Fiscal Decentralization in The Philippines

Local Fiscal Administration
FISCAL DECENTRALIZATION
IN THE PHILIPPINES:
FIRST STEPS, NEXT STEPS1
It would be fair to say that the political motive

was a strong factor that influenced devolution in the
Philippines in 1991. It was perceived as a tool to
diffuse power from the center that could effectively
prevent an authoritarian regime from re-emerging in
the future. Decentralization was a common response of
many governments all over the world to the clamor for
a greater voice in the way they are governed.2
The efficiency factor in devolution became

sharper during the Ramos administration. More
sectors of the economy were freed from government
control. Industries were opened to competition and
private sector participation. Government recognized
that resource allocation would be more efficient if
communities were given the responsibility to decide on
goods and services that they need.
1
A policy paper written by Dr. Milwida M. Guevara, President, Synergeia and Former
Career Undersecretary, Department of Finance, Republic of the Philippines, in her
capacity as a guest writer of the Strategic Studies Council of the Local Government
Development Foundation. Synergeia is a coalition of institutions and individuals to
promote access of Filipino children to quality basic education.
2
William Dillinger and Marianne Fay, "From Centralized to Decentralized Governance"
Finance and Development, International Monetary Fund, December 1999.
Local Government Development Foundation 83
Decentralization continues to be one of the

priorities of government for various reasons, including
political survival.3 Fortunately, there are good cases of
local governance that demonstrate the value of
decentralization beyond politics and rhetoric. Local
governments make things work : deliver health
services efficiently (Negros Oriental, Nueva Vizcaya,
Pasay City), re-engineer the bureaucracy (Bulacan,
Marikina City), put public finance in order (Quezon
City), and make operations transparent and
accountable (Naga City). The number of LGUs that are
cited for good governance is continuously growing and
extends to rural LGUs and unknown public officials.
There is of course a good number of LGU officials

who remain in the traditional realm of politics. These
are warlords who perpetuate the politics of patronage.
These LGUs have been unable to free themselves from
an inefficient framework of devolution, the lack of clear
and stable rules, a bad incentive system, and the
inability of government agencies to transform their
mindsets and processes into a culture where
empowerment and autonomy can prosper.
This paper looks at the system of fiscal

decentralization in the Philippines, the structures that
are in place, and, their effects on strengthening LGUs
to raise robust revenues to finance the needs of their
constituents.
3
For example, a Constitutional Change is presented as the means to provide greater
power to LGUs.
1. More Than What Meets the Eyes. Devolution has

given LGUs with more resources. In 2004, the central
government allocated 21.08 percent of its total
revenues in 2004 as transfers to LGUs compared to
only about 6.3 percent before devolution. Transfers
accounted for 16.63 percent of total expenditures of the
national government in 2001 compared to only 3.96
percent before devolution. In addition to a 40 percent
share from internal revenue taxes, LGUs are given a
share from royalties from mining, oil exploration and
forest charges. The latter however accounts for less
than one percent of transfers.
Grants to LGUs in relation to

revenues and Expenditures of
National Government
Grants as
Percent to Total
percent of
30
NG
20 revenues
10
Grants as
0
percent of
1985 1991 1997 2004
NG
Ye ar Expenditu
res
Grants have become a dominant source of

revenues for LGUs. From merely accounting for over a
third (34.4 percent) of total revenues of LGUs prior to
devolution (1989), grants constitute 64.92 percent of
their total revenues in 2004. The relative importance
of local revenues has declined from 65.64 percent in
1989 to 35.08 percent in 2004. The real property tax
that used to contribute 25 percent of total revenues has
declined in relative strength and accounted for only
12.35 percent in 2004.
The share of business taxes has remained at an
average of 12.0 percent over the 16-year period.

