increase production, income and employment. Regulation 3582 includes a list of such activities and explicitly excludes some uses of funds from eligibility. For example, consumer loans do not qualify for the use of 936 deposits.

These regulations stimulate financial institutions to assume an activist position in seeking qualified borrowers and in keeping the cost of 936 funds low. They also encourage the pass-through of low deposit costs to final borrowers by forcing the institutions to compete for eligible activity. And if local demand for financing is weak--as may happen during a slow period in the Island's economy--institutions will tend to offer unattractive rates to 936 depositors, thus encouraging repatriation of earnings to the mainland. Therefore, the rules are consonant with Congress' dual intent of promoting productive investment in the possessions and fostering repatriation of earnings not absorbed productively by the possession economy.

A 1985 study by the Government Development Bank (GDB) points out that $3,731 million of direct 936 funds received by commercial banks up to March 1985 went into commercial, industrial and agricultural loans, representing 86% of total commercial bank loans in that category and 45% of eligible activity. The remainder went into mortgage loans(14.4%), government obligations (22.8%) and other eligible activities (17.9%). As of February 1988, the share of commercial loans in total eligible activity was 51% and the outstanding balance amounted to $4.5 billion. Total financing of eligible activity as of February 1988 amounted to $9.4 billion, 56% higher than the $6 billion in direct 936 deposits at commercial banks.

It should be noted that the creation in 1977 of the Puerto Rico Industrial, Medical, Educational and Environmental Control Facilities Financing Authority (AFICA), an affiliate of the Government Development Bank, offered another channel for the use of 936 funds in productive investment. AFICA offers medium- and long-term financing through the issuing of tax-exempt industrial revenue bonds at rates below conventional lending rates. As of fiscal year 1986, AFICA had financed 99 projects for a total of about $2.1 billion, of which more than two-thirds went into industrial projects.

Another important effect of 936 funds has been to reduce the cost of credit in Puerto Rico. According to data reported by commercial banks to the Commissioner of Financial Institutions, the average rate charged on commercial loans originated in August 1988 was 12 basis points under the U.S. prime rate, which suggests that credit to local productive activities is relatively inexpensive thanks to the availability of 936 deposits. GDB's 1985 study had already found that in March 1985 the four largest commercial banks on the Island were charging 59 basis points less than the prime rate on commercial, industrial, agricultural and construction loans, a sharp contrast with the rate of 346 basis points over the prime rate charged on the same loan categories in March 1975, before Section 936 was enacted.

Studies of Puerto Rico's economic structure show that commercial bank financing is an important input in many productive sectors, particularly in trade, services, government, and in some areas of manufacturing. Inputoutput data for 1984 show that financial intermediation has strong linkages to service-sector activities with a substantial representation of local capital that have a significant impact on employment and income on the Island. A

reduction in bank lending such as would result from the loss of 936 deposits would therefore have strong negative effects on important sectors of local economic activity.

More than 90% of the banks' commercial and industrial loans are small loans, that is, loans of less than $100,000, which support the operations of small and medium-size businesses. In fact, more than 65% of these loans do not exceed $25,000. Other items of interest include the fact that four Puerto Rico banks were listed recently among the 300 leading U.S. banks in commercial loans. Similarly, one local bank ranks second in the United States in the issuing of Small Business Administration loans and another ranks 67th among the top 100 banks in granting agricultural loans. To put the significance of these rankings in the proper perspective, it should be noted that there are 14,000 commercial banks in the United States.

Although 936 deposits in commercial banks constitute the single largest investment of such funds by 936 corporations, substantial amounts have also been intermediated through other segments of the local financial system, such as savings and loans banks and brokerage houses. In addition, 936 corporations also invest a significant amount of funds directly in local financial instruments, such as GNMA issues to finance mortgages originated in Puerto Rico. The spreading of these funds through the financial system, and the direct investment by the corporations have extended the benefits of 936 funds through the local economy, sustaining the development of a wide array of financial activities and allowing for a broader scale of operations in financial institutions.

As of May 1988, the local financial system had $10.6 billion of 936 funds, of which $6.4 billion were deposited in commercial banks, $1.9 billion were in savings and loans banks and $2.4 billion were held by brokerage houses. In addition, it is estimated that corporations had invested about $2 billion directly, without recourse to financial intermediaries. By contrast, in 1983 the funds were much more concentrated in commercial banks. At the end of that year, banks held $4.9 billion in deposits out of a total of $5.7 billion, while brokers held the remaining $800 million and savings and loans banks had no participation in the market. This trend towards a better distribution of deposits across the financial system has amplified the positive effects of 936 funds on the local economy.

The growth and diversification of the 936 funds market has led to the development of innovative ways of financing productive activity in Puerto Rico. One recent example is the creation of a special fund for agricultural loans which has channeled about $250 million to farmers in Puerto Rico through the Farm Credit Bank of Baltimore. The Bank sold notes to 936 companies to fund its credit activities in Puerto Rico, and passed through the relatively low cost of the funds to the borrowers. This is also the first known instance of a federal government agency directly tapping the local 936 market.

Costs and Benefits of Section 936

A cause for much concern in Puerto Rico has been the assertion in various U.S. Treasury reports that Section 936 is cost-ineffective, that is, that costs to Treasury from the Section's operation outweigh the benefits to Puerto Rico's economy. This assertion has been effectively contested in several public and private-sector studies in Puerto Rico, which have shown the

opposite to be true: the cost-benefit balance in effect argues for the Section's permanence.

The essence of Treasury's approach has been to regard the tax credits claimed by 936 corporations as the cost of the Section's operation and to consider as benefits only the compensation to workers employed directly by 936 corporations. Thus, in the Treasury's Sixth Report on the operation of Section 936, it is pointed out that in tax year 1983 all manufacturing 936 companies received $18,523 in tax benefits per employee, while the average compensation per employee was $14,836.

This approach has been effectively challenged on the following grounds:

• Treasury overestimates the costs of the Section's operation in assuming that tax benefits obtained by 936 corporations would become tax revenues, dollar by dollar, in the absence of Section 936. In effect, many 936 corporations would reincorporate in Puerto Rico or relocate elsewhere outside the United States, such that the anticipated tax revenues to the U.S. Treasury would not materialize. If companies reincorporate in Puerto Rico, the Island would be the primary tax jurisdiction, and the U.S. Treasury would only be able to tax dividends repatriated to the United States after fulfilling Puerto Rico's tax obligations. A similar situation would arise if companies were to relocate elsewhere outside the United States.

• Treasury underestimates the benefits of Section 936 to Puerto Rico by looking only at direct employment and compensation in 936 corporations. The indirect employment and compensation effects