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Proposed Commonwealth taxes will squeeze banks, other business sectors, and all consumers, thereby hurting the total economy


April 21, 2005
Copyright © 2005 CARIBBEAN BUSINESS. All Rights Reserved.

Proposed new tax on Puerto Rico’s financial sector sends stock value plummeting

With the Commonwealth government struggling to find a solution to its fiscal crisis, Puerto Rico’s financial sector has come under fire and is expected to be hit with a special tax estimated to increase its income tax bill by over 50%

News of the Commonwealth’s special tax on Puerto Rico’s financial sector is having a negative impact on the Puerto Rico Stock Index (PRSI), which consists mostly of the island’s banks. Stock values have simply plummeted since word got out that Gov. Aníbal Acevedo Vilá would hit them with $360 million in additional taxes during the next two years. Puerto Rico’s banking sector is just one of many industries on the island that will be impacted by the $1.3 billion in additional taxes the Acevedo Vilá administration plans to collect in fiscal 2006 (CB April 7).

The value of Puerto Rico’s publicly traded companies has gone from $18.7 billion on March 15, the day before the governor’s budget speech, to $14.79 billion on April 12, a loss of $4 billion. On Jan. 3, the day after Gov. Acevedo Vilá took office, the market value of Puerto Rico’s bank stock was $21.4 billion.

Uncertainty affects stock values

The slightest hint of uncertainty in any publicly traded company can result in declining stock values. Since Gov. Acevedo Vilá delivered his speech on the proposed fiscal 2006 budget, the Puerto Rico Stock Index didn’t only go down, it plummeted.

Even before the budget speech, rumors of the proposed tax on Puerto Rico’s financial sector created havoc on Wall Street. Stateside analysts were scrambling to obtain English translations of the governor’s budget speech in order to evaluate the potential impact on island stocks. Uncertainty was widespread, generated not only by the percentage of the tax increase on these publicly traded companies and the impact on Puerto Rico’s financial sector, but also because of the reasons that led to the tax proposal increase in the first place.

The Commonwealth’s fiscal crisis and the nearly $2 billion budget deficit in fiscal 2006 are the primary reasons behind the administration’s proposed tax increases. The government of Puerto Rico seeks to collect an additional $1.3 billion in tax revenues and reduce spending on capital improvement projects by over 10% in fiscal 2006 in order to balance the Commonwealth’s budget and not risk a downgrading of its credit rating any further. The government of Puerto Rico already has the lowest bond rating of any state in the U.S. Among the tax increases proposed by the administration are the removal of exemptions to the 6.6% excise tax on items imported to Puerto Rico by many now exempt industries and imposing a special tax on the island’s financial sector for the next two years.

The additional special tax proposed for Puerto Rico’s financial sector in the fiscal 2006 budget submitted by Gov. Acevedo Vilá increases this sector’s income tax burden by $180 million a year and represents an increase of over 50% in comparison with the estimated $345.2 million the financial sector paid in income taxes to the commonwealth government in 2004. This $345.2 million doesn’t include municipal patents, licenses, property taxes, and other fees now paid by Puerto Rico’s financial sector. Banking analysts estimate that the special tax increase ranges from 2% to 10% on net interest income.

In 2003, members of the Puerto Rico Bankers Association paid $345 million in income taxes, municipal patents, licenses, and other fees. In 2004, the island’s banking sector paid $345.2 million in income tax alone, plus an additional $62.6 million in municipal patents, $28.5 million in property taxes, $1.5 million in license fees, and $13.5 million in examination fees for a total of $451 million, an increase of $95 million compared to 2003. The effective tax rate of Puerto Rico’s banking sector is almost 30%, according to industry experts. In 2003, 10 banks paid 13.8% of the total corporate taxes collected by the government of Puerto Rico. In 2004, these 10 banks paid 17.2% of the island’s corporate taxes.

Governor spoke and PRSI plummeted

Until now, Puerto Rico’s financial sector has proven to be one of the few healthy sectors of the local economy. As a result of that success, the industry has now become a target in the governor’s attempt to generate higher revenues. The insular thinking of the commonwealth government and the governor’s populist rhetoric has ignored the consequences of his fiscal actions and the impact of his statements on the U.S. mainland’s financial markets.

