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IX. Conclusions and Policy Directions

9.1 Differences in the Viability of Smallholder Broiler and Hog Farming Across Sample Commodities

Viability is evaluated from two perspectives: profitability of an activity per unit of output and total farm profits per cycle. The sections below address first the viability of broiler farms and then that of hog farms.

9.1.1 Broiler farms

For broiler farms, the major determinant of profit per unit of output was not scale of operations but access to opportunities for contract production. Profit margins of independent producers were very thin in both relative and absolute terms. Regardless of scale, independent production was less than half as profitable as contract production. Under independent production, smallholder operations were more profitable than large-scale farms, although absolute margins in both categories were thin. Under contract production, smallholder farms were slightly more profitable per unit of output than large-scale contract farms.

In terms of overall farm profits, independent smallholder net income was extremely low even in absolute terms, stemming from the small scale of their operations and compounded by slim profit margins. Compared with smallholders with contracts, independent farm profits per cycle were less than a tenth of those earned by contract growers. With such a low farm income per batch, independent smallholders cannot rely on broiler production as a main source of income.

9.1.2 Hog farms

In terms of profit per unit, differences in profit margins were more marked across types of activities engaged in rather than across scales of operations. Grow-to-finish operations, which required the purchase or the holding on credit of growing stock, had the narrowest margins. For grow-to-finish activities, margins of smallholders were even narrower than those of large-scale operations. Due to the narrow margins in this activity, compounded by production and market risks, smallholders rarely engaged in grow-to-finish on an independent basis. Profit per unit was highest in the farrow-to-weaning activity for all scales of operations. It is here where a full third of independent smallholders have flocked. Although few large producers were engaged in pure farrow-to-weaning, commercial farms did engage significantly in piglet production in combination with standard farrow-to-finish operations. For the standard farrow-to-finish activity, smallholders performed at an even keel with commercial producers.

In terms of total farm profits per cycle, however, farrow-to-weaning smallholders earned less than half of the net income of smallholders engaged in farrow-to-finish or in such operations combined with the sale of weanlings. Although profit margins per unit were least on grow-to-finish farms, operating at a larger scale enabled these farms to approximate the total profits earned by farrow-to-weaning operations. Moreover, since grow-to-finish farms were predominantly under profit-sharing contracts, the burden of investment in growing stocks and feed was shared with external investors (feed-milling integrators).

Among smallholder farms, engagement in farrow-to-finish or combined farrow-to-finish and sale of weanlings generated the largest net farm income. Compared to farrow-to-weaning smallholders, these farms also operated on a significantly larger scale. Smallholder farm profits paled in comparison to commercial-scale farms. Mean profits of commercial farms were greater by a factor of seven over medium-sized operations and by as much as a factor of 30 over the large independent commercial farms. Although profit per kilogram was relatively low among large-scale contract farms, total farm profits were nine times greater than those of smallholders, by virtue of sheer scale of operations.

In hog production viability therefore, in terms of net farm income per cycle, scale matters. To survive, smallholders need to be able to expand output potential.

9.2 Expenditures on Environmental Abatement

In both broiler and hog production, smallholders spent more on environmental abatement per unit of output than the large farms. The magnitude of the difference is not entirely explained by scale economies in the disposal of waste and animal carcasses.

For similar scale categories, in hog production, independent farms incurred significantly higher expenditures on environmental abatement per unit of output than contract growers. Between smallholder groups, this reflects differences in scale of production between independents and contract farms, as well as differences in efforts to deal with the disposal of manure and animal carcasses. Between large independent and contract producers, differences in expenditures were mainly due to different environmental abatement behavior, with independent farms being more responsive to institutional pressures.

On broiler farms, for similar scale categories, contract growers spent significantly more per unit of output on environmental mitigation than independent farms. Among smallholders, this mainly reflects the differential access to poultry manure markets, with contract growers having the advantage of higher scale, in relative terms, to create a market for manure within their own localities. It also reflects differential access to croplands: independent smallholders have less access to agricultural lands, by either ownership or lease.

Between commercial farm groups, differences in the level of expenditures depended mainly on the ability of large contract farms to sell poultry manure and on the location of the farm relative to a formal institution that had powers to enforce environmental laws in a certain region (e.g., Laguna Lake Development Authority).

9.3 Enforcement of Environmental Regulations and Farm Competitiveness

In general, a more even-handed enforcement of environmental regulations would hit smallholders the hardest where profit margins are the narrowest. In broiler production, this would be the group of independent smallholders. In hog production, this would be the grow-to-finish producers, profit-sharing contract growers, and a few independent producers. Where environmental regulations require investments in lumpy fixed structures, smallholders with an extremely small scale of operations, with low absolute farm profits per cycle, would also be adversely affected. This includes farrow-to-weaning pig producers, not withstanding the fact that they registered the highest per unit profits.

