Thursday, June 16, 2016

Structural and Governance Reform of the Philippine Pension System

World Bank ASEM Trust Fund Project (TF052298)

Contract No. 7138110

Final Report

Submitted by The Services Group (TSG) August 31, 2006

(Revised March 2007)

EXECUTIVE SUMMARY

The Government of the Philippines faces an important fiscal, demographic, and political window of opportunity to improve the structure and governance of its pension system so that the system is more adequate, affordable, sustainable, and robust. This report is intended to assist such reforms.

The Philippine pension system consists of several components: The Social Security System (SSS) and the Government Services Insurance System (GSIS) provide pensions and related programs to private- and public-sector workers, respectively. (Some civil-service workers have schemes separate from GSIS, such as the Armed Forces of the Philippines Retirement and Separation Benefits System, AFP-RSBS, for the military.) Additionally, private and public workers contribute to the Home Development Mutual Fund (HDMF, also known as Pag-IBIG). Private firms, commercial banks, insurance companies, and Pre-Need companies also provide various pension-related programs. This set of institutions is successful in many respects in providing pensions to the population. Nonetheless, the system suffers from a number of weaknesses:

Investment decision-making is not sufficiently robust or protected from political processes.

Pension assets are insufficiently diversified and not well matched to risk/return needs.

Supervision, regulation, and auditing are fragmented and in some instances inadequate.

The mandatory system provides replacement rates that are too high given policy objectives, threatening fiscal sustainability and necessitating onerous payroll tax rates.

Benefit formulas are not harmonized and equitable across ages and participant categories.

The defined-contribution, fully-funded element of the pension system is quite small.

Taxation is not harmonized or consistent.

Administration in some respects needs improvement.

The system provides limited coverage – not sufficiently reaching poor elderly.

The following key recommendations are made by the report:

The governance institutions of SSS, GSIS, Pag-IBIG, and AFP-RSBS should be strengthened:

•

Members of SSS Social Security Commission, GSIS Board of Trustees, and other boards should have clear legal “fiduciary” responsibility to make decisions solely in the interest of members, and should be chosen through a selection process that ensures professionalism and protects from political interference.

• A professional Investment Board should be formed for each institution, to take specific investment decisions, under the broad investment strategy to be set by the governing board. Investment Boards similarly should have fiduciary responsibility and professional, depoliticized selection processes.

• Strict rules should apply to governing and investment board members regarding conflict-of-interest, financial disclosure, accountability, and transparency.

Investment processes should be further strengthened:

• Institutions should adopt explicit investment policies that set objectives regarding returns, risk management, types of assets, etc., in order to guide specific investment decisions.

• Institutions should solicit outside professional investment advice.

• Independent asset managers and custodians should be used.

• Investment restrictions should eliminate minimum limits, reconsider maximum limits, and prohibit inappropriate investments. Principles of overall risk management should guide rule making.

Investment portfolios should be better diversified and shifted out of inappropriate assets:

• Some investments should be made internationally to diversify beyond the relatively small Philippine capital market.

• Domestically, equity investments should be shifted toward pooled instruments such as an allocation matching representation in the Philippine Stock Exchange index, thereby reducing influence on specific share prices and avoiding the need to place members on corporate boards of directors.

• SSS, GSIS, Pag-IBIG, and AFP-RSBS should divest entirely of loans to members. Any new loan programs should be run by unrelated institutions without cross-subsidization. Pension institutions only should invest in such instruments through market-priced, arms-length transactions, for instance by buying freely traded mortgage-backed securities.

• A limit on investment in government bonds or loans should be set at no more than 30%. Institutions only should invest in tradable securities, not in government loans. Practices should change to permit trading of government securities between tax-exempt and non-tax-exempt entities.

Supervision should be unified and strengthened. A new Insurance and Pensions Commission, built on the foundation of the current Insurance Commission, should supervise SSS, GSIS, Pag-IBIG, AFP-RSBS, all private pension schemes, and any similar instruments.

SSS, GSIS, Pag-IBIG, and AFP-RSBS should be required to be audited annually by a private international audit firm experienced with auditing assets, liabilities and procedures of partially funded defined-benefit pension funds.

Replacement rates should be reduced gradually to 40-50% for SSS, GSIS and AFP-RSBS. This should apply to younger workers and new entrants, not to current retirees or older workers close to retirement. A uniform ceiling on wages should apply across all programs. Benefit formulas should be revised to provide more consistent rates of return for varying categories of members.

The contribution rate to SSS should not be raised any further. The contribution rate to GSIS gradually should be reduced somewhat, to the extent permitted within the constraint of maintaining financial sustainability.

The role of Pag-IBIG should be re-defined and gradually expanded, to provide a fully-funded defined-contribution pension. Initially, the cap on wages subject to contributions should be increased to the same level as SSS. Investment decisionmaking capacity would need to be improved, and Pag-IBIG should divest of member loans.

Taxation should be rationalized and harmonized, following an “Exempt-Exempt-Tax” model, treating similar instruments similarly, with a cap to prevent excessive tax avoidance by the affluent.

The Government should consider the merits of a universal or needs-based pension, paid from general state revenues, to complement existing pension programs, in order to expand coverage and reduce elderly poverty. An eligibility age of 70 or even higher should be considered. Poverty data needs to be improved to facilitate analysis of this issue.

The benefit formulas of military pensions need to be gradually reduced and harmonized with those of GSIS and SSS, affecting younger participants but not the current elderly. Investment processes need to be improved. Increased contributions to a reformed Pag-IBIG might be a good means for providing a larger share of military pensions rather than creating a new specialized fund for the military.

PERA legislation needs to be improved including ensuring sufficient caps on tax exemptions. Pre-Need supervision and regulation need to be strengthened and made consistent with regulation of similar pension instruments.

Pension reform needs to fit into a context of overall financial sector development. Only with greater financial sector development in parallel will the pension system itself be able to develop and gain access to increasing numbers of suitable investment opportunities.

An Action Plan is needed to move pension reform forward. Reforms requiring changes in legislation could be developed in draft form between now and Spring 2007 elections, to be considered by the post-election Congress. Reforms just requiring executive decision could be implemented sooner. Some reforms requiring greatly increased capacity would require more time; those just requiring policy decisions could be implemented sooner.

Part One gives summary recommendations, and Part Two presents supporting analyses. Chapter 1 of Part Two describes the programs of each pension and related institution and gives an overview of recent reform efforts. Chapter 2 reviews governance structures and investment decision-making processes. Chapter 3 examines the appropriateness of investments. Chapter 4 considers how to strengthen supervision and external auditing of pension institutions. Chapter 5 evaluates financial sustainability, projecting when SSS and GSIS expenditures will begin to exceed revenues and when reserves will be exhausted. Chapter 6 addresses inconsistencies and inequities in benefit formulas and replacement rates. Chapter 7 considers administration of programs. Chapter 8 deals with taxation issues. Chapter 9 analyzes demography, poverty among elderly relative to other age groups, and the extent of coverage of current pension programs. Chapter 10 considers options for increasing coverage through either a universal or needs-tested pension program funded from general revenues, not linked to previous contributions. Chapter 11 examines military pensions. Chapter 12 discusses issues related to Pre-Need, PERA, and other programs. Chapter 13 presents an Action Plan for reforms. Annex 1 identifies legislative and regulatory gaps. Annex 2 gives the presentations from an August 2006 seminar on pension reform. Annex 3 presents organizational charts of key pension institutions.

