Plugging the Leaks in the Financial Ship of State

"Senior citizens' monthly subsidy to be increased." "NT$30 billion to be appropriated for teacher retirement after teacher kneels before President Chen to seek help." "KMT promises no interest on student loans, plus fully subsidized tuition for Aborigines, the handicapped, and low and middle income households." With the approach of next year's presidential election, newspaper headlines reveal how both governing and opposition parties are promising special programs to win over voters. Citizens might come away happy, but officials and scholars are left with the nightmarish task of figuring out where the money will come from to pay for these schemes.

Last year at about this time, tens of thousands of teachers took to the streets to demand classroom autonomy. They also declared a willingness to begin paying taxes on their incomes in exchange for greater dignity. It seems that the time is ripe for the long-discussed levying of imposts on the heretofore tax-exempt incomes of teachers, civil servants, and military personnel. (photo by Chuang Kung-ju)

The money pit

"If I were running for election, I would tell voters 'If I play up to you today, it will be at the expense of your children and grandchildren, and at the cost of making your daughter-in-law afraid to give birth to your grandson!" says Democratic Progressive Party legislator Shen Fu-hsiung, known for pulling no punches. As a veteran member of the Legislative Yuan's finance committee, he knows full well that the government is in a precarious situation, and says so.

So what is Taiwan's financial condition?

The national budget report shows that in 2002 the government took in revenues of NT$1.34 trillion, while paying out NT$1.6 trillion, leaving it short NT$260 billion. The situation is even more dire today. Even if you exclude special off-budget items (which are not limited by the law restricting public debt), the government is running a 15% budget deficit (that is, NT$15 out of every NT$100 spent must be borrowed). That's twice the level of Japan, which is widely seen as being in disastrous financial straits.

Not only is the central government in fiscal difficulty, there are many counties, cities, and townships that can't even pay the salaries of their employees, and are even closer to the brink of financial disintegration. Steve Tsui, a professor in the Department of Public Finance at National Chengchi University and a member of the Executive Yuan's finance reform commission, offers up the following statistic: In 2001, outlays by the three levels of government (central, county and city, and township) amounted to 24.7% of GNP, but their total revenues were only 18%.

In other words, in a single year the amount of government spending not covered by income was 6.7% of GNP, equivalent to more than NT$600 billion. "Just do some basic math, and you will have no trouble discovering just how enormous the government deficit is!" says Tsui.

With the deficit increasing year by year, naturally the accumulated debt is astonishing. At book value, the central government currently owes more than NT$3 trillion, or 31.8% of GNP. Back in 1986, this figure was a mere 2.2%!

During an economic downturn, social welfare expenditures go up while tax revenues decline. While several approaches can be tried to rescue the government's finances, there is no substitute for economic recovery.

The disappearing tax base

So what is the underlying cause of the rapid deterioration in the government's financial position?

Looking back over the financial history of Taiwan, when the Nationalist government first moved to Taiwan, it experienced hyperinflation and financial collapse, during which paper currency became worthless. Perhaps as a result of this harsh lesson, from the 1950s to the 1990s, the government maintained a very conservative posture, and its finances were continually in a healthy state.

Taiwan did not experience its first large-scale deficit until 1991. That was a period of rapid appreciation of the NT dollar, of a massive influx of "hot money" speculating against the currency, and of wild booms in the real estate and stock markets. In the midst of all that, the cabinet of then-premier Hau Pei-tsun launched the Six-Year National Development Plan, projected to cost NT$8 trillion, not counting the NT$700 billion already spent acquiring land for large infrastructure projects. These factors caused financial problems to surface for the first time.

After the development plan was suspended, there was a period of rest and recuperation for government finances until finally, in 1997 and 1998, there was a return to budget surpluses. But all good things must come to an end. First came the Asian financial crisis (1997), then the September 21 earthquake (1999), then the bursting of the global dot.com bubble, and then the September 11 terrorist attacks in the US, and Taiwan's financial situation steadily deteriorated.

This time, however, the culprit has not been bloated government spending, but inadequate revenues.

Crunching the numbers, "total spending by the various levels of government peaked at about 30% of GNP in 1991, and has since steadily declined to the current level of less than 25%, so you can see that the government has been doing pretty well at keeping expenditures down," notes Sun Keh-nan, a researcher at the Chung Hua Institution for Economic Research and also a member of the government's financial reform advisory commission. But over the same period, the tax burden on citizens (the proportion of total taxes to GNP) has declined significantly, from 19% in 1990 to 12.25% today. This is far below the OECD average of 27%, and is in fact the lowest level in the world.

