40493 Technical Working PaPer PHILIPPINES: AGRICULTURE PUBLIC EXPENDITURE REVIEW THE WoRLD BANk GRoUP The World Bank group in the Philippines east asia and the Pacific region rural Development, natural resources, and environment Sector Unit Supporting islands of good governance DISCLAIMER Technical Papers are published to communicate the results of The World Bank's work to the development community with the least possible delay. The typescript manuscript of this paper therefore has not been prepared in accordance with the procedures appropriate to formally edited texts. Some sources cited in the paper may be informal documents that are not readily available. The findings, interpretations, and conclusions expressed herein are those of the author(s), and do not necessarily reflect the views of the International Bank for Reconstruction and Development / The World Bank and its affiliated organizations, or those of the Executive Directors of The World Bank or the governments they represent. The World Bank does not guarantee the accuracy of the data included in this work. The boundaries, colors, denominations, and other information shown on any map in this work do not imply any judgement on the part of The World Bank concerning the legal status of any territory or the endorsement or acceptance of such boundaries. a Technical Working PaPer PhiliPPines: Agriculture Public exPenditure review JUne 2007 rural Development, natural resources and environment Sector Unit Sustainable Development Department east asia and Pacific region TheWorld Bank group i ii ACKNOWLEDGMENTS This report is a product of the World Bank's Rural Development, Natural Resources and Environment Sector Unit of the East Asia and Pacific Region. The core task team includes Messieurs and Mesdames Sergiy Zorya (Task Team Leader, EASRE), Felizardo K. Virtucio (EASRE, Agricultural Policy), Yvette Guinto (Consultant, Public Expenditure Management), Amy Beasley (Consultant, Rice Policy), Marife Ballesteros (Consultant, CARP), Carolina V. Figueroa-Geron (EASRE, Rural Development), Idah Z. Pswarayi-Riddihough (EASRE, Natural Resource Management) and Yoshiharu Kobayashi (EASRE, Water Resources and Irrigation). The report was prepared under the overall guidance of Mr. Stephen Mink (Lead Economist, AFTPI) and Mr. Rahul Raturi (Sector Manager, EASRE). The Peer Reviewers are Mr. Donald Larson (DECRG), Ms. Mona Sur (SARES) and Mr. David Dawe (FAO). Valuable comments were also received from Mr. Yasuhiko Matsuda (EASPR). Mr. Andrew Mendoza (EACPF) provided assistance in coordinating logistics, layout, and printing. The AgPER report substantially draws on earlier work by the World Bank, International Rice ResearchInstitute,PhilippineRiceResearchInstituteandPhilippineInstituteforDevelopment Studies. The support and information of the Department of Budget and Management, the Department of Agriculture, the Department of Agrarian Reform, the National Economic and Development Authority, the Department of Finance, and the National Food Authority is gratefully acknowledged. The financial support of the Australian Agency for International Development (AusAID) is gratefully acknowledged. iii ACRONYMS AND ABBREVIATIONS AFMA Agriculture and Fisheries Modernization Act AgGVA Agricultural Gross Value Added AgPER Agriculture Public Expenditure Review AJD Agrarian Justice Delivery ARB Agrarian Reform Beneficiaries ARC Agrarian Reform Community CARP Comprehensive Agrarian Reform Program CPI Consumer Price Index DA Department of Agriculture DAR Department of Agrarian Reform DBM Department of Budget and Management DENR Department of Environment and Natural Resources GMA Ginintuang Masaganang Ani GOCC Government-owned and -controlled corporation FAP Foreign-assisted project LAD Land Acquisition and Distribution LBP Land Bank of the Philippines LGU Local Government Unit MFO Major Final Output M&E Monitoring and evaluation NIA National Irrigation Administration NEDA National Economic and Development Authority NFA National Food Authority PARC Presidential Agrarian Reform Council PBD Program Beneficiary Development PCAMRD Philippine Council for Aquatic and Marine Resources Research and Development PCARRD Philippine Council for Agriculture, Forestry and Natural Resources Research and Development PhilRice Philippine Rice Research Institute R&D Research and Development iv TABLE OF CONTENTS Executive Summary ............................................................................................................. ix 1 Introduction....................................................................................................................... 1 2 Recent Developments in the Agriculture Sector.............................................................. 3 3 Public Expenditures and Pro-Poor Agricultural Growth: Some Principles and Key Lessons from International Experience...................................................................... 9 4 Trends in the Aggregate Level of Agricultural Public Expenditures in the Philippines ............................................................................................................ 12 5 Allocative Efficiency of Public Spending In the Department of Agriculture................. 16 5.1 Major Final Output 1: Production Support............................................................ 20 5.2 Major Final Output 4: Irrigation Investments........................................................ 25 5.3 Improved Allocative Efficiency of Public Expenditures: A Shift from Private Subsidies to Public Goods.......................................................................... 28 6 Rice Self-Sufficiency in the Philippines: Benefits, Costs, and Moving Forward....................33 6.1 Overview of the Philippine Rice Industry.............................................................. 33 6.2 How is the Policy for Rice Self-Sufficiency Currently Pursued?............................ 35 6.3 What are the Welfare Effects of the Rice Self-Sufficiency Policy? ........................ 39 6.4 Are There Better Policy Instruments to Increase Net Social Welfare While Supporting Agricultural Producers? ............................................................ 47 6.5 What is the Appropriate Role for Government and Associated Policy and Budget Reforms to Support Rice Sector?.............................................. 54 7 Department of Agrarian Reform ..................................................................................... 59 7.1 DAR as the CARP Implementing Agency ............................................................ 59 7.2 Synthesis of Economic and Social Impact of CARP.............................................. 63 7.3 Improving the Allocative Efficiency of DAR's Expenditures................................. 70 8 Policy Recommendations................................................................................................ 73 9 Annexes........................................................................................................................... 77 10 Statistical Appendix........................................................................................................ 83 11 References ..................................................................................................................... 104 v LIST OF FIGURES 1. Sectoral gross value added per worker in the Philippines, 1995-2005 (pesos)................5 2. Diversification of farmland in rice-based farm households by province..........................6 3. Public spending on agriculture, 1998-2005 (million pesos, in real terms)....................13 4. Estimated functional structure of public expenditures by MFOs, (appropriations), 2001-2007 (million pesos and in percent to total) ...........................17 5. Estimated distribution of obligations (AFMA) for DA by commodity, 2000-2005.......................................................................................................................18 6. Economic composition of DA-OSEC expenditures, 1998-2005 (million pesos)................................................................................................................19 7. Percentage of rice area that is irrigated in the East and South Asia .............................26 8. Rice production and consumption in the Philippines, 1978-2005 ...............................34 9. Trends in farm-gate prices of palay, 1991-2003 (US$ per ton) .....................................36 10. Variations in domestic and world market prices, 1987-2005 (pesos per kg).................37 11. The snapshot of the average situation in the rice market, 2000-2005..........................39 12. Schematic presentation of welfare effects of rice import protection on consumer, producers, and budget in the Philippines, average 2000-2005.....................40 13. Relationship between changes in inventories, tax subsidy and NFA's deficit, 2000-2006 (million pesos) .............................................................................................45 14. Labor wages and gross national income per capita across Asia.....................................46 15. Structure of marketing costs and margins in the Philippines and Thailand (as % of wholesale price) ...............................................................................................48 16. Components of wholesale rice prices in the Philippines and Thailand (pesos per kg) .................................................................................................................48 17. Dry season nitrogen use by farmers compared with profit-maximizing use at the experiment station...............................................................................................53 18. DAR expenditures (actual obligations), 1998-2005 (million pesos) ............................60 19. Post-LAD scenarios presented in 2006..........................................................................62 vi LIST OF TABLES 1. Agriculture's share in national economy of the Philippines, 1980-2005 ........................ 3 2. Contribution to growth in AgGVA, 1999-2005 (in percent share to total growth)...... 4 3. Trends in productivity: Philippines, Thailand and Indonesia......................................... 5 4. Structure of agricultural gross value-added, 1980-2005 (in percent to total AgGVA) .. 6 5. Trends in nominal rate of direct and total assistance of major agricultural products in the Philippines, 1980-2004 (in percent) ...................................................... 8 6. Trends in nominal rate of direct assistance of major agricultural products in the Philippines, 1990-2004 (in percent)..................................................................... 8 7. Effects on productivity and poverty of public expenditures .......................................... 11 8. Trends in total public expenditures on the agriculture sector, 1998-2005 (million pesos)13 9. Total public spending on agriculture as a percentage share in total budget expenditures, gross domestic product, gross agricultural output and agricultural value-added ........... 14 10. Rising share of NFA's deficit in GOCC's total deficit, 2000-2006................................ 14 11. Share of allotments in total appropriations by programs, 2000-2005 ........................... 18 12. Economic and functional composition of DA-OSEC budget of 2007 (`000 pesos)...... 20 13. Local and foreign finance in DA's budget (obligations), 2000-2005, (million pesos)... 20 14. Estimated structure of MFO 1, 2001-2005 (million pesos) ........................................... 21 15. Other incentives provided to farmers per bag of hybrid seeds, dry and wet season ...... 22 16. Area planted to hybrid rice as percentage of target area and total rice area................. 22 17. Distribution of sample municipalities by percent drop out rate (in percent) ............... 22 18. Estimated cost of hybrid seed production and distribution (pesos per 20 kg/bag) ........ 24 19. Summary of the existing public irrigation investments as of December 2005......................25 20. Estimated opportunity costs to develop new irrigation systems .................................... 27 21. Public spending on agricultural R&D and research intensity ratio in the Philippines, 2000-2005 (million pesos, actual obligations) .......................................... 29 22. International comparison of rice production in 2005 ................................................... 34 23. Per capita rice consumption, 2000-2004 (grams per day) ............................................. 35 24. Household expenditure on different types of rice, 2003................................................ 38 25. Welfare effects of the rice policy in the Philippines, 2000-2005 (billion pesos) .......... 41 26. Household rice expenditures (as percentage of total expenditures).............................. 42 27. Income loss due to high rice prices across deciles, 2003................................................ 