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Tax Reform Now!

There is broad consensus on the need for a complete overhaul of our 50-year-old tax system, including the replacement of the current excise tax with a sales or value-added tax paid at the cash register


December 11, 2003
Copyright © 2003 CARIBBEAN BUSINESS. All Rights Reserved.

Call For A New Tax System That Can Reduce Costs To Consumers

Business leaders, politicians, professional organizations, and economists agree the implementation of a sales tax or value-added tax in Puerto Rico must be part of a comprehensive tax reform

It’s coming, so you had better get ready. After years of getting bogged down by status politics, the proposal to implement a sales tax system in Puerto Rico finally has consensus across political party lines. Legislation to that effect is likely to be presented next year. If it isn’t, it is almost certain to be soon after the 2004 general elections.

According to experts, the implementation of a sales tax or value-added tax (VAT) will probably be part of a far-reaching tax-reform package that will include the elimination of the current excise tax system, a broad-based consumer tax that is imposed at the point of entry (i.e., the ports) instead of at the point of sale.

Although the issue of replacing the old excise tax system with a sales tax or VAT has been raised before, recent developments have brought it to the forefront. When the Calderon administration in June 2002 increased excise taxes on alcoholic beverages, cigarettes, sport utility vehicles, and luxury vehicles as a means to balance the budget, it returned to the spotlight the idea of implementing a sales tax or VAT in Puerto Rico as part of a much-needed tax reform.

Additionally, a federal court order in 2002 asking the local Treasury Department (Hacienda) to refrain from requiring that air carriers (namely UPS) collect excise taxes on goods shipped to the island caused an unexpected hole in the government’s budget. The controversy raised concerns in the private and public sectors about the usefulness of the current excise tax system and the need to replace it with a general sales tax or a VAT.

Since then, several business leaders, professional organizations, government agencies, the Legislature, and politicians have expressed their support for substituting the burdensome excise tax system. Some organizations have gone a step further, commissioning their own studies or reports on including a sales tax or VAT as part of a sweeping tax reform.

Supporters include the Puerto Rico Society of Certified Public Accountants (Society of CPAs), the Chamber of the Food Marketing & Distribution Industry, the Puerto Rico Chamber of Commerce (PRCC), the United Retailers Association, the Puerto Rico Automobile Distributors Association, House Speaker Carlos Vizcarrondo, Treasury Secretary Juan Flores Galarza, House Treasury Committee Chairman Francisco Zayas Seijo, Sen. Roberto Prats, and New Progressive Party (NPP) gubernatorial candidate Pedro Rossello.

Consensus beyond party politics

Although the details of Rossello’s economic platform are still being worked out, he has said that if he is elected governor in November 2004, he will replace the island’s 6.6% excise tax with a sales tax (CB Oct. 30).

According to spokeswoman Juanita Colombani, Popular Democratic Party (PDP) gubernatorial candidate Anibal Acevedo Vila is working on his tax proposal. And PDP candidate for resident commissioner Roberto Prats has said that Mission 2025, a think tank he co-founded and directs in sketching a blueprint of the island’s future, would consider a sales tax as one of the 100 initiatives outlined in its final report.

Although Mission 2025 has purported to be nonpartisan, sources say Prats’ selection as the PDP’s resident commissioner candidate means the group’s report will probably become the center of the party’s economic platform in the 2004 elections (CB May 29).

Excise tax system outdated

One of the reasons there is consensus that something must be done about Puerto Rico’s tax system is that the 6.6% excise tax dates to 1954 and has become ineffective.

"The current excise tax system is worn out; it has reached maturity and has lost effectiveness," Heidi Calero, president of H. Calero Consulting Group, told CARIBBEAN BUSINESS. "The amount of excise tax collected no longer relates to the growth rate of consumer goods sold or even to the growth rate of Puerto Rico’s economy, which makes projecting tax revenue extremely difficult."

The Puerto Rico Treasury Department, said Calero, doesn’t have sufficient personnel to inspect each container of merchandise that arrives on the island; therefore, the current system promotes tax evasion.

According to published reports, only 3% of the containers that enter the island are inspected. That means a large number of commercial transactions go undetected—and untaxed—by Hacienda.

Another big problem of the excise tax system is its cascading effect, or the additional costs it adds to merchandise as it passes through the supply chain—from distributor to wholesaler to retailer to consumer. This added cost includes nonproperty taxes, inventory finance charges, and insurance. Some tax experts estimate the added cost is as high as 17%.

