Decades of debt: The Puerto Rico fiscal crisis
The drama surrounding Puerto Rico this year has been centered on the debt crisis, with politicians on the island and in the mainland United States calling for immediate action. While concern has escalated quickly, the fundamental problems that provoked the debt crisis have been unaddressed for decades – from the exodus of the diaspora and overspending by Puerto Rican officials to the island’s troubles with tax collection.
These factors have led to the standoff the island finds itself in now, in which some of the debt has become untenable and action, in some form, by the U.S. government appears inevitable. With the debate ramping up, it’s important to understand how Puerto Rico got to this place.
The problems for Puerto Rico, a semi-autonomous territory of the United States, began accelerating in 2006. A fiscal crisis hit the island when a preferential tax credit allowed by Congress for mainland U.S. corporations that manufactured on the island expired. Since 2006 the island has massively ramped up debt issuance in the municipal bond market to make up for low tax collections and has done little to reduce government spending. Puerto Rico politicians of both parties have put off the hard choices of matching spending to revenues, and now the island is bankrupt.
Adding to the fiscal crisis has been a substantial out-migration to the mainland. The island had seen enormous population growth since it was acquired by the U.S. in 1898, but since 2005, many Puerto Ricans, who are full U.S. citizens and can relocate to the mainland without restrictions, have chosen to move to the U.S. This out-migration has hurt the Puerto Rico’s tax revenue, furthering the debt crisis.
Puerto Rico’s central government
The U.S. Congress approved Puerto Rico’s Constitution in 1952 and created a central government with three branches: the executive branch led by an elected governor, a bicameral legislature and the judiciary. In doing this, it also gave Puerto Rico broad power over its own affairs, which would later allow the debt crisis to intensify unchecked.
Unlike mainland states, Puerto Rico’s central government is responsible for almost all social services, including primary and secondary education, police services, corrections and the island’s electric and water utilities.
The island currently receives substantial funds from the federal government. This includes over $7 billion in direct grants to the island’s central government and municipalities and $17 billion in transfer payments to individuals via Medicare, Social Security and other federal programs. Federal funds account for approximately 24 percent ($24 billion) of the island’s gross domestic product. While the U.S. Congress is responsible for oversight of the funds, it has not been active in earmarking spending outside of specific federal programs.
Puerto Rico’s central government has a consolidated budget of $27 billion, funded through general revenue from tax collections, federal funds and public enterprise revenue (water and electricity fees).
Puerto Rico tax collections
Like mainland states, Puerto Rico has authority to levy and collect taxes. Unlike mainland states, Puerto Rico residents and businesses are exempt from paying federal income taxes on income earned on the island, but citizens do pay Social Security and Medicare taxes.
Puerto Rico has substantially lower tax rates and collects fewer taxes than any Organisation for Economic Co-operation and Development countries, according to a report from KPMG commissioned by the Puerto Rico Treasury.
In addition to lower tax rates, Puerto Rico has historically had a significant problem with tax compliance. KPMG estimated that the government collects about 56 percent of taxes due on average, and recommended making an effort to collect 75 percent of taxes due, more in line with other taxing authorities.
This persistent shortfall in tax compliance has substantially contributed to Puerto Rico’s fiscal problems as it continuously issued debt over several decades rather than increasing tax collections.
U.S. Sen. Orrin Hatch from Utah has raised the issue of the island being a tax haven for U.S. citizens to shelter their personal and corporate income through Puerto Rico’s Act 20 and 22. It’s likely that Congress will examine this issue more closely as it devises a framework to assist Puerto Rico.
The largest source of central government revenue is the individual income tax followed by Act 154 revenues, which U.S. companies operating in Puerto Rico pay to the central government. Act 154 taxes, paid mostly by 28 U.S. corporations, are credited by the U.S. Treasury when these corporations pay federal taxes. Act 154 taxes are considered a form of backdoor bailout by the federal government for Puerto Rico, because these corporate income taxes should be paid to the U.S. Treasury rather than the Puerto Rico Treasury.
Central government spending
Puerto Rico’s central government general fund allocates money to education, health care, pensions, police, corrections, debt service and subsidies to the University of Puerto Rico. Many of these spending categories also receive federal funds.
