MANILA, October 21, 2004 (STAR) By Eduardo H. Yap - The looming fiscal crisis and the risk of contamination to the private sector economy have sparked a debate on its causes and a frantic search for solutions. Conventional wisdom, reinforced by the Department of Finance’s report of a massive decline in the "tax effort" rate in recent years, attributes the severe downturn in government tax revenue after 1997 to the usual suspects, i.e. tax evasion and poor "collection efficiency".

The DOF’s tax effort rate is a measure of the country’s tax revenue generated from the economy. It is derived as a percentage of tax revenue to the tax base, i.e. the country’s entire gross domestic product (GDP) regardless of whether the same is contributed by taxable or tax-exempt sectors of the economy. As reported by the DOF, the rate dropped to a record low 12.5 percent of GDP in 2003 compared to the high 17 percent attained in 1997. Meaning, only P0.125 was collected in taxes for every P1 of goods and services produced in 2003 while it was P0.17 in 1997. This effort rate is interchangeably used as a measure of tax collection efficiency.

Major factors

The decline in the tax effort rate by 5.5 percentage points of GDP was of such a great magnitude that tax evasion and low collection efficiency alone can not account for it. Official data from DOF indicate the decline in tax revenue and effort rate started after 1997. It never recovered even after the effects of the 1997 Asian financial crisis were shaken off and the economy posted subsequent year-on-year growth. In effect, the country had been experiencing growth without a corresponding increase in tax revenue, i.e. a tax-less growth.

Globalization and a transformed economy

Analysis of the data indicates the following policy-driven factors, which resulted from initiatives in the mid-90s, accounted for a significant proportion of the decline. To wit:

Massive displacement of Customs revenue after 1997, coinciding with the far-reaching reduction in import tariff rates instituted during the mid-90s to qualify for accession to the WTO. This was pursuant to the adoption of the trade globalization policy that replaced the long held protectionist and import substitution policy of earlier years;

Transformation of the economy, post 1997, into a less tax generating economy with the emergence of tax-exempt export-oriented industries such as the electronic components, apparel and electric wiring harness industries. These sectors are now the export drivers and major contributors to GDP while at the same time, by policy intent, not generating direct tax revenue. On the other hand, the traditional tax revenue generating sectors of the economy such as construction and public infrastructure, mining, housing and manufacturing, among others, underperformed in the new economy.

If the effects of these factors are considered, the tax effort rate will be significantly higher and may be comparable to its peers in the region. The performance of tax administrators will also appear much better than impression would permit.

Tax effort rate not measure of efficiency

The question arises whether DOF’s tax effort rate, as currently computed, is an accurate measure of government tax collection efficiency in the context of a now changed economy after the institution of the globalization policy. The method of computing this rate is a carryover from pre-globalization days and is still being used notwithstanding the significantly changed tax base, which now includes the very large production attributable to tax-exempt industries. Thereby the rate is distorted and flawed as a measure of collection efficiency. No direct tax revenue, by government policy, is expected to be generated from these sectors and their inclusion in the tax base, for the purpose of measuring efficiency, is meaningless. This was not the case, pre-globalization, when the economy was dominated by traditional non tax-exempt sectors. To compare the tax effort rate, say, in 2003 with that of 1997, as it is often done by many quarters, is not apples to apples comparison.

Tax-less growth phenomenon

The trend towards globalization after the mid-90s had seen the economy undergo a radical transformation. Three export-oriented tax-exempt industries sectors, electronic components, apparel and wiring harness manufacturing sector, constitute a full 75 percent of the country’s total exports. Imports of the electronics sector, alone, constitute 42 percent of total this year and 47 percent of the preceding period based on latest data gathered from the NSO. Arguably, these sectors represent a very significant portion of the economy. On the other hand, more traditional tax generating sectors of the economy have under-performed. In 2003, mining was only two percent of GDP, construction five percent, housing and real estate five percent. Manufacturing contributed 23 percent of which a large chunk came from electronics, apparel and wiring harness. As a consequence, the country had a tax-less growth phenomenon and the likelihood that taxes are being collected from a small proportion of the population and economy. (Chart #3 – A Changed Economy)

More accurate efficiency measure

To equalize the rate to those of pre-globalization years and to arrive at a more accurate measure of tax collection efficiency, the tax base (GDP) must exclude GDP attributable to companies that have been given tax incentives or operate under a tax holiday. Using this principle, the effort rate should instead be computed thus: Tax Revenue – [(GDP (-) Tax-exempt GDP)]. In addition, the massive displaced tax revenue resulting from import tariff rate reduction, which accelerated in 1998, must be factored-in. This foregone Customs revenue is estimated at 2.5 percent of GDP per annum. Conservatively estimated, this is equivalent to P560 billion for the period from 1997 to the 1st semester of 2004. If adjusted accordingly, the country’s post 1997 tax effort rate would be comparable to those of 1997 and preceding years. The revised tax effort rate would be significantly higher and likely comparable to its regional peers. It would also appear that the indictment against the revenue agencies may be unfair. (See chart #2 – "Tax Effort Higher")

