America’s well-known Atlantic territory, Puerto Rico, is known for its beautiful beaches, year-round sunny weather, and GREAT mojitos (the main Bacardi distillery is just outside of San Juan). What is slowly overwriting these island life features is a mounting debt crisis that’s been going on for years.
Because of over-spending and relying on a possible federal bailout, the Commonwealth is saddled with over $70 billion in debts and recently was denied on constitutional grounds the ability to allow some state agencies to restructure their debts, totaling almost $9 billion. Bondholders, who expect to receive returns on their investments, anticipate that the “decision will ultimately result in a resolution being dragged out over a longer period of time, having the administrative costs incurred eat in to the ultimate recovery … .” Even though the PR government is expected to appeal the ruling, taxpayers in the Commonwealth are on edge.
How Puerto Rico got to the cliff.
There are many factors that have resulted in this ongoing crisis, some by design and others by circumstance*:
- The Jones Act: This law, which prohibits foreign ships from carrying goods between U.S. ports, results in higher costs for Puerto Rico businesses and shipments. Even though PR is much closer to Caribbean nations, PR must have a U.S.-flagged ship to deliver cargo from a U.S. port. It’s protectionism at its best for U.S. shipping and at its worst if you’re a Dominican Republican, Haitian, or British Virgin Islander ship trying to maximize space. It’s not just an issue for PR. Hawaii and Alaska are also against this law.
- High Compliance Costs: For such a small landmass, PR has a mountain of company and labor regulations that increase the cost of doing business. Coupled with higher costs for utilities, firms are disincentivized from hiring new workers and are handcuffed by spending considerably more of their budgets on electricity and water. Though NTU Foundation has not done an extensive amount of research into Puerto Rico’s budget, our sister organization, National Taxpayers Union, has long called for simplifying their tax code.
- Incompetence and/or Corruption: A glaring source of the island’s debt problem is that the government cannot or will not collect on a large portion (up to 44%) of its sales and use taxes. Add in a culture of over-promising benefits and it is little surprise that spending constantly exceeds revenues, adding to an explosion of debt.
- Recession and Slow Recovery: PR’s tax base has been shrinking and aging since 2000. For a population of only 3.7 million in 2012, the loss of a few thousand can mean a significant hit to one’s revenue. The global economic downturn compounded the island’s problems as fewer tourists visited and jobs were lost. Worse still, PR was already in recession when the credit crunch hit, further making budget deficits a permanent fixture.
* This Wikipedia article sums up PR’s debt crisis quite well. Some sources are in Spanish.
What are the implications for a debt default?
Like those discussed when the federal government was shut down and taxpayers were left wondering if Washington, D.C. would figure out how to avoid another credit downgrade, the ramifications are hypothetical but, in this case, it is potentially much more impactful because PR’s population is smaller and therefore economic shocks are spread over fewer people. What could happen:
- Uncertainty Runs Rampant: Already a factor for the PR government, if residents don’t know what to expect in the future, they will prepare for the worst the best they can. This means that firms might not expand because they are not sure if they will get a return on their investment. Why hire additional staff or expand the factory if you can’t expect the economy to grow? Entrepreneurs will also try to mitigate their risk by not opening new businesses, even though they may see a market opportunity. More broadly, local taxpayers may save more and/or divest themselves of traditional financial tools like municipal bonds because they refuse to receive marginal or negative returns. With these groups simultaneously acting to protect their assets and dollars, the economy could plunge into freefall.
- The Vulnerable Suffer the Most: For those who have little or who have invested too much, a default could mean their livelihood. For low-income families, the government might not be able to provide benefits such as welfare and food assistance. The federal government could continue to provide funding for TANF and Medicaid but these programs have state-matching requirements. Suddenly losing public food and medical assistance could be disastrous. The same could go for the elderly. A particularly concerning feature of this situation is who will decide which group will continue to get benefits or by how much everyone must do without.
- Higher Costs: A default would almost certainly mean a downgrade in PR’s credit rating. This would mean that investors would require a higher rate of return (interest rate) if they buy Puerto Rican bonds. The government would then need to determine what they would need to do to achieve those new higher interest rates. Typically, this means either decreasing spending (something it seems the PR government refuses to do) and/or increasing tax revenues (something they seem unwilling to do and incompetent to enforce). Like with greater uncertainty, a lower credit rating will mean the government will have less to do the same.
Options in the short-run.
Including Resident Commissioner Pedro Pierluisi (D-PR), Congress has mulled over some options to temporarily resolve the situation or to absolve PR from the most pressing fiscal issues:
- Permit Chapter 9 Restructuring: Rep. Pierluisi introduced H.R. 870, the Puerto Rico Chapter 9 Uniformity Act, last week to treat Puerto Rico as a state, which would allow PR to restructure its utilities’ and municipalities’ debts. It would accomplish this by expanding the definition of a state in the Tax Code to include the island. The Economist made note of this issue last year in that the U.S. does not have real bankruptcy procedures for territories like it does for states. H.R. 870 would at least partially address the short-term legal grey area but it does not go further to address the overall problem. According to Rep. Pierluisi’s office, the bill itself would not increase federal spending.
