Last week, Puerto Rico took another step in its long, mostly futile attempt to stabilize its economy and budget when it filed for a modified version of municipal bankruptcy. It was the latest chapter in a 20-year struggle that began when an odd coalition of budget hawks, statehood advocates, and critics of corporate giveaways convinced Congress to phase out tax benefits that businesses could garner by locating operations in Puerto Rico. Since then, efforts to make Puerto Rico’s economy more independent and sustainable have come to little, in part because the 1996 reforms were incomplete, leaving in place tax advantages that encouraged the territory to borrow its way to fiscal oblivion, while requiring local employers to adhere to burdensome U.S. labor market requirements. The result is a floundering economy and a mountain of debt. Now bondholders will be asked to take a big haircut, including some lenders who assumed that Puerto Rico would never be able to enter bankruptcy protection. In that regard, Puerto Rico’s filing represents not just a problem for its citizens but also another blow to the protections that municipal-bond investors once believed that they had—but have seen eroded by a series of high-profile bankruptcies in recent years.
It’s a long, twisted story. Puerto Rico has enjoyed some U.S. tax advantages dating all the way back to 1921, when Congress encouraged businesses to set up operations in American territories. Puerto Rico added its own sweeteners after World War II, and the combination of these incentives sparked an economic surge in the 1950s and 1960s as the island developed a manufacturing base, thanks to new investment. Puerto Rico grew at an exceptional annual rate for a Caribbean economy, and even surpassed U.S. GDP growth. But the cost of the incentives to the U.S. Treasury began rocketing in the 1970s as companies found ways to exploit the tax code without necessarily adding new operations or hiring workers in Puerto Rico. Between 1973 and 1995, for instance, the credits cost the U.S. some $70 billion in tax collections, and a study estimated that over the next five years the cost would reach another $20 billion. Meanwhile, job creation stagnated as the mix of companies investing in the island shifted away from labor-intensive firms such as apparel manufacturers to technology-related industries like pharmaceuticals, whose heaviest investments were in research and development.
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