Philippines - Domestic and external resources for development

Report No. 2674-PH FILE COPY" The Philippines: Domestic and External Resources for Development November 12, 1979 Country Programs Department East Asia and Pacific Regional Office FOR OFFICIAL USE ONLY Document of the World Bank This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  CURRENCY EQUIVALENTS Currency unit = Pesos (P) US$1.00 = P 7.4 P 1.00 = US$0.135 FISCAL YEAR January 1 to December 31 ABBREVIATIONS AND ACRONYMS CDC - Cash Disbursement Ceiling IMF - International Monetary Fund MPH - Ministry of Public Highways MPWTC - Ministry of Public Works, Transportation and Communications MWSS - Metropolitan Waterworks and Sewerage System NEDA - National Economic and Development Authority NPC - National Power Corporation NTRC - National Tax Research Center OPEC - Organization of Oil Exporting Countries  FOR OFFICIAL USE ONLY This report was prepared by an economic mission which visited the Philippines in May/June 1979. The mission consisted of Bruce Jones (Chief), Chrik Poortman, James McGibbon, Liaquat Ahamed, and Christian Moulin. This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.   Page 1 of 2 COUNTRY DATA - PHILIPPINES AREA POPULATION /a DENSITY 300,000 sq km 47.1 million (mid-1979) 148.3 per sq km Rate of growth: 2.8 (from 1970 to 1975) POPULATION CHARACTERISTICS (1977) HEALTH (1975) Crude birth rate (per 1,000) 35.0 Population per physician 3,150 Crude death rate (per 1,000) 9.0 Population per hospital bed 880 (1974) INCOME DISTRIBUTION (1975) DISTRIBUTION OF LAND OWNERSHIP (1971) % of national income, highest 20% 53.3 Z owned by top 10% of owners 18 lowest 20X 5.5 Z owned by smallest 10% of owners 2 ACCESS TO PIPED WATER (1975) ACCESS TO ELECTRICITY (1975) Occupied dwellings without 1 of population - total 31 piped water (%) 57 - rural 10 NUTRITION (1976) EDUCATION (1974) Calorie intake as S of Adult literacy rate (x) 87 requirement 87 Primary school enrollment (Z) 104 Per capita protein intake (grams/day) 50.0 /b GNP PER CAPITA IN 1978: US$510 GROSS NATIONAL PRODUCT IN 1978 ANNUAL RATE OF GROWTH (x. constant prices) US$ million X 1966-71 1971-78 1978 GNP at market prices 23,308 100.0 5.1 6.5 6.1 Gross domestic investment 5,681 24.4 5.9 11.6 12.6 Gross national saving 4,407 18.9 2.4 5.6 5.5 Current account balance -1,274 -5.5 Exports of goods, nfs 4,380 18.8 -0.5 6.9 , 2.1 Imports of goods, nfs 5,627 24.1 4.1 7.2 13.2 OUTPUT, LABOR FORCE AND PRODUCTIVITY IN 1978 Value Added Labor Force V.A. per Worker USS million % Million . US$ x Agriculture 6,386 27.2 7.4/a 47.4 863 57.8 Industry 8,149 34.8 2.7/a 17.3 3,018 202.3 Services 8,895 38.0 5.6/a 35.3 1,588 106.4 Total/Average 23,430 100.0 15.7/c 100.0 1.492 100.0 GOVERNMENT FINANCE General Government Central Government (P billion) I of GDP (P billion) % of GDP 1978 1978 1971 1978 1978 1971 Current receipts 27.0 15.6 11.3 24.0 13.9 9.2 Current expenditure 22.0 12.7 10.1 19.3 11.2 7.6' Current s:urplus 5.0 2.9 1.2 4.7 2.7 1.6 Capito1 ixpenditures 7.2 4.2 1.6 7.0 4.1 1.3 /a Estimate. Lb The Per Capita GNP estimate calculated by the conversion technique used for the World Bank Atlas. All other conversions to dollarb In tl.ts table are at the average exchange rate prevailing during the period covered. Lc Total employed lahor force; second quarter, 1978  Page 2 of 2 pages COUNTRY DATA - PHILIPPINES MONEY. CREDIT AND PRICES 1972 1973 1974 1975 1976 1977 1978 (P billion outstanding end period) Money supply 6.5 7.3 9.0 10.3 12.1 14.9 16.9 Bank credit to public sector 3.9 2.4 2.0 5.8 8.9 11.0 11.9 Bank credit to private sector 12.6 16.2 24.2 28.5 33.6 40.6 52.0 (Percentage or index numbers) Money as 2 of GDP 11.5 10.1 9.0 8.9 9.2 9.7 9.8 General price index (1972 - 100) 100.0 116.5 156.3 166.9 182.3 200.4 215.0 Annual percentage changes in: General price index 8.3 16.5 34.2 6.8 9.3 9.9 7.3 Bank credit to public sector -2.1 -38.5 -16.7 190.0 53.4 23.6 8.2 Bank credit to private sector 21.7 28.6 49.4 17.8 17.9 20.8 28.1 BALANCE OF PAYMENTS MERCHANDISE EXPORTS (AVERAGE 1976-78) 1976 1977 1978 US$ million % (USS million) Exports of goods, nfs 3,260 4,021 4,555 Nontraditional manufactureasc 767 25.2 Imports of goods, nfs 4,370 4.788 5.735 Coconut products 738 24.2 Resource gap (deficit - -) -1,110 -767 -1,180 Mineral products 495 16.2 Sugar products 402 13.2 Interest payments (net) -133 -164 -261 Forest products 287 9.4 Other factor payments (net) -133 -156 -145 Fruits and vegetables 159 5.2 Net transfers 269 260 312 Others 201 6.6 Balance on current account -1,107 -827 -1,274 Total 3.049 100.0 Direct foreign investment 144 216 163 EXTERNAL DEBT. December 31. 1978 /d US$ million Net MLT borrowing Disbursements 1,407 1,241 1,775 Public debt 4,109 Amortization 367 579 941 Private debt 2.091 Subtotal 1,040 662 834 Total outstanding & disbursed 6,200 DEBT SERVICE RATIO FOR 1978 e % Other capital (net) /a -238 113 223 Overall balance -161 164 -54 On public debt 11.1 Gross reserves On private debt 8.1 (end year) /b 1,642 1,525 1,883 Total 19.2 Petroleum imports 801 859 907 RATE OF EXCHANGE IBRD/IDA LENDING. December 31. 1978 (US$ million) Annual AveraRe End Period IBRD IDA 1976 1977 1978 1978 Outstanding and disbursed 545.9 29.7 US$1.00 - p 7.447 7.407 7.375 7.384 Undisbursed 1,087.3 30.5 P 1.00 - US$ 0.134 0.135 0.136 0.135 Outstanding, including undisbursed 1,633.2 60.2 /a Includes SDRs, short-term private loans, errors and omission, and monetization of gold. lt. Gross rescr;es of the Central Bank. tc Major items in this group are: garments, electrical equipment and components, handicrafts, chemicals, cement, food products and beverages. /d Excludes short-term debt and liabilities to IMF. le Ratio of debt service to receipts from exports of goods and services. Excludes prepayntcnts.  THE PHILIPPINES: DOMESTIC AND EXTERNAL RESOURCES FOR DEVELOPMENT TABLE OF CONTENTS Page No. WORLD BANK REPORTS ON THE PHILIPPINES, 1978-79 INTRODUCTION AND SUMMARY 1. RECENT ECONOMIC DEVELOPMENTS ... . . . . . . . . . . . . . . 1 2. PUBLIC FINANCE: RECENT DEVELOPMENTS AND FUTURE RESOURCE NEED AND AVAILABILITY A. Domestic Resource Mobilization . . . . . . . . . . . . . 7 B. Current Expenditures . . . . . . . . . . . . . . . . . 13 C. The Public Investment Program and Foreign-assisted Projects . . . . . . . . . . . . . . 14 D. Management of the Public Investment Program. . . . . . . 22 3. MEDIUM-TERM BALANCE OF PAYMENTS PROSPECTS A. The Need for Adjustment . . . . . . . . . . . . . . . . 24 B. Adjustment Policies and Current Account Prospects . . . 25 C. Financing the Current Account Deficit . . . . . . . . . 30 4. CONCLUSIONS AND AID RECOMMENDATION . . . . . . . . . . . . . . 34 STATISTICAL APPENDIX Table of Contents . . . . . . . . . . . . . . . . . . . . . . . . 37 Section 1 - Population and Employment . . . . . . . . . . . . . . 41 Section 2 - National Accounts ..... . ....... . . .. . 44 Section 3 - Balance of Payments . . . . . . . . . . . . . . . . 56 Section 4 - External Debt . . . . . . . . . . . . . . . ... . . . 68 Section 5 - Public Finance . . . . . . . . . . . . . . . . . . . 72 Section 6 - Money and Credit . . . . . . . . . . . . . . . . . 87 Section 7 - Agriculture ...... .. ........ .. .. . 92 Section 8 - Industry ....... . ........ .. .. . . 102 Section 9 - Services . . . . . . . . . . . . . . . . . . . . . 109 Section 10 - Prices and Wages . . . . . . . . . . . . . . . . . .111 MAP  Page No. TABLES IN TEXT Table No. 1. Growth Rates of Components of Real GDP 2 2. Investment Ratios 5 3. Estimates of Additional Revenue Generated by New Tax Measures, 1976-78 8 4. National Government Tax Revenues and Tax Ratio, 1976-79 8 5. Current Operating Expenditures 13 6. Public Investment, 1976-79 16 7. National Government Capital Outlays, 1978-80 18 8. Public Investment and its Financing, 1978-82 20 9. Exports, Actual and Projected 28 10. Imports, Actual and Projected 30 11. Balance of Payments Summary 32 12. External Debt Service 33  WORLD BANK REPORTS ON THE PHILIPPINES, 1978-1979 A. Sector Reports and Special Economic Studies Grain Production Policy Review No. 2192a-PH, January 22, 1979 A Development Strategy and Investment Priorities for the Central Visayas (Region VII), No. 2264-PH, January 4, 1979 Industrial Development Strategy and Policies, No. 2513-PH, October 29, 1979 (Joint Bank/IMF) Aspects of the Financial Sector, No. 2546-PH, October 1, 1979 B. Appraisal Reports Agriculture and Rural Development National Irrigation Systems Improvement Project II, No. 1785b-PH, February 14, 1978 Rural Infrastructure Project I, No. 1884a-PH, March 23, 1978 Magat River Multipurpose Project, Stage II, No. 1911-PH, April 28, 1978 Magat River Multipurpose Project Stage II Irrigation, No. 2150a-PH, November 17, 1978 Small Farmer Development Project-Land Bank of the Philippines No. 2189-PH, November 27, 1978 Samar Island Rural Development Project, No. 2627-PH (forthcoming, November 1979) Industry The Philippine Investments Systems Organization, No. 1900-PH, April 11, 1978 Third Loan for the Development Bank of the Philippines, No. 1972-PH, April 21, 1978 The Second Small and Mledium Industries Development Project, No. 2417-PH, May 18, 1979  Transportation and Power Rural Electrification Project, No. 1848-PH, March 13, 1978 Fourth Highway Project, No. 2258-PH, February 20, 1979 Water Supply and Urban Development Manila Water Supply Project II, No. 1978-PH, July 7, 1978 Second Urban Development Project, No. 2048a-PH, December 1, 1978 Provincial Cities Water