Este informe no está disponible en español. CARIBBEAN BUSINESS The Economy Is A Matter Of Status Puerto Rico’s Most Important Political Decision By CARLOS MARQUEZ October 21, 2004 Copyright © 2004 CARIBBEAN BUSINESS. All Rights Reserved. In 1898, after 390 years as a Spanish colony, Puerto Rico was ceded by Spain to the U.S. Since then, the island’s economy has depended heavily on its relationship with the mainland U.S. and on decisions made in Congress. Now, after 106 years as a U.S. territory, Puerto Rico has reached a crossroads. Global economic and political changes have made it essential for Puerto Rico to decide as soon as possible which status is the best political and economic choice for the 21st century. Recognizing Puerto Rico’s economic future—as most political and business leaders agree—depends on solving the status issue, for the past six months, CARIBBEAN BUSINESS has put these status options and their economic and political implications for the island under the microscope. We have presented the findings in a series of special reports titled "What if?," which have been published every week for the past three months. In this issue, CARIBBEAN BUSINESS reviews these findings, based on unbiased economic data, to put them in perspective for our readers, leaving out the usual emotional considerations that tend to dominate status discussions in Puerto Rico. Commonwealth and new commonwealth In 1952, after more than 50 years as a U.S. possession, Puerto Rico adopted its own constitution that allowed it to set up its own local government, including a local legislature and judiciary. However, the island continued to be subject to the decisions of Congress, the U.S. President, and the U.S. Supreme Court. While Puerto Rico experienced substantial economic growth from 1952 to 1972, the commonwealth’s economic development strategies have become stagnant at best. Indeed, they have failed to achieve the levels Gov. Luis Muñoz Marin had targeted—to reach the same economic growth as the poorest state in the nation, Mississippi. We are still at 50% below the per capita income of Mississippi. Recognizing the status issue wasn’t resolved in 1952, as some Popular Democratic Party (PDP) leaders have publicly admitted, the PDP has presented a proposal for a new, or enhanced, form of commonwealth. Before discussing the enhanced commonwealth, we outline some of the most significant findings regarding commonwealth: High unemployment and low employment participation rate: Under Commonwealth, Puerto Rico has always suffered from low labor force participation rates (i.e. people holding or seeking jobs) and high unemployment. The low participation rate figures mask the real unemployment situation. Puerto Rico’s labor force participation rate in 2003 was 46.7%, way below the 66.2% participation rate on the U.S. mainland. With a labor-force-participation rate (people employed or actively seeking jobs) similar to the U.S., the island’s unemployment rate would top 38%. Even with such low work-force participation rates, Puerto Rico’s official unemployment rate stands at 12%, double the U.S. national average. The inability of the commonwealth’s economic model to create sufficient job opportunities in the private sector prompted the government to create an economic safety valve: government employment. By 2003, 274,000 people were working for the government, a six-fold increase since 1950. Commonwealth government employment is high by national and international standards. What’s more, it places a heavy burden on the private sector and individuals to maintain an inefficient government that often establishes policies limiting competitiveness and economic participation. Commonwealth’s inability to create adequate economic conditions capable of providing the required number of job opportunities has kept approximately 50% of the U.S. citizens in Puerto Rico living below the federal poverty line. II. Dependence on tax incentives Puerto Rico’s economy is unsound and historically dependent on federal tax exemptions, which have stunted competitiveness and economic development. Incentives, mostly through tax exemption, have benefited large multinationals that contribute the least to Puerto Rico’s income, employment, and gross product (GP). Congress, not the local government, is the one that approves federal tax incentives and decides whether they remain. Since 1976, mainland corporations under Section 936 of the Internal Revenue Code have claimed more than $60 billion in possession tax credits on their federal taxes. During these years, however, Puerto Rico’s average annual unemployment rate was 17.7%, until the code started to be phased out by the U.S. Congress. In 1976, when Section 936 was enacted, Puerto Rico’s per capita Personal Income (PI) was $2,592, or 38.4% of the U.S. mainland average. By 2003, Puerto Rico’s per capita PI was 35.6% of the U.S. mainland average, a drop of 3.4 percentage points. Instead of converging economically with the States, Puerto Rico has been diverging. By the end of 2003, Puerto Rico’s annual per capita PI was $11,279 or 48.1% of that of Mississippi, the poorest state in the nation, which had reached $23,448 or 4.7 percentage points less than it had been