Grants and Revenues of Local

Percent of
Governments grants to total
revenues of
Percent to total LGUs
80
Revenues of Percent of local
LGUs 60 sources to total
revenues of
40
LGUs
20 Percent of real
property tax to
0 total revenues of
1989 1993 1997 2002 LGUs
Percent of
Year business taxes
The paradox is that while the IRA has provided

LGUs with more resources; it has weakened their fiscal
independence. LGUs substitute the IRA for revenues
which should have been raised locally. LGUs either
accumulated the increase in allotment in cash balances
or they substituted the allotment for what should have
been higher collection from taxation. 4.There is no
incentive system in the grant system that can push
LGU towards greater utilization of their taxing powers.
The IRA does not increase or decrease relative to their
efforts to generate more resources. Thus, the grant
system does not have any fiscal stimulation effect on
any level of local government.
The IRA is also counter-equalizing and LGUs

with more revenues, higher taxable capacity, and more
expenditure outlays receive more grants. 5 On a
4
Milwida M. Guevara, Figueroa, Gracia, and Espano, Internal Revenue Allotment
System of the Philippines: trends, Patterns, and Effects" (A study prepared under the
Local Development Assistance Program), June, 1994.
5
Studies on the effects of the IRA since the sixties have come out with similar results.
The system is inequitable and does not support fiscal stimulation. These studies include
those made by the Joint Legislative-Executive tax Commissions, now the National Tax
regional level, grants tend to flow more heavily to more

developed regions like Region 4, Region 3, and the
National Capital region. Likewise, if the number of
people that an LGU has to support is an indicator of
need, regions that are more populous are not fully
assisted by the allotment system. Heavily populated
LGUs like Manila, Quezon City, and Caloocan City
receive smaller per capita allotments (grants).
2. Vertical Fiscal Imbalance. The Philippines

breaks the first rule in devolution which states
that LGU revenues should match their
expenditures. The central government receives
revenues that exceed its expenditures (net of
debt service) by 10 percent on the average. In
contrast, revenues of local governments from
local sources are only able to cover 41.0 percent
of their expenditures. Put in another way, LGU
revenues are only able to finance 41.0 percent of
their expenditures.
Table 1. Ratio of Own Revenues to Own Expenditures6

In percent
1990 1993 1995 1997 1999 2001 2004

National 129.8 152.2 161.0 146.8 119.4 105.2 112
Local 67.5 42.6 37.9 41.5 38.8 32.1 38.33
Source of Basic data: Department of Finance
Research Center, Roy Bahl and Larry Schroeder "Intergovernmental Fiscal Relations" in
Local Government Finance in the Third World, Praeger Publishers, 1983. Associates in
Rural Development by M. Guevara et. al. "Internal revenue Allotment System of the
Philippines: Trends, Patterns, and Effects, USAID, 1994.
6
Expenditures of the national government are net of debt service.
3. A Compartmentalized Approach to Devolution. The

separate formulation of the revenue-expenditure
structure of LGUs resulted to their mismatch. Book I
of the Local Government Code which deals with the
principles of devolution and expenditure allocation was
formulated by the Senate. Book II on financing and
budgeting was crafted by the House of
Representatives.
The expenditure assignment was generally

consistent with principles of efficiency in resource
allocation. Expenditures were devolved to LGUs that
were closest to their beneficiaries. The revenue-raising
powers under the Code were essentially based on the
Local Tax Code (1973) and the Real Property Tax Code
(1974). These Codes used the following criteria in the
assignment of taxing powers to LGUs:7
a. The tax base should be evenly distributed

among local jurisdictions.
b. The tax base should not be mobile to avoid tax-

induced movements of factors of production.
c. Local taxes should be revenue-productive and

buoyant over time.
d. They should be easy to administer and to

comply with.
There were minor changes in the composition of

the revenue raising powers of local governments, i.e.
the tax bases, remained thin and the tax rates, inelastic
to changes in income and prices. Provincial
7
The studies were made by the then Joint Executive legislative Tax Commission (now
the National tax Research Center under the leadership of Dr. Angel Q. Yoingco.
governments have nominal revenue raising powers.

The tax on professionals, sand and gravel, and on
delivery vans are low and fixed. They are also difficult
to administer. Their other taxing powers, e.g. the tax
on franchise and amusement, have been weakened by
the proclivity of the central government to grant
exemptions. In the case of the franchise tax, LGUs
have to go through a long and difficult litigation
process to impose it.
The local business tax remains as the major

revenue-source of municipalities and cities. Congress
adopted tax rates that varied depending on the type of
business and gross receipts. Producers are taxed more
heavily than wholesalers. Tax rates on "essential
products" are reduced by 50 percent. The lawmakers
held that differentiated rates promote vertical equity.
The new tax provision is the power of LGUs to
impose a 2.0 percent rate on businesses that are not
mentioned in the Code. Cities have used this to their
advantage. They are also given the power to increase
the tax rates by 50 percent.
The real property tax is as a mainstay in local finance.

