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Puerto Rican Independence:

The Economic Implications for the U.S. and Puerto Rico


J. Thomas Hexner

Glenn Jenkins

Neil Allison


June 22, 1998

Prepared for the Citizens Educational Foundation



1.1 The independence option for Puerto Rico offers finite benefits to the U.S. in the eventual reduction of federal transfers, but it poses enormous potential risks: regional instability; drug and migration problems; losses to U.S. investors; and possibly significant bail-out costs in the event of political or economic crisis.

1.2 With a voice in its future an independent Puerto Rico presents the promise of new growth. As a result of normal investor behavior and the aspirations and needs of its citizens, the costs of independence would be staggering, e.g. the costs of creating and operating a new government, assuming obligations such as Social Security and Medicare for its citizens, increased costs of borrowing, and capital flight. In the expected democratic setting, what would be the prospects for economic reform with a large public sector and a tradition somewhat biased against the vicissitudes of a market economy?


2.1 Economic failure in an independent Puerto Rico might impose high bail out costs on the U.S. Creating new countries has a high learning curve. Recent experience across Asia and the former Soviet Union indicates the difficulties and risks faced by developing economies, and the high rescue costs they have imposed on developed nations dependent on their economic and political stability.

2.2 Independence would impose significant fiscal pressure on Puerto Rico. The new nation would lose more than $4 billion in federal transfers, and face the steep costs of establishing and maintaining a national government and upgrading the island's infrastructure and educational system. For instance, Puerto Rico's water utility, the Puerto Rico Aqueducts and Sewers Authority (PRASA) maintains a deteriorating water supply and sewer system that is insufficient for the island's needs. Droughts in three of the last summers have required water rationing in San Juan. The PRASA lost an estimated $40.5 million in 1997, and has run up debts of over $1.1 billion. (1) How would the independent Puerto Rico generate the necessary revenues without imposing burdensome tax levels on individuals and businesses?

2.3 At the same time, independence would raise the cost of borrowing by the downgrading of the government's bond ratings. A new nation must prove itself to the capital market, and this raises the cost of borrowing. Potential economic and political uncertainty are anathema to capital markets, which have global options.

2.4 Funding a transition to an independent Puerto Rican social security system might cost up to $64 billion. The U.S. social security program is a "pay as you go" system in which current contributors pay for current retirees. Any transition to a new system that continued to pay current retirees and compensated those who have paid into the system would be extremely costly. At $11,000 to $17,000 per capita, how would Puerto Rico fund this obligation? Funding a Puerto Rican Medicare system might be equally burdensome.

2.5 Investment in Puerto Rico would effectively cease during any transition period to independence. The prospect of independence would generate uncertainty and risk for investors, particularly in light of the economic agenda articulated by the Puerto Rican Independence Party. Existing investors would phase out operations in Puerto Rico and prospective investors would adopt a "wait and see" attitude until the economic policies and prospects of the independence nation become clear. Local investors are already seeking refuge from uncertainty in the U.S. market, and independence would escalate this capital flight. It is unlikely that investors would contemplate putting capital at risk in Puerto Rico until after the transition period and probably three to five years into independence.

2.6 Puerto Rico would face difficulty attracting external (and local) investment under independence. Puerto Rico would become just another NAFTA or APEC country competing for limited funds in a volatile marketplace, and investors would lose the protections of the U.S. legal and regulatory framework. With increasing globalization, how would Puerto Rico distinguish itself from Costa Rica, the Dominican Republic, Cuba (when it returns to the fold), and other developing countries?

2.7 An independent Puerto Rico would need the will to carry out the economic reform and privatization necessary to be globally competitive. Economic reform requires political courage. Would an independent Puerto Rico be able to manage the unions? Would an independent Puerto Rico have the political will to trim the public sector? Such moves have a destabilizing effect, and instability slows economic growth and presents a security and financial risk to the U.S.

2.8 An independent Puerto Rico would be in no position to pursue the traditional incentive strategies so far espoused by the commonwealth and independence parties. Incentives are expensive; Section 936 tax breaks still cost the U.S. $3.4 billion a year. How could Puerto Rico offer better competitive advantages than Chile, Mexico, and other developing countries? How could an independent Puerto Rico better the incentives offered by Texas, Michigan or Alabama?

2.9 Puerto Rico's steep current account deficit would be difficult to finance under independence. Puerto Rico's deficit in its balance of payments was $5.4 billion in 1996. Independence would threaten Puerto Rico's primary means of financing the deficit: federal transfers, business investment, and outside borrowing. Any "financing gap" would result in decreased economic output and reduced incomes.

2.10 U.S. business and government have billions in assets at risk in Puerto Rico. U.S. investors hold $21 billion in bonds issued by the Commonwealth government. The U.S. government has guaranteed or insured $8 billion of home loans in Puerto Rico. Freddie Mac and Fannie Mae have guaranteed an additional $3 billion in securities based on Puerto Rican loans. American manufacturers have $15 billion in depreciable assets invested, which are particularly dependent on long-term economic stability. Other U.S. firms are heavily invested in retail and tourism on the island.

2.11 Puerto Rico's emergence as an independent nation might pose serious risks to the United States. Together with the Government of Puerto Rico, the U.S. invests tremendous resources keeping Puerto Rico safe for U.S. citizens living in Puerto Rico and on the mainland, e.g. the I.R.S., D.E.A., A.T.F., I.N.S., and U.S. Customs, and the U.S. military and Coast Guard. The major issues are not only national security (at the extreme a Cuba redux), but also drugs and illegal immigration. Can a new Puerto Rico do this job and bear the costs? Can the U.S. live with this uncertainty?



Regardless of its political status, the Puerto Rico of tomorrow will inherit an unwelcome and powerful legacy: a stagnant economy, a large public sector, and economic policies based on government direction and regulation. Any regime faces daunting challenges in Puerto Rico.