42 28. A comparison of different types of rice farmers in the Philippines, top and bottom quintile, 1996-1997........................................................................................................ 43 29. Fiscal costs of NFA's operations, 2000-2006 (million pesos)......................................... 44 30. Total welfare costs of rice policy, 2000-2005 (billion pesos)......................................... 45 vii 31. Simulation of reduction in import tariffs....................................................................... 50 32. Simulation of reduction in import tariffs and reduced margins..................................... 51 33. International comparison of production costs, 1999 (US$ per hectare) ...................... 51 34. Economic composition of DAR's expenditures, 1998-2005 (million pesos).........................60 35. Land acquisition and distribution by the DAR, as of December 2006 (million hectares)........................................................................................................... 61 36. Studies on the investment impact of Agrarian Reform Program.................................. 63 37. Studies of the agrarian reform's impact on the land productivity of the ARBs ............ 66 38. Studies on poverty impact of agrarian reform................................................................ 67 39. Poverty measures, agrarian reform beneficiaries ............................................................ 68 40. Local and foreign financing of DAR's budget, 2000-2005............................................. 72 viii ExECUTIVE SUMMARY 1. Notwithstanding its high growth and poverty reduction potential, Philippine agriculture continues to under-perform.Aweakpolicyenvironmentandpublicexpendituresupportdonot encourage growth and competitiveness in the sector. Farm incomes have kept lagging non-farm incomes mainly because of the low agricultural productivity and the slow out-migration from the sector. Philippine agriculture has the potential for higher growth through crop diversification, but traditional low-value commodities continue to dominate production (and land use). At the same time, dynamic high-value products with high export potential and income growth, such as tropical fruits, are not provided with sufficient level of government support to generate significant benefits for the sector and beyond. The choice of producing the traditional (mainly import-competing) agricultural products is determined by their continued support through high import tariffs, non-tariff barriers, and budget expenditures.1This has artificially raised the profitability of these products thereby encouraging the distortion of resource allocation within agriculture and between the agriculture and the non-agriculture sectors. 2. The distortions have been the largest in the rice sector. The welfare costs of rice self- sufficiency were estimated to reach PhP68 billion per year or 1.6 percent of GDP during 2000- 2005 and these are expected to keep rising if the current policy continues. These costs are disproportionately born by the poorest Filipinos. Instead of contributing to the broadly shared growth in the agriculture sector, the rice self-sufficiency policy has increased income disparity within the sector since only 40 percent of rice farm households obtained the two thirds of benefits from price support.2 Meanwhile, the poorest members of the rural community such as small rice farmers, non-rice farmers, marginal fishers, upland dwellers, and landless laborers, as well as the urban poor, bear the costs of the high rice prices that result from the current rice policy. The rice policy has also retarded crop diversification and, together with other protected import-competing wage goods, raised the costs of living in the Philippines, putting upward pressure on wages and undermining competitiveness of unskilled labor. 3. The allocation of public expenditures has reflected the policy bias toward traditional commodities, mainly the policy supporting rice self-sufficiency, diverting scarce fiscal resources from provision of necessary public goods that would have benefited most farmers and agribusinessesandnotjustriceproducers.During1998-2005,amorethantwofoldincreaseinthe agricultural public spending was largely directed to production subsidies, large-scale irrigation systems and the National Food Authority (NFA)'s operations on rice importation, stock keeping, and distribution. The production subsidies (largely to the rice sector) and irrigation investments (designed to produce mainly rice) accounted for 60 percent of the Department of Agriculture's Office of Secretary (OSEC) expenditures, while the share of NFA's stabilization and tax subsidy in total agricultural budget (excluding DAR) increased from 4.6 percent in 2001 to 30.4 percent in 2005. An emerging concern is the non-budget aspects of NFA's fiscal costs, i.e. the rapidly rising contingent liabilities associated with NFA's borrowing. In 2006, they surged to PhP16.4 billion compared to already high PhP10 billion in 2005. 1The major import-competing products are rice, corn, sugar and poultry. 2Based on Dawe (2006c), this comprises about 12 percent of all agricultural households. ix 4. The best way of increasing the impact of public expenditure on pro-poor agricultural growth in the Philippines is to improve the composition of expenditure rather than increasing its level. Improved allocative efficiency within its current level of spending should be given priority because a large percentage of agricultural public expenditures are allocated to subsidies that do not provide much benefit to most farmers and fisherfolk but detrimental to productivity growth and agricultural diversification. A focus on expenditure composition would also support the government's fiscal consolidation efforts, necessary to create an investment climate conducive for growth in both agriculture and non-agriculture sectors. 5. The reallocation of agricultural budget expenditures would produce greater effects with a reform of the policy of rice self-sufficiency. Actually, an effective reallocation of expenditures is possible only within a strategic adjustment in rice self-sufficiency policy because this policy drives publicexpenditures.Governmentmaywishtoreplacethepolicyofriceself-sufficiencywithapolicy to support food security at the household level. Such a change would entail adjustments in both budget and agricultural trade policies. The adjustments can be implemented gradually over several years, starting with a realignment of the agricultural budget composition, away from commodity- specific support, toward public goods provision and market development support. Specifically, the gradual realignment of DA's budget composition may contain the following elements: · Phasing out production support. Production support is economically distortionary and fiscally expensive. The hybrid rice seed commercialization program, for instance, unintentionally supported the better-off farmers who had access to irrigation and modern farming techniques. It, therefore, contributed to the increasing inequality within the sector and discouraged crop diversification. In the short term, some production subsidies to food-insecure farm households without ready access to markets can be provided, but even those should be time-bound, targeted and closely monitored and evaluated. · Increasing the sustainability of investments in irrigation. The benefits would be larger when public expenditure is directed to rehabilitation of existing gravity irrigation systems while the expansion into new irrigated areas is done through the support of small-scale irrigation systems. Small-scale irrigation systems require less investment costs compared to the larger-scale irrigation systems, have shorter gestation periods, yield higher productivity, givefarmersagreaterdegreeofcontrolovertheirirrigationwater,andprovidemoreoptions for crop diversification. To ensure that the existing large-scale irrigation systems are well- maintained and that the large-scale systems do not reduce the financial attractiveness of smaller-scale irrigation, institutional reforms to allow a full cost recovery and self management of national irrigation systems by irrigators associations would be desirable. The rationalization of the National Irrigation Administration to make it more lean and efficient would be an appropriate complement to these measures. · Shifting expenditures to market-related Major Final Outputs (MFO). A critical role for the government is to invest in essential public goods, in particular infrastructure (rural roads and wholesale markets), market information, research and development, and food safety and quality. These investments would be beneficial as they would reduce marketing and palay production costs, allowing rice farmers to generate higher incomes even at lower consumer rice prices and allowing non-rice farmers to benefit from public goods. x · Designing and implementing appropriate monitoring and evaluation of public expenditures and programs. MFOs are useful devices for measuring government agencies' performance in producing targeted policy outputs, but by design, these are not meant to provide information about real impact of publicly-funded programs. The absence of a regular and accessible system for outcome and impact evaluations makes it difficult to have objective public policy debates and to change the current approaches to public expenditure and agricultural policy in the Philippines. 6. A more fundamental step to enhance the effectiveness of agricultural policy, both in strengthening the sector's international competitiveness and in contributing to hunger mitigation and poverty reduction, would require trade reform and revisiting NFA's policy mandate. These measures would have the additional benefit of eliminating the sources of NFA's current financial difficulties which are expected to worsen in the coming years. Improvements in NFA's operational efficiency could reduce some costs in the short term but are unlikely to produce significant cuts in the medium to longer term. The recommended trade reform may include the following strategic elements: · Replacing the quantitative restrictions for rice imports with import tariff. The Philippines is due to lift its quantitative restrictions on rice imports by 2012 and this is an opportunity to reduce the effective import protection, simplify import procedures, allow the private sector to profitably import rice, and refocus NFA's mandates on regulation and emergency stock-keeping. · Successively reducing import tariff. Lower rice prices in the Philippines will be effectively attained only by reducing the current prohibitive import tariff levels. The medium-termgoalwouldbetoreducethericetarifftoamoremoderatelevel.Otherwise, the economic benefits for consumers and producers (through lower marketing costs) from mere "tariffication" would likely be small. · Separating NFA's regulatory and trade functions. NFA may continue its responsibility for keeping buffers for emergency and safety net reasons but not for market interventions. International experience shows that the purpose of stabilization is to insure against risks associated with international commodity price movements. However, within a fairly wide band, the system should allow domestic prices to move freely and buffer only very high or verylowinternationalprices.Thiswouldpromoteprivateagribusinessdevelopmentandalso free substantial public funds to be allocated to other priority public good investments. · Optimizingthevolumeofpublicstocks.ThePhilippinesispronetotyphoonsandother natural calamities that severely damage agricultural production and incomes of poor farmers. Thus, the role of public stocks can be re-defined to focus on disaster mitigation and safety net programs, thereby reducing its volume to minimize the fiscal losses from foregone interest and physical deterioration of stocks. The shift in policy emphasis from price stabilization to emergency assistance would also have more impact on the poor. · Encouraging private sector marketing system.Theprivatesectorrequiresincentivesto import rice. Private import is a long-term financial business which requires secure access to the right to import rice, not just in 2007, but over the longer term. The annual quotas forimportareunlikelytoencouragetheprivatesectortoinvestinlogisticalinfrastructure, contracts with exporting countries and knowledge in trading and marketing. A strong xi government commitment to fully withdraw from commercial import and lower import tariff might be needed to create proper incentives for the private traders to satisfy domestic demand in rice in a timely and cost-efficient manner. 