Report No. 10716-PH

The PhilippinesFiscal Decentralization StudyJanuary 7, 1993

Infrastructure Operations Division MI CROF I CE CcOPY

Country Department IEast Asia and Pacific Region Report No.:107 15-PHI Type: (SEC')

'I t1 : rI FISCAL DECFNTROLIIZTICJN ;-,TUIDY(titithc.r: ICH1IMUNR, Y

FOR OFFICIAL USE ONLY Ext BQ452 Room:18021 DPt. :L1 10

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.

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

CURRENCY EOUIVALENTSfas of June 1992)US$1.00 - Peso 25

ABBREVIATIONS AND ACRONYMS

BALGU - Budgetary Assistance to Local Government UnitsBC - Bicameral CommitteeBOT - Build Operate TransferDA - Department of AgricultureDECS - Department of Education Culture and SportsDENR - Department of the Environment and Natural ResourcesDBM - Department of Budget and ManagementDILG - Department of the Interior and Local GovernmentDOF - Department of FinanceDOH - Department of HealthDPWH - Department of Public Works and HighwaysDSWD - Department of Social Welfare DevelopmentEO - Executive OrderGAA - General Appropriations ActCDP - Gross Domestic ProductGFI - Government Finance InstitutionGOCC - Government Owned or Control CorporationGRP - Gross Regional ProductIRR - Implementing Rules and RegulationsIRA - Internal Revenue AllotmentINP - Integrated National PoliceLDC - Local Development CouncilLGC - Local Government CodeLGRSF - Local Government Revenue Stabilization FundMMA - Metro Manila AuthorityMMC - Metro Manila CommissionMWSS - Metropolitan Water and Sewerage SystemNALGU - National Assistance to Local Government UnitsNCR - National Capital Region (Metro Manila)NGO - Non-Governmental OrganizationNIA - National Irrigation AuthorityNPC - National Power CorporationPD - Presidential DecreePNP - Philippine National PoliceRA - Republic ActRDC - Regional Development CouncilSEF - Special Education FundSTA - Specific Tax Allotment

GOVERNMENT FISCAL YEAR

January , to December 31

FOR OMCIUL USE ONLY

PHILIPPINES

FISCAL DECENTRALIZATION STUDY

Table of Contents

EXECUTIVE SUMMARY ...................... I........................ i

1. INTRODUCTION ............................. 1

II. LOCAL GOVERNMENT IN THE PHILIPPINES

A. Local Government Structure ...................... 3B. Budgetary and Operational Autonomy .............. 6C. Local Government Expenditures .......................... 7D. Revenue Raising Powers ......... ........................ 15E. National Assistance to Local Governrents ..... .......... 27

III. THE DECENTRALIZATION PROGRAM: 1987-91

A. The Rationale for Decentralization ...... ............... 51B. Regional Autonomy ........... ........................... 52C. The 1990 General Appropriations Act ..... ............... 54D. Other Measures ............... .......................... 58

IV. THE REVISED LOCAL GOVERNMENT CODE

A. Definition and Functions of Local Governments .... ...... 59B. Devolution of Central Government Functions ..... ........ 65C. Revenue Sharing ............. ........................... 70D. Local Government Taxation ........ ...................... 79E. Credit Financing ............ ........................... 87F. Local Fiscal Administration ............................ 92G. Conclusions . ........................................... 96

V. IMPACT OF DECENTRALIZATION

A. Analytical Framework ......... .......................... 99B. Cost to the Central Government ......................... 100C. Local Government Fiscal Balance ........................ 104D. Composition Effects .......... .......................... 108E. Increases in Local Fiscal Autonomy ..................... 112F. Local Resource Mobilization .......... .................. 115G. Technical Efficiency .................................... 116H. Issues with the Government's Decentralization Program .. 120

VI. DECENTRALIZATION: OPPORTUNITIES AND RISKS

A. Possible Benefits of Decentralization ...... ............ 122B. Potential Risks in the Government's Decentralization

Program ............. ......................... 123C. Furth#: Actions that the Government Can Consider .... ... 124

This document has a restricted distribution and may be used by recipients only in the performanceof their official duties. Its contents may not otherwise be disclosed without World Bank authorization.

TEXT TABL

2.1: Distribution of Provinces, Cities and MunicipalitiesBy Income Class: Average 1983-86 ............................. 5

2.2: Distribution of Local Government General Fund Expendituresby Function: Average 1986-1988 ............................... 8

2.3: Average Per Capita Expenditures - 1986-1988 .... ............... 92.4: Linear Regression of Per Capita Local Government

Expenditures on Selected Independant Variables .... ........... 112.5: Trends in Local Government Expenditures ....................... 132.6: Trends in Per Capita Local Government Revenues .... ............ 142.7: Share of Own Source Revenues and Average Per Capita Own

Source Revenues - 1986-88 .................................... 172.8: Indicators of Real Property Tax Performance - 1986-1988 ....... 182.9: Reil Property Tax Collection Efficiency - 1986-1988 .... ....... 192.10: Ordinary Least Squares Estimates of the Determinants of

Variations in Property Tax Revenues .......................... 202.11: Property Tax Performance and Tax Mapping: Municipalities ...... 222.12: Indicators of Other Local Tax Performance 1986-1988 .... ....... 232.13: Ordinary L;ast Squares Estimates of the Determinants of

Variations in Per Capita Local Government Non-PropertyTax Revenues ................................................. 25

2.14: Trends in Local Government Revenues ........................... 272.15: Budgetary Allocations for National Assistance to Local

Government Units 1990-1992 ................................... 282.16: Revenue Sharing Grants in Real Terms - 1980-1990 .... .......... 322.17: Share of Revenue Sharing Grants ............................... 332.18: Distribution of Central Government Expenditures .... ........... 342.19: GDP Elasticity of Internal Revenues and Allotments .... ........ 352.20: The Distribution of Allotments By Regions ..................... 372.21: Simple Correlation Between Per Capita Allotments and Selected

Characteristics of Provincial and Local Governments .... ...... 392.22: Linear Regression on Per Capita Total Allotments: Povincial

Aggregate Data ............................................... 412.23: Linear Regression on Per Capita Total Allotments and

Collection Efficiency: Provincial Governments .... ............ 422.24: Linear Regression on Per Capita Total Allotments and

Collection Efficiency: Cities ................................ 432.25: Linear Regression on Per Capita Total Allotments and

Collection Efficiency: Municipalities ........................ 442.26: Linear Regression on Per Capita Local Revenues: Provincial

Aggregates ................................................... 472.27: Linear Regression.on Per Capita Local Revenues: Provincial

Governments .................................................. 482.28: Linear Regression on Per Capita Local Revenues: Cities ........ 492.29: Linear Regression on Per Capita Local Revenues:

Municipalities ............................................... 50

TEXT TABLES

3.1: Comparison of Per Capita. National and Local Revenues andExpenditures by Region, 1985 ................................. 52

3.2: Mandated Transfers: Estimated Amounts for 1986-1988 .... ....... 553.3: Regression Estimates of the Determinants of Variations in

Mandated Transfers: Cities ................................... 563.4: Regression Estimates of the Determinants of Variations in

Mandated Transfers: Municipalities ........................... 57

4.1: Minimum Requirements by Type of Local Governmert .... .......... 604.2: Basic Services to be °rovided by Level of Local Government .... 614.3: Local Appointed Officials ........ ........................ 644.4: Devolution of National Functions to Local Governments.664.5: Estimated Reduction in 1992 Budget Allocations From

Devolution of Programs and Projects to Local Governments ..... 694.6: Estimated Impact of the Revised Code on Central Government

Grants to Local Governments ................................. 714.7: Comparison of the Allocation of 1990 IRA Between Different

Levels of Local Government With and Without the Revised LGC .. 724.8: Comparison of Distribution Weights ............................ 744.9: Comparison of IRA Distribution Formulas ....................... 744.10: Comparison of Per Capita IRA Allocations ...................... 754.11: Comparison of Equalization Features; Per Capita Allocation

by System .................................................... 764.12: Ordinary Least Squares Estimates of the Determinants

of Per Capita Allotments Bicameral Committee (BC):Provincial Aggregates ................... .................... 77

4.13: Comparison of Business Tax Rates for a Municipality forSelected Levels of Gross Annual Receipts by Type of Business . 82

4.14: Estimated Property Values and Real Property Taxes forSelected Government Owned Corporations ................... 84

4.15: Comparison of Assessment Levels ..... .............. 854.16: Comparison of Effective Real Property Tax Rates . 864.17: Estimated Losses in Residental Real Property Taxes For

Bacolod City from the Revised Assessment Levels . 864.18: Summary of Domestic Local Government Debt - Obligations

Outstanding As of End 1988 . 894.19: Per Capita Debt by Region and Income Level . 91

5.1: Simulated Impact of Decentralization on the 1990 CentralGovernment Budget . 101

5.2: Simulated Impact of Decentralization on 1990 Local GovernmentFinances . 106

5.3: Simulated Impact of Decentralization on 1990 Local GovernmentRevenues and Expenditures . 107

5.4: Simulated Impact of Decentralization on 1990 Provincial,City, Municipal, and Barangay Budgets . 109

5.5: Estimated Breakdown of 1993 Devolved Central GovernmentExpenditures by Different Level of Local Government . 110

5.6: Assumptions Used in Allocating Devolved Central GovernmentExpenditures by Levels of Local Government, 1990 . 112

5.7: Comparison of Restrictions on Local Government Expenditures . 113

ANNEX TABLE 1: Consolidated Income and Expenditure forLocal Governments ............................... 129

ANNEX TABLE 2: Consulidated Income and Expenditure forLocal Governments in Real Terms .130

ANNEX TABLE 3: Summary of Revenue Sharing Grants . 131

ANNEX TABLE 4: Centreal Government Revenues and Expenditures --Cash Basis . 132

ANNEX TABLE 5: Local Government Debt Outstanding as ofDecember 31, 1988 . 133

Map No. IBRD 23945 . 134

PHILIPPINESFISCAL DECENTRALIZATION STUDY

EXECUTIVE SUMMARY

1. Fiscal lecentralization was a major policy concern in the Philippinesduring the Aquino Administration. The 1987 Constitution required enactment ofa new Local Government Code (LGC) to provide for a more accountable localgovernment structure. The Cordilleras and Muslim Mindanao Autonomous Regions,created in 1989, were given broad fiscal powers and responsibilities, whichprovided a model for local governments. Under the 1990 General AppropriationsAct, central government addressed some local government concerns: it eliminatedthe mandatory contribution (from local revenues) to the Integrated NationalPolice (INP) and hoipital services and provided some debt relief. Finally, theLGC was revised in October 1991 so as to consolidate most laws and regulationsgoverning local government operations and inter-governmental relationships.

2. The Government's decentralization program includes specific measuresto address many local grievances. However, it is unclear whether it constitutesa sustainable, comprehansive program that will strengthen local governments andimprove delivery of infrastructure, facilities and services. Thus, this studyaddresses these concerns. Its objectives include: (a) to assess the impact ofvarious decentralization measures; (b) to identify potential problems; and (c)to recommend steps to improve the effectiveness of local government operations.

3. First, the study assesses the present status of local governmentfinances and bottlenecks to fiscal development under the current system: fiscalinformation from individual provinces, cities, and municipalities for 1986-1988was collected for an in-depth analysis of the local government sector. Next, theGovernment's decentralization initiatives of 1987-1991 and the recently revisedLGC were reviewed and their impact on the fiscal position of central and localgovernments, local fiscal autonomy, local resource mobilization, and equalizationamong different local governments, was evaluated. Based on these findings, thereport recommends various measures.

A. ImDact of the System Prior to 1992.

Local Government Structure

4. Local government in the Philippines consists of 75 provinces, 60cities, 1,533 municipalities and over 40,000 barangays (the latter resemblecommunity organizations). The provinces are headed by elected governors whoreport to elected provincial councils and cities and municipalities are headedby elected mayors who report to elected city and municipal councils. Theprovinces, cities and municipalities are responsible for providing basicservices, such as garbage collection, traffic management and public markets, aswell as local infrastructure, such as roads and drainage. Prior to 1992, centralgovernment agencies provided a wide range of public services for which localgovernments would be responsible in other countries. These included tertiary(barangay) roads, rural water supply (wells), primary and secondary education,tertiary health services and police protection.

- ii -

5. Local governments in the 1980'a were highly regulated by the centralgovernment. First, the central government strictly limited the ';ypes of taxes,tax rates, and specific fees and charges to be levied. Second, the centralgovernment also restricted the local governments' use of their own funds. Forex&--le, they we e required to contribute local revenues to the IntegratedNational Police a.ad hospitals, to set aside funds for reserves and elections, tocap personnel expenditures, and to allocate funds for investment projects. Infact, one study estimated local executives had discretion over only half of theirbudget. Third, the central government also intervened in local governmentoperations. For example, it appointed their key financial officers--i.e. theTreasurer, Assessor and budget Officer. Further, it required their taxordinances be approved by the Department of Finance (DOF) and their budget beapproved by the Department of Budget and Management (DBM).

6. Significant differences exist between provinces, cities, andmunicipalities as well as among the provinces, cities and municipalities.Average per capita local government expenditures of the four cities and 13municipalities that comprise Merro Manila are about twice the national averagefor local governments, and per capita locally raised revenues are about six timesgreater. Outside this area, city governments spend about 30% more per capitathan do provincial and municipal governments combined. Municipalities spendmore of their budget on general administration while cities are more heavilyinvolved in service delivery. Further, within each type of local government, thelevel of per capita spending also varies dramatically. For example, average percapita expenditures between 1986-1988 for provinces range between P 20 to P 171,cities from P 84 to P 947, and municipalities from P 8 to P 1,001. Higher levelsof local government spending are associated with urbanization, increased incomeand wealth, and larger revenue sharing grants--with disparities closely tied tothe level of economic development.

7. The local government sector in the Philippines is small and has beendeclining during the 1980's. The ratio of provincial, city and municipalexpenditures to GDP dropped from a peak of 1.7% in 1982 to 1.3% in 1990 and theirshare in total government expenditure was halved from a peak of 12% in 1983 to6% in 1990. This level of fiscal decentralization is low by world standards,even considering the country's level of income.

8.. Not only are local governments a small sector of the economy, butthey are providing substantially less in real expenditures per resident todayrelative to the early 1980s. Real per capita local government expendituresdeclined by one-third (or by P 106 in constant 1990 prices) from P 346 in 1982to P 232 in 1990 (Chart 1). The impact of this decline can be observed in localflooding, poor roads, inadequate solid waste collection and disposal, dilapidatedand congested public markets, and unsanitary public slaughterhouses.

9. The primary cause of the drop in spending is the limited increase inlocal government revenues and central government grants. By law, localgovernments cannot accumulate deficits and can spend only as much as they collectin taxes, fees and charges or receive in central government grants or loans fromgovernment financial institutions: All these sources declined in real termsduring the 1980s (see Chart 1).

i ii -

Chart 1: Per Capita Local Expenditures,Local Revenues and Central Government

GrantsPeace (In Constant 1990 Prices)

260 --324 0 -_ ................................................

260 _- .. .^__..... 240 -

I B0 ~~~~~~~~- --- _- ------ ---- --- -- --- .

80 -.1980 81 82 88 84 8S 86 87 88 89 90

0c Local Revenues )*~ Govt G ran~ Z; Total EspendIltu r.a

LocaL Revenues

10. The real property tax is the largest source of local revenues,accounting for more than one-third of local income and financing 10% of localgovernment expenditures. Until the LGC was revised In 1991, real property taxeswere regulated by the Real Property Tax Code which established tax rate ceilingsof 1% for provinces and municipalities and 2% for cities. Howeverj the effectivetax rates were lower because the law also determined assessment levels at a fixedpercentage of market value based on actual use, by type of property. A crosssectional analysis of local governments found that higher levels of per capitaproperty tax revenues were associated with a larger population, a greater levelof per capita allotments, and location within Metro Manila. Thus, property taxesappear most lucrative in the larger urban areas and where the economy is most ad-vanced.

11. Local taxes (such as the business tax), fees and charges were alsohighly regulated. The Local Tax Code determined the taxes, fees and charges thatprovinces, cities and municipalities may levy. For example, it specified theamount of tax to be charged by type of business by level of gross receipts for

- iv -

cities and municipalities and set fees for various services. A cross sectionalanalysis of local governments found that local non-property taxes, chiefly thebusiness tax, accounted for 32% of own-source revenues for cities and 25% formunicipalities. Also, it found that per capita non-property tax revenues werehigher in more urbanized provinces, in those where assessed values were higher,and in mtnicipalities with large pcpulations. Mcreover, the analysis noted thatthose which generated larger revenues through property taxes also made greatereffort with respect to non-property taxes: For example, these were about 44 pesoshigher in cities (27 pesos for municipalities) in the Manila region than in therest of the country, even where the level of urb'ar.'zation and income were heldconstant.

12. Per capita local revenues, especially other than property taxes,declined in real terms during the 1980s. It is believed the decrease was due tothe following:

(a) Legal impediments. The Local Tax Code and the Real Property TaxCode limited local government flexibility to adjust the local taxstructure. Also, because of political resistance in urban areas toproperty tax hikes, the central government deferred reassessments--although, under the Real Property Tax Code, these should be carriedout every three years.

(b) Administrative impediments. Because the management of tax recordsis poor, many local governments collect less than 60% of propertytaxes each year. Also, most local governments are unable to judgethe accuracy of the annual declarations (of gross receipts) whichform the oasis for calculating business taxes.

(c) Lack of Rolitical will. Many local governments have not imposedthe maximum property tax rate allowed under the law. They have notimposed sanctions on delinquent tax payers. Local councils have notincreased rental rates for public market spaces which are notregulated; instead, many have opted to maintain them at the samenominal levels for more than 1C' years.

It should be noted that limited expenditures and the resulting poor levels ofinfrastructure, facilities and services have made it difficult for localpoliticians to raise tax levels. This has produced a vicious circle of poorservices, political relu ..in:e to increase charges, lack of additional fun'ds, andfurther deterioration in services.

Goverrment Grants

13. Central government grants are an important source of revenue forlocal governments, accounting for approximately 40% of total revenues. Theyinclude project specific and revenue sharing grants--the Internal RevenueAllotment (IRA) and the Specific Tax Allotment (STA). The Local GovernmentRevenue Stabilization Fund (LGRSF) was created in 1987 to adjust for shortfallsin the STA and maintain it at 1986 levels. These block grants, called"allotments," accounted for about 33% of local revenues in 1990. Dependence on

Vv

central government grants varie._ significar.tly from less than 20% in Metro Manilato over 90% in some provinces, cities and municipalities.

14. The IRA and STA amount for each loc;al government was determined byformula. A maximum of 20% of internal tax revenues of the third precedingyear' (net of accruals to special funds) was set aside to redistribute among thelocal governments under the IRA. Fixed amounts of revenues from taxes ongasoline and other petroleum products (e.g. P 0.2 per liter of lubricating oil)of the second preceding year were distributed to local governments under the STA.The IRA and STA were first distributed by ratios between the provinces, cities,municipalities, and barangays, and then among different local governments basedon a formula consisting of population, land area end equal share.

15. The study reviewed the impact of the allotments (IRA, STA and LGRSF)on tax effort as well as on equalization of fiscal capacity among localgovernments. The impact on tax efforts was mixed: an empirical analysis ofvariations in per capita revenues shows that increase in grants would result inan increase local source revenues (i.e. would be stimulative) in municipalities,but would reduce local, non-property tax revenues (i.e. would be substitutive)in cities. On equalization, cross-sectional analysis across all provinces showsno relationship between allotments and either average household income or thepoverty rate. This result was expected since the criteria (i.e. population, landarea and equal shares) do not promote equalization.

16. Budgetary constraints at the national level resulted in decliningfinancial support for local governments during the 1980s. While personnelexpenditures accounted for 20-30% of central government expenditures, debtservice began to claim a larger share of government spending, increasing fromabout 6% in 1980 to 33% in 1990. As a result, other expenditures (such ascapital investments, operations and maintenance, and grants to local govern-ments), declined from 70% of total spending to 38% in 1990. The combined shareof the allotments in central government tax revenues and expenditures of thecurrent year dropped from a peak of about 7% of tax revenues and expenditures in1982-83 to 4.7% of revenues and 4.0% of expenditures in 1990.

17. Financial constraints also influenced the implementation of theallotment system. The actual share of the IRA in internal tax revenues wassignificantly below the 20% ceiling2 and differed each year, averaging around10% of the internal revenues of ths third preceding year since 1986. In theearly and mid-1980's, actual releases were lower than appropriations, sometimesby as much as 60!. Thus, provinces, cities and municipalities were never sureof the amount they would receive, which hampered planning at the local level.

1 For example, the 1990 IRA amount would be based on 1987 internal taxrevenues.

2 Originally, the law required the central government to share 20% of.nternal revenues of the third preceding year with the local governments. Thelaw was amended in 1980 to make 20% the maximum amount available for sharing.

- vi -

18. In sum, there is justification for the local executives call fordecentralization. Population growth and urbanization during the 1980's pressuredthe government to increase education, health care, water supply, sanitation, andother essential local services and facilities. However, the previous system hasnot proven to be effective; the provision of baslc services and facilities haslagged behind demand resulting in a deterioratlon in the quality of life. Localgovernment expenditures declined in real terms during the 1980s. Localgovernments were limited in what they could ralse as revenues and how they couldspend their funds by various laws and central government regulations. Provincialgovernors and city at,d municipal mayors were frustrated by their the limitedresources and by the central government's excessive intervention in localoperations- -which hampered their ability to meet the needs of their constituents.

B. The Decentralization Program

19. Decentralization was a key concern for the Aquino Government andseveral measures were taken to promote local governments. First, the 1987Constitution called for a revised Local Government Code (LGC) that generated areview of all legislation pertaining to local government affairs. Second, the1989 Organic Acts created autonomous regions for Muslim Mindanao and theCordilleras which passed over to them significant power and responsibilities.Although the new regions were smaller than originally anticipated (since manycities and provinces voted not to join the newly created regions), the Acts seta precedent and local executives pressured central authorities to provide localgovernments with similar arrangements. Third, the central government devolvedsome of its activities by providing local and regional development councils moresay in the allocation of departmental resources. Fourth, the 1990 GeneralAppropriations Act abolished the mandatory contributions to the IntegratedNational Police (INP) and hospitals and included funds for relief to financiallyweaker local governments for debt incurred prior- to February 1988 from governmentcorporations.

The Revised Local Government Code

20. The centerpiece of the Government's Decentralization Program is therevised LGC which was signed into law in October 1991 and became effective onJanuary 1, 1992. Its key features are: (a) devolution of basic services fromcentral to locai governments; (b) greater revenue sharing with local governments;and (c) improved administrative autonomy for local governments. Each of thesepoints is expanded below.

21. Devolution of basic services. The LGC outlines the basic functionsto be performed by the provinces, cities, municipalities and barangays. Centralgovernment agencies currently performing these functions were required to devolvethese operations to local governments by June 30, 19923. The main functionsare:

I Due to the limited time, just six months, the transfers were not allcompleted on time. Devolution is still continuing.

- vii -

(a) DeRartment of Agriculture (DA): Agricultural and fishery extensionservices, regulation and research; procurement and disbursement ofseeds; purchase, expansion and conservation of breeding stocks; andconstruction, repair and rehabilitation of small dams;

(b) Department of Environment and Natural Resources (DENR): Forestmanagement services; mine and geo-science services; environmentalmanagement services; and reforestation, integrated social forestry,and watershed rehabilitation projects;

(c) Department of Health (DOH): Provincial health office and district,municipal and medicare community hospitals; purchase of drugs andmedicines; implementing primary health care programs; field healthservices; aid to puericulture; operating 5-bed infirmaries;

(d) Devartment of Public Works and Highways (DPWH): Repair andmaintenance of infrastructure; barangay road, water supply andcommunal irrigation projects;

(e) DeRartuent of Social Welfare Develogment (DSWD): Program for rebelreturnees; barangay day care centers; poverty alleviation programsin low-incomc municipalities and barangays.

Other entities, such as the Departments of Agrarian Reform, Budget andManagement, Trade and Industry, and Transportation and Communications, will alsobe affected, but to a lesser degree. DSWD and DOH are expected to be hardest hitby devolution, losing approximately half their annual budgets.

22. Central government also reserved the option to continue financingspecific programs or projects and exempted those that were externally funded frombeing devolved. In addition, the executive branch and legislature can maintaincontrol over specific programs by appropriating funds under the annual budgets(the General Appropriations Act). Further, central government (or the next levelof gover.ament) can take on the provision of basic services and facilitiespreviously assigned to lower levels of government if the service appearsinadequate.

23. Revenue sharing. Local governments will receive a larger share ofnational tax revenues, since, under the revised LGC, the IRA will be increasedas follows. During the first year the new Code takes effect (1992), they willbe given 30% of internal revenue taxes of the third preceding year preceding4.In 1993, the figure will rise to 35% and in 1994 and afterwards, it will reach40%. However, if central government incurs an "unmanageable public sectordeficit," it can reduce the allotment from 40% to a minimum of 30% (of internalrevenues). The concept of "unmanageable" is not defined; the President canreduce the share on the recommendation of the Secretaries of Finance, Interiorand Local Government, and Budget and Management, after consulting the presiding

4 For 1992, the Code also required the central government to provide localgovernments with funds to cover the cost of personnel devolved to the localgovernments in addition to the 30% IRA.

- viii -

officers of both Houses of Congress and the presidents of the local governmentleagues. The STA, LGRSF and other grants to local governments were discontinued.

24. The formula for sharing IRA among the different levels of localgovernments was modified in amanner whereby the barangayswill gain5, municipalities ChCrt 2will experience a loss, and Compalison of the Allocadion of 1990 MRAcities and provinces will Betmeen Levels of Local Government (%)receive shares comparable tobefore (Chart 2). Alloca-tions will continue to be citiaebased on population, land and 29equal share. However, more Bwasonweight will be given to equal p nanoa 20Qshare and land, and less to 25.population (see Chart 3). 28 v nw

25. When the impact MIlunicinpailtlsof the new allotment system 4aiwas simulated for the various Old System Revised Systemlevels, the following wereobserved: (a) it would notredistribute revenues, since the size of allotments was not significantlyassociated with either average household income or the poverty index; (b) itwould distribute significantly less in per capita terms to more heavily populatedprovinces; (c) it would favor more heavily urbanized provinces. However,compared with the previous

arrangement, the new system Cwould shift revenues away Chart3:from Metro Manila to other Comparison of Distribution Weights (%)local governments.

26. In addition tothe IRA, local governments Poulationwill be given a share of bpultlOionnatural resource-related tax- 70es and charges and of reve-nues from government-owned orcontrolled corporations EquhU MShw(GOCCs) that utilize natural Land Sqalareresources. First, local gov- Land X Mernments will receive 40% of 20central government's gross Old System Revised Systemcollection from the precedingfiscal year of mining taxes,royalties, forestry and fishery charges, and from their share in anyco-production or joint venture to use or develop national wealth (within their

5 The actual gain would be smaller, since the Barangay Administration Fund,which was used to pay salaries of barangay officials, was dropped.

- ix -

jurisdiction). Second, GOCCa engaged in natural resource development will givethem the higher of the following: (a) One percent (1%) of the grose' palesreceipts of the preceding calendar year; or (b) 40% of the mining taxes,royalties, forestry and fishery charges which the GOCC would have paid if it werenot exempt. (Such revenues will only be distributed among local governments wherethe natural resource is located).

27. Certain rest.ictions were retained on the use of shared revenues.First, local governments are required to appropriate at least 20% of their annualIRAs for development projects, sending copies of the local development plans tothe Department of the Interior and Local Government. Second, GOCC funds are tofinance development and livelihood projects. Where proceeds are derived fromhydrothermal, geothermal and other sources of energy, at least 80% must beapplied to lower electricity costs in the jurisdiction where the source of energyis located.

28. Administrative autonomy. Under the new Code, local governments weregiven more flexibility to raise local revenues, borrow and determine localexpenditures. Although provinces are still limited to collecting only thosetaxes and fees specified in the revised Code, cities and municipalities areallowed to introduce new taxes and fees. Details on the types of fees and rates,included in the former Local Tax Code, were eliminated. Further, localgovernments are not required to submit their local tax ordinances or schedule ofmarket values used to assess property to the DOF for approval.

29. Local governments are not required to obtain DOF recommendations toacquire loans. Now, they may borrow from private financial institutions, whilebefore they were limited to transactions with government financial institutionsand corporations6. DOF will no longer determine the terms and conditions oflocal bond issues, but bonds issued by local governments will no longer be exemptfrom taxation nor be guaranteed by the central government. Foreign borrowing bylocal governments, however, will still be subject to central government approval.

30. The two most important local taxes, the real property tax andbusiness tax, remain highly regulated. The central government, through therevised LGC, still limits real property tax rates and sets assessment levels.In fact, assessments were lowered and residential buildings of less than P175,000 were exempted from taxation, thereby reducing the potential yield fromthe real property tax. Also, the revised LOGC still specifies the taxes to belevied by type of business and level of gross annual receipts, although theamount of the tax was increased by about 10%.

31. Limitations on local government expenditures were maintained. Localgovernment budgets must still comply with the following: (a) the aggregate amountappropriated cannot exceed income estimates; (b) debt service cannot exceed 20%

6 At the same time it promotes the practice of borrowing, the revised LGCincludes a debt relief provision, whereby the central government will forgiveunremitted contributions to the central government and buy back at a discountlocal government debt to government financial institutions and corporations andprivate utilities as of December 31, 1988.

of regular income; (c) provinces, cities and municipalities must provide at leastP 1,000 to each barangay; (d) five percent of estimated revenues from regularsources must be earmarked as a reserve for calamities. In addition, 20% of IRAsmust be used for development projects, as must all funds from the share ofnatural resources, except for proceeds from hydrothermal, geothermal and othersources of energy where at least 80% will be used to lower electricity costs.The Code also limited the level of personnel expenditures, with financiallystronger local governments (first through third class provinces, cities andmunicipalities) allowed to appropriate 45% of the annual income for this purposeand the financially weaker local governments (fourth and lower class provinces,cities and municip&lities) 55%.

32. Direct central government involvement in local government operationswas reduced. The local budget officer position will revert from DBM to the localgovernments. The local assessor will now be appointed by local executives andnot by the DOF. The Provincial Council, and not the provincial budget officer,will be responsible for reviewing the budgets of the cities and municipalities.While the DOF will still appoint the treasurer, estimates of the next year'srevenues (used to determine the scale of the local budget), will be prepared bya local finance committee and not by the treasurer alone.

C. Potential Impact of the Program

33. Many of the critical aspects of the Government's decentralizationprogram were developed separately. The issue is whether the changes in revenuesharing, allocation of functions, local taxation and local administration,constitute a coherent program when taken together and whether they are likely toresult in more effective local government. To find answers, the impact of thechanges on the following were reviewed: (a) the cost to the central government;(b) local fiscal balance; (c) local fiscal autonomy and revenue mobilization; (d)technical efficiency; and (e) composition effects. Overall fiscal impact on thecentral and local governments was simulated using 1990 data, the latest year forwhich local government revenue and expenditure data were available. The impacton individual local governments was simulated using 1986-1988 data collected forthe study.

Cost to the Central Government

34. For decentralization to succeed, central government should be ableto sustain the new system. Thus, it must be affordable, given the other claimson central resources.

35. The costs of decentralization include: (a) revenues foregone due tosharing natural resource-related national taxes with local governments andeliminating local government contributions for the INP and hospitals; and (b)additional expenditures from increased revenue sharing and transitional costs.However, these costs would be offset by savings from national functions andpersonnel that will be devolved to local governments. Thus, decentralization caneither increase or reduce central government expenditures--depending on thebalance between these additional costs and savings.

- xi -

36. The impact on central government revenues is expected to be minimal.Total revenues losses in 1990 from sharing 40% of mining taxes, royalties,forestry and fishery charges with the local governments and from the eliminationof the INP and hospital contributions were estimated be P 0.9 billion or lessthan 1% of total central government revenues for that year.

37. The element that has the greatest impact in determining the cost ofdecentralization is the level of revenue sharing under the IRA--whether it is setat 30%, 35% or 40% of internal tax revenues. For example, in 1990, if therevised LGC had been in place and the allotment was based on a 30% share, the IRAwould have been P 17.6 billion or P 10.3 billion more than under the previoussystem. If local governments receive 40% (of internal tax revenues), the IRAreaches P 23.4 billion, a net increase of P 16.1 billion over the previoussystem. When combined with the P 0.9 billion in revenue losses, the added costto the central government is estimated to be P 11.2 billion with a 30% IRA share,increasing to P 17.0 billion at 40% (Chart 4).

38. At the same time, however, decentralization lowers some centralgovernment expenditures, since grants --other than the IRA- -would be decreased anidmany functions would be passed on to local governments. For example, it isestimated that in 1990, by eliminating the Barangay Road Concreting Program, theLocal Roads Maintenance Program, and other assistance to local governments, thecentral government will save about P 6.7 billion. Further, it will save anadditional P 8.2 billion by devolving agricultural extension, health services andother functions. Thus, total savings for 1990 are estimated at P 14.9 billion(Chart 4)--a figure that would be the same regardless of the level of revenuesharing.

39. Thus, the Chart 4: Impact of Decentrallzcalon ont o t a 1 c 0 a t o f The 1990 Central Goverment Budgetdecentralization would bethe net effect of 18.0 miu"|)additional expenses, _- ---- *---._

primarily from increased 14 0-revenue sharieg, minus 12.0 ............the savings generated b 1n-i-from devolving re- ....- . .. ~... .. sponsibilities to local 6A ...governments (P 14.94),billion). For example, if 2.0. ... .......the share had been set at30% for 1990, the added 0.0 rnm3t.0% 4Teo%expenditures are esti- Luldof Rdefici sbaringmated at P 11.e2 billion,or less than the savings laddeonud Costis esavingsP 14.9 billion (Chart 4),generating net savings ofP 3.7 billion for the central govertment. This would reduce total centralexpenditures by 1.1's and the budget deficit by 10.0%. If the share increases to40%, the extra expenditures (P 17.0 billion) would be greater than the estimatedsavings of P 14.9 billion. Ultimately, the added cost is estimated at P 2.1

- xii -

billion, thereby increasing total expenditures by 1.0% and the budget deficit by5.7%.

40. It is believed that decentralization will most likely cost more thanwhat was estimated above, due to some items that have not been factored into theanalysis, as they are difficult to estimate. These include: (a) transitionalcosts, such as severance pay for central government staff who choose to resigninstead of transferring to a province, city or municipality; (b) debt relief, setup under the revised LGC; and (c) monitoring, technical assistance to localgovernments or other new functions central government will have to perform.Further, because the implementation of the revised LGC is being conducted rapidlyto meet the deadline set by law (full devolution by the end of 1992), there couldbe inefficiencies that will lead to higher transitional costs.

41. By increasing the amount of funds to be released automatically byformula to local governments, the central government reduces its control overfiscal policy and thus its ability to absorb unexDected shocks through budgetaryadjustments. Although not readily quantifiable, this can be considered a realcost. Stabilization policy is especially important to developing economies (thatare more vulnerable to international fluctuations in commodity prices, naturaldisasters and worldwide recessions); for this reason, central governments needgreater control over tax, expenditure and borrowing instruments. While theincrease in transfers and other quantifiable costs may not be significantrelative to total central government expenditures, the amount over which it hasdiscretion, such as capital and maintenance expenditures, has been reduced overthe last few years, from over two-thirds to one-third of central governmentexpenditures, as debt service absorbed a larger share of the government budget.Therefore, the increase in revenue sharing may, on the margin, have a substantialaffect on governments' ability to pursue stabilization policies.

42. A key issue, therefore, is whether the central government can afforddecentralization. Because the current budget deficit is 2%-3% of GDP, it haslittle room to take on additional expenditures without increasing taxes orreducing other expenditures. The decentralization program would be budgetneutral --that is, the additional expenditures are offset by savings generated--if the figure for revenue sharing were set at 35% (Chart 4). However, Governmentmay have difficulty in increasing local government share to 40% in 1994 asrequired under the revised LGC.

Local Government Fiscal Balance

43. Decentralization should result in a shift in the balance between theamount of revenues local governments have at their disposal (with a reasonabletax effort) and what they must spend to provide an adequate level of services.

44. The impact on local fiscal balance is the flip side of the questionabout how much decentralization would cost the central government. The level ofrevenue sharing under the IRA will have the greatest impact on the resourcesavailable to the local governments as a whole. At 30% IRA share, the localgovernments will receive more devolved expenditure responsibilities (P 14.9billion) from the central government than additional revenues (P 11.2 billion),or a net decrease in locally available funds by P 3.7 billion. At 40%, the

- xiii -

additional revenues (P 17.0 billion) would be greater than the devolvedexpenditures (P 14.9 billion); i.e. a net increase in local funds by P 2.1billion.

45. Further, local governments were estimated to raise an additional P1.0 billion in 1990 from the following: (a) a share of the gross receipts orforgone taxes from GOCCs engaged in natural resource utilization, P 0.2 billion;(b) loss of COCCs' real property tax exemption status, P 0.6 billion; and (c)additional business tax revenues from the increase in the business tax rate(assumed to be 10%), P 0.2 billion. Although property tax assessment levels werereduced, it was expected that total revenues would rise due to the revaluationof properties.

46. Had decentralization been in effect in 1990, the local governmentsector would have received P 3.1 billion more in discretionary resources with a40% share of internal revenues: i.e. they would have received P 17.0 billion fromthe central government and raised P 1.0 billion in additional local resourcesagainst P 14.9 billion in devolved expenditure responsibilities (Chart 5). Witha 35% revenue share, the additional expenses and revenues would balance, and witha 30% revenue share, the local governments would have lost P 3.7 billion indiscretional revenues if they continued to fund the devolved expenditures attheir original levels. Since local governments are legally required to maintainbalanced budgets, they would have had to cut programs previously funded bycentral government, such as road maintenance.

47. The localgovernments may feel Chart 5: Additional Local Revenues anobliged to spend more Expenditures from DecentrcdlzoRionthan the central pgovernment on the ( tPulUou)devolved functions. 20.0First, they may need to i1s8. ............................. ............ .: : ............

.ehabilitate facilities ~~16 0 .--- .gEg ........ .............................. _ .a3§_.......p/ s rehabilitate facilities 14' L............and/or improve services 12.0 ...... % . 4...to meet their residents' 10.0 ----- ......... ..

increase, as scale nltcnehaleconomies will be lost.

Third, local start-up E Revenues m Ezpendlture3costs were not includedin the analysis and thesecould be significant. Even with a 40% share of internal revenues, the localgovernments may find that there is very little additional discretional funds.

48. Finally, decentralization would have a significant impact on thelevel of local government operations. In 1990, the estimated cost of thedevolved functions, P 14.9 billion, 40 equivalent to total local governmentspending, P 14.1 billion. Assuming that the local governments continue to fund

- xiv -

and carry out the devolved functions, decentralization would result in a doublingof local expenditures.

Composition Effects

49. The decentralization program would not impact uniformly on all localgovernments. While a fiscal balance may be maintained for the local governmentsas a whole, this may not be the case at different levels of local government oramong different local governments.

50. The changes in the IRA allocation formula and the devolution ofcentral government expenditures would be the two principal factors affectingfiscal balances at the provincial, city, municipal and barangay levels, With therevised LGC, the barangays will receive a larger share of the IRA, municipalitiesa smaller share, and provinces and cities roughly the same shares as before.The additional IRA revenues would be offset by the new expenditures incurred fromthe devolution of agricultural extension, health services, social welfare,barangay roads and other central government functions. In addition the localgovernment would be expected to finance local roads maintenance and otherprograms that were previously supported by national grants.

