Philippines lowering taxes and easing the business climate

Years of robust macroeconomic growth combined with prudent fiscal policy have left the Philippines well positioned to boost public spending in 2017, with infrastructure, security and education set to benefit from double-digit increases this year. Although the fiscal deficit is set to hit a record high, the country’s positive growth outlook, improved transparency and rising public expenditure on new infrastructure projects have led to a number of ratings upgrades, thus enabling it to tap the international debt market to finance some of its growth. Sweeping tax reforms, which include expanding the value-added tax (VAT) base and reducing corporate and personal income tax rates to improve compliance should also help offset spending increases, keeping the country’s infrastructure agenda on track in 2017.

Spending Surge

Public spending has been on the rise in the Philippines in recent years. Under the administration of former president Benigno Aquino III, Congress approved a 15% increase to the 2016 national budget in December 2015, which was expected to boost infrastructure and defence spending. Budget expenditure rose to a record P3trn ($63.5bn), up from P2.6trn ($55bn) in 2015, according to media reports.

Infrastructure is set to become a leading economic growth driver for the country in the coming years, under the government’s far-reaching public-private partnership (PPP) programme. The segment was the recipient of increased funding during 2016, to the tune of a 29% increase on the previous year. This has helped the economy maintain strong real GDP growth, which stood at 6.8% for the year. The previous administration targeted an increase in infrastructure spending to 5% of GDP in 2016, from 4% in 2015, a trend which is being continued by the new government.

Defence

Ongoing territorial disputes with China over the South China Sea, where $5trn of seaborne goods travel annually, have also necessitated new defence investment, with the 2016 budget allocating a record P25bn ($528.9m) of spending to purchase frigates, surveillance planes and new radar equipment to bolster monitoring activities along the Philippines’ maritime borders. This is in line with broader regional trends. According to IHS Janes, a UK publishing company that specialises in defence analysis, total defence spending in the Asia-Pacific region reached $533bn in 2016, from $435bn in 2015. The Aquino administration also moved to boost the salaries of public employees for the first time since 2009. The February 2016 announcement approved an order to raise the compensation for over 1.3m public sector employees, with P57.9bn ($1.2bn) allocated in the 2016 budget. The move is expected to have a positive effect on domestic consumption, a key growth driver in the country.

Ratings Upgrade

Although public spending rose considerably during 2016, the government’s prudent fiscal policies have left it with plenty of fiscal space. In September 2016 the IMF reported that the Philippines’ fiscal position remained robust in 2015: the national government’s fiscal deficit stood at just 1.4% of GDP, and general government debt at 35% of GDP. In June 2016 the country’s outgoing minister of finance, Cesar Purisima, told media the new administration of President Rodrigo Duterte was set to have ample fiscal space to support future growth as a result of the prudent fiscal policies that had been pursued.

Purisima also noted that these policies, combined with robust macroeconomic expansion and positive growth forecasts, have made the country increasingly attractive to potential international investors. This is evident in the number of recent ratings upgrades from international ratings agencies. For instance, Moody’s upgraded the country from “Baa3” to “Baa2” in December 2014, citing lower public debt levels and strong economic growth prospects, following which the country issued $2bn of 25-year, US dollar-denominated bonds. Moody’s reaffirmed the “Baa2” rating in October 2016. Meanwhile, in January 2016 NICE Investors Service upgraded the Philippines’ sovereign credit rating from “BBB-” to “BBB” as a result of improved government transparency and rising infrastructure investment, putting the country in investment-grade territory. The following month, the country sold another $2bn of 25-year, US dollar-denominated bonds, with a record low yield of 3.7%, reflecting the significant level of investor confidence despite ongoing global volatility.

The Latest Budget

The new administration of President Duterte is keen to make progress on planned new infrastructure projects, in addition to boosting budgets for education and security, touting what it describes as the “golden age” of public infrastructure spending in the 2017 budget, which was submitted to the House of Representatives in August 2016.

Total spending will rise by 12% to $72bn in 2017, according to the draft budget. Areas benefitting most from the budget hike include a 25% increase on police spending and a 31% expansion in education funding. Infrastructure is another big winner, with spending set to rise to 7% of GDP – well above the 5% targeted by both the current and previous administrations. The president’s office will also see a surge of new funding, with budgetary allocations rising from P2.86bn ($60.5m) in 2016, to P20bn ($423m) this year, in part to support the country’s plans to host the ASEAN summit.

