    Puerto Rico: Fiscal Relations with the Federal Government and
    Economic Trends during the Phaseout of the Possessions Tax Credit
    (19-MAY-06, GAO-06-541).

    The federal possessions tax credit, which was designed to
    encourage U.S. corporate investment in Puerto Rico and other
    insular areas, expires this year. Proponents of continued federal
    economic assistance to Puerto Rico have presented a variety of
    proposals for congressional consideration. In response to a
    request from the U.S. Senate Committee on Finance, this study
    compares trends in Puerto Rico's principal economic indicators
    with those for the United States; reports on changes in the
    activities and tax status of the corporations that have claimed
    the possessions tax credit; explains how fiscal relations between
    the federal government and Puerto Rico differs from the federal
    government's relations with the states and other insular areas;
    and compares the taxes paid to all levels of government by
    residents of Puerto Rico, the states, and other insular areas.
    GAO used the latest data available from multiple federal and
    Puerto Rican government agencies. Data limitations are noted
    where relevant. Key findings are based on multiple measures from
    different sources. GAO is not making any recommendations in this
    report. In comments on this report the Governor of Puerto Rico
    said the report will be useful for evaluating policy options.
    -------------------------Indexing Terms-------------------------
    REPORTNUM:   GAO-06-541
        ACCNO:   A54519
      TITLE:     Puerto Rico: Fiscal Relations with the Federal Government
    and Economic Trends during the Phaseout of the Possessions Tax
    Credit
         DATE:   05/19/2006
      SUBJECT:   Comparative analysis
    	     Corporations
    	     Foreign economic assistance
    	     International economic relations
    	     Investments abroad
    	     Tax credit
    	     Puerto Rico
    	     Possessions Tax Credit

    ******************************************************************
    ** This file contains an ASCII representation of the text of a  **
    ** GAO Product.                                                 **
    **                                                              **
    ** No attempt has been made to display graphic images, although **
    ** figure captions are reproduced.  Tables are included, but    **
    ** may not resemble those in the printed version.               **
    **                                                              **
    ** Please see the PDF (Portable Document Format) file, when     **
    ** available, for a complete electronic file of the printed     **
    ** document's contents.                                         **
    **                                                              **
    ******************************************************************
    GAO-06-541

         * Report to the Chairman and Ranking Minority Member, Committee on
           Finance, U.S. Senate
              * May 2006
         * Puerto Rico
              * Fiscal Relations with the Federal Government and Economic Trends
                during the Phaseout of the Possessions Tax Credit
         * Contents
         * Executive Summary
              * Purpose
              * Background
              * Scope and Methodology
                   * Federal Tax Treatment
                   * Economic Indicators and Capital Flows
                   * Changes in Possessions Corporation Activity
                   * Distribution of Business Activity
                   * Fiscal Comparison
                   * Federal Social Programs
              * Results in Brief
              * Principal Findings
                   * U.S. Federal Tax Treatment of Puerto Rico and Other Insular
                     Areas Differs by Area and Type of Tax
                   * Measuring Economic Progress in Puerto Rico Is Challenging,
                     but the Income of Commonwealth Residents Remains Well Below
                     That of U.S. Residents
                   * Some Measures of Aggregate Manufacturing Activity Have
                     Remained Constant Despite a Decline in Possessions
                     Corporation Activity
                   * U.S.-owned or U.S.- incorporated Businesses Dominated Puerto
                     Rican Manufacturing in 2002 but Played Much Smaller Roles in
                     Other Sectors of the Economy
                   * Taxes Paid Per Capita in Puerto Rico Are Considerably Lower
                     Than Those in the States but the Taxes are About the Same
                     Share of Personal Income in Both Places
                   * The Extent to Which Federal Social Programs in Puerto Rico
                     Mirror Those in the States and U.S. Insular Areas Varies
              * Agency Comments
         * Introduction
              * Background
                   * Puerto Rico's Relationship with the United States
                   * Characteristics of Puerto Rico
              * Possessions Tax Credit
                   * Additional Studies Relating to the Economy of Puerto Rico
              * Scope and Methodology
                   * Federal Tax Treatment
                   * Economic Indicators and Capital Flows
                   * Changes in Possessions Corporation Activity
                   * Distribution of Business Activity
                   * Fiscal Comparison
                   * Federal Social Programs
         * U.S. Federal Tax Treatment of Puerto Rico and Other Insular Areas
           Varies by Area and Type of Tax
              * U.S. Tax Treatment of Insular Area Residents with U.S.-source
                Income and U.S. Residents with Insular Area-source Income Varies
                by Area
              * While FICA Taxes Are Imposed on Wages Paid to Employees in All
                Insular Areas, Unemployment Insurance Tax Applies Only to Wages
                Paid in Puerto Rico and U.S. Virgin Islands
              * Taxation of Corporations Incorporated in the United States
              * Taxation of Corporations Incorporated outside the United States
              * Deduction for Income from Domestic Production Activities
              * Goods Imported to Insular Areas Are Generally Exempt from U.S.
                Excise Taxes, but a Special Tax Is Imposed on Goods Made in
                Puerto Rico and U.S. Virgin Islands
              * U.S. Government Is Responsible for Collecting Customs Duties in
                Puerto Rico and Helps Collect Duties in U.S. Virgin Islands
         * Trends in Production, Income, and Other Economic Indicators for Puerto
           Rico
              * Measuring Economic Progress in Puerto Rico Is Challenging but the
                Income of Commonwealth Residents Remains Well Below That of U.S.
                Residents
              * Puerto Rico Relies Heavily on Nonresidents to Finance Local
                Investment
                   * Investment Appears Insufficient to Reduce the U.S.-Puerto
                     Rican Income Gap
              * Data on Value Added and Income Show That the Pharmaceuticals
                Industry Has Significantly Increased Its Dominance of Puerto
                Rican Manufacturing but Evidence Suggests That These Measures May
                Be Overstated
              * International Trade Plays a Large Role in Puerto Rico's Economy
              * Official Statistics Indicate That Unemployment Has Been Much
                Higher in Puerto Rico Than in the United States and Labor Force
                Participation Has Been Lower
              * Since 1980, Real Per Capita Personal Income in Puerto Rico Has
                Not Grown Enough to Substantially Reduce the Gap between U.S. and
                Puerto Rican Living Standards
         * Much Possessions Corporation Activity Has Shifted to Affiliated
           Corporations
              * Possessions Corporations Dominated Puerto Rico's Manufacturing
                Sector up until the Late 1990s
              * The Pharmaceutical Industry Has Dominated the Use of the
                Possessions Tax Credit in Puerto Rico
              * Businesses Have a Variety of Options for Continuing Operations in
                Puerto Rico after They Cease Operating as Possessions
                Corporations
              * Some Measures of Aggregate Manufacturing Activity Have Remained
                Constant Despite a Decline in Possessions Corporation Activity
                   * Tax Return and Economic Census Data Indicate That Much of
                     the Income and Value Added of Possessions Corporations
                     Declined While That of Affiliated Businesses Increased
                   * Data on Capital Expenditures, Total Assets, and Employment
                     Also Indicate That a Substantial Amount of Possessions
                     Corporation Activity Has Been Continued by Other Types of
                     Businesses in Certain Industries
         * U.S. Businesses Dominated Puerto Rican Manufacturing in 2002 but
           Played Smaller Roles in Other Sectors
              * U.S. CFCs Have Become the Most Important Type of Business Entity
                in Puerto Rico's Manufacturing Sector in Terms of Value Added but
                Not in Terms of Employment
              * The Role of U.S. Corporations Is Much Smaller in Puerto Rico's
                Wholesale and Retail Trade Than in Manufacturing
              * Neither Possessions Corporations nor CFCs Were Significant
                Employers in 2002 in Most Puerto Rican Service Industries for
                Which Data Are Available
         * Taxes Per Capita in Puerto Rico Are Lower Than in the States but Are
           about the Same Share of Income
              * Taxes Paid Per Capita in Puerto Rico Are Lower Than Those in the
                States but the Taxes Are about the Same Share of Personal Income
                in Both Places
              * Income and Employment Taxes Account for about Two-thirds of the
                Taxes Paid in Both Puerto Rico and the States, but the Allocation
                of Those Taxes by Level of Government Differs between the Two
                Locations
              * Puerto Rico's Outstanding Government Debt in 2002 Was Much Higher
                Than That of State and Local Governments as a Share of Personal
                Income, Partly Because the Commonwealth Government Has a Wider
                Range of Responsibilities
              * Federal Grants and Payments to Governments Per Capita Are the
                Same for Puerto Rico and the States but Direct Federal Payments
                to Individuals Per Capita Are Significantly Lower in Puerto Rico
         * The Extent That Federal Social Programs in Puerto Rico Mirror Those in
           the States and Other U.S. Insular Areas Varies
              * Comparison of Selected Federal Social Programs
         * Methodology for Allocating the Assets and Liabilities of Depository
           Banks by Geographic Location
         * Additional Information on Puerto Rican Economic Trends and Capital
           Flows
              * A Comparison of Rates of Return for Possessions Corporations and
                Controlled Foreign Corporations (CFC) in Puerto Rico's Chemical
                Industry
         * Methodology for Analyses of Business Activities
              * Methodology for Determining How Economic Activity in Puerto Rico
                is Distributed across Types of Business Entities
         * Additional Data on Possessions Corporations and Their Affiliates
         * Additional Data on the Distribution of Business Activity by Type of
           Business Entity
         * Additional Comparative Fiscal Data
         * Additional Details on the Application of Federal Social Programs
              * Education Programs
                   * Individuals with Disabilities Education Act Part B
                   * Title I of the Elementary and Secondary Education Act
              * Food and Nutrition Programs
                   * The Child and Adult Care Food Program
                   * Food Stamp and Nutrition Assistance Programs
                   * National School Lunch Program
                   * Special Supplemental Nutrition Program for Women, Infants,
                     and Children
              * Health Care Financing and Grants Programs
                   * Medicare
                   * Medicaid
                        * Financing
                        * Eligibility
                        * Services and Administration
                   * State Children's Health Insurance Program
                   * Health Grants
              * Income Assistance Programs
                   * Aid to the Aged, Blind, or Disabled
                   * Temporary Assistance for Needy Families
              * Programs for the Care of Children
                   * Child Care and Development Fund
                   * Foster Care and Adoption Assistance Funds
              * Housing Programs
                   * Public Housing Program
                        * Administration and Funding
                        * Public Housing in Puerto Rico and Other Insular Areas
                   * Housing Choice Voucher Program
                        * Program Administration and Funding
                        * Housing Choice Vouchers in Puerto Rico and the Other
                          Insular Areas
                   * Community Development Block Grant Program
                        * Program Administration and Funding
                        * CDBG in Puerto Rico and the Other Insular Areas
                   * HOPE VI Program
                        * Program Administration and Funding
                        * HOPE VI in Puerto Rico and the Other Insular Areas
                        * HOPE VI Grants
                   * HOME Investment Partnerships Program
                        * Program Administration and Funding
                        * HOME in Puerto Rico and the Other Insular Areas
                   * Project-based Section 8 Program
                        * Program Administration and Funding
                        * Project-based Section 8 in Puerto Rico
                   * Section 203(b) Single Family Mortgage Insurance Program
                        * The Section 203(b) Single-Family Mortgage Insurance
                          Program in Puerto Rico and the Other Insular Areas
         * U.S. Gross Domestic Product Deflator and Puerto Rican Gross Product
           Deflator, 1980-2005
         * Agency Comments
         * GAO Contact and Staff Acknowledgments
              * Strategic Issues
              * Applied Research and Methods
              * General Counsel
              * Health Care
              * Education, Workforce, and Income Security
              * Financial Markets and Community Investment

    Report to the Chairman and Ranking Minority Member, Committee on Finance,
    U.S. Senate

    May 2006

    PUERTO RICO

    Fiscal Relations with the Federal Government and Economic Trends during
    the Phaseout of the Possessions Tax Credit

    Contents

    Tables

    Figures

    Abbreviations

    May 19, 2006
    Letter

    The Honorable Charles E. Grassley Chairman The Honorable Max Baucus
    Ranking Minority Member Committee on Finance United States Senate

    In response to your request, this report provides information on the
    Puerto Rican economy, including corporate activity, during the phaseout of
    the possessions tax credit, as well as descriptions of the application of
    federal tax law and federal social policy programs in Puerto Rico.

    As we agreed with your office, unless you publicly announce the contents
    of this report earlier, we plan no further distribution of it until 30
    days from the date of this letter. We will then send copies to the
    Governor's office in Puerto Rico, Resident Commissioner Fortuno, and other
    interested parties. We will also make copies available to others who
    request them. This report will also be available at no charge on the GAO
    Web site at h  ttp://www.gao.gov. If you or your staffs have any questions
    on this report, please call me on (202) 512-9110. Key contributors are
    listed in appendix X.

    James R. White Director, Tax Issues Strategic Issues Team

    Executive Summary

    Purpose

    For the past 30 years, the U.S. Tax Code has provided a possessions tax
    credit specifically designed to encourage U.S. corporations to invest in
    Puerto Rico and the other U.S. insular areas and create jobs.1 The credit
    had the effect of reducing federal taxes on income earned by qualifying
    U.S. corporations. Congress repealed the credit in 1996, but allowed
    existing credit claimants to continue use of the credit during a 10-year
    phaseout period ending in 2006.2

    As the expiration date of the credit approached, Congress naturally became
    interested in reviewing the effects of the phaseout, particularly on the
    Puerto Rican economy, where over 98 percent of the credit has been
    claimed. At the same time, proponents of continued economic assistance to
    Puerto Rico have offered up a variety of proposals, including tax
    incentives to both businesses and low income workers, for congressional
    consideration. Congress could better assess the merits of the various
    proposals if it had more complete information relating to the current
    treatment that Puerto Rico receives under both federal tax policies and
    federal social programs, and information relating to the taxes paid by
    residents of Puerto Rico, relative to those paid by residents of the
    states and the other U.S. insular areas.3

    To help inform itself and other members of Congress as they decide on
    future policy toward Puerto Rico, the Senate Committee on Finance asked
    GAO to

    1.explain how the U.S. federal tax treatment of individuals and businesses
    in Puerto Rico and of the insular government differs relative to the
    treatment of governments, businesses, and individuals in the states and
    the other U.S. insular areas;

    2.compare trends in Puerto Rico's principal economic indicators since the
    early 1980s with similar indicators at the national level for the United
    States and describe what is known about capital flows between Puerto Rico
    and the United States and between Puerto Rico and foreign countries;

    3.report on changes in the activities and tax status of the corporations
    that have claimed the possessions tax credit since 1993;

    4.provide information on the distribution of private-sector economic
    activity in Puerto Rico by type of business entity;

    5.describe the total amount of tax paid by individuals and businesses in
    the states and the U.S. insular areas and show percentage breakdowns by
    type of tax; and

    6.describe how the principal U.S. federal social programs apply to Puerto
    Rican residents relative to residents of the states and the other U.S.
    insular areas.

    This report does not contain any recommendations. Members of the Senate
    Committee on Finance have asked the Joint Committee on Taxation to prepare
    a companion report evaluating legislative options concerning Puerto Rico.

    Background

    This report focuses on the Commonwealth of Puerto Rico, the largest
    insular area associated with the United States, and compares Puerto Rico
    to the states and the other insular areas-Guam, the U.S. Virgin Islands,
    the Commonwealth of the Northern Mariana Islands (CNMI), and American
    Samoa. Although fiscally autonomous, Puerto Rico is similar to the states
    in many aspects. For example, matters of currency, interstate commerce,
    and defense are all within the jurisdiction of the U.S. federal
    government.

    Puerto Rico is thought to have one of the most dynamic economies in the
    Caribbean region, an economy in which manufacturing, driven by the
    pharmaceutical industry, has surpassed agriculture as the primary sector
    in terms of domestic income. Over 40 percent of Puerto Rico's domestic
    income since the mid-1980s has been derived from manufacturing.
    Pharmaceuticals accounted for about 40 percent of total value added in
    manufacturing in 1987; that share rose to over 70 percent by 2002.

    The Tax Reform Act of 19764 established the possessions tax credit under
    Section 936 of the Internal Revenue Code (IRC), with the stated goal of
    assisting the insular areas in "obtaining employment-producing investment
    by U.S. corporations."5 Prior to 1994, the tax credit was equal to the
    full amount of the corporation's U.S. income tax liability on income from
    an insular area. The amount of possession tax credit claimed by
    corporations operating in Puerto Rico peaked at about $5.8 billion in
    1993.6 A series of limits were placed on the credit beginning with 1994
    tax years, which significantly reduced the generosity of the credit
    throughout the period leading up to the credit's final expiration for tax
    years beginning after December 31, 2005.7

    Numerous measures of business activity and broader economic activity
    exist. Some broad measures that are commonly recognized as key indicators
    of aggregate economic activity and were included in our past review of
    Puerto Rico's economy are8

    o employment;

    o investment, which is spending devoted to projects producing goods that
    are not intended for immediate consumption;9

    o gross domestic product (GDP), which is a comprehensive measure of income
    earned by both residents and nonresidents within a country's (or, in the
    case of Puerto Rico, a Commonwealth's) borders;10 and

    o gross national product (GNP), which is the total income earned by
    residents of a country or other entity.

    Measures that focus more specifically on business activity or value are

    o value added, which essentially is the difference between the value of
    the goods and services produced by a firm and the firm's payments for
    materials, supplies, energy, and contract work, and which is considered to
    be the best measure of the relative economic importance of manufacturing
    across industries and geographic areas;

    o gross profits, which, in the case of manufacturing firms, is roughly
    equivalent to value added and which is available from tax returns (whereas
    value added is not);

    o total income, which is the sum of gross profits plus various types of
    investment income, such as interest, dividends, rents, and royalties;

    o net income, which is total income less all expenses; and

    o total assets, which is the sum of the value of a business's physical
    assets (plant, machinery, land, inventories), financial assets (cash,
    accounts receivable, investments), intangible assets (patents and other
    intellectual property), and other assets.

    To qualify for the possessions tax credit, a corporation has to be
    organized in the United States; derive 80 percent or more of its gross
    income from U.S. possessions; derive 75 percent or more of its gross
    income from the active conduct of a trade or business in the possessions;
    and file a form with the IRS electing to be treated as a possessions
    corporation. As a result of these requirements, possessions corporations
    usually are established as subsidiaries of a U.S. corporate parent, making
    the possessions corporation a member of a corporate group. In addition,
    one option under the credit allowed the U.S. corporate parent and the
    possessions corporation to apply a 50/50 split of their combined taxable
    income from the sale of products to third parties. Although a substantial
    portion of this income can be attributed to manufacturing intangible
    assets developed and owned by the U.S. corporate parent, there is no
    requirement that the allocation of income from such manufacturing
    intangible assets reflect where costs were actually generated, or where
    value was actually added to the products. Consequently, corporate groups
    that produced pharmaceuticals, or other products whose final values are
    largely based on the value of intellectual property, were given
    flexibility under the law to shift net income to the possessions
    corporation operating in Puerto Rico or another insular area.

    In addition to possessions corporations, U.S. corporate groups often owned
    other types of businesses that operate in Puerto Rico. These affiliated
    businesses could include

    o corporations incorporated within the United States but operating in
    Puerto Rico;

    o U.S. controlled foreign corporations (CFC), which are incorporated in
    Puerto Rico or elsewhere outside of the United States, but which are
    majority-owned (by vote or value) by one or more U.S. shareholders, each
    of whom owns at least 10 percent of the CFC's voting stock; or

    o a "pass-though entity," such as a partnership, a subchapter-S
    corporation, or a limited liability company (LLC), which generally does
    not pay federal income tax at the entity level, but whose income passes
    through, and is taxed in the hands of its partners or shareholders.

    Scope and Methodology

    Federal Tax Treatment

    To determine the U.S. federal tax treatment of individuals and businesses
    in Puerto Rico, relative to the states and the other insular areas, we
    examined the IRC, Department of the Treasury regulations, relevant
    Treasury rulings and notices, and legislation.

    Economic Indicators and Capital Flows

    To compare trends in principal economic indicators for the United States
    and Puerto Rico, we obtained data from both U.S. and Puerto Rican sources.
    The trends we present are commonly used measures of overall economic
    activity and important components of economic activity, such as saving,
    investment, labor force participation and unemployment. The data shown are
    largely drawn from the National Income and Product Account series produced
    annually by economic statistics agencies in the United States and Puerto
    Rico. Most of the data we used for the U.S. economic series are produced
    by the Bureau of Economic Analysis and the Bureau of Labor Statistics.
    Most of the annual data we used for Puerto Rico economic trends are
    produced by the Planning Board of Puerto Rico. We also used data from the
    Economic Census of Puerto Rico and the Economic Census of the United
    States, produced by the U.S. Census Bureau (Census).

    In some instances, the methodologies used by the Planning Board to produce
    certain data series are outdated relative to the methodologies now used by
    the United States. In these cases, we reviewed literature concerning the
    limitations of various series and interviewed Puerto Rican officials about
    the methods they use to collect and develop their data. These limitations
    are noted in the report. Wherever possible, we used alternative
    assumptions and data sources to determine if any conclusions drawn from
    the data are sensitive to the particular data series used.

    To provide information on what is known regarding the flow of capital into
    and out of Puerto Rico, we interviewed Puerto Rican government officials
    and private sector experts to help us to ascertain what data were
    available. We determined that the available data would not allow us to
    present a comprehensive picture of the trends in capital flows. We can,
    however, report on changes between 1995 and 2004 in the amount of funds
    that nonresidents hold in the Puerto Rican banking system and the amount
    of funds that the banking system invests within and outside of the
    Commonwealth. In order to identify where the assets held in the Puerto
    Rican banking system are invested and where the owners of the banks'
    liabilities reside, we analyzed institution-specific data that the Office
    of the Commissioner of Financial Institutions (OCFI) collects for
    oversight purposes. We also use data provided by Puerto Rico's Government
    Development Bank to show trends in Puerto Rican government borrowing in
    the U.S. and local capital markets.

    Changes in Possessions Corporation Activity

    In order to examine changes in the activities of possessions corporations
    operating in Puerto Rico since the early 1990s, we constructed several
    databases from an assortment of tax return data we obtained from IRS and
    Puerto Rico's Department of Treasury. Our principal source of data was
    IRS's Statistics of Income unit (SOI), which compiles comprehensive data
    on possessions corporations every other year. We obtained the complete set
    of these biennial databases from 1993 through 2003 and used information
    from SOI to identify those possessions corporations that operated in
    Puerto Rico. We combined these separate databases into a single one that
    covered 656 possessions corporations that operated in at least 1 year
    between 1993 and 2003 to report on changes over time in the aggregate
    income, tax credit and total assets of this population of corporations and
    to show how these particular variables were distributed across different
    industries. We also used data from the past four Economic Censuses of
    Puerto Rico (1987, 1992, 1997, and 2002) compiled by Census to show how
    the importance of possessions corporations in Puerto Rico's manufacturing
    sector has changed over time.

    For the second stage of our analysis, we focused on a subpopulation of the
    largest groups of affiliated possessions corporations operating in Puerto
    Rico. For each of these groups we compiled data on other affiliated
    corporations (i.e., those sharing the same ultimate parent corporations)
    that also operated in Puerto Rico, but were not possessions corporations.
    The objective of this analysis was to assess the extent to which the large
    corporate groups that accounted for most of the activity of possessions
    corporations remained active in Puerto Rico, even as the operations of
    their possessions corporations were being phased out. We started by
    identifying the 77 largest groups of possessions corporations that
    accounted for over 90 percent of the tax credit and income earned and over
    90 percent of the assets owned by possessions corporations between 1993
    and 2003. We then used the database in which IRS maintained the records of
    all CFCs, as well as a database that the Puerto Rican Department of
    Treasury had recently transcribed from all Puerto Rican tax returns for
    tax years 1998 through 2001 filed by all corporations or partnerships that
    received tax incentives from the Government of Puerto Rico. We linked CFCs
    and other types of companies from these two databases to our 77 large
    corporate groups by using identification numbers and names. We determined
    that the quality of the data was sufficient for the purposes of our report
    when viewed with the cautions we raise at various points in the text.

    Distribution of Business Activity

    In order to show how economic activity in Puerto Rico is distributed
    across different forms of businesses, we negotiated a special arrangement
    with IRS and Census that enabled us to disaggregate the data from Census's
    recently completed 2002 Economic Census of Puerto Rico by categories of
    business entities that are more specifically relevant to tax policymakers
    than the categories Census uses for its own publications. The data that we
    used to determine the tax filing status and place of incorporation for the
    employers in the Census database came from the IRS and Puerto Rico
    databases described above, plus a couple of additional sources. Another
    important source of data was IRS's National Accounts Profile (NAP)
    database, which contains selected information for all individuals and
    businesses that have federal tax filing requirements.

    Fiscal Comparison

    To compare the overall taxes paid by individuals and businesses in Puerto
    Rico with the taxes paid by individuals and businesses in the states and
    in the other insular areas, we obtained and analyzed detailed data on
    state and local government revenues from the U.S. Census of Governments,
    data on Commonwealth government revenue from the Puerto Rican Department
    of Treasury, data on municipal tax revenue in Puerto Rico from Oficina del
    Comisionado de Asuntos Municipales, Centro de Estadisticas Municipales,
    and revenue data for the other insular areas reported in their 2002 Single
    Audit reports. We also obtained data on federal taxes collected in Puerto
    Rico and the states from IRS's 2002 Data Book.11 We compared taxes paid on
    a per capita basis and as a percent of personal income. We make our
    comparison for year 2002 because that is the year of the most recent
    Census of Governments. We also compare federal expenditures for the
    states, Puerto Rico and the insular areas using data we obtained from the
    Consolidated Federal Funds Report for Fiscal Year 2002 and the Federal Aid
    to States for Fiscal Year 2002.

    Federal Social Programs

    Interviews with federal agencies and prior GAO work provided the basis for
    our description of the application of the principal U.S. federal social
    programs to Puerto Rico residents, relative to the states, and the other
    insular areas. To select the social programs included in this report we
    consulted with GAO experts in the areas of health care policy; education,
    workforce, and income security policy; and financial markets and community
    investment policy. With the help of these experts, we arrived at a list of
    the principal federal social programs, which we then pared down, based on
    program availability in Puerto Rico and expenditure level in Puerto Rico.
    We relied on prior GAO work and interviews with federal agency officials
    to determine how each program is applied in Puerto Rico, relative to the
    other areas. We used program-level data, supplied by federal agencies, to
    report program expenditures for fiscal year 2002. We selected fiscal year
    2002 because in chapter 6 of this report, we provide a more complete
    analysis of the revenue and expenditures of Puerto Rico, the states, and
    the other insular areas using the year of the most recent Census of
    Governments, 2002.

    Results in Brief

    Individuals who are residents of Puerto Rico or the other U.S. insular
    areas pay no federal income tax on income from sources within the insular
    area; however, their wages are subject to Social Security and Medicare
    taxes. Wages paid to residents of Puerto Rico and the U.S. Virgin Islands
    also are subject to federal unemployment tax. Corporations organized in
    Puerto Rico, like those organized in the other U.S. insular areas, are
    generally treated as foreign corporations for U.S. tax purposes and do not
    pay federal tax on their income earned in Puerto Rico, but are generally
    subject to federal tax on any income earned in the United States.
    Corporations organized in the United States are subject to federal tax on
    their worldwide income, including that earned in Puerto Rico. U.S.
    corporations that qualified for the possessions tax credit could reduce
    the federal tax on their income from Puerto Rico by using the credit.

    The economic well-being of Puerto Rican residents, measured in terms of
    either per capita or median income, remains well below that of residents
    of the states. Puerto Rico's per capita GNP of about $14,000 in 2005 was
    significantly below the $41,000 figure for the United States. The latest
    available data show that in 1999, Puerto Rico's median household income of
    $14,412 also was well below the U.S. median value of $41,994. The relative
    progress that the Puerto Rican economy has made since 1980 is difficult to
    measure with precision for a number of reasons, including the fact that
    the income U.S. corporations have reported earning in the Commonwealth may
    overstate their actual activity there. The low rate of labor participation
    is a crucial issue in Puerto Rico's economic performance, and the rate of
    investment appears insufficient to significantly reduce the disparity
    between mainland and Puerto Rican incomes.

    Possessions corporations have played an important role in the Puerto Rican
    economy, particularly in the manufacturing sector, where they accounted
    for well over half of valued added throughout the 1990s. Most of the
    possessions tax credit and income earned by possessions corporations in
    Puerto Rico has been earned by corporations in the pharmaceutical
    industry. Once the possessions tax credit was repealed, many of the large
    corporate groups that owned possessions corporations in Puerto Rico began
    to shift their operations to other types of business entities, such as
    CFCs and LLCs. According to various measures, the decline in activity of
    possessions corporations in the chemical industry, which is dominated by
    pharmaceuticals, has been largely offset by the increased activity of
    other members of the same corporate groups (i.e., who have the same parent
    companies) as the possessions corporations. For example, valued added,
    employment, and capital expenditures in the chemical industry all
    increased between 1997 and 2002-a period during which the activity of
    possessions corporations decreased significantly. Declines in the
    remainder of Puerto Rico's manufacturing sector have not been similarly
    offset.

    U.S.-owned or incorporated businesses accounted for at least 71 percent of
    value added and at least 54 percent of employment in Puerto Rico's
    manufacturing sector in 2002. CFCs produced most of this value added but
    possessions corporations still accounted for most of the employment by
    U.S. firms. The CFCs are particularly important in the pharmaceutical
    industry and much less so in other manufacturing industries. U.S.-owned or
    incorporated businesses appear to account for less than 25 percent of
    employment in Puerto Rico's wholesale and retail trade sectors, where
    local corporations are the most important employers. Similarly, U.S.-owned
    corporations are not the majority employers in any of the large Puerto
    Rican service industries for which data are available.

    Residents of Puerto Rico pay considerably less total tax per capita than
    do U.S. residents, but they pay about the same percentage of their
    personal income in taxes. The average burden of federal taxes (excluding
    the corporate income tax) in Puerto Rico was considerably lower than that
    in the states, but the difference was made up by the fact that
    Commonwealth and local taxes in Puerto Rico were higher than the average
    state and local taxes. Federal grants and payments to the Puerto Rican
    government in 2002 were about the same as those to all state and local
    governments in the states on a per capita basis; however, direct federal
    payments to individuals in Puerto Rico were well below the per capita
    amounts paid to residents in the states. Similarly, per capita federal
    payments for salaries and wages and for procurement were significantly
    lower in Puerto Rico than in the states.

    Like the states, Puerto Rico and the other insular areas receive federal
    funds for a variety of social programs, which provide assistance to the
    elderly and low-income families and individuals. The social programs that
    we examined in the insular areas targeted similar populations and
    delivered similar services to those in the states-although sometimes the
    program had different rules and funding than in the states.

    Principal Findings

    U.S. Federal Tax Treatment of Puerto Rico and Other Insular Areas Differs
    by Area and Type of Tax

    Individuals who are residents of Puerto Rico or the other U.S. insular
    areas pay no federal income tax on income from sources within the insular
    area. The federal tax treatment of U.S.-source income earned by these
    individuals varies by insular area. Federal Insurance Contributions Act
    (FICA) taxes are imposed on wages paid to residents of all of the U.S.
    insular areas, but the unemployment insurance tax applies only to wages
    paid to residents of Puerto Rico and the U.S. Virgin Islands.

    Corporations created or organized in the United States or under the laws
    of the United States or of a state are taxed by the federal government on
    their worldwide income, including that earned in Puerto Rico and the other
    insular areas. U.S. corporations may be able, however, to reduce their
    U.S. tax liability on their foreign source income by way of a credit
    against their U.S. tax for foreign income taxes paid. Additionally, while
    income from a foreign business operation that is not organized as a
    separate legal entity is taxed currently, income from the active conduct
    of business operations set up by U.S. shareholders as separate
    corporations organized under the laws of a foreign country generally is
    not taxed to the U.S. shareholders until it is repatriated as dividends.
    Although, if the income from the foreign corporation is connected to
    business that the foreign corporation has in the U.S., the income is taxed
    currently to the foreign corporation.

    Corporations organized in Puerto Rico, like those organized in the other
    insular areas, are generally treated for U.S. tax purposes as if they were
    organized under the laws of a foreign country. Until this year, a
    possessions tax credit enabled corporations organized in the United States
    that met certain conditions to reduce the federal tax payable on income
    earned in and repatriated from Puerto Rico and other insular areas. The
    credit had been designed to encourage U.S.-based corporations to invest in
    these areas.