51. The impact of decentralization on the revenues and expenditures ofthe provinces, cities, municipalities, and barangays were simulated for 1990.The net increase in IRA were obtained for each level of local government basedon the allocation formulas to estimate additional revenues. Whether the centralgovernment shared 30%, 35% or 40% of the internal revenues had a major impact onthe amount of funds available. The impact of additional revenues from sharingin natural resources and GOCCs were not included because of the difficulty ofallocating these revenues to the different local governments. The cost of thedevolved central government expenditures were assumed to be P 14.9 billion.This amount was distributed between the provinces, cities, municipalities andbarangays based on Government estimates of the allocation of expenditures bylevel of local government and indicators of demand (e.g. 1990 populationdistribution, length of roads, etc.). These assumptions are discussed in detailin Chapter V, Section D.

52. The simulated impact for 1990 shows that the provinces andmunicipalities will suffer a short fall; i.e. additional funds would not beenough to offset new expenditures. The cities and barangays, on the other hand,will be receiving more new revenues than expenditures. With a 35% localgovernment share in IRA, the provinces are estimated to receive P 2.9 billion inadditional IRA compared to P 4.0 billion in devolved expenditures (Chart 6). Thecities would receive P 3.1 billion in new revenue but only P 1.6 billion inexpenditure responsibilities. The provinces and municipalities are expected toshoulder most of the agricultural extension and health services, and would be ina better suited to carry out many of the smaller local investments, such asbarangay roads and rural infrastructure.

53. Cities are expented to benefit from decentralization. First, itappears that they would not be expected to take on too many devolved responsibil-ities. Second, the cities are in a better position to raise additional revenues.

- xv -

The relatively well developed and growing economic base in the urban areas willresult in increased local revenues from real property and business taxes. Therewill also be more scope for introducing additional taxes and/or fees and charges.Third, the abolition of contributions for the INP and hospitals will benefit thecities with a larger revenue base because their previous contributions were basedon their revenues (the larger base, the larger the amount).

Increases in Local Fiscal Autonomy and Resource Mobilization

54. The success of the decentralization program turns on the ability oflocal governments to respond to the public's wish for better services, and to tapits willingness to pay for them. Local governments must also be free todetermine their budgets and collect revenues.

55. In general,decentralization has Chart 6: Comparison of Additionalincreased local autonomy Revenues and Expenditures bysince local officialshave larger budgets, as Level of Local Government, 1990well as more discretionto set priorities and 10 I' eallocate funds (due to .....the devolution of ._ .-.-.................. . ............ ...... ...._national functions). 7 ... ......... ........ .....Further, 1 o c a 1 . ..6... ... .... _..__ . _ =......governments have more --... .........

freedom to borrow for ~..-investment projects. In I.. .

addition, while local I__governments are required 0to appropriate 20% of the Province City MunlcipaMty BurangayIRA for development pro-j*ects, they no longer Adc ItioncdRA No N E Bzpndldtumust follow DILG and DBMguidelines but insteadmust only submit their plans to DILG.

56. Local executives have more control over the appointment of key staff.The Local Assessor and Local Budget Officer, previously appointed by the DOF andDBM respectively, are now chosen by provincial governors and city and municipalmayors. The Local Treasurers are still appointed by the Secretary of Finance butfrom a list of candidates submitted by local officials.

57. However, local governments are still limited with respect togenerating revenues7. The revised LGC provides the cities and municipalities(but not the provinces) with a little more flexibility in setting taxes, fees andcharges; however, the two most important--property and business taxes--remainhighly regulated. In addition, the lower assessment levels for properties

7 It should be noted that local governments do not fully exploit their taxbase due to poor administration and lack of political will to pursue non-payers.

- xvi -

reduced the effective tax rate and potential revenues. Thus, while localautonomy increased, such restrictions constrain local governments' ability todevelop revenue and exper.aiture programs in line with local needs and willingnessto pay.

58. The decentralization program will affect local resource mobilizationboth positively and negatively8. On the one hand, local governments may beencouraged to raise local revenues because they will keep more of what theycollect (with the elimination of INP and hospital transfers). Also, the devolvedcentral government functions transfer responsibility for some important programs,and it may be easier to levy taxes or fees to pay for them. Experience (withBank projects) demonstrates that local residents are more willing to pay andlocal politicians more willing to calarge when increased taxes or fees aredirectly linked to improved services; i.e. where the benefits can be more closelyassociated to the costs.

59. On the other hand, local governments may substitute new revenuesobtained through the increased IRAs for funds they otherwise might raise locally.The smaller, administratively weak local governments may reduce local revenuesbecause they cannot absorb the influx of funding and expenditure responsibili-ties. More importantly, the net effect of the changes in the revenue sharingformula and devolution of national functions would provide cities with moreresources and could act as a disincentive for improved resource mobilization,despite the fact that the cities have more potential to raise revenues becauseof their stronger economic base.

60. In sum, it is difficult to determine the impact of the governmentprogram on resource mobilization. Some local governments may aggressively usethe opportunities under the revised LGC to raise tax rates and fees and/orinstitute new fees and charges through new local tax ordinances. However, theprogram contains no explicit measures to promote local resource mobilization(which can be considered a weakness), and it is difficult to predict how localgovernments will react.

Technical Efficiency

61. The local governments' ability to absorb the additional resource,staff and the devolved responsibility following the changes introduced by therevised LGC is often raised as an issue. Will the quality of health services,the construction of barangay roads, or the delivery of agricultural extensionservices deteriorate as - result of decentralization?

62. Changes in themselves prove to be disruptive and the level of servicedelivery can be expected to deteriorate over the short term as the localgovernments become familiar with their new roles and absorb the devolved nationalgovernment functions. For those functions where the staff and facilities are

8 The only explicit measure to improve revenue collection with theGovernment's decentralization program, is a provision in the debt relief programwhereby the central government will write off higher levels of local debtdepending on local success in generating revenues.

- xvii -

already located at the local level, the technical expertise and administrativesystems should also transfer with the staff so that the issue will be the abilityof the local executives to manage the newly acquired functions. Where only thefunctions will be transferred, the question will be the capacity of the localgovernments themselves to plan and carry out the additional responsibilities.There is scope to improve planning at the local level. While lists of projectsdo exist, most local governments lack basic information to prioritize theirinvestment needs, such as an inventory of the infrastructure and facilities andan assessment of extent of their deterioration under their jurisdiction.

63. The managerial, technical, and administrative capacity of the localgovernments would impact on the effectiveness of service delivery and investment.To the extent that the absorptive capacity would differ by the amount of new workcompared to their existing work programs, the financially stronger localgovernments would naturally be better suited to take on additional expenditureresponsibilities. Cities would be in a better position since they generally havehigher existing levels of operations and, at the same time, are being asked totake on less devolved functions. Municipalities would probably find it moredifficult to absorb the devolved functions given their limited scope of workperformed to date and their lack of experienced, technical personnel.

64. The imbalance between devolution of revenues and expenditures and theresulting fiscal imbalance would most likely result in a significant drop inservices and cutbacks in investments at the provincial and municipal levels,especially if operating and capital expenditures are reduced in order to pay thestaff that the local government is required to taken on from the centralgovernment.

65. Finally, the effectiveness of the central government in implementingthese functions in the first place would be a factor in assessing whetherdevolution would result in an improvement or deterioration in services. Whereshortcoming do exist at the national level, devolution and the many adjustmentsthat it entails also present an opportunity to undertake reforms to improveservice delivery and investments. For example, questions had been raised oneffectiveness of DA's agricultural extension service in addressing local needs.With proper leadership at the local level and technical support from DA,decentralization could make agricultural services more accountable to the farmersand responsive to local priorities. In another case, the smaller and morenumerous barangay roads were often considered a lower priority relative to largernational works in the DPWH's district offices. The revised LGC provides anopportunity to improve both construction and maintenance by soliciting greatercommunity participation in planning, building and maintaining barangay roads.The barangays themselves have limited technical capability and support would needto be provided through DPWH and/or the Provincial Engineer's Office.

- xviii -

D. Decentralization: Opportunities and Risks

Risks of Decentralization

66. When taken as a whole, there are inconsistencies in the Government'sdecentralization program which pose the danger that it would not achieve itsobjective of increasing local autonomy and improving service delivery at thelocal level.

67. There is the risk that the central government cannot afford theincrease in revenue sharing. The simulation of the impact on decentralizationon the 1990 central government budget indicated that the revenue loses would beoffset by savings from devolved national expenditurea and elimination ofassistance to local governments (other than the IRA) when the level of the IRAis set at 35% of the internal revenues of the third preceding year. When thelocal governments' share is eventually increased to 40%, there is projected tobe a net increase in transfers to the local governments which would putadditional pressures on the central government budget which is alreadyconstrained by debt service payments, personnel expenditures, and increasingdemands for large infrastructure investments.

68. The central government budget situation could worsen if the projectedsavings do not materialize. The estimates of savings from devolution aregradually being reduced as different Departments make a case why certainexpenditures should be retained. The revised LGC includes a provision allowingthe central government or a higher level of local government to take over adevolved function if service delivery at the local level deteriorates. Shouldthe central govornment exercise this option, this would result in additionalexpenditures at the national level and duplication of effort between the centraland local governments.

69. A second risk is that the local governments cannot absorb theadditional responsibilities devolved to them, resulting in a deterioration ofservice delivery and investment. First, the imbalance between devolved revenuesand expenditure responsi-ilities at the provincial and municipal levels couldresult in a reduction of - rvices as the provinces and municipalities are forcedto cut back expenditures. Second, decentralization is expected to result inclose to a doubling of expenditures for the local governments as a whole whichcould strain their managerial, technical and administrative capacity. Thoselocal governments with 'imited resources, i.e. the provinces and municipalitiesin the less developed areas, would be least equipped to handle additionalexpenditure responsibilities.

70. A third risk is that decentralization could result in reduced localresource mobilization. The revised LGC weakened the real property tax byreducing the assessment levels and lowering the effective tax rate. Those localgovernments in the less developed areas with slower growth in property valueswould be most affected. In the cities, the natural growth in real propertyvalues and businesses could provide opportunities to increase local revenuesdespite the limitation of the revised LGC. However, the cities are projected toreceive a net increase in funds from the central government through the IRA.This could act as a disincentive to resource mobilization.

- xix -

71. A fourth risk is that the revised LOC does not provide localexecutives and councils with sufficient discretion over local administratLon.The main benefit from decentralization is more effective use of funds and serviceprovision at the local level. Through their elected governors, mayors and localcouncils, the people can vote on the package of services and investments forwhich they would be willing to pay in taxes, fees and charges, and would holdlocal officials accountable for the provision of these services and investments.However, the local governments still face limitations on their ability todetermine their revenue mixes: i.e. the provinces are still limited to raisingonly those revenues specified in the revised LGC and the real property andbusiness taxes still remain highly regulated. In addition, the revised LGC stillcontains expenditure mandates and limitations: e.g. mandatory expenditurerequirements for development projects and limitation on personnel expenditures9.

72. The program in its present form could lead to a deterioration ofservices, reduced local resource mobiliz:-tion, and increased disparities betweenurban and rural areas and between richer and poorer regions. The local officialswould still feel that they are not given sufficient autonomy and would continueto blame the central government for failures to deliver services at the locallevel. At the same time, the central government may be hard pressed to increasethe local government's share in national revenues to the 40% required by therevised LGC. Unless these risks are addressed, decentralization could prove tobe an expensive experiment if the central government is forced to take overagain, at a later date, many of the functions that had been devolved to the localgovernments 1 0 .

ODgortinities and Further Actions

73. The call for decentralization reflects general dissatisfaction withthe performance of the central government in meeting local needs. Momentum hasbuilt up to alter the status quo, creating an atmosphere for change in both localand central governments. The transfer of specific central government functions,resources, staff and facilities to the local government also presents an occasionfor the central government to review its own operations and make necessarychanges to improve its own effectiveness.

74. The changes brought about by the revised LGC present an opportunityto remedy some of the existing problems with the devolved activities, such asagricultural extension, and barangay roads. The local governments could explore

I The effectiveness and practicality of these expenditure requirements arequestionable. For example, markets and other ecenomic enterprises have beenexempted from the ceiling on personnel expenditures with the result that anexcessive number of staff are shown as working for these enterprises. Thisdistorts the true operating costs making it difficult to develop proper pricingfor the enterprises' outputs.

10 While these are shortcomings in the Government's program, the localgovernments should play a larger role in the provision of basic services. Theproblems with implementing decentralization should not be taken as a rationalefor reverting to the status quo ante.

- xx -

ways to improve the effectiveness the devolved activities, e.g. through greatercommunity involvement in barangay road construction and maintenance. At thenational level, the central government would need to adjust to the shift in itsrole from direct intervention and close regulation in local affaIrs to policyformulation, monitoring and support of local government operations, e.gincreasing technical support such as agricultural research for agriculturalextension or labor-based construction techniques for barangay roads.

75. The central and local governments can take actions to minimize therisks from decentralization and maximize the benefits. At the national level,the Government should consider modifying the LGC to: (a) maintain revenue sharingthrough the IRA at levels which would be achievable under the central governmentbudget constraints; (b) reduce the fiscal imbalances at the provincial, city,municipal and barangay levels; (c) provide more flexibility to determine realproperty and business tax rates; and (d) eliminate mandates and limitations onexpenditures.

76. When modifying its decentralization program, the Government couldadopt a two-tiered approach differentiating between local governments withgreater financial and administrative capacity and those without. The cities ingeneral and the provinces and municipalities in the developing areas such asCentral Luzon have a stronger economic base and potential for increasing localtax revenues. They could benefit from greater taxing powers, fewer controls onexpenditures, and less central government support. They could be provided lessby way of grants but encouraged to utilize loan funds at market rates for someof their capital investments. On the other hand, the financially weaker localgovernments, the remaining provinces and municipalities, would continue to relyon central government grants and assistance. The central government may considerselective reintroduction of matching grants to encourage local governmentexpenditures in those areas, such as poverty alleviation, that it considerspriority areas.

77. The Government should take a comprehensive approach, examining theimpact of the proposed changes simultaneously, and avoid taking ad hoc measuresto problems as they become apparent because this would create uncertainty andconfusion at the local level. This report focussed on provinces, cities, andmunicipalities as a whole due to limitations in readily available information.Further analysis would need to be carried out on the impact of decentralizationon the different local governments, especially on the financially poorer oneswhich may not be in a position to absorb additional functions or centralgovernment staff.

78. In addition to modifications to the revised LGC, the Governmentshould consider developing a detailed transition plan to: (a) phase devolutionof expenditures in line with perceived local capacity, i.e. beginning with largerlocal governments with better administrative capacity and financial base; (b)identifying priority areas for central government support for local governments;and (c) restructuring of the central government to eliminate redundancies andestablishing support functions. At present. the central government agencies arestruggling to meet the tight deadlines established under the revised LGC indevolving its functions to the local governments. Most of the focus to dateappears to have been on identifying staff and assets to be shifted from the

- xxi -

central government to the provinces, cities and municipalities, and reachingagreement with the governors and mayors to accept the transfers. However, thereis also a need to identify activities which have become redundant followingdecentralization and others which need to be strengthened. The revised LGC hasremoved many of the regulatory functions of the central government, such as thereview of local tax ordinances and schedule of values within the DOF. At thesame time, the central government would need to expand or add new functions tooversee local government operations, e.g. to monitor local government financialoerformance within DOF, and provide support to local governments in their newly.cquired responsibilities, e.g. to conduct agricultural research for agriculturalextension services.

79. At the local level, there are possible steps the provinces, cities,and municipalities could take to improve local resource mobilization and deliveryof services within the framework of the revised LGC. Even within the existinglegislation which places restrictions on the local government's ability to adjusttax rates, there is scope for improving local resource mobilization through thefollowing: (a) improving the collection of real property and business taxes due;and (b) increasing direct cost recovery through greater use of user fees to linkpayment to local governments with the provision of services and special levieson the real property tax for lands which have benefitted from public works orimprovements funded by the local government. Direct cost recovery wculd helpbreak the vicious circle of poor services, lack of additional funds, furtherdeterioration in services. Central government would need to provide support tothe local executives: e.g. DOF would need to develop guidelines on the use ofspecial levies or conduct a nationwide campaign to pursue delinquent tax payers(in addition to the tax mapping and real property administration program beingcarried out in specific local governments).

80. To develop local institutional capacity, both the personnel and thetechnical and administrative tools at their disposal would need to be strength-ened. The following are some of the measures that could be considered: (a)training key local staff through programs to enhance the technical capabilitiesof the local government staff in those areas where they will taking on additionalfunctions; (b) improving local planning procedures by developing basicinformation available to decision makers and better targeting of investments; (c)automating routine administration with greater use of computers. The provincialgovernors and the city and municipal mayors would need to take the lead inidentifying the training needs and developing a capacity enhancement programs forthe respective provinces, cities and municipalities.

- 1 -

I. INTRODUCTION

1.01 Fiscal decentralization was a central policy concern of thePhilippines during the Aquino Administration. At the national level, there wasa perception that concentration of power in the central government and ofeconomic activity in Manila resulted in alienation in the regions which in turnadded fuel to insurgency and independence movements. At the local level,provincial governors and city and municipal mayors were frustrated with theirlack of resources and excessive intervention by the central government on localoperations which hampered their ability to meet the needs of their constituents.It was felt that by giving local officials more say over local matters, theywould be able to provide their residents with better services and facilities andreduce public dissatisfaction and apathy towards government.

1.02 The Government instituted several measures to increase localautonomy. The 1987 Constitution required enactment of a new local governmentcode (LGC) to provide for a more responsive and accountable local governmentstructure through a system of decentralization. The Cordilleras and MuslimMindanao Autonomous Regions, created in 1989, were given broader fiscal powersand responsibilities, which provided local governments with a model to emulate.Under the 1990 General Appropriations Act, the central government addressed somelocal government concerns by eliminating the mandatory, local contribution to theIntegrated National Police (INP) and hospital services and by providing partialdebt relief. At the same time, provincial governors and city and municipalmayors were given more control over the police with the integration of the INPwith the Department of Local Government and the creation of the Department of theInterior and Local Government in 1990. Finally, the President signed into lawa revised LGC in October 1991 which consolidated most of the existing laws andregulations governing local government operations and inter-governmentalrelationships. The revised LGC was the center piece of the Government'sDecentralization Program and the Government accelerated its implementation inorder to have the measures effective and the program completed by June 30, 1992,when its term expired.

1.03 The decentralization program includes various measures that addressmany of the grievances of the local governments; but, taken as a whole, it is notclear whether it would constitute a sustainable, comprehensive program that couldstrengthen local governments and improve delivery of infrastructure, facilitiesand government services to the popuiation. Political considerations have beenthe primary concern for many of the steps taken and there does not appear to havebeen sufficient review to the fiscal impact of some of these measures. Variousparts of the Government were asked to review legislation pertaining to theirrelationship with local governments but no agency analyzed the potentialinteraction among the proposed decentralization measures, especially with regardto their impact on central and local government finances.

1.04 For this reason, this report assesses the Government'sdecentralization program. The objectives are to:

(a) Evaluate the impact of the various decentralization measures;

(b) Identify possible problem areas related to the program;

-2-

(c) Develop recommendations on steps to be taken to improve theeffectiveness of local government operations.

1.05 The report first assesses the present status of local governmentfinance in the Philippines and the bottlenecks to local government fiscaldevelopment under the current system. Fiscal information from individualprovinces, cities and municipalities for 1986-1988 was collected so as to conducta detailed statistical analysis of the local government sector. This informationis referred to as the "local government database" through out the report. Also,it reviewed the Government's decentralization initiatives, especially the revisedLGC. It also assessed the impact of these initiatives on the fiscal position ofcentral and local governments, local fiscal autonomy, local resource mobilizationand equalization among different local governments.

1.06 Chapter II describes the local governments and assesses existinglocal government finances and central-local government relations. Chapter IIIsummarizes the various measures taken by the Government during 1987-1991 topromote decentralization. Chapter IV reviews the salient features of the revisedLGC which,among other measures, devolved responsibilities for providing basicservices from the central government to the local governments, revised theallocation formula for central government revenue sharing block grants, andmodified the laws and regulations on local government taxes, fees and charges,and local government administration. Chapter V assesses the overall impact ofthe Government's decentralization initiatives on central and local governmentfinances, local autonomy, local revenue mobilization, and local absorptivecapacity (technical efficiency). Chapter VI summarizes the conclusions andrecommendations to improve local government operations. Since this reportattempts to conduct a comprehensive overview, it was not possible to look indetail into the impact of decentralization on specific local government services,e.g. environmental administration or health, which would affected by theGovernment's program.

1.07 This report is based on a Bank mission consisting of Messrs. LawrenceHannah and Yoshine Uchimura (AS2IN) and Roy Bahl, Jorge Martinez and LarrySchroeder (consultants) who visited the Philippines in March 1990. The passageof the revised LGC in October 1991 required a major restructuring of the originalreport. Mr. Uchimura visited the Philippines in November 1991 to follow up withthe Government on the possible impact of the new LGC.

-3-

II. LQCAL GOVERNMENT IN THE PHILIPPINES

2.1 The centerpiece of the Government decentralization program was therevision of the local government code (LGC). The revised LMC, passed into lawin October 1991, consolidated all existing legislation on local governmentaffairs and modified the relationship between central and local governments,local governments' authority to raise revenues, and the conduct of localoperations. (These changes are discussed in detail in Chapter IV). However, itis important to understand the existing situation at the local level in order toevaluate the possible impact of the changes. Therefore, this chapter reviewslocal government structure prior to 1991 (when the revised code took effect).

A. Local Government Structure

2.2 The government of the Philippines has a multi-tier structureconsisting of (a) central government departments, agencies and corporations; (b)provinces; (c) cities and municipalities and (d) barangays--with the last threeconsidered local governments. In addition, the country is divided into 14geographical regions (including the National Capital Region/Metro Manila butexcluding the Cordillera Administrative Region; Map IBRD 23945).

2.3 The region is the unit of plannisg and coordination and, with theexception of Metro Manila (the National Capital Region), does not performadministrative or service provision functions. Each region has a RegionalDevelopment Council (RDC) composed of: (a) all provincial governors and charteredcity mayors; (b) mayors of municipalities which are provincial capitals orregional centers; (c) the regional directors of the eight national governmentdepartments on the NEDA Board; and (d) representatives of the private sector andnon-governmental organizations. The RDCs' role is to: (a) review and approveregional development plans and multi-year and annual regional investmentprograms; (b) endorse regional budget proposals of national government agenciesin their regions; (c) endorse specific project proposals, including thoserequiring foreign financing; and (d) assess implementation of regionaldevelopment plans.

2.4 A special case is Metro Manila', where a separate agency was createdto integrate investment planning and provide certain services such as garbagecollection or traffic management, which could be better operated at ametropolitan level2.

1 Metro Manila consists of four cities--Manila, Caloocan, Quezon and Pasay--and 13 municipalities--Las Pinas, Makati, Malabon, Mandaluyong, Marikina,Muntinlupa, Navotas, Paranaque, Pasig, Pateros, San Juan Del Monte, Taguig andValenzuela, which were removed from the surrounding provinces of Bulacan, Lagunaand Cavite.

2 Another special case is the Cordillera Administrative Region (CAR) whichwas created in 1987. The CAR is discussed in more detail in Chapter III togetherwith the Mindanao Muslim Autonomous Region.

- 4 -

2.5 The Metro Manila Commission (MMC) was established in 1975 to overseeand coordinate the activities of all its cities and municipalities. A MetroManila Authority (MMA) was created in January 1990 under Executive Order 392 toreplace the MMC. The MMA is governed by a Metro Manila Council consisting of thecity and municipal mayors and the Secretaries of the Departments of Public Worksand Highways and Budget and Management as non-voting members. The Chairman ofthe Council, who heads the HMA, is chosen from among the council members andserves a six-month term. A General Manager and three Deputy General Managers,appointed by the President, are responsible for administering the MMA. The MMAis funded from central government grants, contributions from the cities andmunicipalities, and its own revenue sources. Its main functions are sanitationand waste management, traffic management, land use planning and zoning.

2.6 The provinces, cities, municipalities and barangays constitute localgovernment in the Philippines. There are presently 75 provinces, 60 cities,1,533 municipalities and over 40,000 barangays. The barangay is more of acommunity organization and is considered too small to be an effective providerof servires. The cities and municipalities, on the other hand, are consideredto be the basic unit for providing daily services since they are close to thepeople and have a sufficient critical mass and financial base to deliver them.The province covers a larger area and is considered more remote from the people(than cities and municipalities). Therefore, they are expected to providespecialized services that would benefit from economies of scale.

2.7 Under the previous LGC (Batas Pambansa Blg. 337), the followingrequirements were set for the different levels of local government: (a)baranzavs, a minimum of 500 inhabitants; (b) municipalities, a minimum of 10,000inhabitants and an average estimated income of at least P 200,000 for the lastthree consecutive years; (c) cities, a minimum of 100,000 inhabitants and anaverage estimated income of at least P 10 million for the last three consecutiveyears; and (d) 2rovinces, a minimum of 350,000 sq. km., 500,000 inhabitants, andan average estimated income of at least P 10 million for the last threecorsecutive years. Cities with over 150,000 inhabitants and average estimatedincomes of over P 30 million for the last three consecutive years were classifiedas Highly Urbanized Cities.

2.8 Local governments are controlled by the central government. Theprovinces, highly urbanized cities and chartered cities report directly to thecentral government. The province is subdivided into and exercises administrativecontrol over component cities and municipalities within its boundaries. Both thecities and municipalities are further subdivided into barangays. The localgovernment structure can be seen as having three legs, each leg reportingdirectly to the central government. The first is the local government structurein Metro Manila which is made up of the MMA, the four cities and 13municipalities. The second is the 75 provinces and the more than 1,500municipalities under the jurisdiction of these provincial governments (whichmight be seen as the rural government structure). The third is the 60 highlyurbanized and chartered cities, which are independent of the provinces, and whichcan be considered the urban government structure.

2.9 Each unit of local government has an executive and legislative arm.The provinces are headed by governors who report to provincial councils

-5 -

(Sangguniang Panlalawigan); the cities and municipalities are headed by mayorswho report to city councils (Sanguniang Panlungsod) and the municipal councils(Sanguniang Bayan) respectively; and the barangay is headed by a barangay captainwho reports to a barangay council (Sanguniang Barangay). Provincial governors,vice-governors, mayors, vice-mayors, barangay captains and council members3 areelected by popular vote. The provlncial governors and the city and municipalmayors have the authority to set and collect charges and taxes, prepare budgets,hire staff and invest in and manage local servlces and enterprises withinlimitations set by the LGC and various central government regulations.

Iable 2.1: DISTRIBUTION OF PROVINCES, CITIES AND MUNICIPALITIESBY INCOME CLASS: AVERAGE 1983-86

Numbers

Income LevelsClass (in P millions) Provinces Cities Municipalities

First More than 30 18 15Second 20.0 to 29.9 13 8Third 15.0 to 19.9 12 16Fourth 10.0 to 14.9 17 10Fifth 5.0 to 9.9 9 7Sixth Less than 5 6 2

First More than 15 - 11Second 10.0 to 14.9 - - 4Third 5.0 to 9.9 - - 20Fourth 3.0 to 4.9 _ 51Fifth 1.0 to 2.9 - - 555Sixth Less than 1 - - 892

Total 75 60 1,533

Source: Department of Finance; Based on EO 249

2.10 The provlnces, cities and municipalities were categorized based onaverage annual income over the last four consecutive years under EO 249 and werereclassified every four years, the latest in July 1987 (see Table 2.1). Theseincome classifications are used to determine local tax ceilings, financial aidand other assistance from the central government, and salary levels of localexecutlves. Only 31 provlnces (418 of total provinces) and 23 clties (38%) were

3 Under the previous LGC (Batas Pambansa Blg. 337), some municipal councilmembers were appointed by the PresLdent.

classified as first or second class, i.e. averaging incomes of over P 20 million(about US$ 1 million) from 1983-1986. On the other hand, 1,447 municipalities(94%) were classified as fifth and sixth Class, i.e. averaging incomes of lessthan P 1 million (about US$ 50,000) over 1983-86. Of the 11 first classmunicipalities, 10 are located in Metro Manila.

B. Budgetary and Onerational Autonomy

2.11 Until 1992, the central government maintained a strong influence overlocal affairs through administrative and regulatory controls. Key financialofficers in local governmez.'s were appointed by the central government; thetreasurer and assessor by the Department of Finance (DOF) and the budget officerby the Department of Budget and Management (DBM). The treasurer plays anextremely important role in the local government, being responsible for thecollection and disbursement of funds and the maintenance of accounts. Inaddition, the Decree on Local Fiscal Administration, Presidential Decree (PD)477, established that local government budgets could not exceed the estimatedincome the treasurer certified as collectable. This gave treasurers the de factoauthority to set budget ceilings for their respective provinces, cities andmunicipalities.

2.12 PD 477 was issued in 1974 to regulate local government fiscal affairsand determined the fund structure, budgeting process, and the handling of funds.The PD required the budgets of the provinces, cities and municipalities to complywith the following requirements:

(a) The aggregate amount appropriated could not exceed the estimatedincome certified as collectable by the local treasurer;

(b) Full provision would be made for the local government's statutoryand contractual obligations;

(c) 20% of the revenue sharing grant (the Internal Revenue Allotment)would need to be appropriated for development projects;

(d) Aid would be provided to barangays in amounts up to P 500 perbarangay; and

(e) 2% of the estimated revenues from regular sources would be set asidefor calamities.

Furthermore, PD 477 limited the total appropriations for salaries and wages oflocal personnel to a maximum of 45% of the annual income for first and secondclass provinces, cities and municipalities and 55% for lower class localgovernments. Personnel expenditures for health and agricultural services, publicutilities, markets and slaughterhouses, and other economic enterprises wereexempted from the ceiling. This provision made it difficult to determine theexact cost of operating markets in some jurisdictions since some of the staffwould be listed as working for the market to get around the limitation onpersonnel expenditures.

2.13 In addition, local governments were required to include the followingexpenditures in their annual budgets:

(a) Integrated national police: Local police and fire protection wassupported by a contribution of 18% of general fund income fromregular sources (PD 632);

(b) Aid to hospitals: 5% of annual general fund income for first andsecond class cities and municipalities and 3% for third and fourthclass municipalities was to be set aside for the provision ofhospital services (RA 1939); and

(c) Election reserve: One quarter of the local election costs from theprevious election had to be set aside (PD 1296).

Many local executives were unhappy with the requirement to contribute to theintegrated national police and hospitals over which they had no control and manywithheld their contributions from the central government. One study4 estimatedvarious mandatory expenditures accounted for around 46% of local expenditures,leaving local executives discretion over just over half of their budgets.However, many of the funds at executive discretion were for personnel costs, sovery little was left for new local initiatives.

2.14 The central government reviewed local government budgets to ascertainthat various laws and regulations were being followed. All budgets approved bythe respective local councils were subject to review by the DBM which had theauthority to declare parts of the budget inoperative (PD 477 as amended by PD1375). The Department of the Interior and Local Government reviewed and approvedthe development expenditures from 20% of the Internal Revenue Allotment (requiredto be set aside for that purpose).

C. Local Government ExRenditures

2.15 Local governments are responsible for providing basic services, suchas garbage collection, traffic management and public markets, as well as localinfrastructure such as roads and drains. However, these responsibilities wereminor when compared to those of the central government, whose agencies wereresponsible for providing a wide range of public services nationwide (such asroads, ports, irrigation systems, water supply and drainage, electricity,education and health care). Primary education is a shared responsibility, withthe center covering all personnel costs. Until the end of 1991, many local

I This was based on estimates of a typical local government budget in S.B. Ursai, "Some Salient Issues in and Problems in Local Government Budgeting,*National Policy Seminar, 1987.

services, such as the barangay road network or the local health centers, werecontrolled by the central government5.

2.16 Prior to 1992, local budgets were divided into three accounts: aGeneral Fund, Infrastructure Fund and a Special Education Fund. The General Fundincluded both current and capital expenditures, and was made up of outlays for:(a) general administration; (b) public welfare and safety, including courts,registrar of deeds, health services, and education and (c) economic development,including expenditures on the offices of the veterinarian and engineer, andspending for markets and slaughterhouses. The Infrastructure Fund primarilycovered the building and maintenance of roads and bridges. The Special EducationFund (SEF), administered by Local Treasurers, was for primary education: Centralgovernment directly covered the cost of teachers and the SEF supported otherexpenses. General Fund expenditures accounted for about 75%-85% of total localgovernment expenditures.

Table 2.2: DISTRIBUTION OF LOCAL GOVERNMENT GENERAL FUNDEXPENDITURES BY FUNCTION: Average 1986-1988

Munici- MetroProvinces palities Cities Manila

General Administration 20% 36% 16% 17%Government Finance 12% 18% 10% 5%Protection Services 5% 2% 8% 9%Social Improvements 10% 11% 12% 33%Economic Development 34% 9% 28% 12%Economic Enterprises 4% 9% 7% 1%Intergovernmental Aid 3% 8% 8% 14%Others 127 .1% 11. 21

Total 100% 100% 100% 100%

Note: Cities and municipalities in Metro Manila are excluded from the total ofcities and municipalities

Source: Local government database

2.17 Significant differences exist in the expenditure patterns betweendifferent levels of local government and between the cities and municipalitiesof Metro Manila and the rest of the Philippines (see Table 2.2). Data illustratethe different roles played by the different classes of local government in thepresent system. For example, municipalities spend twice as great a share of

5 These services were subject to decentralization, which is discussed ingreater detail in Chapter 4 (para. 4.09)

- 9 .

their budgets on general housekeeping functions (general administration andfinance) than do other types of local governments, which is not surprising giventheir smaller size. They spend more through their economic enterprises and muchless on general economic development; i.e., they are more activity-oriented(markets, slaughterhouses). Provincial governments, on the other hand, are moreinvolved with general economic development activities, and spend more than citieson administration, due perhaps to their responsibility for regulating theoperations and finances of municipalities. Cities are more heavily involved indirect service delivery, and appear to do less through economic enterprises thanmunicipalities. Manila local governments, possibly because of the large urbanagglomeration, spend one-third of their budget on social improvement while theother classes of local government allocate about 10 percent.

Table 2.3: AVERAGE PER CAPITA EXPENDITURES - 1986-1988(in pesos)

CoefficientMean High Low of Variation'

All Local Governments 178.3 - -

Metro Manila 344.9 - -

Other 153.2 - - -

Provinces 61.7 171.1 28.5 43%Citiesb 302.8 946.6 83.8 44%Municipalitiesb 78.6 1,001.4 7.8. 69%Provincial Aggregates 165.5 486.8 64.5 42%

a Coefficients of variation are expressed in percentages.b Exnludes Metro Manila cities and municipalities.

Source: Local government database

2.18 Significant variation exists in the levels of expenditures betweentypes of local governments, and among the local governments within any givenclass. As can be seen from Table 2.3, average expenditure per capita by thelocal governments as a whole between 1986-1988 was relatively modest, P 178.City governments, as might be expected, spent considerably more--an average P 303per person in 1986-1988 or almost twice the national average. Th1 cities andmunicipalities in Metro Manila on average spend more per capita than the averagefor cities as a whole. Further, there is considerable variation in fiscalactivity within each class of local government. For example, provincialaggregate per capita expenditures6 range from a high of P 486 to a low of P 65,

6 Expenditure data for provincial governments and the municipalities withinthe provinces were combined to obtain the consolidated figures for each province.

- 10 -

and the standard deviation of this distribution is nearly half as large as themean. There is much more variation in per capita expenditures amongmunicipalities than among cities and provinces.

2.19 What are the determinants of per capita expenditure variations amonglocal governments in the Philippines? To what extent are these variations in percapita expenditures associated with differences in fiscal capacity and serviceneeds? The following determinants (and direction of relationship) can beconsidered:

(a) Average household income and Rer capita assessed value of Dropertyto indicate the capacity to finance public services (+).

(b) PoRulation size to indicate scale effects (-).

(c) Land area (+) and RoRulation density (-) to account for the highercosts of servicing a more spread-out population.

(d) Poverty index to indicate a higher level of need (+).

(e) A national capital region dummy variable to account for the specialsituation and developed status of Metro Manila local governments.+).

(f) Per capita internal revenue allotment (IRA)7 to account for theeffects of central government grants on local spending (+).

(g) Urbanization (city population as a percent of provincial population)to account for the greater fiscal capacity of urban localgovernments, and for their greater demand for local public services(+).

2.20 The relationship between per capita expenditures and the abovedeterminants was investigated with a linear regression. Results are presentedin Table 2.4 for aggregate expenditures of local governments, provincialgovernments, city and municipal governments.

2.21 Except for cities, the proportion of the total variation explainedis high, and most of the explanatory variables have the expected sign. Four mainconclusions can be drawn from these results:

(a) Per capita expenditures are significantly higher where the capacityto finance services is higher. This positive income elasticity ofdemand suggests that public services are "normal goods" in thePhilippines as in other countries.

7 Revenue sharing grants (the IRA) are a major source of local revenues.These grants are discussed in more detail in paras. 2.47 to 2.49.

Table 2.4: LINEAR REGRESSION OF PER CAPITA LOCAL GOVERNMENT EXPENDITURESON SELECTED INDEPENDENT VARIABLESa

Provincial City MunicipalProvincial AaareQates Governments Governments Governments

Variables Equation 1 Equation 2 Equation 3 Equation 4 Equation 5

Constant -128.89 -102.11 0.72 115.14 0.78(2.84)* (2.02)* (0.08) (2.35)* (0.40)

Average Household 0.50x10 2 0.47x10 2 0.21x10-3 -- --

Income (5.88) (5.40) (0.71) -- __

Population -6.14x10-6 -1.78x10-5-- 6.07x10-5 0.41x10-3

(0.94) (1.52) -- (0.67) (11.76)

Land Area -- -- -- -- -0.16x10 4

__ __ -- -- (4.35) X

Poverty Index (1988) 111.24 * 99.59 * -- -- --(2.34) (2.06) -- -- --

Manila Dummy -- 103.76 -- -43.38 68.77-- (1.19) -- (0.43) (5.79)

Per Capita 1.37 * 1.26 * 1.59 * 1.34 * 1.46Allotments (7.03) (5.93) (7.72) (3.53) (52.38)

Urbanization 181.18 * 195 48 * -- -- --(4.94) (5.09) -- -- --

Per Capita -- -- 0.011 0.011 0.66x10-2Assessed Value -- -- (4.08)* (2.05)* (16.94)*

Population -- -- -0.19 -- --Density -- -- (0.09) -- --

R 0.68 0.68 0.59 0.19 0.73

N 69 69 67 57 1,331

Absolute value of t. statistics shown in parenthesis.Significant at 0.05 level.

- 12

(b) Urbanization, cet. par., is associated with significantly higherlevels of per capita expenditures.

(c) Per capita local government expenditures are significantly higherin provinces that have a greater incidence of poverty, indicatingthat expenditures by local governments are to some extentsensitive to needs for public services.

(d) IRA are associated with higher levels of expenditures. Onaverage, and holding othe: things constant, a province whose localgovernments receive 10 pesos more in per capita allotment can beexpected to spend nearly 14 pesos more.

The positive association of per capita expenditures with a higher capacity tofinance and a higher level of urbanization suggest that fiscal disparitiesfollow economic disparities. Higher-income, wealthier and more urbanizedlocal governments spend more on a per capita basis, i.e., much of thevariation is attributable to a greater capacity to finance. This finding isreinforced by the positive coefficient for municipalities located in MetroManila, which might be interpreted as showing that all else held constant,Manila municipal governments spend nearly 69 pesos more per capita than doother municipalities in the Philippines.

2.22 Local governments have played a limited and declining rolerelative to Lhe central government and the economy during the 1980s. At thestart of the decade, expenditures of the provinces, cities and municipalitiescombined accounted for 1.6% of gross domestic product (GDP) and around 10% oftotal government expenditures (Table 2.5). During the early 1980s, localgovernments increased their share slightly in both the economy (as measured byGDP), and total government expenditures. Per capita local governmentexpenditures in real terms (in constant 1990 prices) rose from P 313 in 1980to a peak of P 346 in 1982. However, local government expenditures declinedin the late 1980s relative to the economy and total government expendituresand in real terms per capita. By 1990, the local government share had droppedto 1.2% of GDP and 6% of total government expenditure. Per capita realexpenditures dropped to P 232 in 1992, or P 114 lower than the level in 1982.

