Economic Principals

Rx: Statehood By David Warsh, Globe Columnist, 11/29/98

Puerto Rico has been in the news recently. The descendents of Theodore Roosevelt are lobbying for a posthumous Medal of Honor for their sire. (Roosevelt himself liked to put it this way: ``The bravest man I ever knew was the black sergeant who followed me up San Juan Hill.'') San Juan Hill is in Cuba, of course, but one of the outcomes of the Spanish American War was to cede the island of Puerto Rico to the United States under the terms of the Treaty of Paris - on Dec. 10, 1898.

What better timing than that for the plebescite two weeks from today that will determine whether the citizens of Puerto Rico choose to seek statehood among the United States?

The vote is the brainchild of Governor Pedro Rosello, who saw that the island economy was going nowhere fast. For many years, Puerto Rico had been considered a model of economic development in the postwar world - the ``fifth tiger,'' as economists William Baumol and Edward Wolff called it in 1994.

But by 1996, when Rosello was re-elected to a second, four-year term, it was clear that something had gone badly wrong. Despite bouyant job growth in the states, the Puerto Rican economy was stagnating. By then, Rosello and experts in economic development had identified a surprising villain.

A little background: The United States claimed the Philippines and Puerto Rico after its war with Spain in 1898 because it felt it should take something for its trouble - it was the fashion among nations. For a time the Pacific archipelago and the easternmost of the major Caribbean islands looked suspiciously like colonies.

The Jones Act of 1917 conferred US citizenship on Puerto Ricans. In 1950 Congress created a special commonwealth status for it, Guam, and the Northern Mariana islands, establishing procedures to draft and adopt constitutions resembling those of the states.

During the 1950s and 1960s, ``Operation Bootstrap,'' directed by the planning agency Fomento (meaning ``promotion'' in Spanish), did all the things that planning agencies did in those days: built industrial parks, targeted ``winners'' and ``losers'' among local businesses, and offered tax breaks to US industries. For a time, the strategy worked as well as anything else: The economy grew at an annual rate of 6.5 percent between 1959 and 1974.

The productivity shocks of the 1970s - the oil price hikes in particular - hit Puerto Rico hard. The top-down, subsidy-driven planning continued, with few good effects. The unemployment rate, always high relative to the 50 states, hit a depression-level 22 percent in the 1980s. Income per capita in Puerto Rico is $8,100, less than a third of the $25,660 level that is the US average.

What is stalling Puerto Rico's growth? Local politics and strong local unions surely are part of the answer - the effects of a hundred years of dependency. The public sector employs a third of the work force - more than double the US average. Efforts at privatization have gone nowhere. And restrictive work rules have raised costs and discouraged investment.

But an even more pernicious mechanism was discerned in the early 1990s by, among others, development consultant J. Tomas Hexner, in an obscure provision of the US tax code known as Section 936. Hexner had specialized in the development of East Pakistan in the 1960s, before it was reborn as Bangladesh; he knew an exploited economy when he saw one.

The offshore tax subsidy found in Section 936 of the US tax code dated as far back as the 1920s, Hexner discovered; initially it had been intended to spur labor-intensive manufacturing that otherwise would not have located on the island.

But after World War II, the advantage of the lowest labor costs shifted abruptly to Asia. The hefty tax breaks offered by 936 attracted capital intensive industries like pharmaceuticals and electronics to Puerto Rico instead. The cleverest corporate tax attorneys in Washington went to work to re-engineer, for purposes of maximizing the profitability of the latest designer molecules, a tax law intended to stimulate the manufacture of baseballs and baseball gloves. Complementary Puerto Rican incentives were devised and shepherded into law by well-connected lobbyists as well.

The result by the late 1980s was the emergence in Puerto Rico of a giant tax shelter for drug companies. They transferred patents and other intangibles into their San Juan filing cabinets, and record profits out - with very little corresponding increase in real investment except in the sophisticated financial institutions, world class hotels, and thriving service sector.

Meanwhile, little new indigenous industry of any sort has appeared. Domestic capital formation has failed to take off; the share of investment in the economy fell from 29 percent of gross domestic product during the 1960s to 14 percent in 1994. In short: a disaster.

Section 936 came under scrutiny in the early 1990s, not because of any concern for its ill effects on Puerto Rico, but because of congressional concern with a balanced budget. The discovery that the Treasury was foregoing up to $4 billion a year in taxes led to a decision to phase it out in the next few years - thus depriving Puerto Rico of the subsidy of its high-end service industries, and forcing a sweeping re-examination of policies toward economic growth. The end of the subsidy to the Gucci-clad crowd put statehood firmly on the docket.

True, Puerto Rico still looks good compared with other Caribbean islands. But its performance is downright crummy compared with the United States - barely half that of Mississippi, which, like South Carolina, was steadily pulling ahead. When a young Chilean economist named Fernando Lefort studied Puerto Rico's convergence with the United States - or lack thereof - for his PhD thesis at Harvard University a few years ago, he found it was the lack of clear-cut political integration, more than any other single factor, that was holding back Puerto Rico.

Were Puerto Rico to become a state, Lefort argued, the convergence effect - the same forces on whose strength Mississippi is rising - would guarantee Puerto Rico a higher rate of growth, and its citizens higher incomes.

Hence the complicated discussion of statehood that has taken place among Puerto Ricans throughout the 1990s. To judge from polls and the local press, support for maintaining its commonwealth status has been dwindling, even though Puerto Ricans don't pay federal income taxes under the status quo. A small but dependable faction of voters apparently continues to favor outright independence. The pro-statehood New Progressive Party of Governor Rosello appears to be gaining.

The vote is scheduled for Dec. 13. More than 80 percent of the eligible voters among Puerto Rico's 3.8 million citizens are expected to turn out; more than half of them are expected to vote for statehood. The referendum binds no one, not even the government of Puerto Rico. But remember this: No group of citizens in American territories yet has organized to seek statehood - and failed to get it.

This story ran on page E01 of the Boston Globe on 11/29/98.

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