Treating PR as a State Under Federal Tax and Expenditure Programs: As Preliminary Economic Analysis

77-202 E

TREATING PUERTO RICO AS A STATE UNDER FEDERAL TAX AND EXPENDITURE PROGRAMS: A PRELIMINARY ECONOMIC ANALYSIS

DONALO W. KIEFER Economist in Taxation and Fiscal

Policy Economics División

September 7, 1977

CONGRESSIONAL RESEARCH SERVICE UBRARY OF CONGRESS

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The Congressional Research Service works exclusively for the Congress, conducting research, analyzing legislation, and providíng information at the request of Committees, Members and their staffs.

The Service makes such research available, without partisan

bias, in tnany forms íncluding studies, reports, compilations, digests, and background briefíngs. Upon request, the CRS assists Comniittees in analyzing legislative proposals and issues, and in assessing the possibie effects of these proposals and their altematives. The Service's sénior specialists and subject analysts are also available for personal consultations in their respective fields of expertise.

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TABLE OF CONTENTS

Pages

I. II. III.

IV.

V.

Introduction And Summary of Findings

1

The Present Application of U.S. Tax Laws to Puerto Rico

5

The Present Puerto Rican Tax Structure

8

The Economic Setting

12

The Impact of Fully Treating Puerto Rico as a State Under Federal Tax Laws

VI.

21

The Impact of Fully Treating Puerto Rico as a State Under Federal Grant and Revenue Programa

31

VII. A Preliminary Analysis of the Economic Impact of Fully Treating Puerto Rico as a State Under Federal Tax and Expenditure Programa

36

TABLES

Table 1

Real Groas National Product and Personal Income For Puerto Rico, 1950 - 1975

13

Table 2

Estimates of the Fiscal Impact of Full State Tax Treatment of Puerto Rico, Fiscal Year 1975

23

Table 3

Transfer Payments from Federal General Revenues and

Trust Funda to Individuáis Resident in Puerto Rico, FY 1975

32

Table 4

Federal Grants to Puerto Rican Governments, FY 1975

33

Table 5

Estimated lacreases in Federal Funding Levels From Fully Treating Puerto Rico as a State Under Federal

Grant and Revenue Programa in 1975

35

Table 6

Net Impact of Fully Treating Puerto Rico as a State Under Federal Tax and Expenditure Programs in 1975

37

TREATING PUERTO RICO AS A STATE UNDER FEDERAL TAX AND EXPENDITURE PROGRAME: A PRELIMINARY ECONOMIC ANALYSIS

I. Introduction and Summary of Findings

Puerto Rico was ceded to the United States in 1898 in partial settlement

of the Spanish-American War. Ever since^ the political status of the island

has been the subject of considerable interest and controversy. During the

first two years of possession Puerto Rico was governed by a military admini-

stration. In 1900 the island was placed under a civilian government with the key officials appointed by the President. Puerto Ricans became United States

citizens in 1917 and the same year chose their first elected legislature. In 1948 the office of Governor became an elected position. And in 1952 Puerto

Rico was changed from a "territory" to a "commonwealth" with its own constitution.

Twenty five years later the question of the political status of Puerto

Rico is still at issue. In the last Puerto Rican election, in which one of the primary campaign issues was the positions of the political parties on the

question of political status, the pro-statehood New Progressive Party defeated the incumbent pro-commonwealth Popular Demócrata, who had governed the island f

for 36 years. On January 1, 1977, in the final days of his administration, President Ford proposed that Puerto Rico be granted statehood. President Cárter

CRS - 2

has responded that he will support the desires of the Puerto Rican people, but the initiative must come from them.

p

A nxnnber of bilis on the subject have been

introduced in the U.S. Congress, including H.J. Res. 54 (95th Congress) which would grant independence to Puerto Rico; H.R. 11200 (94th Congress) which would revise the commonwealth status of Puerto Rico (the Puerto Rican Compact); and

H.R. 2201 (94th Congress), which would establish a procedure leading to Puerto

Rican statehood. Most recently the issue of the political status of Puerto Rico has been debated before the Special Committee on Decolonization of the 1/ United Nations.

Of course, this issue has many dimensions: political, cultural, social,

and economic. One of the central economic questions which has been vigorously debated with regard to the status issue is whether the Puerto Rican economy would be viable under statehood status, or whether it requires the special economic relations with the United States which characterize the commonwealth

arrangement. This paper provides a preliminary analysis of one of the key

elementa of this quesiton, specifically: what would be the economic impact of

treating Puerto Rico as a state under Federal tax and expenditure programa?

Sections II and III summarize the present applicability of U.S. tax laws to

Puerto Rico and the Puerto Rican tax structure. Section IV provides a brief

^

analysis of the relevant economic conditions in Puerto Rico, and sections

w

V, VI and VII analyze the impact of full state fiscal treatment of Puerto Rico.

t

J./ Puerto Rican Factions Hit Island Status, Washington Post, August 19, 1977. pp. Al, A16.

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At the outset it should be stated what this papar does not do. dees not provide an economic analysis of statehood.

It

Full State fiscal

treatment of Puerto Rico could occur independently of statehood;

1/

it is

this possibility which is examined in the present analysis so as to focus on the effects of the fiscal changas in isolation from othar affacts that

might result from the political transformation to statehood. Secondly, this papar does not analyze the impact of full application to Puerto Rico

of all U.S. laws which have economic impacts. For example, the U.S.

minimum wage laws have limitad and specialized applicability in Puerto

Rico and the present analysis does not explore the impact of removing this special treatment.

Rather, this papar focuses on the economic impact of fully treating

Puerto Rico as a State under Federal tax and expenditure programa, assuming no other political or economic changas. The analytical technique is to

examine the year 1975 (the last year for which necessary data are available) and compare the actual situation with estimates of what would have occurred

had full State fiscal treatment been in effect. This "comparativa statics" approach does not take into account any potential reaction ("feedback effect") to an immediate transition from the present status to full State fiscal ■4

treatment, ñor does it consider the possibility of a gradual or "phased—in"

\J For example, H.R. 588 {95th Congress) would repeal section 933 of the Internal Revenue Coda, which provides the exclusión from taxable income

for Puerto Rican source income received by residents of Puerto Rico.

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y

transición to full State fiscal treatment.

Such an analysis would require

speculation regarding economic reactions and/or potencial future political arrangements about which little or no información is presenCly available.

Thus, Che analysis herein is highly preliminary in naCure.

Sutmnary of Findings

Even such a "firsC-run" examinaCion, however, can provide valuable

insighC inCo Che potencial economic effecCs of a major policy change, Chus

enabling a sharper focus of subsequenC research and discussion. For example, Che presenC analysis reveáis Cwo major policy concerns which would resulc from full SCaCe fiscal CreaCmenC of Puerto Rico: 1) while Che individual

and governmenC sectors of Che Puerto Rican economy, on balance, would gain about as much from increased Federal Cransfers as Chey would lose from increased Federal Caxes, che distribución of gains versus losses would cause

a redistribución of personal income from upper-income Co lower-income groups and may forcé a realignmenC of governmenC expendiCure programa, and 2) che

mosC crucial issue Co Che viabiliCy of Che Puerto Rican economy under full State fiscal CreaCmenC is Che reacción of Che business sector — mosC imporCanCly, U.S. corporaCions operaCing under sección 936 of Che InCernal Revenue Code

Co Che loss of full Cax exempCion on Cheir Puerto Rican

operaCions. These Cwo policy areas require furCher sCudy before che econo mic effecCs of full SCaCe fiscal CreaCmenC can be compleCely undersCood.

