Expeditious reform of the public finance system is necessary to prevent mounting debt from crimping future economic growth.

Taiwan’s public finances are increasingly strained by debt, aggravating the island’s fiscal woes as it struggles with flagging exports and weak GDP growth. Last year, the central government’s debt reached NT$5.28 trillion (US$161 billion). At 35.85% of GDP, it was just below the statutory ceiling of 40.6%, according to the Directorate-General of Budget, Accounting and Statistics (DGBAS). But when government obligations over the next 30 years are added in, public debt swells to nearly NT$24 trillion (US$740 billion), or about 160% of current GDP, the Taiwan Institute of Economic Research (TIER) estimates.

As Taiwan ages – it is set to surpass Japan as Asia’s fastest graying nation – and its birthrate falls, government funds are increasingly insufficient to cover generous social welfare programs. Taiwan spends NT$467.5 billion (US$14.4 billion) annually on pension schemes and social insurance, comprising 23.4% of its annual NT$1.95 trillion (US$60.1 billion) budget, according to the Ministry of Finance (MOF). Those expenditures have become a “heavy burden” for the government, the Ministry said in an email responding to questions from Taiwan Business TOPICS, adding that “annuity system reform is urgent.”

Taiwan’s public-service pension fund will run a deficit for the first time this year, with payouts to retired public-school teachers and armed services personnel in 2014 having exceeded contributions to their money pool, according to the Ministry of Civil Service (MOCS) under the Examination Yuan. The shortfall was around NT$3.3 billion (US$102.8 million),“but there was no immediate financial crisis” because the fund still enjoyed a surplus of NT$32.3 billion (US$996 million) when its utilization income of NT$35.6 billion (US$1.1 billion) is included, according to the 2014 annual report of the Public-Service Pension Fund Management Board (PSPFMB).

However, the payment-to-contribution ratio for each type of participant in the pension system – civil servants, public-school teachers, and the armed forces – has surged in recent years, the PSPFMB noted in the report. “If we don’t take action promptly, we are going to have serious fiscal problems down the road,” Dennis Liu, a section chief at DGBAS told TOPICS in an interview. “The money will run out.”

Taiwan’s fast-shrinking public-service pension fund is not a recent problem. Policymakers have been conscious of the severity of the problem for years. But the administration of President Ma Ying-jeou made the first substantial attempt to reform the flawed system more than two years ago. “The pension-system time bomb won’t explode during my term…However, the train will definitely fall off the cliff if we don’t start building a bridge right now,” Ma said in January 2013, as he unveiled the government’s proposals.

One of the proposals was to lower the income-replacement rate for retirees from 95% of double the base pre-retirement salary to 80% of 1.6 to 1.7 times the previous salary level. The purpose of that amendment was to put an end to public servants’ earning more income in retirement than during their careers. In most developed countries, pensions offer an income-replacement rate of 60% to 70%.

In September, Finance Minister Chang Sheng-ford highlighted this point by mentioning the case of his wife, who receives a monthly pension of NT$68,000 (US$2,096), higher than the NT$64,000 (US$1,973) salary she earned as a junior high school teacher.

The Ma administration also proposed that the premium rate for payment into the pension fund be increased to 18% from 12%. Under that change, the government and employees would contributed 60% and 40% respectively, rather than the current 65% and 35%.

While none of the proposed amendments were drastic, pension reform stalled in the Legislative Yuan, as lawmakers bickered over the details. “Ma understands that the current pension system is unsustainable, but he simply couldn’t muster enough political support to get the reforms through the legislature,” says Hank Huang, a research advisor at TIER.

More optimistically, in July the Chinese-language Business Today weekly reported the results of a survey showing that 70% of public-sector employees would accept pension reform, with more than half open to lowering the current income-replacement rate.

Cheng Cheng-Mount, one of Taiwan’s leading economists and president of the Agricultural Bank of Taiwan, is not so sure. “Pension reform is Taiwan’s most urgent fiscal issue, so any proposal to lower the income replacement rate and increase employee pay-in is a good idea,” he says. “But public servants aren’t going to be happy about it, and every legislator wants to be seen as a good guy. Nobody wants to face the problem.”

In the meantime, Taiwan is spending less on necessities like national defense, even as the People’s Republic of China continues to boost defense spending at a double-digit rate. In 2015, Taiwan’s Ministry of National Defense (MND) increased its budget for the first time since 2012: a 2.6% uptick from US$10.5 to $10.7 billion. Defense spending will rise as a percentage of overall government spending for the first time since 2008 this year, but by a paltry 0.2%. Indeed, despite President Ma’s pledge to maintain defense spending as at least 3% of GDP, that figure has been closer to 2% during his tenure in office.

Critics say the defense budget is being spent disproportionately on personnel and office facilities instead of weapons procurement. “Transparency is an issue with defense spending,” says Huang of TIER. “There is no independent external body evaluating where the money is being spent, and so it’s unclear that it’s being spent on the most important things.”