For independent smallholder broiler producers, the impact of enforcement of environmental regulations could be dampened by an expansion of operations sufficient to generate a market for poultry manure in their locality (and thus to generate by-product revenue). Expansion would also result in the spreading of fixed costs over a greater scale of output. Scale could be expanded by engaging in the less stringent profit-sharing production contracts with local feed-milling integrators. In the case of smallholder grow-to-finish and farrow-to-weaning hog producers, the adverse impact of environmental enforcement could be dampened by the creation of a market for hog manure or by opening access to small plots of cropland. For farrow-to-weaning farmers, in particular, expansion in scale (increasing sow numbers, increasing the number of batches per year) would dampen the impact of mitigation expenditures on fixed structures. Expansion through profit-sharing contracts with small local feed mills or other investors is a feasible avenue.

To create a market for hog manure, a simple and practical technology is needed by which fresh manure can be rapidly transformed into a dry, odorless, and sanitized form. This would ease handling, collection, transport, and trading of this by-product-in the model of the poultry manure market.

9.4 Impact on Smallholders of Operating in Certified Disease-Free Zones

While Bukidnon in Northern Mindanao is certified as FMD-free, it is not entirely a disease-free zone for hog production. The impact of being located in Bukidnon does not register among smallholders as a group, but it does have a significant impact among large farms, both independent producers and contract growers.

Large farms in Bukidnon spent more on environment mitigation than large farms in Luzon. Yet expenditures on environmental mitigation had efficiency-improving impacts on all subgroups (smallholders, independent producers, contract growers) except in the pooled large-farms sample. Moreover, large farms located in Bukidnon were on average more efficient than their large counterparts in Luzon. This may stem from the sidetracking of impacts of policy distortions on feed-grain imports in Luzon, as Bukidnon is a major yellow-corn-producing province.

While no significant similar advantage of being located in Bukidnon emerges among the smallholders, the advantages registered by large farms point to potential gains that smallholders might make, given sufficient scale. Output has to reach more discriminating markets outside the locality and region for price premiums to register.

For smallholders, aside from the existence of a market for manure, access to croplands is a significant determinant of environmental mitigation. For large farms, location in Bukidnon may simply be capturing access to agricultural lands on which hog manure is used as a fertilizer.

Where both animal health considerations and environmentally relevant behavior become significant positive attributes of internationally and domestically traded output, smallholder farms in Bukidnon are in a strategic position to take hold of their locational advantage. Institutional conditions, however, first need to be put in place.

9.5 Impact on Competitiveness of Costing Family Labor

The impact of explicitly costing family labor is relatively strongest for independent smallholder broiler producers. As a group, they not only had very narrow profit margins, but also they operated on a very small scale. The impact on smallholder contract growers was less, because the contract growers operated on a significantly larger scale than their independent counterparts.

The costing of family labor has less impact on smallholder hog producers than on independent smallholder broiler households. This arises from the dominance of feed costs in hog production and the relatively small share of labor costs, even when hired labor is employed. For grow-to-finish smallholder operations, the substantial additional cost of weanling stocks further suppresses the significance of family labor in production cost. Among smallholder producers, however, the costing of family labor most affects the farrow-to-finish farmers, who generally have the lowest absolute farm profits per cycle.

9.6 Importance of Direct Subsidies to Different Size Categories of Producers

Direct subsidies are not apparent in any of the size categories. Indirect subsidies, however, are identifiable in the form of special access for large integrators to duty-free imports of breeding stock and capital equipment (as investment incentives for locating industrial activities outside of Metro-Manila for the development of the regional industrial centers). Other forms of indirect subsidy are access to lower tariffs on minimum access volumes (MAV) of imports of corn and low tariffs on food wheat (which is then used as feed wheat) by large integrators.

Implicit subsidies are also enjoyed by cooperatives in general, and in particular, by feed-milling and multipurpose cooperatives engaged in contract growing in broilers and hogs. Subsidy takes the form of an exemption from payment of the normal corporate tax levied on formal business enterprises, pegged at the rate of 32 percent of net income or pre-tax corporate profit (Republic Act 6938, The Cooperative Code of the Philippines, 1989). The impact of such implicit subsidies on the profitability of fee contractors of large integrators in broiler and hog contract growing is not readily extractable or quantifiable. In the absence of direct proof, this study resorted to anecdotal evidence.

In broiler production, regardless of scale, contract growers had significantly higher profit per unit than independent producers. More revealing, assuming that identical technology is used, net profit per kilogram of output was significantly higher on fee contract farms than on large independent farms. Such was the case even considering that net returns per unit by contract growers constituted effectively just their share of total activity profits.

