The Development Trap

In his weekly column Cielito Habito has been following the jobless growth phenomenon that plagues a number of developing states like the Philippines. This was evident in the first quarter figures for 2010 which showed that just as the economy expanded by 7.3%, unemployment rose by 300 thousand. The country's growth did not translate into a lower unemployment rate. Habito rhetorically poses the question

Where did the impressive first-quarter growth come from? (...M)oslty from petroleum refining, electronics and processed food (...P)etroleum refining is (...) an industry not particularly known to be job-rich (...) Electronics (...) is an industry with almost zero linkages elsewhere in the economy. 

(...) The message is clear: We need economic growth that widely involves and benefits more industries, more geographical areas and more sectors of society—not the narrow, shallow and hollow growth ... in recent years (emphasis added).

This paints the picture of a dual economy where growth and opportunity are restricted to a few enclaves to the exclusion of the vast majority of participants. In recent years, the Philippine macro economy has been on solid footing. Just as some beleaguered European nations were applying for IMF assistance, the Philippines was exiting from its supervision after a thorough process of market liberalization, privatization and deregulation.

Having finally weened itself off the assistance of the DC-based institution, the country can now begin to chart its own development path without the policy impositions of the Washington Consensus. One silver lining  from the recent North Atlantic crisis according to Robert Wade is the opportunity to re-examine strategies for promoting industrial development, a recognition that other paths, for instance the BeST consensus (from Beijing, Seoul and Tokyo), are equally if not more viable. He explains that

(o)n the face of it, raising the state's capacity to coordinate a selected set of economic agents is a more feasible task than across-the-board formalization and enforcement of the rules - a task which requires high fixed costs and many decades, and which often provokes fierce resistance, especially from those already in the elite.

(...) Concrete manifestations of this kind of institutionalized coordination include Japan's MITI, Taiwan's Economic Planning Council and its Industrial Development Bureau, South Korea's Economic Planning Board, Singapore's Economic Development Board; and also numerous industry associations.

In contrast to "developmental state" forged by its East Asian neighbors, the Philippine state in its post-independence, pre-martial law incarnation was corrupted from the bottom-up as

the big landed families (...) used personalized rules of the game to obtain political protection in order to oppose industrial transformation, and used corruption to protect their existing sources of rents.

(...D)emocratization has somewhat restrained a state which under Marcos plundered from the top down, and has moved the nation a little way in the direction of a joint state-business project of a developmental state.

A typical developmental state would not score highly against the World Bank governance indicators based on the experience of East Asia. This is because in a bid to foster more inclusionary growth, state officials may have to actively steer the value stream of investors who might otherwise not source from local firms. This might require gentle nudging and incentives to begin with to strong arm tactics to get their message across as in the case of Taiwan, where

(t)he Industrial Development Bureau (IDB) officials in charge of ... specialised glass considered that at least two Taiwan glass makers could meet the price and quality of the glass imported by the Philips TV factory if given a long-term supply contract and some technical help.

(...) Philips (...) refused to consider the idea, saying it was happy with its existing arrangement to import from a Philips factory elsewhere. But then Philips began to experience delays in authorization to import the glass, which previously had been granted without delay. Philips protested. The delays lengthened. The IDB officials reminded Philips of the advantages of switching to domestic suppliers ... eventually Philips got the message, entered into a long-term supply contract with a domestic producer and in so doing built up goodwill in the IDB.

This example demonstrates that while generous tax concessions and free trade areas might foster foreign direct investments in specific industry sectors, they do not inevitably lead to greater industrial diversification. Pro-active and sometimes robust engagement with industry is required in order to accomplish that.

Among the organizational features of a developmental state observed by Wade are the targeted improvement of state agencies in charge of industrial policy, the fostering of a public service mindset among its officials, the bifurcation of political patronage channels and economic bureaucracy so that the former do not affect the latter and an industrial extension service with tight limits on the use of discretionary resources.

With the weak fiscal position awaiting the incoming government of Benigno Aquino, the immediate task of shoring up the budget situation is imperative. But in order to simultaneously pursue his vision of good governance and the rule of law, a more targeted approach than would otherwise be recommended by the good governance (GG) adherents of the Washington Consensus is required. One which would make more judicious use of limited public resources in building up state capacity towards more inclusive development.

A New Social Contract for the Philippines

At the start of his campaign for president, Benigno Aquino stated in an advertisement that he was not a thief and that he would not steal using a play on the filipino word "magnanakaw" which means both "thief" and "to steal". A similar statement was issued by his late mother, ex-president Corazon Aquino twenty five years earlier when she ran against Ferdinand Marcos.

So ingrained and apparent was the greed that motivated candidates to pursue public office that it had been assumed to be the case among all of them. With the installation of president-elect Aquino at 12 noon on June 30 2010, there are a few assumptions regarding the state and its role in society that also need to be challenged.

In a paternalistic society such as the Philippines, it is the role of the state to dole out benefits to the connected, by that I mean both the wealthy and the needy. The state is captured from both above by the wealthy who seek regulations that favor their commercial interests and from below by the incessant demands of constituents whose need for support drives their elected representatives to capture "rents" from government transactions to provide personal help and thus perpetuate their electability.

This it would seem is the existing social contract as it stands - it is one based on personal dealings between (1) Big Business and the power brokers of the state and (2) the disenfranchised and their political bosses. A society based on personal kinship and relations does not reward individuals who want to strike out on their own, away from the established networks. It is one where one cannot get ahead simply by working hard and relying on fair play. That is why so many have sought to pursue their fortunes outside the country.

