Saving tax reform from TRAIN

Some years back, University of Chicago economists Raghuram Rajan and Luigi Zingales wrote a book called “Saving Capitalism from the Capitalists.” They argued that while unfettered competition trumps protectionism for long-term growth and job creation, some protection should still be extended to counteract anti-market sentiments among those unable to compete.

Having followed the government’s tax reform efforts over the past year, we cannot help but draw an analogy between Rajan and Zingales’ point and the recent implementation of TRAIN (R.A. 10963)— hence the title of this article.

TRAIN was meant to address Philippine tax policies that have become dysfunctional over the past two decades. Three issues were prominent: 

REVENUE: Tax effort in the Philippines has lagged, partly due to our inability to levy significant new taxes, and partly due to tax collection issues. Our tax system is filled with holes, which fuels a general sense of unfairness among many taxpayers.

EQUITY: The progressivity of our income taxes has deteriorated because of bracket creep in unadjusted personal income tax schedules. Rising wages have pushed more and more taxpayers into higher tax brackets, so that many are taxed at the same rate as far wealthier individuals.

COMPETITIVENESS AND PROTECTION: Tax breaks to industries and vulnerable sectors (e.g. the elderly, poor) have caused excessive leakages in the tax system. This is despite evidence that many tax incentives are ineffective at boosting competitiveness, investment, and job creation, while those directed are vulnerable groups also suffer from leakages (e.g. tax breaks for the elderly are enjoyed by wealthy individuals as well).

Juggling reforms meant to fix all these challenges has been a gargantuan undertaking. Clearly, some of these objectives contradict each other— for instance, indirect tax hikes to increase revenues will weaken progressivity and hurt the poor, notably if compensating transfers or spending strategies do not materialize.

These contradictions meant that from the outset, TRAIN was unlikely to make everyone happy. Certainly, the first tax reform package (i.e. there are supposed to be 5 packages of TRAIN) scores well on revenues— around PhP92.3 billion will be generated— and credit rating agencies will look favorably on this. By supporting the government’s ambitious infrastructure plans, TRAIN will strengthen the country’s prospects for robust growth in the coming years.

TRAIN also brings substantial tax relief to many households in the middle class. If this boon is not saved, then part of it will drive further business growth and economic expansion. If these resources are instead invested, then they could also spur entrepreneurship, which is also good for the economy.

But TRAIN is weak elsewhere— and it does not particularly score high on equity, which is the main focus of our article. In fact, if we have learned anything from our last decade of growth, it is that growth alone will not take care of poverty; and that inequality can worsen with that growth.

There are ways to address this, which are good not just for inclusive growth, but for sustaining reform momentum. Like Rahan and Zingales, we highlight the need to expand measures to protect the vulnerable, and directly address poverty and inequality through greater pro-poor spending and investments. But for this, a whole-of-government approach should nest the tax reform package in a wider basket of reforms that ultimately benefit the poor.

Equity

Last October 2017, the Ateneo School of Government released an assessment of the TRAIN version approved by the House of Representatives, House Bill (HB) 5636. Our analysis showed that if adopted as HB 5636 (see Table 1), TRAIN would have regressive impacts, raising the Gini index of inequality from 49.1 to 50.0 (even after P2,400 cash transfers), while putting 30% of households, mainly from the poor and near-poor population, at risk of absolute losses from increased indirect levies.

Table 1. TRAIN House Version (HB 5636): Impacts on Gini Index

Our focus on progressivity was driven by what we saw to be a worrisome lack of evidence-based discussion of the effects of TRAIN on inequality, which was striking given how inequality metrics such as the Gini index are commonly used to evaluate tax proposals. While there are indeed problems in the tax system that go beyond progressivity, our main concern was that the lower attention paid to TRAIN’s inequality impacts might lead to its shifting the overburdening of the middle class from income taxes, to that of the poor and near-poor via indirect taxes.

We were not alone among economists in warning against such risks. Former NEDA Director-General Winnie Monsod, Dr. Rosario Manasan of the Philippine Institute for Development Studies (PIDS), and former DOF Undersecretary Milwida Guevara also vocally raised concerns over the regressivity of HB 5636 and its disproportionate burden on the poor.  

The TRAIN Ride: HB 5636 to RA 10963

But credit is due to TRAIN’s final form, R.A. 10963, for adopting amendments meant to address some of these equity gaps.

The Senate, under the leadership of Sonny Angara’s Committee, was able to bring some of these issues back in.

Cash transfers meant to ameliorate higher indirect taxes have been substantially broadened and deepened (see Table 2). From P2,400 per household annually in HB 5636 covering 50% of the population, they have been expanded to span the bottom 70% of households, and will be raised to P3,600 for 2019 and 2020.

Other changes in RA 10963 will lessen the burden of indirect taxes on the poor and near-poor. The tax rate on sugar-sweetened beverages— a tax lauded for its health objectives, but regressive in the short-term— has been reduced from proposed rates of P10/L and P20/L, to P6/L and P12/L respectively.

Petroleum excise tax hikes have also been lessened for fuels which are consumed especially by poor and near-poor households, particularly for LPG and to a lesser extent for kerosene.

