Puerto Rico is in a dire financial situation, as the island is a record $120 billion in debt. For some perspective, that is more debt than 22 states have combined on the state-level, according to U.S Census Bureau data. Climbing out of this deficit may prove especially difficult, as President Trump currently opposes any form of federal bailout for the territory.
In this interview, Bloomberg BNA portfolio author Jeanelle Alemar-Escabí discusses the impact of Puerto Rico’s tax policy on the U.S. territory’s current fiscal situation. She touches on Puerto Rico’s sales taxes, underground economy, credits and incentives, and repeal of the value added tax.
Bloomberg BNA: Puerto Rico is an unprecedented $120 billion in debt. What role, if any, do you think Puerto Rico’s system of taxation has in the island’s current fiscal situation?
Alemar-Escabí: Puerto Rico’s taxation system has been revamped throughout the years to try to mitigate the prolonged economic weakness Puerto Rico’s public finances have endured since the elimination by the U.S. Congress of § 936 of the U.S. Internal Revenue Code, which was a federal tax exemption on net income to U.S. corporations operating in Puerto Rico concerning their Puerto Rico source income and distributions. This credit, also known as the Possession Tax Credit, was phased out starting in 1996 with a 10-year phase-out period. Since its enactment in 1976, more than 260 U.S. corporations established themselves in Puerto Rico generating significant federal tax-free profits, and Puerto Rico had an unprecedented economic growth spurt.
Unfortunately, the island’s economy became too dependent on the incentive. When it was finally eliminated in 1996, the corporations that were benefiting from the tax credit and contributing to the island’s gross national product closed shop and left. This had a devastating economic ripple effect on Puerto Rico's economy. The economic activity produced by these corporations under § 936 was replaced with the issuance of Puerto Rican bonds by the local government (so called “triple-exempt debt”) that had no real repayment source in the long run.
In my view, the elimination of this tax credit forced Puerto Rico to develop its own tax policy based on tax advantages, but they haven’t been enough to replace the economic activity generated by § 936. The taxation system in Puerto Rico should improve on issues such as tax revenue collection, simplifying the tax code, and alleviating the effect caused by the lower amount of tax revenue caused by migration of residents of Puerto Rico to the mainland U.S. Moreover, the taxation system needs to work hand on hand with an economic development policy and have the intent to promote economic activity rather than just collect revenue.
Bloomberg BNA: Puerto has a sales tax of 11.5 percent, which is higher than any state in the U.S. What effect does this tax have on the Puerto Rican economy?
Alemar-Escabí: It is no surprise that the high sales tax impacts the amount of money circulating in the island's economy. The high sales tax caused an increase in the cost of doing business, which translated to higher prices for products and services. Although Puerto Rico still maintains a competitive edge for businesses within several industries, such as the export service industry or tourism industry, the high sales tax rate could be considered a factor that has prolonged the recession.
Bloomberg BNA: In what way, if any, has the underground economy impacted Puerto Rico’s fiscal situation?
Alemar-Escabí: Historically, the collection of tax revenue and the broadening of a tax base have been a challenge for governments. Most of the tax policies that have been adopted recently have been to circumvent the large “underground” or “informal” economy in Puerto Rico. A report issued in 2016 by the U.S. Congressional Task Force on Economic Growth in Puerto Rico estimated that the underground economy ranges from 15 percent of gross national product to about 20 percent. I share the report’s view that the underground economy has several negative effects on Puerto Rico’s fiscal situation, such as depriving Puerto Rico of revenue needed to finance the services provided by the government and payment of public debt obligations.
Bloomberg BNA: Are there any changes in the tax system that could help bring in more revenue to the territory?
Alemar-Escabí: Puerto Rico is looking to raise revenues at all levels. There are many initiatives pending in the Legislature that will help bring more revenue to the island. As of March 2017, the government has announced that it will propose to raise the effective property tax rates, new excise taxes on tobacco products, and collect the sales and use tax on internet transactions, among other initiatives.