in 1970. III. Commonwealth’s economic growth Puerto Rico’s real rate of economic growth has been deteriorating since the early 1970s. During the 1960s, it averaged 7%; since 2000, it has fallen to 1.5%. The rate of growth of the GP per capita has dropped even more dramatically. From an average 5.4% in the 1960s, it has been 1% since 2000. The gap in economic development between Puerto Rico and the States is growing wider, and Puerto Rico keeps falling further behind. Local enterprise is small and has limited productivity, growth, and exports. The lack of investment in local businesses has also limited the island’s capacity for technological innovation. The growing fiscal deficit is hidden in government accounts, public debt tops $30 billion, and a weak Research & Development infrastructure will send the next generation of advanced industries to more competitive locations. As foreign markets gain further access to the U.S. mainland, Puerto Rico’s competitive edge will become a thing of the past. IV. Commonwealth’s taxes Commonwealth’s tax system stifles economic activity with high taxes, unevenly distributed among society. Commonwealth imposes taxes as though it were a national government. Income taxes are higher here than those imposed by any state government. Individuals and corporations in Puerto Rico pay federal, commonwealth, and municipal taxes. These include income taxes for individuals and corporations, employment taxes, real and personal property taxes, and an inefficient excise tax. Indeed, it is a myth that Puerto Rico is exempt from federal taxes. For years, locals have paid federal taxes in the form of Social Security, Medicare, and unemployment insurance, plus federal income tax on non-Puerto Rico source income. Federal employees in Puerto Rico pay federal income taxes as well. V. Congressional powers over Commonwealth Congress makes the laws governing the U.S. mainland and Puerto Rico, but island residents don’t elect any voting member to that legislative body. Even under an enhanced or new commonwealth status, this situation wouldn’t change. Congress can pass or eliminate laws that directly impact Puerto Rico’s economy. Its decision to phase out Section 936 of the Internal Revenue Code in 1996, and Gov. Sila M. Calderon’s failure to get Congress to act on the proposed amendment to Section 956 of the Internal Revenue Code, demonstrate Congress’ power. The U.S. Internal Revenue Service’s tax rules for residents of Puerto Rico are different from those for stateside residents. The most important is Section 933, which exempts U.S. citizens residing in Puerto Rico from paying federal income taxes on locally sourced income. This exemption has nothing to do with commonwealth government and everything to do with Section 933, which can be amended, phased-out, or eliminated by Congress at any time, as was Section 936. Puerto Rico’s territorial status means it receives proportionately fewer federal funds than any state on the mainland, whether one measures by population or per capita. These funds are allocated by Congress. VI. Stateside vs. Island Puerto Ricans More than half of all Puerto Ricans reside in the States. Migration from the island has proved to be an effective way for the commonwealth government to reduce or try to reduce the local unemployment rate. The U.S. mainland’s higher living standards and Puerto Ricans’ freedom to move to the States have led to the massive migrations northward for the past five decades. In 2003, 4.9 million Puerto Ricans lived on the U.S. mainland, while Puerto Rico’s population didn’t even reach four million, and approximately 300,000 of the population of the island are not Puerto Rican. The number of stateside Puerto Ricans living below the federal poverty level was 26.1%; in Puerto Rico, it was 48.2%. The median household income for Puerto Ricans residing on the U.S. mainland was $28,734 a year, or double the $14,412 locals were earning. Puerto Rico residents also tend to retire with fewer benefits than those on the U.S. mainland. VII. Lack of political power and representation under Commonwealth Puerto Rico has no real congressional representation, and it is limited to a sole nonvoting, and therefore powerless, resident commissioner in the House of Representatives. Puerto Rico has no representation whatsoever in the U.S. Senate. Puerto Ricans residing on the island don’t have the right to vote for president of the United States or for senators and representatives in Congress, although, as mentioned, Congress has the authority to enact laws that apply to the island. The repercussions of the Supreme Court’s power were demonstrated when it formulated the unincorporated territory theory; through the years, it has allowed Congress to treat U.S. citizens in Puerto Rico differently from U.S. mainland citizens. Supreme Court members are appointed by the president and confirmed by the Senate, government officials who aren’t elected by the residents of Puerto Rico. This lack of political power translates into a lack of economic power. VIII. Proposals under new or enhanced Commonwealth To redress some of the problems inherent in commonwealth status, the PDP’s Governing Board approved a proposal for a new, or enhanced, commonwealth