Obama Administration Proposes Expanding EITC to Puerto Rico

"Puerto Rico, and the 3.5 million American citizens who call the island home, are facing a serious crisis that requires immediate congressional action. The Commonwealth has been mired in a decade long recession, during which more than 300,000 people left the island, the islands economy shrank and unemployment soared, and the Commonwealth's fiscal hole deepened. Puerto Rico has taken emergency actions to address these challenges, but those actions will be exhausted this winter. Puerto Rico has already taken significant steps to address its fiscal crisis, but more action is required.

"The Administration has been working with the Puerto Rico government to ensure that the Commonwealth is able to access all available, existing federal resources. We have helped Puerto Rico attract job-creating investments, secure new funds to accelerate infrastructure projects, and lower energy costs on the island. These efforts are ongoing, but administrative actions cannot solve the crisis. Only Congress has the authority to provide Puerto Rico with the necessary tools to address its near-term challenges and promote long-term growth.

"The proposal the Administration released today includes four central elements. First, Congress must provide Puerto Rico with an orderly restructuring regime to comprehensively address its financial liabilities by restructuring its debts. Second, Congress should provide independent fiscal oversight to certify that Puerto Rico adheres to the recovery plan it is implementing in a credible and transparent way. Third, Congress needs to reform the Commonwealth's Medicaid program and ensure that the program provides better access to healthcare services. Fourth, Congress should provide Puerto Rico with access to the Earned Income Tax Credit (EITC), a proven tool that has bipartisan support for rewarding work and supporting growth. "Working together, Congress and the Administration can help Puerto Rico emerge from the current crisis. Without congressional action, Puerto Rico will face a long and difficult recovery that could have harmful consequences for the residents on the island and beyond."

Puerto Rico's government is out of cash and is running out of options. The Commonwealth ran out of the cash to fund normal operations earlier this year. Government services and debt payments have only continued because Puerto Rico is deploying onerous and unsustainable emergency liquidity actions. Despite these actions, the Commonwealth projects it will completely run out of liquidity before year-end. Once that happens, Puerto Rico will face the unenviable and difficult choice between repaying its debts and maintaining vital public services. The latest reliable estimates reveal that, without further steps, Puerto Rico will not have resources to pay for both.

Puerto Rico must further strengthen its fiscal discipline. Additional fiscal adjustment is needed, together with stronger governance. While the Commonwealth has already taken significant action, its efforts have been stymied by Puerto Rico's long history of insufficient fiscal oversight and failure to achieve revenue and expense targets. Puerto Rico has proposed important reforms, such as increasing tax collection, as well as significant additional revenue and expense measures. To be successful, Puerto Rico will need to implement sufficient fiscal controls and oversight to make these measures credible. Puerto Rico must ensure it does its part by adopting tighter fiscal discipline and transparency.

However, Puerto Rico cannot solve this crisis alone. Austerity alone is not a path to recovery. While Puerto Rico needs to do more, there are limits to the scale and pace of additional fiscal adjustment that can be achieved. Puerto Rico projects it will face a $28 billion fiscal shortfall over the next five years and has identified additional actions it can take, through revenue and expense proposals, to partly close that gap. However, full implementation of Puerto Rico's proposed actions, including a return to economic growth, only reduces the five-year gap to $14 billion. The remaining shortfall must be filled, in no small part, through the restructuring of Puerto Rico's large and complex debt burden. The federal government must also do its part to address this crisis and help restart growth, which will require Congressional action, as detailed below.

The Administration is committed to continuing to work with Puerto Rico, but Congress must act to resolve this crisis. The Administration has been working with officials from Puerto Rico to stimulate investment and support economic growth, ensure a steady flow of previously obligated federal funds to the Island, and provide our technical and financial expertise wherever appropriate. We have dedicated a team to closely monitor the crisis and provide financial expertise. But existing administrative authorities are not enough. There is no set of administrative authorities that can fully address and resolve this crisis. The administration has been clear that no one is contemplating a federal bailout for Puerto Rico, and the legislative proposals below are not a bailout. They are the reforms that Puerto Rico needs to effectively manage through its crisis. Only Congress can provide the critical tools Puerto Rico needs to restructure its debt, enhance its fiscal governance, fix its healthcare system, and help jumpstart its economy.

