That we are facing high and rising unemployment has an important implication: In searching for solutions to our fiscal woes, the employment goal must take primary consideration. The government’s top priority now is to protect jobs and livelihood. It should avoid destroying them; it must continue creating them.

From this perspective, government’s solution to the fiscal crisis is wanting. We argue that its tax-cum-spending-cut approach to the fiscal problem threatens jobs and livelihood. Moreover, the government adamantly refuses to see the key culprit in this crisis, and ignores a solution that addresses both the growing deficit and rising unemployment.

To begin with, there is no getting around the fact that raising taxes and slashing government spending will dampen aggregate demand, hence threaten employment. The most likely to pass of the proposed measures (because they are the most convenient) that can make a dent on the deficit are also the most dangerous to growth and employment.

Consider the following: higher power tariffs, a squeeze on local government spending [2], a two-step increase in the VAT rate of 2 percentage points each, additional tax on petroleum. However each measure may be individually justified, they have one thing in common: they all reduce total demand in the economy.

It should be pointed out that raising taxes involves more than moving purchasing power from firms and households to the government sector. Given that interest payments constitute a growing share of government expenditures, higher taxes to pay for the debt represent a drain on aggregate demand.

How can measures that dampen demand attract investments that will create jobs? The official response is appealing: restoring fiscal balance will ensure investor confidence [3] and protect future growth and employment. Never mind if along the way, the economy stumbles into a recession, the very thing balancing the budget seeks to pre-empt. But there’s the rub. For if indeed government is successful in taming the deficit and allaying investors’ fears, but the economy plunges into a recession anyway because demand has been battered, then what? Then we would have won the battle against the fiscal deficit, but lost the war on joblessness.

Is there a way out of this dilemma? Is there a solution to the fiscal crisis that is compatible with job creation? The answer is yes. But to appreciate this, it is necessary to lay down a longer view of our fiscal condition.

Turning point

Most accounts of the fiscal crisis begin with 1997, the year the government last posted a surplus. Since there was no appreciable change in government spending around that period, the deterioration in the fiscal balance can be traced to the revenue side. The total tax effort (total tax revenues as a percentage of GDP) declined from 17% in 1997 to 12.4% in 2003, or a loss of 4.6% of GDP. Thus, we may add, the government squandered in six years what took all of the previous 12 years (1986-1997) to build up.

This account is true, but it is not the whole truth.

A longer view of the fiscal balance since the 1990s reveals that the turning point for the current deficit cycle was 1994. (Chart 1) Coming from the 1990 recession, the fiscal deficit (NG deficit as a percentage of GDP) gradually improved up to 1994, largely on the back of rising revenue effort (total revenues as a percentage of GDP). But by 1995, the government’s financial position came under pressure—this despite slightly lower expenditures (as a percentage of GDP). The pressure clearly came from the revenue side.

Turning to the revenue side, a few points are worth noting. (Chart 2) First, there was a surge in non-tax revenues, a large part of it coming from privatization proceeds. But this lasted no more than two years, 1994 and 1995. (For lack of space, we ignore the issue of non-tax revenues) Second, the internal tax effort (local tax revenues as a percentage of GDP) was improving—and continued to improve up to 1997, understandably so since the economy was on the upswing. Normally, the economic boom that lasted up to 1997 would have improved government’s fiscal position. Instead, as early as 1995 it began to deteriorate.

Chart 2: What caused the decline in revenues? Falling import duties

Third, the reason the fiscal position began to deteriorate in the mid 1990s was the sharp drop in import tariff revenues. This was the price of aggressive import liberalization which went into full swing around this period. Alongside the reduction in tariff rates, the government went into a frenzy giving import tariff exemptions to exporters, firms in special economic zones, bonded warehouses, and so on—all part of trade liberalization.


The speed of liberalization can be gleaned from the following:

— The weighted average tariff fell from a peak of 32% in 1993 to 22% in 1997, a reduction of 10 percentage points in four years.

— In a span of six years, import duty collections dropped from 31% in 1991 of the country’s total dutiable goods import to a mere 17% in 1997.

— The share of non-dutiable imports to total imports rose from 12% in 1986 to 37% in 1990 and 49% in 1997, resulting in even bigger revenue losses.

The impact on fiscal revenues was staggering:

— The share of customs collections to total government revenues shrank from 36% in 1993 to 23% in 1997, a loss of 10 percentage points.

— Import duties and taxes as a percentage of GDP came down from a high of 5.6% in 1993 to 3.9% in 1997, or a decrease of 1.7% in only four years.

All this shows that, owing to the import liberalization program, government’s fiscal position was already headed towards deficit territory by the time internal revenue collections fell in 1998. True, falling internal tax effort accounted for the major share of the loss in total revenues during the period 1997-2003. Even so, dwindling import duties continued to escalate as tariff reduction continued unabated despite the onset of the 1998 recession and the anticipated deterioration in local tax collections.

