with respect to education, DECS should seek more effectiveways of spending its resources.

Increasing available resources

2.79 Increasing resource availability for DECS can be achieved in two ways; i.e., by: (i)increasing DECS' share in the total education sector budget; and (ii) rationalizing expenditurewithin DECS' budget.

2.80 Some of these measures would include: (a) devolution of some of its presentresponsibilities (e.g. school construction and maintenance) to LGUs. DECS would provideselective compensatory financing to disadvantaged LGUs. This support would have to be granted inways that do not discourage local taxation efforts, nor the extent of local resource commitment toeducation in this sense some equalization fund, providing matching grants, might be considered(see Chapter 4); (b) phasing out of the burden of State Universities and Colleges on the nationalbudget by promoting fuller cost recovery, decentralized financing, and greater financial autonomyfor tllese institutions; (c) rationalization and consolidation of public sector teacher education into

These issues are being addressed in the proposed Third Elementary Education Project, identified jointly byDECS and the World Bank, which would promote bottom-up participatory planning processes geared tomeet specific needs in targeted areas. The latter would not be limited to the 19 priority provinces.

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fewer, more cost-effective programs; (d) extension of career opportunities within the teachingprofession so that quality teachers stay in teaching rather than moving on to higher payingadministrative positions; (e) DECS' elementary and secondary school construction program, to theextent that it is not devolved to LGUs, needs to be reassessed to emphasize proper maintenance ofthe existing stock; and (f) better coordination between budget preparation and execution, moretransparency in budget coimmitment, and disbursement and monitoring procedures for achievinggreater cost-effectiveness in the various programs and operations

Effective use of resources

2.81 With more resources at its disposal, DECS should promote universal achievementof quality for basic education, particularly at the elementary level while targeting a higherproportion of expenditure towards the most disadvantaged areas and population groups.

2.82 In particular: (a) DECS needs to improve the extent and efficiency of expendituretargetling, away from the prevailing principle of strict proportionality -- per student, per teacher,per school, or other mechaniistic norms uniformly applied throughout the country -- towardsaddressing priority needs identified at the basis of the education system. This impliesdecentralization of sector management; (b) Overall budget appropriations for MOOE shouldincrease at elementary and secondary levels, but regional allocations should again be based onactual needs; (c) Improving the quality and retention of public elementary sclhools will requirelenygtlheninig the elementary cycle from five to six years, hence a considerable additionalcommiiiiitmiienit of DECS resources; finally (d) A case can be made for subsidizing elementary schoolparticipationi for children from the poorest households. Also, the GATSPE benefit should betargeted to students from lower income households.

HEALTH AND NUTRITION

2.83 This section briefly reviews issues on the healthl and nutrition. The brevity is due,for the health sector, to the fact that it may not be the best tilme to discuss the public finance indetail given that the massive chaniges in the sector caused by devolution have yet to workthemiiselves out. Furthermore, the World Bank (Philippines, 1993) has already discussed the roleot the cenitral government in the health sector. On the nutrition, there is also an ongoing effort ofthe Governmllent and the World Bank to assess poverty. Therefore, this report only touches on afew issues of interest which reach beyond the sector.

Health

2.84 Following observations can be made on health: (i) in so far as regional allocation ofpublic sector resources is concernied, the expenditure pattern lhad shifted from regressive toprogressive in around 1986; (ii) the devolution has likely increased inequity (see chapter III below)altlhouhll it is too early to tell accurately what has happened; (iii) public expenditures in improvinggenerail sanitary conditions improves the population's health status measured by infant mortalityrates. anid importantly (iv) public expenditure in health improves the healtlh status of the poor, butnot the riclh.

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2.85 Equity in Public Health Expenditure The changes in health expenditures towardhigher progressivity from the period 1987 to 1991 stand in contrast with the allocation patterns inthe other sectors. The others tend to exhibit a rough degree of proportionality betweenbeneficiaries (per student in school, per capita, etc.) while the health budget indicated a muchstronger pro-poor bent. It should be noted that the change in 1987 toward more equitable carewas associated with a shift from preventive to curative. Devolution had reversed this and made theDOH focus more on the preventive care since curative care takes a disproportionate share ofdevolved activities.

2.86 Within regions, the pattern of use of public facilities across income classes (asopposed to residents of regions with different average incomes) is not as clear. The most recentinforilationi on the subject comes from the 1992 National Health Survey. Use of public facilities(for curative and patient - initiated preventive care) appears to rise with per capita householdincome up to levels of about 3000 pesos per month and fall thereafter. Indeed, the rate of increasein use seems to be faster than the rate of increase in tax collection up to the middle ranges of theincomze distribution. This indicates that the health care system on the curative side, at least, isprogressive in the sense of transferring money from the relatively rich to the lower and middleclasses but does not reach the poorest groups any more than it does the middle classes. Combiningthe regional and per household information, the largest benefits to recipients of health services(relative to payments made in support of these services) was in the poorer areas and within theseareas, the lower to middle income residents.

2.87 Effectiveness of Public Expenditures in Health The main reason why governmenthealtlh services are important is that there are numerous ways in which the private markets relatedto healtlh (quite robust in the Philippines) tend to fail to provide efficient levels of services. Whilethe overall profile of health problems of the country has been changing (away from infectiousdiseases towards the chronic, degenerative diseases of richer countries), there is still a large,unifiiislhed, agenda for addressing the infectious diseases and other burdens on poor people forwhich public action is essential.

2.88 An numerical analysis of the effectiveness of public expenditures in the healthsector for 1984 to 1991 shows that health status (here infant mortality is used as an example,Background Paper Section VIII) is affected by three categories of factors: personal income; publicintervent?'on that improves general sanitation condition (safe water sources, sanitation services andimmunllization rates) with their obvious externalities; and the provision of cliical care which makesup the bulk of the Department of Health's budget.

2.89 The results show that (i) income is obviously a key factor in improving healthstatus: (ii) in general the first category of intervention (safe water, better sanitation, and moreimmuinization of children) is quite important nation-wide. Those services which have fewacceptable private alternatives are the ones with the highest public payoff: and (iii) when theanalysis is made more region specific, health care expenditures are quite potent in their impact oninfant mortality but only when spent in poorer regions . At higher levels of income, the effect ofpublic expenditure on health disappears entirely. This last result is important as it indicates thatthe public provision of medical care (which can be provided by the private sector) could wellsubstitute for private provision of the same good. In the poorer areas where private provision isless reliable (and expensive enough to be out of reach of the poor for anythiig but minor services),

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the public provision actually adds to the poor's budget and demand for services in ways which cantranslate into needed and effective medical care.

2.90 Devolution and Health Policy With newly devolved services, it is important to pindown the cause of the previous success in pro-poor provision of the health service. If the realbenefits were due to a public health system which was well attuned to its clients, there may be littlecause for alarm. The formerly NG workers who have been assigned to local health units wouldstill, presumably, be able to identify local needs. The risk would be that health services as a wholemight unduly lose out in conflicts with other local claims on the budget. On the other hand, if theunderlying cause of these results is the level of overall health service budgets, devolution could bequite harmful by limiting the amount of services available in poor areas relative to the veryprogressive allocation which had been policy in the pre-devolution period.

2.91 Further issues which devolution brings to the fore are also related to the appropriaterole of government; this time, the appropriate role of national governmenit. Once again, theprimary question is: what can (national) government do which cannot be expected to be done by thepeople themselves or by the local governments. The main candidates are intectious disease controland health education campaigns of various types (smoking, AIDS and nutrition primarily) wheremany of the benefits of the activity will accrue to people outside of the jurisdiction in which thehealthl expenditures are borne. Either because effects directly transcend political boundaries (as inpest control operations), or migration spreads the effects of interventions across jurisdictions,these policies may be underprovided by units with local responsibilities.

NUTRITION

2.92 The overall malnutrition incidence in the Philippines continues to be high relative toits income level. This is due to (i) the limited resource allocation for nutritional interventionsoverall; and (ii) spending of modest amount without targeting.

2.93 The Philippines, with one third of children undernourished, spends 0.03 percent ofGNP on nutrition intervention, an extremely low amount. Indonesia, Malaysia and Thailandspends more relative to GNP although they have less incidence of malnutrition. In India where twoout of three children are malnourished, 0. 18 percent of GDP is spend on nutrition. Per childexpenditures were four times more in India than in the Philippines.

2.94 One key expenditure for nutrition intervention is the NFA's grain consumptionsubsidy. NFA purchases 2-10 percent of the domestic production of rice and distribute at asubsidized price. The program is highly inefficient because it costs P 2-3 to subsidize P I toconsumers, and, in addition, it is a general untargeted subsidy, the Metro Manila region which has0.3 percent of the poor receive more than 20 percent of subsidized rice. It is estimated at most 50percent of the truly poor have had some access to the subsidized rice. The cost of transferring PI to the poor then would be P 5-6.

2.95 Recognizing this and other efficiency problem, the GOP has started a program tostreamline the NFA and phase out consumption subsidy. Instead, more targeted nutritionintervention programs are being considered. It is a highly commendable direction that the GOP istaking. The benefit to the poor would increase the earlier the GOP can take this action.

3. DEVOLUTION AND LOCAL GOVERNMENTS

3.1 Following the enactment of the Local Government Code (LGC) in 1991, a numberof fiscal responsibilities have been devolved to local governments and the national governmenttransfers to them were increased. This chapter reviews the consequences of devolution for fiscalmanagement, spending patterns and equity . Detailed discussions of the background and theimplementation of devolution appear in Background Paper Section 1. The GOP should becommended for the smooth implementation of this highly complex process in a very short periodof time.

3.2 This chapter makes recommendation that, if adopted, would further increase theadvantages of decentralization of decision making achieved as a result of devolution while betterserving certain national goals. First, to make the LGUs accountable and face hard budgetconstraints, the NG needs to: remove uncertainty on the amount and timing of the LGU transfers;stop funding devolved activities; and monitor LGU borrowing strictly, without giving LGUs anexpectation that the NG would bail them out of any possible debt service difficulties. Second, theNG may consider a reform in the allocation mechanism of resource transfer among the LGUs toincorporate concerns about equity and local resource mobilization by considering an equalizationgrant based on the tax base and revenue efforts. Third, another part of the resource transfer shouldbe based on the cost share principle on a selected small number of activities that the NationalGovernment consider critical. Finally, many LGUs have insufficient capacity in fiscal plamringand implementation especially in view of the need to coordinate with the National Government.The National Government may consider giving technical assistance to LGUs in these areas. Itshould be kept in mind, however, that these recommendations are based on limited expendituredata by the LGUs; the whole devolution is only a few years old and 1994 was the first year of fullimplementation.

Background and Rationale

3.3 The intent of devolution was to improve the well being of the people byempowering local voters to change the kind, quantities and qualities of the public services theyreceive from their local authorities. More specifically, there were three rationales: First, ThePhilippines has substantial spatial variations in physical conditions, economic circumstances andsocial attributes. It was accepted in the LGC that some types of services could be better deliveredby local authorities who could take into account these differences and provide services that suitlocal needs and preferences better than the central government that is predisposed to provide auniform bundle of services throughout the country. Second, less national government interventionwould make it possible for local residences to hold locally elected officials accountable for theiractions. Third, a higher degree of local autonomy, and hence local participation in collectivedecision making, was believed to reduce feelings of political alienation among residents and policynakers outside the Metro Manila Region.

3.4 Devolved Functions As of January 1994, the following functions have beendevolved from central departments to LGUs:

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Department of Agriculture (DA): agricultural and fishery extension services, regulation andresearch; procurement and disbursement of seeds; purchase, expansion and conservation ofbreeding stocks; and construction, repair and rehabilitation of water impounding systems.

Department of Environment and Natural Resources (DENR): forest management services;mine and geo-science services; environmental management services; and reforestation, integratedsocial forestry, and watershed rehabilitation projects.

Department of Health (DOH): provincial health offices and district, municipal and medicarecommunity hospitals; purchase of drugs and medicines; implementation of primary health careprogram; field health services; aid to puericulture; and operation of 5-bed lhealth infirmaries.

Department of Public Works and Highways (DPWH): repair and maintenance ofinfrastructure; and barangay road, water supply and communal irrigation projects.

Department of Social Welfare Development (DSWD): program for rebel returnees;barangay day care centers; and poverty alleviation programs in low-income municipalitiesbarangays and depressed urban barangays.

3.5 Basic education is also considered as a candidate for devolution. Especially, schoolbuilding construction is specifically mentioned in the LGC as an activity to be devolved. But, sofar no education activity has been officially devolved by Congress. Given the diversity of culturaland other backgrounds of various areas in the Philippines, the GOP may also consider devolvingthe basic education so that localized decision making will be possible.

3.6 National Government Transfers to LGUs Under the LGC of 1991, the total amountof the unconditional block grants to the LGUs, called Internal Revenue Allotments (IRAs), weresignificantly increased. All smaller NG transfers to LGUs were absorbed into the new IRA andthe IRA itself was increased from a maximum of 20 percent to a fixed 40 percent of internalrevenue collections for the third preceding year. This transfer now amounts to 2-3 percent ofGNP per year. Also, natural resource related taxes, that previously were shared by the LGUs andthe NG, are now devolved to the LGUs where they are physically located. These latter devolvedrevenues amount to about we I billion in 1992 (0.1 percent of GNP) prices. Of the total IRA, 23percent is shared by 77 provinces, 23 percent by 62 cities, 34 percent by 1,542 municipalities, and20 percent by 41,891 barangays. Allocation among individual LGUs within the same category ofLGUs (provinces, cities, and municipalities) is determined as follows: 50 percent is allocated basedon population; 25 percent is allocated by the land area; and the remaining 25 percent is divided

equally by all LGUs of the same category (called an equal share)

3.7 This formula gives greater weights to land area and equal share and less topopulation than in the past. This is because the GOP wishes to transfer more resources to thesparsely populated (and presumably poorer) areas and less to more densely populated (and more

After initial adjustments, the allocation among barangays will be: population, 60 pcrccni; and cqual sharc, 40perccnt from 1995. However, each barangay with at least 100 inhabitants will be provided a minimumallocalion of P80,000 per annum.

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developecl) areas. The GOP also hopes that such an allocation rule will, at the margin, slow therural-urban migration, by improving the quality of life in less populated rural areas. As set forthbelow, however, the available evidence strongly suggests that, because the services devolved to thecities were considerably less costly than the additional IRA funds transferred to them, the cities, onbalance, gained more from devolution than the provinces and the municipalities. The attempt toimprove rural relative to urban public services to discourage migration from the former to the latterwas tlhus negated, in whole or in part.

3.8 The formula for allocating the IRA among levels of local governments and amongindividual LGUs was based on no other economic grounds. Therefore, the amounts transferredbear no necessary relationship to the actual cost implications of devolved functions. Nor do theytake into account the capacity of local governments to raise their own resources or to carry outdevolved functions.

3.9 Also notably absent from the devolution policy was the imposition by the NationalGovernmlenit of any conditions upon local governments (such as provision of essential services ormobilization of local revenues) that must be met if they are to receive their formula-determinedshares of national government revenues.

3. 10 One of the objectives of the devolution was precisely to make the intergovernmentaltranster system both transparent and predictable. Yet, LGUs still do not have certainty as to whenand h1ow much transfers they will receive because the budget proposals and some directives (e.g.,Local Budget Memorandum No. 22 dated June 15, 1994) contain instructions that diverge from theLGC. This has resulted in lower fund flows to local govermuents than the Local GovernmentCode of 1991 stipulates. 1993 releases to LGUs were 82 percent of the appropriated amount. Inaddition, the budget is usually passed in December (or even January of the ensuing fiscal year),while the LGUs need to prepare their fiscal plans by September, without the knowledge of theexact amount of their IRA allocation for the next year.