2.23 The impact of the low and declining level of local expenditurescan be observed through Bank projects. The provision of basis services hasnot kept pace with the increase in demand brought about by population growthand urbanization. Public markets, the core of commercial activities in mostcities and municipalities, have become dilapidated and overcrowded because nomajor expansion a.id/or rehabilitation have occurred. Market activities havespilled onto surrounding streets causing major traffic problems. In the urbanareas, inadequate sanitation and drainage facilities lead to periodic floodingand stagnant waters, posing a health hazard to the residents. The problem ofinadequate infrastructure and public facilities is made worse due to irregularmaintenance that shortens the effective life of many government investments.

- 13 -

Table 2.5: TRENDS IN LOCAL GOVERNMENT EXPENDITURES

1980 1982 1984 1986 1988 1990

Local Govt. Expenditures as Share of:

GDP (in %) 1.6 1.7 1.4 1.4 1.2 1.2Total Govt. Expenditures (in %) 9.9 10.0 10.9 7.2 7.0 6.1

Per Capita Real Expenditures(In Pesos, 1990 constant prices) 313 346 250 233 223 232

Source: Annex Tables 1 and 2

2.24 The local governments' limited role and their perceived inability toprovide infrastructure, facilities and services has resulted in the centralgovernment assuming some local functions; but this further erodes their position.For example, a road inventory conducted in the mid-1980s8 found that nationaland provincial roads are not properly classified, sometimes to the point wherea road changes classification at provincial boundaries. Some national roadsserved only as access roads for a few towns and barangays in remote, rural areas,or only as city/municipal roads in some urban areas. The study observed that:

"In the past 30 years or so, a (high) number of roads have beenreclassified to national roads or provincial roads. This was and isallowed for under existing legislation. Upon recommendation andapproval, roads can be declared national roads or provincial roadsas the case may be. Prestige and lack of funds, equipment and(engineering personnel) were (most likely) the main reasons forreclassification or classification not in line with the word andspirit of the legislation governing road classification."

In a similar fashion, the central government, through the Department of PublicWorks and Highways, took over the responsibility for constructing and maintainingbarangay roads, the lowest form of road in the hierarchy.

8 Ministry of Public Works and Highways, "Punctional Road ClassificationStudy: Final Report," October 1986.

- 14 -

Table 2.6: TRENDS IN PER CAPITA LOCAL GOVERNMENT REVENUES(in pesos, constant 1990 prices)

1980 i982 1984 1986 1988 1990

Locally Generated Revenues 208 217 166 154 146 160Central Government Grants 115 152 104 101 98 93Total Revenues 322 369 270 255 244 253

Source: Annex Table 2

2.25 The minimal increase in local government revenues is considered aprime cause of the drop in local government expenditures. By law, localgovernments cannot accumulate deficits and were limited to spending only as muchas they collect in local taxes and fees, receive from the central government asgrants, or borrow from government financial institutions. Local governmentborrowing has been limited. During the 1980s, both locally generated taxes, feesand other non-tax revenues and central government grants decreased on a percapita basis in real terms. After reaching a peak of P 217 in 1982, per capitalocally generated revenues, in 1990 prices, dropped to P 146, or by 33%, in 1988.Per capita locally generated revenues is estimated to have recovered to P 160 in1990, but this is still, in real terms, below the level achieved in 1982.Similarly, central government grants are estimated to have decreased from P 152per capita in 1990 prices in 1982 to P 93 per capita in 1990. The localgovernments' inability to generate additional local resources along withreductions in central government grants are two reasons for their inability tomaintain expenditures during the 1980s. Local government revenues and centralgovernment grants are discussed in the next two sections.

2.26 Finally, it is not unusual for local governments to play a relativelysmall role compared to the central government during the early stages of economicdevelopment. An analysis of developing countries was carried out by Wasylenko(1986), using mostly IMF data for 1980-19839. Using a linear regression, heattempted to estimate the "average" local government expenditure share,controlling for the level of per capita GDP, population si:;e, urbanization,openness of the economy, larl area and whether or not c federal form ofgovernment is used. According to his results, a country with the economic and

9 Michael Wasylenko, "Fiscal Decentralization and Economic Development,"Public Budgeting and Finance, Winter 1987. The actual expenditures reported byWasylenko for the Philippines are different from those in this report (Table 2.5)because he used a slightly narrower definition. The expenditure decentralizationmeasure he used excluded national defense and social security from centralgovernment expenditures.

- 15 -

population characteristics of the Philippines would be "expected" to have a sub-national government expenditure share of 18.8%. However, from 1980-1983, theactual average share was 9.6% in the Philippines, about half of the "expected"level. The role of the local government in the Philippines relative to thecentral government and the economy declined since the early 1980s. Thus, it maybe concluded from this analysis that the degree of fiscal decentralization in thePhilippines is low by international standards, even when country characteristicsare considered.

D. Revenue Raising Powers

2.27 Local governments have the power to levy local taxes, collect feesand charges and borrow funds within the limitation set by various laws andregulations. The Local Tax Code, Presidential Decree (PD) 231, 1973, and theReal Property Tax Code, PD 464, 1974, provided the legal framework for the localtaxes, fees and charges. The Decree on Credit Financing for Local Governments,PD 752, 1975, regulated borrowings by local governments. All these decrees weremodified and incorporated in the revised LGC which went into effect in 1992.Changes and their potential impact are discussed in Chapter IV. The followingdiscussions are based on the previous laws and regulations which were in effectuntil the end of 1991.

2.28 Real proRerty taxes are a major source of local revenue and arelevied on the assessed value of land, buildings and equipment. The assessmentsare a fixed percentage of the market value of the property baseo on actual use.Prior to 1992, these assessment levels varied from 15%-80% of market valuedepending on use for land and equipment and value for buildings. Each localgovernment established its own real property tax rate, within ranges determinedby the Real Property Tax Code. Provinces and municipalities combined werelimited to imposing a tax rate of no less than 0.5% but no more than 1.0%, whilecities could impose a tax rate of no less than 1% but no more than 2%. Anadditional 1% was levied on properties and was earmarked for the SpecialEducation Fund. Since these rates are applied to assessed values which are inturn adjusted from market values by the assessment levels, the effective realproperty tax rate was significantly lower and differed between different typesof land usel.

2.29 A general revision of assessments was to be carried out every threeyears. The process was to have worked as follows. All property owners wererequired to file a sworn statement of the fair market value of their realproperty. The local assessor then prepared two types of schedules: (a) themarket value of land based on stated sales values, capitalized income values,owners' sworn statements, realtors' opinions and the assessor's judgement; and

10 For example, PD 464 mandates an assessment level of 30% for residentialland and 40% for agricultural land. Assuming that a city sets the maximum 2%allowable under PD 464, the effective real property tax rate would be 0.6%residential land and 0.8% for agricultural land.

- 16 -

(b) market value of building and improvements based on building material andlabor costs, building permit data, stated sales value, owners' sworn statementsand the assessor's judgement. Land was classified by use, grade and location.Buildings were classified by use, grade and quality of construction andmaterials. Machinery was appraised on a case by case basis based on owners'records of purchase and replacement cost surveys. Market values were expressedin pesos per sq. m. and were approved by the Department of Finance (DOF). Theassessments for each property were then prepared based on these unit values andfurnished to the recorded owners. In fact, assessment roles were based mainlyon owners' sworn statements; however, these were considered to be inaccurate orincomplete. Therefore, the assessment role were thought not to accuratelyreflect variations in the current market values.

2.30 Another major source of local revenue was the business tax. Businesstaxes include: (a) graduated fixed taxes levied on a business' gross annualreceipts; and (b) fixed taxes based on the type of business (e.g. P 4,000 peritnnum for night clubs, P 100 per automatic lane per annum for bowling alleys).The Local Tax Code set the tax rates to be paid based on the type of business andlevel of annual sales. The (implicit) tax rate decreased with increased sales.

2.31 The Local Tax Code included a wide array of additional taxes (suchas the amusement tax on admissions to theaters, cinemas and other places ofamusement), fees and charges. Public markets are also an important source oflocal revenue, especially for the smaller cities and municipality where theoperation of the market is the main municipal activity. The Code specified whattypes of fees should be charged (e.g. monthly rental fees for permanent stalls)but the actual rates were to be set by the local councils. At the same time, theCode set the fees and charges for many local operations: e.g. for a municipality,P 12 for registering a cart, P 17 for marriage licenses, P 2 for dog licenses,etc. Local governments were limited to only those taxes, charges and feesspecified in the Local Tax Code and local tax ordinances were subject to reviewby DOF which haa the power to return an ordinance for redrafting if it did notconform with the Local Tax Code.

2.32 Under the Decree for Credit Financing, local governments could borrowfunds or issue bonds to finance a variety of investment projects such as powerplants, public markets and slaughterhouses, waterworks and irrigation systems,telephone and radio communication systems, government housing projects, purchaseof rural and urban estates, and other capital investment projects. Localgovernments were limited to borrowing only from government financialinstitutions, e.g. the Development Bank of the Philippines and the Land Bank, andonly upon the recommendation of the Secretary of Finance. Provinces and citiescould issue bonds but the terms and conditions of the bonds were set by DOF.Borrowings by local governments have been limited: By the end of 1988, loansoutstanding to the government financial institutions totalled only P 358.6million.

- 17 -

Table 2.7: SHARE OF OWN SOURCE REVENUES AND AVERAGE PERCAPITA OWN SOURCE REVENUES - 1986-88

CoefficientMean High Low of Variation

A. Own Source Share of Inclusive Total Revenue*

All Local Governments 56% - -

Metro Manila 83% - -

Other 44% - -

Provinces 25% 65% 3% 56%Citiesb 44% 92% 9% 43%Municipalitiesb 34% 92% 1% 55%Provincial Aggregates 37% 83% 5% 45%

B. Per Capita Own Source Revenues: in pesos

All Local Governments 72.2 - - -Metro Manila 251.0 - -

Other 45.3 - -

Provinces 8.3 29.9 0.6 68%Citiesb 107.3 783.9 11.2 105%Municipalitiesb 21.1 568.8 0.4 125%Provincial Aggregates 44.9 318.0 2.3 104%

' Total revenues includes own source revenue and central government revenuesharing grants (allotments).

b Excludes Metro Manila cities and municipalities.

Source: Local Government Database

2.33 Local governments raise about 60% of their revenues from their ownsources and rely on central government grants, primarily revenue sharing throughthe IRA, for the remainder. From 1986-1988, they raised an average of P 72 perresident from local sources, or 56% of total local revenues (see Table 2.7).Significant differences exist between different levels of local government andamong the provinces, cities and municipalities. The cities and municipalitiesof Metro Manila were able to raise 83% of their revenues from their own sourcesand generate P 251 per resident in local taxes and fees or close to six times theaverage of the remainder of the Philippines, which was P 45. Further, cities andmunicipalities rely more on their own resources and the provinces less, while

- 18 -

cities raise significantly more than provinces and municipalities combined. Also,within each level of local government, large differences exist: The averagerevenue per capita in the highest city, P 784, is more than 70 times that of thelowest city, at P 11. Even larger disparities exist among municipalities.

Table 2.8: INDICATORS OF REAL PROPERTY TAX PERFORMANCE - 1986-1988-

ProvincialAggregates Cities Municipalities Provinces

Real Property TaxPer Capita P 16.1 P 37.6 P 7.3 P 4.7

(108%) (102%) (192%) (78%)

Real Property Tax as a percent of:Local Govt. Own Sources 35% 36% 34% 58%

(31%) (43%) (47%) (30%)

Local Govt. Expenditures 9% 12% 9% 8%(70%) (73%) (92%) (130%)

Collection Efficiencyb - 48% 17% 39%(37%) (93%) (43%)

Effective Tax Rate" - 1.04% 0.48% 0.32%(44%) (206%) (34%)

Per Capita Assess Valued - P 3,613 P 1,518 P 1,373(94%) (146%) (68%)

* Note: Coefficient of variation shown in parenthesis.b Actual taxes collected/taxes duee Actual taxes collected/assessed valuesd Assessed values/population

Source: Local government database

2.34 The real property tax is an important local government levy in thePhilippines, accounting for 35% of locally raised revenues and financing 9% ofall local government expenditures (see Table 2.8). There is significantvariation in the level of collection among the local governments, with citiescollecting more per capita than the provinces and municipalities combined andwith the co-efficient of variation being higher among municipalities than cities.

- 19 -

2.35 Not all real property taxes are actually collected; in fact, justover half are paid. Table 2.9 shows the number and per capita real property taxof tne cities and municipalities by different levels of collection efficiency,which is defined as actual collections relative to taxes due. Of the 919municipalities and 59 cities reporting, only 26 and 15, respectively, showed acollection efficiency greater than 60%. For those local governments with acollection efficiency greater than 60%, the average revenues per capita weresubstantially higher. Tax administration is better in the higher-incomejurisdictions, and it is associated with a more intensive use of the propertytax.

Table 2.9: REAL PROPERTY TAX COLLECTION EFFICIENCY - 1986-1988

Collection Number Per CaRita ProRerty TaxEfficiency Cities Municipalities Cities Municipalities

M%) (pesos) (pesos)

90 - 100 1 6 ) 5289 - 89 2 5 )72 870 - 79 2 9 ) 2060 - 69 10 6 64 94Under 60 44 893 28 7Total Reporting 59 919

Source: Local government database

2.36 There are several reasons for inefficient collections. One is pooradministration. Many of the real property tax records are out of date but havenot been revised. Property tax rolls contain names of owners who no longer ownthe land or have duplicate records of ownership. This inflates the estimates oftaxes due and contributes to the problem. Records of payments are kept manuallyso that preparation of lists of delinquent payers takes a good deal of time.Another is the lack of political will to enforce penalties for non-payment:While the Real Property Tax Code allows local governments to seize the personalproperty of non-payers and auction it off, this is rarely enforced.

2.37 To identify the local governments that tax properties more heavily,the linear relationship was estimated between per capita property tax revenuesand the effective property tax rate (the ratio of actual taxes collected toassessed property values) and a set of possible determinants of the intensity ofproperty taxation. These included average household income, urbanization, percapita I1'A, population, collection efficiency (as measured by the ratio of actualcollections to collectibles), per capita assessed value of property, tax mapping

- 20 -

(i.e. whether a local government carried out a tax mapping program), and a MetroManila regional dummy variable (see Table 2.10).

2.38 The results of the analysis support the not surprising conclusionthat property tax is most revenue productive in urban areas where the economy ismore advanced. For provincial aggregates, nearly 80% of the variation in percapita property tax revenues could be explained. As expected, per capitaproperty tax revenues and the effective tax rate are higher where householdincome is higher, the province is more urbanized, and, other things heldconstant, in Metro Manila. For cities and municipalities, over half the variationin per capita revenues could be explained: Property tax collections are highestin jurisdictions with larger populations and with higher levels of per capitaproperty wealth. These results also indicate the importance of tax administrationin determining the level of collections. Both the level of collection efficiencyand the level of per capita assessed value are shown to significantly affect thelevel of property tax collections.

2.39 The above regressions indicate that jurisdictions with higher percapita assessed values raised a higher level of per capita property taxes. Butdo these jurisdictions choose to tax property wealth more intensively, i.e., dothey exert a greater tax effort? Further regression analysis was carried outwith the effective property tax rate as a dependent variable, i.e., as a roughindicator of the level of property tax effort, for cities and municipalities.The results shown in Table 2.10 indicate that a smaller proportion of thevariation can be explained (than in the case of per capita property taxrevenues). The results for cities show that the effective property tax rate is,cet. gar., lower when per capita assessed value is higher. This is a reasonableresult: As a property tax ceiling exists, the higher the tax base with a givenrate, the lower the effective property tax rate. These results also show thatcities have higher effective property tax rates when they exert a greatercollection efficiency and if they are located in Metro Manila. In municipalities,the same response is found for per capita assessed value and the collectionefficiency. Property tax effort also appears to be higher in more heavilypopulated municipalities, and allotments appear to stimulate property taxefforts. Effective tax rates are higher in Metro Manila municipalities than forothers in the country.

2.40 Another issue is whether those jurisdictions that are tax mapped are,=. 2a., able to collect more revenue than those which are not. Bahl, Hollandand Wasylenko (1985) compared a small sample of mapped and non- mappedlook-a-like, municipalities and concluded that mapping did not necessarily leadto higher levels of property tax revenue. Their explanation for this finding,and also that of Dillinger (1988) In a follow-up analysis, was that tax mappingdealt only with the discovery and valuation steps of property tax administration,since revenue yield also depends on record keeping and collection efficiency.

Table 2 10O ORDRY LEMST SQUARESESTIMATES OF THE D rNwATS OF VARIATIOUS IV PROPM1 TAr REVENJa

Provinaial Maa te Cities Mzmiciitl*sPer Capita Per Capita P r Capita P r Capita Per CapitaProperty Tar Propaty Tur Property Tax affective Property Tax Preperty Tax affective_ujapeadeut Varible Reve_ma Reense Revenues TAX Rate RevemwS Reveaas hrn Rate

Co"at -7.74 -9.36 -13.50 0.7,,i0 2 -7.75 -5.1S -0.13 dl-2(1.77) (2.67)' (1.45) (3.8)a (12.98) a (7.21)a (1.50)

Avawe Bo hsebold 0.079xdO- 2a.Ol0- -- -- -- - -Ibem (6. 4 5) (6.69) __ __ __ _

bona DM" 68.33 68.57 -- 0.7snb 2-- 27.23 0.0(7.07)* (7.14)* -- 2.46).47) 12.1)

Ughbalatioa 53.15 34.51 -_ __ -- _ (5.56) (5.3)' -- __ -. -_ _

Per Capita Totl -2.06 0-2 -- .74X10-6 0.05 0.02 2.844dO 5Alltments (0.56) -- -- (0.72) (5.40)' (1.94)* (2.92)'

Fopulatios -- -- 4.07x10-5 4.57xlO110 0.17xlO-3 0.11n10d-3 1.2x1dO-7__ -- (3.46)' (0.10) (20.02)* (9.24)' (9.40)'

Collaction Effioieaoy -- -- 0.47 0.l1uIO-3 0.16 0.11 0.09xlO-3__ -- (2.54)' (3.72)* (0.62) (7.24)' (4.10)'For Capita -- -- 0.49x102 -5.57xl-7 0.38x10- 2

O.3Sxl02 -2.69xlO-7Assessed Value -- -- (4.65)' (3.27)* (30.52)* (3 0 *8 7 ) (1.85)-

Tax Napped -- -- -- -- -- 0.19 O.llxlO'__ _- -- -- -- (0.55) (0.17)

Value y -- -- -- -- -- -- -6Du9mmy0Interactos -- -- -- -- -- --

0.78 0.79 0.55 0.27 0.72 0.74 0.58* 71 71 57 57 910 910 910

Absolute value of t. *tatiatieg shom in parentbsesa Significant at 0.05 leel

- 22 -

2.41 The Bahl, Holland, Wasylenko analysis was repeated with a much largersample (909 municipalities) and produced many of the same findings. The resultsof a straightforward comparison of tax mapped and non-mapped municipalities arepresented in Table 2.11. Those which are mapped have a higher per capitaassessed value and a higher level of per capita property tax revenues, but theyalso have a substantially higher effective tax rate. In addition, they have aslightly better collection efficiency, which refutes one of the earlierexplanations for why their revenues are not higler. Thus, it shows that otherfactors must be controlled, since mapped municipalities appear to be quitedifferent in their characteristics--in particular, they have a lower per capitaassessed value. A "tax mapped" dummy variable was inserted in the regressionanalysis for property tax revenues, which controls for differences in assessedvalue; again, the result is that there is no significant impact.

Table 2.11: PROPERTY TAX PERFORMANCE AND TAX MAPPING:MUNICIPALITIES

Mean Values

Indicator Mapped Not Mapped

Number of Jurisdictions 339 570

Per Capita Property Tax Revenues P 9.35 P 6.56

Property Tax as Percent ofTotal Expenditure 9.28% 7.95%

Effective Tax Rate 0.62 0.44

Collection Efficiency (in percent) 17.7% 17.0%

Per Capita Assessed Value P 1,647 P 1,553

Source: Local government database

Local Non-Progerty Taxation

2.42 Local governments in the Philippines raise a significant amount ofrevenue from cther local taxes, principally the business license tax; in some,it can account for as much as 32% of revenues (see Table 2.12). Surprisingly,

- 23 -

there is less variation in the degree to which they rely on non-property taxesthan on property tax- -as indicated by the coefficients of variation: For example,in 1986-1988, the co-efficient for variation for real property taxes (in cities)was 43% (see Table 2.8) compared to 39% for other local taxes (see Table 2.12).

Table 2.12a: INDICATORS OF OTHER LOCAL TAX PERFORMANCE - 1986-1988

ProvincialAggregates Cities Municipalities Provinces

Other Local TaxesPer Capita P 11.5 P 32.0 P 5.3 P 1.3

(102%) (80%) (185%) (84%)

Other Local Taxesas a Percent of:

Local Govt. Own Sources 27% 32% 25% 17%(33%) (39%) (49%) (54%)

Local Govt. Expenditures 7% 11% 7% 2%(62%) (71%) (83%) (134%)

Note: Coefficient of variation shown in parenthesis

Source: Local gov,rnment database

2.43 To better understand the underlying reasons for variation, thelinear relationship was estimated between per capita non-property tax revenuesand a set of explanatory variables that define the economic and fiscalenvironment in which the taxes are collected (see Table 2.13). Half or more ofthe variation is explained, whether the sample is composed of provincialaggregates, cities or municipalities. The results might be summarized asfollows:

(a) Per capita non-property taxes are higher in more urbanizedprovinces, in municipalities where per capita assessed value andpopulation are larger, and in cities with a better property taxcollection efficiency.

(b) Determinants of higher levels of property taxes--collectionefficiency and assessed value--also determine higher levels ofnon-property taxes. Local governments that succeed in mobilizing

24 -

larger amounts of resources with the property tax also make agreater effort with respect to non-property taxes.

(c) Non-property taxes are higher in Metro Manila than in the rest ofthe country, even if the level of urbanization and the per capitaamount of allotments received are held constant. This is true bothfor cities and municipalities.

(d) All else equal, a 100-peso higher level of per capita allotment isassociated with 19 pesos less in per capita non-property taxrevenues in cities, and 2 pesos more in municipalities.

This implies that decentralization of taxing powers with respect to localnon-property taxes is likely to stimulate revenue mobilization in the moreeconomically advanced urban areas.

2.44 Locally generated revenues stagnated in real terms during the 1980s(see Table 2.14). Excluding grants, they increased to P 10.9 billion in 1982, butdropped to around P 8.5 billion before recovering to P 9.7 billion in 1990, (in1990 prices). While real property tax revenue remained around P 3.4 billion overthe decade, other local revenues registered a decrease in real terms. Local taxesand fees reached P 217 per capita in 1982 but declined over the next years in aperiod of recession and high inflation. Per capita locally generated revenuesrecovered somewhat in real terms towards 1990, but the improvements were in realproperty taxes where collections per capita surpassed the levels achieved duringthe early 1980s in real terms. Growth in per capita income from other local taxesand fees continued to stagnate. In addition, the share of locally generatedrevenues as a share of total government revenues declined from a peak of 9% in1982 to 5% in 1990.

2.45 There are several impediments to improving resource mobilization atthe local level. First are the legal impediments--the restrictions placed onlocal governments by the Local Tax Code, the Real Property Tax Code and otherlaws. These regulations establish ceilings on real property tax rates, setbusiness tax levels, set many of the fees and charges that local governmentscould collect, and generally limit their flexibility to determine the local taxstructure that will suit local needs. The central government also intervened inthe administration of the real property tax, deferring the reassessment ofproperties (which should have been carried out every three years under the RealProperty Tax Code) because of political resistance in the urban areas.

2.46 Second, administrative bottlenecks impede local resourcemobilization. Malintaining tax records, preparing tax bills and recording taxpayments are generally done manually in almost all local governments. Poormanagement of records is considered a major cause of poor collection efficienciesin real property taxes (para. 2.36). With business taxes, the issue is the lackof capacity within local governments to assess gross annual receipts. The tax

- 25 -

assessment is based on an entrepreneur's declaration of gross sales for theprevious year; however, oany grossly under-declarel1.

Tabl- 2.13: ORDINARY LEAST SQUARESESTIM&TES OF THE DETERMINANTS OF VARIATIONS

IN PER CAPITA LOCAL GOVERNMENT NON-PROPERTY TAX REV)NUES'

Independent Variables Provincial Aggregates Cities Municipal

Constant 8.44x10-3 26.01 -0.69(5.21)* (3.03)* (1.44)

Per Capita Total -0.02 -0.19 0.02Allotments (0.83) (3.57)* (2.52)-

Manila Dummy 65.78 43.61 26.96(12.06)' (3.97)^ (9.52)*

UrbanizatLon 30.53 --

(7.68)*

Per Capita -- 0.12x10-2 0.11x10-2Assessed Value -- (1.61) (11.46)'

Collection Efficiency -- 0.37(2.89)*

Population -- -- 0.10x10-3=- -- (12.08)*

i! 0.82 0.51 0.47

N 72 57 1350

^ Absolute value of t-statistics shown in parenthesesSignificant at 0.05 level

11 One simple test is to divide the declaration by the estimated number ofbusiness days to obtaln an estimate of daily sales and compare it with a roughestimate of what the business could be making. For example, if the owner of abusy local restaurant declares income equivalent to less than five customers perday, it is llkely the flgure understates the annual sales.

- 26 -

While local governments have the legal authority to examine the business'accounts, examinations are not systematically carried out.

2.47 Further, the present system is not convenient for the tax payers.In the case of real property taxes, they are notified of their tax obligationswhen they receive their revised assessments, but they are not sent annualreminders. Tax payers were required to go to the city or municipal hall and lnmany cases, line up to pay.

2.48 A third impediment is the lack of political will to improve localresource mobilization. While there are limitations on property tax rates underthe Real Property Tax Code, many local governments have not yet reached theceiling allowed under law. The local council could increase property tax ratesthrough a local ordinance; similarly, local governments could increase rentalrates for their public markets. However, many have opted to maintain them at thesame nominal levels for more than 10 years.

Table 2.14: TRENDS IN LOCAL GOVERNMENT REVENUES

1980 1982 1984 1986 1988 1990

Local revenues fn constant 1990 prices:Total local revenues (P billfons) 10.0 10.9 8.8 8.5 8.5 9.7Real property taxes (P biltlons) 3.0 3.4 3.4 3.4 3.4 4.3other local revenues (P biltlons) 7.0 7.5 5.4 5.2 5.1 5.4

Per capita revenues fn constant 1990 prices:Total local revonues 208 217 166 154 146 160Real property taxes 61 67 64 61 58 71other local revenues 146 150 103 93 88 89

Locally raised funds as share of:Total local revenues 64X 59X 61X 60X 60X 63XTotal govt. revenues (in X) 7X 9% 8X 7% 6X 5X

Source: Annex table 2

2.49 Limited expenditures and the resulting poor levels of infrastructure,facilities and services have made it difficult for local politicians to raise taxlevels. This produces a vicious circle of poor services, lack of additionalfunds, and further deterioration in services. For example, local governmentshave lacked the resources to properly maintain ard/or rehabilitate existingpublic markets which have become dirty, congested and unsanitary. Thus, vendorshave resisted increases in their rental payments, especially where theenvironment was deteriorating. On the other hand, vendors have said they would

- 27 -

pay substantially higher rent if the facilities were improved. Under the Bank'sMunicipal Development Projects, vendors agreed to a quadrupling of market rents(in public hearings) as long as local governments assured them that improvementsin the market would be completed.

E. National Assistance to Local Governments

2.50 The central government provides assistance to local governmentsthrough revenue sharing and specific project grants. It also funds centralgovernment programs that benefit local governments. Assistance is provided underNational Assistance to Local Government Units (NALGU) which account for about 6%of central government budget expenditures. The main NALGU programs were therevenue sharing grants (the IRA, the Specific Tax Allotment and the LocalGovernment Revenue Stabilization Fund), the Barangay Administration Fund,Budgetary Aid to Local Government Units (BALGU), the Concreting of BarangayRoads/Multipurpose Pavement Program, and the Local Road Construction, Repair andMaintenance Program which together accounted for over 95% of the NALGU funds.The NtJU= program for 1990 to 1992 is listed in Table 2.15 be.ow.

- 28 -

Table 2.15: BUDGETARY ALLOCATIONS FOR NATIONAL ASSISTANCE TOLOCAL GOVERNMENT UNITS: 1990-1992

(In P billions)

1990 1991 1992'

Internal Revenue Allotment, SpecificTax Allotment, Local Government RevenueStabilization Fund 7.3 10.2 12.2

Concrete Barangay Roads/MultipurposePavement Construction Program 1.5 1.5 1.5

Local Road Constructiot., Repair andMaintenance 1.5 1.3 1.5

Budgetary Aid to Local Government Units 1.5 1.5 1.6

Barangay Administration Fund 1.5 1.5 1.7

Others 0.7 0.6 0.4

Total NALGU 14.0 16.4 18.9

Share of NALGU to Total CentralGovernment Budgeted Expenditures" 6.3% 6.3% 6.9%

Government budgetary proposal prior to implementation of revised WU. TheNALGU was consolidated into the IRA following the-implementation of therevisedI.CU.

b Central government expenditures excludes principal amortization.

Source: DBM, Budget of Expenditures and Sources of Finance

2.51 Of these major programs, revenue sharlng through the IRA, theSpecific Tax Allotment and the Local Government Revenue Stabilization Fund weremost imvirtant, accounting for over half of NALGU funds. These grants were alsothe miain a'ource of financial assistance to local governments, acccunting foraround 40% of total local government revenues.

2.52 Of the three revenue sharing grants, the IRA was the largest. In1973, the Government issued PD 144 which consolidated the various revenue sharingschemes in order to establish a more administratively simple, efficient andequitable scheme. PD 144 established the revenue sharing formula as follows:

- 29 -

(a) Overall allocation, PD 144 required the central government to setaside 20% of the collections from national internal revenue taxesnot accruing to special funds and special accounts 12 for the thirdpreceding year (e.g. 1989 revenues would determine the allocation in1992) for sharing with local governments. However, PD 1741, 1980,established 20% as the MazNMiM amount available for revenue sharing,giving the central government more flexibility In setting the IRA.In addition, half a percent (0.5%) of net internal tax revenues wasdeducted and allocated to the Commission on Audit.

(b) Allocation of funds among different levels of local government.Ut,der PD 144, the IRA was to be shared as follows: provinces, 30%,municipalities, 45%; and cities, 25%. PD 559, 1974, provided thebarangays with a 10% share of the IRA. The allocations among theprovinces, municipalities and cities were made in accordance withthe above formula after the 10% barangay share was deducted from thetotal allocation.

(c) Allocation of share of each local government. The allocation amongindividual provinces, municipalities and cities was based on thefollowing formula: population, 70%, land area, 20% and equal share,10%. However, limits were set on the annual increase of theallocation--initially 15% per annum and latter 25% per annum. Localgovernments were also assured their allotments would not fall belowthe level of the previous year.

PD 144 required local governments to appropriate at least 20% of their IRA fordevelopment projects that were subject to the review and approval of theSecretary of Interior and Local Government and subsequently the Secretary ofBudget and Management.

2.53 Another source of revenue sharing for local governments was thesRecific tax allotment (STA) which was obtained from taxes on gasoline and otherpetroleum products. PD 436, 1974, provided the local governments with thefollowing allocations based on collections of the second preceding year: (a) P0.20 per liter of lubricating oil (or 40% of the national tax); (b) P 0.40 perliter for naphtha, gasoline and other distilled oil products (or 14% of thenational tax); (c) P 0.005 per liter for bunker fuel oil (or ?3% of the nationaltax); and (d) P 0.005 per liter for diesel fuel oil (or 5% of the national tax).PD 558, 1974, which amended PD 436, provided the barangays with 25% of the STA.The remaining 75% was divided among the different levels of local government asfollows: provinces, 20%, municipalities, 30% and cities, 50%. The distributionamong local governments was based on the same formula as the IRA: population,70%, land area, 20% and equal share, 10%. STAs were to be used for theconstruction and maintenance of roads, bridges and highways.

12 The Special Funds and Accounts differ depending on the year. Recently,these accounts have been small, less than 1% of total internal tax revenues sothat the difference between gross and not internal revenues has becomeinsignificant.

- 30 -

2.54 The local government revenue stabilization fuld (LGRSF) was createdin 1987 under the General Appropriations Act to adjust for shortfalls in the STAand thereby maintain it at 1986 levels. The allocation for each local governmentwas based on the difference between its actual STA and that of 1986.

2.55 The other major NALGU programs included:

(a) Concrete Barangay Roads/MultiRurnose Pavement Construction andImRrovement Program: This program funded the pavement of barangayroads and construction of multipurpose pavements, a wide section ofconcrete road used for drying crops, informal meetings andrecreation. Funding was provided to the Department of Public Worksand Highways (DPWH) which constructed the facilities through itsdistrict offices.

(b) Local road construction/imRrovement. repair and maintenance: 'undingwas provided to DPWH for the construction and improvement ofmunicipal roads and bridges. Additional funding was provided to thelocal governments, under the technical supervision of DPWH, for therepair and maintenahce of provincial, city, municipal and barangayroads ane bridges, except for the amount for barangay roads whichwas released to the district offices of DPWH. The allocation ofmaintenance funds was based on the length of road in the localgovernment concerned.

(c) Budgetary aid to local government units (BALGU): PD 144 requiredthat an additional 5% of national internal tax collections, net ofspecial funds and accounts, be set aside for a local government fundto be released by the President. Local governments could accessBALGU funds by providing proposals for approval to an interagencycommittee composed of the Secretaries of the Interior and LocalGovernment, Finance, and Budget. The President approved projectsfor funding based on the recommendation of the committee. The fundswere released directly to the local governments and were used forconstructing, among others, municipal buildings, public markets,warehouses, school buildings, and health facilities.

(d) Barangay administration fund: This was used to provide monthlypayments for barangay captains, council members, treasurers andsecretaries. The Department of the Interior and Local Governmentwas responsible for administering it.

Evaluation of the IRA. STA and LGRSF

2.56 The IRA, STA and LGRSF, to be called "the allotments" for simplicity,were the main instrument of central government support for local governmentfinances as well as the most important source of revenue for local governments.To evaluate the effect these grants had on local government finances this reviewexplored the following:

- 31 -

(a) Adequacy of amounts: Do the grants allow local governments tofinance all their expenditure needs?

(b) Certainty of flow: Can local governments know with some certaintythe amounts they will receive so they can plan their finances moreeffectively?

(c) Eualization: Do the allotments narrow the gap between rich andpoor local governments?

(d) Tax effort: Do the allotments encourage or discourage localgovernments from raising more revenues from their own sources?

Fiscal information from the individual local governments was used to carry outthe evaluation.

2.57 Revenue Adeguacy. There is no objective way to determine whether theamount of resources provided through the revenue sharing system was adequatesince there is no easy way to establish local expenditure needs or the amountthat should be financed from local sources. One crude way to measure the revenueadequacy, however, is to examine the growth in allotments relative to the growthin population and prices, two key determinants of expenditure needs. Asdemonstrated in Table 2.1613, overall allotments increased in real terms duringthe early 1980s, declined during the mid-1980s when the Philippines experiencedan economic crisis with rapid inflation and negative economic growth, andrecovered in the end of the decade. However, the amounts did not keep pace withrapid population growth, as per capita allotments in real terms were unable torecover to early 1980 levels: For example, total per capita allotments inconstant 1990 prices were P 117 in 1990 or only 86% of the 1982 figure of P 136.Thus, support for local government services through the allotment system is lessnow than it was a decade ago.

13 This discussion is based on information provided by the centralgovernment on appropriations and releases of allotments (Annex Table 3). Theactual amounts do not necessarily correspond to the data collected from the localgovernments (Annex Table 1). However, both sets of data appear to show similaroverall trends in real per capita allotments.

- 32 -

Table 2.16: REVENUE SHARING GRANTS IN REAL TERMS - 1980-1990(in constant 1990 prices)

1980 1982 1984 1986 1988 1990

Funds Releases: in P billionIRA 2.4 3.1 2.6 3.3 4.0 5.6STA & LGRSF 2.8 3.7 2.5 1.8 1.9 1.5Total 5.2 6.8 5.1 5.1 5.9 7.1

Per Capita Releases- in pesosIRA 49 62 49 59 69 93STA & LGRSF 57 74 46 32 32 24Total 107 136 96 91 102 118

Per Capita Central Govt: in pesosTax Revenues 2,283 2,005 1.697 1,770 1,970 2,500Total Revenues 2,597 2,266 1,925 2,142 2,461 2.981Total Expenditures 2,850 3,120 2,265 2,987 2,967 3,567

Source: Annex Tables 3 and 4

2.58 Why has the system performed so poorly? There appear to be threereasons. First, the STA and LGRSF were fixed in nominal terms so their realvalue eroded with inflation. In 1980, the STA accounted for 548 of the totalallotments; by 1990, the STA and LGRSF combined accounted for only 21%. Second,the primary base for the IRA--internal tax collections--fluctuated with thebusiness cycle and with changes in central government tax efforts. The economyexperienced a severe downturn during the mid-1980s and per capita tax collectionsand expenditures by the central government declined in real terms. However, bothcentral government per capita revenues and expenditures increased in real termsduring the late 1980s, with both revenues and expenditures surpassing levelsreached in the early part of the decade (see Table 2.16). Per capita allotments,while growing during the late 1980's, did not recover in real terms to the levelsachieved earlier in the decade. The third and probably most important reason isin the actual implementation of the system.

- 33 -

Table 2.17: SHARE OF REVENUE SHARING GRANTS(in percent)

1980 1982 1984 1986 1988 1990

IRA as Share of BIR 3rd Year Preceding:Appropriations 7.7% 14.2% 16.7% 18.0% 10.0% 10.4%Releases 6.9% 6.7% 7.7% 10.1% 10.0% 9.8%

IRA, STA and LGRSFActual Release as a Shareof Appropriations 95% 56% 63% 53% 100% 95%

IRA, STA and LGRSFAs a Share of Central Govt:Tax Revenues' 4.7% 6.8% 5.6% 5.2% 5.2% 4.7%Total Expenditures 3.7% 4.4% 4.2% 3.1% 3.4% 3.3%

C Current year (and not the third preceding year).

Source: Annex Tables 3 and 4

2.59 The central government distributed significantly lower levels of IRAthan the maximum allowed under the law (which is 20% of internal revenues of thethird preceding year): Actual IRA was, in fact, around 10% of the internalrevenue collection of the third preceding year--for example, 6.9% of 1977revenues in 1980 and 9.8% of 1987 revenues in 1990 (see Table 2.17). The IRA,STA and LGRSF together accounted for around 15% of the internal revenue of thethird preceding year.

2.60 During the early 1980s, the central government appropriated a highershare of internal revenues for the IRA but actually released less: For example,in 1982, only 56% of appropriations were released. in the latter part of thedecade, the central government appropriated an even lower share of internalrevenues but released a higher portion of them. The share of the allotments intotal central government expenditures declined gradually from a peak of 4.4% in1982 to 3.3% in 1990. Similarly, the relative amounts of tax revenues in thecurrent year released to local governments as IRA, STA and LGRSF have decreasedduring the 1980's.

2.61 This decline does not reflect intentional neglect by the centralgovernment, but rather the increase of debt service (see Table 2.18) and thesubsequent cutback of other government expenditures. During this period,personnel expenditures ranged between 20%-30%, while interest payments increasedfrom 6% of total expenditures in 1980 to 33% in 1990. As a result, other items,

- 34 -

such as operation and maintenance and capital investments, were scaled back:Operations and maintenance expenditures dropped from 28% of total expendituresin 1980 to 14% in 1990 and capital expenditures declined from 34% to 19%.