7. Reforms may be opposed by those who benefit from current policy, thus, short- to medium-term compensation mechanisms may be needed. As experience in other countries shows, direct transfers to farmers may be considered as a compensation mechanism that softens the impact of trade reform in the short run, while favoring adjustment and diversification of the agriculture sector over the medium to longer run. Decoupling production from price support was the cornerstone of agricultural policy reform in Mexico and Turkey, for example. A design of a compensation package in the Philippines, however, is not straightforward. It requires a consideration of several issues, such as the eligibility criteria (rice versus non-rice farmers and poor rice farmers versus non-poor rice farmers), mode of payments, validation of historical data on yields and land areas, an identification of landowners and the exact location and size of their land plots, the price gap to be compensated, a cap on fiscal transfers, phase out period for subsidy, penalties for misreporting, etc. A compensation mechanism, therefore, needs to be thoroughly designed if this strategy would be used to ease the reluctance to trade and budget reforms. 8. Another key element for pro-poor growth in the rural areas is a well-functioning land market. The delays in completion of Comprehensive Agrarian Reform Program (CARP) divert large budget expenditure from other uses and are likely to hamper agricultural pro-poor growth. Evidence suggests that, so far, CARP has not contributed much to unlocking the poverty problem in the rural areas. Although the agrarian reform beneficiaries are reported to have increased investmentsandimprovedtheirwelfare,thesepositiveeffectshavebeennegatedby(a)thereduced investment of land acquisition and distribution-pending landowners, (b) the lower access of the landless poor to tenured and other rental agreements, and (c) a rural finance market hampered by a distorted land market. In addition, the limited poverty impact of CARP is explained by several exogenous factors, i.e. increasing population, scarcity of cultivated land, and slow growth of farm and non-farm employment opportunities in the countryside. The following actions are being recommended to improve the operational efficiency and effectiveness of CARP: · Completing land acquisition and distribution. While the intensification of fund generation and a validation of the revised land balance are prerequisites to complete the land acquisition and distribution, serious efforts are also required to overcome institutional and legislative hurdles. These hurdles include cumbersome land valuation procedures, tedious documentation process, ineffective coordination of land reform- relatedactivitiesamongtheCARPimplementingagencies,counterclaimsbylandowners at DAR Adjudication Board, and bias of some local governments toward land conversion in view of higher tax revenues from lands devoted to non-agricultural uses. Addressing these hurdles would be essential for improving the effectiveness of CARP. · Developing a strategy for converged delivery of public services to rural areas. This might include the following directions: (a) continued delivery of support services in agrarian reform communities (ARC) where DAR has prior commitments; (b) inclusion of non-agrarian reform beneficiaries in ARC programs; (c) expansion of support service coverage to new reform beneficiaries in areas only if there are no other providers; (d) strengtheningofpartnershipsforservicedeliverywithotheragencies;and(e)preparation of a time-bound exit strategy focusing on areas with strong local government units (LGU) and geographic overlaps with other departments, as well as on LGU capacity building, in order to carry out long-term provision of frontline support services. xii A Technical Working Paper: Philippines Agriculture Public Expenditure Review 1. INTRODUCTION 1. Despite its high potential to grow and reduce poverty, Philippine agriculture continues to under-perform. A weak policy environment and public expenditure support do not encourage growth and competitiveness in the sector. This Agriculture Public Expenditure Review (AgPER) assesses the ways of increasing the impact of public expenditures on broad-based agricultural growth in the Philippines. 2. The AgPER presents recent developments in the agriculture sector of the Philippines in Chapter 2. It describes the farm structure, sector growth, performance compared to nearby countries and the level of agricultural diversification. The presentation of development of price incentives helps to understand the bias toward import-competing products and whether current public expenditures strengthen or negate that bias. 3. The AgPER provides lessons from international experience on the role of public expenditures in a pro-poor agricultural growth in Chapter 3 and follows with an analysis of trends in the aggregate level of expenditures for the agriculture in Chapter 4. The AgPER establishes a knowledge base on the relative share of agricultural budget spending in GDP, total budget expenditures and agricultural output and then compares this base with those in some East Asian neighbors and other countries, and asks the question: Are current public expenditures aligned with fiscal discipline and fiscal consolidation agenda of the Government of the Philippines? 4. The review of allocative efficiency of public expenditures begins with the Department of Agriculture in Chapter 5. This establishes a knowledge base on the composition and efficiency of public expenditures. Are they being allocated to the right priorities that are likely to foster pro- poor agricultural growth? Well-managed and properly allocated public expenditures, based on rational policies, are important pre-condition for broad-based growth. Thus, significant efficiency and impact gains could be achieved by shifting from less to more effective types of expenditures even without a budget increase. 5. Since public expenditures are driven by policy, their reallocation is possible within strategic adjustments in agricultural policies. In the Philippines, largest gains can be expected from adjustments in rice policy, given that the rice sector gets the lion's share of public resources within the agriculture sector. The AgPER focuses on this dominant agricultural policy goal and estimates the efficiency gains from the policy and budget reforms described in Chapter 6. The analysis identifies the main winners and losers of policies supporting rice self-sufficiency, quantifies the welfare losses and gains, and proposes concomitant policy reforms. Along with trade liberalization, these include recommendations to reduce the marketing and production costs of rice, as well as further clarification of the proper role of government in the sector. 6. The review of DAR's public expenditures in Chapter 7 covers the implementation period of CARP. It analyzes the public spending across three MFOs during 1998-2005. It also presents 1 rural development, natural resources and environment sector unit the synthesis of the existing economic and social impact assessments of CARP and derives the lessons from this synthesis to improve allocative efficiency of public expenditures in the context of completion of CARP and post-CARP developments. 7. The major policy recommendations are presented in Chapter 8. They aim to encourage the broadly shared economic growth through a better allocation of public expenditures and agricultural policy adjustments. 2 A Technical Working Paper: Philippines Agriculture Public Expenditure Review 2. RECENT DEVELOPMENTS IN THE AGRICULTURE SECTOR 8. Despite the declining share in the Philippine output, agriculture remains an important sector of the country's economy. It accounts for 15 percent of the national GDP and nearly 40 percent of employment (Table 1).3 Some analysts estimate that agribusiness as a whole (adding in forestry, agro-processing, production of agricultural inputs, and agricultural trade) contributes about 40 percent of the GDP and two-thirds of national employment (World Bank, 2005b). Nevertheless, rural poverty remains a major component of total poverty as some 70 percent of the country's poor live in rural areas. Thus, agricultural performance remains crucial to the nation's development and poverty reduction goals: a fact emphasized by the Medium- Term Philippine Development Plan 2004-2010. table 1: Agriculture's share in national economy of the Philippines, 1980-2005 1980-1990 1991-2000 2001-2005 GDP 21.7 19.5 14.8 Employment 47.5 39.9 36.4 Exports 8.4 7.8 6.9 Imports 18.6 8.2 4.0 Source: nScB (2006) and nBaS (2006). 9. Philippine agriculture is mainly characterized by growing traditional crops on small family-owned farms. There are about 4.8 million farms in the Philippines, covering 9.7 million hectares. A typical farming system consists of major crops with rice, corn, and coconut as common base crops, and a few heads of livestock and poultry. Two-thirds of all farms are no larger than 3 hectares. Eighty-five percent of all farms are no more than 5 hectares (DA, 2006b). In 2002, the average farm size was reported to be 2 hectares, falling from 2.2 hectares in 1991 (NSO, 2002). This is mainly due to the population growth but also due to CARP which seeks to distribute 8.1 million hectares of land to agrarian reform beneficiaries (DAR, 2006a).4 Under CARP, a farm household cannot own a farm larger than 5 hectares. 10. Agriculture has recently grown at historically high rates fueled by the non-crops sub- sector. If 1998 - the year of El Niño - is excluded from the analysis, the gross agricultural output grew at about 5 percent per year, while the agricultural gross value added (AgGVA) increased by 3.8 percent annually during 1999-2005. Where did this growth come from? The bulk of it was fueled by non-crop sources where government financial support was far less than what was given for rice. Fisheries provided the strongest impetus accounting for 37 percent of the sector's growth (Table 2). Crops closely followed contributing over one-third of AgGVA growth. This was, however, not a commensurate contribution given that most farmers are from this subsector. Palay contributed 13 percent, or about one-third of crop growth, in spite 3Agriculture includes crops, livestock and fishery. 4Recently the land balance was increased by additional 1.3 million hectares (refer to Chapter 3.3.2). 3 rural development, natural resources and environment sector unit of the fact that it accounts for 31 percent of total harvested area.5 Crop growth leaders were bananas, mangos, pineapples, and other fruits. Poultry and livestock accounted for 21 percent of total growth. table 2: contribution to growth in AggvA, 1999-2005 (in percent share to total growth, cumulative) sub sector/commodity 1999-2005 Crops 36.8 Livestock 7.3 Poultry 12.2 Agricultural activities and services 6.3 Fishery 37.3 Total AgGVA 100.0 Memo items: Harvested area (thousand ha) in 2003 Palay 4,006 12.5 Corn 2,140 4.0 Coconut 3,124 2.6 Sugarcane 389 1.8 Banana 410 1.8 Other crops 2,931 14.0 Source: nScB (2006). 11. Despite the rising agricultural output (and continued high protection), farm income has increasingly lagged behind non-farm incomes. In 1995, AgGVA per worker was 24 percent and 42 percent that of industry and services, respectively (Figure 1). In 2005, the ratio between agricultural and industrial per capita gross value-added and between agricultural and service per capita gross value-added fell to 18 percent and 38 percent, respectively. Two factors played a role for such a development: (a) the slow outflow of workers from the agriculture sector and (b) the low agricultural productivity. 12. The out-migration of agricultural labor in the country was lower than that of Indonesia and Thailand, partially explaining the weaker productivity growth in the Philippines. Butzer and others (2003) report this out-migration rate is greatly and directly proportional to the labor-absorbing capacity of the non-agriculture sectors, more so than even the level of marketable skills among farmers and fishermen. Thus, the creation of nonagricultural jobs can offer new opportunities for many agricultural workers even for those with relatively poor education and skills. 13. Low agricultural incomes have also resulted from the heavy reliance on increases in physical inputs rather than on total factor productivity (Table 3).6 During 1980-1998, the total factor productivity in the Philippines grew by 9 percent, compared to 27 percent in Thailand and 49 percent in Indonesia. 5Palay is a local term for unmilled grain of rice or paddy rice. 6Total factor productivity is the composition of land, labor and capital productivities. 4 A Technical Working Paper: Philippines Agriculture Public Expenditure Review Figure 1: sectoral gross value added per worker in the Philippines, 1995-2005 (current pesos) Source: nScB (2006). table 3: trends in productivity: Philippines, thailand and indonesia 1961-1998 1961-1980 1980-1998 Philippines Growth rate of output, percent per year 2.6 3.8 1.4 Shares in growth: Factors 90 74 91 Total factor productivity 10 36 9 thailand Growth rate of output, percent per year 3.4 3.8 3.2 Shares in growth: Factors 8 66 73 Total factor productivity 32 34 27 indonesia Growth rate of output, percent per year 3.4 3.7 3.2 Shares in growth: Factors 56 57 51 Total factor productivity 44 43 49 Source: Mundlak and others (2002). 