Supply Project II, No. 2398-PH, May 11, 1979 Population and Education Second Population Project, No. 2453-PH, May 23, 1979 Fishery Training Project, No. 2628-PH (forthcoming, November 1979)  INTRODUCTION AND SUMMARY This report follows upon a series of earlier reports to the Consultative Group: a basic economic report, The Philippines: Priorities and Prospects for Development (1976); a Country Economic Memorandum (1977); and the Government's 1978 Economic Report on the Philippines. The Government's Five-Year Development Plan for the period 1978-82 was also presented to the Consultative Group in 1977. The basic report and the Development Plan provided broadly consistent longer-term frameworks for analysis of Philippine development issues. The present report focuses on public finance and the balance of payments. These topics were chosen because recent developments have intensi- fied the importance of public finance and balance of payments issues for Philippine growth prospects, and have outdated some aspects of the previous analyses. Other important topics have been covered in separate Bank reports: Grain Production Policy Review, Industrial Development Strategy and Policies, and (Joint Bank/IMF) Aspects of the Financial Sector. Additionally, work has been initiated on poverty alleviation and basic needs in the Philippines, which is expected to provide the basis for a report to the Consultative Group in 1980. Recent Economic Developments The principal features of recent Philippines economic developments are: continuation of an economic growth pattern combining impressive agri- cultural performance and slower than desired industrial growth; maintenance of a high level of investment; the acceleration of inflation; the emergence, despite substantial new revenue-generating measures, of public sector resource constraints; and widening of the current account deficit, resulting in a more difficult balance of payments situation. The real output of the Philippine economy increased by 6% in 1978 and an estimated 5-6% in 1979. Although it thus has not been possible to accelerate growth, the Philippine economy has continued to perform signifi- cantly better than oil-importing developing economies generally in recent years. A critical element of growth has been continued impressive agricul- tural production, with the rice subsector yielding exportable surpluses. On the other hand, the construction sector has inevitably decelerated from the very rapid growth rates of the mid-1970s, and the growth of the manufacturing sector has remained slower than desired. A significant achievement has been the maintenance, despite more difficult external conditions, of the high level of investment of 24% of GNP initially achieved in 1975. This reflects increases in public investment from 2% of GNP in the early 1970s to 5% of GNP recently, and in private investment from 15% of GNP in the early 1970s to 19% of GNP recently. However, effort needs to be devoted to improving the efficiency of invest- ment, particularly in the manufacturing sector.  - ii - Inflation, after several years of relatively moderate price in- creases, accelerated sharply in 1979. This reflects both external develop- ments, particularly related to oil, and internal liberalization of price controls. Inflation should begin to subside in 1980. Public Finance During each of the years 1976-79 the Government has enacted packages of measures relating to domestic taxation, which have contributed substantially to its revenue generation, equity, elasticity, and efficiency objectives. However, because of the reduction of dependence on taxes on international trade, and the limited inherent responsiveness of revenues to the growth of nominal GNP, the ratio of tax revenues to GNP has improved only marginally. Priorities for additional tax reform include further broadening of the bases of the individual and corporate income taxes; reduction and evening of import tariffs to promote better resource allocation, with compensating adjustments in domestic taxation; and reduction in remaining earmarking of revenues. The Government has also taken steps to improve resource mobilization by government corporations, but further such measures will be needed in the future. As a consequence of the Government's policy of giving priority to capital expenditures, the share of GNP devoted to government current expenditures declined from 1976 to 1979. In view of the considerable needs for more competitive compensation for professional and management level staff in the civil service, operating expenditures in the social sectors, and maintenance of the public sector's growing capital assets, a further decline in this ratio would be undesirable. The reasonable scope for expansion of capital expenditure availability through relative reduction of current expenditures has now been fully exploited. The remarkable increase during 1972-77 of the ratio of public investment to GNP reflected the initiation of new programs; improvements in project preparation and implementation capacity, and in government revenue performance; and increases in official assistance. It was expected in the Development Plan that there would be a further increase in the ratio during the early years of the Plan period. However, this has not yet been achieved, and there have been instances of peso funding shortfalls in both foreign- assisted and locally-funded projects. This reflects a complex interaction of resource constraints and administrative difficulties. The Government's room for maneuver in response to these constraints is limited by its commit- ments to foreign-assisted projects, which now account for 75% of the public investment program. It appears that 1980 will be another tight year, but that the planned public investment program will be financeable.  - iii - A public investment program amounting to 6% of GNP during the remainder of the Plan period is desirable for providing needed infrastruc- ture, particularly in the outlying regions. From the standpoint of likely resource availability, it probably would be premature to consider a program significantly larger than 6% of GNP at the present time. Most of the program would be devoted to ongoing and firmly committed projects, leaving relatively little room for major new programs. Financing the recommended level of public investment would require further measures of domestic resource mobilization, increased financing of local currency costs by external donors, and possibly a more flexible domestic borrowing policy. The recent emergence of constraints highlights the need for the best possible management of the public investment program. Improvements are desirable in expenditure forecasting by the implementing line agencies; revenue forecasting by the Ministry of Finance; and medium-term investment programming and capital budgeting by NEDA and the Budget Ministry. The Balance of Payments The Philippine balance of payments was initially protected from the adverse impact of the oil price increase of 1973 by exceptionally high prices for coconut products, sugar and copper. The subsequent decline in the prices of these export commodities led to a severe deterioration in the external terms of trade. This, combined with the Government's determination to maintain high levels of investment and growth, resulted in the emergence of large current account deficits in the balance of payments. By 1976, the deficit reached $1.1 billion, or 6% of GNP. The Bank's basic economic report (1976) and the Government's Development Plan (1977) provided broadly consistent frameworks for the containment of the deficit in nominal terms and its gradual reduction in real terms. However, actual developments have deviated somewhat from pre- vious expectations. Import volume has grown at about the same rate as export volume, rather than somewhat less rapidly as projected. Additionally, although prices have recovered for some commodity exports, the expected secular recovery in the terms of trade has been forestalled by higher prices for both oil and non-oil imports. The result has been a widening of the deficit to an estimated $1.6 billion in 1979 and an estimated $2 billion in 1980. Deficits of this magnitude appear to be financeable in the short term without an excessive increase in the debt service ratio. However, maintenance of creditworthiness over the longer term will require making progress in the early 1980s toward the Development Plan's objective of reducing reliance on net foreign capital inflow. This can be accomplished through adjustment measures designed to accelerate the growth of exports, decelerate the growth of imports, and improve the efficiency of investment. Particularly important are: tariff reform, accompanied by adjustments in  - i v - domestic taxation; simplification and further extension of export incen- tives; reform of fiscal incentives; and appropriate energy pricing. Conclusions The more difficult public finance and balance of payments situations have implications for both the Government and the Consultative Group. For the Government, the implication is that new projects and programs will have to be scrutinized closely to ensure that only the -very highest priority ones are selected for implementation. For the Consultative Croup, the recent developments have increased the Philippines' need for Official Development Assistance. Tt is recommended that the Consultatic-e Group aim at conmmitting at least $1 billion of ODA in 1980, with considerable financing of local costs.  