Ethical Issues of the Puerto Rico Debt Crisis

December 23rd, 2015 by Kara in Case Studies

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By: Audrey Zhang

With $73 billion in debt, Puerto Rico defaulted for the first time in its history on August 3rd.[1] The island’s economy was in a downwards spiral for some time, yet existing laws exclude the U.S. territory’s public entities from federal bankruptcy laws.[2] Puerto Rico’s Governor Alejandro Garcia Padilla appealed to Washington to make changes to the laws to rescue the island’s finance in June, yet Congress was not able to respond in time to a crisis that was largely its fault.[3] How ethical was Congress’s response to the call from a land that has been U.S. territory for over a century?

Puerto Rico’s Special Status

The Commonwealth of Puerto Rico is a United States territory that includes the main island of Puerto Rico and a number of smaller islands. Originally claimed by the Spaniards, the island was ceded to the United States under terms of the Treaty of Paris in 1898 after the Spanish-American War.

Puerto Ricans have been recognized as U.S. citizens since 1917 as a result of the Jones-Shafroth Act. Although opinions differ on the intent of offering citizenship on Puerto Ricans, the act allows them to be conscripted for military service during World War I. The Act also grants civil rights to Puerto Ricans, but denies them voting representation in the U.S. federal government. Instead of being able to elect Members of Senate and the House of Representatives, Puerto Ricans have one non-voting Resident Commissioner in the House of Representatives.[4] They also are unable to vote in the U.S. Presidential elections.[5] In addition, the Act grants the United States Congress power to override any legislative decision made by the Puerto Rican government, and maintains ultimate control over fiscal and economic matters of the territory.

Roots of Puerto Rico Debt Problems

Corporate Tax Breaks

The import and export of goods on islands is not cheap. The special case with Puerto Rico further complicates the issue due to an outdated law from the post-World War I years called the Jones Act.[6] Originally instated to restrict coastal shipping’s vulnerabilities to German U-boats and maintain a dependable merchant fleet, the act bans foreign vessels from shipping goods between U.S. ports. Thus, businesses in Puerto Rico have to use the U.S. merchant marine to import any merchandise or products.[7] This makes shipping even more expensive, to the point that the cost of transportation in Puerto Rico is twice that of Caribbean nations, which greatly impacts Puerto Rico’s ability to trade with neighboring nations.[8]

Due to the lack of natural resources used to produce raw materials, Puerto Rico’s economy is mainly driven by U.S. firms highly dependent on imports.[9] To offset high import costs and spur industrialization of the island, the U.S. government granted a tax break to incentivize U.S. corporations to invest and operate in Puerto Rico.[10] Beginning in 1976, section 936 of the tax code allowed U.S. corporations to receive a tax exemption from income originating from the U.S. territories.[11] Additional incentives in the Puerto Rican corporate tax code also encouraged corporations to locate subsidiaries on the island—it allowed a subsidiary to have no corporate income tax liability as long as its profits are distributed as dividends.[12] Basically, this means income generated by subsidiaries of U.S. corporations can be paid to U.S. parents as dividends, without being subject to U.S. corporate income tax under section 936, and are also deductible from Puerto Rico’s corporate income tax.[13]

Due to these generous tax breaks, Puerto Rico became reliant on U.S. manufacturing corporations, developing rapidly throughout the 20th century and turning itself from a poor, rural society into a “manufacturing powerhouse”. [14] First clothing and shoe manufacturing, then more capital-intensive businesses like pharmaceutical production, drove the economic development, and the island became “more dependent on manufacturing than any state in the U.S.”[15] According to the New Yorker, at one point, more than half the drugs sold in the United States were manufactured in Puerto Rico.[16]

Unlike the bonds of most states and municipalities, Puerto Rico’s bonds are exempt from local, state, and federal taxes everywhere in the U.S.[17] This encouraged middle class Americans to loan money to Puerto Rico without considering the consequences. For years, investors with little to no knowledge of the conditions of the island lined up to lend money to the Puerto Rican government. Residents of higher-tax jurisdictions, like New York City, San Francisco, and Philadelphia, opted for such funds because they appear to be both low-risk and offered a lawful way to avoid taxes.[18]

