Puerto Rico Bankruptcy: How Did It End Up With so Much Debt? (2024)

The U.S. territory of Puerto Rico has made many attempts to reduce its debt burden and save its economy. However, it proved unsuccessful, and former Governor Ricardo Rossello moved the crisis to a form of bankruptcy court in 2017. With approximately $74 billion in bond obligations and $49 billion in unfunded pensions at the time, it was the largest government to seek bankruptcy in U.S. history.

To put this in perspective, the money Puerto Rico owes represents nearly 70% of the territory'sgross domestic product (GDP). For comparison, the average debt-to-GDP ratio for states in the United States was 17%. The territory's escalating debt, combined with its weakening economy, caused three major credit rating agencies in 2014 to downgrade Puerto Rico's debt tonon-investmentgrade, also known as junk status.

Puerto Rico is seeking to exit four years of bankruptcy by the end of 2021. Puerto Rico's oversight board, which was created by Congress in 2016, filed a restructuring plan in May 2021 with the goal of reducing $22 billion of debt.

Origins of the Debt Crisis

The Puerto Rican debt crisis has many origins. Most notably, investors in Puerto Rican municipal bonds received favorable tax treatment for years. Bond investors from all 50 states took advantage of this benefit by purchasing Puerto Rican bonds. When a government issues bonds, it is effectively lending money, with interest, to bondholders. Prompted in large part by this tax advantage, Puerto Rico issued too much bond debt and began relying on borrowed funds from bond issuance to balance its budget.

An economic decline in Puerto Rico led to widening budget deficits over the years. The tiny island is ill-equipped for the manufacturing and production of goods. Its economy was sustained for decades by the presence of technology and service-oriented companies that were located on the island due to its favorable tax treatment. Many of Puerto Rico's tax advantages, however, were ephemeral. The U.S. tax code called for these advantages to expire over time. When that began to happen, companies fled the island, eviscerating its economy.

Hurricane Maria in 2017 delivered another blow to Puerto Rico. The island took a direct hit from the Category 4 storm: knocking out power grids, flooding streets, and flattening entire neighborhoods. Bond values plummeted amid concerns Puerto Rico will never be able to repay its debt. By 2017, bond values had mostly returned to levels seen in 2014-2015 but then fell again in 2019 under the proposal that would allow Puerto Rico to reduce debt under bankruptcy protection.

Compared to other states and territories, spending on social programs is disproportionately high in Puerto Rico. About half of the island's residents receive Medicaid or assistance through the Children Health Insurance Program (CHIP). A high poverty rate in Puerto Rico invariably means a lot of its inhabitants seek welfare and other government benefits. Compounding the issue is the fact that Puerto Rico receives far fewer federal dollars to assist with social spending than states with comparable populations.

Puerto Rico has been shedding residents since 2005. The island's population is also aging. These combined factors have reduced its tax base substantially; not only has the territory taken on increasing debt in the 21st century, but it has less revenue coming in to pay that debt.

The Puerto Rican Bond Boom

The Jones-Shafroth Act of 1917 granted U.S. citizenship to residents in Puerto Rico. It also spelled out a number of stipulations defining the territory's relationship with the U.S. mainland. One of these stipulations involved Puerto Rican municipal bonds and the ways in which they would be treated differently than bonds issued by states.

Interest income on most municipal bonds is subject to taxes by various levels of government, including federal, state, and local. The primary exception is when an investor purchases a bond issued by their state of residence, as in a Floridian buying a Florida municipal bond. Jones-Shafroth exempted Puerto Rican municipal bonds from all three levels of taxation. As a result, residents of all 50 states and other U.S. territories could invest in Puerto Rican bonds without paying interest on the income.

Unsurprisingly, investment dollars began flooding into Puerto Rican government bonds. This failed to cause major problems for many decades. During the 1970s, however, the territory's government started using bond investment money to balance its budget, despite it being borrowed funds and not actual revenue. This practice resulted in the rapid accumulation of debt, the interest payments on which Puerto Rico covered by issuing even more debt. The resulting debt snowball comprises a large part of the territory's current crisis.

Puerto Rico's Disappearing Tax Advantages

Unlike most states in the U.S., Puerto Rico has never, in its history, sustained a strong economy on the back of manufacturing or producing goods. The territory's remote island location, tiny land area, and lack of natural resources precluded it from ever developing a strong manufacturing base.

For a while, Puerto Rico had something else to drive its economy. The federal government created an incentive for companies to locate there by establishing corporate tax exemptions. This was especially attractive to technology and service-oriented companies, for which Puerto Rico's remote location and dearth of resources posed few challenges.

These tax advantages, however, were not permanent. As they expired over time, many companies elected to discontinue their Puerto Rican presence. The economic decline that resulted was tantamount to what Detroit experienced during the darkest days of the Big Three auto slump. Reduced corporate presence led to GDP declines, worsening the island's debt-to-GDP ratio and hastening its credit downgrade.

Oppressive Social Spending

Half of Puerto Ricans receive Medicaid or CHIP assistance. However, compared to other states with high percentages of poor residents, such as Mississippi, Puerto Rico receives a tiny fraction of federal funds to assist with social spending.

As a result, the territory must heavily earmark its own budget to provide money for these programs, along with welfare and other safety net initiatives to help the needy. Over the past few decades, declining tax revenues and mounting debt in other areas have forced Puerto Rico to borrow money to keep its Medicaid program solvent.

Another serious problem stems from Puerto Rico's underfunded social safety net. Because so many of the territory's residents receive government assistance to pay for healthcare, providers struggle perpetually, and their workers are underpaid compared to their peers on the mainland. As a result, many of Puerto Rico's most skilled healthcare workers have jumped ship in favor of more lucrative jobs in other parts of the U.S.

Population Decline

Puerto Rico's population peaked in 2005 at 3.91 million and has been steadily declining. It is estimated that 3.2 million residents lived on the island in 2019. Puerto Ricans are relocating to the mainland in droves due to better economic opportunities and low airfare and moving costs.

Moreover, the population that Puerto Rico has managed to retain is aging rapidly. An aging population means less tax revenue and greater expenditures. When a Puerto Rican resident is no longer of working age, the government not only loses out on tax revenue from their income but, due to high levels of poverty among the elderly, it often must spend money on this resident in the form of social welfare.

The Bottom Line

Levels of debt in Puerto Rico became untenable, as the tax advantages of holding Puerto Rico's bonds expired, and Hurricane Maria wreaked additional havoc on the island's floundering economy. An aging population, mounting costs of social programs, and a declining population, have exacerbated debt problems as well. The territory continues to seek ways to reduce its debt and exit bankruptcy, with the goal of doing so by the end of 2021.