Tax Policy: Analysis of Certain Potential Effects of Extending Federal
Income Taxation to Puerto Rico (Letter Report, 08/15/96, GAO/GGD-96-127).

Pursuant to a congressional request, GAO provided information on the
potential effects of extending the Internal Revenue Code (IRC) to
residents of Puerto Rico.

GAO found that if IRC tax rules are applied to residents of Puerto Rico:
(1) the residents would owe around $623 million in federal income tax
before taking into account the earned income tax credit (EITC); (2) the
aggregate amount of EITC would total $574 million; (3) 59 percent of the
population filing individual income tax returns would earn some EITC;
(4) 41 percent of the households filing income tax returns would have
positive federal income tax liabilities, 53 percent would receive net
transfers from the federal government, and 6 percent would have no
federal tax liability; (5) more Puerto Rican residents and married
couples would file federal tax returns if they qualified for EITC; (6)
the average EITC earned by eligible taxpayers would be $1,494; (7) the
Puerto Rican government would have to reduce its own individual revenue
by 5 percent to keep the aggregate amount of income tax levied on its
residents constant; (8) the taxes paid by certain classes of Puerto
Ricans would change drastically; (9) the per capita combined individual
income tax in Puerto Rico would increase by 5.5 percent; and (10) tax
expenditures would total $2.8 billion in 1996 and $3.4 billion in 2000.

--------------------------- Indexing Terms -----------------------------

 REPORTNUM:  GGD-96-127
     TITLE:  Tax Policy: Analysis of Certain Potential Effects of 
             Extending Federal Income Taxation to Puerto Rico
      DATE:  08/15/96
   SUBJECT:  Personal income taxes
             Tax returns
             Taxpayers
             Territories and possessions
             Tax administration
             Tax credit
             Tax expenditures
             Tax law
IDENTIFIER:  Puerto Rico
             
******************************************************************
** This file contains an ASCII representation of the text of a  **
** GAO report.  Delineations within the text indicating chapter **
** titles, headings, and bullets are preserved.  Major          **
** divisions and subdivisions of the text, such as Chapters,    **
** Sections, and Appendixes, are identified by double and       **
** single lines.  The numbers on the right end of these lines   **
** indicate the position of each of the subsections in the      **
** document outline.  These numbers do NOT correspond with the  **
** page numbers of the printed product.                         **
**                                                              **
** No attempt has been made to display graphic images, although **
** figure captions are reproduced.  Tables are included, but    **
** may not resemble those in the printed version.               **
**                                                              **
** Please see the PDF (Portable Document Format) file, when     **
** available, for a complete electronic file of the printed     **
** document's contents.                                         **
**                                                              **
** A printed copy of this report may be obtained from the GAO   **
** Document Distribution Center.  For further details, please   **
** send an e-mail message to:                                   **
**                                                              **
**                                            **
**                                                              **
** with the message 'info' in the body.                         **
******************************************************************


Cover
================================================================ COVER


Report to Congressional Requesters

August 1996

TAX POLICY - ANALYSIS OF CERTAIN
POTENTIAL EFFECTS OF EXTENDING
FEDERAL INCOME TAXATION TO PUERTO
RICO

GAO/GGD-96-127

Puerto Rico Taxation

(268682)


Abbreviations
=============================================================== ABBREV

  ACIR - Advisory Commission on Intergovernmental Relations
  AGI - Adjusted Gross Income
  AMT - Alternative Minimum Tax
  DCTC - Child and Dependent Care Tax Credit
  EITC - Earned Income Tax Credit
  IRA - Individual Retirement Account
  IRC - Internal Revenue Code
  IRS - Internal Revenue Service
  OBRA - Omnibus Budget Reconciliation Act
  SEP - Simplified Employee Pension
  SOI - Statistics of Income

Letter
=============================================================== LETTER


B-265968

August 15, 1996

The Honorable Don Young
Chairman, Committee on Resources
House of Representatives

The Honorable Elton Gallegly
Chairman, Subcommittee on Native
American and Insular Affairs
Committee on Resources
House of Representatives

In response to your request, this report presents information on some
potential consequences of extending the income tax provisions of the
federal Internal Revenue Code (IRC) to residents of the Commonwealth
of Puerto Rico.  Specifically, you asked us for estimates of

(1) the amount of federal income tax that individuals residing in
Puerto Rico would pay if they were treated in the same manner as
residents of the 50 states, the amount of earned income tax credits
(EITC) Puerto Rican residents would receive, the percentage of
taxpayers who would have positive federal tax liabilities, and the
percentage who would earn EITC;

(2) the extent to which the Government of Puerto Rico would have to
reduce its own income tax if it were to keep the amount of combined
income tax (both federal and Commonwealth) on individuals the same as
it was without the full imposition of the federal tax;

(3) how the amount of income taxes paid by the average taxpayer in
Puerto Rico compares with the amount of combined federal, state, and
local income taxes paid by residents in the 50 states and the
District of Columbia; and

(4) the amount of revenue the U.S.  Treasury could obtain by the
repeal of the possessions tax credit, which effectively exempts from
federal taxation a portion of the income that subsidiaries of U.S. 
corporations earn in Puerto Rico. 

As agreed with your offices, our estimates relating to federal tax
liabilities and earned income tax credits are based on the income and
demographic characteristics of Puerto Rican taxpayers in 1992, the
latest year for which detailed data were available.  We did not
attempt to adjust these estimates to reflect changes in the Puerto
Rican economy, changes in the behavior of individual taxpayers, or
different compliance rates that might result from the imposition of
federal income taxes.  The data that we used in making our estimates
also had some limitations that are explained in the scope and
methodology section of this letter and in appendix I. 

Estimates of the impact of tax policy changes are inherently
imprecise.  Data limitations and the necessity to make certain
behavioral and economic assumptions limits the precision of the
estimates.  Despite these limitations, we believe our analysis is
adequate to provide general information about the magnitude of the
potential revenue effect of extending full federal income taxation to
the residents of Puerto Rico. 

The discussion of the implications of extending federal income taxes
to the Commonwealth of Puerto Rico should also be viewed in the
context of the broader debate about the status of the Commonwealth
under the Constitution.  The broader issue of whether the benefits
and obligations of statehood or independence should be sought for or
granted to Puerto Rico is outside the scope of this analysis. 
However, any changes to tax policy as it affects Puerto Rico may have
an impact on or be affected by this broader debate. 


   BACKGROUND
------------------------------------------------------------ Letter :1

Under the Jones Act, Puerto Rico is part of the United States for
purposes of acquiring citizenship of the United States by place of
birth.  Thus, a person born in Puerto Rico is typically considered a
U.S.  person for U.S.  tax purposes and thus is subject to the U.S. 
Internal Revenue Code (IRC).  However, IRC has different tax rules
for residents of Puerto Rico than it does for residents of the United
States.  Section 933 of IRC provides that income derived from sources
within Puerto Rico by an individual who is a resident of Puerto Rico
generally will be excluded from gross income and exempt from U.S. 
taxation, even if such resident is a U.S.  citizen.  Section 933 does
not exempt residents of Puerto Rico from paying federal taxes on U.S. 
source income and foreign source income.  Nor does section 933 affect
the federal payroll taxes that residents of Puerto Rico pay.  Federal
employment taxes for social security, medicare, and unemployment
insurance apply to residents of Puerto Rico on the same basis and for
the same sources of income that they are applied to all other U.S. 
residents. 


      INCOME TAXES
---------------------------------------------------------- Letter :1.1

Puerto Rico has had authority to enact its own income tax system
since 1918.  The current individual income tax system of Puerto Rico
is broadly similar to the U.S.  individual income tax system.  The
Puerto Rican and the U.S.  corporate income tax rules have many
similarities and some differences.  The structure of Puerto Rico's
income tax system is discussed in appendixes II and III. 

The current Puerto Rican income tax system is a significant source of
revenue for the Puerto Rican government.  In fiscal year 1992,\1
individual and corporate income taxes totaled about 40 percent of
Puerto Rico's total revenues, with transfers from the federal
government accounting for about 30 percent of revenue and other
taxes, such as excise taxes, generating about 18 percent.  The
balance of the Commonwealth's revenues came mainly from nontax
sources.  For fiscal year 1992, the Puerto Rico Treasury collected
about $1.1 billion in individual income taxes and about $1.02 billion
in corporate income taxes.\2 About 42 percent of the corporate tax
(about $426 million) was paid by U.S.  subsidiaries covered by the
possessions tax credit.\3 The remaining 58 percent (about $594
million) was paid by corporations not covered by the credit.  In
addition, about $10 billion of income earned by corporations in
Puerto Rico was exempted from the local corporate income tax as a
result of Puerto Rico's industrial tax incentive legislation. 

Currently IRC has special income tax provisions that extend tax
benefits to Puerto Rico that are not available to the states.  The
United States exempts from income taxation--at the federal, state,
and local levels--all bonds issued by the Government of Puerto
Rico.\4 Corporations organized in Puerto Rico are generally treated
as foreign corporations for U.S.  income tax purposes.  Like other
foreign corporations, they are taxed on their U.S.  source income,
but their Puerto Rico source income is not subject to U.S.  tax. 
Foreign corporations pay U.S.  tax at two rates--a flat 30-percent
tax is withheld on certain forms of income not effectively connected
with the conduct of a trade or business within the United States, and
tax at progressive rates is imposed on income that is effectively
connected with a U.S.  trade or business.  Much interest income is
exempt from the withholding tax.  Also, IRC's possessions tax credit
effectively exempts from federal taxation a portion of the income
qualified subsidiaries of U.S.  corporations (corporations organized
in any state of the United States) earn in the possessions.  Tax
rules related to possessions source income are discussed in more
detail in appendix III. 


--------------------
\1 Puerto Rico's 1992 fiscal year was from July 1991 through June
1992. 

\2 These amounts do not include $99 million of tollgate tax (tax paid
by corporations on income repatriated from Puerto Rico), $32.1
million of alternative tax withheld on interests and dividends, $62.1
million of income tax withheld from nonresidents, or $1.2 million of
tax paid on partnership income. 

\3 Section 936 of IRC provides a tax credit to those subsidiaries of
U.S.  companies with possessions source income.  This credit is
commonly known as the "possessions tax credit."

\4 48 U.S.C.  745. 


   RESULTS IN BRIEF
------------------------------------------------------------ Letter :2

Our estimates of the potential revenue effect of extending current
federal income tax rules to taxpayers in Puerto Rico were derived
from our analysis of individual income tax data for tax year 1992
provided by the Government of Puerto Rico.  If the characteristics of
the Puerto Rican taxpayer population were the same in 1995 as they
were in 1992, we estimated that their net aggregate federal tax
liability after subtracting EITC would have been about $49 million
under U.S.  tax rules that had been adopted as of the end of 1995.\5
The aggregate tax liability in the absence of EITC would have been
about $623 million, but Puerto Rican taxpayers would have qualified
for a total of about $574 million of EITC. 

We estimated that about 59 percent of the taxpayers who filed Puerto
Rico individual income tax returns in 1992 would have earned some
EITC.  The average EITC earned by eligible taxpayers would have been
about $1,494; the median amount would have been about $1,623.  Over
half of the taxpayers would have received net transfers from the
federal government because their EITC would have been larger than
their precredit federal income tax liabilities.  We estimated that
about 41 percent of the Puerto Rican taxpayers would have had
positive federal income tax liabilities including EITC. 

Had current federal tax rules been in effect in Puerto Rico at the
time, it is probable that some Puerto Rican residents who did not
file Puerto Rican tax returns in 1992 would have had an incentive to
file federal tax returns because they could have qualified for the
refundable EITC.  We have no way of knowing with certainty how many
of these nonfiler residents would claim EITC.  However, we did derive
an estimate of the amount of EITC that might have been claimed by
residents who were not legally required to file tax returns in 1992. 
We considered the number of people who had income levels below the
income tax threshold and were exempt from withholding as an upper
limit on the number of those potential additional filers.  If all of
those residents claimed EITC, we estimated that they would have
qualified for about $64 million.\6

If the additional EITC that could have been claimed by legal nonfiler
residents were about $64 million, our estimate of the aggregate
amount of EITC that would have been earned would have increased from
about $574 million to about $638 million.  This additional EITC would
be sufficient to eliminate the $49 million of aggregate net federal
income tax liability that we estimated would exist for the population
that did file.  Again, it is important to note that our estimates do
not reflect other potential behavioral responses to the availability
of the credit or the imposition of the federal income tax. 

For tax year 1992, Puerto Rican taxpayers reported about $1.03
billion in individual Puerto Rican income tax.  If application of
federal income tax resulted in an additional $49 million in tax
liability after subtracting EITC as we estimated, and if the
Government of Puerto Rico wanted to keep constant the aggregate
amount of combined federal and Puerto Rican individual income tax
levied on its residents, then it would have had to reduce its own
individual income tax revenue by about 5 percent.  If, because of
additional EITC for residents who did not file returns in 1992, the
estimated aggregate federal tax liability were eliminated, then the
Government of Puerto Rico would not have had to change its individual
income tax revenue to keep the aggregate combined taxes constant. 
However, even though the aggregate taxes may not have changed
significantly, the taxes paid by certain classes of taxpayers could
have changed dramatically. 

The per-capita amount of Puerto Rico's individual income tax was
lower than the state and local income tax in most states and the
District of Columbia in 1992.  However, the Puerto Rican income tax
as a percentage of total personal income was higher than the state
and local income tax as a percentage of total personal income of any
state and the District of Columbia.  Nevertheless, since residents of
Puerto Rico paid only about $4.4 million\7 in federal income tax in
1992 (see discussion of foreign tax credit in app.  II), the combined
federal and Puerto Rican income tax was lower, in dollars per capita
or as a percentage of personal income, than the combined federal,
state, and local tax of any state and the District of Columbia.  In
Puerto Rico, the per-capita combined tax was about $342, and the tax
as a percentage of personal income was about 5.3 percent.  In
Mississippi, which had the lowest combined income tax of any state,
the per-capita tax was about $1,147 and the tax as a percentage of
personal income was about 8.2 percent.  If the federal income tax had
been extended fully to Puerto Rico, and the Government of Puerto Rico
did not adjust its own tax, we estimated that the per-capita combined
individual income tax in Puerto Rico would have increased slightly to
about $355--equivalent to about 5.5 percent as a percentage of
personal income. 

The Joint Committee on Taxation's most recent estimates indicate that
the federal tax expenditure for the possessions tax credit would be
$3.4 billion in 1996, growing to $4.4 billion by 2000.  The U.S. 
Department of the Treasury's most recent estimates are that the tax
expenditure would be $2.8 billion in 1996, growing to $3.4 billion by
2000.\8 Tax expenditure estimates are computed to indicate how much
revenue the U.S.  Treasury would forgo due to the existence of a tax
benefit.  The Joint Committee and the Treasury both use a different
methodology to estimate tax expenditures than they use to estimate
the amounts of revenue that would be saved if specific tax
preferences were eliminated.  Estimates of revenue savings take into
account expected tax avoidance behavior by taxpayers in response to
the elimination of preferences; tax expenditure estimates do not
reflect these responses. 