in October 1998. In some sections of the proposal, Puerto Rico is treated as an independent nation; in others, it remains to some degree subject to U.S. sovereignty. In other words, Puerto Rico would be a hybrid state. The proposal also calls for the commonwealth to retain all powers not specifically delegated to the U.S. Powers delegated to the federal government would include federal laws relating to defense, currency, U.S. citizenship, Social Security, Medicare, unemployment insurance, banking, the postal service, public assistance and education programs. Under this proposal, Congress and the federal government’s executive branch would continue to exercise control over the U.S. citizens living in Puerto Rico. Free-associated state or dependent republic Some, particularly in the PDP, have considered free association a viable status option. It has received little support, however, as most Puerto Rico residents don’t clearly understand what it means to have a free association with the U.S. To help its readers gain a better understanding, CARIBBEAN BUSINESS examined three independent nations that have free association with the U.S.: the Federated States of Micronesia (FSM), the Republic of the Marshall Islands (RMI), and the Republic of Palau. It must be understood that none of the residents of these countries had U.S. citizenship before they entered into the compact, nor were they granted citizenship after the compact was approved. Below we have included some of the most significant characteristics of free association. I. Free association: A compact with the U.S. Puerto Rico’s commonwealth status was established by congressional powers provided by the Territorial Clause of the Constitution; free association, on the other hand, is created through the treaty-making process. The U.S. recognizes the sovereign independence of the three nations with whom it maintains treaties of free association. Compacts of free association may be terminated unilaterally by any of the parties or by mutual consent. The association lasts as long as it is in the interest of both countries to continue it. As independent nations, FSM, RMI, and the Republic of Palau don’t have any representation in Congress; neither do they have a say in the economic assistance with which Congress provides them. Free-Associated States (FAS) can conclude commercial agreements and seek membership in regional and international organizations, can have representation in the United Nations, and can have embassies in Washington and other countries. The FAS are sovereign states governed largely by their own laws. In general, they act bilaterally with other nations, except for defense and security-related matters. For all practical purposes, the compacts of free association mean the U.S. can control the territories of these "almost" sovereign countries for as long as it wishes. II. A strategic military and economic alliance The U.S. maintains an interest in the FAS for strategic military reasons. The FAS’ main concern and interest is financial. The economic future of FAS citizens depends on the U.S.’ strategic military policies and on decisions in Congress. The U.S. can deny access to third parties to the FAS for security and defense reasons, a right that doesn’t expire. In addition, the U.S.’ defense veto grants it the right to veto local actions that it determines are incompatible with its defense responsibilities. American strategic and security interests in the Pacific have shaped the FAS economies. U.S. rent payments and economic assistance have been the main sources of income for the FAS, with the governments being the largest beneficiary so far. Government plays a critical role in the FAS economies and has been the main employer in these countries for decades. It provides not only public services, but is also expected to provide income and, as a last resort, is an employment security net. III. Economy of FAS Despite assistance from the U.S. government, the FAS have one of the lowest growth rates among Pacific Island nations. Personal income in the FSM and the RMI is around $2,000, less than 20% of Puerto Rico’s $11,279. The dependent nature of FAS’ economic structures on U.S. assistance to their governments has converted the private sector into a support, or secondary, structure dependent on the public sector. The FAS are more dependent on outside income, especially U.S. assistance, than ever before. Given today’s geographic, economic, and technological realities, this is unlikely to change any time soon. The FAS have failed to attract new investment from the U.S. and their nearest neighbors, Asia, and Australia. U.S. financial assistance has been diminishing, and will be terminated for the FSM and RMI at the end of fiscal year (FY) 2024, according to these nations’ recently amended compacts. Trust funds were created for the FAS to ensure economic and social stability and smooth the transition to FY 2024. The U.S. government, however, manages the trust funds and requires that they be incorporated in Washington, D.C. The expectation is that the trust funds’ annual earnings will replace the reduction in grant assistance. This is highly speculative, however, given that the trust funds’ rate of