For the same technical performance, the consistently higher profit per unit earned by the commercial-scale fee contract growers must come largely from the lower, though unrevealed cost of day-old-chicks and feed provided by the large integrators. These lower costs are part of the benefits that integrators pass on to their contract growers to keep them from shifting loyalties to other large integrators or to smaller, local feed-milling integrators.

In hog contract growing by the large integrators, the significance of differential subsidies on feeds and breeding stock is not readily visible in differences in profits because the activity where contract growing is specialized in (grow-to-finish) is exactly that which independent producers do not engage in. Profit per unit for different activities is not directly comparable. Suffice to say, however, that profits per unit under large fee contracts are slightly higher than profits per unit under smallholder price contracts and under independent production in grow-to-finish operations. Both scales of contract growing receive implicit subsidies. For large integrators, the duty-free importation of breeding stock and reduced tariffs for imported feed grains apply. For local feed-milling and multipurpose cooperatives engaged in price contracts, implicit subsidy comes in the form of zero corporate income tax.

The implicit subsidy for large integrators is more significant than that for feed-milling cooperatives. That is because the reduction in the cost of feed and breeding stock applies at any point in time, regardless of the profit position of the activity. For small feed-milling cooperatives engaged in contract growing, the enjoyment of zero corporate tax does not apply when the cooperative business as a whole earns zero or negative net income.

The impact of implicit subsidies to local feed-milling and multipurpose cooperatives on the profitability of smallholder price contract farms relative to independent smallholders cannot be established directly. What is simply observable is that in broiler production, smallholder contract farms' per unit profit was significantly higher than that of the smallholder independents. In hog production, likewise, for comparable activities, per unit profit of smallholder price contract farms was higher on average than that of the few independent smallholders engaged in grow-to-finish operations. The contract growing programs of the feed-milling and multipurpose cooperatives are known to be only a small part of their income generating activities. Net income generated from contract growing is small relative to aggregate net value of income, and the equivalent implicit subsidy of exemption from the corporate income tax is far larger than the total net income contribution of the contract growing activity. In effect, whether the program has net losses in any given year has no substantial or significant impact on the total cooperative net income. Thus, despite relatively thin profit margins in the contract growing program, the cooperative nevertheless gains social stature in simply undertaking a community-oriented income-generating program in the locality where it is situated.

9.7 Smallholders and Transaction Costs

Smallholders face higher transaction costs than large producers. In broiler production, this is reflected in the significantly lower average cost of day-old-chicks for independent large farms compared to independent and price contract smallholders. Large farms have direct access to wholesale prices from the large integrators. Differential access to wholesale-priced feeds, however, does not explicitly register in significantly lower feed prices for large-scale farms. Feed quality differences interfere.

Large fee contract farms, on the other hand, automatically gain access not only to day-old chicks of relatively high genetic quality, but also to high quality feeds and to veterinary services from their large integrators in the jointly beneficial pursuit of achieving better FCR and harvest recovery results.

Access to feeds credit and to telecommunications and information infrastructure are two factors determining inefficiency of smallholder broiler producers. Smallholder independents have less access to feeds credit than large-scale independents. Smallholders also in general have less access to telecommunications infrastructure than large-scale producers with or without contracts.

For smallholders, thus, the engagement in a contract matters, significantly and substantially, in changing the configuration of transaction costs that they face. This holds true whether the contract is a fee or profit-sharing arrangement.

On the output side, differences in transaction costs are not reflected as differences in output prices in favor of large-scale producers. Independent smallholders and independent large producers have different output markets, with smallholders catering mostly to the local retail markets closer to the end consumer. Large producers focus on wholesale markets for live broilers in the major urban centers. Although output prices are nominally higher in local retail markets, transaction costs are higher there. Seeking alternative local meat dealers is more time-consuming than engaging with buyers in major wholesale markets. For contract growers, the integrator assumes the transaction costs on the output side.

Significantly, only among smallholder broiler producers do expenditures on environmental mitigation have adverse impact on farm efficiency. Access to markets for manure and to croplands (to use manure directly), however, is least among smallholders.

For hog farms, higher transaction costs on the output side are reflected in the fact that independent large-scale farms receive higher weanling output prices than smallholders. Similarly, price contract growers received higher prices for slaughter hogs than independent grow-to-finish producers. Large commercial farms have the reputation for producing weanling stocks of certifiable genetic lines. Smallholder weanling raisers generally produce generic hybrids, which are sold to neighboring farms or to meat dealers who also engage in small-scale pig fattening contract growing with backyard raisers.