After strong growth and modernization in the 1950's and 1960's, the Puerto Rican economy has essentially stagnated. During its transition to a manufacturing-based economy, Puerto Rico experienced real growth rates per capita of 4.1% from 1955 to 1975. Growth dropped off dramatically after 1975, with real annual growth rates of 1.1% from 1975 to 1995.

Income per capita is $8,100 on the island, less than a third of the U.S. level, $25,660, and half of the poorest U.S. State. Despite virtual integration with the U.S. economy, Puerto Rico has made negligible progress in closing the gap with the U.S. since the early 1970's. In 1975, income per capita in Puerto Rico was 52.5% of that of Mississippi. By 1995, Puerto Rico was relatively poorer, with only 44.2% of Mississippi's per capita income. Similarly, Puerto Rico's GNP per capita has remained at less than a third of the U.S. level since the early 1970's.

High unemployment has also been a perennial problem for Puerto Rico, consistently topping 10% and running at more than double the U.S. rate. It reached 22% in the 1980's and currently stands at 14%, higher than in any of the fifty States. More recently, overall employment grew at only 0.83% in 1997, at almost a third of the U.S. rate and slower than in any state.

The public sector employs a third of the island's workforce (more than double the equivalent U.S. rate) (2). Efforts to privatize and reduce the size of government have been opposed by unions that wield considerable power in politics and the economy. Met with stiff resistance and remain largely ineffective. Aggressive union behavior has raised the cost of conducting business, and restricted employer flexibility on the island. Puerto Rico also continues to pursue ineffective development policies based on government initiative and tax breaks.

Puerto Rico faces a future of increasing global integration and competition for markets and investment, and it is not well placed for success in this environment. Sustainable growth will require difficult and painful government and economic reforms, and targeted and continued investment in the people and physical infrastructure. Because of the political realities of investment and economic needs, Puerto Rico will regrettably face a bumpy road.




4.1.1 U.S. business investments

In addition to extensive trade with Puerto Rico, U.S. businesses also have consider capital invested on the island. Over 550 U.S. firms hold an estimated $61.0 billion of assets in Puerto Rico (3). Of these assets, approximately $15.1 billion is tied up in land and depreciable assets (see table 1 below)(4). These assets in particular would be vulnerable under a move to independence. Many U.S. firms have relied upon the protection of federal laws, a stable political regime, a dollar-based economy, and open access to the U.S. market for their operations, conditions that may change under independence.

 Table 1: U.S. Possessions Corporations Assets in Puerto Rico, 1998
 Total assets  $61.00 billion
 Depreciable assets  $14.82 billion
 Land  $ 0.29 billion
Source: 1993 data from the Department of the Treasury, "U.S. Possessions Corporations, 1993," Statistics of Income Bulletin, Fall 1997. 1998 figures based on a projected annual growth rate in assets of 6%.

These assets represent firms selling primarily to the U.S. market. U.S. corporations have also invested to conduct business directly in the Puerto Rican market, particularly in retail and tourism. The department store J.C. Penney's five best performing stores are in Puerto Rico. Walmart, Kmart, and Walgreens also conduct significant business on the island. Most major U.S. hotel chains also have a presence on the island to take advantage of the strong tourism trade. Choice Hotels International recently announced they would invest $15 million to build a hotel and casino on the island.

4.1.2 U.S. Exposure in the Puerto Rican Housing Market

Independence in Puerto Rico might also affect the housing market in Puerto Rico, putting at risk the federal government that guarantees and insures loans in Puerto Rico, and the U.S. corporations who guarantee securities backed by mortgages in Puerto Rico. If large numbers of Puerto Ricans left the island, a sharp decline in property values might result thereby threatening the U.S. government and investors with exposure in the Puerto Rican market. In total, an estimated $11 billion could be placed at risk. The federal government has guaranteed or insured over $8 billion in home loans, and Freddie Mac and Fannie Mae have guarantees on $3 billion in mortgage-backed securities (MBS) based on loans in Puerto Rico.

Federal government. The Federal Housing Administration (FHA) insures and the Veterans' Administration (VA) guarantees home loans in Puerto Rico. The FHA currently has insured 165,460 loans in Puerto Rico for a combined value of $8.14 billion (5). The federal government now provides $905 million in mortgage insurance through the FHA each year in Puerto Rico. The Government National Mortgage Association (Ginnie Mae) guarantees FHA and VA loans for sale as mortgage-backed securities (MBS's) in the U.S. market. Ginnie Mae reports that it has $6.9 billion in securities sold on the U.S. market backed by loans in Puerto Rico (6).

Corporations. Freddie Mac (the Federal Home Loan Mortgage Corporation) and Fannie Mae (Federal National Mortgage Association) have purchased approximately $3.3 billion in Puerto Rican loans that are now held as mortgage-backed securities by U.S. investors. Both corporations are at risk in the event of any property dislocation in Puerto Rico, as they both guarantee the payments on the securities. Neither corporation undergoes any economic analysis of such dislocation because it is considered so unlikely.

 Table 2: U.S. Exposure in the Puerto Rico Housing Market
 Federal Housing Administration $ 8.14 billion
 Freddie Mac and Fannie Mae $ 3.30 billion
 Total $ 11.44 billion
Notes: An estimate based on June 1998 sample of major mortgage lenders active in Puerto Rican market and estimated share of total outstanding Fannie Mae and Freddie Mac portfolios in Puerto Rico. Company specific numbers are not listed at the companies' request.


Puerto Rico is a major market for U.S. goods, importing approximately $12 billion in 1996. Based on Commerce Department estimates that $1 billion in exports generates 20,000 jobs, trade with Puerto Rico sustains almost a quarter of a million U.S. jobs. While the future trade arrangement between the U.S. and Puerto Rico under independence is speculative, any restrictions on U.S. goods and services entering Puerto Rico could result in the loss of jobs for Americans. Agricultural products in particular have been consistently targeted by the independence party for restrictions to protect local farmers. It is unlikely, though, that Puerto Rico could become competitive in commodity agriculture for a variety of reasons: more expensive labor, no economies of scale, and high transport costs for supplies.

