News Is My Business / July 10, 2015
By Larry Luxner
WASHINGTON — The loss of Section 936 tax breaks, combined with overly indulgent local labor laws and a federal policy that encourages people to stay on the dole rather than work, have all contributed to Puerto Rico’s current fiscal nightmare.
But only through drastic measures that spur real, sustained growth can the island beat this crisis, says prominent economist Anne O. Krueger.
In a Wednesday speech at the Washington-based Heritage Foundation, Kreuger warned that time was running out for a solution.
“Without restoring growth, there is no possibility of turning around the fiscal crisis. These must be addressed simultaneously,” said the former International Monetary Fund executive. “As we speak, the government’s cash balances are critically low, and further delays will reduce the room for maneuvering and the chance they can get out of this without further damage.”
Krueger is a senior research professor of international studies at Washington’s Johns Hopkins University. Among other things, she was founding director of Harvard’s Center for International Development, and was the IMF’s first deputy managing director from 2001 to 2006, later moving to the World Bank.
Krueger’s 26-page report, commissioned by Puerto Rico’s Government Development Bank and released June 29, warns that the island’s true fiscal deficit is much larger than assumed and suggests an array of structural and fiscal reforms to help Puerto Rico recover.
“Our report focuses on the desperate need for change. Projections of revenue have been overly optimistic, with revenues too high and expenditures too low, and there’s been no midterm check that could do anything about it,” Krueger explained. “The most they did was stuff their bills in the drawer and wait to pay them. Arrears were not counted as part of the deficit.”
She added: “As cash becomes tight, the government goes to large companies and negotiates with them, promising ‘if you pay taxes early, we’ll give you a better deal.’ So companies negotiate their actual tax rates in order to get early payment. It’s highly contagious. The average take on taxes is well below anything listed on the books.”
Complicating the situation, she said, “there are numerous tax credits and even an agency that bargains with incoming businesses. Statistical and accounting practices don’t monitor what’s going on. We don’t even have GDP data for the fiscal year which ended a year ago, not to mention this past fiscal year, which ended June 30.”
The problem, said Krueger, is that because Puerto Rico — whose economy has stagnated for more than 10 years — isn’t a country, it can’t go to the IMF for help.
“Puerto Rico has borrowed year after year at very favorable terms, while debt has gone way up. The fiscal position is unsustainable,” she said. “Population started falling awhile back, so the labor force is falling in size too. So not only do we have no growth, we have a reduction in the labor force.”
Krueger said the gradual loss of federal tax breaks under Section 936 of the Internal Revenue Code helped spur the downward cycle.
“Special tax exemptions for U.S. companies were enacted in the 1970s, but in 1996 that legislation was partially removed, and completely removed by 2005. Puerto Rico had a wonderful boom, but since then, things have not gone so well,” she told her Heritage Foundation audience.
Other factors were the financial crisis of 2008, the sharp rise in oil prices later on, and the high cost of transportation and electricity; Puerto Ricans pay 28˘ per kilowatt-hour compared to 10˘ per kilowatt-hour in Texas.
“Employers are reluctant to hire because the federal minimum wage is high relative to productivity. There’s no way that at $7.25 an hour, an unskilled Puerto Rican can compete with the Dominican Republic, where wages are $1 an hour or less — or even Mexico — in things like package tourism,” she said. “In addition, local legislation has added significant labor costs. Puerto Rico has shot itself in the foot by requiring a 13th month bonus in December, very generous sick leave, generous holiday benefits, vacations and very short probationary periods.”
Even worse, she said, “the welfare system makes employment unattractive for workers whose productivity isn’t that much above the minimum wage. Suppose a wage earner with three children makes $1,100 a month. If he instead goes on welfare and food stamps, he’s entitled to $1,700. Why work when you can sit at home and make more money — especially when you’re not that skilled?”
She said that as a result, the labor force comprises only 40 percent of Puerto Rico’s population, compared to 62 percent on the U.S. mainland, “and we’re worried that it’s dropped from 66 percent.” In terms of doing business, the United States ranks seventh globally in the World Bank’s latest index, while Puerto Rico is 47th out of 189 nations on the list — better than Romania but just worse than the Central African nation of Rwanda.
In addition, she said, transport costs are high and local laws restrict competition in a variety of fields.
“Growth and fiscal adjustment go hand in hand, and is it absolutely essential to do things to restore Puerto Rico’s growth,” she said. “There’s a little bit of room for a few taxes to be raised, but if they start trying to raise tax revenues too much, people will get on those planes and migrate to the mainland — and revenue will go down.”
Krueger called for a “bold approach” of fiscal adjustments and measures to improve Puerto Rico’s business climate.
“Remove disincentives to hiring workers in whatever way possible. Define apprenticeships in such a way that the minimum wage would not apply during training. Cut out the 13th month bonus and cut sick days,” she suggested.
But even if Puerto Rico did everything right, two to three years would still be required for new laws to take hold, she said.
“There has to be some way of phasing out the debt to give them time. Nobody knows how well they’ll do, or how fast they’ll go,” she said. “Part of it depends on the world economy and how quickly they act. They themselves have to realize that if they don’t do it now, it’s going to be even harder — and even worse — later on.”