Puerto Rico: Fiscal Relations with the Federal Government and Economic Trends during the Phaseout of the Possessions Tax Credit
Published: 2006-05-19T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: The federal possessions tax credit, which was designed to encourage U.S. corporate investment in Puerto Rico and other insular areas, expires this year. Proponents of continued federal economic assistance to Puerto Rico have presented a variety of proposals for congressional consideration. In response to a request from the U.S. Senate Committee on Finance, this study compares trends in Puerto Rico's principal economic indicators with those for the United States; reports on changes in the activities and tax status of the corporations that have claimed the possessions tax credit; explains how fiscal relations between the federal government and Puerto Rico differs from the federal government's relations with the states and other insular areas; and compares the taxes paid to all levels of government by residents of Puerto Rico, the states, and other insular areas. GAO used the latest data available from multiple federal and Puerto Rican government agencies. Data limitations are noted where relevant. Key findings are based on multiple measures from different sources. GAO is not making any recommendations in this report. In comments on this report the Governor of Puerto Rico said the report will be useful for evaluating policy options.
section_title: What GAO Found
paragraphs: Puerto Rico's per capita gross domestic product (GDP, a broad measure of income earned within the Commonwealth) in 2005 was a little over half of that for the United States. Puerto Rico's per capita gross national product (GNP, which covers income earned only by residents of the Commonwealth) was even lower relative to the United States. Concerns about Puerto Rico's official price indexes make it difficult to say whether the per capita GNP of Puerto Rican residents has grown more rapidly than that of U.S. residents; however, the absolute gap between the two has increased. U.S. corporations claiming the possessions tax credit dominated Puerto Rico's manufacturing sector into the late 1990s. After the tax credit was repealed in 1996 beginning a 10-year phaseout period, the activity of these corporations decreased significantly. Between 1997 and 2002 (the latest data available) valued added in these corporations decreased by about two-thirds. A variety of data indicates that much of this decline was offset by growth in other corporations, so that some measures of aggregate activity remained close to their 1997 levels. For example, value added in manufacturing remained fairly constant between 1997 and 2002. Most of the offsetting growth was in the pharmaceutical industry. Residents of Puerto Rico pay considerably less total tax per capita than U.S. residents. However, because of lower incomes they pay about the same percentage of their personal income in taxes. The composition of taxes differed between Puerto Rico and the states with federal taxes being a larger share of the total in the states. This difference reflects the facts that (1) residents of Puerto Rico generally do not pay federal income tax on income they earn in the Commonwealth and (2) the Commonwealth government has a wider range of responsibilities than do U.S. state and local governments.

section_title: Letter
paragraphs: In response to your request, this report provides information on the Puerto  Rican economy, including corporate activity, during the phaseout of the  possessions tax credit, as well as descriptions of the application of federal  tax law and federal social policy programs in Puerto Rico.
As we agreed with your office, unless you publicly announce the contents  of this report earlier, we plan no further distribution of it until 30 days from  the date of this letter. We will then send copies to the Governor's office in  Puerto Rico, Resident Commissioner Fortuno, and other interested parties.   We will also make copies available to others who request them. This report  will also be available at no charge on the GAO Web site at  http://www.gao.gov. If you or your staffs have any questions on this report,  please call me on (202) 512-9110. Key contributors are listed in appendix X.
subsections: section_title: Introduction
paragraphs: The federal and Commonwealth governments have had a long-term interest  in policies to stimulate economic growth in Puerto Rico. Historically, the  centerpiece of these policies has been the combination of the possessions  tax credit in the U.S. Internal Revenue Code (IRC) and extensive tax  incentives in the Puerto Rican tax code for U.S. and foreign businesses. In  the early 1990s Congress became dissatisfied with the effectiveness of the  credit and introduced restrictions to better target employment-generating  activities. Then in 1996 Congress repealed the credit but allowed existing  possessions corporations to earn either the possessions credit or a  replacement credit during a 10-year phaseout period ending in 2006.  Various proposals have been placed before Congress for some form of  replacement assistance to the Puerto Rican economy. Congress could  better assess the merits of the various proposals if it had more complete  information relating to the recent performance of the Puerto Rican  economy, the current treatment that Commonwealth residents receive  under both federal tax policies and federal social programs, and  information relating to the burden of taxes that residents of Puerto Rico  pay, relative to those paid by residents of the states and the other U.S.  insular areas.
To provide a basis for future decisions regarding legislation on Puerto  Rican economic issues, this report  explains how the U.S. federal tax treatment of individuals and  businesses in Puerto Rico and of the insular government differs relative  to the treatment of governments, businesses, and individuals in the  states and the other U.S. insular areas;  compares trends in Puerto Rico’s principal economic indicators since  the early 1980s with similar indicators at the national level for the  United States and provides what is known about capital flows between  Puerto Rico and the United States and between Puerto Rico and foreign  countries;  reports on changes in the activities and tax status of the corporations  that have claimed the possessions tax credit since 1993;  provides information on the distribution of private-sector economic  activity in Puerto Rico by type of business entity;  describes the total amount of tax paid by individuals and businesses in  the states and the U.S. insular areas and shows percentage breakdowns  by type of tax; and  describes how the principal U.S. federal social programs apply to Puerto  Rican residents, relative to residents of the states and the other U.S.  insular areas.
subsections: section_title: Background
paragraphs: Puerto Rico is one of the two nonstate Commonwealths associated with  the United States. The other is the Commonwealth of the Northern Mariana  Islands (CNMI). The United States also has three major territories under  the jurisdiction of the U.S. Department of Interior. The major territories are  Guam, the U.S. Virgin Islands, and American Samoa. The three major  territories plus the two nonstate Commonwealths are referred to in this  report as “the insular areas.” These areas are often grouped together in this  manner for the purpose of federal legislation. For this reason, and when  necessary for the purpose of comparison to Puerto Rico, this report  provides a limited discussion on the other insular areas.
With the exception of American Samoa, those born in the insular areas are  U.S. citizens; however, insular area residents are not afforded all of the  rights of citizens residing in the states. More than four million U.S. citizens  and nationals live in the insular areas. These areas vary in terms of how  they came under the sovereignty of the United States and also in terms of  their demographics, such as median age and education levels. Each of the  insular areas has its own government and maintains a unique diplomatic  relationship with the United States. General federal administrative  responsibility for all insular areas but Puerto Rico is vested in the  Department of the Interior. All departments, agencies, and officials of the  executive branch treat Puerto Rico administratively “as if it were a state”;  any matters concerning the fundamentals of the U.S.-Puerto Rican  relationship are referred to the Office of the President.
Residents of all the insular areas enjoy many of the rights enjoyed by U.S.  citizens in the states. But some rights that, under the Constitution, are  reserved for citizens residing in the states have not been extended to  residents of the insular areas. For example, residents of the insular areas  cannot vote in national elections, nor do their representatives have full  voting rights in Congress. Residents of all of the insular areas receive  federally funded aid for a variety of social programs. Although residents of  an insular area do not pay federal income taxes on income earned in that  insular area, federal tax policy does play an important role in the  economies of the insular areas. Historically, the federal government has  used tax policy as a tool to encourage investment and increase employment  in the insular areas.
subsections: section_title: Puerto Rico’s Relationship with the United States
paragraphs: Puerto Rico’s Constitution of 1952 defines Puerto Rico as a self-governing  Commonwealth of the United States. Although fiscally autonomous,  Puerto Rico is similar to the states in many aspects. For example, matters  of currency, interstate commerce, and defense are all within the  jurisdiction of the U.S. federal government. Puerto Rican residents are  required to pay local income taxes on income earned from Puerto Rican  sources, but not federal income taxes. Puerto Rican residents, however, do  contribute to the U.S. national Medicare and Social Security systems.  Generally, federal labor, safety, minimum wage laws and standards also  apply in Puerto Rican to the same extent they apply to the states. The  federal government plays a pervasive role in Puerto Rico that stems not  only from the applicability of the United States Constitution, laws and  regulations, but from the transfer to the island of more than $13 billion in  federal funds every year to fund social programs to aid Puerto Rican  residents, including earned benefits such as Social Security and  unemployment benefits.
Chapters 2 and 7 of this report discuss in detail the how the U.S. federal tax  code applies to residents of Puerto Rico and how the principal U.S. federal  social programs are applied in Puerto Rico, respectively.
section_title: Characteristics of Puerto Rico
paragraphs: Puerto Rico occupies a central position in the West Indies. It comprises six  main islands with a land area of 3,421 square miles and a population of  almost four million people. Puerto Rico is thought to have one of the most  dynamic economies in the Caribbean region, an economy in which  manufacturing, driven by the pharmaceutical industry, has surpassed  agriculture as the primary sector in terms of domestic income. Over 40  percent of Puerto Rico’s domestic income since the mid-1980s has been  derived from manufacturing. Pharmaceuticals accounted for almost 40  percent of total value added in manufacturing in 1987; that share rose to  over 70 percent by 2002. Table 2 describes some of the demographic  characteristics of Puerto Rico and compares them to national averages in  2000. possessions has been subject to special tax provisions. The Tax Reform Act  of 1976 modified the form of the preferential tax treatment by establishing  the possessions tax credit under Section 936 of the Internal Revenue Code.  The stated purpose of this tax credit was to “assist the U.S. possessions in  obtaining employment-producing investments by U.S. corporations.” Prior  to 1994, the possessions tax credit was equal to the full amount of the U.S.  income tax liability on income from a possession. The credit effectively  exempted two kinds of income from U.S. taxation:  income from the active conduct of a trade or business in a possession,  or from the sale or exchange of substantially all of the assets used by the  corporation in the active conduct of such trade or business and  certain income earned from financial investments in U.S. possessions or  certain foreign countries, generally referred to as qualified possession  source investment income (QPSII).
In order for the income from an investment to qualify as QPSII, the funds  for the investment must have been generated from an active business in a  possession, and they must be reinvested in the same possession. Dividends  repatriated from a U.S. subsidiary to a mainland parent have qualified for a  dividend-received deduction since 1976, thus allowing tax-free repatriation  of possession income.
The possessions tax credit was criticized on the grounds that the  associated revenue cost was high compared to the employment it  generated, that a large share of the benefits of the credit were not reaped  by Puerto Rican residents and that it distorted debate over Puerto Rico’s  political status. The Omnibus Budget Reconciliation Act of 1993 placed  caps on the amounts of possessions credits that corporations could earn  for tax years beginning in 1994 or later. The Small Business Job Protection  Act of 1996 repealed the possessions tax credit for taxable years beginning  after 1995. However, the act provided transition rules under which a  corporation that was an existing credit claimant was eligible to claim  credits with respect to possessions business income for a period lasting  through taxable years beginning before 2006. Additional background on  Section 936 of the U.S. Tax Code and the possessions credit is provided in  chapters 2 and 4.
section_title: Additional Studies Relating to the Economy of Puerto Rico
paragraphs: Several of our previous studies, as well as work done by the Internal  Revenue Service (IRS) and the U.S. Census Bureau (Census), address  aspects of the Puerto Rican economy discussed in this report, including the  business activity of possessions corporations and employment, payroll,  value added, and capital expenditures by economic sector. Our previous  work also addresses broader trends in the Puerto Rican economy, as does  work underway by the Brookings Institution. A related study is also  expected shortly by the Joint Committee on Taxation. Its work will  evaluate legislative options concerning Puerto Rico. Table 3 highlights the  scope of several recent reports on Puerto Rico, as well as the two studies  that are in progress.
section_title: Scope and Methodology
paragraphs: The Chairman and Ranking Minority Member of the U.S. Senate Committee  on Finance asked us to study fiscal relations between the federal  government and Puerto Rico and trends in the Commonwealth’s economy  with a particular focus on the activities of possessions corporations  operating there.
subsections: section_title: Federal Tax Treatment
paragraphs: To determine the U.S. federal tax treatment of individuals and businesses in  Puerto Rico, relative to the states and the other insular areas, we examined  the IRC, Department of the Treasury regulations, relevant Treasury rulings  and notices, and legislation.
section_title: Economic Indicators and Capital Flows
paragraphs: To compare trends in principal economic indicators for the United States  and Puerto Rico, we obtained data from both U.S. and Puerto Rican  sources. The trends we present are commonly used measures of overall  economic activity and important components of economic activity, such as  saving, investment, labor force participation, and unemployment. We  reported on many of these indicators in our previous report on economic  trends in Puerto Rico. The data shown are largely drawn from the National  Income and Product Account series produced annually by economic  statistics agencies in the United States and Puerto Rico. Most of the data  we used for the U.S. economic series are produced by the Bureau of  Economic Analysis and the Bureau of Labor Statistics and are publicly  available from the Internet. When we compared U.S. data to Puerto Rican  data that are based on the Puerto Rican July 1–June 30 fiscal year, we  computed annual U.S. figures using monthly or quarterly data to match the  Puerto Rican fiscal year.
