Puerto Rico, with about 3.6 million residents, is the largest U.S. territory. As a territory, Puerto Rico is subject to congressional authority, although Congress has granted Puerto Rico authority over matters of internal governance. Puerto Rico has held 4 plebiscites intended to determine its preferred status relationship with the United States. The most recent plebiscite, held in November 2012, asked voters in Puerto Rico two questions: (1) whether Puerto Rico should continue its present form of territorial status, and (2) regardless of how voters answered the first question, which non- territorial status option is preferred—statehood, independence, or a sovereign free associated state. For the first question, about 54 percent of voters indicated that Puerto Rico should not continue its present form of territorial status. For the second question, about 61 percent of voters who chose a non-territorial status option chose statehood. The Consolidated Appropriations Act, 2014 includes $2.5 million in funding for objective, nonpartisan voter education about, and a plebiscite on, options that would resolve Puerto Rico’s future political status. The funds are to be provided to the State Elections Commission of Puerto Rico. Congress generally determines whether Puerto Rico is eligible for federal programs on a case-by-case basis, and defines any different treatment in law. For example, federal programs in Puerto Rico may be subject to certain funding or eligibility restrictions. For some programs, current law applies certain limitations or exceptions to Puerto Rico by name. For other programs, the governing statutes refer to the 50 states or the 50 states and the District of Columbia. Where differences are not mandated by law, federal agencies generally treat Puerto Rico the same as the states. Yet, characteristics of federal programs in Puerto Rico may differ from the states for other reasons. For example, a study by the U.S. President’s Task Force on Puerto Rico’s Status found that governments and organizations in Puerto Rico were not applying for and seeking all available federal funds. It also found that a significant amount of funds available in Puerto Rico are not spent in a timely manner. Pub. L. No. 113-76, 128 Stat. 5, 61 (2014). exempt from federal taxes on income from Puerto Rico sources.differences contribute to Puerto Rico and its residents receiving fewer federal payments, and paying less in federal tax, than residents of the states on a per capita basis, as shown in figure 1. Historically, trends in Puerto Rico’s economy have tended to follow those in the rest of United States. However, Puerto Rico’s latest economic downturn has been longer and more extreme than the mainland U.S. downturn. Specifically, the U.S. economy entered into a recession in December 2007, which ended in June 2009, according to the Business Cycle Dating Committee of the National Bureau of Economic Research. In contrast, Puerto Rico’s recession began in the fourth quarter of 2006, and the economy contracted every fiscal year from 2007 to 2011. After growth of 0.1 percent in fiscal year 2012, the economy is projected to have contracted in fiscal year 2013 by 0.4 percent, according to the Government Development Bank for Puerto Rico. Recently, Puerto Rico’s government has faced various fiscal challenges, including an imbalance between its general fund revenues and expenditures. In fiscal year 2009, Puerto Rico’s fiscal deficit reached a high of $2.9 billion—based on $7.8 billion in revenues and $10.7 billion of expenditures. Persistent deficits have resulted in an increase in Puerto Rico’s public debt, which represents a much larger share of personal income than in any of the states. In February 2014, Puerto Rico’s general obligation bonds were downgraded to speculative—noninvestment— grade by three ratings agencies. Recently, Puerto Rico has taken steps to improve its fiscal position. Beginning in 2007, Puerto Rico began to reduce the size of its government workforce. For example, between 2007 and 2009, government employment declined almost 10 percent. However, as of July 2012, government employment still accounted for a larger share of overall employment in Puerto Rico when compared to the states (although, government employment as a share of the population older than 15 in Puerto Rico was similar to that in the states). In 2009, a fiscal stabilization plan was put into effect that reduced government spending and increased tax revenues. In April 2013, Puerto Rico enacted comprehensive reform of its largest public employee retirement system, which is funded primarily with budget appropriations from the government’s general fund. The reform was intended to address the retirement system’s deteriorating solvency. Through measures like these, Puerto Rico has reduced its annual deficits. However, the fiscal year 2013 deficit was approximately $1.3 billion, based on projected expenditures of approximately $10 billion. As the Government Development Bank for Puerto Rico notes in its Financial Information and Operating Data Report from October 2013, Puerto Rico’s ability to continue to reduce its deficit will depend in part on its ability to continue increasing revenues and reducing expenditures, which in turn depends on a number of factors, including improvements in economic conditions. Of the 29 selected federal programs we reviewed, statehood would likely affect 11 programs. For 3 other programs, while the programs themselves would likely not change under statehood, eligibility determinations for these programs could be affected indirectly by changes that could occur to benefits in other programs. Statehood would not likely affect the 15 remaining programs. Ultimately, changes to programs under statehood would depend on decisions by Congress and, to some extent, on decisions by federal agencies. For example, Congress could enact legislation that creates or maintains certain exceptions for Puerto Rico. Figure 3 shows whether and how statehood would potentially affect the programs we reviewed. Additional details on programs that statehood would likely affect appear in appendix II. The extent to which federal spending would change for some of the programs that would be affected by Puerto Rico statehood depends on various assumptions, such as which program eligibility options Puerto Rico might select, and the rates at which eligible residents might participate in the programs. For example, for the four largest programs for which federal spending would be likely to change under statehood— Medicare, Medicaid, SNAP, and SSI—and for the ninth largest program for which federal spending would be likely to change—CHIP—GAO used various assumptions to estimate a range of federal spending. Figure 4 below shows the range of estimated federal spending for these programs based on these assumptions, which are described in detail for each program in appendix II. Figure 4 also shows a Federal Highway Administration estimate for federal spending for Federal-Aid Highways, the fifth largest program for which federal spending would be likely to change under statehood. The estimates were developed for a single year in the past, as if Puerto Rico were treated the same as the states in the year specified for each program. For programs other than Federal-Aid Highways, the estimates are in calendar-year terms because the eligibility and other data used to develop the estimates were in calendar-year terms. The estimate for Federal-Aid Highways is in fiscal-year terms. Actual spending in Puerto Rico, to which we compare the estimates, is in fiscal-year terms because the spending data were reported in fiscal-year terms. All the federal revenue sources we reviewed could be affected if Puerto Rico became a state. As with our review of programs, we assumed that if Puerto Rico becomes a state, it would be treated as such for purposes of revenue collection. For example, under statehood, Puerto Rico residents would be subject to federal tax on all their income: currently they are subject to federal tax only on income from sources outside of Puerto Rico. However, for two revenue sources through which Puerto Rico receives revenue not provided to other states—excise taxes and customs duties—whether or how statehood would result in changes would depend on decisions by Congress. Figure 5 shows how the revenue sources we reviewed potentially would change under statehood. Additional details on the two largest revenue sources that would be affected substantially by statehood—individual and corporate income taxes—appear after figure 5 and in appendix III. The extent to which statehood would affect federal revenue depends on various assumptions. For example, for the two largest revenue sources that would be affected substantially by statehood—individual and corporate income taxes—we used various assumptions to estimate a range of federal revenue. The estimate ranges are based on Puerto Rico being treated the same as the states in either 2009 or 2010, based on the year for which the most recent data were available. An example of how assumptions affect the estimates is illustrated by the estimate range for corporate income tax. That estimate is influenced by assumptions on applicable tax rates for business with activities in Puerto Rico, the extent of ownership of Puerto Rico businesses by U.S. corporations, and the extent to which U.S. corporations use prior-year losses from their affiliated Puerto Rico businesses to offset their federal taxable income. For example, the low end of the estimate range shown in figure 6 below is based on lower-bound assumptions for applicable corporate income tax rates, upper-bound assumptions for the extent of U.S. ownership of Puerto Rico businesses, and the assumption that U.S. corporations would have used prior-year losses of affiliated Puerto Rico corporations to offset their federal taxable income to the maximum extent. The high end of the estimate range shown in figure 6 is based on the upper-bound assumptions for applicable tax rates, lower-bound assumptions for the extent of U.S. ownership of Puerto Rico businesses, and the assumption that U.S. corporations would not have used any prior-year losses of affiliated Puerto Rico corporations to offset their federal taxable income. The estimates for corporate income tax in figure 6 do not take into account any changes in behavior of businesses with activities in Puerto Rico. For example, according to tax policy experts at the Department of the Treasury and the Joint Committee on Taxation, changes in federal income tax requirements under Puerto Rico statehood are likely to motivate some corporations with substantial amounts of income derived from intangible (and therefore mobile) assets to relocate from Puerto Rico to a lower tax foreign location. The extent to which such corporations might relocate from Puerto Rico is unknown. Consequently, we produced an alternative set of corporate income tax revenue estimates to account for some businesses with activities in Puerto Rico potentially relocating under statehood. Accounting for this assumption, in conjunction with the other assumptions described previously, resulted in an estimated range of corporate income tax revenue of -$0.1 billion to $3.4 billion. Statehood could result in dynamic economic and fiscal changes for Puerto Rico, changes that could ultimately impact the level of federal spending in Puerto Rico, and the revenue collected from residents of, and corporations in, Puerto Rico. However, the precise nature of how such changes would affect federal spending and revenue is uncertain. Because statehood would cause numerous adjustments important to Puerto Rico’s future, it would require careful consideration by Congress and the residents of Puerto Rico. Consequently, statehood’s