Current Issues in Economics and Finance

Trends and Developments in the Economy of Puerto Rico

March 2008Volume 14, Number 2
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Jason Bram, Francisco E. Martínez, and Charles Steindel

A two-year-long economic downturn and a persistent income gap with the U.S. mainland contribute to an uncertain outlook for PuertoRico. Still, the commonwealth possesses a skilled and educated workforce, a favorable business climate, and the benefits of U.S. legal and financial structures—advantages that could encourage the development of new industries and create the potential for sustained growth.

Readers of this publication who are accustomed to thinking of the Federal Reserve System’s Second District as New York State and nearby counties in New Jersey and Connecticut may be surprised to learn that the District includes the Commonwealth of Puerto Rico.1 In this issue of Second District Highlights, we present an overview of Puerto Rico’s economy, examining its basic characteristics, long-term industry and labor trends, and prospects for growth.

In our analysis, we apply many of the tools used to examine the economy of a U.S. state. After all, PuertoRico’s population of nearly 3.9million exceeds that of twenty-four states, and its area of about 3,500 square miles, while small, roughly matches that of Connecticut. However, our analysis also recognizes that PuertoRico possesses unique institutional and structural features—its location, status as a commonwealth, and large public sector—that set it apart from the fifty states. Its economy is unusual too in having been directly influenced by federal legislation—most notably, section936 of the Internal Revenue Code, which until its recent repeal provided incentives for the capital-intensive production of chemicals and pharmaceuticals.

Our look at the economy of Puerto Rico highlights some dramatic changes over the last half century: a shift away from agriculture, a large out-migration of people to the mainland UnitedStates, and the growth of certain sophisticated manufacturing industries. Despite economic advances, however, PuertoRico remains considerably less affluent than any U.S. state. Indeed, while the UnitedStates as a whole and other parts of the Second District continued to grow through 2007, recent economic data suggest that the commonwealth’s economy has contracted over the last two years.

Puerto Rico and Its Economy: Some Background
Commonwealth Status and Location
The institutional framework in which the PuertoRican economy operates bears significant similarities to that of a state, but it also has some unique characteristics. Like a state, PuertoRico is part of the U.S. banking and financial system and adheres to all U.S. international trade regulations and tariffs; labor and capital move freely between the island and the mainland, just as they do across state borders. PuertoRico differs from the states, however, in that federal taxes are generally not levied on personal and corporate income earned on the island.

A key characteristic of PuertoRico is its relative isolation from the U.S. mainland. SanJuan is approximately 1,000 miles from Miami, the closest major U.S. city. The remoteness of PuertoRico from the mainland has likely lessened its attractiveness as a location for firms siting operations to serve the broad U.S. market. Still, the bulk of PuertoRico’s trade is with the UnitedStates: for instance, more than 80percent of the commonwealth’s exports are to the states. Moreover, it is interesting to note that PuertoRico is less isolated than either Hawaii or Alaska: Honolulu is about 2,500 miles from LosAngeles, and Anchorage, the center of Alaska’s population, is roughly 1,400miles from Seattle.

Migration and Current Human Resources
Midway through the twentieth century, Puerto Rico underwent a major transition from an agricultural to an industrial economy. This turnover in the economy prompted much of the island’s population to migrate to the mainland United States, and especially to NewYorkCity. The heaviest out-migration occurred between 1950 and 1975, and the 1980s witnessed some return migration (Martínez, Máttar, and Rivera2005). Nevertheless, on net, about one million people (equal to 45percent of the island’s 1950 population) moved from PuertoRico to the mainland between 1950 and 2000. The effects of this large population outflow are widely debated in PuertoRico. Some conventional wisdom holds that the island has suffered a “brain drain”—a loss of skilled workers—to the United States. The economic literature on the topic, however, generally does not support this conclusion. In fact, studies suggest that in the 1950-70 period, those who left PuertoRico for the mainland were largely rural residents, unable to find work in the industrial sector.