Most of the annual data we used for Puerto Rican economic trends are  produced by the Planning Board of Puerto Rico and are also publicly  available. In some instances, the methodologies used by the Planning  Board to produce certain data series are outdated relative to the  methodologies now used by the United States. For example, the  methodology used in calculating certain price indices in Puerto Rico is  outdated and the methods used to obtain unemployment data have been  somewhat less rigorous than in the United States. In these cases, we  reviewed literature concerning the limitations of various series and  interviewed Puerto Rican officials about the methods they use to collect  and develop their data. These limitations are noted in the report. Wherever  possible, we used alternative assumptions and data sources to determine if  any conclusions drawn from the data are sensitive to the particular data  series used. For example, we applied both U.S. and Puerto Rican price  indices to Puerto Rican gross domestic product (GDP) data to see if  applying different measures of price changes would lead to different  conclusions about whether the Puerto Rican economy has been growing  faster or slower than the U.S. economy. Puerto Rico’s Planning Board has  recently contracted with several consultants for a review of their entire set  of methodologies for preparing the Commonwealth’s income and product  accounts, including the deflators. The Board has also been negotiating a  memorandum of agreement with the U.S. Bureau of Economic Analysis for  the latter to provide advice on this effort.
For some indicators of interest, annual data are not available for Puerto  Rico. In some of these cases, we used decennial census data. The decennial  census covers both the United States and Puerto Rico and produces  comparable statistics on educational attainment and poverty levels. We  also used data from the Economic Census of Puerto Rico and the  Economic Census of the United States, also produced by Census. These  data included detailed information on employment, investment, and value  added broken down by sector of the economy. These data, produced by  Census every 5th year, are of particular relevance to the possible effects of  phaseout of the possessions tax credit.
To provide information on what is known regarding the flow of capital into  and out of Puerto Rico, we interviewed Puerto Rican government officials  and private sector experts to help us to ascertain what data were available.  We determined that the available data would not allow us to present a  comprehensive picture of the trends in capital flows. The most significant  gap in that picture is data relating to direct investment by corporations  incorporated outside of Puerto Rico, which is financed from within their  own affiliated groups, rather than through financial institutions. We can,  however, report on changes over the years between 1995 and 2004 in the  amount of funds that nonresidents hold in the Puerto Rican banking system  and the amount of funds that the banking system invests within and outside  of the Commonwealth. In order to identify where the assets held in the  Puerto Rican banking system are invested and where the owners of the  banks’ liabilities reside, we analyzed institution-specific data that the Office  of the Commissioner of Financial Institutions (OCFI) collects for oversight  purposes. Banks and certain other financial institutions in Puerto Rico are  required to report detailed information regarding their assets, liabilities,  and capital to the OCFI through a computerized “CALL report” data system.  Appendix I describes our analysis of the financial data.
We also used data provided by Puerto Rico’s Government Development  Bank to show trends in Puerto Rican government borrowing in the U.S. and  local capital markets. The consensus of the government and private sector  financial experts whom we interviewed was that all Puerto Rican  government bonds that qualify for tax exemption under Section 103 of the  IRC, such as bonds that are issued for the purpose of capital improvement  projects, are sold in the U.S. market. All other Puerto Rican government  bonds that are taxable in the United States but tax exempt in Puerto Rico  are sold in the local market. The Government Development Bank was able  to provide us with a complete and detailed accounting of each of their debt  issues and to identify which ones did or did not qualify for the U.S. tax  exemption.
section_title: Changes in Possessions Corporation Activity
paragraphs: In order to examine changes in the activities of possessions corporations  operating in Puerto Rico since the early 1990s, we constructed several  databases from an assortment of tax return data we obtained from IRS and  Puerto Rico’s Department of Treasury. Our principal source of data was  IRS’s Statistics of Income unit (SOI), which compiles comprehensive data  on possessions corporations every other year. We obtained the complete  set of these biennial databases from 1993 through 2003 and used  information from SOI to identify those possessions corporations that  operated in Puerto Rico. For the first stage of our analysis, we linked the  biennial records for each individual corporation by its employer  identification number (EIN) so that we could identify any data gaps for  specific corporations in particular years and so we could complete a  second, more complicated data analysis (described below). We filled in  missing data for individual corporations to the extent possible from other  IRS files and through imputations based on surrounding-year data. The  extent of the imputations were minimal relative to the population totals we  report. We used the final database on 656 possessions corporations that  operated in at least 1 year between 1993 and 2003 to report on changes over  time in the aggregate income, tax credit, and total assets of this population  of corporations and to show how these particular variables were  distributed across different industries. We also used data from the past four  Economic Censuses of Puerto Rico (1987, 1992, 1997, and 2002) compiled  by Census to show how the importance of possessions corporations in  Puerto Rico’s manufacturing sector has changed over time.
For the second stage of our analysis, we focused on a subpopulation of the  largest groups of affiliated possessions corporations operating in Puerto  Rico. For each of these groups we compiled data on other affiliated  corporations (i.e., those sharing the same ultimate parent corporations)  that also operated in Puerto Rico, but were not possessions corporations.  The objective of this analysis was to assess the extent to which the large  corporate groups that accounted for most of the activity of possessions  corporations remained active in Puerto Rico, even as the operations of  their possessions corporations were being phased out. We started by  identifying the 77 largest groups of possessions corporations in terms of  the amount of credit they earned, their total income, and their total assets.  These large groups gave us a subpopulation that accounted for over 90  percent of the tax credit and income earned and over 90 percent of the  assets owned by possessions corporations between 1993 and 2003, and at  the same time reduced the number of corporations we had to work with  from 656 to 172. This reduction in the number of corporations we had to  work with was important because data limitations caused some of the  steps in our database development to be very labor intensive.
We used two key data sources to identify and obtain data for the members  of the large groups that operated in Puerto Rico but which were not  possessions corporations. The first source was the database in which IRS  maintained the records of all forms 5471 that had been filed between 1996  and 2002. (The owners of controlled foreign corporations  must file a  separate form 5471 every year for each CFC that they own.) The second  source was a database that the Puerto Rican Department of Treasury (with  the assistance of the Government Development Bank) had recently  transcribed from all Puerto Rican tax returns for tax years 1998 through  2001 filed by all corporations or partnerships that received tax incentives  from the Government of Puerto Rico. Officials from the Department of  Treasury and from the Puerto Rico Industrial Development Company  (PRIDCO) told us that almost all U.S.- or foreign-owned manufacturing  corporations operating in Puerto Rico receive tax incentives, as do  corporations in designated service industries that export products or  services from Puerto Rico. A total of 1,758 different taxpayers appeared in  the database for at least 1 of the tax years. We used a series of both  automated and manual search and matching approaches to link the CFCs  and other types of companies from these two databases to our 77 large  corporate groups. We also used information from both databases to  determine which of the CFCs had operations in Puerto Rico and, in the  case of CFCs with operations in multiple countries, to make a range of  estimates for the amount of income they earned in Puerto Rico. The data  on income, assets, taxes paid, and place of incorporation that we extracted  from the two databases for these linked corporations allow us to provide a  more complete picture of the trends in activities of the corporate groups  that have taken advantage of the possessions tax credit over the years.
Through interviews with officials from the agencies providing the data and  our own computer checks for internal consistency in the data, we  determined that the quality of the data was sufficient for the purposes of  our report when viewed with the cautions we raise at various points in the  text. One problem that afflicted all of the databases to some degree was  missing values arising from the fact that IRS and the Puerto Rican  Department of Treasury could not always obtain every tax return that  should have been in their databases in a particular year and the fact that  taxpayers did not always accurately fill in every line of the return that they  should have. Our access to multiple databases that overlapped to some  extent enabled us to address this problem by filling in gaps with data from  an alternative file, making reasonable imputations, or at a minimum  assessing whether missing values would have made a significant difference  to our results.
section_title: Distribution of Business Activity
paragraphs: In order to show how economic activity in Puerto Rico is distributed across  different forms of businesses, we negotiated a special arrangement with  IRS and Census that enabled us to disaggregate the data from Census’s  recently completed 2002 Economic Census of Puerto Rico by categories of  business entities that are more specifically relevant to tax policymakers  than the categories Census uses for its own publications. The 2002  Economic Census collected data on employment, payroll, and other  economic measures from all nonfarm, private sector employers in Puerto  Rico, making it a comprehensive enumeration of Puerto Rican businesses.  We used taxpayer data from IRS and Puerto Rico to determine, in as many  cases as possible, the type of federal or Puerto Rican income tax return  each of these employers filed and, in the case of corporations, where they  were incorporated. We then used this information to place each employer  into a business entity group, such as possessions corporation, CFC  incorporated in Puerto Rico, CFC incorporated elsewhere, sole proprietor,  and so forth. Census then provided us with tabulations of their data for  each of these groups, disaggregated by industry to the extent that their  disclosure rules would permit. We developed a coding system and a data- exchange procedure that enabled us to link tax and Census data for  specific employers in such a way that Census did not have to view  restricted IRS data and we did not have to view confidential Census data  for specific survey respondents. (See app. III for details.)
The data that we used to determine the tax filing status and place of  incorporation for the employers in the Census database came from the IRS  and Puerto Rico databases described above, plus a couple of additional  sources. Another important new source of data was IRS’s National  Accounts Profile (NAP) database, which contains selected information for  all individuals and businesses that have an EIN. Each employer in Puerto  Rico has a federal EIN because it must collect Federal Insurance  Contributions Act (FICA) taxes on behalf of its employees. Consequently,  we were able to access NAP data for a very high percentage of the  employers included in the Census. For those employers we were able to  determine what, if any, federal income tax form they were required to file,  whether they were included in their parent corporation’s consolidated  return, and whether or not IRS had identified them as being sole  proprietors.
The other data sources that we used for this particular analysis included  sets of income tax returns for some of the businesses operating in Puerto  Rico that IRS had provided to Census, and a list of CFCs operating in  Puerto Rico that PRIDCO had compiled. None of the non-Census data  sources that we used was comprehensive and some of the sources more  closely met our needs than others. Appendix III describes how we used  these data to place each employer into a business entity group. For those  cases where we could not reliably place an employer into a group based on  tax data or data from PRIDCO we asked Census to place them into certain  groups based on their survey responses.
section_title: Fiscal Comparison
paragraphs: To compare the overall tax burden borne by individuals and businesses in  Puerto Rico with the burden borne by individuals and businesses in the  states and in the other insular areas, we obtained and analyzed detailed  data on state and local government revenues from the U.S. Census of  Governments, data on Commonwealth government revenue from the  Puerto Rican Department of Treasury, data on municipal tax revenue in  Puerto Rico from Oficina del Comisionado de Asuntos Municipales, Centro  de Estadisticas Municipales, and revenue data for the other insular areas  reported in their 2002 Single Audit reports. We also obtained data on  federal taxes collected in Puerto Rico and the states from IRS’s 2002 Data  book. (No such data were available for the insular areas.) We compared  taxes paid on a per capita basis and as a percent of personal income. We  make our comparison for year 2002 because that is the year of the most  recent Census of Governments.
We also compared federal expenditures for the states, Puerto Rico, and the  insular areas using data we obtained from the Consolidated Federal Funds  Report for Fiscal Year 2002 and the Federal Aid to States for Fiscal Year  2002. In addition, we report specifically on transfers of excise tax and  customs duty revenues that the federal government makes to Puerto Rico  using data obtained from U.S. Customs and the Alcohol and Tobacco Tax  and Trade Bureau.
