Phasing out tax exemptions for PR bonds plank solves economic growth

Yesterday, the governor of Puerto Rico announced that his government’s $72 billion of debts are not payable, in advance of $1.92 billion in debt service payments due on Wednesday. This announcement follows over a year and a half of uncertainty about Puerto Rico’s ability to meet its financial obligations, including a downgrade of its government bonds to junk status and discussions about the possibility of a partial government shutdown.

As waves of shock from the announcement ripple through bond markets and the news media, it is worth reflecting on the role that taxes played in creating the current crisis. The treatment of Puerto Rico in the United States federal tax code helped create the island’s current fiscal situation, and the failure of Puerto Rico’s government to reform its tax code exacerbated matters further.

Section 936 and Puerto Rico’s Nine-Year Recession

Throughout the modern economic history of Puerto Rico, one of the central drivers of its economic growth has been the United States tax code. For over eighty years, the federal government granted various tax incentives to U.S. corporations operating in Puerto Rico, in order to spur the industrialization of the island. Most recently, beginning in 1976, section 936 of the tax code granted U.S. corporations a tax exemption from income originating from U.S. territories.

In addition to section 936, the Puerto Rican corporate tax code gave significant incentives for U.S. corporations to locate subsidiaries on the island. Puerto Rican tax law allowed a subsidiary more the 80% owned by a foreign entity to deduct 100% of the dividends paid to its parent. As such, subsidiaries in Puerto Rico had no corporate income tax liability as long as their profits are distributed as dividends.

When section 936 was in effect, U.S. corporations benefited greatly from locating subsidiaries in Puerto Rico. Income generated by these subsidiaries could be paid to U.S. parents as dividends, which were not subject to U.S. corporate income tax under section 936, and were deductible from Puerto Rico’s corporate income tax.

Because of these generous tax incentives for business, Puerto Rico grew rapidly throughout the 20th century and developed a substantial manufacturing sector, though it remained relatively poor compared to the U.S. mainland. However, because section 936 made foreign investment in Puerto Rico artificially attractive – creating, in effect, an economic bubble – it left the island vulnerable to a crash if the tax provisions were ever to be repealed.

As it happened, section 936 became increasingly unpopular throughout the early 1990s, as many saw it as a way for large corporations to avoid taxes. Ultimately, in 1996, President Clinton signed legislation that phased out section 936 over a ten year period, leaving it to be fully repealed at the beginning of 2006. Without section 936, Puerto Rican subsidiaries of U.S. businesses were subject to the same worldwide corporate income tax as other foreign subsidiary.

Not coincidentally, 2006 also marked the beginning of a deep recession for Puerto Rico, which has lasted until today. Puerto Rico’s high corporate taxes on domestic corporations along with low taxes on U.S. subsidiaries had skewed the Puerto Rican economy toward foreign investment from the U.S. When section 936 was repealed in 2006, foreign investment began to flee. Without a strong domestic corporate presence to fill the void, the economy began to contract, along with tax revenues.

Since then, Puerto Rico’s economy has shrunk nearly every year, with unemployment at 12% and fewer than half of civilians in the labor force. Economists from the Federal Reserve and the private financial sector have pointed to the repeal of section 936 as a major cause of Puerto Rico’s current recession.

Puerto Rico’s nine-year recession drove government deficits up and played a central role in creating its present budgetary situation. Given that the repeal of section 936 helped cause the current recession, it too is implicated in Puerto Rico’s fiscal woes.

Triple Tax Exempt Bonds

In addition to subsidizing Puerto Rican business activity for eighty years, the U.S. federal government continues to subsidize Puerto Rico’s debt. When Congress established a civil government for Puerto Rico in 1917, it specified that:

All bonds issued by the Government of Puerto Rico, or by its authority, shall be exempt from taxation by the Government of the United States… or by any State, Territory, or possession, or by any county, municipality, or other municipal subdivision…

Because of this, the interest on bonds issued by Puerto Rico’s government is “triple tax-exempt”: it cannot be taxed by federal, state, or local governments. Because few municipal bonds are triple tax-exempt in every state, Puerto Rican bonds have always been unusually attractive investments. According to Morningstar, an investment research firm, over 180 municipal bond mutual funds hold more than 5% of their portfolios in Puerto Rican bonds.

Unfortunately, the favorable tax treatment of Puerto Rican bonds led investors to continue to buy up Puerto Rican debt even as the island’s finances began to look more and more unsustainable. Between 2000 and 2015, Puerto Rico’s debt rose from 63.2% of GNP to 100.2% of GNP. Now that Puerto Rico looks increasingly likely to restructure its obligations, news sources have pointed to the triple tax exempt status of Puerto Rican bonds as a factor that drove up the island’s debt.