Meanwhile, several VAT exemptions bearing on lower-income households have been retained, and in a few cases, added, such as for monthly rentals less than P15,000, for socialized/low-cost housing, and for prescription medicines for diabetes, cholesterol, and hypertension. These are in addition to a higher VAT exemption threshold, present in all TRAIN versions, for businesses with gross annual sales below P3-million– a measure which will largely benefit poor and near-poor consumers.

Should these changes be implemented, will TRAIN still be regressive?

Our estimates (Table 1) suggest that a P3,600 transfer for the bottom 50% would lower the post-transfer Gini index to 49.7. But when the coverage of an additional 20% of households for the transfer program, lower excise tax hikes, and the retaining of key exemptions are factored in, it seems fair to say that the regressive impacts of HB 5636 will be minimized in TRAIN’s implementation.

All these adjustments, however, are only to meant protect poor and near-poor households, not to ensure that they gain as much as the middle class from TRAIN. For that, it is critical to embed TRAIN within a wider package of reforms— especially a rethinking of food security policy—as this could deepen the inclusiveness of the country’s growth, something even past administrations were unable to address.

Revamping Philippine rice policy

Poverty and hunger are inextricably linked – for the poor to escape poverty, food prices must be stabilized at much more affordable levels. For instance, a 2015 study by Mapa, Castillo and Francisco indicated that a spike in rice prices tends to significantly increase hunger incidence. They estimated that a P5 increase in the price of rice per kilogram, would worsen hunger among 1.67-million of the poorest families within a quarter of a year.

Stabilizing and lowering rice prices will help mitigate TRAIN’s impact on the poorest Filipinos, and this can be achieved through two policies. Firstly, reforms must be undertaken at the National Food Authority (NFA) to curb corruption within the agency’s permitting, distribution, and procurement processes. Due to such rent-seeking, the NFA has been ineffective at stopping rice price inflation, which has wiped out most income gains among poor Filipinos in past years.

Secondly, a 2015 PIDS study found that replacing quantitative restrictions on rice imports with moderate tariffs would reduce rice prices by as much as P13 per kilogram, while fetching the government additional income. In fact, the fiscal returns from such a move could be substantial: the DOF itself has recently calculated that imposing a rice tariff rate of 35% could net as much as P27.3-billion in public revenues.

By generating such revenues, rice tariffs could provide another major financing source for the TRAIN’s social protection measures. While they are crucial for lightening the burden of food price inflation on the poorest Filipinos, rice tariffs are also essential for another reason: TRAIN’s insufficient funding for its planned cash transfers. 

Spending challenges

As displayed in Figure 1, the DOF has estimated that the implementation of the TRAIN law will generate P92.3-billion in incremental revenues, of which P27.7-billion (30% of total) should be earmarked for cash transfers and other pledged social benefits.

But a glimpse of the financing needs for 2018 cash transfers reveals a glaring mismatch. Delivering P2,400 to 70% of Filipino households (16.1 million) would require at least P38.6-billion in funding– more than P10-billion above present levels of earmarked revenues. Add the administrative costs of the transfer program, and other social benefits promised by TRAIN (e.g. fuel vouchers), and it is clear that the revenue-spending gap will be substantially larger than this estimate. Absent such funding, TRAIN’s promised cash transfers and social benefits will only remain promises for many— if not most— targeted households.

A second overriding challenge concerns serious obstacles in the targeting of transfers. The effectiveness of the transfer program hinges on the availability of reliable data concerning beneficiaries, and for this TRAIN’s champions have pinned their hopes on the Department of Social Welfare and Development’s (DSWD) Listahan— a nationwide household database for targeting social protection programs.

But DSWD’s Listahan has come under fire for reliability issues. In fact, an October 2017 Performance Review by the Commission on Audit (COA) found that the database has been prone to “discrepancies, duplicates, and/or errors” resulting from “poor data gathering” during the DSWD’s 2009 household assessment. As a result, COA found, the Listahan’s exclusion error rate (i.e. exclusion of eligible beneficiaries) is currently at an alarming 30%, while its inclusion error rate (i.e. inclusion of non-eligible households) is at 25%.

Predictably, programs based on the Listahan have suffered from high leakages: in 2015, the World Bank estimated that the Pantawid Pamilya Pilipino Program (4Ps)— the biggest precedent for TRAIN’s transfer program— suffered from leakage rates concerning 35% of beneficiaries.

Quo vadis TRAIN?

Clearly, TRAIN brings immediate benefits to the middle class, by adjusting our personal income tax system. But additional policies and programs will be needed before the poor and low income households gain, if at all, from the tax package.

For one, DSWD’s Listahan needs to be fixed for transfers to be well-targeted, and much more revenues have to be generated to ensure that pledged social protection spending and pro-poor infrastructure investments materialize. Here, rice policy reforms could turn the tables in favor of the poor by decreasing the burden of food prices on their budgets, while at the same time raising additional funding for social protection.

Just as capitalism must sometimes be saved from capitalists, our momentum for tax reform must now be shielded from TRAIN’s weaknesses. For TRAIN’s benefits for low-income Filipinos to be reaped, much will hinge on the adoption of pro-poor policies in the months ahead, as well as their effective execution.

More than once, government has fallen short of this task. History will repeat itself if we continue to fixate on economic growth while forgetting inclusiveness yet again.

Ron Mendoza is the Dean of the Ateneo School of Government (ASOG). Jerik Cruz is an economist at ASOG. The views expressed by the authors do not necessarily reflect those of the Ateneo de Manila University.