"In Puerto Rico, we have a broad-based tax on consumer goods, what we call the 6.6% excise tax, which is collected at the time merchandise enters a local port of entry," said economist Ramon Cao. "It is inefficient because it has a big cascading effect. The cascading effect means that in the end, consumers have less money to spend in relation to what Hacienda has collected."

Ernst & Young Partner Teresita Fuentes, a member of the PRCC and Society of CPAs committees on tax reform, said tax systems must be fair and simple. "Trade barriers are being lifted and many tax systems are being simplified," she said. "Our excise tax system causes a series of business interruptions and is complicated, not only for accountants but for merchants as well. Because of its high technical level and numerous provisions, the excise tax system promotes tax evasion."

Cao noted the design of Puerto Rico’s tax system was completed in 1954. Since then, it has received numerous small modifications or patches, except to the excise tax component. "The structure of the system was good for 1954 but isn’t for 2003," he said.

In the past 50 years, said Cao, the island’s tax system has been eroded to the point that numerous legislative measures have created contradictory incentives. "That’s not desirable or convenient because these measures generate inequities and inefficiencies in the system," he said. "What we need is a complete tax reform where a general sales tax is among the tools."

Tax reform issue not new

The proposal for a tax reform that involves replacing the excise tax with a sales tax or VAT isn’t new. The matter was raised during the 1994 tax reform—and even before that—by several organizations, among them the PRCC and the Society of CPAs.

"For the 1994 tax reform, we visited several states to evaluate their sales tax systems," said Fuentes. "A group even went to evaluate Chile’s value-added tax to see how compatible the two systems were with Puerto Rico."

A report was issued then, but politics derailed any possibility of enacting legislation that would have resulted in tax reform.

Society of CPAs President Jerry de Cordova said the organization has long been recommending that gubernatorial candidates include in their campaigns completely overhauling the island’s tax system, especially increasing the tax base and reducing income tax brackets for individuals.

"For many years, Puerto Rico’s tax system has been considered inefficient and unequal, not only by the Society of CPAs but by other people and other institutions as well," said de Cordova. "Everybody talks about the underground economy, and many administrations have made genuine efforts to tackle it, but many recognize those efforts haven’t been successful."

Tax studies galore

Society of CPAs

De Cordova said that in light of all the discussion about the current tax system, the Society of CPAs decided in 2002 to commission a study on one of the alternatives that has been discussed for over 30 years: implementing a sales tax or a VAT.

"After more than a year of searching for funds, we commissioned the study and are revising the final draft before releasing the findings," said de Cordova. The Society of CPAs’ foundation and the cities of Ponce and Caguas contributed funds for the study.

Among the participants in the study were local economists Cao and Fernando Zalacain as well as stateside group Hex, led by Thomas Hexner, which submitted a report on sales tax administration and implementation.

"Hexner’s group is composed of college economics professors who help implement tax reforms around the world," said de Cordova. "We are gathering all of the information to make our own report, which we will make public in the coming weeks."

The Society’s goal with the study, said de Cordova, was to foster an open discussion of the tax reform issued. To that end, he feels the Society has achieved its goal, even if the study hasn’t been released yet. "Both the New Progressive and Popular Democratic parties will include tax reform and a sales tax in their respective platforms," said de Cordova.

De Cordova is hopeful the discussions about tax reform will continue after the study’s findings are released and that legislation will be submitted following the House of Representative’s study.

"The idea regarding the implementation of a sales tax in Puerto Rico has transcended politics, and that was one of our goals with the study," said de Cordova. "One of the things the study will show is that in order for tax reform to work, it must have three characteristics: There must be equality in the system; income tax brackets must be reduced substantially; and the 6.6% excise tax must be eliminated."

House Resolution 3005

The House of Representatives’ study on implementing a sales tax, included in H.R. 3005, is complete and is under evaluation by House Treasury Committee Chairman Francisco Zayas Seijo, said Francisco Martinez, Zayas Seijo’s adviser on economic affairs.

"The House resolution is being evaluated, as it may be presented as legislation," said Martinez on behalf of Zayas Seijo, who wasn’t available for comment. "The study could present several scenarios, including one supporting the study Hacienda intends to conduct or one totally supporting a House study as it relates to the sales tax issue."

