Country Partnership Strategy: Philippines, 20112016

ECONOMIC ANALYSIS (SUMMARY)1 A. Recent Development and Longterm Growth Trends

1. Long-term growth performance. The Philippines had one of the highest per capita incomes in East and Southeast Asia in the 1950s and 1960s with an advanced manufacturing sector compared with its neighbors and well-developed human capital. From 1960 to 2008, however, real gross domestic product (GDP) grew at an average annual rate of 4.0%. With rapid population growth of 2.5%, per capita GDP increased by only 1.5%. Over the same period, neighboring economies such as Indonesia, Malaysia, and Thailand grew about 4% per capita. Although reforms in the past two decades (19902008) made the Philippine economy one of the most open to trade and capital inflows, its growth continued to lag. By the end of the 1990s, the Philippines per capita GDP had dropped below Indonesia, Malaysia, and Thailand (Figure 1). Figure 1: Real GDP per Capita 19502008 (constant 2005 $)
18,000 16,000 14,000 12,000 10,000 8,000 6,000 4,000 2,000 0 Indonesia Malaysia Philippines

Figure 2: Unemployment Rate, 19802008 (% of total labor force)

14

12
10 8

Thailand
Viet Nam PRC

6
4

2
0
1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008

Indonesia
1960 1970
1950 1955 1965 1975 1980 1985 1990 1995 2000 2005

Malaysia Viet Nam

Philippines PRC

Thailand

GDP = gross domestic product, PRC = Peoples Republic of China. Source: Penn World Table (PWT 6.3).

PRC = Peoples Republic of China. Source: World Bank, World Development Indicators.

2. Strong economic growth in the past decade. During 20002010, real economic growth averaged 4.8%, which was higher than in the previous decade (2.8%). Growth during this period was accompanied by low inflation, strengthening external accounts, and a healthier and better capitalized domestic banking sector. GDP growth slowed to 3.8% in 2008 and 1.1% in 2009 when the economy was hit by global food and fuel price hikes, the subsequent financial crisis, and typhoons that caused massive floods in the capital region. Since late 2009, the economy has recovered rapidly because of a sharp rebound in exports, especially in the electronics industry and emergence of strong growth in business process outsourcing, a real
1

This summary is based on: ADB. 2007. Philippines: Critical Development Constraints. Manila; ADB. 2010. Diagnosing the Philippine Economy: Toward Inclusive Growth. Manila; N. Usui. 2011. Transforming the Philippine Economy: Walking on Two Legs. ADB Economics Working Paper Series. No. 252. Manila: Asian Development Bank; and ADB. 2010. Tax Reforms towards Fiscal Consolidation: Policy Options to the New Administration. Philippine Country Office Policy Note (July). Manila. The national income accounts have been recently revised and the base year shifted from 1985 to 2000. The figures in this report are still based on the unrevised figures (for constant prices).

2 estate construction boom, and solid private consumption backed by remittance inflows. While the restocking of inventories led the early recovery, private investment has become another growth engine. The GDP growth rate reached 7.3% in 2010, the highest since the mid-1980s. 3. Unemployment, underemployment, and poverty. 2 Since the mid-1980s, the unemployment rate in the Philippines has fluctuated between 6% and 11%, compared with about 2%3% for Viet Nam and about 1%6% in Thailand (Figure 2). Even during the recent rapid economic growth period (5.5% average in 20022007), unemployment averaged 9.8% and underemployment averaged 19.2%. In 2010, despite the strong economic recovery, the unemployment rate remained high at 7.3%, only slightly improved from 7.5% in 2009. 4. Vulnerable and overseas employment. The deployment of large numbers of workers abroad (more than 1.4 million in 2009) and the high rate of so-called vulnerable employment further mask the extent of domestic unemployment. The proportion of workers classified as vulnerable3 remained high at 41.7% of all employed in 2010 (although this share had fallen from 45.2% in 2001). The average hourly wage of workers in the bottom 20% of the income distribution is only 14% of the average hourly wage of workers in the top 20%, pointing to huge differences in educational attainment. 4 Reflecting the limited job opportunities, the pace of poverty reduction has been slower than in neighboring countries.5 5. Dynamic structural transformation in Asian economies. The rapid growth of East Asian countries started in the 1970s when they shifted their development strategy towards export promotion and attracted foreign direct investment. This process was accelerated in the 1980s when foreign firms relocated their production bases across the region. Structural transformation in these countries had three dimensions: (i) output shifted from low-productivity goods into high-productivity ones, particularly manufactured goods; (ii) the labor force moved from traditional activities in the primary sector to modern industry; and (iii) the export basket diversified toward more sophisticated products. The industry sector has continually raised its productivity through product diversification and sophistication, and has absorbed the labor force from low-productivity sectors. The dynamic structural transformation has sustained growth and reduced poverty by creating more affluent jobs. 6. Stagnant industry sector performance. The Philippines has not seen significant structural transformation as experienced in other Southeast Asian countries. The industry sectors share of GDP decreased from 39% in 1980 to 32% in 2007. The labor force employed in the industry remained stagnant at about 15% over the same period. Trade liberalization in the 1990s, and even during the recent rapid growth period, did not trigger a rising share of industry. As of 2007, the manufacturing sector accounted for only 22% of GDP and less than 10% of employment (Table 1). This is in marked contrast to neighboring economies, where the share of manufacturing has steadily increased in both output and employment. In the Philippines, the decline in agricultures share of employment has been offset by the growing services sector, which accounted for more than 54% of GDP and employed 49% of total workers as of 2007. The countrys export base remains narrow: two industrieselectronics and garmentsaccount for about 70% of exports. Both of these industries are essentially importexport operations, mainly in the form of assembly labor, with a thin layer of local value added.
2

