Puerto Rico Attempts to Raise Sales Tax as Bond Payments Loom

May 20, 2015

Update: The Sales and Use Tax bill was signed into law by Alejandro Garcia Padilla on May 29th, 2015.

The Governor of Puerto Rico, Alejandro Garcia Padilla, has sent the legislature a proposal to increase the Sales and Use Tax (SUT) from the current 7% to 11.5%. The proposal would also replace the SUT after nine months with a Value Added Tax (VAT).

In addition, professional services, which were previously exempt from the SUT, will be taxed at 4%.

This new proposal comes less than a month after the Puerto Rican House of Representatives voted down a comprehensive tax reform bill on April 30th.

The impetus behind both tax proposals is a weary bond market. Puerto Rican bond yields on a taxable basis have been around 17%, a rather high cost of borrowing. Even the Greeks with their crumbling economy can borrow at around 8.6% on an equivalent basis.

The government hopes that the increased tax revenues along with budget cuts will sure up the bond markets and lower the cost of borrowing. This medicine has already been shown to settle the markets. An agreement between lawmakers on Thursday over the direction of tax reform led to a bond market rally on Friday, lowering bond yields.

The proposal is particularly timely since $630 million of bond payments are due on July 1st. If the new proposal can convince investors that there are future tax revenues to cover new borrowing, then the cost of refinancing the $630 million should drop dramatically.

This would seem like a good deal for Puerto Rico, but hastefully passing a tax bill can be treacherous. There are several dangers lurking behind the current proposal.

First, unlike the comprehensive tax reform voted down in April, the new proposal does not remove any of the economically damaging taxes, such as the gross receipts tax. The new proposal only increases the tax burden on consumers. Thus, there are no pro-growth reforms to help stimulate the struggling economy.

Second, it is unlikely that the VAT can be implemented in nine months. The proposal calls for the SUT increase to start on July 1st, 2015 and be replaced by the VAT on April 1st, 2016. That is less than a year to implement the administrative infrastructure for complying with the VAT.

Moreover, it is unlikely the new bill will bundle the SUT rate increase with the VAT implementation. The lack of political support for the comprehensive tax reform will like make the bundling of the rate increase and VAT implementation politically infeasible. Thus, the VAT implementation would require another, more difficult vote in nine months, which is closer to Puerto Rico’s elections.

Lastly, the opposition party has denounced the proposal, claiming that the economic damage for an increase in the SUT would be greater than the revenues collected and the current tax code is imperfectly enforced. They claim that poor enforcement of the current tax code only captures 56% of the actual sales in the economy. The opposition party has argued that much of the additional tax revenues needed to pay bonds can be collected through stricter enforcement.

With a loom bond payment and lack of political consensus, Puerto Rico will likely be forced into a rash and flawed tax plan. The ramification to an economy struggling with recession for over a decade could be dire.

Puerto Rico’s experience is a clear warning to other countries: if you wait until bond markets react for tax reform, you will be forced into a flawed choice. A wiser approach is to debate tax reform well ahead of market discipline. Hopefully, Puerto Rico's big brothers to the north will learn from their experience.


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