T7 See Che sCaCemenC of Che Honorable Baltasar Corrada, Congressional Record, July 25, 1977, pp. E4812 - E4814, for a suggesCion of Che form such a transición mighc assume.

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1/ II. The Present Applícation of U.S. Tax Laws to Puerto Rico ♦

The U.S. Internal Revenue Code contains several special provisions which

treat individuáis and businesses in Puerto Rico differently than the treatment which applies in the States.

For U.S. citizens who are bona fide

residente of Puerto Rico during an entire tax, year Puerto Rican source income, except income earned as an employee of the U.S. Government, is exempt from the

U.S. individual income tax. This exemption does not apply to income earned from sources outside Puerto Rico.

Deductions which would be attributable to

the exempt income (including deductions for subnational taxes) are disallowed

in computing any individual income tax liability. If a U.S. citizen has been a bona fide resident of Puerto Rico for at least 2 years and moves from

Puerto Rico, Puerto Rican source income attributable to the period before the move qualifies for the exemption.

The U.S. social security tax and unemployment insurance tax apply fully

in Puerto Rico. The Federal estáte and gift taxes apply to persons in Puerto Rico except those who acquired U.S. citizenship solely by virtue of being a Puerto Rican citizen or by birth or residence in Puerto Rico. U.S.

H

customs duties apply to goods importad into Puerto Rico from foreign coun— tries, and U.S. excise taxes apply to goods produced in Puerto Rico for sale

#

in the States (goods produced in the States for sale in Puerto Rico are

1/ This section and the next draw heavily on two sources: 1) What You Should Know About Taxes in Puerto Rico. Office of Economic Research, Department of the Treasury, Commonwealth of Puerto Rico, 1976 Edition;

and 2) Business Operations in Puerto Rico. Barry A. Woods, Tax Manage ment Inc., 1977.

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exempt from U.S. excises if they can be identified), however, both of these

collections are paid from the U.S. to the Treasury of the Commonwealth of Puerto Rico.

The U.S. corporate income tax may be avoided on Puerto Rican income

earned by qualifying corporations, which may be subsidiarles of U.S. corpora-

tions, under section 936 of the Internal Revenue Code. Corporations which

elect to opérate under this section are generally referred to as "possessions

corporations" (or "section 936 corporations") because the tax provisión applies to U.S. possessions (except the Virgin Islands) as well as Puerto Rico, which is a Commonwealth (section 936 of the tax code defines the word

"possession" to include the Commonwealth of Puerto Rico for purposes of this section).

To qualify as a possessions corporation at least 80 percent of the corporation *s gross income must be from sources within a possession for the

three-year period preceding the end of the tax year (or the life of the cor

poration, if less), and at least 50 percent of the corporation's gross income must be from the active conduct of a trade or business within a possession.

A Doraestic International Sales Corporation (DISC) or former DISC, as well as

corporations holding stock in DISCs or former DISCs, may not qualify as a possessions corporation.

Once possessions corporation status is elected,

the election must remain in effect for at least 10 years unless the Secretary

of the Treasury consents to an early revocation, which is to occur only in cases of special hardship and where no tax avoidance results.

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A possessions corporatíon receives a full tax credit for U.S. income taxes which would otherwise be due on possessions source income regardiess

o£ the amount of taxes, i£ any, paid to the possession.

This credit is

entirely sepárate from the normal foreign tax credit and is computad independently.

The possessions corporation credit applies against only the

income tax and not the minimum tax, the accumulated earnings tax, or the

personal holding company tax.

The possessions corporation credit does not

shelter from taxation income earned within the United States or foreign

source income. Additionally, if a possessions corporation pays foreign taxes on income which is counted as possessions source income, and for 1/

which the corporation receives a section 936 credit,

it is not allowed

to claim the foreign tax credit with regard to this income. A possessions corporation may not join in the filing of a consolidated return, and, thus, possessions corporation losses may not be used to offset taxable income of

affiliated corporations. However, dividends received by a domestic cor

poration from a possessions corporation qualify for the intercorporate dividend deduction.

T7 Such income may arise if, for example, a possessions corporation manu facturera goods in the possession and markets the goods in a foreign country. The corporation may pay taxes on the foreign source income

to the foreign country, but the income would also qualify for a sec tion 936 credit because it resulta from the active conduct of a trade

or business within the possession.

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III.

The Present Puerto Rican Tax Structure

The present Puerto Rican tax structure in many ways resembles that of a nation rather than that of the States of the United States.

The Puerto Rican

individual income tax applies to the worldwide income of Puerto Rican residents, who include all U.S. citizens having resided in Puerto Rico for at least one

year.

Individuáis who are not residents of Puerto Rico are taxed only on

their Puerto Rican income. A credit is allowed against the Puerto Rican tax

for taxes paid to the United States, U.S. possessions, and foreign countries.

The structure of the tax base for the Puerto Rican individual income tax

is similar to that of the U.S. tax, but particular items differ. As examples: 1) winnings from the Puerto Rican lottery are not taxable income, 2) tenants may deduct 10 percent of their rent, up to $240, on their personal residence

from their income in determining taxable income, and 3) the size of the stan dard deduction and personal exemptions are different from those in the U.S. tax code.

The Puerto Rican tax rates are steeply graduated, ranging from

12.6 percent of taxable income below $2,000 to 82.95 percent of taxable in

come above $200,000, and are generally higher than the U.S. rates except for y low levels of taxable income.

The Puerto Rican estáte and gift tax is similar in structure and

application to the U.S. estáte and gift tax prior to the Tax Reform Act of

y The Puerto Rican marginal tax rates are higher than the U.S. rates for taxable income levels above $4000, however, as indicated above the definitions of taxable income are different.

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1976. The tax applies fully to Puerto Rican citizens; for nonresident Ü.S.

citizens, and resident Ü.S. citizens who acquired Ü.S. citizenship by reasons other than their Puerto Rican citizenship, birth, or residence, the Puerto Rican estáte tax equals the máximum allowable foreign death tax credit under the U.S. tax code.

Puerto Rxco also has a series of excise taxes on commodities and

transactions. The excises apply to such items as alcoholic beverages, ci-

garettes, petroleum products, motor vehicles, matches, appliances, jewelry, hotel accomodations, and admissions. The Puerto Rican excise tax rates are not uniformly higher or lower than rates imposed in the States. The Puerto Rican excise tax on automobiles has a graduated tax rate schedule, from

14 percent to 85 percent, depending on the horsepower and weight of the

vehicle. However, most of the Puerto Rican excises are structured similarly to the U.S. State excise taxes. In 1975 Puerto Rico first imposed a

"general excise tax", but the tax produced little revenue."^ Puerto Rico does not impose a general retail sales tax.

The Puerto Rican corporate income tax is structured somewhat similarly to the U.S. tax except for the rates, depreciation system, and the allowance

of special industrial incentive exemptions. The tax applies to the worldwide gross income, less allowable deductions, of Puerto Rican corporations; it 1/ Apparently one of the reasons the tax produces little revenue is poor enforcement See Andic, Fuat M. and Arthur J. Mann, Redesigning Puerto Rico s Tax System: An Overview, Bulletin For International Fiscal Documentation, May 1975.

p. 188.

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applies to Puerto Rican income of foreign corporations. Allowable deductions

are similar to those allowed under the Ü.S. tax code except that Puerto Rico

§'

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allovs use of a "flexible depreciation" system which permits, subject to

certain limitations, complete flexibility in the amount of qualifying property which can be depreciated each year. Thus, under this system a taxpayer may

deduct up to 100 percent of the cost of qualifying property in the first year, or may schedule depreciation charges in añy way to meet the needs of the busi ness. However, the total amount of depreciation claimed under this system in any year cannot exceed 50 percent of the net income of the business before 1/

depreciation.

