By Dr. Pierre Canac—This is a two-part blog; the second part will appear next week. I usually write about international economics; however, this time I will let the reader decide whether this is what I am doing in this post.
The Status of Puerto Rico
Puerto Rico is a Commonwealth or a territory that belongs to the U.S. (since the end of the Spanish American war in 1898) but is not part of the U.S. Being a U.S. territory, it is neither a U.S. state nor an independent country but something more like a colony of the U.S. Although the 3.5 million people who live on the island (versus about 5 million Puerto Ricans living on the mainland U.S.) have their own distinct identity (they speak Spanish although English is one of the official languages of the island since 1993), they are U.S. citizens (since 1917) and as such hold a U.S. passport and can serve in the U.S. military. However, Puerto Rico is only represented by a non-voting commissioner in the House of Representatives (currently Pedro Pierluisi) and has no representation in the Senate.
Moreover, since Puerto Rico is not represented in the Electoral College, Puerto Ricans who reside on the island, even though they are U.S. citizens, cannot vote in U.S. presidential elections (while those who have immigrated to the U.S. mainland can vote). The island residents do not pay federal income taxes, unlike U.S. states residents, but pay Medicare taxes although the Medicaid benefits they receive are capped. They are also not eligible to claim the Earned Income Tax Credit (EITC), a program that is fairly effective at reducing poverty on the mainland U.S. The U.S. dollar is the only currency used on the island.
Why is Puerto Rico in the News?
Today Puerto Rico is facing some severe financial difficulties as it is unable to service its $72 billion debt (70% of its GDP); this debt is owed by three main entities: the Puerto Rican central government, headed by Governor Alejandro Garcia Padilla, its public corporations (utilities), and its cities. What makes the Puerto Rican case interesting is the fact that, unlike Greece, its debt is owed by U.S. citizens to other U.S. citizens and not to foreigners; unfortunately for Puerto Rico, its status is not the same as Detroit, whose debt was $18 billion when it defaulted. Although on the U.S. mainland states cannot declare bankruptcy, entities within a state (cities, judicial districts, and public corporations) can. This is not the case in Puerto Rico, where no entity can declare chapter 9 bankruptcy making it impossible to restructure its debt (or give it a “haircut”). Only an action of Congress can change that, as prescribed by the territorial clause of the U.S. constitution.
The Source of the Financial Crisis
Why did Puerto Rico’s financial conditions deteriorate to the point that the territory is not able to service its debt? We really need to go back to the mid-twentieth century, if not earlier, to really make sense of current Puerto Rican economic conditions. As a start, Puerto Rico must follow the same labor standard and since 1974 must have the same federal minimum wage as the U.S. mainland ($7.25 per hour) even though its mean per capita income is about half that of the poorest U.S. state. This has made it very hard for Puerto Rico to compete and to attract investment from the mainland as U.S. firms find it more profitable to invest in developing countries instead. In order to help Puerto Rico, the U.S. authorities decided in 1976 to give tax breaks to U.S. firms that invest on the island. Those tax breaks made it possible for Puerto Rico to have for example a pharmaceutical industry.
However in 1996, President Bill Clinton negotiated a deal with the then speaker of the House, Newt Gingrich, to raise the federal U.S. minimum wage in exchange for a $7 billion tax credit to small business firms. In order to pay for this small business tax credit, Congress phased out over a ten-year period (1996-2006) the tax breaks that benefited U.S. firms that had invested on the island. As a result, the industries that had moved to the Caribbean island to take advantage of those tax breaks had all relocated by 2006 to tax friendlier locations such as the Cayman Islands.
This caused Puerto Rico to suffer a severe recession which got worse two years later when the so-called 2008 Great Recession (GR) spread to the island. Although the U.S. recovered from the GR fairly quickly, Puerto Rico’s economy is still depressed today. Only 40% of its population is employed (compared to 63% on the U.S. mainland). The unemployment rate in 2015 was 12.5% (versus 5% on the U.S. mainland) and would be much higher if it were not for the fact that Puerto Ricans being U.S. citizens can move easily to the U.S. The median household income was $19,429 in 2012 (versus $51,017 on the mainland). 45% of the island’s population lives below the poverty line. It is no wonder that Puerto Rico has been referred to as America’s Greece.
Like Greece, which borrowed heavily from the core European countries prior to 2009, Puerto Rico borrowed heavily from the U.S. mainland due to a quirky feature of the U.S. tax code that makes Puerto Rican bonds somewhat similar to U.S. municipal bonds. U.S. investors who purchase Puerto Rican bonds do not pay federal, state or local taxes on them regardless of where they live in the U.S. while they must reside in the U.S. city whose bonds they buy in order to benefit from the same triple tax exemption. Thus there are no residency requirements for the U.S. investor who buys Puerto Rican bonds; the bondholder gets the triple tax exemption regardless of where on the U.S. mainland he/she resides. Thus the purchase of Puerto Rican bonds was very attractive to U.S. hedge funds, pension funds, and mutual bonds funds.
This borrowing lessened, somewhat, the impact of the Puerto Rican recession until it eventually became excessive, and Puerto Rico became unable to service its debt. From $40 billion in 2006, the debt increased to $72 billion in 2015. Standard & Poor’s rated Puerto Rican bonds CC before the island defaulted, which is lower than Greece.
The severe recession caused the out-migration to accelerate, resulting in even fewer people paying taxes and increasing further the island’s deficit. To make matters worse, unlike Mexicans or Cubans, Puerto Ricans tend not to send remittances back home due to the fact that not only it is easier for Puerto Ricans to move to the U.S. but also because the U.S. dollar does not purchase as much in Puerto Rico as in Mexico or Cuba. Consequently, Governor Padilla was forced to institute severe austerity measures (like in Greece) as demanded by the lenders who wanted their money back.
Thus 21% of government employees including school teachers have been laid off since 2008; 160 schools were closed in 2014-15; the local sales tax was increased from 7% to 11.5% in June 2015. Overall, Puerto Rican residents can pay as much as 33% of their income in local taxes. Those measures caused economic conditions to deteriorate further as more people emigrated to the U.S., forcing the Puerto Rican authorities to use unsustainable emergency measures to pay the interest on the debt; these include selling assets from pension funds, borrowing from the workers’ compensation fund and other insurance funds and withholding millions of dollars in tax refunds. Such measures did not prevent the island from defaulting on $37 million in interest payment on bonds at the end of 2015. Another $400 million in interest payments due in May 2016 will not be made if some solution is not found by then.
Next week, I will discuss remedies before concluding.
Pierre Canac, Ph.D.
Associate Professor of Economics