Puerto Rico and Section 936: A Taxing Lesson from History

The U.S. general election kicked off this week, and that means we’re going to be hearing about a lot of tax proposals—some good, others very bad—from House, Senate, and Presidential hopefuls. While the Puerto Rican debt crisis has taken a back seat in politics due to political conventions and a contentious presidential race, there is some talk in tax circles about resurrecting a lucrative business-friendly tax benefit centered on the island: Section 936. This is a bad idea.

Also known as the Possession Tax Credit, Section 936 was a provision in our tax code enacted in 1976 ostensibly to encourage business investment in Puerto Rico and other U.S. possessions. Congress voted to phase out Section 936 in 1996, citing excessive cost and the very limited number of U.S. companies that received the tax break. In 2006, the phase-out was completed.

Section 936 worked by exempting from federal income tax profits earned by U.S. companies in Puerto Rico and other possessions (under certain conditions). Corporations were quick to set up subsidiaries in Puerto Rico, and massive tax-dodging and profit shifting soon followed.

Over the 30 year lifespan of Section 936, companies shifted billions in corporate income to their Puerto Rican subsidiaries to receive partial or full exemption from federal taxes. In the 80s, corporations had an estimated total of $8.5 billion in tax savings and, in 1987 alone, these profit shifting activities are estimated to have cost the Treasury Department $2.33 billion in revenues. In 1998, during the phase-out period of the credit and when corporations were significantly disinvesting in Puerto Rico, six companies had a total of $912 million in tax breaks thanks to Section 936.

Even while the credit reduced corporate tax bills, Puerto Ricans did not see a proportional benefit. In fact, Puerto Rico soon found itself stuck with the “finance curse,” which occurs when a nation’s political and economic institutions are increasingly oriented towards and co-opted by wealthy international elites to the detriment of its people.

This is evidenced by the discrepancies between corporate investment in Puerto Rico and the development of the island. Despite some economic growth, Puerto Rican per capita income remained less than 30 percent of the U.S. average and local unemployment remained more than double the mainland’s rate. Meanwhile, the firms located on the island enjoyed large profits and low tax bills. Pharmaceutical companies, by far the biggest beneficiaries of Section 936, enjoyed a $70,788 tax break per employee on the island in 1987. In general, when faced with the decision to make investments that maximized profits or promoted Puerto Rican development, firms overwhelmingly chose to pursue the former, eventually convincing the U.S. Congress that the costs of Section 936 greatly outweighed its benefits.

The possibility that Puerto Rico would suffer greatly from the finance curse was inherent from its beginning as a commonwealth. In 1952, Puerto Rico’s constitution was ratified. It included a severely shortsighted provision. Section 8 of Article 6 requires that the Puerto Rican government must make payments to reduce its public debt before paying any other expenses, including the funding of basic public services. From the start, economic institutions were working against the people of Puerto Rico.

Despite Section 936’s shortcomings, some U.S. legislators, backed by corporate lobbyists, are considering reenacting it. They argue that such a step is necessary in light of Puerto Rico’s current debt crisis. But such a step would be like putting a Band-Aid on a bullet wound with the bullet still inside the body. It may look nice from the outside, but the heart of the problem is merely covered up.

There are much better policy solutions to Puerto Rico’s debt crisis that will create sustainable growth. One option would be for the U.S. to expand the Earned Income Tax Credit (EITC) to include Puerto Rico, which it currently does not. Expanding the EITC in this way could encourage low-income and out-of-work Puerto Ricans to enter the labor force and help Puerto Rican businesses through higher demand for their products and services.

More broadly, Puerto Rico needs to embrace public investments, not new corporate tax breaks, as the best way toward economic development. To this end, the U.S. government needs to give Puerto Rico the ability to fully fund critical public investments rather than subjecting it to continued austerity policies to satisfy U.S. hedge funds and other wealthy investors that have bought Puerto Rican bonds cheaply and hope for a windfall if the bonds are redeemed at their face value.

Repealing the Possession Tax Credit was one of the few corporate tax-reform achievements in the 1990s. Bringing it back would be an expensive move in exactly the wrong direction.

Aaron Mendelson, a CTJ intern, contributed to this report.