Report and Recommendation of the President to the Board of Directors

Transcription

1 Report and Recommendation of the President to the Board of Directors Project Number: October 2009 Proposed Loan for Subprogram 2 Republic of the Philippines: Local Government Financing and Budget Reform Program

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3 CURRENCY EQUIVALENTS (as of 6 October 2009) Currency Unit peso (P) P1.00 = $ $1.00 = P46.61 ABBREVIATIONS ADB Asian Development Bank BIR Bureau of Internal Revenue BLGF Bureau of Local Government Finance CCD Coordination Committee on Decentralization CDP comprehensive development plan COA Commission on Audit COBP country operations business plan CSC CSP - Civil Service Commission country strategy and program DBM Department of Budget and Management DENR Department of Environment and Natural Resources DepEd Department of Education DILG Department of the Interior and Local Government DOF Department of Finance DPSP Development Policy Support Program DPWH Department of Public Works and Highways GAA general appropriations act GDP gross domestic product GFI government financial institution GPRA Government Procurement Reform Act IRA internal revenue allotment LBM local budget memorandum LEE local economic enterprise LGC Local Government Code LGFBR Local Government Financing and Budget Reform LGFPMS local government financial performance monitoring system LGPMS local governance performance management system LGU local government unit LIBOR London interbank offered rate LOGOFIND Local Government Finance and Development MDFO Municipal Development Fund Office MDG Millennium Development Goal MTPDP Medium-Term Philippine Development Plan NEDA National Economic and Development Authority ODA official development assistance OPIF organization performance indicator framework PDAF Priority Development Assistance Fund PDF Philippines Development Forum PGB Policy Governing Board PROLEND program lending facility Q quarter

4 SEF Special Education Fund SRE statement of receipts and expenditures TA technical assistance NOTES (i) (ii) The fiscal year (FY) of the Government and its agencies ends on 31 December. In this report, "$" refers to US dollars. Vice-President C. Lawrence Greenwood, Jr., Operations 2 Director General A. Thapan, Southeast Asia Department (SERD) Directors N. Jain, Philippines Country Office, SERD J. Ahmed, Financial Sector, Public Management, and Trade Division, SERD Team leader Team members T. Niazi, Senior Public Sector Management Specialist, SERD J. Balbosa, Economist (Fiscal Management), SERD C. Buentjen, Senior Governance and Capacity Development Specialist, SERD R. O Sullivan, Senior Counsel, Office of the General Counsel C. Planco, Administrative Assistant, SERD In preparing any country program or strategy, financing any project, or by making any designation of or reference to a particular territory or geographic area in this document, the Asian Development Bank does not intend to make any judgments as to the legal or other status of any territory or area.

5 CONTENTS Page LOAN AND PROGRAM SUMMARY i I. THE PROPOSAL 1 II. THE MACROECONOMIC CONTEXT 1 III. THE SECTOR 4 A. Review of the Sector and Performance 4 B. Issues and Opportunities 11 C. Lessons 16 IV. THE PROPOSED PROGRAM 17 A. Impact and Outcome 17 B. Policy Framework and Assessment of Subprogram 2 Core Policy Actions 18 C. Proposed LGFBR 2 Indicative Policy Actions 23 D. Important Features 25 E. Financing Plan 25 F. Implementation Arrangements 26 V. TECHNICAL ASSISTANCE 29 VI. PROGRAM BENEFITS, IMPACTS, ASSUMPTIONS, AND RISKS 30 A. Expected Impact 30 B. Risks and Mitigating Measures 31 VII. ASSURANCES 32 VIII. RECOMMENDATION 32 APPENDIXES 1. Design and Monitoring Framework Development Policy Letter Policy Matrix Progress in Achieving Design and Monitoring Framework Impact and Outcome Indicators Performance of Local Government Financing and Budget Reform Subprogram 2 Triggers Proposed Second Local Government Financing and Budget Reform Subprogram 1 Triggers and Milestones ( ) Development Partners Coordination Matrix Sector Analysis: Decentralization, Service Delivery, and Governance Summary Poverty Reduction and Social Strategy List of Ineligible Items 73 SUPPLEMENTARY APPENDIX (available on request) A. Detailed Sector Analysis: Fiscal Decentralization in the Philippines