Given the differences in behavioral assumptions, if either the Joint
Committee or the Treasury were to make both a tax expenditure
estimate for a tax credit and a revenue gain estimate for the
elimination of the credit, using the same set of economic forecasts
and the same data, the revenue gain estimate could very well be
smaller than the tax expenditure estimate.  However, imprecisions in
other assumptions, or in the economic forecasts that the Joint
Committee or the Treasury uses, could cause both the tax expenditure
estimate and the revenue gain estimate to either overstate or
understate the true amount of revenue that would flow into the
Treasury if the credit were eliminated.  The last publicly available
revenue savings estimates, made by either the Joint Committee or the
Treasury, for the immediate elimination of the possessions tax credit
do not reflect the significant limitations that were placed on the
credit by the Omnibus Budget Reconciliation Act of 1993. 


--------------------
\5 EITC is a refundable tax credit made available to certain low-
income workers to offset the impact of Social Security taxes and
encourage low-income workers to seek employment rather than welfare. 
Because there have been significant changes to EITC that do not fully
phase in until 1996 and because EITC is an important factor in our
results, we used the 1996 rules for the EITC in our analysis. 

\6 There were some additional taxpayers in 1992 who had tax withheld
but did not file Puerto Rican tax returns.  The potential amount of
additional EITC these taxpayers could have qualified for would likely
have been relatively low because their earned incomes probably were
very low. 

\7 The Government of Puerto Rico does not compile data on the amount
of federal income tax paid by individuals residing in Puerto Rico,
and although the Internal Revenue Service (IRS) compiles data, the
individual income tax is not segregated from other taxes paid by
residents of Puerto Rico to the United States.  In 1992, individuals
claimed a total of $4.4 million in foreign tax credits on their
Puerto Rican income tax returns.  Officials from the Puerto Rico
Treasury told us that a very large percentage of these credits are
attributable to income taxes paid to the U.S.  federal government. 
Therefore, for purposes of determining the combined federal and
Puerto Rican income tax, we assumed this amount was all for U.S. 
federal income taxes. 

\8 Differences in the estimating methodologies and databases used by
each set of estimators account for the differences in the estimates. 


   ESTIMATED TOTAL FEDERAL TAX
   WOULD HAVE BEEN SUBSTANTIALLY
   REDUCED BY EITC
------------------------------------------------------------ Letter :3

As of July 1995, 651,201 individual income tax returns for tax year
1992 had been filed with the Government of Puerto Rico.  Some of the
individuals filing those returns paid federal income tax because they
had income from sources within the United States.  However, due to
section 933 of IRC, which excludes Puerto Rico source income from
federal taxation, the vast majority of Puerto Rican taxpayers were
not subject to the federal income tax. 

If current federal tax rules were applied to residents of Puerto Rico
in the same manner as they are applied to residents of the 50 states,
and if the income and demographic characteristics of Puerto Rican
taxpayers were the same as they reported on their 1992 tax returns,
we estimate that the 651,201 filers would have owed about $623
million in federal income tax before taking EITC into account.\9 The
aggregate amount of EITC earned by these taxpayers would have been
about $574 million, thus the aggregate net federal tax liability
would have been about $49 million (see table 1).  We estimate that
384,107 filers, or about 59 percent of the total number, would have
earned some EITC.  The average amount of EITC earned by the 384,107
filers would have been about $1,494.  The median EITC would have been
about $1,623 (see table 2). 



                                     Table 1
                     
                     Estimated Potential U.S. Tax Liabilities
                      and EITC for Residents of Puerto Rico

                              (Dollars in millions)

                                                  U.S. tax
                                   Number of     liability              U.S. tax
U.S. adjusted gross income      Puerto Rican        before    U.S.     liability
(AGI) classes                        returns        EITC\a    EITC  after EITC\b
----------------------------  --------------  ------------  ------  ------------
Less than $0                             922            $0      $0            $0
$0 to $2,999                          34,906             0       7            -7
$3,000 to $5,999                      50,719             0      40           -40
$6,000 to $9,999                     133,266             8     200          -192
$10,000 to $14,999                   152,916            33     226          -193
$15,000 to $24,999                   151,122           118     101            17
$25,000 to $49,999                   103,758           261       0           261
$50,000 to $99,999                    20,493           128       0           128
$100,000 and over                      3,099            75       0            75
================================================================================
Total                                651,201          $623    $574           $49
--------------------------------------------------------------------------------
\a U.S.  tax liabilities before EITC are reduced by estimated child
and dependent care tax credits totaling about $15 million. 

\b Puerto Rican residents and nonresidents claimed as a tax credit on
their Puerto Rican tax returns about $4.4 million in U.S.  individual
taxes in 1992.  Estimated U.S.  tax liabilities of $49 million under
state-like taxation is gross of this amount. 

Source:  GAO simulation of U.S.  tax law applied to 1992 Puerto Rican
individual income tax returns. 



                                     Table 2
                     
                       Estimates of Potential Puerto Rican
                         Total, Average, and Median EITCs

                                                     Estimate of
                           Number of    Percentage         total  Averag
                              credit     of credit   credits (in       e  Median
Earned income range           filers       returns     millions)  credit  credit
----------------------  ------------  ------------  ------------  ------  ------
Phase-in                      59,721           16%           $71  $1,192  $1,026
Maximum                       90,759            24           193   2,126   1,920
Phase-out                    233,627            61           310   1,326   1,346
================================================================================
Total                        384,107          100%          $574  $1,494  $1,623
--------------------------------------------------------------------------------
Note:  Totals may not add because of rounding. 

Source:  GAO simulation of U.S.  tax law applied to 1992 Puerto Rican
individual income tax returns. 

Our estimates indicate that, before taking the federal child and
dependent care tax credit (DCTC) into account, about 41 percent of
the 651,201 households that filed Puerto Rican income tax returns in
1992 would have had positive federal income tax liabilities, about 53
percent would have received net transfers from the federal government
because their EITC would have more than offset their precredit
liabilities, and the remaining 6 percent would have had no federal
tax liability.  The lack of adequate information on the child and
dependent care expenses of Puerto Rican taxpayers made it impossible
for us to estimate the amount of DCTC that each taxpayer in our
Puerto Rico database would have earned.\10 The nonrefundable DCTC
could only have reduced the number of households having positive tax
liabilities and increased the numbers with zero liabilities or net
transfers.  However, it seems unlikely that the DCTC would have
caused a large number of taxpayers to shift from one status to
another because our estimates indicate that the average credit earned
by those claiming the credit would likely be less than $500. 
Taxpayers would only move from having a positive tax liability to
having a zero tax liability, or receiving a net transfer, if they
claimed the credit and if their precredit tax liability were less
than the amount of credit claimed.\11

If the federal income tax had been fully extended to residents of
Puerto Rico in 1992, it seems likely that additional individuals and
married couples who had not filed Puerto Rican tax returns would have
filed federal tax returns in order to take advantage of EITC. 
Individuals with AGIs less than or equal to $3,300 and married
couples with AGIs less than or equal to $6,000 were not required to
file Commonwealth tax returns in 1992.  However, some of these
individuals filed in order to claim refunds of taxes that had been
withheld on their wages, dividends, or interest.  Others did not
file, for example, because they were not subject to withholding taxes
on their wages or salaries, as is the case for domestic workers and
farm laborers, or because the amount withheld was small. 

We have no way of knowing with certainty how many of these residents
who currently are not required to file would file in order to claim
EITC.  However, to derive an estimate of what this number might be,
we considered the number of people who had income levels below the
income tax threshold and also were exempt from withholding as an
upper limit of the number of these potential additional filers.\12 If
all of those residents claimed EITC, we estimated that they would
have qualified for about $64 million.\13

If the additional EITC that could have been claimed by nonfiler
residents were about $64 million, our estimate of the aggregate
amount of EITC that would have been earned would have increased from
about $574 million to about $638 million.  This additional EITC would
be sufficient to eliminate the $49 million of aggregate net federal
income tax liability that we estimated would exist for the population
that did file. 

Our estimates do not reflect other potential behavioral responses to
the availability of the credit or the imposition of the federal
income tax.  For example, we were not able to estimate the number of
potential EITC claimants who currently are not filing, even though
they are legally obligated to file. 


--------------------
\9 By "current" federal tax rules, we mean rules adopted as of the
end of 1995.  For the most part these are the rules that were
effective for tax year 1995.  The one exception is that we used the
rules for the EITC that did not become fully phased in until tax year
1996. 

\10 We did use the experience of U.S.  taxpayers as a basis for
estimating the aggregate amount of the federal DCTC that Puerto Rican
taxpayers might earn (see app.  I for details.) This aggregate amount
of DCTC is factored into our estimate of the aggregate federal tax
liability in table 1.  However, we were unable to assign DCTC to
specific taxpayers and, consequently, were unable to determine how
those credits affected the net federal tax liability of each
individual taxpayer. 

\11 We estimate that between 30,000 and 40,000 Puerto Rican taxpayers
would have qualified for DCTC in 1992--roughly 5 to 6 percent of the
taxfiling population.  (See app.  I for the estimating methodology.)
The number who would have moved from a positive tax liability to a
zero or negative one simply by the addition of this credit probably
would have been small, since the average amount of credit earned by
DCTC recipients in the United States in 1992 was about $427. 

\12 There were some additional taxpayers in 1992 who had tax withheld
but did not file Puerto Rican tax returns.  The potential amount of
additional EITC these taxpayers could have qualified for would likely
have been relatively low because their earned incomes probably were
very low. 

\13 According to officials from the Puerto Rican Treasury, the number
of domestic workers and farm laborers who were exempt from income tax
withholding in Puerto Rico in 1992 was approximately 43,000.  We
estimated the upper bound for the amount of EITC that these
individuals would have earned by assuming that (1) none of the 43,000
workers actually filed a return in 1992; (2) none of these workers
were from the same family; (3) all of these workers were qualified
for EITC; and (4) they each earned the average EITC which we
estimated to be about $1,494. 


   PUERTO RICO WOULD HAVE HAD TO
   REDUCE ITS OWN TAX TO KEEP THE
   AVERAGE COMBINED INCOME TAX AT
   ITS CURRENT LEVEL
------------------------------------------------------------ Letter :4

For tax year 1992, Puerto Rican taxpayers reported about $1.03
billion in individual income tax.  We estimated that, if current
federal tax rules had been fully applied to residents of Puerto Rico
and, if there were no behavioral responses to this new taxation, then
the aggregate federal income tax liability of Puerto Rican taxpayers
in 1992 would have been about $49 million.  If the Government of
Puerto Rico had wanted to keep the amount of combined federal and
commonwealth individual income tax the same as it was without the
imposition of full federal income tax, then it would have had to
reduce the aggregate liability imposed by its own individual income
tax by about 5 percent.  If we allowed for the potential expansion of
the filing population in response to the availability of EITC (to
include residents who had no withholding), then the estimated
aggregate federal income tax liability would have been essentially
eliminated.  In that case, the Government of Puerto Rico would not
have to change its own income tax to keep the aggregate combined
income tax constant.  There are, however, other reasons why the
Government of Puerto Rico may have adjusted its own income tax under
these circumstances. 

In comments on a draft of this report, the Secretary of the Treasury
of Puerto Rico stated that his government would adjust the island's
fiscal system to provide relief to taxpayers who would have positive
federal income tax liabilities if the federal income tax were fully
extended to residents of Puerto Rico. 


   AVERAGE COMBINED INDIVIDUAL
   INCOME TAX IN PUERTO RICO WAS
   LOW RELATIVE TO THAT IN THE 50
   STATES
------------------------------------------------------------ Letter :5

There are several ways to compare individual income tax across
jurisdictions.  A comparison of per-capita tax shows how much, in
dollars, the average resident in each jurisdiction bears.  Personal
income provides a better indication of a jurisdiction's tax capacity
than does population because a person's ability to pay taxes rises as
his or her income rises.  A comparison of taxes paid as a percentage
of total state or commonwealth personal income shows, approximately,
the relative extent to which each jurisdiction draws upon its
residents' ability to pay.  When comparing individual income taxes
paid, however, it is important to recognize that some jurisdictions
may have relatively low individual income taxes because they rely
more heavily on other revenue sources.  It is also important to note
that comparisons of average taxes paid across jurisdictions do not
show the comparative taxes paid by specific classes of taxpayers in
each jurisdiction. 

In per-capita terms, Puerto Rico's individual income tax is
relatively low.  In 1992, the per-capita tax burden of Puerto Rico's
individual income tax was about $341.  The state and local income
taxes in 33 states, and the District of Columbia, were higher per
capita.  Moreover, since residents of Puerto Rico currently pay a
relatively small amount of federal income tax, the combined federal
and Commonwealth per-capita income taxes in Puerto Rico are lower
than those in any of the 50 states and the District of Columbia.  If
residents of Puerto Rico had been fully subject to the federal income
tax in the same manner as residents of the 50 states were, we
estimate that the per-capita federal income tax in Puerto Rico would
have been about $14 in 1992.\14 In this case, if the Government of
Puerto Rico did not adjust its own income tax in response to the
imposition of the federal tax, the combined federal and Commonwealth
income tax in Puerto Rico would have been about $355 per capita. 
This amount is about a third of the per-capita combined federal,
state, and local income taxes in Mississippi, which has the lowest
per-capita income taxes of any state.  (See app.  IV.)

One reason why Puerto Rico's per-capita income tax is relatively low
is that per-capita personal income in Puerto Rico is significantly
lower than that in any of the 50 states and the District of Columbia. 
In 1992, Puerto Rico's per-capita personal income was $6,428,
compared to $14,083 in Mississippi, the state with the lowest
per-capita personal income. 

Puerto Rico's individual income tax collections amounted to 5.3
percent of the Commonwealth's personal income in 1992.  This
percentage is higher than that of the state and local income tax
collections in any of the states and the District of Columbia.  New
York state, where state and local income taxes amounted to 4.2
percent of state personal income, ranked closest to Puerto Rico. 
(See app.  IV). 

One reason why Puerto Rico's income tax as a percentage of personal
income is high, relative to those of the 50 states and the District
of Columbia, is because Puerto Rico relies more heavily on income
taxes as a source of revenue than do most of those other
jurisdictions.  In 1992, only two states, Maryland and Massachusetts,
relied more heavily on their state and local individual income taxes
than Puerto Rico did.  Puerto Rico's reliance on its corporate income
tax was also much higher than that of any state or the District of
Columbia.  Puerto Rico does not levy a general sales tax and received
only 5.8 percent of its general revenues from property taxes.  In
contrast, in the vast majority of states, general sales taxes and
property taxes account for at least 25 percent of general revenues. 
(See app.  IV). 

