Trying to respond to the coronavirus economic crisis through a change in the tax status of U.S. territories, specifically Puerto Rico, would recreate the island as a corporate tax haven. That would terminate any effort to grant Puerto Rico statehood and likely would not help the Puerto Rican economy.
When that territory was a popular tax haven between 1950 to 1980, the economy saw some limited growth, because the corporations taking advantage of the tax law merely put just enough corporate resources in Puerto Rico to qualify for the temporary tax provision.
Some seek to justify tax change by using the pre-text of insourcing pharmaceutical company manufacturing from China. The problem is that the history of the prior law did not result in job creation, but merely tax avoidance.
The result likely will be more tax revenues for the Puerto Rican government, yet domestic corporations will be hit with higher taxation to make up the difference while multinationals relocate some headquarters to the island to take temporary advantage of the new proposal.
For those seeking statehood for Puerto Rico, this tax proposal, if enacted, would end that idea because any corporation that relocates some operations to Puerto Rico will be motivated to fight statehood to preserve the Commonwealth’s tax haven status. Restoring the old tax incentive will neither revive the island’s economy, nor insource drug production from China to the United States.
A better idea would be to change the tax treatment of U.S. corporations nationwide in a way that would draw manufacturing back from China to the United States as a whole. Trying to set up Puerto Rico as a special place for drug manufacturing is destined to be a failure.
The history of this tax provision shows that it did not create Puerto Rican jobs. Section 936 of the Tax Reform Act of 1976 was a modification of a long-standing special tax provision that created U.S. territories as tax havens. The 1976 changes preserved a tax credit for wages and capital investment by manufacturers in U.S. territories, but narrowed other tax provisions.
Many pharmaceutical companies moved just enough manufacturing to Puerto Rico to take advantage of the tax haven status granted to territories. This made good business sense, but did not create a promised economic boom to Puerto Rico.
In 1996, President Bill Clinton signed a law that phased out the tax break over 10 years. Many companies established subsidiaries in foreign tax havens that took over the Puerto Rico operations as a way around the modification of the law. The U.S. doesn’t tax income of foreign corporations abroad and foreign corporations’ income wasn’t taxed until it was paid to a parent company and deposited in a bank in the States.
Microsoft is a good case study in how many corporations treated Puerto Rico under the law. A hearing by the Senate Permanent Subcommittee on Investigations in 2012 investigated allegations that Microsoft attributed an average of 44% of its profits from the States to Microsoft Puerto Rico in 2009 and the following two years.
This allowed the company to shift income and to pay Puerto Rico $40 million in taxes a year, instead of about $1.5 billion that would have been owed to the United States treasury had the company been wholly run out of the states. They had under 200 employees in Puerto Rico. This is not a knock against Microsoft, because other corporations were doing the same thing to avoid high U.S. corporate taxation and using the law to pay less in corporate taxation.
According to law Professor Reuven Avi-Yonah from the University of Michigan who testified at the hearing, “going back to a period before 1986, it was standard practice for U.S. multinationals to conduct research and development in the United States, deduct the costs, and then transfer the resulting intangibles overseas to places such as Puerto Rico where all the profit was accumulated.” The 2017 tax reform passed under President Trump changed the tax rate to half the corporate tax rate, or 10.5%, in territories.
Some are advocating a new cut to taxes in territories to 5.25% to recreate Puerto Rico as a tax haven, using the cover of the coronavirus controversy for this change. This would be a good proposal if it were to actually produce a boom in business for Puerto Rico, and not inhibit statehood. But tax law is far more complicated, and corporations are more likely to make some paper changes to locating headquarters, relocating just enough to Puerto Rico without actually moving significant manufacturing to the island.
What would work to move manufacturing from China to the U.S., and recreate the booming economy nationwide, would be immediate expensing (deductions) for investing in plant and equipment in the U.S., and a payroll tax holiday for the rest of the year. That would be more likely to restore Trump’s V-shaped recovery.
Peter Ferrara is the Dunn Liberty Fellow in Economics at the King’s College in New York, and a Senior Fellow at the National Tax Limitation Foundation. He served on the Domestic Policy Council under President Reagan, and as Associate Deputy Attorney General of the United States under President George H.W. Bush.