Other evidence that undercuts the notion of a brain drain is the steady growth in college-educated residents after 1970—a development seen as placing “substantial downward pressure on the relative wages of college-educated workers” (Ladd and Rivera-Batiz2006). If the out-migration had drawn away a significant share of PuertoRico’s highly skilled workers, the relative wages of the more educated workers who remained on the island would have been under upward, not downward, pressure. Still, it is conceivable that emigration may have deprived Puerto Rico of people with skills that could have contributed to the island’s development.

Fortunately, the displacement of the agricultural population did not result in a surge in the urban population, as it did in other developing regions, where the influx of rural residents put a severe strain on city infrastructure. The population of the SanJuan metropolitan area grew 18percent from 1950 to 20002—a much more modest expansion than the 87percent increase observed in the UnitedStates population as a whole. Moreover, the migration of the population has had some favorable consequences for the island economy: PuertoRicans continue to receive remittances from relatives residing elsewhere in the United States, though as a share of personal income these payments have dropped from about 3 1/2 percent in the 1950s and 1960s to a little more than 1percent in 2006 (PuertoRico Planning Board2006). In addition, the large population on the mainland with close ties to PuertoRico has likely helped create markets for goods and services produced on the island—for example, one major bank in PuertoRico has an extensive mainland branch network.3

As for the current state of the workforce, we have already noted the increase in college-educated workers. The younger portion of the working-age population of PuertoRico now has, on average, a level of educational attainment close to that of mainland residents (Table1). While it is hard to generalize from such statistics, these characteristics suggest that the workforce may be comparable to that of much of the developed world.

Industry Profile
Agriculture now plays a small role in the commonwealth’s economy. Employment data indicate that goods-producing industries such as construction and manufacturing are significant relative to U.S. norms (Table2). Government also figures importantly: many utilities, educational services and, to a lesser extent, health services are supplied by government entities. In fact, the public sector’s share of total employment is so large that it reduces industries like construction or manufacturing to a share of total employment that is little more than the U.S. average, even though these industries claim a notably high share of private employment. Within manufacturing, employment in pharmaceutical production is unusually high: nearly 4percent of all private sector workers on the island are employed in this industry—more than ten times the mainland average. Educational services account for a substantial share of private sector jobs on the island. By contrast, employment in professional and technical service industries is relatively low, and even financial services’ share is somewhat below average.

The high concentration of pharmaceutical employment appears to reflect incentives created by section936 of the Internal Revenue Code, in force from 1976 to 2006. This rule exempted corporations from paying U.S. corporate income taxes on profits earned from sales of items produced in PuertoRico.4 In practice, the provision appeared to encourage the siting in Puerto Rico of plants producing high-profit, easily transportable items such as pharmaceuticals and electronic components. To get the maximum benefit from section936, manufacturing facilities in PuertoRico tended to have relatively small and lower-wage workforces; other, higher-value-added components of the enterprises (such as management or research and development) generally remained elsewhere.

The share of employment in tourism-related industries—accommodation and food services, the arts, entertainment, and recreation—is below the mainland average, even though PuertoRico can be viewed as an important tourist destination. Certainly, the deep connections between PuertoRico and the mainland United States create considerable potential for travel and tourism to become a leading growth sector.

Economic Development and Income Profile
The current level of development in PuertoRico is high by the standards of much of the world, but not relative to the United States as a whole. In 2005, median wage and salary income for full-time workers was barely one-third of the U.S. average and a bit less than two-thirds of the figure for Mississippi, the state with the lowest median income. By a different economic metric, output (or GDP), PuertoRico appears somewhat more prosperous, with a per capita figure just short of half that for the UnitedStates as a whole. Output has performed better than labor income primarily because of the robust production of the capital-intensive “section936 plants.” However, while the profits and other capital income earned by these establishments may be taxed by the commonwealth—and thus can contribute indirectly to the well-being of PuertoRico—the income itself for the most part accrues to mainland U.S. owners. Thus, the wage and salary numbers, reflecting income directly earned by PuertoRicans, likely give a better sense of the island’s economic performance.5 Still, while wages are relatively low, home ownership rates are quite high: as of 2006, three-fourths of PuertoRican households owned their homes, compared with two-thirds of households on the mainland. Moreover, an exceptionally large share of these homes—more than 60percent, almost double the share on the mainland—had no mortgage debt.6

Over the last thirty years, average weekly earnings of PuertoRico’s private sector workers have grown less rapidly than the earnings of their mainland counterparts, slipping from 63percent of the U.S. average in 1977 to 55percent in 2003 (Burtless and Sotomayor 2006). Thus, while the island has become substantially more prosperous, there has been no reduction of the large income gap with the UnitedStates. With the expiration of section936 and the income inducements this provision created for corporations to locate in PuertoRico, the persistence of the income gap has led to some rethinking of growth prospects for PuertoRico.