Despite Puerto Rico's heavy reliance on its individual income tax,
the combined federal, state, and local individual income taxes, as a
percentage of personal income, were significantly lower in Puerto
Rico than in any of the states or the District of Columbia because
residents of Puerto Rico paid little federal income tax.  If
residents of Puerto Rico had been fully subject to the federal income
tax in 1992, and Puerto Rico did not alter its own income tax, we
estimate that the combined income taxes would have amounted to about
5.5 percent of Commonwealth personal income.  Combined income taxes
in Mississippi amounted to 8.2 percent of state personal income in
1992.  In no other state or the District of Columbia did combined
income taxes amounted to less than 9 percent of personal income. 
(See app.  IV). 

Although the combined average income tax rates paid by residents of
Puerto Rico would not have changed substantially, unless the
Government of Puerto Rico adjusted its own income tax rate schedule,
higher income residents of Puerto Rico would face substantial
increases in their combined marginal income tax rates if they were
fully subject to the federal income tax.  These individuals would
face much higher combined marginal income tax rates than similar
individuals residing in any of the 50 states or the District of
Columbia face.  Under Puerto Rico's current income tax law, marginal
tax rates can reach as high as 38 percent over certain ranges of
income.  Rates for single taxpayers and married taxpayers filing
joint returns in Puerto Rico reach 31 percent when taxable income is
as little as $30,001.  Rates for married taxpayers filing separately
reach 31 percent when taxable income is as little as $15,001.\15 In
contrast, as of 1994, in no state or the District of Columbia did
state and local marginal tax rates exceed 12 percent for any
taxpayers at any income level.  With the full imposition of the
federal income tax, some residents of Puerto Rico could face combined
marginal income tax rates of over 70 percent, unless the Government
of Puerto Rico adjusted its own tax. 


--------------------
\14 This estimate of the per-capita burden is based on the estimated
aggregate burden of $49 million. 

\15 These current rates became effective for tax years beginning
after June 30, 1995.  For tax year 1992 the comparable rates would
have been 41, 36, and 36 percent.  See app.  II for further details
on the changes made to Puerto Rico's income tax since 1992. 


   REVENUE ESTIMATES FOR THE
   ELIMINATION OR PHASE-OUT OF THE
   POSSESSIONS TAX CREDIT
------------------------------------------------------------ Letter :6

Neither the Joint Committee on Taxation nor the U.S.  Department of
the Treasury has made public any recent estimates of the amount of
revenue that would be saved if the possessions tax credit were
eliminated immediately.  The last publicly available revenue estimate
that the Joint Committee made for an immediate repeal of the
possessions tax credit, without any phase out, was in February 1993. 
At that time, it estimated that the repeal of the credit would
increase revenues by $4.1 billion in 1996.  That estimate did not
reflect the significant limitations that the Omnibus Budget
Reconciliation Act (OBRA) of 1993 subsequently placed on the use of
the credit.  Since the 1993 changes reduced the benefits provided by
the credit, the February 1993 estimate was higher than it would have
been if the Joint Committee had known about the changes.\16 The U.S. 
Department of the Treasury also has not publicly released a revenue
estimate for the immediate repeal of the credit since the OBRA 1993
changes. 

The Seven-Year Balanced Budget Reconciliation Act of 1995 (H.R. 
2491) would have repealed the possessions tax credit after December
31, 1995, had it not been vetoed by the President.  The act contained
a grandfather rule that would have gradually phased out the credit
for existing credit claimants over a period of up to 10 years.  The
Joint Committee on Taxation estimated that this phasing out of the
credit would save the Treasury $255 million in 1996 and a total of
$2.5 billion from 1996 through 2000.  This revenue estimate is
relevant only to the very specific phase-out rules contained in the
act.  Other phase-out schemes could have much different revenue
consequences. 

The Joint Committee on Taxation and the Treasury Department have made
"tax expenditure" estimates for the possessions tax credit as
recently as September 1995 and March 1996, respectively.  The latest
Joint Committee estimates indicated that the tax expenditure would be
$3.4 billion in 1996, growing to $4.4 billion by 2000.  The Treasury
Department estimated that the tax expenditure would be $2.8 billion
in 1996, rising to $3.4 billion by 2000.  The Joint Committee and
Treasury both use a different approach for making tax expenditure
estimates for specific tax preferences than they use for estimating
the revenue gains that would occur if those preferences were
eliminated.  A revenue gain estimate reflects expected behavioral
changes on the part of taxpayers in response to the elimination of a
particular preference; a tax expenditure estimate, which represents
the amount of tax benefit that taxpayers would receive if the
preference were not repealed, does not reflect any behavioral
changes. 

If a tax credit were eliminated, taxpayers would be likely to seek
ways to avoid paying the full amount of tax that the credit had
previously offset.  For example, if the possessions tax credit were
repealed, U.S.  corporations might shift some of their investment out
of Puerto Rico to operations in foreign countries, where some of the
income might not be immediately subject to U.S.  taxation.  Due to
the differences in behavioral assumptions, if either the Joint
Committee or Treasury were to make both a tax expenditure estimate
for a tax credit and a revenue gain estimate for the elimination of
the credit, using the same set of economic forecasts and the same
data, the revenue gain estimate could very well be smaller than the
tax expenditure estimate.  On the other hand, imprecisions in other
assumptions and in the economic forecasts that the Joint Committee or
Treasury uses could cause both the tax expenditure estimate and the
revenue gain estimate to either overstate or understate the true
amount of revenue that would flow into the treasury if the credit
were eliminated. 


--------------------
\16 The economic assumptions that the Joint Committee would use when
making an estimate now are also likely to be different from the ones
used in 1993.  We do not know the effect that the change in
assumptions would have on the estimate. 


   SCOPE AND METHODOLOGY
------------------------------------------------------------ Letter :7

To calculate an estimate of the amount of personal income taxes the
United States would collect from residents of Puerto Rico and to
analyze issues related to EITC, we obtained individual income tax
data from the Government of Puerto Rico.  The data included selected
items from each individual income tax return filed with the
Department of the Treasury of Puerto Rico in 1992, the last year for
which detailed information was available. 

The data we used were the best available.  However, they were taken
from an administrative database that had not been cleaned of all
errors or inconsistencies.  We did our own consistency checks and,
with the assistance of the Department of the Treasury of Puerto Rico,
corrected the significant errors we detected.  Some inconsistencies
remain in the data, but we determined that the data is adequate to
provide general information about the magnitude of the potential
revenue effect of extending full federal income taxation to the
residents of Puerto Rico. 

We documented the structure of the Puerto Rican individual income tax
system and compared it to the U.S.  tax system.  On the basis of the
tax law summary table in appendix II and the data provided by the
Commonwealth, we prepared a computer program to estimate the federal
income tax that would have been paid if each Puerto Rican 1992
individual filer had filed a U.S.  individual tax return according to
U.S.  tax rules that had been adopted as of December 31, 1995.  With
one exception, we used U.S.  tax rules that were effective for tax
year 1995.  The one exception was that we used the rules governing
EITC that became fully phased in for tax year 1996. 

We did not attempt to predict how taxpayers would respond to the new
incentives and disincentives they would face under U.S.  tax law. 
Behavioral responses of corporate taxpayers to the elimination of the
possessions tax credit would be of particular importance to the
aggregate amount of income earned in Puerto Rico.  According to
officials from the Department of the Treasury of Puerto Rico,
corporations covered by the credit directly employed about 109,000
Puerto Rican residents in 1995.  As we concluded in our earlier
report on the possessions tax credit, reliable estimates of the
impact that the elimination of the credit would have on Puerto Rico's
economy cannot be made.\17

A second important limitation of our estimate of federal individual
income tax liabilities results from deficiencies of the data
available for our estimate.  The Puerto Rican tax returns do not
contain all of the information that we would need to accurately
simulate certain aspects of the federal tax code.  For example, under
Puerto Rico tax rules, interest from U.S.  federal securities is
exempt from taxation.  No information about this type of interest is
reported on the return, and accordingly, we do not have the data to
estimate its effect on a possible U.S.  tax liability. 

To compare the combined income tax burden of the Commonwealth of
Puerto Rico to the combined income tax burden of the 50 states and
the District of Columbia, we analyzed federal, state, and local
individual income taxes in per-capita terms and as a percentage of
personal income using published data from the Advisory Commission on
Intergovernmental Relations (ACIR), the Commonwealth of Puerto Rico,
and IRS statistics of income.  Further details on our methodology are
contained in appendix I. 

As agreed with your staff, we did not produce our own estimate of the
amount of revenue the U.S.  Treasury could obtain by eliminating the
possessions tax credit.  We have simply presented the Joint Committee
on Taxation's and the U.S.  Treasury's estimates of the tax
expenditure for the credit. 

The Puerto Rico Treasury was unable to provide us with detailed data
relating to corporations operating in Puerto Rico that are not
covered by the possessions tax credit.  There are differences between
Puerto Rico's corporate income tax and the federal corporate income
tax.  In the absence of detailed data relating to the incomes and
deductions reported by corporations not covered by the possessions
tax credit, we cannot say whether federal income taxation of these
corporations would have yielded significantly more or significantly
less revenue than the approximately $594 million of income tax
actually collected from these corporations by Puerto Rico in 1992. 
Marginal tax rates for corporations are generally higher in Puerto
Rico than in the United States, but Puerto Rico provides significant
tax exemptions for income earned from certain designated activities. 
Appendix III provides a description of the principal differences in
the treatment of corporate and partnership income under the Puerto
Rican and federal tax codes. 

We did our work in Washington, D.C., between August 1995 and June
1996 in accordance with generally accepted government auditing
standards. 


--------------------
\17 Tax Policy:  Puerto Rico and the Section 936 Tax Credit,
(GAO/GGD-93-109, June 8, 1993). 


   AGENCY COMMENTS
------------------------------------------------------------ Letter :8

We requested comments on a draft of this report from the Secretary of
the Treasury of the Commonwealth of Puerto Rico, from officials of
the U.S.  Treasury, and from the Internal Revenue Service.  We
discussed the draft on June 7, 1996, with responsible officials from
the Office of the Assistant Secretary of the Treasury for Tax Policy. 
We discussed the draft on June 11, 1996, with the Secretary of the
Treasury of Puerto Rico and members of his staff.  The Secretary also
provided us with written comments, the full text of which, excluding
an attachment of technical comments, is presented in appendix V. 
IRS' Office of the Associate Chief Counsel provided us with written
comments relating to our descriptions of sections of IRC.  Most of
the comments that the various officials made brought to our attention
corrected and updated information.  There were also suggestions that
parts of our presentation needed to be clarified.  We considered
their comments and modified the report where appropriate. 

The U.S.  and Puerto Rican officials made several comments that merit
special attention.  First, officials from both the U.S.  and Puerto
Rican Departments of the Treasury pointed out that we did not address
the distributional effects that a full imposition of the federal
income tax would have in Puerto Rico.  An official from the U.S. 
Treasury noted that the combined marginal income tax rates of higher
income individuals in Puerto Rico would be significantly higher than
the combined marginal rates on similar individuals in any of the 50
states or the District of Columbia.  He suggested that the Government
of Puerto Rico would be compelled to modify its own tax system to
avoid these extremely high rates.  The Secretary of the Treasury of
Puerto Rico noted that his government would have to make significant
adjustments to the island's fiscal system to provide relief for those
who would have positive federal income tax liabilities.  IRS'
Associate Chief Counsel noted that U.S.  persons who currently pay
Puerto Rican income tax as well as federal income tax, such as U.S. 
military personnel stationed on the island, can claim a foreign tax
credit against their federal income tax liability.  If the Puerto
Rican income tax were to be treated as a state income tax, these
individuals would only be allowed to claim a deduction for that tax,
not a credit.  As a result, their U.S.  income tax liabilities could
increase significantly if Puerto Rico did not adjust its income tax. 

We agree that the full imposition of the federal income tax could
have significant impacts on specific groups of taxpayers in Puerto
Rico, even though the impact on aggregate federal revenue might be
negligible.  However, the data and our estimating methodology did not
support a detailed distributional analysis.  We did not mention
possible policy responses by the Government of Puerto Rico because
that was beyond the scope of this study.  In the section of our
report that compares the combined individual income taxes in Puerto
Rico with those in the 50 states and the District of Columbia, we
have added a comparison of the marginal tax rates for Puerto Rico's
income tax with the marginal income tax rates for other U.S. 
jurisdictions.  The top marginal income tax rate in Puerto Rico is
significantly higher than the rates in the other jurisdictions. 

Officials from both the U.S.  and Puerto Rican Treasuries were
concerned about our discussion of local corporations operating in
Puerto Rico that are not covered by the possessions tax credit.  The
officials felt that we improperly implied that the amount of income
tax revenue that the Government of Puerto Rico currently collects
from these corporations indicates roughly the amount of revenue that
the federal government might collect if the corporations were subject
to the full federal income tax.  We tried to make clear in our draft
that there are differences between Puerto Rico's corporate income tax
and the federal corporate income tax and that potential federal
revenues could be greater or less than the amount that the Government
of Puerto Rico currently collects.  In response to the comments, we
moved some of the discussion of differences between the two corporate
income taxes forward from an appendix to the body of the letter. 

Finally, the Secretary of the Treasury of Puerto Rico noted that our
report does not address all of the consequences that are likely to
follow from a major change in the fiscal relations between Puerto
Rico and the federal government.  He said that, in particular, we do
not address potential changes in federal transfers to Puerto Rico. 
We agree that there are important considerations relating to
potential changes in fiscal relations that are beyond the scope of
this report. 


---------------------------------------------------------- Letter :8.1

Unless you publicly announce its contents earlier, we plan no further
distribution of this report until 30 days from the date of this
report.  At that time, we will send copies of this report to the
Ranking Minority Members of the House Committee on Resources, and the
Subcommittee on Native Americans and Insular Affairs, and to other
appropriate congressional committees.  We will also send copies to
the Commissioner of the IRS, Secretary of the Treasury,
representatives of the government of Puerto Rico, and other
interested parties.  Copies will also be made available to others
upon request. 

This work was performed under the direction of James Wozny, Assistant
Director, Tax Policy and Administration Issues.  Major contributors
to this report are listed in appendix VI.  If you have any questions
please contact me on (202) 512-9044. 