    Federal customs duties apply to foreign goods imported into Puerto Rico,
    and federal excise taxes apply to selected goods manufactured in Puerto
    Rico and exported to the United States, but the revenues from these taxes
    and duties are given to the Puerto Rican Treasury.

    Measuring Economic Progress in Puerto Rico Is Challenging, but the Income
    of Commonwealth Residents Remains Well Below That of U.S. Residents

    As shown in figure 1, Puerto Rico's per capita GDP of about $21,000 in
    2005 remained well below U.S. per capita GDP of about $41,000. According
    to the Puerto Rican and U.S. national income and product accounts, this
    measure has grown more rapidly in Puerto Rico than in the United States
    since 1980, when viewed on a per capita basis after adjustments for
    inflation. However, for a number of reasons, the growth rate of real
    (meaning inflation-adjusted) GDP likely does not represent a very accurate
    measure of changes in the economic well-being of Puerto Rican residents.
    One important reason is that a significant amount of the investment income
    included in GDP is paid out to U.S. and foreign investors. Per capita GNP
    and median household income are better measures of the income earned by
    residents. Puerto Rico's per capita GNP of about $14,000 in 2005 was
    significantly below the $41,000 figure for the United States. The latest
    available data show that in 1999, Puerto Rico's median household income of
    $14,412 also was well below the U.S. median value of $41,994. Puerto Rican
    government officials acknowledged significant concerns regarding the
    accuracy of their official implicit price deflator (a measure of price
    changes), due to the age of the underlying methodology.12 (There are plans
    to overhaul this methodology with the assistance of the U.S. Bureau of
    Economic Analysis.) The likelihood of inaccuracy in the existing deflator
    makes it difficult to say precisely how fast Puerto Rican incomes have
    grown in real (inflation-adjusted) terms. The U.S. price deflator is an
    alternative for converting the Puerto Rican data into real terms; however,
    since that deflator is designed to measure price changes in the U.S.
    economy, it is not clear how well it reflects changes in Puerto Rican
    prices. Using the amounts shown in figure 1, inflation-adjusted per capita
    GNP increased at an average annual rate of 1.9 percent in the United
    States, while it rose at 1.5 percent in Puerto Rico if the Puerto Rican
    deflator is used. However, if the U.S. deflator is applied to Puerto Rican
    GNP, annual real per capita GNP rose by 2.5 percent annually, faster than
    the growth in the United States.

    Figure 1: U.S. and Puerto Rican Real Per Capita GDP and GNP, 1980-2005

    Note: Figures were adjusted for inflation using U.S. and Puerto Rican
    gross product deflators.

    The other problems with using the trend in per capita GDP as a measure of
    Puerto Rico's economic progress are that (1) federal tax rules have given
    U.S.-owned corporations an incentive to overstate the amount of income
    they earn in Puerto Rico and those rules changed during the 1990s in a way
    that may have affected the extent of the overstatement, and (2) the scale
    of the informal, or underground, economy in Puerto Rico relative to the
    informal economy in the United States is unknown. The first of these
    problems results in an overstatement of Puerto Rico's GDP, but not its
    GNP. If the size and growth in the informal economy in Puerto Rico is
    large relative to the size and growth of informal economy in the United
    States, comparisons between levels and growth in both per capita GDP and
    GNP in the two jurisdictions could be affected.

    Overall, employment in Puerto Rico has grown over the past two decades,
    despite a decline in manufacturing jobs. The gap in the rate of
    unemployment between Puerto Rico and the United States has narrowed in
    recent years, but Puerto Rico's rate of 10.6 percent in 2005 was still
    notably higher than the rate in the United States, which was below 6
    percent. Puerto Rico's labor participation has been under 50 percent
    throughout the past two decades, well below the U.S. rate, which has
    generally been above 65 percent. This low labor participation rate in
    Puerto Rico, along with a relatively low rate of investment there, despite
    considerable investment from nonresidents, are two key issues that affect
    Puerto Rico's economic performance.

    Some Measures of Aggregate Manufacturing Activity Have Remained Constant
    Despite a Decline in Possessions Corporation Activity

    U.S. corporations claiming a possessions tax credit played a dominant role
    in Puerto Rico's manufacturing sector into the late 1990s. According to
    the economic censuses of the Puerto Rican manufacturing sector that Census
    compiles every five years, possessions corporations accounted for 38.2
    percent of employment and 61.6 percent of output in the manufacturing
    sector in 1987. These shares rose to 40.8 percent and 72.0 percent in
    1997, before falling to 31.8 percent and 26.7 percent by 2002. Tax data
    show that the amount of possessions tax credit that these corporations
    claimed peaked at $5.8 billion in 1993, the last year before the
    generosity of the credit was significantly curtailed, and that the gross
    profits of these corporations earned in Puerto Rico peaked at $28.8
    billion in 1997, the year after the possessions tax credit was repealed
    (starting a 10-year phaseout period).

    From 1993 to 2003, the number of corporations claiming the credit for
    operations in Puerto Rico fell from 378 to 124, and the amount of credit
    claimed declined from $5.8 billion to $1.1 billion. The gross profits that
    these corporations earned in Puerto Rico dropped from $24.8 billion to
    $12.1 billion, and their total assets declined from $59.5 billion to $41.1
    billion.

    A combination of tax return and Economic Census data indicate that the
    decline in income and value added of possessions corporations has been
    largely offset by an increase in the income and value added of affiliated
    corporations that left aggregate income and value added roughly the same.
    GAO tracked the best available data on the affiliated corporate groups
    that have claimed almost all of the possessions tax credit since 1993 and
    found that the decline in the reported gross profits, total income, and
    total assets of possessions corporations within those groups was largely
    offset by increases in the reported gross profits and assets of affiliated
    corporations operating in Puerto Rico between 1997 and 2001, particularly
    those incorporated outside of the United States. Data from recent Economic
    Censuses of Puerto Rico, presented in figure 2, show that the decline in
    value added by possessions corporations in the chemical industry (which is
    dominated by pharmaceuticals) between 1997 and 2002 was more than offset
    by increases in the value added of other types of businesses. In contrast,
    value added for both possessions corporations and all other types of
    businesses declined in the remainder of the manufacturing sector over that
    period. A change in Census's industrial classification system between 1997
    and 2002 means that the scope of the industries being compared for those
    two years in the following figures may not be exactly the same.13 However,
    the basic point of each of these figures is not invalidated by this
    factor.

    Although some evidence of a possible change in income-shifting behavior by
    U.S.-owned businesses makes it difficult to say how accurately trends in
    reported income and value-added data represent trends in actual economic
    activity in Puerto Rico, data on capital expenditures (fig. 3), employment
    (fig. 4), and total assets (none of which should be distorted by income
    shifting) support the conclusion that a substantial amount of possessions
    corporation activity has been continued by other types of businesses.
    However, most of this continued activity is concentrated in the
    pharmaceutical industry and the decline in possessions corporation
    activity in the remainder of Puerto Rico's manufacturing sector has not
    been offset. None of the data GAO presents addresses the question of what
    corporate activity would have taken place during this period if the
    possessions tax credit had not been repealed.

    Figure 2: Value Added for Possessions Corporations and Other Types of
    Employers in the Chemical Industry and All Other Manufacturing Industries,
    1997-2002

    Note: Figures were adjusted for inflation using Puerto Rico's gross
    product deflator.

    Figure 3: Capital Expenditures in Puerto Rico's Manufacturing Sector, by
    Industry, 1987-2002

    Note: Figures were adjusted for inflation using Puerto Rico's gross
    product deflator.

    Figure 4: Employment in Possessions Corporations and Other Types of
    Employers in the Chemical Industry and All Other Manufacturing Industries,
    1997-2002

    Note: Figures were adjusted for inflation using Puerto Rico's gross
    product deflator.

    U.S.-owned or U.S.-incorporated Businesses Dominated Puerto Rican
    Manufacturing in 2002 but Played Much Smaller Roles in Other Sectors of
    the Economy

    U.S.-owned businesses accounted for at least 71 percent of value added and
    at least 54 percent of employment in Puerto Rico's manufacturing sector in
    2002. CFCs produced most of this value added but possessions corporations
    still accounted for most of the employment by U.S. firms. The CFCs are
    particularly important in the pharmaceutical industry and much less so in
    other manufacturing industries. U.S. corporations appear to account for
    less than 25 percent of employment in Puerto Rico's wholesale and retail
    trade sectors, where local corporations are the most important employers.
    Similarly, U.S.-owned corporations are not the majority employers in any
    of the large Puerto Rican service industries for which data are available.

    As of 2002, U.S. CFCs accounted for 42 percent of value added in Puerto
    Rico's manufacturing sector-a larger share than that of any other type of
    business entity (see fig. 5). They were able to produce this value added
    with a relatively small share-14 percent-of the sector's total employment
    (see fig. 6). Possessions corporations, which had the next largest share
    of value added, with 27 percent, remained the largest single type of
    employer, with 31 percent of the sector's employment.

    Figure 5: Distribution of Value Added for All Puerto Rican Manufacturing
    by Type of Business Entity, 2002

    Note: Value-added figures for sole proprietors round to 0 percent.

    Figure 6: Distribution of Employment for All Puerto Rican Manufacturing by
    Type of Business Entity, 2002

    Taxes Paid Per Capita in Puerto Rico Are Considerably Lower Than Those in
    the States but the Taxes are About the Same Share of Personal Income in
    Both Places

    The per capita tax burden imposed by all levels of government (federal,
    Commonwealth, and local) in Puerto Rico in 2002 was $3,071, considerably
    less than the per capita burden of $9,426 in the states (see fig. 7).
    However, the combined tax burden in Puerto Rico amounted to 28 percent of
    personal income, which was close to the 30 percent burden in the states
    (see fig. 8).14 The rate for the five states with the highest combined tax
    burden was 39 percent, while that for the five states with the lowest
    burden

    was 23 percent.15 The average burden of federal taxes (excluding the
    corporate income tax, which is difficult to allocate by location) in
    Puerto Rico was considerably lower than in the states, but this difference
    was made up by the fact that Commonwealth and local taxes in Puerto Rico
    were higher than the average state and local taxes. Commonwealth income
    and sales taxes were higher as a percent of personal income than those of
    state and local governments, but property taxes in the Commonwealth were
    lower.

    Figure 7: Per Capita Taxes Paid in the United States and Insular Areas,
    Fiscal Year 2002

    Federal grants and payments to the Puerto Rican government in 2002
    amounted to $1,242 per capita, about the same as the $1,264 per capita
    paid to all state and local governments in the states, but less than the
    $1,703 per capita paid to the other insular area governments. The $2,057
    per capita of direct federal payments to individuals in Puerto Rico was
    well below the $3,648 per capita paid to state residents, but higher than
    the $1,418 per capita paid to residents of the other insular areas. The
    per capita federal payments of $336 for salaries, wages, and procurement
    in Puerto Rico were about 20 percent of payments for those purposes in the
    states and the other insular areas.

    Figure 8: Taxes Paid as a Share of Personal Income in the United States
    and Insular Areas, Fiscal Year 2002

    The Extent to Which Federal Social Programs in Puerto Rico Mirror Those in
    the States and U.S. Insular Areas Varies

    The social programs that we examined in the insular areas generally
    targeted similar populations and delivered similar services to those in
    the states-although sometimes the program had different rules and funding
    than in the states. For example, in lieu of the Food Stamp Program
    available in the states, which is an entitlement program based on the
    number of participants, Puerto Rico receives a capped block grant that has
    similar eligibility requirements. The major difference between some of the
    social programs GAO examined in the states versus those in Puerto Rico and
    the other insular areas is how they are funded. For example, under HOME
    Investment Partnerships eligibility rules are the same in Puerto Rico and
    the states; however, unlike for the states, the amount of HOME funding is
    subject to a cap. To cite another example, where federal Medicaid spending
    is an open-ended entitlement to the states, it is subject to a statutory
    cap and a limited matching rate in Puerto Rico and the other insular
    areas. Some of the social programs that GAO examined are available in the
    states, but not in some of the insular areas. Table 1 summarizes how
    selected social programs compare between Puerto Rico and the states.

    Table 1: Summary of Selected Social Programs in Puerto Rico Compared to
    Those in the States

    Same in Puerto Rico and the    Operates the same in   Some components have
                  states                Puerto Rico, or           financing
                                      comparable programs    differences and some
                                     operate, but financing         do not
                                            differs
    Individuals with             Food Stamp or Nutrition  Health Grants
    Disabilities Education Act   Programs
    (IDEA) Part B
    Title I of the Elementary    Medicare
    and Secondary Education Act,
    reauthorized by the No Child
    Left Behind Act of 2001
    Child and Adult Care Food    Medicaid
    Program
    National School Lunch        State Children's Health
    Program                      Insurance Program
                                    (SCHIP)
    Special Supplemental         Aid to the Aged, Blind,
    Nutrition Program for Women, or Disabled (AABD)
    Infants, and Children (WIC)
    HOPE VI                      Temporary Assistance for
                                    Needy Families (TANF)
    Housing Choice Vouchers      Child Care and
                                    Development Fund (CCDF)
    Community Development Block  Foster Care and Adoption
    Grants                       Assistance
    Project-based Section 8      HOME Investment
                                    Partnerships
    Public Housing
    Section 203 (b) Single
    Family Mortgage Insurance
    Program

    Source: GAO analysis of U.S. federal social programs.

    Agency Comments

    GAO shared a draft of this report with representatives of the Governor of
    Puerto Rico. In written comments the Governor said that he is confident
    the report will be useful to Congress for evaluating options for promoting
    jobs and investment in Puerto Rico. The Governor highlights the
    disproportionate job loss in Puerto Rican manufacturing over the last 10
    years and notes, as the report states, that the report does not attempt to
    project what the current level of manufacturing employment and value added
    would have been had the credit not been repealed. The Governor's letter is
    reprinted in appendix IX.

    IntroductionChapter 1

    The federal and Commonwealth governments have had a long-term interest in
    policies to stimulate economic growth in Puerto Rico. Historically, the
    centerpiece of these policies has been the combination of the possessions
    tax credit in the U.S. Internal Revenue Code (IRC) and extensive tax
    incentives in the Puerto Rican tax code for U.S. and foreign businesses.
    In the early 1990s Congress became dissatisfied with the effectiveness of
    the credit and introduced restrictions to better target
    employment-generating activities. Then in 1996 Congress repealed the
    credit but allowed existing possessions corporations to earn either the
    possessions credit or a replacement credit during a 10-year phaseout
    period ending in 2006. Various proposals have been placed before Congress
    for some form of replacement assistance to the Puerto Rican economy.
    Congress could better assess the merits of the various proposals if it had
    more complete information relating to the recent performance of the Puerto
    Rican economy, the current treatment that Commonwealth residents receive
    under both federal tax policies and federal social programs, and
    information relating to the burden of taxes that residents of Puerto Rico
    pay, relative to those paid by residents of the states and the other U.S.
    insular areas.

    To provide a basis for future decisions regarding legislation on Puerto
    Rican economic issues, this report

    o explains how the U.S. federal tax treatment of individuals and
    businesses in Puerto Rico and of the insular government differs relative
    to the treatment of governments, businesses, and individuals in the states
    and the other U.S. insular areas;

    o compares trends in Puerto Rico's principal economic indicators since the
    early 1980s with similar indicators at the national level for the United
    States and provides what is known about capital flows between Puerto Rico
    and the United States and between Puerto Rico and foreign countries;

    o reports on changes in the activities and tax status of the corporations
    that have claimed the possessions tax credit since 1993;

    o provides information on the distribution of private-sector economic
    activity in Puerto Rico by type of business entity;

    o describes the total amount of tax paid by individuals and businesses in
    the states and the U.S. insular areas and shows percentage breakdowns by
    type of tax; and

    o describes how the principal U.S. federal social programs apply to Puerto
    Rican residents, relative to residents of the states and the other U.S.
    insular areas.

    Background

    Puerto Rico is one of the two nonstate Commonwealths associated with the
    United States. The other is the Commonwealth of the Northern Mariana
    Islands (CNMI). The United States also has three major territories under
    the jurisdiction of the U.S. Department of Interior. The major territories
    are Guam, the U.S. Virgin Islands, and American Samoa. The three major
    territories plus the two nonstate Commonwealths are referred to in this
    report as "the insular areas."1 These areas are often grouped together in
    this manner for the purpose of federal legislation. For this reason, and
    when necessary for the purpose of comparison to Puerto Rico, this report
    provides a limited discussion on the other insular areas.

    With the exception of American Samoa, those born in the insular areas are
    U.S. citizens; however, insular area residents are not afforded all of the
    rights of citizens residing in the states.2 More than four million U.S.
    citizens and nationals live in the insular areas. These areas vary in
    terms of how they came under the sovereignty of the United States and also
    in terms of their demographics, such as median age and education levels.
    Each of the insular areas has its own government and maintains a unique
    diplomatic relationship with the United States. General federal
    administrative responsibility for all insular areas but Puerto Rico is
    vested in the Department of the Interior. All departments, agencies, and
    officials of the executive branch treat Puerto Rico administratively "as
    if it were a state"; any matters concerning the fundamentals of the
    U.S.-Puerto Rican relationship are referred to the Office of the
    President.3

    Residents of all the insular areas enjoy many of the rights enjoyed by
    U.S. citizens in the states. But some rights that, under the Constitution,
    are reserved for citizens residing in the states have not been extended to
    residents of the insular areas. For example, residents of the insular
    areas cannot vote in national elections, nor do their representatives have
    full voting rights in Congress. Residents of all of the insular areas
    receive federally funded aid for a variety of social programs. Although
    residents of an insular area do not pay federal income taxes on income
    earned in that insular area, federal tax policy does play an important
    role in the economies of the insular areas.4 Historically, the federal
    government has used tax policy as a tool to encourage investment and
    increase employment in the insular areas.

    Puerto Rico's Relationship with the United States

    Puerto Rico's Constitution of 1952 defines Puerto Rico as a self-governing
    Commonwealth of the United States.5 Although fiscally autonomous, Puerto
    Rico is similar to the states in many aspects. For example, matters of
    currency, interstate commerce, and defense are all within the jurisdiction
    of the U.S. federal government. Puerto Rican residents are required to pay
    local income taxes on income earned from Puerto Rican sources, but not
    federal income taxes. Puerto Rican residents, however, do contribute to
    the U.S. national Medicare and Social Security systems. Generally, federal
    labor, safety, minimum wage laws and standards also apply in Puerto Rican
    to the same extent they apply to the states. The federal government plays
    a pervasive role in Puerto Rico that stems not only from the applicability
    of the United States Constitution, laws and regulations, but from the
    transfer to the island of more than $13 billion in federal funds every
    year to fund social programs to aid Puerto Rican residents, including
    earned benefits such as Social Security and unemployment benefits.

    Chapters 2 and 7 of this report discuss in detail the how the U.S. federal
    tax code applies to residents of Puerto Rico and how the principal U.S.
    federal social programs are applied in Puerto Rico, respectively.

    Characteristics of Puerto Rico

    Puerto Rico occupies a central position in the West Indies. It comprises
    six main islands with a land area of 3,421 square miles and a population
    of almost four million people. Puerto Rico is thought to have one of the
    most dynamic economies in the Caribbean region, an economy in which
    manufacturing, driven by the pharmaceutical industry, has surpassed
    agriculture as the primary sector in terms of domestic income. Over 40
    percent of Puerto Rico's domestic income since the mid-1980s has been
    derived from manufacturing. Pharmaceuticals accounted for almost 40
    percent of total value added in manufacturing in 1987; that share rose to
    over 70 percent by 2002. Table 2 describes some of the demographic
    characteristics of Puerto Rico and compares them to national averages in
    2000.

    Table 2: Demographic Characteristics of Puerto Rico Compared to the United
    States

                       Characteristics                  Puerto Rico The 50 states
    Population                                         3,808,610   281,421,906
    Median age                                              32.1          35.3
    Percent under 19 years of age                           32.0          27.1
    Percent over 65 years of age                            11.2          12.4
    Infant mortality per 1,000 live births                   9.4           6.9
    Percent high school graduate or more (over age          60.0          80.4
    25)
    Percent bachelor's degree or more (over age 25)         18.3          24.4
    Estimated median household income                    $14,412       $41,994
    Percentage of individuals below poverty level           48.2          12.4

    Source: 2000 Census of the United States.

    Possessions Tax Credit

    Historically, income derived from operations of U.S. corporations in U.S.
    possessions has been subject to special tax provisions. The Tax Reform Act
    of 1976 modified the form of the preferential tax treatment by
    establishing the possessions tax credit under Section 936 of the Internal
    Revenue Code. The stated purpose of this tax credit was to "assist the
    U.S. possessions in obtaining employment-producing investments by U.S.
    corporations." Prior to 1994, the possessions tax credit was equal to the
    full amount of the U.S. income tax liability on income from a possession.
    The credit effectively exempted two kinds of income from U.S. taxation:

    o income from the active conduct of a trade or business in a possession,
    or from the sale or exchange of substantially all of the assets used by
    the corporation in the active conduct of such trade or business and

    o certain income earned from financial investments in U.S. possessions or
    certain foreign countries, generally referred to as qualified possession
    source investment income (QPSII).

    In order for the income from an investment to qualify as QPSII, the funds
    for the investment must have been generated from an active business in a
    possession, and they must be reinvested in the same possession. Dividends
    repatriated from a U.S. subsidiary to a mainland parent have qualified for
    a dividend-received deduction since 1976, thus allowing tax-free
    repatriation of possession income.

    The possessions tax credit was criticized on the grounds that the
    associated revenue cost was high compared to the employment it generated,
    that a large share of the benefits of the credit were not reaped by Puerto
    Rican residents and that it distorted debate over Puerto Rico's political
    status. The Omnibus Budget Reconciliation Act of 1993 placed caps on the
    amounts of possessions credits that corporations could earn for tax years
    beginning in 1994 or later.6 The Small Business Job Protection Act of 1996
    repealed the possessions tax credit for taxable years beginning after
    1995.7 However, the act provided transition rules under which a
    corporation that was an existing credit claimant was eligible to claim
    credits with respect to possessions business income for a period lasting
    through taxable years beginning before 2006. Additional background on
    Section 936 of the U.S. Tax Code and the possessions credit is provided in
    chapters 2 and 4.

    Additional Studies Relating to the Economy of Puerto Rico

    Several of our previous studies, as well as work done by the Internal
    Revenue Service (IRS) and the U.S. Census Bureau (Census), address aspects
    of the Puerto Rican economy discussed in this report, including the
    business activity of possessions corporations and employment, payroll,
    value added, and capital expenditures by economic sector. Our previous
    work also addresses broader trends in the Puerto Rican economy, as does
    work underway by the Brookings Institution. A related study is also
    expected shortly by the Joint Committee on Taxation. Its work will
    evaluate legislative options concerning Puerto Rico. Table 3 highlights
    the scope of several recent reports on Puerto Rico, as well as the two
    studies that are in progress.

    Table 3: Recent and Forthcoming Reports on Puerto Rico

                  Report                                Scope
    GAO, Puerto Rico and the     This report presented information relevant to
    Section 936 Tax Credit,      Congress's consideration of proposals to
    GAO/GGD-93-109 (Washington,  revise Section 936 of the IRC.
    D.C.: June 8, 1993)
    GAO, Tax Policy: Puerto      This report provided information on economic
    Rican Economic Trends,       activity in Puerto Rico, before and after the
    GAO/GGD-97-101 (Washington,  changes in U.S. tax benefits, under Section
    D.C.: May 14, 1997)          936 of the IRC.
    GAO, U.S. Insular Areas:     This report identified the key sources of
    Multiple Factors Affect      federal health care funding in the insular
    Federal Health Care Funding, areas, the differences between insular areas
    GAO-06-75 (Washington, D.C.: and the states in the methods used to
    Oct. 14, 2005)               allocate these funds, and the differences in
                                    spending levels per individual between the
                                    insular areas and the states.
    IRS research on possessions  In odd years, from 1993 to 2001, IRS's
    corporations, published by   Statistics of Income division studied
    Statistics of Income, in odd corporations claiming the possessions tax
    yearsa                       credit in Puerto Rico.
    Census's 1992, 1997, and     The censuses include information on
    2002 Economic Census of      employment, payroll, value added, and capital
    Island Areas                 expenditures by economic sector.
    Brookings Institution's      Economists from the United States and Puerto
    report on restoring growth   Rico address a range of major policy issues
    in Puerto Ricob              affecting the island's economic development
                                    and propose a strategy for jumpstarting
                                    Puerto Rican economic growth. The book
                                    includes Puerto Rico's past experience with
                                    growth policies, and an analysis of several
                                    reforms and new initiatives in labor,
                                    education, entrepreneurship, fiscal policy,
                                    migration, trade, and financing development.
    Forthcoming study by the     This study will analyze the tax and economic
    Joint Committee on Taxation  policy implications of legislative options
                                    concerning Puerto Rico. In particular it will
                                    examine the revenue costs of these options
                                    and compare the options to current laws
                                    relative to the states and the other U.S.
                                    insular areas.

    Source: GAO.

    aRandy Miller, "U.S. Possessions Corporations, 1995," SOI Bulletin, IRS;
    Sarah Nutter, "U.S. Possessions Corporations Returns, 1997 and 1999," SOI
    Bulletin, IRS; Daniel Holik, "U.S. Possessions Corporations Returns,
    2001," SOI Bulletin, IRS.

    bSusan M. Collins, Barry P. Bosworth, and Miguel Soto-Class, eds.,The
    Economy of Puerto Rico: Restoring Growth, (Washington, D.C.: The Brookings
    Institution, 2006).

    Scope and Methodology

    The Chairman and Ranking Minority Member of the U.S. Senate Committee on
    Finance asked us to study fiscal relations between the federal government
    and Puerto Rico and trends in the Commonwealth's economy with a particular
    focus on the activities of possessions corporations operating there.

    Federal Tax Treatment

    To determine the U.S. federal tax treatment of individuals and businesses
    in Puerto Rico, relative to the states and the other insular areas, we
    examined the IRC, Department of the Treasury regulations, relevant
    Treasury rulings and notices, and legislation.

    Economic Indicators and Capital Flows

    To compare trends in principal economic indicators for the United States
    and Puerto Rico, we obtained data from both U.S. and Puerto Rican sources.
    The trends we present are commonly used measures of overall economic
    activity and important components of economic activity, such as saving,
    investment, labor force participation, and unemployment. We reported on
    many of these indicators in our previous report on economic trends in
    Puerto Rico.8 The data shown are largely drawn from the National Income
    and Product Account series produced annually by economic statistics
    agencies in the United States and Puerto Rico. Most of the data we used
    for the U.S. economic series are produced by the Bureau of Economic
    Analysis and the Bureau of Labor Statistics and are publicly available
    from the Internet. When we compared U.S. data to Puerto Rican data that
    are based on the Puerto Rican July 1-June 30 fiscal year, we computed
    annual U.S. figures using monthly or quarterly data to match the Puerto
    Rican fiscal year.

    Most of the annual data we used for Puerto Rican economic trends are
    produced by the Planning Board of Puerto Rico and are also publicly
    available. In some instances, the methodologies used by the Planning Board
    to produce certain data series are outdated relative to the methodologies
    now used by the United States. For example, the methodology used in
    calculating certain price indices in Puerto Rico is outdated and the
    methods used to obtain unemployment data have been somewhat less rigorous
    than in the United States. In these cases, we reviewed literature
    concerning the limitations of various series and interviewed Puerto Rican
    officials about the methods they use to collect and develop their data.
    These limitations are noted in the report. Wherever possible, we used
    alternative assumptions and data sources to determine if any conclusions
    drawn from the data are sensitive to the particular data series used. For
    example, we applied both U.S. and Puerto Rican price indices to Puerto
    Rican gross domestic product (GDP) data to see if applying different
    measures of price changes would lead to different conclusions about
    whether the Puerto Rican economy has been growing faster or slower than
    the U.S. economy. Puerto Rico's Planning Board has recently contracted
    with several consultants for a review of their entire set of methodologies
    for preparing the Commonwealth's income and product accounts, including
    the deflators. The Board has also been negotiating a memorandum of
    agreement with the U.S. Bureau of Economic Analysis for the latter to
    provide advice on this effort.

    For some indicators of interest, annual data are not available for Puerto
    Rico. In some of these cases, we used decennial census data. The decennial
    census covers both the United States and Puerto Rico and produces
    comparable statistics on educational attainment and poverty levels. We
    also used data from the Economic Census of Puerto Rico and the Economic
    Census of the United States, also produced by Census. These data included
    detailed information on employment, investment, and value added broken
    down by sector of the economy. These data, produced by Census every 5th
    year, are of particular relevance to the possible effects of phaseout of
    the possessions tax credit.

    To provide information on what is known regarding the flow of capital into
    and out of Puerto Rico, we interviewed Puerto Rican government officials
    and private sector experts to help us to ascertain what data were
    available. We determined that the available data would not allow us to
    present a comprehensive picture of the trends in capital flows. The most
    significant gap in that picture is data relating to direct investment by
    corporations incorporated outside of Puerto Rico, which is financed from
    within their own affiliated groups, rather than through financial
    institutions.9 We can, however, report on changes over the years between
    1995 and 2004 in the amount of funds that nonresidents hold in the Puerto
    Rican banking system and the amount of funds that the banking system
    invests within and outside of the Commonwealth. In order to identify where
    the assets held in the Puerto Rican banking system are invested and where
    the owners of the banks' liabilities reside, we analyzed
    institution-specific data that the Office of the Commissioner of Financial
    Institutions (OCFI) collects for oversight purposes. Banks and certain
    other financial institutions in Puerto Rico are required to report
    detailed information regarding their assets, liabilities, and capital to
    the OCFI through a computerized "CALL report" data system. Appendix I
    describes our analysis of the financial data.

    We also used data provided by Puerto Rico's Government Development Bank to
    show trends in Puerto Rican government borrowing in the U.S. and local
    capital markets. The consensus of the government and private sector
    financial experts whom we interviewed was that all Puerto Rican government
    bonds that qualify for tax exemption under Section 103 of the IRC, such as
    bonds that are issued for the purpose of capital improvement projects, are
    sold in the U.S. market. All other Puerto Rican government bonds that are
    taxable in the United States but tax exempt in Puerto Rico are sold in the
    local market. The Government Development Bank was able to provide us with
    a complete and detailed accounting of each of their debt issues and to
    identify which ones did or did not qualify for the U.S. tax exemption.

    Changes in Possessions Corporation Activity

    In order to examine changes in the activities of possessions corporations
    operating in Puerto Rico since the early 1990s, we constructed several
    databases from an assortment of tax return data we obtained from IRS and
    Puerto Rico's Department of Treasury. Our principal source of data was
    IRS's Statistics of Income unit (SOI), which compiles comprehensive data
    on possessions corporations every other year. We obtained the complete set
    of these biennial databases from 1993 through 2003 and used information
    from SOI to identify those possessions corporations that operated in
    Puerto Rico. For the first stage of our analysis, we linked the biennial
    records for each individual corporation by its employer identification
    number (EIN) so that we could identify any data gaps for specific
    corporations in particular years and so we could complete a second, more
    complicated data analysis (described below). We filled in missing data for
    individual corporations to the extent possible from other IRS files and
    through imputations based on surrounding-year data. The extent of the
    imputations were minimal relative to the population totals we report. We
    used the final database on 656 possessions corporations that operated in
    at least 1 year between 1993 and 2003 to report on changes over time in
    the aggregate income, tax credit, and total assets of this population of
    corporations and to show how these particular variables were distributed
    across different industries. We also used data from the past four Economic
    Censuses of Puerto Rico (1987, 1992, 1997, and 2002) compiled by Census to
    show how the importance of possessions corporations in Puerto Rico's
    manufacturing sector has changed over time.

    For the second stage of our analysis, we focused on a subpopulation of the
    largest groups of affiliated possessions corporations operating in Puerto
    Rico. For each of these groups we compiled data on other affiliated
    corporations (i.e., those sharing the same ultimate parent corporations)
    that also operated in Puerto Rico, but were not possessions corporations.
    The objective of this analysis was to assess the extent to which the large
    corporate groups that accounted for most of the activity of possessions
    corporations remained active in Puerto Rico, even as the operations of
    their possessions corporations were being phased out. We started by
    identifying the 77 largest groups of possessions corporations in terms of
    the amount of credit they earned, their total income, and their total
    assets. These large groups gave us a subpopulation that accounted for over
    90 percent of the tax credit and income earned and over 90 percent of the
    assets owned by possessions corporations between 1993 and 2003, and at the
    same time reduced the number of corporations we had to work with from 656
    to 172. This reduction in the number of corporations we had to work with
    was important because data limitations caused some of the steps in our
    database development to be very labor intensive.