Martinez said the proposed legislation could be ready for the next ordinary session, which begins in January. "That’s why we decided to evaluate the resolution and harmonize it with everything else that’s being done," he said. "House Speaker Carlos Vizcarrondo will be presenting a report on the subject. To that end, we are working separately—[the committee] with the resolution, and the speaker with a much wider agenda."

Treasury Department

In November, Treasury Secretary Juan Flores Galarza invited 10 stateside firms that specialize in economic studies to present proposals for implementing in Puerto Rico a tax reform that includes a sales tax and the reduction of tax brackets for individuals.

Flores Galarza said the firms have implemented tax reforms in several U.S. states. The chosen firm will have six months to develop a study, which should be completed by June 30, 2004. He added that Hacienda has allocated $5 million for the study, on which some 20 local economists, accountants, and tax attorneys will be working. Flores Galarza named CPA Carlos Cuevas to lead the agency’s tax reform project.

Flores Galarza said the concept of the tax reform already exists; all that is needed is to design the administrative and technical structure to make the change. The reform seeks to lower the income tax brackets of individuals, eliminate the 6.6% excise tax, and implement a sales tax or VAT. This should increase the government’s tax revenue by expanding the tax base, simplify the process for paying income taxes, and improve Hacienda’s investigation ability.

Professional organizations weigh in

P.R. Chamber of Commerce

For many years, the Puerto Rico Chamber of Commerce (PRCC) has advocated a sweeping tax reform that includes a sales tax as a way to lower the cost of doing business, curtail tax evasion, promote work, and increase the tax base in Puerto Rico.

"The current excise tax system is extremely complicated. It delays business transactions, including the export and imports of products, and promotes tax evasion," said PRCC President Hector Mayol. "We see the sales tax system as a more-just, simpler system to administer. It isn’t as complicated as many want to portray it. As part of a tax reform, a sales tax can bring more tax revenue into the Treasury Department."

How much more? According to preliminary estimates by the House, a 5% sales tax could reap as much as $1 billion more than what Hacienda collects under the current excise tax system. In fiscal year 2003 (ended June 30), Hacienda collected some $1.7 billion in excise taxes, representing 21.1% of the general budget.

The old argument that an excise tax is easier to administer because it is collected at the port of entry is false, said Fuentes. "It isn’t humanly possible to inspect every container, and that gives way to large-scale tax evasion," she said. "That’s one of the excise tax system’s greatest defects, as it doesn’t meet the principles of simplicity and equality."

Another old argument is that small business would have a hard time implementing a sales tax. "With the technology we have today, it would be quite simple because most cash registers and debit card machines can be programmed to calculate the sales tax," said Mayol, who is also president of Santander Asset Management and a former Commissioner of Financial Institutions. "Even banks can electronically identify the amount of sales tax collected by a merchant and send it directly to Hacienda."

As it is now, said Mayol, consumers pay the excise tax but don’t see it. With a sales tax, however, consumers will know exactly how much tax they are paying. "This means the government administration that implements the sales tax system will have to explain to taxpayers how the system works and its benefits," he said. "That is why we insist it has to be done as part of a tax reform. That way, taxpayers will see their tax brackets reduced along with the sales tax."

Another plus of the sales tax system, according to Fuentes, is that it would make things simpler not only for local businesses but also for prospective investors in Puerto Rico. "Every day, we see investors walking away, complaining about the high cost of doing business in Puerto Rico, with all the permit requirements and red tape," she said. "Many consider Puerto Rico one of the most complicated jurisdictions in which to do business."

United Retailers Association

In January, then-United Retailers Association President Ricardo Calero announced that the organization, which represents some 18,000 small and midsize businesses, favored placing a sales tax on all services and goods, except food and prescription drugs.

Calero said at the time that small businesses often end up paying for the product and the excise tax if it isn’t sold. Businesses thus incur losses because the excise tax has already been paid even before the product has reached the store.

"A sales tax would benefit small- and midsize-business owners because they would pay the tax when making a sale," Calero said. "The current situation has the business owner paying the tax when receiving the merchandise, which then is stocked, representing additional taxes on inventory plus storage, insurance, and other expenses that could be invested in obtaining more goods or hiring more staff."

Calero emphasized that if a sales tax is imposed, the 6.6% excise tax on imported goods must be eliminated.