1. RECENT ECONOMIC DEVELOPMENTS 1.01 The principal features of recent Philippine economic developments are: (a) continuation of an economic growth pattern combining good agricul- tural performance and slower than desired industrial growth; (b) widening of the current account deficit in the balance of payments; (c) maintenance of a high level of investment; (d) acceleration of inflation; and (e) emergence of public sector resource constraints (Chapter 2). Growth and its Sectoral Composition 1.02 In 1978, the real output of the Philippine economy increased by 6%. Due to the recessionary impact of the oil price increases, the growth rate this year is likely to be in the range of 5-6% (Table 1). Thus, it has not yet been possible to accelerate growth as projected in the Development Plan. On the other hand, the Philippine economy has continued to perform signifi- cantly better than the 4.5% growth achieved by "middle income" oil-importing developing countries generally during the post-1973 period. The aggregate growth reflects impressive agricultural performance, and slower than desired industrial growth. 1.03 Agricultural production has continued to grow by about 5% annually. However, performance among subsectors has been quite diverse. Rice produrtion has continued to increase by 5% a year. In the last two crop years, about 1% of rice production has been exported, and rice stocks are now at an all time high. The Government is concerned about the situation in which the configura- tion of rice production and consumers' incomes yield exportable surpluses, yet inadequate nutrition remains widespread; therefore, it has initiated preparation of a food plan which will contain strategies and objectives for consumption as well as production. Bananas, and roots and tubers have been the most dynamic crops. Corn and coconut production have grown relatively slowly, while sugarcane production has desirably contracted to volumes more in line with domestic and external demand. Production of fish, which is an important wage-good and source of protein, has been increasing by about 5% annually. Forestry production has been slowly declining because the most accessible areas have already been logged over, and because of the Government's policy of forest conservation. 1.04 While the agricultural and services sectors have recently continued to grow at their historical rates, the industrial sectors collectively have displayed decreased growth in 1977 and 1978. This reflects the circumstances that the very rapid growth of the construction industry during 1972-77, led by the growth of public investment, was impossible to sustain indefinitely, while the manufacturing sector did not accelerate its growth as desired and thereby replace construction as the dynamic element. Prospects for 1979 are for increased growth of construction due to the larger public investment program, and a slightly decreased growth for manufacturing because of the recessionary impact of the oil price increases, and the Luzon power outages during the 1979 dry season. Disaggregated manufacturing statistics reveal both rapid growth of labor-intensive export processing industries, and slow growth and capacity underutilization problems  - 2 - Table 1: GROWTH RATES OF COMIPONENTS OF RFAL rDP (in percent) 1972-77 1977 1978 1979 Estimate Expenditure on GDP: Growth Rates at 1972 Prices Personal consumption 4.5 4.1 5.0 4.5 Government consumption 8.6 5.8 6.5 0 Fixed capital formation 14.2 2.0 12.9 13 Goverment construction 28.1 14.0 10.0 20 Durable equipment investment 10.9 -0.8 13.5 10 and private construction Exports (incl. nonfactor services) 7.2 17.6 1.6 6 Of which: exports of goods /a /b 7.3 15.4(18) -0.2(4) 5 Imports (incl. nonfactor services) 7.0 5.3 13.2 7 Of which: imports of goods 7.8 4.7 13.9 7 Gross domestic product 6.6 6.2 5.9 5-6 Industrial Origin of GDP: Growth Rates at 1972 Prices Agriculture 5.0 5.0 4.8 5 Industry /c 8.9 7.7 6.4 6.5 Ilanufacturing 7.0 7.5 6.8 5.5 Construction 20.5 8.0 4.9 8 Services 5.8 5.7 6.3 5.5-6 /a Price and quantity indices in the Philippine statistical system use 1q72 as the base year. This gives rise to problems of interpretation with the export indices, because of the substantial structural change in Philippine exports since 1972. The use of indices that are weighted according to shares in 1972 export receipts gives undue weight to sugar, copra, and logs and insufficient weight to manufactured exports and coconut oil, yielding a downward bias in the export quantity index in recent years. For this reason, the official data for real export growth in 1977 and 1978 are accompanied by mission estimates in parentheses. The mission estimates weight the various commodity groups according to their shares in export receipts in 1977. /b The export growth rates in 1977 and 1978 reflect the large drawdown of sugar stocks in 1977 prior to the effectiveness of the International Sugar Agreement in 1978. /c Industry includes mining; manufacturing; construction; and electricity, gas, and water. Source: NEDA National Accounts Staff; Mission estimates for 1979.  - 3 - in some home industries affected hy fundamental structural problems. It is estimated that, were Lndustrial poli'y reforms to be undertaken, it should be possiLhe to accelerate riintifacturtng ; tr.)wth to at least 8% p.a./l W4idening of the Currenlt Account t)efLcit 1.05 The Philippine balance of payments was initially protected from the adverse impact of the oil price increase of 1973 by exceptionally high prices for coconut products, sugar, and ropper. The subsequent decline in the prices of these export commodities led to a severe deterioration in the external terms of trade. This, combined with the Government's determination to main- tain high levels of investment and growth, resulted in the emergence of large current account deficits in the balance of payments. By 1976, the deficit reached $1.1 billion, or 6.2% of GNP. 1.06 The Bank's basic economic report (1976) and the Government's Development Plan (1977) provided broadly consistent frameworks for the gradual reduction of the deficit in real terms. Exports would have to grow more rapidly than imports to keep the trade and current account deficits from widening. Both frameworks projected a real export growth rate of 9%. The basic report projected a real import growth rate of 7%, while the Plan, with a somewhat more ambitious GNP target, projected a real import growth rate of 87. /2 The margin by which real export growth had to exceed real import growth depended partly, of course, on the external terms of trade. Both frameworks assumed some recovery in the terms of trade in 1978-80, arising from higher prices for commodity exports. The expected current accounts deficits of $1 billion, while remaining approximately constant in nominal terms, would be declining in real terms, as a percentage of GNP, and as a percentage of export earnings. The task of financing these deficits would be sizeable but manageable, and would entail raising the debt service ratio from 17% in 1976 to 19%. 1.07 Actual developments since 1976 have deviated somewhat from the above scenario. First, although the trend of real export growth is difficult to assess precisely because of fluctuations and index number problems, real export growth has been slightly lower than expected, perhaps about 8%./3 /1 This issue is addressed in World Bank Report No. 2513-PH, Industrial Development Strategy and Policies in the Philippines. /2 Both the report and the Plan implicitly assumed an elastLcity of total imports withi respect to GNP of about 1.0. /3 The indi-es of the Central Bank imply negative export volume growth and a maj;r improvement in the terms of trade in 1977-79, whereas the mission's assessment is that there has been positive export growth and relativelv stahle terms of trade. See footnote /a to Table I or, for further discussion, Statistical Appendix Table 3.10.  - 4 - Nontraditional manufactured exports have performed extremely well, with receipts from this group increasing from $550 million in 1976 to an estimated $1.3 billion in 1979. Commodity exports, on the other hard, have performed less well, with sugar exports particularly being constrained by quota. 1.08 Second, the real import growth rate at 8.5% as compared with a real GDP growth rate averaging 6%, has been higher than expected. A somewhat puzzling aspect has been the growth of payments for raw materials and intermediate goods from $1.3 billion in 1976 to an estimated $2.3 billion in 1979. One factor has been the rapid increase in imports of inputs such as textiles and electronic components for the labor-intensive export-processing industries, but speculative importing also appears to be playing a role. In the first half of 1979 the Central Bank tightened credit conditions with the objective of discouraging speculative importing. 1.09 Third, although prices for some commodity exports such as coconut products and copper have increased substantially, the expected secular improvement in the terms of trade has not materialized. This reflects the major oil price increase of June 1979, and the acceleration in 1979 of the rates of inflation in the OECD countries which supply most of the Philippines' non-oil imports. It is estimated that the terms of trade are only 2% better in 1979 than in 1976-77, and that in 1980 when the new oil prices will be in effect for a full year, the terms of trade will decline to below the 1976-77 level. 