Monday, May 2, 2016

Puerto Rican Debt Crisis: Brought to You By Lousy U.S. Federal Government Policy

Puerto Rico. It has not so much been a tourist destination lately as it has been at topic of political discourse. For quite some time, Puerto Rico has had enough fiscal woes by acquiring $72 billion in debt, which is more than 100 percent of its GDP. Its fiscal condition is worse than any of the 50 states in the United States mainland. While the topic of Puerto Rican debt is not necessarily new, the fact that it owed about $400 million in debt by May 1st is news. While Puerto Rico defaulted on the majority of its $400 million debt payment, that will be shadowed by the upcoming $2 billion debt payment due on July 1.

John Oliver actually covered this complicated topic last week (see above), but I would like to delve into this topic a bit further. One of the largest factors that caused the debt crisis was U.S. tax code and its peculiar set of tax preferences for Puerto Rico. The Puerto Rican debt crisis has its origins in the early twentieth century. The Jones-Shafroth Act of 1917 exempted Puerto Rican government bonds from being taxed at the federal, state, and local levels. This Act made Puerto Rican bonds very attractive to American purchasers of bonds. For decades, this Act did not cause a financial ruckus, although a mistranslation in a 1961 amendment to the Puerto Rican Constitution opened the door. It was during the 1970s when the Puerto Rican government decided to use bond investment money to balance its budget. Since the borrowed funds were not actual revenue, this snowballed into a debt crisis because unsurprisingly, when you borrow money with an interest rate that is artificially lower than market value, it only facilitates more capricious borrowing.

As Puerto Rico's situation worsened in the 2000s, investors took advantage of the financial situation and bought up more of these tax-exempt bonds. What exacerbated the whole situation was the repeal of Section 936 of the U.S. tax code. Section 936 allowed for a corporate tax exemption for U.S. corporations doing business in U.S. territories, such as Puerto Rico. While Section 936 helped Puerto Rico evolve from an agrarian society to a manufacturing hub, this provision became increasingly unpopular during the Clinton Administration because it came off as "evil corporations" tax-dodging. A bill was signed in 1996 to phase out the exemption over the next decade. By the time it was completely phased out, Puerto Rico fell into a recession in 2006. Foreign investment fled the country, and the inability to fill the void that the corporate presence once occupied caused the Puerto Rican economy to contract. One of the lessons here is that if you're going to provide a tax break, make it permanent because otherwise, you undermine the economy and creditworthiness, much like with Puerto Rico. Another lesson is to illustrate the many issues with the corporate tax and why in an ideal world, we wouldn't have corporate taxes.

The Jones-Shafroth Act also has a provision that forbids foreign ships from carrying goods between ports in U.S. territories, which, as you can imagine, hampers trade flows. This goes well beyond an Act dating back about a century. Looking at the World Bank's Ease of Doing Business Index, Puerto Rico presently ranks 57th, which is considerably lower than the United States' ranking of 7th. According to the World Bank's ranking, Puerto Rico has horrid rankings in such vital areas as registering property (164th), enforcing contracts (100th), and paying taxes (134th). These are rankings that are on par with developing countries, not a territory that is part of the developed world.

Up to the 1970s, the Puerto Rican minimum wage was below that of the mainland. The federal government, however, stepped in and told Puerto Rico that their minimum wage had to be that of the federal minimum wage, which was a law that was phased in by 1983. A paper published in the National Bureau of Economic Research found that when implementing the minimum wage back in 1977, Puerto Rican employment decreased a number at 8-10 percent lower compared to what would have prevailed without minimum wage by 1992 (Castillo-Freeman and Freeman, 1992). The Federal Reserve Bank of New York found that a third of Puerto Ricans make the minimum wage (p. 8), which is higher than in the United States. The current minimum wage in Puerto Rico is 77 percent of the median wage, which this comprehensive 2015 report on Puerto Rican debt from the International Monetary Fund (IMF) economists admits (p. 6). Minimum wages that are such a high percent of the median wage cause massive unemployment, which is what we see in Puerto Rico: current U-3 unemployment is at 11.8 percent, which is significantly higher than the current 5.0 percent for the mainland.

On top of the high minimum wage, the welfare benefits are also lavish. As the IMF points out, they often exceeds what minimum wage employment yields (e.g., a household of three could receive $1,743, while a minimum-wage worker only earns $1,159 [IMF, p. 7]). Puerto Rico also does not allow for at-will employment without paying huge severance packages, which makes sense given that 23 percent of employees in Puerto Rico work for the government.  Other costs of employment induced by the government are mandatory Christmas bonuses and lavish mandatory paid leave, which includes 15 vacation days, 12 sick days, eight weeks of maternity leave, and one hour per day for breastfeeding. All of these rigidities discourage job creation, which is why Puerto Rico has a declining real GNP, shrinking population [from 3.82 to 3.55 million within the last decade], and a labor force participation rate that decreased from 56.5 to 50.2 percent since 2005.

And let's not forget the lack of fiscal transparency, that the federal government pays a significantly smaller percent of Medicaid costs than it does for the mainland, glaring budgetary inefficiencies in Puerto Rico's Department of Health and Department of Corrections, or that the Puerto Rico Electric Power Authority (PREPA) owes an eighth of the island's debt (CRS, p. 13), the latter of which has caused energy prices to be higher in Puerto Rico than in the rest of the United States (IMF, p. 8). With all this, here's the "shocker": government expenditures in real dollars have increased by 100 percent between 1980 and 2013!

Puerto Rico is a bloated, inefficient government currently without any bankruptcy or restructuring provisions to help. On the other hand, allowing for Chapter 9 bankruptcy would only encourage what has been years of poor governance, which is why a default would be preferable to a bailout. Puerto Rico should be able to restructure its debt without having it fully repudiated. Even if Puerto Rico can get enough money or can restructure its debt to handle the current debt, this will not take care of some the more systemic issues that allowed this debt crisis to manifest in the first place. Its current trajectory is one of large financial gaps (IMF, p. 14), and longer-term solutions will need to be a part of the overall reform to make sure this does not happen again, whether that comes in the form of greater budgetary transparency, exemptions on the minimum wage and Jones Act, increasing the privatization of public companies that have failed, opening the energy market to competitive forces, or less restrictions in the labor market. Whatever the outcome is, what I can tell you is this: government policy is largely to blame for the fiasco. Let's hope that the federal government can work in conjunction with the Puerto Rican government and the private sector to resolve the crisis.

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