GOP Tax Plan Could Devastate Puerto Rico’s Manufacturing Sector With One Line

Hurricane Maria may have devastated Puerto Rico from one end of the island to the other, but now a new force is set to be unleashed upon it: the Republican tax plan.

A small provision in the House version of the tax bill aimed at boosting American industry would — perhaps unintentionally — devastate Puerto Rico’s economy.

That part of the bill, Section 4303, is ostensibly aimed at keeping U.S. profits on U.S. shores. Under its current arrangement with the IRS, certain kinds of U.S.-based companies can purchase goods manufactured by their Puerto Rican subsidiaries. So long as the profits they make on those goods are attributed to those subsidiaries, companies pay no federal income taxes on them and only minimal local taxes.

That effective subsidy is responsible for a significant chunk of Puerto Rico’s manufacturing sector. Now, thanks to its idiosyncratic tax status, language appearing in the House version of the bill would place a 20 percent excise tax on goods coming to the U.S. mainland from Puerto Rico. It would take a sledgehammer to the island’s economy.

Puerto Rico is functionally part of the United States and its residents hold American passports, American jobs, and American citizenship. It has a non-voting member in Congress. But because it’s treated as a foreign entity in the tax code, the change could see major businesses domiciled there — pharmaceuticals, especially — leave for new shores. Industry estimates suggest that the measure could see Puerto Rico shed as many as 250,000 jobs if its status as a tax haven is eliminated.

Puerto Rico Gov. Ricardo Rosselló, a member of the New Progressive Party, wants the House provision axed and lawmakers to simply insert a line in the final bill that would exempt Puerto Rico from the excise tax and others that could damage its manufacturing sector. San Juan Mayor Carmen Yulín Cruz said the measure could be “devastating” for Puerto Rico and “kill any chance we have of putting together a plan for sustained growth that would repopulate the island.”

To the delight of many on the island, similar language did not appear in the Senate bill, though that version did include a 12.5 percent tax on intellectual property. What’s more, either bill would incentivize companies to bring profits back to U.S. shores by letting them repatriate foreign earnings at a preferential rate. Both also include a 10 percent minimum tax on overseas profits. Reports emerged Wednesday that Republicans had reached an agreement on a final version of the bill, though a draft copy is not yet available, and changes are likely to be made up until the final moment. 

As final language is debated in Washington, elected officials in Puerto Rico disagree on how to move forward. While few on the island seem to support an immediate end to the island’s tax breaks, some see it as a path toward putting Puerto Rico on equal footing with mainland U.S. states.

Resident Commissioner Jenniffer González-Colón, the island’s non-voting representative to Congress, has pushed for a phase-out of its differential tax treatment en route to statehood. In its place, she would like to see an alternative set of federal tax incentives to invite private investment. González-Colón did not respond to The Intercept’s request for comment, and details of exactly what she is proposing have yet to be made public.

“We are always looking for more ways to help the island,” she said in a statement after the House bill’s passage. “One of those ways is through additional tax incentives so that our fellow U.S. citizens in Puerto Rico can have all the possible resources to rebuild their lives and their economy. It is our intention to make improvements to our tax reform legislation as it relates to Puerto Rico when we go to conference.”

González-Colón, a member of the pro-statehood New Progressive Party and chair of the island’s Republican Party, has been friendly to President Donald Trump and aligned largely with the GOP in Washington. While she called some of his comments dubbing Puerto Ricans lazy after Maria “shocking,” she generally praised Trump’s handling of recovery efforts. He returned the favor with a complimentary tweet around the time of his public spat with Cruz. “People are used to having politicians that are politically correct, that follow the script, and he’s not like that,” González-Colón said of Trump in an October interview. “I mean, what you see is what you get and that’s the way he is.” She reportedly has a close relationship with House Speaker Paul Ryan, R-Wis.

“[González-Colón] appears to be a true believer on Republican orthodoxy, to my surprise,” said Sergio Marxuach, public policy director and general counsel at the San Juan-based Center for a New Economy. Previously, he served as Puerto Rico’s deputy secretary of commerce and economic development. “She has become a big believer in Republican economic theories. I think that Ryan sees the potential there: She’s a conservative Latino woman, and there aren’t very many of those,” he said.

Her opinion seems to hold sway on Capitol Hill. Texas Republican Kevin Brady, chair of the House Ways and Means Committee overseeing the conference committee process, was asked about the excise tax provision during a recent press gaggle on the Hill. He said last week that he had been working closely with González-Colón, and that “she’s been really involved in trying to find a good way forward. … There are a list of options that we’re working through to try to arrive at the best approach.”

