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Saving Puerto Rico’s Financial Future


February 10, 2005
Copyright © 2005 CARIBBEAN BUSINESS. All Rights Reserved.

Simply put, Puerto Rico’s fiscal policy is on an unsustainable course. Regardless of the assumptions economists and analysts try to come up with, the problem is too big to be solved by economic growth alone or by making modest changes to existing spending and tax policies. Nothing less than a fundamental re-examination of all major economic and financial policies–spending and taxes–and priorities is needed. This re-examination should involve a transparent and candid disclosure about the role Puerto Rico’s government should play in our society. This discussion won’t be easy, but it must take place as time is working against us.

The government can’t afford any more wishful thinking and must wrestle with painful trade-offs this time. The drivers for change must be political and public will. Puerto Rico’s attitude of wanting to "have the cake and eat it too" must come to an end. Although many could find the topic overwhelming with technical jargon and terminology, confusing, and intimidating, it is a very tangible issue that affects everyone as it affects the ability of the government to fund programs that everyone cares about, such as public safety, health, and education.

Slow economic growth, projected at 2.3% for fiscal 2005, low personal income, inability to create jobs in the formal economy, a graying population, a growing fiscal deficit, high public debt burden per capita, and huge government subsidies, further aggravate the issues that are plaguing the economy.

In recent years, the government has opted either to cover the deficits with nonrecurring revenue, that wouldn’t be available during coming years, or incur additional debt to cover the deficiencies. This behavior has increased the public debt at a rate that could limit the government capacity to finance important infrastructure projects. Credit-rating agencies have warned the government of the possibility of downgrading Puerto Rico’s credit rating. This possibility would make it more expensive to borrow money.

To cover the deficit, the government has borrowed money from the Government Development Bank (GDB) or depended on nonrecurrent income. The GDB’s credit rating also has been jeopardized in the process, proven by the recent negative outlook issued for the bank by Standard & Poor’s credit rating agency. As of June 30, 2004, almost 50% of GDB assets were made up of loans to government agencies and public corporations.

As of Sept. 30, 2004, the central government’s debt stood at $15.13 billion. The extra constitutional portion stood at $7.716 billion, an increase of 48.59% in the past two years. This rate of growth is higher than the rate of growth of the island’s Gross Product and the rate of growth of revenue to the general fund. Puerto Rico’s public debt is approaching $40 billion. At this rate of growth, it soon will surpass the island’s Gross Product. During the past four years, the GDB issued $26.566 billion in bonds of which $17 billion was new debt. During fiscal 2004, the GDB had to lend the government $233 million to balance the budget and guarantee repayment of the Tax Revenue Anticipation Notes. The same situation occurred in 2003 when the GDB had to lend the government $250 million. This fiscal year, they are looking at a minimum of $550 million.

The percentage of the government’s budget assigned to permanent investments was reduced by $228 million this fiscal year. This fact is particularly worrisome, as the island requires a major overhaul of its infrastructure.

Currently, the government pension plan doesn’t have sufficient resources to meet its obligations, which includes the payment to retirees on the short and medium term. The unfunded liabilities of the system could point toward a deficiency of $11 billion, a situation that is aggravated by the fact the Puerto Rico Legislature increased benefits by 3% in 2004.

Although constitutionally Puerto Rico could still technically issue approximately an additional $3.38 billion in debt, in practical terms, the margin is substantially less unless a tax and fiscal reform is implemented that addresses the fiscal situation in a structurally permanent manner.

The percentage of the government’s budget assigned to permanent investments also has been declining. The amount assigned to this purpose was even reduced during this fiscal year by $228 million. This fact is particularly worrisome as the island requires major overhaul in its infrastructure. A major revision of the financial structures of the public corporation system is imperative, especially those responsible for the island’s infrastructure. The tariff systems and subsidies structure of these public corporations is imperative. For example, Prasa has uncovered liabilities of $160 million and more than half of its budget is covered by legislative appropriations.

The reduction in government spending requires a rethinking and reformulation of the historically paternalistic philosophy of the role of government in our society, including public corporations.

