Puerto Rico’s VAT: A Path Forward?

Last week, I detailed the potentially catastrophic problem facing Puerto Ricans and their territorial government. As it stands right now, the island is sinking in over $70 billion in debt and was not permitted to restructure almost $9 billion in local utilities debts on constitutional grounds. Now local and federal legislators are trying to figure out what to do in short order. If they fail to find a timely solution, PR risks defaulting, which then would call into question what the U.S. government is legally able to do to assist (because of PR’s status as a territory, not a state).

The reasons for why Puerto Rico got into this mess are many and also highlighted in my post but all is not lost yet. One proposal by local politicians may be able to right the sinking ship, thereby saving residents and all U.S. taxpayers some serious headache. However, what would this new plan do and how would it affect taxpayers?

According to KPMG, an audit, tax, and advisory firm, the Commonwealth’s House of Representatives is considering a bill that would “effectively repeal and replace the tax code in Puerto Rico.” H.B. 2329 could be one of the most comprehensive tax reforms enacted to date on a state or territorial level. In short, the bill would change the income tax system to one based on consumption.

As opposed to a pure consumption tax (like the state sales taxes you pay at cash registers or on your online purchases) or a system like the Fair Tax (which NTU Foundation highlighted in a recent issue of The Taxpayer’s Tab), PR would have a Value-Added Tax (VAT). A VAT taxes buyers according to the final sale price of a good; sellers pay a percentage of the difference between the cost to produce and ultimately distribute the good. At each point of transfer between producers and consumers, the value of the product changes and affects the final sale price. A VAT attempts to collect a certain percentage of that change. The European Union has a VAT system, which, for better or economic worse, is functional on a large scale.

The Details

I’ve broken down the implications of H.B. 2329 below and with the help of posts by Gavin Ekins at the Tax Foundation and that of KPMG:

  • What’s Eliminated: Most of the typical exemptions, exclusions, and preferential tools (credits) would no longer apply. However, there are a number of exempted products that remain. Rates for individuals and businesses would also decrease as, at least in theory, the tax base and individual tax transactions would increase under a VAT system. A $40,000 exemption for individuals ($80,000 for joint filers) would be instituted.
  • What’s Amended: Though minimal right now, Puerto Rican capital gains taxes (as well as those on dividends) would increase to 30%. Right now both are under special treatment and are exempted. The sales tax system would remain but would be expanded to include additional calculations for different products.
  • What’s New: Even though similar systems are used by other countries, this will be the first real use of a VAT system in the United States. As Ekins wrote, “the bill could provide a test case for the viability of a VAT in the [U.S.]. … Although it seems that the bill will pass, the Puerto Rican government still has the task of educating the public on the new taxes.”
  • The Timeline: If enacted this year, the VAT system would go into effect on January 1st, 2016 in two stages. Until April 1st, consumers would pay a 7% VAT, which would eventually increase to 16% within a year. This gradual implementation is designed to ease the transition for taxpayers from the old system and to allow for goods and services to move their way through the supply chain.

The Benefits

Change Can Be Good: A key issue PR has had is being able to collect its local taxes effectively and efficiently. An article from Caribbean Business said that the PR “government is estimated to take in about 56% of tax revenue that it should be collecting, losing about $800 million annually.” By changing to a new collection regime, the government could (emphasis on “could” given how inefficient the current system is) get a leg up and collect more of what it is owed. It also is possible that tax avoiders would be forced to pay some revenues, at least until they figure out how to circumvent the VAT.

Living Simply: The measure also attempts to simplify and streamline what is exempted and what is not (though read: The Concerns). The 500 or so investors that have moved down to the tropical island because of no capital gains taxes did not convince enough people to move down there to make up for either the population loss that has plagued PR for at least a decade or to make up the loss in tax revenue of those who left. Bringing these likely higher-income folks into the fold makes economic sense but it is also imposing new taxes. The VAT rate also is uniform so figuring out what you owe should be easier than the current system. This could potentially help when compliance costs are concerned.

The Concerns

There are many but I’ll try to keep it light:

  • Change is Scary: The local government, tax collectors, and taxpayers will be living through a new way to not only tax a U.S. population but how to think about taxes. This shift could help put PR on the path to prosperity but the odds are not in their favor. With a massive debt and still-decreasing population, uncertainty about a new tax system is high.
  • New Costs: A VAT system is complicated, possibly more so than the current income-based one. If legislators are concerned about making costs for implementation, enforcement, and maintenance go down, it’s unclear that the new system would be the solution. It is especially concerning that a government that is unable to collect on an established tax system now could be required to track many more transactions and tax-eligible actors.
  • Potential For Abuse Still Exists: Even with many credits eliminated, there are still 14 large exemptions that constitute billions in potential revenues. Plus, the system still lacks effective enforcement that would help stave off abuses by politicians (increasing overall or targeted rates) and non-compliant offenders (besides traditional investigations). This is where a regular sales tax could be more efficient.
  • Tax Reform Isn’t Government Reform: A VAT is only one piece in the overall reform puzzle. The territorial government continues to produce budget deficits, add regulations to the books, and rest in a legal grey area with the federal government. This is a first step, but let’s see many, many more.

As a former NTU Foundation staffer always said, “time will tell” when tax reform is concerned.

Photo Credits: Bond Buyer, imgbuddy.com, wiki commons