Tax Analysts Blog

Bond Markets Are Watching: Will Puerto Rico Enact Sweeping Tax Reform?

Posted on Feb 9, 2015

The economic situation in Puerto Rico is desperate. The territory's more than $70 billion of bonds are junk-rated. New issues of its debt are being purchased by hedge funds rather than by traditional municipal bond investors. It is widely expected that despite plunging oil prices, on which Puerto Rico is heavily dependent for electricity, the island's electric power authority will default on its debt sometime this year. That would send the commonwealth’s already sky-high borrowing rates even higher (Jake Zamansky, “Puerto Rico's Government and Assorted Agencies Are Running Out of Money,” Seeking Alpha, Jan. 26, 2015).

Puerto Rico’s problems are structural. In addition to overborrowing fueled by the triple tax-exempt status of its bonds, its rate of investment and its level of workforce participation are incredibly low by international standards. Its unemployment rate in December was 13.7 percent (nearly two and a half times the U.S. average rate of 5.6 percent). Its inefficient public corporations are dependent on government support. The government itself has an overbloated bureaucracy. The population is dramatically shrinking -- by 4.7 percent compared with growth of the overall U.S. population of 3.1 percent over the same period. There has been no economic growth for a decade.

Against all this, Puerto Rican Gov. Alejandro García Padilla is now seeking a bold reform of the commonwealth’s tax system. The reform, if adopted, would raise much-needed revenue and could do a great deal to shore up confidence and economic growth. It is far bolder than any federal tax reform plan now being considered in Washington. The Padilla administration is expected to introduce the bill by mid-February (Robert Slavin, “Puerto Rico Is Getting Feedback on Tax Reform,” Bond Buyer, Jan. 23, 2015).

The Puerto Rican Treasury laid out its general intentions in its last public briefing on the topic (Department of the Treasury, Commonwealth of Puerto Rico, “Commonwealth of Puerto Rico Tax Reform Project,” Oct. 27, 2014). This briefing was based largely on a report by KPMG, which has been paid $4.7 million to advise Puerto Rico on tax reform. On February 3 a judge ordered the release of 14 of the 21 chapters of the report that the Treasury Department had kept from the public (“Judge Orders Tax Reform Report Be Turned Over to Journalists,” San Juan Daily Star, Feb. 4, 2015).

Like most conventional tax reform proposals, the plan outlined by the Treasury Department in October would eliminate loopholes and tax preferences. Puerto Rico’s tax base is especially porous. Of the 85 individual tax preferences, 53 are claimed by fewer than 1,000 taxpayers. The plan proposes repeal of the recently enacted (and subsequently expanded) law that permits U.S. citizens to establish residence in Puerto Rico and escape U.S. and Puerto Rican tax on their capital income. Corporate exemptions, exclusions, and special rates would be eliminated. The top individual rate (currently 40 percent) and the top corporate rate (39 percent) would be reduced to 30 percent. This would be a significant achievement, but it is only the beginning.

The plan would eliminate the corporate tax for all but 4,000 of the commonwealth’s largest businesses. The other 39,000 small and medium-size businesses now taxed as corporations would be taxed as passthroughs. The plan would reform the patchwork of local property taxes. Repeal of the economically inefficient and politically unpopular gross profits tax (patente nacional) is under consideration.

But by far the biggest proposed change would be repeal of the island’s loophole-ridden 7 percent sales and use tax and its replacement with a broad-based VAT (called a goods and services tax) with a rate somewhere in the mid-teens. Like most state sales taxes, Puerto Rico’s sales and use tax provides broad exemptions for services while at the same time double-taxing some final purchases by taxing business-to-business transactions. In addition, the tax has an extremely low compliance rate -- between 56 and 65 percent.

The GST would broaden the tax base to cover services and eliminate net business-to-business transactions. Generally following the norms for VATs in force throughout the world, the GST would have exemptions or zero rating only for financial services, residential housing, water, electricity, and exports. Following modern VATs, the report emphasizes the need to maintain as broad a base as possible to eliminate the well-known and avoidable compliance, enforcement, and revenue loss problems associated with exemptions for such items as food, education, medical services, and prescription drugs. Regressivity relief for low-income households would be provided through cash transfer payments. Compared with current law, this would be a simpler and more neutral system and, perhaps most importantly, would reduce the risk of tax evasion.

Last week, Puerto Rican Treasury Secretary Juan Zaragoza launched a campaign to educate Puerto Ricans about the GST and the advantages of the proposed tax reform plan (“Puerto Rico Government Tries to Sell Public on Value Added Tax,” Fox News Latino, Feb. 3, 2015).

Reductions in compliance and administrative costs would be achieved by major increases in exemption levels under the individual income tax. This, combined with the additional economic growth that can be expected from more neutral taxation and a general shift in emphasis from income to consumption taxation, would make adoption of this plan a major achievement for any jurisdiction.

Professor Michael Graetz of Columbia Law School has proposed a plan for the United States that would use new VAT revenues to reduce individual and corporate taxes. And more recently, Senate Finance Committee member Benjamin L. Cardin, D-Md., introduced the Progressive Consumption Tax Act of 2014. Under the Cardin proposal, a 10 percent VAT would pay for large reductions in the corporate and individual taxes.

For Puerto Rico, the benefits from passage of tax reform would be greater than they would be in most other jurisdictions. Puerto Rico desperately needs a boost in tax compliance rates if it is going to generate sufficient revenue in a fair and efficient manner. But even more importantly, Puerto Rico needs to demonstrate to the financial markets that concerns about economic growth will take priority over special interest politics.

The financial markets are paying close attention. Puerto Rico’s tax reform aspirations would, if realized, replace the commonwealth’s clunky old system of revenue collection with a modern, pro-growth tax system. On so many dimensions -- revenue, job creation, confidence -- tax reform holds great promise for Puerto Rico. But as with any tax reform effort, the political pressures to preserve the status quo are enormous. For Puerto Rico’s lenders, great downside risk stems from the possibility that tax reform will not advance or will be so watered down that the hoped-for benefits will be negligible.

Read Comments (1)

Robert GoulderFeb 9, 2015

All roads lead to VAT. Garcia-Padilla is on to something; perhaps he's been
reading your Tax Notes column.

Two reasons they need to get this right. First, Puerto Rico is approaching
crisis mode, as you've noted. Second, getting the tax policy correct in PR
would provide excellent illustrative guidance for future U.S. tax reform.

It's not enough to merely enact VAT/GST -- you must get the details right. We
would do well to look beyond Europe here; their VAT regimes are not ageing
well. Far better examples to be found Down Under.

Not hard to visualize the headlines, "Puerto Rico: Test Case for U.S. VAT." Big
things sometimes have little beginnings.

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