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Uncertainty plagues stagnant Puerto Rican economy
The Journal of Commerce / January 23, 2006

By Larry Luxner

On Dec. 31, 2005, Puerto Rico finally said good-bye to Section 936, a provision of the U.S. Internal Revenue Code that in one form or another had been the mainstay of the Puerto Rican economy for more than half a century.

Under the controversial Section 936 and its wage-compensation companion, Section 30A, U.S. multinationals enjoyed a lucrative federal tax credit on profits earned by their manufacturing subsidiaries in Puerto Rico.

When it was created in 1954 as Section 931, the idea was to create jobs on a poor, overcrowded Caribbean island that at the time was little better off than the nearby Dominican Republic – despite its status as a U.S. commonwealth. The tax loophole worked, bringing hundreds of large companies from the United States and elsewhere to Puerto Rico to establish factories.

By 1996, those tax incentives provided $11.3 billion, or 63%, of Puerto Rico's $18 billion payroll, of which $3.6 billion came from the pharmaceutical sector alone. Corporate tax-exempt earnings invested in Puerto Rico's many banks reached more than $14 billion.

But many in Congress — especially lawmakers from poor Southern states who were angry about U.S. companies transferring jobs from the mainland to Puerto Rico — objected to the tax breaks, and in 1995, the Clinton administration approved a 10-year phaseout of Section 936, which has now finally taken effect.

"Obviously, the overall impact has been negative, in the sense that no new plants have been given tax exemptions for the past 10 years," said San Juan economist Mohinder Bhatia, president of Puerto Rico Management and Economic Consultants Inc.

"However, what's been happening is that international companies are using an alternative method of going around 936," said Bhatia, explaining the role of Section 901 governing controlled foreign corporations (CFCs). "As a CFC, profits are eventually subject to tax when they are transferred back to the 50 states. However, if the profits are kept outside the U.S., then they will not be subject to federal tax. That's what's helping these former 936 companies reduce the negative impact of 936's elimination."

In fact, the elimination and initial phaseout of 936 only accelerated the departure of apparel and other labor-intensive industries that had already started to leave the island since the mid-1970s. Over the years, Puerto Rico has gradually lost nearly its entire garment, apparel and electronic sectors to countries like the Dominican Republic and Honduras that offer much lower wages.

Yet the island's pharmaceutical industry remains healthy, generating around 30,000 direct jobs — or 25% of Puerto Rico's 120,000 manufacturing jobs — and representing 26% of the island's Gross Domestic Product.

"Pharmaceutical and medical-devices companies have found Section 901 something they could adopt," said William Riefkohl, executive vice-president of the Puerto Rico Manufacturers Association. "Even though it didn't have as many tax incentives, it allowed the pharmaceutical sector to remain in Puerto Rico."

Economist Heidi Calero points out that drug companies are not labor-intensive, so Puerto Rico's relatively high wages aren't a major factor in their overall costs.

Interestingly, while the number of drug factories dropped 10%, from 69 in fiscal 1995 to 62 plants in fiscal 2005, pharmaceutical jobs continued to grow, from 23,616 jobs in fiscal 1995 to 27,884 in fiscal 2005. Most importantly, 17 of the top 20 prescribed medications sold in the United States — from Viagra to Zoloft — are now manufactured in Puerto Rico.

Abbott Laboratories has just completed a $450 million biotech plant in Barceloneta, while Eli Lilly & Co. is sinking $280 million into a new drug production center in suburban Carolina. On the other hand, Pfizer Inc., makers of Viagra, announced that by 2008, it would phase out operations at its Arecibo plant to reduce solid-dose production and because of the loss of exclusivity for some of its best-selling drugs.

Yet pharmaceuticals aren't the only kind of drugs found in Puerto Rico.

In fact, the island has become a stepping stone between South American cocaine producers and the lucrative U.S. mainland market, with the Drug Enforcement Administration now classifies Puerto Rico as a "major Caribbean point of entry" for drugs.

Case in point: a cargo ship arriving from Colombia arrived in San Juan last November when U.S. federal agents boarded with sniffer dogs, zeroed in on a 20-foot-long steel oxygen tank and hauled it away. An X-ray showed it contained nearly two tons of cocaine.

"Once the drugs are in Puerto Rico, they're as good as in Kansas," said Lt. Eric Willis of the U.S. Coast Guard, noting that traffickers love the island because after their drugs arrive in San Juan, they can be hidden amid regular cargo and shipped onward, bypassing routine searches because Puerto Rico is part of the United States.