The Code however introduced major changes in the
structure of the tax that weakened its administration.
The Code withdrew the power of municipal
governments to impose the tax and reposited it solely
on provincial governments. The tax rates were
8
consolidated to 1.0 percent and the proceeds were
distributed as follows: Municipality: 40 percent;
Province: 35 percent; and barangay (village) where the
property is located, 25 percent. The local assessor and
8
Prior to the Local Government Code, both the provincial and municipal governments
were able to levy a tax of one-half of one percent on real properties.
treasurer are in charge of collection but they are

supervised by different levels of government. The
assessor is appointed by the Local Chief Executive
while the treasurer remains an appointee of the
Department of Finance. Inefficiencies in coordination
and collaboration have ensued from disjointed
relationships. The DOF sets revenue targets which
may not be in lockstep with local needs. Treasurers
cannot be censured by Local Chief Executives for
inefficient performance. A civil service career system
that should protect treasurers and assessors from
political harassment is still on the conceptual level.
Congress retained the practice of using a fraction

of the market values as the tax base.9 These
percentages are differentiated relative to land use: 20
percent for residential and timberlands; 40 percent for
agricultural lands, and 50 percent for commercial and
industrial lands. Buildings are also taxed on a fraction
of their market values and the ratios vary depending on
whether buildings are residential, commercial or
industrial.
The Code gave the local legislative council the power to
legislate the assessment values (i.e. taxable values).
This power introduced a greater influence of

politics on real property tax administration.
4. Inequities and Distortions in the Internal

Revenue Allotment (IRA) System. Grants from the
central government can equalize needs and resources.
Revenues of LGUs with weak tax bases can be
supplemented to enable them to deliver public services
in accordance with minimum standards. Its
operationalization needs two factors: 1) a distribution
9
The Department of Finance proposed the use of market values as the tax base.
formula that is based on needs and resources, and, 2) a

definition of minimum standards for public services,
e.g. P15, 000 per student in elementary school. 10 Both
are not present in the IRA system. Grants performed
the role of bridge financing instead of an equalizer
under the Code. The IRA was increased from 20
percent to 40 percent to provide LGUS with P6.6 billion
in 1993, an amount that was equivalent to the salaries
of personnel who were transferred to local
governments from the Department of Health,
Department of Agriculture, the Department of Social
Welfare and Development, and the Department of
Environment and Natural Resources.
The grant system under the Local Government Code

essentially follows the framework under PD 144. It
was essentially a way of assisting local governments by
sharing with them a fraction of internal revenue
collections. The allocation of the IRA was altered to
provide more resources to barangays in recognition of
their role in developmental projects, the barangay
being the lowest unit in touch with the daily lives of
our people".11 The distribution is:
` Provinces: 23 percent
Cities: 23 percent
Municipalities: 34 percent
Barangay: 20 percent
10
The amount should approximate the minimum services that a student should enjoy:
e.g. one textbook, one workbook, a 45 student to teacher ratio.
11
Congressman E. Javier, "Transcripts of the Deliberations on the Local Government
Code" October 11, 1990.
The actual amount that each LGU will receive is

determined in accordance with three criteria with the
following weights:
Population: 50 percent
Land area: 25 percent
Equal sharing: 25 percent
The reduction in weight of the population factor

(formerly 70 percent) was made to "decongest the
urban centers and develop the countryside". The
increased weight on equal sharing (formerly 10
percent) was intended to effect a more equitable
sharing of the IRA.12 Apparently, Congress had a
literal meaning of equity, i.e. giving each local
government the same share regardless of its needs and
resources. There is nothing in the grants system that
can equalize resources of LGUs with their expenditure
functions or any factor that can equalize disparities in
resource capabilities of LGUs. Allotments are not seen
as a mechanism for transferring resources to LGUs to
equalize their capacities to deliver public services.
5. A Disempowering Incentive System. An

incentive system to predispose and influence LGUs to
optimize their revenue-raising powers is not part of the
public finance system. For one, LGUs are under no
hard budget constraint. LGU officials are "saved"
from bearing the costs of under-utilizing their taxing
powers through the pork barrel system and subsidies
that are doled out based on political patronage.
The grant system does not have any fiscal

