How the Tax Cut Sacks Puerto Rico

GDA via AP Images

Hooked on Drugmakers: For decades, tax favoritism—now withdrawn—brought pharmaceutical companies to the island and provided manufacturing jobs at well below mainland wages. 

This article appears in the Summer 2018 issue of The American Prospect magazine. Subscribe here

In keeping with the anti-Latino posture of the Trump administration, Puerto Rico has been subjected to a double policy assault on top of the natural disaster of Hurricane Maria. First, FEMA has failed dismally to respond to the human suffering and nearly $100 billion in damage from the hurricane, a display of both low priority and sheer incompetence that never would have been tolerated in a mainland state such as Florida where citizens can vote. Recent research suggests that the actual death toll caused by the hurricane could be more than 70 times the figure put out by the Puerto Rican government.

And now, in the 2017 Republican Tax Act, the Republican Congress has added to Puerto Rico’s misery. It has undermined artificial tax benefits that have served as partial economic compensation for Puerto Rico’s odd political status as a quasi-colony. Puerto Ricans are U.S. citizens, with partial home rule, but can’t vote for president or for voting representation in Congress. While the commonwealth has its own constitution and locally elected government, Congress retains the ability to revise all aspects of law and policy on the island.

Two new provisions in the Tax Act, of which more shortly, are likely to undercut future investment in major industries in Puerto Rico, including its manufacturing sector, the island’s economic backbone. Despite public and private lobbying efforts from Puerto Rico, Republicans in Congress failed to shield them from these harmful provisions.

The island lacks the autonomy to deal with the weight of its crushing public debt; its sputtering economy remains indentured to foreign and U.S. corporations after a century of learned dependence stemming from the trickle-down piety of politicians in Washington and in San Juan. Lost in the winds of Donald Trump’s protectionist hurricane, Puerto Rico once again finds itself on the outside looking in on the country it pledges allegiance to.

 

THE UNITED STATES acquired Puerto Rico from Spain in 1898 in the aftermath of the Spanish-American War. For nearly five decades, the territory was largely without self-governance. The U.S. president appointed the island’s governors, attorneys general, and justices of its Supreme Court. Even after the 1952 federal ratification of a Puerto Rican constitution, which imparted a new “Commonwealth” label on the island and allowed it the autonomy to deal with local affairs, the island was still legally considered a territory and therefore ultimately under the control of Congress.

Special tax breaks for the island began in its earliest days as a way to subsidize the sugar industry, and then in the mid-20th century as a way to bring low-wage manufacturing to Puerto Rico, often at the expense of local business and the Puerto Rican consumer. Those breaks, which served as an artificial prop, were gradually phased out by the U.S. Congress, leaving the island to rely on local sweetheart corporate tax rates to draw investment. But the new Tax Act undermines this last economic lifeline by raising the price of doing business on the island through new taxes and making investment on the mainland more attractive.

The Foraker Act of 1900 was the first major legislative overhaul of Puerto Rico’s institutions, structuring the island’s economy largely around the needs of sugar refineries and other large corporations extracting raw materials from the territory. In fact, the first U.S.-appointed civilian governor of Puerto Rico became president of the American Sugar Refining Company, the largest sugar refinery in the country, which by 1907 controlled 98 percent of national sugar production.

Under the Foraker Act, companies received relief from various excise taxes (the federal income tax would not be constitutionally legalized until 1913) and, after two years, companies were able to import from and export to the island duty-free. Thanks to a Supreme Court ruling in 1901 allowing for the implementation of non-uniform tax laws in territories like Puerto Rico, Congress could treat the island as a foreign entity for purposes of taxation—a status that would have swiftly been judged unconstitutional in any U.S. state, but continues to this day.

For nearly half a century, Puerto Rico effectively served as a sugar plantation for mainland corporations. The territory was brimming with industry, but little of it belonged to the local people. Sugar giants received more than a 110 percent rate of return in annual dividends on investments over the years. But that wealth largely did not benefit islanders, the majority of whom were landless and lived well under the poverty level.

By the end of the 1940s, faced with a declining agrarian economy, Puerto Rican politicians decided that economic development required further embracing its role as a tax haven for U.S. firms. In 1948, Puerto Rico’s first popularly elected governor, Luis Muñoz Marín, worked to pass a tax overhaul on the island, called Operación Manos a la Obra (“Operation Bootstrap”). Bootstrap aimed to use a series of tax exemptions and economic subsidies for U.S. corporations as a vehicle to industrialize the island.

Between 1950 and 1980, disposable personal income spiked and educational attainment increased, with the average years of schooling of Puerto Ricans more than doubling. Yet at the same time, unemployment rose and labor participation rates fell, stimulating more migration to the mainland. While Puerto Rico celebrated near double-digit annual gains in output and a sprouting manufacturing industry, its public debt ballooned.

In 1976, Congress added more tax incentives for U.S.-based manufacturers opening plants in Puerto Rico, allowing them to repatriate their profits at a special rate. Many of the pharmaceutical giants of the day, including Johnson & Johnson and Glaxo-SmithKline, launched major manufacturing ventures on the island.

