Budget will cover cash shortfall, economic development initiatives

By : JOHN MARINO
Edition: April 25, 2013 | Volume: 41 | No: 15

At least $1.64 billion in new tax measures being considered to pay for it all; increased tariffs also on the horizon

Gov. Alejandro García Padilla is expected to present to the Legislature tonight a budget that aims to make up for shortfalls in government revenue and cover the cost of campaign pledges and new initiatives, including heightened efforts aimed at creating jobs and jumpstarting the stagnant economy.

A series of new tax measures will be implemented to pay for the bigger budget, but government officials insist they are keeping spending under control. The García Padilla administration proposals total $1.64 billion, but the Legislature is also proposing several other fee and tax hikes, which could push this figure up even higher.

Office of Management & Budget Executive Director Carlos Rivas Quiñones said the budget figure may have a “substantially higher dollar” amount than the current budget, but added that it would be “misleading” to assume the administration would be spending more money than this year. Rather, the budget will accurately reflect the government’s total liabilities, something that the budget inherited from the previous administration didn’t do, he said.

Administration officials have also discussed the option of assigning funding to a separate “fiscal responsibility fund,” and drawing on it to pay down its long-term debt and increased pension system obligations. This would allow it to hold down the size of Puerto Rico’s general fund to current levels if it wished. The previous administration of Gov. Luis Fortuño used a similar strategy, creating a “stabilization fund” it drew on to pay down the $3.3 billion budget deficit it faced when entering office.

In any case, Rivas indicated that the administration would remain frugal with public funds but wouldn’t shy away from funding priorities such as economic development and the fight against crime.

Government Development Bank (GDB) President Javier Ferrer has said the García Padilla administration is placing greater emphasis than the previous administration on job creation and economic development because returning growth to the economy is the only way to stabilize and improve government finances on a sustained basis. However, those efforts, which include the Jobs Now Act incentives, cost money and would have to be paid for in the upcoming budget, another factor that could exert upward pressure on its overall price tag.

Administration officials also said the governor’s priority on fighting crime and improving public safety would be reflected in this budget through increased expenditure in these areas.

Complicating the government’s task is that it can’t rely on outside financing for its operations, as its high level of debt and low credit ratings have significantly limited its borrowing capacity. Meanwhile, the U.S. government, which provides the Puerto Rico government $1 out of every $5 it spends, is having its own fiscal challenges. This year, the U.S. government has cut more than $100 million in funding to the local government, and that figure could increase as the White House and Congress aim to bring down the federal government’s deficit spending and its own overall debt load.

Putting forward a responsible budget has been a top priority of García Padilla’s finance team, headed by Treasury Secretary Melba Acosta, which has been working since entering office on a plan to balance government finances, while simultaneously elaborating a reform of Puerto Rico’s ailing public pension system, near collapse with an unfunded liability of more than $37 billion.

Both issues are being closely watched by Wall Street credit-rating agencies, which have pushed down the Puerto Rico government’s credit rating to one level above a “junk” grade rating. While the pension reform plan enacted earlier this month was one sure step away from falling into junk bond status, the administration also has to show with its first budget proposal that it is making substantial progress toward a balanced budget, or the government’s credit will sink into the noninvestment- grade level, the agencies have warned.

Against that backdrop, the administration’s fiscal team has been putting in 16-hour days, six days a week, to come up with a budget that would address Puerto Rico’s fiscal challenges, while funding essential government programs, including a renewed push toward economic development and job creation.

“The budget has been consuming almost our full attention,” Rivas said, adding that this was a “particularly complex” budget to prepare because of the transition from one administration to another. “You have a new team coming in, you have a very tough fiscal situation and you have a very limited margin of error with respect to the rating agencies and the availability of financing.

“Our target is to balance the budget in two fiscal years. If we can do it by the end of three fiscal years, that would still be a great accomplishment. I mean structural balance. You have to balance the budget and recognize the obligations of the budget as they are. You can’t say it’s balanced and pretend some of these obligations don’t exist. That’s been part of the problem we encountered when we came in,” he added.

Rivas said the administration has made “no secret” that the government would raise the additional revenue it needed to fund essential operations and undertake its priorities, such as job creation and economic development initiatives.

A big reason for that, he said, is that the Law 7 firings of public employees and other austerity measures implemented under the previous administration has left little room for additional cuts.

“There isn’t a lot more you can do by just cutting costs. The government payroll has already been reduced by a lot. The patient has been starved to lose weight quickly, and I think it is time for diet and exercise,” Rivas said. “You have to have the right culture of austerity and be responsible with professional services, but you can’t reduce the scope of government so much that you stop providing basic services and meeting the basic needs of the country.”