Without action by Congress and further fiscal discipline by Puerto Rico, the crisis will escalate. All stakeholders, including bondholders, need to be part of the solution. Without a comprehensive solution, which requires Congressional action, Puerto Rico and its creditors risk a long, difficult, and disorderly crisis. In the interim, delaying action will result in continued uncertainty, which will drive additional economic contraction, outmigration, and suffering. This will inevitably lead Puerto Rico's government to an impossible choice between fulfilling its financial obligations and providing essential services to the 3.5 million Americans living in Puerto Rico.

There are four key elements to the Administration's plan:

Only Congress can grant access to a federal restructuring mechanism. Puerto Rico does not have access to the federal bankruptcy courts to restructure its financial obligations. Puerto Rico's officials tried to address this shortfall on their own by passing a law to provide a bankruptcy-like process, but a federal appeals court held that federal law preempts the local legislation. Further, the court held that only Congress may grant Puerto Rico access to bankruptcy protection.

Shared sacrifice is needed. All stakeholders have an interest in Puerto Rico's economic recovery. Puerto Rico must take additional steps to close its fiscal gap, building on the measures it has already taken. However, austerity alone is not a path to recovery. While Puerto Rico needs to do more, there are limits to the scale and pace of additional fiscal adjustment that can be achieved. Against this backdrop, any additional fiscal adjustment must be measured against its potentially adverse effects on Puerto Rico's economy and people.

Puerto Rico's liabilities are unsustainable and need to be restructured. As currently structured, Puerto Rico's debt load is unsustainable. Tax-supported debt service consumes approximately one-third of annual revenues and total liabilities exceed 160 percent of GNP -- a greater burden than likely can be supported even if economic growth resumes. Long-term, Puerto Rico projects it will face a $28 billion fiscal shortfall over the next five years and has identified additional actions it can take, through revenue and expense proposals, to partly close that gap. However, full implementation of Puerto Rico's proposed actions, coupled with economic growth, only reduces the five-year gap to $14 billion. The remaining shortfall must be filled, in no small part, through the restructuring of Puerto Rico's large and complex debt burden.

Puerto Rico's pension systems are at serious risk. Monthly pension payments are the only source of steady income for many of the pension systems' 163,000 retirees. An additional 167,000 workers, who represent nearly 20 percent of Puerto Rico's workforce, are also counting on the pension systems for retirement income. For much of the past decade, Puerto Rico has failed to pay its annual required contributions. As a result, system administrators are currently being forced to sell pension assets to pay current benefits. Once those assets are depleted -- likely by 2019 -- all future pension benefits will need to be paid directly from the Commonwealth's General Fund. Given Puerto Rico's fiscal constraints, it is unclear how the Commonwealth will find the resources to deliver promised pension benefits, make full payment on its debt, and operate essential public services. Any restructuring of Puerto Rico's financial liabilities should account for the promises the Commonwealth has made to its public servants.

Bankruptcy provides a fair process and a comprehensive solution. The Commonwealth and its creditors need a fair and orderly mechanism to restructure Puerto Rico's financial liabilities. Bankruptcy protection is not a federal bailout. Allowing Puerto Rico to resolve its liabilities under the supervision of a bankruptcy court involves no federal financial assistance. Puerto Rico's debt stock is highly complex. More than 20 creditor committees have already formed around Puerto Rico's 18 different debt issuers, each with its own competing interests. This will make it very difficult for Puerto Rico to negotiate a voluntary restructuring on a timely basis. A court-supervised process would help ensure fair treatment to all parties. The alternative -- an untested and potentially disorderly process with numerous creditor lawsuits and years of litigation -- would depress the local economy, increase costs, and make long-term recovery harder to achieve. Absent an orderly process, all stakeholders stand to lose in the face of continued deterioration of Puerto Rico's economic and financial conditions and ongoing uncertainty.

Congress should take the following actions to provide a fair and orderly restructuring mechanism built on the tested principles of the federal bankruptcy code:

• Congress should move swiftly to pass pending legislation that provides Chapter 9 protection to municipalities of the Commonwealth of Puerto Rico in the same manner it is currently provided to municipalities in the fifty states. This legislation would cover approximately one-third of Puerto Rico's debt.

