oversight

Tax Policy: Puerto Rican Economic Trends

Published by the Government Accountability Office on 1997-05-14.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

                 United States General Accounting Office

GAO              Report to the Chairman, Committee on
                 Finance, U.S. Senate



May 1997
                 TAX POLICY
                 Puerto Rican
                 Economic Trends




GAO/GGD-97-101
                                 United States
GAO                              General Accounting Office
                                 Washington, D.C. 20548

                                 General Government Division

                                 B-276674

                                 May 14, 1997

                                 The Honorable William V. Roth, Jr.
                                 Chairman, Committee on Finance
                                 United States Senate

                                 Dear Mr. Chairman:

                                 In response to your request, this report provides information on economic
                                 activity in Puerto Rico, before and after the recent changes in U.S. tax
                                 benefits1 for corporations operating there. Corporations that receive these
                                 tax benefits represent a significant sector of the Puerto Rican economy. In
                                 recent years Congress has reduced the size of the tax benefits and set an
                                 expiration date for the remaining benefits. The last benefits are authorized
                                 to be available for tax years beginning before January 1, 2006, although the
                                 administration’s fiscal year 1998 budget proposes to extend the availability
                                 of some of the tax benefits indefinitely.

                                 In light of these tax law changes, you asked us to present information on
                                 the recent trends in

                             •   Puerto Rico’s principal economic indicators;
                             •   investments by U.S. corporations in Puerto Rico that generate tax-exempt,
                                 nonbusiness income; and
                             •   investment and employment promoted by Puerto Rico’s Economic
                                 Development Administration.



Background

The Section 936 Tax Credit       Income derived from operations of U.S. corporations in U.S. possessions
                                 has been subject to special tax provisions since the Revenue Act of 1921.
                                 These provisions were primarily intended to help U.S. corporations
                                 compete with foreign firms in the Philippines (then a U.S. possession).
                                 With the Tax Reform Act of 1976, Congress connected the special tax
                                 provisions with the development of possessions’ economies. The 1976 Act
                                 created section 936 of the IRC, which revised the treatment of corporate
                                 income from U.S. possessions. The stated purpose of the tax credit
                                 established under that section was to “assist the U.S. possessions in
                                 obtaining employment producing investments by U.S. corporations.”


                                 1
                                  Under section 936 of the Internal Revenue Code (IRC).



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                              Prior to 1994, the section 936 tax credit was equal to the full amount of the
                              U.S. income tax liability on income from a possession. The credit
                              effectively exempted two kinds of income from U.S. taxation:

                          •   income from the active conduct of a trade or business in a possession, or
                              from the sale or exchange of substantially all of the assets used by the
                              corporation in the active conduct of such trade or business and
                          •   certain income earned from financial investments in U.S. possessions or
                              certain foreign countries, generally referred to as qualified possession
                              source investment income (QPSII).

                              In order for the income from an investment to qualify as QPSII, the funds for
                              the investment must have been generated from an active business in a
                              possession, and they must be reinvested in the same possession. Dividends
                              repatriated from a U.S. subsidiary to a mainland parent have qualified for a
                              dividend-received deduction since 1976, thus allowing tax-free repatriation
                              of possessions income.

                              The 1993 Budget Act2 placed caps on the amounts of section 936 credit
                              that corporations could earn for tax years beginning in 1994 or later. The
                              Small Business Job Protection Act of 1996 repealed the tax credit for
                              taxable years beginning after 1995.3 However, the act provides transition
                              rules under which a corporation that was an existing credit claimant is
                              eligible to claim credits with respect to possession business income for a
                              period lasting through taxable years beginning before 2006. For tax years
                              beginning after December 31, 1995, QPSII received or accrued after June 30,
                              1996 may not be used in figuring the credit.


Puerto Rican Investment       Over the years, the government of Puerto Rico has taken several steps to
Incentives                    encourage corporations to invest in the island and to retain their earnings
                              there. Under Puerto Rico’s current industrial incentives law, corporations
                              engaged in manufacturing or export services generally are allowed
                              90-percent exemptions on their industrial development income.4 These
                              exemptions are valid for 10 to 25 years, depending on the location of the
                              business’ operations. The Puerto Rican government encourages the

                              2
                                Omnibus Budget Reconciliation Act of 1993, P. L. No. 103-66, S 13227, 107 Stat. 312, 489 (1993).
                              Appendix I provides additional details on the changes made to the credit by this and other acts signed
                              into law since 1982.
                              3
                               Small Business Job Protection Act, P.L. No. 104-188, S 1601, 110 Stat. 1755, 1827 (1996).
                              4
                               The current Tax Incentives Act became effective in 1987 and is due to expire at the end of 1997. The
                              government is currently drafting new incentive legislation.



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                   partially exempt corporations to reinvest their business profits in the
                   island by including in the definition of industrial development income all
                   income derived from specified financial assets. This financial income
                   exempted under Puerto Rican law was also treated as QPSII under federal
                   tax law if it was earned by a possessions corporation.5

                   The “tollgate tax,” which Puerto Rico imposes on dividends that resident
                   corporations pay to nonresident shareholders, provides an additional
                   incentive for eligible corporations to reinvest their earnings in Puerto
                   Rico. The rate of this tax on dividends paid out of the income of a tax
                   exempt business is generally 10 percent. However, the rate is reduced if a
                   corporation reinvests a certain portion of its earnings in Puerto Rico for a
                   period of 5 or more years.

                   The Economic Development Administration (EDA)/Industrial Development
                   Company (PRIDCO) of Puerto Rico promotes investments on the island by
                   both local and overseas businesses. Generally, but not always, the
                   investments promoted by EDA receive tax exemptions under Puerto Rican
                   tax incentive legislation. EDA compiles data on the number of “promotion
                   projects” initiated each month as a result of its activities. It also compiles
                   data on the amount of investment and employment that businesses
                   commit to when initiating a project.


                   The recent trends in Puerto Rican economic indicators show an economy
Results in Brief   that is growing in income, employment, and investment in most years.
                   Income and employment are traditional indicators of current economic
                   performance, while investment is an indicator of the economy’s capacity
                   to increase income and employment in the future. Although the growth in
                   these indicators continued after the 1993 changes to the section 936 tax
                   credit, we cannot conclude that the changes have had no effect on the
                   Puerto Rican economy. The Puerto Rican economy is strongly influenced
                   by the U.S. economy. If the changes in the credit have had any negative
                   impact on Puerto Rico’s economy to date, this may have been offset by the
                   positive influence of the U.S. economic recovery after 1991. Recent
                   economic initiatives by the Government of Puerto Rico also may have
                   offset any such impacts. Furthermore, the effect of the credit changes may
                   require several years to have an impact on the Puerto Rican economy

                   5
                    A “possession corporation” is one that elects to be taxed under section 936 of the IRC and meets the
                   following two requirements: over a 3-year period preceding a taxable year, 80 percent or more of its
                   income must be derived from sources within a possession; and 75 percent or more of its income must
                   be derived from the active conduct of trade or business within a possession. To qualify for both U.S.
                   and Puerto Rican tax benefits, the corporation would have had to make the investment in the specified
                   assets with earnings derived from its active business in Puerto Rico.



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because (1) it may take time for companies to adjust their investment
plans and (2) each year’s investment by companies represents a relatively
small proportion of the commonwealth’s total capital stock, which
generates employment and income.

Income as measured by Puerto Rico’s gross domestic product (GDP) and
gross national product (GNP) both increased between 1982 and 1996, with
the increases continuing at about the same rates after the 1993 changes in
the credit. GDP, a measure of the total income produced in Puerto Rico,
grew at a faster rate than GNP, which measures the portion of total income
received by Puerto Rican residents. The faster rate of growth of GDP
compared with GNP means that an increasing portion of the income
produced in Puerto Rico went to U.S. and foreign investors. These trends
are consistent with a development strategy based on attracting external
investment. Although the share of domestic net income of Puerto Rican
residents declined from 69.3 to 59.8 percent between 1982 and 1996, their
net income grew in absolute terms from $16.3 billion to $23.8 billion.6

Unemployment declined in most years between 1982 and 1996 and also
declined or remained unchanged in every year after the 1993 changes to
the credit. Investment spending for the plant and equipment that increases
the economy’s ability to generate income also increased in most years
during this period. After leveling off for several years after 1989, possibly
due to the U.S. recession, investment increased again in 1995 and 1996.
The section 936 tax credit was intended to promote investment and
employment in Puerto Rico. Although investment increased, and
unemployment did not increase, after the changes to the credit, we do not
know if the rate of change of either of these indicators would have been
greater if the credit had not been changed.

