Este informe no está disponible en español.


Bitter Medicine

Proposed fiscal measures are not only unpopular and unpalatable but may not bring in expected revenue and could stymie economic recovery in Puerto Rico


March 28, 2002
Copyright © 2002 CARIBBEAN BUSINESS. All Rights Reserved.

Storm center: Private sector leaders believe tax proposals won’t work; propose alternatives

Just when the local economy is starting to show positive signs on the road to recovery, a cluster of storm clouds has appeared over the island’s economic horizon, according to many private sector leaders in Puerto Rico.

The Rain may fall in several important economic sectors, as a result of the fiscal measures that the Calderon Administration is proposing to the Legislative Assembly to remedy a $596 million deficit projected for the Commonwealth’s fiscal 2002-2003 budget.

The measures have raised the ire of business leaders islandwide. They include 50% to 78% tax increases on alcoholic beverages and cigarettes, 12% to 25% tax increases on multiple use vehicles (mainly sport utility vehicles), a stimulus to consumers to encourage withdrawals from financial institutions of $300 million in Individual Retirement Accounts (IRAs), and a 3% retention on professional service contracts.

Nature of the problem

As the Calderon administration sees it, the proposed measures represent the least painful means within its reach to close what it has come to term a "structural deficit" in the government’s finances.

Since coming into office 14 months ago, the administration has increasingly struggled with keeping the government’s budget balanced in a recessionary economy, which has reduced revenue collections to the Treasury.

Last year’s economic downturn caused tax revenue to fall more than $500 million below projections. The situation has been further aggravated by difficulties in keeping health reform cost increases in check, along with a $193 million December 2000 corporate tax payment that was mistakenly calculated to be recurring in subsequent years.

In her State of the Commonwealth speech before the Legislature last month, Gov. Calderon said she had three choices to deal with the deficit: resort to deficit financing, cut $598 million in government spending, or seek new revenue sources.

According to Government Development Bank President Juan Agosto-Alicea, choosing the first option--deficit financing--would have imperiled the government’s credit rating before credit rating agencies Standard and Poors and Moody’s. Standard and Poors has placed the Commonwealth on a negative credit watch. "Without a doubt, their preference is to see us fund recurring expenditures with recurring income," Agosto-Alicea told CARIBBEAN BUSINESS.

Having also rejected the second option--making deep budget cuts that would have allegedly resulted in massive layoffs of public employees and effected essential services, administration officials say they were left with no choice but to opt for the new series of revenue-raising measures currently proposed.

On the table

The government’s biggest revenue-raising proposal–calculated to generate $200 million annually in new revenue–is its 50% to 78% tax increases on alcohol and cigarette consumption.

House Treasury Committee Chairman Francisco Zayas-Seijo (PDP, Dist. 25) concedes that this proposal has also raised the most formidable opposition. While the Treasury Department projects that the hefty tax increases would result in a 9.5% decline in consumption from which the market can quickly recover, distributors estimate that the decline would be on the order of 18%.

"The market decline would be much higher than Treasury estimates, and the government hasn’t taken into account the extent of the economic damage this could do to Puerto Rico," says V. Suarez & Co. President Diego Suarez, Jr.

According to the Puerto Rico Chamber of Commerce (PRCC), which has expressed its opposition to the proposed increase, the Treasury Department’s projected revenues from the additional tax, on the other hand, could be off by as much as $40 million.

Both the PRCC and distributors also blast the proposal as based on false suppositions. "Contrary to what the exposition of motives in House bill 2187 says, alcohol consumption in Puerto Rico has not risen constantly and dramatically," Suarez said. "The Treasury Department’s own figures show that per capita beer and hard liquor consumption have declined over the past decade, and wine consumption has only risen slightly," Suarez pointed out.

In opposing the measure, the PRCC indicates that it would "impose an additional substantial burden on an industry that isn’t growing and that is an important generator of jobs in the economy." The PRCC also rejects the tax increase due to its regressive nature (meaning that it would disproportionately impact middle-to-lower income earners) as well as negative impact on the island’s competitiveness as a tourism destination.

However, the crux of the argument against the proposed increases, distributors say, is that their business sector is already disproportionately over-taxed. "Commonwealth taxes on beer are already 82% higher than the combined federal and state taxes on a standard case of beer in the highest-taxing U.S. state (Florida)," says Suarez. "If the proposed increase becomes law, they’ll be 224% higher than in Florida."

"Even now, a case could be made that the current level of local taxes on beer and alcohol constitute an unconstitutional obstacle to interstate commerce," says Mendez & Co. Vice President Luis Alvarez.

The island’s only local beer producer, Cerveceria India, is also lobbying against the measure and in favor of greater protection for its products. Cerveceria India officials point out that when a 50% tax increase on beer was imposed in 1990, the firm lost 21% of its market share and that the current proposal threatens the continued viability of the operation, which employs some 300 people in Mayaguez.

Implications of cigarette tax increase

The administration is also proposing a 60% hike on cigarette taxes, from $0.83 a pack to $1.33 a pack. As a result of the increase, the Treasury Department expects to rake in an additional $75 million annually.