Issues--Unintended and Intended Consequences of Devolution

3.1 1 As a result, there are at least six consequences that should concern the GOP:

* Total transfers to the LGUs greatly exceed the cost of devolved functions, thus providing alarge iiumber of LGUs with windfall gains of additional discretionary income and jeopardizingthe NG budget;

* The IRA allocations to individual LGUs are not based on their need or capacity, and createdwinnler-s and losers among LGUs;

* Regarding sector spending, LGUs are allocating more resources on social services at theexpense of economic services, maybe because the NG has not established a clear role for thel GUs and continues to fund some devolved economic services;

* Devolution has made it difficult for the NG to provide LGUs with incentive to implementdevelopment projects that have high benefit spill-over effects or for NG to channel donor (loan)resources to devolved activities;

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* Devolution is likely to have reduced local resource mobilization efforts; and

* Devolution is likely to make the fiscal system more inequitable.

3.12 Fiscal Resource Gap at Macro Level At the aggregate level, the reform in the IRAtransfer system devolved more revenues than the cost of the devolved functions. By 1994, whenthe devolution was fully implemented, the national government transfers to LGUs had grown to P46.7 billion from about P 14-16 billion in 1990-91 immediately before inmplementation ofdevolution (see Background Paper Section 1), i.e., an increase of about P 30 billion (1.7 percentof GNP). Savings of the National Government from devolving functions to local governments hasbeen estimated by the DBM to be P 6.3 billion in 1992 prices or about P 7.4 billion in 1994prices. Net resource transfers, therefore, in 1994 were as much as P 22 billion ( 1.4 percent ofGNP). Furthermore, NG is gradually shifting its tax structure away from international trade taxes(lowering of import tariffs) and rmloving towards increasing internal taxes through, for example, anexpanded VAT. Such a move will naturally raise the share of internal revenue, automaticallypushing up the total amount of the IRA allocation in the future relative to the other expenditureitems.

3.13 IRA Allocation Imbalances at Individual LGUs The IRA allocation formula hasno direct linkage to the amount of incremental fiscal resources LGUs need to finance newly

devolved functions. LGUs have Mhus not necessarily received additional IRA transfers that arecommensurate with their increased responsibilities--some have received less resources than theyneed to perform the functions assigned to them, and others have received much more than theyneed. The new IRA formula is highly generous to cities (Table 3-1): 60 cities share 23 percent ofthe total transfer whereas a similar amount is shared by 77 provinces and 34 percent by some 1,500municipalities. In addition, because the cities already provided a high level of services on theirown before devolution, the cost of functions additionally devolved to themii was only P 500 millionas opposed to provinces whose additional responsibilities cost them P 3 billion. The transfer ofresources that are not tied to devolved functions is, on average, P 100 million for a city, while anaverage municipality receives P 4 million, and a province receives P 39 million. There is thusno net resource loser among cities. But more than 100 municipalities and 27 provinces need to paymore for devolved functions than they receive additional IRA allocations. Provinces areparticularly disadvantaged because of the narrow tax bases and the high recurrent costs imposed onthem as a result of higher than average facilities and personnel devolved. Thlese are issues becausethere are no mechanisms that would allow the NG to compensate these LGUs who incurred netlosses from devolution. In the short run, residents of these LGUs may have to suffer less adequate

3levels of public services

2Since other NALGU funds were allocated arbitrarily, only IRA allocation is compared here.

3But. various adjustments are possible in the medium run; there are anecdotal evidences that some cities are

already providing health services for residents in the surrounding municipalitics.

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TABLE 3-1: NET TRANSFERS TO LGUS IN 1993 (NOMINAL MILLION PESOS)

Incremental IRA Cost of devolved Net transfers of Net Transfers perfunctions untied resources LGU

Provlcc, 6046 3008 3037 39

Citie" 6446 494 5952 99

Municil"ditics 8885 3 124 5761 4

5710 0 5710 0.1

Source: DBM

3. 14 Sector Spending Total government (NG and LGUs) expenditures on health,educationl, agriculture, road transport, the sectors expected to have been most affected bydevolutioll, in fact did not change significantly between 1991 and 1993 (Table 3-2). At the localgovernmiilenit levels, social sector expenditures increased significantly from 0.29 percent of GNP in199 1 to 0.71 percent in 1993. But economic services remain rather stagnant (Table 3-3). Thesame table shows a decline in the NG spending in social and economic sectors in 1993, and thedecline was larger than implied by devolution; the cost of devolving some agriculture and naturalresource management functions was about P 1.2 billion or 0. 1 percent of GNP; on social services,the cost of devolving health and social welfare functions was estimated at e 4.9 billion or 0.3percent of GNP. The decline in NG spending appear to involve more general expenditure cuts anda shift towards expenditures on general services

'able 3-2: Consolidated Expenditures of National and Local Governmients: Selected Items

(percent of GNP)

1991 1992 1993

Education 2.67 2.44 2.60

Agriculture 0.45 0.55 0.47

Health 0.79 0.74 0.77

Roads and Trausportation 1.76 1.90 1.93

Source: DBM, Commission on Audit. mission estimates

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Table 3-3: Sectoral Allocation of National and Local Government Expenditures

(percent of GNP)

1986 1990 1991 1992 1993

1. National governimient

Economic services 4.71 4.79 4.66 4.34 3.40

Social services 3.52 4.54 5.14 5.03 3.38

General public services 1.12 1.28 0.86 2.0(2 2.51

2. Local governments


Social services 0.42 0.27 0.29 0.38 0.71

General public services 0.51 0.78 0.82 0.92 1.08

3. Consolidated: 1 +2


Social services 3.94 4.80 5.43 54(1 4.09

General public seivices 1.64 2.06 1 68 2 94 2.91

Source: Commission on Audit, Department of Budget and Management, and theNational Statistical Coordination Board; compiled by mission.

3.15 At all levels of local governments, social expenditures increased impressively withdevolution (Table 3-4). As expected, health expenditures, which have been devolved, increaseddramatically with higher local governmnent resources. While the rise in healtil spending forprovinces and municipalities may be viewed as imposed because so much of additional healthresponsibilities have been devolved to them, at least during the early years of the devolution,cities are voluntarily setting aside more resources for health services. More surprisingly, at alllevels of LGUs, education expenditures (which have not been devolved) not only increased as apercent of GNP but also as a share of the higher LGU spending. Without being forced to do so,the LGUs are choosing to spend a substantial amount of additional resources on educationwhenever they can--over and above the amount earmarked under the Special Education Fund(SEF). The underlying simple elasticity of education expenditures is 9 for provinces and about 3for cities and municipalities. This means for every I percent increase in total resources availablefor a LGU (in real terms), provinces tend to spend 9 percent more on education, and cities and

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munuicipalities spend 3 percent higher real resources on education. In the education sector where therole of the center is well-defined and its financial limitation well-known. LGUs are willing toprovide additional resources to complement NG-provided services.

3. 16 Economic services (including rural roads, water, irrigatioin and agriculturalextensioin) are taking the brunt of adjustment. Provincial spending has actually declined; when realresource availability goes up by I percent, provinces reduce real spending on economic servicesby I percent because so much additional spending is needed for health. For municipalities, theelasticity is very close to zero. Spending on general services seem to be the most stable orinflexible--with elasticity at around 0.7 for all LGU levels.

3.17 The shrinking share of spending on economic services in the LGU expenditurescan be attributed, at least in part, to the willingness of the central governmllelnt to provide resourcesfor devolved functions. Some central departments in the Executive contilue to fund devolvedfunctions, and Congress still votes for appropriations of funds for capital projects that fall withinthe responsibility of the local governments such as local roads and irrigation. These latterexpenditures are not without future costs to the LGUs' finances and accountability. Maintenanceand operation will become recurrent local obligations competilg with other demands on LGUbudgets. Such central interventions in devolved activities make it difficult to hold the localauthorities accountable for their actions with respect to devolved activities. It may also distort theinvestmenit decisions of local authorities as they tend to wait for Congress to act. While data tosupport this statement is still limited, interviews with a large number of LGU officials haverepeatedly made it clear that they would not provide services that central officials are willing toprovide--especially services that substitute local provision--be it irrigation, forestry, or otherinfrastructure facilities.

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Table 3-4: Expenditures by Sector, All Local Government Units: 1991, 1993

(percent of GNP)

Particulars 1991 1993

Provinces Municipalities Cities Provinces Municipalities Cities

General public services 0.19 0.43 0.22 0.21 0.59 1t.30

Social seivices 0.10 0.07 (0 11 0.23 0.26 0.23

Healiti 0.02 0.01 0.05 0.13 0.10 0.06

Education 0.01 0.03 0.03 0.03 (.(9 (0.07

Ecoonomic services 0.24 0.23 0.21 ().18 0.24 0.2 5

OtLlieis 0.02 0.03 0.03 0.03 0.05 0.08

Source: Commission of Audit, National Statistics Coordination Board

3. 18 Project Implementation Another serious problem is that project implementation hasbecome difficult in devolved areas. This is partially because LGUs caninot beniefit from borrowingfrom outside sources as the NG cannot guarantee LGUs' external borrowing. This also constrainsLGUs' access to the expertise and institutional building such projects often provide. At the sametime, due to the unconditional nature of the block grant, the NG has not heeln able to provide localgovernments with effective incentives to implement activities of national priorities, such as povertyalleviation or environmental protection. An associated problemii is that it has become difficult tochannel donors' loan resources to local governments in the devolved sectors. The NG is oftenwilling to be a conduit and "on-lend" these resources to local governimienits, hut local governmentsconsider donor projects, especially in areas where full cost recovery is difficult, as primiiarily NGresponsibilities and demand that the NG on-grant these resources. The NG on the other hand isaverse to on-granting donor loans to local governments claiming that NG has already providedthem with more than adequate financial resources throughi the IRA allocationi. The resultinggridlock has jeopardized preparation and implementation of maniy projects linanced by loans fromdonors.

3.19 Impact of Devolution on Local Revenue Mobilization Local revenue effortsappear to have declined with higher IRA resources. Tables 3-5 confirmis tllat in 1992. when theIRA allocation started to increase significantly, the collection rate (collection as a share of whatwas due) of the real property tax came down about 10 percentage points for all LGUs, and allprovinces and cities. In addition, a detailed econometric study discussed in the Background PaperSection 11 confirms that the increased IRA allocations have had negative and significant effects onlocal government revenues across all levels of LGUs in 1992 and 1993.

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3.20 Disturbing as it may be, this is rather expected from the unconditional grant systemthat the Philippines opted to implement. Residents of LGUs, when their income is augmented bythe additional transfers from the NG, naturally desire to enjoy both increased public serviceprovision and increased consumption of private goods--the latter comes from paying lower taxes(i.e., it may be that the tax collection efforts become lax and default rates rise, rather than tax ratesgoling down). The NG needs to decide if it should give more incentives for further local resourcemobilization through, for example, an IRA transfer system that is conditioned on the local revenueeffort.

Table 3-5: Collection Rates of Real Property Tax (percent)

All LGUs Provinces Cities

1986 51.3 49.6 53.4

1987 52.8 49.5 56.7

1988 54.3 49.4 60.7

1989 58.0 55.6 61.0

1990 57.8 53.6 63.3

1991 58.9 54.1 65.1

1992 49.7 44.3 56.4

Source: Background Paper Section 11

43.21 Devolution and Equitv According to an earlier study, new IRA allocations havenot contributed to any of the equity objectives. These objectives include: provision of moreresources to the poor or poorer LGUs; provision of resources according to the fiscal needs; orprovision of resources to equalize the level of supply of critical services across the country. Theonly significant coincidental relationship found in this study is that the IRA allocation increaseswith a LGU's tax base per capita or its recurrent expenditures. IRA resources are thus beingchanneled primarily to those LGUs who already have more fiscal resources than others. Efforts toshift the IRA allocation weights away from the population and more towards land area has yet toshow significant effects on poverty alleviation.

3.22 Detailed data on LGU spending that could help analyze the impact of devolution onequity are still sketchy. Conjectures, however, can be made that devolution as currentlyimplemented may increase spending in more affluent areas. On health, NG allocations to regionswere cut severely from an average of P 98 per capita in 1991 to P 25 in 1993 and to P 22 percapita in 1994 (all in 1991 prices). This reduction in NG expenditures appears to be accompaniedby a shlift of the allocation pattern from progressive (poorer region received more resources per

4Internal Revenue Allotment System of the Philippines: Trends. Patterns, and Effects, Local Development

Assistance Program (GOP/USAID), 26 July, 1994.

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capita) to regressive. At the same time, because the IRA allocation was not designed to providemore funds to poorer jurisdictions, the spending was each according to its means and preferences.Table 3-6 summarizes the result of a survey of 172 LGUs. The increase in health expenditures percapita in 1991 prices ranges from e 70 in a city in a high income province to P 50 in amunicipality in a low income province. The average real decline in NG's per capita healthexpenditures can be offset by the increase in LGU spending in a more affluent area, but is notenough for poorer areas. If the reduction in NG spending was more for poorer regions, thesituation would be worse. A similar situation appears to be taking place in education--althougheducation has not been devolved, under-funding of the public school system from the NG is leadingto selective defacto decentralization of the sector. Again, winners among LGUs have resourcesavailable for extra support of public schools, and voluntarily supplement teacher salaries, hire extrateachers and provide additional supplies. Given the importance of equity objectives for the GOP, itis critical that more detailed information is compiled to make further analysis of the equity impactof devolution.

Table 3-6: Total, Social and Health Expenditures Per Capita by LGUs

1991 and 1993, in nominal pesos

LGU (Number of obs.) 1991 1993

Total Social Health Total Social llealth Increase inhealth

spending in1991 prices

1. Provinces (36) 96 6 3 133 40 32 24

HiglI lncome(12) 90 7 4 139 53 43 31

Middle Income(12) 109 6 3 115 33 26 9

Low Income (12) 81 4 2 168 40 34 26

2. Cities (19) 483 105 15 708 186 63 39

3. Municipalities 6 (1 17) 170 I5 I 287 54 25 20

Source: Background Paper Section Table Al-12

Thcrc is no income or expenditurc data by city or municipality. Therc are income classcs (from first to sixth) ofcitics and municipalities but thcy are based on the size of tax base rather than incomc per capita, and do notrcflcci accurately how rich or poor residents of a particular jurisdiction are.

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Principles for Improvements

3.23 Improving the way devolution works should be based on the following threeprinciples:

3.24 Define the Roles of Local Governments and the NG. The general rule is that localauthorities should be able to provide the quantities and qualities of public goods and services thattheir residents prefer and are willing to pay for. This is the principal rationale for the devolution offiscal power to LGUs.

3.25 The NG role is to be instrumental in the provision of services that are sociallynecessary according to the national priority, but are under-funded by LGUs. For exampleresidents in a local jurisdiction can be unwilling to fully fund programs, either because benefits andcosts of certain services will be shared by residents of other jurisdictions (e.g., environmentalprotection, infant inoculation), or because residents are not aware of the full extent of benefits(e.g., early childhood care). The NG may also decide that every citizen should have an access to aminiiimum level of certain essential services. Disparities in tax capacity among local authoritiesresult in large variations in the tax costs of providing local services. Given that per capita cost ofservices is likely to be similar in both poorer and richer areas, taxes per capita would be higher inthe former than the latter for the same level of services.

3.26 Define NG Incentive for LGUs Where Necessary Among the services that are ofnational priority, the NG can delegate the service provision to LGUs when it is more efficient toorganiize the service provision at the local govermnent levels. The NG can provide LGUs withadditional incentives for increased provision of these services. Alternatively, given that the size ofthe IRA allocation exceeds the cost of devolved functions by a large margin, minimum provision ofthese critical services could be mandated without further incentives as long as the NG ensures thatLGUs with weaker fiscal capability can provide these minimum services. Thus, the NG needs tomake a number of fundamental decisions:

1. agree on precisely defined services that, in the national interest, the NG needs to insist thatlocal governments provide;

2. identify the size of the fiscal gap between the expenditures of LGUs necessary to fulfill theirlocal and national responsibilities and their own potential revenues;

3. decide whether and how the NG should help meet, at least in part, the fiscal gaps. The NGcould aim to compensate, in part, for the differences in fiscal capacity (per capita tax base)and/or tax efforts (tax collection applied to the tax base) to meet their expenditureresponisibilities. Alternatively, the NG could share the LGUs' costs, at least in part, only whenthey perform certain designated national interest functions ; and

4. assuming appropriate conditions attached to NG transfers to LGUs have been designed, decideif the projected amounts of transfers are likely to be within the fiscal competence of the NG.

