Saving Puerto Rico by reviving long-lost tax incentives

Saving Puerto Rico by reviving long-lost tax incentives
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It isn't just a hurricane that has crippled Puerto Rico's economy. The United States Congress, where Puerto Rico has no representation other than a single non-voting delegate, must take a major part of the responsibility for the island's current dire economic situation.     

The termination of a critical federal incentive more than 20 years ago left a gaping hole in the island's economic well-being resulting in a devastating downward spiral of lost jobs, lost income, lost population and lost dignity. 


In the late 1980s and early 1990s, Puerto Rico was regarded as one of the world's most attractive sites for manufacturing investments. Yet, less than a half a decade later that perception changed radically when the Congress in the mid 1990s took action ending a long-standing and remarkably effective tax incentive that had moved the island from its former “poorhouse of the Caribbean” status to “shining star of the Caribbean.” This was all part of the renowned “Operation Bootstrap” admired throughout the Western Hemisphere and the world.


The so-called Section 936 tax incentive, adopted by Congress in the mid-1970s and phased-out over a 10-year period between 1996 and 2005, had turned the impoverished former agricultural-based economy into a manufacturing-based economy — and the envy of struggling nations around the globe.

The federal incentive did not eliminate the island's endemic poverty, but it did create over 160,000 direct highly paid manufacturing jobs in industries ranging from textiles to electronics to pharmaceuticals. And, in addition, the presence of these industries, their suppliers and the purchasing power generated by their highly-compensated employees created an estimated 400,000 to 600,000 additional jobs throughout the island economy. The incentive stabilized the economy and encouraged residents to stay on the island rather than migrate to the U.S mainland.

What exactly was Section 936?

Simply stated, it was a credit against federal taxes owed. A mainland corporation, by meeting certain criteria, could establish a “possessions corporation” in Puerto Rico. The income generated by that corporation could be brought back to the mainland free of federal tax.

For example, the otherwise federal tax owed on active business income generated by the Puerto Rico corporation would be zeroed out by the application of a 100 percent tax credit when the profit was brought home. Passive income generated by the possessions corporations' deposits in Puerto Rico banks or in other qualified investments, such as “twin plants” in Caribbean Basin Initiative (CBI) countries were treated similarly.

The favorable tax treatment of both active and passive income by Section 936 were powerful incentives for U.S. corporations to not only create well-paying manufacturing jobs but also to retain a substantial portion of their earnings in Puerto Rico banking institutions and other qualified investments.

In fact, in the mid-1990s, 40 percent of the money deposited in Puerto Rico banks were Section 936 funds. Due to the tax-favored treatment of corporations' local banking deposits, the loan rates of the island's financial institutions were highly competitive stimulating much positive local consumer economic activity beyond the manufacturing sector.

So, what happened to this prized tax incentive?

In the early 1990s, a committee of the U.S. Senate undertook an investigation of pharmaceutical drug pricing — always a congressional target. Over the years numerous drug companies had responded to the possessions tax incentive by locating operations in Puerto Rico. The Senate study honed in on the fact that the “tax benefit per job” enjoyed by pharmaceuticals was “excessive,” amounting in some cases to as much as $70,000 per job.

This occasioned a political outcry that Section 936 was “corporate welfare,” not a popular complaint in those — or these — days of federal budget deficits.

It should be noted that, at the time, the federal government estimated the revenue “cost” of Section 936 at roughly $3.5 billion to $4 billion per year. This calculation was based on the static assumption that if the incentive were eliminated this amount would be annually “saved” by the federal government. Of course, this assumed that corporations that lost the federal incentive would take no action (such as re-locating or re-incorporating their operations) to avoid or minimize the imposition of federal taxes.

The Section 936 tax incentive was finally fully terminated in 2005 after a 10-year “grandfathering” of companies operating on the island in 1996 when Congress officially voted to end the incentive.

The end result: It is not known how much, if any, revenue the federal government “saved” from the repeal of Section 936. Most of the recipient companies either moved their operations off the island or re-incorporated them as so-called “controlled foreign corporations” deferring taxes and not contributing revenues to the federal Treasury.

What we do know is that Congress' unfortunate and precipitous action of outright repealing the Section 936 incentive rather than retaining it and making modifications to address its “excessive” benefits, undermined Puerto Rico's economic development plans exacerbating many of the other problems confronting the local commonwealth government. Not just jobs and income were lost but the island's population now has decreased by more than 500,000 residents leaving for a “better life” on the mainland.

Then Puerto Rico was hit by Hurricane Maria last September. The island has a very large population below the federal poverty level. It needs substantial food and medical assistance. It has major electrical grid and other energy problems, as well as fiscal challenges that have brought the island to the brink of bankruptcy. Yet, its people are proud and industrious. They especially take great pride in their U.S citizenship and their willing participation in the U.S. military. 

Congress has taken some steps to address Puerto Rico's many problems, but it needs to do much more. Providing ample hurricane relief and economic incentives at least equivalent to those of the former Section 936 would be major steps in the right direction.

Peter E. Holmes served for over 20 years with the Puerto Rico USA Foundation, a coalition of companies and financial institutions with operations in Puerto Rico.