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of 936 manufacturing companies are substantial, and should not be ignored in the cost-benefit evaluation.

In a study by the Economic Development Administration of Puerto Rico (EDA), which evaluated Treasury's cost-benefit analysis in the Fifth Report, it is argued that Treasury overestimated the cost per employee by "...at least $11,274 and underestimated the average benefit per employee by $34,675." EDA concluded that "...Section 936 generates more than $4.50 in benefits for every $1.00 of cost." (EDA, Analysis of the Treasury Proposal to Repeal Section 936, March 1985, p. 26) Other studies have found similar favorable ratios of benefits to costs by extending Treasury's analysis to include indirect benefits and to incorporate more realistic estimates of the Section's

cost.

As mentioned earlier, Section 936 underwent significant modifications in 1982 and in 1985, which limited tax benefits by placing constraints on

income from intangibles and from financial investments.

Effects of Repeal of Section 936

Should Section 936 be repealed, the assumption made by Treasury in estimating a tax gain of approximately $1.6 billion is that all manufacturing activity presently in Puerto Rico would relocate to the United States. This is a highly questionable assumption, and it would be more correct to assume that the largest share would move to other locations outside the U.S. In this case, tax payments would be substantially below those paid by a U.S. based corporation under present tax legislation. Some firms would opt to remain in Puerto Rico, as Puerto Rican corporations. In this case, Puerto Rico would

be the primary tax jurisdiction and federal taxes would be paid only on that portion of profits sent as dividends to U.S. firms or individuals.

Thus, the benefits to the U.S. Treasury from repeal of Section 936 are questionable at best. On the other hand, the damage to Puerto Rico's economy would be substantial and certain. The direct loss to Puerto Rico in manufacturing output and employment would be significant, but the indirect effects could be even more damaging. Many other domestic sectors of economic activity are linked to 936 corporations through the effects these corporations have on overall employment and on the aggregate demand for goods and services on the Island. In addition, negative effects would spread to other activities through the financial ramifications of the 936 sector, which currently provides a major portion of the supply of capital resources at relatively low cost. Moreover, the indispensable transition to hightechnology manufacturing could be halted, endangering the Island's development prospects in the medium and long terms.

Finally, it should be pointed out that Section 936 also provides benefits to the United States economy, since local economic activity generates a demand for U.S. products that creates and sustains jobs on the mainland. A study by the WEFA Group of Philadelphia for the Puerto Rico Bankers Association found that repeal of Section 936 could result in the loss of as much as 80,000 jobs in the United States over a five-year period. Although this is not a dramatic impact, given the size of the U.S. labor market, it is by no means negligible.

The CHAIRMAN. Thank you very much.
Finally we hear from Mr. Nelson Soto-Velazquez.
Mr. VELAZQUEZ.
STATEMENT OF NELSON E. SOTO-VELAZQUEZ, PUERTO RICO
Mr. SOTO-VELAZQUEZ. Good afternoon, Senators.

The economic policy of Puerto Rico during the last four decades can be described as an extension of the condition of inequality. The economic development model is based on the promotion of manufacturing which arises from the inequalities in salaries between the mainland and locally. It also arises from the differential tax treatment that Puerto Rico is subject to.

After 1970, the government of Puerto Rico realized that this policy alone would not be generating enough economic growth to satisfy the needs of the population. Then another variable was added to the model, federal funds. After 1970 we began to increasingly rely on the federal government, food stamps in 1974, section 936 in 1976. As in the past, these were based on the same proposition, unequal treatment.

Some population sectors and investors could have been under the impression that there is a “free lunch" that can continue forever under the patronage of the federal government. Economists know that, “There is nothing like a free lunch."

This strategy has its accumulated cost. The tax breaks generated a shortage in revenues that have limited the government capacity to finance the development of infrastructure and quality education.

Almost all public corporations engaged in the provision of infrastructure service are now under pressure due to their incapability to provide such services. Their financial leverage is limited by the capacity of consumers to pay additional fares.

Puerto Rico faces a public debt of $11.3 billion and does not have enough resources to finance needed expansion. The federal regulations on clean air, clean water, toxic waste and landfill management, flood control have generated an additional need for improvement of the infrastructure amounted to $10 billion in the next 15 years.

There is no money for paying for this infrastructural development. This is endangering our economic development effort. The tax holiday has also resulted in a narrow tax base that imposed an unbalanced tax burden on local taxpayers.

This strategy developed by the government to deal with the infrastructural development has postponed application of federal regulations via transferring of regulatory authority to local government and to finance the infrastructure by liquidation of governmental assets. The future generations will have to pay for the “free lunch” of tax-exempted corporations and unavoidably, the federal government will pay, too.

Several studies have been carried out related to the evaluation of effectiveness of the special tax provision and treatment and incentives to business. A study made for the multi-state tax commission arrived at the following conclusion:

Clearly a substantial body of evidence suggests that state business taxes are unlikely to affect significantly the locational decision of the firm. Money raised from eliminating provisions that cannot survive a cost benefit analysis could be used for human resource development, job training, research and technological development, providing capital to finance growth and development of state infrastructure and energy and natural resources management.