This new model of economic expansion through corporate courtship provided a shackled sort of salvation for Puerto Rico, binding the commonwealth to fleeting corporate investment. But in 1996, Congress ordered a ten-year phase-out of major federal tax breaks for manufacturers. By 2014, the number of manufacturing jobs on the island had dropped by almost half. The island’s unemployment rate, which over the years grew as high as double the average rate on the mainland, drove more than half a million Puerto Rico residents to leave the island between 2006 and 2016, shrinking an already narrow tax base.

Unable to restructure its debt because of its status as a territory, a bankrupt Puerto Rico is forced to answer to a federally appointed fiscal oversight board that is pushing for austerity cuts to the island’s social safety net. Which brings us to present day and the Republican Tax Act.

 

IN THE TAX ACT, WHICH otherwise drastically cut corporate taxes, Congress included an offset that provided a tax on foreign firms owned by U.S. investors that might evade U.S. taxation altogether. This provision targets income from “intangible” assets such as patents, trademarks, and copyrights—the basis for much of the income in industries such as pharmaceuticals and medical devices, on which Puerto Rico has been heavily reliant. Were Puerto Rico not considered “foreign” for tax purposes, this provision would not bite. It has no impact on the 50 states. But it seriously harms Puerto Rico.

The new tax on Global Intangible Low-Taxed Income (abbreviated in a bad pun, GILTI) was proposed as a way to target profitable firms created by U.S. investors but based abroad, known as controlled foreign corporations. Before the tax overhaul, any income generated by such U.S.-based corporations in Puerto Rico was subject to a mere 4 percent corporate tax. Company profits would only become subject to U.S. corporate rates once they were distributed back to an owner or shareholders stateside. Under the new framework, however, any profits that exceed 10 percent of a company’s hard assets (plant, equipment, furniture, computers, etc.) are subject to a much higher U.S. corporate tax rate, whether dividends are sent back to the mainland or not.

This is bad news for companies doing business on the island. Patent-dependent sectors like pharmaceuticals and medical equipment and supplies account for nearly 35 percent of the total employment in manufacturing. Pharmaceutical companies alone employ approximately 90,000 Puerto Rico residents. Other industries like international insurance and financial services will also likely be forced to leave the island because of GILTI.

But the tax bill doesn’t just raise the cost of operating in Puerto Rico; it also makes huge cuts to the corporate tax rate on the mainland. That shrinkage in the gap between the two effective tax rates will stymie future investment on the island, according to José Villamil, CEO and chairman of Estudios Técnicos, an economic consulting firm in San Juan.

“The gap is not sufficient to compensate for the new tax [on GILTI] that many of these companies will have to pay or for the extra cost of electricity and the risk factor that is entailed in establishing themselves in Puerto Rico after [Hurricane] Maria,” says Villamil. “I think we’re looking at a situation where Puerto Rico has now lost its competitive advantage from tax policy.”

An early analysis of the tax bill conducted by Estudios Técnicos found that it would likely lead to a gradual erosion of the number of plants operated by U.S.-based corporations in the manufacturing sector and a drop in expansions and new investment. Such corporations make up the majority of Puerto Rico’s manufacturing sector and account for more than $2 billion in the island’s tax revenue.

Included in the tax reform is a shift from a global system of taxation to a territorial system, including new anti-abuse rules and a base erosion and anti-abuse tax (BEAT). Whereas GILTI is exclusively concerned with income generated in foreign jurisdictions, BEAT is focused on payments by domestic corporations to foreign entities.

BEAT is essentially an alternative minimum tax. It adds back to taxable income certain otherwise deductible payments made to nominally foreign subsidiaries. If, after considering deductions and depreciation for amounts paid to related foreign subsidiaries, the tax paid is less than a set amount (5 percent this year, then 10 percent through 2025, and 12.5 percent thereafter), the firm pays the difference. Most importantly for Puerto Rico, foreign tax credits (excluding credits for research and development) cannot be used to reduce a corporation’s BEAT liability. So while a medical device manufacturing company with multiple manufacturing plants in Puerto Rico may be able to avoid paying much tax on its GILTI due to its hard assets, it will still have to contend with BEAT.

BEAT and GILTI were both drafted partly as offsets to the net impact on corporate taxation, which amounts to a huge corporate giveaway, and also as means to encourage more domestic investment. But because of its anomalous status as a foreign jurisdiction, Puerto Rico now finds itself competing against countries like Ireland and Singapore for investment, rather than states like Ohio and Wisconsin.

Although the specifics of the legislation remained in constant flux until the very end, the risks in the tax bill were well understood by public and private leaders in Puerto Rico. Lobbyists from Puerto Rico descended upon the Capitol after the House and Senate released drafts of their versions of the tax bill in late October 2017. In the Senate bill, there was the aforementioned GILTI tax. The House counterpart had a 20 percent excise tax on intercompany sales.

