How to fix Puerto Rico’s broken economy

http://www.caribbeanbusiness.pr/prnt_ed/how-to-fix-puerto-ricos-broken-economy-10563.html

See also our recommendations HERE.

11 experts share their ideas on how to fix Puerto Rico’s broken economy

How to fix Puerto Rico’s broken economy

By : CB STAFF
Edition: October 30, 2014 | Volume: 42 | No: 42

Eleven opinions and 11 points of view follow in the next pages, and all bear one thing in common: the need for change to get Puerto Rico out of the ninth year of depression and back on the road to the economic health and growth it enjoyed for so many decades.

Headed by Manuel A. Casiano, the group of big thinkers who gave us their opinions comprises former Govs. Rafael Hernández Colón, Carlos Romero Barceló and Pedro Rosselló; economists HeidiCalero, Elías Gutíerrez, José Villamil, Vicente Feliciano, Sergio Marxuach; as well as financial expert Miguel Ferrer and business leader Manuel Cidre.

Readers will see key words such as fiscal order, status, political armistice, restructuring, job creation, innovation, need to cut operating costs and a handful of other terms and phrases keep repeating themselves in opinion after opinion.

It’s not a matter of reinventing the wheel to end this disastrous decade Puerto Rico has and is suffering. It is a matter of taking the following tried-and-true solutions offered by a wide selection of top business and economic minds and making them happen.

We need vision and creativity

If you read all the downgrades by Moody’s, Fitch and Standard & Poor’s, all of them are saying that Puerto Rico’s economic problems are due to the lack of economic development.

Economic development can mean several things, but the number one without a doubt is the creation of jobs. If people are working, their taxes come into Treasury. If people are working, they become consumers and businesses thrive. Consumers are what move an economy. To aggravate the situation, the underground economy, which is huge in Puerto Rico, is estimated at more than $10 billion a year. However, those in the underground economy only contribute when they pay the sales & use tax (IVU by its Spanish acronym), but less than 50% of IVU money reaches Treasury.

So what is happening? The Treasury Department is taxing businesses and individuals to death. They keep coming up with more and more creative taxes. They have been doing so right through 2013 and are continuing through 2014. It was necessary in 2013, but now taxes, including all the hidden ones, are strangling the economy. We have gotten to the point where businesses and consumers don’t have money because it is being taken out of their pockets by the government to support a bloated bureaucracy. Businesses are going bankrupt left and right—more than 10,000 bankruptcies a year. Many other businesses are just closing without going into bankruptcy; they are just giving up. So where are we going? That is a problem.

Economic development today isn’t the same as when economic development first started under former Gov. Luis Muñoz Marín. At that time, we were the poorhouse of the Caribbean. Muñoz Marín and Teodoro Moscoso did a great job of taking Puerto Rico from an agriculture poorhouse, with many who worked on a seasonal basis, and brought the island up to start the economic development program called Operation Bootstrap. There is no question Muñoz Marín and Moscoso have to be commended for the job they did. First, they were clever enough to obtain Section 931 from the federal government; Section 931 is the predecessor of Section 936. This allowed Puerto Rico to offer incentives to U.S. companies that weren’t available in any state.

At that time, Puerto Rico had very little competition. Europe was devastated after World War II, Japan was demolished by atomic bombs and China was closed to the outside world. Nobody had heard of Singapore or South Korea. South America was so underdeveloped that nobody would think of doing any business there. In the Caribbean, we had no competition. At that time, there was also a tariff for importing foreign-made goods into the U.S. Since Puerto Rico is part of the U.S., the island benefited from all these happenings at that time. We had all of these advantages working for us, and Muñoz Marín and Moscoso, both men of vision, developed Operation Bootstrap with Section 931 that allowed U.S. companies to operate in Puerto Rico without paying federal taxes.

However, all those advantages are gone. Now we have to compete in a global economy with everybody, the Dominican Republic, Colombia, China, Japan, Singapore, South Korea, Mexico, Ireland, etc.; many of these countries are offering much less employee wages. American companies have become global companies. It’s now a different world.

The first thing we have to do to lift up our economy again is to stop the excuse of blaming the loss of Section 936 as the problem that is holding back our economy. The tax break for manufacturers operating here was originally Section 931. It became Section 936 because the federal government tried to take away Section 931 way back starting in the early 1970s. The federal government helped, but they don’t expect to give out handouts forever. So at one point, they felt it was time to take Section 931 away. When I was Fomento administrator, today called the Economic Development secretary, I personally went to Washington, D.C., with the lawyer that was on staff at Fomento and convinced the federal Treasury not to end Section 931.

Later on, Attorney Salvador Casellas, now a federal judge who is also a CPA, went to Washington during the administration of former Gov. Rafael Hernández Colón and he brilliantly turned the tables on the U.S. Treasury. Under Section 931, multinational-company profits couldn’t be sent back to the U.S. The profits stayed here in Puerto Rico and helped our banks and local economy. These companies could invest their money in other countries, but weren’t allowed to take these Section 931 profits back to the U.S. mainland. Casellas brilliantly said, “Treasury, let’s start something new whereby the companies that want to repatriate money back to the U.S. mainland can do so by paying a tollgate tax to Puerto Rico and repatriate the money back.” This way, both the U.S. and Puerto Rico treasuries got money under Section 936. That is what the U.S. Treasury wanted, to get their hands on some of those earnings. The law was changed to Section 936. Everyone won. Companies could now use the money in the States to grow their businesses. Puerto Rico collected up to a 10% tollgate tax and the U.S. Treasury had the money enter the stateside economy.