• Congress should also authorize a broader legal framework that goes beyond the scope of Chapter 9 to allow for a comprehensive restructuring of Puerto Rico's liabilities.

• • The restructuring regime should be reserved exclusively for U.S. territories. As under current law, states would remain ineligible to file for bankruptcy under this or any other bankruptcy regime.

  • The restructuring regime should provide the basic protections of bankruptcy: a stay on creditor collection actions, priority for new private short-term cash flow financing, and voting by creditor classes on any proposed restructuring. Such an approach would, among other things, provide breathing space for consensual negotiations and ensure the uninterrupted provision of essential public services.

  • The restructuring regime should fairly balance the interests of Puerto Rico and all its creditors.

Puerto Rico's efforts have been hampered by a long-standing lack of fiscal oversight and transparency. Historically, Puerto Rico's budgets relied on unrealistic revenue estimates, and, as a result, annual budgets masked recurring structural deficits. Moreover, proposed revenue and expense measures have fallen short because Puerto Rico lacks important fiscal controls to ensure discipline. Financial disclosure is opaque and deadlines have repeatedly been missed, impairing the ability to track progress against proposed reforms.

Independent and credible fiscal oversight is needed. Congress should enact independent and credible fiscal oversight only as part of a comprehensive legislative package that fully equips Puerto Rico with the tools it needs. The oversight should provide sufficient safeguards to ensure Puerto Rico adheres to its recovery plan and fully implements proposed reforms. This would help restore confidence among all stakeholders. Access to the broader restructuring regime should be conditioned on this oversight. The Administration is ready to work with Congress on the details of how to develop the powers of this oversight body and its proposed membership, according to the following principles:

• The oversight body should have broad representation from Puerto Rico's stakeholders. Care must be taken to structure the fiscal oversight in a way that respects Puerto Rico's autonomy.

• The oversight body's powers should include the authority to ensure that annual budgets and expenditures are in conformance with Puerto Rico's multi-year fiscal plan. There are also some authorities, like the ability to impose new taxes and raise fees, which should remain solely within the control of democratically-elected officials.

• Congress should provide funding and authorization for technical assistance to help Puerto Rico make the critical investments needed to bring its accounting and disclosure practices into the 21^st century.

• This includes taking action to fund information technology upgrades, improve economic forecasting capabilities and provide federal technical assistance around budgeting, cash management and spending controls. Agencies in Puerto Rico use different financial systems that are incompatible with one another, making it difficult to provide consistent, timely financial reporting and visibility into expenses.

• The funding involved would be small, but the benefits would be great.

Puerto Rico's residents deserve a higher standard of care. Given the current treatment of Puerto Rico and the other territories under federal law, the 3.5 million Americans in Puerto Rico are left without access to healthcare treatments considered standard in the rest of the nation. There are currently more than 1.6 million Medicaid enrollees, representing nearly one-half of Puerto Rico's population.

Insufficient and unstable funding for Medicaid has contributed to Puerto Rico's fiscal challenges and endangered access to coverage. Despite the significant one-time funding increase provided in the Affordable Care Act, as many as 600,000 Americans living in Puerto Rico could lose their healthcare coverage when those funds run out. Moreover, Puerto Rico's Medicaid program is fundamentally different from the Medicaid program that serves Americans in the 50 states and the District of Columbia. Medicaid funding in Puerto Rico is capped; U.S. citizens in Puerto Rico are offered fewer benefits; and the federal government contributes less on a per-capita basis in Puerto Rico than in the rest of the nation.

Congress can take action today to reform Puerto Rico's Medicaid program to raise the standard of care in Puerto Rico and prevent Medicaid's unstable financing from worsening Puerto Rico's fiscal crisis. The Administration stands ready to work with Congress on reform that advances the following principles:

• Provide access to Medicaid and key health care services that better aligns with what their fellow Americans receive on the mainland, including by:

• • Protecting Medicaid coverage for needy individuals in Puerto Rico during these difficult times, and avoiding a drop in coverage when one-time funds from the Affordable Care Act expire.

