The Heritage Foundation

Issue Brief #4493 on Economy

December 10, 2015

December 10, 2015 | Issue Brief on Economy

Misguided Plan for Puerto Rico Would Set Dangerous Precedent

Puerto Rico faces an imminent financial crisis caused by decades of economically harmful policies, prolific government spending, and broken—if not corrupt—governance.

Claiming that this U.S. territory has no options on its own, the President and some Members of Congress have called for a bailout of Puerto Rico, including access to retroactive bankruptcy and other federal supports. This would set a dangerous and unaffordable precedent. Municipal and state governments throughout the U.S. have accumulated trillions of dollars in debt and unfunded liabilities that will be extremely difficult—if not impossible—to pay off. Policymakers must tread lightly with Puerto Rico, realizing that it is only the first of many economically and fiscally troubled governments that will come seeking a federal bailout.

Puerto Rico’s Problems

Puerto Rico’s problems are plentiful. A detailed examination and report of the territory’s problems, led by renowned economist Anne Krueger, included numerous outside shocks and impediments that have plagued Puerto Rico, and many more internal weaknesses and policy obstacles to economic growth.[1] Among the problems are: economic shocks, such as the housing bust; the U.S. mainland recession; financial market distress and high oil prices; excessive employment costs and regulations; overly generous welfare benefits; a declining population; high energy and transportation costs; and laws and regulations that restrict businesses’ ability to compete.

Puerto Rico’s brokenness and inefficiencies affect residents’ everyday lives. The outdated, inefficient, and overstaffed Puerto Rican Electric Power Authority (PREPA) produces electricity at two-and-a-half times the cost paid by mainland residents;[2] excessive shipping costs resulting from the federal Jones Act make it difficult for businesses to compete, while driving up prices for residents; excessive labor costs and regulations coupled with very generous federal welfare benefits (relative to the island’s lower standard of living) contribute to the dismal 50 percent labor-force-participation rate among working-age individuals (compared to 72 percent on the mainland);[3] and inefficiencies in government are so profuse that a policy requiring employees to collect their paychecks in person was recommended to prevent employees who never show up for work from continuing to collect salaries.

 

The Administration’s “Solution”

Recognizing Puerto Rico’s crisis and wanting to provide support, the Administration issued a “Roadmap for Congressional Action” in Puerto Rico.[4] This roadmap fails to address the heart of Puerto Rico’s problem—its declining economy—and instead offers supports that will make the island more dependent on the mainland.

From the very first line of its four-step solution, the roadmap fails to recognize the problem and appropriate remedies, claiming, “Only Congress has the power to provide Puerto Rico with the tools needed to address this economic and fiscal crisis.”[5] But Congress did not cause Puerto Rico’s economic and fiscal woes and congressional action is certainly not the only way Puerto Rico can address its current situation. The Puerto Rican government—not Congress—needs to put in place policies that will help revitalize its economy. Puerto Rico—not Congress—needs to negotiate with creditors to manage its debts. Indeed, Puerto Rico has already begun work on economic reforms and it is involved in negotiations with creditors, including a tentative deal with a significant group of bondholders.

Rather than congressional action, Puerto Rico needs strong leaders—its own leaders—who are willing to make tough choices and to follow through with an economic and financial revitalization plan as well as skilled negotiators to help manage and reduce the territory’s existing debt.

Chapter 9 and “Super Chapter 9”

The first component of the Administration’s plan calls for access to “Super Chapter 9” bankruptcy, which would allow Puerto Rico’s municipalities and public corporations, as well as the commonwealth itself, to declare bankruptcy.

The federal bankruptcy code explicitly prohibits territories and states from declaring bankruptcy,[6] and Puerto Rico’s constitution protects bondholders of commonwealth debt by backing the bonds with “the full faith credit and taxing power of the Commonwealth,” and specifying that such payments shall receive the highest priority.[7]

While Congress can change the bankruptcy code and override Puerto Rico’s constitutional protection for bondholders, granting Super Chapter 9 bankruptcy protection for Puerto Rico’s municipalities, public corporations, and the commonwealth itself would unfairly shift the ground under those who purchased both municipal and commonwealth debt.