Atilano Cordero Badillo, president of the Chamber of the Food Marketing & Distribution Industry (MIDA by its Spanish acronym), said the organization passed a resolution during its past general assembly that an alternative to Puerto Rico’s tax system must be found, and it must address individual income taxes.

"We have a committee evaluating the tax reform and sales tax issues," said Cordero Badillo. "The committee has met on several occasions, but it hasn’t given its recommendations to the board, so we can’t reveal the organization’s position yet."

Cordero Badillo said, however, that he personally believes Puerto Rico needs a tax system that doesn’t penalize middle- and working-class citizens, who are paying 35% of their wages in taxes.

"I think we need to look at different systems; if a sales tax is implemented, we would have to significantly reduce or eliminate the individual income tax for those earning less than $25,000 a year. To me, that’s paramount," he said. "We would also have to eliminate the 6.6% excise tax because of the cascading effect it has."

With a sales tax, said Cordero Badillo, the government would expand the tax base to include white-collar tax evaders, who are part of the estimated $20 billion-a-year underground economy. "The underground economy is as big as the economy that includes two-income households, street vendors, those who work abroad, welfare recipients," he said. "There are a number of people, from all walks of life, who evade paying income taxes. The best option would be to have a sales tax as in the States."


Angel Perez Muñoz, executive director of the Puerto Rico Automobile Distributors Association (Prada), said the organization has never objected to implementing a sales tax in Puerto Rico. In fact, he recalled, when the 1992 automobile excise-tax law (Law 80) was enacted, there was a proposal to place a sales tax on vehicles.

There were objections to that proposal, and the law ended up being a hybrid: The dealer or distributor pays the excise tax on the vehicle upfront but collects the tax from the customer at the time of sale, explained Perez Muñoz.

"A sales tax would be beneficial to the industry, as it would remove from distributors and dealers the burden of being taxpayers for every vehicle that comes to Puerto Rico," he said. "The excise tax increases our operational costs; therefore, consumers end up paying more.

"I have dealers in the association that pay in excess of $14 million in surety bonds for their vehicles; that’s several hundreds of thousands of dollars on insurance that they wouldn’t have to pay [with a sales tax system]," added Perez Muñoz. "There are many reasons a sales tax is more favorable for everyone."

With a sales tax, he noted, the vehicles’ prices would come down in line with those in the States. "The consumer would then have more options in choosing which vehicle to buy, instead of choosing a vehicle according to the excise tax bracket," said Perez Muñoz. "With a sales tax, the consumer wins."

When a dealer or distributor files his corporate income taxes under the current excise tax system, the excise tax becomes a cost factor and fewer taxes are paid, he said. "With a sales tax, the government would benefit by collecting more in corporate taxes from dealers and distributors," said Perez Muñoz.

"The key is that if a sales tax is implemented, the government mustn’t use that as an excuse to increase the tax on vehicles much higher than what it already is," he added. "If it does that, it will kill the goose that lays the golden eggs."

Disadvantages of the Excise-Tax System

  • Puerto Rico is the only U.S. jurisdiction that taxes goods at the port of entry.
  • The system is burdensome and time-consuming, increasing costs, adversely affecting trade, and making the island less competitive.
  • It promotes the underground economy.
  • Only 3% of shipping containers are inspected, opening the door to large-scale tax evasion.
  • Cascading effect can increase actual cost of tax as much as 17%.
  • Merchants must pay tax before product is sold, increasing operating costs.
  • Taxes aren’t collected on all catalog or Internet sales.

Advantages of the Sales-Tax System

  • Is more efficient, reduces the cost of doing business
  • Is easier to administer
  • Curtails tax evasion, collects from underground economy
  • Eliminates cascading effect
  • Expands tax base, bringing more tax revenue into the government
  • Is optional; without a purchase, no tax is imposed
  • Collects taxes on catalog and Internet sales

Glossary of Terms

Sales tax: A tax imposed on consumer goods at the point of sale

Value-added tax: A tax imposed on the added value of merchandise as it passes through the supply chain—from manufacturer to distributor to wholesaler to retailer to consumer

Excise tax: A broad-based tax on consumer goods that is imposed at the point of entry

Cascading effect: The tax cost added to merchandise as it passes through the supply chain—from distributor to wholesaler to retailer to consumer

This Caribbean Business article appears courtesy of Casiano Communications.
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