Confidential Standard & Poor’s

Appendix
Philippines Intergovernmental System Overview

Local Government Structure in the Philippines

The local government tier in the Philippines is made up of local government units (LGUs)
and one autonomous region, the Autonomous Region of Muslim Mindanao (ARMM). The
governance structure is divided into three layers/levels—the first layer is the provinces, the
provinces are further divided into municipalities and component cities, each of which is
further divided into barangays, the smallest political unit. Further, there are independent
cities (such as those in the Metro Manila region) that are on the same level as provinces
and they share the same functions and authorities.

Philippines Local Government Units

Provinces Highly Urbanized

Cities

Municipalities Component
Cities Barangays

Barangays Barangays

Provinces and highly urbanized cities are headed by an elected Local Chief Executive
(LCE) and have an elected legislative body. These elected officials are given tenure of a
three year term and up to a total of nine consecutive years. As of March 2008, there are 17
administrative regions, 81 provinces, 136 cities, 1,495 municipalities and 41,995
barangays.

The LGC of 1991 and the Organic Act for Muslim Mindanao of 1989 jointly define
central-local relations and these acts started the decentralization process in the Philippines.
Both pieces of legislation included provisions that increased the share of local government
units (LGUs) in central government revenues, broadened LGU taxing authorities, and
devolved to LGUs functions that used to be assigned to central government agencies.

The responsibility for the delivery of basic services and the operation of facilities in the
areas such as land use planning, solid waste disposal, primary health care, social welfare
services, municipal services and enterprises, and local infrastructure facilities now rests
with the LGU after the LGC transferred them from the national government agencies.
LGUs also administer other services and facilities like garbage collection, public
cemeteries, public markets and slaughterhouses. After the passage of the Code, LGUs have
the power to levy and collect local taxes, the issue and enforce regulations governing the
operation of business activities in their jurisdictions,
 Standard & Poor’s

Low Predictability
The central government has a history of passing on unfunded mandates to LGUs. These
include implementation of the salary standardization law, paying for the health insurance
premium of their indigent residents, provide budgetary support to National Government
Agencies like police, fire, local courts etc. LGUs generally have little influence on central
government’s decisions regarding the allocation of revenues and expenditures.

Central transfers (IRA; Internal Revenue Allotment) were previously an unpredictable

source of revenue for LGUs. Although it was mandated by the LGC, the central
government would reduce the amount of IRA transfers to LGUs whenever it was faced
with severe fiscal constraints. In 1998, 5% of IRA was not released to LGUs as a fiscal
austerity measure. In 2000, Congress lopped off PHP 10 billion and set aside this amount
under Un-programmed Funds. In 2001 and 2003, IRA was reduced by PHP 16 billion and
PHP 9 billion respectively due to re-enactment of the budget. However after two Supreme
Court rulings upheld the automatic release of IRA and its distribution strictly as per the
provision of the Code, a significant shift in its treatment became evident. The central
government from 2006 onwards, reclassified IRA in the National Budget to a special annex
section (together with national debt servicing), as opposed to the previous treatment of
parking IRA under Special Purpose Funds (SPF). With the new classification, IRA would
be automatically appropriated for in the annual budget along with national debt servicing,
thus adding certainty to LGUs’ revenue source.

Significant Mismatch in Revenue & Expenditure

The revenue-raising capacity of various levels of local government in the Philippines has
generally not been enough to match its expenditure needs. Total LGU spending increased
from an average of 1.6% of GNP in 1985-1991 to 3.3% of GNP in 1992-2003. However,
local revenues only rose marginally from an average of 0.8% of GNP in the pre-Code
period to an average of 1.2% of GNP in the post-Code period.

LGUs have two main sources of funds, IRA and locally generated revenues. The LGUs’
own source revenue stems mostly from real property taxes, business taxes, community
taxes and professional taxes. Other than IRA which forms the bulk of central transfers,
other transfers includes origin-based share in national revenues, and ad-hoc categorical
grants. LGUs have to allocate 20% of IRA for development purposes, other than that they
have full discretion in its utilization. The categorical grants may only be used for specific
projects that are usually joint programs/projects between national government agencies and
the LGU.

LGUs’ expenditure has doubled relative to the general government’s expenditure in various
sectors such as flood control, health and education. However, this has not been backed up
by sufficient revenue generating capacities. Although the LGC authorizes LGUs to levy
local taxes, the tax base outside of the real property and business tax is not significant, and
the bulk of productive sources of local revenue still rest with the central government. It is
also difficult for LGUs to maintain the real value of their revenues as the Code prescribes
that tax rates can only be adjusted once in 5 years and by not more than 10% each time.
Adding on to the revenue-expenditure mismatches, the central government calculates the
share of IRA to be allocated to LGUs in the current fiscal year base on national revenue
collection three fiscal years preceding it. The backward-looking formula indicates that
LGUs have to support current expenditures based on revenue streams as of three years ago.