Table 2 18: DISTRIBUTION OF CENTRAL GOVERNMENT EXPENDITURES(in percent)

1980 1982 1984 1986 1988 1990

Current ExpendituresPersonnel 25% 20% 25% 23% 30% 29%Op. & Maintenance 28% 25% 19% 14% 14% 14%Interest Payments 6% 7% 16% 20% 34% 33%Others 7% 13% 11% 17% 8% 5%

Capital Expenditures 34% 35% 29% 26% 14% 19%

Source: Annex Table 4

2.62 Certainty of revenue flow. In all countries, the flow of revenuesshould be certain, so local governments can effectively plan their budgets. Thiscertainty is even more important in a country like the Philippines, where thefiscal system is centralized and local governments depend on the center for alarge portion of their revenues. However, such certainty was lacking. First, thecentral government did not distribute the full entitlement, hence localgovernments did not receive the amount expected. Also, the share of IRA releasedto internal taxes of the third preceding year fluctuated on an annual basis andconsistently was below the maximum 20% allowed under PD 144. Further, actualreleases of the grants have been lower than the amounts appropriated, especiallyaround 1982-1986, when they were about 60% of appropriations. Worse still, therelease rate varied enough over time to make local governments uncertain as towhat was coming in a given fiscal year.

2.63 Even with full appropriation and distribution, the allotment systemwas somewhat cyclical because the IRA is tied to internal income and sales taxcollections. The GDP elasticity of internal revenue collections in thePhilippines has been unstable, as is shown in Table 2.19. Overall elasticity oftotal allotments is tempered somewhat by the STA-LGRSF grant, which is held ata constant nominal amount; however, the elasticity of appropriation: or releasesrelative to current year GDP fluctuates even more widely than the internalrevenue base.

- 35 -

Table 2.12: GDP ELAS.ICITY OF INTERNAL REVENUES AND ALLOTMENTS

1980 1982 1984 1986 1988 1990

Internal Tax RevenuesNet of Special Funds 0.46 0.38 2.34 4.91 - -

Allotments:Appropriations - 2.73 0.02 10.59 0.89 1.82Releases - 2.73 0.21 -0.08 1.35 1.46

Source: Annex Table 3

2.64 Allotment distributions lag internal revenue collections by threeyears, in part to offset this instability. The lag allows local governments toplan for ndown years," and it may provide a built-in countercyclical measure fortheir finances. The danger to local governments, however, is that duringrecessions, the central government may simply cut back releases. In fact,releases were declining (relative to appropriations) even before the recessionof 1983-1985 and the share of allotment releases in both central government taxrevenues and total expenditures was dropping throughout the decade (see Table2.17).

2.65 Another source of instability is that appropriations are sensitiveto central government changes, such as with the efficiency of tax administration,with the rate and base of national taxes, and with other policies. Large centralgovernment policy changes can compromise the revenue position of localgovernments. For example, with regard to the STA, the government had to establishthe LGRSF program to offset reduced tax revenues from petroleum products.

2.66 Egualization. A basic goal for a grant system, and a justificationfor using grants in many countries, is to offset differences in the fiscalcapacities or unmet expenditure needs of local governments. This is generallyreferred to as the equalization objective of an intergovernmental transfersystem.

2.67 To determine if the present Philippine allotment system succeeds inits equalizing goals, the issue must be discussed at two levels. First, is thesystem inherently equalizing, and second, is the implementation of the systemtrue to its intent. As discussed above, the government makes yearlydiscretionary adjustments, and these can easily be identified by calculating thepercent of appropriations released or the percent of entitlements appropriated.However, it is difficult to identify the implicit rules used in any discretionaryadjustments.

- 36 -

2.68 As to whether the structare is inherently equalizing--whereallotments compensate local governments with the weakest tax base--there isnothing in the present system that suggests this should happen: The allotmentformula is based on a combination of equal shares, population atid land area, withno allowance for differences in income level, the concentration of poverty,urbanization, property wealth, degree of business activity or deficiencies inpublic services. If the system does result in equalizing fiscal capacity, thisis due to a strong negative intercorrelation between income level and eitherpopulation or land area, or to actual releases that do not follow the formula.

2.69 Another question is whether the grant system accounts for differencesin the cost of providing basic levels of service. The implicit argument is thatper capita costs of providing services are the same everywhere. When populationis used as an allocator, it takes account of the higher costs in jurisdictionswith larger populations. By applying the land area factor, this is expected toreflect the higher cost of providing services in areas that are more spread out.Finally, there is even an argument for the equal shares component as a needsindicator: Every local government must bear some overhead or generaladministrative costs, and this minimum setup may not vary with the level of thepopulation or the land area. However, disparities in expenditure needs cannotbe accounted for with these variables. Moreover, the main allocator, population,is fixed by the census for a five-year period14, hence it is implicitly assumedin the formula that relative expenditure needs do not change for long periods.

2 70 With regard to the implementation of the system, the database onfinancial information for individual local governments provides a basis foranalyzing the distribution of allotments among local governments. However, itis still difficult to empirically test the equalization features againstvariations in fiscal capacity or expenditure needs because of the lack ofessential data, such as estimates of personal income by jurisdiction level.Further, it is difficult to measure deficiencies in public services. Still, itis possible to study the distribution of allotments and to approximate the extentto which it co-varies with the best available measures of expenditure needs andfiscal capacity.

2.71 The measure of allotments used for the analysis was the amountdistributed on a per capita basis. Thus, if all jurisdictions received exactlythe same per capita amount, population would have been the sole allocationcriteria. The question was asked whether the per capita distribution was alsoinfluenced by other factors, because they were part of the formula, they werecorrelated with the allocators used in the formula, or they were part of thediscretion used in the actual releases of the allotment.

14 The census is generally carried out every five years. However, the 1985population census was canceled because of the recession; thus, 1980 populationfigures were used to allocate the IRA and STA until new figures were availablefrom the 1990 census.

Table 2.20 THE DISTRIBUTION OF ALLOTMENTS BY REGION

Per CapitaAllotment Per Capita Mean Household Poverty National Grants (Average forReeion GRP 1198710 Income 11 9 85 )b Incidence 11 9 85 1b i1987) 1 98 6-1 988 1b

I 7475 29949 0.696 74.4 69.82II 6956 27372 0.737 40.5 61.15III 10442 37390 0.544 58.9 60.96IV 13660 29982 0.674 60.2 66.95V 5755 20252 0.854 42.5 60.72VI 9967 14710 0.575 69.; 76.55VII 11673 17645 0.883 69.6 76.88VIII 5406 16708 0.852 70.3 79.22

IX 8284 20452 0.848 64.6 75.00X 10686 23496 0.764 82.8 88.82XI 12874 24846 0.735 71.2 84.92XII 10086 23068 0.790 57.4 68.63NCR 29360 57193 NA 57.3 69.76CAR NA 34462 0.535 NA 112.42

Median 10086 24146 0.737 64.6 75.00

a Gross Regional Product.b Computed as (population) weighted averages from provincial data.

Source: Department of Finance, NEDA.

- 38 -

2.72 To identify the determinants of per capita allotments, it was assumedthat differences in fiscal capacity or ability to pay were roughly indicated byinter-province differences in income. A negative relationship with per capitaallotments would indicate an equalizing distribution. The relationship betweenthe distribution of per capita allotments and population size was alsoconsidered. A positive relationship, for example, would indicate a bias in thedistribution in favor of more heavily populated jurisdictions. This would maanthat jurisdictions with a larger population would, cet. par., receive a greaterper capita allotment than smaller jurisdictions. The data was also examined todetermine whether there was a systematic relationship between the distributionof allotments and the level of local government tax effort. Finally, therelationship between the distribution of per capita allotments and an index ofpoverty was investigated, as another test of the equalization hypothesis.

2.73 The equalization features of the distribution of allotments werestudied in three ways. The first was an aggregate approach where the per capitaallotments were compared to income and an index of poverty at the regional level.The result (see Table 2.20) shows a slight equalizing pattern. Only two of theseven regions with average household income above the median level received percapita allotments above the median level. If per capita regional product is takenas the measure of income level, three of the seven regions with above-averageincome levels received allotment amounts above the national average. Three ofthe four regions with the highest incidence of poverty, above 0.8 by the measurepresented in Table 2.20, received per capita allotments above the average. TheNational Capital Region (Metro Manila), which has an average income of more thantwice the national median, received a per capita level of allotments that is 7%lower than the national average. Another way to examine this result is to notethat Metro Manila has 13% of the national population, generates 26% of nationalhousehold income and receives 11.8% of total allotments.

2.74 A second approach was more disaggregated and used a simplecorrelation analysis to describe the distribution of allotments across allprovinces, cities and municipalities. The correlation coefficients on provincialaggregate data showed there is no significant relationship between the averagelevel of household income in a province and the level of per capita allotment itreceives (see Table 2.21). At the provincial level, there was no evidence ofequalization. These coefficients do show that, on average, more heavilypopulated provinces received significantly lower per capita allocations.

2.75 This experiment was repeated for provincial, municipal and citygovernments, as shown in the other rows of Table 2.21. No household income datawas available for cities and municipalities, but per capita assessed propertyvalue was included as a crude measure of wealth. Again, there was no evidenceof equalization. In all cases, per capita allotments were significantly largerwhere the population was smaller.

Table 2.21: SIMPLE CORRELATION BETWEEN PER CAPITA ALLOTMENTS ANDSELECTED CHARACTERISTICS OF PROVINCIAL AND LOCAL GOVERNMENTS

Average Per Capita PropertyHousehold Poverty Index Assessed CollectionTax Income Population Land Area 1988 1985 Property Value Efficiency

Provincial Aggregates -0.147 -0.334 -0.015 0.113 -0.031 -- --Provincial Goverroents -0.623 -0.135 -- -0.021 -0.176NMunicipatities -0.306 0.102 -- -- -0.045 0.044

Cities -- -0.216 0.397 -- -- -0.100 -0.043

- 40 -

2.76 A third approach studied the relationship between the distributionof per capita allotments and the level of income or wealth (and the concentrationof poverty), holding constant other variables that might affect the level ofallotments: i.e. to determine whether the system is equalizing at the maxgin.A cross section linear regression analysis was carried out with per capitaallotments as the dependent variable and population, land area, the poverty indexand average household income as the independent variables. In variousspecifications, two other independent variables were introduced: (a) roaddensity, the ratio of area of paved roads to the total land area in the province(including the city), as a rough indicator of the degree of urbanization in theprovince; and (b) a dummy variable for the National Capital Region (Metro Manila)to test whether, all things held constant, Metro Manila local governmentsreceived signiflcantly more in per capita allotments. The equation was estimatedwith provincial aggregate data (fiscal data that combine city governments,provincial governments and municipal governments) for all provinces, cities andmunicipalities for which data were available.

2.77 The results, presented in Table 2.22, show some evidence of anequalizing pattern. There is a significant negative relationship between incomelevel and the distribution of allotments. These results suggest that, at themargin, the present system does distribute significantly less on a per capitabasis to those provinces with larger populations, and significantly more to thosewith larger land areas and greater road density (urbanization). If these areplanned effects, it might mean the government chose to allocate less per personin allotments to more populated provinces because it believed there are someeconomies of scale in delivering services; also, that less is given to higherincome provinces because they have a greater capacity to finance from own sourcesand that more per capita is given to more urbanized provinces or those with largeland areas because the delivery costs are higher. These (implicit) determinantsof the distribution of allotments seem more or less reasonable, and suggest adegree of fairness. However, most of the variation among provinces cannot beaccounted for, suggesting either that there are other implicit allocators, orthat distribution is affected by some random events.

2.78 The significant, positive coefficient for the National Capital Region(Metro Manila) dummy variable may show that after variations in income, landarea, poverty and population si3e are accounted for, per capita allotments canbe expected to be higher in the Manila area than the rest of the country. Theconclusion is that the Metro Manila area receives a special, and more favorable,treatment under the allotment system than do other local governments in thecountry.

2.79 This analysis was repeated for provincial governments, cities andmunicipalities, with per capita assessed value introduced as a rough indicatorof waalth. Relatively little of the variation in per capita allotments could beexplained for any level of governments. In none of these cases was there asignificant relationship between per capita allotments and per capita assessedvalue (Tables 2.23, 2.24 and 2.25). Population was consistently significant andnegative in all of these equations, and land area was positive and significantin the case of cities and municipalities. If there was a bias in the system, it

- 41 -

would appear to be tovard allocating a larger per capita amount to the smallerlocal governments, and a larger per capita amount to those with larger land areasto serve. This results partly from the 100 that is allocated on an equal sharesbasis.

Table 2.22: LINEAR REGRESSION ON PER CAPITA TOTALALLOTMENTS: PROVINCIAL AGGREGATE DATA

Dependent Variable: Per Cggita Total Allotments (in pBASA

Rguation A Equation Cb

Constant 89.70 152.06 117.92(2.94)* (3.89)* (3.15)'

Average Household -0.443xlO-3 -1.247x4-3 -1.299x10-2Income (0.75) (1.98)' (2.23)*

Population -1.86x10-5 -1. 74x10-5 -1.37xlO-3(2.89)- (2.79)* (2.34)*

Land Area 1.05x10-5 O.9oxlO-' 1.82x10-5

(0.77) (0.68) (1.45)

Poverty Index (1988) -7.32 --

(0.23) --

Poverty Index (1985) -- -62.07 -44.28=- (1.85)* (1.41)

Road Density 10.58(3.53)*

Capital Region 137.52 -- --

Dummy (2.44)- --

X2 0.07 0.12 0.25

N 73 73 73

* Absoluce values of t-statistics shown in parenthesesb Excludes National Capital Region because 1985 poverty incidence notavailableSignificant at 0.05 level

- 42 -

Table 2.23: LINEAR REGRESSION ON PER CAPITA TOTALALLOTMENTS AND COLLECTION EFFICIENCY: PROVINCIAL GOVERNMENTS

Dependent Variable

Property Tax Per CapitaAllotments Collection Efficiency Total Allotment

Constant 35.35 34.21(3.99)* (8.70)*

Per Capita -0.006 --Total Allotments (0.03)

Collection Efficiency -- -0.002(0.03)

Population 0.995x10-5 -1.34x10-5(2.13)- (5.81)*

Land Area -1.46 0. 30x10-5(1.78)* (0.60)

Per Capita Assessed 0.12x10-2 -3.26x10-5Value (0.56) (0.03)

K2 n0.07 0.35

N 68 68

* Absolute value of t-statistics shown in parentheses.* Significant at 0.05 level.

- 43 -

Table 2.24: LINEAR REGRESSION ON PER CAPITA TOTALALLOTMENTS AND COLLECTION EFFICIENCY: CITIES"

DeRendent VariableProperty Tax Per Capita

Collection Efficiency Total AllotmentAllotments

Constant 42.14 89.54(5.71)* (5.69)*

Per Capita O.C22 --Total Allotments (0.34)

Collection Efficiency -- 0.10(0.34)

Population 0.68x10- -6.47x10-5(0.58) (2.78)*

Land Area -6.26x10-5 0.51x10-3(0.91) (3.95)*

Per Capita Assessed 0.93xl0-3 0.15x10-2Value (1.15) (0.89)

j2 0.002 0.21

N 57 57

* Absolute values in t-statistics shown in parentheses.* Significant at 0.05 level

- 44 -

Table 2.25: LINEAR REGRESSION ON PER CAPITA TOTALALLOTMENTS AND COLLECTION EFFICIENCY: MUNICIPALITIES"

Dependent Variable

Property Tax Per CapitaCollection Efficiency Total Allotment Allotments

Constant 11.28 39.94(10.85)* (19.72)*

Per Capita 0.07 -

Total Allotments (4.41)-

Collection Efficiency -- 0.32(4.41)*

Population 0. 120x10-3 -0.29x10-3(8.55)' (9.57)'

Land Area -9.32x0-5 0.23x10-3(4.30)* (4.90)*

Per Capita Assessed 0.67xlO-3 0.52xIO-3Value (3.09)' (1.08)*

f2 0.10 0.11

N 901 901

' Absolute value of t-statistics shown in parenthesesSignificant at 0.05 level

- 45 -

2.80 lax effort. All countries worry that providing grants willdiscourage local governments from exerting greater effort to raise revenues,and that lower local tax effort will result in lower levels of publicservices--particularly operation and maintenance of the capital stock. Thus,there will be more pressure for central government subsidies. Moreover, theyfear that if local services are financed by grants from the centralgovernment, local officials will not be held accountable for the quality ofpublic services in the way they would if these were financed by local taxes.In effect, the pleasure of public expenditure benefits becomes disconnectedfrom the pain of taxation. Another potential byproduct of overdependence oncentral revenues is that local tax administration efforts will become lax, andthe overall mobilization of resources in the nation will suffer.

2.81 One might suspect that the Philippine allotment system substitutesfor local taxes because the formula contains neither penalties for low taxef%irt nor rewards for high tax effort; instead, the amount of allotmentreceived by a local government is completely independent of the level of localrevenues raised, and even of the fiscal capacity of the local government.

2.82 There is an alternate view: Local governments that receive largerallotments will have better public service levels. Because they will need tospend more to operate and maintain the better-quality facilities, they willneed to raise greater levels of revenue from their constituents. In this case,allotments will have a stimulating effect, i.e., each additional peso ofallotment will call forth an additional amount of locally raised revenues.

2.83 A linear regression analysis was used to estimate the relationshipbetween the per capita level of locally raised revenues and the per capitalevel of allotments. A significant negative relationship would indicate asubstitution effect (higher levels of allotment would be associated with lowerlevels of per capita revenues raised from local sources), and a positiverelationship would indicate stimulation or a complementary effect (the higherthe allotment, the higher the level of locally raised revenues). The averagelevel of household income and the level of population were controlled inmaking an estimate of this relationship. The analysis was carried out forprovincial aggregates of local government revenues, and separately forprovincial governments, municipal governments and city governments.

2.84 The results for provincial aggregates suggest the presentallotment system has no significant marginal effect on local revenuemobilization (see Table 2.26). These results are robust across differentspecifications or when the definition of the dependent variable is changed(e.g., property tax, all local taxes, etc.), and a significant share of thecross-section variation can be explained. Thus, the present allotment systemseems to neither discourage nor encourage local government tax efforts.

2.85 A positive relationship exists between average household incomeand the level of locally raised revenue, but it is weak. For each additional100 pesos of average household income, pe: capita property taxes are 0.1 pesoshighet and per capita total locally raised revenues are 0.3 pesos higher.

- 46 -

2.86 These equations are also applied to provincial governments,municipal governments, and city governments (see Tables 2.27, 2.28 and 2.29,respectively): Per capita assessed property value replaces average householdincome as the proxy measure for fiscal capacity, for reasons explained above.With the substitution/ stimulation issue, for provincial governments andcities, there is no significant relationship between allotments and per capitatotal revenues or total taxes- -that is, neither stimulation nor substitution(see Tables 2.27 and 2.28). For cities, the relationship between allotmentsand revenues raised is negative in all categories, indicating substitution,but is significant only in the case of non-property taxes. The result isinteresting in suggesting that a 100 peso higher per capita allotment isassociated with an approximately 15 peso lower level of per capitanon-property tax revenue. For municipal governments, however, allotmentsappear to be stimulative (see Table 2.29). A 100 peso higher per capitaallotment, all else held constant, is associated with a 3.2 peso higher levelof per capita municipal revenues raised from own sources. The significantstimulative effect for municipalities holds for all classes of local revenues.When the dependent variable is changed to reflect property tax colle.tioneffort (the ratio of property tax collections to property tax collectibles),the same conclusion emerges: Allotments stimulate municipalities but have noeffect for cities and provincial governments (see Tables 2.23, 2.24, and2.25). However, only a small portion of the variation can be explained.

2.87 There are some other interesting findings in the analysis of thedeterminants of local revenue mobilization. Local governments with a greaterpopulation raise more revenue from local sources than do smaller ones. Also,the greater the level of per capita assessed value, the greater the level ofper capita local resource mobilization, both property and non-property tax.For municipalities, all else held equal, it was found that Metro Manilamunicipalities raised significantly more from their own sources than did otherlocal governments.

Table 2.26: LINEAR REGRESSIONS ON PER CAPITA LOCAL REVENUES:PROVINCIAL AGGREGATESaUb

Per Capita Total Per Capita Total Per Capita Per CapitaIndependent Locally Raised Local Tax Property Tax Non-Property TaxVariable Revenues Revenues Revenues Revenues

Constant -50.00 -29.03 -18.81 -10.88(2.63)* (2.56)* (2.74)* (2.21)*

Per Capita 0.108 0.032 0.019 0.027Total Allotments (0.65) (0.33) (0.32) (0.64)

Average Household 0.003 0.002 0.001 0.0008Income (6.71) (7.05) (7.17) (6.07)*

-2~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~--R2 0.39 0.41 0.42 0.34

Nb 69 70 71 70

a Absolute value of t-statistics shown in parentheses.b NCR always included. The results are substantially the same if the NCR is excluded from the sample.* Significant at 0.05 level.

Table 2.27: LINEAR REGRESSION ON PER CAPITA LOCAL REVENUES:PROVINCIAL GOVERNNENTSo.b

Per Capita Total Per Capita Total Per Capita Per CapitaIndependent Locally Raised Local Tax Property Tax Non-Property TaxVariable Revenues Revenues Revenues Revenues

Constant 1.039 -0.15 -0.42 0.27(0.50) (0.13) (0.47) (0.60)

Population 1.04x10'6 0.79x10'6 0.77x10'6 0.02x10'6(0.971) (1.26) (1.66) (0.07)

Per Capita Assessed 0.434xl0O 20.425x10 2

0.353xl0O 20.072x10'2

Property Value (8.70) (14.57) (16.28)' (6.60)*

Per Capita 0.010 -0.015 -0.014 -0.001 XTotal Allotments (0.20) (0.51) (0.63) (0.11)

R2 0.528 0.762 0.802 0.405

Na 67 68 68 68

* Absolute values of t-statistics in parentheses.

b NCR excluded since there is no provincial government.

Significant at 0.05 level.

Table 2.28: LINEAR REGRESSION ON PER CAPITA LOCAL REVENUES: CITIESS

Per Capita Total Per Capita Total Per Capita Per CapitaIndependent Locally Raised Local Tax Property Tax Non-Property TaxVariable Revenues Revenues Revenues Revenues

Constant 80.23 34.06 6.78 27.28(0.67) (0.84) (0.23) (1.46)

Population 0.102x10'30. 091x10 3

4.67x10'5 4.40x10'5(1.30) (3.41)^ (2.41)- (3.60)^

Per Capita Assessed 0.093x10 10.686x10 2

0.544x10 20.142x10 2

Property Value (2.06)' (4.43)' (4.82) (1.99),

Per Capita -0.371 -0.119 0.032 -0.151Total Allotments (1.12) (1.05) (0.38) (2.89)

NCR Dummy -12.93 18.86 8.39 10.47(0.15) (0.64) (0.39) (0.77)

Tax Mayped 9.32 1.08 -3.44 4.52Dummyb (0.09) (0.03) (0.23) (0.27)

R2 0.131 0.569 0.485 0.523

N 58 58 58 58

Absolute values of t-statistics in parentheses.

b Only one city, Trece Martinez, in Region 4 was not mapped.

Significant at 0.05 level.

Table 2.29: LINEAR REGRESSION ON PER CAPITA LOCAL REVENUES: MUNICIPALITIESa

Per Capita Total Per Capita Total Per Capita Per Capi.taIndependent Locally Raised Local Tax Property Tax Non-Property TaxVariable Revenues Revenues Revenues Revenues

Constant 3.64 -1.18 -1.69 0.49(3.16)* (1.37) (3.27)* (0.98)

Population 0.254x10'30. 18x10'3 0.08x10'3 0.09x10'3

(13.81)* (12.72)* (9.81)* (11.79)*

Per Capita Assessed 0.42x10- 20.38x10'2 0.33x10'2 0.45x1O'3Property Value (16.63)* (19.74)* (29.02)* (4.02)*

Per Capita 0.032 0.03 0.01 0.01 oTotal Allotments (2.08)' (2.35)' (2.04)' (1.96)

NCR Dummy 38.12 46.30 28.45 17.81(5.97)* (9.54)* (9.77)* (6.32)*

Tax Mapped Dummy -5.70 -5.42 -2.52 -2.88(5.17)* (6.51)' (5.05)* (5.96)*

Interaction Dummy; Tax Mapped and Assessed Value 0.49x10 20.45x10 2

0.21x10' 30.23xl0O 2

(10.67)* (12.76)* (10.13)* (11.48)*

R2 0.66 0.72 0.74 0.52

N 1311 1344 1344 1350

Absolute values of t-statistics shown in parentheses.

Significant at 0.05 level.

- 51 -

III. THE DECENTRALIZATION PROGRAM: 1987-91

A. The Rationale For Decentralization

3.1 The Aquino Government that took office following the People'sRevolution of 1986 showed a strong interest in decentralization and instrengthening local government autonomy. At the central government level, therewas a perception that centralization under the previous Marcos Government leadto concentration of power and wealth in the capital, Metro Manila. This in turnwas thought to have resulted in alienation of the regions and insurgencymovements against the central government by indigenous peoples, Muslims, and thecommunist New People's Army. It was felt that by giving locally electedofficials more say over local matters, they would be better able to provide theirresidents with better services and facilities and reduce the people's apathytowards the government.

3.2 The 1987 Constitution required enactment of new Local Government Codeto provide for "a more responsive and accountable local government structureinstituted through a system of decentralization". This led to a review of allexisting legislation concerning local government affairs.

3.3 At the local government level, the provincial governors and the cityand municipal mayors were frustrated by their lack of resources and centralgovernment control over local affairs which limited their ability to service theneeds of their residents. Common complaints voiced by the local executives were:(i) they were giving more in taxes to the central gnvernment than they weregetting back in grants and central government expenditures; (ii) they were notgiven enough responsibility for provision of services although many of theirconstituents held them accountable since local governments were much closer tothe people than the central government; and (iii) excessive central governmentcontrols on budgets, staff, etc.

3.4 The analysis of local governments in the Philippine in Chapter IIshowed that there is validity in the local executives' complaints. The localgovernments as a whole have declined in relative importance compared to thecentral government during the 1980's. The local governments have not been giventhe 20% of the internal revenue of the third preceding year as originallyrequired under PD 144. The Local Tax Code limited the local government's abilityto raise revenues. Various restrictions were placed on the expenditures at thelocal level.

3.5 However, an analysis of the central government revenues, centralgovernment expenditures, and local government expenditurze indicates that, on aper capita basis, all the regions other than Metro Manila received more in termsof central government expenditures than they generate in tax revenues. Table 3.1compares per capita local government expenditures, per capita central governmentexpenditures, and per capita central government revenues by region for 1985. Theregions are listed in reverse order of development; i.e. the region with thelowest per capita Gross Regional Product (GRP) in 1985, Eastern Visayas, is shownat the top and the region with the highest, Metro Manila, is shown at the bottom.It can be observed that in all cases per capita central government expendituresare higher than local government expenditures, that per capita central government

- 52 -

Table 3.1: COMPARISON OF PER CAPITA NATIONAL AND LOCALREVENUES AND EXPENDITURES BY REGION, 1985

(IN PESOS)

Local National National RatioRegion Expend- Expend- Tax National

itures itures Revenues To Local

VIII Eastern Visayas 98.6 1,107.1 57.9 11.2II Cagayan Valley 105.8 1,183.5 93.9 11.2V Bicol 89.2 766.2 50.2 8.6I Ilocos 110.8 1,127.9 113.3 10.2IX Western Mindanao 86.3 821.5 113.2 9.3

XII Central Mindanao 105.9 834.1 175.1 7.9VI Western Visayas 124.3 926.2 123.9 7.5X Northern Mindanso 135.6 904.3 203.0 6.7

VII Central Visayas 120.4 644.1 403.1 5.4XI Southern Mindanao 115.4 729.9 260.7 4.7III Central Luzon 162.4 730.4 661.7 4.5IV Southern Tagalog 134.6 789.8 802.9 5.9CAR Cordillera 158.2 1,556.1 298.6 9.8NCR Metro Manila 346.9 1,221.1 6,589.9 3.5

Source: Complied from CAS Memorandum 'Implementing Decentralizationand Local Autonomy*, Aprll 18, 1989

expenditures tend to be bigher in those regions with lower per capita GRP, andthat, except for Metro Manila, per capita expenditures are higher than per capitacentral government revenues. It must be noted that many corporations pay theirtaxes through their headquarters in Manila although not all their activities arein Metro Manila. Also there are probably individual jurisdictions outside ofMetro Manila which generate more in national taxes than they receive in grantsand central government expendltures. However, at the regional level, centralgovernment expenditures in 1985 appear to be equalizing in that they redistributegovernment expenditures frce the richer jurisdictions that generate the taxes tothe poorer juriadictiogs that do not.

B. Regional Autonomy

3.6 The autonomy given to Xuwlim Mindanao and the Cordilleras under theAquino Governmont through the Organic Acts for the Creatlon of the AutonomousRegion of Muslim Mindanao (RA 6734) and Cordillera (RA 6766) in 1989, establisheda precedent for local governments in the Philippines. Increased autonomy ingovernance for the Musli Mindanao and the Cordillera regions is an importantinitiative of the Aquino Administration. Clearly, the primary motivation forthese initiatives was political. Mindanao and Cordillera differ from the rest

- 53 -

of the country in terms of religion and cultural heritage, and this has fueledthe demand for more self-governance. Insurrection and even calls for secessionhave made matters all the more urgent. The response in the Philippines, likethat in most countries, has been to try and head off major unrest by providingfor more self-governance in these regions. Therein lie the major benefits ofthis program.

3.7 The Organic Act for Muslim Mindanao provided for a financialstructure for the new region. The Act devolved significant fiscal powers andresponsibilities to the autonomous region. The regional council was given thepower to approve the budget. There st'll must be audits by the CoLmission OnAudit, and the procedures of the Department of Budget and Management (DBM) mustbe followed, but no central approval of expenditure level or composition wasrequired. This was a major commitment to local autonomy. Local governments wereable to keep their existing charters and their powers were not to diminish, butwithin that constraint, the regional government could write its own local taxcode.

3.8 Most expenditure functions were devolved to the local governments.Only national defense-type functions were kept for the central government.Interestingly, tax administration did not appear on the central government listfor devolution. Moreover, it is stated in Section 3 of Article 10 of the Actthat: "All corporations, partnerships, and other business entities directlyengaged In business in the Autonomous Region shall pay through the RegionalGovernment that portion of their annual income tax corresponding to the netincome generated from business done in the area of autonomy."

3.9 The revenue base for the autonomous region was defined differentlyfrom that for local governments in the rest of the country, and the regionalgovernment was given broad taxing powers. The following is a summary of the mainfeatures concerning the revenue base:

(a) Income taxes and customs duties may not be levied by theregional government.

(b) The region may impose other taxes, levy fees andcharges, and share in the revenues generated by publicutilities within the region.

(c) The region may retain 60% of internal revenuecollections. This is to be divided evenly between theregional government and the provincial governments. Theprovincial share is to be distributed evenly among theprovince, municipalities, and barangays.

(d) The region will continue to share in the InternalRevenue Allotment.

The regional government does have borrowing powers, but these are strictlycircumscribed in the case of foreign borrowing.

- 54

3.10 The Organic Acts were put to a plebiscite and residents of thevarious local governments which were to have made up the Autonomous Regions wereasked whether they would agree to be part of the Autonomous Region. The Mindanaoplebiscite resulted in four Muslim-dominated provinces opting to join theautonomous zegion: Lanao del Sur, Maguindanao, Sulu and Tawi-Tawi. The othernine eligible provinces, and the nine charter cities, opted out. The vote inCordillera resulted in only one (Ifugao) of the five eligible provinces electingto join. This outcome has left two very different but difficult situations. InMindanao, the challenge is to form a regional government from four provinces thatare not physically contiguous and have no cities that are obvious choices for acapital. In Cordillera, the problem is how to make sense of a regionalgovernment which contains only one province. In t1th cases, there is a problemof the provinces being quite poor and/or undeveloped.

3.11 While the Autonomous Regions lost some of their momentum after theplebiscite which limited their area, the fiscal arrangements under the Acts didset a precedent for the local governments. Local executives demanded similararrangements for rhe remaining local governments.

C. The 1990 General AgRroRriations Act

3.12 The Government attempted to incorporate some of the reforms emergingfrom the discussion of the revised Local Government Code in the 1990 GeneralAppropriations Act (GAA). First, revenue sharing with the local governments wasto be consolidated in the Internal Revenue Allotment (IRA) and the Specific TaxAllotment (STA) and the Local Government Revenue Stabilization Fund (LGRSF)abolished. The actual allocation was to be increased to P 13.0 billion. Inaddition, the Government proposed including an incentive allotment whereby thoseprovinces, cities and municipalities with a real property tax collectionefficiency of over 60% would receive additional IRA funds. Second, thecontribution of the provinces, cities and municipalities to the IntegratedNational Police (INP) and hospital was to be discontinued and terminated. Third,the proceeds of all real property taxes, including the 1% for the SpecialEducation Fund, were to accrue fully to the local governments concerned. Fourth,a budget allocation of P 310 million was made to provide debt relief for localgovernments. Fifth, the Barangay Administration Fund, the Budgetary Assistanceto Local Government Units (BALGU) program, and the Local Roads Construction,Repair and Maintenance Program were to be discontinued.

3.13 The legislature did not approve the Government's 1990 budget proposalin this form; i.e. it did not agree to preempt some of the provision of the LocalGovernment Code that was being drafted at the time. The STA and LGRSF weremaintained and the overall revenue sharing with local governments reduced to P7.5 billion. Similarly, the Barangay Administration Fund, the BALGU program, andthe Local Roads Construction, Repair and Maintenance Program were maintained.

3.14 Some of the proposed changes were incorporate into the approved 1990GAM (RA 6831). First, an allocation of P 310 million was approved to settle thedebt obligations of local governments incurred prior to February 2, 1988, toGovernment Financial Institutions and Government Owned and ControlledCorporation. However, debt relief was limited to only 4th, 5th and 6th cla :

- 55 X

local governments. Second, the local governments' contributions to the INP andthe hospitals were discontinued.

Elimination of the INP and Hospital Contributions

3.15 The removal of this mandated transfer is clearly a step in thedirection of decentralization. Previously, local governments were required tocontribute to the central government 18% of local revenues raised for the INP and7% for hospitals. The elimination of the required contribution of local revenuesto support the police and hospital functions strengthened both the expenditurediscretion and the revenue position of Philippine local governments. There aretwo dimensions of this reform that should be examined to assess the effects onthe fiscal position of Philippine local governments: the amount of moneyinvolved, and the distribution of the benefits across local government units.

3.16 The INP allotment is significant in amount, relative to localgovernment revenues. The total is not so easily calculated as a multiplicationof 18% of total general fund income because some local governments have not paidtheir due amounts, and others have underpaid. From the data set developed forthe 1986-1988 period, the INP contributions were estimated to be equivalent to15% of locally raised revenues in cities and 11.6% in municipalities (see Table3.2). Another way to view the importance is to note that for every 100 pesos inallotments received, the equivalent of about 14 pesos for cities and 15 pesos formunicipalities is transferred to the INP. In effect, the elimination of the INPcontribution amounits to giving local governments a larger net allotment.

Table 3.2: MANDATED TRANSFERS: ESTIMATED AMOUNTS FOR 1986-1988

INP Hospitals

City Municipal City Municipal

Average per Capita 15 5 7 1.3Amount (in pesos)

Percent of Total 13.8% 15.1% 6.1% 2.5%Allotments

Percent of Total 15.0% 11.6% 6.6% 1.9%Locally RaisedRevenues

Source: Local Government Database

- 56 -

3.17 How does the INP removal affect different types of cities, i.e., whostands to gain most? To answer this question, the actual per capita INPcontributions was regressed against a set of economic and fiscal environmentalvariables: real property tax collection efficiency, population, land area and percapita assessed property value. The results are presented in Tables 3.3 forcities snd in Table 3.4 for municipalities. Much of the variation among cities,and among munr.cipalities, cannot be explained. This is because many localgovernments simply have not made the required contribution and we have notincluded an explanatory variable that identifies these local governments.

3.18 The results of this regression analysis show that the mainbeneficiaries of the abolition of the INP transfer are: (a) cities andmunicipalities that exert a high property tax effort, as evidenced by theircollection efficiency ratio; and (b) cities an(l municipalities with a high percapita assessed value. Roughly the same results hold true for municipalities.The implication of these findings is that removal of the INP is not an equalizingmeasure; in fact, its main beneficiaries are those local governments who alreadydo the best job of revenue mobilization, and those with a greater wealth base.

Table 3.3: REGRESSION ESTIMATES OF THE DETERMINANTSOF VARIATIONS IN MANDATED TRANSFERS: CITIES'

Per Capita Per CapitaIndependent INP HospitalVariables Transfers Transfers

Constant 4.22 1.93(2.09)* (1-34)

Collection 0.08 0.04Efficiency (2.19)* (1.39)

Population 2.58x10-6 -1.15x10-6(0.88) (0.37)

Land Area 1.44x10-5 1.47x10-3(0.88) (1.35)

Per Capita 0.67x10-$ O.28x10-3Asseased Value (3.06)' (2.13)*

12 (0.28) 0.10

N 55 43

* Absolute values of t-statistics shown in >,.renthesesSignificant at 0.05 level.

- 57 -

Tablg 3.4: REGRESSION ESTIMATES OF THE DETERMINANTS OFVARIATIONS IN NANDATED TRANSFERS: MUNICIPALITIES-

Per Capita Per CapitaIndependent INP HospitalVariables Transf f *d Transfers

Constant 2.93 0.63(13.82)- (5.78)*

Collection 0.04 0.010.04Efficiency (5.16)^ (3.18)*

Population 2.64x10-6 3.02xl0-6(0.83) (1.76)'

Land Area 4.36xl0-6 3.37x10-6(0.88, (1.94)'

Per Capita 0.41x10-3 7.25xl0-6Assessed Value (8.26)' (4.70)*

'K2 0.130 0.07

N 881 467

' Absolute value of t-statistics shown in parenthesis.Significant at 0.05 level.

3.19 As may be seen from Table 3.2, the actual contributions to thehospital account are equivalent to 6.6% of own source revenues of citygovernments and 1.98 for municipalities. Sinc elimination of this earmarkingdoes free up local resources for other uses, it also may be viewed as anadditional allotment. What kinds of local governments benefit most from theseadjustments7 The results presented in Tables 3.3 and 3.4 show that even less ofthe variation in the level of per capita hospital transfers (versus INP) can beexplained. The only clear result for cities is that the per capita level ofhospital transfers is signifieantly higher where per capita assessed value ishigher, i.e., in jurisdictions where more local revenues is raised. Formunicipalities, the hospital transfer benefits larger jurisdictions with moreproperty wealth, and those that make stronger property tax effort.

- 58 -

D. Other Measures

3.20 In 1990, the Government issued RA 6975 reorganizing the Departmentof Local Government into the Department of the Interior and Local Government(DILG) and relocating the national police from under the Department of Defenseto the DILG. The INP was renamed the Philippine National Police (PNP). Throughthis reorganization, the local executives gained control of police operationswithin their jurisdictions, resolving one of the conflicts with the centralgovernment. The Provincial Governors were given the authority to select theProvincial PNP Director from a list of three candidates prepared by the RegionalPNP Director. The City and Municipal Mayors were given operational control overpolice units within their jurisdictions and the authority to choose the chief ofpolice from a list of five candidates recommended by the Provincial PNP Director.Members of the PNP are considered central government employees, promotions aredetermined by the PNP, and PNP salaries are funded by the central government.Local governments in Metro Manila, chartered cities and first classmunicipalities can opt to pay an additional monthly allowance to PNP membersassigned to their jurisdiction.

3.21 The main thrust of the Government's decentralization program was therevision of the Local Government Code as mandated under the 1987 Constitution.The Local Government Code is discussed in more detail in the following Chapter.

