Puerto Rico Secretary of State on Government Reform

On my last post about government reform in Puerto Rico, a commenter pointed out that some of the trends indicating that the territory’s government is shrinking have reversed in the past year. Indeed, the number of government employees increased from 259,000 in December 2010 to 269,000 in December 2011. Likewise, government revenues ticked up in 2010 and 2011 after decreasing in 2008 and 2009.

I wanted to learn more about the reversal of the shrinking central government, so I spoke with Puerto Rico Secretary of State Kenneth McClintock about these trends. He explained, as the commenter pointed out, that the increase in government revenue is in large part due to an excise tax on foreign corporations that went into effect in 2011. This temporary tax is being used to finance broad-based tax reform and is gradually being phased out over the next five years when it will expire in 2016. McClintock explained that a six year plan for tax reform was one of the administration’s top priorities upon Governor Luis Fortuño taking office in 2008.

Reform measures have included cutting corporate tax rates from 39 percent to 30 percent and individual tax rates by 50 percent over the six year period. McClintock said, “Beginning in year one, everybody had more money in their pockets.” These reforms include a unique trigger. If Puerto Rico doesn’t achieve a balanced budget by the end of the six-year reform period, the final tax cuts will not go through. “We wanted to show people that good things happen with fiscal discipline,” McClintock continued.

Regarding the increase in government employees, McClintock said that part of the increase was due to stimulus funds from the American Recovery and Reinvestment Act and hiring by local governments. Additionally,  a negligible number of the initial cutbacks were deemed to be unsustainable and required refilling some positions that were eliminated in the initial round of cuts. Attrition policies are still in place, so longterm cuts should still be expected.

Initially, government job cuts raised Puerto Rico’s already high unemployment rate by about 1.2 percentage points. McClintock said that while hard data is not available on the individuals laid off from government jobs, anecdotally about half of them are now employed in the private sector. The layoffs included a $1 billion severance package which provided $5,000 for each laid off employee that they could use either to go to school or as seed money for a new business.

Of course, not everyone is as optimistic about the success of the territory’s reform efforts. As a blog produced by Center for the New Economy, a Puerto Rican think tank, reports, the tax reform program is not uncontroversial:

The control and reduction of government spending has stabilized the Commonwealth’s financial position.  Unfortunately, this stabilization is not cost free.  The implementation of this contractionary fiscal policy in the middle of a four year recession may have deepened and prolonged the economic recession in Puerto Rico.  Furthermore, the government’s pro-cyclical fiscal policy has been implemented at the same time that commercial banks in the island are undergoing a de-leveraging process that has significantly reduced the availability of credit.

As the article explains, some aspects of the tax reform plan may not point toward long run stability. The territory’s budget is increasingly reliant on federal funds with $1 of every $4 spent by the central government coming from federal transfer payments. Furthermore, debt service payments are increasing as a percent of Puerto Rico’s GDP.

While siginificant economic growth has yet to be seen coming out of the recession, economic indicators are looking better than when Governor Fortuño took office, despite about 12,500 government layoffs by the central government. Unemployment has fallen from 18 percent to under 16 percent and the Economic Activity Index reached positive territory in 2011 for the first time since early 2006. Some recent reforms will have staying power beyond Governor Fortuno’s term in office. The focus has been on improving Puerto Rico’s business climate relative to the states and neighboring countries by expanding trade and lowering taxes.

Reducing bureaucracy has also been a priority. “So far we have approved 11 of 13 reorganization plans to consolidate and eliminate agencies,” McClintock explained. He also said that many of the barriers to the renewable energy industry have been eliminated, leading the territory to become home to the largest wind and solar farms in the United States.

Puerto Rico is also pursuing an institutional change that could reduce long run spending. In August, Puerto Ricans will vote on an amendment to cut the number of legislators from 27 to 17 in the senate and 51 to 39 in the house of representatives. As research from Jowei Chen and Neil Malhotra demonstrates, state spending is likely to decrease with fewer state senators and with a higher ratio of representatives to senators.

Matt Mitchell and Nick Tuszynski covered their research in a literature review, and Matt estimates that these changes could be expected to reduce spending in Puerto Rico by about $77 per person yearly. The change to the legislature would take place ahead of the 2016 elections. McClintock said that this proposal is the result of “courageous legislators who are thinking from the people’s perspective rather than their own. It’s only natural that after cuts in the administration, people would expect cuts in the legislature as well.”

Many of the changes in Puerto Rico could be implemented in states looking to streamline government, particularly their tax reforms and triggers to provide incentives for voters to act as watchdogs to be sure that fiscal discipline is carried through.