During the last 2 calendar quarters of 1996, when the tax benefits for QPSII
were ending, the total value of investments in Puerto Rico that formerly
would have generated QPSII benefits grew from about $15.6 billion to
$16.4 billion and then fell to about $14.6 billion. A recent amendment to a
Puerto Rican financial regulation may have influenced the financial
investment behavior of possessions corporations during that period even
more than the repeal of the exemption for QPSII. Consequently, that
investment behavior may be a poor indicator of the corporations’
longer-term reaction to the repeal.



6
 Unless otherwise noted, all of the dollar values presented in this report have been restated in constant
1996 dollars. Similarly, all growth rates have been computed as changes in constant-dollar figures.



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                     It is possible that the funds that possessions corporations reinvest in
                     Puerto Rico’s financial system simply displace other funds that would have
                     been available to Puerto Rican businesses, rather than expand the pool of
                     available funds. A simple comparison of trends shows that total
                     investment in buildings, machinery, and equipment has grown in all but 1
                     year since 1987, despite the fact that the amount of exempt investment
                     funds held in Puerto Rican financial institutions declined in all but 2 years
                     during that period.

                     The amount of foreign investment dollars committed to projects promoted
                     by EDA were at their highest levels in the late 1980s and early 1990s and
                     have generally declined thereafter. This trend continued immediately after
                     the 1993 changes in the section 936 tax credit, when in 1994 investment by
                     overseas businesses in EDA promotions was at its lowest level for any year
                     between 1982 and 1996. However, this investment increased moderately in
                     1995 and 1996.


                     To present the trends in Puerto Rican economic indicators, we obtained
Objectives, Scope,   the latest economic data available from the Puerto Rican Planning Board.
and Methodology      To present the trends in qualified possessions source investments, we
                     obtained the latest data available from Puerto Rico’s Commissioner of
                     Financial Institutions concerning exempt business investments in financial
                     assets in Puerto Rico. To present the trends in investment and
                     employment promoted by Puerto Rico’s EDA, we obtained the most recent
                     data compiled on those items by EDA. We also interviewed officials from
                     the aforementioned agencies as well as from the Government
                     Development Bank of Puerto Rico and the Puerto Rican Department of the
                     Treasury on issues relating to data and to Puerto Rican tax laws and
                     industrial incentives laws.

                     We restated all dollar figures in constant 1996 dollars, using the most
                     appropriate price indexes available. In most cases we used the implicit
                     price deflator for Puerto Rico’s GNP.7 We did not independently verify the
                     accuracy of the data we obtained for this report.


                     7
                      The implicit price deflator for Puerto Rico’s GNP is available only for the end of each fiscal year.
                     Puerto Rico’s fiscal year ends June 30th. In order to avoid distorting end-of-year adjustments in the
                     report graphs that display quarterly data, we estimated quarterly deflators by assuming that the annual
                     growth in the deflator would occur at a constant rate throughout the year. Also, in order to present
                     consistent trend lines in the cases where our quarterly data extends to December 1996, we projected
                     the deflator to grow for the last two calendar quarters of 1996 at the same pace it did between fiscal
                     year 1995 and fiscal year 1996. Figures for 1996 that we cite in the text have not been adjusted and,
                     therefore, are slightly higher than the adjusted figures represented in the graphs.



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                We also reviewed publications of the U.S. Treasury Department and the
                Internal Revenue Service and some of our prior reports relating to
                activities of possessions corporations and the effectiveness of the section
                936 tax credit. We did not attempt to estimate the effects of the recent
                changes in the section 936 tax credit on the Puerto Rican economy. We
                have simply described changes in that economy in recent years.

                We did our work in Washington, D.C., in March and April 1997 in
                accordance with generally accepted government auditing standards. We
                requested comments on a draft of this report from the Secretary of the
                Treasury of the Commonwealth of Puerto Rico, Puerto Rico’s
                Commissioner of Financial Institutions, the heads of Puerto Rico’s
                Planning Board, and Economic Development Administration, and from the
                Secretary of the Treasury. These comments are summarized and discussed
                at the end of this report and are reprinted in appendices IV through VII.


                As shown by its GNP and GDP, Puerto Rico’s economy has been growing in
Puerto Rico’s   most years, and this trend continued in the 3 years immediately following
Economy         the 1993 changes to the section 936 tax credit. (See fig. 1.) Between 1982
                and 1996, Puerto Rico’s per capita GNP grew at an annual rate of
                1.7 percent, and its GDP grew at an annual rate of 3.5 percent. The growth
                of both indicators slowed somewhat after 1990 following the recession
                that occurred in the U.S., but per capita GDP began to grow more quickly in
                1992 as did per capita GNP in 1993.




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Figure 1: Gross Domestic and Gross
National Product Per Capita, 1982-1996
                                         Dollars (constant 1996)

                                         14,000



                                         12,000



                                         10,000



                                          8,000



                                          6,000



                                          4,000



                                          2,000



                                               0
                                                   1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996
                                                   Year

                                                          GDP per capita
                                                          GNP per capita




                                         Note: Figures were adjusted for inflation using the Puerto Rican GDP and GNP deflators.

                                         Source: Puerto Rico Planning Board, Economic Report to the Governor, various years.




                                         The faster rate of growth for Puerto Rico’s GDP compared with GNP means
                                         that an increasing portion of total income produced in Puerto Rico went to
                                         U.S. and foreign investors rather than to Puerto Rican residents. GDP is a
                                         measure of total income produced in Puerto Rico, and GNP is a measure of
                                         the income produced that is received by the residents of Puerto Rico. The
                                         difference between the two represents, for the most part, remittance of
                                         profit and interest income to U.S. and foreign investors. The trends in GDP
                                         and GNP are consistent with Puerto Rico’s development strategy, which
                                         emphasizes long-term tax reductions to firms that locate in Puerto Rico,



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and with the provisions of the U.S. IRC—such as the section 936 tax credit,
which allowed tax-free repatriation of profits to the mainland. Although
the share of residents of Puerto Rico in total net income from property and
employee compensation declined from 69.3 to 59.8 percent between 1982
and 1996, residents’ income grew in absolute terms from $16.3 billion to
$23.8 billion. (For more details on resident and nonresident income in
Puerto Rico, see app. II.)

Investment in Puerto Rico, which is a key factor in the growth in the
Puerto Rican economy, has begun to grow again after leveling off in the
early 1990s. (See fig. 2.) Gross domestic fixed investment is the amount of
resources used to replace capital consumed during the year and to add to
the capital stock. This investment includes both public and private
spending on the construction of housing and production facilities, and
spending on machinery and equipment. Gross private fixed investment
grew significantly between 1982 and 1989 and then leveled off for several
years, possibly due to the recession that occurred in the United States.
Growth in investment picked up again in 1995 and 1996. (See app. II for
more details on investment.)




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Figure 2: Public and Private Gross Fixed Investment, 1982-1996

Dollars in billions (constant 1996)

8




6




4




2




0
      1982      1983      1984        1985   1986      1987      1988      1989     1990      1991      1992     1993      1994      1995      1996
      Fiscal year

          Gross private fixed investment
          Gross public fixed investment



                                                    Note: Figures were adjusted for inflation using the Puerto Rican GNP deflators for investment.

                                                    Source: Puerto Rico Planning Board, Economic Report to the Governor, various years.




                                                    The section 936 tax credit was intended to promote investment and
                                                    income growth in Puerto Rico, and the limitations on the credit may
                                                    reduce the attractiveness of U.S. investment in Puerto Rico. Although
                                                    investment and income have grown after the limitations became effective,
                                                    we cannot conclude that the credit changes have not had any effect on
                                                    investment or income. The rates of growth may have been greater without
                                                    the credit changes. Moreover, it may require more years for the credit
                                                    changes to affect investment and income because (1) it may take time for




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companies to adjust their investment plans and (2) each year’s investment
by companies represents a relatively small proportion of the
commonwealth’s total capital stock, which generates employment and
income.

From 1982 to 1996, unemployment in Puerto Rico generally declined,
while the participation of Puerto Rican residents in the labor force
increased. (See fig. 3.) The unemployment rate in Puerto Rico was
23.5 percent in 1983, following the recession that the United States entered
in 1981 and 1982, but declined in most years after 1983 to reach a low of
13.8 percent in 1995 and 1996. The labor force participation rate increased
during this period from an average rate of 43 percent during the 1980s to
an average of 46 percent during the 1990s. The trend in employment
continued after the changes to the section 936 tax credit with the
unemployment rate falling or remaining unchanged in every year after
1993.