Eighty thousand Puerto Ricans, of the 2 million on the island, are cane cutters, shown here on Feb. 2, 1942. These men, who currently earn $1.51 a day, are beginning the harvest, which runs from December to June. They attack stalks of sugar cane with razor-edge machetes. Sugar cane grows 10 feet high.

Figueroa, who is Puerto Rican, has been working with his union to organize against Republicans’ tax proposal, with a special focus on the impact it could have on the island. 32BJ has a number of Puerto Rican members, concentrated in the Northeast — which has a sizable diaspora population — and in southern Florida, as well, where many Puerto Ricans have fled in Maria’s wake.

In the 1940s, “Operation Bootstrap” sought to transition Puerto Rico’s agricultural economy into an industrial one through a managed shrinkage of the farming sector, offering generous tax exemptions to corporations for things like capital investments, exporting, and industrial licenses. The move effectively fashioned Puerto Rico into the world’s first special economic zone, a term which — since that time — has come to refer to any number of policies applied to a certain area to attract foreign businesses.

For a time it seemed to work: Consumer goods industries flooded in, wooed also by lower labor costs than those that existed on the mainland. But the results were rosier for corporations than for the people they were ostensibly employing. In the textile industry, for example — previously dominated by a cottage industry — overall employment was nearly halved while corporate profits more than tripled, jumping from $18.5 million to $60.3 million between 1950 and 1960. Hundreds of thousands of people fled the island as unemployment rose across several industries.

As the policy drove Puerto Ricans into poverty, radical social experiments were put on the table. Operation Bootstrap served as an excuse to ramp up an existing program to coerce Puerto Rican women into receiving sterilization surgery, carried out on the dual grounds that women without children could be more effectively integrated into the industrial workforce and that reducing the population could mitigate unemployment in the long run.

A collaborative program between the Puerto Rican government and the International Planned Parenthood federation sterilized at least one third of women on the island by 1968, in part by limiting access to other forms of contraception. Around the same time, Puerto Rico became a literal testing ground for American pharmaceutical companies looking to develop new and often dangerous forms of birth control.

As a Pentagon researcher explained bluntly in 1971, “Capital investment from local resources is a function of individual business, and government saving rates and the profitableness of investment in Puerto Rico is oriented toward exports to the mainland and hence would not be influenced by the size of the Puerto Rican market. Individual saving is more likely to decrease than increase with a higher birth rate.”

The most recent round of business-friendly federal tax reforms in Puerto Rico came in 1976 through the addition of Section 936 to the federal tax code. It exempted U.S. companies from paying federal taxes on income earned in Puerto Rico. Painting it as corporate welfare, President Bill Clinton scheduled the Section 936 exemptions for a decade-long phase-out starting in 1996. They finally ran out in 2006, leading many manufacturers to leave the island, triggering a recession the island has yet to recover from.

After its bond rating collapsed as a result — followed soon after by the global financial crisis — thousands of Puerto Ricans moved elsewhere in search of more economic opportunities, putting further strain on an already stretched economy.

Wall Street saw an opportunity to swoop in, seeing its own opportunity in the tax code. Since 1917, bonds issued by the Puerto Rican government — municipal bonds — have been “triple tax exempt,” meaning their buyers don’t have to pay federal, state, or local taxes on the returns on them. Once its bonds had been downgraded to junk level after the recession, big institutional investors like pension funds backed off, leaving the market essentially wide open for so-called vulture funds.

Desperate for quick cash, the Puerto Rican government and public corporations — like the Puerto Rico Electric Power Authority, known as PREPA — kept issuing junk bonds with the promise of tax-free returns. In turn, major investment banks like Goldman Sachs and Wells Fargo engineered risky, complex new debt products that allowed Puerto Rico to exceed its borrowing limit and continue issuing junk bonds to investors. Some of these operated almost identically to payday loans, complete with astronomical interest rates. Now, nearly half of Puerto Rico’s at least $74 billion debt — $33.5 billion — is owed on interest.

Though many factories have left Puerto Rico since the repeal of the Section 936 exemptions, the island hasn’t done away with tax breaks entirely. So there is still more damage that can be done.

