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Tax break phase-out hurting Puerto Rico: Some U.S. firms looking elsewhere
The Miami Herald / October 19, 1997

By Larry Luxner

WASHINGTON -- Section 936 means absolutely nothing to most Americans. Except, that is, for corporate tax lawyers, Washington lobbyists and hundreds of thousands of puertorriqueños whose highly prized factory jobs are now threatened by the eventual loss of this obscure federal incentive.

It was only a year ago that President Clinton signed into law the Small Business Job Protection Act of 1996, mandating an increase in the federal hourly minimum wage from $4.25 to $5.15. Yet in doing so, he also signed the death warrant for 936 -- a controversial tax program that despite its flaws helped give Puerto Rico the highest standard of living in Latin America.

"It's the end, and Puerto Rico will suffer," warned Antonio J. Colorado Jr., executive director of Caribbean/Latin American Action, at the time.

While the island isn't suffering just yet, there's little doubt that dozens of Fortune 500 companies from Motorola to Maidenform have begun to question the wisdom of operating here without the lure of Section 936 of the U.S. Internal Revenue Code.

Under a provision of the 1996 law, corporate tax breaks for all existing factories operating under 936 will disappear within a decade, with no federal incentives whatsoever for new investments. As such, Section 936, which was sacrificed to offset anticipated federal revenue losses from tax breaks given to small businesses -- and to help Congress pay for the minimum-wage hike -- is effectively eliminated retroactively to Dec. 31, 1995, for any business not already claiming it. For all other companies, the law continues a phase-out process begun in 1993, providing a new cap on the credit beginning in 2002, and abolishing it altogether for active business income by Jan. 1, 2006, meaning that existing 936 companies are grandfathered in for the next nine years.

Clinton himself has never been happy about eliminating the program. Recognizing the damage it could do to Puerto Rico, the president asked Congress immediately after signing the bill to "act to ensure that the incentive for economic activity remains in effect" to prevent multinationals from fleeing Puerto Rico once the tax credit is history.

Yet it may be awfully hard to stop them -- especially when countries like the Dominican Republic and Mexico can offer similar benefits at a fraction of the labor cost.

"The eventual elimination of 936 is affecting Puerto Rico. I have no doubt about that," Héctor Jiménez Juarbe, executive vice-president of the 1,700-member Puerto Rico Manufacturers Association, told The Herald. "Puerto Rico is no longer the first option in the minds of investors looking to locate operations outside the United States. Some expansions are taking place, but these expansions were planned before this latest action regarding 936 was announced. They want to take advantage of what remains of 936."

In fact, Puerto Rico's economy is already sagging, says prominent local economist Heidi Calero. Between July 1996 and April 1997, according to Calero, Puerto Rico's net exports plummeted 42%, from $3.4 billion to $2 billion. At the same time, manufacturing payroll tumbled 4.9%, manufacturing hours fell 3.9% and factory employment dropped 1.1%.

Says Peter Holmes, director of the Puerto Rico-USA Foundation: "Since 936 was modified in 1993, even before the repeal, there's been a significant dropoff in the number of new companies investing in Puerto Rico. Companies already there are hanging on. Some, like Intel, have increased employment, which has helped offset the loss in textile jobs. But in terms of new people coming in, that has dropped off tremendously."

It's hard for outsiders to appreciate just how crucial Section 936 has become to the economy of Puerto Rico, a tropical island of 3.7 million people captured by U.S. forces in the 1898 Spanish-American War and made into a U.S. Commonwealth in 1952.

An outgrowth of President Truman's postwar Operation Bootstrap, Section 936 since the mid-1970s had exempted manufacturers from paying federal income tax on profits earned by their subsidiaries in Puerto Rico. That drew some 2,000 factories to the island, where in the peak year of 1989 they employed 160,000 people in the production and export of everything from Hanes underwear to Microsoft floppy disks -- all for a hungry American market.

Since then, manufacturing employment has fallen to just under 153,000, though U.S. subsidies and direct factory investment have given the island a per-capita income of around $7,500. Though this is far less than the poorest U.S. state, Mississippi, it tops most other Caribbean islands and ranks Puerto Rico the highest in Latin America.

In 1996, nearly $7 billion worth of medications alone were produced and exported, making pharmaceuticals the island's single most important industry and accounting for more than 25% of its gross domestic product. At least 100 drug companies have plants in Puerto Rico, including nearly every pharmaceutical firm on the Fortune 500 list. And they churn out thousands of products, from pain reliever Anacin to the ulcer-fighting Zantac.