CARIBBEAN BUSINESS sat down with Juan Carlos Méndez, appointed secretary of the Treasury Department; Ileana Fas Pacheco, director of the Office of Management & Budget; and William Lockwood Benet, president of the Government Development Bank, to discover how they are dealing with the different aspects of this overwhelming problem and how they plan to put into motion the necessary reforms.

CPA Juan Carlos Méndez, secretary designate of the Treasury Department

The fact Juan Carlos Méndez is a lawyer and CPA, with experience working in some of the top firms in Puerto Rico and was headed on a professional track, would make many wonder why he chose to enter public service. His answer to this question is simple. His main inspiration for working in government is his nine-month-old daughter, whose numerous pictures adorn his new office. Méndez wants to do everything in his power to ensure a healthy future for Puerto Rico, so that someday his daughter need not look elsewhere for a better place to live.

Méndez’s educational and professional preparation surely will assist him in his new endeavors. Méndez has a degree in accounting from the University of Puerto Rico (UPR), a Juris Doctor from UPR’s School of Law, and a degree in Taxation from Georgetown University Law Center. He worked as a tax attorney at McConnell Valdés and subsequently as a technical adviser to the secretary of the Treasury in 2002. He also worked as a senior tax manager for Scherrer Hernández & Co.

CARIBBEAN BUSINESS: How do you feel about your designation as secretary of the Treasury?

Juan Carlos Méndez: I am very happy and honored. It is a great challenge. Puerto Rico’s budgetary issues are well-known and very delicate at the moment. The situation has been dragging on for several administrations, but it is no longer sustainable; and real changes have to take place that can generate benefits in the long term. I am convinced despite the shared government situation, it is time to sit down, talk about this, and reach a consensus.

How would you describe Puerto Rico’s tax system in 2005?

The tax system requires immediate reform. We all know the structural deficit has exceeded $1 billion since the current system doesn’t have the ability to collect the necessary funds for public works and government services. This is a problem that affects us all, no matter our economic level, because those are funds we need to pay the police force, teachers and nurses, and to build better roads. The situation is critical, but I am very positive we are going to solve it. The environment is positive for change. The same way our government is currently shared by two parties, the responsibility also will be shared.

What is your opinion about attempts in 1987 and 1994 to reform the tax system?

In those reforms, to some degree, something was accomplished; but the fixes were more like patches to the system. It hasn’t really been reformed. We have a system that needs real reform today. Patches are continuously implemented to attempt to solve the situation, but that doesn’t really fix the problems of the tax system, which are the inability to collect the funds needed for public works and government services and to track tax evasion.

What would you consider to be the fundamentals of true reform?

For me, the two worst problems of the current tax system are that it doesn’t attack tax evasion and most of the tax burden is placed on the salaried employee. The greatest burden is on the employees, no matter how much they earn, it can be $150,000 or $20,000. Why? They are easier to target because they can be tracked through the W2 and only have the right to two or three deductions. That is very unfair; actually, 90% of the income that is reported to the Treasury [from individual income taxes] comes from salaries.

Would you be satisfied with tax reform that doesn’t come accompanied by fiscal reform?

Any advancement in that direction is welcome, without a doubt. But I am very satisfied with the public debate going on and the governor has recognized more is needed aside from simple tax reform. Fiscal reform must take into consideration the component of the budget that corresponds with government spending, and that has been known for years. How much can we save there? That corresponds with the Office of Management & Budget. Almost 80% of that budget goes to payroll or related professional services. It is hard to reduce spending there without cutting employment, which I know is not an alternative because although our economy is picking up it still isn’t able to absorb enough unemployed people. You can’t expect them to live off welfare because that is even more costly. It’s a catch-22.

Are you satisfied with the statistical and information systems used by the Treasury?

That is an area that can improve, without a doubt. For the Bearing-Point study, we were using statistics from 2002 for individuals and, for corporations, the numbers were even older. Now, for the first time, the Treasury has tools that weren’t available in the past. Bearing-Point prepared software tools, actualized and updated macroeconomic models, and trained people from the Treasury so they would know how to use them properly.

Do you believe the Bearing-Point study can serve as a base for the needed tax reform?

