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* State employee contributions to be raised to 10 pct
* Officials proposing to freeze defined contributions
SAN JUAN, April 3 (Reuters) - Lawmakers in Puerto Rico are expected to approve legislation on Thursday to reform a woefully unfunded public pension system that risks to run out of money in five years.
A major issuer in the $3.7 trillion U.S. municipal bond market, Puerto Rico has seen its credit rating downgraded to near-junk status amid Wall Street's concerns about the cash-strapped finances of the Caribbean island.
Any further drop in its ratings to below investment grade could lead investors to sell Puerto Rican bonds, which are widely held because their interest payments are exempt from federal, state and local taxes.
With government pension funds facing a combined unfunded liability of $37.3 billion, Puerto Rico is under pressure to show it is taking steps to narrow its budget deficit, estimated to reach $2 billion this year, to avoid potential downgrades.
In a marathon session that began Monday and stretched into early Tuesday, lawmakers in the House and Senate passed separate versions of a bill to overhaul the state pension system but agreed to a single bill that Gov. Alejandro Garcia Padilla is expected to sign into law later this week.
Puerto Rico has already ended defined benefit pensions for employees hired after 2000. Officials are proposing that defined benefits currently enjoyed by employees be frozen as of June 30, and those workers be moved into a defined contribution plan.
Under the proposed reform, state employee contributions would be raised to 10 percent from 8.275 percent.
Christmas and summer bonuses for pensioners would be reduced or eliminated for workers and the retirement ages for public workers would be increased.
The proposed pension changes will help keep the system, which is expected to run out of money by 2018, afloat until about 2040, officials say, when the system self-corrects because of the end of the defined benefits for employees hired after 2000.
The government originally estimated it would need to spend an additional $100 million annually on top of the changes to salvage the system and officials say a larger contribution will now be needed since some of the cuts originally proposed have been scaled back.
David Jacobson, a spokesman for Moody's Investor's Service, said the ratings agency would wait until the final legislation was approved to analyze the potential impact of the reforms.
Last month, top Puerto Rico government officials told Wall Street investors they were evaluating new tax hikes and other measures to increase annual revenue by more than $1 billion.
Among analysts there are concerns the tax increase might weigh on an economy that is finally showing some tepid improvements. The island's jobless rate still remains at 14.6 percent down from a recession peak at 16.9 percent in May 2010.
In a private meeting with investors, the officials said they wanted revenue to total $9.7 billion during fiscal year 2014, which begins July 1, and that tax hikes programmed under the previous administration would be scrapped.
They cautioned that the proposals were part of the budget process and subject to change. Garcia Padilla is expected to present his budget before the end of this month.
The government hopes to raise $550 million by eliminating deductions and expanding the base of the sales & use tax, according to Government Development Bank (GDB) officials.
Much of this increase would be made through the elimination of a reseller's exemption certificate, which allows business owners to skip paying the tax for items they purchase and use in products that they sell.
To combat the widespread abuse of the system, the government is proposing the elimination of the certificates and to refund the merchants through tax credits.
An additional $490 million would be raised through new taxes and revenue measures, according to the GDB.
On Tuesday, Garcia Padilla lashed out at Wall Street credit ratings agencies, which have placed Puerto Rico's credit rating on negative watch for potential downgrades.
"I disagree with them and believe they are treating Puerto Rico unjustly," he said during a visit to the southwest coastal town of Guancia.
"I am taking the decisions I have to take to save Puerto Rico's credit so that Puerto Rico can move forward, not because they asked me, but because Puerto Rico deserves highways, hospitals and schools."