How U.S. Tax Policies are Responsible for Puerto Rico’s Financial Crisis

By Donald L. Swanson

Puerto Rico is dealing with the storms of financial disaster and a hurricane’s aftermath.

Here is a false narrative about the financial storm:

Forgiving Puerto Rico’s debt “would only free Puerto Rico’s politicians from having to address the policies that were suffocating its economy to begin with.”

–Wall Street Journal Op. Ed., October 11, 2017

Yikes!  Laying responsibility for Puerto Rico’s debt troubles at the feet of “Puerto Rico’s politicians” is way off base.

The primary responsibility for Puerto Rico’s debt troubles rests, instead, on the shoulders of the U.S. Government and its tax policies for Puerto Rico.

I’ll try to explain.

Some Tax Breaks History

In the Revenue Act of 1921, the U.S. Congress created special tax provisions for U.S. territories like Puerto Rico, with a primary intention of helping U.S. corporations “compete with foreign firms.”  Such provisions exempted U.S. corporations from paying taxes on profits earned in Puerto Rico and other territories.

Thereafter, Congress adjusted and tweaked Federal tax laws, to assist Puerto Rico in “obtaining employment producing investments” from U.S. corporations.  This resulted in a “tax free repatriation of profits” to the mainland from businesses located in Puerto Rico.  So, numerous manufacturing businesses relocated to Puerto Rico and made large capital investments there.

The “federal revenues foregone” for the U.S. Treasury, under such tax laws, became significant — estimated in a 1993 Report [1], for example, at $3.9 billion for 1994.  Such tax breaks then faced political opposition as corporate welfare.

Economic results of such tax laws for Puerto Rico, according to the 1993 Report, are an odd mixture of positives and negatives.  Here are some examples.

Positives:

–Puerto Rico’s economy “improved substantially” during the post-World War II period.  Its “real gross national product (GNP)” increased, for example, “more than four-fold” from 1947 to 1993.

–Puerto Rico’s labor force became highly educated — approximately 40% had “13 years or more of education.”

Negatives:

–The business-attracting tax benefit proved to be an impediment to U.S. statehood for Puerto Rico because statehood would eliminate the tax benefits.

–By mainland U.S. standards, “Puerto Rico remains a poor island.”  For example, (i) Puerto Rico’s “real average per capita income,” in decades prior to 1993, “remained less than 30 percent of the U.S. average,” and (ii) its “unemployment rate of 16 percent” more than doubled the mainland’s rate of 6.6 percent.

So, in 1993 Puerto Rico had an odd economic mixture: businesses were relocating to Puerto Rico and making heavy investments there, yet Puerto Rico still had “high persistent unemployment.”

In light of the positives noted above, how could such negatives exist back then – and persist thereafter?!

The answer is this: the tax benefits encouraged high capital investments instead of job creation.

–U.S. tax policies attracted industries to Puerto Rico that “rely more on capital” than on “labor for manufacturing goods.”

–Since “relatively little of the cost of manufacturing is paid in the form of wages” and since “the capital is owned” by people living elsewhere, “relatively little income” from manufacturing businesses in Puerto Rico “is retained in Puerto Rico.”

Today’s Problems

U.S. tax laws made Puerto Rico “artificially attractive” to manufacturing businesses, “creating, in effect, an economic bubble” that left Puerto Rico “vulnerable to a crash” and susceptible to an economic storm, if such tax laws were ever repealed [2].

Such tax laws became unpopular in the 1990s as helping large corporations avoid taxes.  Beginning in 1996, therefore, the U.S. Government phased out the corporate tax laws “over a ten year period.”  So, beginning in 2006, Puerto Rico’s businesses became subject to full U.S. taxation and to global economic pressures.

The results are dire:

–“Not coincidentally, 2006 also marked the beginning of a deep recession for Puerto Rico,” which has lasted to this day.

–U.S. tax policies “skewed the Puerto Rican economy toward foreign investment from the U.S.”  But when tax benefits were repealed, “foreign investment began to flee” and “the economy began to contract, along with tax revenues.”

–Puerto Rico’s economy continues to shrink, “with unemployment at 12% and fewer than half of civilians in the labor force.”  And experts point “to the repeal” of the U.S. tax benefits “as a major cause of Puerto Rico’s current recession.”

–Puerto Rico’s recession “drove government deficits up” and “played a central role” in creating the “present budgetary situation.”

A Washington Post article from last week provides the following description of what’s happened to Puerto Rico since 2006.  During that time:

Conclusion

So . . . before we disparage Puerto Rico’s politicians for the current financial crisis, let’s give due responsibility to the role of the U.S. Government in creating the situation through its tax policies.

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[Footnote 1:  Information and quotes in the “Some Tax Breaks History” section above are from, (i) “Report to the Chairman, Committee on Finance, U.S. Senate,” from the U.S. General Accounting Office titled, “Tax Policy, Puerto Rico and the Section 936 Tax Credit,” (June 8, 1993), and (ii) J. Toro, “Puerto Rico’s Operation Bootstrap.”]

[Footnote 2:  Information and quotes in the “Today’s Problems” section above are from, (i) S. Greenberg & G. Ekins, “Tax Policy Helped Create Puerto Rico’s Fiscal Crisis,” Tax Foundation (June 30, 2015), and (ii) the Washington Post article linked above, as noted.]