Newsletter: Puerto Rico Economic Pulse©

The Government’s delicate financial position has deteriorated significantly since January 2015. Delays in approving a tax increase on oil imports—against which the PR Highway and Transportation Authority (PRHTA) would issue bonds to service its debt with the Government Development Bank (GDB)—have led to onerous terms for the Commonwealth. Furthermore, the storm set-off by the proposed tax reform, unrelated to the tax hike on oil-related products, has increased uncertainty across the board and possibly tilted the Island’s fragile socioeconomic balance in the wrong direction. Unfortunately, the problem is even more delicate. Recent revisions to employment data meant that economic activity has been even slower than initially thought, perhaps resulting in yet another contraction in GNP. Inflation entered negative territory with the General Fund having at one point only $10 million in its coffers. This issue analyzes the economic and financial risks this is creating.

Why the need to overhaul PR’s tax system now? Is there a convincing case for this tax policy reform to support a recovery in PR’s economic growth? The current tax reform calls for a Value Added Tax (VAT) to replace the current Sales and Use Tax (SUT) while overhauling the current income tax system and generating “adequate” revenues. The proposed VAT to be implemented effective January 2016 calls for a temporary increase in SUT from 7% to 16% on April 2015. A new source of revenues would enable other taxes, such as income taxes for certain brackets, to be abolished. Businesses would be subject to a higher yet flat corporate income tax rate as well as capital and dividend gains. Consumption patterns between income brackets can differ and a complex regressivity mechanism for lower income groups is not yet clear. Employment effects could be larger since smaller firms may have layoffs, ultimately worsening the situation on the island.

Much has been said and speculated about the proposal to replace the current sales tax with a new value-added tax. The arguments for and against it have so far filled media outlets, sometimes with contradictory facts and figures. Moreover, the very nature of the VAT makes it a more complicated and technically involved scheme than the current sales tax. As a result, much of the public conversation so far has been clouded with commentaries that contribute very little analysis regarding the practical consequences that the proposed VAT would bring to businesses, individuals, and municipalities. In addition, there are a number of technical issues regarding the implementation of the proposed tax structure that have not been properly addressed yet either. To help bridge this gap, this issue of the Pulse takes an in-depth look at some of the consequences of implementing a VAT in PR. Anticipated consequences range from uncertainty to high inflation to lower than expected fiscal revenues.

Weaker demand for oil and large increases in US oil production have pushed oil prices to their lowest since the 2008 financial crisis. Oil price has fallen by more than 40% since June, when it was $115 a barrel. It is now below $60. As oil price continues to fall, consumers can expect more money in their pockets to pay for gasoline, electricity, and other goods. The Puerto Rican government proposed a new increase in the excise tax on crude oil and its products to provide liquidity to the Government Development Bank (GDB), which is the fiscal agent of the Commonwealth Government. These additional revenues would service $2.9 billion in bonds to be issued through the Infrastructure Finance Authority (AFI in Spanish). The tax hike is expected to increase gasoline prices but, short term, the impact will be lower due to falling gasoline prices. Energy costs, exempt from the new tax, are expected to drop to pre-2008 levels. Now PR needs to undertake significant reforms before prices begin to rise again. Find out whether cheap oil and a growing US economy will promote growth in PR.

Puerto Rico’s Great Recession, as is the case with any complex phenomena, is not without its own myths. For example, the prevailing wisdom is that those with college degrees have driven the recent loss of population in PR or that US economic growth will somehow induce growth at home. Moreover, a careful look at the evidence shows that our traditional economic thinking is simply no longer applicable to the Island’s current economic reality. This issue of PR Economic Pulse aims to counter several of the myths regarding PR’s present cycle, many of which have even created media headlines. We also provide a fresh look into once firmly rooted economic orthodoxy and offer some insight as to the relevance of such rationale for our present troubles. Now, more than ever, an honest and careful examination of our economy’s current economic fundamentals is needed if we want to permanently reverse our current course.

According to the Merriam Webster Dictionary, a game changer is a newly introduced element or factor that changes an existing situation or activity in a significant way. Over the past eight years, the Puerto Rico economy has been in a terrible slump. Fiscal priorities have taken precedence over economic policies and time is running out. We have eroded our tax base and maximized the limits of public debt of the Central Government as well as its public corporations. Our objective is to provide a concise but compelling look at some key elements that will change the course of the PR economy and lead us to the path of recovery and growth, if only there is the leadership to execute and implement tough choices. This issue focuses on drivers and strategies that we know can work yet nothing happens.

The “elephant in the room” is debt. The PR economy has a hard time escaping a 0.0% to negative real growth level. Meanwhile, the U.S. continues on sluggish 2.0% growth. Shortly put, the PR theme since 2000 has been: “low interest rates help service the public and private debt burden. Pretend to have a credible plan, but never address the structural problem and simply buy more time.” Are households in PR at the end of the line? Time has caught up. Sustained high unemployment, migration flight, and a tax system built on punishing production and rewarding consumption is not sustainable. Households and government are speeding towards the inflection point at which point debt becomes harder to service because pretend-and-extend policy making has created a depression in investment and growth. PR’s public debt is now at 103% of GNP vs 61% ten years ago. Many households in PR are at the point where cash generated by assets is insufficient to service the debt taken on to acquire the asset, particularly regarding mortgages.

A serious particular effect of severe downturns is that declining consumer spending, itself a reaction to the economy’s contraction, also undermines the prospects for recovery. In worst cases, a prolonged and deep plunge in consumption reinforces production driven recessions entering in a negative spiral. This takes place in closed economies, such as the US, where a significant number of consumer goods are produced in the mainland. Consumption is, in other words, a fundamental determinant of business cycles. Consumption is also a measure of the set of socioeconomic conditions that underlie consumer behavior, such as job opportunities, migration, price fluctuations, access to credit, and financial stability. The level of uncertainty in the PR economy and society is currently high. There is nothing to indicate that the current crisis will change quickly. How does the PR consumer behave in times of recession? This issue analyzes the impact of the ongoing recession on household consumption, effects, and threats for the future.

Politics overseas coupled with new technologies and rising economic needs in Asia have been reshaping the fundamentals of world energy markets for some time already. Social and economic upheaval in the Middle East, including the possibility of lifting Iran’s long-standing sanctions, has created new vested interests. Long dormant, yet unresolved, issues in South East Asia have resurfaced as China’s economic and military assertiveness remains in place. On the other side of the globe, the US is edging ever closer to effective energy independence thanks, in small amount, to the development of induced hydraulic fracturing. All these shifts will lead to more competition in energy markets, which, in principle, augurs well for PR. However, that may not necessarily translate into improvements on the ground if conditions on the Island do not change. There is still time but the window of opportunity at home is closing by the hour. PREPA, the electric power authority, is currently the island’s biggest challenge and opportunity for change.

There is a generation gap in the workforce. Baby boomers, born between 1946 to mid 1960s, resent Generation Y or the Millennials, born since the early 1980s to late 1990s. And Generation X, those born between mid 1960s to early 1980s, is fed up being “stuck in the middle between older workers who refuse to retire and younger ones who are treated far better than they ever were.” Puerto Rico needs to manage these three age groups with such differing attitudes. There is a widespread consensus among educators, marketers, and policymakers that digital technologies have given rise to a new generation of students, consumers, and citizens who see the world in a different way. Growing up with the Internet transformed their approach to work. Puerto Rico’s difficult economic and fiscal situation needs to regain competitive advantage in what it can produce and sell. Innovation plays center stage in this transformation. Can Millennials help?