It has the tools, but the study isn’t as encompassing as I would have liked. The biggest problem of the study was the government had a position going in, and they told Bearing-Point basically what they wanted without taking into consideration any previous study. The government told them we want to eliminate the 6.6% [excise tax] and replace it with a sales tax or a value-added tax, and we want to lower the tax rates for individuals; and that is what Bearing-Point did. The government didn’t give them the liberty to consider other reform models. The previous secretary also wanted to come up with the magic number of $550 million, the amount they needed to borrow to balance the budget, and that reform–the Bearing-Point recommendations–equals exactly $550 million. I have studied these [tax systems] in depth, both for Puerto Rico and the U.S. I know the virtues and the disadvantages of the excise tax system, of the value-added tax and the sales tax, and they are all different forms of a consumption tax, some subtract it before, others in the middle, and others afterward. For me, the name is the least of my concerns. I just want it to solve the two basic problems of the current system. More important than talking about which plan to implement, the focus should be on giving Treasury the necessary tools.

Bearing-Point doesn’t make reference to corporate taxes. Is it something that should be discussed as part of an all- encompassing tax reform?

That is another deficiency of the study. It doesn’t deal with exempt or paying corporations, and the reform definitely should include corporations. I already have met with several groups, the College of Certified Public Accountants, the Puerto Rico Chamber of Commerce, and the Puerto Rico Manufacturer’s Association. We spoke with the manufacturers in particular about things they can do on the administrative level that won’t affect them, but that will generate more collections.

How concerned should we be about the negative outlooks issued by the credit-rating agencies?

They have been monitoring the situation for a while. The previous administration [former Gov. Sila Calderon’s] prepared a presentation for Moody’s, which explained how the tax reform is going to fix the gap. For that reason, they postponed a credit downgrade in Puerto Rico general obligation (GO) bonds that would make it more expensive for the government to borrow money, which is equal to less money available for public works and government services. I know that is one of the situations that needs immediate attention, and we already are working on it. I have several battles I have to work on in the short term, and this is one of them. In March, analysts from the credit-rating agencies are coming back to Puerto Rico, and the important thing is that we have to do something. We can no longer show them studies and tell them what we are planning on doing; they are expecting us to do something now, in the short term, in addition to the medium and long terms. The plans they previously presented [to the credit agencies] were for the medium or long term. The Bearing-Point plan will cost $76 million to implement, and the effects won’t be seen for three or four years. So, for this administration, that doesn’t solve the problem; and that won’t prevent them from downgrading the GOs. That is why I am submitting suggestions to the governor before my deadline of Feb. 4, including recommendations for the short, medium, and long terms. We have to show the rating agencies we are effectively doing something. I don’t think we can prevent a downgrade of the GOs by saying we are studying something or another committee is studying something else. No, I don’t think that will work.

Ileana Fas Pacheco, director of the Office of Management & Budget

Political pressure is nothing new to Ileana Fas Pacheco. Being the daughter of Sen. Antonio "Tony" Fas Alzamora, she is familiar with the demands of a political career–a fact that surely will help her during her term as director of the Office of Management & Budget. But, that isn’t all she has in her favor. Her most recent experience working as director of the Office of Federal Affairs of the Department of Education during a period of budgetary crisis, armed her with the necessary tools to undo the challenges of budget management on a larger level; skills she will be using every day during her new undertaking.

The need for innovative ideas in the government surely will be served by her diverse educational and professional preparation. Fas Pacheco has a degree in Electrical Engineering from the University of Puerto Rico in Mayagüez; an MBA in International Management from Thunderbird, the American Graduate School of International Management in Arizona; and is a Juris Doctor candidate from the University of Puerto Rico School of Law. In the past, she worked in Washington, D.C., in the office of then-Resident Commissioner Aníbal Acevedo Vilá, was a special assistant to the Puerto Rico secretary of State in 2001, and worked as an electrical engineer for several years at Motorola Inc. Coupled with her background and experience, Fas’ irrefutable enthusiasm and optimism surely will be an asset in accomplishing all the goals she has set for herself and the challenges of the new appointment.

