A Series on Economic Decline

Unbeknownst to the vast majority of Puerto Rico residents, a two-week partial government shutdown in May 2006 would mark the official beginning of the long-running economic contraction that hits its 10th anniversary this year, with no signs of letting up.

However, the shutdown —caused by the central government running out of money amid a budget impasse between the Executive and Legislative branches, each one controlled by a different political party—was just the tip of the iceberg as to the real reasons for the deepest and longest economic contraction the island has ever experienced.

The completion of the 10-year phaseout of Section 936 in 2006 coincided with the government shutdown that year striking a heavy blow to Puerto Rico’s economy, with lasting effects on all economic sectors to this day.

Ten years later, Puerto Rico once again faces the threat of another public sector shutdown—as early as this summer—when the cash-strapped government has more than $1.5 billion in debt-obligation payments due.

Unlike 2006, however, the situation today is much more dire, as the island faces a fiscal crisis amid a fast-declining population and a much smaller and weaker economy.

Evolution of Puerto Rico’s economic development model

For José Joaquín Villamil, chairman of Estudios Técnicos, to really understand the reasons behind the island’s 10-year depression, one must look back at how Puerto Rico’s economic development evolved through the years up to 2006.

During the 1930s, Puerto Rico benefited from investments of the New Deal program, propelled by U.S. President Franklin D. Roosevelt.

The three key figures who were pushing for the New Deal in Puerto Rico were: Rexford Tugwell, an American economist appointed to be governor of Puerto Rico between 1941 and 1946; Luis Muñoz Marín, founder of the Popular Democratic Party and first elected governor of Puerto Rico; and Carlos Chardón, a well-known educator and scientist who largely penned the reconstruction plan.

“Early efforts of industrialization on the island weren’t very successful. Muñoz Marín and his team realized that to attract a large number of firms to Puerto Rico, the incentives provided needed to be irresistible,” Villamil said.

Section 931 of the U.S. Internal Revenue Service (IRS), in place since the 1920s and until the mid-1970s, allowed subsidiaries of U.S. corporations to establish themselves in U.S. territories without paying federal taxes on the income derived from their Puerto Rico operations—unless the money earned was repatriated to the U.S.

The Puerto Rico Industrial Development Co. (Pridco), which was created in the 1940s to promote the island as an industrial paradise, would ultimately be successful in attracting manufacturing firms to Puerto Rico.

During the first stage in Pridco’s strategy, dubbed Operation Bootstrap’s “sweatshop” phase, the agency was focused primarily on attracting labor-intensive industries (e.g. clothing, textiles and food processing).

Since wages under the first stage were low, Pridco then decided to attract capital-intensive firms that could generally provide higher wages, among other reasons. However, the benefits obtained by Puerto Rico from this strategy were limited because these nonlocal firms made no attempt to forge linkages within the island’s economy and they were not motivated to do so by the government or its incentive package.

Section 936 of the Internal Revenue Code, which substituted Section 931, would usher in a new era for Puerto Rico’s economic development. It provided greater benefits to U.S. firms operating in Puerto Rico since they would be able to repatriate profits earned without paying federal income taxes.

“Although Section 936 was ultimately completely eliminated in 2006, after a 10-year phaseout, many firms that were so-called ‘936 corporations’ were able to be incorporated as controlled foreign corporations [CFCs] and continue to benefit from low taxes, income shifting and hefty profits,” Villamil said.

After the full repeal of Section 936 in 2006, he noted Puerto Rico has been largely unable to develop and execute an economic strategy that raises its level of development to converge with U.S. incomes and standards of living.

After Section 936: Population and economy shrink

Since the demise of Section 936, the population and the economy of Puerto Rico have both become smaller. By 2030, the island’s population could be around 2.8 million, far below the 3.45 million of today, and even more so from the 2000 projection of nearly 4 million by 2020.

Some data illustrates the magnitude of what has happened in Puerto Rico’s economy in recent years: upwards of 250,000 jobs lost since 2006, and manufacturing employment down to 74,000 from a peak of 165,000 in 1996.

Investment in construction—one of the island’s economic pillars during the 1990s—is down to $4.3 billion in 2015 from a high of $6.6 billion in 2004. Home foreclosures reached a record high of 4,000 in 2015.

“What has happened in the economy over the past five decades is a collapse of the capacity to generate growth. The recent experience beginning in 2006 is clearly not a recession, but rather the culmination of a long piece
of weak performance,” Villamil explained.

