J. Tomas Hexner Glenn Jenkins J. Tomas Hexner

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Puerto Rico:

The Economic and Fiscal Dimensions

J. Tomas Hexner

Glenn Jenkins

J. Tomas Hexner is the Chairman of Hex, Inc. Glenn Jenkins is the Director of the International Tax Program at Harvard Law School and Fellow of the Harvard Institute for International Development.

Prepared for the Citizens Educational Foundation

Copyright 1998 Citizens Educational Foundation.

All rights reserved. No part of this report may be reproduced in any form or by any electronic or mechanical means including information storage and retrieval systems without permission in writing from the publisher, except by a reviewer who may quote brief passages for review.

Table of Contents

I. Principal Findings 5

II. Introduction 8

A. Political Status 10

B. A History of ìNew Deal,î Government-Led Development 10

C. Section 936 Tax Credits 15

D. The 1990 Congressional Budget Office Report on Puerto Rico 16

E. Recent Changes and Ideas 17

A. A New Perspective 19

B. Convergence theory and political status 19

1. Evidence for Convergence in the United States 20

2. Evidence for Convergence in the European Union 21

C. Hawaiian Convergence under Statehood 21

D. Commonwealth as a Block to Puerto Ricoís Convergence with the U.S. 23

E. Summary 29

V. The Fiscal Costs of Commonwealth for the United States 30

A. Forfeited Tax Revenues 30

B. Federal Transfers 30

1. Payments to Individuals ($5 billion) 31

2. Grants to State and Local Governments ($2.4 billion) 31

3. Food Stamps ($1.1 billion) 32

C. Wages and Salaries ($535 million) 32

D. Summary 32

A. Introduction 33

B. Possible Changes in Federal Expenditures 33

1. Transfer Payments for Federal Programs 33

2. Wages and Salaries ($60 million) 34

3. Procurements (to be determined) 35

4. Total Changes in Federal Funding 35

C. Net Fiscal Impact 35

1. Impact on the Federal Budget 35

2. Impact of Statehood on Puerto Rico 37

VII. Realizing Potential for Growth through Economic Reform 40

A. Puerto Ricoís Economic Potential 40

B. Privatization of Public Corporations 40

C. Private Sector Infrastructure Initiatives 41

D. Government Efficiency Reform 41

E. Protecting and Capitalizing on Puerto Ricoís Natural Advantages 42

F. Potential Tax Initiatives 43

1. Consumption Tax 43

2. Tax on Public Corporations 43

3. Income Tax Structure 43

G. Summary 44

VIII. The Effect of Statehood on Investment in Puerto Rico 45

A. Statehood would make Puerto Rico a ìdomesticî not ìforeignî investment location 45

B. Uncertainty discourages investment 46

C. Sources of investment in Puerto Rico 46

1. Puerto Rican investors 46

2. External Investors 47

D. Summary 48

IX. Conclusions 49

Appendix I: Correcting the 1990 CBO Report 52

A. Drawbacks of the CBO Model 52

B. Benefits of the Computable General Equilibrium (CGE) Model 52

C. The Impact of Statehood: Comparing Results 53

Appendix II: Recent Developments in Puerto Rico 54

A. Privatization of Public Corporations 54

B. Investment 54

C. Government Efficiency Reform 55

D. Tax Structure Reform 55

Bibliography 57

1 Investment as a Share of GDP in Puerto Rico 9

2 Hawaiian Personal Income 18

3 Puerto Ricoís Economic Performance Relative to the United States 20

3a Puerto Rico and the U.S. Convergence Frontier 21

4 Per Capita Income in Puerto Rico: Two Stories 22

5 Projected Economic Benefits from Statehood, 1994 to 2025 24

6 Net Fiscal Impact of Statehood on the Federal Budget, 1995 32

7 Net Fiscal Impact of Statehood on Puerto Rico, 1995 34
1 Benefits of Statehood Assuming 3.5% Convergence Rate 23

2 Current Costs of Commonwealth to the U.S. Treasury 27

3 Potential Increased Federal Transfers to Puerto under Statehood 30

4 Net Impact of Statehood on the Federal Budget, 1995 31

5 Estimate of Net Impact of Statehood on Puerto Rico, 1995 33

I. Principal Findings

  1. The Puerto Rican economy, contrary to the opinion of many, is not a model of economic growth. In fact, the economy has been beset with slow growth, high unemployment, and little advance in productivity. The Puerto Rican economy has stagnated since the 1970ís, after some successful growth in the 1950ís and 1960ís. Annual growth rates averaged only 1.7% from 1975 to 1984, and unemployment reached 22% in the 1980ís and currently stands at more than double the U.S. rate. In fact, the government sector grew more than three times as fast as the private sector during the period 1970 to 1990. Puerto Rico and the U.S. persisted with a development strategy based on government initiative and tax gimmicks long after it proved ineffective. In short, the Puerto Rican economy is anything but a case of ìif it ainít broke, donít fix it.î

Comparisons with developing economies in the Caribbean and Latin America mask the failure of the Puerto Rican economy and its development policies. Given the close political, economic, geographic, and social ties to the United States, Puerto Rico should be matched up with the fifty states. Puerto Ricoís residents are also already U.S. citizens with the right to unrestricted travel to the mainland. This comparison reveals the paucity of economic progress on the island. The islandís 1995 per capita income of $7296 was less than a third of that in the United States