Are tax revenues so low because of economic hard times, which cause people to come up short at tax time? Not really.

"In the last few years, the government has come out with a number of preferential tax policies, with bizarre results," says Steve Tsui. "Even in years when the rate of economic growth has been decent, tax revenues have continued to fall." Under these circumstances, economic growth alone cannot rescue government finances. The tricky part is going to be dealing with the internal structural factors built into the tax system.

Onlookers admire high-powered foreign motorcycles, with their gleaming exteriors and multi-million NT dollar pricetags. Items like these cause many to think that perhaps there should be a special tax on "luxury items."

Crying poor in a gold mine

Take for example the regulations promulgated in 1992 to encourage industrial upgrading. These measures offered numerous tax incentives to encourage investment in high-tech industries. However, it later proved impossible to resist demands from traditional industries to allow them to also take advantage of the law's provisions. In 2001 alone, businesses were exempted from NT$65 billion in taxes under these rules, even to the point that enormous stock and profit-sharing bonuses at high-tech companies were tax-exempt. This at the same time that the ordinary workingman could find no escape from paying levies on his hard-earned wages!

Moreover, to assist financial institutions clear up their backlog of bad loans and lower their nonperforming loan ratio, beginning in 2000 the business tax rate for financial enterprises was lowered from 5% to 2%. In order to revive the real estate market, meanwhile, the government reduced the land value incremental tax (a tax on the amount by which the value of a piece of land increases from one sale to the next) by half. There have in fact been 73 laws and regulations to lower, or offer exemptions from, taxes, of which the Ministry of Finance-normally responsible for overseeing the nation's purse-has reviewed only 23%. With no integrated authority over taxation, no wonder the government's revenue base has been eroding and the system is riddled with loopholes.

Tseng Chu-wei, a professor of public finance at National Chengchi University and also a member of the government's finance reform commission, has done a study of this problem, and he demonstrates that in 1991 alone, various loopholes and preferences reduced tax revenues by NT$3.48 trillion. "Money to be had, but no one collecting it" and "Crying poor while sitting on a gold mine" are the kinds of phrases scholars of public finance are using to describe the current situation.

To address problems in the tax system, government finance officials and scholars unanimously agree on the need to broaden the tax base and eliminate unnecessary exemptions. But this is easier said than done. A case in point is the question of military personnel, teachers, and civil servants, whose incomes have always been tax-free. There is broad agreement in society that these citizens should also pay taxes, and last year there was even a demonstration involving 100,000 teachers in which the marchers clearly stated that they were willing to pay taxes in order to regain their dignity and be treated as equal members of society. Yet here we are a year later, and the bill is still hung up in the Legislative Yuan with no sign of budging. About the only thing being taxed is the public's patience!

With politicians obviously giving preference to electoral considerations over informed opinion, experts are worried. Tseng Chu-wei points out that finance is the mother of all policy, but "now that mother's milk has been drunk dry, are we going to be able to mature?"

Tseng strongly advocates the "520 plan"-returning the tax burden to 20% within five years and demanding that all government departments put a freeze on any new tax reduction proposals. If any such proposals come up in the Legislative Yuan, he advises, the bar for passage out of committee should be raised from one-half of the committee members to two-thirds, in order to reduce the possibility of legislators shepherding bills through on behalf of special interests.

Source: Directorate General of Budget, Accounting, and Statistics: "Quarterly Statistics, National Economic Trends"

Carrot and stick

From the point of view of tax theory, says Sun Keh-nan, a fundamental function of any state is "concentrating the power of taxation." Also, finance theory emphasizes "deciding revenue based on expenditures"-the state should decide what public services and economic infrastructure it wants to provide, and then tax the population for this amount. But most citizens want the government to provide "free lunch," and any politician who proposes raising taxes is committing political suicide. For example, Margaret Thatcher, the Iron Lady of British politics, was brought down by her advocacy of the poll tax; George Bush lost his bid for reelection after breaking his "no new taxes" pledge; and the cabinet of former Japanese prime minister Ryutaro Hashimoto was undone after he proposed raising the business tax rate.

