As Puerto Rico braces for a debt default on August 1 and is being dubbed as “America’s Greece,” it is also staring at a long list of all that went wrong over the last 40 years or more. Best known for its tourism attractions of beaches, waterfalls and rain forests, the Caribbean island finds itself paying for decades of ill-designed labor laws and ineffective institutional mechanisms, among other constraints. Puerto Rico badly needs bankruptcy protection to contain the chaos that its default could bring about, along with longer-term structural reforms on multiple fronts, experts tell Knowledge at Wharton.

Employers find Puerto Rico’s minimum wage of $7.25 an hour uncompetitive, which discourages job creation in the formal sector. Liberal welfare programs also discourage people from taking jobs in the formal sector. Instead, they seek employment within the informal sector, where workers stay below the radar of labor statisticians and tax collectors. The phasing-out in 2005 of tax incentives for U.S. businesses investing in Puerto Rico also dampened job creation in recent years. Much damage is also attributed to decades of inadequate institutional structures and mechanisms for tax collection, lack of ease in doing business, difficulties in registering property and maritime trade constraints.

All those problems seemed to converge last week when Puerto Rico’s Public Finance Corporation failed to transfer $93.7 million to pay principal and interest obligations on its bonds. With $72 billion in debt, the territory’s immediate problem is it cannot file for protection under U.S. bankruptcy laws. Chapter 9 of the U.S. Bankruptcy Code provides protection to municipalities and helps them restructure their debt. But unlike Detroit or Stockton, Calif., which are among the cities that have filed for Chapter 9 bankruptcy protection in recent years, Puerto Rico is not considered a state or a municipality under U.S. federal laws.

The Key Issues

“Without Chapter 9 [protection], every creditor could go to court and it will be a like a bank run,” said Anne O. Krueger, senior research professor of international economics at Johns Hopkins University’s School of Advanced International Studies.

The “most pressing” need is to work out some way to help the island deal with the fallout of a debt default, according to Frank H. Shafroth, director of George Mason University’s Center for State and Local Government Leadership. He called for a process to ensure that critical public services are not interrupted, with a federal judge overseeing the effort. “[Or else], you’re going to have chaos,” he said. Shafroth has strong family ties with Puerto Rico. His great-grandfather, Sen. John Shafroth, (D-Colorado), was instrumental in drafting the 1917 Jones-Shafroth Act, which granted Puerto Ricans U.S. citizenship.

“Without Chapter 9 [protection], every creditor could go to court and it will be a like a bank run.” –Anne O. Krueger

Puerto Rico needs “new institutions, new structures, new laws and new incentives,” according to Rosario Rivera-Negron, senior economist and economics professor at the University of Puerto Rico. “Without economic activity, there are not going to be any revenues, and we have seen that the fiscal crisis is feeding on the economic crisis — so we have to tackle both,” she said.

Krueger, Shafroth and Rivera-Negron discussed Puerto Rico’s underlying economic problems and suggested ways to revive growth on the Knowledge at Wharton show on Wharton Business Radio on SiriusXM channel 111. (Listen to the podcast at the top of this page.)

A History of Wrong Steps

How did Puerto Rico come to such a sorry pass? “Everybody is somewhat at fault,” said Krueger of Puerto Rico’s problems. The situation in Puerto Rico built up over several years, with the country running fiscal deficits and running down its cash balances, said Krueger. Now the island has exhausted all of its options to cope with its high debt levels, she added. Krueger co-authored a June 2015 report titled, “Puerto Rico — A Way Forward.”

Krueger noted that Puerto Rico has attempted to resolve its debt over the years but none of those initiatives has worked. Excess expenditures and an inability “for a variety of reasons” to collect taxes compounded the damage, she added. According to Krueger, the fault also lies with the U.S., as Puerto Rico is not a state or a country and has fewer options than the 50 U.S. states that could file for bankruptcy protection.