Puerto Rico has made some reductions in central government spending in the last fiscal year but has not materially reduced the number of employees working for the government, the major cost in the central government budget. This drives up the island’s deficit.
Public school enrollment, for example, dropped 8 percent this year but the Department of Education has not reduced its number of teachers and recently announced that it would be moving 800 employees from the central education office into schools rather than downsizing. At an average 12.9 students per classroom, Puerto Rico has the lowest student-to-teacher ratio in America, versus a national average of 16.
Unfortunately, test scores in Puerto Rico rank far below the worst mainland state.
Several Puerto Rican legislators recently proposed early retirement for 5,000 teachers but it is unclear how this would be funded, as the island’s pension systems have few assets.
Puerto Rico’s debt
Puerto Rico has 17 types of debt with varying sources of repayment and legal security. There is currently $72 billion of debt outstanding, or approximately 70 percent of the GDP, which is generally considered sustainable. The Puerto Rico government nevertheless has a problem servicing the debt because it refuses to downsize the government or collect more tax revenue.
Puerto Rico debt that is repaid by the central government (excluding the electric utility PREPA and water utility PRASA) has exploded since 2000. Puerto Rico’s Constitution limits how much debt can be issued, so other types of debt were developed to circumvent those limitations. These debt types are classified as sales tax debt (COFINA), non-tax-supported debt, and appropriated debt, which requires the Puerto Rico Legislature to specifically allocate funds for debt repayment from the general fund.
Meanwhile, Puerto Rico has no legal framework to force bondholders to take reduced repayment for debt (known as haircuts). Last summer the Legislature passed legislation to create a framework for restructuring its public enterprise debt but this was quickly and successfully overturned by bondholders in federal court. The government appealed this decision and was struck down again. Now the Puerto Rico Justice Department has requested the U.S. Supreme Court hear the case to reverse the Appeals Court decision. Whether the Supreme Court will take the case will be known in the next two months.
Puerto Rico debt was issued in the U.S. municipal market and is governed by rules established by the Securities and Exchange Commission and the Municipal Securities Rulemaking Board. All bond documents are in English. This is a cause for concern, since the majority of Puerto Ricans speak only Spanish, so even if they wanted to learn more about the island’s debt they would have to have the documents translated.
Government liquidity and ability to repay
Through its advisers, the Puerto Rico government has made conflicting statements about its cash liquidity and ability to make debt payments this fiscal year. Sales tax revenues have been increasing and the Legislature created numerous reserves that can be allocated to service debt if necessary.
Large debt payments due on Dec. 1 and Jan. 1 will likely be challenging for the government. This liquidity squeeze will likely be used to attempt to force losses on bondholders.
Appropriated debt has the weakest security of the debt types and bondholders essentially have no recourse to force repayment. The Legislature did not appropriate funds for Public Finance Corporation debt in the fiscal year 2016 budget and the government defaulted on this debt on Aug. 1. All other 16 classes of Puerto Rico debt has been repaid on time to this point.
Puerto Rico debt service for fiscal year 2016 includes $1.6 billion of appropriated debt that should be defaulted on if Puerto Rico runs out of cash. The legal security on appropriated debt is weak and the bonds trade at the lowest prices in the debt structure.
The largest part of the appropriated debt was issued by the Puerto Rico Government Development Bank. The GDB is the fiscal agent (or bank) for the Puerto Rico government and has been insolvent for several years. The GDB gave loans to other parts of the Puerto Rico government, some of which cannot be repaid, which means the GDB cannot repay the money it borrowed and is bankrupt.
Recent Puerto Rico news reports suggest that the island’s advisers are negotiating a 15 percent haircut on GDB debt and extending principal and interest payments for five years. This action alone would free up substantial cash for the government and provide sufficient liquidity to repay most other classes of legally secure debt (COFINA and general obligation) on schedule. Recent negotiations between the GDB and some hedge funds broke down recently.
Defaulting on GDB and other appropriated debt would leave cash available to pay more legally secure debt, including constitutionally guaranteed general obligation and sales tax (COFINA) bonds which have substantial legal protections. A restructuring of GDB debt would solve the most pressing and immediate liquidity problems for Puerto Rico.
