Financial systems and development

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Box 4.6 Taxation of financial intermediation in the Philippines
Like many countries, the Philippines collects special more than 47 percent on a short-term loan simply to
taxes from financial institutions. The most important of service money market borrowings, in view of the rethese
are the gross receipts tax (GRT) and the implicit serve requirements and the GRT. In other words, at
tax on reserve requirements.
the margin these taxes added more than 12 percentage
The GRT is imposed on all receipts (income and capi- points to the cost of intermediation. In fact, bank lendtal
gains) of a bank. Formerly applied at a uniform rate, ing rates and spreads were held down by the weakness
it is now imposed on a sliding scale, with a rate of 5 of demand for loans and the banks' continued access to
percent for instruments with maturities of less than funds from depositors at lower interest rates. Nevertwo
years. Lower rates apply to longer maturities, with theless, the combined burden of the GRT and the imthose
of more than seven years free of tax. The implicit plicit tax on reserve requirements in 1984 exceeded 150
tax on reserve requirements arises because these are percent of value added in the banking system. The
remunerated at 4 percent, which is much lower than impact of the taxes has since come down with the demarket
interest rates. Reserve requirements have var- cline in interest rates.
ied but have for several years been more than 20 per- A withholding tax on deposit interest income, which
cent of bank deposit liabilities (except for long-term is levied at the rate of 20 percent, also imposes some
deposits of more than two years, which attract a much distortions. Although a credit against income tax, it is
lower rate).
not refundable if the computed income tax liability falls
The impact of these taxes increased markedly during below the amount of the tax already withheld. A fur-
1983-85. Major devaluations and an acceleration of in- ther imposition is the lending requirement for agrarian
flation led to a sharp increase in interest rates as the reform-10 percent of banks' net loanable fundsauthorities
acted to restore stability. By the end of 1984, which virtually all banks satisfy by investing in eligible
with money market rates at around 35 percent (com- government securities. Although these securities now
pared with inflation of only 5 percent over the follow- carry market interest rates, this was not the case until
ing twelve months), a bank would have had to earn recently.
and various studies have found that financial sav- have maintained low and stable inflation through
ings and the rate at which these are lent are posi- prudent monetary and fiscal policies, financial sectively
related to economic growth. tor growth has been rapid, even where interest
Figure 4.2 compares real interest rates in thirty- rates were (moderately) regulated. The financial
five developing countries (as a group and by re- sectors of Japan and Malaysia have grown rapidly
gion) with the U.S. Treasury bill rate between 1967 during the past three decades, thanks largely to
and 1985. Except for a brief period after the first oil price stability. Malaysia's financial depth, as meashock,
real interest rates were much lower in the sured by the ratio of M2 to GNP, rose from 31
developing countries-and substantially negative percent in 1970 to 75 percent in 1987. Thailand's
for much of the period. Within the sample, aver- financial sector has grown rapidly since inflation
age real rates were almost consistently negative in was brought down; using the same measure, fi-
Africa, Europe, and Latin America. In Asia, how- nancial depth grew from 34 percent in 1980 to 60
ever, average real rates were positive in most years. percent in 1987, as real interest rates became posi-
Negative real interest rates were sometimes the tive. In contrast, Argentina has long suffered from
result of deliberate policy, but sometimes they high and variable inflation; its financial depth,
were inadvertent, a consequence of governments' which exceeded 50 percent of GNP in the late
failure to modify administered rates to compensate 1920s, had declined to around 30 percent of GNP
for rising inflation. Even in the absence of govern- by 1970 and to 18 percent by 1987 (see Figure 4.3).
ment regulation, the level of real interest rates has Other high-inflation countries, such as Bolivia and
been highly sensitive to inflation because of lags in Yugoslavia, have also experienced slow or negative
the adjustment of nominal rates. In Argentina, Is- growth in financial depth.
rael, and Uruguay in the 1980s, volatile inflation In the 1970s the problem was low real interest
caused sharp fluctuations in real rates.
rates. In the 1980s, however, some countries have
Because of this link between inflation and real experienced high real interest rates. Although
interest rates, macroeconomic stability is vital for most developing countries still place restrictions
financial sector development. In countries that on interest rates, there has been a trend toward
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