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7 LOAN AND PROGRAM SUMMARY Borrower The Proposal Classification Environment Assessment Program Rationale Republic of the Philippines A proposed loan of $225 million for subprogram 2 for the Local Government Financing and Budget Reform (LGFBR) Targeting classification: General intervention Sector (subsector): Public sector management (public expenditure and fiscal management) Themes (subthemes): Governance (public administration); economic growth (promoting economic efficiency and enabling business environment); capacity development (organizational development) Location impact: National/regional/rural/urban (high) Partnership: Agence Française de Développement Category C The Local Government Code (LGC), 1991, transferred the main responsibility for the delivery of basic services in health, education, infrastructure, etc., to local government units (LGUs), which are provinces, cities, municipalities, and barangays (villages or neighborhoods). Decentralization has brought choices closer to the people while opening up space for innovative responses and solutions to service delivery issues. The LGC s finance follows function premise set in place an intergovernmental transfer mechanism for sharing the revenues of the Government of the Philippines (the Government) while allowing local governments to raise their own revenues. However, LGUs capability to discharge their functions is constrained, as the Philippines still faces challenges in ensuring that stable mechanisms function to channel adequate resources to local governments. Financial accountability, transparency, and capacity are also significant constraints on local governments. While the scope of decentralization includes fiscal, administrative, and political dimensions, the LGFBR focuses mainly on the fiscal dimension, where implementation difficulties have been challenging and are perceived as binding. It supports the ongoing efforts of the Government to improve local financing by facilitating LGUs access to development credit, service delivery by financing credit for devolved services, and governance by improving public financial management and implementing local procurement reforms. Subprogram 2 of the LGFBR will continue to broaden the reform program in five target areas: (i) improving the completeness, timeliness, and transparency of local governments sharing of national revenues; (ii) deepening reforms in fiscal management, planning, and public expenditure management by enhancing efficiency and accountability in these areas;

8 ii (iii) enhancing effectiveness and transparency in the delivery of critical public services locally; (iv) improving LGUs access to public and private sources of capital for financing policy reforms and development projects; and (v) reducing LGU dependence on internal revenue allotment by developing buoyant local sources of revenue, thereby reducing fiscal pressure on the Government. The Asian Development Bank (ADB) Philippine country strategy and program and the country operations business plan (COBP) strongly support decentralization and good local governance in the country's development, as outlined in the medium-term Philippine development plan. COBP emphasizes alignment with Government priorities, selectivity, and quality at entry. It affirms ADB s continued support for medium-term reforms through the LGFBR, now in its second subprogram. ADB supports the Government's effort to mainstream results management and monitor and strengthen systems for public expenditure management and performance budgeting to help local governments use scarce public resources more efficiently. ADB has played an active role and participated extensively in the activities of the Philippines Development Forum working group for decentralization and local governance toward cascading reforms in public financial management, procurement, and anticorruption to local governments. This supports ADB's second governance and anticorruption action plan. The LGFBR hence complements ADB's policy-based support to justice sector reform through its Governance in Justice Sector Reform Program and Development Policy Support Program, now on its third subprogram. The reform program was prepared by a joint team of representatives of the Government and ADB working together since Impact and Outcome Financing Plan LGFBR subprogram 2 will support the Government in its efforts to help LGUs develop enhanced capacity to plan and budget for the general welfare of their constituents in a transparent and accountable way. It will contribute to increased efficiency and effectiveness in the delivery of basic public services to residents by expanding LGUs fiscal resources and financing options. The intended impact will be achieved by (i) strengthening the policy, financing, financial, and regulatory framework for decentralization and (ii) developing capacity in local governments. A loan of $225 million from ADB s ordinary capital resources will be provided under its London interbank offered rate (LIBOR)- based lending facility. The loan will have a 15-year term including a grace period of 3 years, an interest rate determined in accordance with ADB s LIBOR-based lending facility, a commitment charge of 0.15% per annum, and such other terms and conditions as set forth in the draft program loan agreement. Cofinancing will be provided by Agence Française de Développement in an amount of 150 million (approximately $216 million).

9 iii Period and Tranching The program cluster period is from January 2006 to December 2009, with a single tranche loan of $225 million to be disbursed under subprogram 2 upon the Government s meeting the conditions for effectiveness. Subprogram 1 of the new cluster LGFBR 2 will be submitted for Board consideration approximately 36 months after the effectiveness of subprogram 2, subject to adequate progress of reforms and the Government s readiness to continue with its reform agenda. Counterpart Funds Executing Agency Implementation Arrangements Procurement and Disbursement Program Benefits and Beneficiaries The Government will use the local currency counterpart funds generated by the loan proceeds to meet program expenditures and associated costs of local reforms. Department of Finance (DOF) The Department of Interior and Local Government (DILG), Department of Budget and Management (DBM), National Economic and Development Authority (NEDA), Bureau of Local Government Finance (BLGF), and Municipal Development Fund Office (MDFO) will be the implementing agencies responsible for implementing the Program. An LGFBR coordination committee has been established and is chaired by the undersecretary of DOF and comprises officials from DILG, DBM, and NEDA. It is responsible for coordinating the implementation of LGFBR reforms. The committee meets semi annually to monitor progress and oversee the implementation of the LGFBR, and it provides guidance and direction to the executing and implementing agencies. The loan proceeds will be used to finance the full foreign exchange costs (excluding local duties and taxes) of items produced and procured in ADB member countries, excluding ineligible items and imports financed by other bilateral and multilateral sources. The loan proceeds will be disbursed to the Borrower in accordance with the provisions of ADB s Simplification of Disbursement Procedures and Related Requirements for Program Loans. LGFBR subprogram 2 provides significant benefits and a positive impact on local service delivery, financing, and governance. The key benefits are: (i) (ii) streamlined intergovernmental fiscal relations resulting from completeness, timeliness, and transparency in the release and reporting of LGUs shares of national Government revenues, thereby improving the accuracy of local budgeting and the programming of local expenditures; improved transparency, efficiency, and accountability in planning, public expenditure management, and financial