Some towns are now almost entirely dependent on these multinationals -- and on the jobs and business they generate. In the southeastern town of Humacao, for example, Medtronic of Minneapolis assembles pacemakers, Sandoz of Switzerland makes Ex-Lax and Syntex of Panama produces birth-control pills -- all within 10 minutes of each other.

One of the first drugmakers to set up shop here was G.D. Searle & Co., which in 1969 established a huge factory in the city of Caguas, just south of San Juan. By the mid-1980s, Puerto Rico had surpassed New Jersey in U.S. drug production and was well on its way to becoming the pharmaceutical capital of the world.

Besides the drugs themselves, companies also assemble health-care products such as intravenous solutions, blood-pressure kits and thermometers in island factories.

In fact, Puerto Rico's largest private manufacturing employer is Baxter Healthcare Corp., which has 6,000 workers at seven factories -- in Aibonito, Añasco, Carolina, Guaynabo, Jayuya, Maricao and San German. Other large health-care companies operating on the island include American Home Products Corp., Bristol-Myers Squibb Co., Eil Lilly Industries and Johnson & Johnson.

Baxter, based in Deerfield, Ill., steadfastly denies rumors that it is pulling out of Puerto Rico or reducing its workforce substantially.

"If anything, employment has actually increased by a few hundred over the last couple of years," claims company spokeswoman Deborah Spak. Asked if the repeal of 936 is of major concern to Baxter executives, Spak didn't answer directly but said "it's not having an impact on our operations in the short term."

In the apparel and textile sector, there's no question the end of 936 is having an impact -- as is rising wages in Puerto Rico and competition from Mexico due to NAFTA.

Cadillac Industries, which is closing a Mayaguez garment factory on Oct. 6 -- dismissing 240 employees in the process -- says that without the benefits of Section 936, it simply can't compete with the nearby Dominican Republic, where free-zone workers earn $4 for a nine-hour day. That follows a similar announcement by Phillips-Van Heusen Corp., which is closing a money-losing garment operation in Barranquitas by year's end, leaving 440 jobless.

"A few years ago, we saw we could no longer compete with the wages of Latin American countries," says Osvaldo Santiago Dones, executive director of the Design Council, a unit of Fomento, Puerto Rico's government-run economic development agency. Without federal tax incentives come 2006, there'll be even less reason for labor-intensive companies like Cadillac to remain.

That could really hurt Puerto Rico, whose unemployment rate hovers around 14%, nearly three times that of the U.S. mainland.

According to Fomento, employment in the island's apparel sector has dropped to 27,800 -- a 42.5% drop in garment manufacturing employees over the last 25 years. The number would have fallen even more if not for Puerto Rican government subsidies that have encouraged local manufacturers to invest in R&D and productivity. The only companies that haven't seen a drop are those on contract with the Pentagon, which by law must buy only uniforms, army boots and other supplies bearing the "Made in USA" label. Since Puerto Rico still has the cheapest wages on U.S. soil, those companies have been able to hold their own.

Another industry that's taken a beating is tuna processing. The western city of Mayaguez contains the 600,000-square-foot StarKist packing plant -- the largest of its kind in the world -- though employment there has dropped from 4,300 to 3,500. Thousands of people in Mayaguez, famous for the tuna stench noticeable a mile away, still depend on the export of canned tuna to the U.S. mainland, though most of StarKist's rivals have since been bought out by Far East companies and have shifted production to Thailand or Indonesia, where workers earn 30¢ a day.

Computer and electronic firms aren't immune to the 936 fallout either.

Motorola, which at one point had 3,000 workers assembling beepers in the Puerto Rican coastal town of Vega Baja, continues its downsizing to a current 1,900 -- with plans to further slash its workforce to 1,000. Pager productions are reportedly being shifted to Chihuahua, Mexico, and a new factory to be built in Brazil.

"Motorola will continue to milk Section 936 benefits until these end in nine years," an unnamed executive recently told the San Juan newspaper Caribbean Business. "If some products become hot in the market, Puerto Rico may get some volume, but unless something changes dramatically, the Vega Baja plant will be eliminated. The island is not a big enough market for production, wages are high, and without the tax cushion, Puerto Rico is not attractive."

In fact, Colorado -- a former Puerto Rico resident commissioner in Washington and the island's ex-secretary of state -- spent most of his time in office trying to save 936 from congressmen like Sen. David Pryor (D-Arkansas) who viewed the tax clause as "corporate welfare" and wanted to axe it. At one time, Colorado was so closely linked with the struggle that his Puerto Rican license plate read "AJC-936" and newspaper articles referred to him as "Mr. 936."

