Puerto Rico and Statehood Jude Wanniski December 28, 1979

Executive Summary: Puerto Rico has accelerated its movement toward becoming the 51st state by participating in the presidential primaries. Governor Carlos Romero Barcelo, maintaining neutrality among the presidential contenders, deftly maneuvers statehood support from all of them. The central problem facing statehood is integration of the island and federal fiscal systems. Statehood cannot come until there is overwhelming support for it on the island, support that cannot be achieved if statehood means an added tax burden for the average Puerto Rican. Romero's economic policy mix has been effective in countering short-term stagnation and moving toward fiscal integration. But he will stall in 1980 unless he adopts bolder measures. At some point, discussion must begin about U.S. adoption of the Puerto Rican public debt, a move that would unlock the most difficult barriers to statehood. The idea is justifiable in that Puerto Rico would, for its part, assume a proportionate share of the U.S. national debt.

Puerto Rico and Statehood

In its haste In 1980, for the first time since 1917 when Puerto Ricans were made citizens of the United States, they are engaged directly in presidential politics. For decades the island (three times the size of Rhode Island, one-third larger than Delaware) has sent a handful of delegates to the Democratic and Republican national conventions. But they had been picked by the party machines. Next year, Puerto Rico will hold its first presidential primaries. This means that the presidential contenders must now seriously engage themselves in the question of Puerto Rican statehood as part of their own quest for political power. The result will be an acceleration of the process by which Puerto Rico will become the 51st state.

Puerto Rico's Republican primary, in fact, will be the nation's first in 1980, scheduled for February 17, a week prior to the big event in New Hampshire. And while Ronald Reagan has not entered the Puerto Rico contest, choosing to focus his resources on New Hampshire, the other major contenders are all heavily committed, financially and organizationally. They have already campaigned on the island and will be traveling there again. Bush, Baker and Connally bumper stickers are easily spotted around San Juan.

What is at stake is not so much the winner-take-all 14 delegates. It is momentum. The winner in Puerto Rico will have his smiling face beamed into New Hampshire via Boston television, which will count for more than paid commercials. Each of the contenders has pledged support for statehood, should Puerto Ricans themselves vote support in a planned 1981 plebiscite.

Political analysis in Puerto Rico requires some special orientation because most islanders think of themselves as members of one of the two indigenous political parties. The party in power on the island is the New Progressive Party (NPP), which is the old Republican Statehood Party. Its ties to the mainland GOP are strong, but it has a heavy representation of people who identify with the mainland Democratic Party, yet who favor statehood. Similarly, the Popular Democratic Party (PDF) has its strongest ties to the mainland Democrats. Yet, it contains people who identify with the mainland Republicans, but who also favor a continuation of the Commonwealth status and oppose statehood. Because a majority of the 3.3 million residents seem to favor statehood in principle, Governor Carlos Romero Barcelo winds up in an extraordinary position.

As leader of the NPP, he has been courted by all the Republicans and by both President Carter and Teddy Kennedy, the majority of "Democrats" and "Republicans" on the island being currently affiliated with the NPP. A deft politician, Romero keeps himself in the good graces of all the presidentaial contenders by a lofty neutrality, a tenable position since all have committed to statehood.

The likely winner of the GOP primary is Senator Howard Baker, whose strength derives from the awareness at the top of the NPP that whoever else may occupy the White House from 1981-85, Baker will be the Republican leader in the U.S. Senate, thus in a strategic position to influence statehood legislation. An early December private poll of 53 NPP leaders, undertaken by San Juan Mayor Hernan Padilla (No. 2 behind Romero in the NPP), showed a majority believing Baker would win the Puerto Rico primary, although a majority said they thought Reagan would win the nomination.

Where does this leave the Popular Democratic Party? The POP, the dominant party on the island from 1940 to 1976, lost power not on the statehood issue but over tax policy. In the fall of 1974, as both the U.S. and Puerto Rico were about to go over a recession cliff, Governor Rafael Hernandez Colon embraced the economic advice of his mainland consultant, Yale's James Tobin. A 5 percent surcharge was slapped on personal incomes. The island unemployment rate, which had been just above 10 percent, climbed to about 23 percent at the height of the recession.