On the institutional side, the prominence of government activity also has implications for the island’s growth. Government or government enterprises account for nearly 30percent of employment in PuertoRico, nearly twice the mainland average of 16percent. The large role of government in part reflects efforts to relieve poverty and to provide services such as medical care and utilities at a lower cost to groups unable to afford them otherwise.7 However, it also leaves PuertoRico with a relatively high tax burden, despite the general exemption from federal income taxes.8 Indeed, even with this exemption, PuertoRico collects about one-quarter of its gross product in taxes, a share that slightly exceeds the U.S. norm. Thus, a major issue for the commonwealth is balancing the burden that these high taxes may place on development against the benefits that government interventions provide to distressed groups.

Business Climate
Despite the tax burden, PuertoRico’s general business climate appears to be relatively favorable. In the WorldBank’s most recent poll of the “ease of doing business” in countries worldwide, PuertoRico (considered separately from the UnitedStates) ranked nineteenth, higher than any Caribbean or CentralAmerican nation (WorldBank2006).9 The commonwealth scored particularly high on “starting a business,” “protecting investors,” and “paying taxes.” It received relatively low marks, however, on “dealing with licenses” and “enforcing contracts.”

On balance, PuertoRico has a well-educated labor force and, despite the relatively large size of the government, a more favorable climate for business than its Caribbean neighbors. Before discussing the potential growth sectors for PuertoRico, we consider some current trends.

Recent Developments
PuertoRico’s business cycles have generally tracked those of the nation as a whole—a correspondence that may well reflect the close trade linkages between the island and the mainland. Private sector employment growth on the island fell sharply in each of the last three U.S. recessions, and bottomed out at roughly the end of the downturn on the mainland (Chart1).

Given the close cultural and family links between PuertoRico and NewYork City, one might also expect to find some parallels in the employment patterns of the island and the city. However, monthly employment numbers indicate that private sector job growth in PuertoRico is somewhat more volatile than in the UnitedStates or NewYork City.10 And if we look beyond the monthly swings to the broad movements shown in Chart1, we see that business cycle fluctuations in PuertoRico tend to resemble those of the nation more than they do those of NewYork City.11 For example, the 1982 recession was deep and prolonged in PuertoRico and in the UnitedStates—but not in NewYork City. In addition, the 1990-91 recession was relatively deep in NewYork City but mild in PuertoRico and the nation as a whole. The 2001 recession was also somewhat less severe in PuertoRico than in NewYork City but more severe than in the nation. The ensuing recovery in PuertoRico came sooner and was stronger than the U.S. recovery and markedly stronger than the city’s recovery. PuertoRico’s substantial concentration in manufacturing, as well as its relatively light concentration in the financial sector so important to NewYork City, could help to explain why its cycle may have been more like the nation’s than the city’s over much of the past twenty-five years.12

Beginning in 2006 and continuing through the end of 2007, however, PuertoRico’s employment growth patterns diverged markedly from those of both New York City and the nation, showing considerably more weakness (Chart1). As of January 2008, private sector employment on the island was down 1.1percent from a year earlier and down 3.5 percent from its end-year 2005 cyclical peak. This observation is supported by a standard measure of high-frequency activity on the island, the coincident economic index(CEI). Like similar indexes used to gauge the performance of the U.S. and state economies, PuertoRico’s index combines the employment numbers with other series.13 As Chart2 shows, PuertoRico’s CEI has been substantially weaker than the roughly comparable U.S. index compiled by the Conference Board and the index for NewYork City computed by the FederalReserve Bank of NewYork. Commentators have suggested that PuertoRico entered a recession near the beginning of 2006;14 by contrast, in the nation as a whole, payroll employment and overall output continued to grow throughout 2007, albeit more slowly than earlier in the expansion.