10 iv management as a result of rationalized and streamlined national Government oversight functions and strengthened local capacity; (iii) (iv) (v) enhanced delivery of critical public services locally by providing additional financing options and linking them to performance outcomes, as well as improved national Government LGU arrangements for devolved functions; greater LGU access to public and private sources of capital as a result of an improved policy and institutional environment, thereby contributing to improving LGU ability to finance the delivery of local public services; and expanded LGU own-source revenues to fund social and development expenditures as a result of strengthened LGU capacity to generate revenues from real property and business taxes, thereby reducing LGU reliance on national Government transfers. Risks and Assumptions The potential risks to subprogram 2 and underlying assumptions are as follows: (i) (ii) (iii) Political delays. Delays may be experienced in engaging the national Government and LGUs for subprogram 2, as national elections will be held in May However, the triggers for subprogram 2 have been discussed with the oversight agencies, and the policy directions inherent in the triggers have been discussed with the LGU leagues policy secretariat during meetings of the Coordination Committee on Decentralization (CCD) and other consultations. Financial crisis. Key government agencies at all levels of government may be preoccupied by measures to mitigate the impact of the global financial crisis on the economy and vulnerable groups. This may leave limited resources to implement the agreed program. In addition, internal financial problems may result in a lower internal revenue allotment for LGUs. The risk is mitigated insofar as measures included in the LGFBR, such as the policy on the use of the education fund or those intended to implement the performance-based incentive policy, directly contribute to crisis mitigation and are likely to be prioritized. Coordination problems and capacity constraints. Willingness for coordination among oversight agencies for harmonizing local planning, investment programming, revenue administration, budgeting, and expenditure management may weaken over time. To resolve possible

11 v issues and to ensure continued progress, the CCD has been organized to address issues of intergovernmental coordination raised by the Joint Memorandum Circular and other LGU issues. The CCD has been accepted by oversight agencies and LGU league members as a forum for open discussion of conflicting positions. (iv) Resource constraints. The Government may run out of resources for capacity development planned under the LGFBR. Although these are heavily funded by current ADB projects, it is possible that some training programs may be underfunded. However, many donors are also providing technical assistance (TA) grants for local reforms and capacity development. Technical Assistance In connection with the LGFBR, the Government has asked ADB for an advisory TA grant. The proposed TA for Support to Local Government Financing will be processed separately.

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13 I. THE PROPOSAL 1. I submit for your approval the following report and recommendation on a proposed loan for subprogram 2 to the Republic of the Philippines for the Local Government Financing and Budget Reform (LGFBR) Program. The LGFBR is a program cluster comprising two subprograms prepared by a joint team of representatives of the Government of the Philippines (the Government) and the Asian Development Bank (ADB). The design and monitoring framework is in Appendix 1. II. THE MACROECONOMIC CONTEXT 2. Global financial crisis and Government response. The economic expansion of Philippines has been notable in the past 5 years with sound macroeconomic policies, fiscal consolidation targets on track, and a favorable external economic environment. Growth has been steady and rising, culminating in a 3-decade high of 7.2% in However, the economic expansion in the past 5 years has not translated into substantial poverty reduction. Data from the Government shows that income poverty increased from 30% in 2003 to 32.9% in In addition, a forthcoming ADB report shows that inequality in the Philippines is among the worst in Southeast Asia, with a Gini coefficient of 43.97, higher than for Cambodia, 34.3 for Indonesia, for the Lao People s Democratic Republic, and for Malaysia. 1 The Medium-Term Philippine Development Plan (MTPDP) postulates that poverty is mainly a rural phenomenon, though urban poverty is on the rise and poverty levels vary greatly by region. 2 There are regions where poverty incidence has been persistently high (such as Caraga and regions V, VIII, IX, and IV-B). The MTPDP emphasizes the role of local governments in the fight against poverty. 3. While sustained high growth would have contributed to significant poverty reduction, external shocks have recently come into play. In 2008, gross domestic product (GDP) growth slowed sharply, reflecting the effects of high inflation especially affecting prime commodities. This was reinforced by the global financial crisis and growth slowdown, which weakened global demand. The Philippines was hard-hit first by more restricted access to capital markets and subsequently by slowing remittances and a fall in exports. Prospects for growth remain weak in 2009, as further deceleration of the Philippine economy is expected with the weakening of global demand for Philippine exports, including labor. The likely further dampening of domestic demand and investment will bring higher unemployment and a further setback in the antipoverty efforts of the Government and the achievement of the Millennium Development Goals (MDGs). 3 Table 1 presents data on key indicators for 2007 and In early 2009, the Government announced a P330 billion ($6.9 billion) fiscal stimulus package to counter the effects of weakening external demand and boost domestic economic activity, comprising (i) a P160 billion budget appropriation in 2009 to expand welfare programs such as cash transfers to poor families and road maintenance, (ii) P100 billion for large infrastructure projects to be funded by Government corporations and social security institutions, and (iii) P70 billion in tax breaks. 4 1 ADB. Forthcoming. Poverty in the Philippines: Causes, Constraints and Opportunities. Manila. 2 Government of the Philippines, National Economic and Development Authority Medium-Term Philippine Development Plan Manila. 3 In June 2009, the Government revised its GDP growth targets for 2009 to % from %. The International Monetary Fund in April 2009 revised its projections downward from zero growth to 1.0%. 4 ADB Asian Development Outlook Manila.