- 59 -

IV. THE REVISED LOCAI. GOVERNMENT CODE

4.1 The centerpiece of the Government's decentralization program is therevision of the Local Government Code (LGC). All existing legislation on localgovernment affairs was reviewed and incorporated into the revised LGC. Afterdeliberation in the legislature, where the House and Senate passed differentversions, the revised LGC was signed into law in October 1991 (after a bi-cameralcommittee resolved the differences between the two versions). The Code isdivided into three Books: I-General Provisions; II-Local Taxation and FiscalMatters; and III-Local Government Units. Implementing Rules and Regulations(IRR) were prepared by the line Departments and issued ia February 1992. Thesalient features of the revised Code are described below.

A. Definition and Functions of Local Governments

4.2 The roles of the provinces, cities, municipalities and barangays havenot changed significantly. The province will continue to serve as "a dynamicmechanism for development processes and effective governance of local governmentswithin its jurisdiction". The city and municipality will continue to functionprimarily as "a general purpose government for the coordination and delivery ofbasic, regular and direct services and effective governance of its inhabitants".The barangay will serve as "the primary planning and implementing unit ofgovernment policies, plans, programs, projects, and activities in the community,and as a forum wherein the collective views of the people may be expressed,crystallized and considered and where disputes are amicably settled".

4.3 The revised LGC modified the population and income requirements forprovinces, highly urbanized cities, cities, municipalities, and barangays andadded a minimum area requirement for cities and municipalities. The minimumpopulation was increased for barangays from 500 to 2,000, municipalities from10,000 to 25,000, cities from 100,000 to 150,000, and highly urbanized citiesfrom 150,000 to 200,000. On the other hand, the minimum population requirementsfor provinces were reduced from 500,000 to 250,000, and area requirements from3,500 sq. km. to 2,000 sq. km. The minimum revenue requirements for all levelsof local government were increased in line with the overall growth in localrevenues. Those local governments that existed as of January 1, 1992, wouldcontinue as such. Table 4.1 presents requirements by type of local governmentunder the revised LGC, compared to the previous LGC.

4.4 The central government will continue to exercise supervisory powersover the local governments. The President will exercise authority directly overprovinces, highly urbanized cities, and independent component cities.

- 60 -

Table 4.1: MINIMUM REQUIREMENTS BY TYPE OF LOCAL GOVNMENT

Income(P million; Population Area1991 Prices) ('000) (sq.km.)

Barangay - 2Metro Manila, Urbanized City - 5

(w) ~(0.5)

Municipality 2.5 25 50(0.25) (10) (-)

City 20.0 150 100(10.0) (100) (-)

Highly Urbanized City 50.0 200(30.0) (150) (-)

Province 20.0 250 2,000(10.0) (500) (3,500)

Numbers in ( ) are the requirements under the old LGC; incomerequirements are over 3 consecutive years under the old LGC comparedto 2 years under the revised LGC.

Source: Revised LGC (Book III)

Basic services

4.5 The revised LGC specifies the minimum basic services to be providedby each level of local government. Under the old LWC, the provinces, cities andmunicipalities were given responsibility for construction and maintenance ofroads, bridges, drains and other infrastructure, construction and operation ofpublic markets, slaughterhouses, and other facilities, and provision of garbagecollection, street lighting and other services. With the revised LGC, the localgovernments will be given additional responsibility in agricultural extension,natural resources management, social welfare programs, health programs,education, and tourism. The Code specifies in some detail the types of servicesto be provided by the barangays, municipalities, cities and provinces. Thesesernices are listed In detail under Section 17 (b) of revised LGC and aresummarized in Table 4.2.

Table 4.2: BASIC SERVICES TO BE PROVIDED BS LEVEL Of LOCAL GOVERWJENT

BARANGAY NIHICIPALITI PROVINCE CITYAGRICLTURE Agrfeultural support ervifes Extenslon and on *Ite research Extensfon and on site research All servfces and facilitfes of theAND FISHERIES Aihch inmlude planting mterials related to agriculture & fishery fncluding preventfon & control of muncipelity nd provincedistritiotfn system £ operation of fneluding dfpersal of livestock & plant & animl pests & diseases;farm produce buying stations. poultry, fingerlings & seeding dairy farms livestock markets,m_terial for aqamcutture; seed anial breeding stations, &farms & nurreres; de"mnstration artificial ineamination e nters,farms; Inter-berangay frrigatlon assistance in orgnizing farmer'ssystems mutes and sofi resoarce & fisherman's cooperatives.utilizatfon & conervation

projects; enforement of fidserylaw.

IUDU5IAI - Indutrifal rse rch A development All se vices and fa ilities of the

DEVELOPUENT services, as weil a tranfer otf *mfcipplty and provincepproprEt tecmolo

FOKESTY AMD Puramunt to national polfcie nd Pursumnt to national policfes nd All services and facilities of theNATURAEAL sisrvison of OENR f plentation the supervision of the DEIRM, nmicipalfty Nd provinceUESOURCES of coaity based forestry nforcemnt of foretry lawsproJects uhich include integrated limited to conwinty based

Gsocial forestry progra_ & control for etry projects pollutfanof com sta forests with an area control law, sma sale miningnot exceeding 50 sq. km.; low Z other laow protecting theestablisfhmnt of tree parks. wrirooment; mini-hydro electricgrcew ltts and other sifilier projects for tocal purposes.foret dmvelopmnt projects.

NEALTH Nointenwac of barwngw health I+eoment ation of program A Hospital u tertiary health All servic nd faciifties of theSERVICES renter. projecte en prfimry health care, services. suicipolity *nd provincematerntl A child care, &

counicable & non-arcounicabltdiseas control services; acessto sfondary & tertiary healthservices; purdwase of m*dicfln,medical suppties pquipment.

SOCIAL IELFARE aintenance of berangay day care Progrm A projects on child A Program & projects on rebel All services nd facilities of theSERVICES center. youth wtfore, family A coemmity returnees & evacenes; relief municipelity and prowincewelfore, woments welfare, welfare operations; populetion deveolao ntof elderly & disabled persons; services.comatity based rehabilitation

progrm for vagrants, beggars,str et children, scavcWrs,juvenile dolinquents, & vletim ofdru abuse; livilihood & pro-poorprojects; mutrftlon services;family pltoming service".

Table 4.2: BASIC SERVICES TO BE PROVIDED BY LEVEL OF LOCAL GOVERNMENT

BARANGAY WNUICIPALITY PROVINCE CITY

INFORMATION Information & reading center. Investment & job placement UPgrading & modernization of tax ALl services and facilities of theSERVICES information systems, tax & information & coltection services *unicipality and provincemarketing information syster. , through the use of computermaintenance of a public library. hardware & software & other mans.

GENERAL Services & facilities related to Solid waste disposal or All services ard facilities of theHYGIENE AND general hygiene and sanitation, environmental menagement system & muicipality and provinceSANITATION beautification & solid waste services or facilities related tocollection. general hygiene and sanitation.

PUBLIC Nulti-purpose hall, plaza, sports Municipal buildings, cultural Provincial buildings, provincial All servfces and facilities of theFACILITIES center. centers, public parks including jails, freedom parks ard other amicipality and provincefreedom parks, playgrounds, & public assembly areas.sports facilities & equipment;sites for police & firestations &substations * the nmicipal Jail.

INFRASTRUCTURE Naintenance of barangay roads £ Infrastructure facilities intended Infrastructure facilities intended All services and facilities of the a'bridges * water supply systems; primarily to service the needs of to service the needs of the muicipality and provincemulti-purpose pavement. residents of the mamicipality * residents of the province & whichwhich are funded out of ameicipal are furet d out of provincial fundsfunds including, but not limited including, but not limited to,to, nmicipal roads & brdges; provincial roads & bridges;school buildings & other inter-mnicipal waterworks,facilities for publlic elementory & drainage * sewerage, floodsecondary schools; clinics, health control, * irrigation systems;centers & other health facilities; reclamation projects.conimual irrigation, small waterifpounding projects; fish ports;ortesian wells springdevelopment, rainwater collectors& water supply systems; seawalls,dikes, drainage & sewerage &flood control; traffic signals &road signs.

IUJICIPAL Satellite or pubtic market, wiere Public markets, slaughterhouses; - All services and facilities of theENTERPRISES viable. public cemetary. naicipality and province

TOURISM Tourism facilities and other Tourism devetopment & prowotion All services and facilities of thetourist attractions. includin the programs. mmicipality and provinceacquisition of equipment,regulation & supervision ofbusiness concessions, & security.

Table 4.2: BASIC SERVICES TO BE PROVIDED BY LEVEL OF LOCAL GOVERNMENT

BARANGAY NMMICIPALITY PROVINCE CITY

HOUSING Programs a projects for Low cost AtL services and facilities of thehousing & other mass dweltinos, mlfcipsllty and provinceexcept those funded by SocialSecurity System, GovernsmntServices Insurance System, and theHousing Developmset Mutual Fund.

cWmNICATIONS Inter-smicipal telecommunication Conuication * transportservices. subject to national facilities.policy guidelines.

OTHERS Berangay Justice system Investment support services, Support for edecation, police &(kataruWigang pambarangay) including access to credit. fire services & facilities.

a%

- 64 -

4.6 The number of mandatory local government positions were increasedunder the revised LGC in line with the additional responsibilities. Many of thenew positions are administrative: e.g. the accountant and registrar for theprovinces, cities and municipalities, and the administrator, legal officer, andgeneral services officer for provinces and cities. On the-other hand, positionsfor new functions, such as the agriculturalist and environment and naturalresources officer, are optional in most local governments. The appointed localofficials are listed in Table 4.3.

Table 4.3: LOCAL APPOINTED OFFICIALS

HighlyPosition Urbanized Hunici-

Province City City pality

Secretary e e e eTreasurer e e e eAssessor e a e eAcrtountant N N N NBudget C=ficer e e e ePlanning and DevelopmentCoordinator e a e eEngineer e e e NHealth Officer N N N NCivil Registrar - e N NAdministrator N e N (0)Legal Officer N e N (0)Agriculturalist e (0) (0) -Social Services andDevelopment Officer N e N (0)Environment and NaturalResources Officer (0) (0) (0) (0)Architect (0) (0) (0) (0)Information Office (0) (0) (0) (0)Cooparatives Officer (0) (0) (0) -Population Officer (0) (0) (0) (0)Veterinarian N e N -General Services Officer N e N -

e - Existing, mandatory position.N - New, mandatory position.(0) - New, optional position.

- 65 -

B. Devolution of Central Government Functions

4.7 Several central government agencies were to devolve theresponsibility for the provision of basic services--provided for under Section17 (b)--to the local governments within six months of the date the revised LOCtook effect, or by June 30, 1992. The regional offices of the central governmentagencies previously performing these functions are to be phased out over oneyear, i.e. by end 1992, and the property, equipment and personnel in theseoffices transferred to the local governments.

4.8 At the same time, the central government reserved the option tocontinue financing specific programs or projects and exempted foreign fundedprograms and projects from being devolved to the local governments. Section 17(c) of the revised LGC states that:

"Public works and infrastructure projects and other facilities,programs and services funded by the National Government under theGeneral Appropriations Act, other special laws, pertinent executiveorders, and those wholly or partially funded from foreign sourcesare not covered under this Section, except in those cases where thelocal government unit concerned is duly designated as theimplementing agency for such projects, facilities, programs, andservices"

The executive branch and the legislature can maintain central government controlover specific programs by appropriating funds under the annual budgets (theGeneral Appropriations Act). Section 17 (c) provides the executive branch andthe legislature with the authority to reverse devolution by funding specificprograms, such as the Baranga) Road Concreting Program, under the annual GeneralAppropriations Act. The central government (or the next level of government) canalso take over the provision of basic services and facilities assigned to a lowerlevel of local government "when such facilities are not made available or, ifmade available, are inadequate to meet the requirements of the inhabitants"(Section 17 (f)).

4.9 The President issued Executive Order (EO) 507 in February 1992outlining the operations, projects and regulatory functions to be devolved to thelocal governments. Central government agencies providing agricultural extension,natural resource management, health services, social welfare services, and minorinfrastructure will be most affected by devolution. These include:

(a) Department of Agriculture (DA): Agricultural and fishery extensionservices, regulation and research; procurement and disbursement ofseeds; purchase, expansion and conservation of breeding stocks; andconstruction, repair and rehabilitation of water impounding systems.

(b) Denartment of Environment and Natural Resources (DENR): Forestmanagement services; mine and geo-science services; environmentalmanagement services; and reforestation, integrated social forestry,and watershed rehabilitation projects.

Table 4.4: DEVOLUTION OF NATIONAL FUNCTIONS TO LOCAL GOVERNMENTS

AGENCY REGIONAL OPERATIONS LOCALLY RFIDED PROJECTS REULATORY FUNCTIONS

DEPARTI OF Land & hr dweelopment dqlrovamentMARIAN EROW proJects

DEPARTMENT Of Agricultual £f fihery extensmin service; Procrement & distribution of certified Regulation of agricutture and fisheryASRICJLTURE agriculture & fishery rserch *eedr; purce, son conertion activities.

Of breeding stoks; consitruction, repi r& rehabilitation of water lepomaidingsyste"; sugpo to fishermen, Includingpur'Xe of fishing nets & other _terirls

DEP. OF UDIET 9 Locat goverrent budget officers.

DEPARTNENT OF Forest mnagemt service; mine & Reforestation projects; integrated socialENVIRONNENT & go-science services; awiroraeental foresty projects; watershed rehabilitfonNATURAL ESOURCES _agmnt Svces, projets.

DEPARTMNT OF Provincial health office, district, Contructon, re r, rablitation &HEALTH 1micipel wd medicare comaity renation o princial district,

hwopitals; purdce of drugs * mdicines; ic1pal & mdicre hospitals; operationprimry health care progrm field health of 5bed health infirm essrvices; aid to puerfculture.

DEP. OF PU8LIC Rep1ir & _intennce of Infrastructure Water supply projects; coasulvowRS & NIsMaYS facilities. Irrigation projects.

DEPARTMENT OF Commiuty based program for rebel Berangay day care centers; pilotSOCIAL WELFARE & returnees. couminty based programs for rebelDEVELOPMENT returnees; poverty alleviation in low

income .micipelities & depressed urtbnberanay.

OEP. OF TOURISM omoestic tourism promotion Tourism standard regulation.

OEP. OF TRADE & Promotion & developnent of trade,INDUSTRY Industry & related institutional services._

DEPARTMENT OF Telecoenunication services. Transportation franchising & regulatoryTRANSPORTATION & services.CWSUicATIONS

Source: EO 507 (Cont.)

Table 4.4: DEVOLUTIOU OF NATIONAL FUNCTIONS TO LOCAL GOVERNMENTS

AGENCY REGIONAL OPERATIONS LOCALLY FUNDED PROJECTS REGULTORY FUNCTIONS

COOPERATIVES Cooperatives field operation Promotion, developent & regulation ofEEWLOPHENT cooperativesAUTNORITY

NUS"IG & LAND Regulation of hum settlem ents plans &USE REGULATOMY progr--

NOISING & URBAN Coordination of policy formelation &OEVELOPNENT monitoring of housing activities.COIUICIL

PNILIPPINE Regulation & spervfsion of cockfighting.

CISSIU

Source: EO 507

- 68 -

(c) Legartment of Health (DOH): Provincial health office and district,municipal and medicare community hospitals; purchase of drugs andmedicines; implementation of primary health care program; fieldhealth services; aid to puericulture; and operation of 5-bed healthinfirmaries.

(d) Department of Public Works and Highways (DPWH): Repair andmaintenance of infrastructure; and barangay road, water supply andcommunal irrigation projects.

(e) DeDartment of Social Welfare Development (DSWD): Program for rebelreturnees; barangay day care centers; and poverty alleviationprograms in low-income municipalities barangays and depressed urbanbarangays.

Other agencies, such as the Departments of Agrarian Reform, Budget andManagement, Trade and Industry, and Transportation and Communications, are alsoaffected. A complete listing of the devolved functions by agency based on EO 507is presented in Tc;alo 4.4.

4.10 The President issued EO 503 in January 1992 which outlines theimplementing rules and regulations for the transfer of personnel, assets andliabilities to the local government. Technical and administrative personnel ofthe central government agencies carrying out the devolved functions will betransferred to the local governments which are required to absorb them-- creatingequivalent positions, unless it is administratively impossible due to aduplication of functions. Fcr example, there may be duplication between theprovincial agriculturalist, an existing position, and the DA's provincialagricultural officers. There will be no involuntary termination of permanentemployees of central government agencie3o affected by devolution and thoseemployees who cannot be absorbed by the local government will be retained by thecentral government agency concerned. Permanent central government stafftransferring to the local governments will maintain their current rank, pay andbenefits. Those performing city and municipality specific functions will beabsorbed by the city or municipality where they are assigned and personnelperforming inter-municipal functions will be absorbed by the province where themunicipalities are located.

4.11 It is generally believed that transfer of staff will occur withouttoo much physical relocation since many of those affected, e.g. in DOH, DPWH andDSWD, are already assigned at the provincial, city and municipal levels.However, the question arises on the grading of the transferred central governmentstaff. Both the central and local governments are subject to R.A. 6758, theCompensation and Position Classification Act of 1989. Under R.A. 6758, the ratesof pay at the local level are determined on the basia of "class and financialcapability of each local government unit" (Section 10) and the salary schedulesof provinces and cities below second class and all municipalities are set by thislaw at rates lower than that of the central government. Since central governmentofficials (at least the permanent staff) will be assured their rank, pay andbenefits under EO 503, it is unclear whether they can be integrated into thelocal governments without disrupting their salary structure. Furthermore, there

- 69 -

Table 4,: ESTIMATED REDUCTION IN 1992 BUDGET ALLOCATIONS FROMDEVOLUTION OF PROGRAMS AND PROJECTS TO LOCAL GOVERNMENTS

(In P billion)

Estlmated Reductions 1992 Im-Department Recurrent Capital Total Budget pact

Agriculture 1.326 0.052 1.378 6.744 20%Agrarian Reform - 0.010 0.010 0.734 1%Budget & Management 0.172 - 0.172 0.472 36%Education, Culture & Sports 0.353 1.604 1.957 34.224 6%Environment & Natural Resources 0.124 0.062 0.186 4.420 4%Health 4.217 0.051 4.268 10.408 41%Public Works & Highways 0.038 1.533 1.571 20.065 8%NALGU: barangay & local roads - 1.718 1.718 -Social Welfare & Development 0.899 - 0.899 1.340 67%

Total 7.129 5.030 12.159 299.839 4%

Note: Recurrent expenditures include personnel services and maintenanceand operating expenditures.

Source: DBM (as of November 1991)

is a possibility of a conflict between the expenditure ceilings established underthe revised LGC which limits personnel expenditures to 45% or 55% of regularincome depending on the class of local government (para. 4.81).

4.12 The overall impact of devolution on the central government budget isestimated to be relatively small. The Department of Budget and Management (DBM)prepared estimates of the possible reductions in the 1992 budget from thetransfer of central government operating and capital budgets to the localgovernments following the implementation of the revised LGC. Table 4.5 presentsthe anticipated reductions in the 1992 budget by agency. The total savings tothe central government from devolution is estimated to be P 12.1 billion'. Thebulk of the savings will come from DOH, P 4.3 billion; DPWH, P 3.3 billion,including the Barangay Road Cot.creting Program which is funded under NALGU butimplemented by DPWH; Department of Education Culture and Sports (DECS), P 2.0billion; and DA, P 1.4 billion. These four departments account for 90% of budgetreductions. The impact of devolution is estimated to be only about 4% of theoriginal 1992 central government budget proposal.

1 This discussion is based on information provided by DBM as of November1991. Estimated savings from devolution are constantly being adjusted as budgetfigures are refined. Current estimates of the expected savings are lower.

- 70-

4.13 While devolution's impact on the overall central government budgetmay not be great, certain departments, on the other hand, will be affectec.significan:ly. The impact on each will depend on the extent of the reduction inthe department's overall budget and the nature of the functions to be devolved.Given the size of their budgets, the impact of devolution on DECS and DPWH arenot expected to be significant or overly disruptive. DECS will lose its schoolbuilding construction program but continue to fund h4gher education facilitiesand teacher salaries and other recurrent costs. DPWH Ls estimated to lose about8% of its budget, mostly in capital expenditures. Only about 706 (4% of thetotal) DWPH's regular staff and 6,000 (20% of the total) casual and contractualstaff are expected to be transferred to the local governments as a result of theLGC. On the other hand, it is estimated that about 50,000 or two-thirds of DOH's75,000 staff could be affected by devolution. DSWD, DOH and DA, which areexpected to devolve the bulk of their regular operations, including staff andadministrative expenses, will face more disruption.

C. Revenue Sharing

4.14 Local governments will be given a larger share in national taxrevenues. Under the revised LGC (Book II, Title 3), they will receive a largershare in the allotment of internal tax revenues and of the proceeds from theutilization and development of natural resources within their jurisdictions.

The Internal Revenue Allotment (IRA)

4.15 Local governments will receive an increased share in the internalrevenue taxes. This was the key demand of the local executives and muchdiscussion focussed on the level of local governments' share during the draftingof the LGC. The House, in its version of the revised LGC, increased the sharefrom its present maximum of 20% of internal revenue collections, net of specialfunds, of the third preceding year2 to Z5% of gross collections of the secondpreceding year. The House version included an additional 5% of gross collectionsthat would act as an incentive for improving local resource mobilization andwould be distributed to local governments that exceed collection efficiencytargets set by the Department of Finance. The Senate version set the share at40% of internal revenue collections net of special accounts for the secondpreceding year. In the final version, the increase in local government sharewill be phased in over a three-year period; and the third preceding year (and notthe second preceding year) was maintained as the basis for determining therevenue share.

4.16 Under the revised LGC, the share of the local governments in theinternal tax revenues (the IRA), will be based on the collection of internalrevenue taxes of the third fiscal year preceding the current fiscal year and theshare will be increased as follows: (a) in the first year the Code takes effect(1992), 30%; (b) second year (1993), 35%; and (c) third year (1994) andthereafter, 40%. In 1992, the revised LGC required the central government toprovide local governments with funds to cover the costs of central government

2 For example, the allocation in 1992 is based on collections in 1989.

- 71 -

personnel devolved to the local governments, in addition to the 30% IRA. TheSpecific Tax Allotment (STA), the Local Government Revenue Stabilization Fund(LGRSF) and other grants to locdl governments under the National Assistance toLocal Government (NALGU) were discontinued.

4.17 The revised LGC would result in a significant increase in grants tolocal governments, especially after 1994, when the local governments' sharereaches its maximum of 40%. To date, central government has been releasing lessthan the 20% maximum allowed for the IRA and the IRA, STA and LGRSF combined in1992 was equivalent to 22% of the internal revenues of the ehird preceding year.In 1992, however, local government.-s will receive a significant increase inrevenue sharing as a result of the implementation of the revised LGC--when theirshare is increased from 22% to 30% of gross 1989 internal tax revenues. As thelocal governments' share increases from 30% to 35% and finally to 40%, the IRAis estimated to increase from P 24.7 billion in 1992 to P 36.4 billion in 1993and P 47.1 billion in 1994 (Table 4.6).

Table 4.6: ESTIMATED IMPACT OF THE REVISED CODE ONCENTRAL GOVERNMENT GRANTS TO LOCAL GOVERNMENTS

(In P Billions)

1992 1993 1994

Internal Tax Collection ofthe Third Preceding Year a 82.2 104.1 117.8

IRA with Revised LGC:Share 30% 35% 40%Amount 24.7 36.4 47.1

NALGUIRA, STA and LGRSF b 12.2 17.1 19.2Other NALGU e 6.7 7.4 8.1

18.9 24.5 27.3

Increase in Funds to Local Govt. 5.8 11.9 19.8

a BIR collections for 1989 are shown under 1992. Theestimate for 1991 (for estimating 1994) was taken fromDBN's 1992 "Budget of Expenditures and Sources of Financing".

b IRA assumed to be 15% of gross BIR collections. Grosscollections are used since the Special Accounts areestimated to be only abot;t 1% of gross collection. STAand LGRSF estimated to be constant at P 1.5 billion,their historic levels.

e Assumed 10% increase per annum to be constant in real terms.

- 72 -

4.18 To estimate the net increase in grants to local governments, theamount that local governments would have received through NALGU under theprevious system needs to be subtracted from the revised allocations. In 1992,the net increate is estimated to be P 5.8 billion or a 30% increase over thieoriginal budget proposal; in 1993, P 11.9 billion or 49% above what they wouldhave received under the previous system; and in 1994, P 20 billion or 73% higherthan the previous system. In order to obtain the impact on the centralgovernment budget as a whole, the savings from devolution (para. 4.12) have tobe deducted from these additional net flows. The overall impact ofdecentralization on the central government budget is discussed in Section B inChapter V.

4.19 The revised LGC provides the central government with the option ofreducing the revenue sharing to a minimu, of 30% of internal revenues of thethird preceding year in the event the central governmert incurs an "unmanageablepublic sector deficit." The President can reduce the share upon therecommendation of the Secretaries of Finance, Interior and Local Government, andBudget and Management, after consul.ting the presiding officers of both Houses ofCongress and the presidents of the local government leagues.

4.20 The issue is whether the government will be able to raise the revenueshare to 40%. One of the critical problems with the previous allocatton systemwas not the system per se, but the government's implementation of it, especiallythe government's inability to release 20% of the internal revenues of the thirdpreceding year. The public sector deficit and demands on central governmentresources, especially debt service payments (which hindered them before) areexpected to continue to be serious issues over the next few years.

-table 4.: COMPARISON OF THE ALLOCATION OF 1990 IRA BETWEEN DIFFERENT LEVELSOF LOCAL GOVERNMENT WITH AND WITHOUT THE REVISED LGC

(amounts in P billions)

TotalIRA STA & LGRSF Old System Revised LGC

Amount % Amount % Amount % Amount %

Provinces 2.9 27.0% 0.2 15.0% 3.1 25.5% 5.7 23%Cities 2.4 22.5% 0.3 22.5% 2.7 22.5% 5.7 23%Municipalities 4.3 40.5% 0.6 37.5% 4.9 40.1% 8.4 34%Barangays 1.0 10.0% 0.4 25.0% 1.4 11.9% 4.9 20%

10.7 100.0% 1.5 100.0% 12.2 100.0% 24.7 100%

Mission estimates

- 73 -

4.21 The formula for sharing the IRA among the different levels of localgovernments hali been modified under the revised LGC as follows: (a) provinces,23%; (b) cities, 23%; (c) municipalities, 34%; and (d) barangays 20%. With theoverall increase in the IRA allocations, all levels of local government willreceive additional grants compared to the previous system, but some localgovernments will gain more than others. Table 4.7 compares the allocations for1992 based on the previous and new formulas. Since the IRA, STA and LGRSF weredistributed under different formulas, they were calculated separately. The STAand LGRSF were assumed to be P 1.5 billion, its historical levels, for 1992; forsimplicity, the TLRSF was assumed to be distributed based on the STA formula.The barangays will benefit most from the change in allocation formulas,increasing their share from 12% under the previous system to 20%. The net effectwill be smaller since the barangays will be losing the funds for salaries ofbarangay official which had been paid out of the Barangay Administration Fund.The proposed 1992 budget for the Barangay Administration Fund was P 1.7 billion.If this is taken into consideration, the barangay allocation under the previoussystem would have been P 3.1 billion so that the barangay would have received anadditional P 1.8 billion, or an increase of 58%, with the revised LGC. Thecities will experience a slight growth in their share from 22.5% to 23% and anincrease in their allocation from P 2.7 billion to P 5.7 billion or by 107%. Themunicipalities, on the other hand, will see their share decline from 40% to 34%but their allocation will grow P 4.9 billion to P 8.4 billion or by 72% becauseof the doubling of IRA allocation. These increases in IRA funds will be offsetby additional expenditure responsibilities for the devolved national functions.The net impact of the revised LGC on the fiscal balance of the provinces, cities,municipalities, and barangays will be discussed in Chapter V, Section D.

4.22 The allocation among the provinces, cities and municipalities willcontinue to be based on population, land and equal share. However, more weightwill be given to equal share and land and less to population. The comparison ofthe distribution weights are given in Table 4.8. The allocation among barangayswill be as follows: (a) in 1992, population, 40%, and equal share, 60%; (b) in1993, population, 50%, and equal share, 50%; and (c) 1994 and thereafter,population, 60%, and equal share, 40%. However, each barangay with at least 100inhabitants will be provided with a minimum allocation of P 80,000 per annum.

4.23 Local governments will still be required to appropriate at least 20%of their annual IRA allocation for development projects in their annual budgets.Under the PD 1741 (Governing the Computation of the National Internal RevenueAllotment to Local Government Units), local governments were required to followthe guidelines set by DBM and the Department of the Interior and Local Government(DILG) in determining the projects to be funded from the 20%. Under the revisedLGC, these projects will no longer be subject to central government approval;DILG will only be furnished copies of the local development plans.

- 74 -

Table 4.8: COMPARISON OF DISTRIBUTION WEIGHTS

IRA STA Revised LGC

Population 70% 70% 50%Land 20% 20% 25%Equal Share 10% 10% 25%

Source: PD 144, PD 436, Revised LGC

Impact of the new system

4.24 To estimate the impact of the revised allocation formulas, theirdistributional impact and the kinds of governments that will gain or lose, thepresent distribution of the allotments has been compared to the simulated impacton distribution to each local government for 1986-1988 using the local governmentfinancial data set developed for this report. To perform the experiment in sucha way that the distributive effects can be compared, the total allocation waskept the same. The amount chosen was the average yearly amount for 1986-1988(P3.48 billion or P57.44 per capita). Allocations to barangays are not showr.

Table 4.9: COMPARISON OF 11 A DISTRIBUTION FORMULAS

Bicameral RevisedCommittee 1'GC

a. Between Different Levels:Barangay Share 15% 20%Provinces 25% 23%Municipalities 35% 34%Cities 2 2

100% 100%

b. Among Local Governments:Population 50% 50%Land Area 25% 25%Equal Sharing 25% 2

100% 100%

- 75 -

4.25 Th% simulation was carried out using an earlier allocation formulawhich was agreed to in the Bicameral Committee (BC). Table 4.9 compares the BCformula and the ogie incorporated into the revised LGC. Since individualbarangays are not considered in the analysis, the differences are relativelyminor and only affect th'e distribution between different levels of localgovernment. Therefore, the analysis conducted on the BC version is being used toassess the impact of the changes in the allocation system.

4.26 Table 4.10 compares the per capita allocations under the previoussystem and that under the BC formula, assuming overall amounts are kept constant.One result is clear; the new system will shift allotments away from Metro Manila.For example, the capital region received a per capita amount of about 52 pesosunder the present system, but this drops to 38 pesos under BC. BC achieved thisby changing thb distribution formula to weigh more heavily on equal sharing andland area. In general, BC will raise the per capita allotment in cities andlower it in municipalities.

Table 4.10: COMPARISON OF PER CAPITA IRA ALLOCATIONS(in pesos)

Previous BicameralSystem Committee Difference

Average 57.4 57.4 0.0

Metro Manila 52.1 38.4 -13.7Others 58.2 60.3 +2.1

Provinces 17.7 16.9 -0.8Cities 84.8 110.4 +25.6Municipalities 27.6 19.1 -8.5

Source: Mission estimates

4.27 The revisions to the allocation formula will result in greaterdiversion of per capita allotments between different local governments. Table4.11 compares the distribution of per capita allotment amounts within differentlevels of local governments. The coefficient of variation is higher for the BCsystem at all levels of local government and the differences between the highestand lowest allocations are greater under BC except for municipalities. Takingthe provincial aggregates, i.e. the sum of the provincial, municipal and cityamounts in each of the provinces, Table 4.11 shows the highest per capitaallocations under BC are estimated to be 12 times the lowest compared to 8 timesfor the previous system. At the same time, the correlation between allocationsunder the previous system and the BC is relatively strong--indicating thatallocations for individual local governments may not change all thatsignificantly.

- 76 -

table 4.11: COMPARISON OF EQUALIZATION FEATURES;PER CAPITA ALLOCATION BY SYSTEM (in pesos)

Coefficient SimpleMean of Variation High Low Correlation

Provincial Aggregates:Previous System 66 42.2% 213 26 ) 0.89Bicamertl Committee 69 64.3% 337 27 )

Provincial Governments:Previous System 26 44.9% 86 10 ) 0.86Bicameral Committee 29 100.2% 249 12 )

Cities:Previous System 100 43.1% 285 46 ) 0.81Bicameral Committee 167 59.5% 569 59 )

Municipalities:Previous System 38 76.6% 625 3 ) 0.91Bicameral Committee 27 94.1% 461 9 )

Source: Mission estimates

4.28 What will the distribution of allotments be under the new system?Will they equalizing at the margin? Will there still be a bias against largerplaces and in favor of those with larger land areas? Will Metro Manila localgovernments still receive "more than expected?" To answer these questions,estimated per capita allocation under BC was regressed against the factors thatwere used to explain variations among provincial aggregate per capita allotmentsfor the previous system (para. 2.74 to 2.76), namely average household income,population, land area, poverty, urbanization and a Metro Manila dummy variable.The results presented in Table 4.12 for provincial aggregates show that the BCsystem:

(a) does not equalize, i.e. there is no significant associated withaverage household income or the poverty index;

(b) would distribute significantly less in per capita terms to moreheavily populated provinces; and

(c) would favor more heavily urbanized provinces.

A small proportion of the variation in the simulated allotment amounts could beexplained by these variables. By comparison with the present system, the newsystem would allocate higher levels of per capita allotment to areas with smallerpopulations and greater land areas.

- 77 -

Table !ki: ORDINARY LEAST SQUARES ESTIMATES OF THEDETERMINANTS OF PER CAPITA ALLOTMENTS

BICAMERAL COMMITTEE (BC): PROVINCIAL AGGREGA-ES

Equation 1 Equation 2

Constant 137.87 124.20(2.51)' (2.62)*

Average Household Income -0.94xlO-1 -0.88xO-3(1.06) (0.97)

Population -4.26xlO-3 -2.48xlO-1(4.39)* (2.48)^

Land Area 2.49x10-5 2. 00xlO-5

(1.33) (0.94)

Capital Region Dummy --- 174.79(2. 00)

Poverty Index (1985) -55.87(1.18) --

Urbanization 150.79 --

(4.62) --

Poverty Index (1988) -- -45.74(0.93)

=12 0.26 0.04

N 73 73

a Absolute value of t-statistics shown in parentheses.* Significant at 0.05 level.

Share in natural resources

4.29 Local governmen.ts will be given a share in natural resource-relatedtaxes and charges and in revenues from government owned or controlledcorporations (GOCCs) engaged in natural resource utilization (Book II, Title 3,Chapter 2). The revised LGC provides local governments with a share in theutilization and development of "national wealth" within their jurisdictions.Under the Implementing Rules and Regulations, "national wealth" is defined as"all natural resources situated within the Philippine tarritorial jurisdictionincluding lands of public domain, water, minerals, coal, petroleum, mineral oils,potential energy forces, gas and oil deposits, forest products, wildlife, floraand fauna, fishery and aquatic resources, and all quarry products."

- 78 -

4,30 First, local governments will receive 40% of central government'sgross collection of the preceding fiscal year from mining taxes, royalties,forestry and fishery charges, and such other taxes, fees or charges, and from thecentral government's share in any co-production or joint venture agreement in theutilization and development of national wealth within its jurisdiction.Information on existing revenues from natural resource-related taxes is notreadily available. The initial indications are that this is not expected to bea major source of revenue for local governments and all will not benefit equally.In 1991, forest charges are estimated to be P 100 million and mining taxes, P 934million; the additional revenue for local governments will be just over P 400million. Since this amount will not be shared equally among the localgovernments, it could have a significant impact on those with large reserves ofnatural resources.

4.31 Second, local governments will also receive from GOCCs engaged innatural resource development the higher of the following: (a) 1% of the grosssales receipts of the preceding calendar year; or (b) 40% of the mining taxes,royalties, forestry and fishery charges and such other taxes, fees, or charges,interests, or fines the government agency or GOCC would have paid if it were nototherwise exempt.

4.32 The receipts from the GOCCs will be distributed among the differentlevels of local government in the following manner:

(a) When natural resources are located in the province, the barangayreceives 35%, the cities and municipalities receive 45%, and theprovince, 20%;

(b) When natural resources are located in a highly urbanized orindependent city, the barangay receives 35% and the city 65%.

When natural resources are located in two or more provinces, cities,municipalities or barangays, the respective shares within each category of localgovernment will be determined based on a formula of population, 70%, and landarea, 30%.

4.33 The revised LGC restricts the use of funds from GOCCs, requiringlocal councils to appropriate the amounts to finance development and livelihoodprojects. When proceeds were derived from the development and utilization ofhydrothermal, geothermal, and other sources of energy, at least 80% must be usedto lower the cost of electricity in the local jurisdiction where the energysource is located.

4.34 It is unclear which GOCCs will be affected by this provision or howthe local governments' share will be determined. An obvious candidate would bethe National Power Corporation (NPC), with it hydroelectric and geothermal powerplants. However, not all of NPC's power generation would be subject to revenuesharing since some of its plants are diesel or nuclear powered. Anothercandidate would be the Metropolitan Waterworks and Sewerage System (MWSS) which

- 79 -

currently draws most of its water from the Angat Dam in Bulacan Province3.

4.35 The total amounts may not be substairtial, but some local governmentswill benefit significantly from this provision. For example, NPC's operatingrevenue, for 1991 totAl P 35.6 billion and MWSS' total P 3.4 billion. If thelocal governme-nts r4coive 1% of operating revenues, their share will amount toP 390 million. Since this sum will not necessarily be distributed among alllocal governments, some, such as the Bulacan Province and the municipalities inAngat Dam's watershed, will benefit immensely.

D. Local Government Taxation

4.36 The revised LGC provides local governments with some autonomy todetermine local taxes but maintains many of the previous limitations on localtaxation, especially on real property and business taxes (the main sources oflocal revenues). The old local tax code, PD 231, was reenacted under Book II ofthe revised LGC with some changes and simplifications.

4.37 Central government continues to reserve for itself the major sourcesof tax revenues. As under the previous code, local governments are not allowedto levy incomes taxes, documentary stamp taxes, estate and gift taxes, customsduties, and value added taxes, among others--all which are preserved for centralgovernment (Section 133). However, the revised LGC gives them the power to taxthe income of banks and financial institutions and the profits from forestryproducts--all of which were specifically excluded from t.he local tax base underthe old code.

4.38 'The residence tax was renamed the community tax: Those 18 years andover who have been employed for at least 30 consecutive working days or ownproperty worth more than P 1,000, will be required to pay a flat rate of P 5 perperson and an additional tax of P 1 for every P 1,000 of income up to a maximumof P 5,000. The flat rate was increased from P 1 to P 5 per person. Theadditional tax was simplified with a single rate for all incomes rather than adifferent rate for property (P 2 for every P 5,000 worth of real property),business earnings (P 2 for every P 5,000), and salaries (P 1 per every P 1,000).The maximum ceiling was increased from P 3,000 to P 5,000. For corporations, theflat rate was increased from P 50 to P 500, but the additional tax was maintainedat P 2 for every P 5,000 of real property owned and of gross receipts. Theceiling for corporations was increased from P 6,000 to P 10,000.

4.39 The new code also specifies the sources of revenue for the province.

3 The Angat Dam would be a good example to consider how the revenue sharewould be determined. Currently, NPC, MWSS and the National Irrigation Authority(NIA) draw water from the dam, NPC uses it in addition to fuel powered powerstations to meet the electricity needs of Metro Manila at times of peak demand.Under these circumstances, how would the local governments' share of NPC'srevenues in Metro Manila be determined? In MWSS's case, the bulk of its wateris taken from Angat. However, MWSS revenues include a surcharge for sewage andthe environment. Would the local governments be given 1% of MWSS total operatingreceipts, including the surcharge, or 1% the receipts just from water charges?