Furthermore, the Puerto Rican constitution contains a clause that requires general-obligation bonds to be paid before virtually any other government expense. The government also created backstops, lockboxes, and guarantee mechanisms for general-obligation and other types of debt.[19] Mutual fund companies snatched up these bonds as a way to increase their returns—around 70 percent of U.S. mutual funds own Puerto Rico securities.[20]

Minimum Wage Mandate

Another interesting aspect that stems from Puerto Rico’s unique relationship with the United States is that it is obligated to follow Federal minimum wages, despite the fundamentally different nature of the commonwealth’s economy. Even though local income and productivity are significantly lower than in Mississippi, the poorest American state, the commonwealth is subject to the $7.25/hour minimum wage.[21] Under such circumstances, higher minimum wages reduce employment since businesses cannot afford to hire as many employees in such a weak economy.

Considering neighboring Caribbean nations have lower, more affordable wages, subjecting Puerto Rico to the Federal minimum wage has detrimental effects on the local economy. Similarly, the North American Free Trade Agreement further complicates the issue because of competitively lower wage levels in Mexico, giving the latter an advantage in low-skill labor-intensive manufacturing. A study by Alida Castillo-Freeman (NBER) and Richard Freeman (Harvard) reports the federal minimum wage reduced employment in the island territories by 8 to 10 percent.[22] Perhaps the most striking and alarming statistic is only 40 percent of the population has a job or is even looking for one, a number that has been plummeting in recent years, compared to the 62.9 labor participation rate of the U.S. as a whole.[23]

Other Problems

Other aspects of the Puerto Rican economy are perhaps less significant factors of the financial crisis, but are worth mentioning nonetheless. First, because there is very little alternative energy resources on the islands, about four-fifths of the energy used comes from oil. Since the islands neither produce nor refine petroleum, all petroleum products are imported.[24] This has driven electricity prices up to $28 kW/hour, around double the average price a customer in mainland U.S. would pay.[25] Not only does this energy premium turn away manufacturers, it also makes living on the island extremely expensive, especially when 77 percent of the per capita income on the islands is at the minimum wage level (versus the 28 percent in the U.S. overall).[26]

The island’s lack of competitiveness can also be seen in the absence of growth in the tourist industry. The island’s diverse natural wonders, and the multitude of cultural and historical buildings, have not been enough to attract holidaymakers. Rather, due to the high cost for electricity, and lack of maintenance personnel due to the unaffordable minimum wages, the industry is lagging compared to rival Caribbean islands. The number of tourists has barely changed in 20 years, while both the Dominican Republic and Cuba have seen a surge in tourism.[27]

Onset of the Crisis

The tax breaks made foreign investments artificially attractive, creating an economic bubble that made the island vulnerable to a crash if the tax provisions were repealed. In the meantime, investors eager to buy government bonds reduced borrowing costs for the Puerto Rican government. It soon became easier to borrow money than to fix any financial or structural problems within the island’s economy.[28] Since the 1970s, the government has been borrowing to finance almost all its expenses.[29] As the borrowing increased, the island searched for more and more revenue streams to act as securities for the bonds. Complicated deals were made, in which one branch of the government borrowed on behalf of another, paying off some of its bonds with money borrowed from other investors. Years of maneuvers like this left less money available for governmental obligations such as policing, staffing the public school system, or providing clean water.[30] Government overspending and debt soon became a complicated crisscross of interrelated payments.

The section of the tax code allowing for the tax breaks, section 936, became increasingly unpopular throughout the 1990s as people caught on that it gave the corporations a way to avoid taxes. In 1996, President Clinton signed legislation that phased out section 936 over a ten year period, to be fully repealed at the beginning of 2006, at which point Puerto Rican subsidiaries of U.S. businesses were subject to the same worldwide corporate income tax as any other foreign subsidiary.[31]

Not coincidentally, Puerto Rico’s economy began a deep downward spiral from 2006 onwards. With section 936 repealed, foreign investments began to pull out, and without a strong domestic corporate presence to fill the void, the economy began to collapse upon itself.[32] Factories closed down, jobs were lost. For the next decade, manufacturing jobs reduced by almost a half.[33] The economy shrank noticeably every year, reaching a high unemployment rate of 12 percent, with fewer than half of civilians participating in the labor force.[34] Wall Street debt rating agencies downgraded the island’s bonds to junk status, which further raises loan costs and interest rates for a government that has a pattern of relying heavily on borrowed funds for its daily operations.[35]

This recession left Puerto Rico scrambling to save its economy, but with the only profitable industry—tourism—neglected for years, the island needs to “reinvent” itself, increasing its marketing push and improving infrastructure.[36] In the meantime, the poor economy is driving residents off the territories onto the U.S. mainland in search of better jobs and opportunities. Puerto Rico’s population is on a steady decline. The loss of more than 36,000 people, 1 percent of its population, in 2013 alone, far surpassed that of any of the 50 states.