The House provision consumed much of the focus of lobbying efforts early on, according to Carlos Mercader, the executive director of the Puerto Rico Federal Affairs Administration in Washington. It was ultimately killed during House-Senate conference, but the Senate provision remained intact. The provision was one of many forged in line with the “America First” rhetoric of the president and Republican members of Congress. Efforts to dislodge it were met with polite rejections.

GILTI received significant support from Republicans from states with large manufacturing sectors, according to sources involved in the lobbying of congressional offices. For Republicans seemingly sympathetic to Puerto Rico’s plight, such as Florida Senator Marco Rubio, subjecting the island to new taxes just months after it was ravaged by a hurricane was a travesty. But reopening this provision at the final stage of the drafting process risked sinking the entire bill, which already sat on a knife’s edge as various factions within the GOPworked to find a version that could get 51 votes. A Puerto Rico–only or territory-and-commonwealth-only exclusion clause would have created a new sticking point.

Puerto Rico’s lack of representation in Congress made a key difference. The island’s congressional presence is limited to lobbying efforts by a single elected non-voting House delegate, Jenniffer González-Colón. Unlike Senators Lisa Murkowski, Jeff Flake, and Susan Collins, who were able to hold out on the legislation until their concerns were met, Puerto Rico had no voting member to champion their interests. If Puerto Rico had two voting senators, the outcome could have been entirely different.

In a year-end interview with reporters, Rubio rejected the concern that the new provisions might harm Puerto Rico: “We’ve not heard from a single company, and in fact, every one of these entities involved in Puerto Rico has told us they’re in favor of the tax bill.”

The Florida senator was right that many entities on the island supported the bill, but he was wrong to assume that support means the bill won’t harm Puerto Rico. Companies have already begun to consider refocusing their manufacturing activities on the mainland, where there are no damages to vital infrastructure from the hurricane, no savage cuts in basic services, and new lowered corporate taxes that wipe out Puerto Rico’s tax advantage.

In April, pharma giant Amgen announced that it had chosen Rhode Island as the location for its new $165 million biopharmaceutical plant. The company, whose largest manufacturing plant is currently in Puerto Rico, credited the lower effective tax rate from the Republican overhaul for its decision to locate stateside. “Following U.S. federal tax reform, which provides company incentives to invest in innovation and advanced technologies, the decision was made to locate the new plant in the United States,” says an Amgen spokesperson, repeating the misstatement that Puerto Rico is not part of the United States. She adds, “As Amgen’s largest manufacturing site, we remain committed to Amgen Puerto Rico.”

Puerto Rico’s Private Sector Coalition was united in opposition to these tax changes. Notably absent from the private-sector opposition, however, was the full weight of many large multinational biotech and pharmaceutical firms operating in Puerto Rico, such as Johnson & Johnson and Medtronic, according to a source with direct knowledge.

These multinational corporations stood to gain more from the benefits included in the tax bill—in particular the lowered 15.5 percent repatriation rate on cash held outside of the country—than they would lose from the new taxes on their operations in the commonwealth of Puerto Rico and other U.S. territories. This is likely the real reason Rubio didn’t hear much outcry from large firms.

A Credit Suisse report released in November found that U.S. biotech and pharmaceutical companies make up a third of the top 30 American companies with the most cash stashed overseas, totaling close to $150 billion. Neither Johnson & Johnson nor Medtronic provided comment for this article.

“That’s the sort of decision we’re going to see more of in the future,” says Villamil of Estudios Técnicos, who has already heard reports of other companies considering similar decisions. One passing comment an industry contact made to Villamil is particularly telling: “Twenty years ago, you had to go to your company’s board and explain why you were not in Puerto Rico. Now, you have to go to the board and explain why you would want to be in Puerto Rico.”

The prevailing narrative for more than a century has been that the United States has already been too generous to the commonwealth. It was there in 1900 when Senator J.B. Foraker, nearly three weeks after the passing of his eponymous bill, declared that “no such favor has ever been shown to any other people for whom we have legislated.” It was there in 1909 when President William Howard Taft told Congress that Puerto Rican residents had “forgotten the generosity of the United States in its dealings with them” after the island’s House of Delegates obstructed an appropriations bill. And, most recently, it was there when Trump told Puerto Rico residents in October that they were “throwing [the U.S.] budget a little out of whack.”

“We’ve spent a lot of money in Puerto Rico,” said Trump a few months before signing an estimated $1.5 trillion tax-cut handout to Wall Street and U.S. corporations. Trump has doubled down on the misleading narrative that Puerto Rico should be thankful for what it has, that it is undeserving, and that its crisis is entirely of its own making.

The commonwealth’s situation remains dire and its needs in Washington are urgent. But it will have to wait for any tax relief. The slow slicing of the island’s economy, sped up by the Republican Tax Act, raises familiar and uncomfortable questions about the relationship between legislators in Washington and the nearly 3.4 million people living in Puerto Rico that last surfaced during the U.S. government’s mismanagement of relief efforts following Hurricane Maria: Where does Puerto Rico fit into America?  

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