SUMMARY

RECOMMENDATIONS

I. INTRODUCTION

1. The Government of the Philippines is considering how to improve the structure and governance of its pension system so that the system is more adequate, affordable, sustainable, and robust. This report is intended to assist that effort. The report is prepared for the Department of Finance and the World Bank. It is funded by the World Bank ASEM Trust Fund (TF052298), Contract No. 7138110.¹

2. Part One of this report presents summary recommendations for improving the structure and governance of the pension system. Part Two of the report contains supporting analyses on which the recommendations are based.

II. BRIEF OVERVIEW OF THE PENSION SYSTEM

3. The mandatory pension system of the Philippines is comprised of several institutions. Private-sector firms are required to contribute to the Social Security System (SSS), which provides a pension at retirement and other insurance services. Similarly, most civil-service workers contribute to the Government Services Insurance System (GSIS). SSS and GSIS offer defined-benefit, partially-funded pensions.² Some civil -service workers (military, police, judges and local-government) contribute to their own schemes instead of GSIS. In particular, the armed forces contribute to the Armed Forces of the Philippines Retirement and Separation Benefits System (AFP-RSBS). AFP-RSBS is a defined-benefit, unfunded scheme, with an investment fund not directly related to contributions that is managed separately. Additionally, SSS, GSIS, and AFP-RSBS members also contribute to the Home Development Mutual Fund (HDMF, also known as Pag-IBIG). In addition to subsidized housing loans, Pag-IBIG provides a lump sum benefit after twenty years of affiliation, in a manner similar to a defined-contribution, fully-funded pension.

4. Contribution rates for SSS and GSIS members are shown in TABLE I.1.

TABLE I.1: Payroll Tax Rates

	Private sector firms			Government entities
	(SSS members)			(GSIS members)
	Employer	Employee	Total	Employer	Employee	Total
Social insurance contribution	7.07	3.33	10.4	12.0	9.0	21.0
Retirement pay	2.5		2.5	2.5		2.5
Employee compensation	1.0		1.0	1.0		1.0
Pag-IBIG	2.0	2.0	4.0	2.0	2.0	4.0
Total	11.57	5.33	16.9	17.5	11.5	28.5

5. A number of other institutions also play a role in pensions. Some private firms make contributions to pension schemes in addition to the SSS. Commercial banks, insurance companies, and Pre-Need companies manage employer-sponsored schemes and also can offer schemes directly to individual participants. Some employers manage their schemes themselves.

6. The pension system of the Philippines is successful in that it provides pensions to millions of elderly; it collects and invests contributions from millions of workers; it is financially sustainable in the short run; it achieves a policy objective in some cases of distributing resources to lower-income workers; and it has built a number of relatively efficient, complex administrative structures.

7. Nonetheless, the pension system of the Philippines has a number of weaknesses, some of which are as follows:

Governance weaknesses

• The processes for making investment decisions do not fully follow international best practices for serving the interests of participants in public pension funds.

• Investments of pension assets are not sufficiently diversified and in some cases are not made in the most appropriate instruments given the needs of participants for balancing return expectations and risk management.

• Supervision, regulation, and auditing of pension programs are fragmented across many institutions, and in some instances are inadequate.

Structural weaknesses

• For many participants, the mandatory pension system aims at replacement rates that are too high, given the pension system’s key objectives, such as ameliorating old-age poverty, and constraints, such as the need to ensure long-term fiscal sustainability.

• Payroll tax rates (including pension contribution rates) are often higher than desirable levels.

• SSS, GSIS, and the AFP-RSBS systems are not sustainable in the long term.

• Benefit formulas across institutions and for various types of participants are not harmonized across sectors and are not equitable. Participants of varying ages, lengths of service and income levels do not receive similar internal rates of return on contributions. The present system interferes with portability and therefore with labor mobility and efficient allocation of labor. Equity issues relate to both old-age and to survivor programs.

• The defined-contribution, fully-funded element of the pension system is quite small. World trends have been away from unfunded (or partially funded) defined benefit components, toward larger defined-contribution, fully-funded programs.

• Administration of pension programs in some respects can be improved.

• AFP-RSBS, Pre-Need, and certain other programs have weaknesses specific to them, which need to be addressed.

• The mandatory pension system provides very limited coverage—that is, it only reaches a small share of the elderly population, and in particular does not adequately reach the poorest of the elderly.

8. This report makes recommendations to remedy each of these weaknesses.

III. GOVERNANCE ISSUES

Governance Institutions

9. The Social Security Commission that governs SSS, the Board of Trustees that governs GSIS, and similar institutions for the other institutions do not have a sufficient legal and regulatory foundation to protect them from political interference and to otherwise ensure they take decisions solely for the benefit of members.

10. Recommendation: Measures should be put into law, regulation, and practice to strengthen these governance institutions. Standards and codes of conduct should be specified for governing members. They should be given a legal “fiduciary” responsibility to make decisions solely for the benefit of members, with sanctions including criminal penalties and possibility of removal for violating their responsibilities. Conflict-of-interest and financial disclosure requirements should be enacted. The selection and appointment process should be made as depoliticized as possible.

Investment Processes

11. Guiding principles for organizing the investment processes of a public pension fund are as follows:

• Investment decisionmakers should be professional and protected from political pressure. A professional Investment Board should make specific investment decisions, not a political Governing Board, and not staff. (That is, while Governing Board members might be chosen for political reasons, such as representing employers or employees, Investment Board members should be chosen based on their qualifications and financial-market expertise. Such an Investment Board likely is more protected from political pressures than are Governing Board members or an institution’s staff.) A Governing Board can set broad strategy and parameters.

• Formal structures and processes should protect from mismanagement, corruption and fraud. They should ensure accountability and transparency, and provide performance incentives.

• A nominating and selection process should ensure Investment Board professionalism.

• External audits are important for ensuring transparency and accountability, and for checking that rules and procedures are properly followed.

12. The investment decisionmaking processes within SSS and GSIS only partially follow these guidelines. While the level of professionalism of investment processes has increased markedly within both institutions in recent years, investment decisions still are made largely by internal staff and individuals appointed by the institutions themselves, in an ad hoc manner. While these individuals might be quite competent, they are not as protected from political pressures as a carefully constituted Investment Board would be.

13. Recommendation: SSS, GSIS, Pag-IBIG, and AFP-RSBS should create professional Investment Boards, to assume responsibility for making investment decisions. Investment Boards would focus specifically on deciding in what to invest and divest and would work subject to broad policy guidelines set by the Governing Board, which would have broader governance responsibilities. A best approach would be for the Investment Board to be vested with decisionmaking authority, but alternatively it could act in an advisory role, with decisionmaking authority maintained by professionals within each institution, supervised by Governing Boards. The roles of the SSS Social Security Commission and the GSIS Board of Trustees would be narrowed, to setting broad investment policy but not to making any specific investment decisions.

14. Recommendation: A nominating process should be established whereby prominent individuals in academia, the financial sector and the government nominate skilled professionals to a short-list, from which a Selection Committee proposes appointments to Investment Boards. Regulations should define the rights, responsibilities, and anti-conflict-of-interest rules for Boards. Processes should yield decisions based on merit and protected from political influence.