Allowing one side to change the rules of the game after the game has begun and without consent of the other side is explicitly prohibited by subpart (1) to Section 903 of Chapter 9 bankruptcy code, which says that a state law cannot prescribe a method of composition of debt without the creditor’s consent.[8] Such consent is inherent in the purchase of municipal bonds that are not excluded from Chapter 9 bankruptcy, but those who purchased Puerto Rican bonds did so with the explicit understanding that their investments could not be restructured without their consent.

Allowing Puerto Rico access to Chapter 9 bankruptcy would set the precedent for states to gain access as well, so long as they dig themselves into as deep a hole as Puerto Rico’s. Changing the laws governing state and territorial debt amidst a crisis would not only violate the rule of law, but could wreak havoc on the state and municipal bond market, driving up state borrowing costs.

Chapter 9: No Improvement on Current Law

Chapter 9 is not a cure-all, nor does it necessarily provide a fairer or more orderly process than allowing creditors and debtors to negotiate under the existing, well-defined legal framework.

Detroit’s Chapter 9 bankruptcy, although successful at negotiating down the city’s debts, was neither fair nor orderly. Bondholders received as little as 11 cents on the dollar, while pensioners received either full benefits or marginal cuts alongside a reduction in their cost-of-living adjustments.[9] It is common in Chapter 9 bankruptcy for creditors to receive very low recovery rates while pensioners often emerge unharmed.

 

Moreover, the negotiations in Detroit were not systematic or by the book; private institutions were recruited to provide financial support and the city was allowed to keep its only significant asset—Detroit’s multi-million-dollar art collection.

At the end of the day, a city or territory has only what it has. Chapter 9 bankruptcy cannot create new assets or sources of revenues to pay off creditors. It is merely a way of determining who gets what, and it provides no fairer a process than already exists outside Chapter 9 bankruptcy. What is fair is for creditors and debtors to be forced to negotiate based on the contracts they signed, constrained by their finances and the framework already provided by Puerto Rican law. In the end, even a constitutionally protected debt is worthless if there is no money to pay it.

Political Oversight Without Enforcement

The Administration rightly points out that Puerto Rico must implement credible fiscal reforms to achieve financial stability. It wrongly suggests, however, that Congress would be able to provide independent fiscal oversight, and that it could do so without effectively overruling Puerto Rico’s government.

As was made apparent by all the key players in Detroit’s bankruptcy at a recent event hosted by the George Washington University Law School, bankruptcy resolution requires an outsider who is above politics.[10] Allowing optimal bankruptcy resolution requires that decisions be made with a view toward making all creditors as whole as possible—something that is impossible if an interested party is the trustee. In Detroit’s case, this neutral role was filled by emergency manager and bankruptcy attorney Kevin Orr. With no constituency to represent, nor political ambitions, Mr. Orr provided an independent assessment of the city’s situation and was able to recommend solutions that would have been career-ending for a politician.

Although mainland congressmen do not answer directly to Puerto Rican residents, they nevertheless represent political ideologies as well as constituents with vested interests in Puerto Rico’s fiscal crisis. The last thing Puerto Rico needs is 535 outside politicians telling it what to do.

Some of Puerto Rico’s public corporations may go into receivership if they fail to pay their debts. For the future of those utilities, the best hope may well be management that is unconstrained by politics. Stripping out political favoritism and focusing on efficiently serving customers is the path to solvency that is in the best interests of Puerto Rican residents and bondholders alike. The worst-case scenario for the utilities is that bankruptcy or another politicized intervention shields them from much-needed reforms.