3.27 Establish Hard Budget Constraints Once the respective roles of the NG and LGUshave been established, and changes in the IRA transfer mechanism are, as needed, designed, there

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should not be any exceptions to the rule. The NG should not carry out activities chosen as LGUfunctions, nor should the NG provide more resources than agreed in the design of the resourcetransfer mechanism. In other words, LGUs should face a strictly hard budget constraint and beheld accountable for their action. Similarly, LGUs can borrow from domestic financial institutions(so long as their debt service payments are below 20 percent of the IRA allocation they receive). Itshould be clear that, while the NG monitors such borrowing carefully, it should be a commercialtransaction between LGUs and banks based on LGUs' creditworthiness

Policy Direction and Recommendations

3.28 Since the devolution process has already started, it will be more difficult to addressthese questions. In this section, we discuss two sets of improvements the NG could make to theprocess of devolution given what has already been accomplished. First, the management of theexisting system can be improved by inter alia making LGUs fully accountable for devolvedactivities, encouraging cost recovery, and providing management assistance to LGUs. Second, ifthe NG decides to reform the LGU transfer system, it can consider a set of mieasures by movingaway from the concept of totally unconditional IRA grants.

3.29 Accountability It is first recommended that transfer payments to LGUs be placedon a statutory basis that would make the payments independent of the anniual appropriations of theC(ongress. This is because the NG must minimize the uncertainty associated with the amounts andtiming of IRA grant allocation to each LGU to make LGUs more accountable for devolvedfunctions.

3.30 For the same reason of increasing LGUs' accountability, the Executive branch andthe Congress should not be permitted to propose and appropriate funds for projects and programsthat fall within the responsibilities of the LGUs except for areas where NG provides incentives toLOIUs for selected service provision (e.g., matching grants) or other mutually agreed programs.Despite budgetary constraints, Congress and some executive officials refuse to let go of theactivities devolved to the LGUs. The end result is that the national governmllent continues toappropriate funds for activities that have been devolved to local governmenits despite the mountingevidence that LGUs in aggregate may have more resources at their commllalnd than the nationalgovernment. Some local government officials have expressed the view that for as long as thenational government continues to appropriate funds for these activities, they will continue toallocate local resources away from them.

3.31 Finally, the NG needs to make clear to all LGUs that they cannot expect a bail-outwhen they get into debt service difficulties from voluntary borrowing. The borrowing by LGUsshould be monitored carefully by the NG, and the mandated cap on debt service (20 percent of totalresources of each LGU) should be strictly enforced.

3.32 Cost Recovery The rule should be adopted that those who enjoy the benefitsflowing from public investments should pay for them. NG capital funding of local governmentutilities and other infrastructure projects from which it is feasible to exclude those who do not payfor their services, should be contingent upon the adoption of full cost pricing. NG's cost sharingof activities when direct cost recovery is difficult (for example, local roads) should be contingent

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on improved property tax administration so that increased property values due to infrastructureinvestmenits, be captured by tax net.

3.33 Technical Assistance At their request, the NG should give management/technicalassistance to LGUs related to their problems in qualifying for NG grants. There should be noimplication that the "advice" is. in some sense, binding on the LGUs. However, it would beprudent for the NG to retain responsibility for the definition of each acceptable local tax base,including the real property tax base and the business tax base, and the structure of rates that can beapplied to those bases. Setting the tax rates applied to those bases should, however, be a localprerogative. Retaining NG control of the definitions of tax bases and the structures of rates isnecessary to ensure that the fiscal capacity estimates are comparable among LGUs of the same typeand to prevent the adoption of beggar my neighbor revenue raising practices by LGUs.

3.34 One way to improve the implementation of the existing transfer system is toimprove population statistics within LGU jurisdiction. The current estimates of the size ofpopulation are extrapolated from the last census data. These projections tend to suffer fromsignificant errors in a dynamic economy in which the amount of inter-regional migration is non-trivial. Improved population statistics at local government levels is thus critical for betterfunctioning of the existing system.

3.35 Reform of Intergoveriimenltal Transfers If the govermnent is to modify the transfersystem, significant benefits would be realized, by replacing the present unconiditional IRA grantsystem., with a grant system that combined unconditional revenue deficiency grants, (sometimesknown as equalization grants) and conditional cost sharing programs for national priority activities.

3.36 The unconditionial revenue deficiency grants would be made only to LGUs with percapita tax bases below the national average with respect to a group of standardized taxes. TheseLGUs would receive grants equal to the revenues they would have collected had they applied theircffective tax rates to the national average per capita tax base rather than to their actual per capitatax bases multiplied by their populations. Note that these revenue deficiency grants areunconiditionial in the sense that the NG does not direct the uses of the funds received by the LGUs.The NG. in consultation with the LGUIs, would define a standard bundle of local taxes to beincluded in the calculations.

3.37 With revenue deficiency grants in place, LGUs that set low nominal tax rates or hadpoor collection procedures would receive low per capita revenue deficiency grants. For poor[-GUs (i.e. those with below national average per capita tax bases), the exercise of greater fiscaleffort [defined as the nominal tax rate applied to each of the tax bases included in the standard] andof greater diligenice in tax adminiistration would be rewarded by larger revenue deficiency grants,and conversely.

3.38 The cost sharing programs would encompass a number of activities that are theresponsibility of the LGUs to which the NG attaches a high priority (e.g. preventative health care,basic education, basic sanitation). One possible method of proceeding can be described as follows:Idirst. carefully define the eligible programs in terms of the nature and quality of the outputs and ofthe conditions of access of local residents to these outputs. Donor-assisted loan projects should beevaluaLed with the same criteria that are applied to any other project. Second, only the necessary

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expenses incurred by LGUs in producing and distribution these outputs would be subject to costsharing. Third, the NG would monitor the performance of LGUs in meeting the output and accessrequirements at minimum cost, and LGU programs that failed to meet these requirements wouldnot be eligible for future cost sharing. Fourth, the actual per capita expenditure of each LGU oneach shared cost program in the base period (an average over a few recent years) would bedetermined, and the NG would grant to each of the l GUs with respect to each of its shared costprograms an amount equal to a fraction of the increase in its per capita expenditures on thatprograms relative to the base period multiplied by its population. Finally, the grant fraction wouldbe highest for the LGUs with the lowest per capita revenue raising capacity (i.e. lowest per capitastandard tax bases) and the grant fraction would be lowest for the LGUs with the highest per capitarevenue raising capacity.

3.39 The Department of Health has a head start in this effort of cost sharing/matchinggrants and some lessons may be learned from their initial health care agreements with selected localcommunities. The ability of the DOH to initiate such a program was due to the additional budgetgiven to the department in 1993 and through higher than expected grants from external sources. Inthis respect, it may not be a good model since it is based on unstable sources of financing. Adesirable characteristic of a sound matching grant mechanism is that it should have a predictableand reliable financial source. If one such mechanism is to be designed, one likely source would bea fixed proportion of the IRA grant to LGUs, say 10 percent of the IRA base or 25 percent of theIRA. In the design of the matching grant mechanism, it should take into account the followingconsiderations: (a) provinces have relatively less resources for counterpart funding than cities andmunicipalities; and (b) poorer communities are less able to raise the necessary counterpart fundpartly because of their narrow tax bases and the general unwillingness of local officials to imposeadded burden on their depressed communities.

3.40 The total cost of these two programs should not exceed the amounts to which LGUare entitled by devolution. Perhaps, for example, the total cost of revenue deficiency grants shouldnot exceed, say 50 percent of the present IRA, and a similar limitation should be placed on the totalcost of the shared cost grants. With the improvement in national tax adminiistration, the NG mightreduce its shares of some national priority shared cost programs and offer to collect a personalincome tax for each province defined as a surcharge on the NG's personal income tax.

3.41 Alternatives--Unconditional Grant and Unfunded mandate Should these changes bejudged to be too drastic for political reasons, the NG should at least mandate that entitlement toIRA grants would be conditional on the adequate supply by each LGU of a small set of essentialservice programs (immunization, basic health care, safe water, etc.). Compliance by LGUs wouldbe monitored by the NG and inadequate performance would be penalized hy a reduction in IRAgrant allocation in accordance with a prescribed formula.

4. CIVIL SERVICE REFORM

Introduction

4.1 The public sector's role in the Philippines is undergoing substantial change becauseof the government's recent reforms in the direction of liberalization, privatization and devolution.This change provides a unique opportunity for carefully redefining the roles and priorities of thecivil service. The government has seized this opportunity by starting a process of civil servicereform called "streamlining the bureaucracy" in order to improve the performance of the centraladministration. The purpose of this chapter is to help the government formulate its reform strategyin a way which reflects the lessons of other countries and of the World Bank in this difficult area ofcivil service reform. The chapter begins with a brief summary of the Philippine civil service andcurrent reform initiatives. With this as background, it goes on to examine the rationale, objectivesand strategies for civil service reform. A detailed description of the Philippine civil service and theongoing Government's efforts to streamline the bureaucracy is in Background Paper Section IV.

4.1 It has been found that the existing GOP approach is focused on "reorganizing" theGOP structure and does not emphasize: reform of financial incentives, desired skill mix, andpersonnel management reforms. That the Department of Budget and Management (DBM) isleading the GOP efforts but Civil Service Commission (CSC) has a separate mandate complicatesthe process. The chapter thus recommends: (a) coordination of the GOP efforts should be madewith strong political commitment from the highest level of leadership; (b) a reform of incentivesystem should be implemented to achieve and maintain the desired skills mix, which will probablyinclude a higher proportion of professional staff. Such a reform would allow higher-level civilservants to be remunerated at rates more compatible with their private sector counterparts; (c) toachieve the desired skill mix efficiently, a combination of voluntary retirement and targetedretrenchment of surplus staff would complement the reform of the incentive; (d) a personllelmanagement reform based on a review of the current allocation of management tasks amonig centralagencies would also improve the civil service.

Background analysis

(a) Size, salaries and cost

4.2 Definition and Size According to the most recent count, there are 1.447 milliongovernment employees in the Philippines. Of these, 20.3 percent work for local government, and8.8 percent for government owned and controlled corporations. The remaining 70.9 percentconstitute the national government civil service. Of these 1.025 million, some 25 percent areuniformed (either military or police). The analytical focus of this chapter is on the non-uniformednational government civil service, a group of .773 million. Information on civil service size trendsin the Philippines is available only for the number of permanent, authorized positions, rather thanfor filled positions (whether permanent or not). Using this as the basis for measurement, oneobserves a massive increase under Marcos from .43 million in 1971 to .84 in 1980 and then toalmost I millioni in 1985. There was a further increase under Aquino frorn .95 million in 1985 to1.12 million in 1992. Since then the size of the civil service has fallen somewhat to its current level

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of 1.01 million. However, some two-thirds of this fall is directly attributable to decentralization andso will have been matched by a concurrent rise in local government personnel. Another one-quarterof the fall is due to cuts in the Department of National Defense. Hence one should view the Ramosperiod to date as, apart from the military, one of civil service containmenit rather than contraction.

4.3 Major Government Departments The civil service of the Philippines is veryconcentrated in four agencies: 43.7 percent of all civil servants, mainly teachers, are in theDepartment of Education, Culture and Sports; 13.7 percent are in the Department of NationalDefense (the military); 12.5 percent in the Department of the Interior and Local Governimlenit(DILG, mainly police); and 4.6 percent in the State Universities and Colleges (tertiary educators).

4.4 Salaries The total salary paid to civil servants is made up of the basic salary andvarious allowances. On average, the basic salary makes up about 70 percent of the total salary.However, at the lower grades, this falls to 60 percent, in(dicating that the distribution of allowancesfavors the lower-paid. This is because most, though not all, allowances are of a lump-sum nature.Excluding the President and Vice-President, the civilian civil service is divided into 33 salarygrades. There is a heavy concentration of posts (55.5 percent of the total) in the three grades 10-12. Grade 10, which includes many teachers, by itself contains 31.8 percent of all positionls. Grade11 contains 13.1 and Grade 12 10.5 percent.

4.5 Changes to the Salary Structure The salary structure is currently undergoing majorchange as the result of the ongoing implementation of the Salary Standardization Law 11 (SSL 2),which re-sets basic salary levels for all grades. The law authorizing SSL2. passed in 1993, gives1997 as the date by which SSL2 is to be fully implemented. If and wheni it is fully implemented,SSL2 will have increased the average basic salary by 158 percent (relative to 1993, the last yearprior to implementation, and using a weighted average based on 1993 positions). The uniformedsector is treated even more generously under SSL2, with an average salary increase of 189 percent.The ambitiousness of the SSL2 targets is confirmed by simulations conducted for this report. Theseindicate that even with high rates of growth (7 percent per annum), witlh no staff cuts, SSL2 targetscould onily be met by 2000 given the Government's wage bill target of 5.6 percent of GNP.Moreover, if SSL2 were to be met on time (1997), a massive 26 percent cut in staffing would berequired if the wage bill constraint was to be adhered to, and that is assuminig rapid growth.

4.6 SSL2 will also greatly change the salary structure, by increasing the salaries of thelower-levels by much more than those of the higher-levels. Although the SSL2 target remains along way off, the mode of its partial implementation to date, which is one of equal absoluteincrements to all grades, has already made a big difference to the salary structure. The flatteningthis is causing can be seen in the summary statistics of dispersion, such as the compression ratio,which gives the ratio of the highest-paid to the lowest-paid. The compression ratio for total salariesfell from 6.9 in 1993 to 5.7 in 1994 and will fall again to 4.7 in 1995. That for basic salaries fellfrom 8.8 in 1993 to 6.7 in 1994 and will fall again to 5.2 next year. Fully implementing SSL2would halve the compression ratio for the basic salary from 8.8 in 1993 to 4.4 in the year ofimplemenitation; the compression ratio for the total salary would also fall. from 6.9 to 4.6.

4.7 Public vs. Private Sector Salaries This flattening of the compression ratio comes ata time when available evidence suggests higher-level staff in the civil service are significantly

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underpaid relative to their private-sector counterparts, whereas in most cases the lower grades inthe civil service receive salaries roughly equivalent to those of their private-sector counterparts.

4.8 The Wage Bill The wage bill is a large component of government expenditure. Itcurrently stands at 31 percent of total expenditure. Moreover, the wage bill has been, untilrecently, on an upward trend. As a percentage of GNP, it rose from 3.8 percent in 1983 to 4.1percent in 1985 to 5.8 percent in 1990. It has since declined slightly to 5.4 percent. Overall (end-to-end) growth in the personnel bill between 1983 and 1993 in the real salary bill was 58 percent,compared to real GNP growth over the these years of only 16 percent. This rapid growth in thesalary bill is projected to continue. Despite the much healthier GNP growth predicted (around 7percent a year), the salary bill is still projected to grow 50 percent faster than GNP, a result of theSSL2 targets.

4.9 International Comparisons The size of the civil service in the Philippines is averagefor the Asia region. However, international comparisons of size, while useful in providing context,cannot be used as a basis for policy, mainly because they tell us very little about civil serviceefficiency. To illustrate, note that the Singaporean and Philippine civil services appear to be quitesimilar on the basis of the sort of figures used in international comparisons. Both countries have aratio of civil servants to total population of around 2.1-2.2 percent and both have a wage bill whichcosts 30 percent of total government expenditure and around 5.5 percent of GDP. No-one couldsensibly argue on this basis, however, that the two civil services were similar in terms ofperformance and the need for reform.

