Flags of the United States and Puerto Rico
Last week, the Obama administration proposed legislation that would entail extensive federal involvement in Puerto Rico’s fiscal affairs. The U.S. territory’s financial condition has deteriorated rapidly over the past year and a half, and Puerto Rico now finds itself on the brink of default and in dire need of assistance. However, Congress has yet to decide the extent to which it is willing to intervene on Puerto Rico’s behalf. The outcome of this largely partisan congressional debate has critical implications for the solvency and economic stability of the island territory.
The Debt Problem
Puerto Rico’s toxic relationship with debt has its roots in the Jones-Shafroth Act of 1917, legislation that most notably granted U.S. citizenship to Puerto Ricans. This law primarily dealt with the structure of Puerto Rico’s democratic government, but it also specified the tax status of Puerto Rican government bonds. Congress exempted the territory’s debt from local, state, and federal taxation without regard to the bondholder’s place of residence. As a result, Puerto Rican bonds have enjoyed popularity among investors for their implicit high yields, and Puerto Rican debt issuance has typically been met with strong demand.
Over the past several decades, Puerto Rico’s government has taken advantage of preference for its bonds by issuing debt to cover budget shortfalls. The territory was able to service its mounting debt by periodically selling new bonds with similar maturities and coupons. However, in 2006, Internal Revenue Code § 936 expired, terminating a federal tax credit for companies with subsidiaries in Puerto Rico. Because the island’s economy was largely predicated on this special tax status, its expiration, as well as subsequent tax hikes, prompted many companies to close their Puerto Rican operations. The corresponding loss of jobs, output, and tax revenue induced economic recession and jeopardized the government’s fiscal health.
In order to keep its investment grade credit rating and maintain its ability to refinance its debt, the government was forced to increase taxes on remaining private enterprise, prompting further loss of jobs and exacerbating the Commonwealth’s economic recession. Government spending increased in response to economic contraction, and diminishing tax revenues forced the government to issue large amounts of debt. Consequently, public debt has increased substantially since 2006 and reached a record $72 billion in 2015.
Puerto Rico’s worsening fiscal outlook prompted a reduction in its credit rating to “junk” (non-investment grade) status in March 2014. As a result, investors began to question the ability of the Puerto Rican government to service its debt, and borrowing costs increased dramatically. The downgrade also activated acceleration clauses in previously issued debt that allowed creditors to demand early payment of principal and interest. Because of these factors, the Puerto Rican government has struggled to make debt payments despite efforts to rectify its budget. To facilitate payment, the government has sought to restructure its debt through negotiations with creditors, but these talks have proven futile.
In recent months, internal financial analyses have indicated that Puerto Rico cannot pay $13 billion of its $18 billion of debt payments due over the next five years. Indeed, Puerto Rican Governor Alejandro Garcia Padilla has admitted that without assistance from its creditors or the U.S. government, the Commonwealth will be forced to default. The U.S. Congress has begun to debate various legislation intended to aid the distressed territory, but partisan disagreement and bipartisan aversion to a federal bailout have prevented action. Seeking to motivate lawmakers, the White House has recommended a fairly extensive set of measures that Congress could enact to help Puerto Rico manage its debt. Many of these executive and congressional proposals differ substantially in their approaches to the problem.
The principal issue at stake in congressional deliberations is the extent to which Puerto Rico should be given access to bankruptcy procedures. Democratic lawmakers have introduced legislation that would allow Puerto Rico’s government corporations and municipalities to file for bankruptcy, much as domestic municipalities can under Chapter 9 of the U.S. Bankruptcy Code. Republicans, however, have voiced their opposition to bankruptcy legislation and have used their majority to thwart the progress of these bills. They instead favor the creation of a federal oversight board that would implement necessary spending cuts and ensure proper management of Puerto Rico’s finances.
The Obama administration has proposed more comprehensive measures whereby Congress would legislate a complete bankruptcy process for U.S. territories. Puerto Rico could thus seek court-arbitrated restructuring of general obligations as well as agency debt. In addition, the White House would have Congress expand Medicaid and earned-income tax credits in Puerto Rico while instituting an independent fiscal oversight board. These policies would ease the financial burden on Puerto Rico’s government from social services and encourage economic growth and fiscal responsibility.
