Taxes

Puerto Rico's Economic Disaster Was Made in Washington

A tax break for U.S. corporations was meant to help the island. It may have done the opposite.

Head winds.

Photographer: Derick E. Hingle/Bloomberg

Before it was devastated by Hurricane Maria, Puerto Rico was already in lots of economic trouble. In recent discussions of the territory's woes, mismanagement by its political leaders and intransigence from its creditors have gotten most of the blame.

QuickTake Puerto Rico's Debt

But there is one decision in particular that seems to have been the tipping point for the island's economy, plunging it into a depression that is now in its 12th year -- and that decision was made in Washington in 1996. That's when the Republican Congress overwhelmingly approved and Democratic President Bill Clinton signed legislation repealing a long-standing exemption from corporate taxes for U.S. companies' operations in Puerto Rico. 1 The repeal went into full effect on Jan. 1, 2006. Look what happened after that: 2

Puerto Rico's Rise and Fall

Employment in Puerto Rico*

Sources: Puerto Rico Departamento del Trabajo y Recursos Humanos, U.S. Bureau of Labor Statistics

* From household survey. 2017 number is for August.

Of course, one could argue that what really threw Puerto Rico's economy out of whack were the various acts of Congress that created the tax exemption in the first place. There were certainly lots of strong arguments made in the early 1990s for getting rid of it. In any case, though, it's impossible to understand Puerto Rico's plight without understanding how it was shaped by a tax-policy experiment gone awry. And while this story has been told before, the attention focused on the island by a terrible hurricane and a presidential visit (and the offhand presidential comment that its debts should be wiped out) means this is probably a good time to tell it again.

According to a General Accounting Office 3 report from 1993, Puerto Rico's special status began with the passage by Congress of the Revenue Act of 1921, which in a shift apparently aimed mainly at improving the competitive position of American companies in the Philippines exempted most U.S. corporations operating in U.S. possessions from U.S. income taxes. After the first experiments with industrialization in Puerto Rico during World War II, the island's legislature in 1948 passed a law exempting U.S. corporations from most Puerto Rican taxes as well. And in 1976 the U.S. Congress firmed things up even more with a new Section 936 of the Internal Revenue Code explicitly intended to "assist U.S. possessions in obtaining employment producing investments by U.S. corporations.” 4

This approach bears some resemblance to the low-tax, low-regulation "enterprise zones" later espoused by U.S. Representative Jack Kemp, and supply-side economics guru and Kemp mentor Arthur Laffer actually was an adviser to a Puerto Rican governor elected in 1976 on a promise of tax cuts. But there's no indication that either man was involved significantly in the congressional actions of 1976. It was just a bipartisan effort to help out a relatively impoverished part of the country.

The tax exemption applied to other U.S. territories as well, but it was corporations operating in Puerto Rico that garnered 99 percent of the benefits -- which added up to an estimated $2.6 billion in tax savings in 1989, according to the GAO. The law also allowed U.S. corporations to transfer patents and other intangible assets to their Puerto Rican subsidiaries and avoid U.S. income taxes on their use. This provision was tightened up a bit in the 1980s, but Puerto Rico remained an especially attractive place for for patent-heavy corporations -- such as the makers of pharmaceuticals and computers -- to locate manufacturing operations. (Even now, pharmaceuticals and medicines account for 72.4 percent of Puerto Rico's exports.)

As is clear from the above chart, these tax advantages coincided with decades of employment growth in Puerto Rico. Incomes rose, too. That job growth was actually slower than in the rest of the U.S., though, and Puerto Ricans continued to migrate to the U.S. mainland in search of better opportunities. Giving advantages to big U.S. corporations operating in Puerto Rico also may have had a dampening effect on local entrepreneurship. Finally, though, what sank the tax exemption seems to have been the deficit obsession of the early-to-mid-1990s. Corporations were avoiding billions of dollars a year in taxes, and that had to be stopped. So Congress stopped it, with a 10-year phase-in period.