return will depend on market conditions. The U.S. could withhold payments if a FAS country fails to comply with grant terms and conditions. In addition, funds could be withheld if the FAS governments don’t cooperate with U.S. investigations into possible inappropriate use of compact funds. Free association is a failed economic strategy in the Western Pacific, filled with uncertainties, immigration restrictions, progressive reduction and eventual elimination of financial assistance from the U.S., and potential withholding of funds. In addition, Department of Interior officials continue to oversee FAS. Their future economic growth relies on the volatility of the stock market, the abilities of a fund manager under U.S. government control, a national development plan that requires U.S. approval, and a relationship that can be unilaterally terminated at any time. IV. Puerto Rico compared to FAS Puerto Rico and the FAS are like night and day—geographically, historically, socially, economically, and politically. Puerto Rico lies at the crossroads of the Americas, 1,000 miles from Miami; the FAS are closer to the Philippines than to Hawaii, which is located more than 2,100 miles from San Francisco. The total landmass of the FAS is approximately 517 square miles, less than 15% of Puerto Rico’s 3,515 square miles. The total population of the three FAS is approximately 200,000, 5% of Puerto Rico’s population. The residents of the FAS are scattered over hundreds of small islands and atolls; where lack of adequate transportation and communication limit their economic progress. As in Puerto Rico, there is migration from the FAS to the U.S. The brain drain dulls the FAS’ competitive edge, while the loss of future tax revenue and of people who could otherwise contribute to their future economic development limit the FAS’ future economic growth. V. U.S. and the FAS Congress made explicit the inherent authority of the U.S. government to regulate the terms and conditions of FAS citizens’ admission to and stay in the U.S. It also said the Immigration & Nationality Act applies in full to people requesting admission to, or the right to remain in, the U. S. FAS citizens entering the U.S. need to carry passports, and the U.S. Attorney General has the authority to issue regulations specifying the terms of admission of these nonimmigrants to the U.S. and how long they can stay. The republic of Puerto Rico Puerto Rico has lent little support to independence. For the past 50 years, the overwhelming majority of the electorate has voted to retain its ties to the mainland, whether under some variation of commonwealth, or statehood. While commonwealth and free association wouldn’t end Puerto Rico’s political status uncertainties or Congress’ power over the island, independence would, but many economic worries could follow. If Puerto Rico became independent, residents would have to resolve the issue of citizenship, as the island’s nearly four million U.S. citizens would become part of the new republic. Despite the limited support it has received, CARIBBEAN BUSINESS has examined it as a status option. Independence: An end to Puerto Rico’s political status uncertainty As an independent republic, Puerto Rico would no longer be a U.S. territory. Independence would give Puerto Rico the power to create its own economic policies for industry, commerce, and agriculture; to control immigration; and to sign international treaties. Independence proposals have been submitted to Congress calling for the negotiation of a Treaty of Cooperation & Friendship with the U.S. as well as a transition period. The terms and conditions of such a treaty can’t be guaranteed; indeed, there is no guarantee that such a treaty would ever be made as no foreign country can obligate the U.S. to enter into agreements. The republic would also have the power to enter into international agreements and treaties with other nations. Dozens of small independent countries have had the power to sign international treaties for decades, and yet they are still far behind Puerto Rico’s economic performance as a U.S. territory. Puerto Rico would no longer have a commonwealth governor and the office of resident commissioner would cease to exist in Congress. Instead, the Republic of Puerto Rico would elect a president and appoint an ambassador to the United Nations, where the island would have one vote among 192 other independent nations. Puerto Ricans would become citizens of the Republic of Puerto Rico. Following the proclamation of independence, the Constitution, U.S. laws, and the will of Congress would determine whether Puerto Ricans could retain U.S. citizenship. Citizens of an independent Puerto Rico would also be required to carry passports issued by the republic when traveling abroad, unless Puerto Ricans retain their U.S. citizenship, which would allow them to keep their U.S. passports, or the U.S. government decides otherwise. II. Economy of the Republic Independence would put an end to the uncertainty regarding Puerto Rico’s political status, but the uncertainty regarding the island’s political and economic future could certainly escalate. The Republic of Puerto Rico would inherit from the commonwealth not only a gigantic and