The rise and fall of a tax heaven: The case of Puerto Rico

For almost fifty years Puerto Rico was presented as a showcase of economic development. After World War II, the U.S. possession became a strategic component of the U.S. defense system in the region. The strategic location in the Caribbean was crucial during the “Cold War” and the geopolitical confrontation with the Soviet Union.

By then, Puerto Rico was highly relevant, and federal policy makers were interested in support the economic development of the U.S. possession in the Caribbean. “Operation Bootstrap” and the establishment of the Commonwealth in 1952, endorsed by Congress, provided the new arrangement to promote Puerto Rico’s development and long-term political stability.

Between 1948 and 1996, the political and economic experiment worked almost perfect. The evolution of the economy during the first two decades of the birth of the self-government model, there was a healthy economic growth, with rates that reached 6%. The institutional framework developed in Puerto Rico was so impressive, that it was called “the showcase of democracy” and the United States used us as an example for other developing economies.

During the peak of the industrial-economic takeoff, the country was able to construct a technocracy that would be vital for the development of a good culture in the public administration. Everything was going well, and the democratic experiment created in 1952, even with its limitations, gave considerable space to local politicians and the rest of society, to construct what would be one of the most stable and prosperous economies in its hemisphere.

In two decades, Puerto Rico achieved an industrial transformation that has taken other economies decades. Even after the start of the partisan alternation, in 1968, both main parties looked like they respected the most essential fundamentals of the economic and political model.

The dramatic increase of oil prices triggered by the oil embargo of the Organization of Petroleum Exporting Countries (OPEC), created a global recession that disrupted Puerto Rico’s economy. The 1973-75 recession led to the collapse of the island’s petrochemical industrial model. For the first time since the beginning of Operation Bootstrap, the local economy suffered its first recession.

The rise and fall of a tax gimmick

In 1976, U.S. Congress allowed the amendment of Section 931 into Section 936, providing more flexibility to and greater tax benefits to multinational companies benefiting from federal tax breaks. Section 936 exempt corporations from paying taxes on dividends from subsidiaries to parent companies in the U.S. From 1976 to 1996, under the new federal tax incentive program, Puerto Rico became the most attractive and profitable manufacturing destination in the region.

The local economy developed a sophisticated industrial base of capital-intensive operations, including chemical, electronics and pharmaceutical products. The economic miracle came to an end, after the repeal of Section 936 by Congress in 1996. The economic development tool created twenty years before, became highly expensive for the U.S. Treasury, as corporations exploited its tax benefits and the impact on the local economy started to decrease.

Moreover, in two decades, manufacturing operations became capital intensive, reducing job creation and the economic effects of the tax benefits was highly questioned Treasury Officials. Nevertheless, the legislation that repealed Section 936, provided a ten year phase out period that ended in 2005. During that period corporations where allowed to choose from a 60% credit for investment or a tax credit for wages paid in Puerto Rico.

The elimination of the federal tax benefits was a big blow to the local economy and represented the end the “industrialization by invitation” strategy created by operation bootstrap fifty years before. Between 1997 and 2017, manufacturing employment decreased from 152,000 to 73,000, as corporations left Puerto Rico to Mexico, Dominican Republic and other lower expensive countries. The repeal of Section 936 marked the end of a long story of federal tax gimmicks that began in 1921.

Trump’s tax reform

The end of the tax benefits left the local economy without its main tool to attract new investment, it also marked the end of the expansionary years, and the beginning of the current fiscal and economic crisis. Two decades after the repeal of Section 936, once again, the local economy found itself in another cross road. The U.S. tax reform proposal impose a 20% tax on exports from U.S. companies operating under the Section 901 of the IRC as Controlled Foreign Corporations.

Though the government and the private sector is lobbying to provide Puerto Rico with some special treatment under the new tax code, no progress has been achieved during the legislative process. With the Tax Reform signed into law by Donald Trump in 2017, the administration looks determined to eliminate all the tax loopholes, like the ones that the Island used to become a manufacturing powerhouse since 1948, when the “Operation Bootstrap” was launched.

Finally, we are learning a hard lesson; Puerto Rico cannot longer sustain its economy with tax gimmicks. It is time to create a development strategy based on our capabilities and our competitive advantages.