from Follow the Money and Sovereign and Sub-Sovereign Debt Restructuring

Puerto Rico’s Daunting Fiscal Math (My View)

An applied economics question:

A country with no independent monetary policy, undergoing a ten-year slump that has reduced its real GDP on average by over a percentage point a year, needs to do a fiscal consolidation of roughly 10 percentage points of its GDP. How much does output fall?

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Budget, Debt, and Deficits

The example is not entirely hypothetical.

Puerto Rico isn’t a country, but rather a territory of the United States. It is a part of the U.S. monetary and currency union—though it isn’t completely a part of the U.S. fiscal union (Puerto Ricans—and firms based in Puerto Rico—generally do not pay federal income tax). Puerto Rico’s gross national product (GNP) is down more than 14 percent since 2006 (the last data point is 2015, and the Government Development Banks’s high frequency indicator shows a further decline in 2016). GNP is the relevant measure—GDP is clearly inflated by the tax games played by firms operating in Puerto Rico. And the oversight board has asked Puerto Rico to show the impact of closing a $7 billion (just over 10 percent of GNP) fiscal gap through austerity. More on that later.

The answer—fairly obviously, I think—depends on your view of the fiscal multiplier. The Fed is raising rates: directionally it will be hurting, not helping. There is no monetary offset. If you use a multiplier of around 1.5 (well justified on the basis of recent analysis*) GNP should fall by roughly 15 percent.

That is huge, and it seems unreasonably large. But it is a function of asking for an unreasonably large fiscal adjustment in an economy that lacks the capacity to offset fiscal consolidation through monetary easing. Greece’s experience though shows that a massive fiscal consolidation can produce a massive fall in output. There is plenty of empirical cause to worry.

The Fiscal Gap

So why is the financing gap—$7 billion on average over ten years—so big?

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Budget, Debt, and Deficits

That to me is the interesting bit.

Last fall, the oversight board wanted to see the projected impact of full payment of Puerto Rico’s contractual debt. Debt service is roughly $3.5 billion a year (a bit under 2.5 billion of that is interest). Puerto Rico currently isn’t paying most of its debt (some payments are being made out of trust funds, the bonds backed by the pledge of sales tax revenue are also being paid—which is a drain of about $0.7 billion). So roughly half the fiscal consolidation—about 5 percent of GNP—is the result of the assumption that Puerto Rico should pay all contracted debt service (assumptions behind the huge fall in output are detailed here). Reduce the debt service and the amount of required fiscal consolidation—and the associated fall in output—goes down (note: roughly 20 percent of Puerto Rico’s debt is likely held on island, so there is a feedback loop, but to the extent the on island bonds have already been marked to market, the wealth impact may be smaller).

But where does the need for an additional $3.5 billion in consolidation come from?

The exhaustion of funding from the sale of pension assets (around $1 billion a year), the exhaustion of funding from the affordable care act ($1.5 billion), and the potential loss of revenue from a tax Puerto Rico now imposes on the turnover of multinationals operating in Puerto Rico (Act 154, which generates $2 billion in funding; the Krueger report projected this could fall to $1 billion if the tax stopped being creditable against federal corporate income tax—more on this later). Sum those up and Puerto Rico in effect loses about $3.5 billion in current budget funding (off a budget of about $18 billion now, counting about $6 billion in spending financed by federal transfers, which will rise to $19 billion in 2018 as Puerto Rico can no longer draw on the pension funds’ assets to cover pension benefits).

Puerto Rico Has Its Own Fiscal Cliff

Puerto Rico’s dirty little secret—which really wasn’t much of a secret—was that its financial problems were always likely to get worse before they got better. Puerto Rico faces a series of fiscal cliffs in 2018 and 2019.

Now there isn’t much Congress can or should do about the exhaustion of the assets of Puerto Rico’s pension funds. Promised pension benefits will either have to be paid out of current tax revenues, or not paid at all—at a significant cost to Puerto Rico’s own economy. But Congress could provide more federal funding for health care. There won’t be a new slug of Affordable Care Act money, obviously. But Puerto Rico’s Medicaid funding could be changed: Puerto Rico now gets far less Medicaid support than it would if it were a state. And Congress could make Puerto Rico’s already favorable tax status (no federal income tax, remember) even more favorable by explicitly indicating that Act 154 should be creditable against federal income tax (foreign corporate income tax payments are creditable against U.S. corporate tax on a U.S. firm’s global profits—the potential problem is that Act 154 isn’t exactly a corporate income tax, the IRS to my knowledge has not definitively ruled on this)

The oversight board was right, in my view, to ask that Puerto Rico base its budget on current federal law. Congress, not the oversight board, ultimately has to decide how much federal medical funding Puerto Rico gets. And the debate over the border-adjusted tax highlights the many ways federal corporate tax reform could put Act 154 revenues in jeopardy.**

Sum it up and Puerto Rico needs to do a significant, contractionary fiscal adjustment even if it doesn’t pay much on its debt, absent a change in federal law. That is the (harsh) fiscal math.

