The EITC is Not the Solution to Puerto Rico’s Woes

October 26, 2015

On Wednesday, the Obama administration released a four-point plan for how Congress can assist Puerto Rico in its present fiscal crisis. Some of the points in the plan are entirely sensible, such as allowing Puerto Rico to restructure its debts and improving Puerto Rico’s fiscal governance. However, the last point in the plan – expanding the federal Earned Income Tax Credit to Puerto Rican citizens – would not seriously address the causes of Puerto Rico’s economic malaise.

The administration gave a persuasive explanation for why expanding the EITC to Puerto Rico would help solve the island’s fiscal crisis:

Any credible plan for resolving Puerto Rico’s fiscal crisis must recognize the importance of restoring economic growth… The Earned Income Tax Credit is one of the strongest policy tools for rewarding work and supporting economic growth. At forty percent, Puerto Rico has the lowest labor market participation in the United States and the territories… A large body of economic research has found that the EITC in the fifty states and the District of Columbia has increased work.

It’s lovely to hear this White House supporting the idea that tax cuts lead to growth, and their economic reasoning is sound. Only 42.6 percent of Puerto Rican adults participate in the labor market, compared to 62.5 percent in the rest of the United States. Indeed, the island’s low labor force participation rate is often cited as a central factor behind its economic woes. And the White House is also correct that expanding the EITC to Puerto Rico would give residents more incentives to enter the labor force, which would help grow the island’s economy.

However, while expanding the EITC to Puerto Rico would help treat the symptoms of the island’s broken labor market, it would not address the root causes. If the White House were really looking to strengthen Puerto Rico’s labor market, it would have proposed two different policies: reforming federal welfare programs in Puerto Rico and lowering the island’s minimum wage.

The case for reforming federal welfare in Puerto Rico is simple: it is well-documented that the island’s low labor force participation rates are due, in part, to the generosity of federal welfare programs. In The Economy of Puerto Rico: Restoring Growth, Gary Burtless and Orlando Sotomayor present a convincing case that Puerto Rico’s low labor force participation rate was first caused by “the sharp increase in government transfer payments that begin in the mid-1970s.” And the New York Federal Reserve notes that families in Puerto Rico sometimes face implicit tax rates of over 100 percent due to the phase-out of federal transfer programs. In other words, when Puerto Rican families earn higher wages, they sometimes end up with lower incomes because they are no longer eligible for federal welfare programs.

Introducing the EITC to Puerto Rico would decrease implicit marginal tax rates on the island’s residents, but would not fundamentally alleviate the strong work disincentives created by federal transfer programs. It would be a new federal welfare program created to moderate the incentives created by other welfare programs, a patchwork solution on a long-standing problem.

In addition, the White House neglected to include one policy change that nearly everyone agrees would improve Puerto Rico’s labor market: lowering the minimum wage on the island. In 1974, Congress decided to raise the Puerto Rican minimum wage to U.S. levels; previously it had been far below. As described in a 1992 paper by Alida Castillo-Freeman and Richard Freeman, the effects were disastrous: the higher minimum wage “substantially reduced employment on the island,” by eight to ten percent.

Today, Puerto Rico’s relatively high minimum wage (77 percent of the median hourly wage) is still a significant drag on the island’s labor market. Last June, a report from the IMF identified Puerto Rico’s minimum wage as one of its most serious barriers to growth. Even economist Paul Krugman agrees that Puerto Rico’s minimum wage is too high.

All in all, while expanding the EITC to Puerto Rico would likely encourage more residents to enter the labor force, it would not fix long-standing structural problems with the island’s labor market. For Congress to meaningfully encourage Puerto Rico’s long-run economic prospects, it will have to reform federal policies that have hindered the island’s growth: transfer programs and the minimum wage.

There is a larger lesson here. Congress extended federal welfare programs and the federal minimum wage to Puerto Rico with the best of intentions, hoping to help the island’s residents. Ultimately, because both policies were designed for the mainland, they were unsuited to Puerto Rico’s economy, and led to economic stagnation. Perhaps, the White House should take the hint from history, and shift its focus away from expanding more federal programs, like the EITC, to Puerto Rico.


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