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 Then in 1996 Congress repealed the credit but allowed existing possessions corporations to earn either the possessions credit or a replacement credit during a 10-year phaseout period ending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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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.) 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. 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. 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.) 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. 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. 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. 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). 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. 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. 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.) 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. 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. 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). 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.

Summary: 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. 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.