The decline in PuertoRico’s CEI has been driven primarily by the drop in reported private employment. Moreover, jobs lost in the private sector have compounded earlier job losses stemming from a public sector downsizing that reduced government employment by more than 5percent between mid-2004 and mid-2006.15 Recent job numbers for PuertoRico should be viewed with some caution, however: payroll employment data tend to be revised substantially (seebox). For example, the 2005 decline in employment emerged in the reported statistics only after the employment growth numbers for that year were revised downward a full 7percentage points. Thus, given the uncertainty surrounding the data, a pattern of continuing job loss cannot be definitively established at this time. In fact, some contrary evidence comes from household survey data, which indicate that the unemployment rate remained steady at a little more than 11percent through the end of 2007—up from earlier in the year but still low when compared with readings prior to 2000 (Chart3). Still, the numbers as they stand point to deterioration in the PuertoRican economy’s recent performance, both in absolute terms and relative to the UnitedStates, and there is some contention that the island’s business cycle has become disengaged from that of the mainland (Alameda2007).

Moreover, other developments appear consistent with an economic downturn in PuertoRico: as of second-quarter 2007 (the latest numbers available), growth in total wage and salary earnings was sluggish, up by just 3.0percent from a year earlier, or well below the inflation rate. Housing markets have weakened noticeably; housing permits hit a seven-year low in 2006. Reports indicate that office vacancy rates have also risen.16

What accounts for the apparent contraction of PuertoRico’s economy? Spillovers from the slowdown in sectors of the mainland U.S. economy such as manufacturing and homebuilding may have played a role, but factors specific to PuertoRico have likely contributed as well:

  • The repeal of the section 936 tax provision may be prompting some relocation of manufacturing from Puerto Rico. A portion of the drop-off in economic activity could thus reflect this one-time adjustment rather than a true cyclical decline or more fundamental long-term weakness.
  • The shrinkage in the government sector could also be having some near-term negative effect on aggregate activity. As noted earlier, government employment was cut by more than 5percent over 2004-06, a consolidation of the sector designed to ease the commonwealth’s fiscal problems. Although some might argue that a smaller government would ultimately facilitate higher trend growth in the private sector, the job cuts in the short term could adversely affect growth by contributing to a reduction in government spending on goods and services.17

Growth Prospects for PuertoRico
The longer term outlook for PuertoRico is uncertain. Given the commonwealth’s link to the UnitedStates, output in PuertoRico is likely to grow at least in tandem with output on the mainland. However, the more substantive issue is whether, after the disappointing performance of the last generation, the income gap with the United States will narrow.

In the near term, PuertoRico seems to be experiencing a recession, and the repeal of section936 of the Internal Revenue Code could be putting some further drag on the island’s economy. The hope that Puerto Rico could overcome such problems and become the next Ireland—an island nation that, though long impoverished, has emerged as one of Europe’s wealthiest countries—may not be realistic.18 One reason for skepticism is that in seeking a position in the Americas comparable to Ireland’s in Europe, PuertoRico could face strong competition from its Caribbean neighbors in the coming decades.19

A number of factors could, however, contribute to a more favorable outlook for PuertoRico. The concentration of manufacturing in pharmaceuticals and electronics—a legacy of section936—could be an impetus for further growth in these sectors since industry clusters are thought to increase productivity through the sharing of product and market information. Growth could also be achieved through the emergence of new industries. Indeed, some commentators have speculated that PuertoRico, by virtue of its location, size, and association with the UnitedStates, may have significant comparative advantages as a premier tourist destination, regional center for financial and business services, and shipping and distribution center for the Caribbean and LatinAmerica.20 Finally, the island possesses certain fundamental advantages that create the potential for sustained growth: an increasingly skilled and educated workforce, a favorable business climate, deep familial connections to the mainland UnitedStates, and the benefits of U.S. legal, contractual, and financial structures. The challenge for PuertoRico going forward will be to devise an appropriate set of policies and incentives to build on its many strengths.