inefficient government, but also, as of 2004, a public debt of more than $30 billion. This debt would be payable in U.S. dollars, not in Puerto Rican currency, and fiscal difficulties in the new republic could put these bonds at risk for nonpayment. High public debt would lay the foundation for the government’s financial meltdown. As an independent country, Puerto Rico would have the opportunity to issue a national currency. To claim that a Puerto Rican currency would have the soundness, acceptability, and international conversion capability necessary for Puerto Rico to be a global player in today’s competitive world is highly speculative at best. The protection federal laws provide to U.S. and foreign investors, which have been a key competitive advantage for Puerto Rico and its economic development, would end. Uncertainties and fear about the future would likely trigger capital flight from the island. It is unlikely investors would consider Puerto Rico until it became clear what positions the new government would take, i.e., at least three to five years into independence. The costs of maintaining a national government and the investments required to upgrade electricity, water, ports, waste disposal, and other basic elements of infrastructure would present an overwhelming financial challenge to the new republic. According to the World Bank, in 2003, Latin America & the Caribbean’s per capita national gross income was about $7,080 a year. This is less than half that of Puerto Rico’s ($16,320) and less than one-fifth of the U.S.’ ($37,500). It would take a while to learn strategies to obtain development funds, venture capital, and foreign direct investment. While other countries would be enhancing their competitiveness, Puerto Rico would only just be learning how to use its newfound power. An informal economy would tighten its grip on the social system. High public debt would also keep the government from financing and investing in public construction, triggering a spillover effect on the rest of the economy and hampering its players’ growth capability. Puerto Rico shouldn’t hold its breath for a large influx of foreign aid, as development assistance to Latin America has been declining. III. Decline and end of federal funds The economic prospects for the Republic of Puerto Rico become even more precarious when one takes into account that federal funds and programs would taper off and eventually be eliminated altogether after a transition period. If we use as a base the federal funds Puerto Rico received in FY 2002, the island could expect an immediate reduction in the total amount of $14 billion. This doesn’t take into account loans, loan guarantees, insurance coverage, and disaster assistance. The U.S. Social Security Administration (SSA) would probably be phased out and the government of the republic would create a new Puerto Rican social security system. From 1971 to 2003, residents of Puerto Rico have received a net positive transfer (above and beyond what they paid) of $26.1 billion from the SSA. Medicare benefits would also be phased out. From 1971 to 2003, residents in Puerto Rico received almost $15.9 billion in benefits and contributed $2.8 billion. Federal agencies would also cease operations in Puerto Rico and stop paying salaries and wages to their employees on the island. The U.S. Armed Forces would be fully dismantled and removed from the Republic of Puerto Rico. Under independence, the U.S. Coast Guard, the Federal Bureau of Investigations, the U.S. Marshall Services, the Secret Service, the Bureau of Alcohol, Tobacco & Firearms, and the Drug Enforcement Administration would leave as well. The "security cushion" provided by the U.S. would disappear, leaving Puerto Rico defenseless against foreign intervention, drug cartels, and the world’s terrorist organizations—some of which are as close as Colombia. It is expected that many would migrate to the U.S. in the face of declining employment and disappearing federal benefits. The state of Puerto Rico Over the past 50 years, support for statehood in Puerto Rico has been increasing. Its supporters believe it would end colonialism, lead to political equality, and generate economic prosperity. Statehood would end Puerto Rico’s political uncertainties since it is the only form of permanent union with the U.S. I. Equal treatment for Puerto Rico Unlike statehood, treaties, compacts, agreements, and territorial statuses can’t guarantee permanence. Congress can dispose of a territory and change the rules that apply to it as it pleases. As a U.S. state, Puerto Rico would share the same rights, responsibilities (including paying taxes), and benefits as the 50 states. Puerto Rico would maintain sovereign in matters the U.S. Constitution doesn’t delegate to the federal government. Only as a state could Puerto Rico receive the same proportionate amount of federal funds the 50 states do. Under commonwealth, many federal programs don’t apply to Puerto Rico or it receives less funding than the 50 states. II. Political power U.S. citizenship would be guaranteed by the U.S. Constitution, not by any statute or law. Citizens residing in the state of Puerto Rico would have the right to vote for president and would be