- 80 -

The provinces will continue to receive 35% of the property texes collected bymunicipalities. In addition, they can tax the following: (a) transfer of realproperty; (b) printing and publications; (c) franchises; (d) sand, gravel andother quarry products; (e) professions; (f) theaters, cinemas and other placesof amusement and (g) delivery vehicles. Fees they were allowed to chargepreviously, such as for sealing and licensing of weights and measures and taxeson peddlers, have now been assigned to municipalities. They also lost the rightto charge rental fees for the use of municipal waters such as log ponds. Theloss of these revenues would be made up by increases in existing taxes becauserates they may charge were raised: For example, the tax on the transfer of realproperty was raised from 0.25% to 0.5% of the purchase price or fair market value(whichever is higher), as were fees charged to the professions (from P 75 forlawyers and P 50 for land surveyors to a maximum of P 300). The province isstill limited to levying only those taxes, fees or charges provided for under therevised LGC (Section 134).

4.40 Cities and municipalities are given a little more flexibilit; indetermining their taxes compared to the provinces. Section 142 of the revisedLGC allows municipalities to levy taxes, fees and charges not applied by theprovinces, except those such as income tax and custom duties which are reservedfor the central government. Before, municipalities were limited to those taxesand fees specified in the Local Tax Code. However, the position of cities 'sambivalent: The revised LGC allows them to levy taxes, fees and charges which thb,provinces or municipalities also impose, at rates not more than 50% higher thanthe maximum allowed for the others--except for professional fees and theamusement tax. Most of the specific fees and charges included under the previousLocal Tax Code I were eliminated so that the cities and municipalities now havesome flexibility in determining how much to charge.

The business tax

4.41 The business tax will continue to be a major source of local revenue.However, as before, the revised LGC specifies the amount that can be charged bylevel of annual receipts and type of business--which reflects the uneasinesswithin the business community over local governments' freedom to set rates. Theseamounts were increased by about 10%. Table 4.13 compares taxes to be paid andeffective tax rates for a municipality under the old and revised codes. Thecities and municipalities in Metro Manila will be allowed to impose taxes up to50% higher than the maximum allowed for municipalities. Except for the peddlers,tax (previously a provincial tax), the flat rates that were levied before wereabolished: For example, P 4,000 per annum for night clubs and P 100 per automaticlane per annum for bowling alleys.

4.42 The effective rate for business taxes was increased at the higherlevels. Before, businesses were required to pay a flat rate when their grossreceipts were above a certain level: e.g. at the municipal level, manufacturerspaid P 500 for every P 500,000 in excess of P 20 million but less than P 50million and wholesalers paid P 100 for every P 100,000 above P 1,000,000. The

4 For example, P 12 for registration of a cart, P 17 for a marriage fees.

- 81 -

revised code sets a fixed rate for businesses wlth gross receipts above a cortalnlevel: e.g. at the municipal level, 0.375% for manufacturers with receipts boveP 6.5 million and 0.50% for wholesalers with gross recelpts of P 2.0 million ormore. As a result, a wholasaler ln a municlpalLty wlth gross annual recelpts ofiL 625,000 will be required to pay 10% (or P 600) more under the revised LOC buta wholesaler with P 6 million in gross annual receipts will be requlred to pay114i (or P 16,000) more (Table 4.13). This change will benefit cities and largermunicipalities that have a stronger economic base and more large-scalebusinesses.

4.43 Where businesses operate over several local jurisdictions, taxreceipts will be allocated among them. As before, sales wlll be recorded ln thecity or municipality where the branch is located and taxed accordingly. Formanufacturers, assemblers, contractors and other busLnesses vLth factories,proiect offices and plantations, 30% of all sales recorded in their prLicipaloffice will be taxed by the city or munlcipality where that offlce is located--down from 60% under the previous Local Tax Code--to provide more funding to localgovernments. The remainlng 70% will be taxed by the clty or munLeLpalLty wherethe factory, project offlce or plantation is located. Where there is more thanone factory, etc., the 70% share wlll be apportioned among the dlfferent localgovernments based on volumes of production during the tax period.

- 82 -

Table 4.,13: COMPARISON OF BUSINESS TAX RATES FOR AMUNICIPALITY FOR SELECTED LEVELS OF GROSS

ANNUAL RECEIPTS BY TYPE OF BUSINESS

Old Local Revised LocalTax Code Govt. Code

Gross Annual ReceiptAmount Rate Amount Rate

Manufacturers and Importers125,000 2,000 1.60% 2,200 1.76%625,000 7,500 1.20% 8,000 1.28%

1,250,000 12,500 1.00% 13,750 1.10%6,250,000 24,000 0.38% 24,375 0.39%12,500,000 33,000 0.26% 46,875 0.38%40,000,000 60,000 0.15% 150,000 0.38%

W!holesalers and Distributors25,000 300 1.20% 330 1.32%125,000 1,700 1.36% 1,870 1.50%625,000 6,000 0.96% 6,600 1.11%

1,200,000 8,400 0.70% 10,000 0.83%6,000,000 14,000 0.23% 30,000 0.50%

Contractors25,000 250 1.00% 275 1.10%125,000 1,800 1.44% 1,980 1.58%625,000 8,125 1.30% 9,250 1.48%

1,250,000 11,250 0.90% 11,500 0.92%

Source: Local Tax Code (PD 231), LGC (Book II, Title 1)

4.44 The DOF lost its authority to review and suspend local taxordinances. Previousli, provincial and city tax ordinances had to be submittedto the Secretary of Finance and the municipal tax ordinances to the provincialtreasurer (appointed by the secretary of finance). The Secretary of Finance andprovincial treasurers had the authority to suspend tax ordinances if they wereconsidered unjust, excessive, or incompatible with national. polLcy or the LocalTax Code. Further, appeals of the tax ordinances were made to the Secretary ofFinunce. Under the revised LGC, the central government no longer reviews localtax ordinances; instead, those passed by cities and municipalities will bereviiwed by their respective provincial councils. Appeals against tax ordinanceswill 'e made to the Secretary of Justice.

- 83 -

The Real Progerty Tax

4.45 The revised LGC reenacts the previous Real Property Tax Code (PD464), but with a several key amendments. First, the primary responsibility foradministering real property tax was transferred from the DOF to the provinces,cities and municipalities within Metro Manila. The Schedule of Fair MarketValues, used to determine assessments, will now be prepared by provincial, cityand also municipal assessors but only for Metro Manila municipalities instead ofthe DOF and will be finalized In an ordinance to be enacted by the respectivelocal councils. In additior, authority to appoint local assessor is passed fromthe Secretary of Finance to the provincial governors and city and municipalmayors.

4.46 Second, assessment levels for residential land, buildings andmachinery, which are applied to the market value to determine the property valuefor taxation purposes, will be lower than under the old Real Property Tax Code.Such a decrease will shrink the local governments' real property tax base (theimpact of this change is discussed in para. 4.50 and 4.51)

4.47 Third, the barangay share in real property taxes will be increasedfrom 10% to 25% for provinces and to 30% for cities and municipalities withinMetro Manila. With the provinces, real property tax revenues will be distributedas follows: 35% will be allocated to the province, 40% to the municipality and25% to the barangay. With cities, 70% will go to the city and 30% to thebarangay. For municipalities within Metro Manila, 35% will go to the Metro ManilaAuthority, 35% to the municipality and 35% to the barangay. This is expected todecrease revenues for the Metro Manila Authority which had been entitled to a 35%share of real property tax revenues from the three cities in Metro Manila as wellas the 14 municipalities.

4.48 Fourth, most government corporations will lose their tax exemptstatus which will now only be granted to:

(a) Properties owned by the Government;

(b) Charitable institution and religious organizations;

(c) All machinery and equipment used by local water districts andgovernment owned or controlled corporations (GOCCs) engaged in thesupply and distribution of water and/or generation and transmissionof electrical power;

(d) Properties owned by registered cooperatives under R.A. 6938;

(e) Machinery and equipment used for pollution control and environmentalprotection;

NPC, which has the most fixed asseis among the GOCCs, will presumably be exemptfrom real property tax under (c) above, although its land and buildings such asits headquarters may not be exempt (see Table 4.14 for the possible impact of theloss of exemptions on selected GOCCs).

- 84 -

Table 4.14: ESTIMATED PROPERTY VALUES AND REAL PROPERTY TAXESFOR SELECTED GOVERNMENT OWNED CORPORATIONS

(in P millions)

Equipment, EstimatedLand & Related Real Property

Improvements Taxes1991 1992

National Power Corporation 120,500 0National Irrigation Authority 23,898 239Philippine Port Authority 9,555 96Philippine National Oil Co. 9,393 94Light Rail Transit Authority 5,645 56Philippine National Railways 5,397 54National Housing Authority 4,633 46

4 Assuming effective tax rate of 1%

Source: DBM, Budget of Expenditures and Sources of Financing, 1992

4.49 In 1991, the total equipment and land of government corporations(excluding NPC and MWSS) was estimated to be P 68.8 billion. Based on thisestimate, additional revenue for local governments (from the loss of the taxexempt status) will be P 688 million in 1992, assuming an average effective taxrate of 1%. However, these revenues will accrue only to those local governmentswhere such facilities are located.

4.50 The -educed assessments, plus the limitation on tax rates will lowerthe effective real property tax rates further, reducing the importance of thetax. A comparison of the old and new assessment levels are provided in Table4.15. The most significant change involves residential properties where theassessment level for land was reduced from 30% of market value to 20% andbuildings from a maximum of 80% to 60%. Also, all buildings below P 175,000 willbe assessed at 0%, making them de facto tax exempt, down from 55% under the oldReal. Property Tax Code. Real property tax rates, on the other hand, were notsignificantly changed. Before, provinces could impose a tax rate of 0.25% to0.5%, cities 0.5% to 2%, and municipalities 0.25% to 0.5%. Since municipalityresidents had to pay tax to both the province and municipality, the rates formunicipal residents were 0.5% to 1%. Under the revised LGC, the provinces canset a property tax rate of up to 1% and the cities and municipalities withinMetro Manila, up to 2%.

- 85 -

Table 415.: COMPARISON OF ASSESSMENT LEVELS

Old Real RevisedReal Property Local Govt.

Tax Code Code

LandResidential 30% 20%Agricultural 40% 40%Commercial, Industrial 50% 50%Mineral 50% 50%Timberland - 20%

Buildings and Other StructuresResidential 15%-80% 0%-60%Agricultural 40%-80% 25%-50%Commercial & Industrial 50%-80% 30%-80%Timberland - 45%-70%

MachineryResidential 15%-80% 50%Agricultural 40%-80% 40%Commercial & Industrial 50%-80% 80%

Source: Real Property Tax Code (PD 464), Revised LGC(Book II, Title 2)

4.51 Table 4.16 illustrates the impact of the changes. If a residentialproperty in a city is assessed at P 200,000 (P 100,000 for the land and anotherP 100,000 for the building) and the rate is 2%, the owner will pay only P 400 oran effective tax rate of 0.2% on the market value, compared to P 1,400, or aneffective rate of 0.7%, before.

4.52 These changes could have a significant impact on local revenues. Inthe case of Bacolod City, a major regional city with a population of 364,000 in1990, the changes in assessed levels for residential properties could mean a lossof P 17.6 million in revenues--a 33% reduction in real property tax revenues(Table 4.17).

4.53 In order to minimize the negative impact on real property taxrevenues, local governments will need to assess all property values beforepassing local ordinances implementing the new levels. Until the ordinances arepassed, the existing assessments levels and tax rates would continue to apply.The revised LGC requires local governments to carry out a general reassessmentwithin two years after the code takes effect and once every three yearsthereafter. Current property values have remained assessed at mid-1980 levelsdue to delays in implementing earlier general reassessments. Real property

- 86 -

assessment should be revised to reflect current market values. Thus, it is hopedthe increase in property values from the reassessment will offset the impact ofthe lower assessment levels. However, this will only be true in those major

Table 4.16: COMPARISON OF EFFECTIVE REAL PROPERTY TAXRATES

Old Real RevisedReal Property Local Govt.Tax Code Code

Value of Land 100,000 100,000Assessment Level 30% 20%Assessed Value 30,000 20,000Taxes Due (at 2%) 600 400

Value of Building 100,000 100,000Assessment Level 40% 0%Assessed Value 40,000 0Taxes Due (at 2%) 800 0

Total Taxes 1,400 400

Effective Tax Rate 0.7% 0.2%

Source: Mission estimates

Table 4.17: ESTIMATED LOSSES IN RESIDENTIAL REAL PROPERTY TAXESFOR BACOLOD CITY FROM THE REVISED ASSESSMENT LEVELS -

(in P millions)

Losses

Reduction in Assessment Level of Land to 20% 8.1Exemption for Buildings below P 175,000 4.0Reduction in Assessment Levelsfor Buildings above P 175,000 5.5

Total 17.6Real Property Tax RevenueEstimates Without the Revised LGC 53.0

* Includes the SEF (1% surcharge)Source: Bacolod City Assessor's Office

- 87 -

urban areas which experienced a rise in land prices; local governments in lessdeveloped areas, where land prices did not increase, will most likely experiencea drop in real property tax revenues.

E. Credit Financing

Domestic borrowings

4.54 The revised LGC expands local governments' access to credit financingby allowing them to borrow from domestic private banks and finance institutions(Section 297). The local governments will be able to:

(a) Secure loans to construct, operate and maintain infrastructure andother capital investments from government and private banks andother lending institutions;

(b) Obtain loans against the security of real estate or other acceptableassets to invest in industrial projects, commercial projects,housing finance or other economic enterprises from government banksand lending institutions;

(c) Acquire property, plant, equipment and machinery through suppliercredit, deferred payment plans or other financial schemes fromprivate suppliers.

Borrowings by local governments had been governed previously by PD 752 (theDecree on Credit Financing for Local Governments) which limited local governmentsto borrow for investment projects through government financial institutions, suchas the Land Bank and the Development Bank of the Philippines upon therecommendation of the Secretary of Finance.

4.55 Provinces, cities and municipalities can also issue bonds,debentures, securities, notes and other obligations to fund income producing andself-financing development or livelihood projects, pursuant to the prioritiesestablished in the approved local development plan and the rules and regulationsof the Central Bank and the Securities and Exchange Commission (Section 299).Under PD 752, only provinces and cities were given authority to issue bonds andonly up to 0.5% of the total assessed value of taxable real property within thelocal jurisdiction. The interest rate and term of the bond will no longer bedetermined by the Secretary of Finance; and local councils can set the terms andconditions of bonds through an ordinance approved by the majority of theircouncil members. However, bonds issued by local governments have lost their taxexempt status and are no longer guaranteed by the central government, as requiredunder PD 752.

4.56 Provinces, cities and municipalities can extend loans and grants toother local governments in amounts not exceeding their surplus funds, subject toapproval by their local councils (Section 300). Under the previous PD 752,inter-local governmental loans were allowed only for calamities andbeautification and were limited to 5% of regular income from the next precedingfiscal year.

- 88 -

Foreign borrowings

4.57 Local government borrowing from foreign financial institutions andinternational funding agencies will still be through the central government(Section 301) which will, in turn, lend to provinces, cities, municipalities, andbarangays through government financial or lending institutions. The funds couldbe used to: (a) finance the construction, improvement, operation or maintenanceof public utilities and facilities, infrastructure, or housing projects; (b)acquire real property, and; (c) implement other capital investment projects.

4.58 The central government may also use foreign grants to lend to localgovernments (Section 301). At the same time, local governments are allowed tosecure grants directly from foreign sources (Section 23).

Build. oRerate and transfer

4.59 Local governments are authorized under the revised LGC to enter intobuild, operate and transfer (BOT) contracts with the private sector for thefinancing, construction, operation and maintenance of financially viableinfrastructure facilities (Section 302). They must follow the provisions of RA6957, incorporate BOT schemes into the local development plans and they will needto advertise locally. All BOT agreements will be subject to confirmation bytheir respective local councils.

Limits on borrowings

4.60 The revised LOC sets a cap on local government borrowings, althoughit is under the section on fiscal administration rather than credit financing.Under Section 324 (Budgetary Requirements), local governments are limited toappropriating only up to 20% of their regular income to debt service. Also, theyare obliged to appropriate in their annual budgets the debt service obligationsof their borrowings (Section 303). Failure to provide the necessaryappropriations will render their budgets inoperative and the reviewing agency 3can send the budget back for redrafting. Finally, the central government canwithhold debt service payments from the Internal Revenue Allotment grants to thelocal government with the agreement of the local chief executive and the localcouncil concerned.

4.61 Borrowings have not played a significant part in local governmentfinances in the past. Table 4.18 summarizes the estimated local government debtoutstanding to the national government and to domestic institutions as ofDecember 31, 1988. Most of the obligations are statutory contributions, such asto the Integrated National Police, which the local governments are withholdingfor political purposes. These account for more than half the local government

5 The DMB reviews the budgets of the provinces, highly urbanized cities,independent component cities, and the municipalities within Metro Manila. Theprovincial council reviews the budgets for the component cities andmunicipalities within a province. Review of budgets is discussed in more detailin para. 4.82.

- 89 -

debt. Nonpayment to utilities is another major source of local obligations: NPCaccounted for 11% of the outstanding obligations as of December 31, 1988, andother creditors include the MWSS, MERALCO and the Philippine Long DistanceTelephone Company. Debt to financial institutions which can be consideredborrowing, totalled only P 358.6 million or 16% of total obligations.

Table 4.18J SUMMARY OF DOMESTIC LOCAL GOVERNMENT DEBTOBLIGATIONS OUTSTANDING AS OF END 1988

(in P millions)

Unremitted National Funds 1,164.7 52%Program Loans 31.8 1%Government Financial InstitutionsLand Bank 176.6 8%Development Bank of the Philippines 126.6 6%Government Service Insurance System 55.4 2%Government Owned or Controlled Corp.National Power Corporation 235.6 11%Other GOCCs 204.8 9%Private Utilities 239.4 11%

Total 2,234.9

Source: DOF

4.62 An innovative and unique approach was pioneered by the Cebu Provincewhich issued P 300 million in bonds in 1991 and directly accessed the localcapital market. These bonds, named the Cebu Equity Bond Unit (CEBU), pay anannual interest rate of 16% and are backed by shares in the Cebu PropertyVentures and Development Corporation, a joint venture between the Cebu Provinceand a private developer. The corporation was set up to develop a publicly-owned,unused airstrip in a prime location in rapidly growing Cebu City, the secondlargest metropolitan area in the Philippines. Cebu Province decided it would beable to mobilize more resources by participating in the development and throughthe bond issue rather than through the outright sale of the property to thedeveloper. However, this approach is made viable by the fact that the provincehad in its possession a very valuable piece of real estate and would most likelybe difficult to replicate elsewhere.

4.63 Local governments have also received loans and grants from foreignbilateral and multilateral agencies, including the Bank. These amounts are notreflected in Table 4.18. Bank experience to date indicates that while there isdemand for loans, most local governments have limited capacity to absorbsignificant amounts. Bank loans to cities and municipalities in the Philippineswere through the Regional Cities Development Project (1983) and through a series

- 90 -

of municipal development projects (in 1984, 1989 and 1992). Applications havebeen received from over 200 local governments under these projects whichindicates that many are interested in funding for investment projects.Outstanding commitments under Bank projects as of December 31, 1991 stood ataround US$70 million of which about US$29 million was released to the localgovernments.

4.64 While there is a willingness to borrow, local executives have takena more conservative approach to loans, for example, requesting financing forpublic markets--where there are clear revenues to offset the debt service.Further, they were willing to take potentially unpopular measures, such asraising market rents significantly, if they could show corresponding improvementsto the beneficiaries. Similarly, most were not enthusiastic about lending forroads and other infrastructure investments to be covered through generalrevenues, e.g. through real property tax collections, since the tax burden wouldhave be borne by the residents as a whole while the project would benefit onlythose living in the vicinity. Moreover, borrowing was limited by the smallresource base and difficulties in generating additional revenues for providingboth counterpart funding (a minimum of 10% of project cost in the case of theBank's municipal development projects) and meeting debt service payments. Alarge number of the more than 1,500 provinces, cities and municipalities wouldnot have sufficient financial resources to qualify for borrowings. On the otherhand, there is scope for utilizing loans in the larger cities and municipalitiesin the rapidly growing urban areas, where the economic base (and therefore therevenue base) and the demand for infrastructure and services in growing.

Debt relief

4.65 The government may have weakened the case for local governmentborrowings by providing debt relief to those with outstanding loan obligations.Under the revised LGC, the central government will fully write off the following:(a) its share of taxes, fees and charges collected by the local governments butunremitted as of December 31, 1991; (b) unremitted statutory contributions forthe Integrated National Police, Special Education Fund and hospital fund; and (c)program loans from the national government for community development, livelihood,and other small-scale projects. Program loans relent by the local governmentsto private persons will be written off the local governments, books but thenational government agency that implemented these programs will collect directlyfrom the beneficiaries.

4.66 The central government will buy back outstanding debts incurred bylocal governments as of December 31, 1988, to government finance institutions(GFIs), government owned or controlled corporations (GOCCs) and private utilitiesat a discount. Where the GOCC or the private utility has outstanding obligationsto the central government, the latter may offset the debts due the GOCC from thelocal governments with the GOCC's debt to the central government, again at adiscounted price. In the case of private utilities, the central government maysettle these obligations at a discount rate by offsetting against the outstandingobligations of such private utilities to GOCCs, where they exist, and in turnoffsetting these against the GOCCs' obligations to the central government.

- 91 -

4.67 The central government will recover the amounts advanced or offsetby the central governments to GFIs, GOCCs and private utilities by withholdingthe amounts from the Internal Revenue Allotment (IRA) grants provided to thelocal governments. Local government debt will be restructured by the centralgovernment and a revised amortization schedule will be prepared based on theformer's ability to pay with no interest or penalties. The central governmentwill deduct the amounts from the IRA, but the amount is not to exceed 5% of themonthly allotmenc of the local government concerned. Finally, the centralgovernment will write off a local government's debt at a rate of 5% for every 1%increase in revenues generated by the local government over that of the precedingyear as an incentive to improve fiscal administration.

4.68 Local governments will still be required to pay the followingobligations which are not subject to debt relief: (a) statutory contributions bycites and municipalities of Metro Manila to the Metro Manila Authority thataccrued as of December 31, 1991; (b) foreign loans; (c) national taxes collectedby the Treasurers that accrue in full to the central government; (d) debtsincurred by local gover-nents to GFIs, GOCCs and private utilities after December31, 1988, and; (d) obligations to the Home Development Mutual Fund, Medicare, andpremium contributions and amortization payments to the Government ServiceInsurance System.

Table 4.19: PER CAPITA DEBT BY REGION AND INCOME LEVEL a(in pesos)

Per Per Capita DebtCapita -------------------------

GRP UnremittedRegion 1989 Total National Others

NCR Metro Manila 39,914 156.1 123.7 32.5XI Southern Mindanao 16,627 16.8 6.4 10.5IV Southern Tagalog 16,544 7.1 0.6 6.5

VII Central Visayas 15,626 49.0 4.2 44.8X Northern Mindanao 14,736 68.2 2.5 65.8

III Central Luzon 14,008 5.7 0.6 5.0XII Central Minadanao 12,458 18.6 9.4 9.2VI Western Visayas 10,888 8.5 4.4 44.1IX Western Mindanao 10.507 13.4 4.1 9.2I Ilocos 9,581 5.4 3.5 1.8

II Cagayan Valley 7,658 22.3 5.2 17.0VIII Eastern Visayas 7,665 22.8 3.5 19.2

V Bicol 6,972 8.2 3.1 5.1

£ Excludes Program Loans for which regional breakdown was notavailable.

Source: Annex Table 5

- 92 -

4.69 Local governments In Metro Manila will be the major beneficiariesfrom debt relief. On average, they owe P 156.1 per resident to the nationalgovernment, government financial institutions, government corporations and publicutilities. The bulk of this debt is in unremitted contributions to the centralgovernment--which will be written off entirely. Outside Metro Manila, there doesnot appear to be an obvious relationship between the level of per capita debtsubject to relief and per capita income at the regional level. Table 4.19compares per capita debt levels by regions; further breakdown of debt obligationswas not readily available. The regions are ranked in order of per capita grossregional product (GRP), an indicator of regional income levels, in order todetermine whether there is any relationship between regional income levels anddebt relief.

F. Local Fiscal Administration

4.70 The revised LGC attempts to strengthen local fiscal administrationby incorporating the bottom-up planning process lnitiated by the government underEO 319, 1988, allowing for greater participation of NGOs in the plamiing processat the local level, and reducing the central government role in determining localbudgets.

Local development councils

4.71 Each level of local government is required to organize a localdevelopment council (LDC) that will be responsible for planning and overseeingdevelopment programs and projects (Book I, Title 6). The functions of thebarangay development council will be more community oriented and will includemobilizing local participation in the development effort as well as preparingbarangay development plans and monitoring and evaluating implementation ofnational and local programs and projects. The provincial, city and municipalLDCs will be responsible for: (a) formulating long-term, medium term and annualsocial-economic development plans and policies; (b) formulating the medium termand annual investment programs; (c) appraising and prioritizing socioeconomicdevelopment programs and projects; (d) formulating local investacnt incentivesto promote the inflow and direction of private investment capital; and (e)coordinating, monitoring and evaluating the implementation of developmentprograms and projects.

4.72 The LDCs will be chaired by the local chief executive (the provincialgovernor and the city and municipal mayor) and will consist of local councilmembers, the congressman and representatives from NGOs. The barangay developmentcouncil will be chaired by a barangay chairman and include the barangay councilmembers, representatives from the NGOs who will constitute at least 25% of themembership, and a representative of the congressman. The city and municipaldevelopment councils will be chaired by the mayor and include all barangaychairmen, the chairman of the appropriations committee of the city or municipalcouncil, the congressman or his representative, and representatives from NGOsoperating in the city or municipality who will constitute at least 25% of themembership. Provincial development councils will be headed by the provincialgovernor and include all city or municipal mayors, the chairman of theappropriations committee of the provincial council, the congressman or his

- 93 -

representative, and representatives from NGOs operating In the province who willconstitute at least 25% of the membership. Before, under EO 319, the centralgovernment representative on the LDC was the local representative of thegovernment agencies; now it is the congressman; and NGO participation increasedfrom "not more than 25%" to "not less than 25%". The LDCs may form sectoral orfunctional subcommittees to help them perform their functlons. The provincial,city and municipal planning and development coordinators will provide thetechnical support, reports and ether assistance needed for the LDCs to dischargetheir functions.

4.73 The policies, programs and projects proposed by the LDCs will besubmitted for approval to the local council, after which they may be integratedwith the development plan of the next higher LDC. Projects and programs of boththe central and local governments will be included in these development plans.EO 319 required the development plans of the lower level LDC be integrated intothe plan of the next level LDC; however, this is optional under the revised LGC.The development plans of the provinces, highly urbanized cities and independentcomponent cities will be integrated into the regional development plans by theRegional Development Council for submission to the National Economic andDevelopment Authority.

4.74 These local development plans are expected to facilitateprioritization of expenditures during the preparation of local governmentbudgets. The revised LGC states that local budgets shall operationalize approvedlocal de.velopment plans. The local finance committee, created under the revisedLGC, will base its ceilings (with respect to annual expenditures) on thedevelopment plan. The heads of various departments in the local government willconsider the development plan in preparing their respective requests. Theprovincial governor and the city and municipal mayors are required to outline thesignificance of the budget in relation to the approved local development plan intheir presentation of the budget.

The budgeting Drocess

4.75 The budgeting process was modified under the revised LGC to providemore autonomy to local governments by reducing the supervisory role of centralgovernment agencies. However, many limitations on local expenditures stillremain.

4.76 Local treasurers, who will continue to be appointed by the Secretaryof Finance, will play a sma. 'er role in formulating the local budget. Under PD477 (the Decree on Local Fiscal Administration), local government budgets couldnot exceed the estimated income certified as collectable by the local treasurers,making the treasurers responsible for setting the budget ceiling for thefollowing year. Since treasurers were evaluated on whether they met theircollection targets, they tended to be conservative in estimating the followingyear's collections; this led to conflicts with local chief executives who wereintereste4 in carrying out more programs and projects. Under the revised LGC,local government budgets will continue to be limited by estimated incomes, butthe estimate of the following year's revenues will be determined by local financecommittees consisting of the local planning and development officer, the localbudget officer, and the local treasurer, and not just the treasurer.

- 94 -

4.77 Local finance committees were created under the revised LGC and willbe set up at the province, city and municipal levels (Section 316). They areexpected to improve coordination between planning, budgeting and treasuryoperations within the local governments. In addition to determining projectedrevenues, they will recommend to the local chief executives the following: (a)the appropriate tax and other revenue measures or borrowing appropriate tosupport the budget; (b) the level of annual expenditures and the ceilings ofspending for economic, social and general services based on approved localdevelopment plans; (c) the proper allocation of funds for each developmentactivity (between current operating expenditure and capital outlays), and; (d)the amount to be allocated for capital outlay under each development activity orinfrastructure project. The committees will also assist local councils inreviewing the budgets of lower level local governments and will conductsemiannual examinations of costs and accomplishments of development projects.

4.78 The budget process will be as follows. On or before July 15, localtreasurers will submit to the local chief executives a statement of incomes andexpenditures of the previous year and first two quarters of the current year andestimated incomes and exnenditures for the remaining two quarters of the currentyear. Also, by July 15, all department heads will prepare their budget requestsfor the following year and submit them to local chief executives who will thenprepare a budget for the following year, calculated on the treasurers' statementof income and expenditures, the budget proposals from the heads of departmentsand offices, and estimates of income and budgetary ceilings from the localfinance committees. The budget will be submitted to the local councils by October1 and these have until the end of the year to enact the budget for the followingyear. The local fiscal year is January 1 to December 31.

4.79 PD 477 limited supplemental budgets to one a month; the revised LGCallows supplemental budgets only when supported by additional funds or newrevenue sources.

Budgetary reguirements and limitations

4.80 The revised LGC requires local governments to set aside funds formandated expenditures and limit spending for certain items. Local budgets haveto comply with the following requirements under Section 324:

(a) The aggregate amount appropriated shall not exceed estimated income;

(b) Full provision shall be made for all statutory and contractualobligations of the local government, provided that debt serviceshall not exceed 20% of the regular incomes of the local governmentunit concerned;

(c) Provinces, cities and municipalities will provide aid to componentbarangays in amounts no less than P 1,000 per barangay;

(d) 5% of the estimated revenues from regular sources shall be set asideas an annual lump sum appropriation for unforeseen expendituresarising from calamities, provided however, that it will only be usedin the area declared a calamity by the President.

- 95 -

In addition, local governments are required to appropriate: (a) 20% of theinternal revenue allotment for development projects (para. 4.23); and (b) allfunds from the share in natural resources for development or livelihood projects,except for proceeds from hydrothermal or geothermal and other sources of energywhere et least 80% of revenues will be used to lower the cost of electricity(para. 4.33). Expenditure mandates under the revised LGC are basically the sameas that under PD 477 except the allocation per barangay increased from P 500 toP 1,000 and the calamity reserve from 2% of estimated regular revenues to 5%.

4.81 The revised LGC also sets limitations on personnel expenditures anddiscretionary funds for local chief executives (Section 325). First,appropriations for personnel in one fiscal year are limited to 45% of the annualincome from regular sources realized in the next preceding year for first tothird class provinces, cities and municipalities and to 55% in the case of fourthor lower class 'Local governments. Personnel expenditures for public utilities andpublic enterprises owned by local governments are not included in the annualbudget or in the computation of the maximum amount for personnel. The ceiling forthird class provinces, cities and municipalities was reduced from 55% under PD477 to 45% under the revised LGC. Second, the local chief executivesdiscretionary funds are limited to 2% of the basic real property tax in thepreceding calendar year. Under PD 477, discretionary funds were limited to 1%of real property tax collections realized during the next preceding year or P100,000 (whichever is lower). It is difficult to ascertain the impact of thischange because the base for calculating the discretionary funds was reduced tothe basic real property tax (eliminating the additional 1% for the SpecialEducation Fund) while increasing the share from 1% to 2%.

Budget reviews

4.82 DBM will review the annual and supplemental budgets of provinces,highly urbanized cities, independent component cities, and municipalities withinMetro Manila to determine whether they conform to the law. The provincialcouncils, and not the provincial budget officers, will perform the same reviewfunction for the component cities and municipalities (in the provinces) and willbe assisted by the provincial local finance committees.

Funds

4.83 Finally, the infrastructure fund was abolished under the revised LW .Previously, local governments were required to establish a separate fund forconstruction and maintenance of roads and other infrastructure expenditures(para. 2.16). Now, local governmer-ts will maintain only a general fund, a specialeducation fund for the additional one percent tax on real properties which willbe automatically released to the local school boards, and trust funds to be setup for specific purposes. Local governments will also maintain special accountsin the general fund for: (a) public utilities and other economic enterprises; (b)loans, interest, bond issues and other contributions for specific purposes; and(c) development projects funded from the share of the local government unitconcerned in the internal revenue allotment. The profits or income derived fromthe operation of public utilities and other economic enterprises, after the costof improvements, repairs and other related expenses are deducted, shall be

- 96 -

applied for the return of advances or loans.

G. ConSlusigDa

4.84 Decentralization aim at moving public service provision and fiscaldecisions closer to the people so that it can lead to a more efficient localgovers.ent sector6. If the citizens, through their elected localrepresentatives, can vote on the package of services to be provided, the packagecan be adjusted to fit local preferences. This will allow local governments toincrease resource mobilization since residents will be more willing to pay forexpenditures which they consider to reflect their priorities. If local votersfeel that they have played a role in selecting local servlces, and lf they havepaid for a portion of thesa servlces with local taxes or fees, then they willhold local officials accountable for the way In which the services are delivered.On the other hand, if the central government lecides on what services will beprovided locally, and if local preferences are different from thoie supposed bythe center, then there could be a lower local tax effort and perhaps even a lackof enthusiasm about maintaining capital facilities provided by the centralgovernment.

4.85 Voter preferences must be translated into budget outcomes in orderto realize the benefits of decentralization at the local level. For this tohappen, the following five conditions must hold:

(a) local councils must be elected;

(b) chief local officials must be appointed by the local government, orelected locally;

(c) the allocation of local resources must not be severely constrainedby central government controls;

(d) the local administration machinery must be good enough to deliver anexpanded package of public services; and

(e) local governments must have significant enough taxing power tocapture willingness to pay and to make local officials accountable.

4.86 The local executives, i.e. provinclal governors, city and municipalmayors, as well as local councils are elected in the Philippines. Therefore, thefirst condition is met; the local residents have the opportunity to providefeedback on their preferences and enhance accountability through the politicalprocess.

6 The discussion focus on the economic arguments for fiscaldecentrallzation but the most compelling reasons for the push towards fiscaldecentralizatlon perhaps are political. The needs for increased participationin the government process, for increased incentives to finance local publicservices, for recognizing regional diversity, and for an tying of the red tapethat seems to characterize big government are calls heard in many countries.

- 98 -

between the revised LWC's limit on personnel expenditures, the existing SalaryStandardization Law (RA 6578) which determines the pay scale of the central andlocal government staff, and EO 503 issued as part of the implementation of therevised LMC which requires local governments to absorb practically a'l of thestaff devolved from the central government. Taken as a whole, does the revisedLGC and the other decentralization initiatives taken by the Government (anddiscussed under Chapter III) consist a cohesive program? This question will beaddressed in the next Chapter.

- 97 -

4.87 The revised LOC has increased local government control over theiroperations. First, local executives now have greater say over the appointmentof chief local officials. With the revised LGC, only the Local Treasurer willbe appointed by the central government. The provincial governors and city andmunicipal mayors will be able to appoint, among others, health officers andsocial services officers who were previously central government officials.Second, the local governments have access to more resources through the increasein IRA allocations and control over agricultural extension, health services,social programs, and other functioni devolved to them from the centralgovt nment. Third, the revised LGC does provide the cities and municipalitiesmore flexibility In setting fees and charges which have the additional advantageof linking payment directly with the provision of services.

4.88 On the other hand, some key conditions are not being met even withthe changes introduced under the revised LGC. The most significant shortcomingis the limitations placed on the local government's ability to determine itsrevenue mix. The two major sources of local revenues, the real property tax andthe business tax, remain highly regulated. To make matters worse, the revisedLGC weakens the real property tax by lowering the assessment levels, therebyreducing further the effective real property tax rate. The revised LGC stillmaintains the limitations on personnel expenditure by local governments andrequires that 20% of the IRA and the income from GOCCs engaged in naturalresource development be used for development projects. To ensure therequirements are being followed, the municipalities and component cities arerequired to submit their budgets for review to the Provincial Council and theprovinces, independent cities and municipalities within Metro Manila to DBM.

4.89 The revised LGC consolidated all the existing legislation into anomnibus code which defined the relationship between the central government andthe local governments and set out the revenues, functions and operationalprocedures for the provinces, cities, municipalities, and barangays. Thedrafters of the Code were responding to the demands of the local executives foran increased share in national revenues, more control over delivery of servicesand investments at the local level, and greater autonomy in local governmentoperations. At the same time, they were balancing traditional concerns overlocal government behavior that were reflected in the restrictive provisions underthe previous laws: e.g. the local governments would not be able to effectivelyutilize the additional resources given to them and would spend the funds onhiring more staff (i.e. patronage) rather than on investments or services.

4.90 Insufficient consideration has been given to managing the devolutionof the national functions and the actual implementation of the revised LWC. Therevised LGC was approved in September 1991 and the Government was initially givenuntil end 1991 to develop the Implementing Rules and Regulations and until June30, 1992 to implement the devolution of the functions, despite combined nationaland local elections in Nay 1992. This program proved to be too ambitious,resulting in delays and confusion.

4.91 In sum, its comprehensiveness, the attempt to respond to differentconcerns of the local executives, central government and other parties, andinadequate consideration given to implementation has resulted in somecontradictions within the revised LGC. For example, there is a possible conflict

- 99 -

V. IMPACT OF THE GOVERNMENT'S DECENTRALIZATION PROGRAM

A. The Analytical Framework

5.1 During the formulation of the Government's decentralization program,many of the critical aspects of the program were developed independent of eachother. For example, the discussion on the level of revenue sharing was centeredinitially on a bill proposed by Senator Romulo in response to complaints by thelocal officials that they were not receiving "their fair share" of totalgovernment resources. However, the role of local governments and extent ofdevolution of central government functions were not explicitly taken intoconsideration in the debate over revenue sharing. The level of devolutionresulted from an examination of the basic services that should be provided byeach level of local government. The revised Local Government Code (LGC)responded to other grievances by the local governments (such as direct sharingin revenues from natural resource extraction, control over local officials),incorporated the Romulo Bill, and was passed after a compromise between th.ie Houseand Congress which had each passed their own version of the LGC. A basic issueis whether the changes in revenue sharing, allocation of functions, localtaxation, and local administration, constitute a coherent program when they aretaken together and whether they are likely to result in more effective localgovernments.

5.2 The examination of the Government's program centers on assessingwhether the program as a whole is workable and whether it can generate sufficientbenefits. Specifically, the revised LGC and other Government initiatives willbe reviewed along the following lines:

(a) The Cost to the Central GovernmeD= For decentralization to succeed,the central government should be able to sustain the new system. Thismeans that the new system should be affordable, given the other claimson central resources. Decentralization can fail if the centralgovernment pulls back on the funding after the program has begun.This leaves local governments in a position of uncertainty, notknowing when the newfound autonomy and resources will be taken back.

(b) Local Fiscal Balance The decentralization program should result ina balance between the amount of revenues a local government has at itsdisposal (with a reasonable tax effort) and the amount it must spendto provide an adequate level of services. Decentralization oftenfails because central government passes on to the local governmentsthe responsibility for expenditures, i.e. provision of facilities andservices, without providing the local governments with correspondingincrease in revenue or revenue raising authority.

(c) Composition Effects The decentralization program would not impactuniformly on all local governments. While a fiscal balance may bemaintained for the local governments as a whole, this may not be thecase between different levels of local government or among differentlocal governments. The decentralization program cannot be consideredeffective and sustainable if it exacerbates existing disparitiesbetween regions, a major reason for initiatirg the program in the

- 100 -

first place, and also between local governments.