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Figure 3: Labor Participation and
Unemployment Rates, 1982-1996
                                    Rate of participation/unemployment (percent)

                                    50




                                    40




                                    30




                                    20




                                    10




                                      0
                                          1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996
                                          Fiscal year

                                                   Participation rates
                                                   Unemployment rates



                                    Source: Puerto Rico Planning Board, Economic Report to the Governor, various years.




                                    Total nonagricultural employment in establishments in Puerto Rico grew
                                    from 660,000 in 1982 to 945,000 in 1996. Over this period, the share of
                                    manufacturing employment declined from 22.4 percent of the total to
                                    16.3 percent, and the share of government employment fell from
                                    36.2 percent to 32.6 percent. Manufacturing employment has actually
                                    fallen in absolute terms since it peaked in 1990. In contrast, the share of
                                    employment in the retail trade sector rose from 12 percent to 15.8 percent,
                                    and the share of the nonfinancial service sector rose from 13.3 percent to
                                    18.5 percent. (For more details on employment in Puerto Rico, see app. II.)




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                        Prior to 1996, possessions corporations with active trades or businesses in
Recent Trends in        Puerto Rico could reinvest the earnings from those activities in eligible
Qualified Possessions   financial investments in Puerto Rico and earn income that was effectively
Source Investments      exempt from both U.S. and Puerto Rican income taxes.8 For tax years
                        beginning after December 31, 1995, QPSII received or accrued after June 30,
                        1996, does not qualify for a federal tax credit.9 However, the Puerto Rican
                        income tax exemption and tollgate tax both remain in place and provide
                        some disincentive to an immediate repatriation of all financial assets held
                        by possessions corporations.

                        As of December 1996, total investment in the exempt financial assets
                        amounted to $14.6 billion, or $3,927 per resident of Puerto Rico. This
                        $14.6 billion figure is the best available accounting of the current value of
                        investments that formerly would have generated tax benefits under the
                        QPSII credit. Almost all investments that would have generated QPSII tax
                        benefits are included in that amount,10 and only about 1 percent of that
                        amount is attributable to businesses that would not have qualified for QPSII
                        benefits.11 Exempt businesses can make eligible financial investments
                        either directly or through the intermediation of eligible financial
                        institutions. Businesses invested $10.5 billion of the $14.6 billion through
                        financial institutions and invested the remaining $4.1 billion directly.




                        8
                         A possessions corporation must also have been granted an exemption under Puerto Rico’s industrial
                        incentives law to receive this double benefit. Historically, almost all possessions corporations have
                        been granted at least partial exemptions from Puerto Rican income tax. According to IRS, for tax year
                        1993 there were about 455 active possessions corporations in Puerto Rico. Data from the Puerto Rican
                        Department of Treasury show that 439 possessions corporations received at least partial exemptions
                        in fiscal year 1993.
                        9
                         According to Puerto Rico’s Commissioner of Financial Institutions, most of the tax-year ends for
                        possessions corporations with large investments in Puerto Rican financial institutions are October 31
                        and November 30. For those corporations, the QPSII benefits ended as of October 31 and
                        November 30, 1996.
                        10
                          Possessions corporations operating in Puerto Rico did not receive much, if any, tax benefit from
                        section 936 unless their income from Puerto Rico was also exempt from the commonwealth’s income
                        tax. In the absence of section 936, the corporations would have received foreign tax credits for income
                        taxes paid to Puerto Rico. These foreign tax credits would have provided roughly the same benefit as
                        the section 936 credit. Consequently, only financial investments that produced Puerto Rican exempt
                        income would generate tax benefits under the QPSII credit. The $14.6 billion figure is the Government
                        of Puerto Rico’s best accounting of all financial investments in Puerto Rico that produce tax exempt
                        income.
                        11
                          Locally owned Puerto Rican businesses that have been granted industrial incentive exemptions may
                        also reinvest their earnings in the eligible financial assets. However, an official from Puerto Rico’s
                        Department of Treasury told us that possessions corporations earned 99 percent of all income from
                        eligible financial assets.



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Figure 4 presents aggregate data available on exempt financial
investments in recent years.12 Total exempt financial investment grew
noticeably during the second and third calendar quarters of 1996, reaching
$16.4 billion at the end of September 1996. Most of this increase was offset
by a decline during the fourth quarter of 1996. During those 3 quarters,
exempt investments in eligible financial institutions grew more rapidly and
then declined less sharply than direct exempt financial investments.
Moreover, as the data in figure 5 indicate, there was a pronounced shifting
of funds out of instruments with maturities of 1 year or less and into
instruments with longer maturities.




12
  Although the government of Puerto Rico has compiled data on the amount of eligible investments in
financial institutions for many years, it has been able to collect data on the amount of eligible
investments that corporations make directly only since June of 1995.



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Figure 4: Exempt Financial
Investments, 1992-1996       Dollars in billions (constant 1996)

                             20




                             15




                             10




                              5




                              0
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                                                                                                               Se
                                      1992             1993                1994                  1995          1996
                                  Calendar year quarters

                                         Total exempt financial investment

                                         Exempt investment in eligible financial institutions
                                         Direct exempt financial investment



                             Note: Data points represent end of quarter balances. Figures were adjusted for inflation using the
                             Puerto Rican GNP deflator. Data on direct and total investment were available only since
                             June 1995.

                             Source: Government of Puerto Rico, Commissioner of Financial Institutions.




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Figure 5: Exempt Investments in Eligible Financial Institutions, by Maturity, 1992-1996

Dollars in billions (constant 1996)


12



10



 8



 6



 4



 2



 0
       Jun      Sept     Dec   Mar    Jun     Sept    Dec      Mar    Jun    Sept    Dec     Mar     Jun     Sept   Dec     Mar       Jun     Sept   Dec

            1992                       1993                              1994                         1995                                  1996
     Calendar year quarters

             1 year or less
             over 1 year




                                                     Note: Figures were adjusted for inflation using the Puerto Rican GNP deflator.

                                                     Source: Government of Puerto Rico, Commissioner of Financial Institutions.




                                                     According to Puerto Rico’s Commissioner of Financial Institutions, much
                                                     of the short-term growth in investments with longer maturities may be a
                                                     response to a recent amendment to the commonwealth’s regulation that
                                                     governs tax exempt funds held in eligible financial institutions. The
                                                     amendment had the affect of reducing the rate of interest that financial
                                                     institutions could pay on exempt funds placed in instruments with
                                                     maturities of 5 years or more. Possessions corporations that planned on
                                                     reinvesting earnings in Puerto Rico to obtain a lower tollgate tax rate are



                                                     Page 15                                         GAO/GGD-97-101 Puerto Rican Economic Trends
                            B-276674




                            likely to have accelerated their investments in long-term instruments in
                            order to lock in more favorable rates before the effective date of the
                            amendment.13

                            Due to the influence of the amendment to Puerto Rico’s financial
                            regulation, the investment behavior of possessions corporations during the
                            first 6 months after the repeal of QPSII may be a poor indicator of their
                            longer-term reaction to the repeal. Nevertheless, the sharp increase in
                            long-term investments held in eligible financial institutions indicates that
                            those funds, at least, are not likely to be repatriated in the immediate
                            future.


No Clear Relationship       It is possible that the funds that possessions corporations reinvest in
Between Trend in Exempt     Puerto Rico’s financial system simply displace other funds that would have
Investments in Financial    been available to Puerto Rican businesses, rather than expand the pool of
                            available funds. A 1989 report by the U.S. Treasury Department on the
Institutions and Trend in   effects of the possessions tax credit concluded that the exemption for QPSII
Total Investment            likely had little effect on total real investment in Puerto Rico. The report
                            noted that

                            “In spite of the fact that no 936 funds were available, a much higher level of real private
                            investment was financed in the early 1970s than in the first ten years after the enactment of
                            the QPSII provision. The fact that most of the fluctuations of total private investment since
                            1976 have been attributable to cyclical changes in inventories also suggests that the
                            availability of 936 funds has not had a major impact on Puerto Rican growth.”14


                            The simple graphical comparison in figure 6 reveals no obvious
                            relationship between (1) changes in exempt investment funds held in
                            eligible financial institutions and (2) total gross fixed investment in Puerto
                            Rico each year. Figure 6 shows that the balances of exempt investments in
                            financial institutions declined in every year after 1987, except 1992 and




                            13
                             The effective date of the amendment was October 1, 1996; however, some funds that were held in the
                            Government Development Bank were allowed to be converted to longer maturities after that date,
                            under the old rules.
                            14
                             U.S. Department of the Treasury, The Operation and Effect of the Possessions Corporation System of
                            Taxation, Sixth Report, Mar. 1989, p. 80.