The three transaction cost variables that have a strong impact on the efficiency of smallholder hog producers are access to capital credit, access to telecommunications and information infrastructure, and access to the most advantageous regular buyer. Smallholders have less access to both capital credit (loans) and telecommunications infrastructure relative to large producers. On the other hand, reliance on viajeros (wholesale traders) as regular buyers proved strongly disadvantageous not only to smallholders but to all subgroups except contract growers.

In general, engagement in fee contracts reduced inefficiency. Fee contracts significantly reduced uncertainties in output and input prices as well as in the quality of the inputs. Ironically, however, none of the smallholders had access to fee contracts. All fee contracts involved more than 100 heads of growing stock.

9.8 Relative Competitiveness of Smallholders Under Current Structure

9.8.1 Broiler production

Although mean profit per unit of output was highest among the smallest of all smallholders (first quintile), profit per unit abruptly fell once smallholders crossed into the scale at which significant market involvement occurs. Here, the largest farms (last quintile) exhibited consistently greater profitability per unit of output.

While the smallest scale producers exhibited the highest profit per unit of output, the same group was also the most inefficient. Efficiency rises with scale, but falls upon reaching the last quintile.

The smallest quintile covers largely the independent smallholders. As a group, the independent smallholders generated relatively and absolutely small average total farm profits, not viable as main source of household income.

As a group, independent smallholders are in a precarious position, considering their small absolute net incomes and the higher transaction costs they face in the broiler market.

9.8.2 Hog production

Per unit profit of the smallest of smallholders (first quintile) was significantly higher than for all the rest. This, however, pertains primarily to the small-scale producers of weanlings or piglets for sale to neighboring farms or to small-time meat dealers-'integrators'.

When smallholders expand and enter the market for slaughter hogs, profit per kilogram falls as scale increases. Starting in the second quintile, large farms have only marginally lower profit per unit of output than smallholders.

Smallholders are as efficient on average as the medium-scale commercial farms (100-1,000 heads of inventory), but less efficient than the large-scale farms, whether manage independently or under fee contracts.

Under the above conditions, scale is a determining factor in the relative competitiveness of smallholders vis-à-vis the large producers. While smallholders in the first quintile have relatively high profits per unit of output, total farm income is relatively low due to smallness in scale. On the other hand, while smallholder price contract growers have relatively larger scale, profit margins in grow-to-finish operations are very narrow and smallest per unit of output of all activities and among all scales of operations. Total net farm income for smallholder price contract growers is likewise relatively low. In both cases, scale expansion is the path to viability as a main source of household income. For smallholders, expansion in scale, particularly in grow-to-finish operations, hinges on the ability to engage in contract production. Since fee contracts are not available under current market structures, the second best option is to obtain smaller scale price contracts with local feed millers. For farrow-to-weaning smallholders, there are price contracts that apply to such specialized operations.

9.9 Scope for Policy to Reduce Subsidies Favoring Large-Scale Operations

The removal of a dual tariff system on feed grains-a lower tariff for MAV imports and a higher rate for imports outside MAV-will eliminate differential access to MAV imports due to scale advantages. A lower uniform tariff for corn imports, though in the short run injurious to domestic yellow corn producers, will remove major distortions on the input side for feed grains.

A uniform tariff on food and feed wheat should eliminate differential access to lower duty feed wheat by large integrators. To temper the political economic considerations to domestic corn farmers, raising food wheat tariffs from 3 percent to 10 percent could be explored. The longer term goal, however, is to target at least 5 percent average tariffs for both feed and food wheat, with anticipated adverse, yet relatively small effects on end users and consumers of food wheat.

The Board of Investment (BOI) special tax and duty-free incentives for industries to locate outside Metro-Manila to develop regional industrial centers should be abolished. The incentives scheme appears to have succeeded to the extent that the integrators have indeed located feed-milling operations outside, but just at the doorstep, of Metro-Manila, concentrating activities in the provinces just north and south of Metro-Manila and not in the regions farther out.

Large integrators' decisions on where to locate operations are influenced by proximity to demand centers and input supply chains (e.g., major ports) and not crucially by the magnitude of special investment incentives. Furthermore, large integrators and firms first consider the degree of development and reliability of utilities and telecommunications infrastructure in their decision to locate in regions outside Metro-Manila, and they put less value on special incentives offered. If firms decided that it would be strategic to locate in the chosen regions, the special incentives would be an additional bonus which they may not at all need. In the meantime, tax and duty exemption privileges to these large firms are revenue foregone by government. This forgone revenue is extremely significant, since, paradoxically, the currently chronic and expanding public-sector budget deficit prevents public investments in infrastructure that would serve to improve the investment climate in the regions being developed as regional industrial centers.

The granting of special incentives is a discretionary action. As special privileges granted, their abolition should not be too difficult once the onerous character of these provisions is exposed, publicized, and made transparent and clear alternative uses of government funds are presented, particularly for development of telecommunications and information infrastructure in the regions.