14. ThelowagriculturalproductivityinthePhilippinesislargelyexplainedbyslowagricultural diversification. Relatively few rice farmers have diversified their cropping patterns. The share of crop-harvested areas that are devoted to non-rice crops varies in different provinces, with the largest share of only 10 percent reached in Pangasinan and Iloilo (Figure 2).7 Meanwhile, Nueva Ecija and South Cotabato posted even less shares at 5 percent.8 This is in spite of the fact that rice farming provides employment for less than 40 days per year (Dawe, 2006a) with 7According to Dy (2006), the diversification of coconut farmers is similarly non-existing. 8If the farms were used entirely for rice in the wet season and entirely for other crops in dry season, the diversification percentage would be 50 percent. 5 rural development, natural resources and environment sector unit an annual net income of PhP16,650 for an average rice farm size of about 1.8 hectares in 2004, which is only 20 percent of the annual household poverty threshold (NEDA, 2006). Figure 2: diversification of farmland in rice-based farm households by province note:Diversification is the percentage of total cropped area planted to non-rice crops. Diversification from rainfed and irrigated areas is weighted by the percentages of rainfed and irrigated area in each province for the July to December semester. Source: Dawe and others (2006a). 15. The structure of agricultural production has hardly changed over the past two decades, with traditional low-value crops continuing to dominate. Despite the increased AgGVA share of livestockproductsfrom16percentin1980-1990to23percentin2001-2005,therateofagricultural diversification in the country has been rather modest (Table 4). Crop production continues to account for more than half of AgGVA with palay contribution increasing from 14.5 percent in 1980-2000 to 15.9 percent in 2001-2005. The crop production structure remains unchanged. The dominance of traditional rice, corn and coconut accounted for 82 percent of the total harvested area in 2004, only 3 percent lower than in 1990. In contrast, the share of the harvested areas under bananas and pineapple remained at 0.35 percent between 1990 and 2004. Despite high potential, the share of bananas in total AgGVA remained very low compared to the traditional crops supported by the government programs. The fishery sector's share fell to 15 percent in 2001- 2005 from 21 percent in 1980-1990. table 4: structure of agricultural gross value-added, 1980-2005 (in percent to total AggvA) 1980-1990 1991-2000 2001-2005 crop production, total 59.8 57.8 57.3 Palay 14.4 14.8 15.9 Corn 6.4 5.2 4.5 Coconut 8.0 5.9 4.7 Sugarcane 3.7 3.0 2.9 Banana 2.6 3.0 3.8 Other crops 24.7 25.9 25.5 livestock, total 15.6 21.1 22.9 Beef and Pork 9.6 13.0 13.8 Poultry 6.0 8.1 8.9 Agricultural activities and services 4.1 4.6 4.7 Fishery 20.5 16.5 15.2 Source: nScB (2006). 6 A Technical Working Paper: Philippines Agriculture Public Expenditure Review 16. The Philippines is among the top producers and exporters of tropical fruit products in the world. The major fruits are banana, mango, and pineapple. This sector has performed very well in terms of yield, output growth, and income generation. The Philippines' share of the world's banana production was about 8 percent in 2004, following only Thailand (24 percent) and Brazil (9 percent).9 The growth of Philippine banana production was faster than the global rate. Between 1992 and 1997, production expanded by 26 percent and from 1997 to 2004 it grew by 83 percent. The Philippines has also succeeded in expanding banana export in contrast to Ecuador and Costa Rica, the two largest world banana exporters. The Philippines' share in the world banana export grew from 4 percent in 1997 to about 7 percent in 2003, implying a gained competitive advantage over its competitors. 17. The Philippines account for 11 percent of world production of pineapples, second only to Thailand. Recently, however, production in the Philippines has slowed down to 0.7 percent compared to the expansion of world production by 18 percent.10 Despite this decrease, the Philippines retains the highest yield (315,027 hectogram per hectare), compared to Thailand (233,370) and Indonesia (90,160). Of the four pineapple products exported, only canned pineapple exports declined (Digal, 2005). 18. The Philippines is an important world mango producer. The country's share of world production in 2004 was 3.4 percent, albeit decreasing from its years of large area expansion between 1992 and 1997.11 The Philippines is the second largest exporter of fresh mangos in the world, earning US$45 million in 2003. The Philippines was also the second largest world exporter of mango juice in 1997 although it dropped to effectively zero in 2003 (Digal, 2005). 19. Looking to the future, the Philippines has great potential for agricultural diversification. This diversity suggests that there is a great scope to improve overall sector performance and thus its contribution to general economic growth. Soils, climate, and the degree of economic developmentofdifferentprovinceswillaffectdiversificationinthePhilippines.Someprovinces have many options for alternative crops while others have fewer. But as a whole, the potential is great and if realized, would produce many benefits. 20. Why was there little agricultural diversification so far? The answer lies in the bias of incentives toward traditional commodities. Recently, these incentives have experienced a significant increase, however, to the detriment of consumer welfare and resource allocation efficiency. The average "nominal rate of direct assistance" to Philippine agriculture increased from 14 percent in 1980-1984 to 30 percent in 2000-2004 (David and others, 2007).12 Moreover, the total rate of assistance rose from 1 percent in 1980-1984 to 23 percent in 2000-2004 because of the decreased 9Refer to Table A1. All tables with prefix-A are found in Statistical Appendix (Chapter 10). 10Refer to Table A2. 11Refer to Table A3. 12The methodology for estimating "rate of assistance" is similar to the widely-used OECD methodology for "rate protection". During 2006-2007, the World Bank project (which prepared reports for many countries, including the Philippines) adjusted the original OECD Producer Support Estimates to the Bank's methodology of producer assistance and the new term "rate of assistance" was introduced to distinguish between the Bank and the OECD estimates. 7 rural development, natural resources and environment sector unit assistance to non-agriculture (Table 5). Import-competing products, such as rice, corn, sugar, and poultry, have been supported the most through high import tariffs and non-tariff barriers (Table 6), while the support of export products was close to zero. This artificially raised the profitability of major import-competing commodities, thereby encouraging the distortion of resource allocation within agriculture and between the agriculture and the non-agriculture sectors. table 5: trends in nominal rate of direct and total assistance of major agricultural products in the Philippines, 1980-2004 (in percent) 1980-1984 1990-1994 1995-1999 2000-2004 Direct rate of assistance agriculture total 14 25 25 30 importable 27 36 49 43 exportable -12 -3 -2 -3 rate of assistance of non-agriculture 13 9 8 7 Total rate of assistance of agriculture 1 16 17 23 note: nominal rate of direct assistance is defined as ratio of domestic wholesale price to export or import border reference price. Total rate of assistance is defined as direct assistance to agriculture minus direct assistance to non-agriculture. Source: David and others (2007). table 6: trends in nominal rate of direct assistance of major agricultural products in the Philippines, 1990-2004 (in percent) 1990-1994 1995-1999 2000-2004 Rice 21 53 51 Corn 63 79 55 Sugar 49 97 79 Coconut copra -15 -8 -14 Coconut oil 7 1 6 Beef 26 15 -17 Pork 25 21 -8 Poultry 57 42 52 Others 10 5 5 note: nominal rate of direct assistance is defined as ratio of domestic wholesale price to export or import border reference price. Source: David and others (2007). 21. With this background, the next chapters review public spending on the Philippine agriculture between 1998 and 2005. The following chapters seek to answer two main questions: Do public expenditures follow the same bias as the policy incentives? How can the impact of public expenditures be increased? This review takes into account the importance of agriculture for pro-poor economic growth and argues that public expenditures, if allocated to the right priorities and used efficiently, can indeed play a decisive role in providing stimulus for an enhanced agricultural performance and better livelihood opportunities in the rural areas of the Philippines. 8 A Technical Working Paper: Philippines Agriculture Public Expenditure Review 3. PUBLIC ExPENDITURES AND PRO-POOR AGRICULTURAL GROWTH: SOME PRINCIPLES AND KEY LESSONS FROM INTERNATIONAL ExPERIENCE 22. International experience has established conclusively that expenditures on public goods - such as agricultural research, extension services, education, and rural infrastructure - are indispensable for agricultural growth, competitiveness, and poverty reduction (Fan and Rao, 2003; de Ferranti and others, 2005; Lopez, 2005). These growth-enhancing public expenditures13 bring about the highest returns and, at the same time, encourage private capital in the sector. Thus, it would be informative to contextualize the review of agriculture public expenditures in the Philippines within the backdrop of important lessons derived from international experience. 23. Investments in public goods provide factors of production that the private sector rarely supplies but are complementary and essential to private investments. Well-designed public investment can complement private investments and contribute greatly to increasing productivity in agriculture and other sectors. It helps lubricate the economy and aids in maximizing production of the most valued goods and services as well as in responding flexibly andintelligentlytonewinvestmentopportunities.Inotherwords,expendituresonpublicgoods create assets that are complementary to private capital and the absence of such expenditures would adversely affect the value of human capital and result in the underinvestment in a variety of socially beneficial projects. 24. However, public spending does not always have positive and sizable effects. Public spending creates a favorable environment for agricultural growth and poverty reduction, if and only if, the following conditions are met: ·Itisconsistentwithfiscaldisciplineandsustainableeconomicframework; ·Itisallocatedtotherightpriorities; ·Itavoidsgovernmentfailures. 25. If these conditions are not met, the effects of public spending on agriculture are likely to remain very small because private sector job creation is slowed down, resources are misaligned, and excessive public spending in agriculture results in macroeconomic misalignments. 26. An enabling macroeconomic environment is a necessary pre-condition for pro-poor agricultural growth. Public expenditure policy is a form of direct economic intervention. Like other interventions, public spending on agriculture should be part of a market-friendly approach to economic policy and supportive of development and adjustment goals (van Blarcom and others, 1993). Excessive agricultural public spending can lead to high or 13 In the AgPER, the term "growth-enhancing expenditures" is interchangeably used with Philippine-used term "market- related MFOs". 9 rural development, natural resources and environment sector unit rising budget deficits that can result in different types of macroeconomic imbalances (e.g., higher inflation and misaligned exchange rate) causing lower economic growth and weaker demand for farm products. By investigating the underlying factors in agricultural growth, Gardner (2005a) found "macroeconomic stability" and "real income growth in the non- agriculture economy" as among the most important factors explaining agricultural growth in 85 developing countries during 1960-2001. That's why public spending on agriculture should remain consistent with the aggregate fiscal discipline. 