4 5

The long-term trends in poverty reduction are provided in the Poverty Analysis Summary (accessible from the list of linked documents in Appendix 2). Self-employed and unpaid family workers who are less likely to have formal work arrangements, access to benefits or social protection, and are more at risk in recessions. ADB. 2007. Key Indicators 2007: Inequality in Asia. Manila. Poverty Analysis Summary (accessible from the list of linked documents in Appendix 2).

Table 1: Structural Change, 19802007 Output (% of GDP)

Sector Agriculture Industry Manufacturing Services Indonesia 24.0 41.7 13.0 34.3 13.7 46.8 27.1 39.5 (10.3) 5.1 14.1 5.1 22.6 41.0 21.6 36.3 Malaysia 10.2 47.7 28.0 42.0 (12.4) 6.7 6.4 5.7 1980 2007 Change 1980 2007 Change

Employment (% of total employment)

Sector Indonesia Malaysia 2007 Change 14.8 (22.4) 4.4 28.5 2.7 18.8 56.7 18.0 Thailand 2007 Change 41.7 (29.1) 20.7 10.4 7.1 15.1 37.6 18.7 1980 2007 Change 1980 56.4 41.2 (15.2) 37.2 5.7 13.1 18.8 24.1 3.4 Manufacturing 9.0 12.4 16.1 9.5 Services 30.5 40.0 38.7 Agriculture Industry Philippines 1980 2007 Change 1980 Agriculture 51.8 36.1 (15.7) 70.8 Industry 15.4 15.1 (0.3) 10.3 (1.7) Manufacturing 10.8 9.1 7.9 Services 32.8 48.8 16.0 18.9

Philippines Thailand 1980 2007 Change 1980 2007 Change Agriculture Industry Manufacturing Services 25.1 38.8 25.7 36.1 14.2 (10.9) 23.2 10.7 (12.6) 31.6 (7.2) 28.7 44.7 16.0 22.0 (3.8) 21.5 35.6 14.1 54.2 18.1 48.1 44.6 (3.4)

( ) = negative, GDP = gross domestic product. Sources: World Bank, World Development Indicators, and International Labor Organization, LABORSTA.

Figure 3: Labor Productivity, 19802007 (constant 2000 $) Economy-Wide Labor Productivity Labor Productivity by Sector
14,000
12,000 10,000

12,000
10,000

8,000
6,000

8,000
6,000 4,000

4,000
2,000 0
1986
1980 1983 1989 1992 1995 1998 2001 2004
1998
1980 1983 1986 1989 1992 1995 2001 2004 2007

2,000
0

Indonesia Philippines

Malaysia Thailand

Agriculture Services

Industry Manufacturing

Source: ADB. 2010. Transforming the Philippine Economy. Philippine Country Office Policy Note (October). Manila.