It is precisely because Sun Keh-nan knows that raising taxes is poison to voters that he expects the experts to be especially careful in drafting tax increase proposals. For example, broadening the tax base could be tied to a lower tax rate, or tax increases in some areas could be offset by tax reductions in others. You always have to use the carrot along with the stick so that citizens feel they have not been treated unfairly.

A case in point is the recently much-discussed question of whether the land value incremental tax (LVIT), which was cut in half provisionally a couple of years ago, will be restored to its former level.

Tsai Chi-yuan of the Institute for Social Science and Philosophy at the Academia Sinica relates that Taiwan's LVIT is from 40-60%, and that the longer a property is held, the higher the tax rate on it when it is sold. This encourages investors to unload properties as soon as possible after acquisition, which aggravates the tendency toward short-term speculation in the real estate market. Two years ago the government announced that it would halve the LVIT for two years in order to jump-start the sluggish property market. Today there are signs that the market is coming back, but the preferential tax policy is scheduled to expire next January. What to do?

If the original tax rate is restored, the market could be immediately suffocated. But if the preference is extended, people will suffer from the false impression that "whatever the government gives, it can never take away."

Therefore the best approach would be to undertake a coordinated reform of the LVIT and the land value tax, cutting the former from 60/50/40% to 40/30/20%, while raising the latter. This will cause a slight increase in the cost of holding property (because the land value tax is assessed annually), but sharply reduce taxes when it is bought and sold (because the LVIT is only paid at the time of sale).

That looks straightforward enough, but in fact the situation is still more complex. Tsai Chi-yuan, who served formerly as chief of the Bureau of Finance of Taoyuan County, says that while the LVIT is high on paper, there are many ruses to avoid it. Most county and city governments, trying to reduce the tax burden on their citizens, have always low-balled their assessments of property value (on which the tax is based), so that a piece of land really worth NT$2000 per ping is assessed at, say, NT$200. Another approach is based on the fact that transfer of farmland is not subject to the LVIT. So one hears from time to time of big corporations avoiding taxes by buying land using farmers' ID cards. The way to solve all these problems at once would be to reduce the LVIT, broaden the tax base, raise assessments, and raise the land value tax in one big package.

Frustratingly, given the total lack of cooperation between ruling and opposition parties in the legislature, amending the law is agonizingly slow, but the preferential rate period is fast nearing its end, so action is urgently needed. Lately, some executive branch officials have bruited the idea of first lowering the LVIT in isolation, and then figuring out the rest later. But what does this mean in practice?

"If you give away the carrot first," wonders Tsai Chi-yuan, "who is going to dare pick up the stick? They'll be lucky if they aren't beaten to a pulp by voters." The phenomenon of reducing all taxes that should be reduced, but never getting around to raising those taxes that should be raised, so prevalent in the last few years, really is morale-crushing for people like himself who have long been fighting for tax reform.

Paying the piper

Besides creating packages in which the tax base is broadened while tax rates are reduced, another key concept in tax reform is to transform the system from one in which direct taxes (mainly income tax) play the main role to one in which consumption taxes (mainly the value-added tax, or VAT) is central.

Tsai Chi-yuan points out that in the past the tax system emphasized the idea that "where there is income there should be tax." But given the rapid decline in the birth rate-which means that in the future there will be proportionately fewer young people working, while the main body of society will increasingly be elderly people who consume but who do not earn-reliance on income tax alone will not do the job. It will be necessary to draw more government revenues from consumers. Shifting the tax burden toward consumers will have the added benefit of reducing disincentives to work among income earners.

Currently the VAT in Taiwan is 5%. This is the same as in Japan, but there is still a lot of room to increase it if you compare this figure to the 25% in Northern Europe or the 15% in Western Europe. Shen Fu-hsiung, who advocates raising the VAT to 10%, relates that each percentage point rise will add an estimated NT$35 billion to the nation's coffers; if the rate were raised to 10%, this alone could almost fully deal with the projected budget deficits of NT$200 billion per annum.

But will the need to pay a higher tax affect people's willingness to consume? Finance scholars generally conclude that it will not. For one thing, as Tsai Chi-yuan points out, not all products have VAT levied on them. For example, it does not apply to food, agricultural products, or basic necessities. As for conspicuous luxury goods, if a little extra VAT can reduce their attractiveness, so that the money that would have been spent on them ends up in savings, this could achieve the hidden objective of using the tax system to direct citizens' economic behavior, and would be a good thing.