(d) Local Fiscal Autonomv and Resource Mobilization Local governmentsmust be given some revenue-raising autonomy, and the responsibilityfor provision of some impor-ant functions. The success of thedecentralization program turns on the ability of local governments torespond to the wishes of their constituencies for better services, andto tap their willingness to pay for these services. Local governmentsmust also be given freedom to decide their own budgetary affairs.This implies that they must control local chief officers to a greaterextent, be less encumbered with central government spending mandates,be responsible for selecting their capital improvements, have morecertainty with respect to the receipt of revenues from the allotmentsystem, and, within limits, approve their own budgets. The resultwill be that elected local officials will be more accountable to thelocal electorate.

(e) Technical Efficiency Local governments must have the capability todeliver the broader range of services proposed, and the capability toassess and collect from an expanded tax base. If the localgovernments are unable to absorb the additional responsibilitiesdevolved to them from the central government, this could result in adeterioration in the services, increase in cost of delivery, orduplication of effort between the central and local governments if thecentral government feels compelled to continue provide the service.

These points will be examined in turn in the following sections. The fiscalimpact was simulated on 1990 data, the latest year for which local governmentdata is available, in order to provide analysis at both the central governmentand local government levels.

B. Cost to the Central Government

5.3 For the decentralization program to be sustainable, the additionalexpenditures that the central government will incur as a result ofdecentralization, i.e. the costs of decentralization, would need to be within theflscal capacity of the central government. At present, the Government is facedwith serious budget constraints. Any additional expenditure responsibilitiesresulting from the revised LGC will have to be met by cut backs in other programsor by additional revenue generation. On the other hand, if the reductions inexpenditures from the devolution of national functions to the local governmentsare greater than the additional expenditures incurred, decentralization wouldresult in an improvement in the central government's fiscal position.

- 101 -

alg 5.1: SIMULATED IMPACT OF DECENTRALIZATION ONTHE 1990 CENTRAL GOVERNMENT BUDGET

(in Peso Billions)

Share of Internal Taxes

30% 35% 40%

Revenues ForgoneNatural Resource Related 0.4 0.4 0.4Statutory Contributions 0.5 0.5 0.5

0.9 0.9 0.9

Revenue SharingPrevious System 7.3 7.3 7.3Revised LGC 1 l 23.4Net Increase 10.3 13.2 16.1

Devolution SavingsNALGU -6.7 -6.7 -6.7Central Govt. Functions -8.2 -. 2L -8.2

-14.9 -14.9 -14.9

Central Govt. Outflows .9 2A

Impact on:Central Govt. Expenditures -2% -0% +1%Central Govt. Deficit -10% -2% +6%

Source: DBM; mission estimates.

5.4 The costs to the central government from decentralization are: (i)revenues forgone due to sharing of natural resource related national taxes withlocal governments and elimination of local government contribution to centralgovernment expenditures; and (ii) additional expenditures from increased revenuesharing and transitional costs. These costs would be offset by savings fromnational functions and personnel devolved to local governments. Finally, thereare non-quantifiable costs, namely the flexibility of the central government topursue fiscal policy, especially stabilization policy,

5.5 The impact of decentralization on central government revenues isexpected to be minimal. The estimated impact of the revised LGC and othergovernment decentralization measures are presented in Table 5.1. Under therevised LGC, the local governments will receive a 40% share in mining taxes,royalties, forestry and fishery charges collected by the central government(para. 4.31). These are considered to account for a relatively small part of

- 102 -

central government revenues: mining tax revenues totalling P 0.839 billion andforestry and fishery charges totalling P 0.058 billion in 19901. The revenueloss from the mining and forestry taxes is therefore estimated to be P 0.4billion in 1990. The local governments will not be required to contribute to theformer Integrated National Police or for hospital expenses (para. 3.15). It isestimated that these contributions would have amounted to P 0.5 billion in 1990.If the revised LGC had been in effect in 1990, the combined revenue loss to thecentral government from sharing in natural resource related taxes and eliminatingstatutory contributions would have been P 0.9 million or less than 1% of totalcentral government revenues for that year.

5.6 Under the revised LGC, the local government's share in internal taxrevenues, the Internal Revenue Allotment (IRA), would be increased from currentlevels of around 15% to 30% in 1992, 35% in 1993 and 40% in 1994 and thereafter(para. 4.16). The impact of these changes was simulated in the 1990 centralgovernment budget. In 1990, the central government budgeted P 7.3 billion (orabout 12% of 1987 BIR revenues), including the IRA, the Specific Tax Allotmentand the Local Government Revenue Stabilization Fund, for sharing with localgovernments. If the revised LGC had been in place in 1990 and the localgovernment's share in internal tax revenues was increased to 30%, the IRA wouldhave been P 17.6 billion or P 10.3 billion more than under the previous system.This increase in revenue sharing would have been equivalent to 5% of centralgovernment expenditures for that year. Combined with the sharing of naturalresource related revenues and elimination of the statutory contributions, a totalof P 11.2 billion would have been reallocated from the central government to thelocal governments. If the local government's share had been 35% of internal taxrevenues, the IRA would have been P 20.5 billion, or an increase of P 13.2billion, and a total P 14.1 billion would have gone to the local governments fromthe central government. Finally, if the local governments had received 40% ofthe internal tax revenues, their eventual share, the IRA would have been P 23.4billion, or three times the amount under the previous syctem, and the localgovernments would have received total of P 17.0 billion in additional funds fromthe central government.

5.7 At the same time, the central governments would be generating savingsby cutting back on grants to local governments (other than the IRA) and bydevolving expenditure responsibilities to the local governments. First, thecentral government could eliminate the various programs currently funded as partof the National Assistance to Local Governments (NALGU), such as the BarangayRoad Concreting Program, the Local Roads Maintenance Program, and the BALGUfunds. These programs totalled P 6.7 billion under the government's original1990 budget. Second, the central government budget can be reduced by devolvingexpenditure responsibilities and personnel for agricultural extension, tertiaryhealth services, social welfare and other central government functions to thelocal governments as mandated under the revised LGC (para. 4.12). The estimated

1 It was not possible to isolate royalties taxes in total centralgovernment revenues.

- 103 -

savings from devolution is P 10.4 billion in 19922 or P 8.2 billion in 1990prices when adjusted for inflation. Assuming that the levels of savings fromdevolution in 1990 would be similar to that in 1992, the overall reduction in1990 central government expenditures from the elimination of NALGU and devolutionof national functions would have been P 14.9 billion.

5.8 The net cost of decentralization on the central government woulddepend on the level of revenue sharing. If the local governments had received30% of internal revenues, the level for 1992 and the minimum share under therevised LGC, the central government would have had to provide an additional P10.3 billion to the local governments for revenues forgone and increased revenuesharing, but would have saved an estimated P 14.9 billion from the eliminationof NALGU and the devolution of national functions to local governments. The neteffect would have been a reduction in central government expenditures of P 3.8billion. As a result, the central government budget deficit would have improvedby P 3.8 billion or by 10%. If the local government share had been 40%, theshare that the local governments would be receiving from 1994 onwards, thesituation would have been reversed. The additional funds provided to the localgovernment would have been greater than the savings. Central governmentexpenditures would have increased by P 2.1 billion. The budget deficit wouldhave also increased by this amount or by 6%.

5.9 If the projected savings in central government expenditures do notmaterialize, the fiscal situation would worsen. The revised LGC leaves thecentral government with the option of continuing to fund devolved functionsthrough the central government budget (General Appropriations Act) or take overdevolved functions if the level of services provided by the local governments isinadequate (para. 4.08). If the central government should decide to exercise itsoption of continuing to fund and carry out some of NALGU program and/or thedevolved functions, this would have an adverse affect on the central governmentbudget deficit. Based on the simulation for the 1990, the potential budgetsurplus at a 35% revenue share would be eliminated if savings from devolvedfunctions were reduced by P 3.8 billion or by 46%.

5.10 There are additional costs that the central government would need tobear in mind which have not been factored into the analysis at this time becauseof the difficulty in estimation. One is the transitional costs such as severancepay for central government staff who may elect to resign instead of transferringto a province, city or municipality. Second is the debt relief provision underthe revised LGC where the central government would buy back, at a discount, debtowed by local governments to government financial institutions, government ownedor controlled corporations, and public utilities (para. 4.66). Third is the costof additional expenditures for monitoring, technical assistance to localgovernments or other new functions that the central government would have toperform with decentralization. At present, there is insufficient information onthe devolution plans of the various agencies nor a clear debt relief plan to

2 This amount is different from the total in Table 4.5. Table 4.5 includessome NALGU programs (barangay roads and local roads maintenance) implemented byDPWH on behalf of the local governments. The estimated savings from devolutionnet of DPWH NALGU expenditures is P 10.4 billion.

- 104 -

analyze the potential impact on the central government budget. However, thecentral government would need to take these costs Into consideration lndeveloping the details of its decentralization program.

5.11 By increasing the amount of funds to be released automatically byformula to the local governments, the central government is reducing its controlover fiscal policy, thereby undermining its ability to absorb unexpected shocksthrough budgetary adjustments. Although not readily quantifiable, this can beconsidered a real cost to the central government. Stabilization policy isespecially important to developing economies which are more vulnerable tointernational fluctuations in counodity prices, ratural disasters, worldwiderecession, etc. This argues for gzeater central government control over tax,expenditure and borrowing instruments. While the relative share of the increasein transfers and other quantifiable costs may not be significant relative tototal central government expenditures, the amounts over which the centralgovernment has discretion, such as capital and maintenance expenditures, has beenreduced over the last several years, from over two-thirds to one-third of centralgovernment expenditures, as debt service payments take up a larger share of thegovernment budget (para. 2.61). Therefore, the increase in revenue sharing may,on the margin, have a large impact on the government's ability to pursuestabilization policies.

5.12 The revised LGC provides the central government with some leeway indetermining the level of revenue sharing, allowing for less than a 40% share (buta minimum of 30%) in the event: the central government incurs an "unmanageablepublic deficit' (para. 4.19). It is not clear at which point the public deficitbecomes *unmanageable". The Implementing Rules and Regulations state that theadjustment in the IRA share should be made only after effecting a correspondingreduction in the central government expenditures including cash and non-cashbudgetary aid to government corporations, government financial institutions, theOil Price Stabilization Fund, and the Central Bank. Given the difficulties theGovernment is facing with the public deficit, the situation where the IRA sharewould be reduced could arise. It should be noted that the Government was unableto allocate the maximum 20% share to the local governments under the previousrevenue sharing system because of the pressures on the central government budget.Fluctuating levels of revenue sharing would again add an element of uncertaintywhich would hinder planning and budgeting at the local level.

C. Local Government Fiscal Balance

5.13 The flip side of the question on the impact of the decentralizationprogram on the central government budget is the impact of the changes on thefiscal position of the local governments. The increase in net outflows from thecentral government would be equivalent to the additional funds available to localgovernments.

5.14 Decentralization's Impact on the local government finances will dependon whether the central government is capable of increasing the local governments,share in internal taxes to 40% of the thlrd preceding year. Table 5.2 providesa simulation of the impact in 1990. From Table 5.1, it is estimated that thelocal governments would receive an additional P 0.4 billion from sharing in

- 105 -

natural resource related taxes, P 0.5 billion in elimination of statutorycontributions, and P 10.3 billion in additional IRA allocations if 30% of the1987 internal revenues are shared with the local governments. If 40% of internalrevenues are shared with local governments, the additional IRA allocations wouldbe P 16.1 billion.

5.15 In addition to the funds from the central government, the localgovernments will be receiving resources from the Government Owned or ControlledCorporations (GOCCs) in the form of shares of gross receipts or forgone taxes(para. 4.31) and in real property tax following the GOCCs' loss of their taxexemption status. It is estimated that the local governments will receive: (a)P 0.2 billion from the GOCCs, or 1% of the 1989 operating revenues of theNational Power Corporation, the Metropolitan Waterworks and Sewerage System, andthe National Irrigation Authority; and (b) P 0.6 billion in real property taxrevenues as a result of the GOCCs loosing their tax exemption3. These revenueswill not impact on local governments uniformly since the funds would accrue onlyto those local governments which are affected by the GOCC's operations or whereGOCC's real properties are located.

5.16 The impact of the revised LGC on local taxes, fees and charges wouldhave to be considered when estimating local fiscal balance. First, business taxrevenues were estimated to have grown by 10%, the increase in business tax rate,or by P 0.2 billion. Second, it was assumed that there would be no change inreal property tax revenues for the local governments as whole because theincrease in real property assessments values from revaluation would offset theloss of revenue from the lower effective tax rates. Naturally the impact woulddiffer between local governments with those in rapidly urbanizing areas, such asMetro Manila, experiencing increases in land values and a growth in real propertytax revenues while local governments in less developed areas with minor priceincreases experiencing a reduction in real property tax income. Third, noestimates were made for additional income from the community tax, sand and graveltax and other minor taxes, and fees and charges. At present, there isinsufficient information to make an evaluation on the possible impact of thechanges. The potential for additional local taxation is limited by the fact thatthere are few sources to levy taxes on other than real property and businesses.The local governments do have more flexibility in setting fees and chargesthrough local ordinances and innovative local executives could possibly find waysto increase local revenues. However, it was not possible to make a viableestimate for the sector as a whole since the initiative would rest withindividual local governments.

3 Based on the value of equipment, land and improvements for GOCCs,excluding the National Power Corporation and the Metropolitan Water Supply andSewerage System, as of 1989, taken from DBM's "Budget of Expenditures and Sourcesof Financing".

- 106 -

Table 5.2: SIMULATED IMPACT OF DECENTRALIZATION ON1990 LOCAL GOVERNMENT FINANCES

(Amounts in P billions)

Share of Internal Taxes

30% 35% 40%

Additional Revenues From Central Govt.Natural Resource Related Taxes 0.4 0.4 0.4GOCC Revenue Sharing 0.2 0.2 0.2Statutory Contribution Elimination 0.5 0.5 0.5Additional Revenue Sharing 10.3 13.2 16.1

Subtotal 11.4 14.3 17.2

Increase in Local Govt. Tax RevenuesGOCC Real Property Tax 0.6 0.6 0.6Business Taxes 0.2 0.2

Subtotal 0.8 0.8 0.8

Total Additional Revenues 12.2 15.1 18.0

Additional Expenditures:NALGU (other than IRA) 6.7 6.7 6.7Devolved Functions 8.2 8.2 8.2

14.9 14.9 14.9

Net Additional Revenues From New LGC -2.7 0.2 2.1

Source: Mission Estimates

5.17 The overall increase in revenues at the local level would be offsetby additional expenditure responsibilities for the NALGU programs and devolvedcentral government functions. The estimated cost in 1990 of these expenditureswas estimated at P 14.9 billion (para 5.7).

5.18 Whether the central government shares 30% or 40% of internal revenueswould have a significant impact on fiscal balance of the local governments as awhole. With a 40% share, the local governments would have received in 1990 anestimated P 18.0 billion in revenues compared to P 14.9 billion in newexpenditure responsibilities, or a net gain of P 2.1 billion (Table 5.2). On theother hand, if only 30% of internal revenues is shared with the localgovernments, the increase in expenditures would be greater than the increase inrevenues by P 2.7 billion. Since the local governments are required to maintainbalanced budgets, the local governments would have needed to cutback inexpenditures, e.g. for projects that would have been funded through BALGU or for

- 107 -

local road maintenance.

5.19 The actual costs to the local governments could be much higher.First, the analysis has assumed that the central government had been makingadequate expenditures to date for the facilities and services that are beingdevolved to the local governments. However, it is possible that the localgovernments may find that the facilities that they have taken over to beinadequate or services insufficient due to underfunding by the central governmentso that they are obliged to spend additional amounts of their own funds torehabilitate facilities and/or improve services to meet their residents needs.Second, unit costs of provision may increase, as central government functions aretransferred to individual local governments and any benefits from scale economieslost. Third, the start up costs at the local level have not been taken intoconsideration.

Table 5.3: SIMULATED IMPACT OF DECENTRALIZATION ON 1990LOCAL GOVERNMENT REVENUES AND EXPENDITURES

(Amounts in P billions)

Share of Internal Taxes

30% 35% 40%

Revenues before decentralization 15.3 15.3 15.3Additional Revenues 12.2 15.1 18.0Revenues with decentralization 27.5 30.4 33.3

Expenditures before decentralization 14.1 14.1 14.1Additional Expenditures 14.9 14.9 14.9Expenditures with decentralization 29.0 29.0 29.0

Local Government Surplus/Deficit:Before decentralization 1.2 1.2 1.2With decentralization -1.5 1.4 4.3

Source: DOF; Mission Estimates.

5.20 The revised LGC would have a significant impact on local governmentsas a whole. The revenues and expenditures of the local government sector areprojected to double with decentralization. Even if the IRA share is set at 30%,local government revenues are estimated to have increased from P 15.3 billion toP 27.5 billion in 1990, an increase of 77% (Table 5.3). Since the most of thisincrease would come in the form of additional IRA, decentralization could raisethe local government's dependence on central government grants.

108 -

D. Comoosition Effects

5.21 The changes in revenue sharing and local tax administration and thedevolution of central government expenditure responsibilities were not designedhand in hand and it is unlikely that every jurisdiction would be affected in thesame way. Some local governments will benefit from decentralization; i.e. theywill be able to increase the amount of resources available to them and continueto maintain, or if necessary improve upon, the services that were devolved tothem from the central government. Others may be losers from decentralization,receiving less in resources relative to expenditure responsibilities and thushaving to reduce the level of services provided to their residents. Thesecomposition effects are important because they change the fiscal well being ofall the local governments in the country.

5.22 The increase in the IRA will be the single largest source ofadditional revenues at the local level. All levels of local government areexpected to receive additional amounts because of the increase in overall revenuesharing. The changes in the allocation formula between provinces, cidies,municipalities and barangays will have an effect on the resources available tothe different levels of local government. In 1990, the IRA, the Specific TaxAllotment, and the Local Government Revenue Stabilization Fund resources weredivided among the local governments as follows: provinces 25.5%; cities, 22.5%;municipalities 40.1%; and barangays, 11.9% (Table 4.7). Under the revised LGC,these shares are changed to: provinces, 23%; cities, 23%; municipalities, 34%;and barangays, 20%.

5.23 The simulated impact of the changes in revenue sharing on 1990 IRAallocations are presented in Table 5.4. As with the earlier analysis on theimpact of decentralization on central government budgets and local fiscalbalance, separate allocations for 1990 were calculated based a 30% share ofinternal revenues of the third preceding year, 35% share, and 40% share. Theallocations with and without the revised LGC were estimated to obtain the netincrease in funds for the provinces, cities, municipalities, and barangays. Ata 35% share, total revenue sharing is estimated to increase by P 13.2 billion ifthe revised LGC had been in place in 1990 (Table 5.1). This increase can bebroken down into provinces, P 2.9 billion, cities, P 3.1 billion, municipalities,P 4.0 billion, and barangays, P 3.2 billion.

- 109 -

Table 5.4: SIMULATED IMPACT OF DECENTRALIZATION ON 1990 PROVINCIAL,CITY, MUNICIPAL AND BARANGAY BUDGETS

(In P Billions)

Share of Internal Taxes

30% 35% 40%

A. ProvincesAdditional Revenues from IRA 2.2 2.9 3.5

Additional Expenditures: 4.0 AA 4.0Other NALGU (except IRA) 1.0 1.0 1.0Devolved Functions 3.0 3.0 3.0

Net Additional Revenues -LI -L-

B. CitiesAdditional Revenues from IRA 2.4 3.1 3.7

Additional Expenditures: i6 i. LiOther NALGU (except IRA) 1.0 1.0 1.0Devolved Functions 0.6 0.6 0.6

Net Additional Revenues Q- 15

C. MunicipalitiesAdditional Revenues from IRA 3.1 4.0 5.0

Additional Expenditures: 7.9 LI 22Other NALGU (except IRA) 3.3 3.3 3.3Devolved Functions 4.6 4.6 4.6

Net Additional Revenues -4.8 -la -2.9

D. BarangaysAdditional Revenues from IRA 2.7 3.2 3.8

Additional Expenditures LI 1X 1.Other NALGU (except IRA) 1.5 1.5 1.5Devolved Functions 0.0 0.0 0.0

Net Additional Revenues from IRA LZ L2 L.

Source: Table 5.1; Table 5.6

- 110 -

5.24 The additional IRA revenues would be offset by the new expendituresincurred from the devolution of the central government functions and localgovernment take over of NALGU programs. Table 5.5 presents an estimate of theexpenditures at the provincial, city and municipal levels for devolved functionsof the Departments of Agriculture (DA), Environment and Natural Resources (DENR),Health (DOH). Budget and Management (DBM), and Social Welfare and Development(DSWD) for the 1993 proposed budget. Health services are the single largest itemto be devolved. The provinces and municipalities are expected to take over thebulk of the devolved expenditures. A detailed breakdown by level of localgovernment for the remaining devolved expenditures is not presently available.

Table 5.5: ESTIMATED BREAKDOWN OF 1993 DEVOLVED CENTRAL GOVERNMENTEXPENDITURES BY DIFFERENT LEVEL OF LOCAL GOVERNMENT

Share

Department Amount Munici-(P bil) Provinces Cities palities

Agriculture 1.1 33% 5% 62%Environment & Natural Resources 0.1 98% 1% 1%Health 5.0 56% 3% 41%Social Welfare & Development 0.7 5% 13% 82%Budget & Management 0.2 7% 5% 88%

Total 7.1

Source: Department of Budget and Management

5.25 The estimated additional expenditures incurred by the provinces,cities, municipalities, and barangays (Table 5.4) in 1990 were prepared based onthe following assumptions. The additional expenditures transferred to the localgovernments were based on DBM's initial estimate of savings from the devolvedfunctions adjusted to 1990 prices and the 1990 budgetary allocations for thevarious NALGU programs (para. 5.7). The total amounts by agency/program ispresented in the first column in Table 5.6. The assumptions used in distributingexpenditures between provinces, cities, municipalities, and barangays were asfollows:

(a) DBM's estimates for the 1993 budget (Table 5.5) for the devolvedexpenditures of DA, DENR, DOH, DSWD and DBM.

(b) 1990 population distribution between cities and municipalities forthe devolved expenditures of DECS (school buildings), BudgetaryAssistance to Local Government Units (BALGU), Barangay RoadConcreting Program, and other NALGU expenditures. It was assumed

1 ill -

for simplicity that the provinces and the barangays would not assumeresponsibility for any of the above programs. Total population ofthe cities4 was 13 million or 22% of population in 1990.

(c) Actual road lengths by type of road (excluding barangay roads) in1990 for the Local Road Maintenance Program.

(d) 100% assumption of responsibility by the barangays for the BarangayAdministration Fund which was used to pay barangay officials.

(e) Equal sharing between provinces and municipalities for DPWH's minorlocal infrastructure expenditures (small irrigation systems, ruralwells, etc.).

The above assumptions are summarized in Table 5.6.

5.26 The simulated impact for 1990 shows that the provinces andmunicipalities will suffer a short fall in additional IRA relative toexpenditures responsibility under all revenue sharing assumptions while thecities and barangays will be receiving more revenues than expenditures5. Theassumption that the provinces and municipalities would be expected to shouldermost of the devolved expenditures is the main reason for this result. This isrealistic since the provinces and municipalities are expected to take on the bulkof DOH's health expenditures, the single largest source of devolved expenditures,while most cities already have health offices and are not expected to absorb alarge number of DOH staff. The provinces are more limited in options for raisingrevenues and would most likely find it most difficult to fill the financial gapwithout some assistance from the central government.

I This includes only the people who live in the 60 cities and should notbe confused with "urban population" which includes people in the higher densityareas of municipalities classified as "urban" areas. The actual "urbanpopulation" is significantly higher than the city population.

5 The simulation attempts to bring out the potential problems from thecomposition effects of the Government's decentralization program. It was notpossible to include all possible effects in this analysis. For example, thelocal governments will obtaining additional revenues from local taxation, sharingof GOCC income and GOCC real property taxes payments (para. 5.16 and 5.17). Percapita expenditures would be higher in the urban ereas (para. 2.18) offsettingsome of revenue advantages of the cities.

- 112 -

Table 5.6: ASSUMPTIONS USED IN ALLOCATING DEVOLVED CENTRAL GOVERNMENTEXPENDITURES BY LEVELS OF LOCAL GOVERNMENT, 1990

Share

Amount(P bil) Prov, Cities Mun. Bar.

Devolved National Functions:Agricultural Extension (DA) 1.1 33% 5% 62% 0%Budget Officers (DBM) 0.2 7% 5% 88% 0%School Building (DECS) 1.6 0% 22% 78% 0%Environment (DENR) 0.2 98% 1% 1% 0%Health Services (DOH) 3.3 56% 3% 41% 0%Local Infrastructure (DPWH) 1.2 50% 0% 50% 0%Social Services (DSWD) 0.7 5% 13% 82% 0%Subtotal 8.2NALGU Programs:BALGU 1.5 0% 22% 78% 0%Barangay Road Concreting 1.5 0% 22% 78% 0%Local Rd. Maintenance 1.5 63% 9% 28% 0%Barangay Administration Fund 1.5 0% 0% 0% 100%Others 0.7 0% 22% 78% 0%Subtotal 6.7

5.27 Cities are expected to benefit from decentralization. It is likelythat they would not be expected to take on too many expenditure responsibilities.In addition, the cities are in a better position to raise additional revenues.The relatively well developed and growing economic base in the urban areas willresult in increased local revenues from real property and business taxes. Therewill also be more scope for introducing additional taxes and/or fees and charges.

E. Increases in Local Fiscal Autonomy

5.28 One of the goals of decentralization is to give local governments andlocal residents more discretion over the choice of local projects the level oflocal services provided, the operations of the public sector, and tae size of thelocal budget. The actions taken by the government to date give le..al governmentsmore discretion over the choice of projects and local affairs. The level ofdirect central government intervention in local government operations has beenreduced. At the same time, many of the constraints placed on local governmentshave been maintained.

- 11 3 -

TabLe 5.7: COWAPRISION OF RESTRICTIONS ON LOCAL GOVERINENT EXPEIITURES

Before Revised LOC With Revised LOC

Statutory Reserve 2X of estimat,d revenus from 5 of estfmted regular revenuesregular sources for calmitIes to be set a fd. for cateitioes

(Section 324)

Election Reserve One quarter of the cost of theprevious election to be eat aside

Transfer to 8KX12X of annual ineome of General Abolished (Infrastructure FurdInfrastructure Fund Fund to be transfered to the abolfshed)

Infrastructure Funid

AId to Hospitals 5K-7X of net income Abolfshed (Local Goverrmunts tookover hospitels)

Contribution to the 18X of Ceneral Fund revenues from AbolfshedIntegrated Natfonal regular sourcesPolice

Aid to Barangays P 500 per baranoay P 1,000 per berangay (Section 324)

Earmarking of 20X of IRA allocations to Oeneral 20X of IRA allocations set asideRevenues Funid set asede for develop ent for development projects

projects

100 of revenues from share ofnatural resources et asido fordevelopment and livehood projects

Personnel Personnel expenditures to be Personnel expenditures to beExpenditures limited to 45X of musal income ltited to 45X of annual fncome

for first nd second clast local for first to third class localgovernments and to SSX for lower governments and to SS for lowerclass local goverments. cla local govermwets.

Discretionary Funds One percent (1K) of real property Two percent (2K) of basic reelof the Local Chief tax collections realized urfing property tax In the precodfngExecutive the next proceeding year or year.

P 100,000 whichever is lower.

- 114 -

5.29 Local officials have been given more discretion over setting ofpriorities, allocation of funds and appointment of key personnel at the locallevel. F'rst, the elimination of the statutory contributions for the IntegratedNational Police and the hospital funds, revenue sharing and real property taxesfrom the GOCCs, and larger IRA allocations increase the amount of funds availableto local governments. Second, the local governments would have more say on theselection of projects and levels of local services with the devolution ofbarangay roads, health services and agricultural extension services, among othersfrom the central to local control. Third, local governments are given morefreedom in borrowing funds for investment projects. Fourth, the Local Assessorand Local Budget Officer, who had been appointed by the DOF and DBM respectively,would now be chosen by the provincial governors and city and municipal mayors.Local executive will have more say in the appointment of Local Treasurers andpolice commanders.

5.30 At the same time, many of the expenditure requirements andlimitations on spending have been maintained. A comparison of the previous andcurrent restrictions on expenditures are listed in Table 5.4. Each localgovernment is still required to appropriate at least 20% of its annual IRA fordevelopment projects, set aside 5% of estimated regular income (up from 3%) forcalamities, and provide each barangay under its jurisdiction with a minimum ofP 1,000 (up from a maximum of P 500) each year. The revised LGC requires localgovernments to appropriate funds received through revenue sharing from GOCCs tobe used exclusively for development and livelihood projects. Local governmentsare required to limit the share of personnel costs in their annual budgets(excluding public utilities and economic enterprises) to 45% for first to thirdclass provinces, cities and municipalities and to 55% for fourth and fifth classprovinces, cities and municipalities.

5.31 In addition, local governments' freedom in redirecting spending maybe constrained by the fact that they ate required to take over central governmentstaff who have been involved in providing the devolved functions under EO 5031.There is a possibility that the local governments may not be able to stay withinthe personnel expenditure limits established under the revised LGC or allocate20% of the IRA for development projects as a result of absorbing the centralgovernment staff as provided for under EO 503. The expenditure mandates andlimitations on personnel costs were intended to encourage local governments tobudget more funds for development projects. However, they weaken theaccountability of the local executives to their residents. In addition, thelimits on personnel expenditures create distortions since municipal enterprises,such as markets, are exempted. In many local governments, this makes itdifficult to determine the true cost of operating these enterprises because stafffrom other departments are assigned to the municipal enterprises for budgetpurposes. There is a need to review these mandates and determine whether theyare necessary or effective.

6 EO 503, "Providing for the Rules and Regulations Implementing theTransfer of Personnel and Assets, Liabilities and Records of the NationalGovernment Agencies Whose Functions Are to Be Devolved to the Local GovernmentUnits and for Other Related Purposes", dated January 22, 1992.

- 115 .

5.32 While the revised LGC provides the cities and municipalities (but notthe provinces) with a little more flexibility in setting determining their taxes,fees and charges, many of the previous limitations on real property and businesstaxes are maintained. For example, an uniform tax rate is establishednationwide for business taxes and uniform ceilings are established for realproperty tax rates. DOF is no longer required to approve the schedule of valueswhich are used to assess real property or approve local tax ordinances, reducingthe central government's direct intervention in local taxation administration.At the same time, however, the x<vised LGC weakens the real property taxes bylowering the effective tax rate by reducing the assessment levels whilemaintaining the same ceilings on tax rates.

F. Local Resource Mobilization

5.33 To what extent will this package of decentralization measuresstimulate resource mobilization by local governments? The Government programincludes very little explicit incentives for improved resource mobilization atthe local level. The House Version of the revised LGC had included a provisionwhereby additional IRA funds were to be provided to those local governments witha real property tax collection efficiency of over 60%. However, this incentivewas dropped from the final version of the revised LGC. The only explicit measureto promote improved revenue collection at the local level appears to be aprovision in the debt relief program whereby the central government will writeoff a local government's debt at rate of 5% for every 1% increase in revenuesgenerated by the local government over the preceding year.

5.34 The Government's decentralization program would, however, have anindirect impact on resource mobilization at the local level. There are severalinducements in the program for increased tax effort by local governments. First,the elimination of the mandated contribution for INP and hospitals means thatlocal governments may retain more of what they raise, hence they should bewilling to exert a greater tax effort. Second, the devolution of centralgovernment functions gives local governments some responsibility for importantgovernment programs, and it may be easier to levy taxes or fees to pay for suchprograms. Compared to the previous Local Tax Code, the cities and municipalitieshave a little more freedom in setting fees and charges.

5.35 Experience under the Bank's urban development projects in thePhilippines indicate the local residents are more willing to pay and localpoliticians more willing to charge where the beneficiaries are able associateincrease in taxes or fees with improvements in services and/or facilities. Forexample, market vendors agreed to a tripling or quadrupling of public marketrental rates if the local government proceeded with the renovation orreconstruction of old, dilapidated public markets. However, local councils arevery reluctant raise tax rates, especially if the overall level of public serviceis low. While the old Real Property Tax Code had set ceilings on the realproperty tax rates, most local governments had established rates below thisceiling. The legal constraints were not necessarily the reason that localgovernments did not raise it tax rates. Therefore, scope for improved localresource mobilization is in the increased use of fees and charges where benefitscan be closer linked to costs.

- 116 -

5.36 At same time, the revised LGC includes incentives which would workagainst Improved local resource mobilization. First, central government stillmaintained most of the controls on real property and business taxes, the two mostimportant sources of local revenue. In fact, the real property tax has beenweakened through the mandating of lower assessment levels (para. 4.50), makingit less attractive for the local governments as a source of revenue. Second, thelocal governments may substitute revenues through the increased IRA for fundsthat they otherwise might have raised locally. This is especially likely tohappen in smaller, financially and administratively weaker local governments thatdo not have the capacity to absorb the influx of funding and expenditureresponsibilities.

5.37 More importantly, the net effect of the changes in the revenuesharing formula and devolution of national functions would provide cities withmore IRA funds and could act as a major disincentive to resource mobilization.Among the different local governments, the cities have more potential forincreasing local revenues because of their growing economic base and havestronger administrative capacity to exploit their tax base. The evaluation ofthe local government sector showed that per capita local tax collections werehigher in the more developed and urbanized areas and that increase in centralgovernments grants would result in a decrease in local revenues (other than thereal property tax).

5.38 In sum, it is difficult to determine the impact of decentralizationon resource mobilization. The fiscal imbalance at the city level will act as adisincentive for the cities to raise local revenues. However, urbanization willalso increase demand for services and investments and some local executives mayaggressively use the opportunities under the revised LGC to rais3 tax rates andfees and/or institute new fees and charges.

G. Techilcal Efficlency

5.39 The local governments' ability to absorb the additional resource,staff and the devolved responsibility from the changes introduced by the revisedLGC is often raised as an issue. The key question is the effect ofdecentralization on the efficiency of service delivery and implementation ofcapital projects at the local level. Will the quality of health services, theconstruction of barangay roads, or the delivery of agricultural extensionservices deteriorate as a result of decentralization?

5.40 The amount of financial resources the local governments haveavailable would impact on effectiveness. The imbalance between devolution ofrevenues and expendltures and financial shortages at the provincial and municipallevels could result in a significant drop in services and cutbacks ininvestments. For example, most provinces are very likely to be hard pressed tofinance the health services and hospitals devolved to them from DOH since theprovincial expenditures resulting from devolution are expected to be higher thanthe additional income from increased revenue sharing. Such funding shortfallscould result in a significant decrease in the quality of provincial healthservices. Within the resource constraints, the provinces might give priority tokeeping the hospitals open and paying the salaries of the staff that they have

- 117 -

taken over from DOH but reduce operating expenditures, such as drugs, medicines,fuel for field trips, etc. As a result, supervision activities could becurtailed with field staff in place but with limited operational funds toundertake programs.

5.41 The managerial, technical, and administrative capacity of the localgovernments would impact on the effectiveness of service delivery and investmentat the local level. It is very difficult to address this issue directly becauselocal governments themselves are diverse and making a general assessment of localcapabilities would be impractical. The absorptive capacity would differ by theamount of new work compared to their existing work program. The analysis of theexisting local government structure showed that there were large differences inthe level of expenditures between different levels of local governments and amongprovinces, cities and municipalities (para. 2.18). Average per capitaexpenditures for 1986-88 for the Metro Manila local governments were twice thenational average. Average per capita expenditures for 1986-88 for cities outsideof Metro Manila ranged from P 84 to P 947 with a mean of P 303 and a coefficientof variation of 44%; average per capita expenditures for municipalities outsideof Metro Manila ranged from P 8 to P 1,001 with a mean of P 79 and an coefficientof variation of 69%. The financially stronger local governments with larger workprograms would naturally be in a stronger position to take on the additionalexpenditure responsibilities under decentralization.

5.42 In the case of the devolved national functions, it is necessary todifferentiate between devolution of functions which would involve a transfer ofstaff, equipment and other facilities from the central government to the localgovernments, and those that would not. For DADs agricultural extension services,DOH's health services and hospitals, and DSWD's social services where the staffand facilities are already located at the local level, the local governmentswould be taking over the management and administrative responsibility for thepersonnel and assets. The technical expertise and administrative systems shouldalso transfer with the staff. The issue will be the ability of the localgovernments to absorb the additional staff and the ability of the localexecutives to manage the newly acquired functions.

5.43 Absorbing the additional staff in itself could be problematic. Itis estimated that approximately 50,000 DOH staff would be affected by devolution.This is equivalent to total number of provincial employees (58,000) and about onequarter of the total number of provincial, city and municipal employees (about220,000) in 1988. Many provinces may have difficulty coping administrativelywith a large increase in their work force, especially since records keeping andother administration are mostly being done manually. The provincial governorsand city and municipal mayors would also be faced with the problem of maintainingand enhancing the technical expertise of the agricultural and healthprofessionals who would be faced with limited career prospects having moved fromlarge specialized departments to the local government;

5.44 In the case of barangay roads and other capital expenditures wherethe functions (but not necessarily a large number of staff) would be transferred,a key issue will be the capacity of the local governments to plan and carry outthe n wly acquired responsibilities. The experience with cities andmunlcipalities through Bank projects in the Philippines indicate several

- 118 -

administrative weaknesses in planning and implementing investments at the locallevel. First, there is lack of experienced, technical personnel. Given thelimited scope of work performed by many of the municipalities, most were notrequired under the previous LGC to have municipal engineering offices and hadvery few technical staff. Local officials had limited experience withcontracting or supervising contractors resulting in problems with quality ofconstruct work performed. Second, many cities and municipalities had limitedplanning capabilities. For example, plans may consist only of a list or priorityprojects. In addition, most local governments lacked basic information toprioritize their investment needs, such as an inventory of the infrastructure andfacilities and an assessment of extent of their deterioration under theirjurisdiction.

5.45 Devolution and the many changes and adjustments that it entails alsopresent an opportunity to remedy some of the shortcoming of the centralgovernment system and undertake reforms to improve the effectiveness of servicedelivery and investments. Improvements could be made in agricultural extensionservices, barangay roads and hospital operations which are discussed below.

5.46 Agricultural Extension Many questions were being raised about theeffectiveness of DA's extension services. Extension services at the grass rootslacked direction. Decisions on deployment of staff, their approach to work andthe tasks which they accomplish were left almost entirely to the discretion ofthe Municipal Agricultural Officers, many of whom lacked the training andmanagerial skills required to operate a cost effective service. The agriculturalextension workers themselves were too frequently poorly motivated, inadequatelytrained, and lacked morale. The DA staff were not directly accountable to thelocal communities or the local governments and did not necessarily address localneeds. DA has been attempting to make its extension service more accountable tofarmers and more responsive to local needs even before the passage of the revisedLGC.

5.47 The revised LGC presents an opportunity to streamline and improve theeffectiveness of extension services. Experience suggests that a successfulapproach to agricultural extension should be highly selective, targetingparticular themes and responding directly to the demands of the clientele, whilestaying within the implementation capacity of the manpower. With properleadership at the local level and technical support from DA, decentralizationcould make agricultural services more accountable to the farmers and responsiveto local needs. This would be consistent with the DA's efforts to strengthensupport to farmers and improve productivity.

5.48 Backup from the center and the region on research, training, andtechnical advice would be essential for decentralization to succeed. DA wouldneed to provide technical backing to the local governments at the regional levelthrough training of senior extension staff, assistance in development of trainingand information materials, general Subject Matter Specialist support,interprovincial coordination and consultancy services. At the national level,DA could support its regional offices by providing technical backstopping toregional subject matter specialists, coordinating, monitoring and providingpolicy support and guidelines to the local government extension services, andfacilitating the transfer of successful development models.

