Thursday, October 5, 2017

Trump Suggests Clearing Puerto Rico’s Debt, But Will Puerto Rico Rein In Its European Levels of Spending?

Click here to read the original Cautious Optimism Facebook post with comments

3 MIN READ - Thoughts on Puerto Rico from The Cautious Optimism Correspondent for Economic Affairs and other Egghead Stuff.

As CO has recently reported on Puerto Rico’s post-Hurricane Maria debt position, it’s helpful to look at some numbers that explain why the Commonwealth’s fiscal situation got so desperate in the first place.

When Puerto Rico’s debt crisis made headlines in 2014 and into 2015 most major US newspapers were full of columns blaming low taxes and tax cuts for the Commonwealth’s accumulated budget shortfalls. Meanwhile more conservative/free market outlets blamed out-of-control government spending.

So which narrative was right?

Well it happens that very same year the New York Federal Reserve published its own report on Puerto Rico’s economic competitiveness...

The comprehensive paper analyzed many economic indicators such as GDP, unemployment, private debt, labor markets, regulations, etc… but also included the all-important metrics on tax/fee revenue and government spending.

Despite progressive claims that Puerto Rico’s debt crisis was the product of tax cuts, Puerto Rico ranked #1 for government revenues as a percent of GDP (38.65%) among all 50 states plus District of Columbia plus itself (see page 14, figure 10). 

However, unlike the continental United States, Alaska, and Hawaii the Commonwealth government owns and operates sizable state-owned enterprises (SOE’s) delivering services such as electric power, health insurance, and transportation to the island. And a significant share of its revenue comes from SOE’s.

Yet even after removing SOE revenues, Puerto Rico tax revenues still ranked #2 out of 52 states/districts at 14% of GDP. As the New York Fed report states:

“Puerto Rico’s overall state and local tax burden, at 14 percent of GDP, is heavy compared with that of most mainland states. Among the fifty states plus the District of Columbia, Puerto Rico would rank second in terms of total tax burden.”

Furthermore Puerto Rico residents enjoy the advantage of paying no federal income tax to Washington, DC (except for federal employees) and the island receives Medicare and Social Security payments as well as continuous federal aid. So with the second highest tax revenues in the United States plus sizable intergovernmental transfers it’s hard to see insufficient revenues or tax cuts as a problem.

But what about spending? The New York Fed report did not tally spending minus SOE’s, but when including all government spending Puerto Rico not only exceeded every other state at a mindboggling 50.1% of GDP, its total expenditure ranked it sixth highest out of 31 OECD countries (see page 17, figure 12). 

Let me repeat that. Puerto Rico’s government spends more as a percent of GDP than the overwhelming majority of OECD countries. 

That means more spending than not only the United States itself, but also most European social democracies including Spain, Portugal, the Netherlands, Norway, the UK, Germany, and more—many of which also have their own SOE’s, an amazing display of government inefficiency and largesse. Although in fairness they were still beat out by Greece, a country that was allegedly suffering from “austerity” and draconian spending cuts during the same period (restrain laughter).

Now one important factor to consider is that Puerto Rico is responsible for funding a greater share of its  own highway construction than most states—although it still receives some financial assistance from the federal government—which would necessitate marginally higher spending levels than most states. 

However the island also enjoys the benefit of military protection from the United States while paying no income taxes to Washington, much like the European countries it emulates. Given that total public construction spending (above and beyond just roads and highways) in the United States is less than half that of defense spending (source: St. Louis Federal Reserve), the Commonwealth enjoys a considerable net benefit from the pay-for-highways/free-defense tradeoff. And sharing some of the road transportation costs with Washington is not going to account for the difference between, say… Texas and Norway levels of spending.

Given that Puerto Rico has been devastated by Hurricane Maria, the verdict is still out as to whether or not wiping out its debt obligations is a good idea. Will it encourage other disaster prone states to practice fiscal moral hazard in the hopes of a federal bailout? Or is it simply the humanitarian thing to do?

But one thing is certain: Puerto Rico got into its fiscal mess with European-level taxes, European-level spending, and the burden of vast and expensive government enterprises. No one can pin their fiscal problems on tax cuts.

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