When it comes to the financial industry, words aren’t cheap. In the case of the governor’s budget speech, it has cost billions of dollars to local and stateside investors in Puerto Rico stocks. Puerto Rico banks have lost over 30% or almost one third of their stock value since the administration of Gov. Acevedo Vilá took office. A total of $6.66 billion in market value has been lost as of April 12. A substantial amount of that loss, nearly $4 billion, has occurred following the governor’s budget speech. The administration’s goal is to collect an additional $360 million in tax revenues from the financial sector over the next two years to help pay for the Commonwealth increase in spending.

On Jan. 3, the market value of eight publicly traded Puerto Rico financial institutions was $21.4 billion. On April 12, it stood at $14.8 billion, a loss of over 30% in three and a half months.

UBS reported from March 15, the day before the governor’s budget speech, to March 18 Doral Corp. stock price alone dropped by 44%; Westernbank and R-G by 10%; Eurobank, Banco Popular, and Oriental by 9% each; and FirstBank by 4%. This drop in stock prices has also limited the ability of Puerto Rico’s publicly traded financial institutions to raise new capital in the market since new stock issues will further dilute the position of existing stockholders. This limitation on new capital will limit the growth and ability of the banks.

At the beginning of 2005, Puerto Rico’s financial sector had an optimistic outlook coming out of an outstanding 2004 performance in which local bank stocks outperformed most of their mainland counterparts. Local bank expansion to the mainland was also moving full steam ahead as Banco Popular, R-G, and FirstBank made acquisitions on the U.S. mainland. The financial sector had also taken into consideration the gradual increases expected in interest rates by the Federal Reserve in their strategic plans for 2005. However, 2005 has so far turned out to be a bumpy one for the industry.

PRSI not as bright in 2005

One factor that is further affecting Puerto Rico’s financial industry in 2005 is the sale of local bank stocks as a result of the expiration on June 30 of the lower capital gains tax. The capital gains tax, which has been in effect since July 1, 2004, and is scheduled to expire June 30, is 5%, vs. the previous 10% tax. Over the past few months, some stockholders have been selling shares of local banks to take advantage of the lower tax. To further complicate matters, the governor has proposed increasing the capital gains tax to 20% after July 1, which may have also contributed to some of the recent selling pressure.

Since March 15, it has become painfully obvious that local bank stocks were headed downhill; Popular’s market value has been reduced by almost $800 million, R-G Financial by $260 million, W Holdings by $225 million, FirstBank by $300 million, and Doral by $2 billion. Assuming Gov. Acevedo Vilá was aware of it, he disregarded this and reacted to the $2.7 billion loss in market value in Puerto Rico’s public financial sector since he took office by going ahead with an increase of $360 million in the form of a special tax over the next two years on the sector, resulting in an additional $4 billion loss to investors. This has also had a ripple effect into other sectors of the economy as business people use their stock holdings as collateral for loans for other investments and projects. When this collateral is reduced in value, they are forced to raise additional collateral to cover the required guarantee. In the case of investment accounts that get a "margin call," the investor is forced to sell to cover the margin.

The Puerto Rico Bankers Association (PRBA) initially responded to the government’s proposal with a spirit of collaboration. In a statement released immediately after the governor’s proposal was made public the PRBA stated, "The banking industry is aware of the fiscal situation of the island and recognizes the efforts of the present administration to find permanent solutions to the problem. In attention to this, the banking industry is willing to contribute, along with other commercial sectors, and in a temporary manner, to solve the present situation." Despite the PRBA’s willingness to cooperate, and sending out a clear desire to share the burden with other sectors, the situation hasn’t developed as hoped.

A month after their statement, Arturo Carrión, executive vice president of the PRBA, expressed his ongoing concerns. "We are being left by ourselves. The rest of the financial sectors have said they are already contributing enough. The situation has continued to deteriorate," said Carrión, quickly adding, "We believe it isn’t fair to add an additional tax to an industry that already contributes substantially to the Treasury."

