The Wall Street Journal
Calderon's Success in Puerto Rico Rides on Tax Credits
First Woman to Head Island Sees Overturning 1996 Repeal as Crucial Goal
By Michael Casey
December 26, 2000
When Sila Maria Calderon is sworn in as Puerto Rico's first woman governor on Jan. 2, she will have the kind of policy-making leeway President-elect George W. Bush can only dream of. Ms. Calderon easily won Nov. 7 elections, and her Popular Democratic Party trounced the incumbent New Progressive Party to assume control of the Puerto Rico's Senate and House.
But even with this clear mandate, the success of Ms. Calderon's economic agenda may depend on a legislative issue over which she has no direct control: whether a divided U.S. Congress will restore federal tax incentives designed to attract investment to the island.
Unlike her NPP predecessor, Gov. Pedro Rossello, who wanted Puerto Rico to become the 51st state, Ms. Calderon is a firm believer in the island's political status quo as a self-governing U.S. commonwealth. But like Gov. Rossello, she regards the reinstatement of the tax incentives that were repealed in 1996 as a crucial federal-affairs policy goal.
Ironically, Puerto Ricans are pushing for the credits at a time when their economy has shown remarkable improvement. Puerto Rico's unemployment rate, for example, was at 11% in October. That was nearly triple the U.S. rate of 3.9% in October, but the Puerto Rico rate isdown from 16.5% in 1992 and from 22% in the mid-1980s. Tax collections, aided by a new asset registry and withholding tax system, have almost doubled since 1992 to reach $6.8 billion this year. An increase in the number of tax returns filed, from 649,000 in 1992 to 861,000 in 1998, along with a slide in the evasion rate to 16% from 26%, also suggests many Puerto Ricans have left the so-called underground economy.
The wider tax base has allowed the government to reduce its economic presence. It cut local income taxes 20% in 1994 and 10% in 1998, when it introduced key business tax reforms to offset the Section 936 phase-out. Government employment as a portion of the total is now 18%, down from 24% eight years ago. Last year was the first in which private-sector investment exceeded that of the public sector.
Despite vast improvement, some deep-seated problems remain. Puerto Rico's per capita income, at just under $10,000 is little more than half that of the poorest U.S. state, Mississippi, while 60% of its residents live under the federal poverty line. And its political status excludes it from some federal assistance programs such as President Clinton's New Markets program for low-income areas within the U.S. Puerto Ricans are U.S. citizens, but they can't vote in U.S. elections and have no voting representation in Congress.
As the U.S. economy slows, economists believe Puerto Rico's economy will weaken, giving Ms. Calderon a stronger case to push for tax credits. "When the U.S. gets a cold, we get pneumonia," says Ramon Cantero-Frau, an adviser to Ms. Calderon and a co-head of her transition committee. "More than ever, we have to be creative to direct economic activities," during an economic slowdown.
Tax credits for companies doing business in Puerto Rico were introduced in the 1940s as part of the "Operation Bootstrap" effort to kick-start the island's economic development. Initially, it offered companies full federal tax credits offsetting their tax liability to the local government. The incentives, carried under Section 936 of the Internal Revenue Code, attracted large investment flows, particularly from pharmaceutical companies -- including Schering Plough Corp., Bristol-Myers Squibb Co., Eli Lilly & Co. and Merck -- which now account for 42% of the island's manufacturing output.
The tax credits were "an indispensable tool in the development of Puerto Rico," says Dennis Donovan, principal of Wadley-Donovan Group, a site-selection consultancy that assesses investment conditions in the Caribbean and Latin America. "But the Puerto Rican economy has moved up the food chain. It is no longer such a low-cost location, and without these incentives, I think companies are going to opt to go elsewhere."
The credits always were controversial because investors would figure out ways to attribute more of their income to Puerto Rico than was truly the case. The provisions were slowly whittled down by Congress until a 1993 bill restricted them to a credit based solely on actual spending on the island. Then, in 1996, Congress repealed Section 936 entirely, creating a 10-year phase-out provision under Section 30-A. Although the Clinton administration proposed an extension of the phase-out, Congress rebuffed the proposal each year.
Now that a Republican administration is heading to the White House, what are the chances that the tax incentives will be restored? Most observers say it will be a difficult fight, although the PDP's chief Washington lobbyist, Charles Black, says there is a "decent chance of getting something done." Mr. Black is chief executive officer of BKSH & Associate and a leading Bush campaign strategist, which presumably gives him some level of influence in Washington.
Mr. Black, who concedes that he "can only guess at this stage" on the success of these efforts, will likely play a pivotal role. His success will largely depend on how well he manages the PDP's relationships with key figures in Washington. Another plus for the PDP is that Rep. Bill Archer (R., Texas), a big opponent of special tax treatment for Puerto Rico, is retiring from Congress and vacating the chairmanship of the House Ways and Means Committee.
But this changing of the guard addresses only part of the problem. Other Republican opponents of Mr. Clinton's proposal, such as Senate Majority Leader Trent Lott (R., Miss.), continue to wield considerable power on Capitol Hill. They won't likely be impressed with Ms. Calderon's opposition to the U.S. Navy's presence on the Puerto Rican island of Vieques. Moreover, there is no certainty Democrats will use their improved standing in Congress to field support for tax incentives, either. After all, it was liberal Democrats opposed to "corporate welfare" for pharmaceutical firms who spearheaded the 1993 reforms to Section 936. Also, the highest-profile Democratic supporter of tax-credit extensions, New York Sen. Daniel Patrick Moynihan, is retiring.
A bigger problem for Puerto Rico may actually be its economic strength. Some politicians in Washington are likely to see an average economic growth rate that has exceeded 3% in the past four years as evidence that Puerto Rico can get along fine without tax exemptions.