With a shrinking population, the tax base is also shrinking. Along with the huge debt-service expense, the government can no longer fund its normal activities. Hundreds of schools are closing, and healthcare is facing $150 million in cuts.[37]

After the 10-year phase-out of section 936 and the resulting exodus of business from the islands, the economy suffered other setbacks that further pushed it into a downward death spiral. The 2007 financial crisis made investors more suspicious of risky investments, including Puerto Rican bonds. The global recession in 2009 dealt a bigger blow to the Puerto Rican tourism industry, from which the commonwealth never truly recovered. The Tea Party surge in 2010 clarified that a federal bailout of Puerto Rico was politically untenable. Finally, the 2013 Detroit bankruptcy went through without having disastrous impacts on the rest of the country, which further bolstered the conclusion that Puerto Rico should be left to its own devices.[38]

In sum, the Puerto Rican debt crisis is similar to the Greek debt crisis in that it is a less-developed economy pervaded by hedge-funds seeking high-risk-investments, mainly from neighboring, more developed, regions. They are “pushed, by speculation and ballooning debt-service payments, to its limits”.[39] Unlike Greece, however, there is no bank panic, since Puerto Rican banks are tied to the U.S. Federal Reserve. This crisis can also be compared to the Detroit bankruptcy, with a similar history of inefficient administrations over-borrowing to pay for pension payments and services.[40] However, while Detroit was allowed to declare bankruptcy, Puerto Rico’s special status with the United States means that its municipalities and corporations cannot seek the same federal protection in times of crisis.

 

Bloomberg

What Now?

Garcia Padilla, current Governor of Puerto Rico, is now faced with competing demands for budget cuts and other types of austerity demanded by Wall Street rating agencies, and spending to ignite growth in reinventing the economy. The Puerto Rican constitution also obligates the government to be paid before pensioners and public workers if the government went broke, putting even more pressure on the Governor to come up with a solution—and fast.

Since taking office with the campaign promise to create 50,000 jobs, Padilla has been juggling spending, tax cuts, and investments for job creation with one hand, against government cutbacks and tax increases for bringing the debt situation under control with the other. Since taking office, he enacted $1.3 billion in taxes, including increased corporate taxes, sales taxes, and a new gross receipts levy, at a percentage increase that is far larger than what the federal government has ever imposed in history.[41] He continued governmental job cuts, shifted governmental workers from traditional pensions to 401(k)-type retirement plans while raising retirement ages, and also enacted tax incentives and offered electricity credits to encourage firms which may have been deterred by the high electricity costs.[42]

Governor Padilla also attempted to pass a recovery act to enable the commonwealth to overhaul the debts and labor contracts of the island’s public corporations, which was struck down by the United States District Court in Puerto Rico, deeming it unconstitutional.[43] The ruling is a significant setback for the Puerto Rican government; the act was aimed at granting local municipalities the right to enter bankruptcy in order to deal with the debt bill. Since the commonwealth itself cannot declare bankruptcy, the government had hoped to allow at least some of the state-run corporations that provide electricity, water, and streets and sanitation services to declare bankruptcy to seek some temporary relief from the debt burden. The United States didn’t even allow that. Thus, despite Padilla’s efforts at saving the Puerto Rican economy, the commonwealth is unable to bear the load of $73 billion in outstanding debt, and went into default for the first time in its history this August.[44]

The U.S. Bankruptcy Code allows a person or organization to restructure its payments when they can no longer pay back the debts, and move forward in a rule-governed process designed to improve the situation. With a federal bankruptcy system designed to protect the interests of all relevant parties, Congress has the power to allow Puerto Rico’s debt, including general-obligation bonds and pension obligations, to be restructured through a fair and binding process. This is perhaps the best option for the territories to get out of the fiscal mess it is in. Yet despite Governor Padilla’s pleas for Congress to extend bankruptcy protection to the territory, the legislation is going nowhere, facing resistance from most congressional Republicans.[45]

Ethical Analysis

According to the theory of justice, everyone living within the same society would ideally have access to the same basic liberties as everyone else, and should have equal access to social and economic opportunities. In a country founded upon the principles of freedom and equality, one presumes just principles can be found within the structure of the United States. However, the U.S.’s treatment of Puerto Rico has been anything but fair since it became a territory.

