Why Puerto Rico’s Economy Doesn’t Work

In 1980, Puerto Rico was home to 3. 2 million people — about the same as South Carolina. But whereas South Carolina gained another two million residents over the next 50 years, Puerto Rico gained just two… thousand people. 2,705, to be exact — a net increase of 0. 08%, or 61 people a year. In that time, the island experienced a spectacular rise, followed by a spectacular and unprecedented fall. It went from surpassing the economic growth of the U. S. mainland during the Reagan and dot-com booms, to a 15-year period of negative growth dubbed a “death spiral” by its former governor. So, how did Puerto Rico’s economic future become so bleak, so fast? Sponsored by Nebula. Watch my exclusive series “China, Actually” and dozens more for just $2. 50 per month with the link in the description. By the late 1940s, Puerto Rico had been a U. S. territory for nearly half a century. Unlike the rest of the American economy, however, it remained almost entirely dominated by agriculture. Pressure began growing to close this gap — to develop the island into something more than a giant sugarcane plantation. …Particularly during the Cold War. With Communist Cuba less than 500 miles away, this tiny appendage of the U. S. empire took on ideological and geopolitical significance. Thus came “Operation Bootstrap” — a multi-decade campaign to transform Puerto Rico into a “modern,” industrial, export-oriented economy in the style of Hong Kong or South Korea. …One component of which was something called “Section 936” of the U. S. tax code. Section 936 lowered the federal income tax to zero on money earned in Puerto Rico. This, at the time, was revolutionary. U. S. corporations were then only flirting with the idea of outsourcing. Microsoft, Nike, and Pepsi hadn’t yet left the States for Taiwan, Malaysia, and China. Puerto Rico gave them a chance to experiment: here they got access to cheap labor, generous tax breaks, and pristine white-sand beaches …all within the American empire. But this was really — lucrative for one industry in particular: Big Pharma. Under Section 936, of course, the goal was to claim as much of your revenue as possible in Puerto Rico, making it tax-free. This was ideal for pharmaceutical companies because the price of a drug is almost entirely attributable to its patents. And, as abstract legal property, patents can be instantly moved anywhere on the planet. A U. S. parent company like Pfizer could transfer its intellectual property to its Puerto Rican subsidiary. Then, when someone in Charlottesville or San Jose bought some Lipitor, it could argue those patents were responsible for, say, 90% of the sale price — shifting that income to the tropics. At the same time, you had to prove some tangible link between the island and the product itself. This, too, was perfect. After all, once a drug is developed, tested, and brought to market, producing the two millionth tablet is cheap and can be done just about anywhere. By 1990, 17 of the top 21 most popular drugs in the United States were made in Puerto Rico. One factory singlehandedly produced all of North America’s Viagra. One by one, as new “blockbuster” drugs exploded onto the U. S. market, the island prospered. Manufacturing soon accounted for nearly 40% of its GDP, twice the average in the region. There was just one problem: it all depended on the whims of Congress. Section 936 was signed into law with the stroke of a pen and it could just as easily be taken away. And by the mid-90s, the Cold War was over and Puerto Rico had lost its strategic importance. Meanwhile, America’s focus turned toward tax reform and reducing the deficit. Besides, if the goal was to subsidize the development of its distant territories, Congress realized, this was a wildly inefficient way to do so. For every one employee they hired in Puerto Rico, for example, pharmaceutical companies were saving $70,000 in taxes. In other words, the U. S. government was effectively paying $70,000 to employ a single person — in a place where the per capita GDP was about nine thousand dollars. Section 936 began looking more and more like a giant, wasteful handout to Big Pharma. But rather than reform the law — perhaps by creating new incentives for corporations to

