To: Members and Staff, United States Congress
From: Pete Sepp, President, National Taxpayers Union
Re: Practical Guidance on Debt Restructuring for Puerto Rico and Fiscal Reforms
Background
A great deal has been written on Puerto Rico’s fiscal predicament, which involves contributing factors such as a protracted economic downturn, erratic revenue collection, a bloated public sector, a brittle regulatory regime, and weak controls over borrowing. In a Senate Finance Committee hearing last week former Congressional Budget Office Director Douglas Holtz-Eakin offered a cogent but sobering assessment of conditions on the island:
Over the past 10 years Puerto Rico’s gross domestic output has dropped from over $100 billion annually to roughly $95 billion.
Unemployment spiked between 2005 and 2010, but even today the rate remains quite high at approximately 12 percent.
In addition to population flight from the island, labor force participation for those remaining in Puerto Rico has dropped more precipitously, from about 46 percent in 2005 to 40 percent today.
General fund debt service costs are soaring, and by next year could easily be more than twice the level they reached in 2012 (as a percentage of revenues). Holtz-Eakin astutely pointed out, “A common bright-line for identifying distressed sovereign borrowers is when interest exceeds 10 percent of revenues. The Commonwealth reached this level as of March 2015.”
In mid-2015 total public sector debt in the Commonwealth had surpassed $71 billion; some $48 billion of this amount is the result of borrowing from more than a dozen public corporations.
Few of these trends are likely to see dramatic improvement without a fundamental shift in the economic and fiscal environment, fostered by sensible policies on the part of the federal officials as well as Puerto Rico’s leaders.
On July 8, NTU sent a lengthy communication to Congress (available here) explaining the past history and current pitfalls of the Chapter 9 bankruptcy approach, which has been suggested as a remedy for Puerto Rico’s plight. I would invite you to review the decidedly mixed results of Chapter 9 – and possible alternative pathways – outlined in that letter. In short, Chapter 9, employed infrequently in the first place, has not uniformly led to necessary structural changes in unsustainable government undertakings; nor has it always led to a speedy resolution of existing debts. On the other hand, tools such as control boards or state-level conservatorships proved viable for several cities.
Since our July 8 communication, Governor Alejandro Garcia Padilla has released a “Fiscal and Economic Growth Plan,” (FEGP). Even though the report contains several commendable proposals for reform, their timing and implementation is problematic. After all, the very first item in the plan’s “Requests to the Federal Government” is “[a]ccess to a legal framework to restructure the Commonwealth’s liabilities in an orderly process.” This hierarchy of priorities is troubling, and clashes with other statements expressing preference for “a voluntary adjustment of the Commonwealth’s debt.”
Another thorny timing issue is that the plan’s major revenue enhancement moves – a higher sales tax, base-broadening to business-to-business transactions, and transition of the sales tax to a Value Added Tax (VAT) – are either already underway or will be completed by early next year. In contrast, some of the larger expenditure reduction measures (e.g., reducing subsidies to localities) require new legislation or sweeping executive actions, which have yet to be demonstrated. The economic growth upon which so much of the success of the plan depends is far less likely to occur without engendering confidence among citizens, businesses, and investors that officials are committed to regaining control over government finances.
Third, the framework is strangely selective in enumerating the steps that Puerto Rico’s government could undertake immediately, without action by its own legislative branch or the U.S. Congress. Among these are modest “economies of scale and efficiencies” from government procurement reform by June of 2016, yielding a savings of some 4 percent. In fact, legislation enacted in 2011, which the Executive Branch has neglected to fully implement, could yield savings of more than twice that amount if vigorously applied. Additionally, for more than six years, statutory law has provided for aggressive deployment of public-private partnerships in infrastructure, yet this power has fallen into considerable disuse, depriving the Commonwealth of billions of dollars in savings as well as potential revenue from the creation of non-governmental taxpaying entities.
Fourth, Puerto Rico’s budgetary accountability institutions remain on a foundational equivalent of quicksand. The government has been unable to produce auditable financial statements for the past two years, while consolidation of fiscal reporting agencies is not expected to occur until June of 2017. The Control Board envisioned by the Governor’s task force would not have oversight authority related to PREPA or PRASA, two notoriously mismanaged public corporations, and appears to vest appointment power (and to a lesser extent nominee selection input) with the Governor. These factors certainly do not bolster the credibility of the plan; indeed, even the government itself admits that there are “significant political and execution risks.”