Natwar M.  Gandhi
Associate Director, Tax Policy
 and Administration Issues


OBJECTIVES, SCOPE, AND METHODOLOGY
=========================================================== Appendix I

The Chairman, House Committee on Resources, and the Chairman, House
Subcommittee on Native American and Insular Affairs, Committee on
Resources, requested that we provide certain data regarding the
potential effects of extending federal income taxation to Puerto
Rico.  Specifically, they asked that we provide estimates of

(1) the amount of federal income tax that individuals residing in
Puerto Rico would pay if they were treated in the same manner as
residents of the 50 states, the amount of earned income tax credits
(EITC) Puerto Rican residents would receive, the percentage of
taxpayers who would have positive federal tax liabilities, and the
percentage who would earn EITC;

(2) the extent to which the Government of Puerto Rico would have to
reduce its own income tax if it were to keep the amount of combined
income tax (both federal and Commonwealth) on individuals the same as
it was without the full imposition of the federal tax;

(3) how the amount of income taxes paid by the average taxpayer in
Puerto Rico compares with the amount of combined federal, state, and
local income taxes paid by residents in the 50 states and the
District of Columbia; and

(4) the amount of revenue the U.S.  Treasury could obtain by the
repeal of the possessions tax credit, which effectively exempts from
federal taxation a portion of the income that subsidiaries of U.S. 
corporations earn in Puerto Rico. 

To calculate the amount of personal income taxes the United States
would collect from residents of Puerto Rico and analyze issues
related to EITC, we obtained individual income tax data from the
Government of Puerto Rico.  These data included selected items from
each individual income tax return filed with the Department of the
Treasury of Puerto Rico in 1992, the last year for which detailed
information was available. 

The data we used were the best available.  However, they were taken
from an administrative database that had not been cleaned of all
errors or inconsistencies.  We did our own consistency checks and,
with the assistance of the Department of the Treasury of Puerto Rico,
corrected the significant errors we detected.  Some inconsistencies
remain in the data, but we determined that the data is adequate to
provide general information about the magnitude of the potential
revenue effect of extending full federal income taxation to the
residents of Puerto Rico. 

To estimate the total U.S.  federal income tax related to extending
the federal income tax to Puerto Rico, we documented the elements
that made up Puerto Rico's taxable income, deductions, exemptions,
and credits and compared them to the U.S.  federal income tax.  To
aid that process, we have prepared a summary table tracing each line
item from the U.S.  1040 return and schedule of itemized deductions
to a comparable item in the 1992 Puerto Rican individual income tax
return.  On the basis of the tax law summary table in appendix II and
the data provided by the Commonwealth, we prepared a computer program
to estimate the federal income tax that would have been paid if (1)
each Puerto Rican 1992 individual filer had filed a U.S.  individual
tax return according to U.S.  tax rules that had been adopted as of
the end of 1995 and (2) his or her filing behavior had not changed as
a result of the imposition of U.S.  income taxes.  U.S.  tax law was
used to determine U.S.  tax treatment of Puerto Rican tax return
income, exemption, and deduction items.\1 We assumed that the
taxpayers took advantage of any U.S.  credits or deductions that were
not available under Puerto Rico law, if we had sufficient data to
presume their eligibility for those credits and deductions. 

The estimate of U.S.  federal tax liabilities that we produced in
this manner differs in several important ways from an estimate of the
amount of revenue that the United States would actually receive if
the federal income tax were actually imposed on Puerto Rico residents
for tax year 1995.  We have not attempted to estimate how the
extension of individual and corporate income taxes or any federal aid
programs would affect the pretax incomes of Puerto Rican taxpayers. 

Another important limitation of our estimate results from
deficiencies of the data available for our estimate.  The Puerto
Rican tax returns do not contain all of the information that we would
need to accurately simulate certain aspects of the federal tax code. 
For example, under Puerto Rico's tax rules, interest from federal
securities is exempt from taxation.  Also, for example, unemployment
compensation is not included in Puerto Rico's definition of gross
income, whereas it is in U.S.  tax law.  Information about this
interest and unemployment compensation is not reported on the return,
and accordingly, we did not have the data to estimate its effect on a
possible U.S.  tax liability.  The analysis in appendix II describes
the extent to which we could or could not estimate amounts for each
line item on the federal tax return from data on Puerto Rican
returns. 

Finally, a study of compliance with Puerto Rico's income tax prepared
for the Puerto Rico Treasury revealed that noncompliance with Puerto
Rico income tax laws is significantly more extensive than
noncompliance with federal income tax laws.  This study indicated
that the total income gap (the amount of adjusted gross income (AGI)
that went unreported) in 1991 for Puerto Rico was about $3.71
billion, or 26 percent of total income, while for the United States
the income gap was about $447.1 billion, or 12 percent.  Our
estimates reflect the compliance behavior of Puerto Rican taxpayers
in 1992.  They do not take into account any change in compliance
rates in Puerto Rico that have occurred since 1992 or that might
occur if full federal income taxation were imposed.  Since the
completion of that study, the Department of the Treasury of Puerto
Rico has implemented new compliance initiatives that, according to
Puerto Rico Treasury officials, have increased the number of
individual income tax returns filed from 651,201 in 1992 to 720,000
in 1994 and increased their collections of all taxes by about $430
million in fiscal years 1994 and 1995. 


--------------------
\1 We followed U.S.  tax laws that were in place as of October 1,
1995.  All relevant dollar amounts that are included in the U.S.  tax
code, such as the amounts for exemptions, standard deductions, and
boundaries for tax rate brackets, were deflated into 1992 dollar
equivalents.  Also, prospective changes in the calculation of the
earned income tax credit scheduled to be in place in tax year 1996
were incorporated in the simulation exercise. 


   EITC ESTIMATE
--------------------------------------------------------- Appendix I:1

EITC is a major feature of the U.S.  income tax system that would
significantly affect estimates of federal tax revenues obtained from
Puerto Rico if the federal income tax were extended to Puerto Rico. 
EITC is a refundable credit that is awarded to tax filers who meet
certain earned income requirements and have qualified children
residing in their households.  A smaller credit is awarded tax filers
who have earned incomes but no qualifying children--the so-called
"childless" credit.  Qualification requirements for the credit are
discussed in table II.2.  Because the credit is targeted to tax
filers with relatively low earned incomes, a tax filing population
with a high proportion of low-income earners, such as Puerto Rico's,
would be entitled to a substantial amount of EITC in the aggregate. 

Our EITC simulation methodology relied on available information
contained in Puerto Rican tax returns for 1992 to estimate proxies
for earned income, unearned income, AGI, and qualifying children, as
defined under federal tax law.  We restated all dollar values, such
as income thresholds and maximum credits, contained in the EITC
computation rules as 1992 dollars.  We then applied the restated
rules to the estimated proxies in order to compute an EITC for each
Puerto Rican taxfiler in 1992 that met the necessary conditions. 

A limitation of the simulation described above, apart from the
necessity to approximate the value of certain tax elements, is the
risk of significantly undercounting the potential EITC-qualified
population of tax filers.  The 1992 Puerto Rican tax filing
population may omit potential filers either because their incomes
fell below the filing threshold for the Puerto Rico income tax or
because they evaded their filing obligations in 1992.\2 Because the
number of these potential filers may be substantial at the lower
earned income levels, and thus cause our simulated estimate of EITC
to be understated, we examined Census data in an attempt to estimate
the number of nonfilers that would file if EITC were available. 

The decennial 1990 Census of Puerto Rico contains information on the
incomes and family composition of households during the sample period
1989.  From the family relationships contained on the Census file we
constructed a data file of simulated tax filers, e.g., single,
head-of-household, and married joint returns.  Information about the
age and incomes of nonfiling family members was used to estimate the
number of EITC-qualified children.  Income elements, although not
complete for computing taxable incomes, seemed reasonably adequate
for estimating approximations of AGI and earned income. 

From the simulated tax filing data set, we estimated the number of
potential filers who would qualify for EITC by AGI classes.  These
counts of potential filers were compared to the count of simulated
EITC filers obtained from the 1992 Puerto Rican tax return file.  As
expected, the number of potential filers in the Census data set in
low-AGI groups, roughly those AGIs below tax filing thresholds,
exceeded the number from the tax file data set.  Many of the
simulated filers from the Census data set, in these income groups,
could be agricultural workers or domestic service workers who are
exempt from tax withholding and thus need not file tax returns. 
However, in the higher AGI classes, the number of simulated EITC tax
filers from the Census data set was lower than the number of
simulated EITC filers from the 1992 tax return data set.  This result
is not plausible because the number of potential EITC recipients in
the full Puerto Rican population cannot be lower than the number of
potential recipients in the tax filing population. 

We have more confidence in our simulations based on the tax return
data than those based on the Census data.  The translation of Puerto
Rican filing units into federal filing units is relatively
straightforward from the tax data, although there is considerable
uncertainty as to how households in the Census database should be
translated into filing units.  In addition, income amounts reported
on the Census survey may differ from the amounts that the same
individuals would report for tax purposes.  For these reasons we
concluded that we could not use the Census data to estimate the total
number of nonfilers who might claim EITC if it became available to
them.\3 However, as explained in the letter, we did make an
upper-bound estimate for the amount of EITC that might be claimed by
taxpayers who had legitimate reasons for not filing tax returns in
1992. 

Potential noncompliance with the EITC provisions and behavioral
responses to the availability of the credit could result in a larger
aggregate amount of EITC being earned than we have estimated.  A
previous GAO report and studies by IRS have raised concerns regarding
the vulnerability of EITC to noncompliance including fraud.\4 Also,
the introduction of the earned income credit could induce some
welfare recipients to forego welfare and obtain employment in order
to claim the tax credit.  We did not adjust our estimate for these
factors because there was insufficient information available to
quantify their effect on EITC. 


--------------------
\2 In Puerto Rico, the requirements for filing a return for tax year
1992 were $3,300 in gross income for single persons or married
individuals not living together, and $6,000 in gross income for
married persons living together.  Individuals below these tax
thresholds may have filed, however, to claim refunds of taxes
withheld by employers.  Some taxpayers may not have filed for a
refund if the amounts withheld were small. 

\3 We examined the possibility that the difference in the years
between the two data sets--the Census data were based on information
in 1989, whereas the tax return data set were for the year
1992--might have caused the inconsistency in counts between AGI
groups.  We obtained from the Treasury Department of Puerto Rico a
table of tax filers by AGI groups for the same year as the Census
data--1989.  In order to estimate the number of EITC filers in each
AGI group in 1989, we used our 1992 data to compute the proportions
of all tax filers that qualified for the EITC by AGI class and then
applied these proportions to the 1989 tax filer counts for the
respective AGI groups.  A comparison of the count of Census simulated
EITC tax filers to the imputed EITC tax return simulated filers again
led to a statistical inconsistency across AGI groups. 

\4 Tax Administration:  Earned Income Credit--Data on Noncompliance
and Illegal Alien Recipients, (GAO/GGD-95-27, Oct.  25, 1994). 


   CHILD AND DEPENDENT CARE TAX
   CREDIT ESTIMATE
--------------------------------------------------------- Appendix I:2

Differences between U.S.  and Puerto Rican tax rules relating to
child and dependent care expenses made it impossible for us to
estimate the amount of federal child and dependent care tax credit
(DCTC) that each taxpayer in our Puerto Rico database would earn. 
The federal credit, which is nonrefundable, is equal to a percentage
of the expenses that a taxpayer pays for child or dependent care in
order to be able to obtain gainful employment.  The maximum credit
for taxpayers with AGIs of $10,000 or less is $1,440 for two or more
dependents, and $720 for one dependent.  The maximum credit for
taxpayers with AGIs over $28,000 is $960 for two or more dependents,
and $480 for one dependent.  Puerto Rico allows an itemized deduction
for child-care expenses but not for expenses to care for other
dependents.  The maximum deduction is $800 for two or more children,
and $400 for one child.  A large majority of Puerto Rican taxpayers
do not itemize, so we were unable to determine whether they had any
expenses for child care. 

In the absence of complete information on the child and dependent
care expenses of Puerto Rican taxpayers, we had to rely upon the
experience of U.S.  taxpayers as a basis for estimating the aggregate
amount of federal DCTC that Puerto Rican taxpayers might claim. 
Using a sample of individual tax returns compiled by IRS for tax year
1991, the latest data available, we classified U.S.  returns by nine
AGI categories and by the number of children claimed as qualifying
for the DCTC.  We classified Puerto Rican returns according to
estimated U.S.  AGI and the number of children claimed as dependents. 
We computed an average credit amount per U.S.  return for each class
of return.  We assumed that the average credit per Puerto Rican
return in a given class would be the same as the average credit for
the comparable class of U.S.  returns\5 Thus, we multiplied the
number of Puerto Rican returns in each class by the appropriate U.S. 
average credit to obtain the amount of credit earned by each class of
Puerto Rican returns.  We obtained our overall estimate of about $15
million by summing the estimates for the individual classes. 

We were unable to allocate the aggregate amount of DCTC across
individual taxpayers.  Consequently, we do not know precisely how
many taxpayers might have had their federal tax liabilities
completely offset by this credit.  For this reason, we could not
estimate precisely the number of Puerto Rican taxpayers who would
have had positive federal tax liabilities. 


--------------------
\5 Dependent-care expenses are likely to be lower in Puerto Rico than
in the rest of the United States because labor costs are
significantly lower in Puerto Rico than in the United States. 
However, the amount of expenses that qualify for the credit is capped
at $2,400 per dependent and at $4,800 in total.  These caps should
reduce differences between the average amounts of credit that would
be claimed in Puerto Rico, by income group, and the average amounts
claimed in the rest of the United States. 


   COMBINED INDIVIDUAL INCOME
   TAXES
--------------------------------------------------------- Appendix I:3

Determining the magnitude of the income tax reductions the Government
of Puerto Rico would have to make in order to maintain the same level
of combined income tax paid by individuals resident in Puerto Rico if
they were subject to the federal income tax was a two-step process. 
First, we determined the total amount of 1992 Puerto Rican tax from
the income tax return data provided by the Commonwealth.  Then, we
compared this amount to the total estimated potential U.S.  tax
liability as calculated in the first objective. 

To compare the combined federal and Puerto Rican income tax to the
combined federal, state, and local income tax of the 50 states and
the District of Columbia, we analyzed federal, state, and local
individual income taxes in per-capita terms and as a percentage of
personal income.  In addition, to understand the results of our
analysis of Puerto Rico's income tax, we analyzed the general revenue
sources of Puerto Rico and the states.  We used published data from
the Advisory Commission on Intergovernmental Relations (ACIR), IRS'
Statistics of Income Bulletin, and Puerto Rico's Informe Econï¿½mico al
Gobernador, an annual report to the Governor on the economy of the
Commonwealth.\6 Generally, ACIR based its calculations on state and
local general revenue data collected by the Bureau of the Census.\7
We followed the Census Bureau's Classification Manual definitions of
government and finance data. 


--------------------
\6 ACIR was created by Congress to monitor the operation of the
American federal system and to recommend improvements. 

\7 General revenue, as defined by the Census, includes all revenue
except that classified as liquor store, utility, or insurance trust
revenue.  For purposes of this analysis, the general revenue data we
included for the government of Puerto Rico excludes its public
corporations. 


