The 25% Tax Solution

Early in the last century, the journalist H.L. Mencken said that “there is always an easy solution to every human problem--neat, plausible, and wrong.”

Puerto Rico is in a bind and it is tempting to think that if we lower corporate and individual maximum tax rates to 25%, somehow we would surge ahead. The problem with this solution is that it assumes that Puerto Rico’s economic and fiscal problems are directly related to the high tax levels. While this is partially true, it is only partially so.

The manufacturing sector has tax incentives. According to the Colegio de CPAs report on Law 73 (2008), the effective tax rate of the manufacturing sector is 5%. Lowering taxes of regular corporations to 25% will not help this group. And yet, manufacturing was contracting before the US recession. If nothing is done, it will continue to contract after the US economic recovery.

The tourism sector has tax incentives. Lowering corporate income taxes will not change the basic dynamics of this group. And yet, it has been challenged by the likes of Dominican Republic and Mexico. It has Cuba looming in the distance. Local Paradores are doing better these days because many Puerto Ricans cannot travel abroad, not because their underlying weaknesses have been addressed.

The construction sector has the advantages of the “special partnerships” tax framework and several tax incentive programs. If high income taxes were the main problem, Puerto Rico would observe little construction and pent up demand. And yet, Puerto Rico experienced too much construction and over-investment, particularly in housing construction. Low occupancy rates in commercial buildings are not a sign of a sector hobbled by high taxes but by excessive investment.

The banking sector invests in many tax-free securities, resulting in effective tax rates below 25%. If high taxes were the main problem, this segment would be small. And yet, security analysts complain about overbanking. The sector provided abundant credit, in retrospect too abundant, to the local economy. The strain on the capital bases of the banks are the result of lending issues, not high taxes.

Labor participation in Puerto Rico is extremely low. However, analysis of the issue by the Center for the New Economy signals to the welfare benefit structure as the main culprit. The 25% tax rate applies to individuals with taxable income of $30 thousand or more. In 2007, seventy per cent of the tax returns had gross income below $30 thousand. This is before any deduction.


There is no question that taxes in Puerto Rico are too high and the number of taxpayers who carry the burden is too low. A senator once remarked that the government health reform insurance is paid for by all citizens. The businesspeople at the table correctly responded that it is not paid for by all citizens but by all taxpayers, and they are not one and the same.

Tax reform is necessary to improve the economic performance of the Island. The 25% solution is not a silver bullet.


Vicente Feliciano
President
Advantage Business Consulting