To assess the reliability of the data, for the Census and Puerto Rican  Treasury data we interviewed knowledgeable officials and reviewed  supporting documentation to understand the internal procedures in place  to ensure data quality. For the insular areas we compared data reported in  the Single Audit reports to other published data. We determined that the  data we obtained from the Puerto Rican Department of Treasury is  consistent with what was reported in the Commonwealth’s Comprehensive  Annual Financial Report. Although we found the data reliable for the  purpose of our engagement, we note certain limitations in the data. In  particular, all the state and local data compiled by Census are as-reported  by cognizant government officials responsible for financial matters in each  of the political entities and may not have been subjected to any internal or  external accuracy checks. Checks performed by Census on its data are for  completeness and consistency with internal and external sources. The  independent auditor’s statement in the Single Audit reports for the insular  areas indicated that the auditors generally could not verify the accuracy of  reported information. In addition, federal, state, and insular area fiscal  years differ, so the data do not cover exactly the same period of time.
section_title: Federal Social Programs
paragraphs: Interviews with federal agencies and prior GAO work provided the basis  for our description of the application of the principal U.S. federal social  programs to Puerto Rico residents, relative to the states, and the other  insular areas. To select the social programs included in this report we  consulted with GAO experts in the areas of health care policy; education,  workforce, and income security policy; and financial markets and  community investment policy. With the help of these experts, we arrived at  a list of the principal federal social programs, which we then pared down,  based on program availability in Puerto Rico and expenditure level in  Puerto Rico. We relied on prior GAO work and interviews with federal  agency officials to determine how each program is applied in Puerto Rico,  relative to the other areas. We used program-level data, supplied by federal  agencies, to report program expenditures for fiscal year 2002. We selected  fiscal year 2002 because in chapter 6 of this report, we provide a more  complete analysis of the revenue and expenditures of Puerto Rico, the  states, and the other insular areas using the year of the most recent Census  of Governments, 2002.
Our methodologies for each objective were discussed with experts  including those from the Office of the Comptroller General of Puerto Rico,  Puerto Rico’s Government Development Bank, Puerto Rico’s Planning  Board, Puerto Rico’s Office of the Commissioner of Insurance Institutions  and Puerto Rico’s Office of the Commissioner of Financial Institutions.  Federal-level experts include those from Census and IRS. Our work was  performed from February 2004 to April 2006 in accordance with generally  accepted government accounting standards.
section_title: U.S. Federal Tax Treatment of Puerto Rico and Other Insular Areas Varies by Area and Type of Tax
paragraphs: Individuals who are residents of Puerto Rico or other U.S. insular areas and  who earn income only from sources outside of the states generally pay no  federal income tax; however, their wages are all subject to Social Security  and Medicare taxes, and wages paid to residents of Puerto Rico and the  U.S. Virgin Islands also are subject to federal unemployment tax.  Corporations organized in Puerto Rico, like those organized in the other  U.S. insular areas, are generally treated for U.S. tax purposes as if they  were organized under the laws of a foreign country. Until this year, special  rules enabled corporations organized in the United States that met certain  conditions to reduce the federal tax payable on income earned in and  repatriated from Puerto Rico and other insular areas.
subsections: section_title: U.S. Tax Treatment of Insular Area Residents with U.S.-source Income and U.S. Residents with Insular Area-source Income Varies by Area
paragraphs: Individuals residing in an insular area and who earn income only from  sources there file one income tax return there and are required to pay  income tax only to that area. The U.S. income tax treatment of U.S.-source  income of residents of an insular area (which does not include income  earned in the insular areas, other than that earned by U.S. government  employees) depends on the area:   Residents of American Samoa and Puerto Rico must pay U.S. income  tax on all their income from sources outside American Samoa or Puerto  Rico, respectively, if such income exceeds the federal filing threshold.  The U.S. government retains the tax collected from residents of Puerto  Rico, but is required to transfer the tax collected from residents of  American Samoa to its government.
Residents of Guam and CNMI owe income tax to the territory and  Commonwealth, respectively, on their U.S.-source income; the  governments of these Commonwealths and territories are required to  transfer a portion of this tax revenue to the U.S. government if the  resident’s income exceeds certain income thresholds.
Generally, the U.S. government does not tax, or receive any tax revenue  from U.S. Virgin Island residents who have U.S.-source income so long  as such residents report all of their income, identify the source of their  income, and pay their income taxes to the U.S. Virgin Islands.
The U.S. income tax treatment of U.S. residents with Commonwealth- or  insular area–source income also depends on the insular area:  U.S. residents with income from Puerto Rico or American Samoa are  subject to U.S. federal tax on that income. They also pay tax on that  income to Puerto Rico or American Samoa, respectively, and receive a  foreign tax credit against their U.S. tax liability for this amount.
U.S. residents with income from Guam or CNMI owe U.S. income tax on  that income; the federal government is required to transfer a portion of  the tax revenue received from Guam and CNMI residents back to the  respective territory and Commonwealth.
U.S. residents who earn income in the U.S. Virgin Islands must file  identical tax returns with both the government there and the U.S.  government; each government’s share of the revenues is based on where  the income was earned.
section_title: While FICA Taxes Are Imposed on Wages Paid to Employees in All Insular Areas, Unemployment Insurance Tax Applies Only to Wages Paid in Puerto Rico and U.S. Virgin Islands
paragraphs: The Federal Insurance Contributions Act imposes wage-based taxes on  employers and employees in the United States and the Commonwealths  and territories to support Social Security and Medicare. The employment  upon which taxes are collected includes services performed in the United  States and the insular areas. Taxes collected under the act are not  transferred to the treasuries of the insular areas.
The Federal Unemployment Tax Act imposes a tax on wages paid to  employees, based on wages paid. Puerto Rico and the U.S. Virgin Islands  are the only insular areas covered by the Act. The proceeds of the tax are  used to support the federal-state unemployment compensation program  and are not transferred to the treasuries of either area.
section_title: Taxation of Corporations Incorporated in the United States
paragraphs: The federal government taxes a U.S. corporation on its worldwide income  (reduced by any applicable foreign income tax credit), regardless of where  the income is earned. When the tax is due depends on several factors,  including whether the income is U.S.- or foreign-source and, if it is foreign  income, on the structure of the corporation’s business operations.
However, since 1976, and through taxable years beginning prior to  December 31, 2006, U.S. corporations with a domestic subsidiary  conducting a trade or business in insular areas could qualify to receive  significant tax benefits through the possessions tax credit. Prior to taxable  years beginning in 1994, the credit effectively exempted from U.S. taxation  all possession-source income of a qualified possessions corporation.  Dividends repatriated from a wholly-owned possessions corporation to the  mainland parent qualified for a 100 percent deduction, thus allowing tax- free repatriation of possession income. The credit also exempted qualified  possession-source investment income (QPSII), which is certain income the  possessions corporation earned from financial investments in U.S.  possessions or certain foreign countries. The credit for qualified research  expense was also allowed for such research conducted by a possessions  corporation.
Starting in taxable years beginning in 1994, the amounts of possessions tax  credits that a possessions corporation could claim were capped. Under the  cap, a possessions corporation had to choose between two alternatives—a  “percentage limitation” option or an “economic activity limitation” option.  In 1996, the possessions tax credit was fully repealed for taxable years  beginning after 2005. Existing possessions corporations could continue to  claim the possessions tax credit for tax years beginning prior to 2006.  These existing credit claimants, however, were subject to an income cap  based on the average business income that the corporation earned in a  possession during a specified “base period.” A possessions corporation  electing the percentage limitation was subject to the income cap beginning  in 1998 and a possessions corporation electing the economic limitation was  subject to the income cap beginning in 2002. Only QPSII earned before   July 1, 1996, qualified for the credit for tax years beginning after   December 31, 1995.
section_title: Taxation of Corporations Incorporated outside the United States
paragraphs: Corporations organized outside the United States, including corporations  organized in Puerto Rico and the other insular areas, are generally treated  as foreign corporations for U.S. tax purposes. These corporations are taxed  on their U.S. source earnings—the tax paid generally depends on whether  the income is “effectively connected” with the conduct of a trade or  business within the United States, but income from insular areas is not  subject to U.S. tax.
Foreign corporations pay U.S. tax at two rates—a flat 30 percent rate is  withheld on certain forms of nonbusiness gross income from U.S. sources,  and a tax is imposed at progressive rates on net income from a U.S. trade or  business. Corporations in Puerto Rico must pay the 30 percent  withholding tax; corporations in the other insular areas do not pay the  withholding tax if they meet certain tests that establish close connections  with the insular area in which the corporation was created. U.S.-source  dividends paid to corporations organized in Puerto Rico are subject to a 10  percent withholding tax provided that the same tests mentioned above are  satisfied and the withholding tax on dividends paid to the U.S. corporations  is not greater than 10 percent.
Corporations organized under the laws of an insular area may be treated as  a controlled foreign corporation (CFC) for U.S. income tax purposes. To  qualify as a CFC, the corporation must be more than 50 percent U.S.- owned, taking into account only U.S. shareholders that meet a 10 percent  stock ownership test. Gross income from the active conduct of business in  Puerto Rico or elsewhere outside of the United States is not taxed until it is  repatriated to the U.S. shareholders in the form of dividends. Subject to  certain limitations, these shareholders are entitled to a credit for any  foreign income taxes paid by the CFC with respect to the earnings  distributed.
Certain types of passive income, such as dividends and interest, earned by  CFCs are currently includable in the income of the U.S. shareholders,  under subpart F of the U.S. Tax Code, even though those amounts are not  actually distributed to them. These shareholders are, subject to certain  limitations, also entitled to a credit for foreign income taxes paid with  respect to the amounts includible in income under subpart F.
Certain kinds of income received by a CFC organized under the laws of an  insular area are not considered subpart F income:   income received from the sale in the insular area of personal property  manufactured by the CFC in that area,  dividend or interest income received from a related corporation also  organized under the laws of that insular area, and  rents or royalties from a related corporation received by a CFC  organized under the laws of an insular area for the use of property in the  insular area where the CFC is organized.
The allocation of gross income, deductions, and credits between related  taxpayers, such as intercompany sales from a CFC to a U.S. domestic  parent, is subject to transfer pricing rules that are designed to prevent  manipulation of the overall tax liability.
section_title: Deduction for Income from Domestic Production Activities
paragraphs: In 2004, in response to a long-running dispute with the European Union,  Congress repealed the extraterritorial income (ETI) exclusion and enacted  a deduction relating to income attributable to domestic production activities. For purposes of the ETI exclusion, the United States included  Puerto Rico. Puerto Rico is not included, however, in the definition of U.S.  for purposes of the deduction for domestic production.
section_title: Goods Imported to Insular Areas Are Generally Exempt from U.S. Excise Taxes, but a Special Tax Is Imposed on Goods Made in Puerto Rico and U.S. Virgin Islands
paragraphs: Merchandise imported into an insular area from the United States is  exempt from U.S. excise taxes. The only U.S. excise taxes that apply to  products imported into any of the insular areas from another country are  those where specific language extends the tax beyond the “United States,”  which is generally defined, for tax purposes, as only the states. This  language exists for a tax on petroleum (an environmental tax), a tax on  certain vaccines, a tax on certain chemicals, and a tax on certain imported  substances.
If any revenue from these excise taxes is collected in American Samoa,  Puerto Rico, or the U.S. Virgin Islands, the U.S. government retains the  revenue. The governments of Guam or CNMI receive any revenue from  these taxes collected in their respective territory and Commonwealth.
There is a special “equalization” U.S. excise tax on articles manufactured in  Puerto Rico or the U.S. Virgin Islands and exported to the United States  equal to the tax that would have been imposed had the articles been  manufactured in the United States. Subject to the limitations described  below for distilled spirits, the U.S. Treasury returns all the revenue from the  tax on articles manufactured in Puerto Rico to the Treasury there except  the amounts needed to pay refunds and drawbacks to manufacturers and  the amount needed to cover its enforcement expenses. The return to the  U.S. Virgin Islands also excludes amounts needed to pay refunds and  drawbacks, plus one percent of the total tax collected. All U.S. excise taxes  collected on articles manufactured from Guam and CNMI and exported to  the United States must be transferred to their respective territory and  Commonwealth governments.
A special limitation applies for the U.S. excise tax on distilled spirits  manufactured in Puerto Rico and the U.S. Virgin Islands and exported to  the United States. The tax rate ordinarily applied to rum is $13.50 per proof  gallon exported, of which $10.50 per proof gallon is returned to the  appropriate insular area. Puerto Rico and the U.S. Virgin Islands also share  revenue from the U.S. excise tax collected on all rum imported into the  United States from a foreign country. Their respective shares are  proportionate to the relative sizes of their rum exports to the United States  during the prior fiscal year. Puerto Rico’s share, however, cannot exceed  87.626889 percent or be less than 51 percent while the U.S. Virgin Islands’  share cannot exceed 49 percent nor drop below 12.373111 percent.
section_title: U.S. Government Is Responsible for Collecting Customs Duties in Puerto Rico and Helps Collect Duties in U.S. Virgin Islands
paragraphs: The U.S. government collects duties on goods imported into “U.S. customs  territory,” which encompasses the states and Puerto Rico, unless they are  exempt. U.S. customs duties collected in Puerto Rico are deposited in a  special U.S. Treasury account. After deductions for refunds and the  expenses of administering customs activities in Puerto Rico, the remaining  amounts are transferred to the treasury there.