COMPARISON OF U.S.  AND PUERTO
RICO INDIVIDUAL INCOME TAX RULES
========================================================== Appendix II

The following tables summarize our comparison of United States and
Puerto Rican individual income tax rules relevant to our simulation
for each item on the U.S.  individual income tax return.  These
tables provide comments on issues related to the conversion of the
Puerto Rican income tax return items to the U.S.  individual income
tax return items.  Our conversion is based on 1992 Puerto Rican
income tax rules because that was the latest year for which return
information necessary for our simulation was available on computer
tape.  Since 1992, the Puerto Rican tax system has been changed.  In
October 1994, Puerto Rico enacted tax reform legislation that
according to the government of Puerto Rico, was intended to achieve
several objectives.  These objectives include (1) establishing a more
equitable tax structure, (2) encouraging equal and consistent
application of tax laws, and (3) simplifying the tax structure. 
Generally, the 1994 tax reform lowered individual tax rates and
corporate tax rates.  Effective for tax years commencing after June
30, 1995, the act lowered all statutory individual income tax rates
and increased the level of taxable income subject to the maximum tax
rate, from $30,000 to $50,000 for married filing jointly.  Tax rates
were lowered from 1 to 7 percentage points, depending on the tax
bracket and filing status of the taxpayer.  We noted some of the
significant provisions of the Puerto Rico Tax Reform Act of 1994 in
table II.1. 



                                    Table II.1
                     
                         Conversion of Puerto Rican 1992
                      Individual Income Tax Return Items to
                      U.S. 1995 Individual Income Tax Return
                                      Items

U.S. individual income
tax item                   Issues/comments on conversion to U.S. return
-------------------------  -----------------------------------------------------
Filing status              U.S. reporting: The United States has four filing
                           statuses: single, married filing jointly or surviving
                           spouse, married filing separately, and head-of-
                           household.

                           Puerto Rico reporting: Puerto Rico has five filing
                           statuses: married and living with spouse, head-of-
                           household, married not living with spouse, single,
                           and married filing separately.

                           Conversion to the U.S. return: The United States does
                           not have a married not living with spouse status. For
                           the married not living with spouse status, taxpayers
                           would have to file as married filing jointly or
                           married filing separately status. For the married not
                           living with spouse status, we classified returns
                           filed under this status as head-of-household filing
                           status if the Puerto Rican return reports a dependent
                           child, since that status has more favorable tax
                           rates. If the return did not report a dependent
                           child, then the return was classified as single.

Exemptions                 U.S. reporting: The United States allows a deduction
                           amount based on the number of exemptions claimed.
                           Exemptions can be claimed for the taxpayer, the
                           spouse, and the dependents.

                           Puerto Rico reporting: Puerto Rico allows a deduction
                           amount based on the number of personal exemptions and
                           dependents claimed. However, Puerto Rico allows only
                           one personal exemption for married taxpayers and does
                           not allow a head-of-household taxpayer an exemption
                           for the dependent that qualifies him or her as head-
                           of-household.

                           Conversion to the U.S. return: The number of
                           exemptions was included in the U.S. return as
                           reported on the Puerto Rican return except that
                           married filing jointly taxpayers were considered two
                           exemptions instead of one, and head-of-household
                           taxpayers had an additional dependent added.

Wages, salaries, and tips  U.S. reporting: This includes all compensation for
                           personal services as an employee unless specifically
                           excluded.

                           Puerto Rico reporting: Incudes all amounts paid to
                           employees that constitute compensation.

                           Conversion to the U.S. return: Wages, salaries, and
                           tips on the Puerto Rican return were used as
                           reported.

Taxable interest and tax-  U.S. reporting: All interest is taxable, except for
exempt interest            interest on certain state and local bonds and certain
                           other exceptions.

                           Puerto Rico reporting: Income from federal, state,
                           and local government bonds is exempt in Puerto Rico
                           and is not reported. Also the first $2,000 of
                           interest income from Puerto Rican banking
                           institutions is exempt. However, the exempt amount is
                           reported on the income tax return, but it is excluded
                           from gross income.

                           Conversion to the U.S. return: Only those interest
                           earnings reported on the Puerto Rican income tax
                           return were included in our simulation. Interest
                           earnings included the exempt amount for interest in
                           Puerto Rican banking institutions but not interest
                           from federal, state, and local government bonds
                           because it was not reported on the Puerto Rican
                           return.

Dividend income            The amount of dividend income was included in the
                           U.S. return as reported on the Puerto Rican return.

Taxable refunds, credits   U.S. reporting: This item is an accounting entry in
or other offsets           the federal income tax return used only by taxpayers
                           who, during the tax year, received a refund, credit,
                           or offset of state or local income taxes that they
                           paid and deducted in any prior year.

                           Puerto Rico reporting: There is no equivalent line
                           item on the Puerto Rican tax return.

                           Conversion to the U.S. return: This entry was not
                           necessary for our simulation because no prior year
                           deductions would have been made.

Alimony received           The amount for alimony received was included in the
                           U.S. return as reported on the Puerto Rican return.

Business income or loss    U.S. reporting: Sole proprietor income after related
                           expenses is included on the U.S. individual income
                           tax return with certain limits. However, U.S. passive
                           losses generally can only be deducted against passive
                           income. Related expenses include those that are
                           ordinary and necessary such as depreciation. The U.S.
                           tax rules allow straight line and some accelerated
                           depreciation. The United States also allows an
                           immediate write-off of business assets up to $17,500.
                           This amount is reduced if the total cost of the
                           property placed in service during the year exceeds
                           $200,000.

                           Puerto Rico reporting: Sole proprietor income after
                           related expenses is also included on the Puerto Rican
                           return. Puerto Rico also limits the extent to which
                           business losses can offset salary income. Deductions
                           rules, like depreciation, may differ. For example, in
                           1992, Puerto Rico allowed certain taxpayers to use
                           "flexible depreciation." This depreciation method
                           allows a depreciation deduction up to the full cost
                           of the asset in the year it is first used. However,
                           the deduction was not to exceed the net benefit of
                           the business or commercial activity in which the
                           property was used. This flexible depreciation method
                           was repealed in the Tax Reform Act of 1994 for assets
                           acquired after June 30, 1995.

                           Conversion to the U.S. return: The amount reported on
                           the Puerto Rican return was used as reported.

Capital gain or loss       U.S. reporting: Net capital gains are fully included
                           in income with an alternative 28-percent tax rate for
                           long-term gains net of long-and short-term losses.
                           Capital losses are deductible to the extent of
                           capital gains; up to a $3,000 loss is allowed against
                           other income. Capital losses can be carried forward
                           and deducted in succeeding years. Long-term capital
                           gain or loss means gain or loss from the sale or
                           exchange of a capital asset held for more than 1
                           year.

                           Puerto Rico reporting: Gains are fully taxable;
                           capital losses are limited to capital gains plus net
                           income or $1,000, whichever is lower, with the excess
                           losses carried forward for 5 years. Also, there is an
                           alternative tax on net long-term capital gains, which
                           is either the regular tax or a "special 20-percent
                           tax on capital gains," whichever is more advantageous
                           to the taxpayer. Long-term capital gain or loss means
                           gain or loss from the sale or exchange of a capital
                           asset held for more than 6 months.

                           Puerto Rico also has sale or exchange of principal
                           residence rules that are somewhat similar to those of
                           the United States. In general, if the Puerto Rican
                           taxpayer buys another residence within 1 year before
                           or 1 year after the sale of the old residence (18
                           months after sale is allowed if a new residence is
                           constructed), the gain is not recognized to the
                           extent the selling price does not exceed the cost of
                           the new residence. A one-time exclusion of $50,000 is
                           provided for taxpayers 60 years old or older at the
                           time of the sale, if the taxpayer lived in the old
                           residence for at least 3 years of the last 5 years
                           prior to the sale.

                           Conversion to the U.S. return: The amount of capital
                           gains and losses was included in the U.S. return as
                           reported on the Puerto Rican return.

Other gains or losses      U.S. reporting: This line item is used for gains and
                           losses reported on U.S. Form 4797. Generally, this
                           form is used to report sales or exchanges and
                           involuntary conversions from other than casualty or
                           theft of property used in a trade or business;
                           disposition of noncapital assets other than inventory
                           or property held primarily for sale to customers; and
                           recapture of IRC section 179 expense deductions for
                           partners and S-corporation shareholders. Business
                           real estate and any depreciable property is excluded
                           from the definition of capital asset. However, if the
                           business property qualifies as IRC section 1231
                           property, capital gain treatment may apply. Under IRC
                           section 1231, if there is a net gain during the tax
                           year from (1) sales of property used in a trade or
                           business, (2) involuntary conversion of property used
                           in a trade or business, or (3) sales of capital
                           assets held for more than one year, the gain is
                           treated as a long-term capital gain. A net loss is
                           treated as an ordinary loss.

                           Puerto Rico reporting: Net gains on the involuntary
                           conversion, or on the sale or disposition of property
                           used in a trade or business, held for more than 6
                           months, are treated as "long-term capital gain." This
                           long-term capital gain is reported together with
                           other long-term capital gains and is taxed as
                           explained in the capital gains section. Except for
                           (1) the holding period of 6 months; (2) the inclusion
                           of involuntary conversion from casualty or theft; and
                           (3) the replacement period of 1 year for involuntary
                           conversions, Puerto Rico's capital gains treatment of
                           the property described in this paragraph is
                           consistent with the U.S. tax treatment.

                           Net gains or net losses on the involuntary conversion
                           or on the sale or disposition of property used in a
                           trade or business, held for less than 6 months, are
                           not considered capital gains or losses. These gains
                           or losses are reported as "ordinary income or loss."

                           Conversion to the U.S. return: Other gains and losses
                           were included in the U.S. return as reported on the
                           Puerto Rican return.

Individual Retirement      U.S. reporting: IRA distributions are taxed as
Account (IRA)              ordinary income in the year received. Distributions
distributions              are fully taxable unless nondeductible contributions
                           have been made. In the United States, a penalty
                           applies if the taxpayer is not 59 1/2 years or
                           older.

                           Puerto Rico reporting: Similar rules apply;
                           nondeductible contributions are not permitted. In
                           Puerto Rico, the penalty applies if the taxpayer is
                           not 60 years or older, with certain exceptions.
                           Puerto Rico has a penalty provision that is similar
                           to that of the United States for early withdrawals.

                           Conversion to the U.S. return: This line item was
                           used as reported on the Puerto Rican return.

Pensions and annuities     U.S. reporting: The United States taxes each annuity
                           payment as if composed pro rata of taxable income and
                           recovery of cost, projected over the life expectancy
                           of the annuitant. An alternative method is provided
                           for qualified plans; under this method, the total
                           number of payments is determined based on the
                           annuitant's age at the starting date.

                           Puerto Rico reporting: In the case of government
                           pensions, Puerto Rico excludes either $5,000 or
                           $8,000 based on age. If the taxpayer paid part or the
                           total cost of the pension, he/she can recover that
                           amount tax free. The excess of the amount received
                           over 3 percent of the aggregate premiums paid is
                           excluded from income until the amount excluded equals
                           the aggregate premiums paid for the annuity.
                           Taxpayers with government pensions are not required
                           to submit Schedule H (Income from Annuities or
                           Pensions) if their pension or annuity income is less
                           than the exclusion amount. Since 1992, the $5,000 or
                           $8,000 exclusion has been applied to both government
                           and private sector pensions.

                           Conversion to the U.S. return: This line item was
                           included in the U.S. return as reported on the Puerto
                           Rican return, although the cost recovery rules are
                           different in the United States, and government
                           pensions in the United States are taxed on the same
                           basis as are all other pensions.

Rents, royalties,          U.S. reporting: The United States has complex passive
partnerships, estates,     loss rules, limiting the use of losses from passive
and trusts                 activities to shelter income from other types of
                           activities. Although a passive activity is defined as
                           one involving the conduct of a trade or business in
                           which the taxpayer does not materially participate,
                           the passive loss rules treat rental activities as
                           passive.

                           Puerto Rico reporting: Passive activity losses may
                           not be used to offset income from another activity.
                           Also, excess losses may be carried forward
                           indefinitely to offset any future income from the
                           same activity. Partnerships that derive at least 70
                           percent of their gross income from Puerto Rican
                           sources, and at least 70 percent of such income is
                           produced in a specific enterprise, can elect to be
                           treated as special partnerships. However, distributed
                           losses from Special Partnerships can offset up to 50
                           percent of net income from any source. Puerto Rico's
                           regular partnerships are treated like corporations in
                           the United States. Special partnerships and
                           corporations of individuals (similar to S
                           corporations) are treated like United States
                           partnerships (pass-through entities).

                           Conversion to the U.S. return: These income items
                           were included in the U.S. return as reported on the
                           Puerto Rican return.

Farm income                U.S. reporting: Farm income is reported and taxed in
                           the same way as income from any other business.
                           However, there are inventory and expense deduction
                           rules that recognize the unique issues related to
                           operating a farm. For example, there are special
                           rules for the involuntary conversion of livestock or
                           crop disaster payments.

                           Puerto Rico reporting: Ninety percent of net farm
                           income is exempted from reporting. Puerto Rico also
                           includes some income and expense recognition rules
                           that are specific to farmers.

                           Conversion to the U.S. return: Farm income was
                           included as reported on the Puerto Rican return with
                           the 90-percent exclusion added back to income.

Unemployment compensation  U.S. reporting: Unemployment compensation is included
                           in gross income.

                           Puerto Rico reporting: Unemployment compensation is
                           not included in gross income and, therefore, not
                           reported on the income tax return. According to data
                           provided by the Department of the Treasury of Puerto
                           Rico, unemployment compensation totaled $336.5
                           million in 1994.

                           Conversion to the U.S. return: We were not able to
                           simulate this income item because we did not know how
                           the total unemployment compensation was distributed
                           among Puerto Rican taxpayers.

Social Security benefits   U.S. reporting: A portion of a taxpayer's Social
                           Security benefits may be taxable.

                           Puerto Rico reporting: Social Security payments are
                           not included as income and, therefore, not reported
                           on the income tax return.

                           Conversion to the U.S. return: We were not able to
                           simulate this income item.

IRA deductions             U.S. reporting: A deduction of up to $2,000 per
                           taxpayer is allowed for IRA contributions for
                           employees who cannot participate in certain employer-
                           sponsored pension plans. Taxpayers who are
                           participants in employer-sponsored plans can deduct a
                           limited amount of IRA contributions, depending on
                           their income. Total contributions of up to $2,250 can
                           be made per taxpayer each year to the taxpayer's IRA
                           and a spousal IRA.

                           Puerto Rico reporting: A $2,000 deduction per
                           taxpayer is allowed, or $4,000 for married taxpayers.
                           Limitations apply when the individual participates in
                           cash or deferred accounts. In 1994, the IRA deduction
                           was increased to $2,500 per taxpayer or $5,000 for
                           married taxpayers.

                           Conversion to the U.S. return: The IRA deduction
                           amount was included in the U.S. return as reported on
                           the Puerto Rican return.

Moving expenses            U.S. reporting: Certain moving expenses are
                           deductible as an adjustment to gross income if the
                           move is related to starting work in a new location.