                            Page 16                                        GAO/GGD-97-101 Puerto Rican Economic Trends
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1995.15 This pattern of divestment of financial assets had no obvious
impact on the steady additions to gross fixed investment in Puerto Rico in
most years since 1987. We do not know what the year-to-year changes
have been in the financial assets that possessions corporations hold
directly.




15
  Part of the decline in balances since 1987 may be attributable to changes made to the possessions tax
credit by the Tax Reform Act of 1986. That act increased the share of a possessions corporation’s gross
income that has to be derived from the active conduct of a trade or business from 65 percent to
75 percent. QPSII is passive income, and some corporations may have had to reduce the amount of
that type of income they earned to meet the new requirement. Financial regulations introduced by the
government of Puerto Rico in 1988 may have been another factor contributing to the decline in exempt
investments in financial institutions. The new regulations discouraged institutions from attracting
funds from possessions corporations with the intention of investing the money outside of Puerto Rico.



Page 17                                          GAO/GGD-97-101 Puerto Rican Economic Trends
                                       B-276674




Figure 6: Gross Fixed Investment and
Changes in Exempt Investment Funds
                                       Dollars in billion (constant 1996)
in Eligible Financial Institutions,
1983-1996
                                        8




                                        6




                                        4




                                        2




                                        0




                                       (2)
                                             1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996
                                             Year

                                                     Changes in exempt investment funds from previous year
                                                     Total gross fixed investment




                                       Note: Figures were adjusted for inflation using the Puerto Rican GDP and GNP deflators. The data
                                       on exempt investment funds for each year represent the difference between the average daily
                                       balances for December of that year and the average daily balance for the preceding December.
                                       Exempt investment fund data for December 1991 were not available; data for January 1992 were
                                       used as substitutes.

                                       Source: Government of Puerto Rico, Commissioner of Financial Institutions.



                                       The EDA promotes investments in Puerto Rico by local and overseas
The Economic                           businesses. The EDA promotions generally receive tax exemptions and
Development                            include commitments to hire and pay employees and to invest capital in
Administration of                      amounts negotiated between EDA and the investors. The promotions that
                                       EDA calls “nonlocal,” (i.e., at least 50 percent of the capital invested comes
Puerto Rico                            from the United States or other foreign countries) usually involve



                                       Page 18                                        GAO/GGD-97-101 Puerto Rican Economic Trends
                     B-276674




                     U.S.-owned possessions corporations. According to an EDA official, data
                     regarding the investment dollars, employment, and payroll committed to
                     these projects are likely to be an early indicator of the impact of the credit
                     changes on U.S. investment in Puerto Rico. Compared with the investment
                     data presented in figure 2, the data on investment commitments provide a
                     view of an earlier stage of the investment pipeline. For example,
                     investment dollars committed in 1996 may not appear in the government’s
                     final accounting of investment expenditures until 1997 or later.

                     The number of nonlocal promotions was greatest in 1988 when 120
                     businesses were promoted by EDA. Nonlocal promotions declined in most
                     years after 1988, with this trend of generally declining promotions
                     continuing after the 1993 changes in the tax credit. Nonlocal promotions
                     numbered 33 in 1994, the smallest number of nonlocal promotions for any
                     year between 1982 and 1996.

                     Investment committed to EDA promotions by nonlocal businesses was
                     greatest in the late 1980s and early 1990s but generally declined thereafter.
                     Investment committed to nonlocal promotions, which tended to be more
                     capital intensive than local promotions, reaching its highest level of
                     $363.5 million in 1990. This investment continued a generally declining
                     trend in 1994, immediately after changes in the credit, but increased
                     moderately in 1995 and 1996. (For more details about EDA promotions, see
                     app. III.)


                     We obtained written comments on a draft of this report from the Secretary
Agency Comments      of the Treasury of the Commonwealth of Puerto Rico, Puerto Rico’s
and Our Evaluation   Commissioner of Financial Institutions, the Acting Chairman of the Puerto
                     Rico Planning Board, and the Acting Administrator and Chief Executive
                     Officer of Puerto Rico’s Economic Development Administration. We
                     received oral comments on our draft from an economist from the U.S.
                     Department of the Treasury’s Office of Tax Analysis. Treasury’s Deputy
                     International Tax Counsel also reviewed the draft but had no comments.

                     The Secretary of the Treasury of Puerto Rico agreed that the conclusions
                     in our draft were generally consistent with the data we reviewed.
                     However, he said that the draft did not consider economic reforms
                     implemented by the Government of Puerto Rico since 1993, including new
                     incentives and initiatives to promote tourism, agriculture, research and
                     exports; reductions in individual and corporate income tax rates;
                     investments in infrastructure; and modification of financial regulations to



                     Page 19                              GAO/GGD-97-101 Puerto Rican Economic Trends
B-276674




reduce negative effects arising from the elimination of the credit for QPSII.
The Secretary said that the government’s “New Economic Model,” along
with the expansion of the U.S. economy, had counteracted some of the
effects of recent reductions in section 936 tax benefits. Despite these
reforms, however, the Secretary was concerned with the future of Puerto
Rico’s manufacturing sector and the need to further reduce the
commonwealth’s high unemployment rate and raise its per capita personal
income. The Secretary stated that, for these reasons, Puerto Rico needs a
revision of section 30A of the IRC that would provide federal tax benefits to
new investments in Puerto Rico; specifically a stable wage tax credit as an
incentive to U.S. manufacturing firms operating there.

We agree it is possible that recent economic initiatives of the Government
of Puerto Rico may have partially counteracted potential negative effects
of the changes in section 936. We have added language to this effect in our
final report. It was beyond the scope of our work to evaluate proposed
revisions of section 30A.

The Commissioner of Financial Institutions concurred in general terms
with the conclusions of our draft regarding exempt investment funds in
Puerto Rico. He specifically acknowledged that the level of exempt funds
in eligible financial institutions does not affect the level of investment in
Puerto Rico. The Commissioner provided additional information regarding
several factors, including a change in a commonwealth financial
regulation, that explained the trends in exempt investment funds during
1996 that we had described in our draft. He noted that corporations with
tax years ending after the middle, but before the end, of the calendar year
could take advantage of the QPSII tax benefit for a few months after
June 30, 1996. The Commissioner also noted that the Government of
Puerto Rico was implementing a capital markets reform, which, along with
it’s 1994 tax reform and a significant modernization of the
commonwealth’s legal and regulatory framework, has prepared Puerto
Rico’s financial system to be competitive, even without the QPSII benefits.
He, nevertheless, supported enhanced benefits under section 30A to help
mitigate any possible long-term adverse effects of the repeal of QPSII. We
have revised our discussion of trends in exempt investment funds to
reflect the additional information provided by the Commissioner.

The Puerto Rico Planning Board reviewed our use of their data and
provided some additional and updated data. The Planning Board also
noted several apparent discrepancies between the data that we report and
the data that they provided to us. We made some changes to reflect the



Page 20                             GAO/GGD-97-101 Puerto Rican Economic Trends
B-276674




new data provided by the Planning Board. In most cases we made no
changes where the board identified apparent discrepancies, because the
discrepancies were small and due to differences in rounding methods.

The Planning Board also commented that the year 1982, which was used
as the base year in most growth rate calculations, was a recessionary year
and that this could affect the calculation of the growth rates for GNP and
GDP per capita. We agree that the choice of base year can affect
growth-rate calculations. For example, the growth in GNP per capita would
have been slightly lower with 1981 as the base year and slightly higher
with 1983 as the base year. However, our purpose was to report trends in
the data. The growth rates were used chiefly to summarize the direction of
these trends, which was unaffected by the choice of base year.

The Planning Board also commented that caution should be used in
reporting GDP per capita because it could be misinterpreted as a measure
of the resident population’s well-being, even though it includes income
received by nonresidents of Puerto Rico. We agree and we believe that our
report clearly describes GDP per capita and distinguishes it from GNP per
capita, which is a measure of the income received by residents of Puerto
Rico.