14 2 Table 1: Philippines Economic Indicators Fiscal Year Item st Half 2009 A. Income and Growth 1. GDP per Capita ($, current) 1, , , , GDP Growth (%, in constant prices) a. Agriculture b. Industry (1.3) c. Services B. Saving and Investment (current and market prices, % of GDP) 1. Gross Domestic Investment Gross Domestic Saving C. Money and Inflation (annual % change) 1. Consumer Price Index Total Liquidity (M2) a D. Government Finance (% of GDP) 1. Revenue and Grants Expenditure and Onlending Overall Fiscal Surplus (Deficit) (2.7) (1.1) (0.2) (0.9) (4.3) E. Balance of Payments 1. Merchandise Trade Balance (% of GDP) (7.9) (5.7) (5.8) (7.5) (6.0) 2. Current Account Balance (% of GDP) Merchandise Export ($) Growth (annual % change) (2.6) (33.2) 4. Merchandise Import ($) Growth (annual % change) (32.5) F. External Payments Indicators 1. Gross Official Reserves (including gold, $ million in months of current year's imports of goods) b External Debt Service (% of exports of goods and services) c Total External Debt (% of GDP) c G. Memorandum Items 1. GDP (current prices, P billion) 5, , , , , Exchange Rate (P/$, average) Population (million) ( ) = negative, = not available. GDP = gross domestic product. a 2009 figure refers to June 2009 versus June b Represents average imports of goods and payment of services and income. c 2009 figure refers to January to April Sources: Bangko Sentral ng Pilipinas, Bureau of Treasury, National Statistics Office, National Statistical Coordination Board (August 2009 report). 5. In addition to the benefits that local governments indirectly obtain from the Government's fiscal stimulus program through increased budgetary resources in line agencies, direct transfers to local governments have been increasing as well. Internal revenue allotment (IRA) increased at a rate of 9% annually in , accelerating to 16% in 2008, while its share of total national Government expenditure increased from 16.4% in 2004 to a high of 17.1% in The increased transfers were made possible by the rise in tax collection due to the new value-added tax law, increased corporate income taxes, and greater tax collection efforts. The subsequent weakening of national tax collection will decrease transfers to local governments.

15 Figure 1: Share of Internal Revenue Allotment in Total National Government Expenditure, (% of total national government expenditure) Role of local governments in development strategy. The deteriorating external environment and its impact on the domestic economy brings to the fore the critical role of local governments in stimulating domestic demand in the short run and supporting the development agenda of the country in the medium term. It is therefore important to strengthen the link between national plans and local government plans and programs. The trickle-down effect of the fiscal stimulus package will be maximized only if local governments have effective servicedelivery mechanisms. Local governments need to be supported in the development agenda with performance-based incentives that make them more efficient. With increased resources coming from the national Government, public financial management systems and accountability mechanisms need to be further strengthened. Local governments must not rely only on national Government transfers to finance development; other sources of credit financing, especially ownsource revenue, are critical in an environment where national tax collection is sluggish because of the economic slowdown. 7. ADB and development partners support for local good governance. The Philippines country strategy and program and the country operations business plan (COBP) strongly underscore the role of decentralization and good local governance as outlined in the MTPDP (footnote 2). 5 The COBP emphasizes alignment with government priorities, selectivity, and quality at entry. It affirms ADB s continued support to medium-term decentralization reforms through the LGFBR, a program cluster now in its second subprogram. 6 ADB s strategy supports the Government's effort to mainstream results management and cascade public expenditure management and anticorruption reforms to local governments. In line with this objective, ADB has participated extensively in the activities of the working group for decentralization and local government under the Philippines Development Forum. The working group has evolved into a potent platform for all stakeholders development partners, government agencies, local governments, private sector and civil society to facilitate dialogue and coordinate reform efforts on core local government development issues. The priority reform areas of the governance and anticorruption action plan are supported by the LGFBR and complement ADB's policy-based support to the justice sector through the Governance in Justice Sector Reform Source: Department of Finance 5 ADB Country Strategy and Program ( ): Philippines. Manila; ADB Country Operations Business Plan ( ): Philippines. Manila. 6 ADB Report and Recommendation of the President to the Board of Directors on a Proposed Program Loan and Technical Assistance Grant to the Republic of the Philippines for the Local Government Financing and Budget Reform Program Cluster (Subprogram 1). Manila (Loan 2387-PHI, for $300 million).