27. Public expenditures should be allocated to areas with the highest social payoffs for growth and poverty reduction. This underscores the importance of having the right mix of public expenditures. Using data from 10 Latin American and Caribbean countries for 1985-2000, López (2005) investigated the impact of total public expenditure and its mix on agricultural per capita income, controlling for trade openness and the per capita GDP share of the non- agricultural sector. The major finding is that the structure or composition of such expenditures is important for per capita agricultural growth. A reallocation of 10 percentage points of total public expenditures from subsidies to public goods would increase per capita agricultural income by an average of 2.3 percent; this is obtained without increasing total expenditures.14 These impacts are significant mainly because they capture both the positive effect of increasing the provision of public goods and the positive effect of reducing the distortions created by subsidies, which negatively affect the quantity and quality of private investments. In contrast, increasing public expenditures (without changing their composition) was found to be much less effective in raising per capita agricultural incomes: a 10 percent expansion of government outlays caused only a 0.6 percent increase in agriculture income. 28. The bias in the mix for one type of good or the other has not only efficiency implications but also important equity implications. Studies by the International Food Policy Research Institute in India (Fan and others, 1999) and China (Fan and others, 2001) imply that public investments which have the highest effects on growth are also likely to be most pro-poor. In India, the most effective rural poverty reduction investments were roads, followed by agricultural research and development (Table 7). In China, the most important contributors to poverty reduction (in terms of number of poor reduced per 10,000 Yuan) was education (8.80) followed by agricultural research and development (6.79), and then roads (3.22). 29. Provision of public services and the correction of market failures should not result in government failures. Market failures are not always a sufficient justification for government interventions. If addressed wrongly, a well-intended correction may result in severe and even more costly government failures. Information and governance weaknesses are some of the major reasons behind government failures. Millions of farmers each make unique decisions regarding production, consumption, sales, use of inputs, and leisure at different time and places. Centrally made decisions based on average figures might not suit many farmers. Thus, such unintended negative effects could cause a well-intended intervention to fail and waste public resources. 10 A Technical Working Paper: Philippines Agriculture Public Expenditure Review table 7: effects on productivity and poverty of public expenditures indiA chinA Marginal impact of no. of poor return to no. of poor additional rs100 reduced per agricultural reduced per billion at 1953 rs billion production 10,000 Yuan prices (%) (Yuan/Yuan invested, %) Poverty Productivity agricultural r&D 0.48 6.98 91.4 9.59 6.79 irrigation -0.04 0.56 7.40 1.88 1.33 roads 0.87 3.03 156.0 2.12 3.22 education 0.17 0.43 31.7 3.71 8.80 electricity 0.02 0.02 2.90 0.54 2.21 rural telephone - - - 1.19 1.13 Soil and water 0.04 0.00 6.70 - - rural development -0.15 n/a 27.8 - - health -0.02 n/a 4.0 - - Source: Fan and others (1999) and Fan and others (2001). 30. An example of government failures, through governance weakness and political economy across East Asia, is the continued subsidization of high-yield seed varieties. At the early stages of the Green Revolution, seed subsidies were justified to help ease the introduction of new technologies, reduce the risk of initial adoption, and support market development. But now high-yield rice varieties cover a large proportion of areas sown to rice across Asian countries. This suggests that many farmers have already mastered the technology and that their land allocation decision to cultivate high-yield varieties or other crops is dictated by the profitability of crops, not by unfamiliarity (or familiarity) with the technology. Thus, the continuing provision of input subsidies serve only to increase private profit margins at the expense of broader agricultural growth, and at the expense of public expenditures. "The art of public policy making, therefore, is to know when to introduce government intervention and when to withdraw. The common mistake is to forget the withdrawal part, leading to unsustainably high costs - a dilemma that most Asian countries [including the Philippines]15 are confronted with today" (Cummings and others, 2006). With this background, the next chapter will assess the consistency of public spending on Philippine agriculture with the previously described principles of effective public expenditures management and with the goal to attain growth while reducing poverty. 14 In the López (2005) study, the public goods expenditures include those on technology generation and transfers, soil conservation, sanitary and phytosanitary protection, communications and information services, rural infrastructure, and social services (e.g., education and health). For private goods, expenditures include commodity-specific subsidies, marketing assistance and promotion, subsidized credit, and irrigation. 15Insertion added by the authors. 11 rural development, natural resources and environment sector unit 4. TRENDS IN THE AGGREGATE LEVEL OF AGRICULTURAL PUBLIC ExPENDITURES IN THE PHILIPPINES 31. Trends in public expenditures for Philippine agriculture are presented at a consolidated level to the extent possible during 1998-2005. DA's expenditures include the Office of the Secretary, 13 attached agencies and 11 attached government-owned and -controlled corporations (GOCCs).16 DAR's expenditures include the financing of CARP in the context of land acquisition and distribution, delivery of agrarian justice and provision of public services to the agrarian reform beneficiaries.17 The AgPER does not include the Department of Environment and Natural Resources which focuses on the management of environment and natural resources, and does not consider Local Government Units since the AgPER focuses on national-level management of public expenditures. 32. Public expenditures for agriculture and fisheries increased more than twofold during 1998-2005, totaling PhP47 billion in 2005 (Table 8). The cumulative spending for the period is P252 billion, 42 percent of which was executed by DA-OSEC, while 16 percent (and 23 percent of DA's consolidated spending) was allocated to GOCCs, mainly to NFA. The share of GOCC in DA's spending grew over time, from 4.1 percent in 2002 to 45 percent in 2005. Farmers, however, have not benefited much from GOCC allocations since they were largely used for interventions in the rice market and financing import duties charged for rice imports. For DAR, about 30 percent of its budget was spent on landowner compensations under CARP, while about 32 percent of the total 2000-2005 budget was allocated to the delivery of public services to the agrarian reform beneficiaries. 33. Public expenditures for agriculture also grew in real terms. The total spending increased by 52.3 percent between 1998 and 2005.18 The growth of real spending was the highest during 2002-2005, due to the increase in rice imports which determined tax subsidies (Figure 3). 16A full list of DA-financed agencies and corporations is presented in Annex A. 17The level of consolidated public spending is analyzed using the DBM data on gross budget allocated to DA and DAR. This gross budget includes (a) Regular Appropriations, (b) Automatic Appropriations, (c) Continuing Appropriations and (d) Budgetary Adjustments (i.e., transfer of savings, transfers from miscellaneous personal benefits fund; pension and gratuity fund). "Automatic appropriations" include grant proceeds (including customs duties and taxes derived from monetization of commodity grants), retirement and life insurance premium of personnel, proceeds from sale of unserviceable equipment, etc. "Continuing appropriations" cover the unobligated or unreleased appropriations for operation and maintenance costs and capital outlays of the previous year(s), and any long-term funding from special fund created by law. 18Refer to Table A5. 12 A Technical Working Paper: Philippines Agriculture Public Expenditure Review table 8: trends in total public expenditures on the agriculture sector, 1998-2005 (million pesos) 1998 1999 2000 2001 2002 2003 2004 2005 Da 16,749 17,046 19,831 21,903 18,678 24,787 19,757 30,218 Office of the Secretary 12,628 14,224 14,782 15,795 12,994 11,227 12,036 12,498 Attached agencies 1,243 2,078 2,416 2,710 3,388 2,206 2,171 3,129 Attached corporations* 2,878 744 1,071 3,399 779 11,362 5,500 13,620 Others - - 1,561 - 1,517 - - 971 Dar 4,885 6,741 10,310 9,708 9,672 8,771 16,045 16,855 Landowners compensations 1,952 1,014 4,013 2,885 2,854 516 534 3,874 Delivery of public services 809 1,676 1,219 754 490 956 1,004 1,493 total spending 21,634 23,787 30,141 31,611 28,350 33,558 35,802 47,073 note: * This includes nFa's stabilization and tax subsidies. Source: DBM (2006a) and DoF (2007). Figure 3: Public spending on agriculture, 1998-2005 (million pesos, in real terms adjusted for inflation) Source: DBM (2006a) and DoF (2007). 34. In relative terms, the public spending on agriculture remained stable and moderate in spite of its growth in absolute terms (Table 9). In 2005, the shares of agricultural public spending in total expenditures and GDP were 5 percent and 0.8 percent, respectively. These shares increased only slightly in 2005 compared to 1998. As a proportion of AgGVA, however, the dependence of agriculture on public spending grew from 4.7 percent to 22.1 percent, showing the tendency toward greater reliance of farmers on public programs instead of generating more income from market operations. 35. International comparison shows a relative under-spending by the Philippines on agriculture. Measured as a share of agricultural spending in total GDP (adjusted by the size of the sector), the Philippine spending has been comparable to neighboring Lao PDR and Vietnam.19 However, it is lower than what other middle-income countries, like China and Thailand, were spending. It is however consistent with the more limited fiscal capacities of the Philippines relative to higher-income countries. 13 rural development, natural resources and environment sector unit table 9: total public spending on agriculture as a percentage share in total budget expenditures, gross domestic product, gross agricultural output and agricultural value-added, 1998-2005 1998 1999 2000 2001 2002 2003 2004 2005 Total Public Spending (central government) 4.22 4.03 4.64 4.45 3.64 4.06 4.04 4.99 Total gDP 0.77 0.76 0.85 0.82 0.67 0.72 0.68 0.80 gross agricultural output, incl. fishery 4.00 4.16 5.51 5.43 4.53 5.12 4.64 5.76 agricultural value-added 5.58 16.12 19.57 19.83 17.18 19.80 20.28 26.42 agriculture + Fishery value-added 4.69 13.02 15.93 16.25 14.16 16.40 16.91 22.06 Source: Data from Table 8, nScB (2006) and nBaS (2006). 36. International experience also shows that lower fiscal spending does not necessarily translate into lower agricultural competitiveness. What matters the most is the mix of spending. It is well- known that huge farm subsidies in the United States and the European Union, for example, have failed to increase farm competitiveness, while lower spending in Brazil and Australia did not prevent their farmers from being highly-competitive on the world markets.20 37. The country-specific circumstances matter, too. The international benchmarking of public spending on agriculture should not be considered as standards for appropriate levels of expenditures. The Philippine circumstances should also be taken into consideration. While the budgetary spending on agriculture in the Philippines is not excessive and thus is not a cause of concern from the point of view of maintaining aggregate fiscal balance, an emerging concern is the non-budgetary aspects of the fiscal costs due to the rapidly rising contingent liabilities associated with NFA's off-budget borrowing. These borrowings have substantially grown in recent years in order to cover NFA's surging deficit which resulted from importing rice, distributing it, buffering stocks, and covering the administration costs.21 During 1998-2005, NFA's cumulative deficit totaled PhP27.7 billion (Table 10). In 2005, the deficit equaled PhP10 billion and in 2006 it grew to PhP16.4 billion. NFA's share in GOCC's total deficit rose from 8 percent in 2000 to 43 percent in 2005. The rising debts increase the likelihood that the government would have to step in and absorb them. Chapter 6 shows that NFA's deficit is caused by the efforts to support the policy of rice self-sufficiency and thus can be reduced only by reconsidering that policy. table 10: rising share of nFA's deficit in gOcc's total deficit, 2000-2006 2000 2001 2002 2003 2004 2005 2006 NFA's deficit, million pesos 1,897 2,274 8,086 3,689 1,836 9,978 16,430 Total deficit of GOCC, million pesos 22,581 32,832 25,937 39,649 85,412 22,987 n/a Share of NFA in total GOCC's deficit, % 8 7 31 9 2 43 n/a Source: DoF (2007). 19 Refer to Table A4. 20Refer to Table A4 on fiscal spending on the agriculture sector in different countries. 