aggregate fiscal impact would be influenced greatly by the terms of admission, strategies to promote economic development, and decisions regarding Puerto Rico’s revenue structure. As we have reported in the past, the history of statehood admissions is one of both tradition and flexibility. While Congress has emphasized the traditional principles of democracy, economic capability, and the desire for statehood among the electorate, it has also considered potential states’ unique characteristics, including population size and composition, geographic location, economic development, and historical circumstances when making these decisions. Any decision to transition Puerto Rico to statehood in the future will also involve assessing a complex array of similar factors, in addition to economic and fiscal ones. Some factors that could influence changes in federal spending and in revenue for specific programs or types of tax are discussed in appendix II and appendix III of this report. In this section, we discuss general factors that could influence how Puerto Rico statehood could affect future federal spending and revenue. As previously discussed, Puerto Rico’s economy has largely been in recession since 2006. Likewise, Puerto Rico’s unemployment rate has been relatively high, and its labor force participation rate has been relatively low, compared to those of the states. Statehood—and the resultant changes to spending programs in Puerto Rico, and in tax requirements for Puerto Rico residents and corporations—could have wide-reaching effects on Puerto Rico’s economy and employment. Under statehood, Puerto Rico residents would be eligible for the federal earned income tax credit (EITC)—including refundable payments—which is designed to encourage work. Also, in the short-term, increased federal transfers—such as through SSI benefits, which Puerto Rico residents would become eligible for under statehood—could stimulate Puerto Rico’s economy. However, some Puerto Rico industry group representatives we interviewed worried that the relatively high rate of government transfer payments in Puerto Rico could discourage work. According to the Federal Reserve Bank of New York, such transfer payments equate to roughly 40 percent of personal income, more than double the share in the states. Likewise, the effect of statehood on Puerto Rico migration—and the corresponding effect of that migration on Puerto Rico’s economy and employment—is uncertain. From 2002 to 2012, Puerto Rico’s population decreased by about 5 percent based on U.S. Census Bureau estimates. Migration has been cited as a possible explanation for Puerto Rico’s relatively low labor force participation rate, particularly if those Puerto Rico residents most interested in participating in the labor force are migrating to the states in search of higher wage employment, leaving behind residents that have relatively less attachment to the labor force. From 2002 to 2012, population in the states increased by 9.1 percent, and decreased in only 2 states—Rhode Island and Michigan (by 1.5 percent in both states)—based on U.S. Census Bureau estimates. various factors corporations generally take into account when determining where to locate their operations). Also, local businesses could incur higher costs because of additional tax liabilities. As previously discussed, Puerto Rico has run persistent fiscal deficits in recent years, which has increased Puerto Rico’s public debt. As a result, Puerto Rico government-issued debt represents a much larger share of personal income than in any of the states. Recently, Puerto Rico has taken steps to improve its fiscal position, including reducing the size of its government workforce and reforming its primary public employee retirement system. However, in February 2014, Puerto Rico’s general obligation bonds were downgraded to speculative—noninvestment— grade by three ratings agencies, in part because of concerns about Puerto Rico’s fiscal position. One factor that may have facilitated Puerto Rico’s ability to issue debt is that the interest on most bonds issued by Puerto Rico’s government, its political subdivisions, and its public corporations generally is not subject to income tax at the federal, state, or local levels. Under statehood, if Puerto Rico was treated like the states, its government-issued debt would no longer enjoy this so called triple-exemption, as income accruing to residents of other states would become taxable at the state and/or local levels. The loss of triple-exempt bond status could result in reduced demand for Puerto Rico’s debt. The $152 million estimate is subject to a high level of statistical imprecision, with a margin of error of plus or minus 14.5 percent of the estimate itself. tax burdens for individuals and corporations, it would need to lower its tax rates, which could reduce tax revenue. Under statehood, certain federal programs in Puerto Rico could change substantially if Puerto Rico were treated the same as the states. Likewise, Puerto Rico residents and corporations operating in Puerto Rico would become subject to significant changes in their tax requirements under statehood. Prior bills on Puerto Rico’s status that Congress has considered have included provisions providing for a transition period or plan. Under one approach, if Puerto Rico were to become a state, federal funding would increase incrementally until parity with other states was reached, and federal income tax requirements would be phased in. If Congress granted statehood to Puerto Rico, it could decide to establish a similar transition period. In turn, the characteristics and length of time of such a transition period could affect federal spending and revenue during—and beyond—that period. We provided draft sections of this report to the relevant federal program agencies, the Department of the Treasury, and IRS. We also shared a draft of the report with officials from the Government of Puerto Rico and the Resident Commissioner from Puerto Rico (Puerto Rico’s Congressionally-authorized representative in Washington, D.C.). In total, we sent draft report sections to 16 federal agencies.agencies had no comments on their draft report sections. Ten agencies provided technical comments, which we incorporated as appropriate. We also received technical and written comments from the Governor of Puerto Rico and the Resident Commissioner from Puerto Rico. Technical comments were incorporated as appropriate; the written comments are Six reproduced as appendix V (Governor) and appendix VI (Resident Commissioner) to this report. In his written comments, the Governor of Puerto Rico noted that if we had considered two factors omitted from our estimate of individual income tax revenue under statehood, estimated revenue would have been higher. First, the Governor noted that different federal filing thresholds and tax rates, compared to those for Puerto Rico, would have resulted in more individuals subject to tax and an increased amount of federal taxes paid by individuals. Our individual income tax revenue estimates take these differences into account, as they are based on the federal filing thresholds and federal tax rates. That is to say, we were able to determine which Puerto Rico residents who filed a Puerto Rico tax return for 2010 would have met federal filing thresholds and what tax rates would have applied to their taxable income, if at all. The Governor also noted that Puerto Rico does not tax Social Security benefits, which may be taxable at the federal level. In the individual income tax section of appendix III to this report, we note that because Social Security benefits are not included on Puerto Rico tax returns, our estimates do not take taxable Social Security benefits into account, and as a result our estimates could understate individual income tax revenue. In response to our estimate for corporate income tax revenue, the Governor noted that to counter the effect of increased taxes on Puerto Rico businesses upon the imposition of federal taxes, our draft report suggested that Puerto Rico would reduce its corporate tax rate to 3.8 percent to be on par with the average corporate tax rate in the states (state taxes are deductable against corporate income for federal tax purposes). He noted that this assumption is unrealistic given Puerto Rico’s current level of corporate tax rates and Puerto Rico’s current fiscal situation. We based our modeling of corporate income tax revenue under statehood on the assumption that Puerto Rico would lower its corporate tax rates to be more in line with those in the states. However, we used the average effective rate in the states, which is different than a simple Based on this comment, we conducted a sensitivity marginal rate.analysis to determine how our estimates would change if we assumed that the effective rate of Puerto Rico’s corporate income tax under statehood would have been twice as high as the average effective state rate (an effective rate of 7.6 percent). We found that the estimate ranges would not have changed substantially using this alternative assumption. Finally, the Governor noted that the characterization in the draft report of the percent of votes received by statehood in the 2012 plebiscite is inaccurate, and that the report should explain further the structure and outcomes of the plebiscite. In response to this comment, we provided additional detail on the number of voters and blank votes for both questions from the plebiscite. Assessing the structure of the plebiscite is outside the scope of this report. In his written comments, the Resident Commissioner for Puerto Rico summarized the central findings of the draft report. He also pointed out some of the uncertainties and limitations inherent in developing estimates for how federal spending and revenue would change if Puerto Rico became a state, which we recognize in the report. As agreed with your offices, unless you publicly announce the contents of this report earlier, we plan no further distribution until 30 days from the report date. At that time, we will send copies to the heads of the relevant agencies for the programs and revenue sources in this report, Puerto Rico’s governor, the Resident Commissioner for Puerto Rico, appropriate congressional committees, and other interested parties. In addition, the report will be available at no charge on the GAO website at http://www.gao.gov. If you or your staff members have any questions about this report, please contact me at (202) 512-6520 or at czerwinskis@gao.gov. Contact points for our Offices of Congressional Relations and Public Affairs may be found on the last page of this report. GAO staff who made key contributions to this report are listed in appendix VII. The objectives of this report are to evaluate (1) potential changes to selected federal programs and related changes in federal spending, and (2) potential changes in selected sources of federal revenue, should Puerto Rico become a state. We also describe factors under statehood that could influence changes in federal spending and revenue. To evaluate potential changes in selected federal programs under Puerto Rico statehood, we selected programs to review based on three criteria. Programs that generally provide funds directly to states and territories, or residents and institutions in the states and territories. Based on this criterion, we excluded certain types of federal spending from our review. Specifically, we excluded spending on the military;debt; and administrative, operational, procurement, or capital acquisition expenses at federal agencies, including federal employee salaries and retirement compensation. international aid and affairs; interest on the national Programs with net outlays of at least $5 billion. We used the