An 85 percent dividends received deduction is allowed (there

is no 100 percent deduction similar to the U.S. provisión), and a foreign tax credit is allowed.

The Puerto Rican corporate income tax has a graduated rate schedule.

The tax rate on the first $25,000 of taxable income is 22 percent, and the rate

increases through seven income brackets to a rate of 45 percent which applies to taxable income above $300,000.

In addition, there is presently a 5 percent

income surtax which is scheduled to expire this year, and the announced policy 2/ is that it will be allowed to termínate.

1^/ The flexible depreciation systen is optional. Taxpayers for which this limitation would be restrictive may use ordinary depreciation methods.

2/ The Christian Science Monitor, Thursday, April 21, 1977.

p. 10.

O

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IH

Beginning in the 1940's Puerto Rico adopted a series of economic development programs under the general heading of "Operation Bootstrap",

<é

which are designed to attract and promote businesses engaged in manufac-

turing, tourism, and exporting. Prominent among these programs is the Industrial Incentives Act which offers tax exemptions to qualifying

businesses.

Under this Act businesses can be granted total tax exemption

for periods of 10, 15, 25, or 30 years, with the longer exemption periods

being available in geographic areas which are more economically depressed.

As an alternativa, a qualifying business can choose to be partially tax exempt for a period twice as long as the allowable total tax exemption

period. The tax exemption applies not only to the corporate income tax, but also to the property tax, municipal license taxes, excise taxes on

materials and equipment used by an exempt business, and the individual 1/

income tax on dividends paid by an exempt corporation.

Puerto Rico also

imposes a withholding taz on dividends paid from income exempt from the Puerto Rican income tax to foreign corporations, mainly U.S. parent corporations of Puerto Rican subsidiarias, (see pp. 17-18 for further explanation).

T7 These provisions combinad with the exemption of Puerto Rican corporations from Federal taxation under section 936 próvida for virtually complete tax exemption.

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IV. The Economic Setting

Puerto Rico'8 economic history in this century is one of a poor agrarian economy which has undergone rapid industrialization and economic gro%rCh, but which remains relatively low-income.

Prior to 1940 the economy of Puerto Rico vas based largely on agri cultura; the little industrial development which occurred was devoted

mostly to processing the agricultural products, primarily sugar, tobáceo, and coffee. Beginning in the 1940's and accelerating in the 1950's

Puerto Rico began a progran of incentives for industrial development under the general heading of "Operation Bootstrap". An important part of Opera-

tion Bootstrap has been the exemption from taxes for substantial periods of time for new enterprises, the exemption period depending on the location of the business on the island. The program also includes other incentives

including government financing, availability of buildings under lease or

purchase arrangements, and training for employees. The incentives program, together with other attractions for industry such as relatively low wage rates, has been successful in leading to substantial industrialization of

the Puerto Rican economy and improvement in economic conditions. However, Puerto Rico still suffers from certain economic maladies and the industrial development program has been accompanied by several deficiencias.

y For an econometric analysis of these incentives see Woodward, Robert S. The Effectiveness of Intra-Island Industrial Incentives in Puerto Rico

National Tax Journal, Yol. XXVII, No. 2, June 1974, pp. 261-273.

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One measure of the effects of industrialization is that in 1950

agricultura provided about 25 percent of national income and in 1975 provided only 5.5 percent. Manufacturing, mining, and construction, which in 1950 accbunted for less than 20 percent of national income, in

1975 amounted to 37 percent. Table 1 provides some basic economic indicators for the Puerto Rican economy over the last 25 years. As is clear

from the table the Puerto Rican economy experienced rapid real economic

TABLE 1

Real Gross National Product and Personal Income

For Puerto Rico, 1950 - 1975 (In Constant 1975 Dollars)

Personal

Gross National

Annual Rate

Personal

Year

Product (millions)

of Change (percent)

(millions)

(thousands)

1950

$1,877

$1.743

2,218

2,661

2,360

1,127

2,716

2,072

3,113

2,183

Income

Population

Income

Per Capita

$

3,145

1970

6,056

3.27% 6.3

6.8

5,628

1.1

3.3 1975

7,117

Change

(percent)

786

5.3% 1960

Annual Rate of

6,797

« Note:

Source:

GNP data are adjusted by the GNP deflator; personal :Lncome data are adjusted by the consumer price Índex.

Puerto Rico Planning Board, Socioeconomic Statistics of Puerto Rico; Fiscal Years 1940, 1950, 1960, and 1962 to 1975.

Price adjustments by author.

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growth and improvement in personal income between 1950 and 1970. However, the recent recession has had a major impact on the Island's economy, con—

siderably reduclng the growth in real GNP. Growth in real personal

income per capita has been severely cut since the beginning of the decade due to slower economic growth compounded by abnormally high population growth (Puerto Rico usually experiences substantial in—migration from the y U.S. mainland when the U.S. unemployment rate is high )•

A major factor in Puerto Rico's rapid economic growth and industrialization has been the ability to offer virutally complete tax exemption to

new businesses locating in Puerto Rico. The Economic Development Administration, called "Fomento", is the agency which oversees the tax exemption program. Over half of all the manufacturing planta in Puerto Rico are

Fomento promoted, and these planta provide 81 percent of the joba in manufacturing. Of the Fomento promoted planta, 64 percent are of U.S. ownership, and these provide 85 percent of the emplojnnent in promoted y

plants.

Among the U.S. operations in Puerto Rico are over 400 planta 3/

owned by 120 of the Fortune 500 companies.

y See Maldonado, Rita M., The Economic Costa and Benefits of Puerto Rico's Political Alternatives, Southern Economic Journal, October 1974.

p. 275.

2/ Statement of Honorable Jaime Benitez, Resident Commissioner of Puerto Rico, in Hearings before the Coimnittee on Finance, U.S. Congress, on Tax Reform Act of 1975, March 29, 1976.

p. 1045.

3/ Industrial Development, January/February, 1975.

p. 19.

O

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However, despite rapid industrialization and economic growth severe economic problems remain. Industrialization has not solved the chronic unemployment problem and has brought with it an increased vulnerability to cyclical economic fluctuations. The vulnerability to economic cycles is also a function of extremely high reliance on foreign trade, an in

evitable condition for an island economy with limited resources. In 1975 with a GNP of $7.1 billion Puerto Rico had importa of $4.95 billion, and exporta of $3.14 billion. The vast majority of this trade — 60 percent of importa and 85 percent of exporta — is with the United States.

This

cióse interrelationship with the Ü.S. economy means that Ü.S. economic

cycles have a magnified effect on the island. Unemployment, which ñor— mally averages 10 to 12 percent (despite "exportation" of approximately 50 percent of the island's potential unemployment to the Ü.S. mainland 1/

through migration ) reached levels above 20 percent during the 1975 recession and inflation reached 19 percent. Additionally, the island remains extremely poor; per capita personal income is still 64 percent below the Ü.S. average and 48 percent below the level in Mississippi, the 2/ poorest state.

ó

See Maldonado, op. cit. pp. 274-276.

2/ However, there is evidente that the distribution of income has become somewhat more equal. See Maldonado, op. cit. pp. 268-269.

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Puerto Rico's heavy reliance on industrialization for economic growth, combined with the fact that Puerto Ricans have been net

dissavers for the past 30 years, has forced a heavy reliance on outside capital.