21Some off-budget borrowing is made to overcome the liquidity constraint. Since NFA has to first pay the duties and then get reimbursed through the tax subsidy, it might lack cash at hand to pay these duties (and cover other operational deficits). As a result, it has borrowed from the market (which is only possible with implicit government guarantee). As a whole, however, NFA's total borrowing has consistently exceeded the tax subsidy in recent years in order to service its debts and fulfill the policy mandate that forces NFA to "buy high and sell low" (refer to Table 29 and Table A25 for information on NFA's total costs and NFA's balance sheet). 14 A Technical Working Paper: Philippines Agriculture Public Expenditure Review 38. With this in background, the way to increase the benefits of agricultural public spending in the Philippines while reducing its fiscal costs would be to alter the mix, rather than the level of expenditures. This is notwithstanding the fact that the aggregate agricultural spending as a share of total budget expenditures and of GDP remain at moderate levels. Improving allocative efficiency within the current level of spending should be given more importance because it supports the government's fiscal consolidation efforts and thus creates an investment climate conducive for economic growth. Moreover, a large percentage of public expenditures, allocated to subsidies and other private goods such as NFA's operations, has not really benefited farmers and fisherfolk and has not spurred broadly shared growth. Therefore, substantial efficiency gains could be achieved by improving the expenditure composition alone without increasing its level. 15 rural development, natural resources and environment sector unit 5. ALLOCATIVE EFFICIENCY OF PUBLIC SPENDING IN THE DEPARTMENT OF AGRICULTURE 39. This chapter analyzes the functional (by MFOs) and economic (capital and recurrent expenditures) structures of DA's expenditures. Data used for this analysis are from DA's records that usually report lower levels of spending than what are reported in the Department of Budget and Management (DBM) records (used for reviewing the aggregate levels of expenditures in Chapter 4). The distinction is mainly because DA covers the budget prescribed by the Agriculture and Fishery Modernization Act (AFMA) of 1997, while DBM's records reflect fiscal obligations from all types of appropriations plus funds from other sources, including the Calamity Fund and the Priority Development Assistance Fund of Congress. 40. Where data allows, judgments on allocative efficiency are made based on actual obligations.22 As a whole, budget allocations in the Philippines can be analyzed according to the four key steps of the budget process: (a) appropriation, (b) allotment, (c) obligation, and (d) cash disbursement.23 Allotments have been usually lower than appropriations due to either fiscal constraints resulting in cuts for all departments as a whole, or the failure of a department such as the DA to provide consistent and clear records of past and future allocations of obligated funds so it can receive the next releases of DBM. Obligations are the best proxy of actual expenditures spent by the line departments each year. Typically, the obligated funds are 10-15 percent smaller than allotments. This happens particularly for capital outlays for irrigation and other infrastructure that require a complicated process of bidding or contracting, or in the case of last year's release of allotment not being obligated by the end of the fiscal year. There is no consistent data on the cash disbursements of DA's agencies. Interviews with the budget departments revealed that, on average, the actual cash disbursements were typically 10 percent below the actual obligations while the disbursement rate across commodities and programs were significantly biased towards GMA rice and irrigation investments. 41. DA-OSEC budget comes from regular appropriations and special purpose funds. The regular funds primarily support DA's expenditures for general administration and for support to operations. The special purpose funds largely support DA's operations generally embodied in the AFMA. Special purpose funds are also the source of budget support to GOCCs. 42. In terms of the composition by major final output, DA's largest expenditure was on irrigation services (MFO 4) and production support (MFO 1).24 These two MFOs accounted for 60 percent of DA's total appropriations during 2001-2007 (Figure 4).25 This priority has 22Some date sets are incomplete for 1998-2005 due mainly to unavailability of records. 23Annex B provides the explanation of distinct differences between these categories. 24Detailed description of the MFOs is presented in Annex C. 25For 2007, data is on planned expenditures. Refer to Table A8 and Table A9. Since there is no available data on actual obligations by MFOs for 2001-2007, appropriations are used. A detailed disaggregation of "obliged expenditures" by DA for 2000-2005 is reported in Table A12. In the past (during 1989-1998), production support and irrigation accounted for only 35 percent of DA's total spending (David and Inocencio, 2000) 16 A Technical Working Paper: Philippines Agriculture Public Expenditure Review been strengthened over the last two decades. Public expenditures for research and development accounted for only 5 percent of the total; education and training received about 8 percent. These expenditures were spread over several bureaus and institutions, failing to generate a sufficient amount of qualitative market-driven research outputs and to effectively link research with extension services that would provide farmers with profitable technologies.26 Expenditures for market infrastructure, mainly farm-to-market roads and post-harvest equipment, constituted about 13 percent. Nonetheless, although these are critically important for economic development in general, roads and other market infrastructure are principally the responsibility of the Department of Public Works and Highways, the Local Government Units and the Department of Transportation and Communication. DA's expenditures on farm- to-market roads therefore should be closely coordinated with the LGUs and said departments to ensure synergies and sustainability. Finally, relatively small amounts were allocated to regulatory functions, information collection and dissemination, policy and planning, market development, and other operational support. This is in spite of the fact that these functions are extremely important for agricultural producers and often cannot be sufficiently provided by the private sector. Figure 4: estimated functional structure of public expenditures by MFOs, (appropriations), 2001-2007 (million pesos and in percent to total) Source: general appropriation acts of the Philippines (different years). 43. Althoughtheexpenditureallotments(andcorrespondingly,obligations)wereconsistently below appropriations, irrigation and commodity programs were nevertheless financed at the highest rates. On average, appropriations were fully allocated to irrigation programs, as well as for rice and corn GMA programs. In contrast, other programs/expenditures were financed at only about 60-70 percent of the appropriation, often being residuals in DA's spending priorities (Table 11). 26See below the detailed discussion on agricultural R&D and extension services in the Philippines. 17 rural development, natural resources and environment sector unit table 11: share of allotments in total appropriations by programs, 2000-2005 2000 2001 2002 2003 2004 2005 irrigation Locally-Funded Projects 99.0 104.5 98.1 104.2 100.0 100.0 Foreign-Assisted Projects 100.0 95.7 75.9 84.9 100.0 86.3 Programs: 93.2 88.0 79.7 122.0 87.6 96.3 Rice 93.2 88.0 79.7 122.0 87.6 96.3 Corn 93.2 88.0 79.7 122.0 87.6 96.3 HVCC 93.3 82.8 77.4 91.9 72.5 93.7 Livestock 98.0 79.3 70.3 101.4 101.2 110.8 Fisheries 92.8 87.2 89.9 87.8 87.1 93.8 other expenditures 31.5 62.7 66.5 42.2 63.0 82.1 subtotal AFMA 70.4 99.5 76.7 80.1 89.7 90.3 note: This table excludes regular program spent on personal expenses. Source: Da Budget Division (2006a). 44. The overriding historical concern for food self-sufficiency has led to a disproportionate share of public expenditures for rice. Aside from the budgetary allocations for irrigation and production support, rice dominates public expenditures for farm machinery, post-harvest equipment, research and development, and training programs (Figure 5).27 During 2000-2005, about 60 percent of the AFMA budget was spent on rice programs even though rice accounts for only 16 percent of the total AgGVA (Table 4, Chapter 1). Figure 5: estimated distribution of obligations (AFMA) for dA by commodity, 2000-2005 (million pesos) note: This excludes regular Program being allocated to personal expenses. While these expenses are not possible to attribute to specific commodities, it is probable that it follows the distribution of the aFMa program. irrigation investments are assumed to support only rice. Source: own presentation based on Table a13 and Da Budget Division (2006a). 27Refer to Table A7, Table A10, and Table A11. 18 A Technical Working Paper: Philippines Agriculture Public Expenditure Review 45. In contrast, public expenditure for exportable agricultural products has been quite modest. There have been few resources provided to productivity-enhancing programs to address the problems of declining competitive advantage of major import-competing commodities, particularly corn and sugar. Technology generation, R&D and market infrastructure for sugar and corn have been clearly under-funded. 46. In terms of economic composition, the personnel spending has been under control, but spending on the operations and maintenance has grown at the expense of capital outlays. The wage bill remained under control, remaining at an average of 14.7 percent between 1998 and 2005 (Figure 6). In 2007, it is even expected to decline to 12.7 percent (Table 12).28 However, the capital outlays were reduced from 60.5 percent in 1998 to 45.2 percent in 2005 due to the increased operations and maintenance expenses. There is no information available on developments in operations and maintenance and capital outlays across different major final outputs over time since DA only recently began to structure its budget across them (as in Table 12). If these larger operations and maintenance budgets were allocated to the rehabilitation of existingirrigationsystemswiththeintentionofitstransferforfutureoperationsandmaintenance to irrigators associations, for example, this could be considered a positive development. If the increases in operations and maintenance were allocated to low value-creating activities (such as subsidies under the GMA programs) at the expense of capital outlays to roads and other market infrastructure, this could be considered a very undesirable shift. Figure 6: economic composition of dA-Osec expenditures, 1998-2005 (million pesos) Source: DBM (2006a). 28This applies only to DA-OSEC. The AgPER did not collect the data on economic composition of expenditures for each separate public agency and corporation. They are financed from different private and public funding sources beyond AFMA. 19 rural development, natural resources and environment sector unit table 12: economic and functional composition of dA-Osec budget of 2007 (`000 pesos) Operations Personnel and capital share in spending maintenance outlays total total, % Production Support Services 362,671 1,999,083 183,648 2,545,402 13.17 Market Development Services 105,996 1,230,941 6,715 1,343,652 6.95 Credit Facilitation Services 41,142 129,576 34,700 205,418 1.06 Irrigation Development Services 25,718 475,897 7,534,686 8,036,301 41.59 Post Harvest & Other Infrastructure Development Services 52,978 380,572 1,336,012 1,769,562 9.16 Extension Support, Education & Training Services 328,420 787,238 27,261 1,142,919 5.92 Research & Development Services 395,186 799,039 47,450 1,241,675 6.43 Regulatory Services 344,753 344,830 87,432 777,015 4.02 Information Support Services 280,423 207,829 126,718 614,970 3.18 Policy Formulation, Planning & Advocacy services 503,380 1,073,715 66,922 1,644,017 8.51 total 2,440,667 7,428,720 9,451,544 19,320,931 share in total, % 12.63 38.45 48.92 Source: 2007 Presidential Budget. 47. While core public expenditures were financed from the national budget, capital outlays were increasingly financed from Overseas Development Assistance. Its annual disbursements between 2000 and 2005 averaged P2 billion, peaking at P6 billion in 2002 (Table 13). The share of foreign assistance remained at stable 25 percent of DA's total budget, but it increasingly became the main source of project financing. In 2005, foreign-assisted projects accounted for 71 percent of DA's projects. Main foreign-assisted projects focused on irrigation implemented mainly with the assistance of the World Bank, Asian Development Bank, and Japan Bank for International Cooperation assistance. The government found it necessary to borrow from donors to finance vital projects since domestic resources were diverted for rice support programs. table 13: local and foreign finance in dA's budget (obligations), 2000-2005, (million pesos) 2000 2001 2002 2003 2004 2005 Total obligations (aFMa plus regular program) 15,260 14,877 16,319 14,156 12,547 11,005 Regular funds 9,411 9,491 8,878 8,767 7,267 7,088 Local-financed projects 2,961 1,871 1,468 2,055 1,715 1,121 Foreign-financed projects 2,888 3,515 5,973 3,333 2,565 2,796 Share of FaP in Da's budget, % 19 24 37 24 20 25 Share of FaP in Da's projects, % 49 65 80 62 60 71 Source: Da Budget Division (2006a). 