Florida in particular depends upon the health of the Puerto Rican economy. The State handles an estimated $3 billion in trade with the island each year and is home to 250,000 Hispanics of Puerto Rican descent. Florida ships 45% of all U.S trade with Caribbean nations, and handles 54% of U.S. exports to the region (7).


Independence in Puerto Rico might put at risk U.S. investors who own the Puerto Rican government's $20.6 billion debt (see table 3 below). While the status of Puerto Rican bonds under independence is speculative, it is likely that their rating and value would decline (8).

 Table 3: Puerto Rican Public Sector Debt
January 31, 1998
Puerto Rico direct debt $ 4,919,668
 Municipal debt $ 880,904
 Public corporations debt  
 Puerto Rico guaranteed debt  $ 446,442
Debt supported by Puerto Rico appropriations or taxes  $ 8,216,736
Other non-guaranteed debt $ 6,128,558
Total corporations debt $ 14,791,714 
Total public sector debt $ 20,592,286

Source: Government Development Bank.

The Puerto Rican government already faces a relatively high debt burden. In March, Moody's Investors Services estimated that $14.9 billion of Puerto Rican debt is reliant on taxes, creating a ratio of tax-supported debt to personal income of 46% (9). This ratio is about four times the level in the highest US State, Hawaii, and far above the median figure of 2.1%. Fiscal difficulties in an independent nation could put these bonds at risk for nonpayment. The elimination of federal transfers (a full third of Puerto Rican revenues) and the increased expenses of a new nation would put added pressure on the government's ability to meet debt service requirements.

Puerto Rican government bonds are widely held by investors across the United States (10). Holders of Puerto Rican bonds are a mixture of individual investors, mutual funds, and institutional investors, primarily property and casualty insurance companies. As with U.S. municipal bonds, individual holders are mostly high-income individuals who can take full advantage of the bonds' tax exempt status.


Transition period. The U.S. Treasury would save money during a transition period in comparison to the existing commonwealth status. The independence party has proposed that the U.S. provide Puerto Rico with a fixed annual "compensatory" payment over a "reasonable transition period" (11). Legislation (H.R. 856 and S. 472) now before the Senate provides for a transition period "not to exceed" ten years (12). Under the independence party proposal, transfers would be based on the current level of federal transfers to the island net of entitlements, currently more than $4 billion. During the transition, independence would save the U.S. Treasury the cost of living adjustments on net transfers, as compared to the commonwealth option.

In the long term, independence would put a finite end to increasing federal transfers to Puerto Rico. Under commonwealth status, Puerto Rico costs the federal government over $8 billion a year in unearned benefits and continuing tax breaks, while its people and businesses pay no federal income tax on income earned on the island. Since 1953, the Commonwealth has cost the U.S. Treasury over $150 billion (13).

However, there is a significant risk that U.S. citizens will not remain in Puerto Rico as their federal benefits decline and are eventually cut off completely under independence. It is also unlikely that a new Puerto Rican government will be able to replace federal benefits given reduced revenues, increased costs, and borrowing difficulties. Many Puerto Ricans may decide to move to the mainland if their benefits and livelihoods were threatened (Puerto Ricans are already U.S. citizens with the right to move to and from the mainland).

It has been suggested that the U.S. would pay up to $690 million annually for its military bases in Puerto Rico, both during and after a transition to independence (14). These figures are based on so-called "base-rights" foreign aid that has been provided to the Philippines and other countries, adjusted for the size and value of the Puerto Rican bases. Any such arrangement regarding the military bases would have to be negotiated between the U.S. and Puerto Rico.


Funding a transition to an independent Puerto Rican social security system could cost the on the order of $43 billion to $64 billion. The independence party has proposed that current recipients continue to receive benefits, and that Puerto Rican residents who have paid into the system be compensated for their contributions (15).

Quite simply, the U.S. Social Security system does not operate in that manner. Social Security is a "pay as you go" system in which current contributors pay for the benefits of current retirees. Any transition to a new system would extremely costly if, either up front or over time, the U.S. government had to 1. pay the current recipients and 2. compensate non-retirees for their contributions (which have effectively already been spent for previous retirees) without receiving Social Security payments from Puerto Rico.

In the U.S. as a whole, the Social Security Administration has estimated that outstanding obligations to current contributors and retirees total approximately $9 trillion. Federal Reserve Chairman Alan Greenspan recently testified that the current cost of paying for all future obligations to existing and future retirees in the U.S. would be $9.5 trillion (16). In Puerto Rico, a rough estimate of this cost is $43 to $64 billion, assuming that current retirees continue to receive benefits, and current workers are compensated for their contributions (17).

The federal government would presumably also forgo revenues from the Social Security tax while paying out benefits. From 1989 to 1997, for example, Puerto Ricans paid an estimated $16.1 billion in Social Security taxes. Estimated contributions in 1997 totaled $2.4 billion (18).

Like recipients on the mainland, Puerto Ricans value and rely on their Social Security benefits. It is unlikely that U.S. citizens would tolerate any risk to their primary source of retirement benefits. Further, it is likely that many U.S. citizens would emigrate to the U.S. if threatened with being eliminated from the Social Security program into which they had paid for decades, and placed into a new and untried Puerto Rican system.


Uncertainty creates risk. With the withdrawal of U.S. government involvement, Puerto Rico will have to bear the costs of new responsibilities, and bearing costs does not guarantee performance. The Caribbean has been a region of importance to national security for the past century, and the steady U.S. presence has helped to promote peace and maintain stability. Rapidly increasing trade with Latin America now flows through the region. Any political and economic instability in the Caribbean region directly affects the U.S., as Haiti and Cuba have illustrated. It is feared that the U.S. departure might create instability in the region.

4.6.1 Risk of increased migration to the U.S.

The travel of U.S. citizens in Puerto Rico to and from the mainland is already highly sensitive to economic and political conditions on the island. Independence threatens to increase significantly existing levels of migration to the mainland, through general political and economic instability, the elimination of U.S. citizenship for those born on the island, and the loss of federal benefits.