Going broke

Taiwan’s fiscal problems took on a new urgency recently when in July the Miaoli County government was unable to pay its employees. As of July, the county government was NT$64.8 billion (US$2 billion) in debt. For that month, its expenditures included NT$600 million (US$18.5 million) for employee salaries and an additional NT$600 million in pension obligations for retired staff. “Taiwan thought this would never happen to us,” says Huang of TIER. “It’s the first time in our history that a local government couldn’t pay its public servants.”

Miaoli’s annual revenue is NT$22 billion (US$678.4 million) while its expenditures total NT$32 billion (US$986.7 million), resulting in a shortfall of NT$10 billion (US$308.4 million), according to government data. Construction project payments and retention payments comprise NT$17 billion (US$525 million) of those expenditures.

In 2014, the Miaoli County government’s accumulated public debt with maturity of at least one year comprised more than 61% of its annual expenses, significantly above the 50% ceiling stipulated in the Public Debt Act.

Former Miaoli County magistrate Liu Cheng-hung spent extravagantly during his eight-year term, observers say. At the start of his term, Liu spent NT$1.2 billion (US$37 million) to renovate the county government building, plan a high-speed rail zone, and expropriate large quantities of land for new development, according to an April report in the Chinese-language Liberty Times.

During Liu’s term, Miaoli spent NT$218 million (US$6.7 million) on fireworks and concerts, more than double its NT$100 million (US$3.1 million) budget for school lunches, the report noted. By the end of Liu’s term in December 2014, Miaoli’s debt had risen more than threefold from NT$20.2 billion (US$623 million) to NT$64.8 billion (US$2 billion), according to a May report in the Chinese-language Next Magazine.

Before the Taiwan Province administration was dissolved in 1998, the provincial Department of Finance strictly monitored local government budget plans, wrote Tsai Chi-yuan, a former director of Taoyuan’s Department of Finance, in a July op-ed article for The Taipei Times. However, responsibility for that evaluation system was not completely transferred to the Ministry of Finance, resulting in lax oversight of local government spending.

In July, Miaoli County magistrate Hsu Yao-chang appealed to the central government for a NT$10 billion (US$320.2 billion) bailout, but was rebuffed. Instead, the Executive Yuan promulgated a new regulation permitting the central government to allot general subsidies in advance to a local government in financial trouble – as long as the local government first provides a financial reform proposal and agrees to publicize its spending in a monthly report.

“Miaoli should not be entitled to special treatment from the central government for its debt issues,” says Liu of DGBAS, noting that 20 of Taiwan’s 22 local governments are running budget deficits. “What Miaoli should do is manage its finances better and increase transparency.”

Kinmen County and Lienchiang County (Matsu) are Taiwan’s only debt-free local governments. The offshore islands that make up Kinmen and Lienchiang are governed by the Republic of China, but considered part of Fujian province. Given their small size and distance from Taiwan proper, they receive additional subsidies from the central government, Liu says. The offshore islands further benefit from their profitable production and sale of the fiery sorghum liquor kaoliang.

Debts owed by Taiwan’s 20 other local governments totaled NT$973.5 billion (US$30 billion) in 2013, the most recent year for which statistics are available, which was up NT$33.5 billion (US$1.03 billion) from 2012, according to the DGBAS.

Heavily indebted Yilan County is also at risk of insolvency, experts say. Poor fiscal planning coupled with inadequate revenue have caused the situation to become grave, observes Cheng of the Agricultural Bank of Taiwan. “Yilan has a small agricultural economy,” he says. “But the local government has still spent lavishly for years.”

In southwestern Taiwan, Yunlin County faces growing fiscal troubles of its own. In July, local officials said the county expects to face a funding shortfall of about NT$1 billion (US$30.8 million) in October, as it will not receive any tax revenue until November. In the meantime it will be without money needed to cover the cost of salaries, public works projects, and social welfare, the officials said.

“We have faith that we will be able to overcome the financial difficulties, so it is unlikely that Yunlin will seek financial assistance from the central government as Miaoli County has done,” Hung Jen-sheng, head of Yunlin’s Department of Finance, said in July, according to Taiwan’s Central News Agency. Yunlin will boost revenue by cutting spending and auctioning off land, Hung added.

Returning to the black

Some Taiwanese politicians and commentators have warned that Taiwan, without drastic reform, may become another Greece. That comparison is rather far-fetched (see the accompanying article).

A more analagous comparison to Taiwan would be Japan, which has a 233% ratio of debt to GDP – the highest in the developed world – but has avoided fiscal crisis. Like Taiwan, Japan is an aging East Asian country of voracious savers that holds most of its debt domestically, observes Liu of the DGBAS. Japan’s sovereign credit rating is A-plus, one below Taiwan’s AA-minus, according to S&P.