Office of Management and Budget (OMB) public budget database from fiscal years 2010 and 2011 to select programs to review. We identified budget accounts with at least $5 billion, and then reviewed the programs within each account to identify those with outlays of at least $5 billion. We defined a program as an organized set of activities with the same objective(s) and funded by the federal government. We focused on programs that are expected to have an ongoing impact on the federal budget, meaning we did not consider temporary funding, such as that provided under the American Recovery and Reinvestment Act of 2009. To further support whether the programs met our selection criteria, we compared programs with total federal outlays of at least $5 billion (from the OMB database) to those described in the Catalog of Federal Domestic Assistance and the Appendix to the Budget of the U.S. Government. Through this process, we identified 27 programs to review. Programs for which federal spending in Puerto Rico differed significantly from spending in a set of comparable states. To identify programs with less than $5 billion in net outlays that may be subject to relatively large spending changes under statehood—such as those providing little or no funding to Puerto Rico—we reviewed federal program spending by state from the Census Bureau’s Consolidated Federal Funds Report for fiscal year 2010. We selected five states most similar to Puerto Rico in terms of population and median household income, and identified programs for which the difference in average federal spending between these states and Puerto Rico was at least $100 million. Through this process, we identified two additional programs to review: the Public Housing Operating Fund and the Public Housing Capital Fund. The 29 programs we selected to review accounted for about 86 percent of spending in fiscal year 2010 on federal programs that generally provide funds directly to states and territories, or to residents and institutions in the states and territories. We asked the 12 federal agencies that administer the 29 programs we selected to review our selection methodology and confirm that inclusion of each program was appropriate based on our criteria. The agencies provided additional information and documentation, when necessary. In one instance, a selected program comprised a subset of a larger budget account, and the agency overseeing the program was unable to provide a net outlay figure.programs, we report obligation amounts for the 29 programs we selected for our review, as obligation amounts were available for all selected programs (see figure 3 earlier in this report). To consistently report federal spending across For each selected program, we reviewed federal laws and regulations to determine whether and how statehood might affect funding or other requirements for Puerto Rico. We based our analyses on the assumption that, if it is granted statehood, eventually Puerto Rico would be treated the same as the states. For some programs, current law applies certain limitations or exceptions to Puerto Rico by name. For other programs, the governing statutes refer to the 50 states or the 50 states and the District of Columbia. For these programs, we assumed that, if Puerto Rico became a state, it would be treated the same as any existing state, either because Congress would amend the statutory limitations and exceptions or they would otherwise not apply. We did not evaluate whether Puerto Rico would be required to be treated the same as the states in the context of any specific program. We confirmed with the relevant agencies whether and how statehood would affect funding or other requirements for Puerto Rico. To evaluate potential changes in federal spending related to changes to federal programs, we evaluated the five largest programs that would be likely to change under statehood. We developed estimate ranges of the potential changes in federal spending for the four largest programs that would be likely to change under statehood: Medicare, Medicaid, the Supplemental Nutrition Assistance Program (SNAP), and Supplemental Security Income (SSI). The Federal Highway Administration developed an estimate on our behalf of potential changes in federal spending for the fifth largest program that would be likely to change under statehood— Federal-Aid Highways. We also developed an estimate of potential changes in spending for the ninth largest federal program that would be likely to change under statehood—the Children’s Health Insurance Program (CHIP)—because Puerto Rico receives federal CHIP funding as part of its Medicaid program. The programs for which we developed estimates accounted for about 94 percent of fiscal year 2010 spending on programs that would likely change under statehood. We developed estimate ranges for a single year in the past, as if Puerto Rico had been treated the same as the states in that year. The years of the estimate ranges vary by program and are based on the most recent relevant data when we began our work. For programs other than Federal-Aid Highways, the estimate ranges are in calendar-year terms because the eligibility and other data used to develop the estimates were in calendar- year terms. The estimate for Federal-Aid Highways is in fiscal-year terms. Actual spending in Puerto Rico, to which we compare the estimates, is in fiscal-year terms because the spending data were reported in fiscal-year terms. To estimate potential changes in federal spending for Medicaid, SNAP, SSI, and CHIP, we contracted with the Urban Institute to conduct portions of the work using two simulation models. We also used aspects of the Urban Institute’s simulations in estimating spending for Medicare. The estimates of potential spending changes involve various sources of uncertainty. Except for Federal-Aid Highways, the estimates are based, in part, on sample survey data, which include sampling error. Sample survey data are obtained by following a probability procedure based on the selection of random samples, and each sample is only one of a large number of samples that might have been selected. Since each sample could have provided different estimates, sampling error measures the level of confidence in the precision of a particular sample’s results, which we express as a margin of error at the 95-percent confidence interval. Unless otherwise indicated, the estimates included in this report that used sample survey data—plus or minus 7 percent, or less, of the estimates themselves—would contain the actual value for the populations we analyzed for 95 percent of the samples that could have been selected. There are other sources of uncertainty that are not readily quantifiable. These include the assumptions we used to develop the estimates, such as those for which program eligibility rules Puerto Rico would adopt, and the rates at which eligible Puerto Rico residents would participate in the programs. To some extent, the various scenarios for estimated spending included in this report capture how these assumptions would impact spending. In other instances, there may be sources of uncertainty and dynamic changes to the programs that we could not incorporate into our modeling. These could include further changes in eligibility rules once additional program funding becomes available, the reaction of program beneficiaries to changes in the programs, or congressional action resulting from statehood. To estimate potential changes in federal spending for Medicare for 2010, we estimated spending for the two options through which Medicare beneficiaries can obtain insurance coverage for hospital and medical services—Medicare fee-for-service (Medicare FFS) and Medicare Advantage (MA), the private plan alternative to Medicare FFS—as well as the optional prescription drug benefit. For Medicare FFS, we first calculated average spending for various demographic groups of Medicare beneficiaries in the states, using the Centers for Medicare & Medicaid Services’s (CMS) Medicare Current Beneficiary Survey (MCBS) Cost and Use file for 2010, the most recent available at the time we began our work.information on Medicare beneficiaries, matched to administrative data on actual spending. Using these data, we developed estimates for average Medicare FFS spending by categories of age, gender, disability status, and dual-eligible status—that is, beneficiaries eligible for both Medicare and Medicaid. For some groups of Medicare beneficiaries, the MCBS sample size allowed for finer age and gender group breakdowns; for others, we combined age and gender groups. To identify corresponding groups of Puerto Rico residents by age and gender, we used data from the Census Bureau’s Puerto Rico Community Survey (PRCS) three-year sample for 2009-2011: the years closest to the year of the MCBS data we used. We also used estimates of dual- eligible beneficiaries that the Urban Institute developed. We calculated the number of disabled but non-dual-eligible enrollees by subtracting the number of dual-eligible enrollees and the number of enrollees over age 65 from the total number of enrollees. We multiplied the average Medicare spending amounts from MCBS respondents in the states for each group or category to the corresponding Puerto Rico beneficiary count. To account for different health care costs in Puerto Rico relative to the states, we adjusted the wage indices used to calculate spending for Medicare FFS Part A and the Geographic Practice Cost Indices used to calculate spending for Medicare FFS Part B. We also made adjustments to account for the lower Medicare FFS Part B take-up rate and lower utilization rates in Puerto Rico relative to the states. For MA, we used data from the MCBS file to estimate the average cost for Puerto Rico MA enrollees. Because the benchmark underlying payments to MA plans in Puerto Rico is changing (regardless of whether Puerto Rico becomes a state) because of provisions in the Patient Protection and Affordable Care Act (PPACA), we modeled spending based on two benchmark scenarios: (1) the benchmark generally applicable for Puerto Rico for fiscal year 2014 (147.5 percent), and (2) the benchmark that generally will apply in 2017, when PPACA is fully phased- in (115 percent). Given that these changes in benchmarks could result in Puerto Rico MA enrollees switching to Medicare FFS, we developed estimates based on two MA enrollment scenarios: (1) the percentage of Puerto Rico Medicare beneficiaries enrolled in MA in 2010 (about 64 percent), and (2) the highest MA enrollment percentage in the states (about 42 percent). These changes are the only potential impacts of PPACA we incorporated into our estimates for Medicare. For a description of how PPACA could affect Medicare spending in Puerto Rico, see appendix IV. For the Medicare prescription drug benefit, we estimated the number of enrolled beneficiaries by applying the percentage of Puerto Rico beneficiaries who enroll in a benefit plan (77 percent) to our estimates of Puerto Rico Medicare beneficiaries. Our estimates of Puerto Rico Medicare beneficiaries include the estimates of dual-eligible beneficiaries that the Urban Institute developed. We assumed that there would be different costs per person depending on whether an enrolled beneficiary was a dual-eligible beneficiary, a disabled but non-dual eligible beneficiary, or any other beneficiary (essentially, all other enrolled beneficiaries age 65 or older). Using MCBS data, we estimated average prescription drug benefit costs for each of the three categories of beneficiaries and applied those costs to the number of beneficiaries in each category. We also assumed that the percentage of eligible Puerto Rico Medicare beneficiaries who would have enrolled in the low-income subsidy—which covers all, or a portion of, a beneficiary’s prescription drug benefit plan premiums, deductibles, copayments, and other out-of- pocket costs—would have been the same as that for all Medicare beneficiaries (about 77 percent). We assessed the reliability of the PRCS and MCBS data by performing appropriate electronic data checks, comparing MCBS data to administrative data, and by interviewing CMS officials who were knowledgeable about the data. We found the data were sufficiently reliable for the purposes of this report. To estimate potential changes in federal spending for Medicaid, SNAP, SSI, and CHIP, we contracted with the Urban Institute to conduct portions of the work using two simulation models: (1) the Health Policy Center’s American Community Survey Medicaid/CHIP Eligibility Simulation Model (HPC Medicaid/CHIP model), and (2) the Transfer Income Model, Version 3 (TRIM3), which simulates major federal tax and transfer programs, including SNAP, SSI, and Temporary Assistance for Needy Families (TANF). For this work, these models used 2011 PRCS data and other data sources to estimate the effect of program eligibility changes on the number of eligible and enrolled individuals for a select program and, in certain instances, they estimate the associated costs. We chose PRCS as a data source because of its large sample size and detailed information on the respondents’ demographics and participation in public assistance programs. 