Origins of the Puerto Rico Fiscal Crisis

Marc D. Joffe and Jesse Martinez of Mercatus Research have released a report called “Origins of the Puerto Rico Fiscal Crisis” explaining that the current debt crisis is “the unintended consequence of a series of policy decisions extending back to the US takeover of the island in 1898.”

“Rather than placing Puerto Rico on a path to statehood,” the authors say, “Congress imposed a series of unique governing structures on the island.” These structures, which were different from those of the States, created the environment which made the current problems possible and even probable.

The report begins with a recounting of Puerto Rico’s history as a colony of Spain and then a territory of the United states, pointing out that Hawai’i, acquired at the same time as Puerto Rico, had an elected government and U.S. citizenship at a time when Puerto Rico had federally appointed governors. Puerto Rico gained citizenship and greater local autonomy, including a locally elected government, but heavy borrowing had become a pattern before either of these accomplishments.

In 1913, four years before Puerto Rico gained U.S. citizenship, federally-appointed governors had already racked up $5,800,000 in debt for Puerto Rico’s government and more especially its public works such as utilities. By 1931, the debt stood at $49,100,000. Puerto Rico gained more autonomy in government over the years, and continued to borrow. Attempts to limit borrowing failed for various reasons, and by 1982 economist Tosporn Chotigeat was among those sounding a warning about Puerto Rico’s debt.

He pointed out that new money was being borrowed to service old debt, that the pay off times for the debts were very long, and that the debt was held outside of Puerto Rico, so that money was always flowing off the Island to service the debt, rather than being spent on the Island to create jobs and improve the infrastructure. Chotigeat’s concerns and predictions have proven to be prescient.

In 1984, Congress took Chapter 9 bankruptcy protection away from Puerto Rico, which had previously been treated like a State in the bankruptcy code. “The language apparently received little thought at the time,” the authors say, noting that there is no record of any debate on the change,  “perhaps due to Puerto Rico’s lack of a representative with voting power in Congress.”

In 2006, the phase out of Section 936 of the Internal Revenue Code, which had exempted corporations from many taxes on businesses in Puerto Rico, ended a long period of tax exemptions (since 1921) which had brought revenue to Puerto Rico even though they didn’t lead to sustainable prosperity. This was just the last in a long string of Congressional decisions which contributed to the debt crisis in Puerto Rico.

The authors then consider the question of financial management. While self-righteous media characterization of Puerto Rico’s government as irresponsible spendthrifts clearly would have to include not just the current government but the federally-appointed governors of the 19th and early 20th centuries, the report does agree that they see a “widespread breakdown in auditing discipline across Puerto Rico’s public sector.”

Puerto Rico has millions of dollars in unfunded pension obligations, poor management and inefficiencies throughout the public sector, and a tradition of government open-handedness that is hard for elected officials to end. In a summary of the central problems, the authors describe the situation like this:

Puerto Rico’s public sector has amassed an unsustainable level of bonded debt and pension obligations. As we’ve seen in the historical survey, the commonwealth lacks structures that effectively restrain debt accumulation. Furthermore, because the commonwealth government has relied heavily on bond proceeds and federal subsidies, political leaders lack incentives to balance taxation and expenditures. The electorate receives benefits from government expenditures that exceed the taxes it contributes, so officials who take steps to promote fiscal sustainability are unlikely to maintain political support.

Puerto Rico’s situation has been compared to that of Greece and Detroit, but the authors of this report compare it instead to that of Newfoundland, which found itself in similarly tough financial straits while it was still a British colony. The U.K. and Canada banded together to provide a bailout for Newfoundland, replacing the elected government with a fiscal control board of sorts and eventually — after 15 years — got Newfoundland back on its feet. Newfoundland became a Province of Canada, much the same thing a being a State of the U.S., and started afresh with an elected governor and a financial surplus.

“Had Puerto Rico been treated like Hawaii—a territory taken over by the US in the same time frame—it would have attained statehood and
probably avoided its current troubles,” the authors say. They further suggest that a strong fiscal control board with authority to restructure debt could solve the current problem.

However, they also warn that Puerto Rico can’t be put on its feet again and left with the “bespoke” government style it currently has. The authors recommend either statehood or independence for Puerto Rico. If the U.S. refuses to allow either of these options, the report says, then Puerto Rico’s government and constitution should be revamped in a system that has shown it can work well — that of the States, the authors suggest.

Read the full report.

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