Last summer Taiwan's finance minister Chang Sheng-ford went through the toughest time in his 32-year-long career as a government official.

Traditionally, the central government's general budget must be sent to the Legislative Yuan for review and approval by the end of August. However, in mid-August Chang was still busy trying to mend budget holes: Cutting statutory expenditure, about 70 percent of the budget proposal, was out of the question, and the government wanted a 10 percent increase in public infrastructure expenditure on top of that. On the other hand, the budget allocated for water and electricity fees of cabinet agencies had already been slashed by 10 percent... Chang was in a conundrum: no matter how he shifted around budget items, he still ended up with a gaping fiscal hole of more than NT$50 billion.

He had no choice but to opt for selling shares in highly profitable state-invested companies such as TSMC and Chunghwa Telecom to fill the budget gap. A share sale in the open market, however, would require the prior approval of the Legislative Yuan, which he could not take for granted. Yet if the shares were sold to the four major government-controlled funds – the Labor Insurance Fund, the Labor Pension Fund, the Public Service Pension Fund, and the Postal Savings Fund – through a private placement, control over these assets would remain in state hands. Still, Chang was prepared to come under fire. "Whatever I did, the legislature was bound to lash out at me," he related in an exclusive interview with CommonWealth Magazine.

But what terrified him even more, was the specter of much greater financial trouble in the coming year.

"If we can't put together a budget next year, what exactly is it that I, the finance minister, am doing?" Chang recalls asking himself. "So I decided last September that I would put forward a financial consolidation proposal during the current legislative session."

Chang's financial reform package was born from his nightmares over the NT$50 billion budget gap.

In his policy address to the Legislative Yuan on Feb. 21, Premier Jiang Yi-huah revealed the financial consolidation plan for the first time. He declared that the four major pension funds must complete reforms by the summer and that the tax system would be overhauled to bring it up-to-date and make it conform to international trends in taxation. Wealthy individuals and corporations would have to pay higher taxes.

Subsequently, Chang announced the details of tax reform. The corporate income tax on financial industry companies will be raised back to 5 percent from the present tax rate of 2 percent. The amount of corporate income tax that shareholders can claim as tax credits to be deducted from their personal income tax, under Taiwan's integrated tax system, will be halved. A tax rate of 45 percent will be applied to the portion of rich people's net income that exceeds NT$10 million per year. If all these changes are implemented, the state will raise an additional NT$80 billion in tax revenue.

Together with the proposed tax hikes, which are supposed to help fill the budget gap, the reforms also include tax cuts for the average wage earner. The 6.47 million wage earners and the some 510,000 people with disabilities will have their tax-deductible quota raised by NT$20,000 to lessen their income tax burden. In terms of corporate taxes, the government is for the first time using tax measures to encourage employment. Small and medium enterprises can claim additional salary expenses multiplied by 1.3 as costs. The government also encourages companies to invest in R&D to boost their competitiveness.

Debunking a Myth: Tax Cuts Don't Help Economic Growth

Over the past five years, CommonWealth Magazine has carried a number of cover stories that highlighted the ills of Taiwan's tax system, such as tax loopholes draining government revenue, rich corporations and individuals stashing away their assets in offshore tax havens, taxation causing greater inequality, and the government failing to track down flight capital. We have long pointed out that our inappropriate taxation system erodes the tax base, heavily taxing hard-earned labor income, while lightly taxing capital gains. By constantly implementing more tax cuts, the government has maneuvered itself into a tight spot and has become a "poor government in a sluggish economy." Meanwhile Taiwan's actual tax revenue accounts for just 12.8 percent of its GDP, one of the lowest ratios worldwide.

A CommonWealth Magazine survey discovered the unpleasant truth that large, highly profitable corporations are taxed for their income at a lower rate than the average employee, disproving the government's hallowed theory that "raising fat geese makes them easier to pluck." But the government has been slow to respond. It did not muster the resolve to reform the tax regime until the Jiang cabinet made its recent announcement.

The just-announced financial consolidation plan is not only the first time that President Ma Ying-jeou has faced the truth of worsening government finances and plummeting tax revenues since he came to power in 2008. It is also the very first time since Taiwan became a democracy in the early 1990s that a government has frankly acknowledged that the credo "cutting taxes to stimulate investment will save the economy" – invoked by both the ruling Kuomintang and the major opposition Democratic Progressive Party (DPP) – is an untenable lie.

At a press conference on Feb. 24, finance minister Chang Sheng-ford did not mince words: "Since we began implementing the integrated income tax system, its boosting effect on investment has not been significant. On the contrary, it has only widened the wealth gap."

Among the 34 member nations of the Organization for Economic Cooperation and Development (OECD), only Canada, France, Finland, Germany, Italy and Norway still use full dividend imputation, which means that a shareholder's payable tax on dividend income is fully creditable against the corporate tax paid by the dividend-distributing company. The other 28 OECD members have switched to partial imputation. In that regard Taiwan's dividend taxation method has long fallen behind international taxation trends.