2011 was the most recent available year of PRCS data. We assessed the reliability of these data by reviewing available documentation and conducting reliability tests on the data that we used. We determined that the data were sufficiently reliable for the purposes of this report. We assessed the reliability of the Urban Institute’s modeling procedures by reviewing documentation on TRIM3 and the HPC Medicaid/CHIP model and input data sources, reviewing the Urban Institute's internal quality control procedures, and discussing the program rules and underlying assumptions used in the models with staff from the Urban Institute who were responsible for the work provided under our contract. Further, we evaluated the estimates on the basis of substantive significance (rather than statistical significance) by considering their size and the direction of the effect of changes to the programs under statehood. We determined that none of the modeling assumptions compromised the analysis for this report and that the data were sufficiently reliable for our purposes. Using the HPC Medicaid/CHIP model and TRIM3 to estimate spending changes for these programs required our input on assumptions, and about the rules governing federal programs. Therefore, the information presented in this report is attributable only to GAO. Specific steps taken to estimate spending for these programs appears below. To estimate federal Medicaid spending for 2011, the Urban Institute used the HPC Medicaid/CHIP model to estimate (1) the number of individuals who would have been eligible for Medicaid, and (2) the number of eligible individuals who would have enrolled in Medicaid. We then estimated (1) total (federal and Puerto Rico) Medicaid spending, and (2) the federal share of total Medicaid spending. We also estimated the extent to which Puerto Rico’s spending on Medicaid would change. The Urban Institute estimated eligibility based on our input for income eligibility assumptions. To determine the most appropriate income eligibility assumptions, we identified federal Medicaid mandatory categories of individuals for states and Puerto Rico’s 2011 Medicaid eligibility standards. We asked Puerto Rico officials for input on what optional Medicaid income eligibility standards might be selected under statehood. They told us that it would be difficult to determine what optional coverage groups would be selected, given the significant economic and budgetary restraints Puerto Rico currently faces, and uncertainty around the cost to Puerto Rico of expanding coverage. Ultimately, we chose to model two eligibility scenarios: Assuming Puerto Rico would have covered only mandatory categories of individuals. Under this scenario, Medicaid eligibility would have increased for some categories (such as pregnant women and as well as children). Optional categories (such as childless, non-elderly, non- disabled adults) would no longer be covered. This scenario represents the lower bound of potential federal Medicaid spending under statehood. Assuming Puerto Rico would have covered mandatory categories of individuals and expanded coverage levels for the optional categories it actually covered in 2011. For certain populations, such as pregnant women, infants, and children, Medicaid eligibility is based on a family’s income level as a proportion of a defined poverty level. Although Puerto Rico currently uses its own local poverty level (see the section on Medicaid in appendix II), we assumed that as a state, Puerto Rico would be required to adhere to the same federal poverty guidelines as the 48 contiguous states and the District of Columbia. We based this assumption, in part, on our general assumption that Puerto Rico would be treated in the same manner as the states, and on input from officials with the Department of Health and Human Services’ Office of the Assistant Secretary for Planning and Evaluation (ASPE). This office updates and publishes the annual federal poverty guidelines.participation in federal programs, such as SSI, for which Puerto Rico residents would become eligible under statehood. For other populations, eligibility is based on To estimate enrollments, we assumed that all actual Medicaid beneficiaries and individuals estimated to have received SSI and TANF benefits in 2011 would have enrolled. For all other eligible individuals, we decided to apply participation rates observed for actual Puerto Rico Medicaid and CHIP enrollees in the top decile of the distribution of income-to-poverty ratio by subgroup (i.e., a matrix of age group, insurance coverage, and disability status), based on the assumption that newly eligible individuals would be more similar to higher-income eligible individuals than to lower-income eligible individuals. The enrollment estimates are by geographic region in Puerto Rico. The Urban Institute also estimated the number of beneficiaries dually eligible for Medicare and Medicaid. To estimate total (federal and Puerto Rico) Medicaid spending, we applied annualized per member per month rates paid for different categories of enrolled individuals to estimated enrollments. The annualized per member per month rates we used were those paid by Puerto Rico to its managed care organization for Medicaid enrollees between October 2010 and June 2011 for physical and mental health services. These rates generally varied by geographical area and ranged from about $1,180 to $1,852. For dual-eligible beneficiaries enrolled in Puerto Rico’s Platino program—for whom the majority of health care costs are covered by Medicare—the rate was $120. According to CMS officials, the vast majority of beneficiaries enrolled in the Platino program are dual-eligible beneficiaries. Thus, we used the Urban Institute’s estimates for dual-eligible beneficiaries as a proxy for the number of Platino enrollees when applying per person costs. To estimate the federal share of total Medicaid spending, we applied a predicted Federal Medical Assistance Percentage (FMAP)—the statutory formula that determines the federal share of Medicaid funding provided to states and territories—to total Medicaid spending. For Puerto Rico, the predicted FMAP was 83 percent. We assumed that the statutory limit on federal Medicaid funding to Puerto Rico would have been removed. We also estimated Puerto Rico’s share of total Medicaid spending to show how it would change under statehood. We did not incorporate all aspects of the Medicaid program into our spending model, including the cost of the Medicaid Disproportionate Share Hospital (DSH) program or potential savings resulting from Puerto Rico’s participation in the Medicaid drug rebate program. We did not incorporate Puerto Rico’s Enhanced Allotment into our model, as it would be likely eliminated under statehood and replaced with the Medicare low-income subsidy for prescription drugs. To estimate federal SNAP spending for 2011, the Urban Institute used TRIM3 to estimate (1) the number of household units that would have been eligible for SNAP benefits, (2) the number of eligible household units that would have participated in SNAP, and (3) aggregate SNAP benefits for participating household units. The Urban Institute based its eligibility estimates on program eligibility rules in the states (SNAP is currently unavailable to Puerto Rico residents), including income and resource limits, and rules related to participation in other means-tested programs, such as SSI and TANF. The Urban Institute calculated net income by subtracting various deductions from a household unit’s gross income—such as those for earned income, dependent care expenses, medical care expenses, excess shelter costs, and a standard deduction. Where the rules for allowable deductions differ between (1) the 48 contiguous states and the District of Columbia and (2) other states and territories, the estimates use the rules applicable to the 48 contiguous states and the District of Columbia. The Urban Institute imputed household units’ resources by applying assumed annual rates of return on reported interest, dividends, and rent. To estimate the number of eligible household units that would have participated in SNAP, we directed the Urban Institute to model four different scenarios, based on the following assumptions on household unit definitions and participation rates. Everyone in a household would have filed for SNAP as a single unit, unless the household contained at least one person who received TANF. If the household contained a TANF recipient, it was divided into as many filing units as possible, subject to the requirements involving married couples and children. This household unit definition was modeled using (1) a national probabilities estimate of SNAP participation, resulting in a household participation rate of 75 percent, and (2) full participation, which occurs in some states. Assuming full participation, all related persons in a household would have filed for SNAP as a single unit. Unrelated individuals and subfamilies would have filed as separate units. Assuming full participation, with households that had more than one potential SNAP unit split into as many filing units as permitted. For all scenarios, household units that reported receiving benefits under Puerto Rico’s current federally-funded nutrition assistance program were assumed to have chosen to participate in SNAP if they had qualified. To estimate aggregate SNAP benefits for participating household units, each participating household unit’s benefit amount was determined by subtracting 30 percent of the household unit’s net income from the maximum SNAP allotment for household unit size, using the maximum SNAP allotments for the 48 contiguous states and the District of Columbia. This reduction from the maximum SNAP allotments is made because households are expected to spend 30 percent of their resources on food. We also determined the impact on SNAP benefits of replacing the Aid to the Aged, Blind, and Disabled (AABD) program with the higher- benefit SSI program, since an increase in cash aid could lower a person’s SNAP benefits. To estimate federal SSI spending for 2011, the Urban Institute used TRIM3 to estimate (1) the number of individuals who would have been eligible for SSI benefits, (2) the number of eligible individuals who would have participated in SSI, and (3) aggregate SSI benefits for participating individuals. The