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Puerto Rico: US law change shakes island
Journal of Commerce / December 9, 1997

By Larry Luxner

With passage of the recent federal minimum-wage increase, President Clinton has also signed the death warrant for Section 936 -- a controversial tax-incentive program that helped give Puerto Rico the highest standard of living in Latin America.

Antonio J. Colorado Jr., Puerto Rico's ex-resident commissioner in Washington, said the repeal of what critics had called a blatant form of "corporate welfare" marks one of the darkest days in recent memory for his island's economy.

"It's the end, and Puerto Rico will suffer," warned the politician, who in July took over as executive director of Caribean/Latin American Action, a Washington lobby. "Once you get something off the books, it's very hard to put it back."

Unlike Colorado, Puerto Rico Gov. Pedro Rosselló and his pro-statehood New Progressive Party are elated.

"With the signing of this law, we do justice to thousands of Puerto Rican workers, above all women, who will see their salaries, benefits and working conditions improve substantially," declared Puerto Rico's resident commissioner in Washington, Carlos Romero Barceló, who opposes 936 because he views it as an impediment to statehood.

Puerto Rico's apparel industry -- which owes its existence mainly to Section 936, relatively low wages and duty-free entry to the U.S. mainland market -- now employs only 26,800 people, down from a high of around 35,000 in the 1970s. For one thing, the average garment worker's salary in Puerto Rico now stands at $4.92 an hour. That's about 55-60% of the U.S. average, but far higher than wages in the neighboring Dominican Republic or nearby Central America. And under NAFTA, duty-free access to the U.S. market is also available to Mexico, which has seen its apparel exports skyrocketing. That leaves 936 as one of Puerto Rico's few competitive advantages.

Sadly, only a few days after the repeal of Section 936 was announced in Washing-ton, Crescent Industries -- which had operated for 25 years in the northwestern Puerto Rican town of Aguada -- announced it would close its women's lingerie factory, leaving 987 people jobless. Crescent has been sold to Maidenform, which has decided to transfer operations to the Dominican Republic, where workers are lucky to earn $3 a day.

Yet Jaime Morgan-Stubbe, chief of Puerto Rico's Economic Development Adminis-tration (known as Fomento) and a Rosselló political appointee, argues that federal tax incentives aren't that important for garment manufacturers as they once were.

"I've had nobody telling me they're going to close as a result of the changes in 936," he said, adding that "the most serious impact on the apparel industry is not so much 936 as NAFTA and GATT. We have lost jobs in the apparel sector, particularly in 1993, but our analysis shows those jobs were lost mainly to Asian and, to a lesser degree, Latin American competition."

Under a provision of the Small Business Job Protection Act of 1996, corporate tax breaks for all existing factories operating under Section 936 of the U.S. Internal Revenue Code 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 bill would continue a phase-out process begun in 1993, provide a new cap on the credit beginning in 2002, and abolish it altogether for active business income by Jan. 1, 2006.

Clinton himself isn't happy about eliminating the program. Recognizing the damage it could do to Puerto Rico, the president asked Congress to "act to ensure that the incentive for economic activity remains in effect" to prevent companies from fleeing Puerto Rico once the tax credit is history.

"This legislation ignores the real needs of our citizens in Puerto Rico, ending the incentive for new investment now and phasing out the incentives for existing investments," said a statement issued by the White House. "I urged the Congress to reform the credit and use the resulting revenue for Puerto Rico's social and job-training needs. My proposal would have, over time, prevented companies from obtaining tax benefits by merely attributing income to the islands, but it would have continued to give companies a tax credit for wages and local taxes paid and capital investments made there, as well as for earnings reinvested in Puerto Rico and qualified Caribbean Basin Initiative countries."

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 has since the mid-1970s exempted manufacturers from paying federal income tax on profits earned by their subsidiaries in Puerto Rico. That has drawn some 2,000 factories to the island, where they employ over 130,000 people in the production and export of everything from Microsoft computer diskettes to Star-Kist tuna -- all for a hungry American market.

U.S. subsidies and direct manufacturing investment have given the island a per-capita income of around $7,500. Though this is far less than the poorest state, Mississippi, it tops most other Caribbean islands and ranks second only to Argentina among Latin American economies.

But critics both at home and in Washington, calling 936 an example of "corporate welfare," say the program costs U.S. taxpayers over $2 billion a year while doing little to relieve unemployment in Puerto Rico, currently running at 15.6% -- triple the U.S. rate.

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."

In fact, the program's demise may hurt not only Puerto Rico, but several Caribbean and Central American countries that had come to depend on cheaper financing through so-called "936 funds," a mechanism allowed the granting of low-interest loans to CBI nations that had signed Tax Information Exchange Agreements with the U.S. Treasury.

Said Edison James, the prime minister of Dominica: "The end of 936 funds will have serious repercussions on Dominica's economy. This comes at a time of lower U.S. development aid, which we can ill afford."

Dominica is one of 10 countries throughout the Caribbean and Central America which have signed Tax Information Exchange Agreements with the U.S. Treasury. That qualifies them for so-called "936 funds," which are generally available at one or two percentage points below prevailing interest rates -- thus resulting in up to 20 perent savings in finance costs. The other nine are Barbados, Costa Rica, the Dominican Republic, Grenada, Guyana, Honduras, Jamaica St. Lucia and Trinidad & Tobago.

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