15. The investment procedures within SSS, GSIS, Pag-IBIG and other institutions follow a rather loose set of policies and appear somewhat ad hoc. . Formal investment review and approval systems appear to have not been institutionalized. The institutions do not articulate specific investment objectives with regard to return and risk, and do not hold regular reviews of investment policy.

16. Recommendation: SSS, GSIS, Pag-IBIG and other institutions should adopt and clearly articulate explicit investment policies. Specific investment objectives should be clearly delineated, and a regular review of investment policy should be instituted.

17. Recommendation: Investment decisionmaking processes should be clearly specified in written manuals. The investment procedures should include 1) a risk management process to monitor and measure the risk of investments and their contribution to the overall risk profile; 2) procedures for selecting asset managers and monitoring their performance against appropriate benchmarks; and 3) a process to review the appropriateness of investments in terms of the investment policy on a regular basis and to identify action to be taken when investments do not comply with the policy. The investment policy should include an integrated approach linking long-term liabilities with asset duration and liquidity.

18. Rules regarding in what instruments pension institutions can and cannot invest are set in legislation and charters. The 1997 SSS Act sets broad guidelines for the SSS, defining a list of permissible asset classes with limits on allowable investment, and the 1997 GSIS Act plays a

similar role for the GSIS. While it is appropriate to set such restrictions in legislation and charters, in some cases the specific limitations are not appropriate. As a general rule, it is necessary to set maximums for investment, but not minimums. The overly specific investment limitations defined in the 1997 SSS Act are unnecessarily restrictive and leave little room for the pursuit of other investment objectives, such as diversification. Moreover, both charters permit investment in too many inappropriate vehicles. (Investment portfolios are discussed more in depth immediately following this sub-section.)

19. Recommendation: Investment restrictions set in legislation and charters should be changed. Minimums generally should not be specified, and in some cases more maximums should be specified and inappropriate investments should be prohibited entirely. Restrictions should allow for greater flexibility and diversification in asset allocation, while directing against inappropriate assets.

20. Investment practices often are not consistent with best international practice.

21. Recommendation: Investment practices should be improved. Specifically, investment decisions should be made taken into consideration criteria reflecting risk assessments of the total portfolio; matching the timing of liabilities and assets; and valuation of assets that use mark-to-market approaches.

Investment Portfolios

22. Pension asset portfolios should meet the following criteria:

• Appropriate returns and risks

• Liquidity

• Diversification

• Assets purchased at market values and “marked-to-market”

• Transparency

• No lending or investments to related parties

• No politically directed investments

23. The investment portfolios of SSS, GSIS, Pag-IBIG and AFP-RSBS only partially meet these criteria. Diversification of portfolios is a significant issue for each institution. A basic problem is the diversification of investments within the relatively few opportunities offered by the local financial markets. As noted in TABLE I.2, pension-related institutions already play a substantial role in the Philippines’ capital markets, with a capacity to move market prices. Part of the problem is that the pension institutions tend to hold and manage stocks in individual companies, so even if their share in the overall stock market is not so great, they are able to move market prices for specific companies. Greater diversification domestically and investing through pooled instruments would reduce the impact of investment by these institutions on price movements.

TABLE I.2: Assets as a Percentage of GDP

SSS	GSIS	Pag-IBIG	AFP-RSBS	Pre-Need	Insurance	Total
3.7	6.3	3.3	0.2	2.9	4.5	20.9

24. Recommendation: Pension institutions should reduce their concentrated influence on equity share prices and corporate governance in enterprises in which they invest. Pension

institutions should contract to multiple private fund managers to manage diversified portfolios of equity investments according to clear guidelines, or otherwise invest in indexes and pooled instruments. Related to this, pension institutions should delegate voting rights and become less involved in active management of firms.

25. Other rules on where pension institutions can and cannot invest also reduce the suitability of pension investments. Institutions are likely invested too heavily in government securities of various types, particularly in securities that are not tradable. This problem is partially related to differential tax treatment between public and private institutions. At present, only public institutions (mainly the pension institutions) can trade certain government securities that are exempt from taxation, while other government securities are traded by the private sector.

26. Recommendation: Limits should be set on the extent to which pension institutions can invest in government bonds or loans, at 30% of the total portfolio (including bonds and loans to the government). Investments in government loans and non-tradable securities should be phased out entirely, eventually only permitting investments in tradable securities. Means will have to be developed to allow trading of government securities among public and private institutions, preserving tax exempt status for public institutions but not private institutions. Together with this measure, the Government has to commit to undertaking continuous financial sector reform to increase the availability of eligible private domestic financial instruments.

27. As pension assets grow, there is a limit to the extent of diversification that can be achieved from investments within the Philippines. The size of the Philippine capital market obviously is quite small compared to the size of world capital markets.

28. Recommendation: SSS, GSIS, Pag-IBIG and AFP-RSBS should gradually diversify their investments by increasing their investments abroad with the assistance of leading world financial institutions chosen through open, competitive tenders. Assets abroad generally could be invested in mutual funds and other pooled equity and debt instruments.

29. Salary, housing and multi-purpose loans offered by SSS, GSIS, and Pag-IBIG violate a number of principles of sound pension investment, including: diversification, market rates, liquidity, lending to related parties, and avoiding politically directed investments.

30. Recommendation: Pension institutions should divest of salary, housing, and multi-purpose loans. If socially desirable, new institutions should be created to offer salary and housing loans, with any transparent government subsidies that may be appropriate. Pension institutions may continue to invest in such lending institutions through arms-length market investments, such as mortgage-backed bonds and others.

31. SSS and GSIS offer a number of programs in addition to pensions, including insurance. At least to some degree, the funds of the pension programs are not segregated from the funds of other programs. Pre-Need programs also appear to have only partially segregated pension assets from assets of other programs, including the education programs which have recently experienced severe financial problems. This increases the risk for pension assets. Furthermore, these other programs, while providing some social benefit, do so at a cost – namely, crowding out private-sector provision of such programs.

32. Recommendation: At a minimum, SSS, GSIS, and other institutions should improve the extent to which they segregate pension assets from assets of other programs, both institutionally and legally. This should involve segregated accounts and legal protections to maintain firewalls

between types of assets, to ensure that one program type is not tapped to fill a liability in another. Furthermore, it is preferable that institutions divest themselves of a number of such programs, including insurance, and delegate such functions to the private sector. Careful analysis if administrative costs should ensure that pension programs are not cross-subsidizing the administrative costs of more resource-intensive programs.

Regulation, Supervision and Auditing

33. Supervision and regulation of pensions are fragmented. The Financial Institutions Division of the Department of Finance Corporate Affairs Group supervises SSS, GSIS, AFP-RSBS, and Pag-IBIG. The Tax Administration registers the employer-sponsored schemes. The Central Bank supervises trust accounts at commercial banks. The Insurance Commission supervises insurance companies. And the Securities and Exchange Commission supervises plans of Pre-Need companies. These institutions are audited only on an ad hoc basis, and audits are not publicly available. Only the State Commission on Audit has jurisdiction over auditing these institutions.