7. Slow growth of labor productivity. Compared with ASEAN-4 economies, progress in economy-wide labor productivity in the Philippines has been weak. During 19802007, aggregate labor productivity increased by only 10% (the annual average growth rate was 0.4%), while labor productivity in Indonesia, Malaysia, and Thailand more than doubled (Figure 3). In the Philippines, productivity for all sectors (agriculture, industry, and services) has stagnated over 3 decades. Industry and agriculture contributed negatively to aggregate productivity growth, and only a minor contribution was made by services. The countrys overall productivity grew only slightly through a labor shift from agriculture to services. Workers have continued to move into the services sector, where self-employment is common and wages are more flexible. As a result,

2007

4 more jobs were created in the low-skill, low-wage category.6 8. Remittance-based consumption and weak investment. Supported by remittance inflows, consumption has been the main driver of aggregate demand in the Philippines. Private consumption, accounting for about three-fourths of GDP, has been financed in part by soaring remittances from Filipino workers abroad (10% of GDP in 2010). Reflecting the structural changes in favor of services, which are less capital-intensive and more labor-intensive, the countrys share of fixed investment in GDP decreased from a high of 25% in 1997 to 14%15% in 20052009, contrasting with the recovery in investments in its neighboring countries after the Asian financial crisis (Figure 4). 9. Revisiting the growth strategy. To attain more inclusive economic growth, the Philippines may have to revisit its strategies in lagging areas of the economy. 7 The chronic problems of the economyhigh unemployment, slow poverty reduction, and stagnant investment reflect the slow industrialization process. The economy's real growth potential remains untapped and the slow pace of employment generation despite growth hinders inclusiveness. The Philippines biggest need is to create domestic jobs for the growing working-age population. Figure 4: Gross Fixed Capital Formation, 19802008 (% of GDP)
50
40 30 20

10
0
1998
1980 1982 1984 1986 1988 1990 1992 1994 1996 2000 2002 2004 2006 2008

PRC Republic of Korea Indonesia Malaysia Philippines Thailand Viet Nam GDP = gross domestic product, PRC = Peoples Republic of China. Source: World Bank, World Development Indicators.

B.

Key Constraints to Inclusive Growth

10. Weak revenue generation and public expenditure management. Persistent fiscal imbalances and a lack of sustainable fiscal management have severely constrained growth for a long period. Fiscal deficits result from weaknesses in tax revenue mobilization and poor public expenditure and financial management. After reaching a peak of 17% of GDP in 1997, total tax revenues declined steadily to below 13% in 2002 and 2003, contributing to a fiscal deficit of 5.3% of GDP in 2003. Fiscal measures introduced in 2005, supported by development partners, including ADB, broadened the value-added tax (VAT) base and increased the VAT rate from

H. H. Son. 2010. Growth, Inequality, and the Labor Market: The Philippines. In J. Zhuang, ed. Poverty, Inequality, and Inclusive Growth in Asia: Measurement, Policy Issues, and Country Studies. Manila: Asian Development Bank. N. Usui. 2011. Transforming the Philippine Economy: Walking on Two Legs. ADB Economics Working Paper Series. No. 252. Manila: Asian Development Bank; A. M. Bocchi. 2008. Rising Growth, Declining Investment: The Puzzle of the Philippines. Breaking the "Low-Capital Stock" Equilibrium. Washington, D.C; and World Bank. 2011. Philippine Discussion Notes: Challenges and Options for 2010 and Beyond. Washington, D.C.

5 10% to 12% and the corporate income tax rate from 32% to 35%.8 As a result, the tax-to-GDP ratio increased to 14.3% in 2006, with the budget deficit declining to 1.1% of GDP. However, fiscal pressure has been growing since 2009. While stimulus spending and post-calamity restructuring costs contributed to the larger deficit, the country's weak revenue mobilization capacity has exacerbated the problem. The combination of accelerating spending and weak revenue collection drove the fiscal deficit to 3.9% of GDP and the debt-to-GDP ratio to 57.3% in 2009. Tax revenues fell to 12.8% of GDP in 2009 (Figure 5), the lowest since the 2005 and 2006 tax reforms. It was also the lowest among neighboring members of the Association of Southeast Asian Nations. Figure 5: Tax Revenue Trends, 19972009 (% of GDP)
0.8

Figure 6: Tax Productivities

20

0.7 0.6 0.5

0.49

VAT

CIT

PIT

15

0.4
0.3

10

0.2 0.1 0.0

0.20 0.16

0.18 0.11 0.06

East Asia and the Pacific (2006)

PRC (2006)

Republic of Korea (2007)

Malaysia (2006)

Philippines (2009)

0
1997 1999 2001 2003 2005 2007 2009

CIT

PIT

VAT

Excise tax

Others

CIT = corporate income tax, GDP = gross domestic product, PIT = personal income tax, PRC = Peoples Republic of China, VAT = value-added tax. Source: ADB. 2010. Tax Reforms towards Fiscal Consolidation. Philippine Country Office Policy Note (July). Manila.