In the 1976 election, Romero, then mayor of San Juan, foreshadowed Howard Jarvis. He attacked the PDP's tax policies and pledged tax cuts. Now out of power, the PDF has still not figured out what hit it. Once itself a party of moderate orientation, it lost important elements of support to the NPP and as a result has grown more strident in its liberalism. Its theoreticians have been busily hammering together a "New Thesis" for Puerto Rico that is fervently isolationist and statist. The chief economic features are credit controls and tariff walls. It demands authority for such "autonomy" from Washington, as a counterpole to statehood, and seems prepared to deploy Third World rhetoric, with the U.S. cast as a colonial power, unless it gets its way. One of the main spokesmen for the "New Thesis" is James McDonough, who worked in the Hernandez Colon administration and now writes in the English-language San Juan Star:

The United States is worried about the military and political situation in the Caribbean. Encouraged by Cuba, leftist governments have appeared during the past year in Grenada at one end of the Caribbean and Nicaragua at the other end. Moreover, the U.S. sees Manley in Jamaica as dangerously flirting with Castro and the left.
These ominous changes coupled with the problems in the oil rich Middle East have brought the Caribbean into a new focus at the highest levels of U.S. government.
The Republican answer is now obvious: statehood. Statehood for Puerto Rico, as was true for Hawaii in the Pacific, will guarantee U.S. presence in a vital area of the world. Statehood from this context, then, is not the desire to do justice to Puerto Ricans, but an attempt to make sure the United States does not lose a strategic piece of real estate. Statehood becomes the new face of colonialism; it is being encouraged in the United States not by its liberals, but by its conservatives. Their motives are expansionist; their purpose, to solidify once and for all that land grab of 1898.1

McDonough's analysis is extremely perceptive. The greater Fidel Castro's impudence in fomenting Puerto Rican independence, the more ardent American conservatives become in contemplating statehood. What is interesting, though, is the emptiness of McDonough's complaint. Saying "statehood becomes the new face of colonialism" is the equivalent of arguing that "marriage becomes the new face of concubinage," having lost your mistress to a serious suitor.

But this is about all the PDF has left. Unless Romero does something incredibly foolish, which is not his practice, he easily will win re-election in 1980. And whoever wins the White House will be ready to move on statehood legislation as soon as the plebiscite produces a positive vote in 1981, which it no doubt will. But Romero still will have to overcome a lot of obstacles before Puerto Rico becomes No. 51.

The central problem on the path toward statehood is Puerto Rico's separate fiscal system. This was not a problem for Alaska and Hawaii, which attained statehood in 1959. Since 1917, Puerto Rico has had autonomy over internal taxation, and maintenance of such autonomy has been a central tenet of the Popular Democratic Party in opposing statehood. But while the island citizenry does not face federal tax rates, and even retains the import duties on goods coming into the island, it levies personal income tax rates and gift and estate taxes that are steeper than mainland citizens face. About the only exception is Social Security tax, which Puerto Ricans pay.2

As Romero took office, the top marginal income tax rate was a dizzy 87 percent, encountered at $200,000, including Hernandez Colon's 5 percent surtax—which had been labeled La Vam-parita or "little vampire" by the citizenry. In the past three years, four across-the-board adjustments have been enacted, including repeal of La Vamparita and another surtax that had been collected since the Korean War, plus two 5 percent rate cuts. The top marginal rate is now 71 percent. Tax rates on lower and middle incomes have been cut proportionately and Romero vows to continue these across-the-board cuts until the top rate is down to 50 percent.