16 4 Policy Support Program, now on its third subprogram. 7 Figure 2 captures the interlinkages of Government and ADB reform programs. Figure 2: Links between the Medium-Term Philippine Development Plan, Philippines Development Forum, ADB s CSP, and LGFBR CSP Pillars CSP = country strategy and program, DPSP = Development Policy Support Program, LGFBR = Local Government Financing and Budget Reform, LGU = local government unit, MTPDP = Medium-Term Philippine Development Plan, PDF = Philippines Development Forum. Note: Bold italics show interlinkages. Source: Asian Development Bank staff estimates. III. THE SECTOR A. Review of the Sector and Performance 8. Sector review backed by significant knowledge services. ADB technical assistance (TA) completed in 2009 a set of landmark studies that comprehensively covered the state of decentralization in the Philippines. It recommended improving the allocation and utilization of the Special Education Fund, a personal expenditure policy for local government units (LGUs) incorporating pay and staffing concerns, improved financial management of local economic enterprises, better tracking of the fiscal position of LGUs, and rationalizing LGU access to official development assistance. 8 This work provided great insights into ongoing reforms and promises to break new ground in charting future reforms (Appendix 8). In addition, a local 7 ADB Report and Recommendation of the President to the Board of Directors on a Proposed Program Cluster, Loan for Subprogram 1, and Technical Assistance Grant to the Republic of the Philippines for the Governance in Justice Sector Reform Program. Manila; ADB Report and Recommendation of the President to the Board of Directors on a Proposed Program Cluster, Loan, and Technical Assistance Grant to the Republic of the Philippines for the Development Policy Support Program. Manila. 8 ADB Technical Assistance to the Republic of the Philippines for the Local Governance and Fiscal Management Project. Manila (TA 4778-PHI, $1.8 million).

17 5 service delivery study is clarifying the division of service delivery responsibilities between national and local governments and among LGU levels (province, city, and municipality) and setting up service benchmarks according to LGU income class. 9. One of the studies concluded that the decentralization that started with the enactment of the Local Government Code (LGC) in 1991 has encountered its share of challenges and problems, but there is clear evidence that much progress has been made locally on a number of fronts. On the whole, success in decentralization owes mainly to (i) the presence of an enabling policy environment, (ii) strong local leadership, (iii) improved access to financial resources, (iv) strengthened inter-lgu partnerships, (v) wider participation by nongovernment organizations and civil society, and (vi) a broader role for LGU leagues. The major decentralization challenges identified are (i) inadequate local finances, (ii) weak fiscal management and administrative capacity locally and nationally, (iii) the need to monitor performance based on clearly specified criteria, and (iv) inadequate corporate and taxing powers locally. 10. Evolving administrative and legal framework. Since the passage of LGC many bills have been filed in Congress asking for omnibus amendments to it, increasing LGUs IRA shares and creating new LGUs. In 2007, a bill was drafted with ADB TA 9 focusing on amending the local tax provisions of the code. Consultation with LGU leagues and oversight agencies resulted in a final draft endorsed by the stakeholders. 10 The objective of the bill is to improve own-source income from local taxes by removing low and unrealistic ceilings on local tax rates (which have not been adjusted for inflation since 1991), eliminating subjectivity in the interpretation of the law (e.g., the definition of amusement establishments), and simplifying complicated tax schedules that can facilitate corruption (e.g., the schedule of business taxes). Stakeholders are currently advocating bill passage to the LGU subcommittees of both houses of Congress. 11. The oversight agencies the Department of Interior and Local Government (DILG), Bureau of Local Government Finance (BLGF), and Municipal Development Fund Office (MDFO) of the Department of Finance (DOF), National Economic Development Authority (NEDA), and Department of Budget and Management (DBM) accept their role as providers of capacity development to LGUs, but three factors have characterized developments in the administrative and legal environment of LGUs. First, the agencies have sometimes delayed implementing certain LGC provisions. The release of IRA is a case in point. Although the code ordains IRA to be automatically released to LGUs, it has taken a Supreme Court decision and passage of a republic act for DBM to automatically appropriate and release IRA. Politics have also played a part in shaping the administrative and legal environment. DBM is proposing for 2010 a change in the IRA share of 16 cities that the Supreme Court has restored to municipality status, as they had been converted into cities in violation of criteria laid down in the LGC. Figure 3 illustrates the latest local government structure. 12. Second, the oversight agencies have shown their commitment to improving the implementation of decentralization reforms through nonlegislative measures. DOF issued an executive order clearly defining Bureau of Internal Revenue (BIR) responsibility to share tax information with LGUs, along with implementing rules and regulations for BIR regional offices. DOF issued an amendment to the situs 11 of tax for bank branches, allowing LGUs to benefit 9 ADB Technical Assistance to the Republic of the Philippines for the Local Government Finance and Budget Reform Project. Manila (TA 4556-PHI for $850,000); footnote An Act to Strengthen Local Government Units by Amending Certain Provisions in Book II of Republic Act 7160, otherwise known as the Local Government Code, 1991 (draft bill). 11 Situs refers to the site or location of the taxable entity.

