The End of Section 936

One common misperception about Puerto Rico’s financial woes is that they are the result of the end of Section 936, a law that gave U.S. corporations some tax advantages if they based some part of their company operations in Puerto Rico.

Section 936 provided a tax credit equal to the tax liability of certain kinds of businesses in Puerto Rico. That means that income generated in Puerto Rico could be essentially tax free. In 1992, a report from the Congressional Budget Office calculated that the federal government would lose $15 billion between 1993 and 1997 if the exemptions continued.

The pharmaceuticals industry in particular took advantage of Section 936 in ways that were far from the initial intention of the law, and which didn’t benefit Puerto Rico. The U.S. General Accounting Office (GAO) explained how this could happen in a 1992 report on the pharma industry in Puerto Rico:

A pharmaceutical company would develop a drug in its U.S. research facilities and transfer the drug patent to its wholly owned subsidiary operating in Puerto Rico. The subsidiary would produce the patented drug and claim the income obtained from the drug sales as tax-free income.

In 1982, the law was changed to make it harder for companies to shelter income from “intangibles” such as patents, but the amount of income sheltered continued to outweigh the benefits to Puerto Rico substantially.  As the GAO put it in their report, “the average tax revenue lost per job was higher than the average employee compensation paid by section 936 corporations.”

Pharmaceuticals in particular received 267% in tax savings compared with the income they provided for people in Puerto Rico: for every dollar they paid a worker, they saved $2.67 in taxes they would have paid to the federal government. From the point of view of the government, it would have been much less expensive to provide jobs directly to the people hired by the pharma companies in a 1930s-style WPA program. In fact, such a plan could have employed twice as many people and still cost the government significantly less than Section 936 did.

In the 1970s and 1980s, growth in income and property for people living in Puerto Rico increased by 2.3 percent per year. In most recent years, Puerto Rico’s economy has contracted. But in the same 20th century expansion years, the amount of Puerto Rico-based income and property grew for nonresidents by 7.7 percent each year.  So the benefits of Section 936, to the extent that they helped grow Puerto Rico’s economy, were primarily felt by the investors, not by the residents of the Island.

And throughout those growth years, unemployment in Puerto Rico remained above 11% and per capita income was significantly lower that that of any state. The GAO reports make it clear that the economic benefit to Puerto Rico of Section 936 was not impressive, though it saved U.S. corporations billions of dollars in taxes. The number of corporations which benefited was small, and all U.S. taxpayers subsidized the savings enjoyed by those companies. The tax provisions which had been intended to lure companies to build factories in Puerto Rico became taxpayer subsidies of companies which did not actually provide job growth on the island.

These tax credits were repealed in 1995 and expired at the end of 2005.  A GAO report in 1997 concluded that things were going well for Puerto Rico overall, and found no evidence that the end of Section 936 had been harmful to Puerto Rico’s economy. The report warned that there were many other factors that could affect the economy and did not state that the changes in Section 936 had not been harmful, but no clear indications of harmful effects were identified.

While tax credits can lure businesses to a region, and many states and cities on the U.S. mainland make use of them, corporations will not build businesses in a locality and support the communities with jobs and capital investments just for tax credits. The location must be a good place to do business. Otherwise, corporations will commit themselves to the locality only enough to gain the tax loopholes — and that is not enough to benefit the Island.

Sources:

• 1992 May – Pharmaceutical Industry, Tax Benefits of Operating in Puerto Rico (GAO Report)
• 1993 June – Tax Policy, Puerto Rico and the Section 936 Tax Credit (GAO Report)
• 1997 May – Tax Policy, Puerto Rican Economic Trends (GAO Report)
• Full information on U.S. taxes and Puerto Rico