Puerto Rico and Congress: Rhetoric and Facts

By: Sergio M. Marxuach

On November 30, Senator Orrin Hatch, the powerful chairman of the United States Senate Committee on Finance, made some remarks outlining his “concerns regarding several proposals aimed at addressing the growing debt crisis in Puerto Rico.” While we agree with Senator Hatch’s calls for openness on all sides, good faith, and setting aside opportunistic political rhetoric, we do find some of his remarks to be rather disappointing and, in some instances, frankly quite puzzling.

However, before we address the substantive arguments raised by Senator Hatch, it is important to get out of the way two misleading “factoids” that tend to cloud the policy analysis.

First, we should address this myth that Puerto Rico has a “bloated public sector.” While it is true that public employment accounts for a larger share of overall employment in Puerto Rico when compared to the U.S. states, it is also true that the United States Government Accountability Office concluded in a 2014 report that “government employment as a share of the population over the age of 15 was 8.7 percent in Puerto Rico and 8.9 percent in the states, respectively, based on Census Bureau population estimates for July 2012.” (GAO, Puerto Rico: Information on How Statehood Would Potentially Affect Selected Federal Programs and Revenue Sources, GAO-14-31, March 2014, pp. 12-13 and footnote 27).

This apparent paradox can be explained by Puerto Rico’s low employment rate and underdeveloped private sector. If government employment in Puerto Rico appears larger as a share of overall employment it is because the private sector in Puerto Rico is small relative the public sector. Now, there are multiple reasons that explain the underdeveloped state of the private sector in Puerto Rico, among these we can point to a complicated permitting system, high costs of doing business, and a large informal economy, but regardless of the reason, it is clear to us that the problem is not that government is too big but that the private sector is too small.

The second threshold issue we must address is this argument that Congress is justified in discriminating against the American citizens of Puerto Rico because they do not pay federal personal income taxes. And this is true as far as it goes for residents of Puerto Rico (Puerto Rico residents do pay payroll taxes in full), but it is also true of a large percentage of Americans, as former presidential candidate Mitt Romney rather bluntly reminded us during the 2012 presidential campaign. Certainly Chairman Hatch is not suggesting that federal benefits should be capped for all Americans with no personal income tax liability, so why apply that standard to Puerto Rico?

Having disposed of those threshold issues, lets move on to the substantive arguments made by Senator Hatch.

Chapter 9

The first issue the Senator takes up is the question of allowing Puerto Rico’s agencies and municipalities to petition for relief under Chapter 9 of the Bankruptcy Code or some “even broader debt-resolution” mechanism. The Senator is correct when he states that “Puerto Rico is NOT currently eligible for Chapter 9 bankruptcy, meaning that granting them access to this type of relief will require a legislative change to the Bankruptcy Code, which may come with its own set problems.”

In this context, the Senator’s main concern appears to be the effect of “changing the rules” or, in other words, applying retroactively the provisions of Chapter 9 to alter the terms of existing contracts. Here the Senator makes an important omission as well as some puzzling arguments against the application of Chapter 9 to Puerto Rico.

First, the Senator does not acknowledge that it was Congress that inexplicably changed the rules back in 1984 when it drafted language carving out Puerto Rico from the provisions of Chapter 9. Up until 1984, that part of the Bankruptcy Code applied to Puerto Rico in the same manner as it applied to the fifty states. Furthermore, there is absolutely no evidence, as some analysts have claimed, that this exemption from Chapter 9 was enacted in exchange for the triple tax exemption of Puerto Rico debt, which was legislated as part of the Jones Act of 1917.

Second, Chairman Hatch states that there “are potential rule-of-law issues at stake when we talk about legislative action to retroactively alter the terms of debt contracts”. And, of course, the Senator is right when he makes this argument in the context of the retroactive application of amendments, for example, to the federal securities laws or the federal tax code. But we are frankly puzzled when he makes this argument in the context of amendments to the Bankruptcy Code, which exists precisely to provide an orderly process for restructuring already existing debts and obligations.

Third, the Senator seems to imply that buyers of Puerto Rico’s debt would have required a higher interest rate if they had known, ex ante, that Puerto Rico could avail itself of the protections of Chapter 9. We, however, respectfully disagree for several reasons.

We simply have not seen any evidence that the application of Chapter 9 to thousands of other issuers of municipal securities has adversely affected the pricing of those securities. Indeed, ex ante, Chapter 9 could be construed as a form of insurance that would trigger an orderly process for debt restructuring in the event of the insolvency of the debtor.  So, ex ante, the availability of Chapter 9 may be seen as a desirable feature.

Furthermore, we have not seen any evidence either that bankruptcy concerns were a material fact affecting the investment decision of any buyers of Puerto Rico debt. In fact, it was probably the triple tax exemption enjoyed by Puerto Rico bonds since 1917 that drove so many investors to buy Puerto Rico’s municipal securities. In other words, it was basically greed and the desire to avoid taxes, not protection from bankruptcy or some form of financial patriotism, which led people to gorge on Puerto Rico debt.

Moreover, ex post, it is highly probable that many holders of Puerto Rico debt currently wish that Puerto Rico could avail itself of Chapter 9 right now, as that would at least remove some of the uncertainty surrounding the restructuring of their investments.

Finally, we agree with those who argue that the power to petition for relief under Chapter 9, by itself, would not solve Puerto Rico’s structural problems. In fact, we strongly support that in exchange for obtaining some form of debt relief, Puerto Rico should be required, just like any other debtor obtaining relief under the Bankruptcy Code, to implement substantial reforms to address the fundamental problems that caused the island’s government to become insolvent in the first place.