stimulation effect on any level of local government.
12
Senator Aquilino Pimentel, "Transcripts of the Deliberations of the Senate on the Local
Government Code", February 12, 1991.
Instead, LGUs substitute the IRA for revenues which

should have been raised locally. LGUs accumulated the
increase in allotment in cash balances or they
substituted the allotment for what should have been
higher collection from taxation. 13 There is nothing in
the grant distribution formula which can induce LGUs
to increase their revenue effort. As seen in table 1, the
increase in the revenue to GDP ratio, or the ratio of
LGU revenues to GDP over a 14-year period is
marginal, e.g. from 0.95 percent to 1.5 percent.
Table 2. Ratio of the Revenues of the Central and

LGUs to
GDP
1985 1990 1995 2001 2004

National 13.47 17.66 18.95 15.35 17.03
Local 0.94 0.95 1.28 1.20 1.5
Source of Basic Data: Department of Finance
The collection efficiency of the real property tax

remains at an average of 54 percent for all LGUs...
"Valuation is an art, not a science, and there is much
room for discretion and argument with respect to the
determination of the tax base."14
13
Milwida M. Guevara, Figueroa, Gracia, and Espano, Internal Revenue Allotment
System of the Philippines: trends, Patterns, and Effects" (A study prepared under the
Local Development Assistance Program), June, 1994.
14
Richard M. Bird, "Subnational Revenues: Realities and Prospects" from S.J. Burke and
A. Perry, eds. Decentralization and Accountability of the Public Sector, Annual World
Bank Conference on Development in Latin America and the Caribbean, Washington
D.C.: The World Bank, 2000, pp. 319-36.
Collection Efficiency of the Real

Property Tax
collection to tax
Percent of 80
60 All LGUs
base 40 Provinces
20 Cities
0
1996 1997 1998 1999 2000
Source of Basic Data: 1996-2000 Financial

Reports of Local Governments. Collection
Efficiency is defined as the ratio between actual
tax collection and the tax base i.e. assessed
values of real properties.
Recognition of outstanding performance of LGUs

and their local officials is limited to awards and
programs. An inefficient electoral system does not
allow outstanding LCEs and local officials to bring
their excellence to scale and does not enable them to
assume a higher office. The incentive system
perpetuates political dependency instead of being
performance-based.
6. Limited Access to the Capital Market. LGUs

exposure to credit financing has been restricted to
government financial institutions (GFIs) and to
traditional investments such as markets and
slaughterhouses. 15 LGUs borrowings accounted for
15
The papers of Angel Q. Yoingco, Credit Financing for Local Governments in the
Philippines, Regional Development Dialogue, Vol. 7. Autumn, 1986 and the
background paper of Gilbert Llanto on credit financing that was used in the ADB-World
only 1.25 percent of their total revenues from 1981 to

1993. The pre-devolution difficulties centered on their
lack of creditworthiness, the long and circuitous
processes in getting DOF endorsement, and, in
obtaining loan approval. Banking-relationship of LGUs
has been limited to GFIs since they are governments
depository banks. GFIs enjoy an undue advantage, in
addition to the security that the IRA provides in
cases of defaults.
Devolution did not engender significant changes

in the access to LGUs to the capital market. Credit
financing is primarily made through GFIs and incurred
by LGUs with the ability-to pay. Bond financing is
under-utilized. The Build-Operate-Transfer scheme is
available to a few risk-takers and focused on
infrastructure projects.
Two initiatives have been introduced to provide

broader access of LGUs to the credit market: 1) the
creation of an LGU Guarantee Corporation (LGUCC) to
guarantee debt issues of LGUs financed from private
sources; 2) the reorganization of the Municipal
Development Fund into a separate office (MDFO) under
the Department of Finance. The MDFO is experiencing
birthing pains particularly with the task of
transforming itself from a regulator into an enabler.
The other issues are leveling the playing field between
private lenders and GFIs, and the development of a
secondary market for credit instruments. The core
issue is the optimal utilization of the revenue-raising
powers of LGUs.
Bank study on Decentralization in the Philippines provided useful information and