  • Improving the quality of Medicaid coverage in the Commonwealth by offering access to additional core services Medicaid beneficiaries would receive if they were living on the mainland.

• In a fiscally responsible manner, move toward a permanent and stable funding partnership that would alleviate some of the fiscal challenges and risks created by the current insufficient and unstable federal funding.

• Ensure an adequate transition period needed for Puerto Rico to upgrade its healthcare system required to offer new benefits and strengthen its internal accountability, financial management, and program integrity controls to prevent fraud, waste and abuse.

• Remove the cap on Puerto Rico's Medicaid program and increase the federal support Puerto Rico receives through the federal Medicaid match, after a sufficient transition period.

Any credible plan for resolving Puerto Rico's fiscal crisis must recognize the importance of restoring economic growth. The decade-long recession has taken its toll on Puerto Rico's finances, its economy, and its people. To break this vicious cycle and establish a solid foundation for renewed growth, Congress should extend some of the most proven, bipartisan tools for stimulating growth and rewarding work to the citizens of Puerto Rico.

The Earned Income Tax Credit (EITC) is one of the strongest policy tools for rewarding work and supporting economic growth. At forty percent, Puerto Rico has the lowest labor market participation in the United States and the territories -- participation rates are about two-thirds the U.S. average. Low participation in the formal economy stunts economic growth and undermines Puerto Rico's economic reform efforts. A large body of economic research has found that the EITC in the fifty states and the District of Columbia has increased work. Studies have documented the impact of the mainland EITC enacted in the 1980s and 1990s, which induced more than half a million people to enter the labor force. The existence of an EITC should also increase employment in the official sector relative to the informal economy by providing higher incomes to workers who file taxes.

The EITC would strengthen formal participation in Puerto Rico's economy. This added incentive for formal participation in Puerto Rico's economy should increase tax compliance and tax revenues and likely improve the fiscal position in Puerto Rico. As a result, Congress should provide Puerto Rico access to an earned income tax credit (EITC), which is already available to Americans living in the fifty states and the District of Columbia. An EITC would encourage work in the formal economy and boost Puerto Rico's low level of labor market participation. Puerto Rico does not have an EITC today.

The EITC is a time-tested, bipartisan job creation tool that has garnered broad support. The EITC has historically long garnered broad bipartisan support in Congress. President Reagan proposed a major EITC expansion that was included in his 1986 Tax Reform Act, which he argued was "the best antipoverty, the best pro-family, the best job creation measure to come out of Congress."

Congress should also consider other proven measures, in addition to an EITC, that reward work and support growth, such as the Child Tax Credit. Puerto Rico should support federal action by taking its own steps to enhance incentives for labor force participation, encourage job creation and make it easier to do business in Puerto Rico.

Puerto Rico has experienced a sharper recession than the rest of the United States, and the economy continues to contract. Since Puerto Rico's economy began to contract in 2006, the economy has shrunk by more than 10 percent and employment on the island has fallen by 14 percent.¹ Puerto Rico's unemployment rate was 11.6 percent in August 2015, more than twice the national level. The scale and depth of Puerto Rico's downturn stems from many factors, including a boom and bust cycle in real estate and credit prior to the current fiscal crisis, longstanding problems of fiscal governance, deteriorating confidence among all stakeholders, and a structure of taxation and benefits that fails to provide the same reward for work as in the fifty states.

• Poverty levels are the highest in the nation. The number of residents living at or below the federal poverty level exceeds 45 percent, compared to a national average of about 16 percent. The median annual household income in Puerto Rico is approximately $19,000, roughly one-third of the level of median income in the United States.

• The worsening financial crisis has already caused residents to flee the island at an alarming pace. More than 300,000 people have left Puerto Rico in the past 10years, including 84,000 people in 2014 alone.

• The remaining population is one that is increasingly older and not actively seeking work. Labor force participation in Puerto Rico, at 39.7 percent, is substantially below the U.S. average of 62.4 percent. Persons 60 years and older represent more than 23 percent of the population -- one of the highest in the United States.

 

Local Population

 

 

 

 

Government Development Bank Economic Activity Index

 

 

 

The Current Fiscal Situation is Unsustainable

Puerto Rico's economic challenges predate its current fiscal crisis. The sustained slump in the economy has contributed to the island's fiscal challenges, and Puerto Rico's fiscal challenges have in turn added to the difficulty it faces attracting private investment and restarting growth.