The commonwealth itself may also fail to pay its debts. Nonetheless, Congress should honor the responsibility of Puerto Rican residents to govern their own affairs. Legal action through proper channels may deprive the commonwealth of some of its funding streams. But just as it would be unfair to the bondholders to deprive them of due process under the agreed-upon terms, it would be unfair to Puerto Ricans to preemptively depose their government in favor of a congressionally appointed manager.

Only if the commonwealth shows that it is unable or unwilling to abide by court decisions should Congress consider appointing a fiscal control board to manage Puerto Rico’s affairs—and even then, it should do so in deference to Puerto Rican law, not in defiance.

By contrast, the mix of crisis-induced legal changes and half-measures proposed by the White House would allow Puerto Rico to avoid reform, and inject Congress’s influence in ways that are not only annoying to all involved, but utterly ineffectual. The result would be an endless string of hearings and harangues while real reform is blocked by bankruptcy.

Medicaid and Taxpayer Bailout

As a territory, Puerto Rican citizens do not pay federal income taxes (they do contribute to and receive Social Security and Medicare benefits). Nevertheless, the Administration proposes granting additional Medicaid funding to Puerto Rico and providing its residents with two federal income tax credits—the Earned Income Tax Credit (EITC) and the Child Tax Credit.

About 60 percent of Puerto Rico residents rely on Medicare, Medicare Advantage, or Medicaid for their health care, compared to about 32 percent of mainland residents.[11] Rather than carve out special Medicaid funding for Puerto Rico, however, Congress should grant Puerto Rico more flexibility in how it distributes Medicaid and other welfare funds so that a household of three can no longer receive 50 percent more of its income from welfare than from work.[12]

Granting Puerto Rico citizens access to federal tax credits is a pure transfer, as the island residents do not pay federal income taxes. While many mainland recipients of the EITC and Child Tax Credit also pay no federal income tax or even receive money back from the federal government, they at least could contribute to federal income taxes if their earnings rise in the future.

Granting Puerto Ricans federal tax credits would increase federal deficits and shift Puerto Rico’s fiscal problems onto future U.S. taxpayers.

Puerto Ricans cannot have it both ways. Either they should pay federal taxes and receive federal tax benefits, or they should be exempt from federal taxes and excluded from federal tax benefits.

Other Options

Chapter 9 bankruptcy is not Puerto Rico’s only option. Some of the commonwealth’s debtors are already negotiating down their debts and seeking ways to improve their long-term viability. One of the territories biggest debtors—PREPA—recently announced a tentative deal with bondholders to reduce its overall debt and to provide financing for much-needed infrastructure investments to improve the power company’s viability.[13]

Ironically, while Puerto Rico ranks only 57th in the World Bank Group’s “Ease of Doing Business” scores (compared to seventh for the U.S. mainland), the island received its highest scores—seventh of 189 countries—in the ability to resolve insolvencies and obtain credit.[14] While these rankings apply to private businesses, they nonetheless show that the island’s laws and systems provide a means for resolving unpayable debt.

 

Just as PREPA has begun negotiating its debts without access to Chapter 9 bankruptcy, so, too, can Puerto Rico’s other creditors.

What Congress Can Do

While Congress should not retroactively change existing law by granting Puerto Rico access to Chapter 9 bankruptcy, providing open-end financial assistance through welfare and federal tax benefits, or investing in political oversight without enforcement, there are some things Congress can do to remove some of harmful regulations that contribute to Puerto Rico’s distress: Congress should exempt Puerto Rico from the maritime Jones Act, which roughly doubles shipping costs; eliminate or reduce the federal minimum wage in Puerto Rico; and allow the island flexibility in administering federal welfare benefits so that individuals are better off working than collecting welfare.[15] Moreover, Congress should consider removing the federal tax deduction for Puerto Rican bonds (a deduction not available for U.S. state bonds), which made it easier and cheaper for Puerto Rico to accumulate its $72 billion deficit.

—Rachel Greszler is Senior Policy Analyst in Economics and Entitlements in the Center for Data Analysis, of the Institute for Economic Freedom and Opportunity, at The Heritage Foundation.