The Planning Board provided new information on the number of
possessions corporations that received at least partial exemptions in fiscal
year 1993. They also said that IRS reported that about 474 active
possessions corporations operated in Puerto Rico for tax year 1993. After
checking with IRS, we determined that there were 474 active possessions
corporations in total. Only 455 of those corporations actually operated in
Puerto Rico. We use the updated information in this report.

The Economic Development Administration provided comments to clarify
our description of their promotions. We have incorporated their comments
in our report where appropriate.

The economist from the U.S. Treasury Department suggested minor word
changes to appendix I, which we made, where appropriate. He also
suggested that it would be of interest to have some discussion of the
spread between Eurodollar interest rates and the rates that Puerto Rican
financial institutions were offering on tax exempt funds. He said that
Treasury had found that the spreads were not significant in the late 1980s.
This would imply that the QPSII benefits may not have had a great impact
on the cost of capital in Puerto Rico. We agree that evidence of a small



Page 21                             GAO/GGD-97-101 Puerto Rican Economic Trends
B-276674




difference between Eurodollar rates and those paid on exempt funds in
Puerto Rico would imply that the QPSII provision may not have significantly
reduced the cost of capital (which, in turn, could have expanded total
investment) in Puerto Rico. An analysis that would allow us to determine
whether or not the current spreads between these rates are significant was
beyond the scope of this report.


Unless you publicly announce its contents earlier, we plan no further
distribution of this report until 30 days from the date of this letter. At that
time we will send copies of this report to the Ranking Minority Member of
the Senate Committee on Finance and to the chairmen and ranking
minority members of other appropriate congressional committees. We will
also send copies to the Secretary of the Treasury, representatives of the
Government of Puerto Rico, and other interested parties. Copies will also
be made available to others upon request.

This work was performed under the direction of James Wozny, Assistant
Director, Tax Policy and Administration Issues. Major contributors to this
report are listed in appendix VI. If you have any questions please contact
me on (202) 512-9110.

Sincerely yours,




James R. White
Associate Director, Tax Policy
  and Administration Issues




Page 22                              GAO/GGD-97-101 Puerto Rican Economic Trends
Page 23   GAO/GGD-97-101 Puerto Rican Economic Trends
Contents



Letter                                                                                            1


Appendix I                                                                                       28

Details on Changes in
the Section 936 Tax
Credit Since 1982
Appendix II                                                                                      30
                         Domestic Net Income in Puerto Rico                                      30
Additional Details on    Components of Investment in Puerto Rico                                 35
Puerto Rico’s            Employment by Economic Sector in Puerto Rico                            37
Economy
Appendix III                                                                                     38
                         Promotions of the Economic Development Administration                   38
Information on           Employment Committed to Economic Development                            39
Economic                   Administration Promotions
                         Payroll and Investment Committed to Economic Development                41
Development                Administration Promotions
Administration
Promotions
Appendix IV                                                                                      45

Comments From the
Secretary of the
Treasury of Puerto
Rico
Appendix V                                                                                       48

Comments From the
Commissioner of
Financial Institutions




                         Page 24                         GAO/GGD-97-101 Puerto Rican Economic Trends
                        Contents




Appendix VI                                                                                        53

Comments From the
Puerto Rico Planning
Board
Appendix VII                                                                                       56

Comments From the
Economic
Development
Administration
Appendix VIII                                                                                      57

Major Contributors to
This Report
Tables                  Table II.1: Gross Fixed Private Domestic Investment, 1982-1996             36
                        Table II.2: Employment by Major Industrial Sector, 1982-1996               37

Figures                 Figure 1: Gross Domestic and Gross National Product Per Capita,             7
                          1982-1996
                        Figure 2: Public and Private Gross Fixed Investment, 1982-1996              9
                        Figure 3: Labor Participation and Unemployment Rates,                      11
                          1982-1996
                        Figure 4: Exempt Financial Investments, 1992-1996                          14
                        Figure 5: Exempt Investments in Eligible Financial Institutions,           15
                          by Maturity, 1992-1996
                        Figure 6: Gross Fixed Investment and Changes in Exempt                     18
                          Investment Funds in Eligible Financial Institutions, 1983-1996
                        Figure II.1: Percentage Distribution of Domestic Net Income by             31
                          Employee Compensation and Property Income, 1982-1996
                        Figure II.2: Employee Compensation and Property Income in the              33
                          Manufacturing Sector, 1982-1996
                        Figure II.3: Income on Externally Held Investments, 1982-1996              35
                        Figure III.1: The Number of Local and Nonlocal Promotions by               39
                          the Economic Development Administration, 1982-1996




                        Page 25                            GAO/GGD-97-101 Puerto Rican Economic Trends
Contents




Figure III.2: Employment Committed to Local and Nonlocal                  41
  Promotions, 1982-1996
Figure III.3: Investment Committed to Local and Nonlocal                  43
  Promotions, 1982-1996
Figure III.4: Payroll Committed to Local and Nonlocal                     44
  Promotions, 1982-1996




Abbreviations

EDA        Economic Development Administration
GDP        gross domestic product
GNP        gross national product
IRC        Internal Revenue Code
PRIDCO     Puerto Rico Industrial Development Corporation
QPSII      qualified possessions source investment income


Page 26                           GAO/GGD-97-101 Puerto Rican Economic Trends
Page 27   GAO/GGD-97-101 Puerto Rican Economic Trends
Appendix I

Details on Changes in the Section 936 Tax
Credit Since 1982

                  In the 1982 Tax Equity and Fiscal Responsibility Act and the 1986 Tax
                  Reform Act, Congress adjusted the section 936 provisions in an attempt to
                  reduce the ratio of federal revenue loss to employment created and
                  investments made in U.S. possessions. Congress principally adjusted the
                  tax treatment of income derived from intangible assets (such as
                  trademarks, patents, and trade names) and passive investments.

                  Before the 1982 and 1986 adjustments, corporations could (1) reduce their
                  U.S. income taxes by deducting from their U.S. revenues research and
                  development expenses that led to a patent and then (2) transfer the patent
                  (or other intangible asset) to Puerto Rico and realize tax-free income
                  under section 936 from its use in Puerto Rico. In the 1982 act, Congress
                  required that companies allocate some of their income realized in Puerto
                  Rico from intangible assets to their U.S. parent corporations. The 1986 act
                  changed the allocation procedures again to ensure that a greater portion of
                  income from intangible assets was allocated to U.S. parent corporations.

                  Regarding qualified possessions source income (QPSII), the 1982 act
                  changed the proportion of gross income that a possessions corporation
                  must earn from the active conduct of a possessions trade or business in
                  order to qualify for the section 936 credit. The act increased the proportion
                  from 50 to 65 percent. This, in turn, decreased the proportion of gross
                  income that a firm could earn from passive investments and still qualify as
                  a possessions corporation. The 1986 act raised the proportion again so
                  that a firm must derive 75 percent of its gross income from the active
                  conduct of a trade or business and no more than 25 percent from passive
                  investments.

                  The 1986 act also expanded the eligible activities in which QPSII funds
                  could be invested and still qualify for tax exemption. QPSII could now be
                  earned on deposits from which the Government Development Bank and
                  other financial institutions in Puerto Rico made loans for the acquisition or
                  construction of active business assets or development projects in qualified
                  Caribbean Basin Initiative countries.

                  The 1993 Budget Act limited the section 936 credit as follows. Since 1993
                  taxpayers were to calculate the credit as under prior law, but the credit
                  was capped under one of two alternative options selected by the taxpayer:

              •   The “percentage limitation” option provides for a decreasing credit equal
                  to a decreasing percentage of the amount computed under prior law. The
                  percentages were 60 percent in 1994, 55 percent in 1995, 50 percent in



                  Page 28                             GAO/GGD-97-101 Puerto Rican Economic Trends
    Appendix I
    Details on Changes in the Section 936 Tax
    Credit Since 1982




    1996, and 45 percent in 1997. The percentage was to be 40 percent in 1998
    and thereafter.
•   The “economic-activity limitation” option provides a cap on the credit
    equal to the sum of three factors:

    The first factor is 60 percent of the firm’s wages paid in the territory, plus allocable
    employee fringe benefits, with wages limited for each employee to 85 percent of the
    amount subject to Social Security taxes.


    The second factor is a specified percentage of the firm’s depreciation deductions for each
    taxable year. The type of property defines the applicable percentage: 15 percent for
    property with a relatively short recovery period, 40 percent for property with a
    medium-length recovery period, and 65 percent for assets with a long recovery period.