Later on, also under Hernández Colón’s governorship, the U.S. Treasury again made a strong effort to take away Section 936. Hernández Colón called on former Gov. Luis A. Ferré, who was at that time a top Republican leader. The administration in Washington at that time was also Republican. Hernández Colón asked Ferré for help. Ferré and I went up there and met with the Treasury. Ferré met with the secretary of the Treasury for several hours. I met with the head of the Tax Department of the U.S. Treasury for four hours. In fact, we had lunch together and we were successful in stopping them from taking Section 936 away.

My point is that for years, the federal government had been trying to take Section 936 away and they finally did take it away. Why? Because of a lot of abuse by many of the companies that were taking advantage of it in Puerto Rico, shifting expenses back and forth for the tax convenience and advice of their tax experts. We have to stop using the loss of Section 936 as an excuse for the situation we are in today.

Today we are in a global economy and we have to compete with the rest of the world. We need to have vision; we have to think big. We have to see what opportunities there are under today’s global economic conditions. We have to stop crying about the loss of Section 936. In every industry and every business, there are changes that have to be made on a continuous basis. We have to change our approach to economic development.

What should be done to create economic development under the conditions that prevail today? Right now, the local economy is in a deep, long recession cycle that is in its ninth year. About 1,000 people a week are leaving Puerto Rico today, going to places like Texas and Florida, which incidentally have very few, if any, state labor laws. Of course, there are federal labor laws all over the U.S., which also apply to Puerto Rico, that protect the working class. However, in Puerto Rico, our legislators have to outdo it and we have many additional local labor laws that surpass those in any state. This has been one of the obstacles over the years that hold back the economy of Puerto Rico.

In changing from the economy of the past to the economy of today in the global arena, we have to identify the opportunities that we have that nobody can take away from us. Tourism is one of those opportunities. Tourism is a God-given gift that can’t be taken away, if we develop it with vision. However, we haven’t known how to develop it. We had 7,000 hotel rooms in Puerto Rico 42 years ago. Today we supposedly have 15,000 rooms. What kind of progress is that? About 40 years ago, the Dominican Republic had 3,000 rooms; today they have 70,000 rooms and about 6,000 under construction. Cancún, Mexico, 42 years ago had about 300 rooms; today they have 37,000 rooms and more under construction. Some people will say, of course, these other places have developed their tourism more than we have; they have lower labor costs. However, that isn’t true any more. The Dominican Republic was creative enough to start with all-inclusive low rates and later went into higher rates. Today, the Dominican Republic has many rooms that cost more than $1,000 a day. Why aren’t we as creative as the Dominican Republic in developing tourism? We have the advantages of being part of the U.S., no passports needed, federal laws protecting us and many, many unique attractions that no other island in the Caribbean has. Yet tourism is booming in most of the other islands of the Caribbean and our hotels are barely making any money. They had to close a lot of the casinos and the only reason they are maintaining a decent level of occupancy is because the rates at most of the hotels are equivalent to what our rates were about 10 years ago. If we raise our rates, our tourism, our visitors, would almost disappear. Yet we are the island with the most to offer under the U.S. fl ag, something that because of dangers of foreign countries, many Americans want. There are about 317 million people on the U.S. mainland; more than 50% of that population is east of the Mississippi. We have many of the largest airlines in the States flying to Puerto Rico. We can almost get direct flights from almost any major city on the U.S. mainland to Puerto Rico, and certainly from many other cities with brief stops. Most of the cities east of the Mississippi are less than four hours away.

We have to develop tourism. Other islands in other locations in the world can’t take away the fact that we are in the Caribbean, known worldwide as a tourism destination. We have great beaches, we have the El Morro fortress and we have the residence of Juan Ponce de León. We don’t even promote many of the great things we have in Puerto Rico.

A great movement has developed over the years in which cargo is being moved by ships because of global economies. Mostly every country that is able to develop a transshipment port is doing so. Our neighbors next door, the Dominican Republic, have two small transshipment ports already employing more than 20,000 people. However, they only fit today’s cargo ships. But they are already expanding one of them to receive tomorrow’s Post- Panamax-size ships. We happen to have the biggest port in the Caribbean by far, which already has the infrastructure of a giant harbor for several Post-Panamax ships, with six smaller harbors for the transfer ships, 42 miles of coastline and an infrastructure that the Navy put in over the past 60 years. To do the same today would cost about $3 billion. With a small amount of money, the site could be developed into the greatest transshipment port in the Caribbean. It alone could create as many as 100,000 direct and indirect jobs over the next 10 years in Puerto Rico, and it would be under the U.S. flag. Yet there is a lack of vision on our part to turn our back on this God-given opportunity.