11. Low tax productivity.9 The Philippines tax productivities, in particular for VAT and corporate income tax, are far below the region's averages (Figure 6). The low productivities signal the presence of significant tax loopholes and weak tax administration. From 1997 to 2008, the tax collection fell about 2.9 percentage points, with about two-thirds accounted for by the decline in excise tax revenues (on tobacco, alcoholic products, and gasoline), mainly because of the lack of inflation adjustments. Personal income tax compliance is low and taxing self-employed professionals is difficult. Tax incentives for investors distort economic activity by

The new tax legislation included a sunset clause whereby the corporate income tax rate would be cut to 30% starting 1 January 2009. The rationalization of fiscal incentives that was meant to compensate for the revenue loss did not take place. World Bank. 2011. Philippine Discussion Notes: Challenges and Options for 2010 and Beyond. Washington, D.C. Tax productivity is a conventional index to measure how effectively tax authorities produce revenues from available tax bases. For each tax, the productivity is measured as the ratio of the tax revenue to GDP divided by the tax rate, i.e., (tax revenue/GDP)/(tax rate). It can be regarded as a ratio of actual tax revenue to the hypothetical tax revenue (GDP*tax rate), which reflects the extent to which existing revenue generating capacity has been exploited by tax collection authorities. ADB. 2010. Tax Reforms towards Fiscal Consolidation: Policy Options to the New Administration. Philippine Country Office Policy Note (July). Manila.

Thailand (2007)

Viet Nam (2007)

6 imposing high effective tax rates on companies that are not eligible to receive the incentives.10 The local governments lack of revenue generation capacity is also a concern. 12. Shortfall in provision of basic infrastructure and social services. The countrys lagging outcomes both in physical and human capital accumulation can be explained mainly by shortfalls in the size of public spending rather than shortfalls in the quality or efficiency of public spending.11 Because of the tight fiscal position, the scope for increased physical and human capital accumulation through public spending has been limited. As a result, the provision of these services has been inadequate. Government capital expenditure was equivalent to 2.7% of GDP (20022008 average), lower than in neighboring countries (Table 2).12 There are also public spending gaps in key social sectors (Table 3). Public spending on education averaged 2.5% of GDP compared with 4.0% of GDP in other Asian countries in 20022007. In 2006, overall government spending for health was even lower at 1.3% of GDP. The impact of public investments can get further reduced because of inefficient spending programs. 13 Low and inefficient public spending on social services results in insufficient and unequal access to opportunities.14 Table 2: Central Government Capital Expenditures and Net Lending (average annual percent of GDP)
19962000 20022008 Philippines 3.6 2.7 Malaysia 6.0 7.3 Thailand 5.4 3.5 Viet Nam 6.9 9.2 Sample Mean 6.1 6.6 GDP = gross domestic product. Source: World Bank. 2011. Philippine Discussion Notes: Challenges and Options for 2010 and Beyond. Washington, D.C.

Table 3: Government Spending on Education and Health (% of GDP)

Education Health a a Country 19901995 20022007 2000 2006 Philippines 3.0 2.5 1.6 1.3 Indonesia n.a. 3.5 1.7 1.9 Malaysia 4.4 4.6 1.9 2.3 Thailand 3.2 4.3 1.6 2.1 Viet Nam 2.9 n.a. 1.7 1.9 Sample Mean 3.5 4.1 1.7 2.0 GDP = gross domestic product, n.a. = not available. Source: World Bank. 2011. Philippine Discussion Notes: Challenges and a Options for 2010 and Beyond. Washington, D.C. latest year in period
10