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Currently, 40% of the revenue tax collections of the central government are allocated as
IRA for local governments. In turn, how much each LGU gets is determined by a simplistic
formula of 50% based on population size, 25% on land mass and 25% equally divided
among all the LGUs. The formula does not take into account the own-source revenue
capabilities of the LGU or the per-household income and the per capita IRA allocation has
been found to be positively related to per capita household income. Hence the more
developed LGUs (such as those in the Metro Manila area) which already have substantial
own-source revenues are given more IRA due to their relatively larger populations, while
the poorer regions are given a smaller share. Currently, the Metro Manila cities derive
about one-third or less of their income from IRA, in contrast to the less-developed LGUs
where as much as 80% of their revenue is dependent on IRA. The allocation had added to
the further widening of disparities in economic development in the country.

Weak Transparency and Poor Accountability

The Commission on Audit (COA) as a constitutional office has powers to examine, audit
and settle all accounts of the government revenue and expenditure and use of resources.
COA is also responsible for prescribing accounting standards and auditing rules.

Philippines LGUs are currently transiting from cash basis accounting to a full accrual
system. However the transition has not been smooth. LGUs now report on a mixed accrual
standard, where expenditures are reported on accrual basis and three methods are adopted
for revenue reporting (accrual for IRA, modified accrual on property tax and cash basis for
all other revenues). This makes comparison between budget and the income and
expenditure statement extremely difficult. Cash-flow statement, statement of income and
expenditures and the balance-sheet cannot be reconciled, and there are many deficiencies in
reporting of assets and liabilities.

Transparency of operations is generally poor. Out of the 217 LGUs audited by COA in
2007, only 18% did not receive qualifications on their financial statements, 76% were
given qualified opinions and 6% were given an adverse opinion (financial statements with
defects so material that do not represent fairly the financial position of the LGU). Further,
as there are no penalties for non compliance with audit recommendations, most LGUs
choose to ignore audit recommendations year after year. However, if deficiencies in
reporting involve misappropriation of cash or are graft-related, COA can pass the case to
the Office of Ombudsman for criminal proceedings.

Weak Fiscal Policy Framework

Two broad fiscal principles guide central monitoring of LGUs; The Department of Finance
makes sure that a LGU’s total borrowing is limited at 20% debt servicing of its regular
income, and Department of Budget Management checks that LGUs do not budget more
than 45-55% (depending on class of LGU) of total regular income on salaries. These two
guidelines are strictly monitored by the two agencies and non-compliance can result in
harsh penalties against the LCE and his/her administration. There are no other measures to
promote fiscal discipline.

The LGUs have mostly relied on their traditional sources of funding of IRA and own tax
revenues. Operating expenditures take up most of their revenues and capital outlays only
average around 7.5% of their yearly budget. Such low spending on infrastructure is not

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appropriate for a country with under-developed infrastructure and public sector services
like the Philippines.

Less than 30 % of LGUs have accessed loans from Government Financial Institutions
(GFIs) and only 12 LGUs have issued bonds since 1991 aggregating PHP1.5 billion. The
national government has not further developed the local government bond market and it
does not seem to be a central priority at the moment. LGUs are not allowed to access
international capital markets and any foreign funding would have to be secured by the
national government and then onlend to LGUs as specified in the Local Government Code.

Low Likelihood of Extraordinary Support

The central government’s debt service cap of 20% on LGUs’ borrowings is strictly
enforced by the Bureau of Local Government Finance (BLGF) under the Department of
Finance (DOF). All LGUs must receive prior approval from the BLGF before being
allowed to borrow. In addition, banks would generally only lend if there is IRA pledged
against loans. Overall, these factors have ensured that overall debt levels remain
manageable by respective local governments in the Philippines.

LGU borrowings have thus far been dominated by Government Financial Institutions
(GFIs). Commercial banks and private investors’ generally perceive sub-sovereign credits
as high-risk due to the short-term focus and politicized nature of local government
operations (see FMA ‘Public Finance Environment of Philippines LGUs’). Banks are only
willing to lend to an LGU if it has deposits and/or IRA transfers secured against its loans
before making disbursements. And since LGUs can only bank their IRA transfers through
GFIs, most of the local government borrowings have come from GFIs. The risk of default
is hence alleviated as GFIs automatically deduct debt service payments from the monthly
central government transfers.

The other source of LGU borrowing—bond issuances—is at a nascent stage. Investors

would only buy an LGU bond if it is guaranteed by the LGUGC (LGU Guarantee
Corporation), a private corporation co-owned by Asian Development Bank, Development
Bank of Philippines, and the Bankers Association of the Philippines. However, the take-up
has been slow and the scale of funding from bonds is minuscule; only 12 LGUs have issued
bonds so far, aggregating just PHP1.5 billion (around US $32 million).

If LGUs were to face financial distress, the likelihood of timely extraordinary support by
the central government is very low. There are no formal bailout procedures. In the late 80s,
the national government had attempted to relieve distressed LGUs by passing a special
provision in the Local Government Code: the sovereign shall assume all debts incurred by
local government units from GFIs that are outstanding as of December 31, 1988. However,
the central government never made budget appropriations for this debt relief program and
GFIs mostly ended up having to write off the loans. In recent years, even though the
national government has been reinforcing its fiscal consolidation effort, its financial
position is still constrained by its own heavy debt burden. Public sector debt is estimated at
56% of 2008 GDP, above the median for ‘BB’ rating category. Extraordinary support (if
any) would also not be timely, judging by the history of difficulties in achieving swift
political consensuses at the national government level.