"This volume offers a trove of information and lessons to be avoided. Recommended." E. Pang, Colorado School of Mines, CHOICE, 3/1/2007
The Economy of Puerto Rico: Restoring Growthby Susan M. Collins
A territory of the United States, Puerto Rico operates under U.S. legal, monetary, security and tariff systems. Despite sharing in these and other key U.S. institutions, Puerto Rico has experienced economic stagnation and large scale unemployment since the 1970s. The island's living standards are low by U.S. standards, with a per capita income only half that of Mississippi, the poorest state. While many studies have analyzed the fiscal implications of Puerto Rico's political relationship with the United States, little research has focused broadly on the island's economic experience or assessed its growth prospects.
In this innovative new book, economists from U.S. and Puerto Rican institutions address a range of major policy issues affecting the island's economic development. To frame the current situation, the contributors begin by assessing Puerto Rico's past experience with various growth policies. They then analyze several reforms and new initiatives in labor, education, entrepreneurship, fiscal policy, migration, trade, and financing development, which they incorporate into a proposed strategy for jumpstarting Puerto Rican economic growth.
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The Economy of Puerto RicoRestoring Growth
Brookings Institution PressCopyright © 2006 Brookings Institution Press and the Center for the New Economy
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Chapter OneIntroduction and Summary
SUSAN M. COLLINS, BARRY P. BOSWORTH, and MIGUEL A. SOTO-CLASS
At the close of the millennium, Puerto Rico was a tale of two economies. It had achieved some impressive economic milestones. Per capita income was substantially higher than in the rest of Latin America. In terms of quality of life measures such as literacy rates, years of schooling, and life expectancy, it ranked close to the most highly developed countries. But in other key dimensions, Puerto Rico appeared stuck under an economic glass ceiling. Although Puerto Rican residents have been American citizens since 1917, nearly half of them still lived under the U.S. poverty line, and the income gap relative to the mainland was widening.
As a territory of the United States, Puerto Rico shares key U.S. institutions; in particular, the region operates under U.S. judicial, monetary, and tariff systems. It is one of the world's most open economies, with free mobility of goods, services, capital, and labor to the large, prosperous U.S. market. One might expect these conditions to pave the way for rapid economic development in Puerto Rico, with living standards converging steadily with those enjoyed in the rest of the nation.Indeed, in the decades following World War II, Puerto Rico was hailed as a success story, sustaining impressive rates of economic growth and significantly raising domestic living standards. Its gross domestic product (GDP) per worker rose from 30 percent of the U.S. average in 1950 to 75 percent in 1980, a remarkable achievement.
But over the past twenty-five years, the economic situation on the island has deteriorated. Growth in GDP has slowed substantially, and no further progress has been made in narrowing the gap with the U.S. mainland. Gross national income per capita, a more appropriate measure of living standards, yields an even less favorable picture. While income per capita doubled from just over 20 percent of the U.S. average in 1950 to roughly 40 percent in the early 1970s, it has drifted back down to only about 30 percent more recently. Living standards in Puerto Rico are farther from the U.S. average today than they were in 1970, and per capita income is only about half that of the poorest state.
Why did Puerto Rico's economic progress stall? More important, what can be done to restore growth? These are the questions that motivated the Center for the New Economy and the Brookings Institution to undertake this collaborative research project. The objective was to examine Puerto Rico's economy and propose strategies for sustainable growth. Although it necessarily touches on political issues at times, no assessment of the alternative political options for the region was intended. Indeed, our economic analyses and proposed growth strategy are status neutral and will be relevant regardless of political regime.
The issues raised by Puerto Rico's puzzling economic performance are both important and interesting. Many Americans are unaware that the incomes of a large group of fellow citizens have been far below the average. More broadly, it is critical to understand why an economy with so many of the characteristics economists deem key to growth should not perform better. And as economic integration expands and deepens in Europe and elsewhere, it is ever more essential to understand which policy levers remain available for a small but open peripheral economy to ensure that it does not fall behind.
A preliminary analysis of Puerto Rico's economic situation highlighted a set of overlapping concerns that appeared to be at the heart of Puerto Rico's economic difficulties. These included dimensions of labor supply and demand, entrepreneurship, the fiscal situation, financial markets, and trade. In selecting authors to study each of these topics, we paired Puerto Rican and mainland experts so as to ensure that the analysis was appropriately grounded in the relevant historical context. The authors met for an initial conference in San Juan in May 2004. Drafts of all the papers, as well as commentary by invited discussants, were presented at a second, academic conference in March 2005, also in San Juan. The revised analyses and discussant remarks are presented in this volume.