1.10 While each of the above developments individually has not been decisively important, the combined effect has been a widening of the current account deficit to $1.3 billion (5.5% of GNP) in 1978 and an estimated $1.6 billion (5.7% of GNP) in 1979. The debt service ratio for 1979 is estimated to be 21%. Thus, the balance of payments situation has become significantly more difficult. The adjustment policies needed to reduce the deficit in real terms during the early 1980s are discussed in Chapter 3. Level, Efficiency, and Financing of Investment 1.11 A significant achievement has been the maintenance, despite the deterioration in the external terms of trade, of the relatively high level of fixed investment of 24% of GNP initially achieved in 1975 (Table 2). This reflects increases in both public and private investment over the levels of the early 1970s. 1.12 The public investment ratio increased remarkably from 2% of GNP in 1973 to about 5.5% of GNP in 1977, reflecting major improvements in project preparation and implementation capacity, improved government revenue performance and increased official assistance. The principal elements have been power, highways, and irrigation. The Development Plan projected a further increase in the public investment ratio in 1978 and succeeding years, but this has not yet been achieved due to the emergence of administrative and financial constraints (Chapter 2).  Table 2: INVESTMENT RATIOS (Ratios of fixed investment to GNP, in percent) 1970-72 1973 1974 1975 1976 1977 1978 Total fixed capital formation 16.1 15.4 18.7 24.3 24.7 23.8 24.4 Public investment /a 1.4 2.0 2.9 3.8 5.2 5.6 4.6 Private investment /b 14.7 13.4 15.8 20.5 19.5 18.2 19.8 /a Infrastructure program plus non-infrastructure capital outlays. /b Derived as a residual. 1.13 Private investment increased from 15% of GNP in the early 1970s to 19-20% of GNP in recent years. About 25% of private investment has been devoted to residential construction, 15% to nonresidential construction, and 60% to durable equipment, chiefly for manufacturing. Among manufacturing industries, food processing and textiles have absorbed about 30% of invest- ment followed by nonmetallic mineral processing, pulp and paper, and chemicals. 1.14 However, the incremental output arising from the high level of fixed investment has been somewhat less than reasonably could be expected. Although national accounts data from different countries may not be exactly comparable, available statistics suggest that the Philippines has an incremental capital/ output ratio (ICOR) about 35% higher than neighboring Asian countries which have roughly comparable patterns of investment (including energy and irriga- tion projects with long gestation periods and long benefit payoff periods)./I This indicates that effort should to be devoted to improving the efficiency of investment. Factors relating to relative inefficiency of private investment in the manufacturing sector include the tariff structure and fiscal incentives for investment, which have encouraged capital-intensive import-substitution industries./2 Public investment projects have generally been well selected, but there have been instances of promotion of premature capacity (hotels), and adoption of design standards other than least-cost ones (shelter). The recent problem of project construction periods being prolonged and project benefits postponed, due to funding shortages, is an adverse development for the efficiency of public investment. /1 Statistical Appendix Table 2.8. /2 For further discussion, see Industrial Development Strategy and Policies in the Philippines, especially Chapter II, Incentive System and Policies.  - 6 - 1.15 Domestic savings finance about 80% of total investment in the Philippines with the other 20% being financed by foreign savings. The overall domestic saving ratio is reasonably high, with both the public and private sectors showing good performance. Although the Philippines has a sophis- ticated system of financial institutions, adjustments in financial and regu- latory policies are desirable to facilitate achievement of the Government's objectives for resource mobilization and allocation through the financial sector./1 The Acceleration of Inflation 1.16 During 1976-78, the rate of inflation averaged 8%. Inflation has accelerated this year, because of both external factors and internal price liberalization. Externally, there was a minor OPEC oil price increase in December 1978, and a major one in June 1979. These increases and related Government discretionary measures resulted in higher prices for petroleum products and electricity, and higher transportation fares. The rate of price increase for non-oil imports also accelerated, after several years of relative stability. Internally, a situation had developed in which the prices of many of the commodities subject to control by the Price Stabilization Council provided inadequate incentives for production; for example, rice prices were providing inadequate financial incentives for economically optimum fertilizer use. Therefore, in March 1979 the Government took the difficult but commendable steps of releasing a few items from the controlled list, and increasing the prices of other items by 9-32%. As a result of the external and internal developments, by June 1979 the consumer price index had reached a level 20% greater than one year earlier. Inflation this year is thus at its highest rate since the commodity boom and the onset of the energy problem in 1974. In 1980, with more moderate increases in oil prices and tapering off of the effects of the internal price liberalization, inflation should begin to subside. 1.17 To compensate workers for the price increases, the Governnent also raised minimum wages and cost-of-living allowances in March 1979 with the adjustments tapered to provide relatively greater increases at the bottom of the wage scale. On present evidence, it appears that the lowest paid workers may maintain real earnings this year, but that skilled workers and salaried employees may experience a slight erosion of real income. /1 For further discussion, see WIorld Bank Report No. 2546-PH, (Joint Bank/ IMF) The Philippines: Aspects of the Financial Sector.  2. PUBLIC FINANCE: RECENT DEVELOPMENTS AND FUTURE RESOURCE NEED AND AVAILABILITY 2.01 It was expected in the Development Plan that the remarkable increase in the ratio of public investment to GNP which took place during 1972-77 would continue during the earlier years of the Plan period. However, a 'urther increase in the ratio has not yet been achieved, reflecting the emergence of resource constraints and associated administrative problems. It is therefor timely to examine issues relating to the level and structure of domestic resource mobilization (section A); the desirable and feasible levels of current expenditures and public investment (sections B and C); and management aspects (section D). A. Domestic Resource Mobilization 2.02 The Government's fiscal strategy, set out first in the Fc :--Year Plan for 1974-77 and subsequently in the Five-Year Plan for the period 1978-82, has been two-staged. Initially, needed revenues would be raised through increases in indirect tax rates that could be introduced quickly. However, the Government would also work toward longer-term objectives of: (a) improving the equity and elasticity of the tax system through greater reliance on direct taxes, more progressive indirect taxation, and broadening of the tax base; (b) increasing the stability of tax revenues by reducing dependence on taxes on international trade; and (c) greater efficiency in resource allocation through rationalization of fiscal and tariff incentives. In addition, self-financing of government corporations would be increased by raising their tariff rates. Recent Tax Measures and Revenue Growth 2.03 During the first half of the 1970s, few discretionary measures related to domestic taxation were introduced, but substantial revenue growth from 11.6% of GNP in 1972 to 13.6% of GNP in 1975 resulted from improved administration, and from taking advantage of the opportunity to tax the growth of international trade, particularly commodity exports. By contrast, recent revenue growth has depended more heavily on discretionary measures relating to domestic taxation. In the period 1976-79, the Government introduced annual packages of new tax measures which brought in P 2.2 billion of revenue in 1978, and an estimated P 3.0 billion in 1979 (Table 3). The principal measures, along with their salient non-revenue objectives, were the following:  -8 - Table 3: ESTIMATES OF ADDITIONAL REVENUES GENERATED IN 1978 BY NEW TAX MIEASURES INTRODUCED DURING 1976-78 (Millions of pesos) Additional Type of Tax revenues Percent 1978 of total Direct 42 4 Indirect 2,085 96 License and business tax 361 17 Excise taxes 1,146 52 Petroleum products (1,038) (47) Other (108) (5) Import duties (incl. sales tax on imports) 578 27 Total 2,177 100 /a Cumulative, and including the effects of new tax exemptions resulting in a loss of revenue. Source: National Tax Research Center. Table 4: NATIONAL GOVERNMENT TAX REVENUES AND TOTAL TAX RATIO, 1976-79 (% of GNP) 1976 1977 1978 1979/a Direct taxes (incl. taxes on property) 2.9 3.0 3.3 3.3 Domestic indirect taxes 4.0 4.1 4.1 4.6 Taxes on international trade 4.7 4.1 4.5 4.0 Total national government tax revenues 11.6 11.2 11.9 11.9 (Of which: new 1976-79 taxes) (0.4) (0.8) (1.3) (1.5) Total tax ratio lb 13.3 12.8 13.6 13.5 /a Bank staff estimates. /b Sum of tax revenues of national and local governments and social security contributions, divided by GNP at current prices. Source: Statistical Appendix Tables 5.1, 5.3.  -9 - (a) increases in excise taxes on petroleum products in 1976, 1977 and 1979 (energy conservation); (b) increases in excise taxes on cigarettes and alcoholic beverages in 1977 and 1978; (c) restructuring of the domestic sales tax, according to essentiality of the product sold, in 1978 (equity, elasticity); (d) replacement of duty-free importation privileges, allowed to certain government corporations and granted to private firms by the Board of Investments, by a 5% customs duty and a 5% internal revenue tax (in lieu of the actual tariff), in 1978 (efficiency); (e) establishment of a "development" tax on closely held corporations, in 1977 (encouragement to go public); and (f) establishment of an interest withholding tax on bank deposits (15%) and money market instruments (35%), in 1977 (equity, elasticity, strengthening of the deposit base of the banking system). 2.04 The new measures accounted for about one-third of the total increase in national government tax revenues, with the balance attributable to the growth of GNP and substantially improved tax administration and collection performance. Despite the substantial discretionary measures, the tax ratio for 1979 /1 is estimated to be only marginally higher than the level achieved in 1976 (Table 4). This reflects the limited inherent responsiveness of the tax system to the growth of nominal GNP. Dependence on taxes on international trade was reduced from 40% of national government tax revenues in 1976 to 34% in 1979, and the ratio of all domestic tax revenues to GNP was increased from 8.6% in 1976 to 9.5% in 1979. 2.05 In conjunction with the consideration of the 1980 budget, a sub- stantial tax package was enacted in the third quarter of 1979 which is expected to bring in P 1.6 billion of new revenues in 1980. The package includes: increases in taxes on petroleum products; an export tax on logs (replacing a quota); modification of inventory valuation for purposes of the corporate income tax; a tax on residential electricity consumption; a travel tax; and a capital gains tax on the sale of real property. The latter three taxes are particularly progressive, and the package in general represents a major contribution toward the Government's fiscal objectives. /1 Including those tax measures which were introduced in support of the 1980 budget but which became effective in the latter part of 1979.  - 10 - The Present Tax System: A Summary Assessment of the Issues 2.06 Tax Effort. Although considerable effort has gone into adopting the recent tax measures and improvements in administration, the share of GNP collected in tax revenues is still relatively low. The estimated tax ratio of 11.9% in 1979 (here excluding social security contributions) compares with an average tax ratio of 15.1% for a group of developing countries surveyed by the IMF for the period 1969-72./l However, this group contains some oil- and mineral-exporting countries with a typically high "taxable capacity" (ease of taxation). A more relevant comparison may be made between the actual Philippine tax ratio and the "norm" tax ratio for a country with the Philippines' characteristics, predicted on the basis of a statistical analysis in which the tax ratio is the dependent variable and independent variables measure taxable capacity./2 The observed Philippine ratio is about 10% below the norm, equivalent to about 1% of GNP annually. Thus, there would appear to be scope for further increase in the tax effort in future years. 2.07 Elasticity. Data indicate that during 1975-78 the elasticity of national government tax revenues with respect to nominal GNP remained at its historical level of 0.9, although economic conditions may have prevented the elasticity of the system from being fully observed. Many of the recent measures have had positive implications for elasticity and may have raised the elasticity closer to unity more recently. On the other hand, as the majority of new measures consisted of revisions in indirect tax rates, reliance on direct taxes, potentially the most incomeelastic form of taxation, increased only slightly to about 25% of total tax revenues. This is below the developing country average; in fact, it is the shortfall in direct taxation that accounts for the shortfall in total tax effort, as the Philippines collects approximately average amounts of indirect taxes. Additionally, despite the effects of the recent restructuring of the domestic sales tax, the present indirect tax system is still considerably dependent on taxes with relatively low elasticities, such as excise taxes that are assessed on a specific rather than an ad-valorem basis. 2.08 Equity. A study in 1975 found that the Philippine revenue system of the early 1970s was regressive because of its reliance on taxes on commodi- ties, including those consumed by low-income groups./3 Many of the recent tax /1 Chelliah, Raja J. et.al. "Tax Ratios and Tax Effort in Developing Countries 1969-71", IMF Staff Papers, March 1975. The average tax ratio for the higher income countries, which included the Philippines, was 16.3%. /2 Statistical Appendix Table 5.5. /3 Edita Tan, Taxation, Government Spending, and Income Distribution in the Philippines (University of the Philippines School of Economics, 1975).  - 11 - measures, such as the restructuring of the sales tax and the increases in taxes on motor vehicle transportation (automobile sales tax, fuel taxes), have had positive equity implications, with the effect of making the system more progressive. More progressive indirect taxation has probably redistributed some of the tax burden from the poor to the middle classes, but more effective direct taxation will be necessary to reach the wealthy groups. 2.09 Efficiency. Fiscal incentives, including exemptions from corporate income tax and incentives flowing from the tariff structure have been used widely in the Phillppines to attract investment into activities deemed to have priority in terms of national economic development objectives. However, the effects of the incentive system have been to create a bias favoring production of consumer goods for the domestic market, and to lower the effective price of capital goods relative to labor. Rationalization of the present tariff structure and the fiscal incentive system remains a high priority objective. The Philippine incentive system and suggested reforms are reviewed in detail in the IBRD's recent industrial sector survey./I Priorities for Future Tax Reform 2.10 The individual income tax offers potentially the most promising means of raising revenues equitably and, because of its high income elasticity, automatically. Although the nominal income tax rate structure is quite progressive, deficiencies in its administration have resulted in relatively low effective rates of taxation in the higher brackets. Recent Government efforts have focussed on reducing both business and personal deductions from declared income./2 A remaining problem is that for persons in management levels in the private business sector, declared income is often less than real personal income. This reflects non-reporting of some types of non-salary monetary compensation, such as profit-sharing bonuses, and the practice of compensation in kind (services of essentially a personal consumption nature paid for by the firm). The administrative costs of identifying and taxing these types of income would probably be reasonable in relation to incremental revenues. The income tax withholding system has recently been extended to interest and investment income (1977), professional fees (1978), and partnerships (1979). However, it deserves wider enforcement; with respect to wage incomes, this is illustrated by the fact that only one fourth as many employers were registered as income tax withholding agents as of the end of 1978, as were registered with the Social Security System, and that only about half of the income tax on wages is collected by withholding. /1 Industrial Development Strategy and Policies in the Philippines, Chapter II. /2 Among the further measures under consideration by the Government, the establishment of standard deductions for different types of incomes/business would appear to be particularly desirable because of its obvious administrative advantages.  - 12 - 2.11 The elasticity of the present corporate income tax system could be improved significantly by limiting deductions, exemptions and exclusions. At present, nearly 45% of taxable corporations are exempt from paying taxes while deductions claimed by corporations amount to about 70% of gross income reported. Aside from raising the effective tax rate, limitations on deduc- tions are also essential for rationalization of fiscal incentives. 