Puerto Rico has been relying on the tax incentive laws for its manufacturing promotion efforts. But between 1980 and 1988 no increase has been observed in the manufacturing and employment. International competition and the transformation of the manufacturing industry from a labor-intensive to capital-intensive one has affected the sector.

The Congress of the United States has been engaged in an evaluation of section 936 of the Internal Revenue Code. The need to reduce the federal deficit and the need for a cost benefit analysis of this section has generated changes in the applications of the code. These changes have created uncertainty and instability on the economic climate of Puerto Rico.

Businessmen know that special concessions and features of a tax law cannot be a reliable basis upon which to make a multi-million dollar investment. What one group of legislators might grant today may change for another group tomorrow.

As the multi-state tax commission concluded, "Fiscal stability and predictability are more important than special concessions.”

Factors related to plant or site availability, quality of labor, regulatory environment, quality of state schools, and quality of life are often related to locational decisions by businessmen.

A central issue in the analysis of the political status in Puerto Rico is the future behavior of tax exempted investors. Under the model proposed by the statehooders, an adjustment period to the corporate investors is proposed for a smooth transition from a situation of differential conditions to one where equality will prevail to a large extent. The length of the period will depend on negotiations between interested parties, their objectives and commitments.

But what is important is that stability and predictability of the tax policy enacted under equal conditions will create the economic climate indispensable for the diversification of the economic structure and continued growth.

The infrastructure development financed by the infrastructure trust will induce the continuation of growth of the manufacturing sector and other economic sectors.

In the past we have not done so bad. Nevertheless, those who have entered the union have done better. The advantage of being treated equal will be the impelling force to economic development and better quality of life.

The CHAIRMAN. Thank you very much, Mr. Velazquez. Gentlemen, that was excellent testimony.

Let me begin by asking Mr. Colorado, there is some I believe it is $8.9 billion in 936 funds which are located in Puerto Rico, is that correct?

Mr. COLORADO. In the banking institutions it is probably about 10 and in other areas probably close up 14 or so. The total amount there would be around 14. The ones that are in the banking institutions is very close to 9-10. That varies depending on what time of the year you are in.

The CHAIRMAN. Is the Puerto Rican economy able to absorb those funds?

Mr. COLORADO. All these funds are invested through legislation and regulations and things which are good for the Puerto Rican economy. So, obviously, every penny plus a requirement that requires that an additional part be invested, so many banks not only invest their 936 funds in qualifying investments, but they have to invest additional funds in those investments also to qualify or to be able to qualify under the regulations under the legislation.

The CHAIRMAN. I notice that you point out that the cost of capital here is 1:1.5 points below world rates, and there are no failed savings and loans. That is principally because of the 936 funds? Mr. COLORADO. That is in relation to 936 funds, yes.

The CHAIRMAN. In addition to the fact that 936 funds go directly into industries like pharmaceuticals under so-called qualifying investments, are they in effect also available for consumers?

Mr. COLORADO. No, they are not available for consumer loans. They are available for consumers in very special areas like housing, which is very important, commercial and industrial. But not most of the funds are in the hands of the pharmaceutical companies. They generate most of the funds, but most of the funds are being utilized by the economy in other areas.

The CHAIRMAN. Well, now, when you speak of rights, the cost of capital being 1:1.5 percent below world rates, is there a differential between consumer interest rates and rates for capital?

Mr. COLORADO. Yes, there is, sure. As a matter of fact, it is policy both of the Treasury Department in the States and of Puerto Rico not to lend the 936 forms for consumer loans. And, as a matter of fact, about three years ago we changed the regulations which permitted the use of the funds to buy automobiles. We eliminated that possibility so that the funds go exactly where they are needed in the economy, which is for housing for the different programs of the government and other things which are good for the economy. And for CBI countries, now, under the new legislation.

The CHAIRMAN. Mr. Colorado, the statehood group and the independence group propose a phaseout of section 936 over a period of, I think, 25 years. The last 10 years of their proposal provides for a straight-line phasing out of 936 funds at 10 percent per year.

Now, I know your position is that you think 936 is very important, essential for the economy of Puerto Rico. But my question to you has to do with simply the mechanics of 936 and that is, is it possible, is it proper if you are going to phase out 936 without reference to the number of years, is it possible to do so on a straightline basis, so much a year?

In other words, does that work as a mechanical proposition? I'm not asking you whether that's a good idea substantively, but whether mechanically it would work.

Mr. COLORADO. Let me answer by mentioning two things which I believe are very important. First of all, the desire to eliminate 936 comes because people believe that it is a cost to the U.S. Treasury.

The CHAIRMAN. I am not asking you that.
Mr. COLORADO. I know.

The CHAIRMAN. Well, let us get to the question at hand. Will it work mechanically? We will get into the question of whether we should do it or what people believe later.

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