As a result, a large portion of the capital assets of the

Puerto Rican economy is owned by outside interests, primarily interests on the mainland United States.

One recent estimate indicates that

1/

Puerto Rican residente own less than half of the island's capital assets.

In addition to the political ramifications of substantial outside owner-

ship of the means of production, there are important economic implications.

For example, over $1 billion per year in profits and interest is earned 2/

by mainland owners and creditors of Puerto Rican businesses,

not an

inconsequential sum in an economy with a GNP of just over $7 billion.

The "typical" operating pattern of a U.S. Puerto Rican subsidiary, described well in the recent Report to the Governor of the Committee to

Study Puerto Rico's Finances, is illustrative of the impact of foreign ownership:

The new firm, today more likely to be in pharmaceuticals or electrónica than textiles or apparel, begins with a physical investment provided by its Mainland parent. Since the operation has been established as much, or more, for the exemption from Federal and local taxes as for the low-cost labor or other advantages of Puerto Rico, there are large

y Report to the Governor, The Committee to Study Puerto Rico's Finances, December 11, 1975.

2/ Ibid., p. 15.

pp. 62-63.

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profits. The Mainland corporation has strong reason to lócate in Puerto Rico those of its interdependent operations which are the

most profitable. Federal tax regulations currently prevent pro fits from being returned at once to the Mainland parent. Therefore the subsidiary begins to accumulate financial assets. The income from these assets will also be exempt from Federal taxes if the

investmehts are in U.S. territories, and this explains the popu— larity of high-interest certificates of deposit in banks in Guam.

By the time its Puerto Rican tax-exemption period expires, the subsidiary holds substantial financial wealth as well as its de— preciated operating capital in Puerto Rico. The assets are then

sold, the subsidiary is liquidated, and the accumulated profit of the entire operation is absorbed into the Mainland parent, free throughout of both Puerto Rican and Federal taxes. The physical facilities are still in Puerto Rico, of course. They will be operated only if some firm, perhaps a new child of the oíd parent, finds them profitable, and this in turn may depend on whether or not a new tax exemption can be arranged. 1/

Some of the particulars of this example have been changed by the Tax Reform Act of 1976 and the Puerto Rican reaction to it.

The Federal

tax regulation which prevented profits from being returned at once to the

mainland parent was the provisión that dividends from a possessions cor poration did not qualify for the dividends received deduction, and therefore were fully taxable. The 1976 Act, among other changes, made

dividends from a possessions corporation eligible for the dividends received deduction and thus reduced the incentive to accumulate posses

sions corporation profits. However, to partially offset the potentially large outflow of capital which could result from this change in U.S. tax law. Puerto Rico adopted a 10 percent withholding tax on dividends

paid from income exempt from Puerto Rican income tax to U.S. parent corporations.

Xj Report to the Governor, op. cit. p. 43

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Historically little of the profits earned by U.S. owners of Puerto Rican subsidiarles have been reinvested in the Puerto Rican economy.

Typically as much as 80 percent o£ the assets of a mainland subsidiary on the island are held in financial form, e.g. bonds, securities, and

y certificates of deposit.

Prior to the Tax Reform Act of 1976 substantial

portions of these financial assets were foreign investments because they

qualified for U.S. tax exemption under the previous possessions corporation section.

The Tax Reform Act o£ 1976 restricta possessions corporation

treatment to investments in the possession and thus has been responsible

for a substantial repatriation of earlier Puerto Rican earnings to Puerto Rico.

This inflow of funds has already reached approximately $1.5 billion 2/

and may reach $4 billion in the near future.

However, the inflow is

having a depressing influence on interest ratea due to limited investment opportunities on the island.

Eventually, an equilibrium will be reached

between Puerto Rican investment returns and the 10 percent "tollgate

tax" on dividends paid to the mainland. The equilibrium will probably 3/

leave Puerto Rico with a somewhat higher level of reinvested profits.

y Report to the Governor, op. cit. p. 44.

y The Christian Science Monitor, April 22, 1977. p. 14.

3/ The Governor of Puerto Rico has proposed to reduce the tollgate tax to

7 percent on 75 percent of current earnings if the remaining 25 percent of profits is invested in Puerto Rican government issues. See The Journal of Commerce, May 31, 1977, p. 1. This recommendation, along with other measures designed to increase reinvestment in the Puerto Rican economy, has passed the Puerto Rico legislature in H. 377. See Taxes, August 1977. p. 505.

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^

ünfortunately, the nature of the prívate investment occurring in Puerto Rico is undergoing an important and adverse change. In the past,

$

Ü.S. investment flowed to the island to take advantage of both tax exemp-

tion and low wage ratea. Investments were predominantly in industries with low capital-output and low capital-labor ratios, such as textiles

and apparels, and thus provided relatively high levels of economic growth and ompl oyment.

However, more recently Puerto Rican wage rates have

increased relatively faster than skill levels, thus making Puerto Rican labor lesa attractive to investors.

The result is that recent Puerto

Rican investment is concentrated more heavily in the high capital-output and high capital-labor ratio industries, such as chemicals and pharmaceuticals, and thus provides less economic growth and employment. Henee, tax exemption is increaaingly the main reason for outside investment on

the island, and the reaulting investment is providing reduced benefits to the island.

As a result of these trends the recent Report to the

Governor of the Committee to Study Puerto Rico's Finances recommends some

draatic policy reviaiona to restrain wage increasea and restructure the

y tax exemption program toward a higher level of job-creating investment.

B

Thus, the Puerto Rican economy is characterized by a recent history of rapid economic growth which has failed to overeóme the severe poverty

O

y Report to the Governor, op.cit., see major recommendations 1, 5, 6, 7, and 8.

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and unemployment on the island. Additionally, the contemporary Puerto

Rican economy suffers from several important problems which heighten the

sensativity of the economy to external disturbances and point to an un-

certain economic future. Given such a setting, the potential economic effects of possible changes in the special political and economic relationships which have existed between the United States and Puerto Rico

are obviously of crucial importance.

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V-

The Impact of Fully Treating Puerto Rico as a State Under Federal Tax Lavs

This section presents estimates of the fiscal impact of fully treating Puerto Rico as a State for purposes of Federal taxation.

The estimates are

based on the assumption that if confronted with full State tax treatment by the Federal government. Puerto Rico would adopt a tax system more similar

to that of the states.

The estimates are based primarily on information 1/

provided by the U.S. Department of Treasury,

with adjustments and addi-

tions as noted. The fiscal impact estimates are derived from a comparativa statics analysis based on fiscl year 1975 data (the last year for which full

data are available). In other words, the analysis assumes a change in the Federal and Puerto Rican tax structures, but does not take account of any economic changes which would be expected to result from the different tax

treatment. A discussion of the economic changes which would be anticipated

is contained in section VII. The estimates are also based on the assumption of immediate full imposition of all the tax changes, rather than phased-in state-like taxation.

The fiscal estimates of the impact of full State tax treatment of Puerto Rico are shown in Table 2.

Puerto Rican receipts in 1973 amounted

\J The information is contained primarily in two documente: Sammons, Robert L., Potential New Federal Taxes in Puerto Rico, June 4, 1975, a paper preparad for the Treasury; and a series of four tables updating the Sammons estimates released on April 20, 1976 by the Office of International Tax Affairs, Office of the Secretary of the Treasury. The author also wishes to acknowlegde the helpful comments and suggestions of James Nunns of the Office of International Tax Affairs.