CARIBBEAN BUSINESS: How do you feel about your appointment as director of the Office of Management & Budget?

Ileana Fas Pacheco: I am not only honored to have this privilege, but also very motivated. This is a challenge many view as impossible to accomplish successfully, but I don’t see it that way. On the contrary, I see it as a challenge to achieve something different, and the historic moment to do something is now. I am convinced of that.

How would you describe the situation with the government’s budget?

It is a difficult reality due to the problems that weren’t diagnosed or attended to for many years. We can’t solve the problems we have today with only short-term solutions. What I have perceived until now is that the budgetary process in itself–the criteria, solutions, and alternatives that historically have been used to attend to the services and obligations the government has assumed–are all part of the problem. From the way estimates are made, the resources used for spending, be it recurrent or nonrecurrent, the very process in itself doesn’t facilitate the resolution of the situation of the structural deficit.

What is your projection for this fiscal year’s "structural deficit?"

In the transition report, there is a loan of $550 million. I don’t have the details of what it was used for specifically, but I understand a great part of it was used for the structural deficit. The report also reveals there is an underestimation of government spending for this fiscal year, which means there could be an excess of spending by an amount that could reach $250 million. To that we have to add tax measures that expired. For example, if there was a reduction of the capital-gains tax from 20% to 5%, that kind of change affects collections. Treasury estimates the revenue we won’t receive this year ranges between $168 million and $200 million. If we add $200 million, $250 million, and $550 million, the structural deficit for the coming fiscal year could reach $1 billion; but that is an estimate. Today, it isn’t wrong to say the structural deficit is $550 million because if we could manage to reduce government spending by $250 million, refinance debts, perhaps to cover those expenses, and take other measures, we could end the year with an obligation of $550 million, which would be the structural deficit for the next fiscal year. But today, we don’t owe the $550 million; it was taken care of by the GDBank.

Does Puerto Rico need fiscal reform in addition to tax reform?

Yes. We have to enact measures to ensure we have a tax system that responds to the government’s needs and the government is going to use that money efficiently. After all, that is the whole point of increasing collections for the government; otherwise, in some areas, we won’t have the quality of services that citizens expect and deserve. That is why the governor has laid out the need for fiscal reform, which is precisely where our participation comes in. The governor has asked us that along with tax reform that reduces government spending, we must also consider how to make the government more efficient and do it all at the same time.

Has the government bureaucracy gotten out of control?

If we don’t do something, it will get out of control; but we’re going to do it. That is my inspiration. The present government’s agenda is to improve the way the island is governed and to attend to its needs in a different and responsible way. Gov. Acevedo Vilá has said this isn’t the same government, and he doesn’t want to do more of the same. That is what we hold as our conviction. It is a big challenge, a difficult one from the point of view of the numbers. Perhaps there is no vision about how we are going to do it, but if we look beyond to the long term, I believe we can visualize a responsible achievement, a responsible solution to Puerto Rico’s problems. But, we have to establish it as a long term. Nevertheless, measures at short and medium terms can help in some capacity by having responsible expectations of revenue and expenditures.

Are measures being considered to stop the trend of increasing government employment?

Our recommendations for the governor will be directed at all types of expenses and, obviously, payroll is one of the largest recurrent expenses in government. In some way, we have to ensure the growth in employment is necessary and not unmeasured. But, what we aren’t planning on cutting is personnel. The governor says he doesn’t believe that is part of the plan; nevertheless, we have to see in what areas there are personnel who can be retrained or placed elsewhere. These types of measures will give us the opportunity to provide more efficient service and bring the government closer to the citizens and the citizens to the government. At the end of the day, the government is for the citizens. The revenue received by the government is to provide services citizens expect. We plan to address the problem in an integrated way, not with a patch here and there.

Do you think government salaries are disconnected and independent from productivity or efficiency considerations? How are you going to address the upcoming labor negotiations with over 100,000 government employees?