As U.S. citizens, Puerto Ricans already have free mobility to and from the United States, and travel back and forth frequently to visit friends and family, and to work. The labor markets of the U.S. and Puerto Rico are already closely integrated and movements in unemployment rates are closely correlated in the two economies (19).

In surveys, between 30 and 40 percent of Puerto Ricans have indicated that they would leave the island if independence were established (20). In more recent polls, 85% of Puerto Ricans have identified their U.S. citizenship as their number one political issue. Given the strength of allegiance, it is particularly likely that the U.S. would experience immigration from Puerto Rico on a large scale under the independence option.

Hypothetically, the population of people of Puerto Rican origin in the U.S. could increase from 2.7 million to 4.0 million, if 35 percent of Puerto Ricans decided to leave the island under independence. Social welfare costs would shift from Puerto Rico to Florida, New York, and other States. Anticipated federal savings from Food Stamps, for example, would become costs of $483 million (21).

The likely removal of the minimum wage in Puerto Rico would also stimulate greater emigration to the U.S. A recent study of the effects of the minimum wage on migration by concluded that net emigration to the U.S. would be highest under the independence option. Professor Santiago of the State University of New York found that emigration under independence would be 19% higher than under commonwealth, and almost double the rate under statehood (22).

4.6.2 Threat to federal drug enforcement efforts

Puerto Rico already serves as a major conduit for illegal drugs into the U.S. and independence would curtail increasing federal efforts to combat the trade. In acknowledgement of the increasing drugs trade through Puerto Rico, the Drug Enforcement Agency (DEA) designated Puerto Rico and the Virgin Islands as one of seven High Intensity Drug Trafficking Areas (HIDTA) in 1994. The DEA seized 17.6 tons of cocaine in Puerto Rico and the eastern Caribbean in 1994 alone.

Puerto Rico is a prime location for smuggling drugs into the U.S. It is a major air and sea transportation center, with the third busiest seaport in North America and the 14th busiest in the world (23). Puerto Rico has 300 miles of coastline with numerous isolated bays and inlets. Over six million miles of open water between the U.S. and Columbia also make patrolling and interdiction efforts difficult.

As the U.S. has experienced in South and Central America, conducting the war on drugs through independent nations can be frustrating and ineffective. The federal agencies that presently combat the drugs trade in Puerto Rico would lose their jurisdiction and much of their effectiveness under independence.



Independence would offer a dedicated group of citizens the opportunity to take full charge of the destiny of Puerto Rico. Under the commonwealth status, U.S. citizens in Puerto Rico do not have the right to vote for Congress and the Presidency, and their representative has a voice but no vote. The U.S. federal government makes decisions that profoundly affect Puerto Rico's economy, without their voting influence in the process. The Puerto Rican people would be more involved in a process which was clearly their own.

The economy and government of Puerto Rico remain in urgent need of reform. Independence would place the economy in direct competition with developing countries across Latin America and Asia implementing agendas of privatization, free trade, and economic liberalization. It would be surprising if a newly independent nation had the political resolve to carry out the necessary reforms.

The public sector continues to employ about a third of the economy's workforce, double the U.S. (16%). Irresponsible unions have fiercely opposed the Rosello administration's privatization efforts. Irresponsible unions add to the cost of business and stifle productivity increases through restrictions on working hours, overtime, and work practices. Despite some promising steps, the government consistently falls back on government-directed development and tax breaks. An independent Puerto Rican government could not muster the political capital to implement the difficult policies necessary for growth.

The economic performance of newly independent nations during the post-war period testifies to the difficulty of carrying reform. With few exceptions, newly independent nations have struggled economically. Singapore has experienced stellar growth, but it began with the best resources of Malaysia, a professional and incorruptible government, a well-educated workforce, and no history of democracy, which has costs as well as benefits.


An independent Puerto Rico would tend to converge with the lower incomes of Latin America and the Caribbean. As a part of the U.S., Puerto Rico has been expected to share in the powerful convergence effects among States, in which the less developed catch up with the wealthier ones over time. Recent research indicates that Puerto Rico has not converged to the U.S. economy as expected, and implicates its territorial status as a factor in preventing convergence (24).

Chilean economist Fernando Lefort found that Puerto Rico's growth rate would have been 2.2 to 3.5% faster, had it been converging to the U.S. economy with the 50 States. Instead, the economy has been diverging from the U.S. over time. Under independence, Puerto Rico's economy would continue its two-decade trend of divergence from U.S. income levels and converge with the Latin American and the Caribbean economies.


How could Puerto Rico attract investment as an independent country? How could Puerto Rico distinguish itself from the Dominican Republic, Costa Rica, Chile, and other developing nations? Its tropical climate is not unique in the Caribbean and Latin America. Its location bridging the U.S. and Latin America also fails to set it apart from other economies in the region. Puerto Rico is also a thousand miles from Miami. Cuba, for example, is 90 miles from Key West. Relatively high labor costs make Puerto Rico increasingly unable to attract low-cost manufacturing plants. Average hourly earnings for manufacturing positions are now $8 in Puerto Rico, about 60% of U.S. wages. Water, sewage and electricity rates are approximately double the mainland.

The U.S. legal and regulatory framework has been a key source of competitive advantage for Puerto Rico. Loss of the U.S. economic and political system umbrella would threaten its ability to draw new investment, and threaten existing businesses that depend on U.S. sales (25). A change to a new monetary system would also create numerous risks for U.S. and other external investors in Puerto Rico. The island would lose a key source of market stability, its dollar-based economy, which reduces the risk of currency devaluation and inflation, and lowers transaction costs for U.S. and Puerto Rican businesses.