In NTU’s opinion, such risks can only be mitigated by dramatically strengthening the implementation conditions surrounding those reforms in the Governor’s plan that are worthy, as well as proposing further structural changes to the way fiscal policy is made in Puerto Rico. Some of these changes can be effected through Congress, others through the Executive Branch, and still others from Puerto Rico’s governing bodies. All are essential to restoring the island to the vitality it deserves.
Recommendations
It is worth noting here that many of NTU’s observations are equally applicable to the United States government, which has hardly acted as a paragon of fiscal virtue. Indeed, leaders in Washington could bolster the moral authority of federal guidance by putting these ideas into practice nationwide.
The following recommendations elaborate upon the themes NTU stressed in its letter sent to Representatives and Senators today. That letter can be accessed online at www.ntu.org.
Establish a Control Board with Teeth. The Control Board that Congress created in 1995 to foster better stewardship over the District of Columbia’s finances was not a perfect arrangement. District leaders were initially suspicious of the idea, and it took a high degree of professionalism and political savvy among the Board’s members to establish a productive partnership that led the District out of its woes. Rather than accede to what would ultimately be an ineffective application of Chapter 9, Congress should proactively establish a Puerto Rico Control Board that will give the legislative and executive branches of the U.S. Government statutory authority to appoint designees. The Puerto Rico government should also be able to confirm its own nominees. Staffing, especially for personnel charged with providing quality data to the Board members, should be statutorily defined so as to draw upon more experts who are outside the island’s political power structure.
This does not mean, however, that individuals with a solid technical knowledge of Puerto Rico’s institutions should be excluded. Such staff members, particularly legal counsel, would be indispensable in navigating the complexities of Puerto Rico’s unique policy framework.
Congress should further insist upon the development of stronger, safer communications channels for whistleblowers who wish to report government waste, fraud, and abuse, including anti-retaliation provisions for those who communicate directly with the Control Board. Several models could answer to this purpose, including the Whistleblower Protection Enhancement Act of 2012 and Senator McCaskill’s legislation (S. 795) to extend anti-retaliation protections to federal contractors and grantees. The latter proposal could be especially helpful in regard to Puerto Rico’s plethora of public corporations. Our allies in the whistleblower protection movement, such as the Government Accountability Project (GAP), could also provide invaluable assistance in revising Puerto Rico’s laws based on the organization’s experience in the U.S. and countries across the globe. GAP has assisted the Organization of American States in crafting model whistleblower legislation.
In turn, the Control Board should be empowered to report regularly and directly to the U.S. Congress on actions it is taking to restore budgetary discipline.
Engage in Sweeping Regulatory Revision. As Congress continues to debate increases in the federal minimum wage, it would do well to examine the wreckage of harsh labor rules in Puerto Rico and salvage a more rational policy from them. Immediately granting two proposals to waive future minimum wage hikes for younger workers, and to waive Puerto Rico from the Labor Department’s tougher salary standard for exempt employee status, would be modestly helpful. However, much more sweeping steps are necessary, such as widening the minimum wage waiver to include employees of all ages, or simply allowing the wage to adjust to the regional labor market realities in the Caribbean.
Some would argue the cost of living in Puerto Rico is higher than in nations surrounding it, so wage-floors must remain high. Yet, that cost of living is often directly related to policies within the control of Congress. The FEGP rightfully calls for repeal of the Jones Act’s application to the Commonwealth. While NTU would contend that this law’s antiquated framework is unsuitable for commerce in any area of the United States, dismantling Jones Act restrictions for Puerto Rico is the very least Congress should initiate. As Salim Furth and his colleagues at the Heritage Foundation cogently stated in a recent analysis, Jones Act repeal amounts to “effectively giving everyone on the island a raise.” Likewise, Puerto Rican exports would carry a lower price tag, thereby boosting local manufacturers.
If lawmakers are not willing at this time to consider complete repeal of the Jones Act, we would commend their attention to more incremental reforms. One of these has been developed by the Hawaii Shippers Council (HSC) to “exempt the noncontiguous domestic shipping trades from the U.S. build requirement of the Jones Act for large oceangoing self-propelled ships only.” NTU has recently been given a briefing from HSC about its plan, and the documentation provided us indicates that Congress could readily adapt it to legislation.