    We used two key data sources to identify and obtain data for the members
    of the large groups that operated in Puerto Rico but which were not
    possessions corporations. The first source was the database in which IRS
    maintained the records of all forms 5471 that had been filed between 1996
    and 2002. (The owners of controlled foreign corporations [CFC] must file a
    separate form 5471 every year for each CFC that they own.) The second
    source was a database that the Puerto Rican Department of Treasury (with
    the assistance of the Government Development Bank) had recently
    transcribed from all Puerto Rican tax returns for tax years 1998 through
    2001 filed by all corporations or partnerships that received tax
    incentives from the Government of Puerto Rico. Officials from the
    Department of Treasury and from the Puerto Rico Industrial Development
    Company (PRIDCO) told us that almost all U.S.- or foreign-owned
    manufacturing corporations operating in Puerto Rico receive tax
    incentives, as do corporations in designated service industries that
    export products or services from Puerto Rico. A total of 1,758 different
    taxpayers appeared in the database for at least 1 of the tax years. We
    used a series of both automated and manual search and matching approaches
    to link the CFCs and other types of companies from these two databases to
    our 77 large corporate groups. We also used information from both
    databases to determine which of the CFCs had operations in Puerto Rico
    and, in the case of CFCs with operations in multiple countries, to make a
    range of estimates for the amount of income they earned in Puerto Rico.
    The data on income, assets, taxes paid, and place of incorporation that we
    extracted from the two databases for these linked corporations allow us to
    provide a more complete picture of the trends in activities of the
    corporate groups that have taken advantage of the possessions tax credit
    over the years.

    Through interviews with officials from the agencies providing the data and
    our own computer checks for internal consistency in the data, we
    determined that the quality of the data was sufficient for the purposes of
    our report when viewed with the cautions we raise at various points in the
    text. One problem that afflicted all of the databases to some degree was
    missing values arising from the fact that IRS and the Puerto Rican
    Department of Treasury could not always obtain every tax return that
    should have been in their databases in a particular year and the fact that
    taxpayers did not always accurately fill in every line of the return that
    they should have. Our access to multiple databases that overlapped to some
    extent enabled us to address this problem by filling in gaps with data
    from an alternative file, making reasonable imputations, or at a minimum
    assessing whether missing values would have made a significant difference
    to our results.

    Distribution of Business Activity

    In order to show how economic activity in Puerto Rico is distributed
    across different forms of businesses, we negotiated a special arrangement
    with IRS and Census that enabled us to disaggregate the data from Census's
    recently completed 2002 Economic Census of Puerto Rico by categories of
    business entities that are more specifically relevant to tax policymakers
    than the categories Census uses for its own publications. The 2002
    Economic Census collected data on employment, payroll, and other economic
    measures from all nonfarm, private sector employers in Puerto Rico, making
    it a comprehensive enumeration of Puerto Rican businesses. We used
    taxpayer data from IRS and Puerto Rico to determine, in as many cases as
    possible, the type of federal or Puerto Rican income tax return each of
    these employers filed and, in the case of corporations, where they were
    incorporated. We then used this information to place each employer into a
    business entity group, such as possessions corporation, CFC incorporated
    in Puerto Rico, CFC incorporated elsewhere, sole proprietor, and so forth.
    Census then provided us with tabulations of their data for each of these
    groups, disaggregated by industry to the extent that their disclosure
    rules would permit. We developed a coding system and a data-exchange
    procedure that enabled us to link tax and Census data for specific
    employers in such a way that Census did not have to view restricted IRS
    data and we did not have to view confidential Census data for specific
    survey respondents. (See app. III for details.)

    The data that we used to determine the tax filing status and place of
    incorporation for the employers in the Census database came from the IRS
    and Puerto Rico databases described above, plus a couple of additional
    sources. Another important new source of data was IRS's National Accounts
    Profile (NAP) database, which contains selected information for all
    individuals and businesses that have an EIN. Each employer in Puerto Rico
    has a federal EIN because it must collect Federal Insurance Contributions
    Act (FICA) taxes on behalf of its employees. Consequently, we were able to
    access NAP data for a very high percentage of the employers included in
    the Census. For those employers we were able to determine what, if any,
    federal income tax form they were required to file, whether they were
    included in their parent corporation's consolidated return, and whether or
    not IRS had identified them as being sole proprietors.

    The other data sources that we used for this particular analysis included
    sets of income tax returns for some of the businesses operating in Puerto
    Rico that IRS had provided to Census, and a list of CFCs operating in
    Puerto Rico that PRIDCO had compiled. None of the non-Census data sources
    that we used was comprehensive and some of the sources more closely met
    our needs than others. Appendix III describes how we used these data to
    place each employer into a business entity group. For those cases where we
    could not reliably place an employer into a group based on tax data or
    data from PRIDCO we asked Census to place them into certain groups based
    on their survey responses.

    Fiscal Comparison

    To compare the overall tax burden borne by individuals and businesses in
    Puerto Rico with the burden borne by individuals and businesses in the
    states and in the other insular areas, we obtained and analyzed detailed
    data on state and local government revenues from the U.S. Census of
    Governments, data on Commonwealth government revenue from the Puerto Rican
    Department of Treasury, data on municipal tax revenue in Puerto Rico from
    Oficina del Comisionado de Asuntos Municipales, Centro de Estadisticas
    Municipales,10 and revenue data for the other insular areas reported in
    their 2002 Single Audit reports. We also obtained data on federal taxes
    collected in Puerto Rico and the states from IRS's 2002 Data book.11 (No
    such data were available for the insular areas.) We compared taxes paid on
    a per capita basis and as a percent of personal income. We make our
    comparison for year 2002 because that is the year of the most recent
    Census of Governments.

    We also compared federal expenditures for the states, Puerto Rico, and the
    insular areas using data we obtained from the Consolidated Federal Funds
    Report for Fiscal Year 2002 and the Federal Aid to States for Fiscal Year
    2002. In addition, we report specifically on transfers of excise tax and
    customs duty revenues that the federal government makes to Puerto Rico
    using data obtained from U.S. Customs and the Alcohol and Tobacco Tax and
    Trade Bureau.

    To assess the reliability of the data, for the Census and Puerto Rican
    Treasury data we interviewed knowledgeable officials and reviewed
    supporting documentation to understand the internal procedures in place to
    ensure data quality. For the insular areas we compared data reported in
    the Single Audit reports to other published data. We determined that the
    data we obtained from the Puerto Rican Department of Treasury is
    consistent with what was reported in the Commonwealth's Comprehensive
    Annual Financial Report. Although we found the data reliable for the
    purpose of our engagement, we note certain limitations in the data. In
    particular, all the state and local data compiled by Census are
    as-reported by cognizant government officials responsible for financial
    matters in each of the political entities and may not have been subjected
    to any internal or external accuracy checks. Checks performed by Census on
    its data are for completeness and consistency with internal and external
    sources. The independent auditor's statement in the Single Audit reports
    for the insular areas indicated that the auditors generally could not
    verify the accuracy of reported information. In addition, federal, state,
    and insular area fiscal years differ, so the data do not cover exactly the
    same period of time.

    Federal Social Programs

    Interviews with federal agencies and prior GAO work provided the basis for
    our description of the application of the principal U.S. federal social
    programs to Puerto Rico residents, relative to the states, and the other
    insular areas. To select the social programs included in this report we
    consulted with GAO experts in the areas of health care policy; education,
    workforce, and income security policy; and financial markets and community
    investment policy. With the help of these experts, we arrived at a list of
    the principal federal social programs, which we then pared down, based on
    program availability in Puerto Rico and expenditure level in Puerto Rico.
    We relied on prior GAO work and interviews with federal agency officials
    to determine how each program is applied in Puerto Rico, relative to the
    other areas. We used program-level data, supplied by federal agencies, to
    report program expenditures for fiscal year 2002. We selected fiscal year
    2002 because in chapter 6 of this report, we provide a more complete
    analysis of the revenue and expenditures of Puerto Rico, the states, and
    the other insular areas using the year of the most recent Census of
    Governments, 2002.

    Our methodologies for each objective were discussed with experts including
    those from the Office of the Comptroller General of Puerto Rico, Puerto
    Rico's Government Development Bank, Puerto Rico's Planning Board, Puerto
    Rico's Office of the Commissioner of Insurance Institutions and Puerto
    Rico's Office of the Commissioner of Financial Institutions. Federal-level
    experts include those from Census and IRS. Our work was performed from
    February 2004 to April 2006 in accordance with generally accepted
    government accounting standards.

    U.S. Federal Tax Treatment of Puerto Rico and Other Insular Areas Varies
    by Area and Type of TaxChapter 2

    Individuals who are residents of Puerto Rico or other U.S. insular areas
    and who earn income only from sources outside of the states generally pay
    no federal income tax; however, their wages are all subject to Social
    Security and Medicare taxes, and wages paid to residents of Puerto Rico
    and the U.S. Virgin Islands also are subject to federal unemployment tax.
    Corporations organized in Puerto Rico, like those organized in the other
    U.S. insular areas, are generally treated for U.S. tax purposes as if they
    were organized under the laws of a foreign country. Until this year,
    special rules enabled corporations organized in the United States that met
    certain conditions to reduce the federal tax payable on income earned in
    and repatriated from Puerto Rico and other insular areas.

    U.S. Tax Treatment of Insular Area Residents with U.S.-source Income and
    U.S. Residents with Insular Area-source Income Varies by Area

    Individuals residing in an insular area and who earn income only from
    sources there file one income tax return there and are required to pay
    income tax only to that area. The U.S. income tax treatment of U.S.-source
    income of residents of an insular area (which does not include income
    earned in the insular areas, other than that earned by U.S. government
    employees) depends on the area:

    o Residents of American Samoa and Puerto Rico must pay U.S. income tax on
    all their income from sources outside American Samoa or Puerto Rico,
    respectively, if such income exceeds the federal filing threshold.1 The
    U.S. government retains the tax collected from residents of Puerto Rico,
    but is required to transfer the tax collected from residents of American
    Samoa to its government.

    o Residents of Guam and CNMI owe income tax to the territory and
    Commonwealth, respectively, on their U.S.-source income; the governments
    of these Commonwealths and territories are required to transfer a portion
    of this tax revenue to the U.S. government if the resident's income
    exceeds certain income thresholds.

    o Generally, the U.S. government does not tax, or receive any tax revenue
    from U.S. Virgin Island residents who have U.S.-source income so long as
    such residents report all of their income, identify the source of their
    income, and pay their income taxes to the U.S. Virgin Islands.

    The U.S. income tax treatment of U.S. residents with Commonwealth- or
    insular area-source income also depends on the insular area:

    o U.S. residents with income from Puerto Rico or American Samoa are
    subject to U.S. federal tax on that income. They also pay tax on that
    income to Puerto Rico or American Samoa, respectively, and receive a
    foreign tax credit against their U.S. tax liability for this amount.

    o U.S. residents with income from Guam or CNMI owe U.S. income tax on that
    income; the federal government is required to transfer a portion of the
    tax revenue received from Guam and CNMI residents back to the respective
    territory and Commonwealth.

    o U.S. residents who earn income in the U.S. Virgin Islands must file
    identical tax returns with both the government there and the U.S.
    government; each government's share of the revenues is based on where the
    income was earned.

    While FICA Taxes Are Imposed on Wages Paid to Employees in All Insular
    Areas, Unemployment Insurance Tax Applies Only to Wages Paid in Puerto
    Rico and U.S. Virgin Islands

    The Federal Insurance Contributions Act2 imposes wage-based taxes on
    employers and employees in the United States and the Commonwealths and
    territories to support Social Security and Medicare. The employment upon
    which taxes are collected includes services performed in the United States
    and the insular areas. Taxes collected under the act are not transferred
    to the treasuries of the insular areas.

    The Federal Unemployment Tax Act imposes3 a tax on wages paid to
    employees, based on wages paid. Puerto Rico and the U.S. Virgin Islands
    are the only insular areas covered by the Act. The proceeds of the tax are
    used to support the federal-state unemployment compensation program and
    are not transferred to the treasuries of either area.

    Taxation of Corporations Incorporated in the United States

    The federal government taxes a U.S. corporation on its worldwide income
    (reduced by any applicable foreign income tax credit), regardless of where
    the income is earned. When the tax is due depends on several factors,
    including whether the income is U.S.- or foreign-source and, if it is
    foreign income, on the structure of the corporation's business operations.

    However, since 1976, and through taxable years beginning prior to December
    31, 2006, U.S. corporations with a domestic subsidiary conducting a trade
    or business in insular areas could qualify to receive significant tax
    benefits through the possessions tax credit.4 Prior to taxable years
    beginning in 1994, the credit effectively exempted from U.S. taxation all
    possession-source income of a qualified possessions corporation. Dividends
    repatriated from a wholly-owned possessions corporation to the mainland
    parent qualified for a 100 percent deduction, thus allowing tax-free
    repatriation of possession income. The credit also exempted qualified
    possession-source investment income (QPSII), which is certain income the
    possessions corporation earned from financial investments in U.S.
    possessions or certain foreign countries. The credit for qualified
    research expense was also allowed for such research conducted by a
    possessions corporation.

    Starting in taxable years beginning in 1994, the amounts of possessions
    tax credits that a possessions corporation could claim were capped. Under
    the cap, a possessions corporation had to choose between two
    alternatives-a "percentage limitation" option or an "economic activity
    limitation" option. In 1996, the possessions tax credit was fully repealed
    for taxable years beginning after 2005. Existing possessions corporations
    could continue to claim the possessions tax credit for tax years beginning
    prior to 2006. These existing credit claimants, however, were subject to
    an income cap5 based on the average business income that the corporation
    earned in a possession during a specified "base period." A possessions
    corporation electing the percentage limitation was subject to the income
    cap beginning in 1998 and a possessions corporation electing the economic
    limitation was subject to the income cap beginning in 2002. Only QPSII
    earned before July 1, 1996, qualified for the credit for tax years
    beginning after December 31, 1995.

    Taxation of Corporations Incorporated outside the United States

    Corporations organized outside the United States, including corporations
    organized in Puerto Rico and the other insular areas,6 are generally
    treated as foreign corporations for U.S. tax purposes. These corporations
    are taxed on their U.S. source earnings-the tax paid generally depends on
    whether the income is "effectively connected" with the conduct of a trade
    or business within the United States, but income from insular areas is not
    subject to U.S. tax.

    Foreign corporations pay U.S. tax at two rates-a flat 30 percent rate is
    withheld on certain forms of nonbusiness gross income from U.S. sources,
    and a tax is imposed at progressive rates on net income from a U.S. trade
    or business.7 Corporations in Puerto Rico must pay the 30 percent
    withholding tax; corporations in the other insular areas do not pay the
    withholding tax if they meet certain tests that establish close
    connections with the insular area in which the corporation was created.
    U.S.-source dividends paid to corporations organized in Puerto Rico are
    subject to a 10 percent withholding tax provided that the same tests
    mentioned above are satisfied and the withholding tax on dividends paid to
    the U.S. corporations is not greater than 10 percent.

    Corporations organized under the laws of an insular area may be treated as
    a controlled foreign corporation (CFC) for U.S. income tax purposes. To
    qualify as a CFC, the corporation must be more than 50 percent U.S.-owned,
    taking into account only U.S. shareholders that meet a 10 percent stock
    ownership test. Gross income from the active conduct of business in Puerto
    Rico or elsewhere outside of the United States is not taxed until it is
    repatriated to the U.S. shareholders in the form of dividends. Subject to
    certain limitations, these shareholders are entitled to a credit for any
    foreign income taxes paid by the CFC with respect to the earnings
    distributed.

    Certain types of passive income, such as dividends and interest, earned by
    CFCs are currently includable in the income of the U.S. shareholders,
    under subpart F of the U.S. Tax Code, even though those amounts are not
    actually distributed to them.8 These shareholders are, subject to certain
    limitations, also entitled to a credit for foreign income taxes paid with
    respect to the amounts includible in income under subpart F.

    Certain kinds of income received by a CFC organized under the laws of an
    insular area are not considered subpart F income:

    o income received from the sale in the insular area of personal property
    manufactured by the CFC in that area,

    o dividend or interest income received from a related corporation9 also
    organized under the laws of that insular area, and

    o rents or royalties from a related corporation received by a CFC
    organized under the laws of an insular area for the use of property in the
    insular area where the CFC is organized.

    The allocation of gross income, deductions, and credits between related
    taxpayers, such as intercompany sales from a CFC to a U.S. domestic
    parent, is subject to transfer pricing rules that are designed to prevent
    manipulation of the overall tax liability.

    Deduction for Income from Domestic Production Activities

    In 2004, in response to a long-running dispute with the European Union,
    Congress repealed the extraterritorial income (ETI) exclusion and enacted
    a deduction relating to income attributable to domestic production

    activities.10 For purposes of the ETI exclusion, the United States
    included Puerto Rico. Puerto Rico is not included, however, in the
    definition of U.S. for purposes of the deduction for domestic production.

    Goods Imported to Insular Areas Are Generally Exempt from U.S. Excise
    Taxes, but a Special Tax Is Imposed on Goods Made in Puerto Rico and U.S.
    Virgin Islands

    Merchandise imported into an insular area from the United States is exempt
    from U.S. excise taxes. The only U.S. excise taxes that apply to products
    imported into any of the insular areas from another country are those
    where specific language extends the tax beyond the "United States," which
    is generally defined, for tax purposes, as only the states. This language
    exists for a tax on petroleum (an environmental tax), a tax on certain
    vaccines, a tax on certain chemicals, and a tax on certain imported
    substances.

    If any revenue from these excise taxes is collected in American Samoa,
    Puerto Rico, or the U.S. Virgin Islands, the U.S. government retains the
    revenue. The governments of Guam or CNMI receive any revenue from these
    taxes collected in their respective territory and Commonwealth.

    There is a special "equalization" U.S. excise tax on articles manufactured
    in Puerto Rico or the U.S. Virgin Islands and exported to the United
    States equal to the tax that would have been imposed had the articles been
    manufactured in the United States. Subject to the limitations described
    below for distilled spirits, the U.S. Treasury returns all the revenue
    from the tax on articles manufactured in Puerto Rico to the Treasury there
    except the amounts needed to pay refunds and drawbacks11 to manufacturers
    and the amount needed to cover its enforcement expenses. The return to the
    U.S. Virgin Islands also excludes amounts needed to pay refunds and
    drawbacks, plus one percent of the total tax collected. All U.S. excise
    taxes collected on articles manufactured from Guam and CNMI and exported
    to the United States must be transferred to their respective territory and
    Commonwealth governments.

    A special limitation applies for the U.S. excise tax on distilled spirits
    manufactured in Puerto Rico and the U.S. Virgin Islands and exported to
    the United States. The tax rate ordinarily applied to rum is $13.50 per
    proof gallon exported, of which $10.50 per proof gallon is returned to the
    appropriate insular area. Puerto Rico and the U.S. Virgin Islands also
    share revenue from the U.S. excise tax collected on all rum imported into
    the United States from a foreign country. Their respective shares are
    proportionate to the relative sizes of their rum exports to the United
    States during the prior fiscal year. Puerto Rico's share, however, cannot
    exceed 87.626889 percent or be less than 51 percent while the U.S. Virgin
    Islands' share cannot exceed 49 percent nor drop below 12.373111 percent.

    U.S. Government Is Responsible for Collecting Customs Duties in Puerto
    Rico and Helps Collect Duties in U.S. Virgin Islands

    The U.S. government collects duties on goods imported into "U.S. customs
    territory," which encompasses the states and Puerto Rico, unless they are
    exempt. U.S. customs duties collected in Puerto Rico are deposited in a
    special U.S. Treasury account. After deductions for refunds and the
    expenses of administering customs activities in Puerto Rico, the remaining
    amounts are transferred to the treasury there.

    Although the U.S. Virgin Islands are not in "U.S. customs territory," the
    U.S. government helps collect local duties there. These collections are
    transferred to the government of the U.S. Virgin Islands after items such
    as operational expenses are deducted. The U.S. government has authority to
    administer and enforce collection of custom duties in American Samoa, upon
    request of the Governor. Guam and CNMI administer and enforce their own
    customs policies and procedures. Items imported into "U.S. customs
    territory" from American Samoa, Guam, CNMI, and the U.S. Virgin Islands
    are subject to U.S. customs duties unless the items are exempt.

    Trends in Production, Income, and Other Economic Indicators for Puerto
    RicoChapter 3

    The economic well-being of Puerto Rican residents, measured in terms of
    either per capita or median income, remains well below that of residents
    of the states. The relative progress that the Puerto Rican economy has
    made since 1980 is difficult to measure with precision for a number of
    reasons, including tax-induced distortions in how U.S. corporations have
    reported income earned in the Commonwealth. The low rate of labor
    participation is a crucial issue in Puerto Rico's economic performance,
    and the rate of investment appears insufficient to significantly reduce
    the disparity between mainland and Puerto Rican incomes.

    Measuring Economic Progress in Puerto Rico Is Challenging but the Income
    of Commonwealth Residents Remains Well Below That of U.S. Residents

    As shown in figure 9, Puerto Rico's per capita GDP of about $21,000 in
    2005 remained well below U.S. per capita GDP of about $41,000. GDP is a
    broad measure of overall income or economic activity occurring within a
    nation's borders in a given year. According to the Puerto Rican and U.S.
    national income and product accounts, this measure has grown more rapidly
    in Puerto Rico than in the United States since 1980, when viewed on a per
    capita basis after adjustments for inflation. However, for a number of
    reasons, the growth rate of real (meaning inflation-adjusted) GDP likely
    does not represent a very accurate measure of changes in the economic
    well-being of Puerto Rican residents.

    First, as a result of U.S. tax provisions and a development strategy
    pursued by successive Puerto Rican governments to use local tax incentives
    to attract investment by U.S. and foreign firms, a significant amount of
    the investment income included in GDP is paid out to U.S. and foreign
    investors. In figure 9, the income earned by nonresidents is approximately
    represented by the gap between Puerto Rican GDP and Puerto Rican GNP. GNP
    is a measure of the total amount of income earned by residents in a given
    year from sources within and from outside of the country. In contrast to
    Puerto Rico, GDP has been consistently about the same as GNP in the United
    States, which indicates that the amount of income earned abroad by U.S.
    residents is close to the amount of income earned by foreign owners of
    assets located in the United States. As of 2005, Puerto Rico's per capita
    GNP of about $14,000 remained well below the U.S. level of about $41,000.

    Second, using the possessions tax credit, U.S.-based groups of affiliated
    corporations (i.e., those owned by a common U.S. parent corporation) with
    certain types of operations in Puerto Rico have had incentives to
    attribute as much net income to those operations as is legally
    permissible, rather

    than to related operations in the United States.1 Moreover, the nature of
    these incentives has changed during the period covered by our review.
    Consequently, the income reported by these corporations to have been
    earned in Puerto Rico in a given year may overstate the actual economic
    importance of their Puerto Rican production, and changes in income over
    the years may reflect not only changes in the economic activity of these
    corporations, but also changes in how corporations have computed their
    Puerto Rican source income. Some of the data reported later in this
    chapter suggest that this so-called "income shifting" has taken place.
    This particular issue affects data on GDP and income and possibly value
    added for corporations owned by U.S. parent corporations; it should not
    affect GNP or income and value added for Puerto Rican-owned corporations.

    Third, as is the case for any country, the scale of the informal, or
    underground, economy in Puerto Rico is difficult to measure. If the
    informal economy in Puerto Rico is large relative to the informal economy
    in the United States, as some analysts believe, a relatively large amount
    of economic activity in Puerto Rico may not be reflected in national
    income and labor market statistics. As discussed below, the presence of a
    large informal economy may be one explanation of low reported labor force
    participation rates in Puerto Rico. Analysts who have recently looked at
    this issue disagree on the size of the informal economy and on whether it
    has been growing as a share of the total economy. The size and any growth
    in the informal economy in Puerto Rico, relative to that in the United
    States, would affect comparisons between levels and growth in per capita
    income earned in the two jurisdictions.

    Lastly, as acknowledged by the Puerto Rico Planning Board, there are
    problems with some Puerto Rican price indices, which cause an unknown
    degree of inaccuracy in the inflation adjustments to the long-term trend
    data on the Puerto Rican economy and, therefore, some imprecision in the
    real growth rates of key economic indicators that are stated in terms of
    dollar values. Most concerns center on the Puerto Rican consumer price
    index (CPI, a measure of prices on consumer goods) and the fact that the
    market basket of goods used to compute the index has not been updated
    since the 1970s. This means that the index will tend to overstate price
    changes. In the analysis in this chapter, we have used the Puerto Rican
    gross product deflator-a broad measure of how prices have changed on
    average for goods and services in the economy-for our inflation
    adjustments. Although analysts within and outside of Puerto Rico's
    Planning Board, which produces the deflator, consider it to be less
    problematic than the CPI, they still have concerns relating to fact that
    the CPI is one of the components used in estimating the deflator and the
    fact that methodologies for other components are also outdated.2

    Given the concerns with the Puerto Rican deflator, there is a question as
    to whether that measure or the U.S. gross product deflator more accurately
    accounts for the changes in prices in Puerto Rico. The U.S. deflator shows
    slower price increases over this period than does the Puerto Rican
    deflator. For this reason, we also report some results based on the use of
    the U.S. deflator in cases where they differ notably from those based on
    the Puerto Rican deflator.

    When comparing the trends in real per capita GNP in Puerto Rico and the
    United States from 1980 to 2005, the choice of deflators does make a
    difference. Over that period, inflation-adjusted per capita income
    increased at an average annual rate of 1.9 percent in the United States,
    while it rose at 1.5 percent in Puerto Rico if the Puerto Rican deflator
    is used. However, if the U.S. deflator is applied to Puerto Rican GNP,
    annual real per capita GNP rose by 2.5 percent annually, faster than the
    growth in the United States. Real per capita GDP rose more rapidly in
    Puerto Rico than in the United States, regardless of which deflators are
    used. U.S. GDP rose at an annual average rate of 1.9 percent from 1980 to
    2005, while the average annual growth rate for Puerto Rico was 2.1 percent
    using the Puerto Rican deflator and 3.2 percent using the U.S. deflator.

    Figure 9: U.S. and Puerto Rican Per Capita GDP and GNP, 1980-2005

    Note: Figures were adjusted for inflation using U.S. and Puerto Rican
    gross product deflators.

    Figure 10 shows the composition of Puerto Rican GDP over time and the
    trend in net income payments abroad. GDP consists of expenditures on
    personal consumption, investment, government consumption of goods and
    services, and net exports (the value of exports minus the value of
    imports). The figure shows that net exports have risen substantially from
    1980 to 2005 as a share of GDP, and consumption, which is largely
    determined by Puerto Rican income, has fallen as a share of GDP.

    Figure 10 also shows net income payments abroad, expressed as a share of
    GDP. This series represents the amount of income paid to foreign owners of
    capital located in Puerto Rico, minus income earned by Puerto Ricans from
    investments outside of Puerto Rico. GNP differs from GDP by this amount.
    For Puerto Rico, the net outflow of income has increased as a share of GDP
    over the period, increasing the gap between GDP and GNP.

    Figure 10: Composition of Puerto Rican GDP and Net Income Payments Abroad,
    1980-2005

    Note: Consumption, investment, government, and net export expenditures
    constitute GDP.

    Puerto Rico Relies Heavily on Nonresidents to Finance Local Investment

    Figure 11 shows the relationship between savings and investment in Puerto
    Rico. The components of total national saving in Puerto Rico are personal
    saving, government saving, business saving through retained earnings, and
    depreciation. The figure shows that investment in Puerto Rico has been
    greater than national saving, highlighting again that investment in Puerto
    Rico has been significantly financed by foreign sources. Since 2001,
    government saving has fallen and undistributed corporate profits have
    risen significantly. The personal saving rate as measured in the Puerto
    Rican national accounts has been negative since 1980. If transfers from

    foreigners to residents of Puerto Rico are underreported, however, the
    official data for income and saving would also be understated.3

    Figure 11: Puerto Rico's Gross Domestic Investment and National Saving,
    1980-2005

    Note: Data for 2005 are preliminary.

    We cannot provide a comprehensive picture of the trends in various
    components of U.S. and foreign investment in Puerto Rico because data are
    not available for one of the most important components-direct foreign
    investment, for which corporations obtain financing from within their own

    affiliated groups, rather than through financial institutions.4 We can,
    however, report trends for foreign funds flowing through key types of
    financial institutions and the Puerto Rican government. In the next two
    chapters, we will also provide some information on investments by
    important subpopulations of corporations.

    Over the past decade, the amount of nonresident funds flowing into
    depository institutions in Puerto Rico has increased steadily. Figure 12
    shows Puerto Rico's depository institutions' liabilities between 1995 and
    2004, and figures 52 and 53 in appendix II show the shift in deposits and
    debt, respectively. The composition of deposits has changed significantly
    with "exempt investments" by possessions corporations (which in the past
    had been encouraged by a special component of the possessions tax credit)
    being replaced by deposits obtained through brokers that sell certificates
    of deposits for the banks in the U.S. capital market. (Fig. 54 in app. II
    shows those offsetting trends.)

    Figure 13 below shows that the share of assets held by depository
    institutions in the United States and foreign countries has also increased
    over the past decade. A large part of this growth can be attributed to the
    increase in U.S. and foreign securities investments. Loans made by Puerto
    Rico's depository institutions, which we assume to be primarily local,
    have also increased steadily. Figures 55 and 56 in appendix II show these
    two trends.

    Figure 12: Puerto Rico's Depository Institutions' Liabilities, 1995-2004

    Note: Figures were adjusted for inflation using Puerto Rico's gross
    product deflator.

    Figure 13: Puerto Rico's Depository Institutions' Assets, 1995-2004

    Notes: The allocation of total assets includes the assumption that 95
    percent of depository institution loans are made locally in Puerto Rico
    and 5 percent in the United States or foreign countries.

    Figures were adjusted for inflation using Puerto Rico's gross product
    deflator.

    Puerto Rican government debt has increased steadily over the past decade.
    Between 1995 and 2005, Puerto Rico's real total public debt outstanding
    increased from $25.6 billion to $36.4 billion (see fig. 14 below).5 Most
    of Puerto Rican public debt is sold in the U.S. market, but the amount
    sold within Puerto Rico has increased steadily since 1999. In 2005 an
    estimated $31.6 billion was sold in the United States, and $4.8 billion
    was sold locally in Puerto Rico.

    In appendix II we include both the breakdown of debt payable by the
    government and debt issued by the government but repaid by others (such as
    the federal government or the private sector) because there are
    differences of opinion about what should be termed "government debt" (see
    figs. 58 and 59). An example of this type of debt is the series of bond
    issues linked to The Children's Trust Fund between 2001 and 2005, all of
    which are backed by assets from the United States Attorney General's 1999
    Master Tobacco Settlement Agreement. Between 1995 and 2005, total debt
    issued by the Puerto Rican government, but payable by others, increased
    from an estimated $6.6 billion to an estimated $7.1 billion in 2005.

    Figure 14: Puerto Rico's Total Real Government-issued Debt, by Market of
    Purchaser, 1995-2005

    Note: Figures were adjusted for inflation using Puerto Rico's gross
    product deflator.

    Investment Appears Insufficient to Reduce the U.S.-Puerto Rican Income Gap

    Figure 15 shows the level and composition of gross investment spending in
    Puerto Rico from 1980 to 2005. During the recession of the early 1980s,
    investment fell below 10 percent of GDP by 1983. Thereafter, investment
    recovered and remained around 15 percent of GDP for a number of years
    until a period of rapid growth in largely private-sector investment in the
    late 1990s pushed the share close to 20 percent of GDP by 2000. Investment
    rates have fallen back to about 15 percent of GDP most recently.

    Figure 15: Puerto Rican Gross Fixed Investment as a Percent of GDP,
    1980-2005

    Note: Gross fixed investment does not include changes in inventories or
    subtract depreciation.

    If Puerto Rico's investment rate remains at recent levels, the gap between
    U.S. and Puerto Rican per capita incomes is unlikely to diminish. The U.S.
    investment rate, including both private investment and a measure of
    government investment, has been about 19 percent of GDP in recent years.
    Continuation of these relative investment rates implies that the per
    capita income gap is unlikely to narrow significantly, unless capital
    formation is augmented by increases in employment, education, training, or
    other types of productivity improvements.