CRS - 22

#

to $1,232 million, excluding Federal grants-in-aid. Of this total,

^

$1,133 million was produced by taxes and customs duties, and $99 million was generated by licenses (alcoholic beverages, cigarettes, motor vehicles, gasoline etc.) and miscellaneous sources such as permita, fees, fines, and a lottery.

Of the revenue produced by taxes and duties the largest revenue source

is the excise taxes, which produce a total of $493 million. Nearly one1/

fourth of the excise tax receipts, $112 million in 1975,

are Federal

excise taxes on alcoholic beverages and tobáceo products produced in Puerto Rico for sale in the United States; under the present arrangement these

taxes are collected by the Federal Government and paid ( covered over ) to the Treasury of the Commonwealth. The most productive excise taxes in

2/

Puerto Rico apply to gasoline and petroleum products ($103 million in 1975),

alcoholic beverages ($87 million), tobáceo products ($63 million), and motor vehicles ($54 million).

The Puerto Rican individual income tax produced $324 million in 1975,

despite an underreporting of taxable income which has been estimated at 3/

approximately 40 percent.

.

.

.

The income tax on nonresidents, which is col

lected via a withholding tax on pajrments to nonresidents, generated 1/ This figure represents actual Federal collections from this source, not Puerto Rican receipts. Puerto Rican receipts were slightly higher because a portion of prior year collections were "covered over in FY 1975.

2/ This amount includes $81 million in collections which is earmarked for the Highways Authority and the Port Authority.

3/ Samraons. op. cit. p. 5. See also Andic and Mann. op. cit. p. 196.

0

47

1,133 99

1,279

O

4?

99

1,232

1,180

52

73

12

523

O

23

163

$334

Total

Sources:

U.S. Treasury Estimates and CRS estimates as described in the text.

($81 million).

853

99

754

O

132

3

310

179

7

18

$105

Receipts

52

O

9

257

O

C

562

460

1,340

O

1,340

$

Receipts

U.S. Treasury

State Status

Puerto Rican

y Includes Federal excise taxes "covered over" to the Commonwealth ($112 million) and Puerto Rican Excise tax collections earmarked for highways and the Port Authority

Total

Licenses and Miscellaneous

Total taxes and duties

7

45

Customs Duties

O

73

O

30

O

O

O

$ 10

Property Tax

493

1/

O

23

163

324

Receipts

12

$

Receipts

U.S. Treasury

Estate & Gift laxes

Excise taxes

Sales tax

Nonresident income tax

Cor porate income tast

Individual income tax

Source

Commonvealth Status

Puerto Rictti

(millions)

TREATMENT OF PUERTO RICCV FISCAL YEAR 1975

ESTIMATES OP THE FISCAL IMPACT OF FÜLL STATE TAX

TABLE 2

CRS - 23

$

2,193

99

2,094

52

132

12

567

179

7

580

565

Total

-379

-379

-45

+59

-9

-183

+179

-16

-145

$ -219

Receipts

Puerto Rican

Change

$

+1,293

+1,293

+45

+9

+227

+562

+450

U.S. Treasury Receipts

CRS - 24

$23 million in 1975. The Puerto Rican corporate income tax, which applies only to corporate taxable income not exempt under the Industrial Incentives

Act, yielded $163 million. The $73 million of property tax receipts shown in Table 2 reflects only collections by the Commonwealth from this source; the Puerto Rican local governments collected an additional $129 million from this tax.

The receipts from customs duties reflect U.S. customs

collected by the Federal Treasury on imports into Puerto Rico from foreign countries; these receipts are "covered over" to the Puerto Rican Treasury just as Federal excise tax collections are.

Present U.S. Treasury receipts from Puerto Rico are virtually negligible.

The Federal Government in 1975 collected $10 million from

the individual income tax applied to non-exempt Puerto Rican income, $30 million from excises on products produced in Puerto Rico for the U.S.

market ($28 million of which was derived from excises on petroleum products), and $7 million from customs duties. The amount from customs represents the cost of Treasury collections and administration, and is deducted before

covering over" the net proceeds of the customs duties to the Commonwealth.

If Puerto Rico were fully treated as a State for purposes of Federal

taxation and adopted a tax structure more comparable to that of the States, it is estimated that Puerto Rican receipts (other than grants-in-aid) would diminish by approximately $379 million, and Federal receipts would increase by about $1,293 million. Thus, in total, it is estimated that under full

CRS - 25

State tax treatment $914 million in additional taxes would be generated by the Puerto Rican economy.

The estimates indícate that excise taxes would retain their predominance in the Puerto Rican revenue structure, although at a reduced absoluta level.

The reduction results from the loss of Federal excise taxes on alcoholic

beverages and tobáceo products presently "covered over" to the Commonwealth, as well as reductions in Puerto Rican excises assumed to occur to prevent

the combinad level of Federal and Puerto Rican excise taxes from rising dramatically above lavéis in the States. Puerto Rican receipts from the individual and corporate income taxes are also estimated to diminish sub—

stantially under State tax treatment, due to Federal "preemption" of these revenue sources. On the other hand, the estimates show that if Puerto Rico adoptad a tax structure more similar to that of the States it

could derive increased revenue from the property tax and a retail sales tax.

The estímate of total general revenue of Puerto Rico under a "state-

like" tax structure implies a per capita level of total "State and local"

taxes for fiscal 1975 of $297.20, which is considerably below the level in

any of the States—the lowest state figure for 1975 was $405.26 per capita for Arkansas—and far below the national average per capita State and local tax revenue of $663.77.

On the other hand, the Puerto Rican collections

under this "state-like" system would imply a relatively high tax effort compared to the level of personal income; the Puerto Rican total "State

CRS - 26

and local" taxes per $1,000 of personal income would equal $153«ó?, compared to a national average of $122.84.

This pattern of ranking higher in tax

effort compared to personal income than in tax effort on a per capita basis is typical for low-income States.

The estimates of Federal revenue from Puerto Rico under full State

tax treatment indicate an increase of almost $1.3 billion in Treasury re-

ceipts.

L

This new revenue would result primarily from ending the Puerto Rican

exemption from the U.S. individual and corporate income taxes and secondarily from the full application of Federal excise taxes in Puerto Rico.

A brief indication of the assumptions underlying the estimate and the source of the estimate for each tax follows:

Individual Income Tax

Puerto Rican Receipts: The estimate assumes Puerto Rico would adopt a State income tax which would generate revenues equal to 2 percent of per sonal income excluding transfer payments. This effective tax rate would be higher than some of the poorest States, but lower than the average rate for the ten lowest income states and lower than the national average.

The es

timate also assumes full reporting of income on Puerto Rican tax returns (compliance would probably increase once Federal income taxes applied because most States use the Federal tax return computar tapes in their audit program).

Source of estimate:

U.S. Treasury.

CRS - 27

#

Federal Receipts: The estímate was derived by reprocessing Puerto Rican tax return data to show potential tax liability under the Federal individual income tax.

It assumes a compliance level on par with experience in the

states.

Source of estímate:

U.S. Treasury

Corporate Income Tax:

Puerto Rican Receipts:

The Treasury estímate of Puerto Rican corporate

income tax collections under full State tax treatment is $115 million.