About the Author

Rachel Greszler Senior Policy Analyst, Economics and Entitlements
Center for Data Analysis

Show references in this report

[1] Anne O. Krueger, Ranjit Teja, and Andrew Wolfe, “Puerto Rico: A Way Forward,” Government Development Bank for Puerto Rico, June 29, 2015, pp. 3–4, http://www.gdbpr.com/documents/PuertoRicoAWayForward.pdf (accessed November 19, 2015).

[2] David Savenije, “10 States with the Highest Electricity Prices,” Utility Dive, August 20, 2014, http://www.utilitydive.com/news/the-10-states-with-the-highest-electricity-prices/298112/ (accessed November 19, 2015).

[3] These labor-force-participation rates represent working-age individuals ages 15 to 64. Rachel Greszler and Salim Furth, “An Economic Crisis Is the Heart of Puerto Rico’s Financial Crisis,” Heritage Foundation Issue Brief No. 4442, July 27, 2015, http://www.heritage.org/research/reports/2015/07/an-economic-crisis-is-the-heart-of-puerto-ricos-financial-crisis (accessed November 19, 2015).

[4] The White House, “Addressing Puerto Rico’s Economic and Fiscal Crisis and Creating a Path to Recovery: Roadmap for Congressional Action,” undated, https://www.whitehouse.gov/sites/default/files/roadmap_for_congressional_action___puerto_rico_final.pdf (accessed November 19, 2015).

[5] Ibid.

[6] Chapter 11 of the code permits municipalities to seek permission from their state to enter Chapter 9 bankruptcy protection, but the code specifically says that Puerto Rico (along with the District of Columbia) cannot be defined as a debtor under Chapter 9 of the code, thus it cannot grant its municipalities access to Chapter 9 bankruptcy protection (11 U.S. Code § 101(52)).

[7] Puerto Rican Constitution, Article VI, Sections 2 and 8, http://welcome.topuertorico.org/constitu.shtml (accessed November 19, 2015).

[8] Title 11 U.S. Code § 903, “Reservation of State Power to Control Municipalities,” https://www.law.cornell.edu/uscode/text/11/903 (accessed November 30, 2015).

[9] Richard Lehmann, “Detroit Bankruptcy Settled, Distressed Municipal Debt,” Forbes Investing Newsletters, November 19, 2014, http://www.forbes.com/newsletters/distressed-municipal-debt/2014/11/19/detroit-bankruptcy-settled/ (accessed November 19, 2015).

[10] George Washington University Center for Law, Economics & Finance, “The Detroit Bankruptcy: Then and Now,” November 5, 2015, panel discussion, http://www.law.gwu.edu/News/newsstories/Pages/Detroit-Bankruptcy-Then-and-Now-Advisory.aspx (accessed November 30, 2015).

[11] Michael A. Fletcher, “Already Deep in Debt, Puerto Rico Now Faces a New Crisis,” The Washington Post, May 26, 2015, https://www.washingtonpost.com/news/wonk/wp/2015/05/26/already-deep-in-debt-puerto-rico-now-faces-a-new-crisis/ (accessed November 19, 2015), and The Henry J. Kaiser Family Foundation, “Health Insurance Coverage of the Total Population,” 2014, http://kff.org/other/state-indicator/total-population/ (accessed November 19, 2015).

[12] Krueger, Teja, and Wolfe, “Puerto Rico: A Way Forward.”

[13] Rachel Greszler, “Puerto Rico’s Pathway Forward Without Bankruptcy,” The Daily Signal, September 3, 2015, http://dailysignal.com/2015/09/03/puerto-ricos-pathway-forward-without-bankruptcy/.

[14] World Bank Group, “Doing Business 2016: Measuring Regulatory Quality and Efficiency,” 2015, http://www.doingbusiness.org/reports/global-reports/doing-business-2016 (accessed November 17, 2015).

[15] Greszler and Furth, “An Economic Crisis Is the Heart of Puerto Rico’s Financial Crisis.”