The volume consists of nine substantive chapters-each summarized briefly in the remainder of this chapter. Chapter 2 provides an empirical overview of Puerto Rico's growth experience, setting the stage for subsequent chapters. Motivated by the island's extremely low employment rates, the next two chapters study labor supply from two different perspectives. Chapter 3 focuses on the effects of public transfers on labor supply, and chapter 4 examines the influence of a broader range of determinants. Chapter 5 addresses the quality of the labor supply, looking at the educational system and its performance. Private sector development, a critical component of labor demand, is the focus of chapter 6. Chapter 7 examines fiscal policy, an area of considerable local autonomy but growing difficulties. Puerto Rico has much less control over its monetary and trade policies than it would if it were an independent country. Nonetheless, financial markets and cross-border interactions are central to the island's economic performance. These issues are the subject of chapters 8 and 9. The final chapter of the volume pulls together the lessons from these analyses and sets out a growth strategy for Puerto Rico.
In the second chapter, Barry P. Bosworth and Susan M. Collins examine the level and growth of production and income in Puerto Rico. Pulling together data from a variety of sources, they analyze why economic performance faltered, identify the main characteristics of the current economy, and highlight the key challenges to restoring sustained growth.
The analysis uncovers three main sets of findings. First, official statistics substantially overstate production of goods and services on the island. The problem arises from section 936 of the U.S. tax code, which provided strong incentives for U.S. corporations to use transfer pricing to shift reported income to Puerto Rico. Profits earned in Puerto Rico are effectively exempt from U.S. taxation. These provisions were introduced in 1976 and remained in force until they were repealed in 1995, with a ten-year phase-out. The authors document the magnitude of the distortion in a number of ways and then construct "adjusted" GDP estimates. Their preferred measure cuts the level of Puerto Rican GDP by about 20 percent in 2003 and that of output growth by 0.7 percent a year since 1975. The tax distortion explains much of the growing gap between Puerto Rico's measured production and national income, and the adjusted data highlight the sluggishness of recent economic performance. Bosworth and Collins conclude that U.S. tax policy has done a disservice to Puerto Rico by providing U.S. corporations incentives for investments with few or no employment or local linkages.
Second, their examination of the relationship between GDP per worker (productivity) and income per capita (living standards) highlights the reasons why Puerto Rico's income per capita has fallen relative to the U.S. level since 1970. Using the adjusted GDP data, they find that labor productivity in Puerto Rico stalled and employment as a share of its working-age population declined to just two-thirds of the U.S. level.
Third, they undertake a growth-accounting analysis that decomposes growth in Puerto Rico's output per worker into the contributions from increased physical and human capital per worker and those from a residual measure of total factor productivity. This analysis clearly distinguishes two periods in Puerto Rico's economic performance. In the early period (roughly 1950-75), the island sustained growth rates in output per worker near 5 percent a year, comparable to rates achieved in the rapid growth phases for Ireland and East Asia and well above the Latin American average. With growth rates more than double those on the mainland, this was a period of significant catch-up for Puerto Rico and was characterized by both capital deepening and increased efficiency of factor usage. In contrast, since 1975 Puerto Rico has fallen behind. The authors estimate that Puerto Rican growth in output per worker dropped to just over 1 percent a year, below that of the mainland.
The growth accounts uncover two reasons for Puerto Rico's slow growth in labor productivity. One is that capital accumulation did not keep pace with increases in employment. Although investment rates have recovered somewhat, they are insufficient to support long-term growth at the level achieved in the earlier period. In contrast, Puerto Rico stands out for relatively high contributions of increased human capital to growth, owing to continued gains in educational attainment. Indeed, the island has largely caught up with the mainland in terms of average years of schooling. The other is a sharp, persistent slowing of growth in total factor productivity. Again using the adjusted output measure, the authors find that total factor productivity growth fell after 1970, turning negative in the 1990s. This pattern suggests a secular deterioration, which is more worrisome than the typical Latin American experience of sharp cyclical fluctuations in economic growth.
Puerto Rico's per capita income is less than one-third that of residents of the U.S. mainland. Much of this difference can be traced to employment rate differences-and ultimately to labor force participation rate differences-between the two economies. Furthermore, these differences have increased substantially over time. The labor force participation rate of Puerto Ricans between the ages of twenty and sixty-four is currently just 85 percent of the equivalent participation rate on the U.S. mainland for men and 62 percent for women.
In chapter 3, Gary Burtless and Orlando Sotomayor examine reasons for the trend toward lower relative employment rates in Puerto Rico. Their analysis focuses on implications of the generosity and structure of government transfer benefits available to Puerto Rico residents. The chapter presents empirical evidence, including the timing of changes in policy versus employment rates and differences in trends across differentially affected groups. Although other developments, including a minimum-wage hike and two severe recessions after 1973, account for part of the slump in Puerto Rican labor supply, the authors conclude that changes in the generosity of transfer benefits played a crucial role.
Burtless and Sotomayor document that government transfer payments account for a large percentage of the total income received by Puerto Rico residents. This percentage rose steeply in the 1970s and 1980s. Since 1990, government transfer benefits have provided 25 to 28 percent of Puerto Rico's personal income, twice the equivalent percentage on the U.S. mainland.