For the Estudios Técnicos chairman, it is important to understand that Puerto Rico’s economic malaise refers to production, since consumption has held up fairly well over the years.

The reasons include federal transfer payments to residents that comprise over 20% of personal income; government employment that, although reduced recently, still represents more than 20% of total employment; and a very large informal economy, estimated at 28% of the formal economy.

“These three factors sustain consumption, isolate part of the population from economic volatility, but on the other hand, do little to stimulate investment and production, since consumption is mostly imported,” Villamil said.

According to the Puerto Rico Planning Board’s 2014 Economic Statistical Appendix (the most recent edition available) the island’s gross national product (GNP) decreased in real terms during 2006 (-1.2%), 2007 (-1.2%), 2008 (-2.9%), 2009 (-3.8%) 2010 (-3.6%) and 2011 (-1.7%).

In fiscal 2012, the local economy grew a mere 0.9%, assisted by nearly $7 billion in American Recovery & Reinvestment Act funds. This was followed by negative growth in fiscal 2013 (-0.2%), fiscal 2014 (-0.9%) and projected declines in fiscal 2015 (-0.9%) and fiscal 2016 (-1.2%).

The economy is not expected to reach 2006 real GNP levels until the late 2020s if present trends continue. Assuming growth rates of 1.8% in real GNP beginning in fiscal 2015, it will reach the 2006 level in 2023.

“Forecasts are for at least three more years of zero growth or contraction, so 2023 is an extremely optimistic projection. What this tells us is that the economy will have lost close to 20 years of economic revolution,” Villamil indicated.

The consequences

He said the implications of a smaller population and economy will generate major structural ruptures in the island’s demographics (including age composition and geographic distribution), and its economic structure, labor markets, government and even the spatial distribution of economic activities.

“Even culture, understood as the set of norms that regulates everyday life, including economic aspects, will have been impacted,” the Estudios Técnicos chairman said.

For Villamil, returning to a population age structure that characterizes a growing economy, after the major changes in age composition that have already occurred, is an intractable problem. Likewise, reconstituting the supply of certain skilled occupations will be very difficult, particularly in areas that have seen an exodus to jurisdictions with higher salaries.

“Weakened local economic sectors, either because of the said processes or because of the introduction of new actors intent on securing market share, will mean that breaking the vicious cycle and reconstructing the economy along lines that will generate stability and social equity will be more difficult. This is a major structural issue that needs to be dealt with,” Villamil indicated.

Having competitive conditions is a key component of the institutional framework essential for sustainable economic development, he added. The market has changed in such a way that conditions defining a competitive-market economy are no longer present in some sectors, specifically retail and wholesale, and perhaps in others.

“Competition must not be confused with laissez-faire. Major markets such as banking, housing, food, health services
and other consumer goods and service markets will have been impacted and the industries involved substantially transformed,” Villamil warned.

No one, he added, expects housing to reach the same level of sales that it enjoyed in 2006 of 13,000 new units. Likely levels will be nearer the 2014 level of some 2,200 units a year for the foreseeable future.

“Much of the construction industry, for example, is not only smaller, but also has disappeared completely. Reviving the industry will require major structural measures, not marginal ones such as improving the permitting process or dealing with the Land Use Plan,” Villamil noted.

Less population, more excess capacity

One major impact of a shrinking population and economy is on physical infrastructure planning, with excess capacity developing in some of the major infrastructures, a condition already noticeable in the Puerto Rico Electric Power Authority, for example.

But this, Villamil added, is also true of social infrastructure, as Education Department figures illustrate. Public school enrollment has declined from 613,019 students in 2000, to just 410,950 in 2015. As a result, total employment at the department fell from 72,005 in 2000 to 55,912 in 2015.

Likewise, healthcare services, another component of the social infrastructure, will require major shifts in delivery systems and on the priorities presently in place.

“[Healthcare] will have to serve a very different population, one with greater and very different needs, and with fewer resources,” Villamil said. “The worst impact of what has transpired in Puerto Rico is the erosion in human capital that has taken place. The lack of social mobility and an increase in inequality, amply documented, due to the shrinkage of the economy are other major consequences.”

The Estudios Técnicos executive said many social programs and agencies were planned and implemented for a very different social structure than what characterizes the island at the moment.

Changes in the age composition of the population, the structure of families, the manner in which poverty manifests itself and the lack of social mobility  make agencies such as the Family Department and a number of antipoverty programs obsolete,” Villamil said. “Institutional innovation assumes an urgent character, given the rapid and profound changes in social conditions.”