    Figure 16 shows a breakdown of Census data on capital spending in the
    manufacturing sector for 1987, 1992, 1997, and 2002.6 The data show that
    investment in manufacturing dipped significantly between 1992 and 1997,
    before rebounding by 2002. This slump in investment does not appear in the
    Planning Board investment data for private sector investment shown in
    figure 15. The Planning Board data cover more sectors than do the Census
    data; however, investment in manufacturing should represent a substantial
    portion of the investment in private structures and machinery.

    Figure 16: Puerto Rico's Capital Expenditures as a Percentage of Gross
    Domestic Product, 1987-2002

    Data on Value Added and Income Show That the Pharmaceuticals Industry Has
    Significantly Increased Its Dominance of Puerto Rican Manufacturing but
    Evidence Suggests That These Measures May Be Overstated

    Although both Census data on value added and Puerto Rican government data
    on domestic income show that the pharmaceutical industry has significantly
    increased its already dominant position in the manufacturing sector since
    the early 1990s, evidence suggests that income shifting within U.S.-owned
    corporate groups likely has resulted in overstatements of the importance
    of the manufacturing sector, as a whole, and the pharmaceutical industry,
    in particular, when measured in terms of value added or income.
    Unfortunately, it is difficult to know the extent of any overstatement in
    these economic variables. Evidence is mixed as to whether the extent of
    the overstatement increased as the pharmaceutical operations of
    possessions corporations were shifted over to other types of businesses.
    Other measures of economic activity, such as employment and capital
    spending, should not be affected by income shifting and, therefore, can be
    used to either support or challenge conclusions based on measures of value
    added and income.

    Census data on value added and Puerto Rican Planning Board data on
    domestic income both show steady and significant growth in the
    pharmaceutical industry. Figure 17 shows that value added in the
    pharmaceutical industry more than doubled in real terms from 1992 to 2002,
    while value added in all other manufacturing industries, as a whole,
    declined. Figure 18 shows that the chemical industry, which consists
    mainly of pharmaceuticals, saw its share of net manufacturing domestic
    income increase from around 50 percent in 1992 to over 60 percent in 2005.

    Figure 17: Value Added for Puerto Rican Manufacturing Industries,
    1987-2002

    Figure 18: Share of Net Manufacturing Domestic Income in Puerto Rico,
    1980-2005

    Note: 2005 figures are preliminary.

    The strong reported performance of the pharmaceutical sector is the reason
    that the manufacturing sector has been able to slightly increase its share
    of domestic income, while the share of income of most other manufacturing
    industries has declined. Manufacturing's share of income, shown in figure
    19, greatly exceeds its share of employment, as shown in figures 23 and
    24. Some of the difference may be attributable to a higher level of labor
    productivity in manufacturing than in other sectors. Recent research
    suggests, however, that reported levels of value added in Puerto Rican
    manufacturing are implausible. For example, the official data imply that
    labor's share of value added in manufacturing fell from an average of

    50 percent from 1950 to 1970 to only 14 percent in 2004. Similar declines
    are not evident in data for other sectors or in U.S. manufacturing
    statistics.7

    Figure 19: Shares of Puerto Rico's Domestic Income by Sector, 1980-2005

    Note: 2005 figures are preliminary.

    Over the years, several analysts have concluded that the incentives
    provided by the possessions tax credit have led U.S. corporate groups to

    shift income to Puerto Rican affiliates.8 Until the mid-1990s, the credit
    essentially allowed profits earned from qualified Puerto Rican operations
    to be returned to the mainland free of federal tax (even when largely
    exempted from Puerto Rican income taxes). In addition, one option under
    the credit allowed the U.S. corporate parent to apply a 50-50 split of
    their combined taxable income from the sale of products to third parties
    if the products were derived from an intangible asset, such as a patent,
    invention, formula, or trademark. Although a substantial portion of this
    income can be attributed to manufacturing intangibles developed and owned
    by the U.S. corporate parent, there is no requirement that the allocation
    of income from such manufacturing intangible assets reflect where costs
    were actually generated, or where value was actually added to the
    products. Consequently, corporate groups that produced pharmaceuticals, or
    other products whose final values are largely based on the value of
    intellectual property, were given flexibility under the law to shift net
    income to the possession corporations operating in Puerto Rico or another
    insular area. This shifting of income and value added to the Puerto Rican
    operations of possessions corporations ultimately gets reflected in
    economic data compiled by the Puerto Rican government, which is based
    heavily on data pulled from samples of corporate tax returns, and possibly
    in data that Census collects in its surveys of employers for the economic
    censuses, if the economic data the employers provide are based on their
    tax accounts.

    The nature of income shifting changed significantly after 1995, when the
    phaseout of the possessions tax credit began. Some of the corporate groups
    that owned possessions corporations in Puerto Rico began to close or
    reduce operations in those corporations and shift production to CFCs
    located on the island. Corporate groups still have some incentives to
    retain operations in Puerto Rico rather than shift that production to the
    United States. First, Puerto Rico responded to the phaseout of the credit
    by increasing the generosity of its own tax incentives. Second,
    manufacturing income earned from an active trade or business by the CFCs
    is not subject to federal tax unless it is repatriated to the United
    States. A change in income shifting has also occurred because the rule for
    arbitrarily splitting net income 50-50 between Puerto Rican and U.S.
    operations does not apply to CFCs. Nevertheless, corporate groups may be
    able to shift income to Puerto Rico through the manner in which they set
    prices on goods and services transferred among affiliated corporations.

    Data from the last four economic censuses of manufacturing in Puerto Rico,
    presented in figure 20, show that valued added per employee in the
    pharmaceutical industry was already at least twice as high as the ratio
    for all other industries in 1987 and 1992. The difference between the
    pharmaceutical industry and the other industries grew larger in 1997 and
    then broadened dramatically by 2002. The 2002 figure of $1.5 million for
    value added per employee in Puerto Rican pharmaceutical manufacturing was
    three times as high as the ratio for the U.S. pharmaceutical industry for
    the same year. Moreover, while the U.S. ratio grew only 8 percent in real
    terms between 1997 and 2002, the Puerto Rican ratio grew by 65 percent
    over that same period.9

    The data on value added per employee by type of business in figure 21
    suggest that the sharp increase in that measure between 1997 and 2002 may
    have been a direct result of the shift in pharmaceutical operations from
    possessions corporations to CFCs. (These data are derived from a special
    research effort in which we obtained assistance from Census and IRS to
    aggregate data from the 2002 Economic Census of Puerto Rico by particular
    types of business entities, including possessions corporations and
    CFCs.)10 The value added per employee of $4.2 million for pharmaceuticals
    CFCs incorporated outside of Puerto Rico was dramatically higher than for
    any other type of business in Puerto Rico. The next highest ratio was $1.6
    million for pharmaceuticals CFCs incorporated in Puerto Rico, which was
    still considerably higher than the ratio of $0.9 million for possessions
    corporations in the pharmaceutical industry. That data, combined with the
    data in figure 20, suggest a significant change in transfer pricing by
    large pharmaceuticals groups, which makes it difficult to say how much of
    the strong reported growth in output and income in the Puerto Rican
    pharmaceutical industry, and in the manufacturing sector as a whole,
    represents an increase in actual economic activity.

    Figure 20: Value Added per Employee for Key Puerto Rican Manufacturing
    Industries, 1987-2002

    Note: Figures were adjusted for inflation using Puerto Rico's gross
    product deflator.

    Figure 21: Value Added per Employee in Puerto Rico by Type of Business,
    2002

    Note: Figures were adjusted for inflation using Puerto Rico's gross
    product deflator.

    Data on rates of return on assets for possessions corporations and CFCs in
    the chemical industry do not confirm the conclusion that a dramatic change
    in income-shifting practices occurred as CFCs replaced possessions
    corporations in the industry. We used data from federal tax returns to
    compare various rates of return for CFCs and possessions corporations in
    the Puerto Rican chemical industry. The comparisons we were able to make
    for 1997 through 2001 did not show a consistent difference between the two
    types of corporations. The ratios of gross profits (the closest tax-data
    equivalent to value added) to total assets for CFCs were significantly
    higher than those for possessions corporations in both 1997 and 1999, but
    the ratios were very close together in 2001. We also compared the gross
    and net operating rates of return of the two types of corporations and
    found that neither type dominated the other one consistently across the
    years. The results of our analysis are presented in appendix IV.

    International Trade Plays a Large Role in Puerto Rico's Economy

    International trade plays a much larger role in the Puerto Rican economy
    than it does in the U.S. economy. While the output of an economy (GDP)
    depends on the difference between exports and imports (net exports), the
    size of exports and imports relative to GDP are indicators of the
    importance of trade to the economy. For the United States, exports of
    goods and services averaged about 10 percent of GDP between 1980 and 2005.
    Imports increased from about 10 percent of GDP in the early 1980s to about
    16 percent of GDP in 2005. While potential distortions in trade data
    should be kept in mind, the share of exports and imports has been
    substantially greater in Puerto Rico. For Puerto Rico, the value of
    exported goods and services as a percentage of GDP grew from about 70
    percent of GDP in the 1980s to about 80 percent in 2005. Imports fell as a
    share of GDP from about 70 percent to about 63 percent in recent years.

    As reported in the Puerto Rican national accounts, the value of
    pharmaceutical imports and exports increased substantially from 1996 to
    2005. The value of imported pharmaceuticals increased from about 9 percent
    of all merchandise imports to about 33 percent during that period. As a
    share of GDP, the value of imported pharmaceuticals increased from about 4
    percent to about 15 percent. The value of pharmaceutical exports rose
    rapidly as a share of merchandise exports-from about 27 percent to about
    61 percent. As a percentage of GDP, the value of pharmaceutical exports
    rose from about 14 percent to about 42 percent. However, as noted above, a
    significant portion of the recorded increase in Puerto Rico's trade
    surplus may reflect changes in transfer pricing, with artificially low
    values for Puerto Rico's imports and high values for Puerto Rico's
    exports, rather than increased activity.

    While the United States is the largest trading partner for Puerto Rico for
    exports and is a large source of Puerto Rican imports, the foreign country
    share of imports to Puerto Rico has been growing since 1995. In 2005,
    slightly less than half of the value of imports to Puerto Rico came from
    foreign countries. About 80 percent of Puerto Rico's exports go to the
    United States. Puerto Rico's overall trade surplus reflects a trade
    surplus with the United States as Puerto Rico exports more to the United
    States than it imports from the United States, and a smaller trade deficit
    with the foreign countries.

    Official Statistics Indicate That Unemployment Has Been Much Higher in
    Puerto Rico Than in the United States and Labor Force Participation Has
    Been Lower

    Figure 22 shows the unemployment rates and labor force participation rates
    for the United States and Puerto Rico from 1980 to 2005. The unemployment
    rate has been significantly higher in Puerto Rico than in the United
    States, and the labor force participation rate has been much lower.

    Figure 22: U.S. and Puerto Rican Labor Participation and Unemployment
    Rates, 1980-2005

    Academics and economists from research institutions have offered several
    possible explanations for the relatively low labor force participation
    rate in Puerto Rico and attempted to determine which of these factors
    might be important. While the low labor force participation rate is seen
    as a crucial issue for the economic performance of Puerto Rico, there is
    no consensus on its cause.11

    Possible explanations for the low labor force participation rate include

    o the migration of Puerto Rican citizens with the most interest in
    participating in the labor force to seek higher wage employment in the
    United States, leaving residents that have relatively less attachment to
    the labor force;12

    o the fact that government programs that are in place, such as the
    Nutrition Assistance Program (NAP, the Puerto Rican food stamp program)
    and disability insurance, can discourage work, while the U.S. program that
    encourages labor force participation-the Earned Income Tax Credit-is not a
    part of the tax system in Puerto Rico;

    o the fact that the U.S. minimum wage applies in Puerto Rico may
    discourage business demand for lower-skilled workers, who are likely to
    make up a larger share of the potential work force in Puerto Rico than in
    the United States; and

    o that a relatively large share of Puerto Ricans work in the informal
    economy and that this work is not reflected in economic statistics.

    Regarding this last issue, analysts have raised issues with the quality of
    the Puerto Rican labor force survey, which is the data source for the
    unemployment rate and the labor force participation rate. The survey is
    designed to be similar to the U.S. Current Population Survey (CPS), from
    which the U.S. data are derived, but the questions regarding labor market
    activity in the surveys differed and the question asked by the Puerto Rico
    household survey may not have captured work activity in the informal
    sector of the economy as well as the question asked in the CPS.13 On the
    other hand, labor force participation as measured in the decennial
    census-which uses the same question as the CPS-has also been low and the
    estimate for 2000 was lower than the household survey estimate for that
    year.14 The Bureau of Labor Statistics (BLS) has been working with the
    Puerto Rican government to improve the household survey in several areas.
    In addition, labor force data for 2005 are scheduled to be reported for
    Puerto Rico as a part of the Census Bureau's American Community Survey
    effort.

    Educational attainment can play an important role in developing labor
    market skills. Data on educational attainment in Puerto Rico is collected
    in the decennial census and can be compared to data for the United States.
    These data show that the gap in educational attainment between Puerto Rico
    and the United States narrowed significantly during the 1990s.
    Nonetheless, in 2000, 40 percent of the population over 25 in Puerto Rico
    had not finished high school, which is nearly the double the U.S. share.
    At the same time, about 38 percent of adults reported having at least some
    college education (see table 4).

    Table 4: Educational Attainment in the U.S. and Puerto Rico, 1990 and 2000

        Educational attainment (percent of   1990          2000
        population 25 years old and over)   United      Puerto Rico United Puerto
                                            States                  States   Rico
    High school or more                    75.2 49.7               80.4   60.0
    Some college or more                   45.2 28.7               51.8   37.7
    Bachelor's degree or more              20.3 14.3               24.4   18.3
    Advanced degree                         7.2  3.6                8.9    4.7

    Source: Census.

    Recent research concluded that there is a substantial mismatch between
    Puerto Rico's industry structure and the educational achievement of its
    population.15 While the mean years of schooling among Puerto Rican adults
    was substantially below that of any state in the last three censuses, the
    average years of schooling of people typically employed by the industries
    operating in Puerto Rico exceeds that of at least two-thirds of the
    states. The researchers suggest that the Puerto Rican economy has failed
    to generate jobs that fit the educational qualifications of the
    Commonwealth's population. In some sense, therefore, Puerto Rico's
    "missing jobs" can be found in labor intensive industries heavily reliant
    on less-educated workers. The authors conclude that the Possessions Tax
    Credit and other federal tax incentives contributed to an industry
    structure that is poorly aligned with the sort of job opportunities needed
    by Puerto Rico's population.

    Annual data on employment in Puerto Rico come from two sources: the Puerto
    Rico household survey, and the BLS establishment survey. The Puerto Rico
    household survey has consistent sector definitions across time and
    includes the self-employed. The establishment survey data are limited to
    employees and reflect the new North American Industry Classification
    System industry definitions. In the figures that follow, we aggregated
    some of the industry categories and show the distribution of employment by
    sector. Both surveys show employment in Puerto Rico generally increasing
    since 1991 and show manufacturing employment declining since 1995. As
    shown in figure 25, data from the Census of Manufacturing for Puerto Rico
    for 1997 and 2002 also indicate a decline in manufacturing employment.
    Manufacturing employment fell by about 27 percent from 1995 to 2005,
    according to establishment survey data.16 Both the household and
    establishment data sources show that the government sector employs a large
    percentage of workers-about 23 percent in the household survey and about
    30 percent in the establishment survey.

    For the United States, manufacturing employment has been falling, both in
    absolute numbers of employees and as a percentage of all employees.
    Between 1980 and 2005, manufacturing employment fell by about 4.5 million
    employees (about 24 percent). From 1995 to 2005, manufacturing employment
    fell by about 3 million employees (about 17 percent). As of 2005,
    manufacturing employees represented about 10.7 percent of all employees.
    Government employees constituted about 16 percent of total employees in
    the United States, down from about 18 percent in 1980.

    Figure 23: Puerto Rican Employment by Sector-Household Survey, 1980-2005

    Figure 24: Puerto Rican Employment by Sector-Establishment Survey,
    1991-2005

    Figure 25: Employment in Puerto Rican Manufacturing Industries, 1987-2002

    Since 1980, Real Per Capita Personal Income in Puerto Rico Has Not Grown
    Enough to Substantially Reduce the Gap between U.S. and Puerto Rican
    Living Standards

    Although the likely imprecision of price deflators for Puerto Rico leaves
    the exact growth rate of real per capita personal income there difficult
    to determine, the rate has not been sufficient to substantially reduce the
    gap between U.S. and Puerto Rican living standards. Puerto Rican per
    capita personal income is well below that in the United States (see fig.
    26).

    Figure 26: U.S. and Puerto Rican Real Per Capita Personal Income,
    1980-2005

    Note: Figures were adjusted for inflation using U.S. and Puerto Rican
    gross product deflators.

    As we did in comparing U.S. and Puerto Rican GDP and GNP, we adjusted
    aggregate per capita personal income data using both U.S. and Puerto Rican
    price deflators. The growth rate in per capita personal income is somewhat
    higher in Puerto Rico than in the United States when the U.S. deflator is
    used to adjust Puerto Rican per capita personal income for inflation. In
    this case, the average annual percentage increase in Puerto Rican per
    capita personal income was 2.1 percent while U.S. per capita personal
    income rose by 2.0 percent on average per year. When the Puerto Rican
    deflator is used to make adjustments for inflation, Puerto Rican per
    capita personal income grew at a slower rate (1.1 percent) than in the
    United States (2.0 percent). The difference arises because the U.S. price
    deflator increased less than the Puerto Rico price deflator. Using both
    price indices serves to illustrate the sensitivity of the calculation to
    the index used.

    In addition, private income transfers from Puerto Rico emigrants now
    living in the United States made to Puerto Rican residents may be
    understated, which would lead to an understatement of Puerto Rican
    personal income. As U.S. citizens, Puerto Ricans are free to migrate to
    the mainland United States and return as they wish. According to Census
    estimates, net migration from Puerto Rico to the United States in the
    1980s totaled about 126,000.17 During the 1990s, net migration was
    estimated to be about 111,000.

    Census data show the distribution of income in Puerto Rico and the United
    States and the percentages of individuals and families with incomes below
    official poverty lines.18 The median household income in 1999 was $41,994
    in the United States and $14,412 in Puerto Rico. In 1999, 48.2 percent of
    households in Puerto Rico had incomes below the poverty level, which was
    nearly four times the U.S. share, as shown in table 5.

    Table 5: Poverty Status in the United States and Puerto Rico, Percentage
    below Poverty Levels, 1999

                           Percent
                                                        United States Puerto Rico
    All ages                                                  12.4        48.2
    Related children under 18                                 16.1        58.3
    5-17 years                                                15.4        58.5
    Population 65 and over                                     9.9        44.0
    All families                                               9.2        44.6
    Families with female head and at least one child          34.3        70.8

    Source: Census.

    As the disparity between average incomes in the United States and Puerto
    Rico suggests, a much higher percentage of Puerto Rican households is in
    the lower income categories. In 1999, only about 10 percent of U.S.
    households had annual incomes below $10,000, compared to 37 percent of
    Puerto Rican households (see table 6).

    Table 6: Income Distribution of Households in the United States and Puerto
    Rico, 1999

             Household income                 United States           Puerto Rico
    Less than $10,000                                9.5                  37.1
    10,000-24,999                                   19.2                  32.9
    25,000-49,999                                   29.4                  19.9
    50,000-74,999                                   19.4                   5.7
    75,000-99,999                                   10.2                   2.0
    100,000-149,999                                  7.7                   1.4
    150,000-199,999                                  2.2                   0.4
    200,000 or more                                  2.4                   0.6

    Source: Census.

    Note: Income data do not include capital gains and the value of in-kind
    government benefits and employer contributions.

    The distribution of income is more unequal in Puerto Rico than in the
    United States. Economies in general have a small share of households
    receiving a disproportionately large share of income. As a result, the
    ratio of mean to median household income exceeds 1.0. As an indication of
    the greater degree of income inequality in Puerto Rico, the ratio of mean
    to median household income in 1999 was 1.69 in Puerto Rico19 compared to
    1.35 in the United States.

    Much Possessions Corporation Activity Has Shifted to Affiliated
    CorporationsChapter 4

    Possessions corporations have played an important role in the Puerto Rican
    economy, particularly in the manufacturing sector, where they accounted
    for well over half of valued added throughout the 1990s. Most of the
    possessions tax credit and income earned by possessions corporations in
    Puerto Rico has been earned by corporations in the pharmaceutical
    industry. Once the possessions tax credit was repealed, many of the large
    corporate groups that owned possessions corporations in Puerto Rico began
    to shift their operations to other types of business entities. Although
    the various tax and economic census data that we present in this chapter
    have significant limitations, we believe that, together, they form the
    basis for a reasonably accurate picture of the broad changes that have
    occurred in Puerto Rico's manufacturing sector over the past two decades.
    Those data indicate that much of the decline in activity of possessions
    corporations in the manufacturing sector was offset by the growth in other
    corporations, so that some measures of aggregate activity remained close
    to their 1997 levels. For example, value added in manufacturing remained
    fairly constant between 1997 and 2002. Most of the offsetting growth was
    concentrated in the chemical industry, which is dominated by
    pharmaceuticals.

    Possessions Corporations Dominated Puerto Rico's Manufacturing Sector up
    until the Late 1990s

    Possessions corporations continued to dominate Puerto Rican manufacturing
    through the mid-1990s, despite the legislative changes that made the
    possessions tax credit significantly less generous after 1993. According
    to the 1992 Economic Census of Puerto Rico Manufacturing, these
    corporations accounted for 42.2 percent of employment and 64.3 percent of
    valued added in the manufacturing sector (as seen in fig. 27). By the next
    economic census in 1997, possessions corporations' share of value added
    had increased to 72 percent, while their share of employment remained
    little changed at 40.8 percent.1 This pattern of growth up to 1997 is also
    apparent in the data from the federal tax returns of possessions
    corporations shown in figure 28. The aggregate total income, gross
    profits, and net income of possessions corporations operating in Puerto
    Rico all increased slightly between 1993 and 1997 (after adjusting for
    inflation), although there was a small decline in the corporations' total
    assets.

    Figure 27: Share of Possessions Corporations in Value Added and Employment
    in Puerto Rican Manufacturing, 1987-2002

    Figure 28: Income and Assets from the Tax Returns of Possessions
    Corporations Operating in Puerto Rico, 1993-2003

    The growth in possessions corporation activity occurred despite the
    limitations that Congress placed on the possessions tax credit after 1993
    and a decline in the number of corporations claiming the credit. Figure 29
    shows that those limitations significantly reduced the generosity of the
    credit. Possessions corporations earned about 20 cents of credit for each
    dollar of income they earned in 1993, but only half that amount by 1997.
    Over that period, the number of corporations claiming the credit for
    operations in Puerto Rico fell from 378 to 291 and the amount of credit
    claimed declined from $5.8 billion to $3.2 billion.

    The decline in possessions corporation income, value added, and employment
    began after the Small Business Job Protection Act of 1996, which placed
    additional limits on the amount of credit that corporations could earn
    and, more importantly, repealed the credit completely for tax years
    beginning after 1995, subject to a 10-year phaseout. The generosity of the
    credit reached a low of less than 7 cents per dollar of income by 1999.
    The number of corporations claiming the credit fell to 124 by 2003 and the
    amount of credit they claimed that year fell to $1.1 billion. Moreover, in
    contrast to the period leading up to 1997, the aggregate total income,
    gross profits, and net income earned by possessions corporations all
    declined by more than 50 percent between 1997 and 2003, while their total
    assets declined by almost 30 percent. The significantly decreased
    importance of possessions corporations is also apparent in the most recent
    economic census data (fig. 27), showing that these corporations accounted
    for only 26.7 percent of manufacturing value added and only 31.8 percent
    of manufacturing employment in 2002.

    Figure 29: The Ratio of Possessions Tax Credit to Total Income Earned by
    Possessions Corporations in Puerto Rico, 1993-2003

    Note: The rate of credit per dollar of income increased slightly between
    1999 and 2003, as corporations with relatively low rates of credit were
    more likely to stop operating as possessions corporations (and, therefore,
    drop out of the population represented in fig. 29) than those with higher
    rates.

    Figure 30: The Number of Corporations in Puerto Rico Claiming the
    Possessions Tax Credit and the Amount Claimed, 1993-2003

    The Pharmaceutical Industry Has Dominated the Use of the Possessions Tax
    Credit in Puerto Rico

    Most of the possessions tax credit and income earned by possessions
    corporations in Puerto Rico has been earned by corporations in the
    pharmaceutical industry. Figure 31 shows that pharmaceuticals corporations
    earned over half of all the credit earned each year from 1995 through
    2003. Figure 32 shows that these corporations earned an even larger share
    of the aggregate gross profit earned by possessions corporations in each
    of those years. Manufacturers of beverages and tobacco products, medical
    equipment, and computers, electronics, and electrical equipment were also
    heavy users of the credit during this period, though not nearly to the
    same extent as pharmaceuticals manufacturers. Both of these figures are
    based on data for possessions corporations in the 77 largest corporate
    groups operating in Puerto Rico. (See the following section.)

    Figure 31: Industry Shares of the Possessions Tax Credit in Puerto Rico,
    1993-2003

    Figure 32: Industry Shares of Gross Profits Earned by Possessions
    Corporations in Puerto Rico, 1993-2003

    Businesses Have a Variety of Options for Continuing Operations in Puerto
    Rico after They Cease Operating as Possessions Corporations

    Parent corporations have a number of options for conducting business in
    Puerto Rico if they wish to do so after termination of the possessions tax
    credit. Large corporate groups are believed to have used at least four
    different approaches to rearranging their overall corporate structure
    (including the possessions corporation and their Puerto Rican operations)
    in anticipation of termination of the possessions tax credit. The U.S.
    federal tax consequences of these approaches vary as follows:

    o The possessions corporation loses its 936 status but remains a
    subsidiary incorporated in the United States and is consolidated into its
    parent's federal tax return. The parent corporation includes the relevant
    income and expenses of the subsidiary when computing its own federal
    taxes. Tax attributes, such as carryovers of certain accumulated losses,
    of the former possessions corporation would be governed by applicable IRS
    regulations and guidance.

    o The possessions corporation liquidates into its parent (i.e., it no
    longer remains a separate corporate entity). Generally, if the parent
    satisfies certain ownership requirements, no gain or loss would be
    recognized to either the parent or the subsidiary for U.S. federal income
    tax purposes. The domestic parent would inherit and take into account
    certain items of the former possessions corporation, such as earnings and
    profits, net operating and capital loss carryovers, and methods of
    accounting. No foreign tax credit is allowed for any foreign taxes paid in
    connection with the liquidation, and the deduction of certain losses and
    other tax attributes may be limited.

    o The possessions corporation is converted into or replaced by a CFC. This
    change can occur if the possessions corporation reincorporates and
    conducts business as a CFC; if it sells or contributes most of its assets
    to a CFC; or if it winds down its operations as its parent corporation
    starts up a new CFC to operate in Puerto Rico. Any income that the
    replacement CFC earns from the active conduct of business in Puerto Rico
    or elsewhere outside of the United States generally is not taxed until it
    is repatriated to the U.S. shareholders in the form of dividends. A number
    of tax consequences arise in cases where the possessions corporation
    actually reincorporates as a CFC.2 There are also significant tax issues
    (discussed further below) relating to the transfer of assets (through
    either a contribution or a sale) from possessions corporations to CFCs.

    o The possessions corporation is converted into or replaced by a limited
    liability corporation (LLC) or partnership. An LLC can elect to be treated
    as a corporation, as a partnership, or as a "disregarded entity." If the
    LLC elects to be treated as a corporation, its net earnings would be
    included either individually or, if required to file a consolidated
    return, on its parent's return. If it chose partnership treatment, the LLC
    itself would generally not be subject to federal income tax but its
    income, deductions, gains, and losses would be distributed to its members,
    who would include such amounts in calculating their federal income tax. If
    the LLC is treated as a disregarded entity, its income, deductions, gains,
    and losses are included on the member's federal tax return.

    Parent corporations could substantially change the manner in which income
    from their Puerto Rican business operations were treated for federal tax
    purposes even without making a formal change in the legal status of their
    possessions corporations. The parents could simply reduce production by
    their possessions corporations and start up or expand production in other
    forms of businesses operating in Puerto Rico. We used tax return data from
    both IRS and the Treasury of Puerto Rico to track changes in the activity
    of possessions corporations, as well as to assess the extent to which
    declines in that activity have been offset by increases in the activity of
    affiliated businesses operating in Puerto Rico. In order to make this
    assessment for a particular group of affiliated corporations, we needed to
    examine data for each member of the group that had operations in Puerto
    Rico.3  Given that considerable effort was required to identify the group
    members that operated in Puerto Rico, we limited our review to the largest
    77 groups, which included at least one possessions corporation between
    1993 and 2001. These 77 large groups accounted for over 92 percent of the
    credit and income earned by possessions corporations in every year from
    1993 through 2001 and for over 91 percent of the assets owned by such
    corporations in each of those years.

    The large groups included a total of 172 possessions corporations that we
    tracked between 1993 and 2003.4 The number of possessions corporations
    that these 77 large groups owned and operated in Puerto Rico declined from
    a high of 146 in 1995 to 58 by 2003. As of 2001, these groups also
    conducted operations in Puerto Rico through 49 CFCs and at least 28 other
    businesses. Fourteen of the groups operated both possessions corporations
    and CFCs in Puerto Rico in 2001. In the following section we report on
    trends in the income and assets of these large corporate groups.

    The popular choice of replacing the operations of possessions corporations
    with CFCs offers long-term tax benefits but could entail high initial tax
    costs for some corporations. Many corporate groups have chosen to operate
    in Puerto Rico through CFCs, possibly to take advantage of the federal tax
    deferral on income earned there. Some may have rejected this choice
    because their possessions subsidiaries owned valuable intangible assets,
    such as drug patents or food recipes, and the transfer of these assets to
    a non-U.S. entity, such as a CFC, could have been treated as a taxable
    exchange, possibly resulting in a substantial, one-time tax liability.5
    Affiliated groups can avoid this tax if they keep the intangible assets in
    their U.S. firms, rather than transferring them to their new CFCs.
    However, in order for those CFCs to use those intangibles in their
    production processes, they must pay royalties to the U.S. owners and those
    royalties would be subject to federal income tax.

    IRS officials have expressed concern that the repeal of section 936 has
    not had its intended effect. Congress repealed section 936 because it was
    viewed as providing an overly generous tax benefit to taxpayers with
    operations in Puerto Rico. However, IRS officials believe that despite the
    repeal of section 936, many taxpayers with operations in Puerto Rico could
    be incurring approximately the same or even lower tax liabilities than
    they did under section 936 by restructuring their activities through CFCs.
    Taxpayers who converted into CFCs may have avoided the tax consequences
    typically associated with such a conversion, namely, tax liabilities
    arising from the transfer of intangibles from possessions corporations to
    CFCs or a significant increase in royalty payments from Puerto Rico. One
    private sector tax expert familiar with the practices of U.S. businesses
    operating in Puerto Rico could not recall any case in which a taxpayer
    reported a transfer of intangibles of any significant value from a
    possessions corporation to a CFC. The expert also told us that the reason
    why the IRS has not seen a notable increase in royalty payments from CFCs
    to U.S. firms holding intangibles is that, well before the expiration of
    the possessions tax credit, corporate groups had their existing or newly
    formed CFCs enter into research cost-sharing arrangements with their
    possessions corporations so that they would be codevelopers of new
    intangibles and, thereby, would have certain ownership rights to use the
    technology without paying royalties. The groups also tried to involve
    their CFCs as much as possible in the development of new products through
    other arrangements, such as research partnerships with unrelated
    technology-developing firms.

    Some Measures of Aggregate Manufacturing Activity Have Remained Constant
    Despite a Decline in Possessions Corporation Activity

    A combination of tax return and economic census data indicate that the
    decline in income and value added of possessions corporations between 1997
    and 2002 has been largely offset by an increase in the income and value
    added of affiliated corporations that left aggregate income and value
    added roughly constant. Although some evidence of a change in
    income-shifting behavior by these corporate groups makes it difficult to
    say how accurately trends in reported income and value-added data
    represent trends in actual economic activity in Puerto Rico, data on
    employment, capital expenditures, and total assets (which should not be
    distorted by income shifting) support the conclusion that a substantial
    amount of possessions corporation activity has been continued by other
    types of businesses. However, most of this continued activity is
    concentrated in the pharmaceutical industry and the decline in possessions
    corporation activity in other industries has not been offset. None of the
    data we present address the question of what corporate activity would have
    taken place during this period if the possessions tax credit had not been
    repealed.