The commonwealth was ceded from Spanish control in 1898, the islands have held a special status in relation to the U.S. government, a status that hasn’t changed in a century. Although Puerto Ricans were granted citizenship in 1917, they only gained half of citizenship rights—they are able to be conscripted, but aren’t given the right to vote in the U.S. Congress. Economically, Puerto Rico has been getting the shorter end of the stick as well. Forced to use a currency that is much higher than that of its neighboring nations, and not allowed to import/export directly with foreign ports, an economic system not suited to the islands’ economic conditions was imposed on the commonwealth.

To boost the economy of the territory, Congress added section 926 to attract investments to the island’s municipal bonds. Once people realized the inefficiencies in the tax breaks and how it allows corporations to avoid paying taxes, the U.S. government phased out the tax breaks without seriously considering the implications for Puerto Rico’s economy, which is now a mess caused by an artificially created economic bubble and fueled by over-borrowing from eager lenders. As it becomes evident the commonwealth can not deal with the consequences by itself, Congress turns a deaf ear to pleas to allow Puerto Rico to file for bankruptcy—and to be treated economically equally to other states.

Of course, the issue of granting Puerto Rico statehood is multifaceted. There are strong arguments both for integration and for retaining autonomy as a commonwealth. In the history of referendums regarding the political status of Puerto Rico, citizens voted three times (in 1967, 1993, and 1998) against becoming the 51st state of the United States.[46] Only in 2012 did a majority (61 percent) vote in favor of statehood.[47] Some may argue that, since Puerto Ricans did not want to be treated as a state in the past, the economic crisis and the denial of the commonwealth to file for bankruptcy under federal protection is partially their fault. It is important to keep in mind, however, these plebiscites are nonbinding—despite the vote outcome in 2012, Congress is not obliged to approve the integration of Puerto Rico as the 51st state, and as of 2015 the status of Puerto Rico remains unchanged despite the changing sentiments of citizens. One wonders whether it would have made a difference on the current situation if the vote outcomes were in favor of statehood in previous referendums. In addition, there is strong Republican resistance to keep Puerto Rico from attaining statehood, as “Puerto Ricans vote overwhelmingly for Democrats, and elected officials in Puerto Rico are nearly always Democrats”[48] Despite the people’s wishes, Puerto Rico is unlikely to be included as a state anytime soon.

In summary, although much of the fiscal trouble is due to an irresponsible government that was incompetent in managing its own finances, Congress’s role in creating this financial mess cannot be denied. And considering this is a territory that has been with the U.S. for over a century, the unfairness of the situation can hardly be denied. If the U.S. is not willing to grant the commonwealth independence, then it is long overdue that Puerto Rico be fully integrated within the United States—if not as the 51st state, then at least as a justly integrated territory with equal access to the social and economic opportunities as other states, and granted the same right to file to bankruptcy and rely on federal support in times of need.

 

 

Works Cited

Alida Castillo-Freeman, and Richard Freeman. “When the Minimum Wage Really Bites: The Effect of the US-Level Minimum on Puerto Rico.” In Immigration and the Workforce: Economic Consequences for the United States and Source Areas, 177–212. University Of Chicago Press, 1992.

Bhala, Kara. “Justice as Fairness.Seven Pillars Institute. Accessed August 25, 2015. http://sevenpillarsinstitute.org/dictionary/justice-as-fairness.

Cheap Oil May Not Help Puerto Rico’s Energy Crisis.Living in Puerto Rico. Accessed August 24, 2015. http://livinginpuertorico.com/cheap-oil-puerto-ricos-energy-crisis/.