insights.
7. Positive Notes in LGU Expenditures. LGU

expenditures on social services have risen significantly.
From merely accounting for 12.49 percent of their
budgets in 1990, more than one-fifth of their funds is
devoted to education, health and housing.Their
expenditures on health increased from 0.08 percent of
GNP in 1985-1991 to 0.42 percent of GNP in 1993-
2002. LGU spending on education more than doubled
from 0.12 percent to 0.26 percent.16
General
Expenditure Structure of Administration
Local
Governments Public welfare and
safety
60.00%
Economic
40.00% development
20.00% Operation of Econ
Enterprises
0.00%
1985 1990 1995 2000 Capital Outlays
Resources devoted to general services have declined

from 44.0 percent in 1990 to roughly a quarter in 2000.
A bloated bureaucracy remains as one of the issues
that LGUs have to grapple with. The others are the
installation of greater transparency and accountability
in expenditure management and an engaged
participation of the community in budgeting and
resource allocation.
16
ADB and the World Bank, Decentralization in the Philippines, March 31, 2005.
8. Celebrating More Wins from Fiscal

Decentralization. In addition to the rising importance
of social services in LGU budgets, fiscal
decentralization brought other wins.
8.1. Greater Autonomy in Decision-Making. Local

Revenue Codes are no longer required to be approved
by the central government through the Department of
Finance. Valuation of properties is done by city and
provincial governments without the need of an
imprimatur from the DOF.
The budgets of municipalities and component cities are
now reviewed by the provincial legislative assembly
instead of the central government through the
Department of Budget and Management.
8.2. Development of Processes towards

Accountability. The provisions on referendum and
recall create pressures for local government officials to
be responsive to the demand and needs of their
constituents. They also promote transparency and
accountability. The Code defines the processes through
which voters can propose or amend any ordinance.
There are also provisions that enable voters to recall
any local elective official for loss of confidence. The
power of recall has been used by the electorate in
several communities.
8.3. Heightened Level of Publics Consciousness

on Local Governments. There is vibrant and
enthusiastic recognition of the importance of local
governments in getting things done well, and this is
growing. LGUs are used as entry points for
implementing programs that reduce poverty, protect
the environment, improve service delivery, and promote
welfare of children and women.

The Poverty Alleviation program of the UNDP ranks

LGUs relative to an index that measures efforts of
communities to improve the life of the poor. The Asian
Institute of Management ranks cities in terms of their
competitiveness, e.g. adequacy of infrastructure,
transparency in dealing with the local bureaucracy.
The UNICEF evaluates efforts of LGUs in making their
communities child and women friendly. From being
recipients of assistance, LGUs are considered equal
partners in implementation. Development efforts are
focused on collaborating with LGUs a possible shift in
priorities and strategies towards decentralized program
management.
8.4. Demonstrated Success on Excellence in

Governance. Every year, the Galing Pook
17
Foundation reviews more than a thousand
applications of LGUs that describe how they have
achieved efficiency in service delivery and empowered
communities to implement development programs.
Ten programs are recognized annually and those that
demonstrate continuing excellence in governance are
also awarded.
The programs demonstrate that many LGUs are

able to manage their resources efficiently, explore
innovative ways of doing things, and institute
transparency and accountability in their day-to-day
operations. They define the standards and processes for
good governance.
17
The Program promoting excellence in local governance was initiated by Harvard
University and has the support of the Ford Foundation. The program has been adopted in
nine countries including the Philippines. The Philippine program is collaboratively
managed by the Department of Local Governments, the Galing Pook Awards Foundation,
multilateral institutions, and NGOs.
9. Hope for the Future. The hope that devolution

inspires is the probability that it would enhance
efficiency and accountability in public service delivery.
There is a good chance that publicly provided goods
and services will be produced following the preferences
of constituents under a decentralized system. A
decentralized system tends to be more empowering
because it enables more community members to take
part in decision-making.
Devolution needs a framework where LGU

revenues are aligned with their responsibilities.
Differences in fiscal capacities to provide a minimum
level of public services can be addressed through a
system of equalization transfers.18 A systemic view of
devolution should support a restructuring of the
revenue and expenditure allocations between central
and local governments.
The devolution process must grow into a coherent