    Tax Return and Economic Census Data Indicate That Much of the Income and
    Value Added of Possessions Corporations Declined While That of Affiliated
    Businesses Increased

    Tax return data on the affiliated corporate groups that have claimed
    almost all of the possessions tax credit indicate that between 1997 and
    2001 at least a large portion (and possibly all) of the decline in
    reported incomes of possessions corporations operating in Puerto Rico was
    offset by increases in the reported incomes and total assets of affiliated
    corporations operating in Puerto Rico, particularly that of CFCs. The
    offset left the income that these groups earned in Puerto Rico roughly the
    same in 2001 as in 1997. This finding is consistent with data on value
    added in manufacturing from recent economic censuses of Puerto Rico.

    Gross profit, which equals income from sales minus the cost of goods sold,
    is the income measure from tax returns that is closest in definition to
    the value-added measure from census data that we presented earlier.6 Both
    of these measures may be distorted by income shifting, as we explain in
    the next section; however, value added is considered to be the best
    measure of the economic importance of manufacturing activity. We examined
    data for both of these measures, as well as other measures not distorted
    by income shifting, to assess the extent to which possessions corporation
    activity has been replaced by the activity of other types of businesses.

    Figure 33 shows that the aggregate gross profit of the possessions
    corporations in our 77 large groups peaked at $28.8 billion in 1997 and
    then fell to $11.4 billion by 2003. The figure also presents our
    "lower-bound" estimates for the amount of gross profits from Puerto Rico
    that CFCs reported. These estimates include only the profits of those CFCs
    for which we had Puerto Rican tax returns or that appeared to have
    operations only in Puerto Rico because those are the cases where we can be
    the most confident that our figures represent profits attributable only to
    Puerto Rican operations. The gross profits of those CFCs grew from $2.4
    billion to $7.1 billion between 1997 and 2001.7 These estimates are likely
    to represent a lower bound for the amount of CFC profits in Puerto Rico
    because they do not include any of the profits for CFCs whose income was
    difficult to allocate between Puerto Rico and other locations. We present
    alternative estimates, labeled "CFC total if allocated by tax ratio," of
    the gross profits from Puerto Rico of all of the CFCs in our large
    groups.8 These more comprehensive estimates are not likely to be very
    precise, but they are consistent with some of the census data that we
    present on CFCs in chapter 5. The estimates show CFC gross profits growing
    from $3.0 billion to $11.5 billion between 1997 and 2001. Finally, figure
    33 also shows the gross profits reported on Puerto Rican tax returns by
    members of the 77 large groups, other than possessions corporations and
    CFCs. The gross profits of these businesses increased from $3.0 billion to
    $7.0 billion between 1999 and 2001.

    Figure 33: Gross Profits Earned by Large Corporate Groups in Puerto Rico,
    by Type of Corporation, 1993-2003

    The data in figure 33 indicate that much of the $10.7 billion decline in
    the gross profits of possessions corporations between 1997 and 2001 was
    offset by increases in the profits of affiliated corporations. The
    lower-bound estimates for CFCs grew by $4.7 billion over that period,
    while the profits

    of the other affiliates, including LLCs, grew by $3.9 billion between 1999
    and 2001.9 The combined profits of these two sets of businesses,
    therefore, grew by about $8.7 billion. If we use the "tax ratio" estimate
    for all CFCs, the combined growth in profits grew by about $12.5 billion.
    The gross profit of the "other affiliated" businesses is likely to be
    understated relative to those of the possessions corporations because of
    differences in the income definitions used for federal and Puerto Rican
    tax purposes. For those possessions corporations for which we had both
    federal and Puerto Rican returns, the gross profit from the Puerto Rican
    return averaged about 70 percent of the gross profit on the federal
    return. For this reason figure 33 may understate the extent to which the
    decline in possessions corporations' Puerto Rican operations has been
    offset by these other affiliates.

    Data from recent economic censuses on value added in Puerto Rican
    manufacturing lend additional support to the conclusion that we draw from
    figure 33-that much, if not all, of the decline in income of possessions
    corporations in Puerto Rico between 1997 and 2001 was largely offset by
    increases in the incomes of other types of businesses. Figure 34 shows
    that valued added by possessions corporations in Puerto Rican
    manufacturing followed roughly the same pattern as the gross profits data
    presented in figure 33; it also shows that other types of businesses made
    up for approximately all of the possessions corporations' decline between
    1997 and 2002.

    Figure 34: Value Added for Possessions Corporations and Other Types of
    Employers in Manufacturing in Puerto Rico, 1987-2002

    The extent to which the decline in income and value added of possessions
    corporations was offset by the growth of their affiliates varied
    significantly by industry. Figure 35 decomposes the last two columns of
    figure 34 into the chemical industry (which includes pharmaceuticals) and
    all other manufacturing industries. It shows that a significant drop in
    the value added of possessions corporations in the chemical industry was
    more than offset by the substantial growth in value added by other types
    of businesses. In contrast, the value added of both possessions
    corporations and all other types of businesses declined between 1997 and
    2002 in the remainder of the manufacturing sector, outside of chemicals.

    Figure 35: Value Added for Possessions Corporations and Other Types of
    Employers in the Chemical Industry and All Other Manufacturing Industries
    in Puerto Rico, 1997-2002

    Note: Figures were adjusted for inflation using Puerto Rico's gross
    product deflator.

    Our tax data for large corporate groups showed similar variation across
    industries. The corporate groups in the chemicals and medical equipment
    industry group offset a larger proportion of the decline in the income of
    their possessions corporations between 1997 and 2002 with income from
    other types of affiliates operating in Puerto Rico than was the case for
    large

    corporate groups as a whole.10 Trends in the income of possessions
    corporations in the other two industrial groupings that we are able to
    present with our tax data-computer, electronics, and electrical equipment;
    and food and kindred products-were somewhat erratic between 1993 and 2001
    before declining by 2003. There was negligible to no growth in the incomes
    of CFCs and other types of businesses in these two industrial groupings
    during the period we could observe between 1997 and 2002. (See tables 17
    and 18 in app. IV.)

    Data on Capital Expenditures, Total Assets, and Employment Also Indicate
    That a Substantial Amount of Possessions Corporation Activity Has Been
    Continued by Other Types of Businesses in Certain Industries

    As we explained in chapter 3, the data on income and value added for
    members of large corporate groups operating in Puerto Rico may be
    distorted by changes in the income reporting practices of these groups
    during the late 1990s. For this reason it is difficult to know how
    accurately trends in reported income and value added represent trends in
    actual economic activity in Puerto Rico. Nevertheless, data on capital
    expenditures, total assets, and employment (which should not be distorted
    by income shifting) support the conclusion that a substantial amount of
    possessions corporation activity has been continued by other types of
    businesses. Much of this continued activity is concentrated in the
    chemical industry, which is dominated by pharmaceutical producers.

    The economic census data on capital expenditures on manufacturing plant
    and equipment in figure 36 show that this investment increased
    dramatically between 1997 and 2002 after having dropped from 1992 to 1997.
    We cannot divide this time series of capital spending data between
    possessions corporations and other forms of business; however, figure 36
    shows that most of the spending increase was in the pharmaceutical
    industry, which was the source of about two-thirds of total possessions
    corporations profits in 1997. Consequently, it appears that any overall
    decline in possessions corporations' capital spending that may have
    occurred since 1997 must have been more than offset by the investment of
    other businesses.

    Figure 36: Capital Expenditures in Puerto Rico's Manufacturing Sector, by
    Industry, 1987-2002

    Note: Figures were adjusted for inflation using Puerto Rico's gross
    product deflator.

    The tax data for our 77 large corporate groups show that the $12.1 billion
    decline in the total assets of the possessions corporations in these
    groups between 1997 and 2001 was largely offset by an increase of at least
    $9.4 billion in the total assets of affiliated corporations operating in
    Puerto Rico (see table 15 in app. IV). The decline in assets may have been
    more than fully offset, depending on the growth in the Puerto Rican assets
    of the CFCs that we were not able to include in our estimates.11 However,
    as was the case with income and value added, there were significant
    differences across industries behind the trends for the manufacturing
    sector as a whole. The decline in assets of possessions corporations in
    the chemical and medical equipment industries between 1997 and 2001 was
    more than offset by the increased assets of their affiliates even if we
    use just our lower-bound estimates for CFCs. In comparison, a little over
    half of the decline in possessions corporations' assets in the computer,
    electronics, and electrical equipment industries between 1997 and 2001 was
    offset by the growth in affiliated CFCs' assets. (See tables 16 and 17 in
    app. IV.)

    The economic census data on employment in Puerto Rico's manufacturing
    sector in figure 37 shows that the decline in employment by possessions
    corporations between 1997 and 2002 was not as drastic as the declines in
    their profits or value added over that period (shown previously in figs.
    33 and 34); however, there was no offsetting increase in overall
    employment by other types of manufacturing firms. Figure 38, which
    decomposes the last two columns of figure 37 into the chemical industry
    and all other industries, shows that employment by possessions
    corporations in the chemical industry did, in fact, fall sharply between
    1997 and 2002, but other types of businesses in the industry more than
    made up for that decline. In the remaining industries as a whole, there
    was a smaller percentage decrease in employment by possessions
    corporations but there was also a decrease, rather than an offsetting
    increase, in the employment by other types of businesses. The chemical
    industry is much less important in terms of overall employment in
    manufacturing than it is in terms of value added. For this reason the
    continued strength of that industry was not enough to prevent an overall
    decline in manufacturing employment.

    Figure 37: Employment in Possessions Corporations and Other Types of
    Employers in Manufacturing in Puerto Rico, 1987-2002

    Figure 38: Employment in Possessions Corporations and Other Types of
    Employers in the Chemical Industry and All Other Manufacturing Industries
    in Puerto Rico, 1997-2002

    Note: Figures were adjusted for inflation using Puerto Rico's gross
    product deflator.

    U.S. Businesses Dominated Puerto Rican Manufacturing in 2002 but Played
    Smaller Roles in Other SectorsChapter 5

    U.S.-owned businesses accounted for at least 71 percent of value added and
    at least 54 percent of employment in Puerto Rico's manufacturing sector in
    2002. CFCs produced most of this value added but possessions corporations
    still accounted for most of the employment by U.S. firms. The CFCs are
    particularly important in the pharmaceutical industry and much less so in
    other manufacturing industries. U.S. corporations appear to account for
    less than 25 percent of employment in Puerto Rico's wholesale and retail
    trade sectors, where local corporations are the most important employers.
    Similarly, U.S.-owned corporations are not the majority employers in any
    of the large Puerto Rican service industries for which data are
    available.1

    U.S. CFCs Have Become the Most Important Type of Business Entity in Puerto
    Rico's Manufacturing Sector in Terms of Value Added but Not in Terms of
    Employment

    As of 2002, U.S. CFCs accounted for 42 percent of value added in Puerto
    Rico's manufacturing sector-a larger share than that of any other type of
    business entity (see fig. 39). Possessions corporations had the next
    largest share of value added with 27 percent, and other U.S. corporations
    accounted for 2 percent of the total. Together, these three types of
    businesses produced at least 71 percent of total manufacturing value
    added. A small number of U.S.-owned or U.S.-incorporated businesses may be
    included in the category "corporations of type unknown," but we believe
    that most of the data for that category (in all of the figures in this
    chapter) are attributable to corporations that are not incorporated in the
    United States and are not CFCs.2

    Figure 39: Distribution of Value Added for All Puerto Rican Manufacturing
    by Type of Business Entity, 2002

    Note: Value-added figures for sole proprietors round to 0 percent.

    Possessions corporations remained the largest single type of employer,
    with 31 percent of the sector's total employment (see fig. 40). Despite
    their large share of manufacturing value added, CFCs had a relatively
    small share-14 percent-of the sector's total employment, which resulted in
    the extraordinarily high ratios of value added per employee that we
    discussed earlier. In contrast, other U.S. corporations and corporations
    incorporated in Puerto Rico had significantly larger shares of total
    employment than they did of value added.

    Figure 40: Distribution of Employment for All Puerto Rican Manufacturing
    by Type of Business Entity, 2002

    A little less than two-thirds of the CFCs' value added and half of their
    employment is attributable to CFCs incorporated outside of Puerto Rico.
    This distribution of value added is similar to the estimated distribution
    of gross profit between the two types of CFCs, based on the tax data for
    our 77 large corporate groups for 2001. The estimates presented in figure
    41 are based on our tax ratio approach for attributing portions of the
    income of multilocation CFCs to Puerto Rico. The estimates indicate that
    70 percent of the gross profit and 73 percent of net income that CFCs
    earned in Puerto Rico in 2001 were earned by CFCs incorporated outside of
    Puerto Rico. Using the tax data, we estimate that more than three-quarters
    of the total gross and net income earned by the CFCs incorporated outside
    of Puerto Rico in 2001 is attributable to CFCs incorporated in the Cayman
    Islands, Ireland, the Netherlands, and the U.S. Virgin Islands.

    Figure 41: Distribution of Income in 2001 between CFCs Incorporated in
    Puerto Rico and CFCs Incorporated Elsewhere

    A comparison of figures 42 and 43 shows that the value added of CFCs in
    2002 was concentrated in the pharmaceutical industry. These firms
    accounted for over half of the value added in that industry, or almost
    three times as much as the value added of possessions corporations. In
    contrast, CFCs accounted for only 13 percent of the value added in all of
    the remaining manufacturing sectors, where possessions corporations still
    dominated with a 48 percent share. At this more specific industry level of
    data, Census nondisclosure rules prevent us from providing as much detail
    about other forms of businesses. We needed to add pass-through entities
    into the "all other and unknown" category. However, from table 20 in
    appendix V, we do know that between approximately 80 percent and 90
    percent of the employees of these entities were concentrated in two
    industries-pharmaceuticals and medical equipment-and that between 25
    percent and 63 percent of these employees were in each of these
    industries. If the value added of these entities was distributed across
    industries in approximately the same manner as their employment, then
    pass-through entities would have accounted for between 3 percent and 7
    percent of value added in pharmaceuticals.

    Figure 42: Value Added in the Pharmaceutical Industry by Type of Business
    Entity, 2002

    Figure 43: Value Added in Manufacturing, Excluding Pharmaceuticals, by
    Type of Business Entity, 2002

    Data in table 20 of appendix V show that possessions corporations and CFCs
    were approximately equal in importance in terms of employment in the
    pharmaceutical industry in 2002 and, together, they accounted for 61
    percent of the industry's employment. The data also show that possessions
    accounted for a little over a quarter of total employment in all other
    manufacturing industries, while CFCs accounted for only 9 percent.

    The Role of U.S. Corporations Is Much Smaller in Puerto Rico's Wholesale
    and Retail Trade Than in Manufacturing

    Corporations that were U.S. CFCs and businesses incorporated in the United
    States accounted for less than a quarter of total employment in the Puerto
    Rican wholesale trade sector and, as figure 44 shows, about half of their
    employment was in corporations other than CFCs or possessions
    corporations. Corporations in the unknown category, which we believe to be
    largely ones that are not incorporated in the United States or owned by
    U.S. parent corporations were by far the largest employers in the
    wholesale trade in 2002, as shown in figure 44. Figure 45 indicates that
    this employment distribution was similar for the retail trade sector. The
    primary difference between the two sectors is that possessions
    corporations played no role at all in retail trade and sole proprietors
    played a more important role in that sector than in wholesale trade. The
    distributions of payroll across entities in these two sectors largely
    mirrors the distributions of employment (see table 17 in app. V).

    Figure 44: Share of Employment in Wholesale Trade in Puerto Rico by Type
    of Business Entity, 2002

    Note: Sole proprietors and partnerships could not be reported because of
    disclosure constraints. Therefore, they are captured in the "all other
    employers" category.

    Figure 45: Share of Employment in Retail Trade in Puerto Rico by Type of
    Business Entity, 2002

    Neither Possessions Corporations nor CFCs Were Significant Employers in
    2002 in Most Puerto Rican Service Industries for Which Data Are Available

    In general, possessions corporations and CFCs played minor roles as
    employers in Puerto Rico's service sector. The 2002 Economic Census of
    Island Areas compiled data for 11 service industries, as well as the
    mining, utilities, and transportation and warehousing sectors in Puerto
    Rico. Table 7 shows the distribution of employment across types of
    businesses for the six largest services (in terms of employment) covered
    by the census. Appendix V tables 25-27 show the distribution of
    employment, sales, and payroll, for all 11 service industries and the
    three other sectors.

    CFCs accounted for 32.7 percent of employment in the information services
    industry (which includes telecommunications, broadcasting, publishing,
    motion pictures, and Internet services), but for no more than 5.1 percent
    in any of the other five large services. Possessions corporations
    accounted for 10 percent of employment in the accommodations industry but
    for no more than 2.4 percent in any of the other large services. Other
    U.S. corporations accounted for between 10 percent and 20 percent of
    employment in each of the six services. Most of the remaining employment
    in the large service industry is attributable to local corporations (in
    the type unknown group) and sole proprietors. The category "all other
    employers," which includes nonprofit entities, accounts for up to 22
    percent of total employment in healthcare services, which is the largest
    service industry.

    Table 7: Distribution of Employment by Business Entity Type for the Six
    Largest Services Included in the 2002 Economic Census of Puerto Rico

     Type of business entity      Healthcare services          Accommodations  Administrative support                 Finance Professional Information
                                                                                             services                             services
    Total employment number
    All employers                              68,338                  63,810                  61,703                  36,059       26,197      16,696
    Share of employment
    (percent)
    Possessions corporations  						0.4-0.8                  10.0 						0.2-0.4 						0.1-0.3          2.1         2.4
    Other U.S. corporations                      11.3                    17.4                    15.4                    10.9         20.2        11.0
    U.S. CFCs                                     3.3 						0.4-0.8                     5.1                     5.1          3.4        32.7
    Other corporations                            0.1                     (D)                     1.0                   3.5.2          3.4        10.9
    incorporated in Puerto
    Rico
    Corporations of type                          (D)                     (D)                     (D)                     (D)          (D)         (D)
    unknown
    Sole proprietors                              (D)                     (D)                     (D)                     (D)          (D)         (D)
    Partnerships/pass-through                 1.4-1.8                     6.8                 1.5-2.4                 0.3-1.0         11.2     1.6-1.7
    entities
    All other employers                       33.9-38                 0.2-0.3               10.6-11.5               10.6-11.5      4.3-5.6         0.6

    Source: GAO analysis of IRS data and custom tabulations from the 2002
    Economic Census of Island Areas provided by the U.S. Census Bureau.

    Note: We are unable to report specific figures on "corporations of type
    unknown" or "sole proprietors" due to disclosure contraints.

    Taxes Per Capita in Puerto Rico Are Lower Than in the States but Are about
    the Same Share of IncomeChapter 6

    The taxes paid to all levels of government (federal, Commonwealth, and
    local) in Puerto Rico in 2002 were $3,071 per capita-considerably less
    than the per capita taxes of $9,426 paid in the states. However, the
    combined taxes paid by Puerto Rico residents amounted to 28 percent of
    their personal income, which was close to the 30 percent figure in the
    states. Puerto Rico's outstanding government debt in 2002 was much higher
    than that of state and local governments as a share of personal income,
    partly because the Commonwealth government has a wider range of
    responsibilities.

    Income and Employment Taxes Account for about Two-thirds of the Taxes Paid
    in Both Puerto Rico and the States, but the Allocation of Those Taxes by
    Level of Government Differs between the Two Locations

    As shown in figure 48, about 75 percent of the taxes paid in Puerto Rico
    are levied by the Commonwealth and municipal governments.5 The property
    tax and gross receipts tax imposed by the municipal government accounted
    for a little over 17 percent of taxes paid with the remainder going to the
    Commonwealth government.6 Commonwealth income taxes accounted for 41
    percent of total taxes with slightly more than half of that being paid by
    resident individuals. Sales and excise taxes represented 23 percent of the
    total.

    Data available from IRS for Puerto Rico and the states do not separate
    federal individual income tax payments from payments of federal employment
    taxes, such as those for Social Security, Medicare, and unemployment
    compensation; however, most of the tax shown for that combined category in
    figure 48 should be employment taxes because most residents of Puerto Rico
    pay little, if any federal income tax. Even less federal estate, gift, or
    excise tax is paid in Puerto Rico. Federal excise taxes on goods
    manufactured in Puerto Rico and sold in the states are transferred to the
    Commonwealth and more than offset any federal excise tax on products
    consumed there.7

    Figure 48: The Composition of Taxes Paid in Puerto Rico, Fiscal Year 2002

    Notes: Numbers do not sum because of rounding.

    The figures for federal estate and gift taxes round to 0 percent.

    In contrast to the case of Puerto Rico, more than half of the taxes paid
    in the states go to the federal government, which provides a larger range
    of services to the states than it does to the Commonwealth. Federal
    individual income and employment taxes accounted for 56 percent of the
    taxes paid, while federal estate, gift, and excise taxes amounted to an
    additional 3 percent, resulting in a combined federal share of 59 percent
    (see fig. 49). When the 10 percent of taxes paid in the form of state and
    local income taxes are added to the 56 percent that go to federal
    individual income and employment taxes, the resulting 66 percent share is
    almost equal to the 67 percent share in Puerto Rico for this same group of
    taxes. Of the remaining total, state and local property taxes and "other"
    revenues (including lotteries and licenses) account for greater shares of
    the total taxes paid in the state than they do in Puerto Rico, while sales
    and excise taxes represent a smaller share.

    Figure 49: The Composition of Taxes Paid in the States, Fiscal Year 2002

    Puerto Rico's Outstanding Government Debt in 2002 Was Much Higher Than
    That of State and Local Governments as a Share of Personal Income, Partly
    Because the Commonwealth Government Has a Wider Range of Responsibilities

    The amount of Puerto Rican government-issued debt outstanding as of 2002
    was slightly higher in per capita terms, but much higher as a share of
    personal income, than was state and local government-issued debt. As shown
    in figure 50, the outstanding amount of Puerto Rican government debt per
    capita in 2002 was about $7,580, compared to a national average of $5,820
    for state and local government-issued debt. The per capita debt of the
    governments of the other insular areas in 2002 was about $5,690. Although
    all of this debt was issued by the respective governments, some of it is
    directed to private use and will be paid back by targeted beneficiaries.
    About 16 percent of Puerto Rico's government debt fell into

    this "private use" category, compared to about 23 percent for state and
    local government debt.8

    Figure 50: Per Capita Government Debt in the United States and Insular
    Areas, Fiscal Year 2002

    Note: We did not categorize federal or other insular areas debt into
    "public use" or "private use."

    Figure 51: Government Debt as a Share of Personal Income in the United
    States and Insular Areas, Fiscal Year 2002

    Note: We did not categorize federal debt into "public use" or "private
    use."

    Federal Grants and Payments to Governments Per Capita Are the Same for
    Puerto Rico and the States but Direct Federal Payments to Individuals Per
    Capita Are Significantly Lower in Puerto Rico

    The states and insular areas receive funds from the federal government in
    the form of grants, direct aid, loans, and insurance and procurement
    payments (see table 8). Federal grants and payments to the Puerto Rican
    government in 2002 amounted to $1,242 per capita, about the same as the
    $1,264 per capita paid to all state and local governments in the states,
    but less than the $1,703 per capita paid to the other insular area
    governments. The $2,057 per capita of direct federal payments to
    individuals in Puerto Rico was well below the $3,648 per capita paid to
    state residents, but higher than the $1,418 per capita paid to residents
    of the other insular areas.9 The following chapter and appendix VII
    provide detailed information on the amount of spending for specific
    federal social programs in Puerto Rico, the states, and other insular
    areas and describes similarities and differences in the operation of these
    programs in the various locations. The per capita federal payments of $336
    for salaries, wages, and procurement in Puerto Rico were about 20 percent
    of payments for those purposes in the states and the other insular areas.

    (Page is left blank intentionally.)

    Table 8: Federal Expenditures in Fiscal Year 2002

    Source: GAO analysis of Census data.

    aData reported are actual cash outlays. Includes transfers of custom
    duties and excise tax revenues.

    Some federal funds that Puerto Rico received as grants and direct payments
    were in the form of a rebate on custom duties and a cover over10 of excise
    taxes collected on rum. These funding sources are not available to the
    states or the District of Columbia, or most of the insular areas except
    for the U.S. Virgin Islands. On a per capita basis the U.S. Virgin Islands
    received a larger rebate payment than Puerto Rico and a larger cover over
    payment than Puerto Rico (see table 9).

    Table 9: Federal Custom Duties and Excise Taxes Returned to Puerto Rico in
    Fiscal Year 2002

                       Puerto Rico
                    Rebates of         $33,635 $8.7        $2,405 $22.1      n.a.
                    customs' duties
    Excise cover            339,414    87.9      64,936  595.7       n.a.
    over

    Source: GAO analysis of Customs and Alcohol and Tobacco Tax and Trade
    Bureau data.

    Note: n.a. means not applicable.

    Taxes Paid Per Capita in Puerto Rico Are Lower Than Those in the States
    but the Taxes Are about the Same Share of Personal Income in Both Places

    The amount of taxes that Puerto Rico residents paid per capita in fiscal
    year 2002 ($3,071) was about one-third of the amount paid by residents of
    the states ($9,426) (see fig. 46).1 The mix of the taxes was also quite
    different. While nearly 60 percent ($5,619) of the taxes paid by residents
    of the states were federal taxes, only about 25 percent ($760) of the
    total taxes paid by Puerto Rico residents were federal taxes because those
    residents generally are not subject to federal income tax on the income
    they earn in Puerto Rico. Data on federal taxes paid in the other insular
    areas are not available. Taxes paid by residents of the other insular
    areas to their own governments in 2002 amounted to $2,451 per
    capita-slightly higher than the $2,310 per capita that residents of Puerto
    Rico paid to the Commonwealth and municipal governments. The location
    where a tax is paid is not necessarily the same location as where the
    economic burden of the tax falls. The data we present in this chapter
    pertain to the former.2

    Comparing the taxes Puerto Rico residents paid to the average of the five
    states whose residents paid the least total taxes, we found that Puerto
    Rico residents paid about 54 percent of the amount paid by these state
    residents

    ($5,713).3 The average percentage of taxes paid in these same five states
    that were federal taxes was nearly 47 percent ($2,705), still nearly
    double the percentage for Puerto Rico. The average per capita amount of
    taxes paid in the five highest tax states was $15,491-five times the per
    capita tax in Puerto Rico.4

    Figure 46: Per Capita Taxes Paid in the United States and Insular Areas,
    Fiscal Year 2002

    Note: Data on federal taxes paid in the other insular areas are not
    available.

    Taxes as a share of personal income are about the same in Puerto Rico and
    the states, which is not surprising because Puerto Rico's income per
    capita is so much lower. Taxes paid in Puerto Rico amounted to 28 percent
    of the Commonwealth's personal income, while those paid in the states
    amounted to 30 percent of aggregate state personal income. Taxes in the
    five lowest-tax states were an average of 23 percent of the states'
    aggregate personal income, while those in the five highest-tax states
    averaged 39 percent. (See table 28 in app. VI for additional detail.)

    Figure 47: Taxes Paid as a Share of Personal Income in the United States
    and Insular Areas, Fiscal Year 2002

    Note: Data on personal income in the other insular areas are not
    available.

    The Extent That Federal Social Programs in Puerto Rico Mirror Those in the
    States and Other U.S. Insular Areas VariesChapter 7

    Comparison of Selected Federal Social Programs

    Like the states, Puerto Rico and the other U.S. insular areas receive
    federal funds for a variety of social programs-including federal housing
    assistance, education, and health care financing programs-which provide
    assistance to elderly and needy families and individuals. Generally, the
    social programs we examined in these areas targeted similar populations
    and delivered similar services-although Puerto Rico and the other insular
    areas did not always do so through the program as it exists in the states
    (see table 10). For example, in lieu of the Food Stamp Program available
    in the states, which is an entitlement1 program based on the number of
    participants, Puerto Rico receives a capped block grant that has similar
    eligibility requirements. The major difference between some of the social
    programs we examined in the states versus those in Puerto Rico and the
    other insular areas is how they are funded. For example, where federal
    Medicaid spending is an open-ended entitlement to the states, it is
    subject to a statutory cap and a limited matching rate in Puerto Rico and
    the other insular areas.2 Some of the social programs and housing programs
    that we examined are available in the states, but are not available in
    some of the insular areas.

    Table 10: Comparison of Selected Social Programs in the U.S. Insular Areas
    to Those in the States

                 Program               Program rules in the U.S. insular areas
                                           compared to those in the states
    Education programs
    Individuals with             Puerto Rico and the other insular areas
    Disabilities Education Act   receive IDEA funds and must comply with IDEA
    (IDEA) Part B                requirements that apply in the states as a
                                    condition of funding.
    Title I of the Elementary    Title I funds are provided to schools in
    and Secondary Education Act, Puerto Rico and in the other insular areas.
    reauthorized by the No Child Schools in these locations are subject to the
    Left Behind Act of 2001      same requirements as schools in the states.
    Food and nutrition programs
    Child and Adult Care Food    Same in the states, Puerto Rico, the U.S.
    Program                      Virgin Islands, and Guam; program does not
                                    operate in CNMI and American Samoa.
    Food Stamp or Nutrition      Same in the states, the U.S. Virgin Islands,
    Programs                     and Guam; Puerto Rico, American Samoa, and
                                    CNMI provide assistance similar to the Food
                                    Stamp Program through a capped block grant;
                                    certain eligibility rules for the grant
                                    differ.
    National School Lunch        Same in the states, Puerto Rico, the U.S.
    Program                      Virgin Islands, and Guam; program does not
                                    operate in CNMI and American Samoa, but funds
                                    under capped block grants for nutrition
                                    programs may be used to provide school meals
                                    in these insular areas.
    Special Supplemental         Same in the states, Puerto Rico, American
    Nutrition Program for Women, Samoa, Guam, and the U.S. Virgin Islands;
    Infants, and Children (SS    program does not operate in CNMI.
    Nutrition for WIC)
    Health care financing and
    grant programs
    Medicare                     Program eligibility and benefits largely
                                    similar between the insular areas and the
                                    states; however, differences exist regarding
                                    the new Part D outpatient prescription drug
                                    benefit.
    Medicaid                     Federal share of expenditures in the insular
                                    areas is limited to a 50 percent matching
                                    rate and federal Medicaid spending for the
                                    insular areas is subject to statutory caps.
                                    In light of federal funding limits, the
                                    Centers for Medicare & Medicaid Services
                                    (CMS) does not hold Puerto Rico and the other
                                    insular areas accountable for covering all
                                    the mandatory Medicaid benefits required of
                                    the states.
    State Children's Health      Federal allotment to Puerto Rico and the
    Insurance Program (SCHIP)    other insular areas is based on statutorily
                                    set proportions versus the population of
                                    low-income, uninsured children, as is the
                                    case in the states. Insular areas receive
                                    minimum federal matching contributions that
                                    do not apply to the states.
    Health grants                Method used to determine funding amounts
                                    varies by grant. Certain grants use the same
                                    allocation method for the states and the
                                    insular areas, while other grants treat some
                                    or all of the insular areas differently.
    Income assistance programs
    Aid to the Aged, Blind, or   Supplemental Security Income (SSI), which
    Disabled (AABD)              serves a similar population, exists in the
                                    states and CNMI, but not in the other insular
                                    areas. The other insular areas continue to
                                    operate their grant programs that existed
                                    before SSI was created, specifically AABD for
                                    Puerto Rico.
    Temporary Assistance for     Program provisions generally the same for
    Needy Families (TANF)        Puerto Rico, Guam, and the U.S. Virgin
                                    Islands, but they cannot receive all funding
                                    sources available to the states; American
                                    Samoa and CNMI do not participate.
    Child care programs
    Child Care and Development   Program provisions generally the same for the
    Fund (CCDF)                  states, Puerto Rico, and the insular areas,
                                    but the insular areas cannot receive all
                                    funding sources available to the states.
    Foster Care and Adoption     Puerto Rico participates in these programs
    Assistance Funds             and receives funds, which are limited by the
                                    federal funding cap, set by the 1996 federal
                                    welfare law. Other insular areas do not
                                    participate in these programs.
    Housing programs
    Public Housing               Funding formula the same in the states,
                                    Puerto Rico, the U.S. Virgin Islands, and
                                    Guam.a
    HOPE VI                      Same in the states and insular areas.
    Housing Choice Vouchers      Same in the states and insular areas.
    Community Development Block  Same in the states and Puerto Rico; other
    Grant                        insular areas receive an amount determined by
                                    the U.S. Department of Housing and Urban
                                    Development (HUD) based on population and
                                    performance in previous years.
    HOME Investment Partnerships Puerto Rico subject to a funding cap that
    Program                      does not apply to the other states; the
                                    initial HOME allocation amount for each of
                                    the insular areas is based on its population
                                    and occupied rental units compared to all the
                                    insular areas
    Project-based Section 8      Same in the states and insular areas.
    Program
    Section 203 (b) Single       Same in the contiguous 48 States and Puerto
    Family Mortgage Insurance    Rico; different mortgage insurance limits for
    Program                      Guam, the U.S. Virgin Islands, Alaska, and
                                    Hawaii.a

    Source: GAO analysis of U.S. federal social programs.

    aInformation was not readily available for CNMI and American Samoa.