GOVERNMENT REVENUE, ECONOMY LAGS

Rivas said the driving factor behind the need for additional revenue is a “big gap” in the current fiscal year (FY) budget, plus a host of new challenges for FY 2014, which runs July 1, 2013 through June 30, 2014.

Administration officials have been complaining since before taking office that the outgoing administration, far from its claims of having straightened out government finances, had actually left them with a deficit of more than $2 billion, although in recent days, the size of this estimated shortfall has markedly declined.

Outgoing officials from the Fortuño administration acknowledged a structural budget deficit of about $1.1 billion, comprising an operating deficit of $332 million and a debt refinancing that would push off scheduled bond payments this year of about $775 million. These officials said they inherited a deficit of $3.3 billion when taking office in 2009.

Current officials pointed to decreased economic growth estimates, which the Planning Board late last year revised nearly in half for the current FY 2013, to 0.6% from 1.1%, and expressed concerns the current-year shortfall could get worse. The Planning Board also cut the estimated economic growth rate during FY 2012 (ended June 30) to 0.4% from 0.9%.

Rivas and Treasury chief Acosta have said revenue, as of Dec. 31, 2012, was running about $910 million under estimates, while government spending is $140 million above budget.

More recently, however, after revenue showed year-over-year increases of $316 million in March and $44 million in February, the Treasury secretary said the cash shortfall had been cut by more than half, to $435 million. Acosta said she hoped it would be completely eliminated by the end of the fiscal year on June 30, with a strong last quarter of revenue collection. This could also be assisted by another tax amnesty being considered by the Legislature.

Rivas said more than 90% of the overspending this year stems from the Education Department, which has a $100 million reserve fund from last year that will make up for most of the overspending this year. He said the administration expects the balance to be made up by a $40 million cut in professional services contracts.

GDB chief Ferrer has said he plans to return to Wall Street capital markets before the end of this fiscal year. This could allow the GDB to execute plans to undertake a final $333 million issue in Sales Tax Financing Corp. (Cofina by its Spanish acronym) bonds to cover the previous administration’s stated deficit, as well as the refinancing that would put off the $775 million in scheduled bond payments this year.

That essentially leaves the $435 million revenue shortfall to cover for the rest of the current fiscal year, which the administration is gaining additional ground on by taking steps such as the additional amnesty and stepping up collection efforts.

In planning the upcoming budget, the government would look to fill these gaps on a permanent basis, which is also part of the challenge of drawing up the new budget, slated to take effect July 1, Rivas said.

A CHALLENGING FISCAL HORIZON

There are also a number of new challenges on the horizon that will require recurring sources of financing that would have to be covered in the FY 2014 budget, which is also part of the fiscal team’s focus.

The biggest is probably the government’s need to inject millions of dollars into the public pension system of some $200 million annually, on top of the other measures enacted as part of pension reform.

Government officials had initially pegged the contribution at “at least $100 million annually,” but told Wall Street investors during a meeting in March that it would likely be $200 million. Government Employees Retirement System Deputy Administrator Carlos Ramos said actuaries were running new models on the pension system following the reform and would have a more precise figure of the annual amount the government will have to invest to keep the system afloat through 2040, when it is slated to self-correct.

Regardless of the final figures, the pension bailout will definitely add to the budgetary pressure on the central government, which has been operating under billion-dollar deficits in recent years and will see its annual contribution to the bankrupt retirement system soar over the next two decades.

The additional money is on top of escalating employer contributions the government makes to the retirement system, which increases 1% a year for three years and then 1.25% annually after that. This increase was begun under the previous administration, and Rivas said each 1% increase represents an additional $40 million in public funds.

That means that over the past two years, the government contribution has already increased by $80 million, and this increase will move up to $120 million. In all, the contribution will increase by $40 million annually for five years, and then it clicks up to $50 million in subsequent years. After 10 years, the total increase on the government will be $450 million.

Rivas said the García Padilla administration is also committed to taking concrete steps in cutting down on the use of refinancing to put off debt payments, which will also require assigning significant resources toward debt payment beginning this fiscal year. The previous administration had told Wall Street rating agencies that it would undertake refinancing to defer debt next year of under $500 million, and the administration said it would halve that.

In addition, the Puerto Rico government will have to restructure near-bankrupt public corporations to make them into fiscally autonomous, efficient entities while improving service.

