FIANNCING FEDERALISM: A LOOK AT THE NUMBERS

Milwida M. Guevara and Joyce P. Gracia
Public Finance Institute of the Philippines

Federalism is an exciting concept and very often considered a panacea for solving inequities and poverty in the Philippines. It is easy to be obsessed on possibilities if local governments were more independent of the central government. Federalism carries the benefit of decentralization to the max: greater efficiency because production of public goods and services is demand-driven, greater possibilities to make government officials accountable for their actions due to the proximity between the decision maker and his constituents, and, more opportunities for empowering communities through consultation and collaborative planning and implementation.

This study puts some realism into proposals to organize the Philippine government into a federal government with several states. Realism entails estimating the resources required to enable a state to carry out basic functions of governance and the financial capability of the different administrative regions in the country. Basic indicators such as estimates of Regional Gross Domestic Product, local revenues, and regional collection of taxes and duties are used. The study starts with indicators on how centralized is the current system of governance and looks at scenarios where “states” can finance the requirements of governance.

1. How Big is the Philippine Government?

The budget of the national government in 2008 was P1.23 trillion or 18.45 percent of our GDP in 2007.

The biggest slice of the budget, 24.0 percent, went to the Debt Service Fund. The second largest expenditure was allotments to local governments, the IRA, which accounted for 19.0 percent of the budget. The other major expenditures were those on education, 12.0 percent (Department of Education) and public works projects, i.e. 8.0 percent went to the Department of Public Works (Table 1)

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One-fifth or 19.77 percent of the expenditures of government’s departments was disbursed by the Central Offices and another 33.49 percent was also disbursed by the Central office for “nationwide purposes”. This puts more than one-half of the budget, or 53.26 percent at the disposal of the offices of the central government. The remaining 46.74 percent was budgeted for expenditures of national government agencies in the different regions: 6.0 percent went to the National Capital Region, 4.0 percent went to region 6 and 3, and the rest of the regions got an average of 1.7 percent. The lowest share of the budget went to Region 4, 0.03 percent (Table 2)

The distribution of the internal revenue allotment (IRA) was skewed towards LGUS from Luzon. Almost one-half (47.82 percent) of the IRA was given to LGUs from Luzon. Mindanao’s LGUs shared 25.20 percent while those from the Visayas got 20.25 percent. One question worthy of discussion is the 6.7 percent of the IRA that was disbursed by the central government for “nationwide” purposes.

In terms of proportion, the biggest IRA share went to LGUs from Region 4a, (9.12 percent) followed by LGUs from Region 3 (8.65 percent) and Region 6 (8.0 percent) and NCR with 7.3 percent. CAR received the lowest amount amounting 2.75 percent of the total. The share of other regions ranged from 3.8 percent (Region 9) to 6.57 percent (Region 7) (Table 2).

2. Disparity and Inequity

The generation of income from goods and services among regions is also disparate. Almost 40 percent of our national income, 37.29 percent is generated in the National Capital Region. The other major sources of Gross Domestic Product (GDP) are: CALABARZON (Region 4 a), 11.32 percent; Central Luzon (Region 3), 7.54 percent; Central Visayas (Region 7), 6.95 percent; and, Western Visayas (Region 6) 6.60 percent. The GDP share of other regions is less than 5.0 percent with ARMM contributing the smallest share, 0.84 percent. In terms of the major islands, 67.35 percent of GDP is generated from Luzon, i.e. P7.00 out of P10.00 income is earned in Luzon. About 16.0 percent is earned from the Visayas and 17.0 percent is generated from Mindanao (Table 2).

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Since 20.0 percent of the national budget is disbursed by the central government, and another 33.0 percent is disbursed by the central government for “nationwide” purposes, it cannot be said that the budget is allocated equitably among regions. But the distribution of GDP and the share of the different regions from the national budget can indicate who the winners and losers are.

Most of the regions are losers since they receive direct budgetary expenditures which are lower than their GDP share. For example, compared to the 37.29 percent of GDP that is sourced from NCR, its direct budgetary allocation is only 6.0 percent. The same is also true for CALABARZON with a budgetary allocation of 3.7 percent compared to its 11.32 percent GDP share. Only ARMM emerges as a winner comparing its 1.73 percent share from the budget to its 0.84 percent GDP share. The budgetary expenditures on the other three regions: CARAGA, Eastern Visayas, Region 5, and Region 2, are almost equivalent to their GDP share. (Table 2)

Table 3. Winners and Losers among Regions Relative to their Direct Budgetary Allocation and GDP Share, 2008 (in percent)

|Region |Direct Budgetary Share |GDP Share |
|NCR |5.76 |37.29 |
|CALABARZON |3.7 |11.32 |
|ARMM |1.73 |0.84 |
|CARAGA |1.72 |1.45 |
|Eastern Visayas |2.61 |2.12 |

Most of the regions emerge as winners when their IRA share is compared to their GDP share. The IRA share of twelve of the regions is greater than their contribution to GDP, in particular, ARMM (4.36 % IRA share compared to 0.84% GDP share; Cagayan Valley or Region 2 (4.68 % IRA share compared to 1.76 % GDP share), and Ilocos or Region 1 (5.2%IRA share compared to 2.79% GDP share). The losers are NCR and CALABARZON whose IRA shares are much lower than the amount of income generated in these regions. Regions 11 (Davao), Region 7 (Davao) and CAR receive shares that are almost equal to what they contribute in terms of GDP (Table 2).