Uncertainty and fear about the future will likely trigger capital flight from the island, particularly given the legacy of big government, public sector development, and the economic beliefs articulated by the independence party. Many investors will phase out operations in Puerto Rico and adopt a wait and see approach until the economic policies and prospects of the new nation become clear. The transition period will effectively become an economic purgatory with a severely diminished capital stock. It is unlikely that investors would consider Puerto Rico until at least three to five years into independence, or between twelve and twenty years from the beginning of the transition period.


Independence could have a chilling effect on U.S. tourism spending in Puerto Rico, which constitutes 70% of all visitor spending on the island: 2.2 million U.S. visitors spend $1.32 billion in Puerto Rico each year (26). The establishment of an independent Puerto Rico could discourage and reduce future U.S. travel to the island. U.S. visitors now benefit from the convenience of a dollar-based economy, U.S. legal protections, and open customs. Each of these benefits would likely be eliminated under independence, to be replaced with the fears, particularly of safety, associated with visiting "Third World countries."

The normalization of U.S. relations with Cuba could also pose a serious threat to the Puerto Rican tourist trade. Only 15,000 to 20,000 Americans visit Cuba each year as a result of the travel ban. Nevertheless, tourist earnings in Cuba have increased rapidly in recent years, totaling $1.65 billion in 1996, only slightly less than in Puerto Rico and the Dominican Republic (27). If and when the U.S. trade ban is lifted, the potential for U.S. tourist spending is significant; Rosalie Schwartz estimated that tourist spending would more than double in a recent book, Pleasure Island ­ Tourism and Temptation in Cuba.


Under independence, Puerto Rico could experience significant difficulty financing its high current account deficit. Any inability to finance its balance of payments would lead to reductions in economic output and real income for Puerto Ricans. As the Congressional Budget Office noted in 1990, a current account deficit is "inevitable for a country that, like Puerto Rico, generates little domestic savings but nevertheless carries out significant investment" (28). As table 4 below illustrates, Puerto Rico's balance of payments deficit totaled about $5.4 billion in 1996.

Table 4: Puerto Rico Balance of Payments (millions of $US)



Merchandise Trade Balance



Real Services



Factor Income



Net Capital Movements



Unknown Transactions



Net interest of Commonwealth and Municipal governments



Unilateral Transfers



Federal Transfers






Source: United Nations Economic Commission for Latin America and the Caribbean, "Economic Survey of Puerto Rico 1996," and Puerto Rico Planning Board.

Puerto Rico has funded this deficit through a combination of external business investment, federal transfers, and government borrowing. Independence would put pressure on all three of these financing sources. Federal transfers for social programs would freeze and eventually cease under the independence option. Potential currency, political and economic risk might also threaten the level of business investment. Finally, government borrowing would likely be severely curtailed, and its cost substantially raised under independence. Any inability to finance the deficit in its balance of payments (a "financing gap") would result in reductions in output and income on the island.


Politics and economics have long been intertwined in Puerto Rico. Independence would constitute a definitive resolution of the political status debate in Puerto Rico. The uncertainty over the future and the unceasing debate over status has diverted needed attention from the island's real economic problems (29). The uncertain existing status has hindered Puerto Rico's ability to attract investment. The nebulous nature of territorial status has also proven a liability for investment and business in Puerto Rico.

A firm producing in Puerto Rico was recently challenged before the European Union's Tribunal of Commerce for bearing the label "Made in the U.S.A." The suit alleged that the label was misleading because the goods had not been produced in a State, and goods produced outside the U.S. are often produced in "low wage countries." Independence would serve to clarify the status of Puerto Rico in the eyes of investors, and eliminate the persistent uncertainty over future political status.


An independent Puerto Rico would face intense fiscal pressure from steep start-up costs, the eventual elimination of federal transfers, and increased borrowing costs. The new nation would also need to invest billions to upgrade its weak infrastructure and inadequate education systems. Under these conditions, how could the new nation maintain existing benefits and services without significantly increasing taxes on business and individuals?

Government set-up costs. Establishing and maintaining a national government is a costly and complex undertaking, as countless new nations in Africa, Latin America and Asia have experienced during the post-war period. The U.S. government now provides and finances the infrastructure and services of the federal government: defense, customs and immigration, postal services, product safety, communications and transportation regulation, environmental protection, drug enforcement, foreign relations, etc. An independent Puerto Rico would eventually have to take on these fiscal responsibilities. Whether Puerto Rico would have to pay for existing federal land and facilities would depend on the settlement negotiated with the U.S.

Federal transfers. Puerto Rico would eventually completely lose federal transfers for social welfare programs that now comprise a third of its revenues ($2.6 billion out of $7.9 billion in total revenues in FY 1996). It would also lose numerous other federal benefits like the federal low income housing tax credit, now a major financing source for affordable housing on the island.

Increased cost of borrowing (see section 5.8). Puerto Rico presently relies heavily on borrowing to finance government operations, economic development projects, and infrastructure investments. In the 1998-1999 fiscal year, Puerto Rico will invest $3.5 billion in infrastructure projects (mostly through borrowing) including upgrades to the electrical power system, water system, and public buildings (30). In 1997, the Commonwealth government borrowed over $2 billion, primarily through low-cost, tax-exempt bond markets in the U.S. Independence would increase borrowing costs, and could severely restrict access to international bond markets.

Military bases. The U.S. military presence in Puerto Rico has been a point of contention on the island, particularly for the independence party, which has repeatedly stated that its ultimate aim is total demilitarization. For the time the U.S. military remains, it has been argued that Puerto Rico should receive up to $670 million each year in "base rights" aid for the U.S. military bases during and after a transition to independence (31). Even if such leases were possible, the revenue would replace less than a fifth of lost federal revenues. However, in the context of worldwide base closures and reorganization, the U.S. military could not easily justify high lease rates for the bases.

Any leases for the military bases, which the U.S. government now owns, would be the result of negotiations between the U.S. and the independent Puerto Rican nation. If the U.S. were to shift the bases elsewhere, the economic impact on Puerto Rico would be severe. U.S. Defense Department spending on wages, salaries and procurement in Puerto Rico generated over $1 billion in economic activity in 1997. Direct wage, salary, and procurement totaled $589 million (32), and generated additional indirect economic activity of $442 million on the island (33).

