Development Business / September 16, 1996
By Larry Luxner
WASHINGTON -- With the passage of an increase in the U.S. federal minimum wage, 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 former non-voting resident commissioner in Washington, said the elimination of what many had called "corporate welfare" represents 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 last month 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."
The repeal of Section 936 will also affect half a dozen Caribbean nations that had depended on the program for low-cost financing of major infrastructure and development projects (see box).
Yet the pro-statehood New Progressive Party of Puerto Rico Gov. Pedro Rosselló was clearly 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 the island's current resident commissioner, Carlos Romero Bar-celó, who attended Tuesday's signing ceremony on the South Lawn of the White House.
Under a little-known 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.
In 1995, some $6 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.
Besides the drugs themselves, companies also manufacture health-care products such as intravenous solutions, blood-pressure kits and thermometers in island factories, the oldest of which dates back to 1969. In fact, Puerto Rico's largest private employer is Baxter Healthcare Corp., with has 6,000 workers in nine plants. Other large health-care companies operating there include American Home Products Corp., Bristol-Myers Squibb Co., Eil Lilly Industries and Johnson & Johnson.
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.
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.
Indeed, a paid supplement on Puerto Rico that ran in Fortune back in 1993 called the phaseout of 936 a "positive development" because "for one, it forces a restructuring of the economy away from a manufacturing base that government officials say had lost its dynamism anyway. Secondly, the pared-down 936 credit provision reduces the island's dependence on an incentive that would be inconsistent with statehood. Thus, the revised 936 program becomes a further force for the modernization of the economy and a signal to shift the economy to another footing, where it is not reliant on favors controlled by others."
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."
Adds Kal Wagenheim, publisher of Caribbean Update: "Without a large internal market, and with wage levels higher than those in nearby Caribbean islands, ther is little reason for manufacturers to remain in Puerto Rico. This could trigger a significant increase in migration from the island to the U.S. mainland, as workers and new entrants to the labor force seek jobs."
With Section 936 gone, says Colorado, it'll be next to impossible to get companies think about setting up on the island.