The biggest disparity is noted in the collection of the Bureau of Internal Revenue where almost 87.0 percent is recorded at the NCR; 4.2 percent in Calabarzon; 1.8 percent in Central Luzon; 1.0 percent and 1.2 percent in Western and Central Visayas, respectively. The tax collection from other regions is less than 1.0 percent. This pattern of collection is heavily influenced by the location of major place of business of the taxpayer or where the taxpayer pays his taxes, instead of than where income is generated. (Table 4).

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3. How Much Does it Take to Finance a State?[1]

Under a federal government, the power to govern is shared between federal government and the state. The federal government is responsible for foreign affairs, fiscal policy, immigration, debt management, social security and national defence, national economic planning and trade promotion. On the other hand, the federal government is responsible for delivering basic services that address the needs of communities and promote their welfare and quality of life. These include construction and maintenance of public infrastructure, education, health, internal security, promotion of agriculture, and protection of the environment.

An exploratory exercise was made to estimate the minimum expenditures to run a state. These include maintaining a small bureaucracy that will organize public services that will be delivered by 15 departments, development of a judiciary, internal security, the provision of basic and tertiary education, and development requirements (Table 5).

Under the assumptions, a state will need some P71.66 billion to function. For a Federalist Philippines to maintain 12 states, it will need a total of P931.6 billion which is about P300 billion away from the 2008 budget. This estimate does not even include the expenditures of the central government.

4. A “Statehood” for Every Administrative Region?

A gauge on the capability of the administrative regions in the Philippines to finance their required operations was made by relating the P71.7 billion to their taxable capacity. For the purposes of this study, taxable capacity is estimated at ten percent (10%) of their regional GDPs. This assumes that 10 percent of the incomes generated within the state is taxable. Using this indicator, only the National Capital Region and CALABARZON are viable, with taxable capacity of P247.9 billion and P75.24 billion, respectively (Table 6). All the other regions have taxable capacity of less than P71.7 billion. They will be unable to finance the basic requirements of governance if they are left on their own.

Another measure compares the P71.7 billion with the amount of local revenues raised by the regions, including the allotments they receive from the national government. Under this scenario, no region can be considered as financially viable (Table 6).

What can be financially tenable is a clustering of regions into five (5). By combining resources, all the five regions will have enough resources that they can mobilize through taxation or benefit charges. NCR remains to be the most financially endowed and with a special subsidy scheme, ARMM can be maintained as a separate region.

Table 7. Taxable capacity of Clustered Regions (in thousand pesos)

|Clustered Regions |10% of GDP |
| | |
|CAR, Ilocos, Cagayan, Central Luzon |93,972 |
|NCR |247,895 |
|Southern Tagalog, CALABARZON, MIMAROPA,BICOL |105,904 |
|Eastern, Western, Central Visayas |104,178 |
|Zamboanga, Northern Mindanao, Davao, |107,289 |
|Soccksksargen, Caraga | |
| | |
|ARMM |5,588 |
| | |

With six (6) regions, government will have to raise a minimum of P430.0 billion to finance the operations of the states. The fly in the ointment however is that the estimated minimum expenses are quite inadequate to finance the expansion of regions into clusters. The minimum can double from P71.66 billion to P143.32 billion. This implies that a federalist government should be supported by: 1) an equitable and an efficient transfer/grant system; and, 2) a reallocation of revenue-raising powers between the central and local governments.

5. What About Central Government Finance?

Our model assumes that the central government exercises powers to implement national policies and uniform enforcement of laws relating to trade, development of markets, currency, national finance, subsidies and transfers to state, and debt management. It will also be responsible for national defence, immigration, foreign affairs, social security, and planning. Using the 2008 budgetary appropriations to government departments, the central government will need P675.1 billion.

Table 8. Budgetary Expenditures of Departments Exercising Responsibilities of the Central Government, 2008 (in thousand pesos)

| | |
|Expenditures |Amount |
| | |
|Internal Revenue Allotment |228,190,409 |
|International Commitments Fund |1,908,084 |
|Pension and Gratuity Fund |59,991,491 |
|Debt Service Fund |295,751,000 |
|Congress |5,567,380 |
|Office of the President |5,287,995 |
|Office of the Vice President |178,939 |
|Department of Finance |7,928,617 |
|Foreign Affairs |10,052,648 |
|Department of national Defense |51,052,936 |
|Department of Trade |2,501,037 |
|NEDA |1,776,656 |
|Civil Service Commission |541,510 |
|COMELEC |4,370,099 |
| | |
|Total |675,098,801 |

The estimated expenditures of the federal and central governments come up to a total of P1.1 trillion which is roughly equal to the 2008 budget of P1.2 trillion.