The current administration’s policy to use public-private partnerships (P3s) for new infrastructure projects will help the cash-strapped public corporations undertake important infrastructure projects. However, it looks like the P3 program won’t be used to “monetize” existing assets so it won’t be able to directly “deleverage” the public corporations, which are all buried under steep debt.

Also, the Mi Salud government health insurance program for the medically indigent, faces upward spending pressures because its “population has grown as the economic situation has deteriorated.” Rivas said the government was looking at alternatives to try to “hold down any increase in the state contribution.”

FEDERAL FINANCING TIGHTENING

At the same time, federal funding to Puerto Rico is expected to flatten or be cut over the next several years, as the U.S. government looks to get its fiscal house in order as well.

Extra funding through the American Recovery & Reinvestment Act (ARRA), which buoyed the government during the worst of our recession, has dried up, and regular funding for ongoing programs is expected to be cut back as well.

In many cases, ARRA appropriated funds during the past administration so local governments would retain rather than lay off workers, and this helped commonwealth government finances during the past administration, even though local funding was being slashed. So, this too has a direct impact on present local government financing.

Currently, federal funding to Puerto Rico government agencies has diminished through automatic cuts, called “sequestration,” which were agreed to by Congress and the White House. They took effect when Republican and Democratic negotiators failed to come to an agreement on their own deficit reduction package.

Under sequestration, Puerto Rico is losing $129 million annually in federal funds, Rivas said, with the Health, Education, Family, Housing and Labor departments taking the biggest hits. He explained that Puerto Rico would be losing that amount through a six-month period ending Oct. 30, with the end of the federal fiscal year. Unless an agreement is reached, that amount is slated to be taken out of subsequent budgets as well, but over a full-year period.

The budget chief said mitigation plans have been worked out so government services wouldn’t be hurt and no increased burden on the government’s general fund would be placed.

“We can cover at least $100 million as a mitigating action without impacting the general fund and not affecting services,” Rivas said. “If it continues to go on, well into the next federal fiscal year, it might require steeper adjustments.”

That doesn’t mean they would be free of pain, however. One example of how the government is adapting to the federal cuts is the Section 8 housing program. Rivas said new Section 8 vouchers would be frozen, rent paid to landlords would be cut by 10% and the commonwealth would be more aggressive about “processing and collecting portability payments,” which occurs when beneficiaries move to other U.S. jurisdictions.

Ironically, the Education Department has been largely cushioned from the cuts because of its historic inefficiency of processing federal appropriations, Rivas added. The agency is still running on federal FY 2012 appropriations even though it is in FY 2013 now.

PAYING FOR ECONOMIC DEVELOPMENT

The García Padilla administration’s first act in office was the enactment of the Jobs Now Act legislation, which grants new and expanding businesses energy credits and other incentives for creating jobs.

Its overall cost isn’t clear, but it will be shared between the local Treasury Department and the Puerto Rico Electric Power Authority (Prepa). Officials reckon that the increased economic activity it will generate will pay for the incentives, and then some.

Rivas said the administration’s pledge to focus on job creation and economic development would be backed up with increased dollars in the new budget proposal.

Under Economic Development & Commerce Secretary Alberto Bacó Bagué, the administration is redoubling efforts to boost trade and promote the island to potential investors, and this is another area that is likely to see improved funding.

Rivas also said the budget would reflect increased resources assigned to public safety agencies, such as the Police Department. The governor’s use of National Guard units to help watch the coasts via radar has reportedly cost the government more than $1 million during its first two months in operation.

The administration has also pledged to develop the island’s knowledge-based economic potential through research & development, bioscience and other initiatives that all cost money, and it is also looking to direct more government purchases locally.

The García Padilla administration has also pledged to boost funding to the University of Puerto Rico by some $90 million annually so it can eliminate a special $800 annual fee, for each student, imposed under the previous administration that sparked widespread student protests.

RAISING REVENUE: $1.64 BILLION

The administration is looking to raise an additional $1.64 billion in tax hikes and adjustments to increase revenue, according to top officials. Several legislative proposals that have been filed in both the House and Senate also look to raise substantial revenue through new taxes or proposed increases of existing ones.

The administration has already raised revenue by $600 million by increasing the Law 154 excise tax applied largely on multinational manufacturing operations in Puerto Rico to its original 4% level, and extending it for five years starting July 1.

The tax is levied on the sales of multinationals operating in Puerto Rico to offshore affiliates. The tax, imposed by the previous administration, began at 4% on such sales, and was slowly being phased down to zero over six years. The García Padilla administration extended the tax for another six years, including the current fiscal year, and kept the rate at 4%.

