Puerto Rico’s June referendum on U.S. statehood was boycotted by the opposition and suffered from low turnout but has once again put a spotlight on the island’s economic depression and debt crisis. Supporters see statehood as a way of easing Puerto Rico’s mounting woes. But Congress has consistently rejected the idea of statehood and even if it approved such a move it would carry heavy costs, warns CFR Senior Fellow and former Treasury Department official Brad W. Setser. “The fact that Puerto Rico has built up a level of debt that is far in excess of any other state would make the transition to statehood quite difficult,” he says. Meanwhile, further hardships loom as a federal oversight board imposes austerity measures. “There will be sacrifices on the part of pretty much everyone,” Setser says.
The pro-statehood position won 97 percent of the vote. What do these results mean?
The results show that Governor Ricardo Rossello’s New Progressive Party, or PNP, is still committed to statehood, and their voters came out and voted in support of statehood. But the level of participation was quite low. The opposition parties boycotted the election. Barely a quarter of eligible voters showed up and voted, when in Puerto Rico, there’s a tradition of high participation in most elections. As a result, I doubt it will have a very significant effect.
Ultimately, it’s up to Congress to decide if Puerto Rico becomes a state or not. It has so far not been willing, and I doubt that this referendum fundamentally changes that dynamic.
Proponents argue that if Puerto Rico becomes a state, its current economic crisis would be ameliorated. Is that true?
That’s actually a quite hard question. Puerto Rico’s current status as a territory provides it with some significant benefits, but it also has costs.
The benefit is that Puerto Ricans don’t pay U.S. federal income tax on income earned in Puerto Rico, and U.S. companies operating in Puerto Rico can structure themselves so that they are offshore for purposes of U.S. corporate income tax. If Puerto Rico were to become a state, there would be a significant shock from the loss of those tax benefits.
On the other hand, Puerto Ricans do not have access to the same level of federal benefits that they would get if the island were a state. While Puerto Rico does receive some federal assistance—food stamps, housing funds, and some highway and transportation funds—it clearly receives less from the federal government than it would if it were a state. It receives, for instance, less in Medicaid funding than it would get if it were a state. And, ironically, many Puerto Ricans would get a rebate if Puerto Rico were part of the personal income tax system, which is progressive and provides subsidies through the earned income tax credit for low-income workers.
But the fact that Puerto Rico has built up a level of debt that is far in excess of any other state, combined with the change in the tax treatment of companies operating in Puerto Rico, would make the transition to statehood quite difficult.
Congress passed the Puerto Rico Oversight, Management, and Economic Stability Act (PROMESA) last year to help Puerto Rico deal with its debt load. Where is that process now?
PROMESA created an oversight board that is charged with working with Puerto Rico’s governor to create a long-run budget plan. The board has to approve annual budgets.
Secondly, the legislation also created two restructuring provisions: Title VI, the so-called voluntary restructuring, and Title III, which is more akin to the municipal bankruptcy process.
Since it’s been created, the oversight board has approved a long-run fiscal plan. It has authorized Puerto Rico’s government and various subcomponents of the Puerto Rican government to file for municipal-bankruptcy-style protection. The Sales Tax Financing Corporation and the highway authority, for instance, which account for a significant share of Puerto Rico’s debt, have filed for Title III protection, as have others. And that court-supervised restructuring process is now in its early stages.
The PROMESA process is playing out more or less as expected. The board’s program for fiscal adjustment requires significant austerity from Puerto Rico. But it also envisions rather limited debt service over the next ten years, and thus a significant debt restructuring.
Are bondholders and the roughly $73 billion in bonds going to be treated differently than the pension system, which is underfunded by almost $50 billion?
There will be sacrifices on the part of pretty much everyone. But a large part of the fiscal plan is putting money into the pensions to cover the legacy obligations that cannot be covered out of the pension system’s assets because the pension system has no assets. Pensioners will have to make some sacrifices, but they likely will come closer to getting their full pension payment than most bondholders will to getting their full payment on their bonds.
An important point here, though, is that there is no single entity that issued $73 billion in bonds. About fourteen different entities have issued that much to different borrowers with different credit profiles. So while the bulk of it is going to be restructured in one way or another, some bondholders will receive a significantly better deal than others. Part of the complexity of the Puerto Rican case is this diversity of debt stock, and the uncertainty surrounding the relative status of different parts of the debt, which is what the PROMESA process seeks to sort out.