Table 1 summarizes how the current fiscal crisis evolved in the last 10 years. During the period 1994-1997, import duties accounted for the decline in the total revenue effort (the large contribution of non-tax revenues to the change in the revenue effort is due to the one-time surge in 1994) (col. 2). During the period 1997-2003, local tax revenues accounted for the deterioration in the total revenue effort. (col. 3), but bleeding at the Bureau of Customs grew more profusely. For the 10-year period 1994-2003, tariff reduction accounted for the bulk of the loss in total revenue effort. (col. 4)

Revenue intake
The above rendition of the evolution of the fiscal crisis underestimates the impact on government finances of import liberalization and the potential relief that could come with a partial reversal of the program. Table 2 presents estimates of foregone revenues from import liberalization from 1997 onwards. The estimates are arrived at using two assumptions. One, we assume a 3% tariff on non-dutiable imports based on EO 264, which took effect in 1994. This is a generous assumption since the 3% rate is a target rate for raw materials and intermediate inputs for the year 2004. Two, we assume an average 13.43% nominal tariff rate on dutiable imports based on the same EO.
The magnitudes involved are simply mind boggling: Total foregone revenue rise from P50 billion in 1997 to P108 billion in 2003, or an average 2.4% of GDP for the period.

The same table gives us an idea of the potential revenue intake from a partial reversal of the trade liberalization program. For example, reverting to 1997 (pre-crisis, pre-deficit, pre-TRP-IV) tariff levels is sufficient to quickly remove the threat of a fiscal crisis spilling over into the real economy. Using 2003 import values, a 3% import surcharge on non-dutiable imports would raise P44 billion for government, equivalent to 1% of GDP. Imposing 1997 tariff rates on dutiable tariffs would generate another P64 billion in Customs revenues, or 1.5% of GDP. Total new revenue from these measures exceeds P100 billion or 2.5% of GDP. This is equivalent to the estimated revenue intake necessary to stabilize the public debt. [4]

These numbers indicate the magnitude of potential relief from raising import tariffs. From a purely fiscal point of view, a complete reversal of the tariff reduction program may not even be necessary. In practice, the reversal may be phased over time. Nor do we have to violate our commitments to the international community. A first step is to bring tariff rates from their ridiculously low levels closer to the bound rates under the WTO agreement.

In sum, aggressive import liberalization and the resulting loss in customs revenues is what drove us into the current fiscal mess. Now, whether it is desirable to reverse the import liberalization program involves larger questions of economic policy. But one cannot deny the key role it played in the evolution of the current fiscal crisis [5] —and the massive potential for relief from raising tariffs.

Protecting jobs
The larger policy question in relation to tariff reduction program is the impact on jobs. From this perspective, the need to quickly lower unemployment presents even more pressing reason to reverse the program. The country’s experience with import liberalization since the 1990s indicates that declining tariff rates may have exacerbated unemployment.
It is easy enough to see that GDP growth should lead to lower unemployment. The strength of this observed relationship, that is, the amount of GDP growth necessary to cause a certain reduction in the unemployment rate varies in place and time. But the inverse relationship by and large holds. Or is supposed to hold.

Chart 3: Weak link between GDP growth and unemployment

The record since the early 1990s, a period of aggressive import liberalization, reveals a perverse link between GDP growth and unemployment. (Chart 3) For example, there are two growth episodes, 1993-1995 and 1999-2003, spanning a total of eight years, when GDP growth is accompanied by rising, not falling, unemployment.

What explains rising unemployment during these periods of economic expansion? A major factor at work was import liberalization. Imports as a percentage of total supply of goods and services in the country rose from 27% in the early 1990s to a high of 39% in 1997, declining to 35% in 2003. The flood of imports occasioned by the tariff reduction program represented massive job creation—abroad.

The detrimental impact of import liberalization may be gleaned from our final chart. (Chart 4) In particular, movements in the average tariff level for agriculture seem to be driving the unemployment rate. A higher tariff in agriculture reduces unemployment while a lower tariff raises joblessness. It was only in 1998 when this pattern was broken. In that year, the combined negative impact on unemployment of the severe drought and the economic recession nullified the positive effect of a higher tariff rate.

The highly negative and significant relationship between the unemployment rate and the average tariff rate in agriculture is quite plausible given that a significant portion of the labor force is found in the sector. This result should give pause to those eager to open up the sector to import competition: The impact on joblessness and poverty can only be staggering. The same inverse relationship holds for manufacturing tariff, albeit less significantly.

Chart 4: Falling tariffs worsen unemployment

Usual objections
The case for raising tariffs to protect existing jobs and create new ones is straightforward. Raising tariffs makes imported goods more expensive relative to locally produced goods, thereby raising domestic demand. The resulting increase in domestic production generates additional employment.
There are at least four objections to raising import tariffs. One, it breeds corruption, smuggling and rent-seeking. Two, it hampers efficiency and economic growth. Three, it discourages labor-intensive export industries, thereby undermining job creation. And four, it does not create additional jobs but simply moves them around.

First, notwithstanding the corruption, rent-seeking and smuggling then, import duties represented 5.6% of GDP in 1993 compared with 2% in 2002. Nor has import liberalization stamped out corruption and smuggling.

