How Bad Laws Penalize Puerto Rico Jude Wanniski June 15, 2001

To: Supply-Side Students
From: Jude Wanniski
Re: How Bad Laws Penalize Puerto Rico (3/9/76)

This is an op-ed I wrote for The Wall Street Journal 25 years ago, when supply-side economics was in its infancy. I'd gone to Puerto Rico because I'd heard the unemployment rate had gone over 20% and I wanted to find out why. This became one of the most important reporting trips of my life, as it hit me that because Puerto Rico had the same monetary system as the United States, monetary policy could not have caused the great weakness in Puerto Rico. The answer had to lie in fiscal policies, which were entirely separate from the U.S. It was the discoveries I made on this trip that persuaded me I had to write a book about supply-side economics, which I did the following year. Chapter XII of The Way the World Works is titled "Experiment in Puerto Rico," which offers an entirely different history of Puerto Rico in the 20th century than anyone else had ever considered. After reading that chapter, any number of Puerto Rican bankers and businessmen told me that they then understood the Commonwealth's history in ways they had never learned in their schools. My visit also had an extraordinary effect on the island's future, as I drew the Laffer Curve for both candidates for governor -- although I did not name it the "Laffer Curve" until the spring of 1977. Carlos Romero Barcelo, the challenger I mention in the article, decided to take my advice and run as a supply-sider, promising to eliminate the income surtax that had been imposed by Governor Rafael Hernandez Colon -- on the recommendation of Professor James Tobin of Yale. It was the Tobin tax that had sent the island economy reeling, the unemployment rate doubling to 20%. Romero Barcelo, whose party had not won the legislature since the 1930s, won in a landslide later that year, eliminated the Tobin tax, and enjoyed re-election four years later in an expanding economy.

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How Bad Laws Penalize Puerto Rico
The Wall Street Journal -- March 9, 1976
By Jude Wanniski

SAN JUAN -- The economy of Puerto Rico is caught between a rock and a hard place. It is being squeezed pitifully by a number of U.S. laws that are preventing the Commonwealth from competing in global trade. And it is being harshly squeezed by its own brutally steep income tax laws that are forcing much of the island of three million people into a barter economy while at the same time driving away the cream of its middle class.

Unemployment is officially at 22%, but officials of the government readily concede that there is also vast underemployment, and perhaps the only thing that has prevented civil disorder is the U.S. food stamp program, which transferred $600 million to the Commonwealth last year and helped feed 70% of the population.

There's a Castroite fringe of revolutionists on the island. But neither of the two main political parties is dominated by leftist ideas, and there remains the persistent hope that the exceptionally keen top political leaders will by trial and error work out of the dilemma that now baffles them.

Given the power of the AFL-CIO in the present U.S. Congress, there seems little chance that these leaders, although they are trying, can do anything about the U.S. laws that are crippling the economy. The U.S. minimum wage law, which has been haunting Puerto Rico since it was first passed in 1938, is now one of the most destructive forces on the island.

Easily 200,000 potential workers who are forbidden from working for less than the $2.35 minimum, and are not productive enough for employers to hire at that wage, do not look for work any longer and are not even counted in the unemployment statistics.

The Jones Act

The other U.S. law that has been a burden to Puerto Rico for almost 40 years is the Jones Act, which subsidizes the U.S. merchant fleet by prohibiting foreign freighters from competing in U.S. coastal shipping. The act is not nearly as destructive to the United States as it is to Puerto Rico, because mainland traders can avoid the excessive freight rates of the U.S. fleet by shipping overland by rail and truck.

Hawaii is hit hard by the act, but because Hawaii has such lively trade with the prosperous Pacific nations at low freight rates not covered by the Jones Act, it is in much better shape than is Puerto Rico.

Because of its location, Puerto Rico must do most of its trading with the united States, and although its people are American citizens, its economy is the only one in the world that faces this extraordinary penalty in trading with the states.

The act adds roughly $60 million to Puerto Rico's freight costs, which is the smallest cost. By discouraging trade, it acts as a protective tariff against Puerto Rican goods, and is a powerful argument for Puerto Rican independence; if it were a foreign nation, the Jones Act would not apply.

Puerto Rico has traditionally been exuberantly pro-business, and now is no exception. There are no U.S. taxes on corporate profits, and manufacturers who can meet easy qualifications can get exemptions on all local capital taxes for 10 years or longer.

But there is much less to these incentives than meets the eye. Because industries built with U.S. capital cannot repatriate earnings without being slugged with the federal profits tax, the investor ultimately cannot benefit much from the exemptions.

There were enough accidental benefits when the exemptions were initiated 20 years ago so that Puerto Ricans and mainland Americans were fooled into thinking that the ensuing prosperity resulted from the island's "tax haven" status.