2.12 Because of their relative progressivity and elasticity, taxes on motor vehicle fuels can also contribute importantly to achieving the Govern- ment's longer term fiscal objectives. However, taxes on motor vehicle fuels are currently levied at specific rates which limits their responsiveness to increases in nominal GNP. Consideration should therefore be given to replacing the specific taxes by ad-valorem rates. Moreover, fuel taxes, including the specific tax and two "special fund" levies, are still somewhat below those in many oil-importing countries, although the repeated increases may have improved the relative position of the Philippines in this respect./l 2.13 Reduction and evening of import tariffs will be necessary to bring about a more efficient allocation of resources and to ensure continued growth of exports. However, tariff reform and reduction will need to be accompanied by adjustments in the domestic sales and excise taxes to (i) offset any revenue loss arising from lower import duty rates, and (ii) restrain consumption of luxury goods currently restricted through a combina- tion of high duty rates and import licensing. 2.14 Although it may be debated as to whether it would properly be classified as a tax reform or an expenditure reform, further disearmarking is desirable. Reduction in the number of earmarked revenues has been a major element of the Government's fiscal reform program. The principal remaining earmarked revenues are the coconut levy which accrues to the Philippine Coconut Authority's Coconut Investment Fund, and the special levy on petroleum products which accrues to the Oil Industry Special Fund./2 Earmarking has the potential for leading to suboptimal resource allocation, as expenditures out of special funds may not be subjected to the same scrutiny as expenditures out of the General Fund. It also undesirably reduces expenditure flexibility. For example, in mid-1979 the Oil Industry Fund had an unappropriated surplus of P 400 million, while some foreign-assisted and locally-funded development projects were being executed slowly because of peso shortages. /1 As of May 1979, the retail price (in Metro Mlanila) for premium gasoline was P 2.23/liter or the equivalent of TJS$1.16/gallon. /2 The latter is a special account within the Government's budgetary operations, whereas the former is an outside fund administered by the Covernment.  - 1 3 - Resource Mobilization by Government Corporations 2.15 The earnings of government corporations represent an additional source of public revenues. However, because tariff rates have been consis- tently lower than justified by efficiency, equity, and resource mobilization considerations, internal cash generation has been quite low. The average percentage of self-financing of corporate investment programs is currently less than 3%. Because of their dependence on government equity contributions, the corporations have therefore become a considerable burden to the taxpaying general public, who probably are poorer on average than the users of the various utilities. Steps have been taken in the last two years to increase the tariff rates of the National Power Corporation and the Mietropolitan Waterworks and Sewerage System. Following a series of power rate revisions during 1978, NPC improved its rate of return on net fixed assets in operation to 6% in 1978. Fuel-price adjustments were introduced in April and September 1979 to compensate NPC for increased costs, but the planned "real" tariff increase (additional to compensation for cost inflation), necessary to meet the targeted 8% rate of return, was deferred. In M4WSS, tariffs were raised by 57% in 1978. However, substantial future increases in tariffs will continue to be required in the future. B. Current Expenditures 2.16 Current expenditures consist chiefly of personnel compensation, and nonpersonnel recurrent costs such as supplies and maintenance. As a consequence of the Government's policy of giving priority to capital expenditures, the share of current expenditures in the national government budget has decreased from 78% in 1976 to 70% in 1979, and the ratio of current expenditures to GNP has fallen from 12% in 1976 to 10.5% in 1979 (Table 5). Table 5: CURRENT OPERATING EXPENDITIJRES (Percentage of GNP) 1976 1977 1978 1979 (Est.) Wages, salaries and other benefits 4.6 4.3 4.7 4.5 Other goods and services 6.3 6.2 5.4 4.7 Allotments to local governments 0.5 0.5 0.5 0.5 Interest payments 0.6 0.6 0.7 0.8 Total 12.0 11.6 11.3 10.5 Source: Statistical Appendix Table 5.1.  - 14 - 2.17 Wages, salaries and other personnel benefits account for about 40% of national government current expenditures. Compensation policv is adminis- tered by the Office of Compensation and Position Classification (OCPC) of the Budget Ministry. The principle underlying official policy is that government compensation should be comparable to that in the private sector, as revealed by periodic surveys. Budgetary constraints have prevented full implementation of this principle. For example, parity with the private sector compensation levels of 1976 (the date of the most recent survey) was achieved only in 1079. In the meantime, private sector compensation has increased considerably, particularly because of inflation. Disparities between private sector and public sector compensation appear to be small or nonexistent at the unskilled and clerical levels, and greatest at the professional and managerial levels. Special adjustments have therefore been undertaken for some groups such as physicians and lawyers, and additional such adjustments are needed for some groups such as computer programmers. Providing more competitive compensation to professional and management staff, while keeping total compensation costs within affordable limits, would probably require widening of compensation differentials or special adjustments for critical positions. 2.18 In order to attain the Government's social objectives, it will be necessary to increase expenditures for items such as school textbooks, health care supplies, and transportation for agricultural extension workers and other staff providing services in rural areas. By statute, allotments to local governments absorb a fixed share of internal revenue collections. Wyith the prospective further shift away from dependence on taxes on external trade, these allotments will increase considerably. Interest payments will also increase with the growth of the Government's foreign and domestic borrowing programs. 2.19 In view of the growing number of capital projects now reaching comr pletion, expenditures to provide for the recurrent cost requirements necessary to maintain and operate these assets will necessarily have to increase. The Government should therefore aim to stem the relative decline of current expen- ditures, and allow such expenditures to stabilize at the present level of 10.5% of GNP. C. The Public Investment Program and Foreign-Assisted Projects 2.21 The Government's remarkable success in raising the level of public investment /1 from 2% of CNP in 1973 to 5.6% of GNP in 1977 was noted in Chapter 1. This section discusses the recent emergence of constraints in the /1 Public investment is defined here as infrastructure expenditures of the National Government proper and of government corporations in areas such as transportation, power, and irrigation, plus the non-infrastructure capital outlays of the National Government proper. The latter consists of projects undertaken by ministries other than the Ministry of Public Works, Transportation and Communications and the Ministry of Public Highways. Capital expenditures of local governments, which are less than 0.2% of GNP, are thus omitted here.  - 15 - in the public investment program during 1978-79; the 1980 budget; and prospects for relieving financial constraints in the medium term. The Public Investment Program in 1978-79 2.21 In 1978, the public investment program was affected by a number of administrative problems. First, the infrastructure program was finalized behind schedule, resulting in some project delays during the good dry-season construction weather at the beginning of the calendar year. Second, changes were introduced in budgetary procedures, with the general objective of strei - thening budgetary control in order to handle an incipient problem ot over- spending, as the planned public investment program exceeded the anticipated availability of financial resources. As might reasonably be expected, the changes were associated with "breaking-in" difficulties in the short-term. One important change was the reduction of the period of validity of Cash Disbursement Ceilings (authority to incur expenditures) for capital projects. Previously these were valid for the life of the project, leading to sizeable outstanding obligational authority, thus complicating cash managemen.:. Under the new procedure the CDCs for capital projects lapsed at the end of each quarter, i.e., in the same manner as for current expenditure CDCs. Addition- ally, the Budget Ministry clarified the prevailing lack of understanding and conflicting practice regarding "non-cash foreign loan availments."/l When the Budget Ministry ruled that such availments were chargeable against Ceilings, agencies which had prepared their 1978 budget requests on the assumption that Ceilings related only to "cash" found themselves underfunded. 2.22 The consequence of the infrastructure program delay and the changes in procedures was that both locally-funded and foreign-assisted projects experienced peso funding shortfalls in 1978. The Government underspent its capital budget and exceeded its intended additions to cash balances. The actual outcome of public investment was 7.9 billion pesos, or 4.6% of GNP (Table 6). From the standpoint of physical implementation capacity, the Government could have spent significantly more on public investment in the absence of these administrative problems, with about half of the incremental amount coming from official loan disbursements deferred by project delays. 