Various publications have recently highlighted Puerto Rico’s economic troubles as reflected in the municipal bond market. The severity and scope of the island’s problems can be inferred from reports that yields on its general obligation bonds are higher than those of Detroit, a city that is currently in bankruptcy.
Other recent news focused on the legal propriety of private meetings with certain investors that Puerto Rico’s Government Development Bank held in March and May of this year. The news suggested that the investors excluded from these meetings were at an informational disadvantage. From the start of the year, Puerto Rico’s bonds have dropped more than 18 percent.
However, any disadvantage to these investors is perhaps immaterial given the widely known dire economic conditions of the island. Yet perhaps less known to the general public is the insistence of local policy makers in pursuing economic development strategies that are simply wrong.
Despite the sudden drop of Puerto Rico bonds in 2008 during the height of the financial crisis, this year’s collapse in bond prices is even steeper and perhaps points to this problem. The fatal flaw of the island’s central economic plan is a longstanding and unrealistic aspiration to be a science and technology-based manufacturing powerhouse. Indeed, island policy makers regularly invoke Singapore as their paradigm.
Their key ingredient to building a high-tech manufacturing economy is not the availability of local inventors and researchers, all in short supply. Rather, their main tool is abundant local tax breaks that continue to drain the island’s treasury. The reasons for this approach date back more than 50 years when Congress granted U.S. corporations operating in Puerto Rico federal tax exemptions for repatriated profits.
The last iteration of this tax break was Section 936 of the U.S. Internal Revenue Code. Coupled with Puerto Rico’s own tax breaks, U.S. corporations could repatriate profits and pay almost no taxes in either jurisdiction. In this tax paradise (now lost), Puerto Rico became a formidable haven for the pharmaceutical industry and other manufacturers.
Unsurprisingly, since 2006 when Section 936 disappeared, Puerto Rico’s economy has been in a virtual free fall. The island has lost 235,000 jobs — an almost 19 percent decrease. The population has shrunk with some 400,000 Puerto Ricans leaving the island and resettling, mostly in the U.S. mainland.
As an antidote to the disappearance of Section 936, island policy makers promoted even more generous local tax breaks and the conversion of U.S. corporations to controlled foreign corporations. This allowed companies to pay low Puerto Rico taxes and defer federal taxes until profits are repatriated. Of course, this arrangement is far less tax-efficient than the prior environment under Section 936.
But despite the generous local breaks, manufacturers rushed to the exits. From 2006 to present, the jobs in factories have declined by more than 37 percent, from 118,000 to some 74,000.
To make up for lost tax revenue, Puerto Rico’s government began a furious borrowing binge that even entered the realm of dubious legality. To avoid constitutional restrictions on debt service and the requirement of a balanced budget, the island resorted a legal fiction embodied by the Puerto Rico Sales Tax Financing Corporation, known under the local acronym COFINA.
In just six years, COFINA racked up more than $15 billion in debt secured by an island sales tax. Total public debt is now about $70 billion. Puerto Rico’s per capita indebtedness eclipses that of every state of the U.S.
When borrowing wasn’t enough to makes ends meet, the government disposed of assets, claiming each time that they would provide lasting financial fixes. One was a concession for two toll roads in late 2011 that netted over $1 billion. Even so, the local highway authority is again on the brink.
Earlier this year, the other was the 40-year private lease of the Luis Muñoz Marin International Airport for — what I consider — a grossly insufficient sum of $615 million plus a small yearly payment (between about $2 million and $6 million) over the term of the lease. Coincidentally, upon closing this deal, the government turned around to pay off a $600 million bond issue that came due.
The new administration headed by Gov. Alejandro García-Padilla has plunged again into debt markets with two private placements for approximately $800 million and a $600 million public bond issuance backed by revenue of the state-owned (and teetering) power company.
No alternative growth plan
Although Congress had for decades threatened to kill Section 936, no one ever put together an alternative growth plan based on Puerto Rico’s true competitive advantages. The enduring and erroneous belief is that local tax exemptions — even without homegrown inventors and technology — will return Puerto Rico to its subsidized glory among industrial stalwarts.
This narrow view has led to an almost deliberate neglect of activities in which Puerto Rico has clear competitive advantages. These activities primarily involve Puerto Rico’s human resources and geographical attributes as a major venue for tourism, entertainment, music, the arts and professional sports.
Glaring proof of this neglect is Puerto Rico’s miniscule hotel capacity. At just 14,500 rooms for the entire archipelago, this U.S. territory needs approximately 30,000 more rooms to be on par with Hawaii, which has a third of Puerto Rico’s population and sits 1,000 miles further out in the ocean from the U.S. mainland.
Looking back at bond yields, we see the market’s dim view of Puerto Rico’s hopes that local tax exemptions will grow an economy driven by science and technology.
Time is running out for the fundamental shift that we need. This major change involves embracing wholeheartedly those attributes and talents for which Puerto Rico and Puerto Ricans are known to excel.
Except perhaps in the eyes of a few geeks, these attributes and talents are far more memorable, exciting, and dynamic than formulating pills and algorithms.