The Heritage Foundation’s Furth also argues that Congress should grant flexibility to Commonwealth officials in spending federal welfare grants and in reorienting their own benefit programs so that they no longer penalize work as heavily. A report for the Government Development Bank undertaken by economist Anne Krueger observed that monthly government payments for an eligible household of three actually exceed the median wage earner’s income. This is not a formula for incentivizing work, and is reflected in a labor force participation rate that is far lower than the average for the rest of the United States.
Other initiatives must address impediments to business activity. Privatization programs, especially of public corporations and with education and transportation infrastructure, must be accelerated. Laws already in place can facilitate this process if they are wielded with zeal, but here again, Congress can assist, by fast-tracking approval from U.S. federal agencies for transfers of airports and other assets.
Last year, Puerto Rico’s Legislative Assembly passed legislation requiring public agencies to embrace wherever possible a public-private partnership that NTU supports: Energy Savings Performance Contracts (ESPCs). Through a competitive bidding process, private firms are awarded ESPCs to make energy-efficiency upgrades, using their own up-front financing and employing their own labor. Contractors then recoup their investment from resulting cost savings (which are verified using contractually negotiated criteria), but statutory law stipulates that taxpayers must be first in line to receive the dividends before any appropriations against cost reductions are made. If savings fail to materialize in any given ESPC, the contractor is responsible for making the government whole. ESPCs are only one example of the innovative approaches that Puerto Rico’s policymakers (and their counterparts in Washington) should be pursuing with assets that remain in government hands but could still benefit from private know-how in their operation.
Permitting processes, long an obstacle to business starts, must be streamlined in Puerto Rico. As Mario Lopez of the Hispanic Leadership Fund recently wrote, “In Puerto Rico, it can take six years to get a permit for a large-scale development project or six months for a standard construction permit. The permitting process in Puerto Rico stifles private sector investment and construction.”
Conduct a Top-to-Bottom “Housecleaning” of Government. Puerto Rico needs a systematic procedure for evaluating all government spending programs in terms of their efficiency and effectiveness. U.S. state experience can provide useful guidance in this regard. Texas, for example, has a highly-evolved “sunsetting” process that ensures every state program is regularly subject to rigorous assessment rather than rote reauthorization (in fact all federal programs in the U.S. should receive such scrutiny). Relevant federal legislation has been introduced in the form of H.R. 183 by your colleague, Representative Hudson.
Other techniques, such as technical auditing, life-cycle cost analysis, and open competition for materials selection should be required for any projects in Puerto Rico involving U.S. federal funds (again, a good standard that should be applied everywhere, not just in Puerto Rico). In 2014, NTU testified about the applicability of these policies for federally funded water projects. A section of that testimony bears repeating here:
Although far from perfect, recent Congressional action on a pilot program version of the Water Infrastructure Finance and Innovation Act is a sign of bipartisan interest in developing alternatives to high-cost funding processes for water and sewer initiatives. Other commendable strides have been made in the clean-water grant programs of the U.S. Department of Agriculture’s Rural Development Office and Rural Utilities Service, both of which build safeguards into their disbursement procedures that hold project leaders accountable for practicing open procurement policies.
Furthermore, though it was flawed in numerous aspects, the Moving Ahead for Progress in the 21st Century Act made a more robust federal (and state) commitment to Life Cycle Cost Analysis (LCCA) techniques for transportation projects. LCCA has an integral role in ensuring that open competition procedures yield the most effective result for taxpayers.
To reiterate, these are not mere semantic or academic exercises; they translate into genuine, significant, budgetary savings. In 2013 a Government Accountability Office study of state transportation project-evaluation practices determined that 13 of the 16 agencies analysts contacted had embraced some form of LCCA. The GAO report noted that “Officials in all 13 states indicated that LCCA helped ensure that the agency selected the pavement that was most cost-effective over the long term… .”
Unfortunately, government procurement practices at the municipal level are too often steered by antiquated rules that prevent taxpayers and ratepayers from receiving the effective return they deserve for the dollars they are required to pour into local infrastructure of all kinds. This is especially the case with water and sewer systems.