Infrastructure problems also continue to plague the island.

Vassallo Industries Inc., with annual sales of $51 million, employs 300 people in Ponce in the production of PVC pipes and other accessories. Having lost $1.5 million in equipment ruptures and interruption costs due to 38 power failures in 2005, company president Rafael Vassallo decided to play hardball, threatening to transfer his factory to Arkansas — where electricity costs just one-fifth as much as in Puerto Rico.

That sufficiently scared the government, which scrambled to dispatch economic adviser Gustavo Vélez and top executives of the Puerto Rico Electric Power Authority (PREPA) to Ponce for a meeting with Vassallo, who has demanded compensation for his company's losses.

"Gov. Aníbal Acevedo Vilá gave me specific instructions to evaluate and resolve Vassallo's most pressing problem, which is the need for efficient power distribution," said Vélez. "We have informed Vassallo Industries that there will soon be a 38-kilovolt station operating in Juana Díaz with a direct power line to Vassallo's manufacturing plant."

PREPA said this will stabilize the power system not only for Vassallo Industries but also for the entire region. It's part of a $12 million investment by PREPA in the region, which includes a transmission tower that will supply electricity to Ponce's industrial sector and should be ready by April 2006.

Bhatia predicts the Puerto Rican economy will grow by 2% in fiscal 2006, though Calero is less optimistic, projecting GNP growth at only 1%.

"We are not very enthusiastic," she said. "Consturction is at a standstill because of permitting problems. Interest rates are going up but good projects will get financing anyway. The other monkey wrench is what continues to happen betwen the legislature and the executive branches of government. They don't seem to be working together."

Calero said a proposed 7% sales tax could raise an additional $800 million in revenue. Puerto Rico currently has no sales tax, though it does have an excise tax on goods coming in from the U.S. mainland. The sales tax is one of the main sticking points in the current debate on fiscal reform, which aims among other things to lighten the burden for middle-class taxpayers.

"We have a large underground economy which goes unchecked," she said. "It doesn't pay anything in taxes, and the government continues providing services, and they need the revenue."

Despite the uncertainty, Puerto Rico's retail sales climbed to more than $32 billion in 2004, according to a study prepared by the Puerto Rico Trade Commerce and Export Co.

Automobile sales — including those of luxury cars — also continue to grow on an island that already has one of the world's highest concentrations of vehicles and paved roads per square mile. At last count, there were 2.5 million registered cars, pickup trucks, minivans and other SUVs for Puerto Rico's four million inhabitants.

In August 2005, the most recent month for which statistics are available, new-car sales came to 11,896 units, up 14.6% from August 2004. During the first eight months of 2005, Puerto Ricans bought 90,488 new cars, a 6.7% from the year-ago period — despite concerns about the government's fiscal crisis, higher vehicle taxes and rising gasoline prices.

Likewise, the island's exports continue to grow, with September 2005 exports valued at $5.2 billion. That's an increase of 32.4% over the year-ago figure, says Angel Rodríguez, president of the Puerto Rico Planning Board.

"These figures indicate that our industrial manufacturing sector is strong and remains competitive at the global level," said Rodríguez, explaining that the jump can be partially attributed to a $853.9 million increase in chemical exports to the U.S. mainland.

Yet long-standing political issues connected to the island's relationship with the United States threaten Puerto Rico's long-term economic outlook.

Bhatia criticized a White House report issued Dec. 22 that calls on Congress to set a date for a plebiscite, in which the people of Puerto Rico would be asked whether they want to change the island's commonwealth status. If they choose to do so, said the task force, Congress should then set another vote on whether to become the 51st state or declare independence.

In 1993, a status plebiscite resulted in 48.58% of voters supporting commonwealth, 46.34% statehood and 4.45% independence. A subsequent plebiscite in 1998 was inconclusive; voters remain as deeply divided as ever on the issue.

"Uncertainty is the worst enemy of economic development, and this report creates uncertainty because we don't know what our status will be in one, two, three or 10 years," said Bhatia.

Calero, noting that both S&P and Moody's downgraded Puerto Rico's bond ratings last year, said this is one debate Puerto Rico doesn't need right now.

"We don't have time for this discussion. There are more important things to discuss, like tax reform and the budget," she insisted. "Political status is a waste of time. If you want a change in political status — whether it's statehood or independence — you must have a strong economy. So let's focus on that."

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