Urban Institute based its eligibility estimates on program eligibility rules for individuals’ age, blindness, or disability status, and income and resource limits. To qualify for benefits based on age, an individual must be at least 65 years old. Adults younger than 65 can qualify for benefits based on blindness or a permanent disability that prevents work; children can qualify based on a disability with conditions that severely limit their activities. To determine disability status, doctors examine prospective adult and child beneficiaries. Because the PRCS data do not precisely capture the same criteria that are assessed by doctors, assumptions were required to estimate potential SSI eligibility among the non-elderly. TRIM3 designated an adult as blind or disabled where the survey responses showed (1) that the adult did not work in the prior year or earned income less than the substantial gainful activity limit, and (2) at least one of the following was true: The adult indicated having a physical, remembering, or vision limitation. The adult was between 22 and 61 years old, not a widow, and reported Social Security income. TRIM3 treated children ages 15 and older as adults for the disability eligibility determination since children are asked the same survey questions asked of adults. TRIM3 identified children younger than 15 as potentially disabled if they reported a remembering or vision disability. The model was not used to estimate the number of children younger than age 5 who were potentially disabled, because the remembering limitation question is not asked of them. Instead a sufficient number of children under age 5 were included so that the portion of the total children’s caseload that is under age 5 is the same as in the states. Regardless of age or disability status, individuals must have limited assets and income to be eligible for SSI benefits. TRIM3 imposed the eligibility asset test of $2,000 for a unit with one eligible person and $3,000 for an eligible couple. Asset values were inferred from the level of reported asset-based income (interest, dividend, and rental income). Adults may qualify either individually or as couples. The simulation model found that 81 percent of eligible adults were either unmarried or married to an ineligible individual. To estimate the number of eligible individuals who would have participated in SSI, we present two scenarios—with participation rates that varied by age group and disability status—assuming that eligible individuals would participate based on (1) national average participation rates, and (2) the average of participation rates for the five states with the highest three-year average poverty rate for 2009 to 2011. For children younger than 5, the data were not sufficient to estimate a participation rate; instead, a sufficient number of children younger than 5 were included so that their share of all eligible children was the same as in the states. Individuals in the simulation determined to be participating in AABD, which SSI would replace, were included as participating in SSI. To estimate aggregate benefits, we used participant benefits following the SSI program rules. To determine the actual benefit, the maximum SSI benefits (in 2011, $674 for individuals and $1,011 for couples) were reduced, based on countable income. In determining countable income, SSI program rules disregard the first $20 of most income per month, plus the first $65 of earned income and 50 percent of any additional earned income. One-third of child support is also disregarded. For an individual with a spouse who is not potentially eligible for SSI, the amount of the spouse’s income to be deemed available is determined. For children, some income is deemed from their parents. To estimate federal CHIP spending for 2011, the Urban Institute used the HPC Medicaid/CHIP model to estimate (1) the number of individuals who would have been eligible for CHIP, and (2) the number of eligible individuals who would have enrolled in CHIP. We then estimated total (federal and Puerto Rico) CHIP spending. The Urban Institute estimated eligibility based on our input on eligibility rule assumptions. To qualify for federal CHIP funding, states’ CHIP cannot cover children who are eligible for Medicaid. In 2011, states were required to provide Medicaid coverage to children with family incomes up to 100 percent and 133 percent of the federal poverty level (FPL), depending on a child’s age. States have discretion in setting CHIP eligibility standards. Forty-five states and the District of Columbia covered children between 200 percent and 300 percent of the FPL in 2011. Given required increases to Medicaid income eligibility limits under statehood, Puerto Rico residents enrolled in CHIP in 2011 would have qualified for Medicaid, but not for CHIP. To draw down federal CHIP funding, Puerto Rico would have needed to raise its CHIP income eligibility standards. When asked what income eligibility rules might be adopted under statehood, officials from Puerto Rico’s Department of Health responded that it would be difficult for Puerto Rico to determine what income eligibility rules would be adopted. Ultimately, we chose to model three eligibility scenarios. Assuming Puerto Rico had opted to cover children up to 300 percent of the FPL. Assuming Puerto Rico had opted to cover children up to 200 percent of the FPL. Assuming Puerto Rico had opted to discontinue its version of CHIP. To estimate enrollments, we followed a process similar to that for Medicaid. We assumed that all actual CHIP beneficiaries and individuals estimated to have received SSI and TANF benefits in 2011 would have enrolled. As previously described for Medicaid, for all other eligible individuals, we decided to apply participation rates observed for actual Puerto Rico Medicaid and CHIP enrollees in the top decile of the distribution of income-to-poverty ratio by subgroup (i.e., a matrix of age group, insurance coverage, and disability status), based on the assumption that newly eligible individuals would be more similar to higher-income eligible individuals than to lower-income eligible individuals. The enrollment estimates are by geographic region in Puerto Rico. To estimate total (federal and Puerto Rico) CHIP spending, we applied annualized per member per month rates paid for different categories of enrolled individuals to estimated enrollments. The annualized per member per month rates are the same as for Medicaid. To estimate the federal share of total CHIP spending, we applied a predicted enhanced federal medical assistance percentage (enhanced FMAP) to total CHIP spending. The enhanced FMAP is the statutory formula that determines the federal share of CHIP funding provided to states and territories. For Puerto Rico, the predicted enhanced FMAP was 85 percent. We also estimated Puerto Rico’s share of total CHIP spending to show how it would change under statehood. To estimate federal spending on Federal-Aid Highways for fiscal year 2013, we obtained estimates from the Federal Highway Administration (FHWA) on (1) Puerto Rico highway users’ expected contribution to the Highway Account of the Highway Trust Fund (the Fund), and (2) Puerto Rico’s expected apportionment—a division of authorized highway funding according to statutory formulas. Using these estimates, we determined Puerto Rico’s net deficit for Federal-Aid Highways. To estimate Puerto Rico highway user’s expected contribution to the Fund for fiscal year 2013, FWHA multiplied Puerto Rico’s reported number of gallons of motor fuel consumed on highways for fiscal year 2011 by the applicable federal tax rate. We confirmed that FHWA calculated Puerto Rico highway user’s expected contribution to the Fund with the same process it used for highway users in the states. We did not independently review FHWA’s process for estimating state users’ contributions into the Fund. However, we reviewed the process in the past, and FHWA made changes to the process as a result of that review. Regarding the motor fuel data collected by Puerto Rico, FHWA officials were unaware of any specific limitations to the data. To estimate Puerto Rico’s apportionment, FHWA officials ran Puerto Rico data through a series of formulas on our behalf. Under legislation passed in July 2012, apportionments for the states in fiscal year 2013 are virtually the same as apportionments for fiscal year 2012, which, in turn, were based on apportionments for fiscal years 2009 and 2011.apportionment for fiscal year 2009 was calculated using a series of 13 statutory formulas linked to sub-programs. The formulas rely on data elements—referred to as factors—such as total lane miles eligible for Federal-Aid Highways, and vehicle miles traveled on open Interstates. Some factors were unavailable for Puerto Rico and were entered as zero in the calculations. According to FHWA officials, the unavailable data had no effect on the estimated apportionment because of Equity Bonus computations. The Equity Bonus, in effect for fiscal year 2009, guaranteed that each state received at least a share of combined apportionments and High Priority Projects equal to 92 percent of contributions from highway users from that state to the Highway Account of the Fund. Similarly, as stated in prior work, the underlying data and factors are ultimately not meaningful for determining apportionments because they are overridden by other provisions that yield a predetermined outcome—in particular, the Equity Bonus under prior legislation. The estimated Puerto Rico apportionment for fiscal year 2009 was adjusted to meet the 92 percent Equity Bonus minimum relative rate of return. Given the overriding effect of Equity Bonus on the estimated Puerto Rico fiscal year 2009 apportionment—and, consequently, the fiscal year 2013 estimated apportionment—we did not verify the reliability of the Puerto Rico data that fed into the apportionment calculations. Additionally, we did not verify that the formulas FHWA used were consistent with the relevant statutes. However, we confirmed that FHWA used the same formulas and process for calculating state apportionments as were used for fiscal year 2009, which, by law, is the basis for fiscal year 2013 apportionments. To evaluate potential changes to selected sources of federal revenue under Puerto Rico statehood, we reviewed federal laws and regulations related to the main sources of federal revenue in 2012—individual income tax (which accounted for 46.2 percent of federal revenue in 2012), employment tax (34.5 percent), corporate income tax (9.9 percent), excise tax (3.2 percent), customs duties (1.2 percent), and estate and gift taxes (0.6 percent). We also estimated potential changes in revenue for individual and corporate income taxes—the two largest revenue sources that would be affected substantially by statehood. As with our estimates of potential changes in federal spending, our estimates of potential changes in federal revenue involve uncertainty. To some extent, the various scenarios for estimates revenue capture how these assumptions would impact revenue. However, there may be sources of uncertainty and dynamic changes in economic activity that would affect revenue that we could not incorporate into our modeling. To estimate potential changes to individual income tax, we obtained data for all individuals who filed a Puerto Rico individual income tax return for tax year 2010, the most recent complete year of tax return data available when we began our work. We obtained these data from Puerto Rico’s Department of Internal Revenue. The 2010 Puerto Rico individual income tax return generally includes information comparable to the federal individual income tax return. However, it does not include some items that are included on the federal return, and