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CNE: Next tax reform for Puerto Rico must strike balance among policy goals

The Center for a New Economy (CNE) is once again keeping track of the next comprehensive tax reform for Puerto Rico that is currently being designed and which the think-tank believes must strike a “reasonable balance” among several competing considerations on the table.

“This would be fourth or fifth such ‘tax reform’ (the exact number depends on how you define ‘tax reform’) in Puerto Rico since 2006,” said Sergio Marxuach, editor and author of an analysis published in the the most recent edition of its “CNE Review” newsletter.

“Puerto Rico has a tax system that no one consciously would have built from the ground up,” said Marxuach, who is also policy director at CNE. 

“It is unduly burdensome to administer and enforce; it is inequitable, along both horizontal and vertical dimensions; it oftentimes encourages the inefficient allocation of resources; and it discourages certain kinds of economic activity,” he said.

“The world today is significantly different from when our tax system was originally designed in the 1950s. Yet, our tax system has evolved through the slow accretion of legislation into a complex web of preferential tax rates layered on top of multiple credits, deductions, exclusions, and exemptions that in many instances are not justified. In addition, it imposes high marginal rates on income, levying the heaviest burden on the middle class,” Marxuach said.

Puerto Rico’s tax system, which in theory should promote, or at least not hinder, economic growth by channeling financial resources to the productive sectors of the economy, “has actually undermined our competitiveness; penalizes work, especially at the lower levels of the wage scale; encourages the informal sector; and deters entrepreneurial activity,” he said.

In his analysis, Marxuach said it should not surprise anyone that the island’s growth rate has slowed down during the last 25 years, that close to half of its population lives in poverty and that more than 50% of its people do not participate in labor force.

According to the analysis, the following principles should guide any tax reform effort in Puerto Rico: 

  1. The tax reform needs to be comprehensive. The objective is to look at the system as a whole. This means that all the elements of the tax system — personal and corporate income taxes, sales taxes, excise taxes, and property taxes — should be on the table.
  2. The tax system should provide adequate financing for government operations. It should be able to raise enough revenues to pay for the services provided by the public sector.
  3. Expand the tax base. Eliminate some of those credits, deductions, exclusions, exemptions, and deferrals that have proliferated throughout the years and replace them with a universal refundable credit (for individuals) of 15%.
  4. Lower marginal tax rates. Recent research, especially in the field of behavioral economics, shows that high marginal tax rates make it worthwhile for people to change their economic activities and to spend considerable resources to both legally avoid and unlawfully evade taxes. Lowering marginal tax rates reduces the incentive to engage in this kind of behavior and, if complemented with an expanded tax base, could lead to higher tax collections.
  5. Simplify the system. A simpler tax code, if drafted correctly, would generate lower enforcement and compliance costs and higher tax collections.
  6. Make the system fairer and more equitable among and between different sectors of society and between generations.
  7. Consider green taxes. To discourage activities that are harmful to the environment.

“The consensus in Puerto Rico is that a broad-based tax reform is long overdue. It is important to understand, however, that tax policy involves difficult trade-offs among various objectives, such as revenue generation, efficiency, simplicity, and equity, states the analysis,” he said.

“As a result, there is no single ‘correct’ policy answer, each society must decide about the proper balance among and between these policy objectives. Therefore, the art, and the difficulty, of tax reform lies in achieving a reasonable balance among these various competing considerations,” Marxuach said.

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This story was written by our staff based on a press release.

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