Furthermore, Puerto Rico should establish a military Base Realignment and Closure (BRAC)-style mechanism that would routinely develop rosters of government assets for sale or conversion to private uses. The same could be done for ineffective programs, unwarranted business subsidies, and bureaucratic institutions. This could provide for an “up-or-down” vote of Puerto Rico’s Legislative Assembly on a package of items which, if considered individually, might otherwise meet too much resistance from affected interests.
The plan presented by the Governor’s task force only scratches the surface of what is possible – and necessary – for a transformation in the way Puerto Rico sets its spending priorities for personnel. Mr. Holtz-Eakin’s testimony cited an interesting statistic that for some Puerto Rican municipalities, worker overhead comprised 98 percent of expenditures – a figure which, even if subject to revision, is startling. Compensation for government employees should reflect experience with defined contribution retirement options, and with health savings accounts, at both the federal and state levels. Although still not the primary retirement arrangement for state and local employees, Federal Reserve statistics show that more than half a trillion dollars are held in defined contribution plans for workers in those areas of government.
Finally, the basis for all future exercises to evaluate government spending is reliable, consistent data subject to public scrutiny. Such a concept has only recently proliferated in the continental United States. The Federal Funding Accountability and Transparency Act of 2006, along with the Digital Accountability and Transparency Act of 2014, have opened wide avenues for the public to access searchable information on grants, contracts, and other federal expenditures.
Some might argue that these laws would require massive technological leaps to adapt them for Puerto Rico’s institutions, which suffer from serious impediments to transparency. NTU would assert that even if this is the case, there are other routes to pursue. In the mid- and late-2000s, numerous U.S. state governments, with varying degrees of technological sophistication and commitment to enhancing public information, managed to create highly functional online spending databases. NTU’s allies in this movement, such as American Transparency and the Sunlight Foundation, can furnish important insights on initiatives with direct applicability to Puerto Rico.
Keep Tax Levels Reasonable. Puerto Rico has made some good strides toward creating an income tax system that is friendly to investment for those who choose to relocate there. Although there are certain restrictions and requirements, individuals and businesses can earn interest and dividends tax-free if they become residents, pay zero tax on capital gains appreciations going forward, and pay a five percent tax on appreciations that occur prior to establishing residency. These are positive steps that could, over time, help to offset the flight of talented individuals and capital from the Commonwealth.
However, the island still must make additional progress in a number of areas, such as eliminating its alternative minimum tax, establishing a less burdensome and stable corporate tax regime, and setting more rational guidelines for taxation of property. As the Tax Foundation notes, even though the top corporate tax rate in Puerto Rico is advertised at 20 percent, a surtax pushes the actual statutory rate to roughly the same level as the U.S. federal and average state rate. Attempts to lower this rate, broaden the base, and do away with an onerous gross receipts tax were thwarted, even as a large sales tax hike (which will transform into a Value Added Tax) was cemented into law. This is a dangerous combination of events that must be rebalanced quickly.
Congress must take care not to hinder positive, pro-growth developments in Puerto Rico tax policy, and should to the greatest extent feasible encourage more evolution. Should lawmakers take the much-needed step of introducing a territorial approach to our tax system, protecting Puerto Rico from minimum tax measures or excessive base erosion strictures would be helpful.
Restoring Constitutional Fiscal Discipline and Reaffirming Rule of Law. Puerto Rico’s Constitution contains what appears to be a robust requirement that “appropriations” in a given fiscal year “shall not exceed total revenues, including available surplus, estimated for said fiscal year, unless the imposition of taxes sufficient to cover said appropriations is provided by law.” Yet, according to a September 5 analysis for The Hill from David R. Martin, this English-language version of the constitutional balanced budget requirement officially accepted by Congress in 1952 has been subsequently translated into irrelevance. Martin recounted how, in 1974, Puerto Rico’s Attorney General interpreted earlier debates over this section as justification to embrace a Spanish-language iteration of “total revenues” that carried the meaning of “total resources” – thereby enabling receipts from government bonds to be satisfy balanced budget strictures.
Moreover, Martin demonstrated how Congress made the “monumental mistake” of allowing Puerto Rico’s separate debt ceiling law to be weakened over 50 years ago. He noted that even under this porous ceiling, Puerto Rico’s general obligation bond authority would have been exceeded earlier this year. Yet because of further legerdemain, such as new borrowing through “appropriation debt,” the limit has been completely eviscerated. Unlike areas of the continental U.S., taxpayers in Puerto Rico have no standing in court to enjoin evasion of this type.