The PRCC has joined forces with cigarette companies Phillip Morris and RJ Reynolds in opposing the increase. However, the PRCC has qualified its opposition somewhat pending further study of the impact the increase would have on the federal Master Settlement Agreement (MSA) payments to the Commonwealth as a result of a 1999 judicial agreement between major U.S. tobacco companies and U.S. states and territories.

Nevertheless, according to an RJ Reynolds study, the Commonwealth stands to lose more than $68 million over the next five years in MSA payments if the proposed increase is approved. "That’s because the payments depend on market share," RJ Reynolds Vice President Denise Santos told CARIBBEAN BUSINESS. "The proposed increase would lead to a decrease of our market share and an increase in market share for MSA non-participant cigarette brands from other countries, mostly South America."

Moreover, industry officials believe that the proposed increase wouldn’t deliver even half of the $75 million in additional annual tax revenues projected by the Treasury Department. According to industry projections, the proposed increase would only add about $31 million to Treasury’s coffers.

"We also estimate that an increase of this magnitude would reduce demand by 20%," Santos said. The uncertainty over volume reduction has also placed in jeopardy RJ Reynolds plans to go forward with a new 50-employee manufacturing plant in Yabucoa, she added.

According to tobacco industry figures, Puerto Rico is already one of the highest cigarette-taxing U.S. jurisdictions, and the proposed $0.50 increase would make it the highest overall by $0.22.

As an alternative, the industry is proposing a $0.17-per-pack hike in cigarette taxes. This hike, Phillip Morris Corporate Affairs Manager Sandy Gutierrez says, would have a less severe impact on Puerto Rico’s share of MSA payments, would be less disruptive to the market, and provide higher tax revenues over the long run.

Targeting multiuse vehicles

Meanwhile, most of the island’s automobile dealers are bristling over the Administration’s proposal to end preferential treatment in excise taxes applied to multiuse vehicles–mostly sport utility vehicles (SUV)–in order to put them on an equal footing with other passenger vehicles.

According to the government’s proposal, only bona fide, Department of Agriculture-registered farmers will be exempted from the increase. By means of this tax hike, the government aims to increase annual tax revenue generated through new automobiles sales by about $69 million (from the current $151 million to more than $220 million).

SUVs, which make up the bulk of the light-truck vehicles (LTV) category, accounted for about half of the 120,000 new vehicles sold in Puerto Rico last year. At present, there are two rates for LTVs--13% for vehicles that retail for $20,000 or less and 20% for more expensive models. Excise taxes on passenger cars already range from 14% to 40%, based on value.

"We do not support the tax proposal as it currently stands," said Ramon Vega, Jr., president of Autos Vega and the 18-member Puerto Rico Automobile Dealers’ Association. "We are trying to explore alternatives."

However, the PRCC has announced its support for the measure. "Establishing equal tax treatment in this case corrects the current distortion in vehicle prices," PRCC President Jose Joaquin Villamil told CARIBBEAN BUSINESS. "The preferential treatment modified relative prices in favor of those vehicles, which are principally used by consumers and not farmers, as was the original intent of the preferential treatment."

If the proposed new tax is passed, Carlos Vaillant, executive vice president of United Auto Group of Puerto Rico, owners of Triangle Motors, anticipates shifts in consumer behavior. "It‘s going to motivate a lot of people to go back to used cars, which is something that had really been turning around," Vaillant said, adding that used imports accounted for about 35% of the market ten years ago. Used imports make up only 10% to 15% percent of the current market.

Raiding IRA funds

In order to obtain an estimated $30 million in revenue, the administration has proposed opening a three-month window between Aug. 1 and Oct. 31, 2002 during which Individual Retirement Account (IRA) holders could withdraw up to $20,000 from their accounts at a preferential 10% tax rate.

The $30 million revenue estimate is based on Treasury Department calculations that $300 million of a total of $1.9 billion held in IRA accounts on the island will be withdrawn during the eligible period.

To the surprise of many, the Puerto Rico Bankers Association (PRBA) has expressed its neutrality on the proposal. "It goes against the purpose for which IRAs were created," PRBA President David Chafey told CARIBBEAN BUSINESS. "But we’re not too critical of it because we understand the government’s position and the need to cover the budget deficit."

The PRBA’s position has been interpreted as a green light for the proposal by several industry observers, who speculate that the measure effectively provides banks with an opportunity to free themselves of a significant quantity of their IRA portfolios tied to higher than present day interest rate returns.

The proposal doesn’t enjoy the support, however, of the PRCC. "It’s bad public policy," Villamil declared. "Promoting savings and investment is an essential component of a sound tax system, a component that shouldn’t be violated with a proposal like that one."

During a joint hearing of the House and Senate Treasury Committees, even PRBA Executive Vice President Arturo Carrion conceded that the measure "could set precedents that don’t serve the best interests of consumers, the economy and perhaps even government coffers." In fact, Zayas-Seijo told CARIBBEAN BUSINESS that he doesn’t think Treasury’s projections that it will raise $30 million through the proposed mechanism are realistic.