Drastic tariff rate reduction

The government’s decision to liberalize trade was effected through a far-reaching and very substantial reduction in tariff rates, among other measures. Data from the Philippine Institute for Development Studies (PIDS) show that in 1995 the average nominal import tariff rate was 26.8 percent. By 2000 this was reduced to 19.5 percent. In 2001, the average tariff rate had fallen to just 7.7 percent. In 2002, the rate was down to six percent with many items, particularly plant machinery and raw materials, being imported duty-free. The consequent fall in customs revenue was similarly dramatic. (See chart #1 – "Drastic Reduction in Import Tariff Rates")

Massive decline in customs revenue

The tariff reduction was accompanied by a massive displacement in tax revenues. Prior to 1996, Customs revenue was a major contributor to government tax revenues. An analysis of DOF data show 32 percent of total tax revenue in 1995 came from import duties and taxes while 68 percent came from income and other taxes collected by the Bureau of Internal Revenue. That was when the average import tariff rate was a high 26.8 percent. After 1997, this tax contribution share changed greatly. In 1998, import value rose to P1.225 trillion or 71.5 percent higher than the P714 billion in 1995, but Customs collected only P76 billion. This was equivalent to a sharply lower 18.4-percent share of total government tax revenues. It was the lowest contribution ratio during the last 10 years. By 2002, import values rose 189 percent to P2.061 trillion, compared to P714 billion 1995 import levels but average tariff rates had since fallen to six percent. Consequently, Customs collected only P106 billion in duties and taxes for a revenue contribution rate of 20 percent, which was way below the 31.7- percent level reached in 1995. The slack was taken up by income and other taxes collected by the Bureau of Internal Revenue. In 1995 BIR contributed only 68.3 percent of total tax revenue. By 1998, BIR had a very high 81.6-percent share of total because of the depressed 18.4-percent Customs contribution.

P560 billion effect on revenue

Various methods used to calculate the effect of the tariff cuts on customs revenue show a significant annual average of over two percent of GDP. This was equivalent to P560 billion or an annual average of P62 billion for the period from 1997 to the first half of 2004. Another method shows a high P784 billion effect. To put P560 billion in perspective, P688 billion was the total fiscal deficit, inclusive of debt payments, from 1995 to 2000, and P617 billion was the total borrowings from foreign and domestic sources between 1995 to 1999. We must, however, not lose sight of the fact that without fiscal incentives and reductions in tariffs, the incremental imports and economic growth attributable to the tax-exempt sector during the period under review may not have materialized. This analysis is not intended to debate the merits of globalization but to show the significant impact of government policy on tax revenue and effort rate.

Effect on tax effort rate

If the cited factors were considered the tax effort picture would be completely different. There would have been no significant decline from those of pre-globalization years. Instead of 17-percent tax effort rate in 1997, it would be higher at 17.9 percent. Instead of only 12.5 percent in 2003, it would be a much higher 14.9 percent. (See chart #1 – "Tax Effort Higher")

It is quite apparent from official data that government’s decision to reduce tariff rates to qualify for accession to the World Trade Organization has had significantly negative repercussions on government revenues. The consequent restructuring of the economy, with export-oriented tax-exempt sectors playing a substantial role and the underperformance of traditional tax-generating sectors of the economy, produced economic expansion without generating sufficient compensating tax revenue. These were the major contributory factors to government’s large fiscal imbalance and the low tax effort rate. The recent initiative coming as it does from an unexpected quarter, the Speaker of the House, and appropriately adopted by the President, will revitalize the underperforming traditional sectors and addresses this tax-less growth phenomenon.

By Eduardo H. Yap, BSBA, CPA. This analysis is part of a study "Understanding the Fiscal Crisis" presented at the meeting of the Rotary Club of Makati, Oct. 2, 2004, Manila Peninsula Hotel. Previous study: The 1997 Asian Financial Crisis, presented on Nov. 4, 1998 at the forum on "Who’s afraid of capital controls?" hosted by The Human Development Network, Solita Collas-Monsod, president. Past president and chairman of the Subdivision and Housing Developers Association. Past chairman of the Council of Rotary Past Presidents, R.I. Dist. 3810, then inclusive of Manila, Makati, Pasay, southern Manila suburbs, Mindoro and Palawan.

Reported by: Sol Jose Vanzi

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