2.23 In 1979, the Government made considerable progress toward resolving administrative problems, as programming went according to schedule, the period of validity of CDCs for capital projects was subsequently extended, and agencies have accustomed themselves to budgeting for and recording as desired their non-cash availments. Nonetheless, instances of peso funding shortfalls have persisted. It appears that there is insufficient financing for the infrastructure program. The initial infrastructure program of P 13.3 billion was subsequently reduced to P 13.0 billion./2 The /1 This term refers to equipment for which payment is made directly by a foreign lender to a foreign supplier without any cash flow through the Philippine Treasury. /2 Republic of the Philippines, 1978 Economic Report on the Philippines, Tables 3.3 and 3.4; Statistical Appendix Table 5.13.  - 16 - Table 6: PUBLIC INVESTMENT 1976-1979 (Cash Basis) Actual Estimate /a 1976 1977 1978 1979 A. Expenditures (P billion) Infrastructure program 6.6 8.0 7.4 10.0 Non-infrastructure capital outlays 0.3 0.4 0.5 1.2 Total Public Investment 6.9 8.4 7.9 11.2 B. Percentage of GNP Infrastructure program 5.0 5.3 4.3 4.8 Non-infrastructure capital outlays 0.2 0.3 0.3 0.6 Total Public Investment 5.2 5.6 4.6 5.4 Memorandum Item Foreign Assisted Projects as: /b - percentage of NEDA infrastructure program 48 71 69 73 - percentage of fixed public investment 47 70 67 69 /a Bank staff estimate based on Budget documents and information provided by government corporations. /b Estimated from NEDA data on foreign loan availments for infrastructure projects. In addition, it is estimated on the basis of budget data that 30% of non-infrastructure capital outlays consist of foreign-assisted projects. budgetary support for the infrastructure program, consisting of allocations for MPH and MPWTC, plus equity contributions to government corporations in the program, is P 7.2 billion. The other sources of financing for the program are corporate internal cash generation, and direct borrowing (borrowing not channelled through the budget) by those government corpora- tions permitted to do this. On the basis of recent experience, these two sources would probably not provide more than P 3.5-4 billion, implying an overall funding shortfall. The initial difficulty of the situation has been heightened by inflation, and by spending on new housing programs that  - 17 - were not anticipated when the 1979 budget was prepared in mid-1978. The National Power Corporation and the National Irrigation Administration have been affected by inadequate peso financing and have had to revise their investment programs downwards in 1979. A "realignment" of the infrastructure program for the second half of the year, reallocating obligational authority from projects with surplus funding to projects with insufficient funding, appears to have alleviated funding problems somewhat. Despite the problems, it appears that public investment will recover this year to about the 5.5% level of GNP achieved in 1977. 2.24 Issues Relating to the Rapid Growth of Foreign-assisted Projects. The Government's room for maneuver is response to the recent resource con- straints has been limited by its commitments to foreign-assisted projects. The percentage of infrastructure expenditures accounted for by foreign- assisted projects has increased from 48% in 1976 to 73% in 1979 (Table 7). Part of this increase can be attributed to the growing proportion of resources that have been devoted to expansion in power generation and distribution, an overwhelming proportion of which consists of foreign- assisted projects. Nevertheless, in other sectors the proportion of capital expenditures absorbed by foreign-assisted projects has also increased. 2.25 There is justification for avoiding committing an excessive share of the public investment program to foreign-assisted projects. First, although foreign donors have modified their traditional preference for large-scale infrastructure projects during the past decade and now finance a wider variety of projects, these remain certain types of projects, such as government office buildings, hospitals and small public works not easily packaged, which are necessary but which foreign donors rarely if ever finance. Second, while foreign assistance brings with it nonfinancial benefits of technical expertise and additional scrutiny of project assump- tions, it also imposes considerable administrative burdens on the Government. The share of the public investment program committed to foreign-assisted projects is projected to reach 75% in 1980. This ratio is probably undesirably high, and foreign donors should adopt policies (as discussed later) that would permit it to be gradually reduced during the next few years. The 1980 Budget 2.26 In view of the problems that have been experienced, it is appro- priate to assess the provision for public investment and foreign-assisted projects in the 1980 budget. The 1980 budget provides for National Government capital outlays of 13.5 billion pesos (Table 7). Of this total, 40% is intended for infrastructure projects implemented by the Ministry of Public Highways and the Ministry of Public Works, Transportation and Communications, 30% for equity contributions, and 12% for non-infrastructure capital outlays. The remaining 18% of national government capital outlays is allocated to a variety of lump-sum funds that are held in reserve. These lump-sum funds, principally the National Priorities Support Fund and the Calamity Fund, are resources that are not initially budgeted for specific projects, but are held in reserve by the Ministry of Budget and released during the year to meet a variety of contingencies not provided for elsewhere in the budget.  - 18 - Table 7: NATIONAL GOVERNMENT CAPITAL OUTLAYS, 1978-80 (Million pesos, obligation basis) 1978 1979 1980 (Actual) (Estimate) (Budgeted) MPH/MPWTC 3,919 4,742 5,404 Equity Contributions 2,770 3,500 4,075 NPC 1,194 1,300 1,800 MWSS 61 300 600 Other Government corporations 1,267 1,402 1,352 Government financial institutions 248 498 323 Non-infrastructure Capital Outlays 955 1,564 1,577 Agriculture and Agrarian Reform 181 251 222 Educatlon and State Universities 229 407 163 Health 25 202 115 Human settlements - 105 517 Other agencies 520 599 559 Lump-Sum Funds /a 182 1,219 2,415 Total (Obligation Basis) 7,826 11,025 13,471 /a Ex ante, these lump-sum funds are not budgeted for specific projects, but are held in reserve and released during the budget year to agencies to meet a variety of contingencies. Ex post, expenditure for these funds are classified as incurred by the recipient agency. 1978 expendi- ture figures are therefore not fully comparable to 1979 and 1980 budget allocations, since the lump-sum funds for 1979 and 1980 have not yet been allocated as of July 1979. Source: Republic of the Philippines, Bridges to the Future: The President's Ilessage for 1980 Annex K.3. 2.27 It is estimated that the budgetary requirements of foreign-assisted projects (excluding the current expenditure requirements which are relatively small) are P 10.9 billion in 1980./l On the basis of recent experience, purely locally-funded capital projects would claim P 2-3 billion. Thus the budgetary requirements of public investment of P 13-14 billion would appear to be just financeable, provided that: (a) inflation is not worse /1 Statistical Appendix Table 5.15.  - 19 - than foreseen; (b) most of the discretionary funds such as the National Priorities Support Fund are devoted to high priority projects needing supple- mentary financing; (c) obligational authority is reallocated promptly from projects with surplus financing (because of slow physical implementation or lesser than expected costs) to projects needing additional financing. Future Level and Financing of Public Investment 2.28 Despite the initiation of major new programs in recent years, as a consequence of the long earlier period of low public investment, the rural areas and the outlying regions generally remain underprovided with needed infrastructure such as electricity, transportation, and water supply. For a variety of reasons, private investment is heavily concentrated in Manila and the surrounding two regions;/1 this pattern can be expected to continue until the outlying regions, as the Government has recognized through its regional planning effort, are better provided with public infrastructure. At the same time, there are considerable needs in Manila such as water supply and sanita- tion, and the energy diversification and irrigation programs have large resource requirements. It therefore remains essential to proceed with a sizeable program of public investment. A program amounting to 6% of GNP during the remainder of the Plan period would enable the Government to maintain momentum toward its objectives. The bulk of this would consist of the large expenditures required for ongoing and firmly committed projects, which would require at least 5% of GNP in 1980. On the other hand, from the standpoint of likely resource availability it is probably premature to consider a public investment program significantly larger than 6% of GNP at the present time. This analysis implies a somewhat smaller a public investment program than provided for in the Development Plan, but one that would still allow for achievement of the Plan's priority objectives. However, there would not appear to be room for major new programs. 