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

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

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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

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

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

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

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. 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.

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.

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.

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, [email protected]

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
[email protected].

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. ***