We have a problem with the high cost of electricity, yet we don’t keep up with the times and realize that more than 30 underwater electricity cables have been laid from one country to another around the world, and about 15 more are in different stages of development right now. If we were to bring the power from Florida by an underwater cable, which could be built completely and working in less than three years, this would provide the quickest and surest way to bring down electricity rates on the island. Florida now has two nuclear powerplants and a third one under construction. They also generate electricity with natural gas and coal plants; all of this is over 1,000 miles away and would cause no danger to Puerto Rico. The average electricity cost in the U.S. is 12 cents per kilowatt-hour, and is less than that in Florida. A power cable from Puerto Rico to Florida will interconnect with the U.S. power grid, which is regulated by federal law, and we would constantly have power unless a full power grid went down throughout the whole U.S. The undersea power cables have proven effective and reliable throughout the world. The estimated time to lay this cable to Puerto Rico is less than three years. The Puerto Rico Electric Power Authority (Prepa) barely has enough money to operate. Where is it going to get the estimated $5 billion per plant to convert each of the three powerplants in Puerto Rico?

The way we are going, we are destined to retain our rates for electricity for many, many more years. I am sure that under a public-private-partnership investment, electric power could be brought from Florida at about 15 cents per kilowatt-hour. The one power that doesn’t go up in price very much is nuclear power, which is what Florida has plenty of. Even natural gas, which today is supposed to be inexpensive, could be higher in five or 10 years, but not nuclear power. Prepa wouldn’t generate power.

This newspaper over the years has also brought out some very creative ideas of how to develop agriculture in Puerto Rico. Right now, we import about 80% of our food and the fact is that we can grow about 90% of that food locally, which would reduce prices to the consumer and create thousands of jobs.

I repeat, if we want to change Puerto Rico, if we want to stop Puerto Rico’s nine-year depression, which is what this is, we have to start thinking big, with vision and creativity.

Follow my lead

Can anything be done to put an end to Puerto Rico’s depressing recession?

Yes. The economic recession can be turned around. But to do so, Gov. Alejandro García Padilla, as well as his financial and economic advisers, must first understand the roots of our problem and must stop fantasizing and face the facts.

To put it as clearly and simply as possible, we owe more money than we can pay, and if we continue burdening our middle and working class with more and more taxes, their situation will just get worse.

To turn our economy around, we must (1) reduce our expenditure and (2) increase our revenue. How can this be done while reducing the tax burden on our middle and working class?

Can it be done?

The answer is yes to both questions. But certainly it can’t be done by increasing expenditure as the governor did in his first budget. Instead of reducing it, he increased expenditure by $850 million.

And you can’t increase government revenue by borrowing more money and imposing more and more regressive taxes such as the patente nacional (gross receipts tax), sales taxes on wholesalers’ sales to retailers, use taxes on banking and insurance services, additional sales taxes on gasoline, and many other taxes on consumption that have a negative effect on our economy, as this administration has done.

But the governor will ask, how can we increase our revenue if we eliminate all those new taxes? The answer: Do what I did during my two terms as governor, from 1977 to 1984, when the price of oil increased by 400%, from $11 a barrel to $44; when the prime lending rate at the national level increased to 21.5%; and when unemployment in Puerto Rico went up to 20%, while in the States it went up to more than 10%.

When the recession started during my administration, I called my cabinet and all executive directors of the government agencies and public corporations, and I ordered them to reduce their expenditures by 10%. I also reduced income taxes on the working class, the middle class and small businesses to stimulate the economy. I eliminated the excise taxes that [former Gov.] Rafael Hernández Colón had imposed on items such as soap, toothpaste, diapers and other indispensable items.

But how could government expenditure be met if those tax-revenue measures were eliminated? In the first place, small businesses started increasing their sales and services, the economy started recovering, taxpayers started meeting their obligations, and tax evasion was reduced. Nevertheless, additional revenue was needed to meet government expenditure without affecting public safety, education and health services. The only source of additional revenue available were the 100%-tax-exempt nonlocal companies, which had just been granted additional tax-exemption benefits by Congress when Section 936 was enacted in 1976.

I campaigned in 1976 promising to reduce income taxes to middle- and low-income taxpayers and to increase revenue by legislative imposition of income taxes to 100%-tax-exempt companies, which came to be known as 936 companies.

In 1978, the 100% tax exemption granted to nonlocal manufacturing companies was revoked and for the first time, manufacturing companies were subject to income tax. The law enacted in 1978 reduced the 100% tax credits to 90% during the first five years, and continued dropping over the next years to full payment of income taxes after 20 years. Instead of leaving the island, the number of electric manufacturing companies establishing in Puerto Rico increased more during my two terms as governor than in any other eight years.

We did what every government should do: We provided tax relief to those who needed it and we imposed taxes on those that could pay. We did then exactly what the government should do now.

If we merely reduce the 90% income- tax credit to “foreign” companies and multimillion-dollar individual investors to a 60% tax credit, government tax revenue from multimillion- dollar-income manufacturing companies and individuals would be increased by no less than $3 billion.

This amount would solve our deficit budget and give us a balanced budget, while the additional and oppressive sales & use tax and the patente nacional imposed by the governor are eliminated. Only then will our economy begin to recover. These moves would jumpstart our economy again.

Resolving the status issue

There are three major issues that must be addressed to attend the prolonged nine-year economic recession Puerto Rico has been facing: fiscal order, status resolution and congressional assistance for economic activity.

Puerto Rico must put the fiscal house in order, solve the island’s political situation (i.e., status) and identify those areas in which the U.S. Congress could assist Puerto Rico in both its economic recovery and future economic development.

Putting the fiscal house in order: The fiscal crisis and the prolonged recession that Puerto Rico is undergoing present challenges that, to be surmounted, require innovation as well as bold and continued policies for more than four years.