How-

ever, this estímate assumes a 10 percent Puerto Rican corporate income tax, which would be higher than the rate in all but five States and substantially higher than the rates in the low-income States, and also assumes immediate termination of the Industrial Incentives Act tax exemption program. Given the state of the Puerto Rican economy and the heavy dependence on externally financed industrial investment, such a drastic reversal of policy seems implausible. Additionally, since the grant of tax exemption under the

Industrial Incentives Act is a contractual agreement between the Commonwealth and each tax-exempt corporation, there is controversy over whether and under what circumstances the tax exemption may be terminated. For these reasons, the estímate in this study assumes a 5 percent Puerto Rican corporate income tax and continuation, at least in the short-run, of the Industrial Incentives Act Tax exemptions. Under these circumstances the total tax liability

(Federal and Puerto Rican) on corporations which presently are not exempt would increase only slightly. The total tax liability for exempt corpora tions, of course, would substantially increase despite the continued Puerto Rican exemption because of the termination of section 936 treatment.

Source of estímate: Congressional Research Service adjustment of U.S. Treasury estímate.

Federal Receipts: The Treasury estímate of Federal corporate income tax ^

collections in Puerto Rico under full State tax treatment is $515 million.

This figure has been adjusted upward to reflect the lower deductions attributable to the CRS estímate of Puerto Rican corporate tax collections

^

under State treatment (see discussion above). The Treasury estímate is based on an assumed effective corporate tax rate of 48 percent which may overstate the potential revenue somewhat because of the investment tax credit. However, because of the considerable uncertainty in the data base for this estímate (taxable income of the exempt corporations is difficult to estímate) a high degree of precisión is unattainable.

Source of estímate: Congressional Research Service adjustment of U.S. Treasury estímate.

CRS - 28

# Nonresident Income Tax: c

Puerto Rican Receipts:

The estímate assumes a reduction in income tax

collected from nonresidents proportionate to the reduction in individual income tax collections from residents.

Source of estímate:

Congressional Research Service

Federal Receipts:

None.

Sales Tax:

Puerto Rican Receipts: The estímate assumes Puerto Rico would adopt a general retail sales tax if confronted with full State tax treatment by the Federal Government.

revenue in the States.

The sales tax is the largest single source of

It is an especially productiva and appropriate

revenue source for States with substantial tourism. In fiscal year 1975 the ten lowest—income States derivad sales tax revenues which averaged

3.06 percent of 1974 personal income. The estímate assumes a Puerto Rican sales tax would yield 3.0 percent of personal income.

Source of estímate:

Congressional Research Service

Federal Receipts:

None

Excise Taxes:

Puerto Rican Receipts:

The estímate assumes the Federal excise tax

collections on Puerto Rican alcoholic beverages and tobáceo products sold

in the U.S. would no longer be "covered ovar" to the Commonwealth Treasury.

The estímate is also basad on assumptions about ratas and lavéis for each excise tax. Basically, the estímate assumes that for those Puerto Rican excise taxes which are presently as high as or higher than the highest

combinad Federal State lavéis in the States, the Puerto Rican excise tax would be reduced to offset the newly applicable Federal tax.

cases in which the imposition of the Federal excise would not increase the total Federal-Puerto Rican tax beyond the highest lavéis of combinad taxes in the States, the Puerto Rican taxes are assumed to remain at their present lavéis.

Source of estímate:

U.S. Treasury

^

For those

^

CRS - 29

# Federal Receipts;

The estímate assumes the Federal excise tax

collections on Puerto Rican alcoholic beverages and tobáceo products would

no longer be "covered over" to the Commonwealth Treasury, and that all other Federal excises would be fully applicable within Puerto Rico. The estimates for each excise tax are based on present Puerto Rican excise tax collection data where available.

Source of estímate:

U.S. Treasury

Estate and Gift Taxes:

Puerto Rican Receipts:

The estímate assumes that Puerto Rican estáte

tax collections under State tax treatment would equal 20 percent of Federal collections; this is slightly lower than the average ratio in the states.

The estímate also assumes the present Puerto Rican gift tax would be retained.

Source of estímate:

U.S. Treasury

Federal Receipts: The estímate is based on present Puerto Rican estáte and gift tax collections, and allows for a credit for Puerto Rican collections under a State-type system.

Source of estímate:

U.S. Treasury

Property Tax:

Puerto Rican Receipts: There is evidence that Puerto Rico presently underutilizes the property tax, however, estimating potential revenue

from a more "typical" reliance on the property tax is fraught with ambiguities. Puerto Rico presently derives a higher ratio of revenue compared to personal income from the property tax than the average for the poorest States, but the Puerto Rican average is below the national average. On the other hand, on a per capita basis the Puerto Rican property tax collections appear extremely low. In fiscal 1975 the per capita Puerto Rican property tax revenue amounted to $65.76 whereas the

See for example, Report to the Governor, The Committee to Study

Puerto Rico's Finances, December 11, 1975. number 2.

Major Recommendation

CRS - 30

average for the five lowest-income States was $126.91 (Alabama, the

State with the lowest per capita amount, had a level of $52.95; Arkansas, the second lowest, was at $89.60), the average for the ten lowest-income States was $116.78 and the U.S. average was $241.60. Based on these observations, the estímate assumes, rather arbitrarily, that Puerto Rico could increase its property tax revenue to a level of $85 per capita.

This would still leave Puerto Rico with a lower per capita level than any State but Alabama. The estímate shows the entire increase in property tax revenue in the column "Puerto Rican Receipts", even though

most of the increase would probably go to the municipalities (which collected $129 million from the property tax in 1975). This is because the increased municipal property tax collections would substituto for "State"-local transfers, and thus benefit the Commonwealth by an equal amount.

Source of estímate:

Congressional Research Service

Federal Receipts:

None

Customs Duties:

Puerto Rican Receipts: The estímate assumes Federal customs collec tions on foreign imports into Puerto Rico would no longer be covered over" to the Commonwealth.

Source of estímate:

U.S. Treasury

Federal Receipts: The estímate assumes Federal customs collections

on foreign imports into Puerto Rico would no longer be covered over to the Commonwealth.

Source of estímate:

U.S. Treasury

Licenses and Miscellaneous:

Puerto Rican Receipts: The estímate assumes there would be no change as a result of State tax treatment.

Federal Receipts:

None

CRS - 31

€ VI. The Impact of Fully Treating Puerto Rico as a State ünder Federal Grant and Revenue Programs

This section provides estimates of the increase in Federal funds

which would flow to Puerto Rico if it were fully treated as a State for all Federal grant and revenue programa. Tablea 3 and 4 show the present

Federal grants and transfers to Puerto Rico in fiscal year 1975.

Total

Federal grants to Puerto Rico amounted to $464.5 million and net trans—

fer receipts of Puerto Rican individuáis totaled $606 million.

For purposes of most Federal grant programs Puerto Rico is already treated as a State. Of course, like the States, Puerto Rico does not

presently receive all of its potential funding under every possible Federal grant program because some programs are less applicable to the

needs of the area, some available Federal funds go unused because of a failure to file grant applications, and some Federal funds are not

claimed due to insufficient local matching funds.

However, there are

some twenty-two significant Federal grant-in-aid programs, most of which flow through the Department of Health, Education and Welfare, which cony tain statutory restrictions on funding levels for Puerto Rico.

Additionally, Puerto Rico does not receive Federal revenue sharing funds under present law.

Table 5 presente estimates for 1975 of the increases

y McManis Associates, Inc., Analysis of Utilization of Federal Funds in San Juan and Puerto Rico, July 1976. See especially p. II-5.