                           Puerto Rico reporting: Moving expenses are deductible
                           as ordinary and necessary expenses within certain
                           limitations.

                           Conversion to the U.S. return: Because moving
                           expenses are reported with other ordinary and
                           necessary expenses, they were included in our
                           simulation of miscellaneous deductions.

One-half self-employment   U.S. reporting: One half of self-employment tax is
tax                        deductible as an adjustment to income. Dividends
                           typically are not included as earnings for self-
                           employment income. However, a taxpayer's distributed
                           share of ordinary income from a trade or business
                           carried on by a partnership is included in self-
                           employment income.

                           Puerto Rico reporting: Residents of Puerto Rico are
                           subject to federal self-employment tax under IRC
                           section 1402(b). Self-employed residents of Puerto
                           Rico are to file a U.S. Internal Revenue Form 1040PR
                           to compute self-employment tax. This return follows
                           the same employment tax rules applicable to residents
                           of the United States.

                           Conversion to the U.S. return: The tax was computed
                           by multiplying the self-employment tax rate (15.3
                           percent) times the amount of self-employment income.
                           The Puerto Rican individual income tax return
                           includes corporation dividends and distributions from
                           regular partnerships on the same line of the return.
                           Accordingly, we could not determine the regular
                           partnership distribution amount that would be
                           included as U.S. self-employment income. So that we
                           would not overstate self-employed income and the
                           related tax, we excluded any items from the Puerto
                           Rican return that would not be entirely included as
                           U.S. self-employment income.

Self-employed health       U.S. reporting: Up to 30 percent of health insurance
insurance deduction        premiums for self-employed persons are deductible as
                           an adjustment to gross income.

                           Puerto Rico reporting: There is no similar provision
                           in the Puerto Rican return. Health insurance premiums
                           for self-employed persons are deductible as an
                           itemized deduction.

                           Conversion to the U.S. return: Self-employed health
                           insurance deduction was not simulated because self-
                           employed insurance premiums and other business
                           adjustments are offset against self-employment income
                           in the Puerto Rican return, and our Puerto Rican
                           individual income tax data file showed only the net
                           self-employment income amount.

Keogh retirement or        U.S. reporting: Keogh retirement or SEP payments are
Simplified Employee        deductible as an adjustment to gross income.
Pension (SEP) plans
deduction                  Puerto Rico reporting: Keogh retirement or SEP
                           payments are deductible as an adjustment to self-
                           employment income.

                           Conversion to the U.S. return: A Keogh retirement or
                           SEP deduction was not simulated because Keogh
                           retirement or SEP payments and other business
                           adjustments are offset against self-employment income
                           in the Puerto Rican return, and our Puerto Rican
                           individual income tax data file showed only the net
                           self-employment income amount.

Penalty on early           U.S. reporting: Penalties paid on early withdrawal of
withdrawal of savings      savings are deductible.

                           Puerto Rico reporting: There is no similar line item
                           in the Puerto Rican tax return.

                           Conversion to the U.S. return: We were not able to
                           simulate this income adjustment.

Alimony paid               U.S. reporting: Alimony paid is deductible as an
                           adjustment to income.

                           Puerto Rico reporting: Alimony paid is deductible as
                           an adjustment to income.

                           Conversion to the U.S. return: Alimony paid was
                           included in the U.S. return as reported on the Puerto
                           Rican tax return.

Medical and dental         U.S. reporting: Unreimbursed medical and dental
expenses                   expenses are deductible as itemized deductions to the
                           extent they exceed 7.5 percent of AGI.

                           Puerto Rico reporting: Under Puerto Rico's rules,
                           generally, the same kind of medical and dental
                           expenses, except drug expenses, are deductible, but
                           only 50 percent of total medical expenses paid are
                           deductible in the year paid and to the extent they
                           exceed 3 percent of AGI.

                           Conversion to the U.S. return: The gross medical and
                           dental expense amount and any orthopedic equipment
                           expenses (see miscellaneous deductions) were included
                           in the U.S. return as reported on the Puerto Rican
                           tax return and adjusted for U.S. income limitation
                           rules.

Taxes                      U.S. reporting: Under U.S. tax rules, certain state,
                           local, and foreign government taxes--such as real
                           property and income taxes--are deductible as an
                           itemized deduction. Personal property taxes are
                           deductible only if paid or accrued to state or local
                           governments.

                           Puerto Rico reporting: Puerto Rico allows as an
                           itemized deduction property taxes paid on the
                           taxpayer's principal residence. Puerto Rico has no
                           personal property or local individual income taxes
                           (below the Commonwealth level).

                           Conversion to the U.S. return: We used the amount of
                           property taxes as reported on the Puerto Rican tax
                           return. No amount was simulated for personal property
                           or local income taxes because they do not exist. We
                           used the actual Puerto Rican tax liability after
                           credits except for the foreign tax credit, which is
                           largely a credit for U.S. income taxes (see foreign
                           tax credit).

Interest                   U.S. reporting: The U.S. itemized deduction includes
                           home mortgage interest and points, home equity loans,
                           and refinanced mortgages for a qualified residence.
                           The deduction is limited to principal amounts of $1
                           million for mortgages and $100,000 for home equity
                           loans. These limits apply to mortgage or home equity
                           loans taken out after October 1987. Additional limits
                           apply if the mortgage exceeds the fair market value
                           of the residence.

                           Puerto Rico reporting: The Puerto Rican deduction
                           includes many of the U.S. provisions, except that
                           there are no limitation amounts and no deduction is
                           allowed if the mortgage exceeds the fair market value
                           of the residence at the time the debt was incurred.

                           Conversion to the U.S. return: The Puerto Rican tax
                           return item was used. The Puerto Rican deduction
                           could be limited under U.S. rules. However, we did
                           not know whether the principal amount exceeded the
                           U.S. limits because that information is not reported
                           on the Puerto Rican income tax return.

Gifts to charity           U.S. reporting: U.S. tax rules generally allow as an
                           itemized deduction total contributions to
                           governmental entities, charitable organizations,
                           cemetery companies, war veterans groups, and certain
                           domestic fraternal societies, which are usually
                           limited to 50 percent of AGI. Certain contributions
                           are also limited to 30 percent or 20 percent of AGI,
                           depending on the type of contribution. A carryover is
                           allowed for any excess up to 5 years.

                           Puerto Rico reporting: The Puerto Rican allowable
                           deduction is the total amount of contributions in
                           excess of 3 percent of AGI. The actual deduction
                           taken must not exceed 15 percent of AGI, except an
                           additional deduction of up to 15 percent of AGI is
                           allowed for contributions to accredited university-
                           level educational institutions established in Puerto
                           Rico. Under certain circumstances an unlimited
                           deduction for charitable contributions is allowed.
                           After 1994, a carryover for excess charitable
                           contributions up to 5 years was allowed.

                           Conversion to the U.S. return: The Puerto Rican tax
                           return line item was used. However, because of the
                           differences stated above, the U.S. deduction may be
                           understated.

Casualty and theft losses  U.S. reporting: U.S. rules allow an itemized
                           deduction for theft, vandalism, fire, storm, or
                           similar causes; car, boat, and other accidents; and
                           money lost due to insolvency or bankruptcy of
                           financial institutions. Each separate casualty or
                           theft loss must be $100 or more. Only losses that
                           total more than 10 percent of AGI are deductible.

                           Puerto Rico reporting: Puerto Rico limits losses of
                           personal property to $5,000 for the year in which the
                           loss was incurred. The carryover of excess losses is
                           allowed for 2 years. Puerto Rico has no limit for
                           casualty loss on a principal residence.

                           Conversion to the U.S. return: The amount reported on
                           the Puerto Rican return was included in the U.S.
                           return as reported, but the U.S. limits were applied.

Miscellaneous deductions   U.S. reporting: The United States allows itemized
                           deductions for unreimbursed employee expenses such as
                           job travel, union dues, and job education. Other
                           expenses are also deductible such as for investing,
                           preparing tax returns, and renting a safe deposit
                           box. Only amounts in excess of 2 percent of AGI are
                           deductible. All itemized deductions are reduced by 3
                           percent of the amount that AGI exceeds a threshold
                           amount.

                           Puerto Rico reporting: Puerto Rican job expenses are
                           deductible from AGI as "ordinary and necessary
                           expenses" instead of as an itemized deduction.
                           Taxpayers can deduct ordinary and necessary expenses
                           whether or not they itemize. Generally, the expenses
                           deductible are the same as in the United States. The
                           amount deductible is limited to $1,500, or 3 percent
                           of gross income from salaries, whichever is less. In
                           1994, the deduction of meals and entertainment
                           expenses was reduced from 80 percent to 50 percent of
                           the amount incurred.

                           Conversion to the U.S. return: The amount reported on
                           the Puerto Rican return was included in the U.S.
                           return as a miscellaneous deduction but limited by
                           the U.S. rules. In 1992, the rules on the deduction
                           of meals and entertainment expenses were more
                           restrictive in the United States.

Other miscellaneous        U.S. reporting: Several expenses are deductible as
deductions                 miscellaneous itemized deductions. However, they are
                           not subject to the 2-percent limit. Examples of
                           deductible items include the following:

                           Amortizable premium on taxable bonds: Bond premiums
                           are deductible for a bond purchased before October
                           23, 1986.

                           Gambling losses to the extent of gambling winnings:
                           The taxpayer cannot offset the losses against the
                           winnings. He/she must report the full amount of the
                           winnings and claim the losses as an itemized
                           deduction.

                           Impairment-related work expense of persons with
                           disabilities: These are allowable business expenses
                           incurred for the taxpayer to be able to work.

                           Puerto Rico reporting: Bond premium amortization is
                           allowed as an offset against interest income, and the
                           net amount is reported as miscellaneous income;
                           however, no deduction is allowed for interest-exempt
                           bonds. Gambling losses are deducted from gambling
                           winnings, and net gambling winnings are reported as
                           miscellaneous income. Net gambling losses are not
                           deductible. An itemized deduction is allowed for
                           "orthopedic equipment expenses for the handicapped."
                           However, this deduction does not have to be directly
                           related to the employment of the taxpayer.

                           Conversion to the U.S. return: Since bond premium
                           amortization is offset against interest income and
                           gambling losses are offset against gambling winnings,
                           we were not able to simulate a miscellaneous
                           deduction for these items.

                           Also, we were not able to simulate a miscellaneous
                           deduction for orthopedic equipment expenses because
                           under Puerto Rico's tax law the orthopedic equipment
                           expense deduction is not required to be work related
                           to be deductible. However, orthopedic equipment
                           expenses were included as medical and dental expenses
                           (see medical and dental expenses).

Child and dependent care   U.S. reporting: Under U.S. tax rules, the DCTC allows
tax credit (DCTC)          a portion of the child and dependent care expenses
                           for the taxpayer to obtain gainful employment, as a
                           nonrefundable tax credit. A child must be under the
                           age of 13 to qualify. The credit is computed on the
                           basis of maximum allowable related expenses of $2,400
                           for one child, or $4,800 for two or more children.
                           Then, depending on the AGI of the taxpayer, a credit
                           is computed on a sliding scale from 20 percent to 30
                           percent of the allowable expenses.

                           Puerto Rico reporting: Puerto Rico allows a child-
                           care, but not dependent-care, itemized deduction of
                           $400 for one child and $800 for two children. The
                           expenses must be for work or a profitable activity.
                           The child must not be over 14 years of age to
                           qualify. The Puerto Rican return lists the expenses,
                           but up to the limitation amount.

                           Conversion to the U.S. return: Because Puerto Rican
                           taxpayers that do not itemize cannot claim the child-
                           care deduction and because the expense limits are low
                           in comparison to the United States, simulating the
                           credit on the basis of the information reported on
                           the Puerto Rican return would significantly
                           understate the potential use of the credit. Because
                           the DCTC could be an important feature of the federal
                           income tax system extended to Puerto Rico, we imputed
                           the potential value of the credit on the basis of
                           available 1991 IRS Statistics of Income data (SOI).

                           From the SOI data, we identified the dollar value of
                           the credit claimed by all taxpayers categorized by
                           the number of dependent children reported and by AGI
                           class. We then calculated the average credit claimed
                           for each number of dependents in each AGI class. This
                           average credit was given to each Puerto Rican
                           taxpayer with the same number of dependents in the
                           same AGI group.

Credit for the elderly     U.S. reporting: U.S. rules allow the credit for
                           taxpayers who are 65 or older or who have a permanent
                           and total disability. The amount of the credit
                           depends on the taxpayer's filing status, age, and
                           level of pension, disability, or annuity income.

                           Puerto Rico reporting: There is no similar credit in
                           Puerto Rico.

                           Conversion to the U.S. return: We were not able to
                           calculate the credit because the necessary data were
                           not available.

EITC                       U.S. reporting: See table II.2.

                           Puerto Rico reporting: Puerto Rico does not have a
                           similar credit.

                           Conversion to the U.S. return: EITC was computed
                           using information reported on the Puerto Rican tax
                           return.

Foreign tax credit         U.S. reporting: The United States allows a credit or
                           a deduction for any income, war profits, and excess
                           profits taxes paid or accrued during the taxable year
                           to any foreign country or to any possession of the
                           United States.

                           Puerto Rico reporting: Puerto Rico allows a credit
                           for the amount of income, war profits, and excess
                           profits taxes imposed by the United States,
                           possessions of the United States, and foreign
                           countries.

                           Conversion to the U.S. return: Officials from the
                           Department of the Treasury of Puerto Rico told us
                           that almost all of the foreign tax credits claimed by
                           Puerto Rican residents (about $4.4 million) on Puerto
                           Rican individual income tax returns was from income
                           taxes paid to the United States. (Puerto Rican
                           residents with income from sources outside Puerto
                           Rico are subject to federal income taxes.) Because
                           these amounts would be the equivalent of federal tax
                           paid, they would not be deductible on a federal
                           income tax return.

Miscellaneous credits      U.S. reporting: The United States has several
                           targeted credits such as the general business credit,
                           jobs credit, alcohol fuels credit, etc.

                           Puerto Rico reporting: Data were not available from
                           the Puerto Rican return to calculate any of these
                           credits.

                           Conversion to the U.S. return: These credits were not
                           included in our simulation.

Alternative minimum tax    U.S. reporting: AMT was developed to ensure that
(AMT)                      high-income taxpayers who make extensive use of
                           certain tax deductions and exemptions pay a minimum
                           amount of tax. AMT is computed by adding back certain
                           tax preference items, such as certain itemized
                           deductions, investment interest, depletion, and
                           certain tax-exempt interest to taxable income.
                           Certain tax preference items may have to be
                           recomputed under special AMT rules before they are
                           added back. After deducting an exemption amount, a
                           tentative AMT amount is computed by multiplying the
                           remaining income by either a 26-percent or 28-
                           percent tax rate. The difference between the
                           tentative AMT and the regular tax is the amount of
                           AMT actually owed. The tentative AMT is then added to
                           the regular income tax if it is greater than the
                           regular tax.