    More detailed information on how each of the programs is applied in the
    insular areas and the states can be found in appendix VII.

    Appendix I  Methodology for Allocating the Assets and Liabilities of Depository Banks
    by Geographic Location

    In order to identify where the assets held in the Puerto Rican banking
    system are invested and where the owners of the banks' liabilities reside,
    we analyzed institution-specific data that the Office of the Commissioner
    of Financial Institutions (OCFI) collects for oversight purposes. Banks
    and certain other financial institutions in Puerto Rico are required to
    report detailed information regarding their assets, liabilities, and
    capital to OCFI through a computerized "CALL report" data system.1 In
    addition to a basic balance sheet, the institutions are required to file
    various supporting schedules and addenda. In the case of depository banks
    (Puerto Rican, U.S., and foreign commercial banks, plus Puerto Rican
    government banks) some of the schedules and addenda ask the institutions
    to identify the geographic location of assets they own; others ask for the
    residency of the owners of the banks' liabilities. We obtained a copy of
    the computer file OCFI has compiled containing all of the detailed CALL
    report data submitted by each of these institutions for the years 1997
    through 2004. The data, in combination with other information, allowed us
    to allocate substantial portions of the total assets and liabilities of
    depository banks between Puerto Rico and elsewhere. (There were no
    reporting requirements that enabled us to allocate the banks' capital by
    residency of shareholders.) In 2004 the depository banks accounted for
    about two-thirds of the assets held in financial institutions supervised
    by OCFI. Given the lack of location-specific data for the other financial
    institutions, we simply report their total assets to indicate their size
    in relation to the depository banks.

    Table 11 identifies the lines from the various schedules that we used to
    allocate specific balance sheet items by geographic location. We sent a
    draft version of this allocation methodology to OFCI for their review and
    incorporated several corrections that they identified for us. We
    ultimately allocated each dollar from the balance sheets into one of three
    categories: U.S. and foreign, Puerto Rican, or unknown. The last category
    covers all amounts that we could not identify as belonging to either of
    the first two categories. The CALL report data did not provide a means for
    allocating most loans and leases. For this line item we assume that 95
    percent of loans and leases are made to borrowers in Puerto Rico, based on
    the fact that several financial experts from Puerto Rico all agreed that
    at least 95 percent of the loans were made locally, even though some of
    the larger banks have begun to enter the U.S. market.

    Table 11: Allocation of Balance Sheet Items by Geographic Location

              Sheet line item         Sources identified for portions that could
                                                     be allocated
    ASSETS
    Cash
    Non-interest-bearing balances U.S. and Foreign combined identified:
                                     Addendum-RC-Balance sheet (CALL report) line
                                     1b. Puerto Rican identified:
                                     Addendum-RC-Balance sheet (CALL report) line
                                     1a.
    Interest-bearing balances     U.S. and Foreign combined identified:
                                     Addendum-RC-Balance sheet (CALL report) line
                                     2b. Puerto Rican identified:
                                     Addendum-RC-Balance sheet (CALL report) line
                                     2a.
    Securities                    U.S. identified: Schedule RC-B Securities
                                     lines 1, 2a, 2b, 4a(1), 4a(2), 4b(1), and
                                     4b(2). Foreign identified: RC-B Securities
                                     line 6b. U.S. and Puerto Rican combined
                                     identified: RC-B Securities lines 3 and 6a.
    Federal funds sold and        U.S. and Foreign combined identified:
    securities purchased          Addendum-RC-Balance sheet (CALL report)
                                     lines 3a and 4a. Puerto Rican identified:
                                     Addendum-RC-Balance sheet (CALL report)
                                     lines 3b and 4b.
    Loans and leases              Allocated 95 percent to Puerto Rico and 5
                                     percent to the U.S. and Foreign categories
                                     based on the consensus of experts that we
                                     interviewed.
    Trading assets                No ability to allocate to any source.
    Other assets                  No ability to allocate to any source.
    LIABILITIES
    Deposits
    Private                       Puerto Rican identified: Addendum-RC-Balance
                                     sheet lines 17a, 17b. U.S. and Foreign
                                     identified: line17d.
    936 deposits                  U.S. identified: Addendum-RC-Balance sheet
                                     lines 17c.
    States, political divisions   U.S. identified: Addendum-RC-Balance sheet
                                     (CALL report) lines 18b, 18c, 18d. Puerto
                                     Rican identified: Addendum-RC-Balance sheet
                                     (CALL report) lines 18a.
    Commercial banks              U.S. identified: Addendum-RC-Balance sheet
                                     (CALL report) lines 20b(1) and 20b(2).
                                     Foreign identified: Addendum-RC-Balance
                                     sheet (CALL report) lines 20a(1) and 20a(2).
    Foreign/government banks      U.S. identified: Schedule RC-E-Deposit
                                     liabilities line 2. Foreign identified:
                                     Schedule RC-E-Deposit liabilities lines 5
                                     and 6.
    Total debt                    Puerto Rican identified: Addendum-RC-Balance
                                     sheet (CALL report) lines 6a, 7a, and 8a.
                                     U.S. identified: Addendum-RC-Balance sheet
                                     (CALL report) line 7c. U.S. and Foreign
                                     combined identified: Addendum-RC-Balance
                                     sheet (CALL report) lines 6b, 7b, and 8b.
    Trading liabilities           No ability to allocate to any source.
    Other liabilities             U.S. and Foreign identified:
                                     Addendum-RC-Balance sheet (CALL report) line
                                     9b. Puerto Rican identified:
                                     Addendum-RC-Balance sheet (CALL report) line
                                     9a.

    Source: GAO.

    OCFI conducts a set of quality reviews on the CALL report data that the
    financial institutions submit. We undertook our own consistency checks on
    the data relevant to our allocation analysis. We detected some differences
    between the total amounts reported on the balance sheet and the summations
    of amounts listed in the addenda that should have totaled to the balance
    sheet amounts. Some differences were extremely small, which we attributed
    to inconsequential reporting errors. However, we identified three types of
    significant discrepancies. The first type of discrepancy was due to
    financial institutions reporting a positive amount for a balance sheet
    item but not providing the geographic detail that should have been
    reported in an addendum. The second type of discrepancy resulted from
    financial institutions listing more in the addendum than in the balance
    sheet for a given line item. In these cases there was always a specific
    amount that appeared to be either double-counted in the addendum or not
    reported in the balance sheet amount. The last type of discrepancy
    comprised cases of financial institutions that reported either too little
    or too much in the addendum for corresponding balance sheet items but with
    no obvious pattern or explanation.

    We provided experts in OCFI a spreadsheet with the specific cases of
    discrepancies for each type of discrepancy and each affected balance sheet
    line item along with a detailed explanation and suggested resolutions
    where we could offer any. Based on OCFI's responses, we adjusted our
    unknown group to include discrepancy amounts due to financial institutions
    reporting zero on the addendum. Officials from the Commissioner's office
    considered the balance sheet values to be more accurate than the addendum
    breakouts so in the second and third types of discrepancies we were unable
    to make any corrections to adjust for these differences. In our
    consultation with Puerto Rican officials we further determined that in
    early years the financial institutions were not required to fill out the
    addendum and that the remaining differences result largely from reporting
    discrepancies at the institution level.

    Table 12 provides a summary of the absolute value of the unexplained
    discrepancies as a percentage of the balance sheet line item for selected
    items. For those cases where the unexplained discrepancies exceeded 5
    percent of the total value for a line item in a given year we decided that
    our allocation results were too uncertain to be presented and we simply
    show the totals for those items in our figures.

    Table 12: Percent of Discrepancies by Line Item (percent)

    Year   Total assets Loans and leases Total liabilities Deposits Total debt
    2004            0.3              0.5               4.6      0.8        0.3
    2003            1.5              2.2               2.0      0.8        1.5
    2002            1.0              2.0               4.2      0.2        1.0
    2001            2.6              3.5               2.6      2.4        2.6
    2000            1.2              0.7               4.2      5.7        1.2
    1999            1.8              0.9               3.1      2.5        1.8
    1998            0.6              0.5               5.0      2.4        0.6
    1997            2.5              1.0              17.7     15.0        2.5
    1996            0.4              0.7              16.5      5.5        0.4
    1995            0.4              0.7              10.1      1.3        0.4

    Source: GAO.

    Appendix II  Additional Information on Puerto Rican Economic Trends and Capital
    Flows

    The following series of figures present additional information on the
    sources and uses of funds for financial institutions operating in Puerto
    Rico.

    Figure 52: Puerto Rico's Depository Institutions' Deposits, 1995-2004

    Notes: Figures were adjusted for inflation using Puerto Rico's gross
    product deflator.

    In 1997 and 2000, the sum of Puerto Rican, U.S., and foreign deposits from
    the addenda exceeded the balance sheet totals by $4,811 and $86 million,
    respectively.

    Figure 53: Puerto Rico's Depository Institutions' Debt, 1995-2004

    Notes: Figures were adjusted for inflation using Puerto Rico's gross
    product deflator.

    In 2004, the sum of Puerto Rican, U.S., and foreign debt from the addenda
    exceeded the balance sheet totals by $823 million.

    Figure 54: Exempt Deposits of Possessions Corporations and Brokered
    Deposits in Puerto Rican Banks, 1997-2004

    Note: Figures were adjusted for inflation using Puerto Rico's gross
    product deflator.

    Figure 55: Puerto Rico's Depository Institutions' Securities Investments,
    1995-2004

    Notes: No securities were clearly identified as being located in Puerto
    Rico.

    Known investment in foreign securities make up less than 1 percent of the
    total for every year between 1995 and 2004.

    Figures were adjusted for inflation using Puerto Rico's gross product
    deflator.

    Figure 56: Puerto Rico's Depository Institutions' Loans and Leases,
    1995-2004

    Note: Figures were adjusted for inflation using Puerto Rico's gross
    product deflator.

    In chapter 3 of this report we provided information on the physical
    location of the assets and liabilities of depository institutions
    operating in Puerto Rico. Although we are unable to report this kind of
    detail for the other types of financial institutions in Puerto Rico, in
    figure 57 we are able to present data from OCIF on selected other types of
    institutions. Table 14 presents summary descriptions of the sources and
    uses of funds for these institutions, as explained to us by several
    private sector financial experts in Puerto Rico and confirmed by OCIF. The
    figure and table do not include international banking entities, which OCIF
    also oversees, because those entities do not form part of the local
    capital market.

    Figure 57: Assets of Selected Financial Institutions in Puerto Rico,
    1995-2004

    Notes: Figures were adjusted for inflation using Puerto Rico's gross
    product deflator.

    No data were available for investment or venture capital prior to 1997; no
    data were available for securities brokers prior to 2002.

    Table 13: The Source and Use of Funds for Selected Financial Institutions
    in Puerto Rico

    Type of Institution         Description of Source and Use of Funds
    Credit unions        They obtain and use their funds in the local (Puerto
                            Rican) market.
    Broker/dealers       The broker/dealers represented in fig. 57 obtain all
                            but a small portion of their funds locally and invest
                            most of those funds locally.
    Small-loan companies These companies obtain their funds in the U.S. market
                            and lend to subprime borrowers in Puerto Rico.
    Mortgage banks       On the funding side the Puerto Rican mortgage market
                            is indistinguishable from the U.S. market. Most funds
                            are lent locally.
    Investment companies Only Puerto Rican residents can invest in these
                            companies. Most of their funds are invested in Puerto
                            Rico with a minor portion going to the United States.
    Leasing companies    These companies are subsidiaries of banks and their
                            funding is the same as for their parent banks.
    Financing companies  These companies, which operate in the car loan
                            market, obtain their funds in the United States and
                            lend locally.

    Source: GAO.

    Figure 58: Real Debt Issued by the Government of Puerto Rico, but Payable
    from Private or Federal Funds, or Asset Sales, by Market of Purchaser,
    1995-2005

    Note: Figures were adjusted for inflation using Puerto Rico's gross
    product deflator.

    Figure 59: Real Debt Issued and Payable by the Government of Puerto Rico,
    by Market of Purchaser, 1995-2005

    Note: Figures were adjusted for inflation using Puerto Rico's gross
    product deflator.

    A Comparison of Rates of Return for Possessions Corporations and
    Controlled Foreign Corporations (CFC) in Puerto Rico's Chemical Industry

    In contrast to the various U.S. Census Bureau (Census) data we have
    presented that show a sharp increase in value added per employee as
    pharmaceuticals production was shifted from possessions corporations to
    CFCs, the tax data for our large corporate groups do not show a clear
    trend in the rates of return on assets for these two types of
    corporations. We could not exactly replicate the comparison we made with
    the Census data with our tax data because we lacked employment data for
    our large groups of corporations. Instead, we compared the ratios of gross
    profit (the closest tax data equivalent of value added) to total assets.
    The results presented in figure 60 shows that the ratios for CFCs in the
    chemical industry were significantly higher than those for possessions
    corporations in the same industry in both 1997 and 1999, but the ratios
    were very close in

    2001.1 We also compared the ratio of net income over total assets and
    found a similar pattern, except for the fact that the net return for
    possessions corporations in 2001 was slightly higher than that for CFCs.

    Figure 60: Rates of Return on Total Assets for Possessions Corporations
    and CFCs in the Chemical Industry, Puerto Rico, 1997, 1999, 2001

    In addition, we compared the gross and net operating rates of return of
    possessions corporations and CFCs in the chemical industry and found that
    neither type of corporation dominated the other type consistently across
    the years (see fig. 61). We used the same measure of net operating rate of
    return that Grubert and Slemrod had computed for possessions

    corporations for 1987.2 With one exception (for CFCs in 2001), our net
    return estimates for both types of corporations for 1997, 1999, and 2001
    all exceeded 200 percent and were significantly higher than Grubert and
    Slemrod's estimate of 138.6 percent for possessions corporations in the
    pharmaceutical industry in 1987.

    Figure 61: Rates of Return on Operating Assets for Possessions
    Corporations and CFCs in the Chemical Industry, Puerto Rico, 1997, 1999,
    2001

    Possessions corporations fared better relative to CFCs in terms of their
    returns on operating assets, rather than total assets, because the
    operating assets of possessions corporations represented a significantly
    lower share of their total assets than was the case for CFCs. Figure 62
    shows that as the large corporate groups gradually decreased the size of
    their possessions corporations' operations in Puerto Rico after 1997,
    operating assets accounted for a progressively smaller share of total
    assets until 2003, when an accumulation of inventories stopped the
    decline. In 2001, operating assets accounted for only 17.7 percent of
    possessions corporations' total assets in the chemical industry. In
    contrast, operating assets accounted for 41.9 percent of the total assets
    of all of the CFCs in the chemical industy for which we had reliable asset
    information in 2001. Internal Revenue Service (IRS) officials with
    expertise in possessions corporations issues told us that the large
    corporate groups would have an incentive to keep as many of the liquid
    assets of the possessions corporations (everything but land and
    depreciable and depletable assets) within those entities, even as they
    transferred the latter's fixed assets to CFCs, because a transfer of those
    liquid assets to a foreign corporation could be subject to federal income
    tax.

    Figure 62: Composition of Assets of the Possessions Corporations of All
    Large Groups, Puerto Rico, 1993-2003

    Appendix III  Methodology for Analyses of Business Activities

    Methodology for Determining How Economic Activity in Puerto Rico is
    Distributed across Types of Business Entities

    We used a combination of data provided by Census, IRS, and the Puerto
    Rican Department of Treasury to determine how economic activity in Puerto
    Rico is distributed across types of business entities. The multistage
    procedure we followed in cooperation with Census and IRS was as follows:

    1.We obtained a database from IRS that contained the employer
    identification numbers (EIN) and names for approximately 50,126 employers
    that either (1) operated in Puerto Rico or (2) were businesses related to
    those operating in Puerto Rico. The initial population for Census's
    surveys of employers for the 2002 Economic Census of Puerto Rico was
    included among these 50,126 employers.

    2.We assigned each EIN to one of 11 groups based on IRS or Puerto Rican
    tax data, using the criteria described below. Ten of the groups
    represented types of businesses. We assigned each group an identification
    letter and did not tell Census the types of businesses that they
    represented. We labeled the 11th group "unknown" and assigned all of the
    EINs that we could not place into other groups into that one.1

    3.Census matched the EINs in each group to the EINs of respondents to
    their surveys. Census then aggregated the economic data, such as value
    added, number of paid employees, and capital expenditures, for all of the
    EINs in a given group and industry. Census did the same for the EINs in
    our "unknown" group, but for that group they also provided a breakdown
    according to the type of business entity that the respondents reported
    themselves to be in the Census surveys. Census reviewed these results to
    ensure compliance with their legal requirement to ensure confidentiality
    of individual survey respondents; they suppressed the data in any
    entity-industry grouping that, otherwise, would have disclosed
    confidential information. In some cases we combined two of our original
    groups to avoid having data suppressed.

    4.Where possible, we added the data from 1 of our 10 entity groups to the
    data from one or more of the entity categories that Census identified in
    our unknown group. For example, we added data for partnerships that Census
    identified to the data for our pass-through entity group.

    The entity groupings that we report in our figures and tables are defined
    as follows:

    Possessions corporations. All EINs associated with corporations that IRS
    identified as being a possessions corporation in 2002 and which were
    identified as operating in Puerto Rico.

    U.S. CFCs.2 This category contains all EINs belonging to corporations that
    (1) were reported on a form 5471 in 2001 or 2002; (2) were identified for
    us as U.S. CFCs by the Puerto Rico Industrial Development Company
    (PRIDCO), which gathered information from the Office of Industrial Tax; or
    (3) were incorporated outside of the United States, had no record of a
    filing a standard form 1120 (corporate tax return) or 1065 (partnership
    tax return) with IRS, and had names indicating they were members of one of
    the 77 large U.S. corporate groups operating in Puerto Rico. We divided
    this category into two groups, depending on whether a form 5471 or a
    Puerto Rican tax return identified the corporation as being incorporated
    in Puerto Rico or elsewhere.

    Other U.S. Corporations. This category contains EINs of corporations that
    were incorporated in the United States, but were not possessions or
    pass-through (partnership) corporations.

    Other corporations incorporated in Puerto Rico. These were corporations
    for which we found Puerto Rican tax returns that identified the place of
    incorporation as Puerto Rico, but which did not meet the criteria we used
    to identify CFCs.

    Corporations of type unknown. The overwhelming majority of the EINs that
    we sent to Census in this group were for employers that we determined to
    be corporations (because their name did not suggest they were a
    partnership or LLC, they filed a form 1120-F [tax return of a foreign
    corporation], or their name indicated that they were corporations) and for
    which we had no indicator of a place of incorporation. We also included
    small numbers of three other types of corporations in this category
    because disclosure constraints prevented us from reporting on them
    separately. They are (1) CFCs for which we could not determine a place of
    incorporation, (2) corporations that were incorporated outside of the
    United States or Puerto Rico but which were not CFCs, and (3) nonprofit
    corporations that Census identified from our unknown group but whose data
    they suppressed.3

    Sole proprietors. This category contains EINs that were associated with
    sole proprietors in IRS's records or in Census's surveys.

    Pass-through entities. This category contains EINs for employers that IRS
    reported to have filing requirements as partnerships or subchapter S
    corporations, or that had names on Puerto Rican tax returns indicating
    that they were partnerships or LLCs.

    Other entities. The IRS codes that we used to identify EINs that we put in
    this category covered government agencies, churches, nonprofits, estates
    and trusts, political organizations, homeowners organizations, and
    settlement funds. This does not imply that the Census population of
    employers included all these type of entities. We also included in this
    category the data that Census provided to us relating to nonprofit
    corporations.

    Appendix IV  Additional Data on Possessions Corporations and Their Affiliates

    Table 14: Selected Data for the Full Population of Possessions
    Corporations Operating in Puerto Rico, 1993-2003

           Dollars in billions (constant 2005)
                                                    1993 1995 1997 1999 2001 2003
    Number of corporations claiming tax credit    378  332  291  204  158  124
    Amount of tax credit                         $5.8 $3.7 $3.2 $1.8 $1.4 $1.1
    Total income                                 28.8 28.6 32.3 27.0 20.5 13.3
    Gross profits                                24.8 26.1 30.1 24.8 18.8 12.1
    Net income                                   16.7 15.9 17.3 13.3  9.5  7.3
    Total assets                                 59.5 59.6 58.7 54.9 45.3 41.1

    Source: GAO analysis of IRS data.

    Table 15: Selected Data for Large Corporate Groups Operating in Puerto
    Rico, by Type of Entity, 1993-2003

        Dollars in billions (constant 2005)
                                               1993  1995  1997  1999  2001  2003
    Number of corporations
    Possessions corporations                 136   146   127   105    79    58
    CFCs                                                  34    43    49
    Other                                                       25    28
    Possessions tax credit
    Possessions corporations                $5.5  $3.5  $3.0  $1.7  $1.3  $1.1
    Total income
    Possessions corporations                26.7  26.8  30.7  25.9  19.8  12.5
    Lower bound for CFCs                                 2.4   5.2   7.4
    CFC total if allocated by tax ratio                  3.0   7.2  11.5
    Other affiliates                                           3.3   7.5
    Gross profit
    Possessions corporations                22.9  24.4  28.8  23.9  18.1  11.4
    Lower bound for CFCs                                 2.4   5.3   7.1
    CFC total if allocated by tax ratio                  3.0   7.5  11.5
    Other affiliates                                           3.0   7.0
    Net income
    Possessions corporations                15.9  15.1  16.6  12.8   9.3   7.1
    Lower bound for CFCs                                 1.6   2.4   3.9
    CFC total if allocated by tax ratio                  1.9   3.4   6.0
    Other affiliates                                           2.1   5.8
    Total assets
    Possessions corporations                54.3  54.4  54.4  50.8  42.3  38.2
    Lower bound for CFCs                                 7.8  14.5  16.7
    Other affiliates                                           6.7   7.2

    Source: GAO analysis of data from IRS and the Puerto Rican Department of
    Treasury.

    Table 16: Selected Data for Large Corporate Groups Operating in the
    Chemical and Medical Equipment Industries in Puerto Rico, by Type of
    Entity, 1993-2003

        Dollars in billions (constant 2005)
                                               1993  1995  1997  1999  2001  2003
    Number of corporations
    Possessions corporations                  74    74    60    52    38    27
    CFCs                                                  15    21    26
    Other                                                       17    18
    Possessions tax credit
    Possessions corporations                $3.1  $2.3  $2.2  $1.2  $0.9  $0.8
    Total income
    Possessions corporations                15.9  18.2  22.0  19.4  13.0   9.3
    Lower bound for CFCs                                 1.8   3.7   4.7
    CFC total if allocated by tax ratio                  1.8   5.7   8.8
    Other affiliates                                           2.8   7.3
    Gross profit
    Possessions corporations                15.4  17.0  21.0  18.3  12.0   8.6
    Lower bound for CFCs                                 1.8   4.0   4.8
    CFC total if allocated by tax ratio                  1.8   6.1   9.1
    Other affiliates                                           2.7   6.9
    Net Income
    Possessions corporations                 8.9  10.7  12.4  10.2   6.8   5.5
    Lower bound for CFCs                                 1.2   2.3   2.8
    CFC total if allocated by tax ratio                  1.2   3.4   4.8
    Other affiliates                                           2.0   5.8
    Total assets
    Possessions corporations                29.7  32.7  30.1  33.1  25.2  23.3
    Lower bound for CFCs                                 2.3   4.9   7.7
    Other affiliates                                           5.5   6.0

    Source: GAO analysis of data from IRS and the Puerto Rican Department of
    Treasury.

    Table 17: Selected Data for Large Corporate Groups Operating in the
    Computer, Electronics, and Electrical Equipment Industries in Puerto Rico,
    by Type of Entity, 1993-2003

         Dollars in
          billions
    (constant 2005)
                                     Large
                        computer/electronics/electrical
                               equipment groups
                                                    1993 1995 1997 1999 2001 2003
    Number of
    corporations
    Possessions                                    15   29   25   16   13   11
    corporations
    CFCs                                                     10   10   12
    Other                                                          6    4
    Possessions tax
    credit
    Possessions                                  $1.2 $0.3 $0.2 $0.1 $0.1 $0.1
    corporations
    Total income
    Possessions                                   3.9  1.9  2.1  0.8  1.8  0.6
    corporations
    CFCs                                                    0.2  0.2  0.3
    Other                                                        0.5  0.1
    affiliates
    Gross profit
    Possessions                                   1.6  1.8  2.0  0.7  1.7  0.4
    corporations
    CFCs                                                    0.2  0.2  0.2
    Other                                                        0.4  0.0
    affiliates
    Net income
    Possessions                                   3.3  1.1  1.0  0.5  0.5  0.5
    corporations
    CFCs                                                    0.1  0.2  0.2
    Other                                                        0.1  0.0
    affiliates
    Total assets
    Possessions                                   3.3  5.0  5.2  2.8  2.1  1.7
    corporations
    CFCs                                                    0.5  0.7  2.3
    Other                                                        1.2  0.8
    affiliates

    Source: GAO analysis of data from IRS and the Puerto Rican Department of
    Treasury.

    Table 18: Selected Data for Large Corporate Groups Operating in the Food
    and Kindred Products Industries in Puerto Rico, by Type of Entity,
    1993-2003

        Dollars in billions
          (constant 2005)
                               Possessions corporations
                                in the large food and
                               kindred products groups
                                                    1993 1995 1997 1999 2001 2003
    Number of corporations                         14   17   17   15   11    6
    Possessions tax credit                        0.7  0.4  0.2  0.2  0.2  0.1
    Total income                                  3.1  3.0  2.3  4.0  3.9  1.6
    Gross profit                                  2.9  2.3  1.8  3.2  3.4  1.6
    Net income                                    2.1  1.8  1.5  1.6  1.5  0.9
    Total assets                                  5.4  6.4  9.2 10.6 11.3  9.8

    Source: GAO analysis of data from IRS and the Puerto Rican Department of
    Treasury.

    Note: Other affiliates of possessions corporations had less than $0.1
    billion of all of these measures.

    Table 19: Distribution of Tax Credits, Income, and Assets of Possessions
    Corporations Operating in Puerto Rico, by Industry, 1993-2003

                         Percent
                                                    1993 1995 1997 1999 2001 2003
    Possessions tax credit
    Apparel                                       1.2  1.9  2.4  6.1  5.7  0.8
    Beverages and tobacco                        12.8 10.8  6.6  9.3 12.7 10.8
    Computers, electronics, and electrical       21.5  9.4  8.2  8.5  9.7 13.8
    equipment
    Medical equipment                             8.6 10.1 11.3  9.8 11.6  7.8
    Nonmanufacturing                              3.7  4.8  4.9  2.4  2.7 10.6
    Other manufacturing                           5.7  7.4  6.0  6.4  6.7  5.8
    Pharmaceuticals                              46.5 55.7 60.5 57.6 50.9 50.4
    Total income
    Apparel                                       0.8  1.1  1.0  1.4  1.7  1.1
    Beverages and tobacco                        10.9 10.4  6.9 14.6 19.2 12.5
    Computers, electronics, and electrical       14.7  7.3  7.0  3.1  9.0  5.4
    equipment
    Medical equipment                             7.9  7.7  9.3  6.3  7.6  7.8
    Nonmanufacturing                             10.0  9.1  8.9  5.4  4.6  6.1
    Other manufacturing                           5.8  6.0  4.2  2.8  3.4  3.7
    Pharmaceuticals                              49.9 58.4 62.7 66.4 54.4 63.5
    Gross profits
    Apparel                                       0.9  1.2  1.0  1.5  1.8  1.2
    Beverages and tobacco                        12.1  8.7  5.8 12.9 18.2 13.5
    Computers, electronics, and electrical        7.2  7.5  7.0  3.2  9.8  3.6
    equipment
    Medical equipment                             8.7  7.9  9.3  6.3  7.8  6.9
    Nonmanufacturing                              7.9  9.0  8.7  4.3  2.9  4.8
    Other manufacturing                           6.5  5.8  4.2  2.7  3.8  4.0
    Pharmaceuticals                              56.6 60.0 64.0 69.1 55.8 66.0
    Net income
    Apparel                                       1.2  1.8  1.6  2.5  3.0  1.5
    Beverages and tobacco                        13.0 11.7  8.5 12.1 16.0 11.6
    Computers, electronics, and electrical       21.3  7.7  6.0  3.8  5.9  7.1
    equipment
    Medical equipment                             8.8  9.3 10.9  6.2  8.4  8.9
    Nonmanufacturing                              3.9  3.4  2.8  1.6  1.6  0.8
    Other manufacturing                           5.7  6.6  4.5  2.0  1.5  2.1
    Pharmaceuticals                              46.2 59.6 65.7 71.8 63.6 67.9
    Total assets
    Apparel                                       0.5  0.5  0.5  0.8  2.5  3.0
    Beverages and tobacco                         9.5 11.1 16.0 19.4 25.2 25.4
    Computers, electronics, and electrical        6.3  8.9  7.9  5.6  4.9  4.4
    equipment
    Medical equipment                            10.8 12.9 10.7  5.1  5.4  6.4
    Nonmanufacturing                             21.1 10.2 12.9 11.7 10.9 11.6
    Other manufacturing                           9.0  8.1  7.0  5.9  5.5  3.4
    Pharmaceuticals                              42.8 48.3 45.1 51.5 45.6 45.7

    Source: GAO analysis of data from IRS.

    Appendix V  Additional Data on the Distribution of Business Activity by Type of
    Business Entity

    (Page is left blank intentionally.)

    Table 20: Employment in Puerto Rican Manufacturing by Industry and
    Business Entity Type, 2002

    Source: GAO analysis of IRS data and custom tabulations from the 2002
    Economic Census of Island Areas provided by the U.S. Census Bureau.

    Notes: We use the symbol (D) in this table to represent data that Census
    withheld to avoid disclosing information for individual companies.

    aCensus did not disclose specific figures for entities in the "all other
    employers" group in manufacturing. However, we were able to impute
    employment figures for this group by calculating the residual of employees
    not included in any other group.

    bThe data in this line do not include those for five partnerships that we
    were able to identify, but which we could not add into this line (see app.
    III for explanation). Data for those five partnerships, which together had
    between 100 and 249 employees, are included in the "all other employers"
    line.

    cThe data for sole proprietors are from the published version of the 2002
    Economic Census of Island Areas (see app. III for explanation).

    Table 21: Value Added in Puerto Rican Manufacturing by Industry and
    Business Entity Type, 2002

    Source: GAO analysis of IRS data and custom tabulations from the 2002
    Economic Census of Island Areas provided by the U.S. Census Bureau.

    Notes: We use the symbol (D) in this table to represent data that Census
    withheld to avoid disclosing information for individual companies.

    aCensus did not disclose specific figures for entities in the "all other
    employers" group in manufacturing. However, we were able to impute payroll
    figures for this group by calculating the residual of value added that was
    not included in any other group.

    bThe data in this line do not include those for five partnerships that we
    were able to identify, but which we could not add into this line. Data for
    those five partnerships, which together had between 100 and 249 employees,
    are included in the "all other employers" line.

    cThe data for sole proprietors are from the published version of the 2002
    Economic Census of Island Areas (see app. III for explanation).

    Table 22: Annual Payroll in Puerto Rican Manufacturing by Industry and
    Business Entity Type, 2002

    Source: GAO analysis of IRS data and custom tabulations from the 2002
    Economic Census of Island Areas provided by the U.S. Census Bureau.

