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Here's how an obscure tax change sank Puerto Rico's economy

  • Even before a devastating hurricane brought Puerto Rico to a near standstill, the government there was struggling with an economy in shambles and a default on billions of dollars of public debt.
  • That fiscal mess has its roots in the repeal of a controversial corporate tax break that helped spark an exodus from the island that sent its economy into reverse.
A line of people wraps around the Banco Popular in San Juan as people are desperate to get cash. Nearly one week after hurricane Maria devastated the island of Puerto Rico, residents are still trying to get the basics of food, water, gas, and money from banks.
Carolyn Cole | Los Angeles Times | Getty Images
A line of people wraps around the Banco Popular in San Juan as people are desperate to get cash. Nearly one week after hurricane Maria devastated the island of Puerto Rico, residents are still trying to get the basics of food, water, gas, and money from banks.

As GOP lawmakers and the White House put the finishing touches on a proposal to overhaul the American tax code, Congress and the Trump administration are also considering multiple options to help storm-ravaged Puerto Rico get back on its feet.

The two issues aren't as unrelated as they might appear.

After Hurricane Maria last week left Puerto Rico and its 3.4 million residents without power, officials are still assessing what is needed to provide shelter, clean water, refrigeration, safe food and medical supplies for the U.S. territory.

Even before the storm brought Puerto Rico to a near standstill, the government there already struggled with an economy in shambles and a default on billions of dollars of public debt.

That fiscal mess, partly the result of a prolonged downturn that lingered long after the rest of the U.S. had recovered from the Great Recession, has its roots in the repeal of a controversial corporate tax break that helped spark an exodus from the island and sent its economy into reverse.

More than half a century ago, U.S. lawmakers sought to help Puerto Rico emerge from a colonial past, transforming its largely agrarian economy into a manufacturing powerhouse. The effort, known as Operation Bootstrap, began with a series of tax breaks designed to attract manufacturers who would provide steady factory jobs.

For a time the plan seemed to work, as standards of living in Puerto Rico rose. Between 1950 and 1980, per capita gross national product grew nearly tenfold in Puerto Rico, and disposable income and educational attainment rose sharply, according to the Center for a New Economy, a think tank based in San Juan, Puerto Rico.

One of those tax breaks, enacted in 1976, allowed U.S. manufacturing companies to avoid corporate income taxes on profits made in U.S. territories, including Puerto Rico. Manufacturers, led by the pharmaceutical industry, flocked to the island.

But by the early 1990s, the provision faced growing opposition from critics who attacked the tax break as a form of corporate welfare. Much like the current debate over corporations parking profits offshore to avoid taxes, tax reformers saw the provision, known as Section 936, as too costly for the Treasury.

The tax break also had some unintended consequences, notably the unfair tax burden that fell to domestic Puerto Rican companies.

In 1996, President Bill Clinton signed the law that would phase out Section 936 over 10 years.

Plant closures and job losses followed. Ten years later, on the eve of the Great Recession, employment in Puerto Rico peaked. Left with a dwindling tax base, the Puerto Rican government borrowed heavily to replace the lost revenue.

Today, the U.S. territory has nearly $70 billion in debt, an unemployment rate 2.5 times the U.S. average, a 45 percent poverty rate, nearly insolvent pension systems and a chronically underfunded Medicaid insurance program for the poor.

Puerto Rico's job base continues to shrink, taking its economy along with it. Since the recession ended, a lack of job prospects has sent many Puerto Ricans fleeing to the mainland, where the job market is much stronger.

The out-migration began before the recession sent the U.S. economy into reverse in 2007. From a peak of 3.8 million in 2004, Puerto Rico's population fell to about 3.4 million last year, according to census estimates, a decline of nearly 11 percent.

The departure of younger workers has left the territory with an older, poorer population, further straining the government's social services. It's also left the local economy with fewer active workers; as of June, just over 40 percent of Puerto Rico's population was officially counted as part of the labor force.

Some of those missing from the workforce are part of an "informal" economy that employs "a large segment of the population" and allows "workers and firms to avoid many of the taxes and other costs associated with formal employment," according a 2014 report by the New York Federal Reserve.

The devastation brought by Hurricane Maria has accelerated the exodus, as families who have lost their homes seek shelter with relatives on the U.S. mainland. Many likely see the relocation as temporary. Others may find better opportunities in one of the 50 states, where the average weekly wage is nearly twice that of Puerto Rico.

It remains to be seen how many will return, leaving even fewer workers to rebuild the territory's battered economy.