US: Puerto Rico: Failure of the State

Executive Summary

The Puerto Rican economy has come a long way since it started to industrialize and modernize in the mid-1900s through what was called “Operation Bootstrap” in English, or “Operación Manos a la Obra” in Spanish. The process of industrialization was, by many measures, a success, even though some economic indicators have continued to point to many economic disequilibria that have persisted over time, such as a persistently high rate of unemployment as well as a high rate of inflation compared to the U.S. mainland, even though Puerto Rico uses the U.S. dollar as its currency and monetary policy is conducted by the U.S. Federal Reserve.

Authorities on the island have not been able to integrate the whole of the economy, as a large percentage of economic activity still happens underground in the informal sector. Several authors have written about this and have concluded that too much regulation, at the business permitting levels, labor regulations and the application of the U.S. minimum-wage law have kept the rate of unemployment high. Furthermore, many high-income individuals feel that they should not have to pay taxes or that they pay a disproportionate amount of taxes. This is not uncommon of an economy that has a large underground or informal economy, as governments tend to increase the tax burden on the “legal” or “formal” sectors of the economy because it is almost impossible to broaden the tax base and collect taxes from a larger number of individuals.

By some estimates, the Puerto Rican underground economy is as large as 30 percent of all economic activity on the island. 1 The inability to eliminate this underground economy has had serious consequences for the economy at all levels and for the island’s government, with its inability to collect taxes due to the limited tax base from “legal” tax payers. At a conference on the island at the end of the 1990s, an economist indicated that only about 10,000 Puerto Ricans say they earn more than $100,000 per year, according to data from the “Departamento de Hacienda,” the Puerto Rican Treasury Department, out of a population of almost 4 million, according to the U.S. Census Bureau. The comment was probably an exaggeration, but was not that farfetched. The truth is that, by the year 2000, a little more than 14,000 Puerto Ricans claimed to earn more than $100,000 according to official numbers released by the Puerto Rican Treasury Department. By 2009, the last official number available, that number had risen to 25,257 individuals/filers. This is an important increase in “wealthy” taxpayers and could be showing advances made in tax compliance during the last decade.

However, just by looking at Puerto Rico’s property prices (even after the severe housing downturn), the number of cars sold per year and the price of those cars (which is approximately 10 percent higher for “popular” cars and 30 percent to 40 percent higher for “luxury” cars than in the U.S. mainland), plus the number of luxury cars and yachts on the island’s piers, it is very difficult to believe that even these higher figures of individuals who earn more than $100,000 are correct. 2 Thus, while advances have been made, the road to make the Puerto Rican tax system inclusive and reduce the size of the underground economy has not ended.

Facing serious issues on its fiscal accounts and potentially more credit risk downgrades by the major rating agencies, the government of Puerto Rico embarked on a tax reform in 2010 that is still struggling to give the results it pursued. Some of the proposals included a reduction in tax rates, a change in tax scales, a “temporary” tax on multinational corporations, a reduction in tax credits and incentives and added measures to catch tax evaders. According to the government, the tax reform should “save” $1.2 billion from taxpayers’ pockets during the period of 2010-2016. However, little of those objectives have been met as reflected by labor and consumer market indicators.

In an effort to increase tax collections and refinance some “under the line” debt, the government of Puerto Rico implemented, in 2006, a consumption tax called IVU (Impuesto a la Venta y Uso, or Sales and Use Tax). The current tax rate for this consumption tax is 7 percent, 5.5 percent collected by the island government and 1.5 percent by the island municipalities. This tax has partially substituted an import tax called “arbitrios,” on which the government relied heavily. The government has not eliminated “arbitrios” completely, but now does not rely on the tax as much as it did in the past. The new IVU consumption tax started in November 2006 and part of the collection is a dedicated sales tax to pay for the “non-constitutional” debt incurred by the Puerto Rican government, or debt that was above and beyond what the island’s constitution allowed.

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