National defense for an independent Puerto Rico. The base issue brings up the broader question of defense in Puerto Rico under independence. Over 200,000 Puerto Ricans have served in American wars since 1917. Four servicemen have received the Congressional Medal of Honor. Does Puerto Rico plan on establishing its own military force, or would it continue to rely on the U.S. for protection?

Cost of tax breaks and subsidies. Plans for independence, to the extent they have been expressed, rely heavily on the provision of tax breaks and subsidies to attract external investment. It is unlikely that an independent Puerto Rico would have the fiscal resources available to finance such an incentive program, given the loss of federal transfers, increased cost of borrowing, and increased costs associated with a new government. Tax breaks do not come without cost. Section 936 tax breaks for firms operating in Puerto Rico continue to cost the U.S. Treasury more than $3.4 billion in lost revenues each year, and have cost $72 billion in inflation-adjusted dollars since 1976. It is similarly unclear how Puerto Rico could offer an incentive program that would distinguish it from those offered by Mexico, Chile, Brazil, and other developing countries.

Loss of federally guaranteed loans and insurance. The independence party has requested that the federal government continue its guarantees and insurance on existing loans in Puerto Rico. It is certain, however, that the federal government would cease to guarantee or insure any new home loans. FHA mortgage insurance presently plays a critical role enabling many Puerto Ricans to buy new homes. In FY 1997 alone, the federal government provided $905 million in mortgage insurance for homes, $207 million for condominiums, and $27 million in guaranteed and insured loans for veterans on the island (34). Would an independent Puerto Rico be able to guarantee or insure home loans for the disadvantaged at similar levels?


The Puerto Rican government would experience significantly higher borrowing costs under independence, if it were able to access overseas debt markets at all. In 1990, the Congressional Budget Office noted that borrowing by the Puerto Rican government would become "more costly at the least, and may be significantly curtailed" (35) The Puerto Rican government is heavily reliant on borrowing to finance operations and infrastructure projects in particular. The government is projected to borrow $2.1 billion during 1997 to 1998, and $2.4 billion in 1998-1999 through loans and bond issues, for an increase of 14% (36).

Loss of tax exempt status in itself would result in higher borrowing costs as investors demand returns comparable to other taxable securities. Under independence, Puerto Rico would lose access to the tax exempt bond markets in the U.S. where there is now ample demand for Puerto Rican debt, which is tax exempt in every State and locality. Cost of borrowing under independence would also depend on Puerto Rico's bond rating, which would be based in part on the level of debt and the ability of the government to service it, as well as the balance of payments situation. The Puerto Rican government paid $2.2 billion in debt service in 1997-1998, of which $1.3 billion was paid by public corporations, $458 million by the central government, and $452 million in extra-constitutional debt (37).

Puerto Rico now receives relatively high bond ratings in comparison to most developing countries (38). Appendix 1 provides the ratings for government bonds of developing countries in Latin America and the Caribbean. As a result, Puerto Rico pays significantly lower borrowing costs. Table 5 below provides the interest rates paid by developing countries in Latin America and the Caribbean and the difference or spread over U.S. Treasury bonds of equivalent length. The cost of borrowing for Puerto Rico is about 55 basis points lower than Treasuries because of its exemption from State taxation (39). The table illustrates that the cost of capital for Latin American and Caribbean governments is significantly higher than in the U.S., although it varies by country. Interest rates range from about three to five percentage points (329 to 522 basis points) more than 30 year U.S. Treasuries and an additional half a percentage more than Puerto Rico currently pays (384 to 577 basis points).

Table 5: Cost of Government Borrowing in Latin America and the Caribbean
 Country Maturity Yield Spread over US Treasury (basis points)
 Argentina 11.1999 7.29% 179
  12.2001 8.09% 251
  12.2003 8.37% 278
  01.2017 10.32% 454
  09.2027 10.32% 454
Brazil 11.2001 8.53% 296
  05.2008 10.29% 471
  05.2027 10.99% 522
Costa Rica 05.2003 7.87% 228
Ecuador 05.2002 10.44% 487
Jamaica 07.2002 10.47% 489
Mexico 02.2001 7.50% 193
  01.2007 8.82% 323
Panama 02.2002 7.95% 238
  09.2027 9.07% 329
Venezuela 06.2007 10.07% 448
  09.2027 10.91% 514
Note: Representative selection of government debt issues. Spread is calculated as number of basis points of yield on foreign government debt stripped of U.S. government guarantees ("strip yield") over the yield on a U.S. Treasury of similar duration.

Under independence Puerto Rico would experience a cost of borrowing at least 2 to 3.5 percentage points higher than at present. This increase reflects the difference between the tax-exempt rate the commonwealth government now pays and the rate paid by the better-rated Latin American countries like Chile or Mexico, taking into account fiscal, financial, trade and other factors like the loss of tax-exempt status.



The independence option in Puerto Rico has garnered so little electoral support that its economic implications have been rarely addressed. It is clear that independence would entail a radically different economic and investment environment than the present. New nations create uncertainty and uncertainty, both political and economic, is costly. Thus, there are certain benefits and significant risks associated with independence for both the U.S. and Puerto Rico.

For the United States, an independent Puerto Rico poses difficult questions. How many U.S. citizens would leave Puerto Rico in the event of independence, political or economic instability, or the loss of federal benefits? Would the U.S. pay for the transition to a Puerto Rican social security system, and would the independent nation have the resources assume the heavy obligations? How much would the Puerto Rican government bonds held by U.S. investors decline in value under independence? How much of U.S. business and government exposure in the Puerto Rican market might be lost in the event of economic crisis? Might a newly independent Puerto Rico destabilize a region of strategic importance to the U.S.? How much would it cost the U.S. to bail out Puerto Rico in the event of a major economic crisis?

