Puerto Rico Needs a Growth Agenda Too
June 8, 2016
The House of Representatives is about to consider the Puerto Rico Oversight, Management, and Economic Stability Act (the Act). The Act will set up an Oversight Board to help deal with the current financial crisis on the island. The proximate cause of the crisis is the pending default on the island’s heavy debt load, run up in a decade-long burst of spending beyond the island’s means. The bill may deal with the short term budget excesses, and help to trim spending and unwind the debt.
However, the more fundamental problem facing the island is an ongoing lack of economic growth, inadequate capital formation, and a flight of population to the mainland. Federal tax and regulatory barriers contribute to the problem. The bill does not adequately address these issues.
The U.S. used to offer its possessions favorable tax treatment to encourage economic growth and job creation. No longer. The Revenue Act of 1921 largely exempted possession-sourced income from federal tax. Section 936 was added to the code in the Tax Reform Act of 1976 to revise the taxation of income in U.S. possessions. According to the Senate Finance Committee report on the 1976 Act, the purpose of the provision was to “assist the U.S. possessions in obtaining employment producing investments by U.S. corporations.”
Section 936 continued the practice of making business income from the possessions largely exempt from federal income tax, but listed certain conditions. A U.S. firm would receive a tax credit on dividends received from its possessions subsidiary (repatriated earnings) equal to the U.S. tax otherwise due if the firm had, over the three years prior to the tax year, derived 80% of its income from the possession and at least 75% of the income was from a trade or active business. According to the GAO, from 1983 to 1993, about 99% of the affected income was from Puerto Rico.[i]
The U.S. pharmaceutical industry in particular made use of the provision, creating tens of thousands of jobs on the island either directly, or through local suppliers, and by boosting island incomes and consumption. The pharmaceutical industry based intellectual property on the island, as well as manufacturing operations, in what could be described as an early version of the modern “patent box” concept.
The Tax Reform Act of 1996 phased out section 936 over ten years, ending it completely in 2006, and with it went the dividend deduction. This made Puerto Rican subsidiaries of U.S. businesses subject to the same world-wide U.S. corporate income tax as other offshore subsidiaries of U.S. businesses. It ended the island’s favored tax status relative to any other global location. In 2006, Puerto Rico began an economic decline that continues to this day.
At present, Puerto Rico and the other possessions are treated like a foreign country for the purpose of corporate income taxes, but are treated like a state under the minimum wage, safety, health, and environmental regulations. Both treatments hurt the development of the possessions.
The United States taxes the worldwide income of U.S. businesses when it is brought back to the country. The income is tax deferred as long as it remains abroad. Business income from Puerto Rico and the other possessions enjoys the same deferral of tax as income from other countries, but, like income from other countries, it face a topping up of the tax to U.S. levels when the earnings are sent back to the U.S. parent. This discourages U.S. investment in the possessions.
Production costs in the possessions are boosted by U.S. regulations. Puerto Rico and the other possessions (and Hawaii, and Alaska) also suffer relatively severely from being subject to the Jones Act, which mandates the use of high cost U.S. shipping companies between U.S. ports. Given their island natures and/or distant locations, this makes their exports to the rest of the country more expensive and less competitive with products of other nations, particularly versus nations with free trade agreements with the U.S. Puerto Rico, in particular, must compete with beneficiaries of the Caribbean Basin Initiative and CAFTA.[ii] The high shipping fees also raises the cost of imports from the lower forty-eight, increasing the possessions’ cost of living, and favoring imports from non-U.S. sources. The bill gives no relief from the Jones Act.
Another source of difficulty is the imposition of federal economic and environmental regulations and mandates that Puerto Rico and the other possessions cannot afford.[iii] For example, there is simply not enough capital on the islands to raise labor productivity to justify the payment of the federal minimum wage. The federal minimum wage prices a large portion of the Puerto Rican labor force out of the market. One result is an April 2016 unemployment rate of 11.7%, more than double that on the mainland. Another result is migration of people from Puerto Rico to the mainland. If capital and jobs cannot come to the people, people must go to the capital and the jobs.
The House bill being considered allows the island some latitude in creating a sub-minimum wage for youth employment for the next four years. It would enable a $4.25 minimum wage for those under age 25, for employees initially employed after the date of enactment.[iv] This is a small step in the right direction, but it is temporary, and will not deal with adult unemployment due to lack of training and capital investment in the island.
None of this is to excuse problems with the Puerto Rico tax system. See the Tax Foundation blog by Scott Greenberg and Gavin Ekins, “Tax Policy Helped Create Puerto Rico’s Fiscal Crisis” at https://taxfoundation.org/blog/tax-policy-helped-create-puerto-rico-s-fiscal-crisis.
Puerto Rico imposes a corporate tax that is crudely equal to the combined federal and average U.S. state rate. It rises in stages with business income from 20% to 25% to 35%, and then point by point to 39%. Repatriated earnings to the United States would face taxes about as high, before foreign tax credits and the deductibility of state taxes. To levy less would simply hand income over the U.S. Treasury, with no added incentive to invest on the island.
Unfortunately, the high tax rates discourage the growth of indigenous businesses and investment from non-U.S. sources. Therefore, Puerto Rico can, and does, encourage firms to locate on the island by offering sharply reduced tax rates via special tax covenants. These can attract U.S. firms to the extent that the firms can defer the add-on U.S. tax until they repatriate the profits to the U.S. Such tax covenants can be of more benefit to indigenous Puerto Rican firms, and to non-U.S. investors whose home countries have territorial tax systems, and do not tax earnings of their firms’ Puerto Rico subsidiaries. Those subsidiaries could send money home at any time without penalty. However, foreign companies may prefer to produce in other jurisdictions not subject to U.S. minimum wages and environmental rules. Unfortunately, the tax covenants result in a low tax base with high rates for non-favored activities. Puerto Rico would do better to rely on a broad-based consumption tax, but a proposal to that effect was recently rejected.
In summation, some relief from the minimum wage and environmental regulations would help Puerto Rico and the other possessions attract capital from the U.S. and from other countries. The islands would also be better able to attract U.S. capital if the United States were to adopt a territorial tax system, ideally vis-à-vis the whole world, but if not, at least for its possessions on an experimental basis. Barring that, Congress should consider some form of reconstituted Section 936 relief for investment in the possessions.
[i] “Tax Policy, Puerto Rico and the Section 936 Tax Credit,” GGD-93-109, United States General Accounting Office, June 1993.
[ii] Central American Free Trade Agreement.
[iii] Indeed, they impose trillions of dollars in economic costs on the rest of the country too.
[iv] “Initially employed after the date of enactment” is meant to prevent a firm from reducing wages of those currently employed. It would also forestall a firm’s laying off its young employees and then rehiring the same people to qualify them for the minimum wage. But perhaps a Burger King and McDonalds operating across the street from each other could swap staffs instead?