Its marginal corporate tax rate is roughly similar to that in the U.S. mainland, around 39 percent. Several local tax breaks, however, mean that few corporations located there actually pay it. “Few places on earth offer a return on investment the way Puerto Rico does,” Sotheby’s International Realty writes. “With an ever-growing array of services and emerging industries, part of your success will be directly attributable to the incentives available.” The remainder of the page details aspects of Puerto Rico’s tax code that are friendly to foreign investors: Policies — drafted mainly after the financial crisis — to attract wealthy individuals and certain kinds of businesses to the island with low rates and outright exemptions.

Such carve-outs account for around $250 million to $500 million per year in lost revenue. A Microsoft manufacturing subsidiary in Puerto Rico, for instance, made $4 billion in 2011 and paid just 1 percent of that back to Puerto Rico’s government. It paid nothing to the U.S. government and created only 177  jobs on the island. To help fill the revenue gap, Puerto Rico has enacted one of the highest sales taxes in the United States, set at 10.5 percent.

Perhaps the biggest beneficiary of those breaks in recent years has been the pharmaceutical industry, which now makes up about a third of Puerto Rico’s GDP. The island accounts for about 10 percent of U.S. drug manufacturing, and local tax breaks have been a boon to corporate profits. Drugmaker Amgen has swelled its offshore earnings by several orders of magnitude since restructuring its arm in Puerto Rico into a foreign subsidiary. It now has some $35.9 billion in Puerto Rico and pays an effective take rate of just 15.7 percent.

Still, despite the size of the pharmaceutical industry, the island still ends up having to re-import drugs as common as aspirin and cold medicine from the United States. “We manufacture very little for the local market,” Marxuach said.

“These companies are very capital intensive,” he said of Puerto Rico’s manufacturing sector. “But precisely because they are very capital intensive, they haven’t created that many jobs. The jobs they have created are very high-paid and high-skilled. A $1 billion investment in one of these manufacturing plants may generate 500 or 600 direct jobs. … There’s very little connection to the local supply chain, and there has been very little research and development.” What this means, Marxuach explained, is that Puerto Rico has been slow to develop its own manufacturing base and lacked the investments in R&D or workforce development that could build up local businesses.

Because so many of the benefits of manufacturing in Puerto Rico already go to mainland companies, Marxuach is weary of embracing doomsday scenarios about the tax bill’s potential impact — especially when so few details are known of what will make it into the final bill. “It’s difficult to say upfront how many firms will be affected and how. These companies have very sophisticated tax strategies. … It will have some effect. How bad it will be is hard to tell.”

He also noted that “if the excise tax is still on the books, it would affect them anywhere they move anyway,” and the costs associated with moving could outweigh the benefits for some firms.

Residents watch Puerto Rico Electric and Power Authority linemen attaching an electrical insulator to a new utility pole in a residential area in Gurabo, Puerto Rico, on Nov. 29, 2017.

“Given that we are part of the U.S. economy,” Marxuach told The Intercept, “it would make sense eventually for Puerto Rico to be treated as a domestic economy. The question is how to make that transition and structure it in such a way that you don’t have the investment you already have leaving. Where we are right now after Maria, adding that level of uncertainty to this environment really doesn’t help the island in the short term.”

As Puerto Rico continues the long process of storm recovery, pulling the rug out from under its manufacturing sector would seem to needlessly throw a wrench in an already fractured economic system. But there are more options available to the island going forward than to simply refashion it into a playground for foreign capital. Sens. Bernie Sanders, I-Vt., and Elizabeth Warren, D. Mass., have proposed a $146 billion package to invest in everything from the island’s energy infrastructure to its health care system, with an emphasis on local job creation, economic development, and self-government — in short, making the investments the private sector in Puerto Rico never has.

“After nearly three decades of privatization and a decade of government spending cuts, layoffs, wage suppression, and overall attrition of the public institutions,” Figueroa said, “it is no surprise that Puerto Rico was too weak to withstand successive hurricanes, let alone a category 5 like Hurricane Maria ripping the island down the middle. The federal government, however, has also shown itself weak and unprepared to handle this situation.”

Before Maria hit, Puerto Rico was already dealing with several catastrophes: a century of colonial influence from the United States, decades of austerity, and — relatedly — at least $74 billion in debt, much of it owed to American hedge funds. If it passes, the tax bill could saddle the island with one more.

Top photo: Daniel Santiago works on seat tapestry at Colls Manufacturing Inc, in Juana Diaz, Puerto Rico, on Oct. 24, 2011.