Continuity of developmental and economic policies hasn’t been possible since the pro-statehood New Progressive Party (NPP) came into power on and off since 1969. Contrary to commonwealth administrations, the NPP prioritized the political goal of statehood over economic development.

To put a policy framework in place to surmount the fiscal crisis and the economic recession, and thereafter, economic development, the people of Puerto Rico must chart a course toward the future that will give continuity to these policies. This requires a resolution as to status.

The White House Task Force on Puerto Rico recognized that the status question and the economy are intimately linked. Many participants in the forums conducted by the task force argued that uncertainty about status is holding the island back in economic areas. And although there are a number of economic actions that should be taken immediately or in the short term, regardless of the ultimate outcome of the status question, identifying the most effective means of assisting the economy depends on resolving the ultimate question of status.

Resolving the status question requires a meeting of the minds between Congress and the people of Puerto Rico. In the past, there have been serious differences among congressional committees, the White House Task Force and our political parties as to the constitutional viability of the status alternatives proposed by our parties in their electoral platform or bills sponsored in Congress. Now, the White House has devised a way to solve this problem. Congress and the president have acted to chart a course for Puerto Rico to take its final decision as to status.

The third issue of congressional assistance is intrinsically linked to the status option the people of Puerto Rico decide upon.

I am not saying that Congress will bail out Puerto Rico. What I am suggesting is a series of initiatives that could assist in the economic development of the island. But these initiatives will be based on the status decision. The congressional objectives and those of the people of Puerto Rico will be very different depending on the status option decided.

One thing is to ask congressional assistance under the statehood option and another is to ask for it under commonwealth. There are two different frameworks.

So, we will be charting two alternatives and different futures for our economic recovery and development. The task force has said that before Puerto Rico becomes a state, Congress may phase in federal taxes and parity in a few federal programs. It will be a very different scenario for business, economic activity and jobs than the improved commonwealth scenario with fiscal autonomy that we now have and other measures that Congress can tailor to an improved commonwealth for economic recovery.

The way to statehood implies equalizing Puerto Rico with the states of the Union, which implies federal taxation, and there won’t be the flexibility to provide such measures as Section 936 of the U.S. Internal Revenue Code to help improve Puerto Rico’s economy.

The improved commonwealth option will allow Puerto Rico to solicit from Congress programs to attract investments and promote employment opportunities.

We are facing a decisive moment. Puerto Rico and the U.S. are better off by facing it now with a fully democratic process, with all the alternatives on the table, than running the risk of a skewed process structured by the NPP toward the triumph of statehood by eliminating improved commonwealth from the ballot.

Regarding budgets and public debt

It is a fact that all government administrations must establish a budget and assume some level of debt. That is an inherent reality of running any modern government, akin to any family having to live within a budget and assume debt, such as a mortgage, car payment or personal loan. This debt affords a family an easier way to pay for housing, transportation or even a well-deserved vacation, just like assuming debt allows a government to leverage the funds to invest in infrastructure and social welfare projects. And just as a family must live within its means, leaving a portion aside to pay debt, so must a government run its finances and service its debt, according to the amount of revenue it receives. This revenue varies depending on the strength or weakness of the economy, measured by gross domestic product (GDP).

Regarding government budgets, during fiscal years 1994 to 2000 (through my administration), there is evidence proving slight budget surpluses at the end of every year, with actual revenue exceeding estimates by 3% to 9% throughout that period. In fact, revenues jumped from $4 billion in 1993 to $7 billion in 2000. Moreover, our budgets received recognition for their accuracy and transparency from the National Association of State Budget Officers and the Government Finance Officers Association.

It should be noted that this increase in revenue was achieved within a framework of significant tax reductions of about $400 million a year, legislated between 1994 and 1999. This translated into a total of about $2 billion returned to taxpayers’ pockets so that they could spend their hard-earned cash as they saw fit, thus helping fuel the economy as consumers. While it may sound contradictory to boost revenue while lowering taxes, it was possible to do so because of parallel measures implemented to improve tax collection and reduce evasion, plus other initiatives under a New Economic Development Model aimed at expansion, which fostered a yearly GDP growth of 3%.

During this time of fiscal responsibility and economic prosperity (i.e., repayment capacity), we assumed the debt invested in infrastructure works such as the Superaqueduct, Urban Train, Convention Center, the Coliseum, Art Museum, 200 miles of new roads, new bridges and accesses, new schools, power stations, and many other projects that are still serving Puerto Rico.

Certainly, the public debt grew during this time, but it didn’t grow disproportionately as some have argued. The constitutional debt (limited to a maximum of 15% of the average revenues of the previous two years) during my administration never exceeded 9.9%, and was at 8.97% in 2000, making it the lowest in the previous 19 years.

Likewise, the extra-constitutional debt we assumed during both terms of my administration actually decreased by $637 million between 1993 ($3.7 billion) and 2000 ($3.042 billion). Also, if we look at the debt relative to GDP at the time (per four-year term), my administration contributed only 2.5% to the debt per term, while other administrations, before and after mine, show debt increases of 13%, 18% and even 25% per term. In terms of numbers, by 1965, this extra-constitutional debt hovered at around $910 million, or 32.9% of GDP at the time. By 1990, it had already climbed to 58.5% of GDP, or $17.6 billion, which resulted in a downgrade of Puerto Rico’s credit in the bond market two years before my administration.