truly invest in the Puerto Rican economy — Congress simply deleted Section 936 from the tax code and quickly moved on, leaving Puerto Rico in the dust. That was bad enough. But things soon got worse. Previously, Puerto Rico held a privileged position when it came to trade. Unlike all other U. S. territories — Guam, American Samoa, the U. S. Virgin Islands, and the Northern Mariana Islands — Puerto Rico is located within the U. S. customs area — meaning drugs manufactured on the island and shipped to the American mainland weren’t subject to tariffs or trade restrictions, while those in, say, the Bahamas, or Trinidad, or Colombia were. But as free trade became the norm with the passage of NAFTA, China’s joining of the WTO, and dozens of other bilateral trade agreements, Puerto Rico became just like the rest of them. So, companies left for Ireland, Mexico, China, and elsewhere. After Section 936 was fully phased-out in 2006, the Puerto Rican economy plunged into freefall. And to make matters even worse: the Great Recession came two years later. By 2013, 230,000 out of Puerto Rico’s 1. 2 million total jobs had permanently disappeared. At this point, the island had been losing revenue for decades as companies moved elsewhere. At the same time, the government had accumulated a large and growing bureaucracy. Even between 1960 and 80 alone, the number of public employees had already tripled. Facing shrinking revenue and rising expenses, something had to change. Now, 49 of the 50 states are legally required to balance their budgets — spending no more than they earn. Of course, cities and states can and do borrow money. When the city of Binghamton, New York decides it needs a new freeway, it can ask for a loan by selling municipal bonds. But when those investors ask how it intends to repay them, it can’t shrug its shoulders and say “we’ll figure that out later. ” It needs a plan. And the same is true of Puerto Rico. Its constitution states that “appropriations… shall not exceed total revenues. ” …At least, that’s what it says in English. The problem is that when written in Spanish — the language widely spoken on the island — the word “revenues” in the phrase “total revenues” was mis-translated as “resources. ” And in 1974, it decided that those “resources” included bonds. …Meaning, the Commonwealth of Puerto Rico can only spend as much as it earns …unless it takes on debt, in which case, it can spend as much as it wants with no real plan for repayment. So much for a balanced budget. This loophole proved far too tempting to resist. The alternative, after all, was initiating layoffs, and politicians who use the “l-word” tend to lose their re-elections. Now, it would be one thing if the government used this… creative interpretation of its constitution to invest in its future. If it borrowed money to build a new highway to lower transportation costs and thus attract manufacturing companies to return to the island, that might be a good use of the loophole. But these were not one-off, revenue-generating projects. The government was borrowing money for regular, ongoing expenses — to pay the salaries of the firefighters and teachers and garbage collectors it had too many of. Before long, it was taking on new loans to pay back the old ones — sinking further and further into a giant hole of debt. A U. S. government report found that 16 out of 20 bonds issued between 2000 and 2017 were used exclusively to repay or refinance existing loans. In 2006, Puerto Rico even introduced a new sales tax for this very purpose — effectively making ordinary citizens pay directly for the mistakes its politicians made years ago — all while scaring away companies and reducing economic activity. By 2015, it had one of the highest sales taxes in the United States, at 11. 5%, despite nearly half of its residents living below the poverty line. Normally, this would all end fairly quickly. You can’t keep borrowing money if no one is willing to lend it. And who would keep lending money to someone who so clearly can’t repay you? Normally. But Puerto Rico was no “normal” borrower. For three reasons: First, its constitution states that bondholders are prioritized in case of default. Meaning, if the government ran out of money, lenders would get paid first — before, for example, teachers and doctors got their salaries.