(b) Management issues

4.10 Management Agencies There are two main central personnel agencies. The CivilService Commission (CSC), a constitutional body, has wide-ranging powers, exceeding those ofmost CSCs around the world. Its role in the Philippines has expanded in recent years, and the CSCnow not only ensures adherence to CS laws and regulations, but also controls recruitment andpromotes efficiency, performance evaluation and the professionalization of the civil service. Theother central personnel agency is the Department of Budget and Management (DBM), the executiveagency responsible for the budget. It controls the number of positions available, and also gradespositions and advises on salaries and allowances. This division of responsibilities between CSC andDBM gives rise to several difficulties. For one, it can be a source of delay. Say an agency wants tocreate and then fill a new position. First it must clear the creation of the nrw position with DBM.Then, if external recruitment is sought, this must be cleared with the CSC. Finally, assumingappointment goes ahead, the agency must once again clear its intended appointee with CSC.Clearance with both agencies can be a slow process and may take up to six months or longer tocomplete.

l. i I Promotion and Performance Review Advancement within grades is based purely onseniority. There are eight steps within each grade and movement to the next step is automatic afterthree years. Promotion to a higher grade is, at least in principle, based on merit. Recent reformshave given more emphasis to performance. The CSC has recently introduced a six-monthlyperformance evaluation system. The precise manner in which the evaluation is carried out is left upto each agency to decide. These evaluations are intended to provide a basis for promotion anddismissal decisions. (For example, two verdicts of unsatisfactory performance will result in

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dismissal.) Performance Incentive Benefits have also been introduced to reward top performers.Agency heads are to nominate annually their best performers to share in a fund worth some 2% ofthe total personnel budget.

4.12 Exit Although attrition rates have only become available since the passing of theAttrition Law, they are widely held to be low and stable in the aggregate. The recent figurescertainly confirm this. At the national government civilian level, 1993 figures give an attrition rateof just 1.3 percent. The most common cause of exit is retirement or death. Retrenchment is rare.Entrance to the public sector from graduation followed by mid-career transfer to the private sectoris a well-known career path in the Philippines, as it is in many other countries. Demands for theskills of professionals from the private sector will rise with liberalization, and exit can be expectedto increase.

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(c) Reform initiatives

4.13 A historical Perspective Civil service reform in the Philippines has a long butunhappy history. The Marcos era, after a promising beginning, left an legacy of corruption,politicization and over-staffing, which still plagues the public sector. The Aquino Government setout on a reform program to fundamentally alter the nature of the civil service. However, while itwas successful in establishing institutions to guard against the future abuse of government, such asthe Office of the Ombudsman, its reform efforts achieved little systemic change to the way inwhichi the public sector operated.

4. 14 Reform under Ramos President Ramos has made civil service reform a keyobjective of his administration: according to his speech at the 1992 Economic Summit, one of eightgoals which would guide his presidency. The most important current initiative is the Governrnent's"Streamlining of Bureaucracy" plan. A Reorganization Bill has been submitted to Congress. Ifpassed, it would give the President authority to re-organize the civil service via a series ofExecutive Orders which would reduce the overlap between different spheres of government, andattempt to check the ad hoc way in which government has grown. At the time of writing, thepassage of the Act seems unlikely before the adjournmuent of Congress before elections scheduledfor May. However, the administration is confident that the new Congress will act quickly to passthe Act. In the meantime, DBM, the agency with responsibility for this initiative, is undertakingpreparatory studies. It is also encouraging individual agencies to go ahead with restructuringinitiatives on their own rather than wait for legislation to be passed.

Box I Civil Service reform in Individual Agencies: the Case of the Central Bank

Following the act reconstituting the Bank in 1992, BSP Management appointed first a Task Force and then aStudy Team to address questions of intemal management. Though much remains to be improved, there are positivesigns. Eight departments have been abolished. And the total number of layers in the hierarchy has been reduced fromeleven to eight.

Staff size has also fallen: from 6,170 in 1992 to 5,570 in 1993 to 4,520 in 1994. This was achieved by agenerous voluntary retirement program (on which, see the text).

The BSP has also been given greater control over its salary structure, though the initial plan to give it full controlwas watered down so that it now only sets the salaries of grades 19 and above (the grading system has not beenchlaniged and the Bank still adheres to CSC qualification requirements). Salaries for these relatively senior positions,have been upgraded on the basis of a comparison with private-sector banking salaries. Though BSP salaries are stillbelow private sector levels, the gap has been substantially reduced. Since the gap was found to be the highest at theexecultive level, salaries at this level have been increased the most: by between 120 and 220 percent. The differencebetween the BSP and the rest of the civil service is most vividly illustrated by consideration of the Governor's salary.The Governor of the Central Bank receives iR 150,000 a month, about half what a secretary of a department earns in ayear.

Despite these pay rises, total personnel costs have fallen as a result of the massive staff cuts: by 12 percent innominal terrns between 1992 and 1993.

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4.15 Civil service reform has made the most progress in two government agenciesregarded as pivotal to economic recovery and therefore given increased autonomy under speciallegislation: the new Central Bank of the Philippines (BSP) and the National Power Corporation.The BSP's use of this greater independence is detailed in Box 1 and is illuminating as an exampleof wlhat could be achieved in relation to the civil service as a whole.

4.16 The other major area of reform activity has been efforts to check civil servicegrowth. The Attrition Law, passed in 1992, forbids external filling of vacated CS positions, exceptin exempt sectors, such as education and local government. Alternative, more flexible ways ofcontrolling civil service size are also being explored. DBM has introduced wage bill targets (5.6percent of GNP), and early retirement is also being considered.

Ratioiiale and objectives

4.17 Lessons of Experience During the Marcos and Aquino eras, the size of the publicsector grew dramatically, yet its effectiveness and credibility were severely undermined. Thepresent civil service, while not growing, still suffers, at a time when the Government is launchinginto an economic transition based on outwardness and competition, from the endemic problems ofthe past. Drawing both on the (largely unsuccessful) experience of civil service reform in thePhilippines and also on international experience, we would suggest that the following elements areneeded for a successful CS reform:

* a precise and convincing rationale;

* clear objectives;

* a strong and continuing political commitment to reform on the part of the President, manifest in boththe institutionalization of the reform process and his continuing personal involvement; and

* a coherent and phased strategy which begins with the objectives and considers tradeoffs betweentheml.

4. 18 In this section, we consider the rationale for civil service reform and the objectivesof reform. In the next section, we consider the questions of political commitment and strategy.

(a) Rationale

4.19 There are three fundamental reasons for undertaking a reform of the Philippine civilservice: efficiency; the changing role of government; and macroeconomic constraints.

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Box 2 An Audit of DECS

In 1993, a privately-funded study was undertaken by the Centre for Corporate Citizenship into managementpractices of the Department of Education, Culture and Sport, the department with the largest budget and themost employees. The study investigated a large number of business processes undertaken within DECS. Itfound(I problems across the board, a sample of which are presented below.

.. Technology and skills of manpower in information gathering, storage, processing and retrieval areinadequate ... One explanation for this is the inability of DECS to recruit and retain the most qualifiedpersonnel for various reasons, [such as] low compensation and the outdated information network. (p.7)

... [Tihe Planning Service of Central Office receives only an average of 60 percent of enrollment datarequired. [The result is] ... some areas of the country have sufficient or even excess classrooms while manyothers suffer chronic shortages. (p.8)

... Some schools being approved for construction are not in the priority list submitted by the elementaryschools. This happens because of "congressional insertions", while the local government officials also"participate" and influence the final selection of school beneficiaries. This results in having some schools withtotally dilapidated classrooms while other schools have relatively new classrooms. (p. 10)

... [Diuring the field work, all turned-over new classrooms and buildings supervised by DPWH in the schoolsvisited were incomplete ... The quality of work done by contractors ... supervised by DPWH was inferior ...if compared to the work done by the contractors supervised by DECS/School Heads. (p. 11)

... [The allocation of additional positions] required 14 signatories from the school level up to the regional level(Signatory School -2, District Office -2, Division Office -4, and Regional Office -6). (p. 12)

... JAIpproval of [authorized positions] by the Central Offices (DECS and DBM) takes about 6 to 12 months.(p. 15)

.. 1 Illiplementing] salary increases resulting from promotions usually [takes] ... several years. (p. 15)

... Budget implementation is too centralized at the Regional Office. [Tihey decide how much to give and towhom to give as they please ... This creates opportunities for misappropriating the budget. [Lless priorityiieeds are allocated funds and ... funds are sometimes diverted for other purposes. ... Once the budget isapproved, lit] loses the purpose for which it was prepared and becomes an exercise in futility. (p.20)

... [Tlwo of the three sample divisions were not able to deliver the textbooks before the opening of classes for[thel school year. (p.3 4 )

Source: Diagnostic Review and Systems Audit of the Department of Education, Culture and Sports, aconfidenltial study by the Centre for Corporate Citizenship and SGV & Co. for DECS, 1994.

4.20 Improving Efficiency There is widespread agreement that the public sector isinefficiently managed. Three key sources of inefficiency can be identified, namely an unwieldystructure, red-tape and graft, and demoralization. For insight into how these manifest themselves inparticular agencies, see Box 2, which extracts findings from a recent management audit of DECS.

4.21 The Changing Role of Government Economic reform, in the form of devolution,privatization and liberalization, is already well underway in the Philippines. All these imply a

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different, narrower, though crucially important role for the civil service, one of management ratherthan control. The changes may also require adjustments to the skills mix and remuneration system.A deregulated, open and outward-oriented economy needs a professional corps of technicians toprovide the public sector with the required highly specialized skills. It lias already become evidentthat certain economic, financial and legal skills are difficult to retain within tihe civil servicebecause of the present incentive structures. If the economy really does begini to grow at a high rateanid in a sustained fashion, then how will the talent be retained or recruited to undertake, forexamiple, highily technical supervisory tasks like the oversight of government corporations or of thefinanicial and bankiig sector? In addition, if economic reforms are to be sustained and deepenedand dlevelopment priorities articulated and met, then the civil service will need to be transformedinto a higilly motivated professional force for change and development - as it is elsewhere in Asia,see Box 3 for examples. The momiientum for economic reform will not be sustained unless acomipetent, well motivated and professional civil service emerges to create the institutions andorganizations which are necessary for steering a liberal economy.

Box 3: Competent Bureaucracies and Rapid Economic Growth

In Chapter 4 of The East Asian Miracle study by the World Bank, the authors focus on the specificinstitutional mechanisms which governments have used to foster shared economic growth and at the same timeenhance their own legitimacy and effectiveness.

The main mechanisms arc: wealth-sharing programs designed to include non-elites in economic growth; acadic of cconomic technocrats insulated from narrow political pressures; institutions and mechanisms to shareinformation and win the support of business elites.

In discussing the characteristics of successful insulation of the technocrats, the following lessons arepartiCularly pertinent to the Philippine situation:

- the primacy given to the bureaucracy over the legislature in the drafting of laws and the considerablelevcrage available to bureaucrats for minimizing political pressure on the approval process, particularly in thecasc of thc annual budget.

- the development of honest and competent civil services based on: competitive entry; promotion bymerit; total compensation competitive with the private sector; ample rewards for the top echelons.

The East Asian experience also shows that only a competent and honest civil service can create a credibleand enforceable legal and regulatory environment conducive to rapid private sector investment anddevelopment. An important aspect of the relationship between the public and private sectors in the high growthEast Asian economies is the development of formal institutions in order to ensurc that the rules of the game arema(le transparent to all potential investors on an equal and shared footing. In many cases deliberation councilshave served to create a forum to discuss policy, exchange information and arrive at a consensus on criticalpolicy dircctions. Research on the determinants of effective councils clearly shows that they are not able tofunction without an efficient, competent and honest bureaucracy which can establish a level playing field for alllirilis active in the market. This in tnLrn ensures that profits and rents are made through open marketcompetition hased on information-sharing and clear rules and not on the basis of special favors from

I,O goTllnlelllt.

4.22 Macroeconomic Constraints Another key element of any rationale is the importanceof the wage-bill as a macroeconomnic variable. The government faces a tight budgetary situation.

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Civil service management needs to be reformed so that costs are contained without sacrificing theflexibility required to meet future needs. A central objective in this regard is the setting of firmtargets as part of overall fiscal and financial management.

4.23 The present streamlining effort finds its rationale mainly in response to the first twofactors discussed above, namely inefficiency and the changing role of government. More recently,DBM has begun to set wage-bill targets and it plans to undertake its salary and impact mitigationstudies within the framework of the budgetary targets it has set. The aim ultimately is "to achieveand maintain a lean, efficient and effective national government bureaucracy" (Re-engineeringproposal). This is a laudable, but also, in the light of past experience, difficult goal. Thlegovernment will need to take every opportunity to link the rationale for CS reform to a vision of aneconomy which is undertaking a fundamental transition away from government control andprotection towards competition, liberalization and outward-orientation.

(b) Objectives

4.24 Juxtaposing this rationale against the CS status quo in the Philippines implies fivekey objectives for civil service reform:

i) oni the basis of a redefinition of the role of the public sector and the civil service,restructure and reorganize departments and agencies;

ii) identify and reconfigure as required the civil service skills mix;

iii) improve incentives to attract and maintain the desired skills;

iv) establish controls over the size and cost of the public service; and

v) develop a more integrated system for managing personnel budgets, positions andindividuals.

4.25 In the current streamlining initiative, some of these objectives have received moreattention than others. The first has been key to the government's efforts. More recently, DBM hasbroadened its agenda to cover, to varying degrees, all five of the above objectives. This broadeningof the government's agenda is a positive development, since all five objectives are not onlyimportant hut also interrelated. While it may not be possible to pursue all aspects of reformsimultaneously, it is important that those responsible for the reform are able to articulate theiroverall goals and how these will be realized over time.

Strategic issues

4.26 In this final section, we outline, in sub-sections (a) to (e) respectively, five keystrategic issues which will arise in the pursuit of the objectives outlined in the previous section. Thefirst is the basic question of how best to institutionalize the reform process. The second is the needfor consistency and transparency in the way in which the goal of streamlining is pursued across thegovernment. The third is the tradeoff between improving salaries and skills-mix, on the one hand,and the need to contain the wage bill on the other. The fourth is the question of controlling civil

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service size while allowing for a change in the skills mix. The fifth and final issue is that ofpersonnel management.

(a) Political commitment and institutional arrangements

4.27 Any civil service reform effort will inevitably face a large numllber of political,management and technical challenges. For it to be successful, it is essential that the reform effortbe backed at the highest political levels and that this backing be effectively institutionalized.Countries which have successfully carried out civil service reform have usually achieved it throughthe establishment of a strong, central unit equipped with the authority, independence and requisitetechnical expertise to plan and implement the process. This unit is usually located in the office ofthe Prime Minister or President and is seen to be operating under his authority. Malaysia'sAdministrative Modernization and Manpower Planning Unit (MAMPU). established to spearheadCS reform in the late seventies, provides a good example of what is required.

4.28 In the Philippines, a different route has been followed. As we have already detailed,the reform process is a presidential initiative (para. 14) and a Presidential Committee on1Streamlining the Bureaucracy, whichi has representatives from a number of government agencies.has been established. An Interagenicy Technical Committee on1 Streamlining has also beenestablished, which meets regularly to review the streamlining program. In addition, the CabinetCommittee on Development Administration - with representation from DBM, NEDA, thePresidenit's Office, CSC and the Commission on Audit - has an oversight role. However, the actualpreparation, execution and implementation for the streamlining program remain the exclusiveresponsibility of the DBM. The choice of DBM as sole executing body does carry with it certainrisks. DBM itself is an integral part of the bureaucracy, and some of its own procedures andarrangemilenits, for example in the area of personnel management, themselves need to be reformed.Nev. r theless, at this stage, drastic, mid-stream change to the institutional arrangements for ther "oi mn process would be counter-productive. However, it must be acknowledged that the reformgoals DBM has been charged with implementing are demanding ones. If the delays alreadyencountered in the course of preparatory work are not to be repeated, senior DBM staff responsiblefor the exercise should be provided with adequate resources and be supported as necessary bysenior national and international consultants. Moreover, to minimize the risks implicit in exclusivereliance on DBM as the sole executing agency, it is important that the Presidential Committee onStreamlininig, and its technical counterpart, be as active and broadly representative as possible,both to hielp bring about consensus and to send out the strongest signal possible that the reformprocess has the full backing of the President. It is also essential that the Civil Service Commission,which has such important personnel responsibilities, actively involve itself in the streamliniiiigprocess. Without CSC's involvement, it will not be possible for the reformz process to address therealignmiiienit of the skills Imix and the rationalization of persoinnel management.