The national government however is on a deficit financing scheme since its tax and duty collection for 2007 is only enough to finance a budget of P923.0 billion. This implies that a federal government will have to: 1) significantly streamline operations of the central government to reduce expenditures; 2) continuously borrow from the markets; and, 3) improve its revenue administration.

6. Restructuring the Revenue-Raising and Grants System

Even under the current system of public finance, the expenditure- responsibilities and revenue powers of the central and local government are mismatched. The revenue and expenditure assignment is vertically out of balance, i.e. revenues exceed expenditures at the central level and fall short at the local level. The central government receives revenues that exceed its expenditures (net of debt service) by 36 percent n the average. In contrast, revenues from taxes that are allocated to LGUs amount to only an average of 41.0 percent of their expenditures making them heavily reliant on the IRA.[2]

The grant system has been proven to be inefficient and inequitable. . They have been counter-equalizing and LGUs with more revenues, higher taxable capacity, and more expenditure outlays receive more grants. On a regional level, grants tend to flow more heavily to more developed regions like Region 4, Region 3, and the National Capital region. Likewise, if the number of people that an LGU has to support is an indicator of need, regions that are more populous are not fully assisted by the allotment system. Heavily populated LGUs like Manila, Quezon City, and Caloocan City receive smaller per capita allotments (grants).[3]

Clearly, the current allocation of revenue-raising powers cannot support a shift to a federal government and radical changes have to be made.

The most productive revenue sources of the central government are the income tax and the VAT (Table 9). The income tax raised about P427.3 billion accounting for 46 percent of total government revenues. The VAT on the other hand (which is collected by both BIR and Customs) generated P287.51 billion or 31.15 percent of the total.

It may be opportune to look at providing the states with the power to impose a local income tax. In the short-run, this may be a surtax on the national income tax for ease of administration. As the states develop greater capacity on assessment and tax administration, it can move towards the development of its own income tax. Similarly, states can be authorized to impose a surtax on the VAT.

The use of these two major taxes can significantly improve state financing. A one percent tax on 40 percent of the taxable capacity [4]of NCR will provide it with P99.0 million and another one percent VAT would raise its additional revenues to almost P2.0 billion.

A stronger grant system will augment resources of states with low taxable capacity. This can only be possible with the establishment of average minimum standards on basic needs, e.g. education and health, per capita... The grant system can transfer resources to states with inadequate resources to provide each person with the standard per capita expenditure.

To illustrate, let us assume that every Filipino child is entitled to a P20, 000 expenditure allocation for basic education. The taxable capacity of State B is only sufficient to provide P15, 000 for each child. The grant system should subsidize the education of each child by P5, 000.

7. Summary and Conclusions

Financial considerations provide a big touch of reality on proposals for federalism. A minimum of P71.7 billion is needed to be able to run a state. With inequities in growth and development, it appears that only two regions, NCR and CALABARZON have the wherewithal to finance their basic operations as federal states. Their taxable capacity is P247.9 billion and P75.2 billion, respectively. Other indicators of financial viability, i.e. local revenues and collection of national taxes and duties, impose more binding constraints. There is no region in the Philippines with local revenues equivalent to P71.7 billion.

The number of financially viable regions can grow into five (and six with political considerations for the creation of ARMM) if they are clustered into Northern and Central Luzon; NCR, Southern Luzon, Visayas, and Mindanao. Their taxable capacity by clusters can reach P71.7 billion.

However, financial constraints should not define the possibilities of adopting federalism in the Philippines. Greater openness and innovations can be used in defining the allocation of revenues between the central and state governments, downsizing the bureaucracy in the central government, and designing a grant system that is equitable and efficient.

A shift to federalism can be only possible if: 1) revenue raising powers are allocated in line with the distribution of expenditures between the federal and state governments; and 2) a grant system is formulated that can enable each state to provide every citizen with minimum standards of expenditures on health, education, water and public safety .
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[1] The assumptions were taken from a study made by Dr. Gaudioso Sosmena on the Minimum Expenditures of Running a State. The figures were modified using estimates from the General Appropriations Act.

[2] Milwida M. Guevara, “The Fiscal Decentralization in the Philippines: Lessons from Experience”, a Paper presented before Hitotsubashi University, 2004.
[3] Ibid.
[4] The estimated tax base is 40 percent of the taxable capacity to simulate the concept of net income. In this exercise, 60 percent of gross income is allowed as deductions.