Puerto Rico law defines certain items differently. According to Puerto Rico officials, variations between the two returns include the following: Puerto Rico does not tax income from Social Security benefits or unemployment compensation. Thus, these items are not included on the Puerto Rico return. Under statehood, these forms of income would be subject to federal income tax. Because we excluded these items, our estimates of aggregate individual income tax revenue under statehood could be understated. Winnings from the Lottery of Puerto Rico and racetracks are exempt from Puerto Rico income tax. Under statehood, this income would be subject to federal income tax. Excluding these items could have resulted in understated estimates. Some federal income tax deductions—such as for taxpayers and their spouses who are blind—and some tax credits (such as for qualified expenses paid to adopt an eligible child) have no equivalent under Puerto Rico income tax law and therefore are not reported on Puerto Rico returns. Excluding these items could have result in overstated estimates. Puerto Rico defines short-term capital gains as those from the sale or exchange of capital assets held for 6 months or less. In comparison, federal tax law defines short-term capital gains as those from capital assets held for one year or less. Under the federal income tax, short- term gains are taxed as ordinary income, at rates that may be higher than those at which long-term gains are taxed for some taxpayers. Because we used capital gain information as reported on the Puerto Rico returns, our estimates may be understated. The Puerto Rico tax return does not distinguish between qualified and ordinary dividends. Qualified dividends generally are subject to a lower federal income tax rate than are ordinary dividends. For our estimate, we assumed that Puerto Rico qualified dividends would have comprised the same percentage of total dividends (74 percent) as for dividends reported on federal income tax returns in 2010. The federal tax system generally allows taxpayers to carry back and carry forward net operating losses for 2 and 20 years, respectively; in contrast, Puerto Rico only allows net operating losses to be carried forward for 10 years. Consequently Puerto Rico filers might have been able to reduce their federal tax liabilities to a greater extent than observed on the Puerto Rico tax returns we used. We used the National Bureau of Economic Research’s TAXSIM program—which models U.S. federal and state income tax systems—to estimate the aggregate federal income tax liability for 2010, as if each Puerto Rico individual income tax filer had filed a U.S. individual tax return per U.S. tax law as of January 2, 2013.payments in excess of tax liability for the three largest refundable tax credits: the American Opportunity Tax Credit (AOTC), child tax credit We also estimated (CTC), and earned income tax credit (EITC).accounted for 94 percent of obligations from refundable credits in fiscal year 2012. In addition to the variations between Puerto Rico and federal tax returns as described above, the estimates are based on the following assumptions: Puerto Rico filers would not have changed their behavior related to work, investment, or income reporting as a result of the imposition of federal tax requirements. All filers who would have been eligible for the refundable credits would have claimed them. Puerto Rico residents’ compliance with tax laws would have remained constant under statehood. Different assumptions would have resulted in different estimates. For example, some Puerto Rico residents who decided not to file a Puerto Rico return might have filed a federal return in order to receive payment from one or more of the refundable tax credits, had they been eligible. In addition, the Joint Committee on Taxation has noted that taxpayer compliance would likely increase under statehood because the federal Internal Revenue Service (IRS) has relatively more resources to enforce tax laws than does Puerto Rico’s Department of Internal Revenue. Under statehood, Puerto Rico filers may report their income at higher levels of compliance as a result. We also developed an assumption to account for the possibility that Puerto Rico could change its own local income tax rates under statehood. Puerto Rico’s local income tax rates would be relatively high compared to those of the states. For example, the highest marginal tax rate in Puerto Rico for 2010 was 33 percent. In comparison, the 2010 highest marginal tax rate in the states was 11 percent (Hawaii and Oregon). How Puerto Rico’s government would respond to the imposition of federal income taxes is unknown. However, one possibility is that it would reduce its income tax rates to be more in line with those from other states. Puerto Rico’s equivalent of a state income tax rate is relevant to estimates of aggregate tax liability and refundable credit payments because some filers would be able to deduct state and local taxes paid on their federal returns. Accordingly, we developed an alternate scenario for estimating aggregate tax liability and refundable credit payments based on Puerto Rico reducing its income tax rates. Under this alternative scenario, we imputed amounts for the deduction for state and local taxes paid (using reported data from IRS’s Statistics of Income program for 2010) based on the national average deduction as a percentage of adjusted gross income (3.3 percent). To determine the amount of federal income tax that Puerto Rico residents actually paid for 2010, we used data reported on Puerto Rico tax returns. We used these data because, although IRS publishes data on taxes collected by state (and for Puerto Rico) the amounts for individual and employment taxes are combined. According to IRS officials, the agency cannot separate the amounts for these two types of taxes at the state level. Instead, we used information reported on the Puerto Rico tax returns as a proxy for the amount of federal income tax paid. Puerto Rico allows a credit for taxes paid to the United States, its possessions, and foreign countries. According to officials from Puerto Rico’s Department of Internal Revenue, most of these taxes would have been paid to the United States. As a result, we used the aggregate tax amount that taxpayers reported in calculating the credit as the upper bound of federal income tax that would have been paid for 2010. To estimate potential changes to corporate income tax revenue, we obtained data on net operating income or losses, losses carried forward from prior years, and credits for taxes paid to the United States for every entity that filed a business income tax return for tax year 2009, the most recent complete year of tax return data available when we began our work. We obtained these data from Puerto Rico’s Department of Internal Revenue. We focused on these items because they are the best available proxies for the income and losses that would be taxed under the federal corporate income tax if Puerto Rico were to become a state. Net operating income or losses reported on Puerto Rico tax returns are computed in a manner broadly similar to how they are computed on federal returns (although the manner in which that income is taxed, if at all, can differ). We divided the Puerto Rico business entities into three categories based on the type of tax returns they filed. Regular corporations, which filed the standard corporate income tax return. Regular partnerships, which (in 2009) were subject to an entity-level income tax and filed returns largely identical to the regular corporate income tax return. Exempt businesses, which had been granted partial or full exemptions of their business income under one of Puerto Rico’s tax incentive laws, and filed special tax returns. Within the Puerto Rico tax return data, we could not always determine whether the filing entities were (1) branches of other corporations, (2) subsidiaries of other corporations, or (3) separate Puerto Rico entities. Likewise, officials from Puerto Rico’s Department of Internal Revenue told us that the data would not provide sufficient or reliable information on the country of incorporation for any of the filing businesses or for their parent corporations. Consequently, we made a range of assumptions regarding the percentage of the filing entities’ income attributable to either (1) branches or subsidiaries that would have been included in the consolidated federal corporate income tax return of a U.S. corporation, or (2) corporations that would have been taxed as separate entities under statehood. These distinctions mattered in terms of which tax rates we applied when making our estimates and how we treated accumulated losses. In addition, we did not have data for the amount of state and local income taxes that the filing entities would have paid in Puerto Rico if it had been a state. As a result, we needed to estimate these amounts, because they represent an important deduction under the federal corporate income tax. As with the individual income tax, Puerto Rico’s corporate income tax rates are relatively high compared to those in the states. For example, Puerto Rico’s highest marginal tax rate in 2010 for regular corporations was 19 percent; the highest corporate tax rate in the states in 2010 was 12 percent (Iowa). How Puerto Rico’s government would respond to the imposition of federal corporate income tax is unknown; however, if Puerto Rico were placed in the same fiscal relationship to the federal government as the 50 states, it might reduce its rates to be more in line with those from other states. Consequently, we assumed that under statehood, the effective rate of Puerto Rico’s income tax would be similar to the average effective rate for income taxes levied in the states (the rate for profitable corporations was 3.8 percent of net income; for corporations with losses it was -1.0 percent).estimate this average rate for the states. We used data compiled by IRS to We also needed to make assumptions regarding which federal tax rates would have applied to these entities’ net income under statehood. In the case of corporations taxed as separate entities, we assumed an effective tax rate falling within a broad range (from 15 percent to 35 percent) around the average effective tax rate that U.S. corporations paid for tax year 2009. We used this range to reflect the possibility that the tax attributes of the typical corporation operating in Puerto Rico could have differed from those of the typical U.S. corporation. On the advice of tax experts from the Joint Committee on Taxation, we used a different approach to determine tax rates for entities included in the consolidated returns of controlled groups of U.S. corporations. For these corporations, the applicable rate of tax depended not only on the Puerto Rico entities’ net income, but also on the income and losses of other group members, and on the credits earned by the group as a whole. For these entities, we applied the marginal federal tax rate for the consolidated group to the net income (or losses) that the Puerto Rico entity would have added to the group’s tax return. For entities in the financial services and social services industries, we applied the full 35 percent corporate marginal tax rate based on the assumption that these entities would not have qualified for the domestic production activities deduction. For all other corporations, we reduced the marginal rate to 31.85 percent to reflect the effect of this deduction. We estimated tax liabilities both before and after applying prior-year losses to offset income from 2009. We did so because the initial effect that these prior-year losses would have had on tax revenue may not have been representative of their effects over a longer