Carrión noted the municipal taxes, or patents, the banks pay are taken from gross income, as opposed to net income as applies to other businesses. Another tax distinction that applies to the banking industry is banks pay property taxes on their cash position, since the bank’s raw material is money.

Contributions made by the island’s banking industry go beyond direct monetary payments. The banking sector also makes an important contribution to employment in Puerto Rico. The sector employs 23,336 people, an increase of 2,740 from 2003. With a high multiplier effect of 3.33 due to the financial sector’s impact on a substantial number of other economic activities on the island, total direct and indirect employment generated by the industry is estimated at over 77,700. Carrión estimates that in direct payroll alone the banking industry paid $546 million in 2003 and an estimated $602 million in 2004.

Carrión further admits that part of the PRSI’s recent decline has resulted from isolated incidents in the sector and from the natural cycles of the market. However, the Bankers Association’s executive vice president is concerned that this decline has been considerably higher than previous ones that resulted from similar factors. In other words, the PRBA is concerned that the tax proposal is the major factor behind the stocks’ steep downfall.

"Considering the fact that the industry is dealing with the challenge of falling stock prices, it doesn’t seem like the best time to impose an additional burden," stated Carrión. Not only is the association concerned over the tax, but over the possibility that what has been presented as a temporary two-year tax may eventually become a permanent burden.

"Our position is we want to collaborate, we understand there is a fiscal problem; but we would like our contribution to be a reasonable one, that is not arrived at in an arbitrary manner, and that the burden will not only be carried by us," stated Carrión.

Although the proposed tax is apparently meant for all financial institutions, most of the burden will fall on the banks when you consider the island’s banks account for about 70% of the total assets and net interest income of Puerto Rico’s financial institutions, according to a recent report prepared by Keefe, Bruyette, & Woods.

Private sector pays for big government

Industry insiders point out that the issue shouldn’t be how much the government needs but how much the private sector can afford. During the first two years of Gov. Sila María Calderón’s Buen Camino (good path) campaign, Puerto Rico’s economy came to a halt when construction permits were paralyzed in the middle of a recession, and the implosion of the now highly successful Puerto Rico Coliseum and the Millennium apartment building were debated in the Calderón administration. The construction industry, one of the pillars of Puerto Rico’s economic growth, suffered from the Commonwealth’s interventionist policies.

During Calderón’s four years in office, government employment increased by 40,000; public debt increased by over 50% or $13.2 billion, from $26.183 billion to $39.419 billion; and the Commonwealth’s operational expenses increased by $4 billon. Gov. Acevedo Vilá now talks about a New Direction, but instead of reducing the size of government, he seeks to increase the Commonwealth’s operational budget by nearly $1 billion, while cutting only capital (infrastructure) expenses. As a source of additional revenues, Acevedo Vilá has targeted taxpayers, consumers, and the financial sector.

A little more than a month has passed since Gov. Acevedo Vilá presented his 2006 fiscal budget proposal, and the reaction of the market has been qualified by stateside analysts as historically unprecedented. Although analysts believe, for the most part, local stocks have been overpriced, the uncertainty regarding the government actions, both from the executive and the legislative branches, regarding the special tax doesn’t help.

Although their expansion to the U.S. mainland is proof of the development and sophistication of the banking sector on the island, the commonwealth government apparently is penalizing banks for their success. The commonwealth government is using improvisation and temporary measures to collect revenues from the private sector to pay for the massive and growing bureaucracy. Many industries will be affected, and the ultimate result will be every consumer on the island will be paying more.

Banking: A lifeline of the economy

The commercial banking system is an essential part of Puerto Rico’s economic infrastructure and provides a world-class technology platform. Without a solid and modern financial sector such as the one Puerto Rico has, the island’s development wouldn’t have been possible. For example, bank loans have an impact on all aspects of the economy. In December 2004, Puerto Rico’s banking sector had $2.9 billion in construction loans, $29 billion in residential loans, $13 billion in commercial and industrial loans, and $5.9 billion in consumer loans. These add up to a total of $49.1 billion in loans, almost equivalent to the size of Puerto Rico’s $50 billion economy.