Many commentators have seized on the potential for transformation under a new Aquino presidency based on its reputation for probity. In order for it to be transformational, it would have to restructure the "rules of the game" or negotiate a new social contract between the state and its stakeholders. The new arrangement will have to resource the state appropriately to lessen the need for its constituents to rely on personal interventions by their representatives.

It will have to ensure that the wealthy contribute a fairer share of their profits to the state. The productive sectors in turn would expect a predictable regulatory environment and a skilled laborforce enabling them to take advantage of new opportunities. For this to happen, a series of reforms are needed in areas such as social welfare, human capital, regulation and taxation which are discussed here.

1. Social Welfare Reform. This includes the re-alignment of poorly targeted, improperly designed and ineffective programs towards those with greater impact. The rice subsidy program is one example of a program which has suffered a leakage of 71%, whose coverage of intended recipients is a mere 18%, and is costly to administer. It cost the government about Php40 billion in 2008 alone. Other similar programs that provided rebates on electricity suffered similar flaws, but were hurriedly engineered during the height of the global financial crisis and are non-recurring. The grains program on the other hand represents a recurring expense for the government. Manasan of the government think tank PIDS suggests that the same expenditure if it were spent on the more effective conditional cash transfer program or 4Ps targeting public school children would have a greater impact in terms of alleviating poverty by providing support to poorer households while improving school participation and completion rates (see her slideshow below). They are also proven to be less costly to administer and have a reduced level of leakage. At the same time preventive programs like child immunization and maternal health connected with the 4P's program would help reduce the cost burden of treating diseases and supporting larger families. 
Social Welfare Programs and Social Safety Nets in the Philippines: In Times of Crisis and Beyond
2. Education and Skills Reform. The next step would be to undertake reforms that would improve the stock of human capital through educational and health reform. As school children improve their participation and completion rates, it becomes necessary to strengthen the content of their education to ensure they are equipped with necessary skills and knowledge needed in the workplace both here and abroad.  Part of the solution lies in extending the years of schooling from 10 to 12 years with the option of leaving school after year 10. The senior years of high school should offer students the option of either college preparation or vocational education and training (VET). There is a need to address the imbalance between college and VET that is leading to the strange anomaly of skills shortages alongside high unemployment. Work-based apprenticeships and traineeships in partnership with industry can also be introduced. The "adopt a school" program can be leveraged in order to provide such a partnership. Metropolitan and provincial polytechnics could also be tapped to provide instructors and facilities for such training. A voucher or entitlement system that would allow public school students to take up a place in a technical college can be designed to allow the funding to move with the student to any local technical college or institution to complete the equivalent of years 11 and 12. It is also important for such VET courses to feed into the higher education system in a seamless manner. The lack of vertical integration currently is a disincentive to pursue technical training.
3. Health and social insurance reform. The Philippines has a health system akin to the US, where a mixture of public and private hospitals abound and the state funds them through what amounts to a health insurance program called PhilHealth, the key challenge here as it is in the US would be to increase the coverage of the program. This cannot be done without mandates and concurrent subsidies to firms that employ people to increase contributions. Part of the reform process also involves looking at the funding rate of various treatments. Chronic diseases are on the rise in developing countries. While the Philippines does not have an ageing population, there is a high dependency ratio. This means the problem confronted by households at-risk of slipping into poverty due to lost income of primary breadwinners has to be addressed through a combination of social and health insurance improvements.
4. Regulatory Reform. The cost of doing business in the country has to be lowered through regulatory reform. This entails opening up many sectors including aviation, ports, power and transportation to greater competition. It also involves red-tape reduction and strengthening the property rights of investors. A comprehensive review and consultation process needs to take place to give direction to many of the reforms in these areas. A mix of policy tools could potentially solve many of the bottlenecks in the process of business registration and licensing. Stakeholder consultation would shed light on which tools to use.
5. Tax Reform. From the mid-90s to the mid-noughties the tax collection effort measured in terms of collection to GDP ratio deteriorated from 17 percent to 12 percent. It recovered slightly with the hike of the VAT rate from 10-12%, but leakages such as the granting of fiscal incentives for the country's freeports and special economic zones and the non-indexation of sin taxes have offset much of the improvements in tax collection. The redundancy and inefficacy of many fiscal incentives have been extensively documented (see for instance the article by Dr Reside below). Meanwhile corporate and personal income taxes in the country remain higher than elsewhere in the region. The current deficit amounting to 4% of GDP or roughly Php300B has to be brought down to a sustainable level, say 1-2%. A mixture of improved collection efficiency, fiscal rationalization, indexation of sin taxes along with budget neutral adjustments to the tax system to lessen distortions and improve the country's competitiveness are all justifiable and in keeping with the spirit of Mr Aquino's campaign pledge of no immediate new taxes.
Fiscal Incentives and Investment in the Philippines

The first step of any reform process is for the leader to be honest and committed to it. Mr Aquino satisfies this  condition with his probity and policy seriousness. During this period of transition, his first task involves assembling a competent team to help him in this effort. They should focus on assembling a coherent package of reforms with the help of partners and stakeholders in the community aimed at restructuring incentives in the Philippines that would transform the current set of assumptions about the state and its role in it.

Moving from a padrino society that depends on personal transactions based on kinship and wardship to one where citizens are empowered with greater access to improved services requires a new social contract between the state, market and society. It will be necessary to move towards the new mold in the next six years. 

The state needs to be equipped with the resources necessary to improve the incentives towards human capital acquisition and productive activities. It requires reforms in social welfare, education, health as well as regulation and taxation. At the end of his six year term, if Mr Aquino is able to say that he brought the country forward in these areas, he would have done it a great service worthy of the term transformational.