An additional $1.04 billion in proposed hikes were outlined to Wall Street investors in a meeting held in late March.

In a private meeting with investors, officials said they wanted revenue to total $9.7 billion during FY 2014 and that tax reductions programmed under the previous administration would be scrapped.

The government hopes to raise $550 million by eliminating deductions and expanding the base of the sales & use tax (IVU by its Spanish acronym), according to GDB officials.

Much of this increase would be made through the elimination of a reseller’s exemption certificate, which allows business owners to skip paying the tax for items they purchase and use in products they sell. To combat the widespread abuse of the system, the government is proposing the elimination of the certificates and to refund the merchants through tax credits. However, exemptions will be removed and new services could be taxed.

An additional $490 million would be raised through new taxes and revenue measures, according to the GDB. The administration is looking to raise $172 million in additional corporate taxes: $65 million through changes to the alternate minimum tax; $27 million from a tax on intercompany expenses in agreements with holding companies; $30 million from a special tax on government contractors; and $50 million from a new gross sales tax on merchants selling more than $50 million annually.

Another proposal would raise $150 million through a 4% tax on self-employed professionals earning more than $150,000 annually, while freezing previously legislated tax credits, with questionable impact on economic growth, would raise $78 million. Meanwhile, an increase in the excise tax on cigarettes will raise $50 million, while additional lottery initiatives, such as implementing Powerball, is due to raise $40 million, according to the GDB.

On top of the proposed tax hikes, electric rates have been adjusted upward by a change in the fuel adjustment charge formula, and a 67% water rate hike is slated to take effect July 1. The water hike will provide some relief to the general fund as the government was subsidizing the Puerto Rico Aqueduct & Sewer Authority to hold off on the rate hike. Last year’s subsidy was $186 million, which the central government can presumably end with the rate hike kicking in FY 2014.

IMPLICATIONS FOR THE ECONOMY

Economists said the administration’s call for more tax revenue in its budget proposal is a logical response for the need to present a responsible budget, especially because the Puerto Rico government’s tax revenue as a percentage of the economy is low.

Yet, given the continued economic weakness, there are also concerns that increased taxes, coupled with utility hikes, could sink the local economy further in recession.

“There is always an economic cost. There is no tax that is a free lunch,” said Sergio Marxuach, public policy director at the Center for the New Economy (CNE). “We are definitely in territory where we have to be concerned. If we fall back into recession and we have to take these tax measures to balance the budget, it is going to be a very difficult situation.”

Economist Vicente Feliciano, president of Advantage Business Consulting, said the problem with Puerto Rico’s tax revenue isn’t low rates, but rather too many exemptions. As a result, there remains a need to review the tax code to eliminate unproductive exemptions and broaden the base. Many incentives respond to political pressures and not economic logic, he added.

That is exactly what the administration is doing with its sales tax proposal, and Feliciano said that approach should be extended elsewhere.

“The middle class that earns a salary pays a disproportionate share of total taxes. If you work as a secretary, all your wages are taxable. But if you are a pensioner, the first $11,000 of your pension is tax exempt, so is your Social Security income and probably your passive income,” he said.

Feliciano also urged the administration to undertake “structural changes in tandem with the fiscal measure,” something which the previous administration failed to do, he said.

“The fiscal advances of Law 7 were eroded by an economy in which structural changes didn’t occur, production contracted and the island was sent back to square one. Three key areas are labor, capital markets and energy,” he added.

Joaquín Villamil, president of Estudios Técnicos, said discussion of the budget usually centers on the general fund, which consists of local government funds, when the consolidated budget, which includes federal funding, is actually more indicative as a potential driver of the economy.

“What is perfectly clear looking at the budget figures for the past four years is that total amounts in the consolidated budget have remained essentially at the same level in current dollars,” Villamil said. “In real terms, they have decreased and this means that government has reinforced the recessionary condition of the economy rather than mitigate it.”

The economist puts the upcoming FY 2014 budget in the same category, and said that to stimulate the economy, the government has to emphasize activities that can generate economic growth and use the P3 program to undertake new infrastructure projects to generate economic activity and create jobs.

Villamil also said that his firm and other groups such as the CNE have called for a “zero base budgeting” approach to creating a government budget, in which government entities’ performances would be reviewed to determine if they are performing services that justify their expense.

“Typically, budgets have reflected little analysis of social and economic priorities and have been determined by the distribution of political power. In other words, those agency heads or their political allies that have more power, receive more money regardless of other concerns,” he said.

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