Although the U.S. Virgin Islands are not in “U.S. customs territory,” the U.S.  government helps collect local duties there. These collections are  transferred to the government of the U.S. Virgin Islands after items such as  operational expenses are deducted. The U.S. government has authority to  administer and enforce collection of custom duties in American Samoa,  upon request of the Governor. Guam and CNMI administer and enforce  their own customs policies and procedures. Items imported into “U.S.  customs territory” from American Samoa, Guam, CNMI, and the U.S. Virgin  Islands are subject to U.S. customs duties unless the items are exempt.
section_title: Trends in Production, Income, and Other Economic Indicators for Puerto Rico
paragraphs: The economic well-being of Puerto Rican residents, measured in terms of  either per capita or median income, remains well below that of residents of  the states. The relative progress that the Puerto Rican economy has made  since 1980 is difficult to measure with precision for a number of reasons,  including tax-induced distortions in how U.S. corporations have reported  income earned in the Commonwealth. The low rate of labor participation is  a crucial issue in Puerto Rico’s economic performance, and the rate of  investment appears insufficient to significantly reduce the disparity  between mainland and Puerto Rican incomes.
subsections: section_title: Measuring Economic Progress in Puerto Rico Is Challenging but the Income of Commonwealth Residents Remains Well Below That of U.S. Residents
paragraphs: As shown in figure 9, Puerto Rico’s per capita GDP of about $21,000 in 2005  remained well below U.S. per capita GDP of about $41,000. GDP is a broad  measure of overall income or economic activity occurring within a nation’s  borders in a given year. According to the Puerto Rican and U.S. national  income and product accounts, this measure has grown more rapidly in  Puerto Rico than in the United States since 1980, when viewed on a per  capita basis after adjustments for inflation. However, for a number of  reasons, the growth rate of real (meaning inflation-adjusted) GDP likely  does not represent a very accurate measure of changes in the economic  well-being of Puerto Rican residents.
First, as a result of U.S. tax provisions and a development strategy pursued  by successive Puerto Rican governments to use local tax incentives to  attract investment by U.S. and foreign firms, a significant amount of the  investment income included in GDP is paid out to U.S. and foreign  investors. In figure 9, the income earned by nonresidents is approximately  represented by the gap between Puerto Rican GDP and Puerto Rican GNP.  GNP is a measure of the total amount of income earned by residents in a  given year from sources within and from outside of the country. In contrast  to Puerto Rico, GDP has been consistently about the same as GNP in the  United States, which indicates that the amount of income earned abroad by  U.S. residents is close to the amount of income earned by foreign owners of  assets located in the United States. As of 2005, Puerto Rico’s per capita  GNP of about $14,000 remained well below the U.S. level of about $41,000.
Second, using the possessions tax credit, U.S.-based groups of affiliated  corporations (i.e., those owned by a common U.S. parent corporation) with  certain types of operations in Puerto Rico have had incentives to attribute  as much net income to those operations as is legally permissible, rather than to related operations in the United States. Moreover, the nature of  these incentives has changed during the period covered by our review.  Consequently, the income reported by these corporations to have been  earned in Puerto Rico in a given year may overstate the actual economic  importance of their Puerto Rican production, and changes in income over  the years may reflect not only changes in the economic activity of these  corporations, but also changes in how corporations have computed their  Puerto Rican source income. Some of the data reported later in this chapter  suggest that this so-called “income shifting” has taken place. This particular  issue affects data on GDP and income and possibly value added for  corporations owned by U.S. parent corporations; it should not affect GNP  or income and value added for Puerto Rican-owned corporations.
Third, as is the case for any country, the scale of the informal, or  underground, economy in Puerto Rico is difficult to measure. If the  informal economy in Puerto Rico is large relative to the informal economy  in the United States, as some analysts believe, a relatively large amount of  economic activity in Puerto Rico may not be reflected in national income  and labor market statistics. As discussed below, the presence of a large  informal economy may be one explanation of low reported labor force  participation rates in Puerto Rico. Analysts who have recently looked at  this issue disagree on the size of the informal economy and on whether it  has been growing as a share of the total economy. The size and any growth  in the informal economy in Puerto Rico, relative to that in the United  States, would affect comparisons between levels and growth in per capita  income earned in the two jurisdictions.
Lastly, as acknowledged by the Puerto Rico Planning Board, there are  problems with some Puerto Rican price indices, which cause an unknown  degree of inaccuracy in the inflation adjustments to the long-term trend  data on the Puerto Rican economy and, therefore, some imprecision in the  real growth rates of key economic indicators that are stated in terms of  dollar values. Most concerns center on the Puerto Rican consumer price  index (CPI, a measure of prices on consumer goods) and the fact that the  market basket of goods used to compute the index has not been updated  since the 1970s. This means that the index will tend to overstate price  changes. In the analysis in this chapter, we have used the Puerto Rican  gross product deflator—a broad measure of how prices have changed on  average for goods and services in the economy—for our inflation  adjustments. Although analysts within and outside of Puerto Rico’s  Planning Board, which produces the deflator, consider it to be less  problematic than the CPI, they still have concerns relating to fact that the  CPI is one of the components used in estimating the deflator and the fact  that methodologies for other components are also outdated.
Given the concerns with the Puerto Rican deflator, there is a question as to  whether that measure or the U.S. gross product deflator more accurately  accounts for the changes in prices in Puerto Rico. The U.S. deflator shows  slower price increases over this period than does the Puerto Rican deflator.  For this reason, we also report some results based on the use of the U.S.  deflator in cases where they differ notably from those based on the Puerto  Rican deflator.
When comparing the trends in real per capita GNP in Puerto Rico and the  United States from 1980 to 2005, the choice of deflators does make a  difference. Over that period, inflation-adjusted per capita income increased  at an average annual rate of 1.9 percent in the United States, while it rose at  1.5 percent in Puerto Rico if the Puerto Rican deflator is used. However, if  the U.S. deflator is applied to Puerto Rican GNP, annual real per capita  GNP rose by 2.5 percent annually, faster than the growth in the United  States. Real per capita GDP rose more rapidly in Puerto Rico than in the  United States, regardless of which deflators are used. U.S. GDP rose at an  annual average rate of 1.9 percent from 1980 to 2005, while the average  annual growth rate for Puerto Rico was 2.1 percent using the Puerto Rican  deflator and 3.2 percent using the U.S. deflator.
Figure 10 shows the composition of Puerto Rican GDP over time and the  trend in net income payments abroad. GDP consists of expenditures on  personal consumption, investment, government consumption of goods and  services, and net exports (the value of exports minus the value of imports).  The figure shows that net exports have risen substantially from 1980 to  2005 as a share of GDP, and consumption, which is largely determined by  Puerto Rican income, has fallen as a share of GDP.
Figure 10 also shows net income payments abroad, expressed as a share of  GDP. This series represents the amount of income paid to foreign owners  of capital located in Puerto Rico, minus income earned by Puerto Ricans  from investments outside of Puerto Rico. GNP differs from GDP by this  amount. For Puerto Rico, the net outflow of income has increased as a  share of GDP over the period, increasing the gap between GDP and GNP.
section_title: Puerto Rico Relies Heavily on Nonresidents to Finance Local Investment
paragraphs: Figure 11 shows the relationship between savings and investment in Puerto  Rico. The components of total national saving in Puerto Rico are personal  saving, government saving, business saving through retained earnings, and  depreciation. The figure shows that investment in Puerto Rico has been  greater than national saving, highlighting again that investment in Puerto  Rico has been significantly financed by foreign sources. Since 2001,  government saving has fallen and undistributed corporate profits have  risen significantly. The personal saving rate as measured in the Puerto  Rican national accounts has been negative since 1980. If transfers from foreigners to residents of Puerto Rico are underreported, however, the  official data for income and saving would also be understated.
We cannot provide a comprehensive picture of the trends in various  components of U.S. and foreign investment in Puerto Rico because data are  not available for one of the most important components—direct foreign  investment, for which corporations obtain financing from within their own affiliated groups, rather than through financial institutions. We can,  however, report trends for foreign funds flowing through key types of  financial institutions and the Puerto Rican government. In the next two  chapters, we will also provide some information on investments by  important subpopulations of corporations.
Over the past decade, the amount of nonresident funds flowing into  depository institutions in Puerto Rico has increased steadily. Figure 12  shows Puerto Rico’s depository institutions’ liabilities between 1995 and  2004, and figures 52 and 53 in appendix II show the shift in deposits and  debt, respectively. The composition of deposits has changed significantly  with “exempt investments” by possessions corporations (which in the past  had been encouraged by a special component of the possessions tax credit)  being replaced by deposits obtained through brokers that sell certificates  of deposits for the banks in the U.S. capital market. (Fig. 54 in app. II shows  those offsetting trends.)
Figure 13 below shows that the share of assets held by depository  institutions in the United States and foreign countries has also increased  over the past decade. A large part of this growth can be attributed to the  increase in U.S. and foreign securities investments. Loans made by Puerto  Rico’s depository institutions, which we assume to be primarily local, have  also increased steadily. Figures 55 and 56 in appendix II show these two  trends.
Puerto Rican government debt has increased steadily over the past decade.  Between 1995 and 2005, Puerto Rico’s real total public debt outstanding  increased from $25.6 billion to $36.4 billion (see fig. 14 below). Most of  Puerto Rican public debt is sold in the U.S. market, but the amount sold  within Puerto Rico has increased steadily since 1999. In 2005 an estimated  $31.6 billion was sold in the United States, and $4.8 billion was sold locally  in Puerto Rico.
In appendix II we include both the breakdown of debt payable by the  government and debt issued by the government but repaid by others (such  as the federal government or the private sector) because there are  differences of opinion about what should be termed “government debt”  (see figs. 58 and 59). An example of this type of debt is the series of bond  issues linked to The Children’s Trust Fund between 2001 and 2005, all of  which are backed by assets from the United States Attorney General’s 1999  Master Tobacco Settlement Agreement. Between 1995 and 2005, total debt  issued by the Puerto Rican government, but payable by others, increased  from an estimated $6.6 billion to an estimated $7.1 billion in 2005.
subsections: section_title: Investment Appears Insufficient to Reduce the U.S.-Puerto Rican Income Gap
paragraphs: Figure 15 shows the level and composition of gross investment spending in  Puerto Rico from 1980 to 2005. During the recession of the early 1980s,  investment fell below 10 percent of GDP by 1983. Thereafter, investment  recovered and remained around 15 percent of GDP for a number of years  until a period of rapid growth in largely private-sector investment in the  late 1990s pushed the share close to 20 percent of GDP by 2000. Investment  rates have fallen back to about 15 percent of GDP most recently.
If Puerto Rico’s investment rate remains at recent levels, the gap between  U.S. and Puerto Rican per capita incomes is unlikely to diminish. The U.S.  investment rate, including both private investment and a measure of  government investment, has been about 19 percent of GDP in recent years.  Continuation of these relative investment rates implies that the per capita  income gap is unlikely to narrow significantly, unless capital formation is  augmented by increases in employment, education, training, or other types  of productivity improvements.
Figure 16 shows a breakdown of Census data on capital spending in the  manufacturing sector for 1987, 1992, 1997, and 2002. The data show that  investment in manufacturing dipped significantly between 1992 and 1997,  before rebounding by 2002. This slump in investment does not appear in  the Planning Board investment data for private sector investment shown in  figure 15. The Planning Board data cover more sectors than do the Census  data; however, investment in manufacturing should represent a substantial  portion of the investment in private structures and machinery.
section_title: Data on Value Added and Income Show That the Pharmaceuticals Industry Has Significantly Increased Its Dominance of Puerto Rican Manufacturing but Evidence Suggests That These Measures May Be Overstated
paragraphs: Although both Census data on value added and Puerto Rican government  data on domestic income show that the pharmaceutical industry has  significantly increased its already dominant position in the manufacturing  sector since the early 1990s, evidence suggests that income shifting within  U.S.-owned corporate groups likely has resulted in overstatements of the  importance of the manufacturing sector, as a whole, and the  pharmaceutical industry, in particular, when measured in terms of value  added or income. Unfortunately, it is difficult to know the extent of any  overstatement in these economic variables. Evidence is mixed as to  whether the extent of the overstatement increased as the pharmaceutical  operations of possessions corporations were shifted over to other types of  businesses. Other measures of economic activity, such as employment and  capital spending, should not be affected by income shifting and, therefore,  can be used to either support or challenge conclusions based on measures  of value added and income.