system. Incentives and disincentive in the political
system must support a hard budget constraint 19on
local decision makers, i.e. they should bear the costs
and be fully accountable for the consequences of
decisions that they make. Conflicting incentives, such
as the pork barrel system or grants from the
Presidents Office that are distributed through political
patronage are regressive and are inconsistent with
devolution.
18
Bird, op. cit.
19
Bird, op. cit.
The national government and Congress must follow

the rules that that they set on devolution. LGUs need a
break from habits that break the rules such as
the grant of exemption from local taxes, duplication of
functions, and legislation of unfunded mandates.
The downsides to devolution should be equally

recognized... The diverse manner through which
public services are delivered can lead to inefficiencies.
Bringing decision-making closer to the community can
facilitate its capture by powerful vested interests. A
high degree of decentralization may come in serious
conflict with distributional objectives especially where
there are large disparities in income.20 There is also
great diversity in the quality of leadership in local
governments and brings to fore the wisdom of
maintaining a one size fits all policy. There will be
inaccuracies and injustice in generalizing about what
is true for 79 provinces, 115 cities, 1, 4999
municipalities, and 41,969 villages. Non-traditional
concepts such as an asymmetrical fiscal federalism
can be studied and brought into the agenda.
Such an approach can focus on what may work rather
than on fitting everyone into the same centrally
determined box. 21
20
Teresa Ter-Minassian, Fiscal Federalism in Theory in Practice, op. cit. pp.22-23
21
Bird, op. cit
One way of doing this is instituting a process of

accreditation through a report card system where
LGUs which pass minimum standards in service and
product delivery and specific attributes of governance
can be given greater autonomy. Those that do not
should be subject to oversight and capability building
programs by the central government and
nongovernmental organizations. The very essence of
devolution is recognizing diversity, encouraging
creativity and innovation, and mainstreaming cases of
excellence.
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Fiscal Decentralization in The Philippines

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Local Fiscal Administration

It would be fair to say that the political motive

The efficiency factor in devolution became

Decentralization continues to be one of the

There is of course a good number of LGU officials

This paper looks at the system of fiscal

1. More Than What Meets the Eyes. Devolution has

Grants to LGUs in relation to

Grants have become a dominant source of

Local Government Development Foundation 85

Grants and Revenues of Local

The paradox is that while the IRA has provided

The IRA is also counter-equalizing and LGUs

regional level, grants tend to flow more heavily to more

2. Vertical Fiscal Imbalance. The Philippines

Table 1. Ratio of Own Revenues to Own Expenditures6

1990 1993 1995 1997 1999 2001 2004

3. A Compartmentalized Approach to Devolution. The

The expenditure assignment was generally

a. The tax base should be evenly distributed

b. The tax base should not be mobile to avoid tax-

c. Local taxes should be revenue-productive and

d. They should be easy to administer and to

There were minor changes in the composition of

governments have nominal revenue raising powers.

The local business tax remains as the major

The real property tax is as a mainstay in local finance.

treasurer are in charge of collection but they are

Congress retained the practice of using a fraction

This power introduced a greater influence of

4. Inequities and Distortions in the Internal

formula that is based on needs and resources, and, 2) a

The grant system under the Local Government Code

The actual amount that each LGU will receive is

The reduction in weight of the population factor

5. A Disempowering Incentive System. An

The grant system does not have any fiscal

Instead, LGUs substitute the IRA for revenues which

Table 2. Ratio of the Revenues of the Central and

1985 1990 1995 2001 2004

Source of Basic Data: Department of Finance

The collection efficiency of the real property tax

Collection Efficiency of the Real

Source of Basic Data: 1996-2000 Financial

Recognition of outstanding performance of LGUs

6. Limited Access to the Capital Market. LGUs

only 1.25 percent of their total revenues from 1981 to

Devolution did not engender significant changes

Two initiatives have been introduced to provide

Bank study on Decentralization in the Philippines provided useful information and

7. Positive Notes in LGU Expenditures. LGU

Resources devoted to general services have declined

8. Celebrating More Wins from Fiscal

8.1. Greater Autonomy in Decision-Making. Local

8.2. Development of Processes towards

8.3. Heightened Level of Publics Consciousness

Local Government Development Foundation 97

The Poverty Alleviation program of the UNDP ranks

8.4. Demonstrated Success on Excellence in

The programs demonstrate that many LGUs are

9. Hope for the Future. The hope that devolution

Devolution needs a framework where LGU

The devolution process must grow into a coherent