Puerto Rico has a history of poor fiscal performance. Historically, Puerto Rico's budgets relied on unrealistic revenue estimates, and, as a result, annual budgets masked recurring structural deficits. Moreover, past revenue and expense measures have fallen short because Puerto Rico lacks important fiscal controls to ensure discipline. Poor financial disclosure has impaired the ability to track progress against reforms enacted -- reporting is opaque and deadlines have repeatedly been missed.

Puerto Rico effectively has been shut out of the traditional municipal bond market since 2013. Puerto Rico, like any other U.S. state or territory, has historically relied on the municipal markets for relatively low-cost financing. However, over the last two years it has relied on a high-cost bond placed with nontraditional lenders and the sale of assets -- including pension assets -- to meet ongoing commitments and cover fiscal gaps. In the past year, the Commonwealth has completely lost access to market funding; it no longer can raise even short-term financing.

• Most of Puerto Rico's uninsured bonds trade at between 30 and 70 cents on the dollar, prices that imply a high probability of a restructuring.

• Even the most highly-valued Puerto Rico bonds yield 11 percent, making long-term market financing prohibitively expensive. Prior to its crisis, Puerto Rico issued at yields in line with the rest of the market: for example, its 2006 General Obligation (G.O.) bonds were priced to yield 4.8 percent.

• Puerto Rico's bonded indebtedness is approximately $71 billion (over 100% of GNP), including close to $50 billion (70% of GNP) in tax-supported debt.²

• As of FY2014, Puerto Rico's three public pension funds held just $2 billion in net assets against a combined estimated pension liability of $46 billion.

• Government services and debt payments have only continued because Puerto Rico is deploying onerous and unsustainable emergency liquidity actions. These measures include delaying payment of tax refunds to residents, liquidating pension assets early to fund working capital, borrowing from Puerto Rico's proprietary insurance funds, failing to pay certain appropriation debts, withholding monthly set-aside funds for debt service, and stretching payment of accounts payables to vendors and other third parties.

• Even with these emergency actions, Puerto Rico forecasts it will completely run out of liquidity before year end. Once that happens, Puerto Rico will face the unenviable and difficult choice between repaying its debts and maintaining vital public services.

Commonwealth Monthly Cash Balance

 

 

 

Significant Challenges Remain Despite Reform Efforts

Puerto Rico's recently released Fiscal and Economic Growth Plan outlines the scale of the fiscal challenges it faces. The Fiscal and Economic Growth Plan draws on the independent forensic accounting report of Conway MacKenzie and presents a consolidated picture of the public sector finances prepared with the support of former staff from the International Monetary Fund (IMF) led by Anne Krueger. It presents an accurate measure of Puerto Rico's contracted debt payments, without "scoop and toss" off-budget refinancing of various debts. The numbers continue to be refined, but there is no doubt that there is a large gap between Puerto Rico's required operating expenses, contractual debt obligations and its available financial resources.

Debt service now consumes more than one-third of annual revenues when looking comprehensively at the full range of debt supported primarily by the Commonwealth's taxing authority. This compares to a U.S. median of approximately five percent for states in fiscal year 2014, according to Moody's Investors Service. Building on the work of Anne Krueger and her IMF team, the Fiscal and Economic Growth Plan provides, for the first time, a transparent accounting of Puerto Rico's tax-supported debt service beyond what is presented in its general fund budgets.

Important fiscal adjustments have been implemented in recent years:

• Operating expenses are shrinking after taking into consideration debt payments. In fact, general fund expenses for the current fiscal year, net of debt service, are currently at their lowest level since 2005, both in nominal terms and as a share of GNP.

• A strict fiscal sustainability act (Law 66) has been enacted to reduce government expenses. Among other measures, the law froze collective bargaining agreements already in place that involve salary increases and other benefits.

• The tax on petroleum and petroleum products was quintupled from $3.00 to $15.50/barrel -- projected to generate approximately $360 million a year in additional revenues.