9.10 Scope of Reducing Smallholder Transaction Costs through Institutional Innovation

Among smallholders in broiler production, access to feeds credit and to telecommunications and information infrastructure is crucial to reduce inefficiency. Furthermore, access to fee contracts significantly improves profit per unit. On their own, smallholders have the least access to the above services. As a group, smallholders were least efficient on the spectrum of scale by size quintiles.

Among smallholder hog producers, the policy-relevant transaction cost issues are access to capital credit and telecommunications and information infrastructure and access to direct market outlets (not coursed through viajeros). For the entire sample, access to fee contracts significantly improves efficiency.

In broiler production, engagement in production contracts, regardless of type of contract, is systematically associated with expansion in scale and output, though remaining in the smallholder category. Access to contracts is also associated with modest improvement in profit per unit. Engagement in fee contracts is additionally associated with further expansion in scale and systematic increase in profit per unit output. Even among smallholder broiler contract growers, the fee contracts were more prevalent than price contracts. Furthermore, those engaged in fee contracts had the highest mean efficiency among all subgroups. Independent producers, including the few price contract growers, were the least efficient.

In smallholder hog production, engagement in contracts is also associated with expansion in scale. However, unlike in broiler production, this is systematically associated with a fall in per unit profit. This effect, however, is not due to the engagement in contract growing per se, but due to the engagement in a particular activity in which contract growing is specialized-that is, grow-to-finish operations. Whether under contracts or in independent production, grow-to-finish operations have the smallest profit margins among all activities. But the production cycle for grow-to-finish operations is the fastest.

Clearly, in both smallholder broiler and hog production, institutional innovation through participation in contract arrangements shortcircuits adverse effects of intervening transaction costs that are not scale independent. Engagement in contracts permits expansion in scale, and allows systematic access to inputs and services which are otherwise not accessible to smallholders as independent producers. Smallholders, however, have relatively easier access to price contracts with small local feed-milling integrators or multipurpose cooperatives than to fee contracts with large integrators. Smallholder broiler raisers had greater access to fee contracts than hog smallholders. Smallholder price contracts in hog production were present only in one region-South Luzon. They were absent in Central Luzon and in Bukidnon, Northern Mindanao. In all regions, smallholder hog producers showed an absolute lack of access to fee contracts with large integrators.

There appears to be scope for expanded coverage of fee contracts among smallholders in broiler production. Not all smallholders, however, can just engage in fee contracts with the large integrators. A precondition for entering into such a contract is the posting of a bond, usually in cash, determined on a per bird basis. This is a value slightly lower than the cost per bird of a day-old-chick. Fee contracts require a minimum flock size, sufficient to fill one housing unit or module (about 6,000 birds). Thus, although fee contracts have the potential for guaranteeing expanded scale and base compensation per bird or per kilogram of harvest, engagement in fee contracts has a steep price: putting sufficient capital up front.

Yet access to capital, or credit for capital, is one of the major barriers to entry for engagement in expanded independent smallholder activity. Likewise, lack of access to capital, or credit for capital, was revealed as a major barrier to entry of smallholders in engagement in fee contracts.

For hog producers, the need to post a cash bond for each head of stock obtained, to be raised under minimum scale conditions (not less than 100 heads) effectively shuts out smallholders from engaging in fee contracts with large integrators.

Thus, for both broiler and hog production, greater scope for institutional innovation may lie in expanding the scope of smallholder profit-sharing contracts. Under these arrangements, no prior posting of bonds is demanded by local feed millers or multipurpose cooperatives.

9.11 Full Social Costs and Benefits of Institutional Innovations

9.11.1 Removal of tariff distinctions on corn and wheat imports

The convergence of the tariff on MAV imports and on regular imports is a medium-term goal of tariff policy. The schedule could, however, be accelerated to commence immediately after current WTO commitments expire at the end of 2004. A starting uniform tariff rate of 35 percent on corn imports by 2005 should provide ample protection for domestic corn farmers.

Uniform tariff treatment of feed wheat and food wheat should eliminate incentives to misdeclare wheat imports. At the current feed wheat tariff rate of 10 percent, there is no significant complete shift from corn to wheat among major feed millers and large commercial farms. Reduction of tariffs on feed wheat (3%) may trigger greater substitution of wheat for corn and may have unwanted political consequences.

An absolute decline in tariffs on corn from a highly protected 60 percent to the current MAV rate of 35 percent would benefit broiler and hog producers in general by significantly reducing feed costs per kilogram of output. The frontier results showed that for independent broiler and hog producers, feed prices significantly affects profit.