34. Recommendation: An expanded, strengthened Insurance and Pensions Commission should supervise all pensions institutions, including SSS, GSIS, Pag-IBIG, AFP-RSBS and private schemes. The capacity of such a Commission would need to be greatly enhanced, which would necessitate increased resources, exemption from civil-service salary limits and substantial training. Supervision should follow the principles of risk-based supervision. Significant amounts of training would be needed to facilitate undertaking these new responsibilities.

35. Recommendation: Law and regulation should require that SSS, GSIS, Pag-IBIG and AFP-RSBS undergo annual audits by private audit firms experienced with auditing the assets, liabilities and procedures of pension institutions.

IV. STRUCTURAL ISSUES

System Parameters: Replacement Rates, Contribution Rates, Long-term Financial Balance and Harmonization of Benefit Formulas

36. Key parameters of the pension system determine: the size of benefits paid by the system; the burden of the system on workers and firms that comes from contribution obligations; the long-term financial sustainability of the system; and the system’s equity – how various population groups in the system are treated relative to each other. The replacement rate (the ratio of a worker’s pension to previous salary), which is a function of the benefit formula and economic conditions, determines the level of pensions paid. The contribution rate and ceilings on wages determine the burden on firms and workers. Replacement rates and contribution rates, coupled with economic conditions, determine financial sustainability. And the details of the benefit formula determine how various groups within the population are treated relative to each other.

37. Mandatory pension plans should aim for replacement rates in the range of 40-50% of an

average full-career worker’s lifetime average salary (adjusted for wage growth.)³ SSS, GSIS,

³ This target of 40-50% is not a magic number but a broad guideline based on several factors. A government’s main policy objectives in mandating a pension system are to keep the elderly out of poverty and to ensure at least an adequate pension for participating workers, keeping in mind that individuals can and should seek additional forms of saving and inter-generational support. Since the elderly usually fall into lower tax brackets and no longer need to

and AFP-RSBS provide much higher replacement rates (using “base salary”) than this target level.⁴ While SSS has a ceiling on wages for which contributions are made and pensions paid, GSIS has no ceiling, meaning that generous pensions can be paid even to very high income workers. AFP-RSBS offers even more generous replacement rates (and early retirement ages) to members than SSS and GSIS. Given the lack of long-term financial balance in the system, as well as some negative redistributional aspects (whereby the poorer are cross-subsidizing the richer), the replacement rates in the Philippines’s pension system are too high.

38. Recommendation: Replacement rates should be reduced gradually to 40-50% for SSS, GSIS and AFP-RSBS. This should apply to younger workers and new entrants, not to current retirees or older workers close to retirement. A uniform ceiling on wages should apply across all programs.

39. The contribution rate to SSS, 10.4% of wages (7.07% from employers, 3.33% from employees following the January 1, 2007 increase in contribution rate from 9.4%), is somewhat high given what private-sector firms are likely willing to bear and given several other payroll tax deductions. The contribution rate to GSIS, 21% (9% from employees, 12% from employers) is much higher – a fact that is significant in light of the high arrears of the Government to GSIS.

40. Recommendation: The contribution rate to SSS should not be raised any further. The contribution rate to GSIS should be gradually somewhat reduced, to the extent permitted within the constraint of maintaining financial sustainability.

41. SSS and GSIS predict long-term financial imbalance. SSS is expected to experience a negative cash flow (i.e., expenditures exceeding revenues) in 2019, and to be unable to meet its obligations after having exhausted its reserve by 2027. GSIS is in slightly better condition but is also expected to experience a negative cash flow in 2049, and to be unable to meet its obligations by 2060.⁵

42. Recommendation: Long-term financial sustainability needs to be re-established in both SSS and GSIS. This should be done through gradually changing benefit formulas to reduce replacement rates, and by reducing opportunities for receiving pensions that are not commensurate with contributions. For instance, benefit formulas should be based on lifetime contributions, not just final career years, and minimum pensions should not be so easily granted without sufficient contribution history. Contribution rates should not be raised.

43. Benefit formulas are inequitable in that they offer varying internal rates of return on contributions to members of varying ages, lengths of service, and wage-growth and participation patterns. Rules also do not always encourage long contribution periods, instead granting pensions after only a few years of service, or heavily weighting final years of service in the benefit formula.

44. Recommendation: Benefit formulas should be revised to provide more consistent internal rates of return for various categories of members. Benefit levels should be based on lifetime contributions, not just final years, and should reward longer periods of contribution. A ceiling should be placed on wages subject to contributions, and also on the base wage used to calculate pension level, so the system is well targeted toward lower- and middle-income workers. Benefit formulas should be harmonized between SSS and GSIS to permit full portability between the public and private sectors. Survivor benefits should be rationalized, providing lifetime benefits at a reasonable rate with reasonable eligibility. With a good survivor program, life insurance and funeral benefits could be eliminated.

45. Recommendation: Taxation of pensions needs to be rationalized and harmonized so individuals and institutions are subjected to the same taxation regardless of what type of pension program they participate in and in what sector they work. The standard should be E-E-T: Contributions should be tax exempt; income on investments should be exempt; but pension income should be taxed just like any other income type. Caps on tax exemptions should facilitate policy goals without permitting excessive tax avoidance by the affluent. Tax issues should not impede financial market functioning. Specifically, new mechanisms are needed to allow tax-exempt and non-tax-exempt institutions to trade in government securities.

Coverage

46. The pension system reaches less than a third of the Philippines’ elderly. Those not covered by the system tend to be poorer than those who are covered. Recent world experience suggests that coverage can only be expanded to substantial shares of the population in developing countries through some kind of universal or needs-based pension – that is, through a pension that is funded from general revenues and not linked to previous contributions, so that people who either work in the informal sector or who do not work at all can still qualify.

47. Recommendation: The Philippines should consider the merits of a universal or needs-based pension, paid from general state revenues, to complement existing pension programs. Several options are possible. A universal pension could be granted to all citizens over a specific age, or a needs-based pension could be granted, only to the poorest. “Need” could be broadly defined, considering all types of income, or narrowly defined, only considering other pension income. A needs-tested pension has the advantage of being less expensive than a universal pension and better targeted at the poor, but is administratively very hard to implement—verifying need is much harder than simply verifying age. A needs-tested pension also can create incentives to not work or to not contribute to other components of the pension system. Varying eligibility ages could be considered. Analysis suggests that prevalence of poverty among the aged does not increase substantially until age 70 or even 75. We therefore would recommend an age of eligibility for such a pension of not lower than 70. Several options for benefit level also could be considered, ranging from a level as high at the official poverty level, to some estimate of the amount needed to close the gap between poor income’s and the poverty level. Analysis suggests that many reasonable options would be fiscally affordable.

48. Another issue to consider is the extent to which scarce resources should be spent on alleviating old-age poverty relative to other social needs, for instance child poverty. The data on child vs. old-age poverty in the Philippines is flawed in some important respects so must be carefully considered to analyze this question. Poverty data does not take into consideration

Coverage

family economies of scale—adding one more person to a large family does not require the same level of incremental income as one person living alone needs to achieve the same living standard. As a result, data in the Philippines exaggerates the extent of child poverty. (Even correcting for this issue, child poverty will remain a serious social issue.)