When salary increases for public employees come up, we will have to attend to the petitions of labor unions. I believe all human resources issues have to be worked out in an integrated way. We can’t increase salaries in one area and not another, or this one first and another later. We have to really examine the productivity scale of the employees, if they are being paid justly or unjustly, while at the same time attending to it in a responsible way, considering the fiscal situation. There should be limitations, and we can’t simply approve increases without having the resources.

During the present fiscal year, according to budget documents, there was a reduction of federal government grants to the commonwealth from the previous fiscal year. Do you expect this trend to continue and increase an already complicated budget situation?

If there is a decrease in federal funds designated for Puerto Rico, it will impact in some way the services that can be offered with these funds. I think there are ways we can maximize the funds we receive, federal and state. I also understand if we manage to be more efficient, this new challenge can be handled by maximizing the use of available funds.

How concerned should we be about the negative outlook of the credit-ratings agencies?

I feel we have a lot of work to do. The executive and legislative branches need to attend to the fiscal reform with diligence. The change in the outlook sends a message, but that message isn’t just for me, it is for all who are responsible for the budget. I am eager to address this situation urgently; I have told the governor we have to take measures in the short, medium, and long terms to prevent further action in relation to our bonds. But the situation is difficult.

William Lockwood Benet, president of the Government Development Bank

This isn’t the first time the experienced economist has been working for the Government Development Bank. In the late 1980s and early 1990s, Lockwood was vice president and assistant to the presidents of the institution, dealing with privatization transactions and bond issues of the central government and public corporations. In 1989, he also was vice president of the Economic Development Bank under Teodoro Moscoso.

He graduated from Brown University and the Institute for Development Studies at University of Sussex in the United Kingdom. He was president of the board of directors of Guayacán Fund, as well as functioning as director of the Center for New Economy, Puerto Rico’s first nonpolitical think tank, which currently is studying Puerto Rico’s economy in conjunction with the Brookings Institution in Washington, D.C.

The list of his professional experiences is much longer and includes institutions such as Banco Popular, Puerto Rico Conservation Trust, the Office of the Commissioner of Financial Institutions, Citibank Global Finance, Merrill Lynch Tax Exempt Fund, and the Real Estate Investment Trust.

CARIBBEAN BUSINESS: How would you describe the government’s fiscal situation?

William Lockwood Benet: It is time to re-examine everything. It is a challenge for local bankers to emerge in a closer collaboration with their colleagues in the OMB [Office of Management & Budget], those at the Treasury, and the directors of finance and executive directors of public corporations. Along that line, we have identified a series of initiatives to fortify the GDB’s role as a fiscal agent in terms of teamwork, interdisciplinary work to accelerate processes and make sure there are no surprises during the year, and to have more operational control. That includes a much more rigorous evaluation in terms of investment risks and the priorities in investment projects. We are going to work closely with the engineers from Infrastructure Financing Authority (AFI) and with the Planning Board. We are going to closely monitor regional priorities to see the yield of the investments and to watch out for an increase in the budget for the maintenance of the infrastructure. This way we can rapidly propose any spending cuts that should take place to improve levels of maintenance and the coverage for repaying bonds.

What are the main challenges ahead?

There are many challenges ahead. There are corporations that were created at the beginning of the Commonwealth that are self-regulated. I am returning here with the experience of two years in the sale of the PRT [Puerto Rico Telephone] telecommunications company and with the experience of having created a separate regulating entity whose origination came from this bank. It is the moment to create healthy competition among the corporations in the infrastructure sector. We have to look at ways in which public corporations could generate increased private investment.

Are there recommendations on the short term to deal with the recent change in outlook on the GOs?

We can’t talk only about tax reform; we need to talk about fiscal reform. We must look at the revenue side and spending. On the spending side, we must look at the efficiency and effectiveness of government expenditures. We must re-evaluate the decision-making process we use to select what projects to invest in. The GDB’s work agenda includes not only playing the role of fiscal consultant but also interacting with the Office of the Commissioner of Financial Institutions in order to create mechanisms conducive to increasing savings rates in Puerto Rico. Puerto Rico’s financing options must be optimized with new and innovative products that could be sold in Puerto Rico’s financial market to facilitate the capital necessary for the transition to a healthy fiscal situation. In that sense, I am very optimistic the most innovative component of the entire financial system, the bank [GDB], will have an active and leading role in Puerto Rico’s fiscal transformation. I can’t think of any other institution that is more challenging for the new generation of specialized bankers. We are considering entering selectively in developing more internal expertise and specialization so we can more closely monitor important areas of recurrent spending within the central government, specifically in the areas of education and health. We are going to move forward to provide additional support to the Office of Management & Budget, the Treasury, and other government agencies, especially in the area of innovation. A lot can be done in this regard in the areas of higher education and health.