Just how much? Well, it depends on how much debt service Puerto Rico needs to pay in the near term—the oversight board suggested that Puerto Rico aim for $0.8 billion in 2019 (a little over 1 percent of GNP). And it depends on where Puerto Rico is starting from, once you consolidate Puerto Rico’s complex government finances. And finally it depends on what assumptions you make on Act 154 (the government wants to extend it, and bank on a continued revenue stream of $2 billion—rather than a projected loss of about $1 billion).

My Fiscal Math

Here is my guess.

Puerto Rico’s new governor has indicated that Puerto Rico runs a primary fiscal surplus (tax and other revenues, net of spending on items other than debt) of just over $1 billion in fiscal 2017 (see p.20 or p. 89 of the new Governor’s fiscal plan). I have no way of easily verifying that number—but it is a plausible number (reconciling the consolidated general government budget with Conway’s assessment of the cash flows takes a lot of work). The previous governor raised the sales tax by 4.5 percent (to 11.5 percent), generating about $1 billion a year in additional revenues. And the structure of the COFINA/sales tax bond’s pledge forces Puerto Rico to sock away about $0.7 billion a year before the sales tax flows into the Treasury.*** But the exact number depends on getting the right numbers for a lot of spending that isn’t in the formal general fund budget. Everyone agrees that Puerto Rico needs to be more fiscally transparent.

But even if it is right, the $1 billion primary surplus is a bit misleading. In fiscal 2017—as noted above—about $1 billion of pension spending is being funded “off budget” through the sale of pension assets (hence the $1 billion rise in "pay-go" pension spending on p.129 of the latest fiscal plan).

Let’s assume these items net out. Puerto Rico’s “true” primary balance would be about zero in fiscal 2018 if it:

a) Continued to get $1.5 billion in federal health care support and

b) Continued to collect $2 billion in revenues from Act 154 (revenue collected largely from U.S. software and pharmaceutical companies that are tax residents of Puerto Rico—the revenue collected from Act 154 isn’t a drain on the local economy).

Then in the best case scenario for Puerto Rico it would still need to do $1.5 billion (2 percent of GNP) in fiscal adjustment over the next two years to make up for the loss of affordable care act funding, plus what ever additional adjustment is required to make payments on its debt stock. Take the oversight board’s $0.8 number for debt service in fiscal 2019 and the adjustment rises to a bit over 3 percent of GNP. That amount of adjustment would leave Puerto Rico hugely vulnerable to any change in the ability of firms to deduct Act 154 payments against their U.S. corporate income tax—and equally vulnerable to the risk to Act 154 collections from any federal corporate tax reform.

In reality though Puerto Rico would need to do a bit more adjustment than would be implied by a static analysis. To get a billion dollar change in the fiscal deficit in the short-run you actually need to do more than a billion dollars in cuts. That is because big budget cuts (or a big rise in tax collections) reduces the income of Puerto Ricans, and that feeds back into tax revenues and the like. For example, cuts in public spending to make up for a loss of federal health care dollars mean that government workers won’t have as much to spend in Puerto Rico—so less sales tax revenue. Puerto Ricans are U.S. citizens—a laid-off worker can get on the next flight to Florida.

Getting a 3 percent of GNP change in the overall budget thus requires doing more than 3 percent of GNP in actual fiscal measures. Life ain’t fair. The feedback loop is a bit weaker in Puerto Rico because Puerto Rico doesn’t collect all that much tax—but I would assume that you need to do about 20 percent more than the headline adjustment. That puts the needed measures in my little scenario at about 3.6 percent of GNP.

Pick your multiplier. If it is 1.5, GNP would be expected to fall by around 5 percent relative to a “no fiscal adjustment” baseline. I am trying to avoid false precision, so apologies if the math is sometimes not exact. I could easily get a bigger number—

The Latest Plan

The latest fiscal plan from Puerto Rico’s government doesn’t appear to explicitly model the impact of fiscal consolidation on growths. The growth baseline is at least presented independently of the fiscal measures.