49. Recommendation: Poverty data needs to be improved in order to better prioritize social programs for the elderly (such as a universal or needs-based pension) vis-à- vis programs for children and other social groups. Specifically, it is necessary to incorporate understanding of economies of scale and age equivalence in poverty analyses in order to accurately measure and compare poverty across families with varying numbers of individuals and varying ages.

The Defined-Contribution, Fully-Funded Element

50. SSS and GSIS are defined-benefit, partially-funded programs. World trends over the last two decades have been away from such schemes, toward defined-contribution, fully funded programs. In the Philippines, only Pag-IBIG comes close to this type of program. Pag-IBIG is a defined-contribution program, offering a lumpsum benefit after twenty years of affiliation. It invests mostly in housing loans that benefit a small share of members rather than investing solely on behalf of all participants.

51. Recommendation: The Government should aim to gradually increase the share of contributions that go to the defined-contribution, fully-funded element (Pag-IBIG). Initially, the ceiling on wages from which contributions must be paid should be raised to the same level as the ceiling for SSS. The contribution rate to Pag-IBIG should not be raised at present. In parallel, the operations of Pag-IBIG need to be improved. Pag-IBIG should divest itself of housing and multi-purpose loans, and build capacity for other types of investment within the Philippines and worldwide. The program should evolve into a standard defined-contribution pension scheme, with annuities offered at retirement age, rather than a lumpsum paid after 20 years of membership regardless of age. This would require a fundamental re-definition of Pag-IBIG’s mission, a re-direction of investment policies, and greatly enhanced capacity for investment decisionmaking.

Administration

52. Administrative costs need to be transparent so that members know what they are. This is part of accountability to members. Administrative costs also should be rationally funded, without hidden means by which low-cost programs cross-subsidize high-cost programs.

53. Recommendation: Administrative efficiency needs to be analyzed on a per-program basis to assess whether costs for any specific programs are too high. Cross-subsidization of administrative costs across programs should be avoided. An assessment is needed to determine if current administrative costs are high by international standards, compared to other similar and relevant systems.

AFP-RSBS

54. AFP-RSBS offers very high benefit formulas even compared to SSS and GSIS, and only related to final salaries. Related programs for provident fund and retirement benefit are not

rationalized with the pension, and in certain cases investments have been not suitable for a pension fund profile. AFP-RSBS now has been declared bankrupt, but presumably the program will continue to operate in some capacity and so still merits evaluation and reform recommendations.

55. Recommendation: These benefit formulas need to be reduced, at least for younger workers, based on average long-term history (not “rank next higher”), indexed to prices not wages. The target replacement wage should include and not supplement the provident fund and retirement benefit. The provident fund should pay interest rates actually accrued, rather than those that are administratively mandated. Future development of the system should focus on provident fund and Pag-IBIG contributions. That is, for the military going forward, a greater share of pension could come from increased contributions to Pag-IBIG rather than continued contributions to the current or some new specialized military pension fund. (This only would make sense if Pag-IBIG is transformed into a modern defined-contribution pension fund, following international best practices in pension investments, as discussed above.) Investment processes need to be modernized, divesting of member loans and real estate.

PERA, Pre-Need, and Other Programs

56. The PERA bill seeks to rationalize rules and supervision for private-sector supplemental pensions. Gaps still exist in issues related to taxation and ensuring prudent investment. Other related investment instruments, such as Pre-Need programs, are either inadequately regulated or subject to regulation that differs to other institutions offering similar products.

57. Recommendation: PERA needs to be improved to set appropriate limits and conditions for when tax privileges are granted. Investment guidelines need to be tightened. Pre-Need and other programs related to pensions need to be improved so that the same tax and regulatory rules apply to all institutions and products. Regulation and supervision over these various institutions also needs to be harmonized. The recently established financial markets inter-agency commission would be a good forum for facilitating standardization of such rules.

Financial Sector Strengthening

58. A pension system that seeks to improve its investments needs a more developed financial sector. This includes: better and consolidated overall regulation and supervision of pensions, insurance, securities, etc.; new products such as asset-backed securities; improved transparency and accountability; and increased capacity in private financial institutions and in supervisory authorities.

59. Recommendation: Pension reform needs to fit into a context of overall financial sector development. Only with greater financial sector development in parallel will the pension system itself be able to develop and gain access to increasing numbers of suitable investment opportunities.

V. CONCLUSION

60. The Philippines faces a historic window of opportunity to implement fundamental pension reforms over the next two years. The leadership in each of the pension institutions, relevant

supervision agencies, and Department of Finance are thinking about pension reforms at the moment and are positively inclined to make significant steps. The May 2007 Parliamentary elections suggest a calendar for legislative reforms in which legislation could be drafted between now and those elections, for consideration in the early post-election environment. The financial situation is such that significant problems are looming on the horizon, but are sufficiently far off that there is still a fiscal window of opportunity to undertake difficult reforms. All these factors create an auspicious climate to launch reform efforts now.

Sunday, May 22, 2016

Yes, New Taxes 3: A reform program for the new administration

Posted on May 22, 2016 07:54:00 PM

In two earlier columns (“Yes, New Taxes”, 1 February 2016, and “Low Hanging Fruit”, 29 February 2016), I pushed for comprehensive tax reform to make the system fairer, yield more for infrastructure financing, and, at the same time, simplify for ease in compliance and administration, thereby making it less prone to corruption.

We offered some ideas for this both 1) administrative -- like use of technology for security marking, including on oil products, and 2) tax policy, such as a variable excise on oil products, tariffying quantitative restrictions (QRs) on rice with a 30% excise, and a rationalization of redundant incentives and unjustified exemptions.

Earlier this month, the Department of Finance unveiled a work in progress Comprehensive Tax Reform Package. Its elements (and the revenue impact for the first year) are as follows:

1) Lower income tax rate to 25% for individuals and corporations (minus P158 billion to P222 billion);

2) P1 million all-in income tax exemption for wage earners;

3) Fiscal incentives rationalization (P5 billion);

4) Excise tax increase on gas, diesel, and other oil (P132 bilion);

5) Expand VAT base (P80 billion);

6) Increase VAT rate from 12% to 14% (P82 billion); and

7) Tax administration reforms

-Make tax evasion a predicate crime to money laundering

-Repeal Bank Secrecy for BIR

-Remove BIR and BoC from salary standardization and civil service protection

-Allow BIR and BoC to retain 1% of their revenues as their budget for modernization and to fund personnel enhancement measures.

Some quick comments on the tax reform package.

First, it seems aligned with earlier reform proposals from within the DoF and by outside experts. My only regret is that this is being proposed at the tail end of this administration. Tax reform is best pursued early while an administration has abundant political capital, and so that it reaps fiscal dividends early. Nonetheless, it is commendable that Sec. Purisima and his team of mostly career professionals have taken the initiative to help the new administration get off on the right foot.

The personal income tax gives in the plan look fairly aggressive, though almost fully offset by the higher rate and expanded VAT. What will likely be said by critics is that VAT is not a progressive tax; and that we already have the highest VAT rate in the ASEAN region.

Reductions in the corporate income tax side are called for. It makes us more aligned with the corporate income tax rates in the region.

On the other hand, it is disappointing to see the estimated gains from rationalizing tax incentives at only P5 billion. I was hoping for more bite from this reform measure, not only for revenue grounds, but also because it would suggest needed guillotine of incentives and exemptions, and a more level playing field.