• The local sales and use tax was increased from 7.0 percent to 11.5 percent (now the highest in the nation) -- a measure that is expected to generate well over a $1.0billion a year in additional revenues.

However, there are practical limits on the scale and pace of fiscal adjustment in an economy that is significantly smaller than in 2005. Too much adjustment could push Puerto Rico into a downward spiral, with the successive rounds of fiscal consolidation pulling the economy down, encouraging more outmigration, reducing revenues and requiring additional taxes or cuts. Only a return to growth can end this vicious cycle.

Stronger fiscal governance is critical. While the Fiscal and Economic Growth Plan is a welcome first step towards increased transparency, there is more work to do. The Plan proposes a new accounting system, a new budgetary process, reforms to the structure of Puerto Rico's Treasury Department, and steps to improve budget execution across Puerto Rico's many agencies. These steps need to be reinforced by independent and credible fiscal oversight to provide sufficient safeguards to ensure Puerto Rico adheres to its reforms. Doing so would likely restore confidence among stakeholders.

 

General Fund Approved Budget

 

 

 

Source: Puerto Rico Office of Management & Budget FY2016 Proposed Budget Presentation.

Debt Restructuring is Unavoidable

Puerto Rico's Fiscal and Economic Growth Plan outlines a $28 billion fiscal gap over the next five years in the absence of any policy changes. This exceeds the $18 billion in contracted debt service, underscoring the need for improved fiscal controls and additional fiscal adjustment.

The full implementation of the measures outlined in the Fiscal and Economic Growth Plan, including, critically, the increase in the sales tax and transition to a value-added tax, is estimated to close the financing gap by half. This estimate includes sizeable projected revenue gains from an assumed return to stronger growth in 2019 and 2020. Even with these projected gains, there is a five-year gap of $14 billion -- a gap that likely will need to be filled, in part, through a renegotiation of the Commonwealth's large and complex debt burden.

Puerto Rico's Pension Systems are Also at Serious Risk

Puerto Rico's public pension system is also in crisis, and can no longer be used to help finance government operations. There is a long-standing discrepancy between what the Commonwealth contributes to the system and the annual required contribution stipulated by the systems' actuaries. As part of a 2013 reform, required employer contributions will gradually be raised from 10 to over 20 percent of payroll, bringing total employee and employer contributions to 30 percent of payroll, and changes were made to the accrual of future benefits in the largest public pension fund. Nevertheless, Puerto Rico's public pension funds have the lowest funded ratio of any state or territory.

• While legislation designed to comprehensively the Island's largest public pension system, the Employee Retirement System (ERS), was enacted in 2013, the portion of the legislation related to its second largest system, the Puerto Rico's Teachers Retirement System (TRS), was partially overturned by Puerto Rico's Supreme Court.

• Furthermore, the Commonwealth has not made the additional contributions to the public pension system required and contractually mandated under the 2013 reform. In FY2014, the Commonwealth was only able to pay current pension benefits through the sale of close to one billion in assets from its three public pension funds.

• The unsustainable drawdown on pension fund assets has continued. At current drawdown rates, the assets of the two main public pension funds will be depleted before the end of the decade. At the end of FY2014, Puerto Rico's three public pension funds held just $2 billion in net assets against a combined estimated pension liability of $46 billion.

• The Commonwealth recently accelerated public pension fund asset sales to help provide short-term financing for core governmental operations as part of its emergency actions.

• The Commonwealth's forward-looking fiscal plan cannot rely on the sale of pension assets to help the Commonwealth meet its other contractual obligations; future budgets will need to raise contributions to the pension systems to protect the Commonwealth's ability to pay retiree's benefits.

 

Pension Assets (left axis) &

 

Funded Ratios (right axis)

 

 

 

Source: ERS, TRS Actuarial Reports; Commonwealth Quarterly Report, May 2015.

 

ERS & TRS Ending Gross Balances (excluding AUCs)

 

 

 

Source: Puerto Rico Fiscal & Economic Growth Plan, pg. 77.

² Gross National Product (GNP) as opposed to Gross Domestic Product (GDP) is typically a more representative measure of Puerto Rico's economy, as it includes the income accruing to island residents but excludes the significant portion of income generated on the island that accrues to non-island residents, particularly in the manufacturing sector.