The narrow streets of Vega Baja, Puerto Rico, are a world away from Washington. But Mayor Luis Menendez knows that politicians inside the Beltway hold his town's future in their hands. Among the issues at stake in President Clinton's economic plan is the multibillion-dollar tax break that has enticed a panoply of U. S. companies to towns across Puerto Rico. Some 3,500 residents of Vega Baja work for General Electric, Warner-Lambert, Motorola, and Schering-Plough. If Congress makes severe changes in the tax benefit, the workers could lose their jobs. "It will be agony," warns Menendez.

That concern washes clear across the 100-mile-long island. The House in late May voted to phase out the tax break known as Section 936 of the Internal Revenue Code, which allows U. S. corporations to escape federal corporate taxes on products made in Puerto Rico. The substitute: a 60% wage credit, or a tax exemption equal to 60% of wages paid. But that, executives warn, won't allow high enough returns to justify staying in Puerto Rico. Factories there could be shut down in favor of such low-tax locales as Ireland or Singapore, jeopardizing many of Puerto Rico's 152,000 manufacturing jobs. And the companies will withdraw much of their estimated $14 billion in deposits in Puerto Rico's thriving banks. "The U. S. doesn't understand that 936 is the backbone of the Puerto Rican economy," says Daniel Lebron, president of the Puerto Rico Manufacturers Assn. and general manager at G. D. Searle & Co.

Despite the hit it will deliver to the island's $34 billion economy, a change in Section 936 is inevitable. The Senate Finance Committee will take up the issue as it considers Clinton's overall budget. The Administration sees a chance to plug a large loophole and raise a projected $7.3 billion over five years. Senator David H. Pryor (D-Ark.) and other politicians view changing 936 as a way to get at what they see as excess profits for pharmaceutical companies, which enjoy more than half the benefits. And U. S. unions want Congress to gut the tax break they say encourages nonunion "runaway" shops.

NEW PARTNERS. All this adds up to the beginning of the end of a policy of paternalism. That's forcing Puerto Rico to examine how best to survive with fewer Washington handouts--and also whether to stick to its current commonwealth status or push for statehood.

It isn't just the tax fight that's causing the sudden introspection. As the U. S. and Mexico draw nearer to a North American Free Trade Agreement, the potential of a powerful new southern partner threatens to disrupt traditional trade and investment flows between the U. S. and the Caribbean. In short, Puerto Rico must rethink its entire economic formula.

Many Puerto Rican leaders insist only a slow reduction of U. S. tax breaks will prevent steep unemployment and mass migration. While 936 is being phased out, pro-statehood Governor Pedro J. Rossello is pushing a plan to develop sectors of Puerto Rico's economy that are not dependent on 936, including paring bloated government payrolls and boosting tourism from 6% to 12% of gross domestic product. Another pillar: privatizing state-owned companies.

Forging a new economic model will be tough because Puerto Rico's wages, while still below those of the mainland, are high compared with its Caribbean neighbors'. Even with a 60% wage credit, labor costs in the apparel industry, for example, would be the highest in the region. Says Antonio J. Colorado, former Economic Development Authority chief: "The future of Puerto Rico has to be in high tech. All our costs are higher."

Overall, manufacturing today accounts for 40% of the island's gross domestic product. Puerto Rico also has a sizable banking and finance industry to service 936 companies, since interest earned on profits invested in financial instruments in Puerto Rico also is exempt from federal taxes. In all, some 390 U. S. companies have Puerto Rican operations under 936, accounting for 11% of the island's total employment--not including jobs created indirectly.

But per capita income, while high by Caribbean standards at $6,360, still is less than half of that in Mississippi, the poorest U. S. state. About 60% of the island's 3.5 million residents live below the U. S. poverty line. Unemployment is 18%.

"LOUSY VEHICLE." These sad statistics fuel both sides of the 936 argument. Backers of the tax break point out that the bulk of manufacturing jobs on the island is with 936 companies. But Luis P. Costas, a lawyer who has written widely on the subject, says "936 is a lousy promotion vehicle for investment. It's not tied to real employment or investment--it's tied to profits."

And it is costly. The General Accounting Office estimates that the U. S. gave up $2.3 billion in taxes from corporations in Puerto Rico in 1987 alone. Drug companies got the biggest break: It cost the Treasury $70,000 to create each job, which pays an average of $26,000 annually.

If a shift away from 936 isn't handled delicately, efforts to nurture indigenous business could also be set back. MOVA Pharmaceutical Corp., the island's only locally owned drug company, does about 70% of its manufacturing for two U. S. pharmaceuticals, and 30% is in generic drugs. The $30 million company had planned a $5 million expansion this year, but Joaquin B. Viso--who was president of SmithKline Beecham PLC's Puerto Rican unit and left to found MOVA--remains cautious. Now he will invest only $1.5 million to upgrade pollution-control equipment. "Unless what is done is thought through carefully, it will hurt not only 936 but local suppliers and contractors," says Viso. The U. S. may want Puerto Rico to stand on its own two feet, but yanking away 936 without helping to plot a future course could end up deepening the island's dependence.

      Top 10 U.S. companies manufacturing in Puerto Rico under Section 936
      Company              Number of      Major products
      BAXTER INTL.           5,547      Pharmaceutical
      SARA LEE               5,037      Underwear, hosiery
      GENERAL ELECTRIC       3,555      Electric components
      H.J. HEINZ             3,550      Processed tuna
      JOHNSON & JOHNSON      3,354      Health care
      WESTINGHOUSE ELECTRIC  3,281      Electric components
      ABBOTT LABORATORIES    2,633      Pharmaceutical
      BRISTOL-MYERS SQUIBB   2,163      Pharmaceutical
      WARNER-LAMBERT         1,649      Pharmaceutical
      UNITED STATES SURGICAL 1,594      Surgical/medical
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