The debate on whether to not lose tax revenue through tax increases or to lower rates to broaden a base has not been had as of late. Because Puerto Rico is in a financial crisis, the alternative to lower rates has been brushed to the side for the time being. I do believe a step in the right direction in any change to Puerto Rico’s tax system should include a simpler tax code, broader base, improvements in tax collection, and lower rates. For example, elimination of personal property taxes, reconsideration of the worldwide income taxation regime versus a territorial taxation regime, among others, could provide a wide range of different alternatives to tax planning that could attract new capital to the island.
Bloomberg BNA: Do you think Puerto Rico’s tax credits and incentives are drawing businesses to the territory or does more need to be done in this area?
Alemar-Escabí: I have seen many businesses and investors drawn to the island for its tax incentives and quality-of-life concerns. Yes, there is a dire financial situation in Puerto Rico, but it’s a beautiful place to live in and the slow-paced island life is attractive for people who are looking to get away from the daily grind. I also believe that Puerto Rico has a competitive value proposition for young businesses, especially in the tech industry. The Export Services Act, which grants tax incentives to businesses that provide services outside of Puerto Rico, is being heavily promoted to develop a new service-based economy and to promote the island as a hub to enter global markets. Nonetheless, more can be done to draw business interests to Puerto Rico.
Bloomberg BNA: Puerto Rico initially enacted a value-added tax that would have imposed a 10.5 percent tax on all taxable items introduced into Puerto Rico. However, days before this tax was to take effect in 2016, the VAT was repealed. What are your thoughts on the repeal of the value-added tax?
Alemar-Escabí: The VAT repeal process was implemented too hastily and, in my opinion, was counterproductive to the desired effect to present a new solution to an old problem. Also, it reflects one of the major problems with economic and fiscal policy in the island, which in my opinion, is the lack of continuity of the measures taken.
Bloomberg BNA: Last year, you noted the economic and political considerations at play as part of the VAT’s repeal. Do you think the island will try to implement a VAT in the future, or are those considerations still an issue?
Alemar-Escabí: Currently, there are no considerations to implement a VAT in the future in Puerto Rico. I think the issue is still tarnished with last year’s political baggage. The current administration at the Puerto Rico Treasury Department and the current Legislature are investing their time and resources in expanding the base of the sales and use tax and to improve the tax collection processes of the Puerto Rico Treasury Department.
Bloomberg BNA: Are there any changes you would like to see Puerto Rico implement to its tax system that would make the lives of practitioners and taxpayers easier?
Alemar-Escabí: A simpler tax code and simpler ways to raise revenues are my go-to recommendations. All services provided by the Puerto Rico Treasury Department should be automatized and varied efforts to educate taxpayers would ultimate make taxpayers’ lives easier.
Bloomberg BNA: What advice do you have for tax professionals practicing in Puerto Rico?
Alemar-Escabí: In this field, laws and regulations are constantly being amended and we must keep up with the new changes. For the same reason, the tax practice becomes a constant need for businesses and the entire business environment in Puerto Rico. I believe that tax practitioners in the island have a great opportunity to create impact by providing a comprehensive service to their clients that would increase their opportunities to grow and expand.
I would also advise them to talk to the people who oversee the implementation of a new tax law or regulation. Sometimes, the key to correctly interpreting the law is taking into consideration the human element and understanding the way the specific agency has implemented similar measures in the past.
Bloomberg BNA: Do you have any other comments?
Alemar-Escabí: The government should be a facilitator and promoter of business and private activity. Puerto Rico needs to clearly identify its “added value” by defining the goods and services that it will produce as a basis for its economy. Then, focus on developing ecosystems that promote the capitalization of such “added value.” We need to have a major mindset change and move forward into an economy of innovation that creates value for ourselves and the world. It is the only way we can overcome this situation.
In the end, I think that going through all this transformation will be productive, and I think it is an opportunity to start anew.
Continue the discussion on Bloomberg BNA’s State Tax Group on LinkedIn: What impact does Puerto Rico’s tax policy have on the U.S. territory’s current fiscal situation?
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 Seventy billion in outstanding bonds plus $50 billion in unfunded pension obligations.
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