The proposed additional tax on oil and diesel was computed at P10 for gasoline and P6 for diesel, and of the rates to be indexed to inflation at 4% per year. I think more can be squeezed from this tax source. Not just via higher rates, but as observed in my second column (“Low Hanging Fruits”) by adoption of technology to flush out smuggling, now estimated at minimum of 20% of imports. President Duterte is well placed to demonstrate the people’s wrath versus smugglers, who have vexed us for decades.

Nothing was said in the DoF package about tariffication of rice QRs.

As observed in my earlier column, this will not only halve the price of rice and help address poverty and malnutrition, but can raise revenue amounting to P30 billion annually. Just as important, it will release wasted subsidies to NFA in the billions of pesos annually. This has accumulated to around P150 billion in unpayable national government guaranteed debt.

The World Bank estimates that for every P5 of spending for NFA, P4 are wasted leakages that provide no public benefit. (Please see recent statement of the Foundation for Economic Freedom on this “Let change come to the present rice policy: Liberalize ride importation” in fef.org.ph )

The tax administration elements in the program pose high risks. Both in getting these highly sensitive legislation passed, and in actual implementation.

It will take very skillful navigation by new administration to get support by legislators on a law that will repeal the bank secrecy for BIR. Same with a bill to make tax evasion a predicate crime to money laundering. The argument that the Philippines is only one of two countries (the other being Lebanon) in the world where tax evasion is not a predicate crime and only one of three (Lebanon plus Switzerland) that do not allow tax administrations access to bank deposits has not swayed Congress so far. I think we can all guess why.

Exemptions of BIR and BoC from salary standardization and civil service protection will also not be easy -- this is a reform that earlier administrations have tried to push without success. Often it is the employees of the bureaus who lobbied Congress against the lifting of civil service protection.

Choosing the right people to head these two agencies is critical -- with the requisite technical background and experience, but perhaps even more important, the temper and skills to introduce and manage radical reform. They should be fully trusted by, and accountable to the Finance Secretary. The President needs to give him the say on these appointments.

As I said earlier, these reform proposals are not new, but failed to pass or be implemented. We can only hope that under a President who is known for resolute action, we shall see greater demonstration of skill in pushing through the mill and of political will to summarily execute (wink!).

Romeo L. Bernardo is vice-chairman of the Foundation of Economic Freedom and a GlobalSource Partners advisor. He was formerly undersecretary of Finance during the Aquino1 and Ramos administrations.

romeo.lopez.bernardo@gmail.com

Sunday, April 24, 2016

Political economy of reform, take 2

Posted on April 24, 2016 09:42:00 PM

(I stumbled across a column I wrote in this space [July 26, 2010]on lessons learned on the political economy of reform during President Ramos’s term, as documented in a World Bank Growth Commission working paper written with Christine Tang. Excerpts and my current thoughts as Nota Bene, are below.)

At a recent forum organized by the IMF-UP School of Economics-Philippine Economics Society, four speakers -- one IMF economist, two UP professors (Philip Medalla and Ben Diokno) and I -- were asked what we thought were needed to raise potential growth for the Philippines.

IMF Resident Representative Dennis Botman summarized these solutions quite well: a) raising the tax effort, b) increasing public investment, and c) reducing the cost of doing business by improving governance.

I would like to try to answer the corollary question, how to get it done politically, in a complex free-for-all democratic setting like the Philippines.

Some reflections based on the political economy of reform during the Ramos administration, a case study for the World Bank Growth Commission. (http://goo.gl/HovqWM)

We looked at what it took the Ramos administration to successfully push for reform in telecom demonopolization, water privatization, and oil deregulation working against strong special interests (including from affected businessmen, labor constituencies, political ideologues) and using instruments, both formal and informal, at the disposal of the presidency in an environment of weak, lethargic, or sometimes obstructive, and compromised institutions.

Even though the three reform case studies were on specific initiatives done during the Ramos administration, the basic reform agenda was a continuation or, if you will, a fuller articulation and execution of the framework of stabilize, privatize, and liberalize as a way to improve growth performance adopted during the time of President Cory Aquino (the Aquino 1 administration).

While the Aquino 1 government in 1986 had the advantage of having the Filipino people geared up for wide-scale political, economic and social reforms, with the President clothed with full legislative powers early in her term, it also had to contend with the task of rebuilding democracy.

(In comparison the), Ramos government, because of the President’s background, and an orderly succession that was the lasting legacy of the Aquino 1 administration, was not fettered by coup challenges, but rather the normal challenges that a presidency faces such as pushing for laws to a Congress where the President’s party was not the majority.

Below are lessons we took from the reform experience.

1 ARTICULATING A VISION.

The Ramos administration’s vision had been to pursue reforms that would create a Philippines 2000, a carefully crafted strategic vision that brought coherence to his government. Policies like ‘leveling the playing field’, dismantling monopolies, privatizing state assets and services, embracing liberalization and globalization, forging peace agreements with the Moro National Liberation Front (MNLF) and the rightists, etc., were adopted to make the country an Asian economic tiger, or at least a tiger cub.

2 SCORING EARLY SUCCESS

A new president has six years to make a difference and needs to score early wins to build confidence for future reform efforts.

During the Ramos administration, the immediate problem, and opportunity, was getting the economy on track after debilitating outages that saw the GDP contract by 0.6% -- to put the lights back on both literally and in terms of business confidence. This was achieved in a record of 15 months, thanks to Mr. Ramos’s no-nonsense leadership and empowerment of known achievers such as Energy Secretary Del Lazaro and National Power Corp. President Sonny Viray. Such a victory set the stage for reviving investments and rallying public support behind other reforms to improve global competitiveness.

There is no one thing as dramatic as putting the lights back on this time around, but it is clear that this administration is aware of the importance of early wins:

My candidates for demonstration of resolve and early success are topped by the following:

a). Getting the wasting NAIA Terminal 3 operational for international air traffic. This structure otherwise stands as an almost decade-old national monument to folly, corruption and, for failing to find a solution on how to use it, stupidity.

(N. B. Six years hence, alas still a work in progress.)

b). More train cars in MRT-3 and fewer buses along EDSA to decongest traffic. The economics or even just common sense of additional cars with little incremental costs for a system that is already in place is so compelling. (N. B. Go figure. )

c). Taking steps to scrap the National Food Authority (NFA). The NFA lost P37 billion in 2008 and P63 billion in 2009. According to a World Bank study, it cost the NFA an estimated average of P5 to deliver P1 subsidy to the poor, reflecting the wastes, leakages, and governance deficit in its administration. (N. B. Not to mention cost of rice to our people -- twice to thrice that of our neighbors, contributing to poverty and malnutrition, wage uncompetitiveness, and lost jobs). Start by having leadership in Department of Agriculture and NFA that understand and can be committed to such a long overdue reform measure. (N. B. Go figure 2.)

3 POLITICAL WILL

Reform requires a lot of political will on the part of the leader.

For example, in the case of the telecom demonopolization, the situation in 1992 was perhaps best captured by a remark attributed to then PM Lee Kuan Yew -- The Philippines is a country where 98% of the residents are waiting for a telephone line, and the other 2% are waiting for a dial tone. An estimated 800,000 applicants, 75% of the country’s capital (Metro Manila), were then queuing for a telephone.