Second, since 1917, bonds issued by Puerto Rico have been “triple-tax exempt. ” If you’re an investor living in Greenwich, Beverly Hills, or Palo Alto, you could buy bonds from the city of Binghamton, but you’d probably have to pay city, state, and federal taxes. Or you could buy Puerto Rican bonds — even while living in the Hollywood Hills — and never pay a single dime in taxes — not to your city, state, or federal government. Finally, there was an unspoken assumption that Puerto Rico was too big to fail — that Washington would surely step in to bail its territory out. For all these reasons, investors just kept buying more and more of its bonds, even as its economic picture became darker and darker. But all that changed in July of 2013, when the city of Detroit, Michigan filed for bankruptcy. After Obama decided against a bailout, investors in Puerto Rican bonds got very, very nervous. Its bonds were downgraded to “junk” status and interest rates soared past 8% — an incredibly high number for tax-free government bonds in the era of low interest rates. It was only a matter of time before the island would face its economic reckoning. And it finally came in 2015, when the governor admitted the territory was caught in a “death spiral” it could never recover from. It made Detroit’s $18 billion of debt look like child’s play. Puerto Rico owed $73 billion — 120 if you include its unfunded pensions. Per capita, it owed fifteen times as much as the median U. S. state. After months of negotiations, the U. S. federal government reached a deal with the Commonwealth: the island would effectively be allowed to declare bankruptcy — paying its lenders less than they were owed. In exchange, to make sure it didn’t make the same mistakes again, Congress gave an unelected “oversight board” veto power over the Puerto Rican budget. And that board decided the government should temporarily cut back on its expenses — eliminating sick days, reducing pensions, and rationing healthcare. Now, that part was not unusual. If one of Puerto Rico’s neighbors — say, Barbados — defaulted on its loans, it could ask the IMF for help. The IMF would then impose conditions — laying off excess workers, lowering salaries, raising taxes, and so on — just as Congress did with Puerto Rico. The problem is that: Puerto Rico is different in one key respect. The citizens of Barbados would really have no choice but to endure this hardship. They wouldn’t enjoy the reduction in sick days or smaller pensions, of course, but ultimately, what can they do? Puerto Ricans, on the other hand, can simply leave. As U. S. Citizens, they’re free to study, work, and live anywhere in the United States without restrictions — they don’t even need a passport. Which means: anyone can opt out. If taxes are too high, if salaries are too low, or the bus is too slow, you can pack your bags and move to Miami, Orlando, or Brooklyn. And that’s exactly what many did. Each year, 50 to a hundred thousand Puerto Ricans leave for the mainland. Today, nearly twice as many self-identified “Puerto Ricans” live on the mainland than on the island itself. And even these numbers undersell the economic impact of this migration. Those most likely to leave are young, well-educated, and high-earning. With a median age of 43, Puerto Rico is now older than every state except for Maine. Fewer than half of its adults are in the labor force. And the more taxpayers leave, the higher the burden shared by everyone who stays behind, which, in turn, causes even more to flee, in a vicious self-reinforcing cycle. Puerto Rico, in other words, is less like its Caribbean neighbors — a young, thriving, developing economy on the rise — and more like West Virginia — a deindustrialized, de-populating, and declining backwater in a globalized world. To slow the outmigration, the island would first need to improve its economic condition. And condition, it first needs to slow the outmigration. The odds of successfully untying this Gordian Knot are slim. Despite being substantially wealthier, for instance, West Virginia has been unable to slow its population decline. Or, take China. The Chinese government portrays itself as a master of social engineering — governing its 1 billion citizens with efficient, finely-tuned policing. Yet even it has struggled to increase its birth rate or enlarge its labor force.

In fact, its signature achievement in this domain — the cruel yet “effective” One-Child Policy — is something of a myth. In truth, there’s very little evidence it worked as intended. In the words of one of the policy’s foremost experts, quote, “Probably relatively little of the… fertility decline resulted from making the small family mandatory and from using heavy-handed techniques to enforce it. ” To learn why — and explore how this myth became so incredibly popular — watch this exclusive video I made on today’s sponsor, Nebula. It’s just one episode in my Nebula Original series “China, Actually,” in which I take a deeper, more nuanced look at some of the most fascinating parts of the country. In this other episode, we look at how Chinese censorship actually works on the ground, and in this one we debunk the myth that China is racing ahead to build more nuclear weapons than America. On Nebula, you’ll find your favorite creators making bigger, better, and higher-budget dream projects… Projects like RealLifeLore’s “Mad Kings” — a deep dive into the world’s most notorious dictators, from Suddam Hussein’s son to Kim Il-Sung. And projects like DownieExpress’ “Europe 2 Asia” — a five-part journey between continents using only trains. Nebula is ad-free and even gives you free “Guest Passes,” so you can watch along with friends and family. Normally, Nebula costs $6 a month. But you can get it for less than half that by signing up for a year with the link on screen or in the description now. That’s just $2. 50 a month for all the Originals I mentioned and more. If you’re not a fan of subscriptions, you can also get $200 off Nebula Lifetime with the Lifetime link below.