Despite partisan differences, strong consensus exists on the necessity of action. The government of Puerto Rico simply does not have the funds required to make its debt payments, and it cannot justifiably refinance its debt with general obligation yields near 9 percent. Although it is unlikely that a comprehensive default would pose a severe threat to American financial stability, Puerto Rican debt is widely held by bond funds, and default could generate volatility in municipal paper markets. In this manner, a Commonwealth default could interfere with state and local funding domestically and induce a degree of economic uncertainty. In addition, default would prompt bond yields to rise further, essentially precluding the Puerto Rican government from borrowing in private credit markets. The resulting lack of funding would require extreme spending cuts at minimum and imperil the social assistance programs (such as the Nutritional Assistance Program) upon which many Puerto Ricans rely. Thus the wellbeing of American citizens in the short term is contingent upon federal action.
Considering the stakes, it is crucial to assess the economic efficacy and political viability of the congressional and executive aid proposals. From the perspective of the Puerto Rican government, President Obama’s recommendations are clearly the most favorable. A territorial bankruptcy mechanism would allow the Commonwealth to restructure its debt via court adjudication, a goal it has not been able to accomplish through negotiations and one that would considerably reduce its short-term debt burden. Federal oversight of its financial management would also be a small price to pay for increased Medicaid transfers and earned-income tax credits (and would actually benefit long-term stability).
Creditors, however, are naturally opposed to court involvement because it might entail a “haircut” of principal payments and thus reduce their returns. In addition, Puerto Rican bankruptcy would set a dangerous precedent. States are not permitted to declare bankruptcy under U.S. law, and territorial bankruptcy might encourage highly leveraged states to lobby for court arbitration, reducing their incentive to practice fiscal responsibility. Creditors would also be less inclined to lend to state governments, and yields would rise as a result. In any case, the White House plan is politically unfeasible. Republican legislators have a congressional majority and are generally opposed to Puerto Rican bankruptcy and Medicaid expansion.
The Republican proposals are the most punitive. Sweeping spending cuts would exacerbate the Commonwealth’s economic recession, fomenting poverty and reducing the government’s tax base — measures that could actually inhibit the government’s ability to service its debt. Nonetheless, they would clearly incentivize future fiscal prudence, and stricter federal oversight of Puerto Rico’s finances would benefit this purpose and reduce the likelihood of another debt crisis.
A Necessary Compromise
The White House and congressional Republican relief proposals both have advantages and disadvantages, and so the proper course of action likely involves a compromise between the two plans. Puerto Rico clearly cannot pay its debt without restructuring, and creditors have proven unwilling to negotiate to a significant extent. As such, court arbitration is necessary to avert default. However, Congress must specify that this action is warranted only by exceptional circumstances, and that it will not permit territories to file for bankruptcy in the future (contrary to Obama’s proposal).
Furthermore, the courts should be careful to restructure the debt only to the extent necessary for the Puerto Rican government to remain solvent, allocating losses to creditors commensurate with the risk they assumed in purchasing the debt. In addition, the establishment of a financial oversight board would improve Puerto Rican fiscal transparency and discourage another debt crisis. These policies would indicate the federal government’s unwillingness to tolerate fiscal malfeasance by territories and states in the future and so would preserve some disincentive to financial recklessness.
Puerto Rico’s financial predicament underscores the importance of fiscal prudence. Following the expiration of its special tax status in 2006, the Commonwealth government continued to borrow well beyond its means and neglected to support structural reform in the faltering Puerto Rican economy. As a result, Puerto Rico is now confronting considerable financial instability and is at serious risk of default. The U.S. territory is seeking recourse from a divided federal government and must hope for uncommon and unlikely bipartisan agreement to meet future obligations.
Todd Lensman is a freshman in the College of Arts & Sciences at Cornell University, majoring in Mathematics and Economics.