18 6 from incomes generated by these branches by levying local business taxes. Figure 3: Structure of the Local Government System in the Philippines National Government (20 national government departments) Highly Urbanized City (33) Independent Component City(5) Province (81) Level 1 Component City (82) Municipality (1,511) Level 2 Barangays(3,007) Barangays (242) Barangays(3,566) Barangays(35,193) Level 3 Notes: As of January Total number of cities = 120; total number of barangays = 42,008. Source: Department of the Interior and Local Government Bureau of Local Government Supervision and National Barangay Operations Office; National Statistics Coordination Board. Source: Asian Development Bank staff estimates. 13. Third, the oversight agencies and LGU leagues have collectively made efforts to institutionalize coordination on decentralization issues. Under the LGC an oversight committee on devolution was created to address implementation issues and other devolution issues. The oversight committee worked during the early years of decentralization to draft implementing rules and regulations. Under the LGFBR, an informal consultative body, the Coordination Committee on Decentralization (CCD), comprising DILG, DOF, DBM, NEDA, and LGU leagues, has met regularly to review and address operational and policy issues related to local fiscal and financial management, public expenditure management, planning, and capacity development. A memorandum of understanding has been drafted and will be submitted to the DILG, DBM, DOF, NEDA and LGU Leagues in order to formalize this body and provide it with logistical resources. 14. Increasingly decentralized service delivery. Local governments have assumed the key role in the delivery of core services, including education, health, and the development of such basic infrastructure as waterworks and roads. An important issue is the impact of decentralization on the quantity and quality of those services. The performance of local governments can be evaluated from the perspective of (i) expenditure (Has there been an adequate increase in expenditures allocated to decentralized services, i.e., have funds followed functions?), (ii) expenditure composition (Is there a desirable mix or composition of expenditures?), or (iii) service delivery (Has the quality of services improved?). 15. Expenditure levels. Total LGU spending doubled from an average of 1.6% of GDP in to 3.5% of GDP in (Table 2). Similarly, the share of LGUs in general government expenditure net of debt servicing rose from an average of 11.3% before LGC promulgation to an average of 24.2% after. However, it has been fairly constant in recent years, at 25.7% in 2001 and 26.7% in The increase in total LGU expenditure was particularly rapid in , during the early years of decentralization, as the IRA share of LGUs increased to the mandated 40% share of BIR revenues. The growth in LGU expenditures was not as rapid in but was fairly stable, as the aggregate IRA pool stabilized at 40% of BIR revenues 3 years prior to the current year. In contrast, LGU expenditures were fairly erratic in given the concomitant movement in IRA due to the reenactment of the General

19 7 Appropriations Act (GAA) in 2001 and 2004 and the partial withholding of IRA in Aggregate LGU spending in 2007 as expressed as a percentage of GDP is 3.2%, which is lower than the 3.8% of Table 2: LGU Expenditure Relative to GDP and General Government Expenditure Ratio of LGU Expenditure to General Year Ratio of LGU Expenditure to GDP Government Expenditure Net of Debt Service Average GDP = gross domestic product, LGU = local government unit. Source of basic data: Commission on Audit annual financial reports for LGUs, various years. 16. Functional composition of expenditures. The transfer to LGUs of functions previously performed by national Government agencies caused a major shift in the composition of LGU budgets. Among the major sectors, social services posted the fastest rate of growth in General public services and economic services grew at a slower pace. Consequently, the share of social services to total LGU expenditure expanded while those of economic services and general public services contracted somewhat. When expressed relative to GDP, LGU spending on social services increased from 0.3% of GDP in 1991 to 0.7% in 2007, while economic services increased only slightly. Table 3: Ratio to GDP of Local Government Expenditures (%) Item NG-LGU Benchmark Grand Total Total Economic Services of which: Agriculture Transportation and Communication Total Social Services of which: Education Health Social Welfare, Labor and Employment Service General Public Service Others Debt Service GDP = gross domestic product, NG-LGU = national government-local government unit. Note: Distribution of LGU expenditures across sectors for projected on the basis of Bureau of Local Government Finance statement of income and expenditures in current years and Commission on Audit (COA) figures in earlier years. Source of basic data: COA annual financial reports for LGUs various years. 17. The increase in LGU spending on social services went to health, education, housing and community development, and social welfare, in that order. Aggregate LGU expenditure on health rose fourfold from 0.08% of GDP in 1991 to 0.30% of GDP in 2007, while LGU spending on education increased threefold from 0.07% of GDP to 0.21% of GDP (Table 3). In contrast,