5.1 Major Final Output 1: Production Support 48. Public expenditures in agriculture have been often directed to subsidies that turned out to be regressive, rather than on high-payoff investments in rural public goods and human 20 A Technical Working Paper: Philippines Agriculture Public Expenditure Review capital. There are no consistent records of the structure of MFO 1, partially because many such programs were dispersed among numerous bureaus and attached agencies of DA. However, the largest slice of MFO 1 (about 85 percent) was allocated to the GMA rice program, in particular for the Hybrid Seed Commercialization Program. In 2003-2005, the allocations for seed procurement and distribution as well as the distribution of other rice seeds and fertilizers/ pesticides accounted for 54.2 percent of total MFO 1 and 70.3 percent of the GMA rice program (Table 14 and Table 15). Developed with new technology, hybrid rice promises better varieties and higher yields than traditional inbred seeds. Its subsidization has been a part of the strategy of increasing rice production to bring the country closer to self-sufficiency. 49. Despite the sizeable amount of money and public human resources spent, the Hybrid Seed Commercialization Program did not produce much net social benefit. The program was implemented by PhilRice, the state-owned agency tasked to monitor the performances of seed growers, distribute seeds and other inputs (Table 15), collect repayments for supplied seeds from farmers, and provide technical assistance to seed users.29 The adoption of hybrid seeds by farmers has been slow, reaching peak coverage of 11 percent of total rice area in 2005 (Table 16). The size of the target area was bigger than the actual area planted with hybrids because of seed deterioration and geographic/time mismatch between demand and supply. While the rate of hybrid seed adoption increased from 5 percent in 2004 to 11 percent in 2005, the drop-out rate revealingly ranged from 50 to 99 percent (Table 17). Thus, in spite of the substantial support and incentives, the number of farmers planting hybrid seeds posted only a slight increase. There is little doubt that these seed-related subsidies have at least partially achieved their stated objective; hybrid seed use has been increased to some extent. However, the cost has been high in a number of respects as described below. table 14: estimated structure of MFO 1, 2001-2005 (million pesos) 2001 2002 2003 2004 2005 hybrid rice seed program (hScP) 322 424 289 551 785 other rice (certified) seeds 190 168 211 114 118 others, including fertilizers for hScPa 14 118 442 355 210 Subtotal HSCP 526 710 942 1,020 1,113 gMa rice n/a 1,400 1,229 1,667 1,522 total MFO 1b 1,333 1,415 1,948 1,928 1,811 note: See Table 15 for detailed presentation of other incentives in the hybrid seed commercialization program. Due to the lack of consistent records a b on actual obligations, the total MFo 1 budget is proxied by appropriations. Source: Based on David (2006), Da (2006; 2007). 29The presentation of the hybrid seed program is based on David (2004; 2006) and Sebastian and others (2006). 21 rural development, natural resources and environment sector unit table 15: Other incentives provided to farmers per bag of hybrid seeds, dry and wet season, 2004 case 1a case 2c case 3 case 4 case 5 case 6 case 7 Inorganic fertilizers P500 P500 1 bag P500 Buy1, take P500 2 bags discount discount (P700) discount 2 (P700) discount (P1400) Organic fertilizers 2-4 bags (P600) Zinc sulphate 10-15 kg 3 kg 5 kg (P375) (P125) (P125) Soil conditioner 1-3 kg 1-3 kg 1-3 kg 1-3 kg (P175) (P175)c (P175) (P175)c Chemical BLB stopper 1 sachet 1 sachet 1 sachet 1 sachet 1 sachet 1 sachet (P80) (P80) (P80) (P80) (P80) (P80) Kocide 1 bottle (P300)b note: applies to region ii for dry and wet seasons 2004. Provided to those affected by bacterial leaf blight. initial allocation to 20 percent of planted a b area to hybrid rice. ccommonly found in Mindanao, kalinga, etc. Source: David (2006). table 16: Area planted to hybrid rice as percentage of target area and total rice area, 2001-2005 dry season wet season Percentage of targeted area 2001 - 26 2002 54 67 2003 51 58 2004 84 72 2005 76 - Percentage of targeted area 2001 - 0.2 2002 0.4 0.9 2003 1.6 2.3 2004 4.7 5.5 2005 10.9 - Source: David (2006). table 17: distribution of sample municipalities by percent drop out rate (in percent) dry 2002 wet 2002 dry 2003 wet 2003 dry 2004 number of municipalities 8 18 25 37 48 Drop out rate next season (%) 91-100 13 33 40 8 10 81-90 - 22 16 14 19 71-80 38 22 24 24 19 61-70 12 6 8 24 21 51-60 12 11 8 11 17 50-below 25 6 4 19 14 average drop out rate (%) 68 80 80 67 69 Source: David (2006). 22 A Technical Working Paper: Philippines Agriculture Public Expenditure Review 50. The hybrid rice seed commercialization program incurred substantial (sometimes unintended) costs. The following points discuss how significant scope remains for improving the efficient use of public resources by phasing out the production support and increasing expenditures for high priority public goods. Based on David (2004; 2006) and Sebastian and others (2006), the provision of subsidies for goods (which are essentially private in nature) has distorted technological choices, encouraged misallocation of resources, crowded out the private sector, and disproportionately benefited the already better-off farmers. a) Distortion of technological choices. The structure of incentives distorted the farmers' choice of hybrids and between hybrids and inbreds. The distortion led farmers to grow less socially profitable hybrids over the more socially profitable inbreds. Moreover, the hybrid seed subsidy hampered agricultural diversification by diverting some farmers from producing alternative agricultural products. b) Resource misallocation. The program resulted not only in the inefficient and over-use of under-priced seeds and other inputs but also in the misallocation of limited public resources, including the time of public servants. The program substantially diverted the time of DA staff managing the program at the national level; and LGU staff responsible for selling the seeds, providing training, monitoring the program progress and collecting debts from participating farmers.30 LGU staff, for example, was given an additional PhP200 salary per month for selling hybrid seeds and distributing other inputs to farmers (as shown in Table 15). This incentive has diverted LGU staff away from more relevant local projects and the more pressing problems of agriculture and the rural areas. c) Crowding out of the private sector. The government's involvement in seed procurement, distribution and financing has created de facto monopolies by driving out the private sector, in spite of the latter's competitive advantage in serving farmers. Table 18 shows that the estimated cost of hybrid seed production and distribution was high for the government (PhP6,100 per 20 kilogram per bag), while the cost for the private sector was half as much. The cost of wastage alone (because of seed deterioration and mismatch between supply and demand at certain location and time) amounted to around PhP800 per bag for the public sector. d) Increased inequity within the rice sector. Since the program was designed to increase Philippine rice self-sufficiency, it naturally targeted farmers with the best knowledge, especially on certified seeds, and with the access to irrigation. Those farmers could quickly increase production and demonstrate the "success of the program". As a result, the program skewed the rural income distribution, making the already better-off rice farmers even wealthier compared to non-participating poorer rice farmers and farmers producing other crops. 30Participating farmers received seeds upfront, but the government typically subsidized 50 percent of the seed costs. The remaining 50 percent was to be paid by farmers and collected by LGU staff. David (2004) reports that the repayment rate during the dry season of 2003 was only 40-50 percent, which dropped to 5-8 percent during the wet season of 2004. 23 rural development, natural resources and environment sector unit table 18: estimated cost of hybrid seed production and distribution (PhP per 20 kg/bag) government Private sector Procurement/field production cost 2,400 1,600d Direct distribution cost of PhilRice 300a Distribution/promotion costs 1,500b 1,800e Cost of inspection 100 Costs of wages 800c Subtotal 5,100 3,400 Other incentives (fertilizers/others) 1,000 Total (exc. Research and development) 6,100 note: excludes salaries of personnel and other direct costs of Philrice involvement. Based on conservative assumption that 120 agricultural a b technicians are involved in hybrid seed distribution. cassume 30 percent of hybrid seed procured end up not being planted because of germination and purity problems. dBased on estimates of cooperatives. eBased on estimates of Bayer crop Science, which include cost of storage, freight, distribution, market development, and profits. Source: David (2004). 51. The Hybrid Seed Commercialization Program could benefit from a redesign that focuses on research and development, technology promotion through effective devolved extension services and improvement of regulatory functions. Right now, the phasing out of subsidy may be opportune considering that the hybrid seed subsidy has been in place since 2001 and that the benefits of hybrid seeds have been introduced to farmers. At this stage, the program is likely to achieve better outcomes if support shifts from subsidies on seeds, fertilizers and agricultural chemicals to R&D and devolved extension services to improve crop and water management. A useful complement would be to concentrate on inbred seeds research since hybrids do not fit all production areas in the country. Location-specific research will bring scientists closer to clients and focus research on distinct problems and opportunities (Sebastian and others, 2006). Technology promotion through extension services would allow a higher rate of adoption for both hybrid and inbred seeds, because lack of knowledge is a major reason behind the farmers' failure to adopt recommended practices. Even though better-off farmers often achieve higher yields, additional production gains can still be derived from extending known technologies to the more marginal farmers. However, it should be taken into account that poor adoption rates also reflect farmers' tendency to avoid risks in many instances (natural disasters and poorly functioning irrigation systems), as well as lack of financing, unavailability of inputs, and increased labor requirements, particularly in more remote areas. 52. The private sector could play a larger role in producing and distributing high-quality seeds, both inbred and hybrid, at a low cost. But this would require improving government regulations, phasing out direct interventions in seeds distribution, ensuring a better bid for the property rights to private organizations, and increasing public investments in research and extension services. 53. The economic and social benefits would be greater if other production subsidies from MFO 1 are also phased out. The distribution of seedlings for high-value crops, for example, has similar drawbacks as the hybrid seed commercialization program. Its economic costs remain low only because of the small program budgets. A more effective way of promoting high-value crops would be through commodity-neutral policies, regulations and public investments in infrastructure as well as knowledge dissemination. Public expenditures for creation of wholesale markets, for example, could do much more to increase farm incomes than any production support, by encouraging market integration, reducing marketing costs between farmers and consumers and 24 A Technical Working Paper: Philippines Agriculture Public Expenditure Review disseminating information to small farmers. Small subsidies for farmers in remote areas can be justified, but they need to be time-bound and supported by a clear evidence of market failure. 