represented by two senators in the U.S. Senate and about six congressional representatives in the House of Representatives. If Puerto Rico were a state, it would no longer be considered a single congressional district, but would be divided into about six districts whose boundaries would be determined by the population, as is the case now for senatorial districts in local elections. Elected representatives would represent not only the interests of all Puerto Rico residents, but of the congressional district that elected them. As a state, Puerto Rico could have seven to eight electoral votes in the presidential elections, which would put it at the same level as or ahead of 26 states and make it one of the most important campaign stops during the primaries and elections. Puerto Rico would still create and enforce local laws (as the 50 states do), as long as they didn’t conflict with the U.S. Constitution or federal laws. It could also elect its own state legislators and governor. III. Statehood means more revenue Under statehood, Puerto Rico would have full political empowerment, which translates into economic empowerment. Puerto Rico now has no real power to affect decisions made in Washington, including in Congress, about the island, and so it has much less economic power. Statehood would stimulate the Puerto Rican economy to grow 2.2% to 3.5% faster than it is doing now through full integration with the U.S. economy and political system. Had Puerto Rico become a state instead of remaining a territory even after the adoption of the Commonwealth Constitution, U.S. citizens residing on the island would have been earning $6,000 more per year by 1998, through greater integration with the U.S. economy. If Puerto Rico had become a state in 1994, real per capita income would have grown $1,343 more by 2000 and $2,641 more by 2005 than under commonwealth. If Puerto Rico had been able to catch up with Mississippi, the poorest state, island residents would have a per capita income of $23,448 a year, or $12,169 more than they have now. This is double Puerto Rico’s per capita income in 2003 ($11,279). If per capita federal expenditures in Puerto Rico were the same as in Mississippi, the island would have received more than $26 billion from the federal government in 2002, nearly double the $14 billion it received. Statehood would eliminate uncertainties about Puerto Rico’s status and lower its political risk, making the island more secure and attractive to investors. IV. The issue of taxes Under statehood, Puerto Rico income tax rates would be reduced so average taxpayers would pay less than they do under commonwealth. Two-thirds of families in Puerto Rico would pay no federal income tax because of their current low income level and a majority of these would get government checks through the Earned Income Tax Credit (EITC). Through the EITC, the government distributes about $40 billion in checks to the families and individuals who qualify for this tax credit. A substantial number of Puerto Rico residents would qualify for this credit. Most states receive more in federal expenditures than their residents pay in taxes. Such was the case of 34 states in 2002. Under statehood, more than half of all local taxpayers would not pay any federal income tax and a majority would receive a check from the government without having paid federal income tax. Island residents who don’t make enough money to file tax returns now wouldn’t have to pay any federal income taxes, and most would get money back. After taking into account all the available tax credits and deductions, most local tax filers would pay no federal income tax, and the federal government could well owe them money. Business owners could take advantage of an even wider array of credits and deductions to reduce their tax liability. Large corporations that have been largely tax-exempt from local and federal taxes for decades would bear most of the burden of federal corporate income tax in Puerto Rico. The government of Puerto Rico could forgo its inefficient excise tax if tax were assessed instead as a consumption (or retail-sales) tax as it is in most states. It would tax all goods sold to all consumers, including those with unreported income, and impose no tax on business-to-business transactions. Unlike current excise taxes, an end-point tax wouldn’t cascade. In other words, a tax wouldn’t be imposed on top of another tax. With an effective sales tax, as most states have, in place, Puerto Rico would be able to collect revenue from a considerable part of the estimated $26 billion informal economy. The large influx of additional federal funds into the local economy would more than compensate for the taxes Puerto Rico would pay to the federal government. Additional economic growth, investment, and activity because of the additional stability would generate additional revenue for the local and federal government. This Caribbean Business article appears courtesy of Casiano Communications. For further information, please contact: CARIBBEAN BUSINESS Archive or www.casiano.com Self-Determination Legislation | Puerto Rico Herald Home Newsstand | Puerto Rico | U.S. Government | Archives Search | Mailing List | Contact Us | Feedback