(b) Streamlining

4.29 As mentioned earlier, it is unlikely that the Reorganization Act will be passed in thissession ot Congress, though it may be passed soon under existing after the May elections.However. even if the Act is not passed, it should still be possible under existing legislation toreallocate resources based on a redefinition of priorities among existing departments and agencies.The reorganization of the Bureau of Internal Revenue is indicative of just how much can be

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achieved at the agency level. For reform to be achieved without the passing of legislation,however, it is necessary that the legal situation be clarified so that legal challenges can be avoided.Managers are reluctant to implement the powers they have under the law for fear of legal reprisalsor congressional or other political interference. Whether or not the Reorganization Act is passed,the Presidential Committee should review all the existing statutes, such as the "Magna Carta" forprimary teachers, which impede effective personnel management with a view to setting itself anexplicit legislative agenda to remove these anomalies and constraints.

4.30 Whatever the legislative outcome, DBM needs to continue the work of setting downclear guidelines or rules of the game for the redefinition, restructuring and/or reorganization. Theaim is to identify and eliminate overlapping or redundant responsibilities and bottlenecks, simplifyprocedures and improve both productivity and effectiveness. It is essential to require that thisprocess be applied evenly across departments and with objectivity, consistency and transparency.The best way of ensuring such fairness is to insist that departments and the central bodyresponsible be helped in undertaking reviews of their mandates, organization and staffing byoutside teams with international experience in this area. There is a need for the center also toprovide guidelines for the nomenclature and organizational structure of departments and agencies,while recognizing that the actual internal organization will vary from departnent to departmentaccording to sectoral needs. DBM's work is already well advanced in this regard.

(c) Salary Strategies

4.31 In addition to the department-level analysis of objectives, costs and staffingrequirements, it is important that a government-wide analysis of different staffing options beundertaken to ensure consistency with macroeconomic targets. Even in a civil service in whichmore r esponsibility is delegated to departments, some critical parameters will remain under centralcontrol, the most important of these being salaries, the overall CS size and the overall wage bill.Salaries should be set in relation to the experience of the government in being able to recruit andretain the staff it needs. Private sector salaries obviously contain a lot of information in this regard.Determining desired staffing levels is difficult and to some extent arbitrary, but there are standardtools available. Ratio analysis for support positions should be developed by means of a survey ofthe prevailing situation and reference to international comparators. Similarly for population-basedprograms, such as health and education, the adequacy of present ratios may be assessed in the lightof a determination of sectoral priorities.

4.32 Cost Simulations We briefly indicate by illustration what such an analysis of staffingoptions would involve. We cannot be more than illustrative because of the limited information wehave, especially about staffing composition (by skill and occupation). What we hope to show byour simple example is that a more detailed salary simulation exercise would be both feasible andworthwhile. The reform program simulated takes the year 2000 as its target date, and aims toimprove both the skills profile and the salary structure of the civil service by this date (the latter bymoving towards pay-comparability with the private sector) within the constraints imposed by theoverall wage bill target of 5.6 percent of GNP. Since the wage differentia! is greater at higherlevels, the simulation aims for a 180 percent increase in real terms in the salaries of grade 19 andabove, and of 40 percent in the salaries of those below grade 19. In terms of the skills mix, thenumbers of support staff (grades 1-9) are reduced to bring the ratio of support to total staff to theinternational average of approximately 15 percent (a per annum reduction of 5.1 percent turns out

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to be required). Teachers increase on account of population growth by 1.5 percent, while thenumber of high-level professionals is increased by 10 percent over the period. The simulationsindicate that such changes are affordable if the high growth rate (7 percent per annum) thePhilippines is aiming for is achieved. If only a lower growth rate is thought possible, more modesttargets should be aimed for. These alternative reforms would also leave CS size almost unchangedin the aggregate.

4.33 Salary Reform Strategies Unlike the reform package illustrated above, the SSL2program, as shown by our earlier simulations, is unrealistic if macro constraints are to berecognized. The SSL2 target is also unrealistic for another reason: it will become impossible to gofrom giving all grades the same absolute increase to giving some grades (those which will still be along way from their SSL2 target) a large increase and other grades (those which will soon havereached their SSL2 targets) no increase at all. Assuming that the government is bound by SSL2, itshould move away from its policy of giving all civil servants the same absolute increment. At thevery least, it should give equal percentage increases. But, if possible, SSL2 should be replaced bya salary policy which takes greater cognizance of private-public sector wage differentials. If this isnot possible, the government should view SSL2 only as a staging-post and should begin plans forreform-ls to widen the compression ratio once SSL2 has been attained. To this end, it is essentialthat DBM embark as soon as possible on its planned studies on remuneration. A comprehensivesurvey of private-sector salaries will be needed to provide the basis upon which a rescheduling ofpublic-sector Falaries can be undertaken.

4.34 Rapid growth, and the expected increase in fiscal revenues as a consequence, mayprevent the GOP from suffering from a wage-led blowout of the government deficit even if nominalwages are increased significantly. Of course, an alternative strategy would be to employ a moreconiservative wage policy and let the share of GNP which salaries consume decline as the economygrows. This is a choice for government. In our opinion, however, without increased funding,successful reform of the civil service will be very difficult, and without successful civil servicereform growth will be more difficult to maintain. Wage targets should, however, be contingent onsatisfactory attainment of GNP and revenue targets.

(d) Ways of changing the civil service size and skills mix

4.35 Attrition The current strategy of reliance on attrition to downsize is unattractive. Itis highly likely that the present low attrition rate will not be able to bring about either the numberor ret,nisite profile of reductions in staff which will be indicated by the reorganization of'-p r,inef Its. In addition, the notion that the problem of surplus staff can be resolved by attrition isin conitradictioni with the essential purpose of the streamlining: rationalizilg the structure andorganizationl and matching people and jobs. For higher level positions at least, recruitment will beneeded in order to fill new positions and bring in new skills. Through overall controls are required,better tools than the Attrition Law are available. In addition to budgetary caps, absolute caps canalso he placed on civil service numbers (a practice used in Japan and many other countries).

4.36 Retrenchment Compared to attrition, retrenchment is a much more purposive meansof down-sizing. Combined with recruitment, it also enables the skills mIlix to be improved.However, the legal situation as to how easily civil servants can be retrenched is unclear, at least inthe minlds of the key players, and the political difficulties are obvious. Ongoing retrenchment can

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also cause serious morale problems. There are various ways, however, in which some of the stingcan be taken out of retrenchment. Handsome redundancy packages can be crafted, and long lead-uptimes to redundancy can be introduced so that staff have time to search outside, for example.

4.37 Voluntary Retirement Even with sweeteners added, retrenchment may prove neithersufficient or politically feasible. The more that this is so, the more voluntary departure should beconsidered. Voluntary retirement is not a popular notion within either DBM or CSC, althoughDBM has commissioned an "Impact Mitigation Strategy" study as part of its background studies forstreamlining (para. 14). Officials of both agencies feel that in the past voluntary retirement hasresulted in both little movement and the departure of some of the best staff. However, voluntaryretirement can be a very effective transition tool. This is borne out both by international experienceand by the case of the Central Bank in the Philippines (see Box 2), where staff size was reducedfrom 6,170 in 1992 to 4,520 in 1994 through use of a generous early retirement program. Norneed its cost be prohibitive. Analysis carried out for this study shows that the reductions in staffsouglht in the simulation presented in the previous sub-section (40,000 departees) could be achievedat a cost of less than 10% of the 1994 wage bill.

4.38 Experience does point, however, to the importance of design in determining thesuccess or otherwise of a voluntary retirement package. In particular, it should have the followingfeatures:

(i) Any early retirement scheme should, unlike the one tried in the Philippines in 1988, be part of areorganization: no voluntary retirement program should be initiated without the executive also decidingto act decisively on streamlining. This makes it possible to signal to well-motivated workers with goodskills that they have a good future in the organization and to undesired workers that their prospects arenot bright.

(ii) It should be presented as one-off, both to make it effective and so that it does not harm incentives (bybeing seen as a "reward for failure").

(iii) The offer to take early retirement should have a closing date attached to it. Additional incentives forearly signing-up should also be considered. This makes coordinating with a reorganization easier. It willencourage people to leave quickly, rather than waiting until their salary is raised or they find a privatesectnr job. Having a closing date removes the particular problem in the Philippines that people willpo"tpone retirement until the implementation of SSL2, with the huge wage rises it will bring.

(iv) It should be generous relative to existing schemes.

(v) It should be targeted. Exclusion of particular skill categories, age groups and salary grades should beconsidered. Only those considered surplus to requirements - for example, whose positions have beenabolished - should be allowed to leave under the scheme. Some degree of central oversight will berequired to enforce this.

4.39 Retraining In addition to encouraging exit and entry, the skills mix can also beinfluenced, while retaining control on the total number of civil servants, by retraining. This isobviously a politically attractive option. There is a great deal of talent already in the CS andrecenitly training has received more emphasis as a result of initiatives of the CSC. However, for

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some specialized tasks, the execution of which requires long-term training or private-sectorexperience, retraining will not suffice. The precise mix between retraining and hiring will varyfrom agency to agency.

4.40 In summary, a more creative approach to the problem of controlling civil servicesize and skill composition is warranted than the current exclusive reliance on the Attrition Lawallows. Thae Attrition Law should be abandoned or at least allowed to expire in 1997. Overall civilservice size and cost should be controlled through the budget, with additional reliance on absolutesize limits if required. To the extent possible, retraining should be used to improve the skills mix.Exit, whether for downsizing or to make room for recruitment of needed skills, can be encouragedvia a spectrum of options ranging from voluntary retirement to retrenchment.

(e) Personnel management

4.41 Progress has been made in improving personnel management. For example, moreemphasis is now being given to performance evaluation (see para. 11). This is a welcomedevelopment, which should itself be closely monitored, fine-tuned and further emphasized.However, much remains to be done. Personnel policy reform should be guided by two overallobjectives. First, there is a need to review and rationalize the sharing of managementresponisibilities between the central agencies and line departments. Personnel and related budgetaryresources should be managed in a flexible way which is responsive to the needs of departments,enhlances the accountability of managers and contributes to an improved incentive structure formanagers and staff. At the same time effective running controls over posts and costs must beimplemented.

4.42 Second, the current system of uncoordinated central personnel management needs tobecomae m1ore effective and coordinated. There are a variety of ways in which this can be done anddifferenit countries handle the problem in different ways. The key requirements of any successfulsystemii are a clear demarcation of responsibilities among and good coordination between the centralor core malnagement agencies. Current arrangements should be reviewed in the light of this goal.DBM and CSC are the two key central personnel agencies, and better coordination between the twois a sine qua non for rationalizing the personnel management system. The overlapping legaliiiandates of DBM and CSC in relation to personnel management notwithstanding, a morecoordiniated approach from the two agencies should be possible given a constructive attitude onboth sides.

4.43 In addition to these generic problems, there are a number of specific issues whichrequire government attention. One is the paucity of career streams for professionals within the civilservice. A second is the nexus of problems affecting senior management. In addition to improvingsalaries and other incentives, the current lack of security faced by this class must be addressed.Finally, as pointed out earlier, there is little information available on the composition of the civilservice by variables such as age, sex or education. It is crucial to redress this deficiency by the endof the reform period to ensure that over the medium term an human-resource planning, monitoringand control capacity can be developed. In this regard, plans of the central personnel agencies for aconmmiloni data base are a welcome development.

5. BUDGET PLANNING AND MANAGEMENT

5.1 Current budget processes impact the GOP in providing and sustaining neededprojects programs effectively and efficiently. They appear to often: hinder coordination betweenbudget planning, development programming, and project and program implementation; facilitatethe selection of low priority projects over higher priority projects; and contribute to delays inimplementing high priority projects. Furthermore, they sustain a persistent bias against funding foradequate maintenance of existing facilities, with a consequent decline in some public services. Thischapter (1) briefly describes that process; (2) analyzes the characteristics of the process that givesrise to these problems; and (3)concludes with recommendations that could ameliorate them. Thischapter also has an Annex on "Recognition and Management of Contingent and Other Liabilities",which recommends that the cost of these liabilities be recognized explicitly in the budgetaryframework when liabilities are created (i.e., do not wait until the contingency is called).

5.2 The expenditure budget process is complex, especially in a democracy, because itentails the reconciliation and compromises of a multitude of conflicting interests, each seeking tomaximize its net benefits from the public sector. For the Philippines that has a congressional formof government, there are the inhlerent constitutionally designed balance of power among the threebranches of government: the Executive, Congress and the Judiciary.

5.3 The prevailing structures and processes within which the expenditure budget isformulated each year either affect or are perceived to affect budget outcomes, and hence therelative satisfaction of the multitude of interests competing for advantages. Attempting to changethe institutional structures and procedures is tantamount to attempting to change the rules of thebudgetary game and, as such, will generate support from those who perceive themselves to bepotential winners and attract opposition from those who perceive themselves to be potential losers.Althouglh it has what might be termed technical elements. reforming the expeniditure budget processis largely a political matter. Indeed, the recommendations in this Chapter may not change the"proceclures" so much as how the procedures are implemented.

The Formal Budgetary Cycle

5.4 The budget process consists of four phases: development, appropriation andauthorization, implementation and monitoring , and accountability. Details are described inBackground Paper Section 111. The process of preparing the 1996 budget is described as anexample below.

Phase One: Development of President's Proposals for Presentation to Congress.

5.5 Process Broad parameters for the budget year (e.g. interest rates, exchange rates,sectoral growth rates and unemployment rates) are set at 13-14 months prior to the actual start ofthe fiscal year (i.e., October-November 1994 for preparing the 1996 Budget). These assumptionswill allow derivation of the projected rates of growth national government expenditures andrevenues. The "Budget Call: FY 1996" is issued toward the end of 1994 to all departments andagencies, and in January, 1995, the DBM issues to line agencies indicative budget ceilings for 1996

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Cabinet. The DBM uses the baseline budget approach in setting these ceilings. This is defined asthe minimum level of expenditures required to continue the basic functions of the department oragency adjusted for increases in population and productivity improvements. The departments andagencies submit their 1996 budget proposals to the DBM in March 1995, and after intenseconsultations and reviews, the DBM prepares the preliminary budget allocation. In June and Julythe final budgetary figures are confirmed in meetings between DBM, and agency heads and theChairmen of the Regional Development Councils before being printed as the Budget ofExpenditures and Sources of Financing (BESF) document that is placed before Congress by thePresident.

5.6 Analysis It is noteworthy that only foreign-assisted capital projects are scrutinizedas to their costs and benefits in the process of preparing the budget. These projects typicallyoriginate in operating departments, and are evaluated by the NEDA Secretariat in terms of certainplausible criteria. Final selection is made by the Investment Coordinating Committee consisting ofthe Executive Secretary to the President, the Secretaries of Economic Planning, Finance, Budgetand Management, Agriculture, Energy, the Governor of the Central Bank and the Chairman of theCoordinating Committee on Philippine Assisted Projects (CCPAP). Locally funded projects do notget as Imluch scrutiny on project viability that is necessary. Furthermore, the recurrent budgets ofdepartments and agencies are carried forward from year to year virtually without analysis, exceptfor adjustments related to population changes.

5.7 The problems of project selection within the executive, arise not from any lack ofcoordiniation among the major organizational players but rather from the uneven quality of theiiformiiation on which they base decisions. Departments are, of course, unlikely to submit completeand unbiased information in support of the projects they wish to pursue. The NEDA secretariat canhardly be expected to ascertain all of the relevant, but nevertheless obscure, facts about all of theprojects.

Phase Two: Authorization by the Congress

5.8 Process In July, the President's BESF is submitted. Both the House and the Senatesimultaneously conduct hearing. Conflicts between the two bodies are reconciled by jointconference committees.

5.9 Analysis In this process, the Congress, the President and the Executive (DBM)have different but strong powers. The Congress can make amendments to the BESF as long as thetotal budget size remains equal to or less than the BESF. To counter these changes Congress mayintroduce, the President can exercise line-item veto. The DBM exercise somewhat different powerlater on; they can maneuver cash releases during implementation of the budget, especially whencash rationing must be introduced due for example to overestimated revenues, to alter priorities ofprojects from the congressionally approved budget.