Why the difference between constitutional and so-called extraconstitutional debt? Isn’t Puerto Rico’s credit committed in both categories?

Definitely. Puerto Rico takes seriously the commitment to repay all this debt. In every contract, we have very rigorous legal structures in which the first income that flows in goes to the reserve balance for the repayment of the bonds. We are vigilant the coverage of the income is that required by the deed of trust and that the reserve levels are maintained. After the reserve and the bond payments are maintained, then the operational costs are paid, and what is left is used for other expenses. So, even though there are differences in the legal and constitutional obligations between emissions, there is a rigor and a discipline that applies to the contracts and the management of funds.

Will the policy of increasing financial support to public corporations and government agencies continue?

That will drastically change so we can increase the bank’s liquidity. On one side, we are going to resort to the markets so the debt emissions are done in the U.S. and we are reimbursed, to have a flexible resource. In the case of the central government, we are working on the strategic contributions to make sure they are enough to stimulate the increase of collections and allow them to depend less on the bank. It will be a great challenge.

The pension fund faces a situation of unfunded liabilities, estimated at $11 billion. Would the new bond issue ($2 billion) that is being considered to partially cover the situation be added to the constitutional debt?

I am considering it, but this is just my third day [Feb. 2]. To reduce government spending, we are going to have to consider a payroll deduction as well; therefore, adjustments to the retirement plan will have to be made as everything is integrated. There is a new actuarial report, which we haven’t received yet, but we are going to be revising the investments standards. Along this line, we will also view it as a long-term development instrument. Pension plans are the ideal portfolios to invest in private equity and venture capital, which is an area I will be evaluating, to take it to another quality level in the future and support the business priorities mentioned by the governor and projects of high-end technology.

Are we looking at more than fiscal reform, rethinking our economic model and the role of government in our society?

Definitely. We are moving forward on short-term measures for stabilization but, at the same time, we must address long-term measures. If we don’t address our long-term measures, we won’t have clear priorities and objectives. We must conceptualize how the government can become more strategic in terms of economic resources. In general terms, the governor is very willing to implement fiscal reform measures in the short term if it stimulates the long term efficiently. On the short terms is the budget balancing, which requires the highest priority. To achieve this objective, higher revenue and lower spending are required. We are going to be seeing the greatest amount [of changes] possible within the executive branch and we are very conscious of the required interaction with the legislative branch to achieve fiscal responsibility to proceed with our long-term objectives.

How are the finances of the municipalities, and do we visualize an all-encompassing tax reform that would include property taxes?

We have to take short-term measures, but we are going to be working on reform with a wide vision. The governor has an interest in exploring more municipal responsibility, and I think that will require new financing projects from the bank. We are starting to look at the municipalities where there is a center, a pole, as well as the weaker municipalities, to start looking at a possible regional cooperation. We have been working ardently to include corporations in the reform.

To summarize, how big is the problem, how big is the challenge?

We have a serious challenge in the short term, and that is safeguarding the fiscal credibility and the rating quality of the bank and the central government. This year, fiscal responsibility is very important because if we don’t deal with it, what we are doing is making financing more expensive and sending a message that we don’t have the internal capacity to agree and solve these challenges. They are problems that have been here for a long time. It is a very big challenge. I am at peace knowing the governor is conscious of the tough decisions that have to be made this year.

Editor’s note: Secretary Méndez is pending confirmation by the Puerto Rico Senate; Fas’ appointment doesn’t require confirmation; and Lockwood’s appointment was confirmed by the GDB board.

This Caribbean Business article appears courtesy of Casiano Communications.
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