- 119 -

5.49 Barangay Roads The poor condition ot barangay roads is consideredto be one of the major constraints to rural development in the Philippines.Barangay roads have suffered from poor construction quality, lack of maintenance,and the low priority given to them by DPWH's District Offices. While poorconstruction quality and lack of maintenance are not limited to barangay roads,barangay level operations, which are smaller and more numerous, were often givenless priority relative to larger national works and were assigned to junior orcontractual staff in the district offices. The revised LGC provides anopportunity to improve both construction and maintenance by soliciting greatercommunity participation in planning, building and maintaining barangay roads.The barangay residents have the greatest interest in assuring that their roadsare properly built and maintained. They have been given access to additionalrevenues through an increased share in the IRA and could be asked to contributeto road construction/rehabilitation and maintenance expenditures, especially nowthat the Local Road Maintenance Program has been eliminated. The barangaysthemselves have limited technical capability and technical support arrangemnentswould need to be formulated with DPWH and/or the Pruvincial Engineer's Office.The barangays could act as contractors under the technical supervision of DPWHand/or the province.

5.50 DPWH could provide technical guidance and support to the ProvincialEngineer's Office through the setting up of barangay road standards and trainingin labor-based construction techniques. Experience under the Bank's Second RuralRoads Project has demonstrated that barangay roads are also appropriate for useof labor-based construction techniques. Barangay level operations could beconcentrated in DPWH's Central Labor Based Unit providing a focal point forbarangay level works and a link with the Government's efforts to encourage laborbased construction.

5.51 HosRitals Decentralization also presents an opportunity to undertakereforms to improve the provision of health services. The transfer of hospitaloperations to the provinces and financial constraints would necessitate some formof review of health services. First, the provinces could explore possibleredundancies, e.g. between district, municipal and community hospital operations,and eliminate duplication and ineffective activities. Second, increased privatesector participation could be sought in the financing and delivery of healthservices. This could be achieved not necessarily only through the privatizationof some hospitals, but could also by conztracting out of services as well asgreater community involvement in healta operations, say through charitablecontributions, community health drives, etc. The inclusion of a representativeof the private sector as one of the five members of the Local Health Boards isa move in the right direction. Third, given the expected provincial financialconstraints, hospitals might begin to charge fees for services rendered to thosewho can afford to pay and thereby improve financial self sufficiency. Prior todevolution, there was little incentive for the hospitals to increase costrecovery since all hospital revenues directly went to the central government.Prrvincial Health Boards would need to review the fees and safeguards would needto be put in place to assure that the poor are not denied access.

5.52 In sum, decentralization can be expected to lead to some worseningin the effectiveness of the implementation of the devolved functions. Any changewould prove to be disruptive in the short term, leading to a deterioration of

- 120 -

services as various parties learn to adjust to their new roles. Services wouldimprove over time once people become accustomed to their new relationships.However, weaknesses in the design of the decentralization program, i.e. themismatch between devolved revenues and expenditures, or the lack of managerial,technical, and administrative capacity at the local level could result in adeterioration of services over the medium term. At the same time, the changesbrought about by decentralization present the Government with an opportunity toinstitute reforms in the conduct of the devolved functions, especially in thoseareas such as agricultural extension and barangay roads which were facingproblems.

H. Issues with the Government's Decentralization Program

5.53 Many parts of the Aquino Government's decentralization program wereformulated separate from each other as responses to issues raised by the localgovernments. The increase in revenue sharing through the IRA allocation was notconsidered together with the devolution of specific central government functionsto the local level. Similarly, the changes in local financial needs followingdevolution apparently did not factor into the amendments being made to localtaxation. Several shortcomings have been identified in the Government'sdecentraliza_ion program. The following are some of the issues.

5.54 First, the new revenue sharing arrangements in the revised LGC maynot be sustainable. At the national level, it is questionable whether thecentral government could increase the local government's share to 40% of internalrevenues of the third preceding year as required under the Code. The centralgovernment will be under pressure to increase expenditures for power and otherinfrastructure needed for economic growth and at the same time reduce the publicsector deficit. Debt service and personnel expenditures account for around 60%of central government expenditures. Unless the central government drasticallyincreases local revenues or reduces expenditures in other areas, it may not bepossible to provide additional IRA to the local governments as well as makeessential investments in infrastructure within current public sector deficitceilings.

5.55 At the local level, the new IRA allocation formula and the devolutionof the devolved national functions, when taken together, would most likely resultin fiscal deficits at the provincial and municipal levels. The revised LGClimits the provinces' powers to raise additional revenues to cover the budgetaryshortfalls, leaving the province with the option of either cutting backexpenditures or borrowing funds. Operating and maintenance are most likely tobe reduced with the result that many of the national programs turned over to theprovinces would become ineffective.

5.56 Second, decentralization could reduce total expenditures for localservices, infrastructure and facilities. The imbalances in devolved revenues andexpenditure responsibilities discussed above could lead to cutbacks inexpenditures at the provincial and municipal levels after the take over of thedevolved national functions. The cities which are estimated to receiveadditional discretionary revenues may reduce their local tax collection efforts.Even if there is a willingness to increase local revenues, the cities continue

- 121 -

to constrained in the actions they can take on the real property and businesstaxes by the provisions in the revised LGC. Finally, the local governments,espeAally the barangays, may lack the managerial, administrative, and technicalcapacity to effectively absorb the devolved functions or carry out additionalprograms and expenditures. Service delivery and investment could deterioratefollowing decentralization.

5.57 Programs with less visible impact or those than benefit the poorcould be cutback when expenditure cuts are made. For example, the localexecutive may opt to give priority to hospitals and reduce funding for preventivecare. Alternatively, concreting of roads in middle income residential areascould be given priority over improving access (footpaths), drainage andsanitation in the slum areas.

5.58 Third, the decentralization program may worsen disparities betweenurban and rural areas, and between Metro Manila, the single largest urban areain the Philippines, and the rest of the country. The cities as whole areprojected to receiving more IRA allocations than devolved expenditures so theywould be receive more discretional funds following the full implementation of therevised LGC. At the same time, thej would also be the least affected by thelimitations on local taxation. The cities, with their larger financial bases,would benefit most from elimination of the contributions to the IntegratedNational Police, greater freedom in borrowing loan funds, and debt relief. Theywould also benefit from the increased business tax rates and could offset thedecrease in real property tax revenues through higher assessments to reflectgrowth in real property values. The local governments in the poorer regions, onthe other hand, may lack the growth both in economic activity and property valuesthat would allow them to increase revenues. The changes in the formula fordistributing the IRA is not expected to result in the local governments in thepoorer areas obtaining more funds relative to those in the richer areas. To theextent that fiscal disparities are translated into better infrastructure andservices in the richcr: local governments which in turn results in moreconcentration of investment and economic growth in these areas, decentralizationcould worsen regional disparities in the Philippines.

5.59 While these are shortcomings with the Government's program, it shouldnot be taken as a repudiation of decentralization. Local governments areexpected to play larger roles in the provision of basic services and in thecountry's development process. The opportunities and risks associated withdecentralization and possible steps to strengthen the Government's approach arediscussed in the next Chapter.

VI. DECENTRALIZATION: O9PORTUNITIES AND RISKS

6.1 The Government has embarked upon a process of decentralization whichpresents opportunities to expand local community participation in the developmentprocess, improve the delivery of basic services, infrastructure and facilitiesat the local level, and increase local resource mobilization. At the same time,there is a danger that decentralization will have the opposite effect, resultingin a deterioration of services and an increase in the public sector deficit.This chapter will summarize the opportunities and risks presented bydecentralization and recommend a number of steps the Government could considerto maximize the potential benefits and reduce the possible risks from itsprogram.

A. Possible Benefits of Decentralization

6.2 The importance of local governments, especially the cities, isexpected to grow with urbanization. Between 1980-90, the urban population in thePhilippines grew at 5.1% per annum or over twice the overall population growthrate, 2.4% per annum. Population growth will put pressure on the government toincrease education, health care, water supply, sanitation, drainage, and otheressential services and facilities. Urbanization would make government's rolemore critical. In the cities with higher population densities, people cannoteasily sink a well to get water or dump household waste and garbage in open areasor the waterways. Water would have to be piped in, sewage drained and eventuallytreated, and garbage collected and properly disposed of. Higher per capitaexpenditures in the cities bear this out (para. 2.18). At present, the provisionof these services in the urban areas has not kept pace with the increase indemand, resulting in a deterioration in living conditions. Given the magnitudeand localized nature of the needs, the dispersal of demand nationwide, and thelimited resources available to the central government, the communities and thelocal governments would need to be more closely involved in improving thedelivery of infrastructure, facilities and services. At present, the share oflocal governments in the economy in the Philippines is lower than that ofcountries at a similar level of development (para. 2.26).

6.3 The main benefit from decentralization is improvement in theeffectiveness in use of funds and service provision at the local level. Throughtheir elected governors, mayors and local councils, the people can vote on thepackage of services and investments for which they would be willing to pay intaxes, fees and charges, and would hold local officials accountable for theprovision of these services and investments. Local governments will thus be ina better position to mobilize resources locally and determine expendituresaccording to local priorities.

6.4 Decentralization provides an opportunity to carry out institutionalreforms in both local and central governments. The call for decentralizationreflects general dissatisfaction with the performance of the central governmentin meeting local needs. Momentum has built up to alter the status quo, creatingan atmosphere for change. The transfer of specific central government functions,resources, staff and facilities to the local government also presents an occasionfor the central government to review its own operations and make necessary

- 123 -

changes to remedy some of the existing problems with the devolved activities andto improve its own effectiveness, e.g. through greater community involvement inbarangay road construction and maintenance.

B. Potential Risks in the Government's Decentralization Program

6.5 The report identified inconsistencies in the Government'sdecentralization program, when taken as a whole, which pose the danger that itwould not achieve its objective of increasing local autonomy and improvingservice delivery at the local level.

6.6 First, there is the risk that the central government cannot affordthe increase in revenue sharing. The simulation of the impact ondecentralization on the 1990 central government budget indicated that the revenueloses would be offset by savings from devolved national expenditures andelimination of assistance to local governments (other than the IRA) when thelevel of the IRA is set at 35% of the internal revenues of the third precedingyear. When the local governments' share is eventually increased to 40%, thereis projected to be a net increase in transfers to the local governments whichwould put additional pressures on the central government budget which is alreadyconstrained by debt service payments, personnel expenditures, and increasingdemands for large infrastructure investments.

6.7 The central government budget situation could worsen if the projectedsavings do not materialize. The estimates of savings from devolution aregradually being reduced as different Departments make a case why certainexpenditures should be retained. The revised LGC includes a provision allowingthe central government or a higher level of local government to take over adevolved function if service delivery at the local level deteriorates. Shouldthe central government exercise this option, this would result in additionalexpenditures at the national level and duplication of effort between the centraland local governments.

6.8 A second risk is that the local governments cannot absorb theadditional responsibilities devolved to them, resulting in a deterioration ofservice delivery and investment. First, the imbalance between devolved revenuesand expenditure responsibilities at the provincial and municipal levels couldresult in a reduction of services as the provinces and municipalities are forcedto cut back expenditures. Second, decentralization is expected to result inclose to a doubling of expenditures for the local governments as a whole whichcould strain their managerial, technical and administrative capacity. Thoselocal governments with limited resources, i.e. the provinces and municipalitiesin the less developed areas, would be least equipped to handle additionalexpenditure responsibilities.

6.9 A third risk is that decentralization could result in reduced localresource mobilization. The revised LGC weakened the real property tax byreducing the assessment levels and lowering the effective tax rate. Those localgovernments in the less developed areas with slower growth in property valueswould be most affected. In the cities, the natural growth in real propertyvalues and businesses could provide opportunities to increase local revenues

- 124 -

despite the limitation of the revised LGC. However, the cities are projected toreceive a net increase in funds from the central government through the IRA.This could act as a disincentive to resource mobilization.

6.10 A fourth risk is that the revised LGC does not provide localexecutives and councils with sufficient discretion over local administration.The main benefit from decentralization is more effective use of funds and serviceprovision at the local level. Through their elected governors, mayors and localcouncils, the people can vote on the package of services and investments forwhich they would be willing to pay in taxes, fees and charges, and would holdlocal officials accountable for the provision of these services and investments.However, the local governments still face limitations on their ability todetermine their revenue mixes: i.e. the provinces are still limited to raisingonly those revenues specified in the revised LGC and the real property andbusiness taxes still remain highly regulated. In addition, the revised LGC stillcontains expenditure mandates and limitations: e.g. mandatory expenditurerequirements for development projects and limitation on personnel expenditures'.

6.11 The program in its present form could lead to a deterioration ofservices, reduced local resource mobilization, and increased disparities betweenurban and rural areas and between richer and poorer regions. The local officialswould still feel that they are not given sufficient autonomy and would continueto blame the central government for failures to deliver services at the locallevel. At the same time, the central government may be hard pressed to increasethe local government's share in national revenues to the 40% required by therevised LGC. Unless these risks are addressed, decentralization could prove tobe an expensive experiment if the central government is forced to take overagain, at a later date, many of the functions that had been devolved to the localgovernments.

C. Further Actions that the Government Can Consider

6.12 The central and local governments can take actions to minimize therisks from decentralization and maximize the benefits. At the national level,the Government has no choice but to address the issues with the currentdecentralization program and consider modifying the LGC to: (a) maintain revenuesharing through the IRA at levels which would be achievable under the centralgovernment budget constraints; (b) reduce the fiscal imbalances at theprovincial, city, municipal and barangay levels; (c) provide more flexibility todetermine real property and business tax rates; and (d) eliminate mandates andlimitations on expenditures.

6.13 When modifying its decentralization program, the Government could

1 The effectiveness and practicality of these expenditure requirements arequestionable. For example, markets and other economic enterprises have beenexempted from the ceiling on personnel expenditures with the result that anexcessive number of staff are shown as working for these enterprises. Thisdistorts the true operating costs making it difficult to develop proper pricingfor the enterprises' outputs.

- 125 -

adopt a two-tiered approach differentiating between local governments withgreater financial and administrative capacity and those without. The cities ingeneral and the provinces and municipalities in the developing areas such asCentral Luzon have a stronger economic base and potential for increasing localtax revenues. They could benefit from greater taxing powers, fewer controls onexpenditures, and less central government support. They could be provided lessby way of grants but encouraged to utilize loan funds at market rates for someof their capital investments. On the other hand, the financially weaker localgovernments, the remaining provinces and municipalities, would continue to relyon central government grants and assistance. The central government may considerselective reintroduction of matching grants to encourage local governmentexpenditures in those areas, such as poverty alleviation, that it considerspriority areas.

6.14 The Government should take a comprehensive approach, examining theimpact of the proposed changes simultaneously, and avoid taking ad hoc measuresto problems as they become apparent. One of the issues with the Philippinesdecentralization program was that various parts were prepared separately withouta full overview of the potential impacts. This is continuing in the programimplementation phase with the Government develops responses to problems as theyarise. For example, the Government is proposing in its CY1993 budget todistribute only 86% of the IRA (corresponding to a 30% share in internalrevenues) based on the formula and allocate the remaining 14% (corresponding toa 5% share of the internal revenues) based on budgetary shortfalls at the locallevel according to such rules and regulations that DBM woull issue for thispurpose. Ad hoc changes to revenue sharing will create ' -ertainty, makeplanning and budgeting at the local level more difficult.

6.15 This report attempted a comprehensive review but focussed onprovinces, cities, and municipalities as a whole due to limitations in readilyavailable information. Further analysis would need to be carried out on theimpact of decentralization on the different local governments, especially on thefinancially poorer ones which may not be in a position to absorb additionalfunctions or central government staff.

6.16 In addition to modifications to the revised LGC, the Governmentshould consider developing a detailed transition plan to: (a) phase devolutionof expenditures in line with perceived local capacity, i.e. beginning with largerlocal governments with better administrative capacity and financial base; (b)identifying priority areas for central government support for local governments;and (c) restructuring of the central government to eliminate redundancies andestablishing support functions. At present, the central government agencies arestruggling to meet the tight deadlines established usider the revised LGC indevolving its functions to the local governments. Most of the focus to dateappears to have been on identifying staff and assets to be shifted from thecentral government to the provinces, cities and municipalities, and reachingagreement with the governors and mayors to accept the transfers. However, thereis also a need to identify activities which have become redundant followingdecentralization and others which need to be strengthened. The revised LGC hasremoved many of the regulatory functions of the central government, such as thereview of local tax ordinances and schedule of values within the DOF. At thesame time, the central government would need to expand or add new functions to

- 126 -

oversee local government operations, e.g. to monitor local government financialperformance within DOF, and provide support to local governments in their newlyacquired responsibilities, e.g. to conduct agricultural research for agriculturalextension services.

6.17 At the local level, there are several areas where the localexecutives could consider taking action to increase the amount of financialresources available to them and to improve local technical and administrativecapabilities. Even within the existing legislation which places restrictions onthe local government's ability to adjust tax rates, there is scope for improvinglocal resource mobilization through the following:

(a) ImRrove Collection of Existing Taxes Not all real property andbusiness taxes due are actually being collected. One cause of poorcollection performance is administrative inefficiencies. Themaintenance of tax records, the preparation of tax bills, therecording of tax payments are generally done manually. Poor recordsmanagement is considered to be one of the major causes of poorcollection efficiencies in real property taxes. In the case ofbusiness taxes, the lack of local capacity to assess the grossannual receipts of business is leading to under declaration by taxpayers. The present system does not make it convenient for the taxpayers. Another impediment is the lack of political will to pursuedelinquent taxpayers. The issue is not increasing the tax burden ofindividual taxpayers but assuring fairness so that those who pay arenot penalized relative to those who do not.

(b) Increasing Direct Cost Recovery Limited expenditures and theresulting poor levels of infrastructure, facilities and serviceshave made it difficult for local politicians to raise tax levels.This has resulted in a vicious circle of poor services, lack ofadditional funds, further deterioration in services. It may benecessary to move towards greater use of user fees to link paymentto local government with the provision of services: e.g. garbagecollection fees for residential users as well as businesses. In thecase of roads, drainage and other infrastructure improvements, therevisei LGC contains provision for a special levy on the realproperty tax for lands which have benefitted from public works orimprovements funded by the local government. The special levy islimited to 60% of the actual project cost and will be recovered fromthe beneficiaries over 5 to 10 years. Different rates can be fixedbased on an assessment of the level of benefits derived. The localcouncil will need to pass an ordinance to impose the special leveland the ordinance will be subject to public hearing. The provisionfor a special levy was included in the previous Real Property TaxCode but not used due to the administrative difficulties in actuallyimplementing such a levy.

Central government would need to provide support to the local executives: e.g.DOF would need to develop guidelines on the use of special levies or conduct anationwide campaign to pursue delinquent tax payers (in addition to the taxmapping and real property administration program being carried out in specific

- 127 -

local governments).

6.18 To develop local institutional capacity, both the personnel and thetechnical and administrative tools would need to be strengthened. The followingare some of the measures that could be considered:

(a) Training Key Local Staff Programs could be developed to enhance thetechnical capabilities of the local government staff in those areaswhere they will taking on additional functions. For example, themembers of the Local Finance Committee could benefit from formaltraining in fiscal planning or the engineering staff in contractmanagement.

(b) Improving Local Planning Procedures Many local governments lackbasic information needed to identify key deficiencies and prioritizetheir investment. Investment plans may just consist of a list ofprojects submitted by various parties to be implemented as funds aremade available. Local planning procedures would need to beimproved, starting with the development of basic information such asan inventory of the infrastructure and facilities and an assessmentof extent of their deterioration under their jurisdiction.Furthermore, more emphasis would need to be given to improvedplanning and implementation of maintenance.

(c) Automation Except in a few cities, most of the administrative work,such as records management, payroll, is still being done manually.The local government may have difficulty coping administrativelywith a doubling of their expenditures and increases in their workforce resulting from decentralization. Improvements in technologyhave made computer's affordable to local governments. Localgovernments could improve the efficiency of routine administrationwith greater use of computers.

Since local governments are different, the provincial governors and the city andmunicipal mayors would need to take the lead in identifying the training needsand developing a capacity enhancement programs for the respective provinces,cities and municipalities.

128

A X N N I T A B L_E

PHILIPPINESFISCAL DECENTRALIZATION STUDY

AMNEX TAIL! 1: Consotidated Income and Expenditure for Loca Govorruents(In Peso Mitlions)

1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990

A. REVEIESBufnoesn Taxes 744 780 839 953 1,032 1,204 1,266 1,290 1,474 1,800 2,084Real Property Taxes 821 1,068 1,125 1,540 1.875 1,951 2,258 2,375 2,670 3,678 4,307

......... ..... ............ ..... ............... ......... ...... ......... ...... ......... ...... ......... ...... ......... ......

1,565 1,848 1,964 2,493 2,907 3,155 3,524 3,665 4,144 5,478 6,391

Econceic Enterprises 274 433 507 564 632 691 788 822 911 1,276 1,310Fees, Charges & others 939 1,17 1,187 1,188 1,363 1,527 1,394 1,580 1,662 2,738 2,013

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

1,213 1,606 1,694 1,752 1,995 2,218 2,182 2,402 2,573 4.014 3,323

Subtotal: Local Sources 2,778 3,454 3,658 4,245 4,902 5,373 5,706 6,067 6,717 9,492 9.714.uu.m Q 33Uu333 masuaNa uss==" _m m . mu.. _ u_u_ a.....s. inguuuu

SIR & Specific Allotments 1,238 1,650 2,203 2,519 2,676 3,205 3.299 3,142 3,974 4,343 4,877Nationat Aids 295 328 354 365 406 530 41 452 514 626 740

Subtotal: Govt Transfers 1,533 1,978 2,557 2,884 3,082 3,735 3,740 3,594 4,488 4,969 5,617

TOTAL REVENIES 4,311 5,432 6,215 7,129 7,984 9,108 9,46 9,661 11,205 14,461 15,331- - _u. mm mu mu mm m u

S. EXPENDITURESGeneral Goverri_nt 916 1,315 1,460 1,545 1.780 2,041 2,327 2,659 2 902 3,839 4,291P hltc Welfore & Safety 718 859 1,014 1,238 1,449 1,753 1,930 2,080 2.296 2,410 2.726Econmic DveIo ent 982 829 1,025 1,241 1,374 1.673 1,676 1,695 2,016 2,027 2,707Others 1,033 1,416 1,632 1,660 1,902 2,013 2,085 2,101 2,303 3,453 3,504

...... ...... .. ...... ...... ... ...... ...... ... ...... ...... ... ...... ...... ... ...... ......... ..... ............ ..... ............

Sbtotal: Recurrent 3,649 4,419 5,131 5,684 6,505 7,480 8,018 8,535 9,517 11,729 13.228

Capital Expenditures 532 659 697 829 891 868 608 587 733 m 875

TOTAL EXPEIDITIUIS 4,181 5,078 5,828 6,513 7,396 8,348 8,626 9,122 10,250 12,504 14.103- - - mm. _ma _mm _mm - im_mum _mm -

C. SURPLUS (DEFICIT) 130 354 387 616 5se 760 820 539 955 1.957 1,228

AS A SN_ OF GDP:Local Rve 0.5% 0.5X 0.5X 0.5O 0.4 0.4 0.3X 0.31 0.31 0.4" 0.31TotaL Revn 1.6X 1.8 1.8 1.91 1.52 1.5X 1.51 1.42 1.4 1.51 1.41Total Expenditure 1.6" 1.71 1.71 1.71 1.4X 1.41 1.41 1.33 1.23 1.31 1.2XLOCAL EXP.TOTAL GOVT. EXP. 9.9X 9.6X 10.01 10.9X 10.03 9.41 7.2X 7.1S 7.03 6.83 6.11

Source: Depwatent of Finance (BLGF)

PUILSPIMEFISL 0UIUIATIU SIW

alET AKE 2s Ca..Udt IsEs ad r_nditwre for Loat Owenwuuts In ba Torn(in _es of Ut.., Cantv 10 PrIfes)

tun "Il "a2 I1W i iS 1t6 18m7 t" low "go

A. fl IEbAlmAs Tom 2.676 2.3 2.50 2 549 1. 64 1.216 I.M 1m 7 1.02 20516 2* a"Reat PropemCy Toms 2.952 3.61 3,362 4,119 3.350 2.943 3.375 3,M6 3.372 4.20 4.307.... ..... ...... ...... ...... ...... ...... ...... ...... ...... ...... ---

5,618 5,968 5,89 6,"6 5,194 4,O0 5.265 5,03 5,234 6,25S 6,391EcmmIc EnterprIses 905 1,405 1,515 1.506 1,129 1,042 1,17 1,136 1.151 1.456 1,310UsS, oiW Oa oters 3,m3 3.801 3.547 3,177 2,435 2,30K 2.064 2.1ST 2,069 3,12 2,013

4. S62 5.204 5.042 4.65 3.545 3.346 3.262 34325 3. ,S485 ,333Sbttel: Locad Soures 9,990 11,192 10,932 11,354 6,759 3.106 6,530 6,398 5.44 10,863 9,714- ----- _ _- - --

IR & SpecificA Atatmts 4 452 5.347 6,5J3 6,77 4,7M1 4.65 4,931 4,349 5,019 4.961 4,87ationmt Aid 1,061 1.065 1,056 976 725 OO 659 626 649 715 740Subtotat: Gowt Tranfrs 5,513 6,409 r,61 7,714 5,507 5,635 5,591 4.M97 S.6" 5.676 5,617

TOTAL RENES 15,503 17,601 1,6573 19,067 14.266 13.741 14.120 13.373 14,152 16.519 1S,331B. E ITU

Ceni IOwernnt 3,294 4.261 4,33 4,132 3,180 3,079 3,478 3.61 3,665 4 385 4,291tic Welfae & Safety 2,Stt 2,3 3030 3,311 2,569 2,645 2.US 2.679 2,900 27M 2,76Econmic DO lqpet 3.531 2,6J6 3 063 3.319 2 45S 2,524 2,505 2.346 2.546 2,316 2,70Others 3,715 4.588 4.67 4.4O 3.396 3.037 3,117 2,900 2,909 3.945 3.504Sitotal: Reurrent 13,122 14319 15, 15i20 11,623 11,285 11,96 11,814 12,020 13,39 13,228Capitat E htur 1,913 2,135 2,083 2.217 1,592 1.310 909 813 926 S7S 5nTOTAL EXPENDITURES 15,035 16,454 17,416 17,420 13,215 12.594 12,898 12,627 12,9i6 14,284 14,103

mm mm mm mm nmmum m su m m mm mm mmC. SURPLUS tDEFICIT) 467 1,147 1,S7 1,648 1,051 1,147 1,226 46 1,206 2,236 1,226PER CAPITA:Local RbVWY es 208 22? 217 220 166 150 154 146 146 183 1606oVt Tranmfers 115 130 152 150 104 104 101 as 96 96 93Total Renucs 322 3SS 369 370 270 2Y, 255 236 244 279 253Recurrent ExpendIture 273 m 304 295 220 209 217 209 207 226 218Copit t Expendfture 40 43 41 43 30 24 16 14 16 1S 14Total Expend1tures 313 334 346 336 250 233 233 223 223 241 232

Source: Amex Table I

PNILIPPI9SFISCAL DECENITALIZATIO STUDY

ANN TABLE 3: Sunsry of bvws Sharinegrnts(In Po Billion)

1900 1961 192 1 1963 1964 15 1966 16 16 19 990

Wit Colltectons (Third Preeafin Yer)Ibt of Specall Fud/Accounts 9.S02 12.363 1S.73 17.190 1S.940 19.633 21.732 25.312 31.649 46.2S1 5r.765

Intwerl Rtevus AllotmtApprpiations 0.3 1.566 2.233 3.202 3.155 3.343 3.916 2.477 3.175 4.23 6.017Rttees 0.659 0.86S 1.052 1.319 1.457 1.730 2.194 2.343 3.174 4.215 5.647Batance 0.074 0.721 1.181 1.883 1.06 1.613 1.724 0.134 0.001 0.017 0.370

pcific Tax AlloteantAppropri atii 0.767 1.13 1.845 1.266 1.373 s.57s 2.4SS 0.054 0.048 0.061 0.078Rele1ses 0.767 0.81 1.24S 1.215 1.373 1.657 1.187 0.054 0.048 0.061 0.078Baluw 0.000 0.632 0.600 0.001 0.000 0.100 1.266 0.000 0.000 0.000 0.000

IL1SF--llpropriation - 1.3 1.440 1. 1.406Re a - - * - - * - 1.411 144A 1.06 1.408la t * * -* - - 0.122 0.oao 0.001 0.000

Totat-ts tion 1.S00 3.099 4.078 4.488 4.526 5.100 6.373 4.064 4.663 s.no T.50 3

1.426 1.76 2.297 2.604 2.830 3.387 3.361 3.800 4.662 S.702 7.133Balm 0.074 1.353 1.781 1.664 1.696 1.713 2.992 0.256 0.001 0.018 0.370bletse In RetL Tas: corutant 1990 priesIb 2.370 2.3 3.14 3.S2B 2.603 2.610 3.290 3.243 4.009 4.61S 5.647sA & LhhWF 2.718 2.855 3.721 3.437 2.453 2.500 1.774 2.028 1.679 1.699 1.46Total 5.12S S.658 6.864 6.96S S.057 5.110 5.054 5.271 S.S88 6.S14 7.133

Per c tin Relt Tom: peos nIcontent 1990 prieIRA 49 ST 62 66 49 48 59 s7 69 61 95STA & LF ST S6 74 67 6 32 36 32 29 24Total 107 11S 136 135 96 9f 91 93 102 110 11U

NIrt GOP Growth Rate 1S.3 11.6X 12.86 40.78 13.46 2.4 13.0X 16.6X 16.8K 17.1XTotal Appriation Growh Rate - 106.6S 31.66 10.1X 0.93 12.6 25.0S -36.2X 14.73 22.73 31.23Total Rla Growth Rate 22.43 31.6X 13.43 6.73 19.73 -0.23 12.6X 22.43 22.33 25.13OP Elasttcity of Appropriations - 6.9S 2.73 0.79 0.02 0.95 10.59 -2.80 0.89 1.3S 1.82GP Etlsticity of Releas - 1.46 2.73 1.05 0.21 1.47 -0.08 0.97 1.35 1.33 1.46

Satre: D0peutMmt of Finane (BTR)

PHILIPPINESFISCAL DECENTRALIZATION STWY

ANNEX TABLE 4: Central Governeent Revenues *nd Expenditures - Cash Basis(in Peso Biltions)

1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990

REVEEUESTax Revenues 30.533 31.423 33.800 39.848 50.118 61.253 65.491 85.923 90.352 122.462 1bi.700Xontax Revenues 4.198 4.510 4.406 5.784 6.743 7.708 13.754 17.291 22.509 29.948 29.200

34.731 35.933 38.206 45.632 56.861 68.961 79.245 103.214 112.861 152.410 180.900EXPENDITURESCurrent Expenditures

Personnel 9.331 10.631 10.647 13.877 16.854 22.896 24.991 32.527 40.795 51.366 62.200Oam 10.739 11.263 13.183 11.942 12.405 13.196 15.024 18.882 19.546 26.808 30.200Interest Payments 2.296 2.429 3.560 4.996 10.409 14.652 21.612 36.905 45.865 54.714 71.110Others 2.150 2.067 4.356 3.707 3.205 4.531 5.294 7.189 5.961 9.898 14.590

24.516 26.390 31.746 34.522 42.873 55.275 66.921 95.503 112.167 142.786 178.100Capital Expenditure 12.927 20.760 18.646 16.148 19.630 23.149 28.428 17.327 18.4U5 25.526 40.000Met Lending 0.675 0.929 2.218 2.393 4.423 1.678 15.148 7.077 5.415 3.666 -1.650Total Expenditures 38.118 48.079 52.610 53.063 66.926 80.102 110.497 119.907 136.067 171.978 216.450

SURPLUS/DEFICIT -3.387 -12.146 -14.404 -7.431 -10.065 -11.141 -31.252 -16.693 -23.206 -19.568 -35.550FINAMCING 3.387 12.146 14.404 7.431 10.065 11.141 31.252 16.693 23.206 19.568 37.200

Source: World Bank

PHILIPPINESFISCAL DECENTRALIZATION STLIDY

ANNEX TABLE 5: Local Government Debt Outstanding as of Dec. 31, 1988(In Peso Millions)

Govt. Fin. Inst. Loans Obligations to Govt. Owned & Cont. Corps. Public Utilities

Unremitted Program Land MWSS MWSS TotalNational Loans Bank DBP GSIS trade nontrade NHA NPC NEA MERALCO PLDT LWUA Co-ops

NCR 980.4 - 0.0 1.7 39.9 83.2 2.9 22.5 4.9 0.0 91.5 10.8 0.0 0.0 1,237.9Region 1 28.4 - 9.9 16.8 7.5 0.0 0.0 0.0 0.2 0.0 0.0 0.0 0.2 12.2 75.0Region 11 4.6 - 49.7 0.0 0.0 0.0 0.0 (0.0 0.0 0.0 0.0 0.0 0.2 4.0 58.6Region III 19.4 - 49.3 6.6 0.1 0.0 0.1 0.0 89.8 0.0 9.6 0.0 0.2 49.8 225.0Region IV 8.8 - 31.1 26.7 4.7 0.0 0.3 0.0 139.9 0.0 5.1 0.0 0.8 22.2 239.5Region V 3.8 - 6.0 6.6 2.6 0.0 0.6 10.0 0.0 0.0 0.0 0.0 0.5 4.9 35.0Region VI 29.7 . 2.5 16.5 0.4 0.0 0.0 0.0 0.6 0.0 0.0 0.0 0.5 8.7 59.0Region VII 24.0 7.6 2.6 0.0 0.0 0.0 8.7 0.3 0.0 0.0 0.0 0.5 2.0 45.9Region Vill 13.0 - 20.3 2.1 0.2 0.0 3.4 1.9 0.1 0.0 0.0 0.0 0.2 1.1 42.2Region IX 15.4 - 0.0 0.6 0.0 0.0 0.2 5.9 0.0 0.0 0.0 0.0 0.0 1.1 23.2Region X 14.2 - 0.0 23.6 0.0 0.0 0.1 10.7 0.0 0.0 0.0 0.0 0.4 11.0 60.1Region XI 10.8 0.0 11.5 0.0 0.0 0.1 47.1 0.0 0.0 0.0 0.0 0.1 0.0 69.5Region XII 12.3 - 0.2 11.2 0.0 0.0 0.0 6.9 0.0 0.0 0.0 0.0 0.2 1.4 32.1

Total 1,164.6 31.8 176.6 126.6 55.4 83.2 7.9 113.7 235.6 0.0 106.2 10.8 3.8 118.5 2,234.9

1. Unremitted National Collections and Contributions to INP, DECS, DAF/BAI, DPWH, BIR, CID, UP Law Center and Others.2. Program Loans include:

(a) Assessment Loan Advance Fund (RA 78)(b) TLRC Pagkain ng Sayan Loans(c) KKK Loans to LGUs/Borrowers

3. Loans to GFIs contracted prior to Dec. 31, 1987 (prior to Local elections).4. MWSS Non-trade as of June 30, 1986, NPC and NEA as of Sep. 30, 1988.5. Obligations by Olongpapo City for P 81.632 million and by Batangas City for P 13G.999 million.6. MERALCO obligations as of Dec. 31, 1987 still outstanding as of Dec. 31, 1988.

Source: Department of Finance (BLGF)

CLAS2FICA11ON OF PROViNCESBYGEOGRHAPICAL REGIONS F-ISC/L DECI=W'ilTTAI 'Y ¶71

I ILOCOS Vi WESTERN ViSAYAS70' 1 Ifo,ooNonin 38 Akian )O

2 `oos Sur 39 Copirz PRC.VINC-F C^PITAL' * L. Union 40 Anfiqu. nArTAK,1 f

* Pone,inon 41 11°ilo o ISATIC)r'IAL CAPITAL

CORDILLERA ADMINISTRATVE 42 Naog OcOedontolREGION (CAR) 4 Go,mor.s _ rviNCr flOUJI'rJlAQIEq

S Abra \nl CENTRoAL ViSAYA5

6 Kolimgo-Apoyao 44 Cbu c RtCIrcKAl Br)Ut'4r.>APlES!7 Mounbin Provinco 45 Nagro- Orionfola lFugno 4 6 Bohoi c9 Benguet 47 Siqoijor ..rnnt 1 --- I`4TFRNrATICtAL i3CUNrDAIrFS

If CAGAYAN VALLEY VIll EASTERN ViSAYAS fI0 Boaon,, 4a North.,. Soor 61 1 C.ogyan 49 Wonton, See-n 'I...

12 "l'ko0tSeo,0 ( A,

13 N-eva Vzroyo 51 L4 v, L1l IIVItAI rI P" 10 V W(

a A Quirino 52 Sooth.no L.yit V.'..

III r)4TALUZON 53 113 4o1,5 Nwoa Ecija iX WESTERNMiNDANAO p r Ir ,j oo '.0 'JO

1 hTarioc S4 ZonmBongo del Nore I or.'

17 Zonblobr,n S5 Zomboonog dol Sn, 5 ncr,r,d

18 'ampan90 56 B,dn . ,

19 Bulocen S7 Sulu , 1

16. 20 Betaae 58 TbAnev 16 NATONAL CAPITAL X NORTHERN MINDANAO IIt,n.ylnoo..

REGION (NMR A .i. dlWdIV SOUI-ERN TAGALHOG 59 SoriododlNone

21 Aurera 61 AgonondelNorle 1u z22 Q`*zonn 62 M,~.om.'Onronll ;~.,1 'L U 7 C) N23 Rizo 63 M4-4mi Occxd..nhl \

24 Covile 4,64 Bolidnon -",, ,,rn,r 01

251L9gn00 65 Agosonqo- u d.l So, ' 4 " 5 PHItLIPPINE SEA26 Botongo. Xi S'UTHERN MINDANAO C)iI,27 Molrendur;u 6,S S-i;SCK del S.,1 1 t

28 Mndorr Ornobtal 67 D-oOrS.'Il ' 5V

29 Mindoro Oecidental 68 Doovoorento " 2d Nod

30 Romobion 69 Goodcl Nur d . 2S 7 . *r31 Pol`ron 70 Soull,hC.Ib.f.oloboto)

V b lCOL Xll CEIJTRAN MIN6k6dAO / Son \ r' , "_

32 Comanneo ,'7 LonooNdet Nod, -.< ('3\33 Cooonne Sr 72 Lonao del Surr~,Io,zS """

34 C-ntndoones 73 Nrih Colobolo rt. n. ;

3 5 Ajbny 74 MagqundonooI 2

36 MsObaro 75 Sulfna Kudorl MjiAINI)OI'1Y1

."7.37 Mace. .. i>

SOUTh CHII'.IA VI 51~~~~~~~~~~~~~~~~~~~~~~~ Vl

I- ~ ~ ~ ~ ~ VSC-JCTI I CHItNA S'/.a> r , W V

VALAVVAw //J -p

Th onmp hos boo- p.opo-od by A' V I Ts A r -1To' ,Id6oenlno' vffI momodor

Tho vdianis dlolt roclockvly P'-///lj,J A }SCirorn The &'nnonnel5nol mod s 2 / 2 I1 4 ,,'od in o tors h'o r .... o . .lAIn

belemnol on ol Thy- Worhd Bec,Goup Th. d-nolna,7-f- uscd /3 ,

thinen -do,nl er-ln on I-.d ion boucdo.ec slnooc ' I prn j f"'

* '!h'

por/ of T.W ./odd Banf G-op i_wy jadtoonnt on the Io ( SLJIL" Io"h slolon of Pcy o-.oy 01 any r!.ndarsoon'cel or ocooplonoeeol f 1;*Y|h~^j5och brond-'e/h

TI~~~~~~~~~~~~~~~~~~~~~6

t /,-; bt r ........ , /. . ,i

JU PIIP.JPPINES

It ('liIA "4'.,h _ f

Eln -J,NI'C'/%

g>1l[ 1e:1o e aj/

MALYS'A 4 e,,t

IdA\v7 h N An'/+ ' 1

. . i"'

I/ C Ett,s i)/&.1T