With regards to Puerto Rico, additional questions arise. Would Puerto Rico have the political will to implement the necessary reforms? How could Puerto Rico compete on the basis of tax breaks and incentives with this fiscal pressure? How would Puerto Rico distinguish itself from other Latin American and Caribbean economies? How would Puerto Rico manage the fiscal burden without imposing a stifling tax structure that inhibits economic growth? How would Puerto Rico carry out the needed investment in its people and infrastructure with reduced funds and restricted access to world debt markets?

How does one weigh the variables in this complex equation? From the perspective of Puerto Rico its citizens would finally have a full voice in directing their economy. But the tough reform measures required for economic success will approach, if not surpass, political acceptability. Perhaps the most difficult question will be: why invest in Puerto Rico and why invest now?

From the perspective of the U.S., independence will bring an end to the federal transfers and the free ride for Puerto Rico. Anticipated savings from reduced federal transfers might also prove illusory to the extent that U.S. citizens in Puerto Rico emigrate to the U.S. But independence will create some quite likely ramifications (e.g., a Cuba Redux at the extreme, increased illegal immigration and increased flow of drugs outside the realm of U.S. jurisdiction), and the cost of these to the U.S. would be frightening.



Appendix 1. Country Government Bond Ratings
(long term, foreign currency)

 Caribbean Countries   Long Term
Bermuda   Aa1
Bahamas   A3
Barbados   Ba1
Trinidad and Tobago   Ba1
Jamaica   Ba3
Latin American Countries   Long Term
Chile   Baa1
Mexico   Baa2
Colombia   Baa3
El Salvador   Baa3
Uruguay   Baa3
Costa Rica   Ba1
Panama   Ba1
Venezuela   Ba2
Argentina   Ba3
Brazil   B1
Ecuador   B1
Source: Ratings current as of May 4, 1998. Moody's Investors Service, Global Credit Research, Governments and Supranationals: Credit Opinions, June 1998.



Arthur D. Little, "Puerto Rican Capital Markets: Recommendations for their Expansion," Report to the Government Development Bank, May 6, 1994.

Center for Research and Public Policy, "Puerto Rico Status Poll," May 1997.

Commonwealth of Puerto Rico, "$500,000,000 Public Improvement Bonds of 1998 and $38,500,000 Public Improvement Refunding Bonds Series 1998B (General Obligation Bonds)" dated March 15, 1998.

Congressional Budget Office, "Potential Economic Impacts of Changes in Puerto Rio's Status under S. 712," for Senate Finance Committee, April 1990.

Congressional Research Service, Statement on the Implications of Puerto Rico's Independence for U.S. Trade and Tariffs before the Senate Committee on Energy and Natural Resources by Vladimir N. Pregelj, Specialist in International Trade and Finance, Economics Division, June 23, 1998.

Constantine, Thomas A., Testimony before the House Judiciary Committee, Subcommittee on Crime on Puerto Rico and Law Enforcement Efforts in the Caribbean Region, April 3, 1997.

Conversations with major mortgage lenders in Puerto Rico, June 1998.

Del Valle, Luis A., "Where do we go from here?" Business Puerto Rico, March 1998.

Friedman, Robert, "CRB: 'Made in the USA' lawsuit hurt P.R.," The San Juan Star, December 3, 1997.

General Accounting Office, "Puerto Rico's Political Future: A Divisive Issue with Many Dimensions," for the President of the Senate and Speaker of the House of Representatives, March 2, 1981.

General Accounting Office, General Government Division, "Potential Budget and Economic Impacts of Changes in Puerto Rico's Political Status," for Oversight Hearing of the Senate Committee on Energy and Natural Resources, May 19, 1998.

Joint Committee on Taxation, "Estimates of Federal Tax Expenditures for Fiscal Years 1998 ­ 2002," prepared for the House Committee on Ways and Means and the Senate Committee on Finance, December 15, 1997.

Lefort, Fernando, "Is Puerto Rico Converging to the U.S.?" Harvard Law School Working Paper 1003, Harvard University, November 1997.

Melendez, Edwin and Ruiz, Angel L., Economic Effects of the Political Options for Puerto Rico, Interamerican University of Puerto Rico, 1998.

Moody's Investors Service, "Puerto Rico Special Comment: Credit Implications of a Change in Political Status," March 27, 1998.

Moody's Investors Service, New Issue Report, $500 million in Public Improvement Bonds, March 27, 1998.

Moody's Investors Service, Global Credit Research, Governments and Supranationals: Credit Opinions, June 1998.

Price Waterhouse, Section 936 Report. Volume 1, Puerto Rico-USA Foundation, 1991.

Puerto Rico Planning Board, Economic Report to the Governor 1996, November 1997.

Regional Financial Associates, Puerto Rico Precis, March 1998.

Schwartz, Rosalie, Pleasure Island: Tourism and Temptation in Cuba, University of Nebraska Press, 1997.

United Nations Economic Commission for Latin America and the Caribbean, Economic Survey of Puerto Rico, September 25, 1997.

U.S. Department of Commerce, Federal Expenditures by State, various years.

U.S. Government National Mortgage Association, Office of Customer Service, GNMA Issuers with Securities Outstanding, Updated April 6, 1998.

U.S. Social Security Administration, Office of Research, Evaluation and Statistics, "Puerto Rico Workers with Social Security taxable earnings, 1970 to 1995," June 18, 1998.

U.S. Social Security Administration, Social Security Bulletin ­ Annual Statistical Supplement 1998.

Valdes, Jaime Bofill, "The Impact of Federal Disbursements and Taxes on the Puerto Rican Economy Under Different Status Options," Boletin de Economia, Unidad de Investigaciones Economicas, July-September, 1997.