                           Puerto Rico reporting: Puerto Rico has an alternate
                           basic tax that will be assessed if it is greater than
                           the regular tax. The tax is computed by subtracting
                           ordinary and necessary expenses and capital gains
                           from AGI. Then an additional tax of 10 percent to 20
                           percent is calculated on alternative AGIs of over
                           $75,000. The regular tax or the alternate basic tax
                           is paid, whichever is larger.

                           Conversion to the U.S. return: Since computing the
                           U.S. AMT requires the application of complex rules
                           for several income and deduction items, it requires a
                           substantial amount of data to be accurately applied.
                           Some of the data needed to apply these rules is not
                           available on the Puerto Rican return, such as certain
                           types of tax-exempt interest income. Accordingly, the
                           AMT tax was not computed for our simulation.
--------------------------------------------------------------------------------
Source:  GAO analysis of U.S.  and Puerto Rican income tax laws. 


   EITC RULES
-------------------------------------------------------- Appendix II:1

EITC is a refundable tax credit available to low-income working
taxpayers.  The credit was established in 1975 to achieve two
long-term objectives:  (1) to offset the impact of Social Security
taxes on low-income workers with families and (2) to encourage
low-income individuals with families to seek employment rather than
welfare. 

EITC amounts generally are determined according to the amount of the
taxpayers' earned income and whether they have qualifying children
who meet certain age, relationship, and residency tests, which are
described in table II.2.  The credit gradually phases in, plateaus at
a maximum amount, and then phases out until it reaches zero.  If the
taxpayers' earned income or AGI exceeds the maximum qualifying income
level, they are not eligible for the credit.  When the taxpayers' AGI
falls in the credit's phase-out range, they receive the lesser amount
resulting from using either their earned income or AGI in calculating
the credit. 

When changes made in the 1993 Omnibus Budget Reconciliation Act are
fully in effect in tax year 1996, taxpayers with two children and
whose earned income ranges from $1 to $8,890 are to receive $0.40 for
each dollar earned.  Taxpayers with two children and whose incomes
range from $8,890 to $11,610 are to receive the maximum credit amount
of $3,556.  The credit will gradually phase out, declining at a rate
of about $0.21 for each additional dollar of income, for taxpayers
with two children and incomes ranging from $11,610 to $28,495. 
Taxpayers with one qualifying child or no children receive EITC at a
lower rate, with different plateau amounts and phase-out rates. 

Beginning in 1996, taxpayers will be disqualified for EITC if their
unearned income exceeds $2,350.  Unearned income is defined as the
combined amount of taxable and tax-exempt interest income, dividends,
and the net income from rents and royalties not received from a trade
or business. 

The following table summarizes the principal EITC qualification rules
and details the extent to which the Puerto Rican tax return provides
data for determining eligibility for the credit. 



                                    Table II.2
                     
                          Analysis of the Principal EITC
                          Requirements For Tax Year 1996

EITC requirements                   Issues/comments on conversion to U.S. return
------------------------------  --  --------------------------------------------
Eligible individuals
--------------------------------------------------------------------------------
(1) Must have a qualifying          See qualifying child definition below.
 child; must have had earned
 income; must not be a
 qualifying child of another
 person; if married persons,
 must file jointly or qualify
 for head-of-household status;
 or
(2) Must have been a resident       Puerto Rico reporting: The Puerto Rican tax
 of the United States for more       return reports residency in Puerto Rico at
 than one-half of the tax            the end of the tax year, not residency for
 year; must have had earned          more than one-half of the tax year. Though
 income; must not be a               age information is reported on the Puerto
 dependent of another person;        Rican return, this information was not made
 must not be a qualifying            available for our simulation. The return
 child of another person; if         does not ask whether the taxpayer is taken
 married persons, must file          as a dependent on another taxpayer's
 jointly or qualify for head-        return.
 of-household status; must be
 at least 25 but not 65 years        EITC estimate: We assumed that the taxpayer
 of age at the close of the          had been a resident for more than one-half
 tax year; and                       of the tax year, was not taken as a
                                     dependent on another taxpayer's return, and
                                     met the age requirements.
(3) Must not have disqualified      Puerto Rico reporting: Specific income items
 income of more than $2,350.         can be identified on the Puerto Rican tax
 Disqualified income includes        return. However, the Puerto Rican return
 interest, dividends, and net        includes royalties as part of miscellaneous
 income from rents and               income.
 royalties not received from a
 trade or business.                  EITC estimate: Since royalties and net
                                     rental income derived from nonbusiness or
                                     trade activity can not be specifically
                                     identified, they were not included in our
                                     simulation of the U.S. tax return.

Qualifying child
--------------------------------------------------------------------------------
(1) Relationship test: must be      Puerto Rico reporting: The Puerto Rican
 son, daughter, adopted child,       return identifies some relationships
 or descendant of the son,           between the taxpayer and a dependent. The
 daughter, or adopted child;         identified relationships include child,
 stepson or stepdaughter; or         parent, in-laws, and "closely related."
 foster child. Married child         However, the return does not identify the
 is not eligible unless he or        specific relationships needed to comply
 she is a dependent.                 with the EITC requirements.

                                     Qualifying child definition: We only
                                     included as qualifying children those
                                     dependents identified on the Puerto Rican
                                     return as "children." We were unable to
                                     include other eligible dependents in our
                                     simulation, such as "stepson or
                                     stepdaughter," because they are identified
                                     on the Puerto Rican return as "closely
                                     related," which includes other ineligible
                                     dependents.
(2) Age Test: must be under         Puerto Rico reporting: Age and dependent
 age 19, a full-time student         status information is on the Puerto Rican
 under age 24, or permanently        tax return. Disabled persons also qualify
 and totally disabled.               as dependents.

                                     Qualifying child definition: Dependents
                                     listed on the Puerto Rican return as a
                                     nonuniversity student or university student
                                     and who met the age and relationship tests
                                     were counted as qualifying children. In the
                                     special case of head-of-household filers,
                                     when one dependent is selected as
                                     qualifying the filer for head-of-household
                                     status and included in a special dependent
                                     section, we assumed this dependent to have
                                     met the qualifying child requirements (age
                                     and relationship).
(3) Residence test: child's         Puerto Rico reporting: Under Puerto Rican
 principal place of residence        tax rules, a child's residence does not
 is with the taxpayer in the         have to be with the taxpayer to qualify as
 United States for more than         a dependent. Also, the Puerto Rican return
 one-half year (the entire           requests information on residency in Puerto
 year, in the case of an             Rico at the end of the tax year. It does
 eligible foster child). There       not request information about whether more
 are special rules for members       than one-half of the year was spent in the
 of the U.S. armed services.         United States or Puerto Rico.

                                     Qualifying child definition: We assumed
                                     that the child had been a resident for more
                                     than one-half of the tax year.

Earned income
--------------------------------------------------------------------------------
Includes wages, salaries, tips      Puerto Rico reporting: Many earned income
 and self-employment income,         items can be identified on the Puerto Rican
 and certain nontaxable earned       tax returns, including wages, salaries,
 income items such as                tips, and self-employment income. These
 voluntary salary deferrals.         self-employment income items may vary from
                                     those which would have been reported on
                                     U.S. returns because of differences in tax
                                     accounting rules, such as those related to
                                     depreciation of assets.

                                     Earned income definition: We used data
                                     elements for wage, salaries, and tips as
                                     shown on the Puerto Rican return. Items
                                     included in our approximation to U.S. self-
                                     employment income were (1) profits or
                                     losses from special partnerships, (2)
                                     profits or losses from commissions, (3)
                                     profits or losses from agriculture, (4)
                                     profits or losses from professions, and (5)
                                     profits or losses from rental businesses.
--------------------------------------------------------------------------------
Source:  GAO analysis of EITC's principal tax requirements. 


COMPARISON OF U.S.  AND PUERTO
RICO'S TAXATION OF CORPORATE AND
PARTNERSHIP INCOME
========================================================= Appendix III


   CORPORATE TAXATION
------------------------------------------------------- Appendix III:1

Puerto Rican tax rules for corporations have many similarities to and
some differences from U.S.  tax rules.  Both the United States and
Puerto Rico require corporations to report their worldwide income. 
Also, both Puerto Rico and the United States allow the deduction of
"ordinary and necessary" business expenses and have similar rules on
accounting for inventories and cost of goods sold.  Prior to June 30,
1995, Puerto Rico allowed, under certain circumstances, businesses to
expense up to 100 percent of the basis of business assets in the year
of acquisition and thereafter.  This provision was repealed in Puerto
Rico's Tax Reform Act of 1994 for assets acquired after June 30,
1995. 

Puerto Rico has generally higher marginal corporate tax rates than
does the United States.  In 1995, corporate taxes in the United
States started at 15 percent for incomes of up to $50,000, with a
maximum corporate tax rate of 35 percent.\1 In 1992, Puerto Rico's
regular corporation tax rate started at 22 percent.  Also, a sliding
scale surtax was added to the regular tax, starting at a marginal
rate of 6 percent for incomes up to $75,000 with an allowance of a
special credit.  The maximum surtax marginal rate was 20 percent for
incomes over $275,000.  Puerto Rico also has an alternative corporate
capital gains tax rate of 25 percent and an alternative dividend rate
of 20 percent.  The Puerto Rico Tax Reform Act of 1994 lowered the
regular corporate tax rate to 20 percent, the maximum surtax rate to
19 percent, and the alternative dividend rate to 10 percent. 

Both the United States and Puerto Rico offer corporations special tax
incentives to meet a variety of economic goals.  In the United States
these incentives can be either additional deductions from income or
tax credits.  Some examples of these incentives include accelerated
depreciation of buildings, credits for low-income housing, expensing
of research and experimentation expenditures, or the possessions tax
credit. 

Puerto Rico's tax code also includes various deductions and tax
credits as incentives.  However, since 1947, Puerto Rico has offered
a tax incentive program to encourage the establishment and growth of
manufacturing and certain other businesses.  Most recently, the
Puerto Rico Industrial Incentive Act of 1987 provided several tax
reductions to industrial units that, for example, manufacture
products that had not previously been made in Puerto Rico, produce
products designated for export, develop specific types of real
estate, or produce energy from recycling or renewable sources.  In
general, these businesses are exempted from taxation on 90 percent of
the net income derived from these sources; and the same percentage
for eligible interest and dividends; currency exchange; and patents,
royalties, and other rights.  The act also includes a package of
municipal, personal property, and real property tax reductions. 

The rate reductions are not permanent.  The duration of the rate
reductions depends on the location of the exempt business and varies
from 10 to 25 years.  However, the exempted businesses are allowed
the option of selecting the specific years they will be exempt from
taxation under the Industrial Development Act. 

According to statistics provided by the Commonwealth, in 1993, 1,111
corporations were qualified under the Industrial Tax Exemption laws,
with about $10.7 billion of exempted income. 


--------------------
\1 A corporation with taxable income in excess of $100,000 is
required to increase its tax liability by the lesser of 5 percent of
the excess or $11,750.  A corporation with taxable income in excess
of $15 million must increase its tax liability by the lesser of 3
percent of the excess or $100,000. 


   POSSESSIONS TAX CREDIT
------------------------------------------------------- Appendix III:2

One U.S.  tax policy significantly affecting Puerto Rico is the
possessions tax credit defined in section 936 of the federal Internal
Revenue Code (IRC).  Under this section of the IRC, a portion of
income derived from operations of qualified subsidiaries of U.S. 
corporations in U.S.  possessions is effectively exempted from U.S. 
income tax. 

Firms are qualified for the credit if, over the 3-year period
preceding the close of a taxable year, 80 percent or more of their
income was derived from sources within a possession, and 75 percent
or more of their income was derived from the active conduct of a
trade or business within a possession. 

The 1993 Budget Reconciliation Act limited the possessions tax
credit.\2 For tax years beginning after 1993, taxpayers are to
calculate the credit as under prior law, but the credit would be
capped under one of two alternative options selected by the taxpayer: 

  -- The "percentage limitation" option provides for a decreasing
     credit equal to a decreasing percentage of the amount computed
     under prior law.  The percentages are set by law at 60 percent
     for 1994, 55 percent for 1995, 50 percent for 1996, and 45
     percent for 1997.  The percentage will be 40 percent for 1998
     and thereafter. 

  -- The "economic activity limitation" option provides a cap on the
     credit equal to the sum of three factors: 

  -- The first factor is 60 percent of the firm's wages plus
     allocable employee fringe benefits paid in the possession, with
     wages limited for each employee to 85 percent of the maximum
     wage base under the old age survivor and disability insurance
     portion of Social Security. 

  -- The second factor is a specific percentage of the firm's
     depreciation deductions for qualified tangible property for each
     taxable year.  The type of property defines the applicable
     percentage, with factors ranging from 15 percent for property
     with a relatively short recovery period to 65 percent for assets
     with a long recovery period. 

  -- The third factor, which applies only to firms that do not use
     the 50-percent profit-split method of income allocation\3 is a
     portion of the income taxes paid to the possession government. 
     Included taxes, however, cannot exceed a 9-percent effective tax
     rate. 


--------------------
\2 Omnibus Budget Reconciliation Act of 1993, Pub.L.  No.  103-66,
S13227, 107 Stat.  312, 489 (1993). 

\3 This method generally permits allocation to the possession
corporation of 50 percent of the affiliated group of U.S. 
corporations' combined taxable income derived from sales of products
that are manufactured in a possession. 


   PARTNERSHIP TAXATION
------------------------------------------------------- Appendix III:3

U.S.  and Puerto Rico's tax laws for partnerships have several
significant differences.  With a few exceptions, U.S.  partnerships
are not taxable entities.  Distributions of partnership profits are
included on the partner's individual income tax return and are taxed
at personal income tax rates. 

In contrast, Puerto Rico taxes regular partnerships on their net
income at corporate tax rates and also requires partners to include
distributed partnership profits as taxable income on their individual
income tax returns. 

"Special partnerships" in Puerto Rico are not taxed at the entity
level.  Instead, as is the case with U.S.  partnerships, partners
include on their individual income tax returns their distributable
shares of partnership net income.  To qualify as a special
partnership, 70 percent of the partnership's gross income must come
from Puerto Rican sources.  Further, not less than 70 percent of such
income must be generated from one of several activities including
construction, land development, or manufacturing when it generates
substantial employment. 


COMBINED INDIVIDUAL INCOME TAXES: 
PUERTO RICO, THE 50 STATES, AND
THE DISTRICT OF COLUMBIA
========================================================== Appendix IV

The following tables compare the actual federal, state, local, and
combined individual income taxes of the 50 states, the District of
Columbia, and Puerto Rico.  The income tax is measured in per-capita
terms (table IV.1) and as percentage of total personal income (table
IV.2.) In addition, table IV.3 shows the distribution of general
revenue sources for Puerto Rico, the 50 States, and the District of
Columbia. 