It is particularly significant that such statements come from Chang himself, given that he controlled the integrated income tax regime in the past as deputy director-general of the Taxation Administration under the Ministry of Finance. Back then government pamphlets touting the new policy argued that shareholders would be more willing to reinvest their money if double taxation were avoided. This would translate into more investment, which would boost economic growth.

But in reality the integrated income tax regime has resulted in annual tax revenue shortfalls of NT$80 billion to NT$100 billion over the past fifteen years, which adds up to total lost tax revenue of more than NT$1 trillion. But contrary to expectations, Taiwan's investment rate has steadily declined since 1998.

Significance: Improving Tax Fairness

Sun Kenan, head of the Graduate Institute of Accounting and Taxation at National Taipei College of Business, expects the new tax reform proposal to make taxation fairer.

Sun points out that nearly 7 million wage earners, who have had to put up with stagnating wages for a long time already, will benefit from the NT$20,000 rise in their special tax deduction, in that they will pay about NT$1,000 less in personal income tax per year.

The majority of high-income earners with annual personal income in excess of NT$10 million also have dividend income. If personal income tax on dividend income can no longer be fully offset against corporate income tax, this effectively amounts to a tax rise on dividend income, explains Sun. Overall, Sun concludes that "changing the tax rates on wage income and capital gains will improve the fairness of the tax burden."

The chairman of one financial holding company, who did not want to be named, believes that the Finance Ministry's latest tax reform proposal has a better chance to succeed than previous ones. A crucial boost came from William Tseng, chairman of the Financial Supervisory Commission (SFC), who stepped forward to support the resumption of a higher corporate tax for the financial industry, thus demonstrating unity between the Finance Ministry and the financial industry watchdog regarding the proposed tax reforms. "The finance industry is a business that requires special authorization. If the supervising agency has already pledged its support, who would dare to oppose it?" the financier points out.

Turning Point: FSC Backing

Grumbling over the tax reform proposal quickly quieted down, since all cabinet agencies demonstrated unity and the government had lobbied KMT lawmakers for their support before the announcement. As a result, the first step in moving the reforms forward went smoothly.

Still, a cabinet member who is familiar with the machinations of the Legislative Yuan, sounds a note of caution: "If this reform is to succeed, we still need to see whether groups with vested interests will take their lobbying efforts underground." Since financial institutions fear supervisory organs, they don't dare to openly oppose the reforms. The rich, for their part, don't want to be labeled tax avoiders and become the public enemy. But without confrontation and controversy, it will be somewhat more difficult to build support and pressure for the reforms in society.

For their part, the opponents of the proposal continue to rally their forces. A high-ranking member of one of the six major industry associations reveals that the General Chamber of Commerce and the Chinese National Association of Industry and Commerce have both declared their opposition to the planned changes to the integrated income tax regime. If the Finance Ministry is not able to win over the opposing interest groups, it must brace itself for a major showdown. Traditionally, if just one of the six major industry associations opposes a certain government policy, the others close ranks and follow suit.

"So far, the Finance Ministry has only explained how much more tax revenue this move will generate, but it has not explained the possible economic impact. That's not what I call policy evaluation at all," the industry association representative complains. Presently, a huge question mark looms over whether the tax reforms will be successful.

Key Point: Completing the First Step

Critics of the proposed tax reforms such as People First Party lawmaker Lee Tung-hao and DPP legislator Hsu Tain-tsair believe that the biggest problem of Taiwan's tax system is tax base erosion, which can be attributed among others to the way overseas income and land ownership are taxed. They argue that the proposed reforms fail to make structural adjustments to the tax system. Instead they only aim to solve the government's revenue problems, while even more rich people manage to avoid taxes.

"Capital gains which are not income earned through hard work should be the main target of tax hikes," Hsu asserts, adding that an overhaul of the land tax system is even more urgent.

Finance Minister Chang emphasizes that overseas income and the land tax system remain on the agenda. When the Finance Ministry signs the cross-strait taxation agreement with China, it will demand that an anti-avoidance clause for income earned overseas be made a priority issue in the legislature. Chang is not willing to talk much about the land tax for fear the focus of his reform proposals could be diverted.

Over the past two decades, too many absurd theories were aired in Taiwan such as that tax cuts encourage investment and rescue the economy. Or, that tax cuts will attract flight capital back home and turn Taiwan into a financial center. As it turns out, tax revenue as a percentage of GDP in Taiwan has slipped from 20 percent to 12.8 percent, pushing the island into a vicious cycle of poor finances and economic stagnation.

The current financial consolidation plan marks the beginning for reversing this vicious cycle. It is also the starting point for Taiwanese society to face the truth.

Translated from the Chinese by Susanne Ganz