Census data on value added and Puerto Rican Planning Board data on  domestic income both show steady and significant growth in the  pharmaceutical industry. Figure 17 shows that value added in the  pharmaceutical industry more than doubled in real terms from 1992 to  2002, while value added in all other manufacturing industries, as a whole,  declined. Figure 18 shows that the chemical industry, which consists  mainly of pharmaceuticals, saw its share of net manufacturing domestic  income increase from around 50 percent in 1992 to over 60 percent in 2005.
The strong reported performance of the pharmaceutical sector is the  reason that the manufacturing sector has been able to slightly increase its  share of domestic income, while the share of income of most other  manufacturing industries has declined. Manufacturing’s share of income,  shown in figure 19, greatly exceeds its share of employment, as shown in  figures 23 and 24. Some of the difference may be attributable to a higher  level of labor productivity in manufacturing than in other sectors. Recent  research suggests, however, that reported levels of value added in Puerto  Rican manufacturing are implausible. For example, the official data imply  that labor’s share of value added in manufacturing fell from an average of 50 percent from 1950 to 1970 to only 14 percent in 2004. Similar declines  are not evident in data for other sectors or in U.S. manufacturing statistics.
Over the years, several analysts have concluded that the incentives  provided by the possessions tax credit have led U.S. corporate groups to shift income to Puerto Rican affiliates. Until the mid-1990s, the credit  essentially allowed profits earned from qualified Puerto Rican operations  to be returned to the mainland free of federal tax (even when largely  exempted from Puerto Rican income taxes). In addition, one option under  the credit allowed the U.S. corporate parent to apply a 50-50 split of their  combined taxable income from the sale of products to third parties if the  products were derived from an intangible asset, such as a patent, invention,  formula, or trademark. Although a substantial portion of this income can be  attributed to manufacturing intangibles developed and owned by the U.S.  corporate parent, there is no requirement that the allocation of income  from such manufacturing intangible assets reflect where costs were  actually generated, or where value was actually added to the products.  Consequently, corporate groups that produced pharmaceuticals, or other  products whose final values are largely based on the value of intellectual  property, were given flexibility under the law to shift net income to the  possession corporations operating in Puerto Rico or another insular area.  This shifting of income and value added to the Puerto Rican operations of  possessions corporations ultimately gets reflected in economic data  compiled by the Puerto Rican government, which is based heavily on data  pulled from samples of corporate tax returns, and possibly in data that  Census collects in its surveys of employers for the economic censuses, if  the economic data the employers provide are based on their tax accounts.
The nature of income shifting changed significantly after 1995, when the  phaseout of the possessions tax credit began. Some of the corporate  groups that owned possessions corporations in Puerto Rico began to close  or reduce operations in those corporations and shift production to CFCs  located on the island. Corporate groups still have some incentives to retain  operations in Puerto Rico rather than shift that production to the United  States. First, Puerto Rico responded to the phaseout of the credit by  increasing the generosity of its own tax incentives. Second, manufacturing  income earned from an active trade or business by the CFCs is not subject  to federal tax unless it is repatriated to the United States. A change in  income shifting has also occurred because the rule for arbitrarily splitting  net income 50-50 between Puerto Rican and U.S. operations does not apply  to CFCs. Nevertheless, corporate groups may be able to shift income to  Puerto Rico through the manner in which they set prices on goods and  services transferred among affiliated corporations.
Data from the last four economic censuses of manufacturing in Puerto  Rico, presented in figure 20, show that valued added per employee in the  pharmaceutical industry was already at least twice as high as the ratio for  all other industries in 1987 and 1992. The difference between the  pharmaceutical industry and the other industries grew larger in 1997 and  then broadened dramatically by 2002. The 2002 figure of $1.5 million for  value added per employee in Puerto Rican pharmaceutical manufacturing  was three times as high as the ratio for the U.S. pharmaceutical industry for  the same year. Moreover, while the U.S. ratio grew only 8 percent in real  terms between 1997 and 2002, the Puerto Rican ratio grew by 65 percent  over that same period.
The data on value added per employee by type of business in figure 21  suggest that the sharp increase in that measure between 1997 and 2002 may  have been a direct result of the shift in pharmaceutical operations from  possessions corporations to CFCs. (These data are derived from a special  research effort in which we obtained assistance from Census and IRS to  aggregate data from the 2002 Economic Census of Puerto Rico by  particular types of business entities, including possessions corporations  and CFCs.) The value added per employee of $4.2 million for  pharmaceuticals CFCs incorporated outside of Puerto Rico was  dramatically higher than for any other type of business in Puerto Rico. The  next highest ratio was $1.6 million for pharmaceuticals CFCs incorporated  in Puerto Rico, which was still considerably higher than the ratio of   $0.9 million for possessions corporations in the pharmaceutical industry.  That data, combined with the data in figure 20, suggest a significant change  in transfer pricing by large pharmaceuticals groups, which makes it  difficult to say how much of the strong reported growth in output and  income in the Puerto Rican pharmaceutical industry, and in the  manufacturing sector as a whole, represents an increase in actual  economic activity.
Data on rates of return on assets for possessions corporations and CFCs in  the chemical industry do not confirm the conclusion that a dramatic  change in income-shifting practices occurred as CFCs replaced  possessions corporations in the industry. We used data from federal tax  returns to compare various rates of return for CFCs and possessions  corporations in the Puerto Rican chemical industry. The comparisons we  were able to make for 1997 through 2001 did not show a consistent  difference between the two types of corporations. The ratios of gross  profits (the closest tax-data equivalent to value added) to total assets for  CFCs were significantly higher than those for possessions corporations in  both 1997 and 1999, but the ratios were very close together in 2001. We also  compared the gross and net operating rates of return of the two types of  corporations and found that neither type dominated the other one  consistently across the years. The results of our analysis are presented in  appendix IV.
section_title: International Trade Plays a Large Role in Puerto Rico’s Economy
paragraphs: International trade plays a much larger role in the Puerto Rican economy  than it does in the U.S. economy. While the output of an economy (GDP)  depends on the difference between exports and imports (net exports), the  size of exports and imports relative to GDP are indicators of the  importance of trade to the economy. For the United States, exports of  goods and services averaged about 10 percent of GDP between 1980 and  2005. Imports increased from about 10 percent of GDP in the early 1980s to  about 16 percent of GDP in 2005. While potential distortions in trade data  should be kept in mind, the share of exports and imports has been  substantially greater in Puerto Rico. For Puerto Rico, the value of exported  goods and services as a percentage of GDP grew from about 70 percent of  GDP in the 1980s to about 80 percent in 2005. Imports fell as a share of GDP  from about 70 percent to about 63 percent in recent years.
As reported in the Puerto Rican national accounts, the value of  pharmaceutical imports and exports increased substantially from 1996 to  2005. The value of imported pharmaceuticals increased from about 9  percent of all merchandise imports to about 33 percent during that period.  As a share of GDP, the value of imported pharmaceuticals increased from  about 4 percent to about 15 percent. The value of pharmaceutical exports  rose rapidly as a share of merchandise exports—from about 27 percent to  about 61 percent. As a percentage of GDP, the value of pharmaceutical  exports rose from about 14 percent to about 42 percent. However, as noted  above, a significant portion of the recorded increase in Puerto Rico’s trade  surplus may reflect changes in transfer pricing, with artificially low values  for Puerto Rico’s imports and high values for Puerto Rico’s exports, rather  than increased activity.
While the United States is the largest trading partner for Puerto Rico for  exports and is a large source of Puerto Rican imports, the foreign country  share of imports to Puerto Rico has been growing since 1995. In 2005,  slightly less than half of the value of imports to Puerto Rico came from  foreign countries. About 80 percent of Puerto Rico’s exports go to the  United States. Puerto Rico’s overall trade surplus reflects a trade surplus  with the United States as Puerto Rico exports more to the United States  than it imports from the United States, and a smaller trade deficit with the  foreign countries.
section_title: Official Statistics Indicate That Unemployment Has Been Much Higher in Puerto Rico Than in the United States and Labor Force Participation Has Been Lower
paragraphs: Figure 22 shows the unemployment rates and labor force participation  rates for the United States and Puerto Rico from 1980 to 2005. The  unemployment rate has been significantly higher in Puerto Rico than in the  United States, and the labor force participation rate has been much lower.
Academics and economists from research institutions have offered several  possible explanations for the relatively low labor force participation rate in  Puerto Rico and attempted to determine which of these factors might be  important. While the low labor force participation rate is seen as a crucial  issue for the economic performance of Puerto Rico, there is no consensus  on its cause.
Possible explanations for the low labor force participation rate include   the migration of Puerto Rican citizens with the most interest in  participating in the labor force to seek higher wage employment in the  United States, leaving residents that have relatively less attachment to  the labor force;   the fact that government programs that are in place, such as the  Nutrition Assistance Program (NAP, the Puerto Rican food stamp  program) and disability insurance, can discourage work, while the U.S.  program that encourages labor force participation—the Earned Income  Tax Credit—is not a part of the tax system in Puerto Rico;   the fact that the U.S. minimum wage applies in Puerto Rico may  discourage business demand for lower-skilled workers, who are likely to  make up a larger share of the potential work force in Puerto Rico than in  the United States; and  that a relatively large share of Puerto Ricans work in the informal  economy and that this work is not reflected in economic statistics.
Regarding this last issue, analysts have raised issues with the quality of the  Puerto Rican labor force survey, which is the data source for the  unemployment rate and the labor force participation rate. The survey is  designed to be similar to the U.S. Current Population Survey (CPS), from  which the U.S. data are derived, but the questions regarding labor market  activity in the surveys differed and the question asked by the Puerto Rico  household survey may not have captured work activity in the informal  sector of the economy as well as the question asked in the CPS. On the  other hand, labor force participation as measured in the decennial  census—which uses the same question as the CPS—has also been low and  the estimate for 2000 was lower than the household survey estimate for  that year. The Bureau of Labor Statistics (BLS) has been working with the  Puerto Rican government to improve the household survey in several  areas. In addition, labor force data for 2005 are scheduled to be reported  for Puerto Rico as a part of the Census Bureau’s American Community  Survey effort.
Educational attainment can play an important role in developing labor  market skills. Data on educational attainment in Puerto Rico is collected in  the decennial census and can be compared to data for the United States.  These data show that the gap in educational attainment between Puerto  Rico and the United States narrowed significantly during the 1990s.  Nonetheless, in 2000, 40 percent of the population over 25 in Puerto Rico  had not finished high school, which is nearly the double the U.S. share. At  the same time, about 38 percent of adults reported having at least some  college education (see table 4).
Recent research concluded that there is a substantial mismatch between  Puerto Rico’s industry structure and the educational achievement of its  population. While the mean years of schooling among Puerto Rican adults  was substantially below that of any state in the last three censuses, the  average years of schooling of people typically employed by the industries  operating in Puerto Rico exceeds that of at least two-thirds of the states.  The researchers suggest that the Puerto Rican economy has failed to  generate jobs that fit the educational qualifications of the Commonwealth’s  population. In some sense, therefore, Puerto Rico’s “missing jobs” can be  found in labor intensive industries heavily reliant on less-educated  workers. The authors conclude that the Possessions Tax Credit and other  federal tax incentives contributed to an industry structure that is poorly  aligned with the sort of job opportunities needed by Puerto Rico’s  population.
Annual data on employment in Puerto Rico come from two sources: the  Puerto Rico household survey, and the BLS establishment survey. The  Puerto Rico household survey has consistent sector definitions across time  and includes the self-employed. The establishment survey data are limited  to employees and reflect the new North American Industry Classification  System industry definitions. In the figures that follow, we aggregated some  of the industry categories and show the distribution of employment by  sector. Both surveys show employment in Puerto Rico generally increasing  since 1991 and show manufacturing employment declining since 1995. As  shown in figure 25, data from the Census of Manufacturing for Puerto Rico  for 1997 and 2002 also indicate a decline in manufacturing employment.  Manufacturing employment fell by about 27 percent from 1995 to 2005,  according to establishment survey data. Both the household and  establishment data sources show that the government sector employs a  large percentage of workers—about 23 percent in the household survey  and about 30 percent in the establishment survey.