This leads us to consider the credit ratings of the government. Between 1992 and 2000, our outlook was always deemed “stable,” “favorable” or “positive,” and ratings remained at A (S&P) or Baa1 (Moody’s). It was after 2001 that Puerto Rico began to experience negative outlooks (October 2001; April 2003-July 2006). And it was after 2001 that the debt relative to GDP increased from 62% to nearly 100% as it is today.

Game changers in Puerto Rico

According to the Merriam-Webster Dictionary, a game changer is “a newly introduced element or factor that changes an existing situation or activity in a significant way.” Our objective is to provide a compelling look at some key elements that will change the course of Puerto Rico’s economy and lead us to the path of recovery and growth.

  • Increase investment as a percentage of GNP: At the heart of economic growth lies the process of investment, capital formation in infrastructure, industrial and commercial buildings, hotels, and machinery and equipment. Puerto Rico achieved rates of real gross-national- product (GNP) growth in the 1960s, when real investment reached an average 30% of real GNP. As of 2013, this percentage was less than 22% and GNP growth has either been negative or close to zero. How can this growth be achieved? If public debt isn’t an option, then we have to go the route of alliances with public-private partnerships (P3s).
  • Hub for world-class innovation and telecommunications: In today’s world, connectivity and competitiveness are buzzwords that represent economic opportunities. Puerto Rico can boast having broadband that shortly will wrap the entire island. Productivity, not consumption, needs to be boosted. Information-communications technology needs to be world class, and in key sectors, including health and education, if we are to compete. Lower salaries and unique access to the U.S. market are no longer an option. The public sector, together with the private sector, needs to identify technology gaps and training opportunities at all levels. The regulatory environment must also follow best practices worldwide and make it so Puerto Rico’s technology sector comes to the forefront of this economy. The upcoming tax reform can tackle the need to make it attractive for knowledge workers and mavericks to come to Puerto Rico instead of depending on factors such as low costs and tax incentives.
  • Overhaul the island’s public utilities, particularly electricity: The cost of electricity is an important consideration for both local and foreign businesses. There is no reason why we haven’t been able to address this issue rationally. Today, our electric power utility appears to be drowning in debt, inefficiencies and low productivity, to the point that a restructuring officer has been appointed to the Puerto Rico Electric Power Authority’s management. A lower cost of electricity is possible, but if Puerto Rico can’t access public-debt financing, again the route has to be through P3s that can invest in badly needed infrastructure, shifting toward gas instead of oil.
  • Decentralize the public education system: The island faces increasing challenges in its public education system. There is absolutely no excuse for our children not to be fluent in English as a second language, which should be taught in schools for 12 years. If we are to increase investment and become a hub for innovation, public education at all levels must be overhauled. This can’t be solely a discussion of higher salaries and pension benefits for teachers; decentralize the Education Department and adopt accountability as a standard.
  • Incentivize work instead of dependence: Time was when Puerto Rico had a need to excel and work instead of being dependent on food stamps and other welfare payments. That safety net is important in some cases, but it can’t be—for almost 50% of our population—forever. Poverty in Puerto Rico remains high, compared with the U.S. mainland, and welfare payments, though important, have become negative incentives in too many cases. Labor participation is at its lowest at only 40% of the working-age population. We need a strategy to require work accompanied by welfare assistance until these individuals graduate from dependence into independence.

In the end, Puerto Rico’s economic survival rests on the leadership to execute greater reforms, in such areas as tax, labor, education and welfare. That will be the real game changer.

A political armistice before the economy can grow

Before anything can be done to jumpstart Puerto Rico’s economy, the New Progressive Party (NPP) and Popular Democratic Party (PDP) must first work together on matters that are urgently needed to be addressed in order to spur local economic growth.

The two major political parties have to reach an armistice in which they both agree not to take credit for and not to prevent certain things from happening. If there is no agreement of this nature on urgent matters, then there is nothing to be done to get out of our present state of affairs. This is why the island’s economy went down the tubes in the first place.

If nothing is done, Puerto Rico will become a wasteland of only poor and old people.

If the NPP and PDP can stop destroying each other’s initiatives and get on the same page, the rest of the steps to kick-start the economy are relatively simple.

These include reforming the island’s tax system so that it no longer punishes people for working, saving and accumulating capital, as is now the case.

The island’s main political parties must also have the willpower to decrease the size of government so the commonwealth’s operating expenses are the same or preferably less than annual collections. Reducing the government’s size is of the utmost importance, even if thousands of government workers must be fired, because as things stand now, the government is like a form of trichinosis in that it will continue sucking blood out of the private productive sector until the private sector dies and the government dies with it.

If nothing is done to shore up the commonwealth’s finances, things will go from bad to worse. Among the worst things could be Aeela’s [Employees Association of the Commonwealth of Puerto Rico] pension system going belly-up and closing down as early as 2015.

The solutions have always been there. The problem is that the government has been unwilling to step aside and let the private sector rebuild itself because the government’s priority is finding the money to maintain its current size.

Also urgently needed is that the government backtracks on its Public Corporation Debt Compliance & Recovery Act, which sets up a bankruptcy-type process for certain public corporations to restructure their debts and promises to make good on all the government’s existing debt obligations. By doing this, we will regain investors’ trust and attract capital to Puerto Rico.