  1. As of January 31, 1998, the PRASA itself had $715 million in outstanding debt. To help PRASA avoid defaulting on its loans, the Commonwealth government guaranteed $400.3 million in PRASA revenue bonds in December 1995.
  2. Puerto Rico estimate of 32.8% from Regional Financial Associates, Puerto Rico Precis.
  3. Regional Financial Associates, Puerto Rico Precis, 1998.
  4. 1993 data from the Department of the Treasury, "U.S. Possessions Corporations, 1993," Statistics of Income Bulletin, Fall 1997. 1998 figures based on a conservative assumed growth rate in assets of 6%. Estimate of 550 companies from Regional Financial Associates, 1998.
  5. U.S. Department of Housing and Urban Development, Single Family Statistical Systems, "Volume of FHA Insurance in Force as of 03/98." The Veterans Administration does not track loans by location.
  6. U.S. Government National Mortgage Association, GNMA Issuers with Securities Outstanding.
  7. Florida International University, Latin American and Caribbean Center, Caribbean Integration Report, section iv.
  8. It is the position of Moody's Investors Service that Puerto Rico's bond rating would not improve under independence. June 15, 1998 conversation with Tim Blake, Moody's Investors Service.
  9. Moody's Investors Service, New Issue Report, March 27, 1998.
  10. Puerto Rican bonds are popular because they are exempt from taxation in every State and locality, unlike State bonds that are generally only held in the issuing State.
  11. Written Testimony of Fernando Martin-Garcia to the Senate Energy and Natural Resources Committee, p. 9.
  12. During the 1989-1991 congressional deliberations over Puerto Rico's status, the bill before the Senate, S. 712, provided for a nine-year transition period.
  13. Expressed in 1997, inflation adjusted dollars, and excluding earned benefits like Social Security, federal pensions, and veterans' benefits.
  14. Price Waterhouse, Section 936 Report. Volume 1.
  15. The previous legislation on Puerto Rican status provided that Social Security benefits would continue under independence.
  16. Testimony of Federal Reserve Chairman Alan Greenspan before the Task Force on Social Security of the Committee on the Budget, U.S. Senate, November 20, 1997.
  17. Greenspan estimates that it would cost the U.S. $9.5 trillion to cover "liabilities" to existing beneficiaries and current contributors by issuing annuities today. A range for estimating the cost of funding existing obligations in Puerto Rico could be derived by adjusting the total cost for the U.S. by the ratio of Puerto Rican earnings and benefits to total U.S. earnings and benefits. In 1995, the most recent year for which there is detailed data, total taxable earnings in Puerto Rico was $12.378 billion, or about 45/100ths of 1% of the U.S. total, $2.756 trillion. Social Security Administration, Office of Research, Evaluation and Statistics, "Puerto Rican workers with Social Security taxable earnings, 1970-1995." In December 1997, Social Security benefits paid in Puerto Rico totaled $159.5 million, or 67/100 of 1% of the $23.6 billion paid in the U.S. Social Security Bulletin, Annual Statistical Supplement, Table 5.J3, "Number and Monthly Benefit for beneficiaries aged 65 or older, by State, December 1997."
  18. Data on fiscal years 1989 to 1995 is available in "Puerto Rico Workers with Social Security taxable earnings, 1970-1995," June 18, 1998, Social Security Administration, Office of Research, Evaluation, and Statistics. Contributions from fiscal years 1996 and 1997 were estimated by projecting forward the 8% average annual growth rate from 1989 to 1995.
  19. See, for example, Carlos E. Santiago, "Political Status, Minimum Wages, and Puerto Rican Migration," Proximo Boletin de Economia, July-September, 1997.
  20. More recently, in May 1997, thirty percent of Puerto Ricans polled indicated they would move to one of the fifty States if Puerto Rico were to become a separate sovereign nation.
  21. Assuming 35 percent out-migration of a representative sample of the Puerto Rican population which would receive Food Stamp benefits at average per person costs in the U.S.
  22. C. Santiago, "Political Status, Minimum Wages, and Puerto Rican Migration," in Ruiz and Melendez, (eds.) Economic Effects of the Political Options for Puerto Rico, p. 267.
  23. Thomas A. Constantine of the Drug Enforcement Administration (DEA) recently testified that "the traffickers' biggest asset is the sheer volume of the commercial trade" in Puerto Rico. Testimony before the House Judiciary Committee Subcommittee on Crime on Puerto Rico and Law Enforcement Efforts in the Caribbean Region, April 3, 1997.
  24. See Fernando Lefort, "Is Puerto Rico Converging to the U.S.?" Harvard Law School Working Paper 1004.
  25. In written testimony before the Senate Committee on Energy and Natural Resources, the Puerto Rican Independence Party requested that the independence option include a free trade agreement with the U.S. and an agreement to allow the free transit of people between each country.
  26. Puerto Rico Planning Board, Economic Report to the Governor, 1996, Table 19.
  27. Based on information from the Association of Caribbean States.
  28. Congressional Budget Office, p. 24.
  29. See Jose Trias Monge, Puerto Rico: The Trials of the Oldest Colony in the World, p. 40
  30. Puerto Rican Treasury Department, Consolidated Budget of Puerto Rico, 1998-99 Fiscal Year.
  31. See, for example, Jaime Bofill Valdes, "The Impact of Federal Disbursements and Taxes on the Puerto Rican Economy Under Different Status Options," p. 14.
  32. Wages and salaries, $271.4 million and procurement spending, $317.7 million. Census Bureau, Federal Expenditures by State for Fiscal Year 1997, Tables 3 and 5.
  33. Assuming a conservative economic multiplier of 1.75 for federal spending.
  34. Census Bureau, Federal Expenditures by State for FY 1997, Table 7.
  35. Congressional Budget Office, p. 25.
  36. Puerto Rican Budget, "Consolidated Budget of the Government of Puerto Rico, 1998-1999."
  37. Budget of Puerto Rico, 1997-1998.
  38. Moody's Investors Services gives Commonwealth bonds a Baa1municipal rating, just above speculative grade.
  39. Based on a recent yield of 5.23% on 30 year Puerto Rican Public Improvement Bonds, 55 basis points below the equivalent U.S. Treasury Yields. June 9, 1998. The Bond Buyer.

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