CRS - 32

Table 3

Transfer Payments £rom Federal General Revenues and Trust Funds to Individuáis Resident in Puerto Rico, FY 1975 (Millions o£ Dollars)

Associated

payments by

Food stamps

Total receipts

or on behalf

Net receipts

of individuáis resident in Puerto Rico

of individuáis resident in Puerto Rico

of individuáis resident in Puerto Rico

98

$ 252

480

390

90

50

8

42

Unemployment compensation

110

79

31

Veterana benefits

183

$

OASDI

Medicare

$

-

183

22

14

8

$ 1,195

$ 589

$ 606

Civil service retirement Total

350

April 20, 1976 Office of International Tax Affairs

CRS - 33

Table 4

Federal Grants to Puerto Rican Governments, FY 1975 (Millions of dollars)

Federal Department or Agency

Amount

fe

Department of Agriculture

$ 57.0

Civil Service Commission

0.3

Department of Commerce

12.2

Community Services Administration

14.9

Corporation for Public Broadcasting

0.3

Department of Defense

3.5

Environmental Protection Agency

9.4

Federal Power Commission

*

Funds Appropriated to the President

11.2

Department of Health, Education, and Welfare

185.5

Department of Housing and Urban Development

55.6

Department of the Interior

2.1

Department of Justice

11.7

Department of Labor

82.9

National Foundation on the Arts and Humanities

0.2

Department of Transportation

17.4

Miscellaneous

0.4

$464.5

Total

* Less than $50,000 Note:

April 20, 1976

Exeludes customs duties and excise taxes "covered over" to the

Puerto Rican Treasury.

Source:

Office of the Secretary of the Treasury

Office of International Tax Affairs

U.S. Department of the Treasury, Federal Aid to States:

Fiscal Year 1975

CRS - 34

in Federal funding levels which would result from fully treating Puerto Rico as a State under the most important Federal grant and revenue programa which are presently restricted or inapplicable•

The estimates have been provided

by the Department o£ Health, Education, and Welfare and the Department of

y the Treasury and are used here without evaluation.

The estimates indicate

that under full State treatment, Puerto Rican governments could have received

up to an additional $370.3 million in 1975, principally from revenue sharing,

AFDC, and Title I of the Elementary and Secondary Education Act. Puerto Rican individuáis could have received increased net transfers of $378.4 million,

primarily from Supplemental Security Income. Receipt of these increased

funding levels would not be entirely costless, however; Puerto Rican govern ments and individuáis would have to increase matching funds and personal

payments by a total of $49.1 million to receive the full increased benefit

levels. This implies the possibility of receiving lesa than the full funding

amounts, if Puerto Rican matching and payment levels do not rise sufficiently, and also implies a possible shift in the mix of government programing under State fiscal treatment.

y A detailed study of increased funding levels under full state treatment^ of Puerto Rico is presently underway in the Congressional Research Service and will be available at a later date.

CRS - 35

Table 5 t

Estimated lacreases in Federal Funding Levels From Fully Treating Puerto Rico as a State Under Federal Grant and Revenue Programa in 1975 (millions of dollars) Puerto Rican lacrease ia Federal Funda

Program

Matching Requirement

or Payment

To governments;

Revenue sharing

$ 200.0

AFDC

76.3

21.6

Title XX of SSA

30.0

10.0

Title I of ESEA

64.0

Sub Total

$ 370.3

$ 31.6

61.9

17.3

WIN

6.5

0.2

SSI

300.0

To individuáis; Medicaid

Prouty Amendments

10.0

Sub Total

$378.4

$ 17.5

Total

$748.7

$ 49.1

Sources: Revenue sharing estimate: unofficial estimate of Ü.S. Department of Treasury.

Other Estimates;

Author's adjustments to year 1975 of estimates provided by Office of the Secretary of the Department of Health, Education, and Welfare from, "Report of the Under Secretary': Advisory Group on Puerto Rico, Guam, and the Virgin Islands".

October 1976, p. 26 (all estimates except Title I of ESEA) and from the National Center for Education Statistics.

CRS - 36

VII. A Preliminary Analysis of the Economic Impact of Fully Treating Puerto Rico as a State Under Federal Tax and Expendíture Programs

The previous two sections provide estimates of the potential fiscal

impacts of fully treating Puerto Rico as a State for purposes of Federal taxation and expenditure programs. This section presents an indication of

the pótential implications of these estimates for the Puerto Rican economy.y The analysis is highly preliminary, and to some extent conjectural, because

it is not based on econometric measures of the Puerto Rican economy, and ultimately rests on a question which requires further research.

Table 6 combines the data from the two previous sections. to show the

net flow-of-funds impact on the government, individuáis, and corporations sectors in the Puerto Rican economy under full State fiscal treatment. The table indicates that under full State treatment the government sector in

Puerto Rico would sustain a fiscal loss of approximately $8.7 million.

However, the proper interpretation of this estimate is that State treatment

would have a negligible impact on the revenues available to governments in Puerto Rico.

This is because the estimates in Tables 2 and 5 are suffi-

ciently imprecise that the $8.7 million figure in Table 6, which representa less than 1 percent of Puerto Rican-generated revenues in 1975, cannot actually be distinguished from a zero impact. Additionally, the estimates

are based on a number of behavioral assumptions which may not be accurate, especially if fiscal balance could be achieved by relatively modest y The economic impact on the Federal Government is also of interest and is readily determinable from Tables 2 and 5. The estimates indicate that

fully treating Puerto Rico as a State under Federal tax and expenditure

programs would yield a net annual increase in Federal revenues of ap proximately $345 million. Of course, if full State treatment were phased in, or had a severe negativa impact on the Puerto Rican economy, this figure would be reduced.

CRS - 37 Table 6

Net Impact of Fully Treating Puerto Rico as a State Under Federal Tax and Expenditure Programs in 1975 •# Gain Amount

or

Sector

Losa

Governments:

loss:

($ millions)

Item

W

Reduced revenue receipts

$379

gain:

Increased transiera from

Federal government _2/

370.3

net impact: Individuáis;

loss:

$-8.7

y

individual income tax

231

sales tax V

143.2

excise taxes

35.2

property tax

29.5

total loss

$ 438.9

gain:

increased transiera irom Federal government

net impact: Corporations;

loss:

378.4

$-60.5

1/

corporate income tax

sales tax _3/ excise taxes 3_/ property tax 4/ total loss

417

35.8 8.8 29.5

$ 491.1

gain: none

1/ Source:

Table 2, p. 23

Source:

Table 5, p. 35

Source:

Table 2, p. 23. Assumes 20 percent oi sales and excise taxes is paid by business.

Source:

Table 2, p. 23. Assumes 50 percent oi property tax is paid by business. See: Signiiicant Features oi Fiscal Federalism, 1976-77

edition, voí II—Revenue and Debt, Advisory Commission on Intergovernmental Relations, Table 70, p. 106.

CRS - 38

behavioral changas. For exanple, if indeed a small gap in available funds

would develop under State treatment, Puerto Rican officials might increase

matching funds for already available Federal matching grants, thus increasing Federal transfers to offset the shortfall.

However, while the aggregate revenue impact on governments in Puerto

Rico of full State fiscal treatment may be negligible, the programmatic im pact may be important.

While some of the increased Federal revenue Puerto

Rico would receive as a result of full State treatment would be general purpose revenue, such as revenue sharing, other revenue, such as AFDC and

Title I funds, is earmarked for a specific purpose and may even require local matching funds to receive. Therefore, unless the revenue gain categories fit well into the present Puerto Rican expenditure pattern, a shift

in the mixture of government programming or a change in the overall level of government services would result.

Table 6 reveáis that under full State fiscal treatment Puerto Rican

individuáis would sustain an aggregate loss of slightly over $60 million, or less than 1 percent of personal income. This figure, like the estimated revenue loss for the government sector, is sufficiently small that the

possibility that it may result from estimation error cannot be discounted.