The percentage of bank loans to the island’s Gross Product (GP) has been increasing every year since 2000 when it stood at 71%. As of June 2004, the percentage of loans to GP had increased to 90% (see chart). While Puerto Rico’s economy has been at a virtual standstill, growing about an average real growth of just over 2% in recent years, commercial bank loans have increased at an annual average of over 10% a year for the last four years.

Banks have a fiduciary responsibility to their shareholders, a moral responsibility to their clients, and the pressure of operating as critical support to the communities they serve. It is important to remember the banking industry functions as the backbone of a modern society. Its functions are at the center of every individual and corporate transaction, decision, or achievement. If the industry’s function is compromised in any way, the economic repercussions can go beyond any monetary calculation.

All major international economic crises of our times have been related in some way to the debilitation of banking systems, as has occurred, for example, in Japan and Argentina. In developing economies, the vulnerability of the banking sector can make or break any achieved advancements. Although the Puerto Rico banking industry runs under the supervision of federal law, the consequences of the local actions could leave the industry without sufficient protection. The president of a local bank once said banks function as the mirror of the economy they serve. If that is true, the reflection now seen in that mirror shows an economy that can’t sustain itself without burdening the one sector that has continued to shine through economic uncertainty.

Needless to say, there have been persistent questions and reactions emanating from Wall Street with respect to the proposed tax to Puerto Rico’s financial industry. UBS analyst Omotayo Okusanya prepared a report that highlighted the potential consequences of the special tax on local banks. In the report, Okusanya explained that although the initial intention of the tax appeared to be a 5% tax on the net interest income of all local financial institutions, there has been a move away from that specific point because it may be unconstitutional in Puerto Rico for the governor to attempt to tax the tax-exempt net interest income generated by the international banking entities of the local financial institutions.

The UBS analyst also pointed out that nonbanking financial institutions apparently have successfully lobbied to be exempt from the tax proposal. The one thing that looms throughout the entire report is the uncertainty that haunts the economic, political, and financial spheres on the island, and stocks are not fans of uncertainty.

In 2003, Estudios Técnicos, a Puerto Rico economic research firm, prepared a study on the important role the financial market plays in the island’s economy. In that study, the Bankers Association had several goals they hoped to achieve in order to accelerate the development of the financial markets on the island. As part of that process, the association mentioned it was vital to "encourage investment in Puerto Rico, to create and retain capital, to reduce uncertainty, reduce transaction costs, and to provide greater security to consumers." Nearly two years after the Estudios Técnicos study was released, those goals find themselves at risk after the governor’s budget speech.

Amid all the uncertainty, one thing is certain and that is the Commonwealth must find a way to bring itself and spending under control. One of the most worrisome areas of spending is the government’s payroll. The island’s government employs one out of every three salaried employees in Puerto Rico.

For too long, Puerto Rico has failed to recognize the economy won’t be able to endure the constant governmental intervention trying to tie odds and ends in the economic system to justify its existence. The commonwealth government has punished individual and corporate taxpayers with high taxes to maintain an obsolete and obese bureaucratic system with the sole objective of preserving its prominent status in our society. That is "government wealth" not commonwealth.

The bottom line is Puerto Rico’s underground economy and government are too big and spend too much money. Provisional economic development strategies and tactics based on "temporary or special" taxes or fiscal arrangements initiated by the Commonwealth are no longer viable. The Commonwealth must stop putting the stability of Puerto Rico’s economy in danger to satisfy short-term fiscal needs. Puerto Rico’s private sector and public financial corporations shouldn’t be subject to the political risks associated with Commonwealth initiatives implemented to correct the mistakes of its own doing.

Bank Loans

As of December 2004

Type of Loan: Balance (In Billions)

Construction: $2.88


FHA: 0.28

Conventional: 15.04

Nonfarm, Nonresidential: 8.07

Other: 2.53

Total secured by RE: $28.92

Commercial & Industrial: $13.25


Auto: 2.17

Credit Cards: 1.28

Other: 2.35

Total Personal Loans: $5.96

Total Loans: $49.11

Source: Financial Institutions Commissioner

This Caribbean Business article appears courtesy of Casiano Communications.
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