To Understand the Purpose, Function and Desired Result of Federal Reforms and Disaster Recovery, It Is Important to Understand the Systemic Causes of Puerto Ricos Financial Distress

by James Spiotto

Puerto Ricos financial problems did not begin with the Great Recession of 2007

The systemic roots of Puerto Rico‘s financial problems go back to systemic issues which have their beginnings in the 20th century. These issues may not have had a severe impact taken individually, but they worked in tandem with each other over time to create the crisis of the 21st century.

  • Merchant Marine Act of 1920 – Puerto Rico’s import costs are at least double those of neighboring island countries due to this Act (a/k/a Jones Act), which encourages all goods transported by water to be carried by U.S. flagships and taxes those foreign flagships that carry cargo between the U.S. mainland and Puerto Rico.
  • Puerto Ricos constitutional changes loosen balanced budgets and debt limits – In 1952, Puerto Rico enacted a constitutional amendment allowing the government to balance budgets with non-revenue sources, such as federal aid. In 1961, it further amended its debt limit to a percentage of tax revenue from percentage of property value, which allowed the Puerto Rican government to borrow more if it increased tax rates.
  • Repeal of Section 936 IRC tax credits – In 1996, federal legislation sunsetted Section 936 benefits over a 10-year period effective 2006. Section 936 tax credits are attributed to encourage many capital-intensive businesses to chose to relocate to Puerto Rico, providing new jobs and accompanying economic benefits. Section 936 made the Puerto Rican economy vulnerable to its own repeal.
  • Unequal treatment under Medicare and Medicaid, SSI, EITC and CTC – Puerto Rico claimed to lose billions due to 50 years of unequal treatment of Puerto Rico under Medicaid and Medicare, 40 years of unequal treatment under Supplemental Security Income (“SSI”) and Earned Income Tax Credit (“EITC”) programs, and nearly 20 years of unequal treatment under the Child Tax Credit (“CTC”).

By 2006, because of the adverse effects of the repeal of Section 936, Jones Act, unequal treatment under Medicaid, Medicare, SSI, EITC, and CTC, Puerto Rico had a budget crisis and a short shutdown of government:

In hindsight, federal action would have been more helpful and less drastic if it or something similar was initiated in 2006, rather than ten years later. On May 1, 2006, with a lack of agreement on a budget, 45 government agencies including public schools closed, leaving 95,762 people temporarily unemployed.

Part of the Puerto Rico solution to the 2006 budget crisis was to borrow funds to help balance the budget – a fatal budgetary policy:

In 2006, Puerto Rico public debt was approximately $40 billion, with a public debt per capita of $10,666.66 and public debt as a percentage of GDP of 45.82%. Comparatively in 2015 (the eve of federal action through creation of the Puerto Rico Oversight, Management, and Economic Stability Act (PROMESA)) public debt had increased to $72 billion, with a public debt per capita of $20,727.38 (nearly double 2006) and public debt as a percentage of GDP of 69.83% (24 percentage points more than 2006). The average for state and local governments in U.S.A. is $5,663.88, one-fourth the debt per capita of Puerto Rico.

Public debt is not the cause of financial distress of a government; it is a symptom of a systemic problem.

Public debt is not the cause of financial distress of a government; it is a symptom of a systemic problem.

After 2006, Puerto Ricos financial situation took a steeper downward path into financial distress:
  • GNP declined since 2007 – 2016 by 14%, and employment in Puerto Rico fell by 250,000 to less than one million.
  • Unemployment rate in Puerto Rico was 12.1% in October 2016, with a 23% drop in persons employed since December 2006 (from 1,277,599 to 987,606).
  • Labor participation rate of Puerto Rico in 2016 was 40%, two-thirds the 63% level on the U.S. mainland.
  • Puerto Rico’s population declined by 10% in the last ten years, about 1% per year.
  • Poverty rate for Puerto Rico in 2015 was 45.1% of Puerto Rico residents, compared to the U.S. mainland average of 14.7%.
  • Puerto Rico’s Economic Activity Index (payroll employment, electric power generation, cement sale, and gasoline consumption) dropped from 160.4 in August of 2005 to 124.1 in August 2016.
There are systematic causes of Puerto Ricos financial distress separate and apart from the devastation caused by Hurricane Maria that PROMESA and any recovery plan must address:

Counter past economic downturn with economic stimulation and development – With the repeal of Section 936 and exit of corporate and individual taxpayers, with the accompanying loss of tax revenues, there has been no real replacement or long-term economic development strategy to expand business in Puerto Rico. Key to recovery is attracting new business to Puerto Rico, thereby providing new, good jobs for Puerto Rico’s population, and attracting a significant increase in population and taxpayers.

Correction of adverse federal policies that cost Puerto Rico billions such as the permanent repeal of the Jones Act, elimination of any inequalities in Medicare, Medicaid, SSI, EITC and CTC – Federal assistance in programs to develop new commerce and economic stimulation (such as encourage increased business activity and support of manufacturing opportunities, high tech, green tech, creation of new energy generation, and a strategy for short- and long-range economic development by Puerto Rico that its creditors can buy into).

Solving the tax collection problem through identification and implementation of new or increased tax sources along with increasing collection efficiency  – The exploration of new tax policies that would stimulate economic development, and new tax sources that do not adversely affect economic development efforts. Furthermore dealing with subterranean economy and deficiencies in tax collection methods are problems that can be solved or at least greatly reduced, which would bring in additional revenues even without adding new or higher taxes.

Reverse the stigma of financial distress by improving financial credibility in the capital markets – It would be counter-productive to have the result of any recovery plan be less access to markets, and increased borrowing cost for Puerto Rico. Accordingly, steps should be taken to assure that the recovery plan will increase market access and lower the cost of borrowing, both short-term and long-term. This can be done by following established best practices of governmental accounting, administrative budgeting, and financing.

Treatment of outstanding public debt by PROMESA process must be perceived by the market as fair – As a result of the widespread devastation of the island caused by Hurricane Maria, holders of the public debt of the Commonwealth and other related issuers are faced with an inability to pay situation. While federal assistance to the island will be forthcoming, it is unlikely that this assistance will take the form of a bailout of outstanding public debt. Some members of Congress, while rejecting any notion that such debt will be cancelled by executive order, have suggested that the PROMESA process, to be discussed in detail later in this series, should be allowed to play out for such debt, but that revenues to debtholders would be reduced from those proposed by the fiscal plan. It will be important that the ultimate resolution of the outstanding public debt be perceived as fair to all parties, including the citizens of Puerto Rico, and not arbitrary under the circumstances.

Proposed further response to Hurricane Maria to address the need to rebuild Puerto Rico’s infrastructure and stimulate its economy:

First stop human suffering and develop a Marshall-type plan for Puerto Rico’s governmental services and infrastructure – The first immediate action is to assure the health, safety and welfare of the citizens of Puerto Rico with food, water, medical services, governmental service and infrastructure, all to a level deemed acceptable. This is a Marshall-type plan for Puerto Rico for services and infrastructure (roads, water, sewer, electricity, etc.) at a level that citizens find will justify wanting to remain there,  can attract new citizens and businesses that want to be there, and to expand current businesses in Puerto Rico. This will create new, good jobs that produce additional tax revenues needed for a long-term recovery.

Develop a long-range economic development strategy as part of a Puerto Rico recovery plan to elevate Puerto Rico’s business opportunities and roles in the Caribbean – There should be a long-range economic recovery plan for Puerto Rico which is implemented at the same time or in coordination with the Marshall-type plan, that establishes viable and desirable services and infrastructure at the appropriate level, as noted above. This economic development plan should provide assured liquidity for continued uninterrupted governmental operations and any necessary bridge financing, in coordination with the implementation of the “Marshall-type plan.”

  • Puerto Rico as the center of commerce to the Caribbean. The economic recovery plan should consider making Puerto Rico (which means ‘Rich Port’) the key point of commerce for the Caribbean.