Corkery, Michael. “Judge Strikes Down Puerto Rico’s Debt Restructuring Law.” DealBook. Accessed August 25, 2015. http://dealbook.nytimes.com/2015/02/08/judge-strikes-down-puerto-ricos-debt-restructuring-law/.

Dinapoli, Jessica. “Puerto Rico Tourism Industry Lags Rivals, Offers Little Relief from Debt Crisis.Reuters, July 27, 2015. http://www.reuters.com/article/2015/07/27/us-usa-puertorico-tourism-insight-idUSKCN0Q11AN20150727.

Ehrenfreund, Max. “Things in Puerto Rico Are Getting Really Bad: What You Need to Know.” The Washington Post, June 29, 2015. http://www.washingtonpost.com/news/wonkblog/wp/2015/06/29/things-in-puerto-rico-are-getting-really-bad-what-you-need-to-know/.

Fletcher, Michael A. “Puerto Rico, with at Least $70 Billion in Debt, Confronts a Rising Economic Misery.” The Washington Post, November 30, 2013. https://www.washingtonpost.com/business/economy/puerto-rico-with-at-least-70-billion-in-debt-confronts-a-rising-economic-misery/2013/11/30/f40a22c6-5376-11e3-9fe0-fd2ca728e67c_story.html.

Gavin, Erkins, and Scott Greensberg. “Tax Policy Helped Create Puerto Rico’s Fiscal Crisis.Tax Foundation. Accessed August 24, 2015. http://taxfoundation.org/blog/tax-policy-helped-create-puerto-rico-s-fiscal-crisis.

Gillespie, Patrick. “Puerto Rico Just Defaulted for the First Time in Its History.” CNNMoney, August 3, 2015. http://money.cnn.com/2015/08/03/investing/puerto-rico-default/index.html.

Gonzales, Rocio. “Puerto Rico’s Status Debate 61 Years Later.” The Huffington Post. Accessed September 5, 2015. http://www.huffingtonpost.com/2013/07/25/puerto-rico-status-debate_n_3651755.html.

Koebler, Jason. “Despite Referendum, Puerto Rico Statehood Unlikely Until At Least 2015.” US News & World Report. Accessed September 5, 2015. http://www.usnews.com/news/articles/2012/11/07/despite-referendum-puerto-rican-statehood-unlikely-until-at-least-2015.

Krudy, Edward. “U.S. Court Upholds Ruling against Puerto Rico Bankruptcy Law.” Reuters, July 7, 2015. http://www.reuters.com/article/2015/07/07/us-puertorico-bankruptcy-idUSKCN0PH0BI20150707.

Morales, Ed. “The Roots of Puerto Rico’s Debt Crisis—and Why Austerity Will Not Solve It.” The Nation. Accessed August 25, 2015. http://www.thenation.com/article/the-roots-of-puerto-ricos-debt-crisis-and-why-austerity-will-not-solve-it/.

Mufson, Steven, and Michael A. Fletcher. “Puerto Rico Urges U.S. to Help Save It from Default.” The Washington Post, June 29, 2015. http://www.washingtonpost.com/business/economy/puerto-ricos-leader-says-washington-must-help-with-staggering-debt/2015/06/29/dbb99b6e-1e83-11e5-aeb9-a411a84c9d55_story.html.

“Puerto Rico’s Relationship with the United States?” US History Scene. Accessed August 19, 2015. http://ushistoryscene.com/article/puerto-rico/.

Sreenisvasan, Hari. “Everything You Should Know about Puerto Rico’s Debt Crisis.” PBS NewsHour. Accessed August 24, 2015. http://www.pbs.org/newshour/bb/everything-know-puerto-ricos-debt-crisis/.

Surowiecki, James. “The Puerto Rican Problem.” The New Yorker. Accessed August 24, 2015. http://www.newyorker.com/magazine/2015/04/06/the-puerto-rican-problem.

“The Jones Act Ship Law Has Outlived Its Usefulness.” The Washington Post, June 25, 2010, sec. Opinions. http://www.washingtonpost.com/wp-dyn/content/article/2010/06/24/AR2010062405500.html.

Trianni, Francesca, Ellie Ismailidou, and Harry Swartout. “The Next Financial Catastrophe You Haven’t Heard About Yet: Puerto Rico.” Time, 24:50,  -09-04 14:11:12 2014. http://time.com/20416/the-next-financial-catastrophe-you-havent-heard-about-yet-puerto-rico/.