For the United States, manufacturing employment has been falling, both in  absolute numbers of employees and as a percentage of all employees.  Between 1980 and 2005, manufacturing employment fell by about 4.5  million employees (about 24 percent). From 1995 to 2005, manufacturing  employment fell by about 3 million employees (about 17 percent). As of  2005, manufacturing employees represented about 10.7 percent of all  employees. Government employees constituted about 16 percent of total  employees in the United States, down from about 18 percent in 1980.
section_title: Since 1980, Real Per Capita Personal Income in Puerto Rico Has Not Grown Enough to Substantially Reduce the Gap between U.S. and Puerto Rican Living Standards
paragraphs: Although the likely imprecision of price deflators for Puerto Rico leaves the  exact growth rate of real per capita personal income there difficult to  determine, the rate has not been sufficient to substantially reduce the gap  between U.S. and Puerto Rican living standards. Puerto Rican per capita  personal income is well below that in the United States (see fig. 26).
As we did in comparing U.S. and Puerto Rican GDP and GNP, we adjusted  aggregate per capita personal income data using both U.S. and Puerto  Rican price deflators. The growth rate in per capita personal income is  somewhat higher in Puerto Rico than in the United States when the U.S.  deflator is used to adjust Puerto Rican per capita personal income for  inflation. In this case, the average annual percentage increase in Puerto  Rican per capita personal income was 2.1 percent while U.S. per capita  personal income rose by 2.0 percent on average per year. When the Puerto  Rican deflator is used to make adjustments for inflation, Puerto Rican per  capita personal income grew at a slower rate (1.1 percent) than in the  United States (2.0 percent). The difference arises because the U.S. price  deflator increased less than the Puerto Rico price deflator. Using both price  indices serves to illustrate the sensitivity of the calculation to the index  used.
In addition, private income transfers from Puerto Rico emigrants now  living in the United States made to Puerto Rican residents may be  understated, which would lead to an understatement of Puerto Rican  personal income. As U.S. citizens, Puerto Ricans are free to migrate to the  mainland United States and return as they wish. According to Census  estimates, net migration from Puerto Rico to the United States in the 1980s  totaled about 126,000. During the 1990s, net migration was estimated to  be about 111,000.
Census data show the distribution of income in Puerto Rico and the United  States and the percentages of individuals and families with incomes below  official poverty lines. The median household income in 1999 was $41,994  in the United States and $14,412 in Puerto Rico. In 1999, 48.2 percent of  households in Puerto Rico had incomes below the poverty level, which was  nearly four times the U.S. share, as shown in table 5.
As the disparity between average incomes in the United States and Puerto  Rico suggests, a much higher percentage of Puerto Rican households is in  the lower income categories. In 1999, only about 10 percent of U.S.  households had annual incomes below $10,000, compared to 37 percent of  Puerto Rican households (see table 6).
The distribution of income is more unequal in Puerto Rico than in the  United States. Economies in general have a small share of households  receiving a disproportionately large share of income. As a result, the ratio  of mean to median household income exceeds 1.0. As an indication of the  greater degree of income inequality in Puerto Rico, the ratio of mean to  median household income in 1999 was 1.69 in Puerto Rico compared to  1.35 in the United States.
section_title: Much Possessions Corporation Activity Has Shifted to Affiliated Corporations
paragraphs: Possessions corporations have played an important role in the Puerto  Rican economy, particularly in the manufacturing sector, where they  accounted for well over half of valued added throughout the 1990s. Most of  the possessions tax credit and income earned by possessions corporations  in Puerto Rico has been earned by corporations in the pharmaceutical  industry. Once the possessions tax credit was repealed, many of the large  corporate groups that owned possessions corporations in Puerto Rico  began to shift their operations to other types of business entities. Although  the various tax and economic census data that we present in this chapter  have significant limitations, we believe that, together, they form the basis  for a reasonably accurate picture of the broad changes that have occurred  in Puerto Rico’s manufacturing sector over the past two decades. Those  data indicate that much of the decline in activity of possessions  corporations in the manufacturing sector was offset by the growth in other  corporations, so that some measures of aggregate activity remained close  to their 1997 levels. For example, value added in manufacturing remained  fairly constant between 1997 and 2002. Most of the offsetting growth was  concentrated in the chemical industry, which is dominated by  pharmaceuticals.
subsections: section_title: Possessions Corporations Dominated Puerto Rico’s Manufacturing Sector up until the Late 1990s
paragraphs: Possessions corporations continued to dominate Puerto Rican  manufacturing through the mid-1990s, despite the legislative changes that  made the possessions tax credit significantly less generous after 1993.  According to the 1992 Economic Census of Puerto Rico Manufacturing,  these corporations accounted for 42.2 percent of employment and 64.3  percent of valued added in the manufacturing sector (as seen in fig. 27). By  the next economic census in 1997, possessions corporations’ share of value  added had increased to 72 percent, while their share of employment  remained little changed at 40.8 percent. This pattern of growth up to 1997  is also apparent in the data from the federal tax returns of possessions  corporations shown in figure 28. The aggregate total income, gross profits,  and net income of possessions corporations operating in Puerto Rico all  increased slightly between 1993 and 1997 (after adjusting for inflation),  although there was a small decline in the corporations’ total assets.
The growth in possessions corporation activity occurred despite the  limitations that Congress placed on the possessions tax credit after 1993  and a decline in the number of corporations claiming the credit. Figure 29  shows that those limitations significantly reduced the generosity of the  credit. Possessions corporations earned about 20 cents of credit for each  dollar of income they earned in 1993, but only half that amount by 1997.  Over that period, the number of corporations claiming the credit for  operations in Puerto Rico fell from 378 to 291 and the amount of credit  claimed declined from $5.8 billion to $3.2 billion.
The decline in possessions corporation income, value added, and  employment began after the Small Business Job Protection Act of 1996,  which placed additional limits on the amount of credit that corporations  could earn and, more importantly, repealed the credit completely for tax  years beginning after 1995, subject to a 10-year phaseout. The generosity of  the credit reached a low of less than 7 cents per dollar of income by 1999.
The number of corporations claiming the credit fell to 124 by 2003 and the  amount of credit they claimed that year fell to $1.1 billion. Moreover, in  contrast to the period leading up to 1997, the aggregate total income, gross  profits, and net income earned by possessions corporations all declined by  more than 50 percent between 1997 and 2003, while their total assets  declined by almost 30 percent. The significantly decreased importance of  possessions corporations is also apparent in the most recent economic  census data (fig. 27), showing that these corporations accounted for only  26.7 percent of manufacturing value added and only 31.8 percent of  manufacturing employment in 2002.
section_title: The Pharmaceutical Industry Has Dominated the Use of the Possessions Tax Credit in Puerto Rico
paragraphs: Most of the possessions tax credit and income earned by possessions  corporations in Puerto Rico has been earned by corporations in the  pharmaceutical industry. Figure 31 shows that pharmaceuticals  corporations earned over half of all the credit earned each year from 1995  through 2003. Figure 32 shows that these corporations earned an even  larger share of the aggregate gross profit earned by possessions  corporations in each of those years. Manufacturers of beverages and  tobacco products, medical equipment, and computers, electronics, and  electrical equipment were also heavy users of the credit during this period,  though not nearly to the same extent as pharmaceuticals manufacturers.  Both of these figures are based on data for possessions corporations in the  77 largest corporate groups operating in Puerto Rico. (See the following  section.)
section_title: Businesses Have a Variety of Options for Continuing Operations in Puerto Rico after They Cease Operating as Possessions Corporations
paragraphs: Parent corporations have a number of options for conducting business in  Puerto Rico if they wish to do so after termination of the possessions tax  credit. Large corporate groups are believed to have used at least four  different approaches to rearranging their overall corporate structure  (including the possessions corporation and their Puerto Rican operations)  in anticipation of termination of the possessions tax credit. The U.S. federal  tax consequences of these approaches vary as follows:  The possessions corporation loses its 936 status but remains a  subsidiary incorporated in the United States and is consolidated into  its parent’s federal tax return. The parent corporation includes the  relevant income and expenses of the subsidiary when computing its  own federal taxes. Tax attributes, such as carryovers of certain  accumulated losses, of the former possessions corporation would be  governed by applicable IRS regulations and guidance.
The possessions corporation liquidates into its parent (i.e., it no  longer remains a separate corporate entity). Generally, if the parent  satisfies certain ownership requirements, no gain or loss would be  recognized to either the parent or the subsidiary for U.S. federal income  tax purposes. The domestic parent would inherit and take into account  certain items of the former possessions corporation, such as earnings  and profits, net operating and capital loss carryovers, and methods of  accounting. No foreign tax credit is allowed for any foreign taxes paid in  connection with the liquidation, and the deduction of certain losses and  other tax attributes may be limited.
The possessions corporation is converted into or replaced by a CFC.
This change can occur if the possessions corporation reincorporates  and conducts business as a CFC; if it sells or contributes most of its  assets to a CFC; or if it winds down its operations as its parent  corporation starts up a new CFC to operate in Puerto Rico. Any income  that the replacement CFC earns from the active conduct of business in  Puerto Rico or elsewhere outside of the United States generally is not  taxed until it is repatriated to the U.S. shareholders in the form of  dividends. A number of tax consequences arise in cases where the  possessions corporation actually reincorporates as a CFC. There are  also significant tax issues (discussed further below) relating to the  transfer of assets (through either a contribution or a sale) from  possessions corporations to CFCs.
The possessions corporation is converted into or replaced by a limited  liability corporation (LLC) or partnership. An LLC can elect to be  treated as a corporation, as a partnership, or as a “disregarded entity.” If  the LLC elects to be treated as a corporation, its net earnings would be  included either individually or, if required to file a consolidated return,  on its parent’s return. If it chose partnership treatment, the LLC itself  would generally not be subject to federal income tax but its income,  deductions, gains, and losses would be distributed to its members, who  would include such amounts in calculating their federal income tax. If  the LLC is treated as a disregarded entity, its income, deductions, gains,  and losses are included on the member’s federal tax return.
Parent corporations could substantially change the manner in which  income from their Puerto Rican business operations were treated for  federal tax purposes even without making a formal change in the legal  status of their possessions corporations. The parents could simply reduce  production by their possessions corporations and start up or expand  production in other forms of businesses operating in Puerto Rico. We used  tax return data from both IRS and the Treasury of Puerto Rico to track  changes in the activity of possessions corporations, as well as to assess the  extent to which declines in that activity have been offset by increases in the  activity of affiliated businesses operating in Puerto Rico. In order to make  this assessment for a particular group of affiliated corporations, we needed  to examine data for each member of the group that had operations in  Puerto Rico.Given that considerable effort was required to identify the  group members that operated in Puerto Rico, we limited our review to the  largest 77 groups, which included at least one possessions corporation  between 1993 and 2001. These 77 large groups accounted for over 92  percent of the credit and income earned by possessions corporations in  every year from 1993 through 2001 and for over 91 percent of the assets  owned by such corporations in each of those years.
The large groups included a total of 172 possessions corporations that we  tracked between 1993 and 2003. The number of possessions corporations  that these 77 large groups owned and operated in Puerto Rico declined  from a high of 146 in 1995 to 58 by 2003. As of 2001, these groups also  conducted operations in Puerto Rico through 49 CFCs and at least 28 other  businesses. Fourteen of the groups operated both possessions  corporations and CFCs in Puerto Rico in 2001. In the following section we  report on trends in the income and assets of these large corporate groups.
The popular choice of replacing the operations of possessions corporations  with CFCs offers long-term tax benefits but could entail high initial tax  costs for some corporations. Many corporate groups have chosen to  operate in Puerto Rico through CFCs, possibly to take advantage of the  federal tax deferral on income earned there. Some may have rejected this  choice because their possessions subsidiaries owned valuable intangible  assets, such as drug patents or food recipes, and the transfer of these assets  to a non-U.S. entity, such as a CFC, could have been treated as a taxable  exchange, possibly resulting in a substantial, one-time tax liability.  Affiliated groups can avoid this tax if they keep the intangible assets in  their U.S. firms, rather than transferring them to their new CFCs. However,  in order for those CFCs to use those intangibles in their production  processes, they must pay royalties to the U.S. owners and those royalties  would be subject to federal income tax.