All in all, the proposed measures imply a roughly 4 percent of GNP fiscal consolidation over the next few years—mostly from spending measures, but also 0.5 percent from better tax compliance and the like (the measure leaves out the revenue from the extension of Act 154, as there is no incremental burden on Puerto Rico).**** Even excluding any change in health care payments, I get a fiscal impulse of just under 2 percent of GNP in fiscal 2018 (in part because the stimulus of 2017 is unwound), around 2 percent of GNP in 2019 and just under 0.5 percent of GNP in 2020.

If Puerto Rico’s economy is now on a trajectory where it would contract by about 1.5 percent of GNP in the absence of any fiscal impulse,***** a 1.5 multiplier implies an expected real contraction of over 4 percent of GNP in both 2018 and 2019, and a real contraction of over 2 percent of GNP in 2020.

The official plan only seems to offer nominal growth forecasts so it is impossible to know exactly how these estimates compare. I though would expect a slightly larger nominal contraction in fiscal 2018 than in the latest fiscal plan, and the forecast of positive nominal growth in fiscal 2020 looks optimistic to me.

The bottom line though, as I have tried to highlight, is that there is no real mystery why the growth projections in the governor’s fiscal plan differ significantly from the oversight board’s baseline. There is a lot less fiscal consolidation in the governor’s baseline—so there should be a lot smaller fall in output.

At the same time, there is a real question in my mind whether the proposed consolidation is still too much. Puerto Rico’s economy has shrunk by at least 15 percent since 2006. Another 10 percent fall would put the cumulative fall at close to Greek levels—though real per capital income will fall by less, thanks to out-migration.

One final note: had PROMESA not passed, Puerto Rico would be struggling not just with a fiscal crisis, but facing the risk from a mass of litigation from creditors seeking to collect on their defaulted bonds. And there would be no oversight board in place to provide a framework for the discussion about the needed fiscal adjustment. Congress would have to act eventually—there really was no alternative to a combination of oversight and an orderly legal restructuring process. But if Congress had not acted before the election, Puerto Rico might have waited for a year or two for the legislative calendar to open up, at immense cost.

Full disclosure: I worked extensively on Puerto Rico while at the Treasury in 2015, and I strongly supported PROMESA in 2016. I believe the numbers here are consistent with the available information on Puerto Rico’s fiscal position, but they come with a reasonable error band. I have no current involvement in Puerto Rico.

* For estimates of the fiscal multiplier when monetary policy is constrained, see Table 1 of Christina Romer (2012); Gabriel Chodorow-Reich and Christopher L. House (2017); and Christian Proebsting and Linda L. Tesar’s (2017) analysis of the euro area.

** It is hard to see how Puerto Rico could remain inside the U.S. for customs purposes and outside the U.S. for income tax purposes if the U.S. adopted a border-adjusted corporate income tax. I would think the customs border and the tax border would need to be aligned to prevent gaming and abuse, though I am curious if any of the advocates of a destination-based cash flow tax have given serious thought to how it might impact Puerto Rico.

*** Conway’s analysis of the Treasury Single Account (the main government account) for fiscal 2016 shows a primary surplus in FY 16, but the primary surplus clearly came as a result of delaying payments to suppliers. Conway’s analysis for FY 2017 seems to show a modest primary deficit. But that leaves out the COFINA pledge, which is counted in the assessment of the general government’s overall fiscal position. See p. 26 and 27 of this presentation

**** I net out the revenue gains from the extension of Act 154, as extending Act 154 doesn’t involve any incremental drag on Puerto Rico’s economy. Improved tax compliance, though, should result in a small fiscal drag. The size of the fiscal consolidation is taken from p. 20 and p. 23 of the governor’s latest fiscal plan. I adjusted the revenue measures for the revenue that come from the extension of Act 154 using the numbers on p. 26, and included the pension savings but not the health care savings on p. 23. If I got this wrong, let me know.

***** Krueger’s team thought Puerto Rico basically would shrink by about a percentage point a year in real terms in the absence of reforms or fiscal consolidation. The December 21st updated fiscal plan suggested trend real growth was now negative 1.5 percent. The last economic indicators from Puerto Rico’s Government Development Bank point to a 2 percent contraction in 2016—with the contraction running close to 3 percent year-over-year in the most recent monthly numbers.