                                    Table IV.1
                     
                         Actual Federal, State, and Local
                      Individual Income Tax Per Capita, 1992

                                                                        Combined
                                                                        federal,
                                                       State and      state, and
                                           Federal  local income    local income
Puerto Rico/fifty states/D.C.           income tax           tax             tax
------------------------------------  ------------  ------------  --------------
================================================================================
Puerto Rico                                     $1          $341            $342
Mississippi                                    979           168           1,147
Louisiana                                    1,315           203           1,518
West Virginia                                1,203           339           1,542
New Mexico                                   1,264           281           1,545
South Dakota                                 1,546          N.T.           1,546
Arkansas                                     1,213           355           1,568
North Dakota                                 1,480           189           1,669
Tennessee                                    1,669            19           1,688
South Carolina                               1,311           392           1,703
Alabama                                      1,391           312           1,703
Oklahoma                                     1,363           380           1,743
Montana                                      1,368           391           1,759
Texas                                        1,781          N.T.           1,781
Utah                                         1,354           431           1,785
Arizona                                      1,532           324           1,856
Wyoming                                      1,880          N.T.           1,880
Kentucky                                     1,358           547           1,905
Maine                                        1,446           479           1,925
Idaho                                        1,430           502           1,932
Florida                                      1,997          N.T.           1,997
Nebraska                                     1,639           408           2,047
Iowa                                         1,569           505           2,074
North Carolina                               1,558           524           2,082
Missouri                                     1,692           397           2,089
Vermont                                      1,623           475           2,098
Kansas                                       1,778           332           2,110
Georgia                                      1,680           455           2,135
Indiana                                      1,735           451           2,186
Michigan                                     1,856           385           2,241
New Hampshire                                2,235            31           2,266
Washington                                   2,287          N.T.           2,287
Rhode Island                                 1,846           478           2,324
Ohio                                         1,753           581           2,334
Wisconsin                                    1,798           629           2,427
Oregon                                       1,688           747           2,435
Pennsylvania                                 1,909           545           2,454
California                                   1,957           551           2,508
Alaska                                       2,534          N.T.           2,534
Nevada                                       2,536          N.T.           2,536
Colorado                                     2,083           465           2,548
Virginia                                     2,039           519           2,558
Illinois                                     2,256           395           2,651
Minnesota                                    2,019           671           2,690
Delaware                                     2,129           759           2,888
Hawaii                                       2,111           785           2,896
Maryland                                     2,276           873           3,149
Massachusetts                                2,404           891           3,295
New Jersey                                   2,816           525           3,341
New York                                     2,341         1,005           3,346
District of Columbia                         2,587         1,073           3,660
Connecticut                                  3,288           569           3,857
--------------------------------------------------------------------------------
N.T.  = No Tax

Note:  Puerto Rico's federal income tax per-capita amount is based on
the foreign income tax credit (about $4.4 million) claimed on the
Puerto Rican tax returns, which is almost all for federal taxes paid
to the United States (see app.  II, foreign tax credit).  However, if
residents of Puerto Rico had been subject to the federal income tax
in the same manner as residents of the states were, we estimate that
the federal individual income tax per-capita in Puerto Rico would
have been about $14 in 1992, and the combined federal and Puerto
Rican individual income tax per-capita would have been about $355 in
1992. 

Sources:  Significant Features to Fiscal Federalism, Vol.  2,
Advisory Commission on Intergovernmental Relations, 1994; Statistics
of Income Bulletin, IRS, Spring 1994; Informe Econï¿½mico al
Gobernador, Puerto Rico Planning Board, 1994; and GAO computations
using Puerto Rico's taxpayer data provided by the Department of the
Treasury of Puerto Rico. 



                                    Table IV.2
                     
                         Actual Federal, State, and Local
                     Individual Income Tax as a Percentage of
                              Personal Income, 1992

                                                                        Combined
                                                                        federal,
                                                       State and      state, and
                                           Federal  local income    local income
Puerto Rico/fifty states/D.C.           income tax           tax             tax
------------------------------------  ------------  ------------  --------------
================================================================================
Puerto Rico                                   0.0%          5.3%            5.3%
Mississippi                                    7.0           1.2             8.2
South Dakota                                   9.0          N.T.             9.0
Tennessee                                      9.4           0.1             9.5
Louisiana                                      8.3           1.3             9.6
Texas                                          9.7          N.T.             9.7
North Dakota                                   8.7           1.1             9.8
West Virginia                                  7.7           2.2             9.9
New Mexico                                     8.2           1.8            10.0
Arkansas                                       7.8           2.3            10.1
Wyoming                                       10.1          N.T.            10.1
Florida                                       10.1          N.T.            10.1
New Hampshire                                 10.2           0.1            10.3
Alabama                                        8.4           1.9            10.3
South Carolina                                 8.1           2.4            10.5
Maine                                          8.0           2.6            10.6
Oklahoma                                       8.3           2.3            10.6
Arizona                                        8.8           1.9            10.7
Washington                                    10.7          N.T.            10.7
Nebraska                                       8.6           2.1            10.7
Montana                                        8.4           2.4            10.8
Kansas                                         9.2           1.7            10.9
Missouri                                       8.9           2.1            11.0
Vermont                                        8.6           2.5            11.1
Iowa                                           8.6           2.8            11.4
Michigan                                       9.5           2.0            11.5
Alaska                                        11.5          N.T.            11.5
Utah                                           8.7           2.8            11.5
Rhode Island                                   9.1           2.4            11.5
Kentucky                                       8.2           3.3            11.5
Georgia                                        9.1           2.5            11.6
Idaho                                          8.6           3.0            11.6
North Carolina                                 8.7           2.9            11.6
California                                     9.2           2.6            11.8
Nevada                                        11.7          N.T.            11.7
Pennsylvania                                   9.2           2.6            11.8
Indiana                                        9.4           2.5            11.9
Illinois                                      10.4           1.8            12.2
Virginia                                       9.8           2.5            12.3
Ohio                                           9.2           3.1            12.3
Colorado                                      10.1           2.3            12.4
Wisconsin                                      9.4           3.3            12.7
New Jersey                                    10.8           2.0            12.8
Hawaii                                         9.5           3.5            13.0
District of Columbia                           9.3           3.8            13.1
Oregon                                         9.1           4.0            13.1
Minnesota                                      9.8           3.3            13.1
Maryland                                       9.8           3.8            13.6
New York                                       9.7           4.2            13.9
Massachusetts                                 10.2           3.8            14.0
Delaware                                      10.3           3.7            14.0
Connecticut                                   12.1           2.1            14.2
--------------------------------------------------------------------------------
N.T.  = No Tax

Note:  Puerto Rico's federal income tax as a percentage of personal
income is based on the foreign income tax credit (about $4.4 million)
claimed on the Puerto Rican tax returns, which is almost all for
federal taxes paid to the United States (see app.  II, foreign tax
credit).  However, if residents of Puerto Rico had been subject to
the federal income tax in the same manner as residents of the states
were, we estimate that the federal individual income tax as a
percentage of personal income in Puerto Rico would have been about
0.2 percent in 1992, and the combined federal and Puerto Rican
individual income tax as a percentage of personal income would have
been about 5.5 percent in 1992. 

Sources:  Significant Features to Fiscal Federalism, Vol.  2,
Advisory Commission on Intergovernmental Relations, 1994; Statistics
of Income Bulletin, IRS, Spring 1994; Informe Econï¿½mico al
Gobernador, Puerto Rico Planning Board, 1994; and GAO computations
using Puerto Rico's taxpayer data provided by the Department of the
Treasury of Puerto Rico. 



                                                                      Table IV.3
                                                       
                                                         Puerto Rico, State, and District of
                                                          Columbia General Revenue Sources,
                                                         Percentage Distribution, Fiscal Year
                                                                         1992



                          Transfer
                              from                                                                                                     Total revenues
Puerto Rico/fifty          federal  Individual  Corporatio                                                                     Nontax        from own
states/D.C.             government      income    n income        Property   General sales         Other   Total taxes       revenues         sources
----------------------  ----------  ----------  ----------  --------------  --------------  ------------  ------------  -------------  --------------
Alabama                      22.8%       10.1%        1.3%            5.6%          14.0 %        15.3 %        46.3 %         30.9 %          77.2 %
Alaska                        12.6        N.T.         3.0             9.4             1.1          20.1          33.6           53.8            87.4
Arizona                       16.8         9.7         1.6            20.1            19.8           9.1          60.4           22.8            83.2
Arkansas                      25.0        12.3         1.8             9.1            17.8          11.7          52.7           22.3            75.0
California                    18.9        13.3         3.5            16.1            14.6           8.7          56.3           24.7            81.1
Colorado                      16.3        12.6         1.0            18.3            14.6           8.4          55.0           28.7            83.7
Connecticut                   16.4        12.4         3.9            26.1            13.9          10.4          66.7           16.8            83.6
Delaware                      14.5        17.4         4.3             7.6            N.T.          24.4          53.6           31.9            85.5
District of Columbia          37.7        13.3         1.9            19.2             9.4           7.3          51.1           11.2            62.3
Florida                       13.8        N.T.         1.5            21.6            18.5          14.7          56.4           29.8            86.2
Georgia                       19.0        13.8         1.7            16.4            15.9           7.6          55.3           25.8            81.0
Hawaii                        16.6        16.0         1.2             9.8            22.8          10.0          59.9           23.6            83.4
Idaho                         19.4        15.6         2.0            13.9            12.8          11.0          55.2           25.3            80.6
Illinois                      16.5        11.2         2.4            24.2            13.4          11.5          62.7           20.8            83.5
Indiana                       18.0        13.8         2.1            17.4            15.1           6.4          54.8           27.1            82.0
Iowa                          17.1        14.0         1.9            19.7            10.4          10.2          56.1           26.8            82.9
Kansas                        16.7         9.8         2.3            21.6            13.9          10.6          58.2           25.1            83.3
Kentucky                      22.8        16.8         2.2             9.1            11.2          14.6          53.9           23.3            77.2
Louisiana                     25.8         5.6         1.5             7.6            17.5          13.2          45.4           28.8            74.2
Maine                         21.3        12.6         1.5            21.7            12.2           8.7          56.7           22.0            78.7
Maryland                      16.3        23.4         1.2            17.5             8.6          11.8          62.5           21.2            83.7
Massachusetts                 18.9        20.8         2.9            20.5             7.7           7.7          59.6           21.5            81.1
Michigan                      17.8        10.1         4.8            25.0            10.2           7.0          57.1           25.1            82.2
Minnesota                     15.9        15.3         2.2            17.7            11.3          10.1          56.5           27.5            84.1
Mississippi                   28.2         5.7         1.9            12.1            15.3           9.8          44.7           27.1            71.8
Missouri                      20.7        13.3         1.5            13.5            16.9          10.8          56.0           23.3            79.3
Montana                       25.1        10.4         1.9            18.9            N.T.          16.1          47.3           27.6            74.9
Nebraska                      17.1        11.3         1.8            20.2            13.3           9.4          55.9           27.0            82.9
Nevada                        15.1        N.T.        N.T.            13.8            19.0          24.5          57.2           27.7            84.9
New Hampshire                 19.6         0.9         2.4            37.5            N.T.          17.7          58.4           22.0            80.4
New Jersey                    14.8        11.3         2.3            27.2            11.1          10.9          62.8           22.4            85.2
New Mexico                    20.6         7.4         1.3             5.7            19.8          12.8          47.0           32.4            79.4
New York                      18.6        17.6         4.3            20.7            10.7           8.7          62.0           19.4            81.4
North Carolina                19.0        16.5         3.0            11.8            13.7          12.2          57.3           23.7            81.0
North Dakota                  24.6         4.9         1.6            13.8            11.1          14.2          45.6           29.7            75.4
Ohio                          19.0        17.2         1.7            16.8            11.7           9.8          57.2           23.8            81.0
Oklahoma                      19.1        12.3         1.5             7.9            15.8          15.4          52.9           28.0            80.9
Oregon                        20.1        18.5         1.3            21.4            N.T.          10.7          51.9           28.0            79.9
Pennsylvania                  19.3        14.3         3.6            16.0             9.9          13.7          57.6           23.2            80.7
=====================================================================================================================================================
Puerto Rico                  29..3        19.3        18.0             5.8            N.T.          18.0          61.2            9.5            70.7
Rhode Island                  25.4        12.0         1.2            23.7             9.8           9.7          56.3           18.3            74.6
South Carolina                22.2        12.4         1.2            14.3            12.9           9.3          50.1           27.7            77.8
South Dakota                  26.1        N.T.         1.5            18.9            16.5          11.4          48.2           25.7            73.9
Tennessee                     24.3         0.6         1.9            11.5            21.8          12.9          48.7           27.0            75.7
Texas                         16.5        N.T.        N.T.            22.8            18.5          16.6          57.9           25.6            83.5
Utah                          20.0        13.1         1.3            14.0            16.4           6.9          51.8           28.3            80.0
Vermont                       22.1        11.6         1.3            23.2             6.7          12.7          55.5           22.4            77.9
Virginia                      13.9        15.6         1.3            19.5             9.7          13.5          59.7           26.4            86.1
Washington                    16.5        N.T.        N.T.            17.3            28.5          13.3          59.1           24.4            83.5
West Virginia                 25.9        10.3         3.1             8.9            13.4          14.8          50.5           23.6            74.1
Wisconsin                     16.8        16.4         2.3            21.5            11.6           9.0          60.7           22.5            83.2
Wyoming                       26.7        N.T.        N.T.            18.2             9.3          15.4          42.9           30.4            73.3
-----------------------------------------------------------------------------------------------------------------------------------------------------
N.T.  = No Tax

Note:  Totals may not add due to rounding. 

Sources:  Significant Features to Fiscal Federalism, Vol.  2,
Advisory Commission on Intergovernmental Relations, 1994; and Informe
Econï¿½mico al Gobernador, Puerto Rico Planning Board, 1994. 




(See figure in printed edition.)Appendix V
COMMENTS FROM THE SECRETARY OF THE
TREASURY OF PUERTO RICO
========================================================== Appendix IV



(See figure in printed edition.)


MAJOR CONTRIBUTORS TO THIS REPORT
========================================================== Appendix VI

GENERAL GOVERNMENT DIVISION,
WASHINGTON, D.C. 

James Wozny, Assistant Director, Tax Policy and
 Administration Issues
Leon H.  Green, Senior Evaluator
Nilsa I.  Pï¿½rez, Evaluator-in-Charge
MacDonald R.  Phillips, Economist
Charles C.  Tuck, Senior Economist

OFFICE OF THE GENERAL COUNSEL,
WASHINGTON, D.C. 

Rachel DeMarcus, Assistant General Counsel

OFFICE OF CHIEF ECONOMIST,
WASHINGTON, D.C. 

Daniel E.  Coates, Senior Economist


*** End of document. ***