In a bid to boost its sagging economy, Puerto Rico is contemplating its biggest tax overhaul in decades.
For several months a government task force has worked on the overhaul of Puerto Rico's tax system. The result is expected to be the biggest reform in 30 to 40 years or more, said Juan Lara, economist and partner at Advantage Business Consulting.
While the task force has not submitted its proposed tax reform, Government Development Bank for Puerto Rico President Melba Acosta Febo and others have spoken publicly about what the taskforce will be proposing.
If passed, the tax reform would shift the tax system towards taxing consumption and away from taxing personal income, and replace the existing sales tax with a value-added tax.
Puerto Rico's weak economy threatens to become a flashpoint for the municipal bond market, as the commonwealth has tens of billions of dollars in outstanding debt, much of which has been downgraded to junk status.
"The tax reform proposed by the government is an important part of the policy package necessary to turn around Puerto Rico's economy but is not sufficient by itself," said Center for a New Economy public policy director Sergio Marxuach.
He is one of five economists in Puerto Rico contacted by The Bond Buyer who said they are optimistic the plan can help Puerto Rico expand its economy and increase its tax revenue.
The government hired KPMG to aid the task force. According to a KPMG source, the consulting firm submitted its report to the task force in the last few days.
In a webcast on October 30, Acosta Febo said that tax reform would increase general fund revenues, equitably distribute the tax burden, promote economic growth, increase the competitiveness of Puerto Rico companies on the world market, and simplify tax compliance and administration.
The threshold for paying income taxes would rise to $35,000 for individuals from the current $20,000 level, according to Marxuach and Advantage Business Consulting President Vicente Feliciano. The threshold for couples would be $70,000. Both CNE and ABC are based in Puerto Rico.
Puerto Rico would replace its 7% sales tax with a 14% to 16% value added tax, Marxuach said. Just as its municipalities get part of its sales tax receipts, the same would presumably be the case with the VAT tax.
While sales taxes are charged by only by retailers, value added taxes are charged all along the supply chain.
While the current sales tax just covers goods, the VAT tax would be extended to cover most services, said José Villamil, chairman of the board for Estudios Técnicos, a Puerto Rico economic and business consulting firm.
Since those who make less income use a greater portion of their income for consumption, a shift to higher consumption taxes and lower income taxes would normally increase the burden on the poor. To address this, Puerto Rico's tax taskforce is anticipating introducing a credit for low income households, said Marxuach and Lara. It would be similar to the earned income tax in the United States, Lara said.
Antonio Fernos-Sagebien, who is on the government's tax reform committee, said he expects there will be exemptions from the VAT. Among these will be for small businesses, exported goods and services, financial services, and residential housing.
Small businesses would be defined as those with gross sales below $75,000 to $100,000.
Fernos-Sagebien is a principal at REOF Capital LLC, an investing firm in Puerto Rico.
The KPMG group is an international group led by Harry Gutman, chief of staff of the United States Congress Joint Committee on Taxation in the early 1990s, Feliciano said.
"Lower individual and corporate taxes would promote labor participation and entrepreneurship, while the consumption tax would provide the required tax revenues," Feliciano said.
Villamil said he was very happy with the shift toward consumption taxes. However, he said he was concerned that none of the tax proposals under development were specifically geared to promoting investment.
Marxuach said the impact of the tax reform on the economy is difficult to project because, among other things, only 3.5% of today's revenues come from income taxes on those earning between $20,000 and $35,000, it is unclear how the low-income-earner rebate will work, and the tax reform is expected to be revenue enhancing.
Marxuach said the task force expected to increase General Fund net revenues by about $1 billion annually. By comparison, Puerto Rico expects to spend $9.56 billion in this year's budget.
Over the medium to long term the shift to consumption-based taxation should make people use some money they would have used for consumption for savings, Marxuach said. This should spur new lending and private investment.
"This new investment, in addition to the implementation of significant institutional reforms, and the development of a medium term economic strategy with the buy-in of stakeholders in the government, private, and non-profit sectors, should eventually increase economic growth, employment, and income," Marxuach said.
Villamil said he is concerned the increase in the income tax threshold might have an adverse social impact. It would mean that 85% of those with income in Puerto Rico would not pay taxes on it. The increased threshold could reduce their sense of social responsibility.
On a different note, Villamil said that if the threshold is increased the Puerto Rico Treasury could use less staff and resources to process tax forms, and use those resources instead to tackle tax evasion.
While Villamil did not think the VAT itself would reduce tax evasion, Feliciano and Lara thought it would.
Municipal Market Advisors managing director Matt Fabian said he had the impression that a "VAT is harder to avoid because it is applied farther away from the end consumer. This means the tax could have a broader base and thus be more resilient to economic shocks."
Feliciano used an analogy from history, citing a quote from a 17th century advisor to the French king, Louis XIV. "The art of taxation consists in so plucking the goose as to obtain the largest amount of feathers with the least possible amount of hissing," is the quote attributed to the king's finance minister, Jean-Baptiste Colbert.
"The hissing from the economy is lower and feathers the largest amount with the use of the value added tax," Feliciano said.
Several economists said Treasury implementation of the VAT would be complicated and time consuming. Businesses would also have to spend time and money to respond to VAT's demands, Feliciano said.
Villamil said introducing the VAT could lead to price inflation. The history of VAT introductions in the world shows that there is initial inflation followed by a return to the inflation levels of the past, Lara said. Inflation is currently low in Puerto Rico, he said.
A sharp increase in consumption taxes might normally lead island residents to try to evade them through online ordering of goods from companies outside the island. Compared to those living in the continental United States, a lower percentage of Puerto Rico's populace has internet access, Villamil said. However, the Treasury will take steps to address attempts to use the internet to evade taxes, he said.
In April, Japan had some problems when it increased its sales tax to 8% from 5%. According to Bloomberg, the economy shrank at an annual rate of 7.1% in this year's second quarter, apparently in response to the sales tax increase. The Japanese government increased the sales tax to help address the Japanese government's debt.
Feliciano and Villamil said there were differences between what Japan experienced and what might happen in Puerto Rico. Feliciano said Japan's sales tax rise was a pure tax rise whereas what Puerto Rico contemplates is more of an exchange of tax types.
Villamil said that while Japanese consumers primarily buy goods produced in Japan, Puerto Rico consumers overwhelmingly purchase goods produced abroad. Because of this, an increase in consumption taxes would be expected to have a major impact on the Japanese economy but a minimal impact on the Puerto Rico economy, he said. Even 85% of the food that Puerto Ricans eat is imported.
The tax reform should also sweep away many of Puerto Rico's excessive number of tax deductions and tax exemptions, Lara said. The tax reform will also probably address property taxes, Villamil said. Right now, these go exclusively to municipalities. The property tax assessments are very low currently, he said. It is possible that there will be an island-wide reassessment. Alternately, a new property tax could be introduced allocated to the central government.