Once the government stops being a burden, the private sector should focus on production—be it producing services such as accounting and tax advice, or producing agricultural and manufactured goods—for export. For example, Puerto Rico could export energy to the U.S. Virgin Islands via a submarine cable.

We need to produce and export if the economy is to grow, and market forces should determine what kinds of goods and services could be offered on the world market. This means we have to make something or provide some service; we can no longer be an economy that consumes more than it produces.

We have to add value of some kind for the economy to grow. This way, we can accumulate the stock of capital—be it institutional capital, physical capital or intellectual capital—that we need to make this a reality. Ideally, the commonwealth government should spend less than it collects, with the aim of gathering a $1 billion cash reserve for the local government, which can be leveraged to cover the cost of capital improvements, etc.

Once these steps are implemented, the sky is the limit for Puerto Rico and its economy.

Puerto Rico must change its economic model

Before anything else can be done, it is imperative that Puerto Rico carries out a change in its economic model, specifically in three important areas.

First, it must move toward an environment conducive to entrepreneurship and nondependency; second, it must reform its social framework to focus on empowerment and personal responsibility; and third, it must shift its environmental policies toward a model of sustainable development.

It is important for these three things to take place, otherwise, any strategy or tactic to be attempted would be eventually undercut by the current economic model.

In the short term, Puerto Rico must cut back its operating costs; there is no other recourse. Difficult decisions must be made with regard to public employment, government agencies, municipalities and, especially, public corporations, which are beset by problems we all know about.

At the same time, Puerto Rico should look into federal bankruptcy as an alternative for some agencies— and I am not referring to the criollo bankruptcy, I think there is no space for that.

A state of economic emergency must be declared so that the government would be forced to purchase all goods and services from local businesses, among other things. This initiative would also go in line with large-scale job creation.

These are examples of short-term measures that the Economic Development & Commerce Department hasn’t looked at with the same level of attention as other initiatives such as the incentives of Acts 20/22.

However, as long as the public sector doesn’t incentivize the private sector to become an important part of our economic development, our road to recovery will remain a hard trek indeed.

Following this line of thought in terms of the lack of willpower to do what is really necessary, it isn’t really prudent to have so many government agencies housed in private buildings when there are so many empty facilities owned by the government.

From a healthcare perspective, public employees must focus all their efforts into using public healthcare for their medical needs. Obviously, inclusion in this regard mustn’t be conceded to private health plans, which undoubtedly have helped increase operational expenses at the government level.

I could talk all day about short-term measures, but my real concern lies in the medium-to-long term. Again, we have to change our economic model; otherwise, the current system will sabotage any measures we try to carry out.

I want to clarify that changing our economic model and adopting strategies for economic development are two different things. For instance, when I say that our economic model must be based on entrepreneurship, what do I mean?

Take the past two years; they represent an example of what not to do if one wants to foster entrepreneurship and economic development. It has become the worst environment for entrepreneurship imaginable, partly due to around $2.5 billion in new taxes that have been levied against the private sector.

Our labor laws represent another factor against entrepreneurship on the island; they aren’t flexible enough to properly address the range of different industries on the island. Yet another issue has to do with the Puerto Rico Electric Power Authority and the Puerto Rico Aqueduct & Sewer Authority. They essentially pass the buck over to the private sector, which has to foot the bill for decisions that, for example, grant huge subsidies to the nonprofit sector and municipalities.

Lastly, when I say that our economic model must also be based on nondependency, it means that the private sector must become an active player. It can’t depend or wait for the government to do something; instead, the private sector must take the lead and look into what it can achieve for the betterment of our country.

Restructuring the economy

I don’t use the word “restructuring” lightly. It refers to transforming a structure, in our case, the economy. Economists typically look at economic processes as continuous, with cyclical ups and downs. The policy initiatives for dealing with these cycles typically rely on fiscal and monetary instruments that leave economic structures unchanged.

Puerto Rico’s economy has very serious structural problems that underlie its performance in the past four decades. I have indicated on a number of occasions that its performance since 2000 is the culmination of a decades-long trend of slowing growth due to structural problems that eroded the economy’s capacity to generate growth.

There have been many suggestions from different quarters to have the economy grow again: lower energy costs; improve the permitting process; reduce taxes; lower labor costs; expense investment in construction; and a number of others. They can be justified as means to jumpstarting the economy, which is urgently needed, yet they are insufficient for achieving sustained growth.

Restructuring our economy is an urgent imperative, particularly in the context of a global economy characterized by rapid and profound changes in technology, competitive conditions, key players and geopolitical realities. It can be done, as a number of countries have demonstrated, and in a relatively short period of time.

What were the key drivers of change? One was a commitment to deal with the complexities of changing the structure of an economic system firmly anchored in the past. A second factor was a correct reading of the rapidly changing external environment within which the economies evolve. Third was a strong participation by the private sector and civil society as drivers of change. Fourth, a commitment to planning, as well as developing a clear and widely accepted vision.