Walsh, Mary Williams. “The Bonds That Broke Puerto Rico.” The New York Times, June 30, 2015. http://www.nytimes.com/2015/07/01/business/dealbook/the-bonds-that-broke-puerto-rico.html.

Worstall, Tim. “Memo To The Fight For $15: Puerto Rico Happens With A Too High Minimum Wage.” Forbes. Accessed August 24, 2015. http://www.forbes.com/sites/timworstall/2015/07/03/memo-to-the-fight-for-15-puerto-rico-happens-with-a-too-high-minimum-wage/.

Yglesias, Matthew. “Puerto Rico Is America’s Greece, and That Is Not a Good Thing.” Vox. Accessed August 24, 2015. http://www.vox.com/2015/7/1/8872553/puerto-rico-crisis.

[1] Gillespie, “Puerto Rico Just Defaulted for the First Time in Its History.”

[2] Krudy, “U.S. Court Upholds Ruling against Puerto Rico Bankruptcy Law.”

[3] Fletcher, “Puerto Rico, with at Least $70 Billion in Debt, Confronts a Rising Economic Misery.”

[4] “Puerto Rico’s Relationship with the United States?”

[5] Ibid.

[6] “The Jones Act Ship Law Has Outlived Its Usefulness.”

[7] Ehrenfreund, “Things in Puerto Rico Are Getting Really Bad.”

[8] Ibid.

[9] Ibid.

[10] Gavin and Greensberg, “Tax Policy Helped Create Puerto Rico’s Fiscal Crisis.”

[11] Ibid.

[12] Ibid.

[13] Ibid.

[14] Ibid.,

Surowiecki, “The Puerto Rican Problem.”

[15] Ibid.

Sreenisvasan, “Everything You Should Know about Puerto Rico’s Debt Crisis.”

[16] Surowiecki, “The Puerto Rican Problem.”

[17] Walsh, “The Bonds That Broke Puerto Rico.”

[18] Ibid.

[19] Ibid.

[20] Trianni, Ismailidou, and Swartout, “The Next Financial Catastrophe You Haven’t Heard About Yet.”

[21] Worstall, “Memo To The Fight For $15.”

[22] Alida Castillo-Freeman and Freeman, “When the Minimum Wage Really Bites: The Effect of the US-Level Minimum on Puerto Rico.”

[23] Ehrenfreund, “Things in Puerto Rico Are Getting Really Bad.”

[24] “Cheap Oil May Not Help Puerto Rico’s Energy Crisis.”

[25] Ibid.

[26] Worstall, “Memo To The Fight For $15.”

[27] Dinapoli, “Puerto Rico Tourism Industry Lags Rivals, Offers Little Relief from Debt Crisis.”

[28] Yglesias, “Puerto Rico Is America’s Greece, and That Is Not a Good Thing.”

[29] Morales, “The Roots of Puerto Rico’s Debt Crisis—and Why Austerity Will Not Solve It.”

[30] Walsh, “The Bonds That Broke Puerto Rico.”

[31] Gavin and Greensberg, “Tax Policy Helped Create Puerto Rico’s Fiscal Crisis.”

[32] Ibid.,

[33] Surowiecki, “The Puerto Rican Problem.”

[34] Ibid.

[35] Ibid.

[36] Ibid.

[37] Morales, “The Roots of Puerto Rico’s Debt Crisis—and Why Austerity Will Not Solve It.”

[38] Yglesias, “Puerto Rico Is America’s Greece, and That Is Not a Good Thing.”

[39] Morales, “The Roots of Puerto Rico’s Debt Crisis—and Why Austerity Will Not Solve It.”

[40] Ibid.

[41] Ibid.

[42] Ibid.

[43] Corkery, “Judge Strikes Down Puerto Rico’s Debt Restructuring Law.”

[44] Gillespie, “Puerto Rico Just Defaulted for the First Time in Its History.”

[45] Mufson and Fletcher, “Puerto Rico Urges U.S. to Help Save It from Default.”

[46] Gonzales, “Puerto Rico’s Status Debate 61 Years Later.”

[47] Ibid.

[48]Koebler, “Despite Referendum, Puerto Rico Statehood Unlikely Until At Least 2015.”

 

 

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