time period. In the first year of statehood, when Puerto Rico subsidiaries of U.S. corporations first become subject to federal tax and are consolidated into their parent corporations’ tax returns, large portions of their losses could be used to offset the taxable income reported on those returns, leaving only smaller amounts (or newly generated losses) available to offset income in subsequent years. We also made assumptions to account for the potential relocation, under statehood, of businesses with activities in Puerto Rico. Tax experts at the U.S. Department of the Treasury and the Joint Committee on Taxation suggested that the changes in tax treatment that would occur under statehood likely would motivate some businesses to move their operations from Puerto Rico to lower-tax foreign locations—particularly those with substantial amounts of income derived from intangible (and therefore mobile) assets. For 2009, exempt corporations in the pharmaceutical and the medical equipment and supplies industries accounted for over 70 percent of the net income (and about 20 percent of accumulated losses) of the full population of exempt corporations. In addition, other industries with potential income from intangible assets accounted for significant shares of total net income. Using the other assumptions described above, we produced an alternative set of estimates to account for the potential relocation, under statehood, of businesses with activities in Puerto Rico. The first set of estimates assumes that all filing businesses would have maintained their activities in Puerto Rico. The second set of estimates assumes that (1) all filing businesses in the pharmaceuticals and the medical equipment and supplies industries would have relocated away from Puerto Rico, and (2) other filing business would have maintained their activities in Puerto Rico. To determine the amount of federal corporate income tax that entities with activities in Puerto Rico actually paid in 2009, we used data that U.S. corporations reported to IRS on Form 1118 on income they received in 2009 from their Puerto Rico branches or subsidiaries. To estimate the amount of tax that would have been paid, we applied a tax rate of 31.85 percent (the 35 percent corporate tax rate reduced to account for the domestic production activities deduction) to the remaining income. Separately, published IRS data show that the agency collected about $145 million (net of refunds) in business income taxes from entities in Puerto Rico in fiscal year 2009. However, this amount included taxes collected from any tax year, and we could not determine whether any of the amounts collected overlapped with amounts we estimated based on Form 1118 (any taxes paid by businesses incorporated in Puerto Rico on their U.S.-source income would not overlap with those amounts). Consequently, we did not include any of the $145 million in our estimate of the amount paid in corporate income tax by entities with activities in Puerto Rico. We took several steps to assess the reliability of the Puerto Rico tax return data we used for our individual and corporate income tax estimates. For example, to identify possible outliers that could reflect data errors, we checked maximum and minimum amounts reported for each tax return line item we used. We also discussed the data with officials from Puerto Rico’s Department of Internal Revenue, and, in some cases, adjusted the data to address errors and inconsistencies. Based on our assessment, we determined that the data were sufficiently reliable for our purposes. We also discussed our methodology for estimating tax revenue with tax experts from the Department of the Treasury and the Joint Committee on Taxation, who generally agreed with our estimation approaches. To identify factors under statehood that could influence changes in federal spending and revenues, we reviewed economic data from the Puerto Rico government and reports on the Puerto Rico economy, such as those from the Federal Reserve Bank of New York and the Congressional Budget Office. We also interviewed officials from the current and past Puerto Rico government administrations and Puerto Rico business associations representing large economic sectors in Puerto Rico to obtain their views on the potential impacts of statehood on Puerto Rico’s economy and public finances. We conducted this performance audit from June 2012 to March 2014 in accordance with generally accepted government auditing standards. Those standards require that we plan and perform the audit to obtain sufficient, appropriate evidence to provide a reasonable basis for our findings and conclusions based on our audit objectives. We believe that the evidence obtained provides a reasonable basis for our findings and conclusions based on our audit objectives. The Patient Protection and Affordable Care Act (PPACA), enacted in March 2010, makes substantial changes to Medicare and Medicaid, as well as other components of the federal budget. There are significant uncertainties surrounding the effects of PPACA on health care spending and on other factors that influence future health care costs more generally—such as how the development and deployment of medical technology, future policy decisions, and cost and availability of insurance affect growth in per-capita health care spending. These factors could influence our estimates of federal spending for Medicare, Medicaid, and the State Children’s Health Insurance Program (CHIP) under Puerto Rico statehood. Below we summarize selected PPACA provisions that may affect federal Medicare, Medicaid, and CHIP spending in Puerto Rico. PPACA is projected to decrease direct Medicare spending by almost $400 billion from fiscal years 2010 to 2019, according to the Congressional Budget Office (CBO). The following table summarizes selected PPACA provisions that have affected, or could potentially affect, federal Medicare spending in Puerto Rico. The Patient Protection and Affordable Care Act (PPACA), enacted in March 2010,makes substantial changes to Medicare and Medicaid, as well as other components of the federal budget. There are significant uncertainties surrounding the effects of PPACA on health care spending and on other factors that influence future health care costs more generally—such as how the development and deployment of medical technology, future policy decisions, and cost and availability of insurance affect growth in per-capita health care spending. These factors could influence our estimates of federal spending for Medicare, Medicaid, and the State Children’s Health Insurance Program (CHIP) under Puerto Rico statehood. Below we summarize selected PPACA provisions that may affect federal Medicare, Medicaid, and CHIP spending in Puerto Rico. PPACA is projected to decrease direct Medicare spending by almost $400 billion from fiscal years 2010 to 2019, according to the Congressional Budget Office (CBO). The following table summarizes selected PPACA provisions that have affected, or could potentially affect, federal Medicare spending in Puerto Rico. PPACA provisions (legal citation) Medicare Advantage (Medicare Part C) Changes benchmarks underlying payments to Medicare Advantage (MA) plans to align more closely with Medicare FFS spending. The new benchmarks will be phased in from 2012 to 2017 and blended with old benchmarks. In 2017, county benchmarks will be one of four values: 95 percent, 100 percent, 107.5 percent or 115 percent of Medicare FFS spending. Benchmarks could be increased for certain plans if they are new, demonstrate indicators of plan quality, or have low enrollment. PPACA, § 3201 (as amended by HCERA, § 1102) (codified at, 42 U.S.C. § 1395w-23(n)). Phased-in from 2012 to 2017. This provision is estimated to reduce payments to MA plans by about $136 billion from fiscal years 2010 to 2019. These reductions could result in reduced benefits and enrollments. When fully phased in 2017, benchmarks for Puerto Rico generally will be 115 percent of Medicare FFS spending plus any quality bonus payments. In the long term, the reduction will result in plans receiving lower payments. Given the high enrollment in MA in Puerto Rico, these changes could significantly affect Medicare spending. Medicare prescription drug benefit (Medicare Part D) Higher premiums will be charged for beneficiaries who exceed certain income thresholds. PPACA, § 3308 (codified at 42 U.S.C. § 1395w-113(a)(7)). January 1, 2011. This provision is estimated to provide an additional $10.7 billion in Medicare funding from fiscal years 2010 to 2019. Although Puerto Rico could benefit from additional funding, relatively few Puerto Rico Medicare beneficiaries may end up paying the higher premiums given relatively low incomes in Puerto Rico. This provision would not be affected by statehood. PPACA provisions (legal citation) Discounts and additional subsidies must be provided to Part D beneficiaries who purchased covered drugs during the coverage gap, or “donut hole.” would not benefit from this provision, as they already receive assistance with costs in the coverage gap. In addition, one-time payments of $250 were provided to certain individuals who incurred costs for covered Part D drugs exceeding the coverage limit in 2010. PPACA, §§ 3301, 3315 (as amended by HCERA, § 1101) (codified at, 42 U.S.C. §§ 1395w-152(c), 1395w–153, 1395w–114a). Potential effects on spending This provision is expected to increase Medicare spending by $42.6 billion from fiscal years 2010 to 2019. As of March 2013, Part D beneficiaries in Puerto Rico have saved $143 million under this provision, according to CMS.This provision would not be affected by statehood. Unless otherwise noted, projections are from: Congressional Budget Office, H.R. 4872, Reconciliation Act of 2010-- Final Health Care Legislation, (Washington, D.C.: Mar. 20, 2010). The donut hole refers to the point when standard Part D plans provide coverage for costs over $2,970, until out-of-pocket costs reach $4,750 (for 2013), when the plan covers most costs. CBO estimated that PPACA will increase federal spending on Medicaid The following and CHIP by $642 billion over fiscal years 2012 to 2022.table summarizes selected PPACA provisions that have affected, or could potentially affect, federal Medicaid and CHIP spending in Puerto Rico. PPACA provisions (legal citation) Provides that Medicaid payments to primary care physicians for services provided in 2013 and 2014 will not be less than the greater of the Medicare rates in those years or the payments rates that would be applicable in those years using the 2009 Medicare physician fee schedule conversion factor. The federal government must provide a 100 percent match for any increased payments. The territories, however, are not required to provide these increased payments to primary care physicians, nor are they eligible for this enhanced federal match. HCERA § 1202 (codified at 42 U.S.C. §§ 1396a(a)(13)(C), 1396d(dd), 1396u-2(f)). Medicaid DSH payments will be reduced under a specified methodology for 2014 through 2020. PPACA, §§ 2551, 10201(e)(1)(B) (as amended by HCERA, § 1203) (codified at 42 U.S.C. § 1396r-4(f)(7)). Effective date January 1, 2013. This provision is expected to increase federal Medicaid spending by $8.3 billion. Puerto Rico is not eligible for this enhanced federal match. Under statehood Puerto Rico would be required to make these increased payments to primary care physicians and would receive an enhanced match for qualified payments, increasing federal and Puerto Rico Medicaid spending. October 1, 2013. This provision is expected to result in $14.1 billion in savings to the federal government from fiscal years 2014 to 2019. Since Puerto Rico does not qualify for a DSH allotment as a territory, there is no direct effect from this provision