Although the subject would require treatment in much greater detail, five structures must be overhauled to promote short-term growth and long-term sustainable development:

  • Labor market: To ensure efficiency and higher productivity, not just lowering labor costs. Best practices: Chile, Finland and Denmark.
  • Energy market: The driver here is creating a competitive market. Restructuring the Puerto Rico Electric Power Authority’s debt is a precondition for change and is unavoidable if a true restructuring of the system is the objective.
  • Tax system: Reforming the tax system for recovery from a prolonged and deep contraction with many structural consequences is a very different proposition than doing so for improving performance in an economy that is doing OK but could do better. Marginal changes won’t make a difference in our case.
  • Institutional framework: Public- sector structures, culture and procedures (including how we measure economic performance) respond for the most part to the needs of an economy that is quickly passing from the scene, and aren’t adequate for, among other things, migrating to a knowledge-based and increasingly intangible economy.
  • Private sector organizations: They need to assume a more diligent, coherent, serious and structured role in defining the economic agenda and its implementation. The private sector has been unable to frame a coherent vision for the economy.

The end result of the restructuring process must be a society in which there is excellent quality of life, in which there is equality of opportunities for economic improvement and in which every generation is better off than its predecessor. Obviously, the role of the political system is key. The World Bank’s Commission on Growth & Development had this to say on the subject: “No issue in development is more controversial than the proper role of government in economic life. Successful economies have generally found a formula that includes a dynamic and innovative private sector supported by government investment in public goods, effective regulation and redistribution to protect the most vulnerable…. What is at stake…is not the size of government but its effectiveness.”

Use Puerto Rico’s fiscal autonomy to power investment and growth

Puerto Rico must use its fiscal autonomy to jumpstart capital investment and growth since we no longer have the luxury of financing economic growth through debt.

Acts 20 and 22 and the recent passage of a new private-equity law are great moves to bring capital to Puerto Rico, but we also need to broaden our tax base by attracting top professionals who relocated to the U.S. mainland back to Puerto Rico.

It is imperative we expand our tax base because right now about 26,500 taxpayers account for 42% of individual tax revenues, or $1.3 billion dollars. If we could attract, say over a period of five years, another 26,500 top earners, that could represent another $1.3 billion in tax revenue, which would sufficiently broaden our tax base to lower taxes for all individuals and corporations in Puerto Rico.

Tax reform must attend to economic growth. Taxes should be used as a development tool instead of only a source to finance the government’s operational budget. These returning residents would also bring their capital to the island. If each person were to bring $5 million in capital, this would inject $132.5 billion into our economy. This could conceivably fuel 5.3% average annual growth in our GDP (gross domestic product) over these five years, while creating tens of thousands of new jobs in the process.

We could reverse the emigration to the U.S. mainland by offering a fl at tax rate of 25% to individuals and corporations who return to the island and now may be paying up to 50% in taxes on the U.S. mainland. These new taxpayers could broaden the tax base sufficiently until reaching parity of a 25% rate for all.

Efforts to broaden the tax base should also include hikes to the island’s consumption tax, be it a sales tax or value-added tax, to include expenditures by the underground economy, which accounts for 28% of GDP, according to economists’ estimates. We must also update the island’s property tax system so that all properties reflect current values. But more importantly, all steps, including tax reform, must be aimed at fueling capital investment in Puerto Rico.

If you don’t get capital investments, you don’t grow anything. The next wave is to bring business entities to Puerto Rico. Every day in the U.S., hundreds of new start-ups have to decide where they are going to set up shop. We have to be on that short list, so that people establishing businesses think of Puerto Rico as the true destination for their companies.

Puerto Rico needs to grow at rates of 4% or 5% a year, which translates into $20 billion to $25 billion in investment a year. This is based on economist Gustavo Vélez’s estimates that each $5 billion in investment generates 1 percentage point growth in the island’s GDP.

Besides favorable tax rates, we must do something immediately to reduce the cost of energy because businesses can’t wait the five to 10 years that it will take to restructure the Puerto Rico Electric Power Authority.

Puerto Rico can’t be a hostage to high costs of energy for that long. Therefore, we have to find quick results while they resolve the big problem. This could be done by allowing the private sector to provide power through onsite powerplants or an undersea power cable from another jurisdiction, generating low-cost energy without the need for subsidies from the cash-strapped Puerto Rico government. The government could establish enterprise zones where private entities could provide the electricity. The zones would be located in areas designated for strategic development, including the former Roosevelt Roads Naval Station in Ceiba, the former Ramey Air Force Base in Aguadilla, the Port of the Americas in Ponce and the Convention Center District.

We also need to regain the confidence of those who have been our allies by giving us money to fuel our economy in the past. We have to be very wise in our determinations about what we do with our existing debt because no other Latin American country has the benefit of being able to access U.S. capital markets, so we need to make sure we don’tdamage this powerful tool.

External sector: the driver for Puerto Rico’s economic recovery

H.L. Mencken once said, “For every complex problem, there is an answer that is clear, simple and wrong.”

In other words, all complex issues appear to have a simple solution that is invariably wrong. Thus, Puerto Rico needs to throw away simple answers such as “we need to execute”; “a 25% tax rate would attract hordes of new taxpayers”; or “we should all get together, hold hands and work for Puerto Rico.”

Right now, Ireland’s manufacturing and export of services are growing strongly on the back of tax incentives that are more competitive than those Puerto Rico is offering and a labor force educated in one of the best school systems in the world.

Ireland is getting net positive migration. The driver for this is neither Ireland’s 41% personal income tax rate nor its 23% value-added tax. What is attracting this migration are thousands of jobs.