Some have warned that the austerity measures foreseen in the new budget will contribute to a downward economic spiral, causing more people to leave the island, and ultimately making things worse. Is there any way to avoid that?
Unless there are significant changes in U.S. federal law, there will be no way for Puerto Rico to avoid a lot of austerity in the next couple of years. That’s for two reasons. The first is that Puerto Rico has covered payments on its existing pensions by running down the assets of its pension system. It has been using the legacy assets of its pension system as a form of fiscal financing. And those assets are exhausted. As a result, Puerto Rico is going to have to undertake some austerity just to make up for the loss of the financing provided by the sale of pension assets.
Second, Puerto Rico benefited from a provision of the Affordable Care Act that gave it funding to offset the limited funding it receives under the current Medicaid program. But that Affordable Care Act grant is running out. Congress provided a bit of short-term funding in the last omnibus bill, but it hasn’t provided clarity about the level of federal support Puerto Rico will receive going forward. And so to maintain the current level of medical care in the face of the imminent loss of Affordable Care Act funding, Puerto Rico has to make some significant cuts. Puerto Rico is going to have to tighten up its budget and there’s no real way to avoid that.
Clearly, one of the big risks associated with austerity is that it leads to a bigger downturn than is envisioned in the fiscal plan, and more people leave than expected. As a result, Puerto Rico’s economic capacity falls and there’s permanent damage done to the economy. There certainly is a risk that the downturn gets significantly worse in the next few years.
But Puerto Rico will also benefit from the legal protections from creditor lawsuits afforded by the PROMESA legislation while it undertakes that adjustment, and hopefully will emerge with a realistic amount of debt at the end of the process.
Are there any signs that the restructuring is spilling over onto the broader municipal bond market on the mainland?
Puerto Rico has been frozen out of traditional municipal financing for at least four years. It did place a bond in 2014, but it placed it with a group of investors that specialize in high-risk debt, not the traditional municipal market. The municipal market has expected a restructuring in Puerto Rico, and so far there’s really no evidence that it has changed conditions for healthy municipal issuers in the United States.
Are there any lessons here for states, like Illinois, that have problems with high debt and pension obligations?
It is a totally different legal issue. Territories are not states. Municipalities are also not states, but rather subdivisions of states. The municipal bond market includes borrowing by both municipalities, which are eligible for Chapter 9 bankruptcy protection, and borrowing by states, which are not eligible for any restructuring process.
The PROMESA legislation as created by Congress is a restructuring tool that is available only to territories. It is not available to states. The constitutional issues associated with creating a restructuring process for states are actually significantly more difficult than the constitutional issues around territories.
This is because bankruptcy restructuring is usually accompanied with some kind of external oversight. For a municipality, that usually means a state—for example, the state of Michigan provided oversight for the city of Detroit. For Puerto Rico, a territory of the United States, the federal government is providing the oversight.
Now that PROMESA is in place, is there anything else the federal government could be doing, or should be doing?
There are fundamental questions about the federal fiscal bargain with Puerto Rico that will need to be settled independently of the statehood issue.
Puerto Rico is poorer than the poorest of U.S. states. It depends more on federal anti-poverty programs than most states. So some of the cuts to things like food stamps or housing assistance that are envisioned in the Republican budget plan would have a disproportionate impact on Puerto Rico—an impact that is not factored in to the island’s current budget projections. Washington needs to be conscious of how changes to federal programs might impact Puerto Rico.
Puerto Rico’s treatment under Medicaid will also have to be addressed. In the long run, it isn’t sustainable for Puerto Rico’s Medicaid benefits to be capped at a level far below what it would receive if it were a state.
In addition, there’s a strong case for a program similar to the federal Earned Income Tax Credit (EITC), which would provide tax credits to low-income Puerto Rican workers below a certain income threshold. Such employment-based tax relief incentivizes work, and would help boost Puerto Rico’s low labor-force participation rate. Moreover, it would encourage Puerto Ricans to stay on the island and continue working there. Right now, the federal government in effect provides a tax incentive for many Puerto Ricans to move off-island to benefit from the EITC.
Finally and probably most controversially, I do think Puerto Rico’s treatment in the U.S. corporate income tax system needs to be clarified, particularly if there is a comprehensive reform of the corporate income tax system. In particular, Puerto Rico still generates a lot of tax revenue from the controversial Act 154—a special tax on multinational companies that operate in Puerto Rico because it isn’t part of the U.S. for corporate income tax purposes.
This interview has been edited and condensed.