Removing uneven tariff treatment of feed and food wheat would eliminate advantages derived by large integrators that create uncertainties in the feed-grain market arising from speculative behavior on whether or not to import food wheat as feed ingredients on a substantial scale. Speculation in substitution of food wheat for corn as a major feed ingredient will disappear as all market transactions become transparent.

Reducing tariffs on corn to a uniform rate of 35 percent from 60 percent certainly entails costs to corn farmers. There are ways to 'compensate' corn producers through public spending on road and telecommunications infrastructure in affected corn areas. Such investments could significantly reduce corn farmers' transaction costs and cost per unit of output.

9.11.2 Removal of special incentives to industries located outside Metro-Manila

The first social benefits of removing duty-free privileges on imported breeding stock and capital equipment for firms that locate outside Metro-Manila will be the recouping of erstwhile forgone tariff and tax revenues due to exemptions. These benefits are significant in the current context in which budget deficits prevent public investments on productivity-enhancing public infrastructure.

The conversion of foregone tariff revenue to investments that improve the business climate in regions outside of Metro-Manila (e.g., by building up reliable public telecommunications and information infrastructure) would reach a constituency wider than exclusively the large firms who now benefit.

9.11.3 Abolition of corporate tax exemption to cooperatives

The abolition of cooperatives' exemption from the 32 percent corporate income tax may be a more difficult proposition to remove distortions in the contract growing program of small feed-milling cooperatives. This would require the repeal of standing legislation on the special status of cooperatives. While the legislation on exemption of cooperatives from the corporate income tax remains unrepealed, feed-milling cooperatives have an undue advantage over small, local feed-milling corporations that engage in contract growing or have the potential to engage in contract growing with smallholders in their respective localities. Under the existing legal framework, correcting the distortion may temporarily involve granting equal treatment to provincial feed-milling companies that have the option of engaging in smallholder contract growing. Equal treatment may be limited to transactions directly related to contract growing, such as equal exemption from corporate tax on income derived from inputs to smallholder contract growing (e.g., feed sales to contract growers, profit shares from contract growing).

The benefits of the equalization of treatment of cooperatives and corporate feed mills are the efficiency gains that smallholders would capture through reduced transaction costs associated with being independent small producers.

The additional social costs of such equalization of treatment should not be large. Regular feed-milling profits from non-contract growing output will still be taxed at the regular corporate rate. Only the additional profits from additional feed-milling output for contract growing purposes would be exempt from tax. Tax revenue losses from the shifting of regular markets of output to contract growing smallholders are expected to be small, since not all customers of output can or desire to be contract growers. Engagement in profit-sharing contracts results in the splitting of profits from an activity, rather than to full appropriation of profits by the risk-taker.

9.11.4 Vertical integration of smallholder production

Vertical integration of small-scale producers by commercial firms engaged in the supply of certifiable quality output simultaneously addresses the two transaction costs most significant to smallholder efficiency: access to feeds credit and access to a strategic regular outlet for output. Moreover, where the integrators directly serve a discriminating final output market (institutional markets, urbanized consumers, meat processors, export market), they address the issue of certifiable quality of intermediate inputs directly, by providing these inputs themselves according to the specifications required. The guarantee of quality of inputs and access to informal veterinary services should lead to better FCR and lower animal mortality rates and directly increase profitability of smallholder activities. Vertical integration also embodies all other inefficiency-reducing effects of being a fee contract grower.

As long as the costs of vertical integration of small-scale production are fully internalized within a competitive market setting, the external costs will be small.

9.11.5 Development of capital markets for smallholders

Access to capital credit emerged as one of the crucial factors that improves efficiency among hog producers, particularly smallholders. Yet access to capital credit is least among smallholders. Because smallholders are asset-poor, they have very little access to formal market sources of credit (such as banks).

The social benefit of developing capital markets for smallholders lies in the resolution of the inefficiency-inducing impact of their lack of access to credit.

The social costs comprise the initial incentives to equalize treatment between regular investment houses and cooperative investment houses. The Soro-Soro Ibaba Development Cooperative offers a prototype of an alternative investment house. Initially such cooperatives could be granted the privilege of zero corporate tax, or zero tax on interest income for investors in the investment house. Entry into the investment house would be through membership. Borrowing privileges would also be predicated on membership.

However, continued access to credit capital from such innovative investment houses is sustainable only if their management is professionally sustained, as the SIDC case has exhibited itself to be. SIDC's privilege of implicit subsidy, however, needs to be further investigated as to whether such implicit subsidy is a major determinant to its viability as an investment house-cooperative.