    Notes: We use the symbol (D) in this table to represent data that Census
    withheld to avoid disclosing information for individual companies.

    aCensus did not disclose specific figures for entities in the "all other
    employers" group in manufacturing. However, we were able to impute payroll
    figures for this group by calculating the residual of payroll that was not
    included in any other group.

    bThe data in this line do not include those for five partnerships that we
    were able to identify, but which we could not add into this line. Data for
    those five partnerships, which together had between 100 and 249 employees,
    are included in the "all other employers" line.

    cThe data for sole proprietors are from the published version of the 2002
    Economic Census of Island Areas (see app. III for explanation).

    Table 23: Capital Expenditures in Puerto Rican Manufacturing by Industry
    and Business Entity Type, 2002

    Source: GAO analysis of IRS data and custom tabulations from the 2002
    Economic Census of Island Areas provided by the U.S. Census Bureau.

    Notes: We use the symbol (D) in this table to represent data that Census
    withheld to avoid disclosing information for individual companies.

    aCensus did not disclose specific figures for entities in the "all other
    employers" group in manufacturing. However, we were able to impute figures
    for this group by calculating the residual of capital expenditures that
    were not included in any other group.

    bThe data in this line do not include those for five partnerships that we
    were able to identify, but which we could not add into this line. Data for
    those five partnerships, which together had between 100 and 249 employees,
    are included in the "all other employers" line.

    cThe data for sole proprietors are from the published version of the 2002
    Economic Census of Island Areas (see app. III for explanation).

    Table 24: Value of Shipments in Puerto Rican Manufacturing by Industry and
    Business Entity Type, 2002

    Source: GAO analysis of IRS data and custom tabulations from the 2002
    Economic Census of Island Areas provided by the U.S. Census Bureau.

    Notes: We use the symbol (D) in this table to represent data that Census
    withheld to avoid disclosing information for individual companies.

    aCensus did not disclose specific figures for entities in the "all other
    employers" group in manufacturing. However, we were able to impute figures
    for this group by calculating the residual of value of shipments that were
    not included in any other group.

    bThe data in this line do not include those for five partnerships that we
    were able to identify, but which we could not add into this line. Data for
    those five partnerships, which together had between 100 and 249 employees,
    are included in the "all other employers" line.

    cThe data for sole proprietors are from the published version of the 2002
    Economic Census of Island Areas (see app. III for explanation).

    Table 25: Share of Employment for Puerto Rico's Manufacturing, Wholesale
    Trade, Retail Trade, and Services Sectors in 2002

    Source: GAO analysis of IRS data and custom tabulations from the 2002
    Economic Census of Island Areas provided by the U.S. Census Bureau.

    Notes: We use the symbol (D) in this table to represent data that Census
    withheld to avoid disclosing information for individual companies.

    aWe included nonprofits in the group labeled "other employers." However,
    Census included these employers in the group labeled "corporations of type
    unknown." In order to be consistent with the groups that we created for
    the manufacturing sector, we removed nonprofits from Census's
    "corporations of type unknown" and combined them with our "other
    employers" group, whenever possible.

    bCensus did not disclose specific employment figures for entities in the
    "other employers" group. However, we were able to impute employment
    figures for this group by calculating the residual of employees not
    included in any other group.

    Table 26: Share of Sales and Value of Shipments for Puerto Rico's
    Manufacturing, Wholesale Trade, Retail Trade, and Services Sectors in 2002

    Source: GAO analysis of IRS data and custom tabulations from the 2002
    Economic Census of Island Areas provided by the U.S. Census Bureau.

    Notes: We use the symbol (D) in this table to represent data that Census
    withheld to avoid disclosing information for individual companies.

    aWe generally included nonprofits in the group labeled "other employers,"
    however, for wholesale trade some nonprofits are included in the group
    labeled "corporations of type unknown," as a result of the disclosure
    constraints under which we worked (see app. III for details).

    bCensus did not disclose specific figures for employers in the "other
    employers" group in manufacturing. However, we were able to impute sales
    figures for this group by calculating the residual of sales not included
    in any other group.

    Table 27: Share of Payroll for Puerto Rico's Manufacturing, Wholesale
    Trade, Retail Trade, and Services Sectors in 2002

    Source: GAO analysis of IRS data and custom tabulations from the 2002
    Economic Census of Island Areas provided by the U.S. Census Bureau.

    Notes: We use the symbol (D) in this table to represent data that Census
    withheld to avoid disclosing information for individual companies.

    aCensus did not disclose specific figures for employers in the "other
    employers" group in manufacturing. However, we were able to impute payroll
    figures for this group by calculating the residual of employees not
    included in any other group.

    Appendix VI  Additional Comparative Fiscal Data

    This appendix provides more detail on how Puerto Rico's fiscal situation
    compares to the states and the other insular areas.

    Table 28: Federal, State, Commonwealth, and Insular Area Revenues
    Collected in Fiscal Year 2002a

    Source: GAO analysis of IRS, Customs, and Insular Area Treasury Department
    data.

    aData reflect fiscal year of the jurisdiction. The federal government's
    fiscal year and those of the other insular areas end September 30, 2002.
    Puerto Rico's and most states' fiscal years end June 30, 2002.

    bExcludes states with zero values.

    cAll federal tax figures represent net tax collections.

    dDoes not include the federal corporate income tax.

    eNot available, IRS does not report data separately for insular areas,
    other than Puerto Rico.

    fA more detailed breakdown is not available.

    gIncludes partnerships and tollgate taxes.

    hCensus data for income tax include dividend and interest income. Puerto
    Rican Treasury data listed these items separately. For the purpose of
    comparison we added them together.

    Additional Details on the Application of Federal Social ProgramsAppendix
    VII

    Education Programs

    Individuals with Disabilities Education Act Part B

    The Individuals with Disabilities Education Act (IDEA) is the primary
    federal law that addresses the unique needs of children with disabilities,
    including children with specific learning disabilities, speech and
    language impairments, mental retardation, and serious emotional
    disturbance. The law mandates that a free, appropriate public education be
    made available for all eligible children with disabilities. As such, local
    education agencies are required to provide accommodations for children as
    needed, including accommodations for instruction and assessment. IDEA also
    requires the inclusion of students with disabilities in state- and
    districtwide assessment programs and the placement of students in the
    least restrictive environment, to the maximum extent appropriate. Teachers
    and staff work with parents and special education experts to create
    individualized education programs (IEP) for students with disabilities.
    These IEPs outline academic goals, appropriate accommodations, and
    measurable objectives. IDEA provides grants to states to help them
    implement the requirements. All 50 states, Puerto Rico, and all insular
    areas must comply with IDEA requirements as a condition of funding. Part B
    of IDEA authorizes grants for children age 3 to 21 with disabilities and
    contains provisions regarding the structure of special education and
    related services and the procedural safeguards that guarantee the
    provision of a free and appropriate public education to children with
    disabilities. Information on the special education students and grants
    provided under IDEA part B for fiscal year 2002 is summarized in table 29.

    Table 29: Special Education Grant Allocation to, and Number of Students
    Covered by IDEA Part B in, the States and Puerto Rico Authorized by IDEA
    Part B, Fiscal Year 2002

                                  Total for the states, Puerto Rico   Puerto Rico
                                   Puerto Rico, and the             as percent of
                                    other insular areas                     total
    Special education                 $7,528,533,000 $67,879,755           0.9
    allocation
    Number of students                    48,995,357     596,502           1.2
    Number of students with                6,531,405      69,327           1.1
    individualized
    education programs

    Source: U.S. Department of Education.

    Title I of the Elementary and Secondary Education Act

    Title I of the Elementary and Secondary Education Act, reauthorized by the
    No Child Left Behind Act of 2001,1 is the largest federal program
    supporting elementary and secondary education; with annual expenditures of
    more than $10.3 billion, the Act accounts for about 3 percent of total
    education expenditures nationally. Title I is an important source of
    funding for many high-poverty school districts and individual schools as
    funds are directed toward states and school districts with greater numbers
    and percentages of poor children. Title I offers grants designed to help
    local education agencies and schools improve the teaching and learning of
    children failing, or most at risk of failing, to meet state academic
    standards. The program aims to ensure that all children have a fair,
    equal, and significant opportunity to obtain a high-quality education and
    reach or exceed proficiency on state academic achievement standards and
    assessments. Program goals can be accomplished by efforts including

    1.ensuring that high-quality academic assessments, accountability systems,
    teacher preparation and training, curriculum, and instructional materials
    are aligned with challenging state academic standards;

    2.meeting the educational needs of low-achieving children in the nation's
    highest-poverty schools, limited-English-proficient children, migratory
    children, children with disabilities, Indian children, neglected or
    delinquent children, and young children in need of reading assistance;

    3.closing the achievement gap between high- and low-performing children;

    4.holding schools, local educational agencies, and states accountable for
    improving the academic achievement of all students and identifying and
    improving low-performing schools, while providing alternatives to students
    in such schools to enable them to receive a high-quality education; and

    5.distributing and targeting resources sufficiently to make a difference
    to local educational agencies and schools where needs are greatest.

    Title I funds are provided to the states, Puerto Rico, and the other
    insular areas, and all must comply with the same requirements of the law
    as a condition of funding. Each location has established its own specific
    performance goals and program accountability system (e.g., academic
    assessments, graduation rates, teacher qualifications), consistent with
    federal regulations. Table 30 shows Title I grant data for Puerto Rico
    relative to national data for fiscal year 2002.

    Table 30: Title I Grant Allocation and Number of Covered Students, Fiscal
    Year 2002

                              Total for the states,  Puerto Rico   Puerto Rico as
                               Puerto Rico, and the              percent of total
                                other insular areas
    Title I grant                 $10.35 billion $333,295,520              3.3
    allocation
    Number of students                48,995,357      596,502              1.2

    Source: U.S. Department of Education.

    Food and Nutrition Programs

    The Child and Adult Care Food Program

    The Child and Adult Care Food Program (CACFP) serves nutritious meals and
    snacks to eligible children and adults who are enrolled for care at
    participating child-care centers, day-care homes, and adult day-care
    centers. CACFP also provides meals to children residing in homeless
    shelters and snacks to youths participating in after-school care programs.
    Meal providers in licensed care facilities or institutions receive
    reimbursement per meals served; meals must meet nutrition guidelines.
    Reimbursement rates are adjusted for changes in the consumer price index
    (CPI)2 for food-away-from-home. This program was started in 1975 as the
    Child Care Food Program. In 1989, the name of the program was changed to
    Child and Adult Care Food Program.3

    CACFP operates in the same way in the states, the U.S. Virgin Islands,
    Puerto Rico, and Guam, and has the following characteristics:

    o The target population includes children, chronically impaired adults,
    and adults 60 or older who eat meals in group settings, such as centers,
    homes, and shelters. Teenagers in after-school programs in low-income
    areas can also participate.

    o Public or private not-for-profit and for-profit centers may participate.
    For-profit centers must have at least 25 percent low-income participants;
    there is no similar requirement for not-for-profit centers.

    o In centers, participants from households with income at or below 130
    percent of the federal poverty level (FPL) can receive free meals, and
    those with income between 130 and 185 percent can receive reduced-price
    meals. Low-income day-care providers or day-care homes in low-income areas
    can receive reimbursement at higher rates than those for other homes.

    CACFP does not operate in CNMI and American Samoa; however, the Nutrition
    Assistance Program block grant can be used to provide such meals and
    snacks in American Samoa.

    Food Stamp and Nutrition Assistance Programs

    Created in 1964, the Food Stamp Program is intended to help low-income
    individuals and families obtain a more nutritious diet by supplementing
    their income with benefits to purchase food.4 The structure of the Food
    Stamp Program is the same in the states, the U.S. Virgin Islands, and
    Guam. Puerto Rico, CNMI, and American Samoa do not operate the Food Stamp
    Program; instead, they receive block grants from the federal government,
    which are referred to as Nutrition Assistance Programs, whose design and
    eligibility rules differ from those of the Food Stamp Program. Table 31
    summarizes the key features of these programs.

    Table 31: Comparison of the Food Stamp and Nutrition Assistance Programs

                         Food Stamp      Nutrition
                           Program      Assistance
                                         Programs
                       The states, the  Puerto Rico      CNMI         American
                         U.S. Virgin                                    Samoa
                        Islands, Guam
    Funding basis   Entitlement      Capped      Capped block    Capped block
                       based on number  block grant grant, the      grant
                       of               adjusted to amount of which adjusted to
                       participants;    reflect the is agreed to    reflect the
                       benefits         percent     annually in a   percent
                       adjusted         change in   memorandum of   change in the
                       annually to      the indexed understanding.  indexed level
                       reflect changes  level of                    of the
                       in the thrifty   the thrifty                 thrifty food
                       food plan.a      food plan.                  plan.
    Eligibility     Complex formula  Formula     Has its own     Has its own
    rules           based on         similar to  rules, some of  rules, some
                       household size,  Food Stamp  which differ    of which
                       income, assets,  Program.    from those in   differ from
                       and other                    the Food Stamp  the Food
                       factors.                     Program, to     Stamp
                       Generally,                   stay within the Program, to
                       household net                capped block    stay within
                       income cannot                grant.          the capped
                       exceed 100                                   block grant.
                       percent of the                               Serves only
                       federal poverty                              low-income
                       level. Hawaii,                               elderly,
                       Alaska, the                                  blind, and
                       U.S. Virgin                                  disabled
                       Islands, and                                 individuals.
                       Guam have
                       slightly
                       different
                       eligibility
                       criteria.
    Average monthly $84 for the 50   $103        $79             $103
    benefit amount  states, $92 for
    per person      the District of
    (fiscal year    Columbia, $119
    2003)           for the U.S.
                       Virgin Islands,
                       and $186 for
                       Guam.
    Administrative  States and       Block grant Block grant     Block grant
    costs           insular areas    and Puerto  funds all.      funds all.
                       each fund about  Rico each
                       half.            fund about
                                        half.

    Source: GAO analysis of U.S. Department of Agriculture (USDA) Food and
    Nutrition Service documents and interviews with program staff.

    aThe thrifty food plan is a market basket of foods for a nutritious,
    low-cost diet for a four-person reference family.

    National School Lunch Program

    The National School Lunch Program (NSLP) was created in 1946 to provide
    nutritionally balanced, low-cost or free lunches to children in public and
    not-for-profit private schools and residential child-care institutions.
    The program was expanded in 1998 to include snacks served in after-school
    and enrichment programs.5

    The NSLP operates in the same way in the states, the U.S. Virgin Islands,
    Puerto Rico, and Guam. The program provides free meals to children from
    families with incomes at or below 130 percent of the FPL.6 Children from
    families with incomes between 130 and 185 percent of the FPL can receive
    reduced-price meals for which no more than 40 cents may be charged.
    Children from families with incomes above 185 percent of the FPL pay full
    price. Local officials who administer the program decide what fees to
    charge for full-price meals and determine participants' eligibility. NSLP
    does not operate in CNMI or American Samoa, but funds provided under the
    Nutrition Assistance Program block grant support lunches and snacks for
    school age children in these insular areas.

    NSLP is an entitlement program. School districts and independent schools
    that take part in the lunch program are reimbursed for each meal served
    and get donated commodities from the U.S. Department of Agriculture
    (USDA). In return, they must serve lunches that meet federal nutrition
    requirements and offer free or reduced-price lunches to eligible children.
    Reimbursement rates are adjusted with changes in the CPI for
    food-away-from-home.7 The reimbursements rates for the 2003-2004 school
    year are summarized in table 32.

    Table 32: National School Lunch Program Reimbursement Rates, School Year
    2003-2004

    Reimbursement 48 contiguous Alaska Hawaii Puerto  Guam     The U.S. Virgin
         category           states                 Rico                   Islands
    Free                  $2.19  $3.55  $2.55  $2.19 $2.21               $2.36
    Reduced                1.79   3.15   2.15   1.79  1.81                1.96
    Full                   0.21   0.34   0.24   0.21  0.23                0.29

    Source: USDA Food and Nutrition Service documents.

    Special Supplemental Nutrition Program for Women, Infants, and Children

    The Special Supplemental Nutrition Program for Women, Infants, and
    Children (WIC) was created in 1972.8 WIC is designed to safeguard the
    health of low-income women who are pregnant, postpartum, or breastfeeding;
    infants; and children up to age 5 who are at nutritional risk.
    Participants receive supplemental nutritious foods, nutrition education
    and counseling, and screening and referrals to other health, welfare, and
    social services. WIC is a federal grant program for which Congress
    authorizes a specific amount each year. Participants' income must not
    exceed 185 percent of the FPL. They must also meet state residency
    requirements and be determined by a health professional to be at
    nutritional risk. WIC operates the same in the states, American Samoa,
    Guam, Puerto Rico, and the Virgin Islands. There is no WIC program in
    CNMI. Table 33 below provides estimated food and nutrition program federal
    expenditures for the states, Puerto Rico, and the other U.S. insular areas
    for fiscal year 2003.

    Table 33: Estimated Food and Nutrition Program Federal Expenditures for
    the States, Puerto Rico, and the Other U.S. Insular Areas, Fiscal Year
    2003

            Program           50      The  Puerto     The    Guam    CNMI American
                          States District    Rico    U.S.                    Samoa
                                       of          Virgin
                                 Columbia         Islands
    Food Stamp          $21.3    $90.1    $1.4   $18.5   $53.4    $7.1     $5.6
    Program/Nutrition billion  million billion million million million  million
    Assistance
    Program
    National School       7.0     16.5     123     4.6     3.8     5.0     11.2
    Lunch Program     billion  million million million million million  million
    WIC                   4.1     11.0     169     5.3     5.3    n.a.      5.9
                         billion  million million million million          million
    Child and Adult       1.9      3.1    20.0 597,000  54,000    n.a.     n.a.
    Care Food Program billion  million million

    Source: GAO analysis of USDA Food and Nutrition Service documents and
    interviews with program staff.

    Note: n.a. = Estimates not available.

    Health Care Financing and Grants Programs

    Medicare

    Created in 1965 as Title XVIII of the Social Security Act, Medicare
    provides health insurance coverage for the elderly and disabled, as well
    as for individuals with end-stage renal disease. The Medicare program
    covers beneficiaries in the states and American Samoa, CNMI, Guam, Puerto
    Rico, and the U.S. Virgin Islands. In fiscal year 2003, over 41 million
    beneficiaries had Medicare coverage, including nearly 600,000 in the U.S.
    insular areas, and Medicare spending represented the largest single source
    of federal health care spending nationwide.

    Medicare includes separate components, or "parts," that cover different
    types of services. Individuals eligible for Medicare automatically receive
    Hospital Insurance, known as Part A, which helps pay for inpatient
    hospital care, skilled nursing facility services following a hospital
    stay, certain home health services, and hospice care. U.S. residents aged
    65 or over are automatically entitled to Medicare Part A if they or their
    spouses are

    eligible for Social Security payments.9  Medicare-eligible individuals may
    elect to purchase Part B Supplemental Medical Insurance, which helps pay
    for certain physician, outpatient hospital care, laboratory, and other
    services. Part C encompasses private health plans that provide Medicare
    covered benefits to enrollees. Part D is the outpatient prescription drug
    benefit that was authorized in 2003 and was implemented in January 2006.
    In fiscal year 2003, federal Medicare expenditures totaled over $274
    billion. In that year, total Medicare enrollment in Puerto Rico was over
    574,000 and total expenditures were nearly $1.6 billion.

    Table 34: Estimated Medicare Enrollment and Expenditures as of July 2003,
    Fiscal Year 2003

                              Total for the states,  Puerto Rico   Puerto Rico as
                               Puerto Rico, and the              percent of total
                                other insular areas
    Enrollmenta                     40.2 million      575,000              1.4
    Federal expendituresb         $274.3 billion $1.6 billion              0.6

    Source: GAO analysis of data from the Centers for Medicare and Medicaid
    Services (CMS).

    aEnrollment includes individuals enrolled in Part A or Parts A and B of
    the program.

    bExpenditures include benefit payments and exclude program administration.

    Medicare beneficiaries in Puerto Rico and the other insular areas have
    been treated the same as those in the states in terms of eligibility and
    entitlement to benefits; however, certain structural differences, such as
    the methods used to calculate Medicare payments to hospitals, exist. For
    example, Medicare reimburses hospitals in Puerto Rico under a prospective
    payment system (PPS) distinct from the PPS used for hospitals in the
    states.10 Each of Puerto Rico's PPS rates is a "blended rate," comprising
    75 percent of the national rate used for hospitals in the states and 25
    percent of a local rate, which is lower than the national rate. The rates
    are further adjusted for each hospital using cost factors. These
    adjustments account for the lower costs of providing hospital services in
    Puerto Rico compared to the states and for differing costs among hospitals
    across Puerto Rico.

    The Medicare Part D prescription drug program marks the first time that
    Medicare beneficiaries in the insular areas are treated differently with
    regard to available benefits. In 2004 and 2005, Medicare beneficiaries in
    the states who enrolled paid a fee to receive a discount drug card, with
    an expected discount of 10 to 15 percent on covered drugs, and certain
    low-income beneficiaries who participated were entitled to assistance to
    subsidize drug costs, in an amount generally $600 per year. In contrast,
    beneficiaries in Puerto Rico and the other insular areas did not receive
    these direct benefits. Instead, each insular area was given a lump sum,
    which most, including Puerto Rico, used to subsidize Medicaid prescription
    drug coverage to certain low-income Medicare beneficiaries. The permanent
    Part D program, which went into effect in January of 2006, allows for
    similar coverage to most beneficiaries in the insular areas and states.
    However, as in the interim program, certain low-income beneficiaries in
    the insular areas will not directly receive funds to subsidize their
    prescription drug expenses. Instead, the insular areas' governments will
    receive a lump-sum payment and administer benefits to certain low-income
    beneficiaries based on a locally developed plan.

    Medicaid

    Created in 1965 as Title XIX of the Social Security Act, Medicaid is a
    federal-state health care financing program that covers medical and
    health-related services to certain categories of the country's low-income
    population, primarily children and individuals who are aged, blind, or
    disabled. Medicaid programs operate in each state, the District of
    Columbia, Puerto Rico, and the other insular areas.

    Table 35: Estimated Medicaid Enrollment and Federal Expenditures, Fiscal
    Year 2004

                               Total for the states, Puerto Rico   Puerto Rico as
                                Puerto Rico, and the             percent of total
                                 other insular areas
    Enrollmenta                      42.9 million     938,000              2.2
    Federal expenditures          $173.7 billionb      $219.4              0.1
                                                         million

    Source: GAO analysis of CMS and Puerto Rico data.

    aThe figure represents the number of enrollees in terms of person years.
    The total number of individuals served by Medicaid in 2004 was nearly 55
    million, some of whom were enrolled in the program for less than the full
    year. A similar number for total individuals served by Medicaid in Puerto
    Rico was not available.

    bThe figure includes expenditures for medical services and administration.

    The Medicaid programs in Puerto Rico and the other insular areas has
    financing, eligibility, service, and administrative requirements that
    differ from Medicaid requirements and operations in the states.

    Financing

    In the states, there are no limits on federal payments for Medicaid as
    long as the state contributes its share of program expenditures for
    services provided under a federally approved plan. A statutory formula is
    used to calculate the portion of each state's Medicaid expenditures for
    medical assistance that the federal government will pay, referred to as
    the federal matching percentage. The matching percentage varies by state,
    depending in part on the state's per capita income in relation to the
    national average, and ranges from 50 to no more than 83 percent of
    Medicaid expenditures.11 For fiscal year 2005, the highest federal
    matching percentage was 77.

    The federal share of expenditures in the insular areas is limited to a 50
    percent matching rate, and in contrast to the states, federal Medicaid
    spending for the insular areas is subject to statutory caps.12 For fiscal
    year 1999 and beyond, the spending caps are increased annually by the
    percentage increase in the medical-care component of the CPI for all urban
    consumers.

    Eligibility

    In the states, Medicaid requires coverage of certain categories of
    low-income individuals, including children, pregnant women, and aged and
    disabled individuals. For example, federal law requires coverage of
    pregnant women and children up to age 6 in families with incomes up to 133
    percent of the FPL, and children age 6 through age 18 in families with
    incomes up to 100 percent of the FPL. However, insular areas are not
    required to meet all Medicaid eligibility requirements, and in light of
    the statutory limits on federal funding, CMS does not hold these areas
    accountable for covering all Medicaid benefit requirements. For example,
    Puerto Rico and the U.S. Virgin Islands have implemented eligibility
    criteria that are more restrictive than federal standards. They determine
    Medicaid eligibility based on locally established poverty levels, which,
    at less than the federal poverty level, are more restrictive in terms of
    enrollment. According to officials in these areas, restricting eligibility
    allows them to target Medicaid services to fewer, albeit needier,
    individuals. Puerto Rico's locally established poverty level, called the
    Commonwealth poverty level (CPL) is currently $8,220 per year for a family
    of four and has not changed since 1998. In contrast, American Samoa, whose
    median household income is less than half that of the United States,
    neither uses specific categories to determine eligibility nor links
    eligibility to income levels that reflect local conditions. Instead, it
    considers every resident with an income at or below the federal poverty
    level-the majority of the population-as eligible for Medicaid.

    Services and Administration

    Medicaid also requires states to cover certain services in their Medicaid
    programs.13 Mandatory services include inpatient and outpatient hospital
    care; physician services; nursing home care; lab and x-ray services;
    immunizations and other early and periodic screening, diagnostic, and
    treatment (EPSDT) services for children under age 21; family planning
    services; health center and rural health-clinic services; and nurse
    midwife and nurse-practitioner services. Services that are optional
    include outpatient prescription drugs, institutional care for persons with
    mental retardation, personal care, and dental and vision care for adults.
    With certain exceptions, states' Medicaid programs must allow recipients
    freedom of choice among health-care providers participating in Medicaid.
    Also, overall administrative expenditures for states are not limited, and
    states receive a 50 percent federal match for most types of administrative
    expenditures.14

    Despite federal requirements for mandatory coverage of certain services,
    the Medicaid programs in the insular areas do not cover all mandatory
    services. For example, while Puerto Rico has skilled nursing facilities
    and home health services, its Medicaid program does not include them in
    its benefit package. Similarly, other mandatory Medicaid services, such as
    nurse midwife services, are also not covered by Puerto Rico's Medicaid
    program.15 However, Puerto Rico and the other insular areas have all
    chosen to add optional benefits under the statute, such as outpatient
    prescription drug coverage. In addition, as is the case with all the
    insular areas, Puerto Rico is exempt from freedom of choice requirements
    that apply to states' Medicaid programs. Also, federal spending for
    administrative expenditures in Puerto Rico and the other insular areas are
    subject to their respective Medicaid caps.

    State Children's Health Insurance Program

    The State Children's Health Insurance Program (SCHIP) was enacted in 1997
    as Title XXI of the Social Security Act to provide health care coverage to
    low-income, uninsured children living in families whose incomes exceed the
    states' eligibility limits for Medicaid.16 In general, states and insular
    areas may design their SCHIP programs in one of three ways-by expanding
    their Medicaid programs, developing separate child health programs that
    function independently of Medicaid, or combining these two approaches. As
    of April 2005, 17 states and insular areas opted to expand their Medicaid
    programs, 18 states opted to develop separate programs, and 21 states had
    combination programs. An SCHIP Medicaid expansion must follow Medicaid
    rules, including enrollment structure and benefits. A state that chooses a
    separate program has greater flexibility in designing its SCHIP program
    and may introduce limited cost-sharing or offer different benefit
    packages. While Puerto Rico expanded its Medicaid program to cover
    additional children, none of the other insular areas has developed a
    unique SCHIP program to extend health insurance coverage to additional
    children as is done in the states.17 Instead, the insular areas, besides
    Puerto Rico, primarily use SCHIP funds to pay for services provided to
    Medicaid-eligible children once the Medicaid cap has been reached.

    Table 36: Estimated SCHIP Enrollment and Federal Allotments, Fiscal Year
    2004

                             Total for the states,   Puerto Rico   Puerto Rico as
                              Puerto Rico, and the               percent of total
                               other insular areas
    Enrollmenta                     4.1 million        78,785              1.9
    Federal allotments           $3.175 billion $30.3 million              1.0

    Source: GAO analysis of CMS and Puerto Rico data.

    aThe SCHIP enrollment figure represents the number of enrollees in terms
    of person years. The total number of individuals served by SCHIP in 2004
    was 6.1 million, some of whom were enrolled in the program for less than
    the full year. A similar number for total individuals served by the SCHIP
    program in Puerto Rico was not available.

    In contrast to Medicaid, where federal funding to states is open-ended,
    the SCHIP statute provides for an annual allotment for each state, Puerto
    Rico, and the other insular areas for fiscal years 1998 through 2007. The
    insular areas, including Puerto Rico, receive a total of 0.25 percent of
    the annual nationwide SCHIP appropriation,18 which is allotted among them
    based on set percentages.19 The SCHIP statute also provides for an
    enhanced federal matching rate that exceeds the rates established by
    Medicaid. The SCHIP enhanced match is equal to each state's and insular
    area's Medicaid matching rate plus 30 percent of the difference between
    the Medicaid match and 100 percent, not to exceed a federal share of 85
    percent. Thus, states that receive the minimum 50 percent Medicaid match,
    receive a 65 percent match under SCHIP. Similarly, because the Medicaid
    match rate for all insular areas is set at 50 percent, they also receive a
    65 percent match rate under SCHIP.

    As with the Medicaid program, eligibility for SCHIP in Puerto Rico is tied
    to its CPL. In 1998, Puerto Rico implemented its SCHIP program for
    children under age 19 with family incomes between 100 and 200 percent of
    the CPL. As a Medicaid expansion, Puerto Rico's SCHIP program covers the
    same benefits and services as provided under its Medicaid program, which
    are similar, but not the same, as those provided in the states. For states
    and insular areas, SCHIP administrative expenses are limited to 10 percent
    of available expenditures.

    Health Grants

    The states and insular areas also receive health-related grants from a
    number of agencies within the Department of Health and Human Services
    (HHS), including the Centers for Disease Control and Prevention (CDC), the
    Health Resources and Services Administration (HRSA), the National
    Institutes of Health (NIH), and the Substance Abuse and Mental Health
    Services Administration (SAMHSA). These four agencies represent the
    largest sources of health-related HHS grant funds apart from Medicare,
    Medicaid, and SCHIP.20 Grants from these agencies may be used to fund a
    variety of services and activities, including immunization programs,
    bioterrorism preparedness programs, community health centers, programs for
    individuals with HIV or AIDS, maternal and child health grants, scientific
    medical research, and substance abuse prevention and treatment. Grants
    from CDC, HRSA, and SAMHSA tend to fund direct health service programs and
    are often awarded to public health agencies, while NIH grants fund
    scientific medical research and are generally awarded to universities.

    Table 37: Population and Estimated Grant Awards from Four Health and Human
    Service Agencies, Fiscal Year 2004

            Dollars in millions
                                      Total for the states, Puerto Puerto Rico as
                                       Puerto Rico, and the   Rico     percent of
                                        other insular areas                 total
    Populationa                                    285.6    3.8            1.3
    Total awards from four HHS                 $33,550.4 $272.5            0.8
    agencies
    Center for Disease Control and               4,480.5   47.5            1.1
    Prevention (CDC)
    Health Resources and Services                5,857.6  131.8            2.2
    Administration (HRSA)
    National Institutes of Health               20,336.1   59.7            0.3
    (NIH)
    Substance Abuse and Mental                   2,876.2   33.5            1.2
    Health Services Administration
    (SAMHSA)

    Source: GAO analysis of HHS Tracking Accountability in Government Grants
    System data.

    aPopulation figures are based on the 2000 census and include the states
    and insular areas.

    In general, the process Puerto Rico and the other insular areas must
    follow to apply for federal grants are the same as in the states. However,
    differences exist in how some grant awards are calculated. For example,
    Puerto Rico and the other insular areas are treated differently from the
    states for two of SAMHSA's grants: The Community Mental Health Block Grant
    and the substance abuse prevention and treatment block grant. These grants
    are allocated among the states based on a set formula with a minimum
    amount for each state. In contrast, Puerto Rico and the other insular
    areas receive 1.5 percent of the total appropriation in block grant funds.
    The funds are divided among each insular area according to its share of
    the total insular area population.21 However, Puerto Rico is treated as a
    state for certain other grants, such as the bioterrorism grants from HRSA
    and CDC.

    Income Assistance Programs

    Aid to the Aged, Blind, or Disabled

    The Social Security Amendments of 197222 created Supplemental Security
    Income (SSI), a cash payment entitlement program that replaced grant
    programs providing economic assistance to low-income adults who are aged,
    blind, or disabled in the states. Eligibility for SSI was extended to
    CNMI, effective 1978. The SSI program does not include Puerto Rico,
    American Samoa, Guam, or the U.S. Virgin Islands.