The federal government and Puerto Rico
The U.S. Treasury has been providing the Puerto Rico government “technical assistance” for over a year. This assistance includes lobbying Congress for the extension of Chapter 9 of the federal bankruptcy code to Puerto Rico, help procuring federal grants and the assignment of two former Lazard Ltd. investment bankers to assist with debt restructuring.
The U.S. Congress, led by Sen. Orrin Hatch and Rep. Fred Upton, have been questioning problems of substantial fraud in Puerto Rico’s use of Medicare funds since October 2014. Congress has recently held several hearings on Puerto Rico but members have stated that Puerto Rico has not been forthcoming about its financial condition, so Congress is currently unwilling to act. Puerto Rico has not filed audited financials since June 30, 2013.
Current proposals for Puerto Rico include:
- The establishment of a federal control board to oversee Puerto Rico government spending and revenues. (No federal legislation has been filed.)
- The establishment of a local control board to oversee spending. This proposal may have constitutional issues since Puerto Rico’s legislative powers cannot be given over to an appointed board. Bondholders generally think this would not be effective in correcting revenue and spending problems. Members of the local board would be appointed by the governor.
- The issuance of a ‘super bond’ by Puerto Rico to aggregate many debt types into one series of bonds. The U.S. Treasury would be responsible for collecting revenue to pay bondholders. (This proposal has been leaked to the media but no public official has endorsed it on the record yet.)
- A federal loan guarantee. (Puerto Rico Resident Commissioner Pedro Pierluisi’s legislation H.R. 3725 is currently unlikely to gain traction.)
- The extension of Chapter 9 bankruptcy protection to Puerto Rico via H.R. 870, which has substantial support from Democrats but almost none from the Republicans who control Congress.
- The repeal or amendment of the Jones Act, which restricts shipping to Puerto Rico to U.S.-flagged and -crewed vessels (which appears to have some support among Republicans in Congress).
- The codification of Act 154 tax credibility by the U.S. Treasury or Congress. (A Puerto Rico official has claimed that the U.S. Treasury will be extending this tax credibility, but the Treasury has not confirmed.)
- Increased funds (parity) for Medicare and Medicaid. (This issue is a wild card, currently with minimal congressional support.)
Puerto Rico’s challenges
Congressional action can only do so much to help Puerto Rico pull itself out of the debt crisis because the island faces many challenges that make it less appealing for the types of private-sector investment needed to bolster the economy.
Puerto Rico competes with other Caribbean islands for foreign direct investment and is outranked by Costa Rica and Panama as prime destinations for investors. It’s likely that Puerto Rico will continue to lag as Cuba attracts new investment and the island’s fiscal and political issues drag on.
Puerto Rico’s citizens are poor by mainland standards but by Caribbean standards rank only behind Bahamas in per-capita income, according to the World Bank, making the island unattractive to many businesses looking to locate in the region.
Puerto Rico has exceptionally high crime rates due in large part to illegal drug transport through the island from Central and South American countries. As Mexico cracks down on illegal drug transport, much of that traffic has shifted to Puerto Rico. This drug trafficking also inflates the underground, untaxed economy.
The Puerto Rico public school system has the lowest test scores in America and is not preparing students for the global competition they will face. Puerto Rico Senate President Eduardo Bhatia is spearheading education reform as a critical component of the push to reform public services. Bhatia’s efforts are a critical element of Puerto Rico’s long-term recovery.
In 2016, Puerto Rico will hold its general election and the winners will face the historic challenge of rebuilding government institutions that have been operating in outdated and inefficient ways. With its low property prices, beautiful beaches and excellent year-round weather, Puerto Rico could be a very attractive destination for U.S. and Spanish retirees. But the government must be made stable and efficient at providing services to attract new residents.
The U.S. Congress has given Puerto Rico wide latitude to conduct its affairs and the island was unable to avoid a crisis. The next several years will determine whether Puerto Rico is able to stabilize its finances and government. And in turn, Congress will need to rethink how Puerto Rico is administered and whether it needs more oversight from the federal government.
Cate Long is a principal of Puerto Rico Clearinghouse, a research service for Puerto Rico bondholders, and a former reporter for Reuters.