Although Taiwan’s debt today remains far smaller than Japan’s, if left unchecked it could hobble economic growth as the population ages. Indeed, over the past two decades, Japan’s economy has grown at an average nominal rate – not adjusted for inflation – of just 1%.

As the working-age population has shrunk, the Japanese economy has been constrained in two ways. First, there have been fewer workers to drive growth or pay taxes to fund public services. Second, the government has had to spend more on social welfare as the number of elderly citizens has risen. The government has borrowed to compensate for the widening gap between what it earns and spends, pushing up public debt.

Worryingly, Taiwan’s demographic trends are similar to Japan’s. According to the French bank Societe Generale, Taiwan’s working-age population – those between 15 and 64 years of age – will shrink 7.3% by 2025, about the same as the 7.2% contraction forecast for Japan.

The speed at which Taiwan is aging is squeezing the public healthcare system, even as critics are pushing the government to boost its healthcare expenditure. At 6.6% of GDP, Taiwan’s spending on healthcare is well below the 9.3% average among developed OECD countries. Reaching Ma Ying-jeou’s pledge of 7.5% made during his 2008 presidential campaign would require spending an additional US$4 billion annually.

Meanwhile, the national health insurance fund’s surplus – US$99 billion as of June 2014 – is expected to run out in 2017. A year later, Taiwan’s National Development Council (NDC) predicts, the island will become an “aged society,” defined as 14% of the population aged 65 or older. By 2025, Taiwan’s elderly population is expected to exceed 20%, making it a “super-aged society.”

Given these troubling demographic trends, how can Taiwan avoid falling into the same debt trap as Japan? In the short term, raising taxes is one way to boost the island’s fiscal well-being. Taiwan’s tax revenue rose almost 10% in the first half of this year. A recent hike in the personal income tax and rising corporate profits were responsible for the increase in taxes collected, experts say.

Another possibility is to create a sovereign-wealth fund, which can generate high returns. Over the past decade, Singapore’s Temasek Holdings’ annual returns have averaged 13%. Norway’s Government Pension Fund Global (GPFG), the world’s largest sovereign-wealth fund, returned 7.6% in 2014.

In July, the MOF said it would suggest to the Cabinet to integrate Taiwan’s four state-operated funds into a “quasi-sovereign wealth fund,” a step that would not require the revision of current law. The four funds are the Labor Insurance Fund, Labor Pension Fund, Public Service Pension Fund, and postal savings deposits, valued together at more than NT$7 trillion (US$215.5 billion).

Currently, the four funds cannot act as a sovereign-wealth fund because they are designed to operate separately, with a focus on the purchase of domestic shareholdings. That restriction has dampened the performance of the funds, market observers say, noting that Taiwan’s small size means the opportunity to earn returns domestically is limited.

Eventually, the MOF intends to push to revise the law and establish a full-fledged sovereign-wealth fund, Finance Minister Chang said in July. The result would be help to diversify the portfolio of the four state funds and allow them to earn higher returns, analysts say.

A number of obstacles stand in the way of establishing a sovereign-wealth fund, says Donna Chen, managing director of the Taipei-based financial-services consultancy Keystone Intelligence. “For legislation, as the parliament changes every four years, it’s difficult to generate consensus,” she says. “The investment targets of the sovereign-wealth fund can also be challenged if different political parties are in power. How to find suitable professionals to run the fund is also an issue, particularly under the current rigid civil-servant compensation scheme.”

Taiwan’s Central Bank has taken a cautious stance toward the idea of a sovereign-wealth fund, calling for the government to “first seek to pass a law for its establishment, management, and oversight so it can operate legally,” according to a July statement.

In the meantime, experts say, the Taiwanese government should first turn its attention toward reforming the pension system for public servants, despite the entrenched opposition that exists to such reform. Both the Democratic Progressive Party (DPP) and Kuomintang (KMT) presidential candidates have touted pension reform as part of their respective platforms to improve Taiwan’s fiscal health. But with the DPP candidate Tsai Ing-wen well ahead in the public opinion polls, observers are paying especially careful attention to her proposals.

In a September post on the website of her Thinking Taiwan Foundation, Tsai wrote: “The national debt is rising, and the national pension system faces bankruptcy…We will make the retirement system fairer and bring all of society together to face and solve its problems together. Young people will be able to avoid drowning in the pension system’s red ink, and we will make it possible for them too to receive pensions when they grow old and retire some day.”

If she is elected in January, will Tsai succeed where Ma Ying-jeou failed? Cheng of the Agricultural Bank of Taiwan regards her prospects as better than Ma’s were. “Tsai understands the problems with the pension system perfectly, and she isn’t beholden to the same constituency of public servants as Ma was,” he says. “So far, pension reform [in Taiwan] has been ‘Mission: Impossible,’ but Tsai could be the one to change that.”