The PLDT, which owned the nationwide transmission backbone, was a virtual monopoly, controlling over 90% of the country’s telephone lines. Its controlling shareholder, the Cojuangco family, was politically well connected, its influence extending across the three branches of government as well as media.

Nevertheless, the Ramos administration proceeded to pry the sector open with various tactics. These ranged from encouraging the formation of consumer groups that took to the streets and clamoured for change, to boardroom battles where the President replaced government’s representatives in the PLDT board, to behind-the-scenes maneuvers to increase the concerned parties’ receptiveness to reform.

As a result, twin executive orders that the President issued within six months of each other in 1993 (i.e., within one year of his assumption of office) opened the floodgates to investment in the sector. This was followed by pushing legislation to insulate the reform from reversal. (N. B. Thus laying the foundations of our BPO industry, together with remittances, our fundamental growth driver. )

Similar demonstrations of political will were evident in the largest water privatization at that time, which required raising water rates prior to selling and reducing the Metropolitan Waterworks and Sewerage System (MWSS) work force, and in pursuing oil deregulation despite ideological opposition and a nullification of the first law by the Supreme Court.

In light of relative weaknesses of Philippine institutions, where the system of checks and balances put in place to stem abuses is often exploited by those opposing reform to block or at least delay it, carrying out the needed changes would have been very difficult if not impossible without the President’s vision and strength of conviction.

4 EFFECTIVE COMMUNICATION AND CONSTITUENCY BUILDING

This entailed establishing a Legislative-Executive Development Advisory Council (LEDAC) where the Executive met weekly with leaders of Congress, pacifying militant elements of society by granting amnesty to rebel soldiers, repealing the law that outlawed the Communist Party, and launching peace talks that led to the 1996 peace agreement with the MNLF.

This also included a penchant for summitry, which earlier annoyed me as a finance undersecretary since I sometimes found little by way of substantive output from them. That was my sentiment until I began to appreciate that the most important output at the end of the day was the process. It allowed stakeholders to participate in and understand what government had in mind and to buy into what government was trying to do.

5 THE REFORM PROCESS -- OPPORTUNISTIC TIMING, PRAGMATISM, JUDICIOUS HASTE, PERSISTENCE

Compared to the resolution of the power crisis, the three reforms discussed may be considered elective surgery, i.e., mending a non-crisis situation. Therefore, they demonstrate better the reform process in a democratic setting where the leader himself has to generate the impetus for reform through his vision and persuasion and to craft the approaches that are politically feasible. The case studies show that the Ramos administration had to address the problems in each area in ways that were possible given the timing, the window of opportunity, conditions prevailing, and other prospects available.

These considerations are perhaps useful in weighing the timing for pushing tax policy reforms needed for fiscal sustainability, immunizing the economy from global financial turbulence, and generating needed resources for social and infrastructure spending. (N. B. Up to now, this is a key governance issue, as discussed in my previous two columns -- “Yes, New Taxes!” 1 and 2)

I have argued that the best time to push for this is early in the administration -- while the government is at the height of its trust and popularity rating and some of the responsibility for needed, possibly unpopular, reform measures can still be rightly laid at the doorstep of its predecessor, and where the new administration can earn credibility dividend from the financial markets that translates into front-loaded savings. One can argue that such an opportunistic approach was observed with the Ramos reforms.

While I can appreciate the reluctance to pass laws on new taxes, I cannot see why some of these measures cannot be pushed as refinements and broadening of the tax base to make it fairer or even as plugging the loopholes. I would easily put in this category the rationalization of fiscal incentives which leads to an even playing field in business.

One can even push the argument further that a retroactive indexation of sin taxes, say, on liquor and tobacco, does not mean new taxes but simply a restoration of the real value of taxes eroded by inflation (even if these two items will not really yield much, tax adjustments are clearly called for on health grounds).

(N. B. Congratulations to the PNoy administration on getting this done two years ago!)

Sooner or later, government should also push for correcting the relative undertaxation of oil products, a more robust progressive source by far, either as a stand-alone or with proceeds earmarked for spending to ease public acceptance.

The best timing for pushing such an increase in oil taxes measures and other difficult measures coupled with a decrease in income taxes is a political call the leader and his economic managers and Congress team will need to make. Waiting too long to do tax policy reform and relying only on administrative measures, however, run the risk of having a fiscal crisis dictate non-elective surgery. Or if we are not too unlucky, muddling through several more years of unremarkable (and un-inclusive) economic performance.

Romeo L. Bernardo is board member of The Institute for Development and Econometric Analysis, Inc., and a GlobalSource partners advisor. He was formerly undersecretary of Finance during the Aquino 1 and Ramos administrations.

Sunday, March 27, 2016

PIDS: Bridging the gap between knowledge and power

Posted on March 27, 2016 09:19:00 PM

Outside of beauty contests and boxing, there are few lists where the Philippines takes top place. Thus, it is a source of particular pride for me to banner in this column that the Philippine Institute for Development Studies (PIDS) was recognized once again as the top social policy think tank in Asia and among the top 50 in this field globally. This high recognition was given by the University of Pennsylvania’s Think Tank and Civil Societies Program (TTCSP).

Commenting on this recognition, PIDS President Dr. Gilbert Llanto observed: “Despite having only a handful of researchers compared to other better endowed research institutes in the region and in the Philippines, PIDS has consistently made significant contributions and influence on Philippine development policy through its active and close collaboration with government agencies, academic and research institutions, and international organizations.”

Its current board includes Planning Secretary Emmanuel Esguerra as ex-officio Chair (succeeding now Competition Council Chairman Dr. Arsenio Balisacan), Dr. William Padolina, Atty. Rafael Perpetuo Lotilla, UP President Alfredo Pascual (incoming Trustee), and Dr. Llanto, who succeeded Dr. Josef Yap. PIDS was first recognized by TTCSP under Dr. Yap’s watch.

I congratulate President Llanto, his predecessors, and the PIDS Trustees, Fellows and staff over four decades of its distinguished life. Its establishment trace back to the vision of Dr. Gerardo Sicat, then Planning Secretary, who saw the need for a think tank to help government planners and policy makers in the executive and legislative branches of government address broad issues of development. While it is a state-funded think tank, PIDS’ fathers imbued it with some independence by giving it a corporate structure and some measure of fiscal autonomy. Moreover, under its charter, its Trustees are not appointed by the Philippine President but are self-electing with staggered terms.

PIDS Fellows are known experts in their fields, and include not just economists in different areas of specialization, but also sociologists, public health specialists, demographers, statisticians, lawyers, etc. who individually and collectively contribute to its rich body of independent evidence-based research, as well as respond to the need for quick policy briefs of officials.

In recent times, PIDS Fellows have appeared, and made their mark in various Senate and Congressional Committees that deliberated on the following: cabotage law, competition policy, taxation of incomes, sin taxes, CCT, SUC’s and scholarships, budget planning, customs and tariff modernization, a bill now awaiting the President’s signature.