20 8 total LGU expenditure in 2007 on social welfare, labor and employment services, and on housing and community development, almost doubled from 1991 levels when expressed relative to GDP. Higher LGU expenditures in education and housing and community development since LGC promulgation largely reflect the higher priority that local officials assign to these sectors. The increase in education expenditure may also be attributed to LGUs Special Education Fund (SEF), which grew significantly since LGC promulgation because of LGCmandated adjustments in real property assessments. 18. Although aggregate LGU spending on social services registered a general upward trend in when measured relative to GDP and in real per capita terms, some stagnation was evident in (Table 3). In addition, although LGU spending on education in was higher than the 1991 national Government LGU benchmark, 12 it was lower than the peak registered in Meanwhile, aggregate LGU spending on health and social welfare services in was lower relative to the 1991 benchmark and to their peak posted in 1998 and These trends apply to provinces and municipalities but not to cities and appear to be related to fiscal difficulties faced by LGUs during this period. This trend is worrisome considering that municipalities are primarily responsible for delivering basic health services. It highlights the need to explore the benefits from conditional grant programs aimed at ensuring that LGUs provide health services that meet minimum service standards of access and quality. 13 LGU spending on economic services expanded only minimally from 0.7% of GDP in 1991 to 0.8% in With the devolution of agricultural extension and environment and natural resource management, the expenditure share of these subsectors rose somewhat between 1991 and Social sector expenditure as a proportion of total expenditures remained fairly constant over the years to 2007 (Figure 4). It should be noted that Table 3 relates LGU expenditures to national Government expenditure on items such as health and education. The data show that LGU expenditure relative to GDP has decreased somewhat or is being replaced by national Government spending for the same expenditure item. It does not mean that expenditures by all levels of government for health and education are declining. In fact, LGU expenditures for have been growing by an average annual rate of 4.9% for health and 7.1% for education. 14 A major reason that they have not been growing as quickly is that they are a shared responsibility and LGUs calibrate their response to that of the national Government. The next reforms should rationalize the expenditure responsibilities of national and local governments and set service delivery standards to ensure compliance. These are the directions being sought in the new LGFBR 2 cluster to be prepared in 2012 in reforming personal expenditures, addressing LGU surpluses, and revising the use of the SEF, among other goals. 19. In contrast, despite the devolution of local infrastructure (including constructing and maintaining local roads), LGU spending on transportation and communication since LGC promulgation has not increased much. There has been a shift in LGU spending on transportation and communication away from provinces and municipalities in favor of cities 12 The benchmark figure in 1991 refers to combined national Government LGU spending in respective sectors in that year. 13 National standards can be enforced by asking local governments to spend more on a particular service with a matching grant program or by designing equalization transfers to provide sufficient resources to enable all local governments to provide a minimum package of local services (McLure, Charles E., and Jorge Martinez-Vasquez The Assignment of Revenues and Expenditures in Intergovernmental Fiscal Relations. Paper presented for the core course on Intergovernmental Fiscal Relations and Local Financial Management, World Bank Institute, Washington, D.C.). 14 BLGF statement of income and expenditure data.

21 9 (Table 4). This appears to be driven by the different fiscal capacity of provinces, municipalities, and cities relative to the cost of expenditure responsibilities assigned to them. Thus, cities, which generally received more resources following decentralization relative to the cost of devolved functions, are better positioned to undertake infrastructure investments than provinces and municipalities. These movements are a cause of concern considering the robust link between economic growth and infrastructure spending. As the LGC assigns the primary responsibility for constructing and maintaining local infrastructure to local governments, this trend also points to the growing disparity in economic development across levels of LGUs. It likewise underscores the importance of creating a regulatory framework for encouraging private sector participation in local infrastructure through build, operate, and transfer contracts and joint ventures, as well as the need for an appropriate grant program for LGU capital investments. 20. Quality and coverage of decentralized service delivery. Notwithstanding the assignment of expenditure responsibilities, in practice the delivery and financing of basic services is shared by different levels of government. The provision of basic education per se has not been devolved, so the Department of Education (DepEd) budget was not reduced. However, the LGC gives LGUs access to the SEF, which is earmarked for the operation and maintenance of public schools. The provision of basic education thus becomes a shared responsibility of national and local governments. Meanwhile, the delivery of basic health services has been devolved to LGUs. Recognizing health services as public goods, the national Government has not fully abdicated its role in the sector, however, so the de facto division of responsibilities in health is also somewhat mixed. 21. Although Section 17 (b) of the LGC categorically assigns the provision of local infrastructure to LGUs, the Department of Public Works and Highways (DPWH) continues to play a major role in this area. It is notable that after decentralization DPWH did not devolve personnel and budget in Thus some 22% of DPWH budget in is for local infrastructure projects, which were typically funded out of the pork barrel funds of legislators. Moreover, DPWH allocation for local infrastructure is even larger; 27% more than total LGU infrastructure investments during that period. This acts as a major disincentive to LGUs providing local infrastructure. Figure 4: Share of Social Expenditures to Total Expenditures, 2007 Source: Bureau of Local Government Finance, statement of income and expenditures, Table 4: LGU Spending on Transportation and Communication Item % of GDP % distribution % of GDP % distribution Provinces Municipalities Cities All LGUs GDP = gross domestic product; LGU = local government unit. Source of basic data: Commission on Audit annual financial report for LGUs, various years.