The country’s deficit is expected to rise to $10.3bn, or 3% of GDP in the upcoming year, which is nearly quadruple the P121.7bn ($2.6bn) deficit recorded in 2015. The deficit was 2.7% of GDP in 2016. Although the IMF, in its most recent Article IV Consultation, wrote that the Philippines should target a deficit of this size, the previous administration was able to earn ratings upgrades as a result of its strict fiscal policy. While public spending will be critical for delivery of big-ticket items, bolstering government revenues is an equally important priority, and here too the government plans to bolster revenues through ambitious tax reforms.

Tax Reforms

On making the August budget announcement, the president also unveiled plans to ask Congress to approve a major tax reform plan, projected to boost tax revenues by 10% in 2017 to hit P2.48trn ($52.4bn). Borrowing is simultaneously forecast to drop by 9.2%. Tax reforms have been on the agenda for some time – the country’s tax code has not been amended or reformed since 1997. Purisima told local media in May 2016 that he had drafted a $7bn tax “wish list” to be shared with his successor, Carlos G Dominguez III.

The wish list reportedly includes proposals to reform both the corporate and income tax systems, as well as increase VAT and introduce new subsidies to sustain the country’s recent fiscal gains. Under Purisima’s proposal, which would raise the VAT rate to 14% and expand its base by replacing exemptions with subsidies, estimated gains range from P164.5bn ($3.5bn) to P351bn ($7.4bn) during the first year of implementation.

High Rates, Low Collection

In September 2016 President Duterte introduced five new legislative packages aimed at bringing down rates and widening the tax base. Since tax brackets have not been indexed to inflation, minimum wage workers in Manila currently pay a 25% marginal tax rate, while the top personal income tax rate of 32% is applied to anyone earning more than $10,284 annually, making the country’s income tax rates the highest in South-east Asia. However, just 6.2% of income tax owed is collected, according to an October 2016 press report, compared to 83.7% in the US.

In January 2016 the Bureau of Internal Revenue (BIR) announced that income taxes are expected to account for the bulk of its P2trn ($42.3bn) revenue collection target, which is a 21% increase over the target set in 2015 of P1.67trn ($35.3bn). Income taxes will comprise 62% of the target, up from 60% in 2015. Corporate income tax is also the highest in the region, at 30%, although most companies pay just 11.6% because of loopholes, which often brings rates down to the minimum of 2% of profits. Corruption also continues to play a role in low levels of tax collected. As a result, corporate income tax revenues comprise just 3.5% of GDP, much less than regional neighbours with lower rates.

Widening The Base

Under President Duterte’s proposed reforms, the corporate tax rate will fall to 25%, while the minimum rate will rise to 15%. Personal income tax reforms will remove taxes for any individuals earning less than $5142 annually, simplifying income tax brackets and indexing them to inflation. The tax on investment income will drop from 20% to 10%, while real estate taxes will be reduced from 20% to 6%, which could help free up the market for land and other assets. The Duterte administration has also proposed an extra tax for the “ultra-rich”, a 35% rate on any individual earning more than $102,902 annually. However, international media notes that there are less than 1000 individuals reporting this level of income, while most very wealthy families in the Philippines earn their income from investments, putting the country at risk of a brain drain under the proposed new regime.

The reforms will also remove exemptions from VAT, in addition to increasing excise taxes on fuel and sugar, to offset falling income and profits rates. The final package also includes an array of luxury and excise taxes. This includes a proposed tax increase on vehicles, with the rate for those worth less than P600,000 ($12,690) rising from 2% to 5%; 20% for vehicles worth between P600,000 ($12,690) and P1.1m ($23,300); 40% for vehicles priced from P1.1m ($23,300) to P2.1m ($44,425); and 60% for vehicles worth more than P2.1m ($44,425).

These measures, in addition to new moves to improve compliance – which could include tax amnesty measures – should help the BIR meet future targets. Domestic reception to the proposed reforms has been largely positive, and in October 2016 the IMF expressed support for the planned reforms, noting the policy will be “net revenue positive with due attention paid to equity”.

Perhaps even more promisingly, Moody’s announced in the same month that it has plans to upgrade the Philippines’ rating again, noting that the planned tax reform plan would be credit positive, and in February 2017 reiterated its position that the country is among the region’s least vulnerable economies. This is expected to help ensure the government has a variety of financing options available to support its rising public spending, which should in turn facilitate further economic growth.