For example, the estímate of Federal individual income tax revenue which would be collected in Puerto Rico under full taxation (Table 2) is based on

incompleta data and assumes a 40 percent underreporting of taxable income;

CRS - 39

considerable margin for error must be allowed in such an estímate. #

Additionally, changes in the Federal individual income tax since 1975,

specifically the enlargement of the standard deduction and adoption of the

general $35 per exemption credit and adoption of the earned income credit, may have reduced the relative fiscal impact of full Federal individual 1/ income taxation in Puerto Rico.

Given the relatively small magnitude of the aggregate impact on

individual income of full state fiscal treatment, a far more important effect is the income redistribution which would occur. The gains and

losses experienced by individuáis as a result of fully treating Puerto Rico as a State under Federal tax and expenditure programe would not be distributed evenly among the population. The increase in Federal

transfer receipts would flow almost entirely to lower-income indivi

duáis whereas upper-income persons would bear a heavy portion of the

increase in taxes, both through higher effective tax rates and improved collection procedures. Thus, full State fiscal treatment implies a sizeable redistribution of after-tax income from upper-income to loweríñ

J

income individuáis.

The increase in corporate taxes resulting from full State tax treatment would not be offset by any increase in government transfers

y This point is addressed in, McManis Associates, op. cit. pp. 1-5 to 1-7.

However, the McManis estimates of the magnitude of this impact appear considerably overstated.

CRS - 40

or grants.

Thus, corporations in Puerto Rico would sustain a net loss

of approximately $490 million per year under full State fiscal treatment.

This potential loss and its consequences are probably the crucial issue surrounding State treatment (see below).

The flow-of-funds analysis provided in Tabla 6 gives a comparativa statics estimate of the "first round" economic implications of full State

fiscal treatment of Puerto Rico; it dees not indicate the full potential

economic effect of the changes once all economic reactions or "feedbacks" have occured. While it has been observed above that the economic impact

estimates in Table 6, with the exception of the corporate sector, are

sufficiently imprecise that their magnitude is uncertain (and may, in fact, be negligible), it may nonetheless be instructive to explore the full potential economic impact of revenue loases of the magnitudes stated in Table 6.

The multiplier for macroeconomic changes in the Puerto Rican

economy is probably rather low because of the extremely large foreign trade sector. The large volume of imports and exporta dampens the

domestic impact of demand-related economic changes (such as income or consumption patterns) and magnifies the domestic impact of supply-related

changes (such as wage or productivity levels).

Thus, the economic multi

plier for changes in personal income and government spending in Puerto Rico

would be relatively low, perhaps in the neighborhood of 1.3 to 1.5. An

CRS - 41

additional factor which would modérate the multiplier effect of State

treatment of Puerto Rico is that the change would involve a redistributíon of income toward lower-income groups in addition to any changes in the

aggregate levels of income and government spending. Since individuáis and families in the lower income brackets have a higher propensity to 1/

consume than higher-income people,

the reduction in aggregate economic

activity would be smaller than if the loss of income were evenly dis-

tributed (of course, this implies a further reduction in the rate of savings in Puerto Rico, a consequence which worsens other problems.

See section IV).

Assuming a multiplier of 1,5 as rqasonable for the

Puerto Rican economy, the reduction in individual income and government

spending indicated in Table 6 could eventually reduce Puerto Rican GNP by approximately $105 million below otherwise attainable levels, a re

duction of approximately 1.5 percent. Thus, the estimates of revenue losses to the government and individuáis sectors in Table 6, to the

extent that they are accurate, imply a small, though not inconsequential, reduction in GNP.

ünfortunately, the impact on the Puerto Rican economy of the change in the taxation of corporatíons cannot be analyzed by simple multiplier techniques.

On the one hand, the approximately $490 million reduction

V For estimates of family savings rates at different income levels for

Puerto Rico see, Report to the Governor. op. cit.

p. 29.

CRS - 42

in after-tax profits that Puerto Rican corporations would sustain as a result of full State tax treatment dees not equate to a withdrawal of that amount from the Puerto Rican economy, because little of these pro fits is presently reinvested in Puerto Rico.

On the other hand, the

change in corporate taxation which would result from full State treat

ment of Puerto Rico—for most corporations a-change from complete tax

exemption to full taxation—has significance far beyond the reduction in funds available for immediate reinvestment in the Puerto Rican

economy. Such a tax change would cause a total reevaluation of the

investment climate in Puerto Rico by the business community and could cause fundamental changes in business activity.

To the extent that Puerto Rico's attractiveness to investors

depends on tax exemption, full State tax treatment would have a serious y

negativa impact on the economy;

.

not only would a reduction in ongoing

investment occur, but an exodus of existing firms might also develop over a period of time. A loss of investment attractiveness to some types

of firms, particularly those interested in Puerto Rico soley for the tax exemption and those which make little contribution to the Puerto

Rican economy (see discussion in section IV), would not be disasterous.

However, an across-the-board reduction in business investment and operation would have serious implications.

J^/ Additionally, Federal minimum wage laws presently do not have full applicability in Puerto Rico. Full State treatment under the minimum wage laws would further reduce incentives to invest in Puerto Rico.

CRS - 43

f

Detailed up-to-date information oti the importance of tax exemption

^

to investment in Puerto Rico and the consequences of reduced investment attractiveness does not exist. The last in-depth study of the issue

i/ vas performed by the Commission on the Status of Puerto Rico in 1966.

That study which included economic and financial analysis of business

locations in Puerto Rico along with interviews of U.S. and Puerto Rican manufacturers and industrial promotion officials, reportad in part the following conclusions:

(a) tax exemption has been of primary importance in attracting industrial investment to Puerto Rico in the past; (b) it will continué to be required in the immediate future because of the

present state of development of the economy; but (c) this form of investment incentive will diminish with continuad economic

growth. It is not possible, however, to predict just how fast the present dependency on tax exemption will diminish, particu— larly in the case of highly capital-intensiva industries. The loss of the ability to grant exemption from taxes of all kinds will, as a consequence, always entail soma risk to the continuad economic growth of Puerto Rico. 2/

Between two-thirds and three-quarters of the pattern of past industrial growth which took place under Commonwealth would have

been adversely affected, and perhaps would not have aven occured,

in the absence of the minimum wage and tax exemptions. 3^/

y Commission on the Status of Puerto Rico, Status of Puerto Rico, House Document No. 464, 89th Congress, 2d Session. August 4, 1966.

y Commission on the Status of Puerto Rico. op. cit. p. 73.

3/ Ibid. p. 75.

CRS - 44

Based on its analysis o£ the combined effects o£ wage and tax exemption, the program o£ economic studies concludes thát soma

25 years would have to elapse before a Puerto Rican economy without fiscal autonoiny is likely to be able to achieve the same ratas of growth in income and employment as the average State. W

To what extent these conclusions remain valid today is unknown.

However, this question remains the central issue in understanding the potential economic impact of full state tax treatment of Puerto Rico.

If full state treatment would substantially diminish the investmént attractiveness of Puerto Rico to business enterprises—largely U.S. corporations operating under section 936 of the internal revenue coda— then state treatment could have disasterous consequences for the Puerto

Rican economy.

However, if state treatment would not seriously curtail

investment in important business sectors in Puerto Rico, or if any

potential negativa impact could be delayed or offset by gradually phas-

ing in full taxation or by development of more vigoróus local investment, then state treatment could be accomplished without serious economic dis—

ruptions. Because of its crucial importance tó the viability of the Puerto Rican economy, this issue should be carefully reviewed once again prior to any serious consideration of state fiscal treatment for Puerto Rico.

1/ Ib id. p. 76.

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