    Instead, for adults in these groups, these insular areas have continued to
    operate their grant programs that existed before SSI was created. Puerto
    Rico, for example, operates an adult assistance program-Aid to the Aged,
    Blind, or Disabled (AABD). The federal government provides a grant in the
    form of a 75 percent match of state funds for payments for AABD
    recipients-subject to a cap on Puerto Rico's combined payments for
    Temporary Assistance for Needy Families (TANF-see below), AABD, and foster
    care and related payments-and a 50 percent match for administrative
    expenses. In contrast to SSI, which has federally determined cash
    benefits, Puerto Rico determines its own benefit amounts for AABD. In
    fiscal year 2003, the federal government provided $21 million in benefits
    to 41,567 AABD recipients. Puerto Rico provided a monthly benefit of $64
    for one person. In contrast, the monthly SSI benefit rate for one person
    not living independently was $368 in January 2003.

    Temporary Assistance for Needy Families

    The Personal Responsibility and Work Opportunity Reconciliation Act of
    1996 (PRWORA) repealed the Aid to Families with Dependent Children, Job
    Opportunities and Basic Skills Training, and Emergency Assistance programs
    and created TANF.23 The purposes of TANF are to increase state flexibility
    in operating a program to (1) help needy families care for children at
    home; (2) end dependence of needy parents upon government benefits by
    promoting job preparation, work, and marriage; (3) reduce out-of-wedlock
    pregnancies; and (4) encourage formation and maintenance of two-parent
    families. TANF has a 5-year time limit on federal cash assistance for most
    families and requires states to impose federally established work and
    other program requirements on most adults receiving aid. Otherwise, states
    and insular areas have broad flexibility to design their own eligibility
    rules and the types of services provided.

    The insular areas participating in TANF are subject to the same
    requirements as the states, although these insular areas are not eligible
    to receive all of the five TANF grants. The states and Puerto Rico, Guam,
    and the U.S. Virgin Islands operate TANF programs.24 American Samoa does
    not participate in TANF, and CNMI is not eligible because it was not
    included in PRWORA. Federal funding for Puerto Rico, Guam, the U.S. Virgin
    Islands, and American Samoa is capped for TANF, AABD, foster care and
    adoption assistance, and independent living programs. The federal
    government provides a basic TANF block grant to cover benefits,
    administrative expenses, and services targeted to needy families in the
    states and insular areas. The amount of the grant reflects expenditures in
    pre-TANF programs. To receive this grant, states and insular areas must
    provide at least 75 percent of the amount of state funds they spent on
    programs replaced by TANF in fiscal year 1994. Like the states, Puerto
    Rico, Guam, and the U.S. Virgin Islands can receive additional TANF
    bonuses for high performance and a reduction in out-of-wedlock births.
    Furthermore, a special provision allows the insular areas to receive
    funding above their federal TANF grant if certain conditions are met.
    Puerto Rico did not qualify to receive such funding in fiscal year 2003.25
    The insular areas are not eligible to receive contingency funds or
    supplemental grants for population increases that states may qualify to
    receive. Table 38 compares selected TANF program data on Puerto Rico to
    national data for fiscal year 2003.

    Table 38: Comparison of Selected Data on TANF Program in Puerto Rico to
    TANF Program in the States, Fiscal Year 2003

                                      The states, Puerto Rico, and    Puerto Rico
                                        the other insular areas
    Total federal expenditure      $16.25 billiona              $38.38 million
    State expenditures at 75       $10.35 billiona              $21.19 million
    percent rate
    Total number of recipients (as 4.96 millionb                        54,544
    of March 2003)
    Monthly TANF benefits for a    Ranges from $170 to $923,              $160
    family of three                depending on state

    Sources: U.S. Department of Health & Human Services, Congressional
    Research Service: TANF Cash Benefits As of January 1, 2004, Puerto Rico
    fiscal year 2003 State Plan.

    aIncludes only the states, not Puerto Rico or the other insular areas.

    bIncludes the states, Guam, the U.S. Virgin Islands, and Puerto Rico.

    Programs for the Care of Children

    Child Care and Development Fund

    PRWORA increased the amount of federal funding for child-care subsidies
    for low-income families, with the expectation that the newly implemented
    work requirements for welfare recipients-many of whom are single
    mothers-would create a greater demand for child-care services as
    recipients went to work or participated in training or education. Funding
    is provided through two funding streams: one discretionary and one
    mandatory. These two streams constitute the Child Care and Development
    Fund (CCDF).

    All states and all insular areas are eligible to receive CCDF funds. All
    states and insular areas can receive funds under the discretionary portion
    of CCDF, but only the states can receive funds under the mandatory portion
    of the grant. Funding amounts for the discretionary portion of CCDF are
    determined in the annual appropriations process, while funding amounts for
    the mandatory portion are directly appropriated by the welfare reform law.
    CCDF gives states and insular areas greater flexibility to design their
    child-care policies than previous federal child-care policy.

    Table 39: Child Care and Development Fund Expenditures and Children
    Served, Fiscal Year 2003

                                     States, Puerto Rico, and the     Puerto Rico
                                              other insular areas
    Expenditures                                $7.25 billiona $57.15 millionb
    Number of children served                    1.75 millionc         25,917d

    Source: U.S. Department of Health & Human Services.

    aIncludes mandatory, matching, and discretionary CCDF funds for the
    states, Puerto Rico, and the other insular areas.

    bIncludes only discretionary funds.

    cAverage number of children served per month for the states, American
    Samoa, and Guam.

    dTotal number of children served for entire year.

    Foster Care and Adoption Assistance Funds

    Title IV-E of the Social Security Act authorizes the foster care and
    adoption assistance programs.26 These programs provide federal funds to
    help offset child welfare costs related to providing (1) safe, appropriate
    substitute care for children who need temporary placement outside their
    homes because of abuse and neglect, and (2) subsidies to families or
    individuals adopting children who meet certain eligibility requirements.
    The states and Puerto Rico participate in these programs and receive
    federal funds for their administration. Table 40 shows the total child
    welfare population and data for Puerto Rico for fiscal year 2001.

    Table 40: Estimated Child Welfare Population, Fiscal Year 2001

                            Total for the states and Puerto Rico   Puerto Rico as
                                         Puerto Rico             percent of total
    Children in foster                    542,000       8,476              1.6
    care
    Children waiting to                   126,000         418              0.3
    be adopteda
    Children adopted                       50,000         257              0.5

    Source: Adoption and Foster Care Analysis and Reporting System,
    preliminary estimates for fiscal year 2001 (as of March 2003), as reported
    in U.S. Department of Health and Human Services, Administration for
    Children and Families, Administration on Children, Youth, and Families,
    Children's Bureau, Child Welfare Outcomes 2001: Annual Report to Congress.

    aWaiting children are children who have a goal of adoption or whose
    parents' parental rights have been terminated.

    For Puerto Rico, foster care and adoption assistance are two of several
    public assistance programs that are subject to a federal funding cap,
    under the 1996 federal welfare law that created the TANF block grant.27
    The total payment to Puerto Rico for all of these programs-adult
    assistance, TANF, foster care, adoption assistance, and independent
    living-cannot exceed $107,255,000.

    Federal funds are set at the applicable Medicaid matching rate. In fiscal
    year 2003, the matching rate, which ranged from 50 to 83 percent
    nationwide, was 50 percent for Puerto Rico. States and insular areas may
    also claim funds at a rate of 50 percent for administrative costs and at a
    rate of 75 percent for training costs. In 2003, Puerto Rico did not claim
    either.

    Table 41: Estimated Federal Foster Care and Adoption Assistance Funding,
    Fiscal Year 2003

                             Federal share for Federal share for   Puerto Rico as
                                the states and       Puerto Rico percent of total
                                   Puerto Rico
    Adoption Assistance       $1.17 billion          $373,000              3.2
    Payments
    Foster Care               $1.69 billion       $14 million            0.008
    Payments

    Source: Title IV-E State Claims for Expenditures for fiscal year 2003 (as
    of May 2004) for Adoption and Foster Care. U.S. Department of Health and
    Human Services, Administration for Children and Families, Administration
    on Children, Youth, and Families, Children's Bureau.

    Note: According to HHS, for both foster care and adoption, Puerto Rico's
    claims for the 4th quarter of fiscal year 2003 were estimated using the
    average of the previous three quarters.

    Housing Programs

    Public Housing Program

    The public housing program was authorized by the United States Housing Act
    of 1937 to provide decent, safe, and affordable housing for low-income
    families through public housing authorities (PHA).28 Through this program,
    eligible families are able to rent units in single-family or multifamily
    public housing properties, such as high-rise apartments. Families are
    generally required to pay 30 percent of their monthly adjusted household
    income in rent.

    Administration and Funding

    Public housing is owned and operated by approximately 3,200 PHAs
    nationwide. Each PHA is responsible for operating and maintaining its
    public housing inventory and managing the selection of residents.

    Public housing can be developed through the construction of units on a
    site owned by a PHA, development of units on a developer-owned site that
    is sold to the PHA after completion, or through units that the PHA
    purchases. The Department of Housing and Urban Development (HUD) has not
    provided new funding for public housing development since fiscal year
    1994. However, PHAs can use capital and HOPE VI funding (see below) for
    development.

    HUD provides annual formula-based subsides to PHAs to operate and maintain
    public housing. These subsidies, which consist of operating and capital
    (formerly modernization) funds, supplement rent paid by tenants.

    Public Housing in Puerto Rico and Other Insular Areas

    Operating subsidies for PHAs in the states, Puerto Rico, the U.S. Virgin
    Islands, and Guam are generally calculated by subtracting estimated rental
    income from the allowable utility and nonutility expense levels.29
    However, these expenses for Puerto Rico, the U.S. Virgin Islands, Guam,
    and Alaska were initially determined using a slightly different
    methodology than that used in most of the states. A HUD public housing
    fund regulation changed the way operating subsidies are calculated for
    Puerto Rico, the U.S. Virgin Islands, Guam, and Alaska-these PHAs will no
    longer receive funding for operating costs outside of the general
    operating fund formula.

    The capital fund grant formula is generally applied in the same way to
    PHAs in the states, Puerto Rico, and the other insular areas. Regulations
    governing the administration of public housing also apply to PHAs in the
    states, Puerto Rico, and the other insular areas. Eligibility rules are
    the same for all residents, regardless of where they live.

    The Puerto Rico Public Housing Administration (PRPHA) administered all
    56,524 units of public housing in Puerto Rico in fiscal year 2005. PRPHA
    ranked third among all PHAs in the amount of annual operating fund subsidy
    received in fiscal year 2002 (see table 42), and second in the number of
    public housing units (see table 43). HUD's Caribbean field office is
    responsible for overseeing PRPHA's administration of these units.

    Table 42: Estimated Amount and Percent of Total Operating Subsidy Received
    by the Five Largest Public Housing Authorities, Fiscal Year 2002

              Public housing authority        Operating subsidy  Percent of total
                                                     (millions) operating subsidy
    New York City Housing Authority                     $752                22
    Chicago Housing Authority                            182                 5
    Philadelphia Housing Authority                       102                 3
    Puerto Rico Public Housing                            96                 3
    Administration
    Housing Authority of Baltimore City                   61                 2
    National                                          $3,495               100

    Source: HUD.

    Table 43: Total Number and Percent of Public Housing Units for the Five
    Largest Public Housing Authorities, Fiscal Year 2005

               Public housing authority         Number of public Percent of total
                                                   housing units            units
    New York City Housing Authority                   161,389               13
    Puerto Rico Public Housing                         56,524                5
    Administration
    Chicago Housing Authority                          28,925                2
    Philadelphia Housing Authority                     16,027                1
    Housing Authority of Baltimore City                14,554                1
    National                                        1,200,000              100

    Source: HUD.

    In fiscal year 2004, PRPHA received approximately $148 million in capital
    fund grants (approximately 6 percent of that year's appropriation for the
    capital fund).

    Housing Choice Voucher Program

    The Housing Choice Voucher Program is HUD's largest housing assistance
    program. Authorized by the Housing and Community Development Act of 1974
    as the Rental Certificate Program, it assists extremely low- to low-income
    families in obtaining decent, safe, and sanitary rental housing.30

    Through this program, eligible families rent privately owned units that
    they would otherwise not be able to afford. Families pay a portion of the
    rent (generally 30 percent of their monthly income, less deductions), and
    the local PHA pays the remainder directly to the property owners.

    Program Administration and Funding

    Expiring increments of Section 8 housing voucher assistance are
    automatically renewed by HUD. Other vouchers are available either on an
    as-needed, noncompetitive basis or through competitive Notices of Funding
    Availability (NOFA).

    HUD is responsible for developing policies, regulations, and guidance for
    the program, allocating funds, providing technical assistance, and
    monitoring PHAs' compliance with program requirements. PHAs are
    responsible for determining eligibility, maintaining waiting lists,
    selecting families for admission, inspecting program units for compliance
    with housing quality standards, and making housing assistance payments to
    property owners. Property owners must be willing to participate in the
    program and are responsible for screening and selecting tenants,
    collecting tenants' share of the rent, and maintaining the property in
    compliance with the program's housing quality standards. Families with
    vouchers are responsible for choosing the house or apartment that they
    want to rent.

    Housing Choice Vouchers in Puerto Rico and the Other Insular Areas

    Like Puerto Rico, Guam, CNMI, and the U.S. Virgin Islands are eligible for
    Housing Choice Vouchers. HUD's Caribbean field office is responsible for
    overseeing PHAs' administration of Housing Choice Vouchers in Puerto Rico.
    The formula that HUD uses to determine the number of vouchers in a given
    area does not make any exceptions for Puerto Rico or the eligible insular
    areas. The regulations governing the administration of the voucher program
    apply to PHAs in the states, Puerto Rico, and the eligible insular areas.
    Eligibility rules are the same for all residents, regardless of where they
    live.

    In fiscal year 2003, PHAs in Puerto Rico received approximately $139
    million in funding from HUD to administer the voucher program, which was
    approximately 1.1 percent of total budget outlays for the voucher program
    for the fiscal year. Seventy-seven PHAs administered approximately 29,000
    vouchers in Puerto Rico, or 1.4 percent of total available vouchers.
    California and New York have the largest number of vouchers, CNMI and the
    U.S. Virgin Islands have the smallest number of vouchers, and Puerto Rico
    ranks 33rd among all the states and insular areas that have vouchers (see
    table 44).

    Table 44: Number of Housing Choice Vouchers and Estimated Budget Authority
    in Puerto Rico and Selected States and Insular Areas, Fiscal Year 2003

              State           Number of housing choice Estimated budget authority
                                              vouchers
    California                              294,701               $2.4 billion
    New York                                201,558               $1.3 billion
    Puerto Rico                              28,654               $139 million
    U.S. Virgin Islands                       1,029                 $7 million
    CNMI                                        215               $1.8 million
    National                              2,054,905            $12,827,326,159

    Source: HUD.

    Community Development Block Grant Program

    HUD's Community Development Block Grant Program (CDBG) is the largest
    source of federal assistance for state and local governments' community
    development and neighborhood revitalization activities. These programs
    include "entitlement grants"-which award grants to qualified units of
    general local government to provide decent housing and a sustainable
    living environment and to expand economic opportunities for low- and
    moderate-income individuals-and state-administered CDBG, which awards
    grants to states which in turn make grants to nonentitlement units of
    general local government to carry out similar developmental activities.

    Program Administration and Funding

    Under the entitlement communities program, HUD determines the amount of
    each grant by a statutory formula that uses several objective measures of
    community needs, including the extent of poverty, population, housing
    overcrowding, age of housing, and population growth lag relative to other
    metropolitan areas. To receive its annual grant, a grantee must develop
    and submit to HUD a consolidated plan, certifications, and application for
    funding. The development goals outlined in the plan serve as the criteria
    against which HUD will evaluate a jurisdiction's performance and future
    eligibility for funding.

    The state-administered CDBG program is designed to provide funding to
    nonentitlement areas, which do not receive CDBG funding as part of the
    entitlement grant program. HUD distributes funds to each state based on a
    statutory formula that takes into account population, poverty, incidence
    of overcrowded housing, and age of housing. Participating states award
    grants to eligible localities to carry out community development
    activities. Each state annually develops funding priorities and criteria
    for selecting projects. HUD ensures participating states' compliance with
    federal laws, regulations, and policies.

    CDBG in Puerto Rico and the Other Insular Areas

    For purposes of determining CDBG grants, Puerto Rico is considered a
    state. Thus, the laws and regulations governing the application for, and
    distribution and use of, CDBG funds apply to Puerto Rico and the states.
    HUD's Caribbean field office is responsible for overseeing the use of CDBG
    funds in Puerto Rico.

    Each fiscal year, the insular areas may apply for $7 million of CDBG
    funding. Grant amounts are based on population.

    Table 45 provides information on the total CDBG funding for fiscal years
    2001 through 2004, and the percentage of those funds that were used by
    eligible cities and states to fund housing initiatives.

    Table 45: Estimated Disbursement of CDBG Funds for Housing, Fiscal Years
    2001-2004

         Dollars in
          billions
                      Entitlement Nonentitlement/state-administered         Total
                          program                           program disbursements
                                                                            (both
                                                                        programs)
    Total CDBG            $3.5                              $1.2          $4.7
    funding,
    fiscal year
    2001
    Percent of            29.4                              15.1
    total funding
    used for
    housing
    initiatives,
    fiscal year
    2001
    Total CDBG            $3.8                              $1.3          $5.1
    funding,
    fiscal year
    2002
    Percent of            27.1                              15.1
    total funding
    used for
    housing
    initiatives,
    fiscal year
    2002
    Total CDBG            $3.4                              $1.3          $4.7
    funding,
    fiscal year
    2003
    Percent of            27.5                              14.9
    total funding
    used for
    housing
    initiatives,
    fiscal year
    2003
    Total CDBG            $3.5                              $1.4          $4.9
    funding,
    fiscal year
    2004
    Percent of            27.0                              16.4
    total funding
    used for
    housing
    initiatives,
    fiscal year
    2004

    Source: HUD.

    In fiscal year 2004, Puerto Rico received approximately $130 million in
    total CDBG funding-3 percent of total funding for the year. Collectively,
    Guam, the U.S. Virgin Islands, American Samoa, and CNMI received about
    $6.96 million in fiscal year 2004. Table 45 provides information on how
    areas in Puerto Rico receiving CDBG funds in fiscal year 2004 used some of
    their CDBG funds for housing-related initiatives.

    HOPE VI Program

    Originally known as the Urban Revitalization Demonstration, the HOPE VI
    Program was developed as a result of recommendations by the National
    Commission on Severely Distressed Public Housing. In its August 10, 1992,
    report to Congress, the commission recommended revitalization in three
    general areas: physical improvements, management improvements, and social
    and community services to address resident needs.

    On the basis of this recommendation, in October 1992, Congress
    appropriated $300 million for the Urban Revitalization Demonstration, also
    known as HOPE VI, as part of the Independent Agencies Appropriations Act
    of 1993.31 The program is designed to replace severely distressed public
    housing with mixed-income housing and to provide housing vouchers to
    enable some of the original public housing residents to rent apartments in
    the private market. The program was authorized through annual
    appropriations until fiscal year 1999 when it was separately authorized as
    part of the Quality Housing and Work Responsibility Act of 1998.32 In
    fiscal years 2004, 2005, and 2006 Congress appropriated $150 million, $144
    million, and $100 million, respectively, for the HOPE VI program.

    Program Administration and Funding

    Any PHA that has severely distressed public housing units is eligible to
    apply for a HOPE VI revitalization or demolition grant. HOPE VI
    revitalization grants fund capital costs of major rehabilitation, new
    construction, and other physical improvements; demolition of severely
    distressed public housing; acquisition of sites for off-site construction;
    and community and supportive service programs for residents, including
    those relocated as a result of revitalization efforts. HOPE VI demolition
    grants fund the demolition of severely distressed public housing and
    relocation of residents as a result of the demolition.

    HUD's requirements for HOPE VI grants are laid out in each fiscal year's
    grant agreement and NOFA, which announces the availability of funds and
    contains application requirements, threshold requirements, rating
    factors,33 and information on the application selection process. HUD has
    used the same procedure each year to screen, review, and rank grant
    applications: when grant applications are received, they are screened to
    determine whether they meet the eligibility and threshold requirements in
    the NOFA. Next, reviewers rate applications on the basis of the rating
    factors described in the NOFA and rank them. Generally, a group of
    applications representing twice the amount of funds available is sent to a
    final review panel. The final review panel assigns a final score and
    recommends for selection the highest rated applications, subject to the
    amount of available funding.

    HOPE VI in Puerto Rico and the Other Insular Areas

    HUD NOFA requirements and guidelines are generally applied to the PHAs in
    the states, Puerto Rico, and the other insular areas in the same way.
    HUD's Office of Public Housing Investments at HUD headquarters is
    responsible for monitoring the implementation of HOPE VI grants and
    revitalization plans.

    HOPE VI Grants

    Between fiscal years 1993 and 2003, PRPHA received one HOPE VI
    revitalization grant, of $50 million. In that same decade, HUD made a
    total of 217 revitalization grants worth approximately $5.5 billion to 118
    PHAs in 34 states, the District of Columbia, and Puerto Rico.34

    Between fiscal years 1996 and 2003, Puerto Rico did not receive a HOPE VI
    demolition grant. During the same period, the U.S. Virgin Islands received
    four such grants, totaling approximately $5 million. In that same period,
    HUD made 287 demolition grants worth $395 million to 125 PHAs in 34
    states, the District of Columbia, and the U.S. Virgin Islands.

    HOME Investment Partnerships Program

    The HOME Investment Partnerships Program is a federal formula block grant
    to state and local governments designed to create affordable housing for
    low-income households. The program provides funds to states and localities
    to build, buy, and rehabilitate affordable housing for rent or
    homeownership. Also, funds can be given to low-income people to help pay
    their rent. At least 90 percent of HOME funds used for rental housing and
    rental assistance must be used for families whose income is below 60
    percent of the median income in their area; in rental projects with five
    or more assisted units, at least 20 percent of the units must be occupied
    by families with incomes that do not exceed 50 percent of the median
    income. Homeownership assistance must benefit families below 80 percent of
    the median income in their area.

    Program Administration and Funding

    Program funds are allocated to state and local governments based on a
    formula that considers the relative inadequacy of each jurisdiction's
    housing supply, incidence of poverty, fiscal distress, and other factors.
    Shortly after HOME funds become available each year, HUD informs eligible
    jurisdictions of the amounts allocated for them. HUD establishes trust
    funds for each grantee, providing a line of credit that the jurisdiction
    may draw upon as needed.

    The participating jurisdiction is responsible for managing the day-to-day
    operations of its HOME program, ensuring that funds are used according to
    program requirements and written agreements and taking appropriate actions
    when performance problems arise.

    HOME in Puerto Rico and the Other Insular Areas

    For purposes of determining grants under the program, Puerto Rico is
    considered a state.35 Thus, the laws and regulations governing the
    application for, and distribution and use of, HOME funds apply to Puerto
    Rico as they do to the states. HUD's Caribbean field office is responsible
    for overseeing the use of HOME funds in Puerto Rico. HUD regulations cap
    the amount of funding Puerto Rico and its localities can receive under
    HOME.

    The initial HOME allocation amount for each of the insular areas is based
    on its population and occupied rental units compared to all the insular
    areas. HUD may reduce an insular area's allocation based on its
    performance in using HOME funds. The Honolulu field office is responsible
    for overseeing the use of HOME funds in Guam, American Samoa, and CNMI.
    HUD's Caribbean office is responsible of overseeing the use of HOME funds
    in the U.S. Virgin Islands.

    For fiscal year 2005, Puerto Rico and the other insular areas received
    HOME grants totaling $37,349,848, approximately 2 percent of total HOME
    funding for the year (see table 46).

    Table 46: Estimated Amount of HOME Grants for Puerto Rico and the Other
    Insular Areas, Fiscal Year 2005

                                                               Total grant amount
    Puerto Rico: state                                           $17.8 million
    Puerto Rico: local (27 localities)                            15.9 million
    Total for Puerto Rico                                        $33.7 million
    Guam                                                           1.4 million
    U.S. Virgin Islands                                            1.2 million
    CNMI                                                               642,000
    American Samoa                                                     338,000
    Total for Insular Areas                                      $37.3 million

    Source: HUD.

    Project-based Section 8 Program

    The Housing and Community Development Act of 197436 amended the U.S.
    Housing Act of 1937 to create project-based Section 8, under which a
    variety of programs provide rental housing assistance payments to private
    landlords on behalf of eligible families.37 The objective of the program
    is to provide decent, safe, and sanitary housing to families that have
    extremely low-to low-incomes.

    Project-based Section 8 subsidies are linked to specific multifamily
    properties, wherein all the units may be subsidized by the program. The
    subsidy can be used in properties with subsidized mortgages or mortgage
    insurance under various multifamily housing programs or in properties that
    have been privately financed.38

    Through rent subsidies, payments to private landlords cover the difference
    between what the family is required to pay (generally 30 percent of
    adjusted income) and the actual rent for the property. Because the subsidy
    is linked to the unit, tenants lose the subsidy if they move.

    Program Administration and Funding

    HUD has primary responsibility for contract administration but has
    assigned portions of these responsibilities to project-based contract
    administrators, generally state housing finance agencies or PHAs. Private
    owners enter into individual housing assistance payment contracts for each
    of their properties receiving assistance.

    Congress appropriates the amount of project-based Section 8 funding
    available to HUD each fiscal year. Funding for project-based Section 8 is
    currently available only as contract renewals for properties with existing
    contracts. While no new funding is available, families that are not
    receiving assistance may apply for subsidies on properties with existing
    project-based rental assistance contracts.

    Project-based Section 8 in Puerto Rico

    In 2000, HUD began transferring the administration of eligible
    project-based Section 8 contracts in Puerto Rico from HUD field offices to
    the Puerto Rico Housing Finance Corporation, a contract administrator.
    HUD's Atlanta field office is responsible for overseeing the corporation's
    oversight of project-based Section 8 contracts in Puerto Rico.

    Regulations governing the administration of the program apply to property
    owners and contract administrators in the particular state or insular area
    (the Guam administrator also oversees CNMI). Eligibility rules are the
    same for residents in all areas. As of 2004, Puerto Rico, Guam, and the
    U.S. Virgin Islands all had project-based Section 8 properties.

    In fiscal year 2005, the Puerto Rico Housing Finance Cooperation
    administered about 180 project-based Section 8 contracts covering more
    than 19,000 units.

    Section 203(b) Single Family Mortgage Insurance Program

    The Federal Housing Administration (FHA) Section 203(b) mortgage insurance
    program promotes homeownership for families with low to moderate incomes
    by providing mortgage insurance for the purchase or refinancing of a
    principal residence. The program provides mortgage insurance to protect
    lenders, such as mortgage companies, banks, and savings and loan
    associations, against the risk of default on loans to

    qualified buyers. The insurance allows homebuyers to finance approximately
    97 percent of the home's cost through their mortgage.39

    The Section 203(b) Single-Family Mortgage Insurance Program in Puerto Rico
    and the Other Insular Areas

    Individuals in the states, Puerto Rico, Guam, and the U.S. Virgin Islands
    are eligible for the program. HUD insures 203(b) mortgages and oversees
    the selling of homes where families with Section 203(b) insurance cannot
    meet their payments.40

    Section 214 of the National Housing Act41 provides that Section 203(b)
    mortgage limits for Alaska, Guam, Hawaii, and the U.S. Virgin Islands may
    be adjusted up to 150 percent of the mortgage ceilings set for those
    areas. This provision, however, does not apply to Puerto Rico or the other
    insular areas.

    For fiscal year 2006, HUD commitments to guarantee single-family loans
    cannot exceed a loan principal of $185 billion for the Section 203(b)
    program. In fiscal year 2004, 8,269 residents of Puerto Rico received a
    Section 203(b) loan. As of April 2005, halfway through fiscal year 2005,
    4,162 residents had received such a loan.

    Appendix VIII  U.S. Gross Domestic Product Deflator and Puerto Rican Gross Product
    Deflator, 1980-2005

    Source: Bureau of Economic Analysis and the Puerto Rico Planning Board.

    Note: The U.S. series has been adjusted to reflect the Puerto Rican fiscal
    year.

    Appendix IX  Agency Comments

    Appendix X  GAO Contact and Staff Acknowledgments

    James R. White, (202) 512-9110, whitej@gao.gov

    Strategic Issues

    Jim Wozny, Assistant Director Tara Carter, Senior Analyst-in-Charge
    Jennifer Gravelle, Senior Analyst Latesha Love, Senior Analyst Elwood
    White, Senior Analyst Tina Younger, Senior Analyst Laura Nielsen, Analyst

    Applied Research and Methods

    Mitch Karpman, Assistant Director Ed Nannenhorn, Senior Economist Jim
    Ungvarsky, Senior Analyst Susan Baker, Data Analyst

    General Counsel

    Cheryl Peterson, Senior Attorney

    Health Care

    Gerardine Brennan, Senior Analyst Margaret Weber, Senior Analyst

    Education, Workforce, and Income Security

    Carolyn Taylor, Assistant Director Carolyn Blocker, Senior Analyst Nagla'a
    El-Hodiri, Senior Analyst Joy Gambino, Senior Analyst Anne Welch, Senior
    Analyst

    Financial Markets and Community Investment

    Cory Roman, Senior Analyst

    (450287)

    www.gao.gov/cgi-bin/getrpt? GAO-06-541 .

    To view the full product, including the scope

    and methodology, click on the link above.

    For more information, contact James White at (202) 512-9110 or
    whitej@gao.gov.

    Highlights of GAO-06-541 , a report to Committee on Finance, U.S. Senate

    May 2006

    PUERTO RICO

    Fiscal Relations with the Federal Government and Economic Trends during
    the Phaseout of the Possessions Tax Credit

    The federal possessions tax credit, which was designed to encourage U.S.
    corporate investment in Puerto Rico and other insular areas, expires this
    year.

    Proponents of continued federal economic assistance to Puerto Rico have
    presented a variety of proposals for congressional consideration.

    In response to a request from the U.S. Senate Committee on Finance, this
    study compares trends in Puerto Rico's principal economic indicators with
    those for the United States; reports on changes in the activities and tax
    status of the corporations that have claimed the possessions tax credit;
    explains how fiscal relations between the federal government and Puerto
    Rico differs from the federal government's relations with the states and
    other insular areas; and compares the taxes paid to all levels of
    government by residents of Puerto Rico, the states, and other insular
    areas.

    GAO used the latest data available from multiple federal and Puerto Rican
    government agencies. Data limitations are noted where relevant. Key
    findings are based on multiple measures from different sources. GAO is not
    making any recommendations in this report.

    In comments on this report the Governor of Puerto Rico said the report
    will be useful for evaluating policy options.

    Puerto Rico's per capita gross domestic product (GDP, a broad measure of
    income earned within the Commonwealth) in 2005 was a little over half of
    that for the United States (see figure below). Puerto Rico's per capita
    gross national product (GNP, which covers income earned only by residents
    of the Commonwealth) was even lower relative to the United States.
    Concerns about Puerto Rico's official price indexes make it difficult to
    say whether the per capita GNP of Puerto Rican residents has grown more
    rapidly than that of U.S. residents; however, the absolute gap between the
    two has increased.

    U.S. corporations claiming the possessions tax credit dominated Puerto
    Rico's manufacturing sector into the late 1990s. After the tax credit was
    repealed in 1996 beginning a 10-year phaseout period, the activity of
    these corporations decreased significantly. Between 1997 and 2002 (the
    latest data available) valued added in these corporations decreased by
    about two-thirds. A variety of data indicates that much of this decline
    was offset by growth in other corporations, so that some measures of
    aggregate activity remained close to their 1997 levels. For example, value
    added in manufacturing remained fairly constant between 1997 and 2002.
    Most of the offsetting growth was in the pharmaceutical industry.

    Residents of Puerto Rico pay considerably less total tax per capita than
    U.S. residents. However, because of lower incomes they pay about the same
    percentage of their personal income in taxes. The composition of taxes
    differed between Puerto Rico and the states with federal taxes being a
    larger share of the total in the states. This difference reflects the
    facts that (1) residents of Puerto Rico generally do not pay federal
    income tax on income they earn in the Commonwealth and (2) the
    Commonwealth government has a wider range of responsibilities than do U.S.
    state and local governments.

    U.S. and Puerto Rican Real Per Capita GDP and GNP, 1980-2005
    *** End of document. ***