Federalism, Money, and Taxes (Part 2)

By Benjamin R. Punongbayan

(Second of two parts)

Under federalism, taxes imposed on production or sale of goods and provision of services (VAT, excise taxes, percentage taxes) are much more difficult to deal with.

To achieve their objective, federalism proponents may want to move the collection of these goods/services tax to the states as much as possible.

Under that scenario, the best solution is a dual-track one. First, convert these goods/services tax into a system of sales tax. For goods sold or services provided in the state territory, the state will collect the sales tax on those transactions.

For imported raw materials for conversion and imported finished goods for sale, the equivalent sales tax on these goods and the corresponding customs duties will be collected by the federal government and subsequently allocated. Similarly, taxes such as gross receipts tax on financial institutions, taxes on insurance companies, documentary stamp tax, and similar other taxes will be collected by the federal government and then allocated.

Under this dual-track system, income tax and sales taxes on goods sold and services provided in the states territory will be collected by the states. The equivalent sales taxes on other goods and services will be collected by the federal government and allocated among itself and the states.

Will such a taxation system achieve the objective of Philippine federalism?

It all depends upon the quantum of the taxes collected respectively by the federal government on the one hand and the states on the other hand. If the former collects more than the amount it needs, then the states will still be in some kind of control by the federal government, as they still will not be truly fiscally independent.

It should be noted that the foregoing dual-track solution requires an overhaul of the system of taxes on goods and services. Such an overhaul needs serious study, especially of the effects of the changes on the overall federal economy.

If a tax overhaul is not desired, then the only alternative is to let the federal government continue to collect all the national taxes, including income tax, as before and allocate all the taxes on a fair basis among the federal government and the states. If this alternative is taken, however, then the whole rationale for Philippine federalism collapses.

Any system of allocation of all national tax collections with the federal government as the sole collector can be done by the present unitary government. So why do we need to shift to federalism and incur additional government restructuring costs?

Who will pay for existing national debt?

On Day 1 of federalism, who will pay the existing national debt which was reported recently at P6.9 trillion? It depends upon who collects the taxes.

If each of the federal units collects a portion of the taxes, the debt maybe be apportioned among the federal government and the various states and each one has to settle its allocated portion as the debts mature.

However, dividing up the existing national debt may not be practicable.

The creditors may not agree as the newly formed states do not have any credit history to speak of. The existing debt may have to stay with the center, but the center must ensure that it has enough money to pay for maturing debt.

There is an additional consideration.

Much of the maturing debts will have to be refinanced, as the maturing amount cannot be paid wholly from tax revenue as is currently happening.

Since it is unlikely that the existing national debt can be divided up, the federal government may have to handle the refinancing. Again, it has to ensure that it has the funds to pay for the refinancing when it matures.

Note, though, that the circumstances of the federal government may have substantially changed — it may no longer earn all the tax revenue to pay for the debt as it was before.

Under this changed condition, international credit rating agencies may likely lower the country’s credit rating, resulting in higher interest costs.

Who will handle new borrowings?

New borrowings (as distinguished from existing debt and its refinancing) will have to be handled separately by the federal government and the various states for their own respective needs.

It does not make sense for the federal government to borrow on behalf of the states. If it does, the entire process will be messy.

This is true irrespective of whether the states collect the national taxes directly or the federal government collects and allocates the total collections.

While it may be difficult for the states to engage in borrowing for the first time, it should be able to eventually, but most likely in small chunks at the start. Note, though, that the states will expectedly pay higher interest cost than what the unitary government is paying presently.

Who will handle national assets?

As the government function for each state will now be devolved, it follows that some or most of the existing national assets have to be transferred to the host states to serve the federalism purpose of having them obtain control over government activities in their respective territories. These assets may include airports, ports, power plants, irrigation systems and similar large infrastructures.

There is an issue though: should the host states pay for those assets or receive them for free?

The important underlying principle must be to provide fairness to all the states. If so, then the host states should pay for the assets transferred to them and the total proceeds allocated among all states on a fair basis that should be consistent with the basis for other kinds of allocation among the states.

But how do we value national assets?

However these are valued, quite likely, the net settlement (value of assets transferred less share in total proceeds of all national assets transferred) for each state will result in rich states paying into a zero-sum pot and the poor states collecting from that pot.

There are some contentious issues, though.

How should the Malampaya funds and other similar funds be disposed of? What about Philippine Amusement and Gaming Corporation’s assets and earnings? Philippine Charity Sweepstakes Office? The national banks — Development Bank of the Philippines and Land Bank — and other government corporations? If the federal government keeps them, is doing so consistent with the federalism that its proponents are advocating?

How do we restructure the national tax system?

To serve the objective of Philippine federalism, I believe that the states will need to have substantial independence in raising its own taxes and debt money to provide the funds to pursue its own development objectives. The state must have command over both the source and the use of its money. That way, the state has a clear accountability to its own citizens.

Unfortunately, the present national tax system cannot be restructured to make the state fully raise its own tax money.