    The third factor, which applies only to firms that do not use the 50-percent profit-split
    method of income allocation, is a portion of the income taxes paid to the territorial
    government. The taxes included, however, cannot exceed a 9 percent effective tax rate.


    The Small Business Job Protection Act of 1996 repealed the tax credit for
    taxable years after December 31, 1995. However, the act provides
    transition rules under which a corporation that is an existing credit
    claimant is eligible to claim credits with respect to possession business
    income for a period lasting through taxable years beginning before
    January 1, 2006. For tax years beginning after December 31, 1995, QPSII
    received or accrued after June 30, 1996, may not be used in figuring the
    credit.

    For any taxable year beginning after December 31, 1995, and before
    January 1, 2006, a corporation that was an existing credit claimant with
    respect to Guam, American Samoa, or the Northern Mariana Islands may
    continue to determine its credit with respect to such possession the way it
    did before the 1996 act. Corporations that were existing credit claimants
    with respect to Puerto Rico and the U.S. Virgin Islands may continue to
    claim credits, but those credits are to be subject to income caps.16 For
    taxable years beginning in 2006 and thereafter, the credit with respect to
    all possessions is to be eliminated.




    16
      The new rules for these corporations are provided in section 30A of the IRC. In order to claim a
    credit for tax years after 1997, these corporations must elect the economic-activity limitation option by
    tax year 1997. The income cap becomes effective for tax years beginning after December 31, 2001.
    Each taxpayer’s cap is based on the average business income that the taxpayer earned in the
    possession during a specific base period.



    Page 29                                           GAO/GGD-97-101 Puerto Rican Economic Trends
Appendix II

Additional Details on Puerto Rico’s
Economy

                        Congress has linked the section 936 tax credit to the development of
                        possessions’ economies. The credit is intended to promote investment by
                        U.S. corporations that leads to increased employment of the possessions’
                        residents. The intended increase in investment and employment should
                        also be reflected in the growth of income and production of the
                        possessions’ economies. In this appendix, we provide additional detail on
                        income, investment, and employment in Puerto Rico.



Domestic Net Income
in Puerto Rico

Employee Compensation   Domestic net income is income produced in a country. It is earned by
and Property Income     workers in wages and other compensation and by property owners in
                        profit and interest. It may also be divided into employee compensation and
                        property income earned by Puerto Rican residents and property income
                        earned by nonresidents

                        As shown in figure II.1, property income has been growing as a share of
                        net income, and the property income of nonresidents has been growing as
                        a share of total property income. The share of property income grew from
                        45.5 percent of domestic net income in 1982 to 54.6 percent in 1996, and
                        the share of nonresidents in total property income grew from 67.6 percent
                        to 73.6 percent. The result of these trends is that the share of domestic net
                        income earned by Puerto Rican residents from both property and
                        employee compensation declined from 69.3 percent to 59.8 percent
                        between 1982 and 1996, although residents’ income grew in absolute terms
                        from $16.3 billion to $23.8 billion.

                        Figure II.1 also shows that these trends were not interrupted by the
                        changes to the credit in 1993. The share of property income in domestic
                        net income increased between 1993 and 1996 from 53.4 percent to 54.6
                        percent, and the nonresident share of property income increased from 70.8
                        percent to 73.6 percent. In contrast, the residents’ share of total net
                        income continued its decline from 62.2 percent to 59.8 percent, although
                        the net income of Puerto Rican residents grew from $22.6 billion to
                        $23.8 billion.




                        Page 30                             GAO/GGD-97-101 Puerto Rican Economic Trends
                                                    Appendix II
                                                    Additional Details on Puerto Rico’s
                                                    Economy




Figure II.1: Percentage Distribution of Domestic Net Income by Employee Compensation and Property Income, 1982-1996

Percentage

100




 80




 60




 40




 20




  0
       1982       1983     1984     1985     1986        1987   1988    1989     1990      1991     1992     1993     1994      1995     1996
      Fiscal year


              Employee compensation of residents
              Property income of residents
              Property income of nonresidents




                                                    Source: Puerto Rico Planning Board, Economic Report to the Governor, various years.




Employee Compensation                               Most of the tax benefits earned under section 936 have been earned by
and Property Income in the                          corporations in the manufacturing sector.17 From 1982 through 1996, both
Manufacturing Sector                                property income and employee compensation increased in the
                                                    manufacturing sector. However, employee compensation decreased as a
                                                    percentage of total net income in manufacturing. These trends for the
                                                    entire period also characterized the period after the changes in the credit
                                                    from 1994 through 1996.

                                                    17
                                                     Puerto Rico’s tax incentives are limited largely to businesses operating in the manufacturing or
                                                    export sectors. Nonmanufacturing companies that pay the full Puerto Rican income tax can claim a
                                                    U.S. foreign tax credit for those taxes paid. Consequently, those companies receive little, if any,
                                                    additional U.S. tax reduction through section 936.



                                                    Page 31                                          GAO/GGD-97-101 Puerto Rican Economic Trends
Appendix II
Additional Details on Puerto Rico’s
Economy




As shown in figure II.2, employee compensation in the manufacturing
sector increased from $3.2 billion in 1982 to $3.6 billion in 1996. As a
percentage of domestic net income produced in the manufacturing sector,
employee compensation dropped from 35 percent to 20.2 percent. This
trend was also true between 1993 and 1996, when the share of employee
compensation declined from 23 to 20.2 percent.

The growth of property income in the manufacturing sector accounted for
a significant share of the growth in property income in the overall
economy. From 1982 through 1996, property income in Puerto Rico
increased by $11 billion, from $10.7 billion to $21.7 billion. The increase in
property income in the manufacturing sector accounted for $8.2 billion, or
74.5 percent of the overall increase. Over the same period, employee
compensation in Puerto Rico increased by $5.2 billion, from $12.8 billion
to $18 billion. The increase in employee compensation in the
manufacturing sector accounted for about $400 million, or 7.7 percent of
the overall increase.




Page 32                               GAO/GGD-97-101 Puerto Rican Economic Trends
                                                Appendix II
                                                Additional Details on Puerto Rico’s
                                                Economy




Figure II.2: Employee Compensation and Property Income in the Manufacturing Sector, 1982-1996

Dollars in billions (constant 1996)

20




15




10




 5




 0
       1982      1983     1984    1985   1986    1987     1988     1989     1990     1991     1992     1993     1994      1995   1996
      Fiscal year

              Employee compensation

              Property income


                                                Note: Figures were adjusted for inflation using the Puerto Rican GNP deflator.

                                                Source: Puerto Rico Planning Board, Economic Report to the Governor, various years




                                                The growth of property income in the manufacturing sector continued to
                                                account for a significant share of overall growth in property income after
                                                the 1993 change to the credit. During this period, the increase in property
                                                income in manufacturing accounted for 79.3 percent of overall growth in
                                                property income. However, the trend in employee compensation was
                                                different. Between 1993 and 1996, total employee compensation increased
                                                by 6.4 percent, while employee compensation in manufacturing declined
                                                by 2.7 percent.




                                                Page 33                                         GAO/GGD-97-101 Puerto Rican Economic Trends
                            Appendix II
                            Additional Details on Puerto Rico’s
                            Economy




Income From Foreign         The increasing role of nonresidents in the growth of the Puerto Rican
Investment in Puerto Rico   economy is indicated by the growth in income from the direct investments
                            of nonresidents in Puerto Rico. The income from direct investments is the
                            profit and interest income of companies operating in Puerto Rico that are
                            owned and controlled by nonresidents. Income from financial investments
                            is income from other assets owned but not controlled by nonresidents
                            such as dividends paid by domestic Puerto Rican companies and interest
                            paid by the Puerto Rican government.

                            As shown in figure II.3, income from the direct investment of nonresidents
                            grew between 1982 and 1996, both in total amount and also as a share of
                            all income from investments owned by nonresidents. The income from
                            direct investment increased from $7.6 billion in 1982 to $15.7 billion in
                            1996, growing at an annual rate of 5.3 percent. This income also increased
                            as a share of total income from investments owned by nonresidents from
                            87.4 percent in 1982 to 92 percent in 1996.

                            Figure II.3 also shows that these trends in income from the investments of
                            nonresidents continued after the changes to the credit in 1993. Between
                            1994 and 1996, income from the direct investment of nonresidents
                            increased from $14.4 billion to $15.7 billion, and increased as a share of
                            total income paid to nonresidents from 91.1 to 92 percent.