5.110 Notable in this appropriation process is the power of the Congress to insertappropriations for items that have lower priority, in the view of the executive, than the itemseliminated. Projects may be approved by the Congress that have not been evaluated by theExecutive and for which no essential preliminary steps have been taken. such as land acquisitionfor capital projects. Congress may also appropriate funds for projects that clearly fall within the

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mandate of the local authorities. As a consequence, local authorities may reduce their funding ofthese types of projects in the expectation that Congress will appropriate additional funds for itemsthat should be funded from their own appropriations. When the congress appropriates funds forcapital projects that have a low priority in the eyes of the local authority, the Congress, in effect,distorts the expenditures of the local authorities that are required to use their own funds to operateand maintain them when they are in place.

Phase Three: Implementation

5.11 Process The DBM prepares the National Expenditures Program (NEP) based onthe approved budget. The NEP delineates the funds that are "expected to be available" to eachgovernment agency to accomplish their assigned tasks. Because the funds thus allocated may likelyexceed the funds actually available (actual revenues plus net borrowing), and because ofCongressional changes have been made in the BESF, several important steps are introduced toreconcile the expenditures that have been formally approved and what can actually be implementedby departments and agencies.

2

5.12 Each line department first prepares an Agency Budget Matrix (ABM) . ABMstypically envisaged expenditures that were less than the funds stated in the NEP. As an interimmeasure pending approval of their ABMs, departments and agencies are permitted to spendamounts based on their last year's recurrent budget. As a consequence, virtually no capital

3spending takes place in the first quarter of the fiscal year.

5.13 After reviewing WFP/ABM of any line agency, DBM issues allotment releaseorders (AROs). Until 1994, advice of allotment (AA) was used instead of AROs. Thesedocumiients authorize agencies to enter into obligations or commitments for specific activities.tJnlike AA which was the same for all expenditures, allotment release orders are classified intotwo kinds depending on the nature of payments: general allotment release orders (GARO) andspecial allotment release orders (SARO). GAROs apply to almost all routine recurrentexpenditures and to some routine capital expenditures (such as school buildings), whereas SAROapplies to most capital projects and other outlays that require additional clearances. AROs can beissued at any time and are meant to increase flexibility of budget management. Later, the DBMthen issues to each agency, on a quarterly basis, a Notice of Cash Allocation (NCA) to authorizethe department or agency to pay obligations up to an approved amount on any of the itemsapproved in the GAROS/SAROs. This process might best be characterized as an attempt to rationcash disbursement among departments and agencies to the cash available to the central governmenton a quarterly basis, as determined by the Cash Programming Committee. The Committeeconsiders the inflow of revenues, the proceeds of net borrowings, the proceeds of asset sales andthe caslh balances carried forward in the accounts of the Central Government and each of itsdepartmiienits and agencies.

This process is changing rapidly with the introduction from FY1995 of the simplified fund release system.2

ABMs wcrc called Work and Financial Plan (WFP) until 1994.3

The samie happens when budget is not approved by the Congress prior to the start of the fiscal year.

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5.14 Analysis The current system with two-layer budget release mechanism (allotmentrelease orders--and NCAs) has been designed to safeguard thie targets for fiscal deficits committedby the Government. It should also be noted that the Executive Branch (DBM, in particular)maximizes its control over the expenditure budget by increasing the appropriations (byoverestimating future revenues) relative to the actual cash available because, while it forces therationing of cash among departments and agencies over the course of the year, it also affords theExecutive an opportunity to ration cash in accordance with its own priorities rather than those ofthe Congress. The overstating the available revenues also has the advantage that it gives theappearance of greater availability of counterpart funds for foreign-assisted projects (FAPs). FAPsincreases the inflow of foreign exchange which can substitute for more foreign borrowing.Although it has not happened every year, the shortfall of the actual flow of revenues can arise formany reasons. Among them are: a) errors in the basic assumptions concerning the majorstatistical indicators of the economy; b) inadequacies of the models used to derive revenue forecastsfrom the projected level of econcmic activity; and c) inclusion in the BESF of future revenuesbased on proposed structural changes in the revenue system that are not approved by Congress orare not implemented to the degree anticipated.

5.15 It should also be noted, that, because departments and agencies generally do notknow the annual quantum of funds that will be made available to them with which to meet theircurrent obligations until the year is virtually at an end, and that quantum is almost certainly lessthan the AA/ARO, they have learned through painful experience to "stockpile" enough idlebalances to meet their annual wage and salary obligations before entering into commitments forcontract maintenance or for capital projects. The inevitable consequence is a deterioration in theexisting stock of physical capital as a result of inadequate maintenance and inordinate delays inundertaking approved capital projects, even those with a high priority.

5.16 Finally, implementation of the budget is monitored by a number of agencies. Inparticular, foreign-assisted capital projects are monitored carefully by both NEDA and CCPAP.But, locally funded projects are not included among those to be monitored oni a timely basis. Thestatus of these projects is reported only annually.

Phase Four: Budget Accountability

5. 17 In the course of any fiscal year each department is required to report to theCongress on their cumulative allotments, obligations incurred/liquidated, total disbursements,unliquidated obligations, unobligated and unexpended balances and the results of expendedappropriations. The general consensus appears to be that Congress makes little use of these data,perhaps because it is so voluminous while not disclosing much about the actual performance ofdepartments and agencies in delivering services to their clients.

5.18 The Commission of Audit is mandated by the Constitution to oversee the integrityof the Government's financial transactions. In other words it conducts a system wide audit toensure that funds are expended only on congressionally approved objects within the authorized timeperiods. The Government also needs what is now commonly termed a management audit that seeksto assess whether government received good value for the money expended and has achievedreasonable cost effectiveness at the program level by improving program1 design and by attaining

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maximum operational efficiency. The COA is authorized to implement such audits but so far hasnot had adequate capacity for management audits.

Recent Budgetary Initiatives: Palliative or Cure?

5.19 Recently, there have been a number of attempts to ensure timely implementation ofpriority projects: Pump-Priming Program, more aptly entitled the "Earlier Release of FundsProgram", introduced in 1993; Resource Based Budgeting Strategy introduced in 1994, with thepurpose of accelerating the implementation of high priority capital projects by assigning priority tocertain projects should cash rationing be necessary; Core Public Investment Program; andFlagship Programs/Projects, which might be considered as an extension of the CP1P to include notonly projects but policies, strategies and programs that have been accorded high Presidentialpriority.

5.20 These attempts have met at best with only limited success. The problem can beattributed to several causes:

(i) The Congress often accords higher priority to some of its own projects than some of thosefavored by the Executive, and inserts them into the budget. Thus, when new projects areintroduced by the Congress into the budget, departments and agencies have to adjust their budgetsto accommodate these changes. It is only after these adjustment has been made and theirWFP/ABM approved by the DBM that the resource releases can be started. This normally takesabout two to three months losing the crucial dry season suitable for construction;

(ii) The departments may stockpile cash releases at first to ensure adequate payments of wages andsalaries;

(iii) In the course of the year departments and agencies may also submit to the DBM revised WFPsfor the current year. These entail new approvals, revised AAs and revised NCAs. For example,project appraisals undertaken by the Executive Branch are sometimes inadequate. Althoughapproved in the General Appropriations Act, as a result of more detailed assessments, someprojects of executive origin may be subsequently modified or abandoned;

(iv) AAs are only approval in principle, and since the total amount of AAs is usually not released,agencies do not enter into contracts until they receive NCAs;

(v) D)epartments and agencies may deliberately delay priority projects as a strategy of directingwork to favored contractors, or to substitute them with their favored, and in the national point ofview, lower priority projects;

(vi) Many construction projects cannot be undertaken in the rainy season. Since the dry season isthe first three months of the year, delays introduced by any of the foregoing factors may becompounded by the fact that when all of the approvals have been obtained and contracts made, itmay not be feasible to undertake the work, or work in progress may be halted for several months,for climatic reasons; and

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(vii) Insufficient funds may be released to departments and agencies to meet their currentobligations.

Issues

5.21 A number of issues can be identified from the situation described above. The firstissue is whether the expenditure priority is established rationally taking into account the goals ofthe Government, the role of the private and the public sectors, and the need for maintenance. Thesecond issue is that if an adequate amount of funds reach line agencies in a timely manner forimplementation of the priority activities. The third, inadequate project preparation or short-termconsiderations appear to be affecting implementation capacity of line agencies. Finally, measuresneed to be taken so accountability of line agencies be enhanced and timely corrective action can betaken if and when priority activities are under-funded.

5.22 Priority Setting There is an inherent tension in reconciling the conflict between thespending priorities of the executive and those of the elected representatives in the Congress. TheCongress can impose their own priority through amendments to the President's budget proposal.In the Philippine's Constitution this power is restricted in two important ways: Congressionaladditions to appropriations must be matched in Peso terms by Congressional deletions so that totalspendinig remains the same as that proposed by the President; and the President has a line item vetoover Congressional additions to appropriations, although this power has been rarely used exceptfor vetoes against debt service cap.

5.23 The Congressional additions are usually on locally-funded activities most notablyrepresented by three sectors: local roads; state colleges and universities; and irrigation. Asdiscussed in Chapter II, these are either of low return (state colleges and universities) or devolvedto local governments. From economic points of view, therefore, continued central funding isinefficient, although the political returns to these activities are presumably quite different. FutureO&M requirements of these projects are also not evaluated adequately straining local governmentbudgets or putting more burden on the scarce education resources that should be better used forbasic education. Furthermore, congressional deletions often include a number of projects, foreignassisted or locally funded, which have been well prepared.

5.24 It might be argued in this environment that a threat of revenue shortfalls during thebudget implementation, and resulting cash rationing represent a conscious strategy by the executivedesigned to reassert its spending priorities. By overestimating revenues, total appropriationsapproved by Congress exceed those that can be financed. This, or more precisely, the threat ofrevenue shortfalls necessitates the introduction of cash rationing by the executive during the fiscalyear. Cash rationing makes it possible for the executive to make funds available to finance theprojects to which it accords the highest priorities and to withhold the funding for projectsintroduced by the Congress. Note that the overestimates of future revenues do not have to beactual every year as long as there has been enough past occasions to make this threat credible andcash rationing possible.

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5.25 Another factor is that the Congress has not approved the Medium-Term PhilippineInvestment Plan (MTPIP) developed by the NEDA, and thus the Congress may not feel constrainedto restrict its project insertions to those that are consistent with the Plan or to treat Presidentialproposals that flow from the Plan as any more deserving than any others. One merit of a multi-year plan is to have both Congress and the Executive agree on the medium-term goals and priorityof the country, and to have direct links between program planning and program budgeting.

5.26 Finally, the allocation of responsibility for judging project priority within theExecutive also poses problems. Operating departments and agencies are supposed to originateproject proposals that are then to be evaluated by the NEDA secretariat and approved by ahierarchy of interagency coordinating committees. The originating departments and agencies areunder no incentive to critically assess their own proposals and NEDA does not have enough humanresources for assessing all of them in depth. In particular, the technical expertise to assess themanagerial feasibility of so many diverse projects (e.g., location, land assembly, costing, futurenet operating costs and contract delivery dates) is in short supply. With weak planning it is notsurprising that implementation delays frequently occur because the decision to proceed is littlemore than a decision to begin the planning that should have taken place before the decision toproceed was made.

5.27 Fund Releases to Priority Activities Cash rationing also has the effect of delayingthe implemnentation of the executive's high priority projects because departments and agencies facegrcat uncertainty concerning the flow of funds that will be forthcoming. They are required tospend much staff time in meeting the reporting and other bureaucratic requirements of the centralagencies in order to secure even a fraction of the cash allocations necessary to finance the projectsapproved by Congress. In addition, given the uncertainty, some agencies try to safeguard theirmontlh by month cash allocations for the payment of wages and salaries first before startingspending on more discretionary budget items.

5.28 Issues at Line Agencies There are, however, factors other than cash releasemeclhaniisnm delaying the implementation of priority activities as can be seen from the limitedsuccess of the several ad hoc attempts of recent years (briefly described in the previous Section) toavoid the delays of cash rationing on the executives highest priority projects. Among theseadditional deterrents are: inadequate project appraisals, inadequate trained manpower indepar-tments and agencies, the time consuming task of keeping track of appropriations, allotments,comllmitment authorities and monthly cash allocations, the diffusion of responsibility among thecentral agencies, and conflicts between the priorities assigned to projects by the central agenciesand the priorities favored by the operating departments and agencies thus subverting the prioritiesestablished by the President

Policy Recommendations

5.29 The recommendations set forth below seek to ameliorate these problems, and thusaccelerate the implementation of projects, by shifting the conflict resolution process from the"behind closed doors" forum where cash rationing takes place, to Congressional debates about theappropriate size of the public sector and the appropriate allocation of spendiig among the broadfunctional areas of national interest.

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5.30 Under the present expenditure budget system, there is an undue emphasis on thelimited flow of funds to government in the short-term and inadequate weight given to the mediumterm economic outlook and the policy options available to government to modify cash flow underalternative scenarios. This myopia tends to obscure the important choices that have to be madebetween achieving in the medium term the appropriate mix among taxing, borrowing and spending.On the other hand, by placing these issues before Congress squarely and unequivocally it may bepossible to secure a higher degree of public and Congressional commitment to the spendingpriorities and the macroeconomic parameters within which annual expenditure budgeting takesplace.

5.31 Taking these into account, recommendations are made here establish a three-yearfiscal framework and a resource allocation consistent with the framework (called a developmentprogram), which would be tabled to the Congress. Reforms in budgetary operations managementand organizational arrangements are also discussed and recommended.

Fiscal Framework

5.32 It is recommended that the National Government adopt a tlhree-year FiscalFramework, which incorporates quarterly projections of: fiscal revenues, expenditures (capital andcurrent), deficit, net loans and advances and net cash requirements. The Fiscal Framework shouldbe updated every quarter, probably every time new national accounts quarterly data is available.(Perhaps the same projections should also be provided on a national accounts basis in addition to agovernment accounting basis to avoid debate about alternative statistical concepts). The netfinancing requirement projections should not simply be derived arithmetically from projections ofthe other items: the Executive must assess the appropriate and sustainable amount of centralgovernment borrowing in the light of emerging economic circumstances, and prudent debtmianagement. Guarantees and other contingent liabilities also have potential real costs attached tothem. The Fiscal Framework and annual budgets need to incorporate these costs explicitly (seeAnnex to this Chapter).

5.33 The Fiscal Framework should be the subject of a Joint Resolution of the Congressat the beginning of the term of every Congress and prior to each tabling of the President'sExpenditure Budget. The Executive should give the reasons for past deviations from theFramework and for modifications in the future. These modifications should be voted uponannually.

5.34 The executive should establish assumptions underlying the Framework inconsultation with the BSP. These parameters include: inflation rate, foreign exchange reservelevels, exchange rate, government cash balances, unemployment rate, and income growth rate. TheExecutive and BSP should carry out sufficient macroeconomic analysis (probably within aframework of a consistent economy-wide model) to be able to specify these assumptions asobjectively and reliably as the state of our understanding permits. It would be prudent to publishthret alternative scenarios together with assumptions when the Framework is tabled at theCongress: a high scenario, a low scenario and the most likely scenario.

5.35 One or more independent institutes and business associations should be encouragedto make public forecasts of these conditions on a regular basis. This will serve to educate the

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commiiunity concerning the factors that affect the mid-term economic outlook. Moreover, theavailability of this information will provide an imiportant check on the Executives assumptions.

5.36 The Fiscal Framework (in particular, the most likely scenario) should be based onexisting tax rates and structures, and the Executive should not raise the allowable expenditures in acurrenit Framework on the assumption that their proposed tax measures will be approved by theCongress. However, a proposal for a tax reform should be accompanied by a revised FiscalFramework that would take into account the changes in revenue that are expected to result from theproposed reform. By the saute token, measures introduced in the Congress that would alter theprojected flow of revenues relative to the existing system should be debated in the light of theirprobable eftects on the Fiscal Framework.

5.37 The Executive would be encouraged to be prudent and should allow sufficient cashreserves on hiand to finance all approved expenditure appropriations when the projected budgetaryrevenues fall short of the amount projected in the most likely case Framework. Should actualrevenues exceed those of the worst case scenario, supplementary appropriations could then beintroduced in the course of the fiscal year.