- Divert Local Spending to Debt Service: Short of bankruptcy litigation (above and below), PR officials could adopt an austerity agenda. By decreasing spending and paying down the debt in a measured way, the territory would avoid further hits to its credit rating and begin to make real budgetary reforms, potentially paving the way to a more business-friendly climate and growth. With its $28 billion budget, there is certainly room to change priorities in favor of the future.
- Bailout Puerto Rico: Though unclear exactly how it would go about doing so, the federal government could provide PR with a multi-million or –billion dollar cash infusion that would help pay for some obligations and give time for the government to develop a plan to fix the larger problems. It would give bond holders and taxpayers some certainty while taking the immediate pressure off of the territorial government. However, there is no indication that this would accomplish anything besides delay the inevitable. It would potentially add billions to the national debt without a payoff. Like an International Monetary Fund or World Bank loan, the move would come with conditions (like a sustainable financial plan) but there is no guarantee that a bailout would be positive in the long-run.
- Rip the Band-Aid off Now: Puerto Rico could default on its debt now. Counter to some of the factors I list above, a default now could mean short-term loss for long-term gain. A default would likely require federal intervention or negotiating, which would give the PR government more resources and leverage to cut down on its repayment total, as seen in Argentina’s 2010 debt exchange agreement. By doing so now, PR could emerge from financial ruin with a plan for growth, especially if it listens to the concerns of investors, citizens, economists, and government officials. It’s asking a lot of everyone but it’s also an extreme situation.
Options after the crisis.
Like the federal and individual state governments, Puerto Rico has the ability to move away from budget deficits. It will take time and effort but few benefit from the Commonwealth’s financial conditions today and continuing this cycle of deficits and near-defaults is no way to run any municipality, state, territory, or country. Some thoughts going forward:
- Live by or Reform Your Balanced Budget Requirement: Officials are already required to pass a balanced budget (seems funny, right?). The Puerto Rican Constitution says that “the appropriations made for any fiscal year shall not exceed the total revenues estimated for that fiscal year … .” The legislature is obligated to do this but it is up to the Governor to do as he or she sees fit to the final law. It’s clear that the current rules are not working so it would do taxpayers well to shore up BBA requirements and make deficits a thing of the past.
- Eliminate Legal Grey Areas: Either by clearly defining federal bankruptcy rules for territories or admitting Puerto Rico as a state, Americans would benefit from clear legal rules. As far as statehood, measures have been introduced in Congress for years, including Rep. Pierluisi’s H.R. 727, the Puerto Rico Statehood Admission Process Act, which would start the process of admitting Puerto Rico as a state. NTU Foundation estimated that last year’s version of the bill would not significantly increase federal spending (i.e. it would be below $500,000) but the greater implication of admitting PR as a state, including expanding the Senate to include two new Members, would incur a cost of at least $6 million over five years (discounting the current spending of the Resident Commissioner’s office costs).
- Grow Your Tax Base: Inc., a small business and entrepreneurial magazine, posted an AP article detailing how Puerto Rico’s tax environment is not entirely a mess. The island is attracting investment professionals because it does not tax capital gains. Coupled with the lack of federal income taxes (except for withholdings), the policy has netted 500 individuals who specifically voted with their feet in favor of the smaller tax burden. If the government could fix its current tax woes and cut local job-killing regulations, more mainlanders would choose to move there. Note to those favoring sand between their toes: the island does have the equivalent of a state income tax so you’re not getting away scot-free but it could be a relief, especially for you New Yorkers, Californians, and especially Connecticuters. Check out your state’s Tax Freedom Day via the Tax Foundation.
Where we go from here.
Your guess is as good as mine right now. The short-term restructuring bill by Rep. Pierluisi was described as a long-shot and the Puerto Rican government seems to have given up on any internal fixes. This leads to the more dire of possibilities: PR will default or the federal government will bail them out.
For taxpayers, these actions (or lack thereof) are unfortunately familiar and costly. The first eventuality will mean a hit to the overall American credit rating, even if PR emerges with a plan to get its debt under control. The second will mean that too-big-to-fail will expand to municipalities and set a dangerous precedent, making more Detroits and taking more money from your wallets in the form of higher taxes or inflation.
Photo Credit: Wiki Commons (Mtmelendez (capitol), Jack Delano (children)), openclipart (Johnny_automatic)
Update 2-20-15: Additional details were added to clarify that a federal judge in San Juan last week blocked a law that would have allowed some Puerto Rican agendies to restructure their debts. The law was ruled unconstitutional and was not a federal Chapter 9 issue.