It started out innocently enough. By making Puerto Rican bonds triple tax exempt – exempt from taxes on the federal, state and local levels – investors would have a special opportunity and Puerto Rico would be able to borrow money more easily. It sounded like a win-win situation. That’s not how it worked out.
All municipal bonds are exempt from federal income taxes. Municipal bonds that are issued and purchased by investors in the place where they live are exempt from state and local income taxes as well. These bonds are considered triple tax exempt.
Puerto Rico’s bonds are triple tax exempt regardless of where you live. For this reason, they are owned by Americans living throughout the fifty states and have been especially attractive in the mutual fund industry.
The triple tax exempt bonds gave Puerto Rico a competitive advantage. They represented a funding mechanism that no states had, and Puerto Rico took advantage of the bonds’ unique status to fund government operations and debt repayment. It was a special deal for investors, a special deal for the mutual funds who sold them, and a special deal for the U.S. territory of Puerto Rico.
The special status of Puerto Rican bonds helped fuel a lot of lending to Puerto Rico. The triple tax exempt product became an easy source of financing for the U.S. territory. The borrowing grew.
On Sunday, Puerto Rico Governor Alejandro Garcia Padilla said that the large debt amassed through Puerto Rico bonds was simply “not payable.” The party was over.
The current problem was caused by Puerto Rico’s overborrowing, which was made possible by the federal government’s special tax treatment of Puerto Rico bonds. In fact, much of Puerto Rico’s economic development and hoped-for-but-unachieved growth has been premised on special federal tax breaks. The expiration of a manufacturing tax (Section 936) has not stopped U.S. based companies from taking advantage of Puerto Rico’s treatment as a foreign country under the Internal Revenue Code — with no apparent benefit to Puerto Rican workers or Puerto Rico generally while remaining profitable for companies. A rum tax that was supposed to be a source of funding for Puerto Rico’s infrastructure is now redirected to the bottom line of rum companies.
Special tax treatment in Puerto Rico doesn’t seem to work.
What next? Perhaps a new approach is worth trying – an opposite approach that would expand federal laws that don’t currently apply to the people of Puerto Rico, who are U.S. citizens. Rather than providing “special treatment” that hasn’t worked, federal policy could call for equal treatment. Inclusion in Chapter 9 of the bankruptcy code – which enables municipalities to qualify for bankruptcy protection — could be a place to start. Other federal policy that has achieved success in the states but is unavailable to Puerto Rico involves refundable tax credits, such as the Earned Income Tax Credit and Child Tax Credit.
Puerto Rico’s problems are deep and multi-faceted. They will require a wide range of solutions. The special treatment of Puerto Rico, especially under tax law, seems to have run its course. Perhaps it is time for equality.