The Governor is justifiably proud of having pushed through tax-rate reductions in the face of budget deficits and dismal credit markets. The economy, public finance, and Puerto Rican bonds have strengthened considerably. Here he is in an October 13,1979, speech to the Puerto Rico Manufacturers Association:

This realignment of tax rates is a plus for the taxpayer and for industry: it reduces the salary differential that must be paid to personnel to equal net salaries of similar executive positions in mainland industries, and at the same time should halt, and perhaps even reverse, the exodus of productive Puerto Rico personnel seeking more favorable tax treatment in the Mainland.
Moreover, as we had predicted, our tax-cutting initiative—combined with a crackdown on tax evasion—has resulted not in a reduction of revenue from individual income taxes but rather in a substantial increase in revenue, as lower taxes have stimulated economic activity throughout the island and helped to increase the general level of prosperity.

Weekly manufacturing payroll, which had averaged $12.7 million in 1976, is running at more than $20 million in the last weeks of 1979. The unemployment rate, which was over 20 percent when Romero took office, is down to 17 percent. That is still a scandalously high number that will be difficult to bring down as long as the U.S. minimum wage law applies in Puerto Rico and unemployment and welfare are subsidized at mainland levels. But even with the lower tax rates, revenues increased sufficiently to permit increased public spending. Yet, in the last three years, the public debt has fallen as a percentage of GNP, growing at a 3.8 percent annual rate against more than the 18 percent compound annual rate of the previous four years.

Romero also has moved to get the "931 corporations" off their exempt status into a taxpaying position. The authority to tax also carries the authority not to tax, and the essence of the PDP's postwar political success was built on tax exemptions to mainland manufacturers who established factories on the island. This was "Operation Bootstrap." The so-called "931 corporations" (after Section 931 of the IRS Code) would normally accumulate profits in Puerto Rico during the 15-year tax holiday, then liquidate the subsidiary into the parent in order to avoid payment of federal corporate income tax and a 15 percent Puerto Rico "tollgate" tax.

In 1976, federal law was changed to permit U.S. manufacturers to repatriate profits from Puerto Rico without payment of federal taxes. This was Section 936 of the IRS Code, aimed at discouraging companies from leaving Puerto Rico at the end of their exemption periods. The inducement was insufficient, however. Liquidation and no tax was still preferable to 15 percent Puerto Rico withholding at repatriation.

Through the "Industrial Incentives Act of 1978," the "931 corporations" were invited to give up the remainder of their grants of exemption in exchange for a 10-year extension of the grant at partial tax rates and a reduced tollgate tax of 10 percent instead of 15 percent (with even lower rates depending on individual circumstances).

"We experienced a pure 'Laffer Curve' effect," says Jose Madera, administrator of Fomento, the Economic Development Administration. "At 15 percent tollgate, we hadn't collected a penny." At the lower rate, which Madera could drop to 4 percent or 5 percent given individual corporate circumstances and commitment, money began flowing into the Puerto Rico Treasury. In 1978, $50 million came in. In 1979, more than $100 million came in. There were 268 applications by "931 corporations" for conversion to the "936" status, of which 168 were approved. And there have been 125 applications for new "936" grants, of which 73 have been approved.

What happens to these grants at statehood? What Romero has in mind is a scenario of fiscal integration that takes place gradually, over 20 years. At the beginning of this process the top rate on personal income tax will have been whittled down to 50 percent. The top rate on corporate income tax will have been whittled down to 25 percent from its present 45 percent. As Romero put it in a November "message to the U.S. business and financial community:"

A transition period of about 20 years is both necessary and reasonable to allow Puerto Rico to adjust to the payment of federal taxes. The first year we would pay five percent, the second year ten percent, and so on, until we were fully integrated into the federal internal revenue system.
But what this means for business, of course, is that Puerto Rico will be the only state in the union where industry and business can enjoy partial federal income tax exemption. Those will be the biggest boom years in Puerto Rico's history, and I cordially invite all of you to get in on the ground floor.

