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Puerto Rico's star losing its luster
Journal of Commerce / December 8, 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 puertorriquenos 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.

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," said Hector Jimenez Juarbe, executive vice-president of the 1,700-member Puerto Rico Manufacturers Association. "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 local economist Heidi Calero. Between July 1996 and April 1997, she says, Puerto Rico's 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."

Manufacturing employment has fallen from 160,000 in 1989 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.

Baxter Healthcare Corp., which has 6,000 workers at seven factories and is Puerto Rico's largest private employer, 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.

According to Puerto Rico's Economic Development Administration (known as 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.

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.

U.S. executives now rarely consider Puerto Rico when thinking about where to put a new factory, says Antonio J. Colorado, executive director of Caribbean/Latin American Action, which organizes the annual Miami Conference on the Caribbean and Latin America.

"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," explained Colorado, a former Puerto Rico secretary of state and ardent supporter of Section 936. "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."

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, Puerto Rico Gov. Pedro Rossello has proposed Senate Bill 680, aimed at making the island 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. The bill's key feature 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.

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 Jimenez 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."

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