IRS officials have expressed concern that the repeal of section 936 has not  had its intended effect. Congress repealed section 936 because it was  viewed as providing an overly generous tax benefit to taxpayers with  operations in Puerto Rico. However, IRS officials believe that despite the  repeal of section 936, many taxpayers with operations in Puerto Rico could  be incurring approximately the same or even lower tax liabilities than they  did under section 936 by restructuring their activities through CFCs.  Taxpayers who converted into CFCs may have avoided the tax  consequences typically associated with such a conversion, namely, tax  liabilities arising from the transfer of intangibles from possessions  corporations to CFCs or a significant increase in royalty payments from  Puerto Rico. One private sector tax expert familiar with the practices of  U.S. businesses operating in Puerto Rico could not recall any case in which  a taxpayer reported a transfer of intangibles of any significant value from a  possessions corporation to a CFC. The expert also told us that the reason  why the IRS has not seen a notable increase in royalty payments from CFCs  to U.S. firms holding intangibles is that, well before the expiration of the  possessions tax credit, corporate groups had their existing or newly  formed CFCs enter into research cost-sharing arrangements with their  possessions corporations so that they would be codevelopers of new  intangibles and, thereby, would have certain ownership rights to use the  technology without paying royalties. The groups also tried to involve their  CFCs as much as possible in the development of new products through  other arrangements, such as research partnerships with unrelated  technology-developing firms.
section_title: Some Measures of Aggregate Manufacturing Activity Have Remained Constant Despite a Decline in Possessions Corporation Activity
paragraphs: A combination of tax return and economic census data indicate that the  decline in income and value added of possessions corporations between  1997 and 2002 has been largely offset by an increase in the income and  value added of affiliated corporations that left aggregate income and value  added roughly constant. Although some evidence of a change in income- shifting behavior by these corporate groups makes it difficult to say how  accurately trends in reported income and value-added data represent  trends in actual economic activity in Puerto Rico, data on employment,  capital expenditures, and total assets (which should not be distorted by  income shifting) support the conclusion that a substantial amount of  possessions corporation activity has been continued by other types of  businesses. However, most of this continued activity is concentrated in the  pharmaceutical industry and the decline in possessions corporation  activity in other industries has not been offset. None of the data we present  address the question of what corporate activity would have taken place  during this period if the possessions tax credit had not been repealed.
subsections: section_title: Tax Return and Economic Census Data Indicate That Much of the Income and Value Added of Possessions Corporations Declined While That of Affiliated Businesses Increased
paragraphs: Tax return data on the affiliated corporate groups that have claimed almost  all of the possessions tax credit indicate that between 1997 and 2001 at  least a large portion (and possibly all) of the decline in reported incomes of  possessions corporations operating in Puerto Rico was offset by increases  in the reported incomes and total assets of affiliated corporations operating  in Puerto Rico, particularly that of CFCs. The offset left the income that  these groups earned in Puerto Rico roughly the same in 2001 as in 1997.  This finding is consistent with data on value added in manufacturing from  recent economic censuses of Puerto Rico.
Gross profit, which equals income from sales minus the cost of goods sold,  is the income measure from tax returns that is closest in definition to the  value-added measure from census data that we presented earlier. Both of  these measures may be distorted by income shifting, as we explain in the  next section; however, value added is considered to be the best measure of  the economic importance of manufacturing activity. We examined data for  both of these measures, as well as other measures not distorted by income  shifting, to assess the extent to which possessions corporation activity has  been replaced by the activity of other types of businesses.
Figure 33 shows that the aggregate gross profit of the possessions  corporations in our 77 large groups peaked at $28.8 billion in 1997 and then  fell to $11.4 billion by 2003. The figure also presents our “lower-bound”  estimates for the amount of gross profits from Puerto Rico that CFCs  reported. These estimates include only the profits of those CFCs for which  we had Puerto Rican tax returns or that appeared to have operations only  in Puerto Rico because those are the cases where we can be the most  confident that our figures represent profits attributable only to Puerto  Rican operations. The gross profits of those CFCs grew from $2.4 billion to  $7.1 billion between 1997 and 2001. These estimates are likely to represent  a lower bound for the amount of CFC profits in Puerto Rico because they  do not include any of the profits for CFCs whose income was difficult to  allocate between Puerto Rico and other locations. We present alternative  estimates, labeled “CFC total if allocated by tax ratio,” of the gross profits  from Puerto Rico of all of the CFCs in our large groups. These more  comprehensive estimates are not likely to be very precise, but they are  consistent with some of the census data that we present on CFCs in  chapter 5. The estimates show CFC gross profits growing from $3.0 billion  to $11.5 billion between 1997 and 2001. Finally, figure 33 also shows the  gross profits reported on Puerto Rican tax returns by members of the 77  large groups, other than possessions corporations and CFCs. The gross  profits of these businesses increased from $3.0 billion to $7.0 billion  between 1999 and 2001.
The data in figure 33 indicate that much of the $10.7 billion decline in the  gross profits of possessions corporations between 1997 and 2001 was offset  by increases in the profits of affiliated corporations. The lower-bound  estimates for CFCs grew by $4.7 billion over that period, while the profits of the other affiliates, including LLCs, grew by $3.9 billion between 1999  and 2001. The combined profits of these two sets of businesses, therefore,  grew by about $8.7 billion. If we use the “tax ratio” estimate for all CFCs,  the combined growth in profits grew by about $12.5 billion. The gross profit  of the “other affiliated” businesses is likely to be understated relative to  those of the possessions corporations because of differences in the income  definitions used for federal and Puerto Rican tax purposes. For those  possessions corporations for which we had both federal and Puerto Rican  returns, the gross profit from the Puerto Rican return averaged about 70  percent of the gross profit on the federal return. For this reason figure 33  may understate the extent to which the decline in possessions  corporations’ Puerto Rican operations has been offset by these other  affiliates.
Data from recent economic censuses on value added in Puerto Rican  manufacturing lend additional support to the conclusion that we draw from  figure 33—that much, if not all, of the decline in income of possessions  corporations in Puerto Rico between 1997 and 2001 was largely offset by  increases in the incomes of other types of businesses. Figure 34 shows that  valued added by possessions corporations in Puerto Rican manufacturing  followed roughly the same pattern as the gross profits data presented in  figure 33; it also shows that other types of businesses made up for  approximately all of the possessions corporations’ decline between 1997  and 2002.
The extent to which the decline in income and value added of possessions  corporations was offset by the growth of their affiliates varied significantly  by industry. Figure 35 decomposes the last two columns of figure 34 into  the chemical industry (which includes pharmaceuticals) and all other  manufacturing industries. It shows that a significant drop in the value  added of possessions corporations in the chemical industry was more than  offset by the substantial growth in value added by other types of  businesses. In contrast, the value added of both possessions corporations  and all other types of businesses declined between 1997 and 2002 in the  remainder of the manufacturing sector, outside of chemicals.
Our tax data for large corporate groups showed similar variation across  industries. The corporate groups in the chemicals and medical equipment  industry group offset a larger proportion of the decline in the income of  their possessions corporations between 1997 and 2002 with income from  other types of affiliates operating in Puerto Rico than was the case for large corporate groups as a whole. Trends in the income of possessions  corporations in the other two industrial groupings that we are able to  present with our tax data—computer, electronics, and electrical  equipment; and food and kindred products—were somewhat erratic  between 1993 and 2001 before declining by 2003. There was negligible to no  growth in the incomes of CFCs and other types of businesses in these two  industrial groupings during the period we could observe between 1997 and  2002. (See tables 17 and 18 in app. IV.)
section_title: Data on Capital Expenditures, Total Assets, and Employment Also Indicate That a Substantial Amount of Possessions Corporation Activity Has Been Continued by Other Types of Businesses in Certain Industries
paragraphs: As we explained in chapter 3, the data on income and value added for  members of large corporate groups operating in Puerto Rico may be  distorted by changes in the income reporting practices of these groups  during the late 1990s. For this reason it is difficult to know how accurately  trends in reported income and value added represent trends in actual  economic activity in Puerto Rico. Nevertheless, data on capital  expenditures, total assets, and employment (which should not be distorted  by income shifting) support the conclusion that a substantial amount of  possessions corporation activity has been continued by other types of  businesses. Much of this continued activity is concentrated in the chemical  industry, which is dominated by pharmaceutical producers.
The economic census data on capital expenditures on manufacturing plant  and equipment in figure 36 show that this investment increased  dramatically between 1997 and 2002 after having dropped from 1992 to  1997. We cannot divide this time series of capital spending data between  possessions corporations and other forms of business; however, figure 36  shows that most of the spending increase was in the pharmaceutical  industry, which was the source of about two-thirds of total possessions  corporations profits in 1997. Consequently, it appears that any overall  decline in possessions corporations’ capital spending that may have  occurred since 1997 must have been more than offset by the investment of  other businesses.
The tax data for our 77 large corporate groups show that the $12.1 billion  decline in the total assets of the possessions corporations in these groups  between 1997 and 2001 was largely offset by an increase of at least $9.4  billion in the total assets of affiliated corporations operating in Puerto Rico  (see table 15 in app. IV). The decline in assets may have been more than  fully offset, depending on the growth in the Puerto Rican assets of the  CFCs that we were not able to include in our estimates. However, as was  the case with income and value added, there were significant differences  across industries behind the trends for the manufacturing sector as a  whole. The decline in assets of possessions corporations in the chemical  and medical equipment industries between 1997 and 2001 was more than  offset by the increased assets of their affiliates even if we use just our  lower-bound estimates for CFCs. In comparison, a little over half of the  decline in possessions corporations’ assets in the computer, electronics,  and electrical equipment industries between 1997 and 2001 was offset by  the growth in affiliated CFCs’ assets. (See tables 16 and 17 in app. IV.)
The economic census data on employment in Puerto Rico’s manufacturing  sector in figure 37 shows that the decline in employment by possessions  corporations between 1997 and 2002 was not as drastic as the declines in  their profits or value added over that period (shown previously in figs. 33  and 34); however, there was no offsetting increase in overall employment  by other types of manufacturing firms. Figure 38, which decomposes the  last two columns of figure 37 into the chemical industry and all other  industries, shows that employment by possessions corporations in the  chemical industry did, in fact, fall sharply between 1997 and 2002, but other  types of businesses in the industry more than made up for that decline. In  the remaining industries as a whole, there was a smaller percentage  decrease in employment by possessions corporations but there was also a  decrease, rather than an offsetting increase, in the employment by other  types of businesses. The chemical industry is much less important in terms  of overall employment in manufacturing than it is in terms of value added.  For this reason the continued strength of that industry was not enough to  prevent an overall decline in manufacturing employment.
section_title: U.S. Businesses Dominated Puerto Rican Manufacturing in 2002 but Played Smaller Roles in Other Sectors
paragraphs: U.S.-owned businesses accounted for at least 71 percent of value added and  at least 54 percent of employment in Puerto Rico’s manufacturing sector in  2002. CFCs produced most of this value added but possessions  corporations still accounted for most of the employment by U.S. firms. The  CFCs are particularly important in the pharmaceutical industry and much  less so in other manufacturing industries. U.S. corporations appear to  account for less than 25 percent of employment in Puerto Rico’s wholesale  and retail trade sectors, where local corporations are the most important  employers. Similarly, U.S.-owned corporations are not the majority  employers in any of the large Puerto Rican service industries for which  data are available.
subsections: section_title: U.S. CFCs Have Become the Most Important Type of Business Entity in Puerto Rico’s Manufacturing Sector in Terms of Value Added but Not in Terms of Employment
paragraphs: As of 2002, U.S. CFCs accounted for 42 percent of value added in Puerto  Rico’s manufacturing sector—a larger share than that of any other type of  business entity (see fig. 39). Possessions corporations had the next largest  share of value added with 27 percent, and other U.S. corporations  accounted for 2 percent of the total. Together, these three types of  businesses produced at least 71 percent of total manufacturing value  added. A small number of U.S.-owned or U.S.-incorporated businesses may  be included in the category “corporations of type unknown,” but we believe  that most of the data for that category (in all of the figures in this chapter)  are attributable to corporations that are not incorporated in the United  States and are not CFCs.
Possessions corporations remained the largest single type of employer,  with 31 percent of the sector’s total employment (see fig. 40). Despite their  large share of manufacturing value added, CFCs had a relatively small  share—14 percent—of the sector’s total employment, which resulted in the  extraordinarily high ratios of value added per employee that we discussed  earlier. In contrast, other U.S. corporations and corporations incorporated  in Puerto Rico had significantly larger shares of total employment than they  did of value added.