It has a rich trove of literature, 1000 completed studies, on these and other areas built over the years, straddling a wide field -- macroeconomics, public finance, trade and industrial policies, health economics, foreign direct investment, housing finance, urban development, governance, agrarian reform, food security/rice policy, just rattling off items I have in the past researched on. (You can find more about PIDS and its research library in www.pids.gov.ph)

Under Dr. Llanto’s watch, it has done several impact evaluation studies on the effectiveness and impacts of key government programs and projects to ascertain whether they are achieving their intended objectives and to ensure that government resources are used wisely. It has likewise trained a large number of bureaucrats on the art and science of impact evaluation.

In the coming years, Gilbert is focusing on doing studies on easing the regulatory burden in various sectors. PIDS researchers are also looking at the supply chain of tuna, a major export industry, and other sectors in manufacturing to follow. In transport, they will be examining the regulatory burden in the land transport sector. This year’s annual public policy conference will focus on the need to build resilient systems -- economic resilience for example in the face of interconnected global risks and external shocks.

As I finish my two terms as a PIDS Trustee with pride and gratitude, I recall what James McGann said about think tanks. “Think tanks seek to bridge the gap between knowledge and power. The role of think tanks is to link the two roles, that of policy maker and academic, by conducting in depth analysis of certain issues and presenting the research in easy-to-read condensed form for policy makers to absorb.”

Globally recognized PIDS has achieved this and through its active live public policy engagements in conferences, Congress, media, even more.

Romeo L. Bernardo was Finance Undersecretary during the Cory Aquino and Ramos administrations and board director of Institute for Development and Econometric Analysis, Inc. (IDEA)

romeo.lopez.bernardo@gmail.com

Sunday, February 28, 2016

Yes, New Taxes 2: Low Hanging Fruit

Posted on February 28, 2016 08:28:00 PM

In the first installment of this column (“Yes, New Taxes,” Feb. 1), we emphasized the need to raise revenues to cover catch-up infrastructure, to offset revenue gives for equity reasons in favor of low to middle-income salaried workers, and to align our corporate income tax regime with our peers to attract investments and create jobs. Moreover, we also need to provide for advance commitments of the administration that go beyond 2016, notably increases in government salaries over the next three years.

Where can all these come from? Let us do some math on how much this would cost.

For simplicity, expressing these in percent of Gross Domestic Product (GDP).

1. Additional spending for infrastructure to raise it to a minimum of 5% of GDP, same as our neighbors, from the present 2%-3%. Needed: additional 2%-3% of GDP or around P200 billion-P300 billion each year.

2. Adjustment in personal income tax exemptions to correct for “bracket creep,” the bloating of income due to inflation that does not reflect real purchasing power. Needed: 0.5% of GDP.

3. Reduction of corporate income taxes to 25% (same as Indonesia and Malaysia) from the current 30%, the highest in ASEAN. Needed: 0.6% of GDP

4. Salary increases under EO 201, Needed: 0.5% of GDP every year for the next three years. Or a total of 1.5% by 2018.

When this is totaled, the required amount ranges from P450 billion to P500 billion, or roughly around 5% of GDP every year. This does not even count other new expenditure claims like the modernization of the AFP and the indexed increases in the pensions of soldiers.

Early in its term, the next administration needs to think about its fiscal program so it can pursue its investment and expenditure program confidently and responsibly without courting macro instability and a credit downgrade. While there is headroom to increase debt due to historic low levels of debt to GDP, credit markets look at the medium term. Unless there is clarity that the medium term fiscal program is sustainable, interest rates will rise, crowding out government development spending and dampening private investment.

Secretary Cesar Purisima, recently deservedly recognized Best Finance Secretary for the sixth time, is cited as saying there is no need to impose new tax measures in order to boost collection -- “I think we need to continue to use technology to make sure that we improve the efficiency of tax collection.” (Phil Star, Feb. 26 -- “Incoming government does not need to impose new taxes” -- Purisima ).

Indeed, improving collection efficiency should be government’s first resort. At the same time, we call attention to the limits of administrative measures, as evidenced by experiences of many countries that this is at most around 0.5% of GDP per year.

In the last 5 years, despite heroic, some would say excruciatingly painful, efforts of the BIR, tax to GDP only rose from 12.1% in 2010 to estimated 13.8% in 2015. If one takes out the effect of the increase in effective tax rates on sin taxes (see Part 1 of column), the net effect of administrative measures over the entire five years is only 1% of GDP. Of course, the figure is a conservative estimate since there were other moving parts that brought down collection -- for example the drop in oil prices that reduced the base. But clearly, 1% is nowhere close to the 5% of GDP we calculated as needed over the medium term.

We do agree with Sec. Purisima that there are ample opportunities for using technology to improve collections. As discussed in Part 1, how BIR/DoF used security stamp taxes to ensure that smuggling and evasion do not rise with the higher sin taxes in cigarettes -- and coming soon in alcohol -- is a model case study on smart and resolute use of technology.

A logical extension on use of technology is plugging smuggling in oil products -- a problem that has vexed our country for decades.

It has been estimated by industry experts, investigative journalists, and a variety of government officials over the past few years that at least 20% of all diesel and gasoline sold at retail in the Philippines has been smuggled into the country -- which means that the government is unable to collect a large portion of the tax that should be paid on these fuels.

In a paper published in October 2015 by the Asian Development Bank, the bank encouraged governments to institute sophisticated fuel marking programs as a proven way to increase government revenues, improve fuel quality and combat criminal activity.

Fuel marking can be the parallel to the successful security stamp program the government instituted here last year.

A well-run fuel marking program puts a high-tech marker (in effect -- a tax stamp) in all legally imported and locally refined fuel before it is distributed. Just like with a cigarette tax stamp, when fuel is then tested throughout the country at retail and commercial sites, any fuel that is found not to have the proper fuel marker is illegal -- and thus subject to confiscation, and the illicit trader is subject to fines, closure and if necessary, criminal prosecution. Deterrence that fuel marking creates has been proven in many countries with similar problems.

Still in the area of oil taxes, the very sharp decline in oil prices provides an opportunity to capture some of it by imposing a variable tax that goes up when oil prices are low, and down when prices are high. This is can also correct for the erosion in the real value of the excise taxes on oil. Just like tobacco and alcohol products until two years ago, oil excise taxes are not indexed to inflation, and thus steadily dropped from 1.1% of GDP in 1997 to only 0.1% of GDP currently. (See graph)

At this time when our thoroughfares sometimes look like giant parking lots during rush hour, a good way to package this variable oil tax is as short-term response to reduce traffic, while at the same time addressing the traffic problem at the roots by earmarking collections for building and upgrading of mass transport and road systems.

The savings of the country from the global oil price drop is around $6 billion annually. If only a third of this is captured via a variable oil tax, we can have $2 billion incremental revenue collection -- around 1% of GDP, thus also restoring oil excise tax to GDP ratio to its 1997 level.

The next installment of this column will talk about other potential revenue sources, rationalizing fiscal incentives, reducing unnecessary exemptions, and tariffication of quantitative restrictions on rice.

The last measure, will not only bring down the cost of rice, historically twice to thrice our neighbors’, but can bring new revenues of P25 billion to P30 billion every year, and save government P4 billion from annual budget subsidy and stem further explosion in unpayable NFA debt (around P 150 billion) guaranteed by the Republic.

Romeo L. Bernardo was Finance Undersecretary during the Cory Aquino and Ramos administrations and board director of Institute for Development and Econometric Analysis, Inc. (IDEA)

romeo.lopez.bernardo@gmail.com