2.29 Table 8 presents an illustrative financing plan for the projected level of public investment. In addition to fixed investment, the resource requirement includes equity contributions to government financial institu- tions, which recently have been successfully restrained to more moderate levels than in 1975-77. The issues relating to increased public savings have been discussed earlier. It is projected that the ratio of national government tax revenues to GNP could be increased from an estimated 12.0% in 1980 to 12.6% in 1982. This could be achieved through some combination of improved elasticity, arising from further broadening of the individual and corporate income tax bases and shifting fuel taxes to an ad-valorem basis, and addi- tional discretionary measures in support of the 1981 and 1982 budgets./l The earnings projected for government corporations assume considerable improve- ment, including the achievement of targeted rates of return by NPC and MWSS. /1 In 1975, Manila and the surrounding two regions accounted for 87% of manufacturing output, other than resource-based food-processing and wood industries. /2 For further detail see Statistical Appendix, Table 5.9.  - 20 - Table 8: PUBLIC INVESTMENT AND ITS FINANCING, 1978-82 (In billion pesos) Actual Estimate 1978 1979 1980 1981 1982 1980-82 Resource Requirement Public Fixed Investment /a 7.9 11.2 15.2 18.0 21.1 54.3 Financial Investment /b 0.2 0.3 0.5 0.6 0.7 1.8 Total 8.1 11.5 15.7 18.6 21.8 56.1 Financing Public Savings 4.9 6.7 8.9 11.4 14.0 34.3 Government budget current surplus /c 4.8 6.4 8.3 10.4 12.7 31.4 Government corporations 0.1 0.3 0.6 1.0 1.3 2.9 Public Borrowings Domestic (net) 2.6 3.4 3.8 4.1 4.4 12.3 Monetary 0.8 1.4 1.8 2.1 2.4 6.3 Non-monetary 1.8 2.0 2.0 2.0 2.0 6.0 External (net) 0.6 1.4 3.0 3.1 3.4 9.5 Amortization 1.0 1.9 2.5 2.6 2.7 7.8 External (gross) 1.6 3.3 5.5 5.7 6.1 17.3 From existing commitments n.a. n.a. 3.7 3.0 2.5 9.2 From new commitments n.a. n.a. 1.8 2.7 3.6 8.1 /a Infrastructure program plus noninfrastructure capital outlays. Excludes commitments of P 8 billion for the nuclear power project which is presently under review. /b Equity contributions to government financial institutions. /c National government revenues (including nontax revenues) minus current expenditures. Note: Nominal values for public investment, national government revenues, and current expenditures were derived using NEDA staff projections of nominal GNP as of June 1979. Source: Bank Staff estimates.  - 21 - 2.30 The borrowing requirements generated by the investment and public savings assumptions are considerable. Government policy on public domestic borrowing has been cautious to avoid displacement of private investment and aggravation of inflation, and the Government appears to have refrained from temporary incremental domestic borrowing as a solution to peso funding shortfalls. The above important concerns should, however, be viewed in appropriate perspective. In the case of private investment, the relevant criterion is not whether private investment would be displaced, but whether the displaced private investment would have a greater social value than the incremental public investment./l In the case of inflation, as long as the total domestic credit expansion (public plus private) is not excessive, there would not be monetary pressure on the price level. Inflation also reflects the real costs of supply in the economy; many public investment projects are cost-reducing or supply-expanding in nature, and postponement of project completion defers these anti-inflationary benefits. In sum, there would appear to be scope for considering a more flexible domestic borrowing policy that would be more sympathetic to the requirements of public investment. It would be reasonable for the public sector to claim 15-20% of the resources generated by monetary growth. 2.31 It is estimated that the gross external disbursements required to meet the public sector domestic resource gap and external amortizations coming due are P 17 billion./2 External disbursements during 1980-82 from existing commitments are estimated to be P 9 billion, implying a need for P 8 bil- lion from new commitments. Under generally prevailing cost-sharing arrange- ments of financing foreign exchange costs only (typically 45% of total project costs), the necessary foreign resource inflow could be achieved only by further increasing the share of the public investment program that is com- mitted to foreign-assisted projects. For the reasons indicated in para. 2.25, this would be undesirable. The cost-sharing ratio should therefore be revised upward. Specifically, it is recommended that external donors, through either financing of some local currency costs of projects, or nonproject lending, adopt financing policies having the effect of financing 60% of project costs. /1 For example, if it is assumed that 24% of GNP is the desired level of total fixed investment, then raising public investment from 5.5% to 6% of GNP will reduce private investment from 19% to 18.5% of GNP. The relevant question is whether the incremental 9% of public investment would have a greater social value than the displaced 3% of private investment. In evaluating this question, distributional concerns should be taken into account. Private investment is probably distributionally neutral, but well planned public investment can have a positive distributional impact. /2 The figures here comprise disbursements to (and amortizations from) both the National Government proper and government corporations in the infra- structure program. There is not a one-to-one correspondence between these numbers and official assistance because: (a) the Government draws upon private as well as official sources of external finance for public invest- ment; (b) some official assistance is devoted to current expenditures or is channelled through financial intermediates to support private investment.  - 22 - D. Management of the Public Investment Program 2.32 The National Economic and Development Authority, which is the Government's economic and development planning agency, and the Budget Ministry are the "core" agencies that are directly concerned with the management of the public investment program. The importance of close coordination between the planning and budgeting functions has been heightened by the change in the relative importance of constraints on the magnitude of public investment. During the period 1973-76, there were suhstantial increases in government revenue because of the commodity boom and improved tax administration, but relatively few projects because of historical limitations in project prepar- ation and implementation capacity. All projects recommended by NEDA's project staff as economically justified were affordable, and the budgeting function of assigning funds to projects was a technical task rather than a policy problem. With thedeceleration of revenue growth and the expansion of project prepara- tion and implementation capacity, finance is now a binding constraint on the magnitude of the public investment program. In this environment, the planning function (deciding which projects are to be undertaken, and when) and the budgeting function (allocating funds for projects) are intellectually much more closely linked than previously. 2.33 NEDA project staff has primary responsibility for preparing the "NEDA infrastructure program," while the Budget Ministry has primary responsibility for preparing current expenditures, and capital expenditures outside the infrastructure program. Collaboration between the NEDA staff and the Budget staff takes place within the framework of the Development Budget Coordination Committee. The Budget Ministry prepares medium-term projections of total current expenditures and total capital expenditures. However, care- ful balancing of the capital program (the aggregation of individual capital projects) with total capital expenditure availability does not begin until the second quarter of the calendar year preceding implementation, when preparation of the annual budget takes place. For a program consisting of projects which typically take 3-5 years to execute, and which are not readily divisible as are current expenditures, this is inadequate lead time. The result has been a tendency for the Government to commit itself to a large number of projects simultaneously, some of which are then executed slowly because of funding constraints, whereas it would be desirable to implement a smaller number of projects expeditiously, with some projects firmly deferred. The Government recognizes the need to improve medium-term financial planning for the capital program, and has been exploring the possibility of obtaining technical assistance for this purpose. 2.34 Other areas in which increased collaboration between the planning and budgeting functions would be useful are "core" agency oversight of government corporation investment programs, regional planning/regional budgeting, and monitoring of foreign-assisted projects. NEDA and the Budget Ministry also need improved management systems to equip them to handle large and continually changing masses of data, and expanded professional staffing, which might require selective increases in compensation.  - 23 - 2.35 MIention should also be made of the revenue forecasting role of the M