Puerto Rico’s courts could act on their own to, in Martin’s words, “finally stop the persistent charade by enforcing the island’s law.” However, legislators here and in San Juan could have a constructive role in ensuring that the constitution’s fiscal discipline mechanisms are updated. One approach would be to convene a joint body charged with ensuring that the original English-language intent of Puerto Rico’s constitutional debt controls is clarified for the Spanish lexicon.
Most versions of the Balanced Budget Constitutional Amendment in the House and Senate specifically stipulate that both “receipts” and “expenditures” “derived from borrowing” are not subject to their strictures. One such amendment, H.J. Res. 95 sponsored by Rep. Amash, also applies the budget-balance requirement using an average of receipts on a three-prior-year basis, thus allaying concerns over the federal government’s ability to respond to downturns. Congress should, to the maximum practical extent, encourage the Legislative Assembly of Puerto Rico to propose a Constitutional Amendment for a popular vote that would incorporate stronger protections such as these.
Giving citizens further rights to challenge illegal government debt in court, as well as approve more forms of bond issues through the ballot box, are also imperative. One of the strongest safeguards afforded citizens to vote on and if necessary mount a lawsuit against government fiscal action has existed in Colorado since 1992. That state’s constitution (Article X, Section 20), provides for voter approval of bonded debt from districts, state and local tax increases, or spending growth beyond benchmarks such as inflation or student enrollment growth in school districts.
Aside from the limits themselves, with which policymakers might disagree, the mechanics of how these limits operate are in NTU’s view the state of the art. Article X, Section 20 specifically outlines when elections concerning the fiscal limits are to be held, how ballot titles are to be phrased and what information they should contain, how individuals and classes may enforce all provisions in court, how priority of resolution is to take place, and how litigants may be compensated. Intensive study of this and other states’ constitutions would be essential for reform in Puerto Rico.
No discussion of restoring respect for constitutional boundaries is complete without recognizing the necessity of honoring Puerto Rico’s commitments to its current debts. Other attempts to cultivate economic growth and fiscal discipline will be useless in a climate of distrust on the part of citizens, businesses, and investors. Little else could make such a climate more intense than for Puerto Rico’s government to retroactively rescind or modify its promises to creditors.
NTU has seen the pernicious effects of such attitudes far from America’s shores, but none more acutely than with the nation of Argentina. That country’s leaders have consistently flouted international judgments and have refused to pay legally incurred debts, despite good-faith efforts from bondholders to negotiate fair settlements at reduced levels. For a number of years, NTU has opposed loans to Argentina from U.S. taxpayer-backed international institutions because of the country’s fiscal irresponsibility and flagrant disregard for the rule of law. Today Argentina is still regarded as a volatile economic danger zone, having triggered debt defaults and having been locked in seemingly perpetual legal battles with investors. The result is an unstable fiscal situation that can lead to wild swings in government revenues and spending – precisely the opposite of what Puerto Rico must establish to thrive.
This object lesson must not be lost on Congress or the Puerto Rico Legislative Assembly when deliberating over debt restructuring options. Arbitrary, retroactive policies toward creditors translate directly into failed policies toward taxpayers.
Boost Tax Collections by Boosting Taxpayer Confidence. Much has been made about Puerto Rico’s anemic rate of compliance with elements of its tax system, particularly sales taxes. Yet, compliance is a multifaceted issue that depends not only on enforcement, but also perceptions of fairness and simple economics. Goods entering Puerto Rico already carry higher prices due to the Jones Act (see above) and import tariffs; the Legislative Assembly’s decision to boost the combined Commonwealth and local sales tax rate to 11.5 percent, which will become a Value Added Tax next year, makes the government-imposed burden on many necessities intolerable for thousands of residents. The provision of partially offsetting VAT credits offers some relief, but only modest comfort to the business owners collecting it – owners who already face a maze of regulations merely to conduct their daily trade.
As explained earlier, policymakers must first focus on reducing the rate of many taxes and keeping others as low as possible. Voluntary compliance rates rise when those paying the taxes feel the levies are reasonable and affordable.
