How Socialism Destroyed Puerto Rico, and How Capitalism Can Save It

While Greece is now dominating the debt default stage, the real tragedy is playing out much closer to home, with the downward spiral of Puerto Rico. As in Greece, the Puerto Rican economy has been destroyed by its participation in an unrealistic monetary system that it does not control and the failure of domestic politicians to confront their own insolvency. But the damage done to the Puerto Rican economy by the United States has been far more debilitating than whatever damage the European Union has inflicted on Greece. In fact, the lessons we should be learning in Puerto Rico, most notably how socialistic labor and tax policies can devastate an economy, should serve as a wake up call to those advocating prescribing the same for the mainland.

The U.S. has bombed the territory of Puerto Rico with five supposedly well-meaning, but economically devastating policies. It has:

1. Exempted the Island’s government debt from all U.S. taxes in the Jones-Shaforth Act.
2. Eliminated U.S. tax breaks for private sector investment with the expiration of section 936 of the U.S. Internal Revenue Code.
3. Required the nation to abide by a restrictive trade arrangement.
4. Made the Island subject to the U.S. minimum wage.
5. Enabled Puerto Rico to offer generous welfare benefits relative to income.

While passage of such politically popular laws seems benign on the surface (and have allowed politicians to claim that their efforts have helped the poorest Puerto Ricans), in reality they have deepened the poverty of the very people the laws were supposedly designed to help. The lessons here are so obvious that only the most ardent supporters of government economic control can fail to comprehend them.

Tax-Free Debt

By exempting U.S. citizens from taxes on interest paid on Puerto Rican sovereign debt, Washington sought to help the Puerto Rican economy by making it easier and cheaper for the Island’s government to borrow from the mainland. As a result, Puerto Rican government bonds became a staple holding of many U.S. municipal bond funds. As with Fannie Mae and Freddie Mac bonds a decade ago, many investors believed that these Puerto Rican bonds had an implied U.S. government guarantee. This meant that the Puerto Rican government could borrow for far less than it could have without such a belief. However, this subsidy did not grow the Puerto Rican economy, but simply the size of the government, which had the perverse effect of stifling private sector growth.

In contrast to the tax-free income earned by Americans who buy Puerto Rican government bonds, those with the bad sense to lend to Puerto Rican businesses were taxed on the interest payments that they received. Businesses could have used the funds for actual capital investment (that could have increased the Island’s productivity), but instead the money flowed to the Government which used it to buy votes with generous public sector benefits that did nothing to grow the Island’s economy or put it in a better position to repay. That problem was left for future taxpayers who no politician seeking votes in the present cared about.

This dynamic is almost identical to what happened in Greece, where low borrowing costs, made possible by the strong euro currency and the implied backstop of the European Central Bank and the more solvent northern European nations, permitted the Greek government to borrow at far lower rates than its strained finances would have otherwise allowed.

Taxing Private Investment

Perversely, as the U.S. government made it easier for the Puerto Rican government to borrow, it made it harder for the private sector to do so. In 2006 the government ended a tax break that exempted corporate profits earned on private sector investment in Puerto Rico from U.S. taxes. As a result, U.S. businesses that had been making investments and hiring workers on the Island pulled up stakes and moved to more tax-friendly jurisdictions. The result was an erosion of the Island’s local tax base, just as more borrowing (made possible by triple tax-free government debt) obligated the remaining Puerto Rican taxpayers to greater future liabilities.

The Jones Act

The Jones Act, a 1920 law designed to protect the U.S. merchant marine from foreign competition, has had a devastating effect on Puerto Rico, and should be used as a cautionary tale to illustrate the dangers of trade barriers. Under the terms of this horrible law, foreign-flagged ships are prevented from carrying cargo between two U.S. ports. According to the law, Puerto Rico counts as a U.S. port. So a container ship bringing goods from China to the U.S. mainland is prevented from stopping in Puerto Rico on the way. Instead, the cargo must be dropped off at a mainland port, then reloaded onto an expensive U.S.-flagged ship, and transported back to Puerto Rico. As a result, shipping costs to and from Puerto Rico are the highest in the Caribbean. This reduces trade between Puerto Rico and the rest of the world. Since a large percentage of the finished goods used by Puerto Ricans are imported, the result is much higher consumer prices and fewer private sector jobs. Even though median incomes in Puerto Rico are only 63% of the poorest U.S. state, thanks to the Jones Act, the cost of living is actually higher than the average state.

The Federal Minimum Wage

In 1938 the Fair Labor Standards Act subjected Puerto Rico to a federal minimum wage, but it was not until 1983 that a 1974 act, which required that the Island match the mainland’s minimum wage, was fully phased in. The current Federal minimum wage of $7.25 per hour is 77% of Puerto Rico’s current median wage of $9.42. In contrast, the Federal minimum is only 43% of the U.S. median wage of almost $17 per hour (Bureau of Labor Statistics (BLS), May 2014). The U.S. minimum wage would have to be more than $13 per hour to match that Puerto Rico proportion. The disparity is greater when comparing minimum wage income to per capita income.