A federal fiscal control board: The best option for Puerto Rico

By Gustavo Velez

THE HILL

The HillTwo months before the end of 2015, all of economic indicators showcased a spiraled fiscal and economic crisis. The contraction cycle that began in May 2006 and which has extended through 2015, has affected the macroeconomic stability and business environment as never before in Puerto Rico’s recent history.

The fiscal policies based on new tax measures, such as the Gross Receipt Tax or the business tax, the crude oil tax, and most recently a hike in the sales and use tax (SUT) from a 7 percent to an 11.5 percent, will weaken the fragile process of an economic recuperation, briefly felt in 2011 and 2012. In addition, the completion of ARRA funds assigned to the island, and the tax reform changes implemented by former Governor Luis Fortuño contributed to the economic stabilization process. The credit downgrade to junk status on February 4, 2014, and the events that followed have hampered any possibility of an economic recovery.

Puerto Rico is currently struggling with its worst economic and fiscal crisis since 1933, when the agricultural economy crumbled during the Great Depression. It is clear that the U.S. territory, faces a structural economic problem associated with the repeal of Section 936 of the Internal Revenue Code in 1996. For almost a five decades, Puerto Rico was the most profitable destination for manufacturing corporations that benefited from federal tax breaks.
Federal tax breaks and local incentives combined with cheap labor and free access to the U.S. market, facilitated the island’s “economic miracle”. Nevertheless, the economic take off was backed by direct foreign investment from the mainland U.S., and minimal participation from local capital. By design, the commonwealth’s economic development process was tied to capital inflows from abroad and highly dependent on external trade.

The repeal of Section 936 finalized the tax regime that benefited mainland corporations with operations in the island. The backbone of Puerto Rico’s economic model was eliminated and this action is partially responsible for the current economic and fiscal crisis. Though hundreds of manufacturing facilities left the island and relocated in other cheaper destinations such as the Dominican Republic and Mexico, other capital intensive manufacturing operations decided to stay in Puerto Rico under Section 901 of the IRC as Controlled Foreign Corporations.

The local economy was able to retain pharmaceutical and medical devices manufacturing facilities, in which Puerto Rico is still relatively competitive. However, since the elimination of Section 936 by U.S. Congress, neither the major political forces nor the private sector have been able to develop a new economic plan. Instead, the New Progressive Party and Popular Democratic Party have been implementing short term fiscal policies such as tax increases and issuing more public debt trying in an attempt to balance the budget.

These policies have in turn shaped a downward spiral creating a further economic recession. Since 2006 to the present, the government collected $12 billion as result of new taxes. Such as the 7 percent sales and use tax (SUT) in 2006, the tax on foreign corporations (2010) and more than a dozen of new taxes imposed by the current administration.

Since 2001, Puerto Rico had experienced three consecutive one term administrations, therefore the commonwealth’s economy lacks a long term plan required to reactivate the economy. It is clear that the major political parties are reluctant to agree and sustain public policies needed to achieve economic growth. During the 2001 – 2015 period, all the strategies implemented where short term oriented, based on new taxes a public debt.

Moreover, the local political parties have ignored the complexity of the economic problems and are reluctant to implement the structural reforms required. Politicians from both parties know that all the reforms to attend the fiscal and economic crisis would have social, economic and political costs. In fact, it would take at least a decade to implement the structural reforms to expect some positive outcomes.

The Popular Democratic Party and the New Progressive Party have shown total incapacity to achieve a political consensus required to implement a long term economic and fiscal plan.

Despite the crisis that is seriously affecting the quality of life of all Puerto Ricans, local politicians are completely indifferent and the political struggle still focuses in the island’s political status. Even after García Padilla’s announcement that the debt is not payable (June 29th 2015, New York Times), the local political leadership has not agreed on any proposal to work together as a civilized country. Under this conditions, the proposed fiscal plan that the García Padilla administration is currently developing is doomed to fail, if the governor is not re-elected in 2016.

Meanwhile, thousands of frustrated Puerto Ricans (mainly well-educated professionals) are leaving to the mainland U.S. looking for a better way of living away from a political and economic dysfunctional island. The massive emigration of professionals and the deterioration of the economy is creating a dangerous situation that could damage Puerto Rico’s long term feasibility.

U.S. Congress should consider the costs of the commonwealth possible economic and fiscal melt down. What would be the costs of a bailout of the financial system? Has Congress considered the impact of massive defaults on U.S. funds and mainland retirees that invested in Puerto Rico bonds? Puerto Rico already receives $17 billion in transfer payments. Has the U.S. Treasury Department considered the costs of increasing welfare and other aids to the island?

Has any other federal government agency considered the potential costs of more drug trafficking using Puerto Rico as gateway due to the current social deterioration? Puerto Ricans are U.S. citizens and there are 4 million Puerto Ricans in the mainland U.S. Has any Congressional committee analyzed the impact of a massive emigration to Florida and other east coast states?

We do believe that under the current circumstances a Fiscal Control Board is the best option for Puerto Rico. The lack of political commitment from local politicians to do what is correct for the island does not leave many options to attend the fiscal crisis. U.S. Congress needs to exercise its legal powers over the commonwealth to implement the fiscal and economic reforms that the majority of the U.S. citizens in Puerto Rico demand.

Velez is an economist based in Puerto Rico.

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