54. Thephasingoutofsubsidiesisapoliticallydifficultbutnecessarystepandshouldbesupported by improvements in the existing monitoring and evaluation (M&E) system. Currently, the MFO- wide performance indicators required in the context of the Organizational Performance Indicator Framework include mainly inputs and outputs (Annex D). However, there are no consistent impact assessments of public programs. It implies that the actual impact of subsidies (and other programs) on real income of beneficiaries, income disparity with non-beneficiaries and non- farmers or changes in farmers' behavior remain largely unknown. This information gap allows some interest groups to manipulate the public debates about public policy and expenditures. For example, some claim that production support encourages competitiveness, reduces the costs of wage goods, and provides the safety nets to poor farmers; and thus provides many benefits. None of these claims is supported by the facts. The lack of a formal system of expenditure evaluations, combined with a lack of access to public information on expenditures and their beneficiaries, dilutes the effectiveness of any formal accountability mechanisms. This might be improved in the context of Organizational Performance Indicator Framework and other initiatives. 5.2 Major Final Output 4: Irrigation Investments 55. Irrigation expenditures are substantial and biased toward rice. Irrigation investments alone accounted for 46 percent of DA-AFMA's total spending during the last decade (refer to Figure 4 in Chapter 3). There are about 30 on-going NIA projects financed from local and foreign funds for both rehabilitation and new irrigation systems (Table 19). The annual irrigation investment budget ranged from P3 billion to P4 billion between 2000 and 2005, with the aggregate value of NIA's recent projects amounting to P73.6 billion (Table 19).31 Irrigation investments have concentratedlargelyinthemainriceproducingareas(i.e.,LuzonandSoccsksargeninMindanao), where the irrigable area accounts for 49 percent of total irrigable area in the country.32 table 19: summary of the existing public irrigation investments as of december 2005 service area new investments (ha) rehabilitation (ha) costs (million pesos) Luzon 91,050 134,545 21,736 Visayas 13,054 13,202 8,046 Mindanao 34,647 4,536 7,928 Nationwide projects 258,430 841,415 35,897 total 73,606 Source: national irrigation administration (2006). 56. Irrigation investments are essential to agricultural production but not a panacea. Irrigated land has higher productivity and fewer risks of lower yields due to adverse weather conditions. In the Philippines, the average rice yield on irrigated land is 35 percent higher than on non-irrigated land (NBAS, 2006). Moreover, irrigation plays an enabling role in the adoption of improved seed varieties. For these reasons, all net rice importers have invested in irrigation systems so that they 31Refer also to Table A7. 32Refer to Table A26. 25 rural development, natural resources and environment sector unit now irrigate a much higher percentage of their rice land than the net rice exporters (Figure 7). However, these increasingly costly efforts have failed to eliminate the need to import rice [not only in the Philippines], underscoring the difficulty in off-setting comparative disadvantages due to geography [of being island nations] and other natural endowments/conditions (Dawe, 2006b). Thus, the lack of irrigation investments per se is not the reason the Philippines imports rice. The country will likely continue importing rice, even with a substantial irrigation budget, especially given its quickly growing population and fixed productive and irrigable land areas. With better designed investments in irrigation, however, it will be possible to reduce the import bill and allow farmers to increase their productivity and incomes, as well as agricultural diversification. Figure 7: Percentage of rice area that is irrigated in the east and south Asia Source: Dawe (2006b). 57. Despite its large share of public investments, the Philippines has inadequate and inefficient irrigation development. Of the estimated potentially irrigable areas of 4.7 million hectares, by 2003 only about 1.34 million hectares, or 29 percent, were actually irrigated (David, 2003). Most public investments went to the construction of gravity irrigation systems serving rice monocultures, with inadequate attention given to the sustainable use of water and cost recovery mechanisms. Most of the existing large gravity irrigation systems have historically and continuously been performing inefficiently and below expectations mainly because of (a) an inadequate database for planning; (b) inadequate institutional capacity and mechanisms for the development of large irrigation projects; (c) design mistakes; (d) poor quality of construction; and (e) the low cost-recovery of irrigation service fees (David, 2003). 58. Sustainability is the overriding issue in irrigation development in the Philippines. It is directly related to issues of cost-effectiveness, efficiency, and cost-recovery. The rehabilitation of irrigation systems needs to be accompanied with improvements in cost recovery because in recent years the collection of irrigation service fees has been reported at only 58 percent of total amount collectable (David, 2003). Small and farmer-controlled irrigation systems such as shallow-tube wells, small inundation schemes, farm reservoirs and low-lift pumps are likely to provide better alternatives to the currently common large-scale irrigation systems. These systems require much less investment costs, have very short gestation periods, yield higher 26 A Technical Working Paper: Philippines Agriculture Public Expenditure Review productivity, give farmers a greater degree of control over their irrigation water, and are more amenable to crop diversification (David, 2003; de los Reyes and Aquilar, 2006). 59. The development of farmer-controlled irrigation has been slow in spite of some support of NIA and other public agencies. This is due to the subsidies given in favor of national irrigation systems and the loose policy toward cost-recovery. Thus, private investments for small-scale irrigation systems have been crowded out. Currently, NIA fully subsidizes the construction of national irrigation systems and about half of their operations and maintenance costs. In the case of communal irrigation systems, farmers are required to finance the operations and maintenance as well as pay for 10 percent of the construction cost upfront and the balance, without interest, within 50 years (David, 2003). These subsidies increase the farmers' demands for national and communalirrigationsystemsrelativetomorecost-effectiveirrigationtechnologiesanddiscourage private sector participation in irrigation development. Apparently, the existing policy framework does neither reward good water users nor penalize the bad ones. 60. Such an approach incurs high opportunity costs. Investments in gravity irrigation systems should range between PhP110 billion to PhP220 billion in the next five years (or almost twice as much as have been invested during the last decade) to reach full self-sufficiency in rice (NEDA, 2006). While there is no guarantee that these levels of investments would actually result in full rice self-sufficiency, it is estimated that the same amount would be sufficient to cover the costs of constructing up to 400,000 new classrooms, around 150,000 kilometers of all weather roads or 60,000 kilometers of paved rural roads; or alternatively the costs of rehabilitation of 200,000 kilometers of all weather and 75,000 kilometers of paved rural roads (Table 20). table 20: estimated opportunity costs to develop new irrigation systems rate of Additional cost equivalent of equivalent of `000 equivalent equivalent rice self- for irrigation `000 km of km of rural number of number of sufficiency development new rural road rehabilitated road classrooms, teachers, (billion pesos) `000 `000 All Paved All Paved weather weather 96% 95.9-191.8 96-192 33-80 120-240 48-96 192-384 758-1,515 146% 257.0-513.9 257-514 89-214 321-643 129-257 514-1,028 2,030-4,060 100% 110.2-220.5 110-221 38-92 138-277 55-111 221-441 871-1,742 note: additional costs are provided from minimum to maximum. Unit cost of classroom is assumed at P500,000. annual salary requirement for teachers is P126,564. Unit cost of construction of 1 km of new rural road ranges from P1 million for all weather and P2.4 million for grave roads. Unit cost of 1 km of rural road's rehabilitation is P800,000 for all weather road and P2 million for grave road. Source: neDa (2006) and World Bank documentation. 61. It is recommended that public expenditures be focused on irrigation infrastructure such as (a) rehabilitation of existing gravity irrigation systems, (b) expansion of new irrigated areas by investments in small-scale irrigation systems and (c) accompanying institutional reforms. The strategic alternative to new irrigation investments (designed to palay production solely) is rehabilitation of the existing irrigation infrastructure along with its enhanced management for more efficient water use. This can potentially improve rice productivity in areas where there is a high comparative advantage for producing rice, encourage crop diversification to bolster and diversify farm incomes, and improve the sustainability of water use. Water scarcity and the degradation of water quality are already serious concerns in some parts of the country: if 27 rural development, natural resources and environment sector unit unchecked, water supplies will be further reduced (Inocencio and Barker, 2006). The benefits would be larger if the expansion of irrigated areas is pursued through investments in farmer- controlled irrigation systems and complemented by reductions of subsidy that favor gravity irrigation systems. The rehabilitation of irrigation systems is a prerequisite for the transfer of national irrigation systems to irrigators' associations. These associations can operate and maintain the self-sustained system (i.e., after rehabilitation the system must be self-sustaining with full cost recovery from irrigation service fees). This would allow the National Irrigation Administration to reduce its operational expenses, downsize its staff, and focus its efforts on creating sustainable management mechanisms for national irrigation systems, as well as policies for irrigation development.33 At the same time, improved irrigation system control would enable the proper management of the water regime required for crop diversification in the paddy fields. This would be a less costly and more sustainable strategy (World Bank, 2006b). 62. Serious attention should be also paid to the M&E system for irrigation as for any public program. Currently, the monitored indicators for irrigation development include only the number of households benefited and areas served by rehabilitation and expansion (Annex D). To strengthen the irrigation M&E system, these existing indicators could be complemented by others, including the areas transferred to water user associations, cost recovery, effects of rehabilitated irrigation on yields and crop diversification, etc. With such an indicator/outcome framework, an efficiency of public expenditures for irrigation development in the Philippines would be greatly increased. 5.3 Improved Allocative Efficiency of Public Expenditures: A Shift from Private Subsidies to Public Goods 63. The strategy for sustainable investments in irrigation and the phasing out of most production support would free public resources for market-related MFOs. This would help create the enabling environment for agricultural growth and crop diversification. It would address the impediments in food supply chains, such as high logistic costs, poor market information dissemination, insufficient R&D, inadequate food safety and quality support. 64. While it is necessary to increase the financing of public goods, it is also important to continue improving the institutional procedures and governance of public expenditures. This is especially true for agricultural research and development, extension services, and the food safety and quality system. The 2006 World Bank economic and sector work, Rural Growth and Development Revisited, covers the wide range of rural development issues and together with the World Bank-assisted Diversified Farm Income and Market Development Project may serve as a valid source for detailed information and recommendations on how to improve market- related services (World Bank, 2006c). Following is a brief discussion of the key issues and recommendations derived from these World Bank and other reports. 33The details and rationale for NIA's rationalization is spelled out in the draft Project Appraisal Document of the World Bank's Participatory Irrigation Development Project (in preparation). 28 A Technical Working Paper: Philippines Agriculture Public Expenditure Review 5.3.1 Agricultural research and development 65. The agricultural research and development budget should be increased since it has been severely under-funded with public expenditures for this purpose representing only 0.36 percent of the AgGVA and 5 percent of DA's total appropriations during 2000-2005 (Table 21 and Figure 4 from Chapter