9.12 Policies Supportive of the Above Innovations

9.12.1 Removal of tariff distinctions

Removal of the distinction between tariffs under minimum access volume (MAV) imports of corn and tariffs outside the MAV and the imposition of a uniform rate starting at 35 percent commencing in 2005 is in line with the current policy of trade liberalization in agricultural commodities. The tariff schedule should gradually decline to a minimum of 5 percent over the period covered by the second round of negotiations under WTO. The overall objective of the trade liberalization policy in feed grains should be to improve the competitive position of the domestic livestock industry. Any restrictions on corn imports should fall under the current safeguard laws on sudden import surges.

A policy of uniform tariffs on feed wheat and food wheat starting at a rate of not more than the current tariff on feed wheat (10%), commencing in 2005, would be consistent with the overall policy of trade liberalization. The uniform tariff schedules should also decline over the relevant period covered by the second round of WTO negotiations. While this may mean a temporary rise in the tariff rate on food wheat, this can be justified on tariff revenue grounds and based on the absence of major wheat-based industries that compete in the export market or are subject to import competition.

9.12.2 Removal of relocation incentives

While the goal of regional industrialization and regional dispersion of industries to decongest Metro-Manila is basically sound, the instruments used to induce industries and firms to locate outside Metro-Manila should be neutral in character. The benefits of the incentives should generally be available at once to firms that relocate and not be dependent on the discretion of government instrumentalities by which some firms qualify for the incentive and other firms do not. Furthermore, the incentives provided should not take the form of tax and duty exemptions for particular firms. Creation of incentives for industries to relocate in planned regional industrial centers should rather focus on the improvement of the general business climate, such as public expenditures on telecommunications systems and reliable supply of utilities and improved transport infrastructure to reduce the costs associated with operations located at some distance from their source of raw materials and main market for output.

This shift in policy instruments requires the modification of the implementing rules and regulations (IRR) of the prevailing laws covered by the relevant investment incentives acts.

A policy of uniform treatment of all firms further requires the recall of tax and duty exemptions for favored firms on imports of breeding stock and capital equipment. Since breeding stock and capital equipment are crucial private investments for developing a competitive domestic livestock industry, policy should aim at the lowest possible duty on these items (e.g., 3%). These duty rates should be justifiable on tariff revenue grounds.

9.12.3 Expansion of contract growing arrangements

Contract growing arrangements exist, but there seems to be scope for their expansion. The question is how can certain forms of contracts (e.g., fee contracts) be expanded without excluding smallholders?

Food markets are evolving towards higher quality and food safety demands. This development requires that livestock and meat firms supplying final products-whether in raw or processed form-are able to guarantee that their products are safe, including the inputs used in their production. They must also ensure that the product quality attributes claimed are verifiable. To achieve this, vertical integration may be in order. Without such integration, primary producers will likely have difficulty gaining access to markets for high-quality products without a link to an institution or institutional arrangement that can guarantee the quality of their output. On the other hand, end suppliers are unlikely to be in the competitive position to engage with direct production of primary products (e.g., broiler or slaughter hogs).

Convergence of interests and complementarities in resources and expertise would provide the grounds for engaging in contracts that result in vertical coordination of input supply, production, processing, and distribution functions in the supply chain.

Smallholders have limited access to fee contracts since such contracts explicitly require the posting of a bond up front at an amount close to the value of the growing stock. Rather, smallholders have greater access to price-based or profit-sharing contracts for which the posting of bonds is not a precondition. The integrators engaged in profit-sharing arrangements are mostly small- and medium-sized local feed mills and multipurpose feed-milling cooperatives. The relatively more visible role of the cooperatives in engaging in profit-sharing contracts points to some advantages that these cooperatives possess over the corporate feed mills in engaging in smallholder contract growing. Cooperatives have the distinct culture of social and community development which makes it seem natural for them to engage in smallholder contract growing. Yet they also benefit from an implicit subsidy in the form of the exemption from corporate income tax. That makes it unlikely that smallholder contract growing schemes would be viable if managed by similar-sized feed-milling corporations, since they would enjoy no such tax privileges.

The policy of special treatment of cooperatives appears to be based on the belief that cooperatives create social value by creating wealth among the less privileged. The corollary to this assumption is that the same benefits cannot be provided as efficiently by government social security and poverty alleviation programs.

If so, then the corporate tax exemption for cooperatives may be justified in recognition of their role in providing social benefits to their underprivileged members, a function and expenditure for which government may then be excused. The cooperative would in such a case play the social function of government-at least to its constituents. Within this same line of reasoning, if private business entities engage in contract arrangements with small-scale livestock producers and create social wealth in a manner that government social programs and budget cannot efficiently do, there is no compelling reason why these ordinary private business entities should not be entitled to the same special tax treatment as cooperatives, on these specific contract transactions that these private firms engage in with smallholders.

A policy granting feed-milling firms involved with smallholder contracts a zero tax on income and a profit sharing similar to smallholder contract growing schemes would equalize the tax treatment between cooperatives, in general, and the "socialized business components" of regular private enterprises. Similar privileges could be granted to meat processors that engage in comparable contracts with smallholders.