The dual tax system (Option 1) may work if the tax take of the federal government is not greater than the amount of funds it needs.

The greater amount that goes to the states makes them source-of-fund independent. If it is the other way around, the federal government retains control of part of the funds that will be allocated to the states.

The remaining option (Option 2) of keeping the status quo where the federal government continues to collect all the national taxes and to allocate the total collections among itself and the states is much worse. The federal government remains in total control, just like before.

In fact, under this scenario, there is really no need for federalism.

The present unitary government can revise the national tax allocations such that it retains only what the national government needs and the balance allocated to the provinces on a fair basis.

Each province will then use the funds it receives for its own economic development.

To be clear, under Option 2, whether under federalism or unitary government, the state of affairs is: (1) the center collects all the taxes, retains the amount it needs, and allocates the remaining funds to the states/provinces; and (2) the states/provinces use their allocations to pursue their own respective economic development.

It now becomes an issue not of government structure — federal or unitary — but that of who can handle the pursuit of the economic development of the states/provinces better — the center or the state/province? It is an issue of government competence.

To stretch Option 2 further, whether under federalism or unitary, there are two other considerations.

On the part of the central government, the share of the center must be clearly specified to prevent it from being profligate. It should not have an open-ended right to the tax collections.

On the part of the states/provinces, there could be a tendency for them to look at their shares of the national tax collections as doleouts and, consequently, waste much of those tax allocations rather than use them effectively and efficiently.

This is a serious issue, because the accountability of the state/province for its share of the tax collections is not clear. Who are they accountable to for the proper use of these fund allocations? To the federal government? To the entire Filipino people? To the state citizens? Here is where I feel that state independence in raising tax money is important under federalism. The accountability becomes clear — to the citizens of the state/province who elect their own state/province leaders.

Poorer provinces may not be better off

Combining the foregoing analysis with our knowledge of the current condition of the poor regions in the Philippines, it is not difficult to see that, under federalism, these poor regions, when structured into states, will be in a very difficult financial position.

This is so whether the collection of the national taxes can be restructured such that the larger portion of these taxes are collected directly by the states, or these taxes are totally collected by the federal government as before and allocated among the federal government and the states on a fair basis.

The economic disparity between the rich states and the poor states will continue to widen and, thus, trigger a massive population shift over time from the poor states to the rich states. Of course, subsidies or better than fair tax allocations can be given to the poor states. But I wonder what good that will serve the entire nation.

A well-known proponent of federalism indicated some weeks ago that the rich states should contribute to a large fund, similar to that of the World Bank or Asian Development Bank, that will be made available to the poor states. This proposal indicates to me that this proponent has in mind that a poor state will have to live with its own tax base and expectedly will not generate enough tax revenue for the poor state. It also confirms to me the federalism proponents’ predisposition to the basic finance concept under Philippine federalism described in this commentary.

A fund of that kind implies borrowing by the poor states.

But these states can only borrow up to the extent of their paying capacity, which is low. After the first loan, they need to worry about the payment of the loan and its interest. Such payments will obviously substantially reduce the amount of funds they can use for economic development in future years.

Such a federalism fund will not help the poor states much. The benefit of borrowing from such a fund can only be the same as the benefit obtained by the present unitary government from the substantial borrowings it made over these many years, which is not much.

The comparatively high economic growth that the country has been experiencing for the past several years has been brought about by the effects of Overseas Filipino Workers money and the incremental jobs created by the foreign jobs outsourced to the Philippines.

With such complexity of money problems attending to a shift to federalism, how did the existing federal countries deal with them and still become highly economically successful? Well, there were actually no such issues in their respective cases; they did not have those problems.

No magic formula for economic growth

At the time of federation long ago, the component states (then independent or autonomous) of these federal countries, the US and Germany in particular, owned all the assets and owed the liabilities; they were taxing their own people and spending for their own development. All they did was to organize the federal government and fund it.

In the case of the US, at the beginning, it didn’t even have a federal army for the states to give support funds to. The revolutionary army before federation was organized from the manpower contributions and war provisions from the former colonies. This army was disbanded and the soldiers returned to their respective states when the revolution was won.

The current US federal government developed from its very simple beginnings over more than 200 years. It now raises its own money to meet its own very large needs. It does not get fund support from the states. The states themselves raise their own money for their own needs. Of course, the federal government collaborates with the states in funding certain activities or occasions.

The federation process in these federal countries, US and Germany, is that of an aggregation — consolidation and harmonization (although some things remain different).

On the other hand, the process for Philippine federalism is the opposite — that of disaggregation from what was once fully aggregated. This is precisely the reason why I believe strongly that federalism does not fit the Philippine situation.

There is no magic formula for sustainable economic development and the reduction of widespread poverty.

There is only one overriding element — government competence. Competence that, sadly, we never had and that, bringing ourselves into federalism, we will not magically acquire.

Benjamin R. Punongbayan (ben.buklod@yahoo.com) is the founder of Punongbayan & Araullo, one of the Philippines’ leading auditing firms.

Read the first part here

As published in BusinessWorld, dated 31 May 2018