“Without economic activity, there are not going to be any revenues, and we have seen that the fiscal crisis is feeding on the economic crisis — so we have to tackle both.” –Rosario Rivera-Negron

“Puerto Rico has not had any growth for 20 years,” said Krueger, noting two big setbacks the territory faced in that period. The removal in 2005 of tax exemptions on profits of U.S. businesses investing in Puerto Rico was “significant,” she noted, and called upon U.S. lawmakers “to do something” to bring back the enthusiasm among businesses to invest in the territory. Soaring oil prices between 2002 and 2008 also hurt the island’s economy badly. Puerto Rico is heavily dependent on oil for its power, and high oil prices raised the costs of its electric company “unbelievably,” she said.

Rivera-Negron noted that Puerto Rico had not adequately heeded “several warnings since the 1970s that somewhere in the future, [its] economy will face what it is facing right now.” The island’s government failed to introduce structural reforms and its economic model relied too heavily on the so-called Section 936 of the U.S. Internal Revenue Code that granted tax-free income for U.S. businesses investing in its economy, she added. “Somewhere along the way, we were going to fail miserably, and we just did.”

Discouraging Work, Encouraging Welfare

According to Shafroth, Puerto Rico failed in trying to establish an effective tax system, thereby limiting benefits for its people. “Right now, unemployment benefits for people make not working more attractive than working for the wages that are available for most people in the territory,” he said. “In effect, you have a government policy that tends to discourage work and encourage spending.”

Krueger’s report has telling details on the impact of Puerto Rico’s labor and wage laws. “Only 40% of the adult population — versus 63% on the U.S. mainland — is employed or looking for work; the rest are economically idle or working in the grey [i.e. informal] economy,” it stated. The report cites two reasons for that situation. One, employers are disinclined to hire workers because the U.S. federal minimum wage is very high relative to the local average, and two, local regulations pertaining to overtime, paid vacation and dismissal are costly and more onerous than on the U.S. mainland.

“Workers are disinclined to take up jobs because the welfare system provides generous benefits that often exceed what minimum wage employment yields,” the report continued. It cites one estimate that a household of three eligible for food stamps, Medicaid and utilities subsidies could receive $1,743 per month, as compared to a minimum-wage earner’s take-home earnings of $1,159. “The result of all of the above is massive underutilization of labor, foregone output, and waning competitiveness,” the report said.

“You have a government policy that tends to discourage work and encourage spending.” –Frank H. Shafroth

Finding Solutions

The political parties that have run the territory’s government over the past 25 years have failed to bring “a credible economic plan and the reformulation of the [existing] economic model,” Rivera-Negron said.

Among other things, Krueger pointed to tourism as an opportunity for Puerto Rico “if they can get their policies domestically and with the mainland sorted out.” She noted that the territory has several “attractive features” such as an English-speaking workforce, an absence of passport requirements and the prevalence of U.S. laws. Yet, for price-sensitive families looking for vacations, it is not competitive with neighboring islands or Mexico, which have lower minimum wages, she said.

Rivera-Negron said that labor reforms should be a prime area for Puerto Rico as it finds a way out of its problems. “How do we create some kind of incentive to draw those people that are working as professionals [in the informal sector] or are not [employed] in jobs to the formal sector with proper incentives?” she asked. A solution to that problem would help the territory collect income taxes and other levies that it needs, she added.

In addition to reforms to promote business investment and job creation, the U.S. Congress could also help lower the cost of living on the island, Rivera-Negron suggested. She pointed in particular to the so-called “cabotage” laws that deny the territory the full benefits of maritime trade. Under cabotage restrictions in U.S. maritime law, only U.S.-flagged ships can be used for cargo traveling between U.S. mainland ports and Puerto Rican ports. Those opposed to such regulations say that Puerto Rico’s economy would benefit if foreign-flagged ships were also allowed to ply between U.S. mainland ports and Puerto Rican ports.