  1. Commonwealth status results in a drain on the U.S. Federal Treasury. In FY 1995, Puerto Rico received $9.7 billion in federal outlays, or approximately $2,620 for every person living on the island, which is approximately half of federal spending distributed to the average state. At the same time, however, the U.S. Treasury is forfeiting tax dollars that it would collect from individuals and corporations in Puerto Rico. U.S. citizens residing in Puerto Rico presently pay no federal income taxes. The most glaring loss of revenue is from corporations benefiting from Section 936 of the Internal Revenue Code (ìsection 936î). Since 1972, the federal government has forfeited at least $70 billion in tax revenues in real terms. While the tax breaks are being phased out, section 936 still costs the federal government over $3.8 billion in lost revenues as of 1994. As long as Puerto Rico remains a commonwealth, there remain political interests supportive of reinstating costly and ineffective tax subsidies.

  1. Statehood would alter the perception of potential investors in Puerto Rico. In this age of globalization, the expansion of NAFTA, and the eventual normalization of relations with Cuba, Puerto Ricoís once privileged trade status is no longer a source of comparative advantage. When considering investing in a U.S. state or Puerto Rico, U.S. and international investors have the choice of investing in the United States, or ìnot exactlyî in the U.S. Investors, corporations and rating agencies presently consider Puerto Rico in the non-United States or ìnot exactlyî category. Statehood will unequivocally remove uncertainty about Puerto Ricoís status and political risk profile, and make Puerto Rico a full and clear part of the U.S. in the eyes of investors.

  1. Statehood would stimulate the Puerto Rican economy to grow 2.2 to 3.5% faster through full integration with the U.S. economy and political system. Modern economic growth analysis indicates that less developed regions of an integrated economy catch up with more affluent regions over time. Since 1940, for example, Mississippi has grown twice as fast as wealthier Northeastern states. It has rapidly narrowed the gap with the rest of the U.S. and now earns 50% as much per capita as the richest state, up from 22% in 1940. Fuller integration has enabled states to expand more than 2% faster than territories over time. Economic growth in Hawaii, for example, almost doubled in the 15 years after statehood and grew even faster than the vibrant U.S. economy.1

  2. Had Puerto Rico become a state instead of a commonwealth in 1955, U.S. citizens living on the islands would now be making $6000 more per year simply through greater integration with the U.S. economy. Alternatively, if Puerto Rico had become a state in 1994, real per capita income would grow $1343 more by the year 2000 than it would have under current status conditions.

  3. The Puerto Rican economy shows a strong potential for growth which the previous development strategy has thwarted. A computable general equilibrium (CGE) model replicating the Puerto Rican economy reveals a latent capacity which could be realized through modest policy initiatives. The Puerto Rican economy remains resilient despite the on-going phase-out of section 936 of the Internal Revenue Code, and government finances have improved.

Widespread fears that the economy would collapse without tax breaks have proven unfounded. In fact, real GDP and employment in Puerto Rico have continued to grow since 1994. Standard & Poors recently revised its outlook on Puerto Rico from negative to table in light of improved tax collections and the current budget surplus.

Puerto Ricoís economic potential cannot be fully realized, however, without a definitive resolution of the political status issue. Failure to resolve the issue has stymied development efforts in the past, and will continue to prevent any economic development strategy from yielding long-term results. To optimize growth, Puerto Rico must become a state so that it converges with the U.S. economy, rather than continue its present path of convergence with the Caribbean and Latin America.

  1. The fiscal impact of statehood on the U.S. Treasury would be favorable. Statehood would bring in federal taxes where none is presently collected and increased growth under statehood would continue to expand the federal tax base and collections. Statehood would also put a definitive end to potential tax breaks which remain a threat to deficit reduction (e.g. still an estimated $3.5 billion a year) under the current status.

Had Puerto Rico been a state in 1995, it would have generated an additional $3.52 to $4.12 billion in tax revenues for the Treasury while resulting in an additional $1.4 billion in increased federal transfers to the island. Thus, contrary to conventional wisdom, statehood would have resulted in a net benefit to the federal budget of between $2.1 to $2.7 billion.

  1. In summary, Puerto Rico can only optimize its significant growth potential through statehood. Without conclusive resolution of the status question, no economic development strategy can hope to actualize this potential in the long-term. Through full integration, statehood will stimulate Puerto Rico to realize its capacity through faster growth and convergence with the U.S. Convergence with the U.S. has not occurred under commonwealth status as predicted by modern growth analysis; in fact, Puerto Rico has been converging with the developing economies of the Caribbean and Latin America.

Statehood will be particularly critical in light of the development of free trade throughout the region. In addition to NAFTA, trade liberalization is accelerating in the Caribbean under CARICOM, and in Latin America under MERCOSUR. Potential investors from the United States and elsewhere will not appreciate Puerto Ricoís nebulous commonwealth status as a source of competitive advantage. Statehood will attract greater investment by creating a more stable, recognizable environment for U.S. and global investors. Faster economic growth under statehood will mean higher incomes for U.S. citizens in Puerto Rico, and higher incomes will bring in more tax revenues to the U.S. Treasury.
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