22 Social indicators. It appears that the decline in real per capita social sector spending of government in general has been accompanied by corresponding stagnation in some human development performance indicators (Tables 5 and 6), which show the relationship between general government spending on basic education and health services and selected education and health performance indicators. The same relationship is evident subnationally, as an analysis of division data for 2005 indicates that a positive and statistically significant relationship exists between the elementary school cohort survival rate and per capita DepEd and LGU spending on education. Table 5: Basic Education Outcomes, (%) Item Elementary level participation rate Secondary level participation rate Elementary level cohort survival Secondary level cohort survival rate Elementary level completion rate Secondary level completion rate Elementary level achievement score a 40.1 b Secondary level achievement score a 35.6 b a Based on National Elementary Achievement Test (NEAT) and National Secondary Achievement Test (NSAT) for and National Achievement Test (NAT) for b Refers to Source: Department of Education. 23. These analyses also show a negative correlation between per student DepEd education spending and per student LGU education spending. In contrast, a positive correlation was found between national Government basic health expenditures and LGU basic health spending. Thus, while DepEd tends to allocate its resources in an equalizing fashion relative to the distribution of LGU education spending per capita, the opposite is true in the case of Department of Health spending. This finding has serious implications for the ability of the central Government to help reduce disparities in human development outcomes across regions and geographic areas. Table 6: Selected Health Indicators, (%) Item % of pregnant women with 3 or more prenatal visits % of pregnant women given tetanus toxoid vaccination % of pregnant women given complete iron dosage % of lactating mothers given vitamin A % of live births attended by medical professional, including trained hilot a % of fully immunized children under % of infants given 3rd dose of Hepa B % of diarrhea cases among children under 5 given oral rehydration solution % of pneumonia cases among children under 5 given treatment % of children under 1 given vitamin A % of children between 1 and 5 given vitamin A Tuberculosis morbidity rate b c Malaria morbidity rate b Note: Data shown is for the entire Philippines. a Therapeutic massage. Per 100,000 population. Respiratory plus other forms of tuberculosis. Source: Department of Health, field health service information system, various years 24. Similarly, there is a negative correlation between LGU investments in transport and performance indicators in the transport sector. The decline in LGU spending on transportation

23 11 and communication since 1998 is associated with stagnation in the proportion of paved roads to total roads in provinces, municipalities, and barangays (villages and neighborhoods). The percentage of provincial roads that are paved declined from 20.4% in 1998 to 20.0% in 2001, while that of barangay roads remained at 6.6% in In contrast, the percentage of city roads that are paved increased from 70.2% to 77.0%, while that of municipal roads rose marginally from 34.1% to 34.6%. Moreover, it is notable that the percentage of provincial roads that are paved (20.0%) is lower than the corresponding percentage of national roads (61%), city roads (77%), and municipal roads (35%) in These movements are consistent with the decreasing share of provinces and municipalities in total LGU spending on transportation and communication since LGC promulgation. 25. Poverty and inequality. As expected, poverty incidence correlates negatively with LGU income class (Table 7). As higher incomes classes generally have higher own-source revenues, it is likely that there is also a negative correlation between higher own-source revenues and poverty incidence. Consequently, higher own-source revenue is important for poverty alleviation. At the same time, simply increasing own-source revenues may not be sufficient to address inequality. The disparity among the poor or the range of poverty incidence is almost the same for all income classes, which suggests unequal access to social goods. This means that, in addition to increasing their own-source revenues, LGUs must improve the planning, budgeting and execution of social expenditures. However, there is a need to better define the expenditure responsibilities of the national Government and various LGU tiers for social services, as these are shared functions. Table 7: Poverty Incidences of Provinces by Income Class, 2008 (%) Item 1st Income Class 2nd Income Class 3rd Income Class 4th Income Class 5th Income Class Average Poverty Incidence Range of Poverty Incidence Source: Panadero, A Insights on the ADB Paper on Poverty in the Philippines: Causes, Constraints, and Opportunities. Presentation made at the Crowne Plaza, Ortigas Center, Philippines, 7 May. B. Issues and Opportunities 26. The LGFBR consolidates key fiscal, expenditure, budget, and planning reforms in local governance under one program cluster targeting reforms in five policy areas, while overarching reforms are also pursued in capacity building, coordination among oversight agencies, and transparency in local fiscal governance. The strategic objective of these reforms is to improve local service delivery and hence reduce poverty and improve community welfare. The LGFBR program cluster is divided into two subprograms, with subprogram 1 designed to establish the foundation of reforms in the five policy areas and subprogram 2 following through on these reforms, institutionalizing them, and providing insights for new reforms toward the objectives of the five policy areas. An initial assessment of the impact and outcome indicators for subprogram 1 shows that the targets have either been achieved or exceeded expectations (Appendix 4). 1. Completeness, Timeliness, and Transparency in Intergovernmental Fiscal Transfers 27. National transfers. Government transfers to LGUs are of three types: (i) formula-based block grants (i.e., IRA); (ii) origin-based share in national Government revenues (i.e., share in national wealth and other taxes); and (iii) ad hoc categorical grants. Under the LGC, the aggregate IRA of LGUs is set at 40% of the actual internal revenue tax collections of the Government 3 years prior to the current year. The aggregate IRA is then divided among