A more important point raised by proponents of import liberalization is that tariffs lead to monopolies and lack of competitiveness in the protected sectors, thereby encouraging rent-seeking. A study by the ADB, however, shows that despite the liberalization in the 1980s and 1990s the mark up rate and degree of monopoly in the Philippines increased during this period. [6]

Second, with regard to efficiency and economic growth, trade liberalization, in theory, may result in one-time (static) gains as local producers gain access to imported inputs and technology. But there is nothing in theory that says that growth will be sustained. That is, until now, the dynamic case for trade liberalization remains to be established. [7]

Our own experience hardly inspires confidence in trade liberalization as a pillar of development strategy. Growth in the 1990s pales in comparison with growth in the 1950s to 1970s, decades marked by protectionism, rent-seeking, and ‘inefficient’ policies by conventional standards. In terms of firm ‘efficiency’, a study by the Philippines Institute for Development Studies (PIDS) concludes that “much work still needs to be done as the share of inefficient establishment remains significant.” [8] More telling, trade liberalization has not translated into industrial growth, the excuse being: “Gains from trade reforms are more long-run in nature and may not already be apparent.” [9] This after two decades of trade liberalization.

Third, it is argued that raising tariffs creates a bias against exports and hinders the production of labor-intensive export goods where the Philippines holds a comparative advantage. The empirical evidence, however, has not been kind to this view. Average annual growth rate of merchandise exports has been declining since the mid-1980s, from 11.3% in the second half of the 1980s, 9.7% in the first half, and 7.3% in the second half of the 1990s [10]. The country has been quite successful with electronics production for exports, notwithstanding warnings that we have among the highest wage rates in the region. But its contribution to job creation has been dismal.

The fourth objection says that raising import tariffs creates jobs in protected industries but destroys those in other industries. Referring to Argentina before the 2002 crisis, prominent economist and foremost trade theorist Paul Krugman explains this point in relation to demands to protect jobs with tariffs or import quotas:

“The conventional response to such demands is to say that they are not really about creating jobs, only about shifting them around: a tariff can add employment in one industry, but at least as many jobs will be lost elsewhere as a result. And this is surely true in the United States, where the inflationary pressures created by protectionism for some industries would force the Federal Reserve to raise interest rates and thereby crowd out as many or more jobs in others.”

He then goes on:

“But in a country that has high unemployment because of inadequate demand and that cannot do anything to increase demand, because it fears capital flight, this argument is simply wrong. Right now a tariff would increase employment in Argentina, and to pretend otherwise is intellectually dishonest.” [11]

Our choice: protect or perish
Krugman raises another point that is relevant to the current debate on the fiscal crisis, namely, the threat of capital flight. One way of dealing with the fiscal deficit without risking higher unemployment is to monetize the deficit, which means that the central bank prints new money which it lends to the national government to cover the deficit.

On the one hand, monetizing the deficit raises aggregate demand (there’s more purchasing power around and interest rates are lower), hence avoids a contraction in the short run. On the other hand, it leads sooner than later to a devaluation of the peso, which could trigger capital flight, practically closing off this option.

Our own economists warn us, thus:

“…monetizing the deficit requires some form of capital controls. Only in this way would the government be able to source its foreign-exchange needs; otherwise the mere threat of a large depreciation and run-away inflation would lead to a massive capital flight and rapid loss of reserves. The Philippines, however, has historically been unable to implement such controls effectively—not even under the Marcos regime, so that the possibility of massive capital flight cannot be fully discounted.” [12]

This point is crucial from the perspective of growth and employment under conditions of unrestricted capital flows. With financial liberalization, the government loses a key policy tool to increase demand and avoid recessions, namely, monetary policy. Likewise, an aggressive devaluation that would make exports more competitive while protecting domestic industries from imports becomes increasingly risky. The only way then that the government can increase demand without risking capital flight is to raise import tariffs, as Krugman points out. The lesson is clear: In a world of capital mobility, countries facing high unemployment have few choices—protect or perish. [13]

The long view
There is a short-term cost to raising import tariffs, namely, that it hurts consumers, among them workers. True, raising tariffs will mean higher consumer prices immediately, perhaps fewer choices for everyone. Moreover, there is an adverse supply-side effect of higher tariffs as imported raw materials, intermediate inputs, and capital equipment become more expensive, potentially hurting output and employment. In our view, in a situation of insufficient demand the positive impact of higher tariffs on the demand side outweighs the negative supply side impact.

Nonetheless, these very real costs must be weighed against the gains from increased demand for local goods, higher investments, more jobs, and eventually better wages. Given the conflicting demands of lowering unemployment and closing the deficit, raising tariffs is the nearest the country can come to a free lunch.

In sum, raising tariffs addresses the fiscal deficit in a way that is compatible with what should be our overriding goal: job creation. Beyond the current crises, protecting and nurturing the domestic market, combined with a credible industrial policy, will resume the task of rebuilding domestic productive capacities [14], and laying down a solid basis for future growth.