Numerous islands have been affected by the hurricanes in the Caribbean and Puerto Rico could be the port and the location where all relief and all commercial activity is focused as the staging and coordinating center. This allows a coordinated effort, and allows Puerto Rico to be elevated to a key economic regional power in the Caribbean.

  • Puerto Rico as the banking hub for the Caribbean. Part of this would include establishing Puerto Rico as the center of commerce for the Caribbean for banking, shipping ,and processing assembly of goods from foreign manufacturers for distribution in the Caribbean, and possibly Central American and other locations.

Also, legislation by Congress and the Commonwealth could provide for financial banking services to be the U.S.A. equivalent of the Cayman Islands, for specialty financings and investment vehicles. This would facilitate Puerto Rico become the banking center for the Caribbean, much in the same way as London has been for Europe.

Puerto Rico as the major foreign trade zone for the Caribbean. Also, as part of the economic recovery plan, the whole island of Puerto Rico should become a foreign trade zone (a free trade zone) where equipment, goods and parts manufactured in foreign countries can be shipped to Puerto Rico duty-free and processed, assembled or manufactured with only limited duties on the finished product. Such actions would stimulate additional business activity, and the benefits of the jobs multiply for new financial, shipping and manufacturing jobs [direct (the new jobs created by the economic policy), indirect (jobs created for goods and services to support direct jobs) and induced (jobs created by salaries spent for goods and services by those with the direct and indirect jobs)]. This would significantly increase employment and the labor participation rate and reduce the poverty rate.

Congress can enact or adjust laws, rules and regulations to promote a Puerto Rico recovery plan, the island’s economic development, and to remedy those that purport to treat Puerto Rico unfairly:
  • Congress has the constitutionally mandated duty to promote economic development for Puerto Rico. The Territorial Clause of the U.S. Constitution provides “Congress shall have power to dispose of and make all needful rules and regulations respecting the territory or other property belonging to the United States.” (U.S. Constitution, Article IV, Section 3).
  • Actions Puerto Rico and Congress should consider taking. Based on this duty and present circumstances, Congress should examine existing legislation that could be modified to assist Puerto Rico in its effort to resolve its financial and infrastructure crisis. The Jones Act that requires foreign flag vessels that stop in the U.S.A. continental ports and Puerto Rico to pay a tariff increasing the cost of goods for Puerto Rico should be repealed in Puerto Rico’s case permanently. The Commonwealth and others have pointed out a needed review of federal laws, rules, regulations, and policy to ensure appropriate fairness compared to the treatment of states and others. Puerto Rico contends it has lost billions of dollars due to unequal treatment compared to U.S. States under Medicaid, Medicaid, and other federal programs. The lack of stimulus for economic and business development in Puerto Rico following the repeal of Section 936 tax exemption for U.S. companies, the claimed disproportionate burden of Medicaid and social programs, the need for effective tax reform, and efficient collection methods suggest the consideration of review and, where needed, modification of existing laws that have impeded Puerto Rico’s economy.
The path forward for Puerto Rico, its citizens, businesses and creditors:
  • The need for consensus by all the parties. Citizens, taxpayers, business interests, and creditors of Puerto Rico should support the above proposal for economic recovery, since it is the economic growth and success of Puerto Rico that is the means by which additional tax revenues will be raised, providing the funds to pay debt and other obligations, and to fund governmental services and infrastructure at acceptable levels.
  • Recovery plan for all – leave no one behind. There is no substitute for the practical ability to be paid from a recovery plan that maximizes value and recovery to the extent reasonable, and reinvests in Puerto Rico to ensure continual operations and sufficient tax revenues to pay off its creditors based on what can be paid. If there is no money, there is no payment no matter the rights or priorities. All the rights legally possible do not necessarily translate into payment of public debt or assurance of funding of essential services and needed infrastructure if an entire tax-base, i.e. U.S. citizens, are left with nothing to rebuild and no opportunity to recover.

Next:   The Enactment of PROMESA and Its Provisions