9.12.4 Facilitation of capital market development

Capital market development has been shown to be one entry point for policy to address the higher transaction costs faced by smallholders. The prototype of the Soro-Soro Ibaba Development Cooperative (SIDC) 'investment house' appears to work in addressing needs for initial capital by members to start a contract-growing business with the cooperative. This model contrasts with past failures of government-initiated special credit programs and facilities for farmers, for their engagement in small-scale income-generating projects.

While the zero corporate tax policy on investment houses may not be tenable, a temporary and time-bound exemption from the regular 20 percent tax on interest income from lending to small-scale livestock contract growers may help spur the generation of funds for small-scale contract growing operations.

9.12.5 Expansion of infrastructure to improve the climate for business

Policy support for further and more rapid development of private telecommunications and information technology should take the form of promoting competition among telecommunications firms in servicing peri-urban as well as rural areas where there is substantial smallholder livestock production.

Policy support to expand telecommunications coverage requires the encouragement and facilitation of applications for setting up communications centers, exchange, and towers in strategic locations in major livestock producing regions and provinces. Such policy should result in the lower cost of provision of private telecommunications services.

9.13 Outlook for Smallholders Under Different Structural and Policy Scenarios

9.13.1 Trade liberalization

Further trade liberalization on corn and feed grains would take the form of, first, reductions in corn tariffs to uniform levels starting at the current MAV rate of 35 percent with further phasing down scheduled and, second, the setting of uniform tariff rates for feed and food wheat starting at 10 percent and phased down over time. Bringing down the absolute protection on corn as well as on other feed grains should lower the cost of feeds. Livestock production profit per unit output should rise, particularly for independent smallholder broiler producers, for whom profit margins are already relatively small and absolutely narrow. Removal of the tariff differential between MAV imports of corn and regular imports should even out the playing field between large integrators and their contract growers in terms of feed cost.

9.13.2 Lifting tax and duty privileges for large integrators

Removal of tax and duty-free privileges for large integrators on imports of breeding stock and capital equipment (as incentives for locating outside Metro-Manila) and enactment of a uniform low tariff treatment on imports of breeding stock and day-old-chicks would remove large integrators' advantages in the market over all others. Options for the direct importation of breeding stock and day-old chicks by other parties should stabilize the general market for breeding stock, and the market for day-old chicks would depend on domestic and international competition forces, rather than on supply control by large integrators. Uniform low duties on imported capital equipment for breeding and livestock production should to some extent lower smallholders' costs in upgrading their facilities.

9.13.3 Enactment of cooperative-type tax privileges for investors in livestock production

Granting comparable corporate income tax privileges to local feed-milling firms and to other potential investors or integrators, for profits earned in engagement with smallholders in contract production, would expand smallholders' access to production contracts. Such investors might include enterprises with technical and business expertise in livestock production, meat processing, and distribution.

Since smallholders now have limited access to fee contracts with large integrators due to up-front bond-posting requirements, the scope of current profit-sharing contracts could be extended beyond the realm of cooperatives. Until such a time that the legal corporate tax exemption privileges of cooperatives is reconsidered, granting equalizing privileges to other potential investors in livestock contract growing would remove the distortion of conferring privileges only to cooperatives for the same entrepreneurial functions with positive social consequences-participation of smallholders in profitable livestock production.

Incentives for vertical coordination should focus on integration up to processing for certifiably safe food products. Thus, it would not be limited to feed-milling, livestock contract growing, and marketing of live output. The significant transaction costs facing smallholders include the cost of linking with strategic market outlets other than viajeros. With a direct linkage to final markets for processed output, market information on consumer preferences will be transmitted to smallholder producers and should provide them with a greater chance of participating in the markets for quality products rather than being automatically excluded from them.

9.13.4 Developing investment houses to provide credit to smallholders

The SIDC provides a prototype of a multipurpose cooperative that functions as an investment house financing smallholders entering contract growing. There seems to be no reason why similar investment houses cannot emerge and develop as alternative financial institutions to regular banks. These may take the form of private cooperatives, but they need not be so. Equalization of tax treatment for cooperatives may mean an initial incentive of a waiver of the 20 percent tax on interest income, or a reduction of the rate, to invite small investors to mobilize savings.

Access to alternative formal sources of credit for capital will provide smallholders with opportunities to expand their operations and engage in contracts, even those types that demand bond posting up front.

9.13.5 Ensuring widespread and rapid development of infrastructures

Greater access to telecommunications and information systems infrastructure by smallholders could have significant efficiency impacts. Access to communications and information infrastructure would enable smallholders to gear their production processes better to consumer demands on product quantities and quality.

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