5.38 If the concept of the Fiscal Framework were implemented as described above, thepossibility of revenue shortfalls and subsequent cash rationing should be substantially reduced. Asdiscussed above, rationing of cash has been the "real" expenditure budget system. This method ofbudgeting is perverse from the point of view of facility maintenance and project implementation.Operational departmiients adopt a defensive strategy of reducing maintenance and delaying projectsto ensure that they have the cash to pay future wages and salaries. On the other hand, cashrationinlg increased the autlhority of the Executive to deny funding for projects and programs that itdid not approve. The Executive will be forced to be more forthright in resisting expenditures forprojects that it does not want to proceed. The Presidential veto is available for just that purpose.

Development Programming

5.39 Based on the available funds for capital and recurrent expenditures within the FiscalFramework, responsible central department(s) should carry out development programming. Thisactivity will determinie resource allocation so as to maximize the rate of growth of per capitaincomiie of Philippine residents while taking into account the needs to alleviate poverty and toprogress towards equality of opportunity.

5.4(0 This activity comprise: (i) evaluating and proposing modification in the proposals ofnew and existing projects and programs prepared by line departments; and (ii) proposing toCongress the allocation of funds among major functional categories including operations andmaintenianice, within the constraints specified in the Fiscal Framework. Congress would be askedto approve this allocation, perhaps after modification, and accept the constraint that additionalappropriations made by Congress must be financed by reductions in appropriations within the samefunctionial category. This would serve to reduce the circumvenltion of Presidential priorities bydepartmiienlts and agencies appealing directly to members of Congress.

5.41 For capital spending, a distinction needs to be made between routine, relatively lowcost, pr-ojects and unique and larger projects. The former would include, say, school buildings and

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health clinics. Here Development Programming would be concerned with establishing, for eachtype of investment common formats for proposals, determining evaluation criteria and establishingrules of thumb in the use of these criteria. For unique projects over a certain cost it would benecessary to proceed on a case by case basis: each requires its own cost-benefit analysis conductedaccording to the best international practice. The Executive needs the capacity to critically evaluatethe proposals submitted by operating departments, taking into account potential economic returns,the relationship with private sector activities (does it complement or substitute the private sector?),maintenance expenditure implications, and operating departments implemelntation capacity.

5.42 Development programming needs to go beyond proposing the allocation of availablefunds among broad government functional categories, for example, education, health,transportation. The appropriate allocation depends upon the cost effectiveness built into the designof the programs and the weight to be attached to competing programs withill the same functionalcategory, e.g. preventative health care vs. curative care, and primary education vs. secondary andhigher education.

5.43 Congressional Insertions Congress will be asked to discuss and approve the FiscalFramework and the Development Program, at the beginning of each congress (i.e. every threeyears) and as updated annually before the budget thereafter. It should also be known that thecongressional changes that are inconsistent with the Framework and the Program will be vetoed.The responsibilities assigned to local authorities should be clarified so there is no ambiguityconcerning them. The president should also announce his intention to veto all insertions of projectexpenditures that relate to local authority responsibilities. It is imperative that these vetoes beexercised with an even hand without regard to political affiliation.

5.44 The criteria established by the Executive (with Congressional approval, preferably)for thc assessment of small, routine projects should be promulgated and the President should makeit cleaf to the Congress in advance that the same criteria will be applied to Congressional insertionsas to those originating in the executive. Furthermore, Congressional insertions involving majorprojeuts would each require an in-depth cost benefit analysis, perhaps carried out by anindependent consultant(s), and the resulting report would be subject to Congressional hearings.

Operational Management

5.45 Once the Fiscal Framework and Development Programming are in place, annualhudgets should be prepared and implemented efficiently--a task of Budget OperationalManagement Group. Operational Management is concerned with the acquisition of inputs at thelowest possible cost, maximizing the operational efficiency with which these inputs are convertedinto efficient delivery ol desired government services to the targeted clientele.

5.46 Operational management is therefore responsible for: (i) preparation of budgetproposals to implement the Development Program; (ii) establishing rules for personnelmanagement and incentives together with the Civil Service Commission, and for procurement ofmaterials and supplies and government contracting; and (iii) monitoring the operationalperformance of other departments and ensuring that efficiency in production and distribution isachieved. In this last regard, the GOP needs to decide which of COA or the OperationsManagement should have the core capacity to conduct management audits.

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5.47 The use of the baseline budget concept for programs should be continued: this is thereal cost (i.e. net of changes in the level of wages/salaries and prices) of providing the same qualityand quantity of outputs to the same types of clients. In short, the only adjustments in the baselineexpenditures from year to year are the change in the size of the clientele as a result of changes inpopulation, internal migration etc. as offset, in whole or in part, by planned changes in operatingefficiency. There should be prior agreement between the operating department and theOperational Manager concerning the projected growth rate of the operating departments baselinebudget expenditures over future years. With this information on ltnd the Operations Manager caneasily project the future cost of programs assuming no policy changes. By aggregating theseprojections across all departments the relatively fixed portion of the expenditure budget is known.When necessary to accommodate new programs or enriched existing programs, it may be necessaryto introduce across the board or preferably selective cuts in baseline budgets through theconstraints specified in the call letters to operating departments.

5.48 Budget proposals submitted by operating departments should state the agreedbaseline budget for the year and the proposed changes from that amount and the reasons for thechanges. A distinction should be made between proposed policy changes that involve changing thetype or quality of the outputs or changes in the type of clients from operational changes that willchange the method of production or distribution of outputs. The former changes must be assessedin terms of the Development Programming; the latter changes must be assessed againstconventional business criteria: what cost savings are to be effected over what period of time.

5.49 Capital expenditure proposals should be accompanied by estimates of the futurerecurrent costs involved. Before capital projects are approved, agreements should be reachedconcerning the financing of these recurrent costs: are they to be added to the baseline budget inwhole or can some be absorbed, i.e. offset by cuts in other programs or by increasing operatingefficiency.

5.50 Operational Management need also to monitor implementation of activities, as partof preparation of periodical management audits. As such, all major projects should be monitored,not only the foreign assisted ones as is currently done. When it is found line departments aresubstituting projects agreed under Fiscal Framework and Development Programming with theirfavored projects, thereby subverting the President's priority, discipline on the department headsand those responsible should be swift and substantial.

5.51 Accounting system There is a need for a computerized accounting system definedin a manual, and operating departments must be staffed with qualified accountants capable ofimplementing that system. The same system should be prescribed for local authorities to permitconsolidation of data. The coding system must retain enough detail to allow classifications byactivity, program, object of expenditure, responsibility center and geographic location of the inputs. id outputs. It is important that the coding system be flexible enough to accommodate changes inprogram design and organizations yet yield consistent data over time at a fine level ofdesegregation. Expenditures should at least be classified as proposed, recommended, appropriated,authorized. comrmitted and actual. The computer system must be robust with much backup andaccessible to poorly trained personnel.

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5.52 In accounting, the Philippine budget is carried out in nominal terms. This couldcause some confusion especially in a multi-year activities. It would be better to requestdepartments and agencies their budget proposals expressed in real terms in the Budget Call Letter.Inflation adjustments can be made later by the Operational Management.

Budgetary Control "

5.53 Once this framework is established, there would seem to be no need for furthercentral control of budgetary resource releases. That is, if the availability of cash is not aconstraint; an agreement has been reached between DBM and each operating department withrespect to the future changes in its base budget; and procurement is governed by acceptable rulesand procedures, the auditor is probably the only protection against the use of funds for purposesother those designated in the appropriation. Thus the whole WFP-AA-NCA (or ABM-GARO/SARO-NCA) procedure would seem to be unnecessary for recurrent spending. Allappropriations included in the General Appropriations Act should be guaranteed funding forrecurrent expenditures as required by the departments and agencies.

5.54 For capital spending, funds may be appropriated in advance of design andassessment. There would appear to be a continuing need for WFPs for each of these projects, atleast those projects above a certain Peso value, and for control of commitments tied to thecompletion of stages of plan development and construction. The Government is addressing thisissue through issuance of SAROs for these projects.

5 55 This may provide a method of achieving co-ordination among agencies. The formof the WFP could be specified so that certain stages are explicit. Thus funds are released fordesign with responsibility assigned to the originating department; the second stage would requireoperational management checks on costing and responsibility would be assigned to OperationalManagement; the next stage would be economic and financial evaluation and this be theresponsibility of development programming. If the proposal passes these stages then the onus is onthe originating department to proceed. The originating department and the OperationalManagement devise, on a case by case basis, the series of benchmarks that would trigger paymentsto the contractor as work proceeds or investigations when progress is behind schedule.

Organizational Arrangements

5.56 There are three tasks to be performed: fiscal management including the preparationof the Fiscal Framework; economic policy formulation, including the preparation of theDevelopment Program; and Operational Management of the Budget. Although outside the scope ofthis paper, to these might be added legislative management and intergovernmental relations(consisting of local governments on the one hand and foreign governments on the other). All ofthese tasks might be called staff/headquarters functions, as distinct from line/operational functions.All are involved in the control/command/direction of operating departments or in negotiatingarrangements with the legislature or other governments. Generally speaking their relationships arewith other government officials (elected or appointed) rather than with the general public.

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5.57 These headquarters functions are highly interdependent. Yet each calls for a highdegree of specialized knowledge. How then should responsibilities be allocated among specializedorganizations while maintaining consistency and coherence? The method of achieving co-ordination often employed in the Philippines is through the establishment of committees. This,however, is not very efficient unless a unanimity rule is always enforced. Otherwise, each membercan deny responsibility for any cormmittee decision. It is thus better that responsibilities beassigned to the individual officers in charge of separate organizational units than to committees,although consultation with those carrying out related responsibilitieg should be mandatory.

5.58 Among the three headquarter functions, those who establish the Fiscal Frameworkand Development Programming should work very closely together due to the nature of the tasks.If these two functions should have to be divided organizationally, it needs to be made clear that thefinancial constraints, which are dominated by macro-economic considerations, were absolutelybinding on development programming. Operational management, together with project monitoringand management audit capacity, should probably be separate from the other two organizationally.

ANNEX TO CHAPTER 5

RECOGNITION AND MANAGEMENT OF CONTINGENT AND OTHERLIABILITIES

Introduction

1. In recent years, many governments throughout the world have suffered from fiscalrestraint. As a consequence, these governments have turned to new financial instruments and morecreative financial mechanisms to pursue their policy objectives and to undertake their programswith the limited resources available to them. Amongst these new instruments are loan andperformance guarantees offered to the private sector to encourage public-private partnerships.Since encountering an energy crises in 1992 and 1993, the Government of the Philippines, throughthe National Power Corporation, has used these types of guarantees to encourage infrastructuredevelopment, particularly power generation facilities under "Build-Operate-Transfer" (BOT) andsimilar arrangements, and there is a likelihood that the use of these guarantees will be extended infuture to other infrastructure projects such as ports, toll roads, and gas pipelines. To the end of1994, the government's exposure through these guarantees may have amounted to near $10 billion.

2. Because loan and performance guarantees do not require an immediate cash outlay by agovernment, there is a tendency to view them as an inexpensive way to provide financial assistanceto the private sector to encourage that sector to undertake activity in keeping with governmentpolicy objectives. However, it must be clearly recognized that loan guarantees have a cost, andexperience of some countries has shown that, in the long run, loan guarantees can be veryexpensive. As a consequence, it is essential that appropriate management practices and controls beimposed on these instruments and that sufficient safeguards be built into the budgetary process toavoid large future losses which could prevent the government from reaching its fiscal targets.

3. In addition to direct loan and performance guarantees, the Government of the Philippines,either directly or through its agencies and state owned corporations, has incurred a number of othercontingent and direct liabilities which do not require any immediate cash outlay. Examples includeliabilities associated with social security institutions (SSS and GSIS) and liabilities associated withagrarian land reform. As is the case for loan guarantee liabilities, these liabilities need to beproperly managed, accounted for and reported in order to avoid future shocks to the government'sfiscal plan or framework. The importance of good management and control of these liabilities isunderscored by the fact that the two social security institutions are found to be financially unviablein the long term under the current terms of contributions and benefits, and with current operating

practices . Also, P 2 billion of guarantees related to agrarian land reform is expected to increaserapidly and could reach as high as P 10 billion in the near term.

4. This annex reviews the definitions of these instruments, examines methods to manage andcontrol their costs in the context of the government's fiscal plan and budgetary targets, andrecommends accounting for and reporting of these liabilities in order to complete the accountabilityloop.

"Philippincs--An Agenda for the Rcform of Social Security Institutions" World Bank. October 12, 1994

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Definitions

5. To assure full comprehension of the issues discussed, there must be a commonunderstanding of the words and terms used in this paper. Abbreviated definitions of some of theseterms follow. The attachment at the end of this annex has a more extensive description of theseterms.

* Liabilities - obligations to outside parties resulting from past txzansactions.

* Contingent liability - a liability that is dependent on some future event that may or may notoccur.

* Actuarially determined liabilities - liabilities related to future events that are virtually certain -not a contingency.

* Disbursements or outlays - amounts of money actually paid out.

* Expcnditures - costs incurred that have been paid for, or will be paid for in the future.

* Costs - both expenditures and non-cash expenses incurred to undertake an activity.

* Reserves - allowance and provisions - amounts set aside to meet future payment requirements.Usually recorded as a liability rather than money placed in a separate bank account.

Management and Control of Contingent Liabilities

(a) Objectives

6. Loan guarantees have a cost. Therefore, an objective of any government should be toimpose appropriate management practices and controls on these instruments to control these costs,and to ensure that sufficient safeguards are built into the budgetary and expenditure process toavoid large future losses which could prevent the government from reaching its fiscal targets as setout in its fiscal plan.

7. A process for management and control of loan guarantees and other contingent liabilitiesshould incorporate a control mechanism which will influence decision-making. Decisions to incurcosts, such as entering into loan guarantee agreements, must have immediate fiscal consequences,otherwise governments will have little incentive to use guarantees judiciously and effective controlsover their use will be weak. A proper fiscal management process, which incorporates agreed uponfiscal parameters or spending limits established at the beginning of the year, must be in place togovern spending decisions. Such a fiscal management process has been recommended in Chapter 5and includes appropriate operational planning, budgeting, accounting and reporting functions.

8. As explained in the definition of a liability, expenditures for loan or performanceguarantees should only be recorded in the year in which the cost is identified. For purposes of thisdiscussion paper, it is assumed the cost is identified at the time the guarantee is issued.

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(b) Budget and expenditure management process

(i) Existing process

9. As noted in Chapter 5, under the existing budget and expenditure management process usedby the Government of the Philippines, rationing of cash has been the "real" budget and expendituremanagement process. Appropriations, while representing the legal limits to government spendingas enacted by Congress, significantly exceed cash availability and Therefore have ceased to beeffective in limiting government spending. The only control on spending is the availability of cash.

10. As explained above, the issuing of a loan or performance guarantee incurs a cost but thatcost has no immediate cash requirement. Due to this absence of a cash requirement, control overthe guarantee falls outside the purview of the "availability of cash" control mechanism and,therefore, guarantee decisions are essentially uncontrolled by the budgetary process.

(ii) Requirements of a revisedprocess

11. To be effectively controlled, loan and performance guarantee costs must be treated asexpenditures in the year guarantee arrangements are entered into and these expenditures must fallwithin congressionally approved spending limits or appropriations. To properly control allspending, the Government of the Philippines must implement an effective budgetary andexpenditure management process as outlined in Chapter 5, incorporating key fiscal targets, such asrevenues, expenditures, deficit and borrowings. These targets should be agreed to by thoseauthorities involved in the spending process and enacted into law by Congress.

12. As noted in Chapter 5, revenues should be a realistic estimate of actual collections, and theexecutive should be required to operate within expenditure limits in order to achieve the targeteddeficit. Since Congress authorizes the executive to incur expenditures by appropriating funds, theappropriation limits allocated to Ministries should become the key control mechanism for spendingdecisions.

13. As stated in the definitions above, the issuing of a loan or performance guarantee incurs anexpenditure which should form part of the annual expenditures charged to an appropriation. In thisway guarantee costs, or expenditures, incurred by issuing a guarantee use up availableappropriations and are limited by the authority to spend money as vested by Congress.

