The loss of 936: good or bad for Puerto Rico?

November 17, 2002
A.W. Maldonado is a journalist and longtime columnist for The Star

On Aug. 20, 1996, President Clinton signed a bill that repealed Section 936. Six years later, has this been good or bad for Puerto Rico?

It is obvious that there has been no collapse of the Puerto Rican economy. In fact, the industry most directly affected, the pharmaceutical, has grown since 1996.

At the annual convention of the Pharmaceutical Industry of Puerto Rico this November, respected economist Heidie Calero gave a positive report. Since 1997, the industry has invested an additional $3.5 billion on the island, an average of $600 million a year, and will invest another $2.9 million in the next six years. Jobs have increased by 3,932 and are expected to grow by another 1,393 this year 2002.

Calero's statistics dramatized even more what everybody knows: how important the pharmaceuticals are to the entire island economy. It contributes a remarkable 66 percent ($31 billion) to Puerto Rico's total exports ($47 billion.) It generated 43 percent of Puerto Rico's total net income. It represents 56 percent of total manufacturing and 20 percent of all industrial jobs.

So the answer to the question seems dear. Since the pharmaceuticals are by far the single most important industry on the island, the repeal of 936, after all, appears to have been good for Puerto Rico.

But what about the $16 billion in 936 funds that were deposited in island banks and financial institutions? About $13 billion have already left the island and the other $3 billion is expected to leave in the new few years.

The answer here is luck. Since the Federal Reserve Board has lowered interest rates dramatically, down to 1.25 percent, Puerto Rico has not suffered from the exit of the low-cost 936 funds.

But there has been a big decline in the "Toll Gate tax" paid by 936 corporations to the Puerto Rico Treasury. In 1995 it was $220.9 million: in fiscal 2001, it was down to $49.1. But this has not hurt Puerto Rico either. And this takes a little explaining.

The fundamental reason why the repeal of 936 did not have a negative effect on the pharmaceutical industry is that many of them 41 percent of the entire industry converted from 936 to Controlled Foreign Corporations. Under 936, they were exempt of federal taxes and could repatriate their profits to the U.S. mainland free of U.S. taxes, playing only the "Toll Gate tax" to the island government. Under CFC, they retain their tax exemption but cannot repatriate free of U.S. taxes.

In 1996, Congress gave the companies a ten-year period to phase out the 936 benefit. By converting to CFC, they retained the essential advantage — federal tax exemption. Puerto Rico remained attractive for expansions, especially for producing what are called "blockbuster" new medicines and drugs.

Now, as CFC's, these companies arc required by the IRS to pay to the island government a "royalty" on their production. In 2001, this was up to $696.8 million.

And this, clearly, more than makes up for the loss in the "Toll Gate tax:"

So, again, does this mean that the repeal of 936 has been "good" for Puerto Rico?

What Congress and Clinton, with the enthusiastic support of Gov. Pedro Rosselló and Resident Commissioner Carlos Romero Barceló, did in repealing 936 was to take away from Puerto Rico the promotional incentive to attract new industrial investment.

Puerto Rico has been losing a large part of its manufacturing, especially its labor-intensive plants such as in the apparel and tuna industries. Some of these left because of the repeal of 936, others for other reasons, such as the increase in the U.S. minimum wages, the effects of globalization and other world trends.

Puerto Rico always has lost industries which is why it has always needed a very strong government program to attract "new business" investment and employment.

Without the 936 incentive, Fomento's promotion of new investment has slowed down from an annual average of over 40 in the 1980s, to less than half since 1996. The decline in new jobs has been even greater.

In spite of the expansions in the pharmaceutical industries, total manufacturing in Puerto Rico is declining: industrial jobs are down to 128,900 — 7,700 less than the previous year. From October 1996 to September 2002, a total of 27,373 industrial jobs have been lost.

So back to the question. No one believes that the expansion in the pharmaceutical industry is a result of the repeal of 936. Losing 936 was not "bad", but it not "good" for the industry. The expansion has taken place in spite of losing 936, essentially because Puerto Rico's political status made it possible to convert to CFC status and thus retain federal tax exemption.

For Puerto Rico there are two vital issues. What will replace 936 as an incentive to attract the large number of "new business" investments and jobs this island needs? And if there is no replacement if, for instance, the government of Puerto Rico does not succeed in getting Congress to approve the Section 956 proposal the other question is: what will replace manufacturing as the engine of the Puerto Rican economy?

Obviously it is not tourism, which generates about seven percent of the economy, and which itself depends greatly on manufacturing. Needless to say it will not be agriculture. Will it be more government spending, or more federal funds?

We have, I believe, arrived at the answer to the question.

The effect of losing of 936 is structural in the fundamental structure of the island economy, which means we have not yet seen it. But we will as manufacturing today, driving 40 percent of the economy, continues to decline. The answer is this. Of course the expansion of the pharmaceutical industry in recent years has been good for the island. But in the coming years, if there is no replacement, it will become painfully evident that the repeal of 936 was bad, very bad, for Puerto Rico