As a possible alternative to the proposal, Villamil and Oriental Financial Group President and CEO Jose Enrique Fernandez have expressed their support for the creation of a new IRA product already in use stateside, known as the ROTH IRA. These IRA accounts require that depositors pay an up-front tax on opening and depositing into the accounts, but offer tax-free returns when the accounts are later tapped for retirement income.

"These pre-paid IRAs provide a win-win situation for the government and for consumers," says economist Dr. Ramon Cao. "They provide the government with a steady stream of new revenue, but a tax deduction incentive is also maintained and taxpayers get an even bigger break later when they start to draw on the benefits of their retirement savings," says Cao.

Playing games

The only revenue-raising measure that hasn’t prompted major complaints is the Administration’s proposal to add more Lottery games–Pega 2 & Pega 4–in order to raise an additional $36 million annually.

Even San Juan Archbishop Roberto Gonzalez has given his tacit blessing of the proposal as a "legitimate effort" given the current fiscal situation. Senate Treasury Committee Chairman Modesto Agosto-Alicea appears to be a lone voice against the measure, expressing his opposition as a matter of principle to discourage gambling.

Wherefore art thou, tax relief?

The Administration has also proposed postponing for two more years the individual tax rate cuts legislated by the previous Rossello Administration. This postponement will save the government an estimated $116 million annually.

Based on the temporary nature of the economic downturn and expected revenue growth in fiscal years 2003 and 2004, the PRCC has expressed its support for postponing the implementation of tax cuts for only one more year instead of two.

On the other hand, the PRCC is energetically opposed to the Administration’s proposal to retain a 3% withholding tax on professional service contracts.

"This is a confiscatory measure," Villamil says. "It resolves a cash flow problem for the government at the expense of a cash flow problem for the private sector."

By way of example, Villamil pointed to its effect on a $100,000 service contract with a profit margin of 5% (in other words, income of $5,000). "This proposal means that the contractor would have $3,000 retained–that’s 60% of his real income, which is a whole lot more than his tax responsibility."

Are there alternatives?

In rejecting the majority of the Administration’s proposed fiscal moves, private sector leaders are also mindful that they need to come up with alternatives for the government to face its current budget shortfall.

"The absolutely first alternative has to be more of an effort by the government to cut spending," Villamil says. The PRCC President doesn’t buy the Administration’s argument that cutting government spending means massive layoffs of public employees.

"The fact is that the proposed fiscal 2002-2003 budget as it stands right now is 6% higher--$700 million higher--than the fiscal 2001-2002 budget," Villamil says.

"Five to eight percent of the government workforce retires or leaves every year, so through a mild attrition process the bureaucracy can be cut," Senate minority leader Kenneth McClintock (PNP at-large) pointed out. "On a payroll of more or less $5 billion, even a 3% attrition gives you at least $150 million right there."

"It’s also time for the government to take a hard look at subsidy levels which are frankly unjustifiable in the macro context," Villamil says. "Such as the current level of sugar subsidies and the disproportionate subsidy of the University of Puerto Rico."

In addition to more fiscal restraint, the PRCC has also proposed an analysis of current exempted products from the 6.6% excise tax, and the elimination of exemptions that aren’t necessary.

As a last resort and short-term measure, the PRCC has also proposed a temporary 5% tax surcharge on individual and corporate income taxes filed next year.

For example, a taxpayer that had a tax year 2002 obligation of $2,000 would pay an additional $100 (5% of $2,000). The PRCC estimates that such a one-time surcharge would generate $175 million in additional tax revenues. It also has the benefit of being a measure that would be applied evenly to all taxpayers, such that it wouldn’t distort any particular industrial sector.

According to Villamil, the current fiscal situation makes it also more necessary than ever for the government and private sector to work together to reform the tax system.

"We’re recommending the creation of a joint commission with representatives of the executive and legislative branches–along with the private sector–to work together on an alternative to the current system," Villamil says. "The Commission’s agenda would necessarily include moving towards a sales or value-added tax as a substitute or complement to the current system."

Comparable Alcoholic Beverage Taxes per Gallon
(2001 figures, without proposed increase)

Jurisdiction Beer Hard liquors Wine
Puerto Rico $2.70 $22.53 $8.17
Florida $1.04 $17.30 $3.36
Hawaii $1.48 $16.72 $2.47
Louisiana $0.88 $13.33 $1.21
New York $0.69 $17.24 $1.30
Wash., D.C $0.66 $12.30 $1.40

Source: Puerto Rico Association of Distributors & Manufacturers of Alcoholic Beverages

Comparable Cigarette taxes, per pack
(2001 figures, without proposed increase)

Jurisdiction Tax
Puerto Rico $0.83
New York $1.11
Hawaii $1.00
Washington, D.C. $0.65
Connecticut $0.50
Florida $0.34

Source: RJ Reynolds

This Caribbean Business article appears courtesy of Casiano Communications.
For further information please contact

Self-Determination Legislation | Puerto Rico Herald Home
Newsstand | Puerto Rico | U.S. Government | Archives
Search | Mailing List | Contact Us | Feedback