Treasury Secretary Jacob J. Lew strived to light a fire under congressional leaders Tuesday by calling the fiscal crisis confronting Puerto Rico "immediate and real," with dire consequences for the island commonwealth's 3.5 million citizens as well as investment markets nationwide.
Puerto Rico defaulted Monday on most of a debt payment of roughly $400 million; another $1.3 billion in bond payments are due July 1, and the island's administration has made clear that it can't meet the obligation. The island has been shut out of the debt markets, while creditors await action on legislation that would restructure its debt under the supervision of an independent oversight board.
Hospitals continue to lay off workers, ration medication, reduce services and close floors. ... Despite the intensifying threat from the Zika virus, financial constraints have made it extremely difficult to counteract.
— Treasury Secretary Jacob J. Lew warns congressional leaders about the situation in Puerto Rico
Without congressional action, Lew told an audience at the Milken Institute Global Conference in Beverly Hills, Puerto Rico could face the unraveling of "what we know of as normal life in an American community." He was interviewed by Jared Bernstein, a senior fellow at the Center on Budget and Policy Priorities and former chief economist to Vice President Joe Biden.
Among other topics touched on in their talk were tax reform and the Treasury's recent decision to place an image of Harriet Tubman on the $20 bill.
The "fundamental obstacle" to achieving tax reform, Lew said, is the notion that personal and business tax reform has to happen in tandem. Lew has been a strong advocate for reforming corporate income taxes, in part to combat "inversions," through which U.S. companies reincorporate overseas purely to avoid U.S. taxes, while keeping their operations in the United States.
Regulations issued by the Treasury earlier this year succeeded in quashing a $160-billion merger between Pfizer and Allergan, through which Pfizer would have changed its legal domicile from New York to Allergan's home in Ireland. But Lew said regulations are only stopgaps to discourage the inversion craze. "I don't believe it can be permanently shut down without legislation," he said.
He also spoke up for changing rules allowing assets with large embedded capital gains to be passed on to heirs tax-free. Typically, stocks and other appreciated assets can be bequeathed at a "stepped-up basis," meaning that their capital gains tax liability is eliminated and the assets are revalued at their market price at the time of inheritance, rather than at the time of purchase. The difference can be worth millions of dollars to a family.
"Salaried people don't have any way of getting out of their taxes," Lew said. The inequities in the tax code are underscored when "people see generations of wealth being passed on and not getting taxed."
He also suggested that the tax rates on capital gains should be brought more in line with rates on ordinary income. Currently, the maximum tax on capital gains is 20%, compared to 39.6% for ordinary income. As a consequence, "our businesses expend so much energy in trying to take advantage of the differential rates."
As for the decision to place an image of the abolitionist and suffragist Harriet Tubman on the front of the $20 bill, relegating President Andrew Jackson to the back, Lew observed that the images on currency help "tell stories about our history." Since the decision was announced last month, he said, "I have not been in a store or on the street when someone has not come up to me and thanked me."
The Puerto Rico crisis has been building for years. The island has been in recession since 2006, when a federal program offering incentives to businesses to relocate there expired. As American citizens, Puerto Ricans have few difficulties leaving the island to work on the mainland, further crippling its economy.
Puerto Rico papered over the shrinkage in its economy by heavy borrowing, issuing bonds that were exempt from local, state or federal taxes. Despite those exemptions, its most recent bond issue still required a high interest rate of 8%.
The consequence, Lew said, is that with 3.5 million residents and debt of $70 billion, Puerto Rico today "is in a league of its own" as a creditor, compared with other U.S. jurisdictions. Congressional action is required, he observed, because Congress in 1984 barred its municipalities from seeking Chapter 9 bankruptcy, a rescue used by Detroit and other strapped cities. Only Congress can legislate a crucial debt restructuring.
Just Monday, Lew wrote congressional leaders to reinforce a warning he issued in January that, without action, "Puerto Rico's fiscal, economic and humanitarian situation would continue to deteriorate." Since then, he wrote, bipartisan discussions have taken place, but no legislation has been passed. "Meanwhile, the crisis in Puerto Rico has deepened."
He wrote that "hospitals continue to lay off workers, ration medication, reduce services and close floors. ... Despite the intensifying threat from the Zika virus, financial constraints have made it extremely difficult to counteract."
He warned that the consequences for bondholders also could be dire: "Bondholders will experience a lengthy, disorderly and chaotic unwinding, with non-payment for many a real possibility."
Thus far, however, Congress hasn't responded to the crisis with any urgency, in part because municipal credit markets haven't appeared rattled by the island's default. In February, analysts at Nuveen Asset Management, which specializes in muni bonds, wrote that the "contagion risk is low" from a default. "We believe most institutional investors understand Puerto Rico's unique situation," the analysts wrote.
Leaders on Capitol Hill now say they hope to have a bill ready before July 1.
Puerto Rico's creditors can't plead that they were blindsided by the crisis. Journalist David Dayen noted last December in American Prospect that some hedge funds see Puerto Rico debt as a "vulture" play, snapping it up at fire sale prices in the hope of extracting a legal settlement at a profit.
Lew said Tuesday that a legislated debt restructuring is needed because otherwise creditors would engage in years of litigation. He seemed especially critical of "vulture" investors who often insist on full payment on their holdings, and who "want to maximize their chance of getting a dollar on a dollar even if everyone else gets nothing. ...If all the creditors are fighting ... there won't be anything left of Puerto Rico."
Some wealthy Americans have taken advantage of a 2012 local law that turned Puerto Rico into a tax haven for U.S. citizens by granting new residents who spend at least six months a year on the island an exemption from taxes on locally generated dividend or interest income for 20 years and from local or federal capital gains tax. That's an incentive for investment funds to relocate their activities to Puerto Rico.
Thus far, however, the island's overall fortunes haven't reflected the influx of investment wealth, whether it comes in the form of relocated fat cats or purchases of the island's bonds.