Furthermore, the administration of the tax system itself must be regarded as fair to encourage compliance. NTU recommends that any legislation from Congress strongly incentivize Puerto Rico officials to evaluate their “collection due process” and other enforcement methods that impact businesses and individuals. Are problem resolution staff being kept at arm’s length from other revenue employees, made accessible, and able to account for facts and circumstances in individual cases? Are vendor compensation rules for collection of sales taxes properly crafted to reflect the actual costs small businesses face on the ground? Can tax amnesty programs be properly calibrated to encourage well-meaning citizens to come forward and pay their obligations? The Governor’s plan calls for restricting amnesties which, depending upon the details, could be counterintuitive to the experiences of other governments. Could Puerto Rico learn from the promising results of independent tax tribunals operating in half of U.S. states? These entities provide taxpayers with an independent, cost-effective, and expeditious way to resolve disputes without protracted litigation. All of these “best practices” – and many more – should be a part of Puerto Rico’s tax strategy.
The IRS National Taxpayer Advocate has conducted highly relevant research in the area of state and international approaches to taxpayer rights – taking account of regional and societal norms – for such a purpose. NTU would particularly direct policymakers to an upcoming International Conference on Taxpayer Rights, to be sponsored by the Advocate in Washington, DC next month.
Congress also has a direct, immediate responsibility to lead by example in this area. According to the Taxpayer Advocate’s most recent annual report to Congress, “twelve states and Puerto Rico … have no Appeals or Settlement Officers with a post of duty within their borders,” and instead must rely on “circuit-riding” personnel. One of your colleagues, Senator Enzi, attempted to rectify this problem by redirecting IRS budget resources toward full appeals staffing, but his proposal was not enacted. Given the increases in enforcement and bureaucracy expenditures at the tax agency over the past 10 years, permanent Appeals and Settlement Officers could be provided for by reprogramming existing funding now. Those taxpayers on the island who must contend with U.S. federal tax issues deserve equal access to justice.
Final Observations and Conclusion
Some have expressed concern that introducing policy matters such as these into the debate over simple proposals such as Chapter 9 authority will muddle the legislative process and raise questions over committee jurisdiction. Yet, many legislative packages in Congress are subject to multiple committee consideration. Elements of financial reforms affecting Puerto Rico could merit scrutiny in the tax writing committees, judiciary committees, the Senate Energy and Natural Resources Committee, and the House Natural Resources Committee, to name a few. If lawmakers of good will recognize the gravity of the situation – and surely they do – then an appropriate division of labor for drafting and a process for floor debate can be devised.
Others believe that statehood for Puerto Rico is an essential condition for a solution to the island’s financial woes. As a recent Government Accountability Office report noted, the island’s residents would be more fully subject to U.S. tax laws, possibly permitting reductions in “home-grown” taxes, while as a state Puerto Rico would qualify for a host of additional federal aid programs and could set create an exchange under the Affordable Care Act. Yet, there would be trade-offs – for instance, with this status Puerto Rico might also face even more mandates from Washington.
Regardless of this cost-benefit analysis, the question of how a state of Puerto Rico approaches existing and future debts would remain. Indeed, tying Chapter 9 to statehood could fuel other states’ arguments that they too should be permitted a bankruptcy resolution process without requisite pro-taxpayer reforms. After all, indebted leaders might argue, if Puerto Rico became a state in the middle of a Chapter 9 process, why not allow an existing state to initiate a Chapter 9 process?
This is not speculative. To give just one example, Illinois is hobbled by well over $100 billion in government retirement liabilities, because of a State Supreme Court ruling that declared even modest changes to its pension system unconstitutional. Given these circumstances, and historical experience in localities, Chapter 9 alone would not completely alleviate Illinois’ taxpayers from irresponsible governing, and could very well worsen the reckoning that U.S. taxpayers might face due to an ensuing bailout when restructuring falls short.
To reiterate, statehood is an issue with many facets; but whatever Puerto Rico’s governing status may be, Congress has a special responsibility to island and mainland residents in crafting specific fiscal remedies that set the proper precedents and avoid future crises of far greater magnitude.
From regulatory relief, to a Control Board with the genuine potential for effectiveness, there many ways that Congress can make a positive contribution to the well-being of Puerto Rico. This salutary evolution begins by thinking beyond Chapter 9 and thinking about the federal government’s obligation to help pave a better path forward. Please feel free to call on NTU as you do so.