But in the end, charges the politician, "Congress didn't take 936 away. Puerto Rico gave 936 away." That's a bitter reference to speeches by former Gov. Carlos Romero Barceló -- the man who later defeated Colorado for the resident commissioner's job -- who argued that 936 amounted to "corporate welfare" and that Puerto Rico would be better off economically as the 51st state of the union.

Kal Wagenheim, publisher of Caribbean Update and an expert on the island's status question, says Congress got a mixed message and saw the issue as partisan politics.

"Had Puerto Rico's two major parties argued that 936 couldn't be touched, that it was critical to the island's economy," he says, "I think Congress would have looked elsewhere for sources of money to balance the budget."

Politics aside, says Colorado, U.S. executives rarely consider Puerto Rico when thinking about where to put their next factory.

"You don't have to be an economist to realize that, although Puerto Rico has a professional workforce and we're part of the United States, the costs of manufacturing in Puerto Rico are very high," he explained. "Different companies have different needs, but we have three important cost factors: electricity, twice that of the mainland; water and sewage, also twice as much as on the mainland, and transportation, which is much more than the mainland. When you put all these things together -- plus the same minimum wage as in the U.S., fringes higher than the U.S. and no federal tax exemption -- Puerto Rico is going to be attractive to very few companies."

Holmes, of the Puerto Rico-USA Foundation, says he's seeing a similar trend.

"In the days when 936 was whole, Puerto Rico was such an attractive site for investment that when multinational corporations had problems requiring a company-wide reorganization, their Puerto Rican factories were never in the equation. It was sort of held separately because it was a great moneymaker thanks to the tax benefits," he said. "Now, with the loss of 936, there's no uniqueness attached to the Puerto Rican operation. So when there's a market change, the Puerto Rican subsidiary is factored into the decision-making process."

Meanwhile, Moody's Investors Service warns that the elimination of 936 "could have long-term, negative effects on the island's economy."

The program's loss, it says, "will likely weaken Puerto Rico's economy by slowing -- possibly even halting -- job generation, particularly in manufacturing. The tax change is also expected to slow economic growth by raising the cost of borrowed funds. That cost has effectively been subsidized by the availability of large amounts of 936 deposits. This adverse economic impact will pose a serious long-term challenge to Puerto Rico's efforts to maintain fiscal balance."

As a result, many U.S. companies are looking at giving up their 936 status and reorganizing as Controlled Foreign Corporations (CFCs), which puts them outside the U.S. tax code until they remit profits back to stateside headquarters. CFCs, says Holmes, "provide a deferred tax benefit that can be put off for many years if the company is global and can invest its Puerto Rican profits in properties around the globe."

Separately, the Rosselló administration has proposed Senate Bill 680, essentially designed to make Puerto Rico more competitive with countries like the Dominican Republic, which has approximately 500 factories in 35 free zones employing 180,000 workers -- a 12% increase over 1995 figures. An even more formidable rival is Mexico, whose low wages and duty-free access to the United States through NAFTA has lured factories away from Puerto Rico and even some Central American nations.

A key feature of the Rosselló bill is the elimination of so-called "tollgate taxes" that companies pay on repatriated dividends. The measure -- aimed at replacing Puerto Rico's 1987 Industrial Incentives Act -- would also drop the island's maximum corporate tax from 14.5% to 7%, and would take effect Jan. 1, 1998. Since Rosselló's New Progressive Party enjoys a majority in the Puerto Rican legislature, passage is likely.

Jaime Morgan Stubbe, the current administrator of Fomento, says a company operating under the 1987 law would have to make "a substantial new investment" to qualify for relief from the tollgate tax under the new proposal.

Manufacturers are encouraged with the measure, but hardly ecstatic.

"Although it is a movement in the right direction, it's not enough," says the PRMA's Jiménez Juarbe. "We have to look for measures that reduce the cost of operating in Puerto Rico and to improve infrastructure in order to make Puerto Rico more competitive and to restore -- if not totally, then in part -- the benefits that we've lost, and the position we used to have under 936."

Jiménez Juarbe says he's hoping Congress will approve get a permanent wage credit option under Section 30A, and open that section to new businesses. "Right now, under the 936 income credit option, you cannot add new lines of products different from what you manufacture now."

Wagenheim says the elimination of tollgate taxes won't help much because once 936 is gone, U.S. manufacturers would still have to pay federal tax -- something over which Puerto Rico has no control.

"Companies are not going to Puerto Rico because of local tax incentives. That's not why they went there in the first place," he says. "No matter what Puerto Rico does, you can't get away from the fact that you're still subject to the federal minimum wage. It's still a good place to do business, but there are productive workers everywhere."

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