(iii) Types of appropriations

14. While the foregoing enunciates the basic principles of congressional control over spending,including spending arising from the issue of guarantees, in reality governments use more detailedmechanisms to impose authorities and limits. Appropriations are frequently divided into varioustypes so that Congress may direct expenditures more specifically. For this reason, separateappropriations for operating expenditures, for capital expenditures, for grants, for specific projects,etc. are created. If Congress wishes to impose limits on annual loan or performance guaranteecosts, a separate appropriation within the fiscal expenditure plan can be established for thispurpose; or a number of appropriations distributed across different ministries or different sectors ofthe economy could be created. Nevertheless, no matter how appropriations are structured, issuing

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a guarantee incurs a cost which must be covered by an appropriation. This basic principle shouldremain rigidly in force.

(iv) Managing contingent liabilities through the budget

15. Instead of providing for the cost of guarantees as an expenditure against an appropriationwhen the guarantee is issued, or when a change in provision is required, an alternative method ofmanaging these costs is through the budget process. This method calls for a reduction in thespending authority or appropriation limit to offset the estimated eventual cost of the guarantee.Reducing spending authority forces the ministry responsible for administering the appropriation tospend less on other activities. The costs of the guarantee would be recorded by a central agency,such as the Department of Finance, rather than by the ministry directly involved.

16. The advantages of this process are two-fold. First, should higher costs need to be recordedin a year subsequent to the year of issue of the guarantee due to failure of the debtor, the increasein costs would be absorbed by the central agency rather than by the ministry involved. This wouldobviate the need to disrupt the financial plans of the ministry in that year due to an action that tookplace in an earlier fiscal year.

17. The second advantage to managing through the budget is that it allows the central agency tomonitor and manage all of the government's contingent liabilities in a uniform and consistentmanner by specialists. This should ensure that objective and high standards of management areapplied to all guarantees.

18. The disadvantage of this process is that the government ministry responsible for thecreation of the guarantee is never accountable for its disposition.

19. Managing through expenditures or managing through the budget are both acceptableprocesses and both will be successful if the government has the will and discipline to apply themvigorously.

(c) Valuation

20. Attributing a cost to a loan or performance guarantee may be a difficult task, butnevertheless it is an important function in the management and control of these instruments. Theamount of this cost, which serves to use up funds available for spending in an appropriation, willinfluence decision-making of managers who are responsible and accountable for appropriations.

21. Various techniques and methods may be used to estimate expected losses on guarantees.The parameters of the guarantee will indicate, to some extent, the amount of the needed provision.Estimations of losses should take into account the principal amount of the loan guaranteed or themaximum exposure to the government under a performance guarantee. Accrued and unpaidinterest, amounts recoverable from the borrower, and value of assets pledged as security areamongst other factors be considered. In some cases, market information may suggest a valuation.Market valuations are discussed in Mody and Patro, (World Bank, March 1995). In othersituations, loss estimates may be made by reference to

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(a) recent financial performance of the borrower as disclosed in financial statements,

(b) economic conditions which may affect the borrower,

(c) independent credit reports,

(d) adequacy of security pledgedfor loans which have been guaranteed, and

(e) recent collection experience on the loans and related interest.

22. Measurement techniques can include statistical models, historical rates and trends, andspecific information on the borrower or the project. Notwithstanding the techniques used, the finalassessment will depend on judgment of government officials to a considerable degree.

(d) Timing of Expenditure Recognition

23. One key issue in accounting for loan and performance guarantees is assessing when aprovision for losses should be recognized as an expenditure and a liability. Proper accountingtreatment requires recognition of losses when it is determined that they are likely. In virtually allcases, it is known that a loss is likely at sometime before the government must make payment on aguarantee and, in some instances, it is known at the time the guarantee is issued. Frequently, thelikelihood of payment becomes evident during the life of the guarantee.

24. Notwithstanding when an initial estimate is recognized, estimates require reappraisal as newevents occur, as more experience is acquired, or as additional information is obtained. Changes inthe circumstances of the borrower may require changes to the provision for losses. Changes in theprovision may be either increases or decreases. As a general principle, the provision for losses onloan guarantees should be reviewed on an ongoing basis and any changes should be charged orcredited to expenditures of the year in which the change occurs.

(e) Minimizing losses

25. For any government that issues loan or performance guarantees, reducing risks andminimizing potential losses is a prime concern. An important way to reduce risk is to share it withthe party being guaranteed. A government can achieve this by guaranteeing only part of a loan,say 75 percent, forcing the lender to bear the risk on the remaining 25 percent. Besides reducingany future losses by 25 percent, this sharing forces the lender to thoroughly assess potential leansand to not lend money for excessively high risk cases. This enables the government to indirectlyuse the credit assessment expertise of a lender to its advantage.

26. Other risk-reducing techniques include obtaining project assets as security in the event ofguarantee payout, and charging loan guarantee fees.

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Management and Control of Actuarially Determined Liabilities

(a) Objectives

27. Actuarially determined costs and liabilities relate to insurance and pension plans where cashpayments are frequently made many years after the costs and liabilities are incurred. Agovernment should aim to impose management practices and contrqls on these costs and liabilities,and to build sufficient safeguards into the budgetary process to ensure that these costs areaccounted for in the multi-year fiscal plan.

28. As is the case with loan guarantees and other contingencies, a process for management andcontrol of pension and insurance plan costs should incorporate a control mechanism which willimpact on decision-making. Costs must be accounted for when incurred and expenditures must berecorded against appropriations at that time.

(b) Budget and Expenditure Management Process

29. The principles for budget and expenditure management for pensions and insurance costs arethe same as those outlined in section (6) on page 86. These include establishment of a fiscal plan,legislative authorization of spending (appropriations) within that plan, and recording ofexpenditures as costs are incurred leaving less spending available for other activities.

30. Annual costs related to pension and insurance plans represent the value of benefits earnedby employees and other plan members during a fiscal year. Since plan members often contribute tothe costs of the plans, government costs equal the total value of benefits earned less contributionsof the plan members. Generally, actuarial assessments of these plans are made on an annual ortriennial basis to establish the amount of the government's annual contribution, and this amount isusually recorded as the government's cost. This amount should be charged as an expenditureagainst appropriations.

31. Actuarially determined costs and liabilities related to pensions require two additionalconsiderations:

(i) plan amendment costs, and

(ii) fluctuations in liabilities caused by changing economic and demographicassumptions used in the actuarial estimates. These can result in experience gainsand loses.

32. A plan amendment occurs when a plan is changed and retroactive credit is given to planmembers for services rendered in the past. For example, a benefit formula may be improved for apension plan or insurance coverage may be increased resulting in higher claims. Plan amendmentsmay have a cost. This cost together with the resulting increased liability should be accounted forby the governnent and charged against an appropriation in the year the amendment is made. Thehigher costs arc the result of a decision to improve benefits and a full accounting of the cost shouldbe made in the fiscal year in which the decision is made.

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33. The periodic actuarial valuation of a government's pension liability will usually determinethat estimation adjustments are required due to experience gains and losses or to changes inactuarial assumptions. Estimation adjustments are inevitable because the actuarial valuationrequires ongoing forecasts of uncertain future events. These adjustments can be sufficiently largeto materially affect the achievement of targets set out in the fiscal plan. Therefore, adjustrnentsshould be amortized over a reasonable future period because of their tentative nature and becausefurther adjustments will likely be required in the future.

34. For amortization of estimation adjustments, a reasonable future period could be related tothe number of years which members of the pension plan have remaining as contributors.Spreading these costs over a number of years should smooth out the annual fluctuations of costsand diminish distortions in the fiscal results.

Accountability

(i) Reporting and confidentiality

35. A govermnent demonstrates its financial accountability to elected representatives and thepublic through financial and performance reporting. Generally, this reporting should disclosesufficient information on outstanding loan guarantees and their related provisions, on othercontingent liabilities and on actuarially determined liabilities to allow Congress to judge thegovernment's management of these obligations. The costs should also be reported relative tocongressionally authorized appropriations.

36. However, disclosing provisions for losses on loan guarantees and other contingencies mayresult in commercially sensitive information entering the public domain. This could be detrimentalto the financial position of both a borrower and the government. It is therefore recommended thatthe government give careful consideration to the extent of information made public and, ifpractical, present only highly aggregated figures.

(ii) Audit

37. Because the government may disclose only summarized information on loan andperformance guarantees, it is essential that detailed information be subject to independent auditscrutiny. Provisions are frequently based on subjective judgments and may be influenced byfactors unrelated to expected losses on outstanding guarantees. Independent audit can provideCongress with assurance as to the credibility of guarantee costs and provisions or, if ihe auditor isnot satisfied with them, he can report accordingly to Congress. The audit function completes theaccountability process.

Conclusion

38. Loan and performance guarantees have become significant tools that governments use toachieve policy objectives. These guarantees have a cost which should be recognized, accounted forand reported as part of the fiscal management and control regime of a government. The sameapplies to actuarially determined costs and liabilities where cash payments may be made manyyears after the costs are incurred. Pension and insurance plans are examples.

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39. To properly develop control mechanisms over these types of costs, a stable fiscalmanagement process incorporating the budgetary and expenditure cycles and fiscal targets shouldbe in place. The elected Congress should authorize realistic spending ceilings throughappropriations. Guarantee, pension and insurance costs should form part of spending limited byappropriations so that issuing guarantees or amending pension or insurance plans will represent aspending decision. A government manager must judge these spending decisions relative toavailable resources and other spending options. The government must impose a high level ofdiscipline over this process to ensure it functions as designed.

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ATTACHMIENT

DEFINITIONS

(a) Liabilities

In accounting terms, liabilities are financial obligations of a government to outsideorganizations and individuals as a result of transactions and events occurring on or before the year-end. They are the result of contracts, agreements and legislation in force at the year end whichrequire a government to make future payments related to transactions or events which have alreadyoccurred.

It should be noted that accounting for a liability effectively recognizes that an expenditurehas been incurred, an expenditure which must be included in the determination of a government'sannual deficit.

In relation to guarantees, the transaction or event giving rise to a future payment is the actof entering into a guarantee arrangement. If it is determined that this guarantee has a cost (seeSection 6 below), that cost in the form of an expenditure should be recorded in the accounts of thegovernment in the year the cost is identified. This may be the year in which the arrangement isentered into or a subsequent year.

(b) Contingent liabilities

A contingent liability is a liability that is dependent on some future event that may or maynot occur. Any future payment on a contingent liability is uncertain as at the reporting date andcosts should only be recorded if there is a likelihood that a payment will eventually be made. Ofnecessity, assessment of amounts to be recorded under contingencies requires judgment andestimations. However, the mere fact that an estimate is involved does not preclude the recognitionthat a cost and liability have been incurred nor the reporting of this cost and liability in financialstatements.

A government guarantee that the "rules of the game" will not change during the life cycleof a project is a form of assurance to a project sponsor and is entirely under the control of thegovernment. In this regard, changing the "rules" and any costs related thereto are not actions thatare "contingent" or "dependent" on some uncontrolled future event. Therefore any costs associatedwith changing the rules should only be recognized in the year when the change takes place and nocontingent liability is created by simply issuing assurance.

(c) Actuarially determined liabilities such as insurance and pensions

While future payments under some contractual arrangements depend on future events, thereis virtual certainty that these events will take place, particularly if these arrangements involve alarge number of individual contracts as is the case for life insurance and pension plans. These

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future payments are not considered to be "contingent liabilities; they are generally treated asdefinitive obligations.

Because future payments are dependent to some extent on mortality rates, demographicsand economic forecasts, estimating these liabilities requires an actuarial valuation, and thereforethey may be referred to as actuarially determined liabilities. They should not be considered ascontingencies.

(d) Government budget and reporting entity

Many governments operate a general fund into which all revenues are credited and againstwhich all expenditures are charged, and for which the government's budget is prepared. Inaddition, governments frequently create a number of agencies or state-owned corporations to whichfunds are transferred from the general fund but whose operating transactions are not recorded inthe general fund. This structure gives rise to "off-budget" transactions. An example would beloan guarantees issued by the Land Bank of the Philippines or performance guarantees of theNational Power Corporation. While the legal structure of these entities clearly distinguishes themfrom the core government (as defined by the general fund), many of them are financially dependenton the government and, in substance, form part of government activity.

To properly manage and control the financial transaction of these organizations whichsubstantively form part of government, and to ensure they are adequately accountable to thecountry's elected body, the government's budget, which is approved by the elected legislature,should encompass these entities. This is not to mean all government owned or controlled entitiesshould form part of the budget and reporting entity, but those which are financially dependentshould be fully consolidated with the government for budget and reporting purposes. Stateenterprises which are financially self-sufficient may be excluded. However, as a rule of thumb,those organizations which derive more than 20 percent of their operating revenue (or costrecovery) from the government should be treated as "government" for budgetary and financialreporting purposes. In this way, financial activities of these organizations which impact the fiscalplan and future fiscal targets will be subject to the same congressional and executive control as"core" government.

Furthermore, for those organizations which appear to be financially self-sufficient butwhose obligations are guaranteed by government, the government should recognize as expendituresany of their liabilities which are expected to be repaid by the government as soon as repayments areidentified as likely.

(e) Disbursements (outlays), expenditures and costs

These terms are frequently used interchangeably to describe government spending.However, when elements of accrual accounting are introduced into government financial reporting(<uch as recognizing contingent liabilities or unfunded pension obligations), it is important todistiinguish amongst them.

Disbursements or outlays refer to amounts of money actually paid out by a governmentduring a fiscal period. Under traditional governmnent cash accounting, disbursements are

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synonymous with expenditures and were deducted from revenues to determine the annual surplusor deficit.

Expenditures represent costs incurred by a government as a result of a transaction oreconomic event. They are paid out, or will be paid out in future, in the form of cash. It isimportant to note that a payment related to an expenditure need not actually be made in the year inwhich the expenditure is recorded. For example, assets physically acquired in the month before ayear-end may not be paid for until the first month of the new year.\ Nevertheless, the expenditurerelated to the acquisition of these assets should be recorded in the old year, when the assets wereacquired. Similarly, expenditures related to contingent liabilities such as loan guarantees should berecorded when that contingency is incurred, even if payment is not made for several years.

The term cost generally means both expenditures and non-cash expenses incurred toundertake an activity. An example of a non-cash expense is depreciation of capital property.

(f) Reserves, allowances and provisions

The terms reserves, allowance and provisions are frequently used interchangeably to denotean amount set aside to meet future payment requirements. They sometimes suggest that cash isphysically transferred to a separate bank account or fund to provide a source for these futurepayments. While this process may, in fact, happen (usually for employee pension funds which aremanaged independently of the employer), the reality is that these reserves are usually "notional".

In a well-developed accounting and financial reporting environment (which goes beyondsimply reporting cash receipts and cash disbursements), revenues due, costs incurred, assetsacquired and liabilities incurred are accounted for and reported. Reserves, allowances andprovisions usually denote a liability incurred by an entity (government) for a cost which does notrequire an immediate cash payment. A reserve or allowance for a loan guarantee is an example.In reality, when a government incurs a cost not immediately requiring cash, this cost serves toreduce other cash expenditures authorized to be made out of an appropriation for a budget year andeffectively results in the government needing less cash for that budget year and hence lessborrowings. This should increase the government's borrowing capacity in future years when,presumably, loan guarantee claims will be called and paid. Thus the "reserve", "allowance" or'provision" represents a balance sheet liability and may be viewed as unused borrowing capacity.

(g) Fiscal plan or fiscal framework

The fiscal plan or fiscal framework is described in Chapter 5. It is a multi-year (usuallythree to five-years) projection of revenues, expenditures and resulting deficits (or surpluses) tiedinto cash requirements and borrowings. k is a planning tool and represents fiscal targets whichdetermine the government's planned spending in keeping with longer term fiscal responsibility.Fxpcniditures of the first year of this plan should directly relate to the current year appropriations.

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Philippines Public Expenditure Management for Sustained and … · Report No. 14680-PH Philippines...

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Transcript of Philippines Public Expenditure Management for Sustained and … · Report No. 14680-PH Philippines...