In Puerto Rico, we need jobs that initially can only come from the external sector, from companies that compete in the global economy. The local economy is depressed while the world around us is not. Thus, the turnaround must come from manufacturing, aeronautics, export of services, tourism and agriculture.

The key to this is labor reform, lower electricity costs, and a tax system that increases the burden on consumption while reducing the burden on workers and entrepreneurs.

Our youth is fleeing the protection of local labor laws (and the joblessness for which these laws are partially responsible) to move to Texas and Florida, which have fewer labor laws and many more jobs. A sensible reform was to eliminate double pay on Sundays to retail sector workers, but few jobs can be created by the weak local demand. We need labor reforms that impact the external sector.

A hotel room in Puerto Rico is more expensive than one in Florida partly because of electricity costs. The island has a limited participation in the booming production of generic pharmaceuticals partly because of high electricity rates. The new regulatory commission on electricity ought to be a bulwark against rate increases.

The tax reform being drafted by the Treasury Department is based on solid evidence and world “best practices.” The KPMG team of consultants is a solid cadre of officers with international experience. The general outline is an increase in revenue through a broad-based value-added tax, allowing for the reduction in corporate and individual income taxes. This would also help increase tax revenue because it would capture unreported income, such as from the underground economy. Act 154, which taxes the manufacturing sector, is being analyzed. These changes are the right route.

Since labor reform, lowering electricity rates and tax reform would need time to have a positive impact, we need infrastructure investment to jumpstart the economy now. This will require the restructuring of public corporations. The Puerto Rico Electric Power Authority is undergoing such restructuring. Right now, the corporation is unable to properly invest in upgrading neither its generation plants nor its grid.

For the long-term sustainability of our economy, an overhaul of the education system needs to be undertaken. According to the results of the reputable Program for International Assessment, or PISA, in reading, math and science—used in 65 countries and territories—Puerto Rico not only lags behind the excellence of Singapore and Ireland, not only is below the modest scores of the U.S., but is also below laggards such as Mexico and Costa Rica.

Thus, we need to propel our external sector through labor reform, electricity-cost reduction and tax reform. The external sector would in turn create the economic activity that will positively impact the rest of the economy.

Debt restructuring needed for long-term economic planning

Unfortunately, Puerto Rico’s economic and fiscal situation has worsened since January 2013. The majority of, not to say all, economic indicators have worsened or remained fl at since then.

Contrary to 2012, the constitutional loan margin is almost exhausted, the Government Development Bank’s (GDB) ability to finance the central government is extremely limited and access to capital markets is at interest rates the island simply can’t pay over the long term.

In accordance to the International Monetary Fund’s terminology, the Puerto Rico government has been left without “fiscal space,” especially after the downgrade of the government’s credit rating to noninvestment grade this February.

My opinion is mixed on the measures the government has taken. It reformed the central government and judiciary retirement systems, but failed to make added investments in the systems as required by the law. The restructuring of the public teachers’ retirement system continues in limbo after the Puerto Rico Supreme Court’s decision. The government closed fiscal 2014 with a deficit of $783 million despite the multiple tax measures passed in 2013.

The Center for a New Economy and other private analysts project the government will close this fiscal year with a deficit of $500 million to $700 million, which doesn’t include the $269.8 million in capital interest from the general-obligation (GO) bond issue in March, despite cuts to the current budget. On the collections side, Treasury is 2% below its estimates. If this tendency continues, Treasury will close the fiscal year with collections $193 million below its initial estimates.

Puerto Rico’s debt has increased by almost $8 billion since the government- transition report was published in 2012, mostly to finance operational expenses and deficits. Given the credit downgrade, I think it will be very unlikely that capital markets will be willing to provide financing at reasonable rates.

What can we do? My opinion is that our short-term agenda should be the following: (a) increase the government’s fiscal space by restructuring payments on debt held by the GDB, public corporations and maybe related securities offered under some GOs; (b) identify absolute priorities for government spending (for example, security and health) and freeze or cut expenses everywhere else; (c) recapitalize the GDB; (d) implement a tax reform that rationalizes the tax system; (e) establish rules that require that any law that increases spending, requires a similar tax increase or cut to other programs, or that any laws that reduce taxes should increase taxes or reduce spending in other areas; (f) establish multi-annual budgets; (g) place expiration dates on any new government program; (h) limit the issue of new debt to the nominal growth of gross national product (GNP); (i) complete the process of pension reform; (j) an in-depth restructuring of public corporations, especially the Aqueduct & Sewer, Electric Power, Highways & Transportation and Ports authorities, including their governing structures; and (k) develop and implement industrial policy over the long term to foster investment and promote economic growth.

I am worried the government is trying to postpone the inevitable.

“There is evidence that policymakers are often reluctant to restructure their debts and sub-optimally postpone unavoidable defaults. Delayed defaults can lead to the destruction of value because a prolonged pre-default crisis may reduce a country’s capacity and willingness to pay. Its capacity to pay is reduced because procrastination prolongs the climate of uncertainty, high interest rates and restrictive fiscal policies that are ineffective in avoiding default but amplify output contractions. Delayed defaults reduce its willingness to pay because electors that have suffered long periods of economic austerity are less likely to support a creditor-friendly debt restructuring,” states a report from the Committee on International Economic Policy &Reform.

Advertisements
This entry was posted in analysis and opinion, finance and tagged , . Bookmark the permalink.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s