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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). Thegovernance 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 isfurther divided into barangays, the smallest political unit. Further, there are independentcities (such as those in the Metro Manila region) that are on the same level as provincesand they share the same functions and authorities.

Philippines Local Government Units

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 athree year term and up to a total of nine consecutive years. As of March 2008, there are 17administrative 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 definecentral-local relations and these acts started the decentralization process in the Philippines.Both pieces of legislation included provisions that increased the share of local governmentunits (LGUs) in central government revenues, broadened LGU taxing authorities, anddevolved 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 theareas such as land use planning, solid waste disposal, primary health care, social welfareservices, municipal services and enterprises, and local infrastructure facilities now restswith the LGU after the LGC transferred them from the national government agencies.LGUs also administer other services and facilities like garbage collection, publiccemeteries, public markets and slaughterhouses. After the passage of the Code, LGUs havethe power to levy and collect local taxes, the issue and enforce regulations governing theoperation of business activities in their jurisdictions,

Highly UrbanizedCitiesMunicipalitiesComponentCitiesBarangays BarangaysProvincesBarangays

Standard & Poor’s

Low Predictability

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

Central transfers (IRA; Internal Revenue Allotment) were previously an unpredictablesource of revenue for LGUs. Although it was mandated by the LGC, the centralgovernment would reduce the amount of IRA transfers to LGUs whenever it was facedwith severe fiscal constraints. In 1998, 5% of IRA was not released to LGUs as a fiscalausterity measure. In 2000, Congress lopped off PHP 10 billion and set aside this amountunder Un-programmed Funds. In 2001 and 2003, IRA was reduced by PHP 16 billion andPHP 9 billion respectively due to re-enactment of the budget. However after two SupremeCourt 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 centralgovernment from 2006 onwards, reclassified IRA in the National Budget to a special annexsection (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 hasgenerally not been enough to match its expenditure needs. Total LGU spending increasedfrom 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, communitytaxes 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 categoricalgrants. LGUs have to allocate 20% of IRA for development purposes, other than that theyhave 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 andthe LGU.LGUs’ expenditure has doubled relative to the general government’s expenditure in varioussectors 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 levylocal taxes, the tax base outside of the real property and business tax is not significant, andthe bulk of productive sources of local revenue still rest with the central government. It isalso difficult for LGUs to maintain the real value of their revenues as the Code prescribesthat 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 theshare of IRA to be allocated to LGUs in the current fiscal year base on national revenuecollection three fiscal years preceding it. The backward-looking formula indicates thatLGUs have to support current expenditures based on revenue streams as of three years ago.2

Standard & Poor’s

Currently, 40% of the revenue tax collections of the central government are allocated asIRA for local governments. In turn, how much each LGU gets is determined by a simplisticformula of 50% based on population size, 25% on land mass and 25% equally dividedamong all the LGUs. The formula does not take into account the own-source revenuecapabilities 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 moredeveloped LGUs (such as those in the Metro Manila area) which already have substantialown-source revenues are given more IRA due to their relatively larger populations, whilethe poorer regions are given a smaller share. Currently, the Metro Manila cities deriveabout one-third or less of their income from IRA, in contrast to the less-developed LGUswhere as much as 80% of their revenue is dependent on IRA. The allocation had added tothe 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, auditand 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 accrualsystem. However the transition has not been smooth. LGUs now report on a mixed accrualstandard, where expenditures are reported on accrual basis and three methods are adoptedfor 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 andexpenditure statement extremely difficult. Cash-flow statement, statement of income andexpenditures and the balance-sheet cannot be reconciled, and there are many deficiencies inreporting of assets and liabilities.Transparency of operations is generally poor. Out of the 217 LGUs audited by COA in2007, only 18% did not receive qualifications on their financial statements, 76% weregiven qualified opinions and 6% were given an adverse opinion (financial statements withdefects 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 LGUschoose to ignore audit recommendations year after year. However, if deficiencies inreporting involve misappropriation of cash or are graft-related, COA can pass the case tothe Office of Ombudsman for criminal proceedings.

Weak Fiscal Policy Framework

Two broad fiscal principles guide central monitoring of LGUs; The Department of Financemakes 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 morethan 45-55% (depending on class of LGU) of total regular income on salaries. These twoguidelines are strictly monitored by the two agencies and non-compliance can result inharsh 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 taxrevenues. Operating expenditures take up most of their revenues and capital outlays onlyaverage around 7.5% of their yearly budget. Such low spending on infrastructure is not3