The only thing the exemption provides by way of incentive to venture capital is permission to average profits and losses over the 10 years or more exemption period, and thus economize on taxes if in that period there are a few widely spaced years of losses.

While this was a help, it was not sufficient to cause the industrial expansion that brought 12% rates of economic growth in the 1950s and early 1960s. Ironically, it was the U.S. minimum wage that was the real force behind the boom.

In 1938, when the U.S. wage act was passed at a 25 cents per hour rate, the top skilled rate in Puerto Rico was below 25 cents, and the island economy was instantly sent reeling into a crushing depression within the Great Depression, 75% of the needlework industry was wiped out in two years.

In response, Congress in 1940 amended the act to permit lower minimum wages in Puerto Rico on a selective, industry-by-industry basis. Thereafter, the marginal difference permitted venture capital to hire skilled labor in Puerto Rico at a price lower than unskilled labor in the states.

The boom of the 1950s was slowed only to the extent organized labor on the mainland forced an acceleration of the minimum wage in Puerto Rico. In 1974, the AFL-CIO pushed Congress into phasing out the differential, and the exodus or collapse of the "tax exempt" factories began in earnest.

With George Meany now talking about pushing the minimum in the United States to $3 per hour, the leaders of the two main political parties -- Gov. Rafael Hernandez Colon and San Juan Mayor Carlos Romero Barcelo -- are at least united in their complete assurance that a $3 minimum would wipe out their economy.

Perhaps the only chance Governor Colon has of winning re-election this year against a challenge by the popular mayor Romero Barcelo is if he can wring minimum wage concessions out of the AFL-CIO and Congress.

The mayor who heads the more conservative New Progressive Party, is popular because he opposed the economic policies of the governor's Popular Democratic Party. In the name of fiscal integrity, the governor last year slapped a 5% surtax on all adjusted gross incomes (AGI) over $10,000 and made it retroactive to 1974.

At the same time he imposed a 6.6% excise tax on all imports of consumer goods but food and medicine; the excise tax on automobiles is already so high that a mid-sized Ford or Chevrolet can't be had for less than $10,000.

The measures immediately forced the entire professional and managerial class into either wholesale tax avoidance through the bartering of services, or sent them packing. Even before the surtax, the Puerto Rico income taxes made the mainland look like a tax haven.

A U.S. couple filing a joint return on $10,000 AGI will pay an average of $1,820; a P.R. couple paid $1,974 before the surtax and $2,974 after. A U.S. couple with $30,000 AGI pays $7,880; a P.R. couple at that amount paid $10,773 before the surtax and $13,773 now.

If these differentials were not sufficient to set up a human arbitrage between the island and the mainland -- i.e., the middle class exodus now underway -- Puerto Rico's tax law has one fiendish feature that almost doubles the disincentive effects of the high marginal tax rates: Spouses are required to file joint returns and are not permitted to average their incomes in the joint returns.

In the United States, if a husband has taxable income of $40,000 and his wife income of $10,000, their tax is calculated as if each made $25,000.

In Puerto Rico, a husband with $40,000 is in the 70% marginal tax bracket. If his wife goes to work, the first dollar she earns yields only 30 cents after taxes, and on $10,000 she'll get to keep roughly $1,600.

The average Puerto Rican is well aware how this provision encourages divorce.

The Real Problem

The Colon government is pining for the day when it can cut tax rates on business, failing to see that the problem is in the confiscatory taxes on labor. Treasury Secretary Salvador Casellas has a tax package "ready to go," but is dissuaded by obsolete U.S. economics professors and Wall Street bond traders, who have encouraged "fiscal integrity" through tax boosts.

Eventually someone in San Juan may notice that every time tax rates go up, or inflation speeds the work force into higher brackets, Puerto Rico's bond prices fall.

Mayor Romero Barcelo, who seems favored to win the gubernatorial race, vigorously opposed both the surtax and the excise taxes. He also is pledged to denationalize the shipping and telephone companies that the Colon government acquired in a desperate, pragmatic attempt to hold back freight and telephone rate increases.

As election nears and Gov. Hernandez Colon sees that the AFL-CIO and the U.S. Congress will not be bent into giving Puerto Rico relief on the minimum wage, he will have no choice if he is to be reelected than to try to outbid his opponent on income-tax reduction.

If the P.R. tax rates in all brackets were pushed below the U.S. rates, the human arbitrage would be reversed. Teodoro Moscoso, who runs the Commonwealth's Economic Development Administration and is among the most distinguished government economists in all of Latin America, readily agrees with a laugh that the easiest way to increase per capita incomes is to import a lot of high-income people.

Should this be done, Puerto Rico might be springing back to life a lot sooner than almost anyone now imagines. The rock would still be there, but not the hard place.