on actual federal spending in Puerto Rico. Under statehood, Puerto Rico would become eligible for a DSH allotment; however, according to CMS officials, the methodology for calculating that allotment is unclear because a state’s allotment is based on its prior year allotment. Beginning October 1, 2015, the enhanced FMAP for CHIP will increase by 23 percentage points, not to exceed 100 percent, which will continue until September 30, 2019. PPACA, §§ 2101(a), 10203(c)(1) (codified at 42 U.S.C. § 1397ee(b)). October 1, 2015. Under statehood, the increased enhanced FMAP may impact the level of CHIP coverage that Puerto Rico would select. Unless otherwise noted, projections are from Congressional Budget Office, H.R. 4872, Reconciliation Act of 2010 (Final Health Care Legislation) (Washington, D.C.: Mar. 20, 2010). The Bipartisan Budget Act of 2013 amended the reduction of Medicaid DSH payments. Specifically, it delayed the reductions for two years until October 1, 2015 and doubled the reduction that otherwise would have applied in that year. Additionally, it added another special rule for calculating Medicaid DSH allotments in 2023. Pub. L. No. 113-67, § 1204, 127 Stat. 1165, 1199. In addition to the individual named above, key contributors to this report were Jeff Arkin, Assistant Director; Susan T. Anthony; Benjamin Bolitzer; Gerardine Brennan; Christine Brudevold; Virginia (Jenny) Chanley; Steve Cohen; James C. Cosgrove; Kevin Daly; Bertha Dong; Deirdre Duffy; Elizabeth Fan; Ellen Grady; Shirley Jones; Michael Kendix; Kathleen M. King; Laurie King; Hayley Landes; Kathryn Larin; Dan Meyer; Donna Miller; John Mingus; Meredith Trauner Moles; Ruben Montes de Oca; Edward Nannenhorn; Jeffrey Niblack; Keith O’Brien; Rhiannon Patterson; Amy Radovich; Robert Robinson; Erin Saunders Rath; Cherié Starck; Andrew J. Stephens; Lindsay Swenson; Hemi Tewarson; Daniel Webb; Monique B. Williams; James Wozny; Robert Yetvin; and Carolyn L. Yocom.

Summary: Puerto Rico has access to many federal programs, and is subject to certain federal tax laws; however, for some programs and for some aspects of tax law, Puerto Rico is treated differently than the states. Options for Puerto Rico's political status include statehood. GAO was asked to review potential fiscal implications for federal programs if Puerto Rico were to become a state. This report examines potential changes to selected federal programs and related spending changes, and changes to selected federal revenue sources that would be expected should Puerto Rico become a state. This report also discusses economic and fiscal factors under statehood that could influence changes in spending and revenues. To evaluate potential changes to selected federal programs and revenue sources, GAO reviewed federal laws and regulations and interviewed federal and Puerto Rico agency officials. To discuss factors that could influence changes in spending and revenue, GAO reviewed economic data from Puerto Rico's government and interviewed officials from the current and past Puerto Rico government administrations. Of the 29 federal programs GAO reviewed (which accounted for about 86 percent of federal program spending for states or their residents in fiscal year 2010), statehood would likely affect 11 programs. For 3 other programs, while the programs themselves would likely not change under statehood, eligibility determinations for these programs could be affected indirectly by changes that could occur to benefits in other programs. Statehood would not likely affect the 15 remaining programs. See figure below. The extent to which federal spending would change for some of the programs affected by Puerto Rico statehood depends on various assumptions: these assumptions include the program eligibility options Puerto Rico might select or the rates at which eligible residents might participate in the programs. For example, for the four largest programs for which federal spending likely would change under statehood—Medicare, Medicaid, the Supplemental Nutrition Assistance Program (SNAP), and Supplemental Security Income (SSI)—GAO used various assumptions to estimate the range of potential effects on federal program spending. The estimated ranges for the four programs, as described below, are based on Puerto Rico being treated the same as the states in either 2010 or 2011, based on the year for which GAO had the most recent data. Medicare: In fiscal year 2010, actual federal Medicare spending in Puerto Rico was $4.5 billion; if Puerto Rico had been a state in calendar year 2010, estimated federal spending would have ranged from $4.5 billion to $6.0 billion. The Medicare estimates take into account certain changes under the Patient Protection and Affordable Care Act occurring after 2010 that would reduce spending. Also, the Medicare estimates depend on the estimates for Medicaid, as some individuals are eligible for both programs. Medicaid: In fiscal year 2011, actual federal Medicaid spending in Puerto Rico was $685 million; if Puerto Rico had been a state in calendar year 2011, estimated federal spending would have ranged from $1.1 billion to $2.1 billion. The Medicaid estimates do not take into account the cost of nursing home and home health services in Puerto Rico due to the lack of available cost data, and because Puerto Rico lacks an infrastructure of nursing home facilities, according to Centers for Medicare & Medicaid Services officials. If these services became available, Medicaid spending would likely increase. SNAP: In fiscal year 2011, actual federal spending for a similar program in Puerto Rico was $1.9 billion; if Puerto Rico had been a state in calendar year 2011, residents would have been eligible for SNAP, and estimated federal spending would have ranged from $1.7 billion to $2.6 billion. One reason why the low end of the estimate range is less than actual spending is because participants' benefits would be reduced because of benefits received from SSI, for which Puerto Rico residents would newly qualify. SSI: In fiscal year 2011, actual federal spending for a similar program in Puerto Rico was $24 million; if Puerto Rico had been a state in calendar year 2011, residents would have been eligible for SSI, and estimated federal spending would have ranged from $1.5 billion to $1.8 billion. All the federal revenue sources GAO reviewed—individual and corporate income taxes, employment tax, excise tax, estate and gift taxes, and customs duties—could be affected if Puerto Rico became a state. For example, under statehood, Puerto Rico residents would be subject to federal tax on all their income: currently, they are subject to federal tax only on income from sources outside of Puerto Rico. Also, some sources of income, such as pension income, are taxed differently in Puerto Rico than in the states. As a result, for 2010, Puerto Rico filers' adjusted gross income for federal tax purposes would have been higher than that for Puerto Rico tax purposes. For some revenue sources, the extent to which federal revenue would change depends on various assumptions. For example, for the two largest revenue sources that would be affected substantially by statehood—individual and corporate income taxes—GAO used various assumptions to estimate a range of federal revenue. The estimate ranges, as described below, are based on Puerto Rico being treated the same as the states in either 2009 or 2010, based on the year for which GAO had the most recent data. Individual income tax: In 2010, Puerto Rico taxpayers reported paying $20 million to the United States, its possessions, or foreign countries. According to officials from Puerto Rico's Department of Internal Revenue, most of these payments would have been to the United States. If Puerto Rico had been a state in 2010, estimated individual income tax revenue from Puerto Rico taxpayers would have ranged from $2.2 billion to $2.3 billion (after accounting for estimated payments in excess of tax liability from refundable tax credits, such as the earned income tax credit). Corporate income tax: In 2009, U.S. corporations paid about an estimated $4.3 billion in tax on income from their affiliates in Puerto Rico. Most of this amount was from an unusually large amount of dividends repatriated from Puerto Rico (compared to amounts repatriated in earlier years or in 2010). Absent that spike in dividends, the federal taxes these corporations would have paid for 2009 would have been about $1.4 billion. If Puerto Rico had been a state in 2009, estimated corporate income tax revenue from businesses that filed a Puerto Rico tax return for that year (or their parent corporations in the United States) would have ranged from $5.0 to $9.3 billion. The low end of this range assumes that U.S. corporations would have used prior-year losses of affiliated Puerto Rico corporations to offset their federal taxable income to the maximum extent (leaving only smaller or newly generated losses available to offset income in subsequent years), among other assumptions. However, this range does not take into account any behavioral changes of businesses with activities in Puerto Rico. For example, according to tax policy experts at the Department of the Treasury and the Joint Committee on Taxation, changes in federal income tax requirements under statehood would likely motivate some corporations with substantial amounts of income derived from intangible (and therefore mobile) assets to relocate from Puerto Rico to lower tax foreign locations. The extent to which such corporations might relocate from Puerto Rico is unknown. Consequently, GAO produced an alternative set of revenue estimates to account for some businesses with activities in Puerto Rico potentially relocating under statehood: this range was -$0.1 billion to $3.4 billion. The low end of this range is negative because U.S. corporations would have used their Puerto Rico affiliates' prior-year losses to reduce their taxes to such an extent that they would have more than offset the positive tax amounts that other corporations continuing to operate in Puerto Rico under statehood would have paid. Puerto Rico faces various economic and fiscal challenges that could potentially impact changes in federal spending and revenue under statehood. For example, its economy largely has been in recession since 2006, and its levels of employment and labor force participation are relatively low, compared to those of the states. Persistent deficits have resulted in an increase in Puerto Rico's public debt, which represents a much larger share of personal income than in any state (and in February 2014, Puerto Rico's general obligation bonds were downgraded to speculative—noninvestment—grade by three ratings agencies). Puerto Rico has taken recent steps to improve its fiscal position, such as reducing its government workforce and reforming its largest public employee retirement system. Changes in federal program spending and to federal tax law under statehood could lead to economic and fiscal changes of their own in Puerto Rico. That may have a cascading effect on federal spending and revenue levels. However, the precise nature of such changes is uncertain. Because statehood would cause numerous adjustments important to Puerto Rico's future, it would require careful consideration by Congress and the residents of Puerto Rico. Consequently, statehood's aggregate fiscal impact would be influenced greatly by the terms of admission, strategies to promote economic development, and decisions regarding Puerto Rico's government revenue structure. GAO is not making recommendations. Federal agency and Puerto Rico government officials reviewed GAO's draft report; their comments were incorporated as appropriate. To view the Spanish translation of this highlights page, please see GAO-14-301 .