GOP tax plan exacerbates Puerto Rico's economic turmoil

GOP tax plan exacerbates Puerto Rico's economic turmoil
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Hurricane Maria caused severe damage to the Puerto Rican economy. However, even more damaging to Puerto Rico could be the long-term output and employment losses associated with the federal tax reform that Congress is discussing. Why?

Thanks to industrialization, Puerto Rico passed from a very poor economy in the first half of the 20th century to a modern economy. During the heyday of Operation Bootstrap (1950s and 1960s), Puerto Rico was one of the world leaders in terms of economic growth.

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Many areas of this industrialization could have been done in a better way, but there is no question that thanks to that structural transformation, Puerto Rico was able to modernize.

 

In fact, the 1996 removal of federal tax incentives for manufacturing in Puerto Rico (Section 936 of the federal tax code) is probably the underlying factor that triggered the current economic depression and subsequent debt crisis.

By losing most of the labor-intensive factories, the economy collapsed, which in turn reduced government revenues that were compensated for with higher levels of borrowing.

After the deindustrialization that followed the removal of Section 936, Puerto Rico was able to keep a number of sophisticated manufacturing industries. Today, most of Puerto Rico manufacturing continues to be owned by U.S. holding companies.

The direct employment of this sector hovers around 70,000 jobs. Indirect and induced employment, jobs created by the expenditures of those 70,000 directly employed, are close to 120,000. Furthermore, more than 20 percent of the central government revenues come from U.S. manufacturing located on the island (either directly or indirectly).

In a nutshell, around 20 percent of the total employment and 20 percent of the central government revenues are generated by manufacturing; the sector that the federal tax reform will destroy if there are no amendments. How?

The tax reform that the House of Representatives approved includes a 20-percent tax on transactions between subsidiaries located in “foreign countries” and their holding companies in the U.S.

Puerto Rico is considered part of the U.S. for some concepts (for example, for the imposition of a fiscal control board), but not for taxes. Thus, U.S. subsidiaries located in Puerto Rico would have to pay the proposed excise tax, which will encourage them to leave the island. In economic jargon, Puerto Rico will lose its comparative advantage in high value-added manufacturing.

Will they move from Puerto Rico to the mainland U.S., as Congress seems to imply? Not likely. After the removal of Section 936, hardly any manufacturer moved from Puerto Rico to the U.S. Most likely, many subsidiaries will move to Asia, where they can hire educated labor at a lower salary and at the same time, negotiate with those countries to depreciate their currency as a way to counteract the effect of the 20-percent excise tax.

Congress does not care much about Puerto Rico because, among other reasons, there are no representatives from Puerto Rico voting in the federal assembly. However, the U.S. will feel the effects of exterminating the Puerto Rican economy (still reeling from the catastrophic effects of Hurricane Maria) in at least two ways: more poor migrants and lower ability of the Puerto Rican government to pay U.S. bondholders.

More poor migrants will flee the island and will increase federal expenditures in the U.S. in the form of Medicaid, Section 8, public education and Supplemental Nutritional Assistance Program, among others.

On the other hand, if the Puerto Rican government loses one of every five dollars in revenues, its ability to pay its debt will be even lower than today. Keep in mind that more than 85 percent of the total debt of Puerto Rico is in the hands of mainland residents.

Thus, if Republicans really want to make sure that their bondholders recover their investments, they should not destroy further the economy of Puerto Rico.

Let me also remind readers that a larger migration wave from Puerto Rico likely implies more Democrats going to Florida and Pennsylvania, two key swing states. Thus, for many reasons, the best interests of the Republican leaders are protected when they support growth in the battered economy of Puerto Rico. 

José G. Caraballo, Ph.D., is an assistant professor at the Business Administration College, a researcher at the Interdisciplinary Research Institute and director of the Census Information Center at the University of Puerto Rico at Cayey.