A little less than two-thirds of the CFCs’ value added and half of their  employment is attributable to CFCs incorporated outside of Puerto Rico.  This distribution of value added is similar to the estimated distribution of  gross profit between the two types of CFCs, based on the tax data for our  77 large corporate groups for 2001. The estimates presented in figure 41 are  based on our tax ratio approach for attributing portions of the income of  multilocation CFCs to Puerto Rico. The estimates indicate that 70 percent  of the gross profit and 73 percent of net income that CFCs earned in Puerto  Rico in 2001 were earned by CFCs incorporated outside of Puerto Rico.  Using the tax data, we estimate that more than three-quarters of the total  gross and net income earned by the CFCs incorporated outside of Puerto  Rico in 2001 is attributable to CFCs incorporated in the Cayman Islands,  Ireland, the Netherlands, and the U.S. Virgin Islands.
A comparison of figures 42 and 43 shows that the value added of CFCs in  2002 was concentrated in the pharmaceutical industry. These firms  accounted for over half of the value added in that industry, or almost three  times as much as the value added of possessions corporations. In contrast,  CFCs accounted for only 13 percent of the value added in all of the  remaining manufacturing sectors, where possessions corporations still  dominated with a 48 percent share. At this more specific industry level of  data, Census nondisclosure rules prevent us from providing as much detail  about other forms of businesses. We needed to add pass-through entities  into the “all other and unknown” category. However, from table 20 in  appendix V, we do know that between approximately 80 percent and 90  percent of the employees of these entities were concentrated in two  industries—pharmaceuticals and medical equipment—and that between 25  percent and 63 percent of these employees were in each of these industries.  If the value added of these entities was distributed across industries in  approximately the same manner as their employment, then pass-through  entities would have accounted for between 3 percent and 7 percent of value  added in pharmaceuticals.
Data in table 20 of appendix V show that possessions corporations and  CFCs were approximately equal in importance in terms of employment in  the pharmaceutical industry in 2002 and, together, they accounted for 61  percent of the industry’s employment. The data also show that possessions  accounted for a little over a quarter of total employment in all other  manufacturing industries, while CFCs accounted for only 9 percent.
section_title: The Role of U.S. Corporations Is Much Smaller in Puerto Rico’s Wholesale and Retail Trade Than in Manufacturing
paragraphs: Corporations that were U.S. CFCs and businesses incorporated in the  United States accounted for less than a quarter of total employment in the  Puerto Rican wholesale trade sector and, as figure 44 shows, about half of  their employment was in corporations other than CFCs or possessions  corporations. Corporations in the unknown category, which we believe to  be largely ones that are not incorporated in the United States or owned by  U.S. parent corporations were by far the largest employers in the wholesale  trade in 2002, as shown in figure 44. Figure 45 indicates that this  employment distribution was similar for the retail trade sector. The  primary difference between the two sectors is that possessions  corporations played no role at all in retail trade and sole proprietors played  a more important role in that sector than in wholesale trade. The  distributions of payroll across entities in these two sectors largely mirrors  the distributions of employment (see table 17 in app. V).
section_title: Neither Possessions Corporations nor CFCs Were Significant Employers in 2002 in Most Puerto Rican Service Industries for Which Data Are Available
paragraphs: In general, possessions corporations and CFCs played minor roles as  employers in Puerto Rico’s service sector. The 2002 Economic Census of  Island Areas compiled data for 11 service industries, as well as the mining,  utilities, and transportation and warehousing sectors in Puerto Rico. Table  7 shows the distribution of employment across types of businesses for the  six largest services (in terms of employment) covered by the census.  Appendix V tables 25–27 show the distribution of employment, sales, and  payroll, for all 11 service industries and the three other sectors.
CFCs accounted for 32.7 percent of employment in the information  services industry (which includes telecommunications, broadcasting,  publishing, motion pictures, and Internet services), but for no more than  5.1 percent in any of the other five large services. Possessions corporations  accounted for 10 percent of employment in the accommodations industry  but for no more than 2.4 percent in any of the other large services. Other  U.S. corporations accounted for between 10 percent and 20 percent of  employment in each of the six services. Most of the remaining employment  in the large service industry is attributable to local corporations (in the type  unknown group) and sole proprietors. The category “all other employers,”  which includes nonprofit entities, accounts for up to 22 percent of total  employment in healthcare services, which is the largest service industry.
section_title: Taxes Per Capita in Puerto Rico Are Lower Than in the States but Are about the Same Share of Income
paragraphs: The taxes paid to all levels of government (federal, Commonwealth, and  local) in Puerto Rico in 2002 were $3,071 per capita—considerably less  than the per capita taxes of $9,426 paid in the states. However, the  combined taxes paid by Puerto Rico residents amounted to 28 percent of  their personal income, which was close to the 30 percent figure in the  states. Puerto Rico’s outstanding government debt in 2002 was much higher  than that of state and local governments as a share of personal income,  partly because the Commonwealth government has a wider range of  responsibilities.
subsections: section_title: Taxes Paid Per Capita in Puerto Rico Are Lower Than Those in the States but the Taxes Are about the Same Share of Personal Income in Both Places
paragraphs: The amount of taxes that Puerto Rico residents paid per capita in fiscal  year 2002 ($3,071) was about one-third of the amount paid by residents of  the states ($9,426) (see fig. 46). The mix of the taxes was also quite  different. While nearly 60 percent ($5,619) of the taxes paid by residents of  the states were federal taxes, only about 25 percent ($760) of the total  taxes paid by Puerto Rico residents were federal taxes because those  residents generally are not subject to federal income tax on the income  they earn in Puerto Rico. Data on federal taxes paid in the other insular  areas are not available. Taxes paid by residents of the other insular areas to  their own governments in 2002 amounted to $2,451 per capita—slightly  higher than the $2,310 per capita that residents of Puerto Rico paid to the  Commonwealth and municipal governments. The location where a tax is  paid is not necessarily the same location as where the economic burden of  the tax falls. The data we present in this chapter pertain to the former.
Comparing the taxes Puerto Rico residents paid to the average of the five  states whose residents paid the least total taxes, we found that Puerto Rico  residents paid about 54 percent of the amount paid by these state residents ($5,713). The average percentage of taxes paid in these same five states  that were federal taxes was nearly 47 percent ($2,705), still nearly double  the percentage for Puerto Rico. The average per capita amount of taxes  paid in the five highest tax states was $15,491—five times the per capita tax  in Puerto Rico.
Taxes as a share of personal income are about the same in Puerto Rico and  the states, which is not surprising because Puerto Rico’s income per capita  is so much lower. Taxes paid in Puerto Rico amounted to 28 percent of the  Commonwealth’s personal income, while those paid in the states amounted  to 30 percent of aggregate state personal income. Taxes in the five lowest- tax states were an average of 23 percent of the states’ aggregate personal  income, while those in the five highest-tax states averaged 39 percent. (See  table 28 in app. VI for additional detail.)
section_title: Income and Employment Taxes Account for about Two-thirds of the Taxes Paid in Both Puerto Rico and the States, but the Allocation of Those Taxes by Level of Government Differs between the Two Locations
paragraphs: As shown in figure 48, about 75 percent of the taxes paid in Puerto Rico are  levied by the Commonwealth and municipal governments. The property  tax and gross receipts tax imposed by the municipal government accounted  for a little over 17 percent of taxes paid with the remainder going to the  Commonwealth government. Commonwealth income taxes accounted for  41 percent of total taxes with slightly more than half of that being paid by  resident individuals. Sales and excise taxes represented 23 percent of the  total.
Data available from IRS for Puerto Rico and the states do not separate  federal individual income tax payments from payments of federal  employment taxes, such as those for Social Security, Medicare, and  unemployment compensation; however, most of the tax shown for that  combined category in figure 48 should be employment taxes because most  residents of Puerto Rico pay little, if any federal income tax. Even less  federal estate, gift, or excise tax is paid in Puerto Rico. Federal excise taxes  on goods manufactured in Puerto Rico and sold in the states are  transferred to the Commonwealth and more than offset any federal excise  tax on products consumed there.
Federal individual income and employment The figures for federal estate and gift taxes round to 0 percent.
In contrast to the case of Puerto Rico, more than half of the taxes paid in  the states go to the federal government, which provides a larger range of  services to the states than it does to the Commonwealth. Federal individual  income and employment taxes accounted for 56 percent of the taxes paid,  while federal estate, gift, and excise taxes amounted to an additional 3  percent, resulting in a combined federal share of 59 percent (see fig. 49).  When the 10 percent of taxes paid in the form of state and local income  taxes are added to the 56 percent that go to federal individual income and  employment taxes, the resulting 66 percent share is almost equal to the 67  percent share in Puerto Rico for this same group of taxes. Of the remaining  total, state and local property taxes and “other” revenues (including  lotteries and licenses) account for greater shares of the total taxes paid in  the state than they do in Puerto Rico, while sales and excise taxes  represent a smaller share.
section_title: Puerto Rico’s Outstanding Government Debt in 2002 Was Much Higher Than That of State and Local Governments as a Share of Personal Income, Partly Because the Commonwealth Government Has a Wider Range of Responsibilities
paragraphs: The amount of Puerto Rican government-issued debt outstanding as of  2002 was slightly higher in per capita terms, but much higher as a share of  personal income, than was state and local government-issued debt. As  shown in figure 50, the outstanding amount of Puerto Rican government  debt per capita in 2002 was about $7,580, compared to a national average of  $5,820 for state and local government-issued debt. The per capita debt of  the governments of the other insular areas in 2002 was about $5,690.  Although all of this debt was issued by the respective governments, some  of it is directed to private use and will be paid back by targeted  beneficiaries. About 16 percent of Puerto Rico’s government debt fell into this “private use” category, compared to about 23 percent for state and  local government debt.
section_title: Federal Grants and Payments to Governments Per Capita Are the Same for Puerto Rico and the States but Direct Federal Payments to Individuals Per Capita Are Significantly Lower in Puerto Rico
paragraphs: The states and insular areas receive funds from the federal government in  the form of grants, direct aid, loans, and insurance and procurement  payments (see table 8). Federal grants and payments to the Puerto Rican  government in 2002 amounted to $1,242 per capita, about the same as the  $1,264 per capita paid to all state and local governments in the states, but  less than the $1,703 per capita paid to the other insular area governments.  The $2,057 per capita of direct federal payments to individuals in Puerto  Rico was well below the $3,648 per capita paid to state residents, but higher  than the $1,418 per capita paid to residents of the other insular areas. The  following chapter and appendix VII provide detailed information on the  amount of spending for specific federal social programs in Puerto Rico, the  states, and other insular areas and describes similarities and differences in  the operation of these programs in the various locations. The per capita  federal payments of $336 for salaries, wages, and procurement in Puerto  Rico were about 20 percent of payments for those purposes in the states  and the other insular areas. (Page is left blank intentionally.)
Some federal funds that Puerto Rico received as grants and direct  payments were in the form of a rebate on custom duties and a cover over  of excise taxes collected on rum. These funding sources are not available  to the states or the District of Columbia, or most of the insular areas except  for the U.S. Virgin Islands. On a per capita basis the U.S. Virgin Islands  received a larger rebate payment than Puerto Rico and a larger cover over  payment than Puerto Rico (see table 9).
section_title: The Extent That Federal Social Programs in Puerto Rico Mirror Those in the States and Other U.S. Insular Areas Varies
subsections: section_title: Comparison of Selected Federal Social Programs
paragraphs: Like the states, Puerto Rico and the other U.S. insular areas receive federal  funds for a variety of social programs—including federal housing  assistance, education, and health care financing programs—which provide  assistance to elderly and needy families and individuals. Generally, the  social programs we examined in these areas targeted similar populations  and delivered similar services—although Puerto Rico and the other insular  areas did not always do so through the program as it exists in the states  (see table 10). For example, in lieu of the Food Stamp Program available in  the states, which is an entitlement program based on the number of  participants, Puerto Rico receives a capped block grant that has similar  eligibility requirements. The major difference between some of the social  programs we examined in the states versus those in Puerto Rico and the  other insular areas is how they are funded. For example, where federal  Medicaid spending is an open-ended entitlement to the states, it is subject  to a statutory cap and a limited matching rate in Puerto Rico and the other  insular areas. Some of the social programs and housing programs that we  examined are available in the states, but are not available in some of the  insular areas.
More detailed information on how each of the programs is applied in the  insular areas and the states can be found in appendix VII.