                            Page 34                               GAO/GGD-97-101 Puerto Rican Economic Trends
                                                  Appendix II
                                                  Additional Details on Puerto Rico’s
                                                  Economy




Figure II.3: Income on Externally Held Investments, 1982-1996

Dollars in millions (constant 1996)


 20




 15




 10




  5




  0
       1982    1983     1984    1985       1986   1987   1988     1989     1990    1991     1992     1993    1994     1995     1996

      Fiscal year



           Income from direct investment
           Income from financial investment




                                                  Note: Figures were adjusted for inflation using the Puerto Rican GNP deflator.

                                                  Source: Puerto Rico Planning Board, Balance of Payments, various years.



                                                  Spending on machinery and equipment was the largest component of
Components of                                     investment in Puerto Rico between 1982 and 1996, representing on average
Investment in Puerto                              about two-thirds of total private investment spending. Table II.1 shows
Rico                                              that spending on machinery and equipment increased in most years from
                                                  about $0.8 billion in 1982 to about $3.2 billion in 1996. This represented an
                                                  annual rate of growth of 10 percent. The other components of private




                                                  Page 35                                          GAO/GGD-97-101 Puerto Rican Economic Trends
                                  Appendix II
                                  Additional Details on Puerto Rico’s
                                  Economy




                                  investment grew less rapidly. Spending on the construction of industrial
                                  and commercial buildings grew from about $0.3 billion in 1982 to
                                  $0.9 billion in 1996, for an annual rate of growth of 8.9 percent. Private
                                  spending on housing construction fluctuated more from year to year than
                                  the other components of investment. Spending on housing construction
                                  was about $0.4 billion in 1982, climbed to $0.72 in 1991, declined to about
                                  $0.57 billion in 1992 and 1993, and grew again to $0.97 billion in 1996.

                                  Investment in machinery and equipment declined in 1991 and 1992
                                  following the U.S. economic downturn, but recovered in 1993 and
                                  continued to grow until it declined slightly in 1996. Investment in
                                  industrial and commercial buildings fell in 1990 but grew through 1996.
                                  Investment in housing fell in 1992 but grew in every year thereafter.

Table II.1: Gross Fixed Private
Domestic Investment, 1982-1996    Dollars in millions (constant 1996)
                                                                                       Private industrial        Private investment
                                                              Private housing           and commercial            in machinery and
                                  Year                             investment                investment                   equipment
                                  1982                                   $405.2                     $269.6                     $834.5
                                  1983                                     362.7                      221.4                        921.7
                                  1984                                     323.6                      375.5                    1,115.3
                                  1985                                     391.5                      333.4                    1,315.2
                                  1986                                     406.9                      338.9                    1,424.1
                                  1987                                     503.6                      462.2                    1,669.4
                                  1988                                     555.9                      554.5                    1,981.0
                                  1989                                     580.7                      595.3                    2,303.9
                                  1990                                     705.7                      575.6                    2,418.1
                                  1991                                     715.9                      634.2                    2,395.0
                                  1992                                     569.8                      676.0                    2,388.3
                                  1993                                     574.0                      775.2                    2,762.0
                                  1994                                     660.6                      804.7                    2,914.1
                                  1995                                     750.9                      809.7                    3,224.0
                                  1996                                     973.6                      884.0                    3,187.6
                                  Note: Figures were adjusted for inflation using the Puerto Rican GNP deflators for investment.

                                  Source: Puerto Rico Planning Board, Economic Report to the Governor, various years




                                  Page 36                                          GAO/GGD-97-101 Puerto Rican Economic Trends
                                           Appendix II
                                           Additional Details on Puerto Rico’s
                                           Economy




                                           As Table II.2 shows, total nonagricultural employment in establishments in
Employment by                              Puerto Rico grew from 660,000 in 1982 to 945,000 in 1996. Over this period,
Economic Sector in                         the share of manufacturing employment declined from 22.4 percent of the
Puerto Rico                                total to 16.3 percent and the share of government employment fell from
                                           36.2 percent to 32.6 percent. Manufacturing employment has actually
                                           fallen in absolute terms since its peak in 1990. In contrast, the share of
                                           employment in the retail trade sector rose from 12 percent to 15.8 percent
                                           and the share of the nonfinancial service sector rose from 13.3 percent to
                                           18.5 percent.


Table II.2: Employment by Major Industrial Sector, 1982-1996
(Numbers in thousands of persons)
                                   1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996
Total                              660    635   665    695     709     746    796     832      841    838      844   862   879   912   945
Manufacturing                      148    141   148    149     149     148    154     156      157    152      152   151   150   153   154
         a
Mining                               a/    a/     a/     a/      a/      a/     a/      a/       a/       a/    a/    a/    a/    a/    a/
Construction                        29     23    25      28     26      32      39     44       44        44    46    47    45   46    52
Trade                              110    107   112    119     124     132    142     149      154    156      155   163   171   181   188
Wholesale                           31     29    30      31     30      32      35     36       37        37    37    37    36   38    40
Retail                              79     77    83      89     94     100    107     113      117    119      118   126   135   143   149
Finance, Insurance & Real Estate    29     28    29      30     32      34      36     37       37        37    37    39    41   42    44
Transportation, Communication
and other Public Utilities          15     15    16      16     16      17      18     19       20        21    21    22    23   23    24
Service                             88     85    88      96    100     108    117     126      132    134      139   147   157   164   175
Government                         239    236   246    257     261     273    289     301      296    291      293   292   291   304   308
                                           a
                                           Totals for mining (a/) represent numbers of less than 2,000.

                                           Source: Puerto Rico Planning Board, Economic Report to the Governor, various years




                                           Page 37                                           GAO/GGD-97-101 Puerto Rican Economic Trends
Appendix III

Information on Economic Development
Administration Promotions

                    The Economic Development Administration (EDA)/ Industrial Development
                    Company of Puerto Rico (PRIDCO) promotes investments by local and
                    overseas businesses. Generally, but not always, the investments promoted
                    by EDA receive tax exemptions under Puerto Rican tax incentive
                    legislation. According to an EDA official, EDA promotions may also receive
                    cash grants from the government of Puerto Rico.

                    The EDA promotions, which are negotiated between EDA and the business
                    owners, include commitments to hire and pay employees and to invest
                    capital in specified amounts. According to an EDA official, for promotions
                    that receive tax incentives, EDA must be convinced that the commitments
                    are realistic and made in good faith. For promotions involving cash grants,
                    the businesses must comply with the employment commitment before the
                    cash is disbursed.

                    To receive a tax exemption, the business owners must submit an
                    application to the Office of Industrial Tax Exemption. This office may
                    recommend a grant of exemption to the Secretary of State for promotions
                    that also receive the endorsement of EDA, the Treasury Department, the
                    Environmental Office, and the municipality in which the business is
                    located. The tax exemption may be granted to local and nonlocal
                    promotions. Promotions are considered nonlocal if they receive at least
                    50 percent of the capital invested from the United States or other foreign
                    countries.


                    EDA promoted a total 2,856 businesses between 1982 and 1996. Local
Promotions of the   promotions accounted for 1,731, or 61 percent of the total promotions. As
Economic            shown in figure III.1, local promotions outnumbered nonlocal promotions
Development         in nearly every year between 1982 and 1996. The number of local
                    promotions reached their highest level of 167 businesses promoted in
Administration      1987. The number of nonlocal promotions was greatest in 1988 when 120
                    businesses were promoted by EDA. Nonlocal promotions declined in most
                    years after 1988 while local promotions declined in most years after 1990.

                    The trend of generally declining promotions continued after the 1993
                    changes in the tax credit. Local promotions numbered 84 in 1995, the
                    smallest number of promotions since the 81 businesses promoted by EDA
                    in 1982, but increased to 112 promotions in 1996. Nonlocal promotions
                    numbered 33 in 1994, the smallest number of nonlocal promotion for any
                    year between 1982 and 1996. Nonlocal promotions increased to 49 in 1995
                    but declined again to 44 in 1996.



                    Page 38                             GAO/GGD-97-101 Puerto Rican Economic Trends
                                        Appendix III
                                        Information on Economic Development
                                        Administration Promotions




Figure III.1: the Number of Local and
Nonlocal Promotions by the Economic
Development Administration,             Number of promotions
1982-1996
                                        180


                                        160


                                        140


                                        120


                                        100


                                         80


                                         60


                                         40


                                         20


                                          0
                                              1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996
                                              Fiscal year

                                                       Local promotions
                                                       Nonlocal promotions




                                        Source: Economic Development Administration of Puerto Rico.