The authors examine the effects of five transfer programs in detail: Puerto Rico's equivalent of the food stamp program, unemployment insurance, Social Security retirement and disability benefits, government-provided health insurance, and Temporary Assistance for Needy Families. All of these programs has important work-discouraging effects because they reduce benefit payments to recipients who find employment. The chapter documents cases in which an increase in earned income may be more than offset by reductions in various public assistance payments.
Burtless and Sotomayor also note that, because average incomes are lower in Puerto Rico than on the mainland, the U.S. Social Security program offers significantly more attractive retirement and disability benefits to Puerto Rican workers. In view of the generosity of disability insurance pensions for low-wage Puerto Rican workers, for example, it is not surprising that the disability rate in Puerto Rico is well above the U.S. average. The authors document differences that may account for 2 to 3 percentage points of the lower labor force participation rate in Puerto Rico relative to the United States.
Burtless and Sotomayor argue that policymakers should aim to increase employment and labor force participation rates on the island so they approach or match those on the U.S. mainland. To reform social protection programs so they encourage rather than discourage work, the authors call for modifications in current benefit schedules and new eligibility rules for assistance that would redesign transfer programs to increase incentives to work and encourage workers to earn higher wages.
The authors emphasize the importance of linking program benefits with incentives to seek employment or to increase the hours of work. An example of such a program is the earned income tax credit in the United States, which provides a supplement to earnings. In contrast, a typical assistance program, such as Puerto Rico's Nutritional Assistance Program, discourages work among recipients by reducing benefits to those who find employment. To reduce program costs and encourage bigger increases in workers' weekly earnings, Burtless and Sotomayor propose a Puerto Rican wage supplement program that requires participating workers to hold jobs with minimum hours conditions. Such restrictions would allocate larger subsidy payments to those workers who make the biggest increases in their monthly hours of work.
María Enchautegui and Richard Freeman also focus on Puerto Rico's strikingly low employment rates. Their analysis concentrates on men, because they find that it is the low male employment rate that is "off the map" in comparison with other countries. A unifying theme of their work is the "rich uncle (Sam) hypothesis": the primary reason for the low employment, the authors posit, is that Puerto Rico's unique relationship with the United States has produced an economic environment that discourages work on both the supply and demand sides of the market. This hypothesis suggests that the close tie between the island and the mainland has been double edged, offering Puerto Ricans many of the benefits of living in a highly advanced economy but also contributing to the employment problem.
The authors begin by documenting what has happened to male labor force participation and employment, using measures of labor force activity from the census and household surveys. They conclude that at the turn of the twenty-first century, Puerto Rican men had an exceptionally low involvement in the labor market by global standards. This resulted from both a downward trend in participation in the 1970s, which produced a permanent detachment of many men from the workforce, and a rising proportion through the 1990s who reported themselves disabled. The remainder of the chapter attempts to answer the question, "Why don't more Puerto Rican men work?"
Enchautegui and Freeman identify and examine a number of interacting factors that may play a role. One is the distorted relationship between aggregate demand and employment. The authors show that employment in Puerto Rico has been more closely related to the slower-growing GNP than to the faster-growing GDP. Furthermore, the tax incentives for investing in capital-intensive activities may have also distorted the pattern of GDP and employment in Puerto Rico.
Second, like Burtless and Sotomayor, they argue that transfer programs-especially the Social Security Disability Insurance and the Nutritional Assistance Programs-are likely to have had large disincentive effects on male employment. A third potential factor is the option for workers to migrate to the mainland. The authors explain that this has both direct effects-such as reducing labor force participation if those most willing to work are more likely to migrate-and indirect effects-such as raising the reservation wage of those on the island.
Finally, the authors focus on Puerto Rico's wage structure in comparison with that on the mainland. Surprisingly, the highest relative earnings are for less educated workers-in contrast with the normal pattern in cross-country earnings differences, whereby the earnings of the most educated workers in developing and high-income countries are more similar because of their greater opportunities for emigration.
Three possible explanations are examined. Puerto Rico's adoption of the U.S. minimum wage has limited downward wage flexibility. Income transfers may have created a reservation wage considerably above the minimum and above the full employment wage rates. Finally, potential migration to the United States may have created a wage floor above the minimum.
There is a widespread belief that many jobless Puerto Rican men work in the informal sector and are therefore not measured by standard labor force surveys. Thus Enchautegui and Freeman undertook a small pilot study to find out what men in communities with potentially low employment were doing. Their results suggest that the official Department of Labor data understate employment considerably but understate labor force participation only modestly.
Excerpted from The Economy of Puerto Rico Copyright © 2006 by Brookings Institution Press and the Center for the New Economy . Excerpted by permission.
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Meet the Author
Susan M. Collins is a senior fellow in Economic Studies at the Brookings Institution and a professor of economics at Georgetown University. Her publications focus on various dimensions of economic policy and performance for developing countries. Barry Bosworth is a senior fellow and Robert V. Roosa Chair in International Economics at the Brookings Institution. Miguel A. Soto-Class is the executive director of the Center for the New Economy, a Puerto Rico-based think tank focusing on economic development issues.
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