An ADB study found that tax incentives are mostly "redundant", which means that firms that were granted the tax incentives would have invested irrespective of receiving the incentives. ADB. 2010. Philippines: Strengthening Investment Climate and Competitiveness. TA report prepared under ADB. 2007. Technical Assistance to the Republic of the Philippines for Strengthening Investment Climate and Competitiveness. Manila. 11 A World Bank study examined the main causes of the countrys underperformance in education, health, and transport. It found that, while spending efficiency is a problem in transport, shortfalls in the size of public spending is the key cause of the underperformance in all these sectors. World Bank. 2010. Philippines: Public Expenditure Review: Strengthening Public Finance for More Inclusive Growth . Unpublished. 12 Footnote 8, p. 5. 13 S. Jha and A. Mehta. 2010. Inclusiveness through Food Security: The Philippines' National Food Program. In J. Zhuang, ed. Poverty, Inequality, and Inclusive Growth in Asia: Measurement, Policy Issues, and Country Studies. Manila: Asian Development Bank. 14 Education Sector Assessment Summary, and Health and Social Protection Sector Assessment Summary (accessible from the list of linked documents in Appendix 2).

7 13. Underinvestment in infrastructure. Private fixed investment in the Philippines, which averaged only 12.5% of GDP during 20022008, compared with about 20% in the rest of the region, has been insufficient to make up for the public spending gap in infrastructure investment, undermining the investment climate.15 14. Limited competition. Enhancing competition has been an important policy objective. After the political and debt crisis of the 1980s, the government implemented market-based economic reforms, such as liberalizing trade, telecommunications, and domestic shipping, and opening up to foreign direct investment. 16 However, the country has been unable to spur domestic investments, and inflows of foreign direct investment have remained low compared with its neighbors. Cartel behavior continues to exist in sectors such as maize, sugar, rice, pharmaceutical drugs, water transport, cement, sea and air transport, energy, mining, and banking.17 Some companies benefit from barriers to entry and dictate high prices for key inputs for other sectors, such as transport, cement, and power. In many sectors, concentration ratios and pricecost ratios have remained high, which suggests the presence of monopoly rents.18 An explicit competition (antimonopoly) policy framework is needed to eliminate current anticompetitive practices. Recent government initiatives in this area are worth noting. 15. Weak business and investment climate. Key constraints identified in business surveys are provided in the private sector assessment summary (footnote 15). The number of procedures required for starting a business is higher than in other countries in the region. 19 Further, the weak bankruptcy law makes it difficult for unprofitable businesses to exit the market. Shareholders rights are not effectively protected, and enforcement of legal rights through the judicial system is still weak. Labor market rigidities, such as difficulties in hiring and firing labor, also deter private investment. 16. Ineffective public support for industry. Despite a long history of using fiscal incentives, the countrys public support for industrial development has been fragmented and ineffective at achieving the primary goal of investment promotion.20 Several agencies, including the Board of Investment and the Philippine Economic Zone Authority, have continued to provide fiscal incentives, but a systematic and updated assessment of the effectiveness of the incentives may need to be conducted. Although priority sectors are stipulated in the annual Investment Priority Plan, its coverage is wide, and the priorities are defined only broadly at the aggregated sector level.21 With only 0.11% of GDP going to research and development, the Philippines ranks 89th of 103 countries and falls far behind other countries in the region.22 Links between universities and research and development in industries are weak, and incentives to pursue higher education in science and technology are low.

15 16

Private Sector Assessment Summary (accessible from the list of linked documents in Appendix 2). R. M. Aldaba. 2008. Assessing Competition in the Philippines. Philippines Development Studies Discussion Paper Series No. 200823. September. Manila. 17 A. M. Bocchi. 2008. Rising Growth, Declining Investment: The Puzzle of the Philippines. Breaking the "Low-Capital Stock" Equilibrium. World Bank Policy Research Working Paper Series. No. 4472. Washington, D.C.: World Bank. 18 Footnote 8, page 4. 19 World Bank and International Finance Corporation. 2011. Doing Business 2011. Washington DC. 20 F. Medalla. 2006. On the Rationalization of Fiscal Incentives. Washington DC.: United States Agency for International Development; and R. Reside. 2006. Fiscal Incentives and Investments in the Philippines. Washington DC: United States Agency for International Development. 21 ADB is conducting a structural transformation study to identify target products for industrial diversification and analyze the potential for public support for industrial development. ADB. 2010. Technical Assistance to Philippines for a Structural Transformation Study of the Philippine Economy . Manila. 22 International Institute for Management Development. 2007. 2007 World Competitiveness Yearbook. Switzerland.