National debt as a percentage of GDP (%)

Share the wealth, share the pain

Given the growing gap between rich and poor in Taiwan, and the fact that more than 70% of the state's tax revenue comes from deductions from salaries and wages, the tax contribution of the wealthy is so low that it constitutes a social injustice. This is why Shen Fu-hsiung emphasizes the need to levy an "assets tax" as soon as possible-especially a capital gains tax on profits from stock transactions. The latter has long been advocated by experts, but equally long avoided like the plague by legislators.

Shen Fu-hsiung takes as an example the case of China Motor Corporation (CMC). Thanks to strong returns from its investments in mainland China, CMC's share price rose from NT$18 last August to an astronomical NT$70 by the end of January of this year. "In this period, CMC's market value increased by NT$65 billion," he says. "But all the government got out of it was the NT$1 billion that CMC paid in taxes on profits earned and the NT$400 million or so from the stock transactions tax. As for the income earned by stockholders on the stock price differential, sorry, but the government could do nothing but drool." In other words, while the company and stockholders made out handsomely, the government's share of the take was a meager two percent.

"If enterprises want to expand abroad to conquer new territories, the government has no reason to stop them," argues Shen. "But if a company's stock on the Taiwan stock exchange shows profits which reflect the money the firm made by moving away, the government should have a mechanism for taxing these capital gains so that it can provide necessary services to those made unemployed by the relocation overseas." If this is done, the government need not worry constantly about companies taking their operations to China. Moreover, since it is the stockholders who pay the tax upon the sale of their shares, there is no direct burden on the company.

Currently many countries use taxes on stock profits as a tool for balancing out the unequal distribution of income between rich and poor. Taiwan should follow suit.

Collect vigorously, spend carefully

Once on track, tax reform could fundamentally resolve the government's longstanding fiscal problems. But it is a very complex undertaking, so for the immediate future there is also a need to take a hard look at government spending.

Over the past half year, because the economy has been in a trough, the government has come out with one economic stimulus plan after another. These include an NT$20 billion public services expansion and employment project, an NT$58 billion infrastructure expansion program, and a five-year NT$500 billion series of major development projects. The government has also spent another NT$50 billion to deal with SARS, a large part of which has gone as economic aid to industries adversely affected by the epidemic. The amounts of these allocations are staggering.

And these have not been the only extraordinary expenditures. Recently there was the case of a teacher who applied for retirement, but was turned down by his local government because of financial difficulties. In a state of extreme agitation, he knelt down before the Ministry of Education to beg for help. The result was a government promise to appropriate NT$30 billion over three years to guarantee that old teachers can retire without a problem.

And on top of this we have also had an increase in the direct payment to elderly persons, a broadening of the scope of subsidies for covering interest on student loans, and an additional NT$15 billion to assist development in townships.... In all of these cases, benefits were promised without careful financial calculations being made, and it is still unclear how much value they will have in terms of the country's long-range development.

Yophy Huang, a researcher at the Chung Hua Institution for Economic Research, says that a policy of "priming the pump"-using large fiscal outlays to jump-start the economy in the expectation that growth will return new revenues to the government that more than make up the initial costs-is only appropriate when the government's own financial situation is sound, since it doesn't necessarily work.

Huang points to Japan's "Santa Claus economics" as a case in point. Over the last decade, Japan has put forward at least 12 economic stimulus plans, spending 120 trillion yen in the process. There was even one scheme to give each elderly citizen and child 20,000 yen just before Christmas in order to encourage consumer spending. But there has been little effect.

Huang cautions that stimulus plans underestimate the intelligence of the population. An economic downturn is a blow to public confidence, so it would seem that people should feel in a better mood (and thus spend to stimulate the economy) when the government hands them money. But actually they fear that if the government continually does this, the financial situation will further deteriorate. The result could be a financial collapse, followed by currency depreciation and economic recession, then losses of jobs or pensions. And in the end taxes would have to be raised. So while people take the government's handouts, they still dare not spend freely. The result is another step down in the vicious circle of declining consumption and investment.

The bottom line, says Sun Keh-nan, is that "you have to be vigorous about collecting money, and you have to be careful about spending it." Only if people feel confident that the government will spend money wisely will they willingly pay taxes. If the tax system can get on track and government spending be brought under control, there will be plenty of money in the government's coffers and the country will be strong and wealthy. At that point there will be no need for any "stimulation"-the people themselves will be cranking out all the money the government needs.