Here's what then happened to employment in the Puerto Rican chemical (which is overwhelmingly pharma-oriented) 5 and computer industries:

Goodbye, Pharma and Computers

Payroll employment, Puerto Rico

Source: U.S. Bureau of Labor Statistics

*Close to 90 percent pharmaceutical and medicine manufacturing

The jobs that disappeared here were good jobs, by Puerto Rican standards, with both industries paying much-higher-than-the-island-average wages. In the case of computer and electronics manufacturing, some of the decline was inevitable, as employment has fallen in the industry nationwide. In pharma, where the U.S. employment total is now near its all-time high, there's much clearer evidence of a Puerto Rico effect.

There's also evidence of an Ireland effect. That's another island known for its low corporate tax rates, favorable treatment of intangible assets and, in recent years, pharmaceutical manufacturers. It's also a sovereign nation, albeit one that's part of the European Union. So while its tax advantages have come under some fire recently from European authorities, they remain mostly intact. And whaddya know -- look what's happened to pharmaceutical imports from Ireland to the U.S.!

Pharma Moves to Ireland

U.S. pharmaceutical imports from Ireland

Source: U.S. Census Bureau

Puerto Rico does have more autonomy on taxes than U.S. states -- its residents aren't subject to the federal income tax unless they work for the federal government, while the money U.S. corporations earn there is treated by the Internal Revenue Service as foreign earnings that aren't taxed until they are repatriated to the mainland. So there remain tax advantages to locating in the territory, and they would probably have more impact if Puerto Rico's own tax code hadn't become such a mishmash of high rates and special exemptions. 6 Other dampers on the business climate include inefficient, debt-overloaded public-sector corporations that provide key services such as electricity, and a big underground economy that narrows the tax base. Bad management and policy choices by Puerto Rican elected officials are part of the story here. But they've been made in the context of huge, economy-skewing policy choices made in Washington. 7

I'll have to admit that I'm not quite sure what the lesson of all this is. Giving U.S. corporations operating in Puerto Rico a tax break was an attempt by Washington politicians to help out the island's economy, and taking that tax break away was an attempt to close what appeared to have become an expensive loophole. Both decisions seem reasonable, on the face of it, but both came with lots of unintended consequences. And while it now seems reasonable -- even morally necessary -- that Washington take bold steps to get Puerto Rico back on its feet, there will clearly be unintended consequences to that, too. 

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

  1. It was technically a tax credit, but I don't think that's worth going into.

  2. The Bureau of Labor Statistics has numbers on total employment in Puerto Rico going back to 1976 that are similar to but not exactly the same as the pre-2011 numbers in the chart. This is because I chose to use data from two Puerto Rican reports that, while somewhat outdated, provide a nice breakdown of agricultural versus nonagricultural employment.

  3. Congress changed the GAO's name in 2004 to Government Accountability Office, which I guess is more accurate but has always struck me as a little pretentious.

  4. That's from a 1976 Senate Finance Committee report cited by the GAO.

  5. How do I know this? The monthly payroll jobs data for Puerto Rico from the Bureau of Labor Statistics doesn't break things down any further than chemical manufacturing, but the Quarterly Census of Employment and Wages does, and shows that of the 16,900 chemical manufacturing workers in the state in March, 14,566 were employed in pharmaceutical and medicine manufacturing.

  6. For example, in 2012 Puerto Rico's legislature passed an "Act to Promote the Relocation of Investors to Puerto Rico" that exempts passive income from local taxation and was supposed to bring a flood of billionaires to the island. As Bloomberg's Katherine Burton reports today, that isn't working out so well.

  7. And I'm not even getting into the Jones Act here.

To contact the author of this story:
Justin Fox at justinfox@bloomberg.net

To contact the editor responsible for this story:
Brooke Sample at bsample1@bloomberg.net

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