There may be a boom following Puerto Rican statehood, but not given Romero's simple scenario. Indeed, the phase-in period is essential to give Puerto Rico time to continue adjusting its own rates downward, or the combination of Puerto Rican and federal taxes would easily be the highest in the nation. Imagine paying a state personal income tax of 50 percent before encountering a federal income tax rate of 50 percent, or a state corporate rate of 25 percent before running into the federal 45 percent rate.

The statehood problem is understood in this light. The average San Juan taxi driver, when asked, associates statehood with higher taxes out of his pocket. Governor Romero tells mainland audiences that Puerto Ricans are prepared to pay federal taxes in exchange for political power (9 electoral votes, 2 U.S. Senators, 7 Representatives), but such sentiment does not exist to any significant degree, either among the working class or among the bankers and businessmen. Romero has to come up with a better sales pitch than "sacrifice" if he wants to attain statehood in the next decade.

Romero's boom would likely occur, though, if the local tax bite would decline at the same or faster rate than federal taxes increased. But how does state public finance withstand the revenue loss? Debt service on Puerto Rico's $6 billion in public debt chews up the $400 million a year that the personal income tax yields. At some point, Romero will have to argue that the Commonwealth's debt be assumed by the national government as a condition of statehood. For their part, the people of Puerto Rico would assume a proportionate burden of the national debt as a condition of statehood, which on a per capita basis probably runs to more than $10 billion.

It is difficult to see how statehood otherwise could be put together. Romero surely will get a majority vote in his 1981 plebiscite, but the PDF opponents are correct in arguing that he needs the overwhelming support of the citizenry in order to commit the island to eternal bonds of statehood. Thus a sizeable minority can easily block statehood peacefully, through the political process. A tiny minority, the Castro/Communist faction in Puerto Rico, will resist through terrorism such as the December 3 attack on a U.S. Navy bus, a few miles from San Juan.

How does Romero get "overwhelming support?" The first consideration for him must be to not lose the support he has, which could easily happen if he mishandles the economy in 1980. The government is braced for the spillover effects of a U.S. recession. But 77-year-old Luis Ferre, the former governor and now close ally of Romero, has the more spirited approach: "We should go out and meet the recession," he told me, suggesting a speedup of Romero's tax-cutting schedule along with a reform of Puerto Rico's almost criminally confiscatory gift and inheritance tax rates. (The estate tax rates rise to 70 percent, yet yield only tiny revenues, a mere $8 million fiscal year 1978.) There is almost universal support in Romero's cabinet for such reforms, along with a belief that they would be politically unpopular. The fear of political attacks by the PDF keeps Romero from acting more audaciously, but I suggested to the Governor that such reforms would be enormously popular and the PDF would oppose them only at its peril.

Because he has so many obstacles to overcome, Romero really has to be bolder, take more chances, or statehood will prove to be elusive. What he has not yet done is paint a finished picture of what the merged structure would look like, not 20 years after the fact but in the first year. What will it do for the San Juan taxi driver and what will it cost him? The picture should be so appealing that even the terrorists put down their AK-47s to listen.

U.S. liquidation of Puerto Rico's public debt in exchange for Puerto Rico's assumption of national debt would eliminate the need for a 20-year phase in. With a blank slate of state debt, Puerto Rico would not need a state income tax at all, and could immediately pay the federal rates in full. This makes it easy for mainland Americans to swallow the idea of taking Puerto Rico's public debt. Unless something of this sort is worked out, Romero will be bogged down through the 1980s, unable to generate overwhelming support. But such a deal is now not only easy to contemplate. It also seems realistic. The citizens of Puerto Rico are, after all, now directly engaged in the process of selecting the next American President. Once they have exercised this political privilege, it becomes easy to picture the President — whoever he is — in 1981 proposing a statehood deal that turns Romero's plebiscite into a landslide.

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1 The San Juan Star, November 23, 1979, p. 19.
2 Victor A. Canto and Arthur B. Laffer, "Report to the Governor: Recommendations for Economic Reform in Puerto Rico/' H. C. Wainwright & Co., Economics, April 20, 1979.