                                        Businesses promoted by EDA committed to hiring a total of 173,195
Employment                              employees between 1982 and 1996. Nonlocal businesses committed to
Committed to                            hiring 111,206 employees, or 64 percent of the total committed
Economic                                employment. As shown in figure III.2, employment committed by nonlocal
                                        businesses exceeded commitments by local businesses in nearly every
Development                             year between 1982 and 1996. The employment commitment of nonlocal
Administration                          businesses reached its highest level of 13,596 in 1988 and declined in most
                                        years thereafter. The employment commitment of local businesses
Promotions


                                        Page 39                                      GAO/GGD-97-101 Puerto Rican Economic Trends
Appendix III
Information on Economic Development
Administration Promotions




reached its highest level of 7,787 in 1986 and declined in most years after
1986.

The trend of generally declining employment commitments continued
after the 1993 changes in the credit for both local and nonlocal businesses.
Nonlocal businesses committed to hire 2,367 employees in 1994, the
smallest commitment by nonlocal businesses of any year between 1982
and 1996. Their employment commitment increased to 6,218 in 1995 but
fell again in 1996 to 3,785. Local businesses committed to hire 1,636
employees in 1995, the smallest commitment by local businesses in any
year between 1982 and 1996. Their commitment increased in 1996 to 2,913.




Page 40                               GAO/GGD-97-101 Puerto Rican Economic Trends
                                        Appendix III
                                        Information on Economic Development
                                        Administration Promotions




Figure III.2: Employment Committed to
Local and Nonlocal Promotions,
                                        Number of positions committed
1982-1996
                                        16,000


                                        14,000


                                        12,000


                                        10,000


                                         8,000


                                         6,000


                                         4,000


                                         2,000


                                             0
                                                 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996
                                                 Fiscal year

                                                        Local promotions
                                                         Nonlocal promotions




                                        Source: Economic Development Administration of Puerto Rico.



                                        Between 1982 and 1996, businesses promoted by EDA committed to
Payroll and                             investing $2.6 billion in Puerto Rico and committed to paying employees
Investment                              $2.2 billion. Nonlocal businesses made the largest share of this
Committed to                            commitment by investing $2.2 billion, or 85 percent of the total investment
                                        commitment, and by paying employees $1.5 billion, or 67 percent of the
Economic                                total payroll commitment.
Development
                                        Investment committed to local and nonlocal promotions was greatest
Administration                          during this period in the late 1980s and early 1990s. Figure III.3 shows that
Promotions                              committed investment for nonlocal promotions reached its highest level in



                                        Page 41                                      GAO/GGD-97-101 Puerto Rican Economic Trends
Appendix III
Information on Economic Development
Administration Promotions




1990 at $363.5 million, and that committed investment for local promotions
which reached its highest level of $48.6 million in 1990. Investment
committed to nonlocal promotions continued a generally declining trend
in 1994 immediately after the changes in the credit but began to rise again
in 1995 and 1996. Investment committed to nonlocal promotions fell to
$19.9 million in 1994, the smallest amount of committed investment for
any year between 1982 and 1996, but increased to $108.4 million in 1995
and $105.7 million in 1996. After increasing to $38.3 million in 1993,
investment committed to local promotions generally declined in
subsequent years.




Page 42                               GAO/GGD-97-101 Puerto Rican Economic Trends
                                                      Appendix III
                                                      Information on Economic Development
                                                      Administration Promotions




Figure III.3: Investment Committed to Local and Nonlocal Promotions, 1982-1996

Dollars in millions (constant 1996)

400




300




200




100




  0
        1982       1983     1984      1985     1986       1987     1988      1989     1990      1991     1992      1993     1994      1995      1996
       Fiscal year


               Investment committed to nonlocal promotions
               Investment committed to local promotions




                                                      Note: Figures were adjusted for inflation using the Puerto Rican GNP deflator for investment in
                                                      machinery and equipment.

                                                      Source: Economic Development Administration of Puerto Rico.




                                                      Payroll committed to nonlocal promotions was generally greater in the
                                                      1980s than the 1990s. Figure III.4 shows that committed payroll for
                                                      nonlocal promotions reached its highest level in 1988 at $193.5 million.
                                                      Committed payroll for local promotions reached its highest level in 1986 at
                                                      $104.8 million. Payroll committed to nonlocal promotions continued a
                                                      declining trend in 1994 immediately after the changes to the credit when it
                                                      fell to $28.2 million, the smallest amount committed for any year between



                                                      Page 43                                          GAO/GGD-97-101 Puerto Rican Economic Trends
                                                       Appendix III
                                                       Information on Economic Development
                                                       Administration Promotions




                                                       1982 and 1996. However, committed payroll increased to $77.4 million in
                                                       1995, and fell again to $46.7 million in 1996. Payroll committed to local
                                                       promotions declined in 1994 and 1995, but increased again in 1996.

                                                       As a comparison of figures III.3 and III.4 shows, nonlocal promotions
                                                       tended to be more capital intensive than the local promotions. Between
                                                       1982 and 1996, the ratio of committed payroll to investment was 1.8 to 1 in
                                                       local promotions while this ratio was 0.64 to 1 in nonlocal promotions.



Figure III.4: Payroll Committed to Local and Nonlocal Promotions, 1982-1996

Dollars in millions (constant 1996)

250




200




150




100




 50




  0
        1982       1983     1984     1985     1986      1987     1988     1989     1990     1991     1992     1993    1994     1995     1996

       Fiscal year


               Payroll committed to nonlocal promotions
               Payroll committed to local promotions




                                                       Note: Figures were adjusted for inflation using the Puerto Rican GNP deflator.

                                                       Source: Economic Development Administration of Puerto Rico.




                                                       Page 44                                         GAO/GGD-97-101 Puerto Rican Economic Trends
Appendix IV

Comments From the Secretary of the
Treasury of Puerto Rico




              Page 45      GAO/GGD-97-101 Puerto Rican Economic Trends
Appendix IV
Comments From the Secretary of the
Treasury of Puerto Rico




Page 46                              GAO/GGD-97-101 Puerto Rican Economic Trends
                Appendix IV
                Comments From the Secretary of the
                Treasury of Puerto Rico




Now on p. 32.




                Page 47                              GAO/GGD-97-101 Puerto Rican Economic Trends
Appendix V

Comments From the Commissioner of
Financial Institutions




             Page 48      GAO/GGD-97-101 Puerto Rican Economic Trends
                       Appendix V
                       Comments From the Commissioner of
                       Financial Institutions




Now on p. 2.




No longer in report.




                       Page 49                             GAO/GGD-97-101 Puerto Rican Economic Trends
                Appendix V
                Comments From the Commissioner of
                Financial Institutions




Now on p. 13.




Now on p. 13.




Now on p. 16.




                Page 50                             GAO/GGD-97-101 Puerto Rican Economic Trends
                Appendix V
                Comments From the Commissioner of
                Financial Institutions




Now on p. 18.




                Page 51                             GAO/GGD-97-101 Puerto Rican Economic Trends
Appendix V
Comments From the Commissioner of
Financial Institutions




Page 52                             GAO/GGD-97-101 Puerto Rican Economic Trends
Appendix VI

Comments From the Puerto Rico Planning
Board




              Page 53      GAO/GGD-97-101 Puerto Rican Economic Trends
                        Appendix VI
                        Comments From the Puerto Rico Planning
                        Board




Now on p. 4.



Now on p. 6.




Now on pp. 11 and 37.




Now on p. 12.




                        Page 54                                  GAO/GGD-97-101 Puerto Rican Economic Trends
Appendix VI
Comments From the Puerto Rico Planning
Board




Page 55                                  GAO/GGD-97-101 Puerto Rican Economic Trends
Appendix VII

Comments From the Economic
Development Administration




Now on p. 18.




Now on p.18.




                Page 56   GAO/GGD-97-101 Puerto Rican Economic Trends
Appendix VIII

Major Contributors to This Report


                        James A. Wozny, Assistant Director, Tax Policy and Administration Issues
General Government      Kevin E. Daly, Economist-in-Charge
Division, Washington,   Eric Hall, Computer Specialist
D.C.




(268789)                Page 57                           GAO/GGD-97-101 Puerto Rican Economic Trends
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