EITC

Second, Chairman Hatch opposes the application of the federal tax EITC to residents of Puerto Rico because “offering these refundable tax credits wouldn’t reduce their tax burden because you can’t reduce a tax burden that is already zero. In other words, these tax credits would ultimately be cash payments offered directly to lower-income residents of Puerto Rico.” But that is precisely the point of applying this program to Puerto Rico.

The federal EITC is the most effective anti-poverty program in the United States. Recent research also shows that it encourages work, promotes savings, helps poor families smooth out the effect of unexpected financial shocks, and builds a strong sense of future orientation among recipients. Extending this program to Puerto Rico, which would provide a significant wage supplement to low-income Puerto Rican working families, could be expected to stimulate aggregate demand in the short-run.

Second, it is true that in 2011, the GAO reported that about $17 billion EITC claims were paid in error in tax year 2010. The reasons for the high level of improper payment included high turnover of eligibility, confusion among eligible claimants, and the complexity of the law. Some conservative critics of the EITC have latched on to the relatively high rate of improper payments to claim that the program is being “gamed” by some recipients. However, most of the evidence points to plain old lack of understanding about how the program works. In our view, this problem could be addressed by simplifying the tax schedule to claim the credit, better outreach efforts by the IRS and the training of more non-profit tax preparers.

Finally, the Chairman suggests that “there are, quite likely, tax incentives we could offer to better incentivize growth and labor force participation, and perhaps investment, in the Puerto Rican economy. I think it would be safe to say that Republicans would be open to such a discussion.” This suggestion is quite puzzling to us, as the Senator seems to be making an appeal for openness and frank dialogue on the one hand but, on the other hand, in this instance he stops short of stating just what those “tax incentives” would be. In this regard, we warn of the mistakes made in the past when Puerto Rico designed an entire economic growth strategy based on a federal tax exemption, which was eventually eliminated by Congress.

Regulatory Relief

We agree with Chairman Hatch when he argues that providing regulatory relief to Puerto Rico could be helpful, if Congress enacted legislation, for example, exempting Puerto Rico from coastwise shipping laws (Jones Act of 1920), which require the use of relatively expensive U.S. vessels for trade between Puerto Rico and the U.S., or approving legislation to relax the overly binding income and asset limits that apply to recipients of certain social assistance programs.

However, we disagree with respect to the minimum wage. Some economists have posited that Puerto Rico’s labor market is dysfunctional due to the application of the federal minimum wage to the island and have suggested reducing the minimum wage applicable to Puerto Rico or allowing Puerto Rico to set its own, presumably lower, minimum wage.

We disagree.

A recent analysis of this issue by Arindrajit Dube and Ben Zipperer reaches the following conclusions:

“First, the current inflation-adjusted value of the federal minimum wage is not higher than it was when Puerto Rico first adopted it. Puerto Rico’s minimum wage is worth slightly less today than in 1983, even though its economy, in terms of GDP per capita, has grown by 72 percent.

Second, real wages in Puerto Rico were lower three decades ago. As a result, if we measure the bite of the minimum wage as the ratio of the minimum wage to the average manufacturing wage, the bite was closer to 70 percent when Puerto Rico first adopted the federal minimum wage, much higher than it is today, at 53 percent. (We use the manufacturing wage for this comparison because the median wage series is not available over as long a historical period, to the best of our knowledge.)

Third, additional evidence suggests the current minimum wage in Puerto Rico is also less consequential today than it was during the 1980s. In 1983 the share of Puerto Rico’s workers affected by the minimum wage was around 44 percent, but by 2010 this share had fallen to around a third. It is difficult to explain the economic crisis in Puerto Rico starting in the mid-2000s with a minimum wage that is, if anything, on the wane.” (Arindrajit Dube and Ben Zipperer Puerto Rico’s predicaments: Is its minimum wage the culprit? accessible at http://equitablegrowth.org/puerto-ricos-predicaments-minimum-wage-culprit/)

Finally, we should add that in an economy with a labor force participation rate of only 40% it is highly unlikely that lowering the minimum wage would provide a strong incentive for people to join the formal labor force. Lowering the minimum wage may lead to more job openings, but is highly unlikely that workers will be lining up to take them.

Cost and Scoring 

Chairman Hatch estimates the cost of the proposed policy package at around $30 to $40 billion. It is not clear to us how the Chairman reaches this estimate, but he seems to be including in that figure programs, such as the application of the Child Tax Credit and changes to Medicare, that are not part of the Obama administration’s proposal.

As of the date of this post we do not have all the details regarding the Treasury’s proposal, but the only publicly available cost estimate we have seen, published by Moody’s Analytics, scores the Treasury proposal at around $2 billion per year in today’s dollars. Perhaps it would be advisable to wait for an official scoring by the Congressional Budget Office before throwing around vague figures that may or may not be correct.

To be fair to the Chairman, it is true that there are a lot of people, both in and outside Washington DC, “throw[ing] around demands and vague proposals” as well as endorsing what in our view are, quite frankly, loony ideas about what the federal government should do with respect to Puerto Rico’s financial crisis. All these batty proposals and the noise and heated rhetoric they generate, while perhaps normal in a healthy democracy, are creating a lot of confusion both in Puerto Rico and in Congress. Advocacy efforts by civil society groups would be far more effective if they all stayed on message and endorsed the same agenda for Puerto Rico: (1) enhanced Chapter 9; (2) Medicaid parity; (3) application of the federal EITC; and (4) some mechanism for federal oversight.

Finally, we agree with Chairman Hatch that helping Puerto Rico is a significant long-term undertaking. Achieving progress requires the goodwill of all parties involved, as well as the willingness, both in the island and in Washington, to set aside the incendiary rhetoric and cheap politicking in order to help Puerto Rico move forward.

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The author is the Policy Director at the Center for the New Economy.