In the wake of the coronavirus outbreak, public health officials and policy experts have raised concerns that the U.S. is too dependent on China for critical active pharmaceutical ingredients—the compounds essential to manufacturing common medicines like penicillin, Advil, and Tylenol. The good news is that there are ways for Congress to jump-start American pharmaceutical ingredient manufacturing, by reforming the tax code of Puerto Rico.
Why Puerto Rican drug manufacturers moved to China
Until relatively recently, Puerto Rico was a dominant player in the manufacture of prescription drugs. The reason? Taxes.
In Gerald Ford’s last year as President, the Democratic Congress passed—and Ford signed—the Tax Reform Act of 1976, which exempted from taxation corporate income generated in U.S. territories, like Puerto Rico, Guam, and the U.S. Virgin Islands. This policy, combined with Puerto Rican tax law, meant that corporate subsidiaries based in Puerto Rico enjoyed a zero percent corporate tax rate, so long as they distributed their profits as dividends.
Pharmaceutical companies were well suited to take advantage of this tax break—contained in Section 936 of the Internal Revenue Code—for drug manufacturing. Companies could base their manufacturing operations in Puerto Rico, and thereby significantly reduce their U.S. tax burden. A 1993 report from the U.S. Government Accountability Office estimated that pharmaceutical companies represented, by far, the largest beneficiaries of the Puerto Rican corporate tax system, benefiting to the tune of $86 million in 1985.
Over time, Congress whittled away at the Puerto Rican tax break. Finally, in 1996, President Bill Clinton signed into law the Small Business Job Protection Act of 1996, which phased out Section 936, fully repealing the tax break in 2006. The measure was hailed at the time as “ending corporate welfare as we know it.”
The end of Section 936 dispersed the global pharmaceutical manufacturing industry to other parts of the globe. Many manufacturers of branded pharmaceuticals moved their factories to Ireland, which has a low 6.25 percent corporate tax rate for revenue tied to patents or other intellectual property. Ruthless price competition among manufacturers of older, generic medicines drove those supply chains to China and India. A U.S. Department of Commerce study found that 97 percent of the antibiotics used in the U.S. now come from China. 40 percent of over-the-counter and generic prescription drugs used in the U.S. now come from India.
Repeal of Section 936 helped crash Puerto Rico’s economy
The loss of pharmaceutical industry jobs helped crash Puerto Rico’s economy, turning economic growth from positive to negative, as this chart from the Tax Foundation shows.
“Not coincidentally,” write Scott Greenberg and Gavin Ekins, the end of the Puerto Rican tax break “marked the beginning of a deep recession for Puerto Rico, which has lasted until today…foreign investment began to flee. Without a strong domestic corporate presence to fill the void, the economy began to contract, along with tax revenues.”
As tax revenues dried up, Puerto Rico fell deeper and deeper into debt. Here, another tax break propped up the island for a time: the Jones-Shafroth Act of 1917, which exempts Puerto Rican bonds from federal, state, and local taxes. The tax exemption of Puerto Rico bonds incentivized institutional investors to hold those bonds, even if Puerto Rico’s credit was shaky.
But in February of 2014, the major credit rating agencies downgraded Puerto Rico’s bonds to non-investment grade, or “junk,” status. In 2015, Puerto Rico governor Garcia Padilla conceded that the island’s debts were “not payable.” But, technically, U.S. territories are not allowed to file for bankruptcy under the U.S. bankruptcy code. Today, Puerto Rico’s finances are governed by a federally appointed Financial Oversight and Management Board, though reform has proven politically difficult. The U.S. Congress remains reluctant to bail out the island with more subsidies.
In the meantime, some of the poorest Americans are struggling. 43 percent of Puerto Rican residents live below the poverty line.
Aiding two policy goals at once
The coincidence of these two problems—the departure of drug manufacturers from Puerto Rico, and the fiscal collapse of the island—could be simultaneously mitigated by partially restoring the Section 936 tax break, in exchange for other Puerto Rican fiscal reforms. Here’s how it could work:
- Exempt generic drug manufacturers from corporate taxes in Puerto Rico. A targeted exemption from taxation for generic drug manufacturers could bring Puerto Rican factories back to life, reduce our dependence on China and India, and possibly lower the cost of generic medicines. Keeping the tax break targeted to the generic sector lowers its fiscal costs while achieving a strategic objective.
- Create a ‘most-favored nation’ Puerto Rican tax rate for pharmaceutical intellectual property. As I mentioned above, countries like Ireland have a special tax rate of 6.25 percent for manufacturing that is tied to intellectual property such as patents. This low tax rate has done much to spur Ireland’s economic growth over the past two decades. Congress could pass a law enabling Puerto Rico to match the lowest such tax rate in Europe or North America, luring branded drug manufacturers back to Puerto Rico.
- Phase out the tax exemption for Puerto Rican bonds. In exchange for the partial restoration of these tax breaks, Congress should phase out the exemption from taxation of Puerto Rican debt for newly issued bonds. That will reduce Puerto Rico’s incentives to engage in deficit spending. It will also offset the fiscal cost of restoring the manufacturing tax breaks.
Congress, in its recent deliberations on an economic relief package, has thrown a lot of policy mud on the wall to see what sticks. Reforming Puerto Rican tax policy may be one of those things that actually works.
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UPDATE 1: On Twitter, tax wonks Nicole Kaeding and Ryan Ellis discuss the merits of this proposal; in particular, how reforming Puerto Rico’s corporate tax rates interacts with the Tax Cuts and Jobs Act of 2017, which significantly reformed corporate taxes.
UPDATE 2: In the above thread, former Puerto Rico governor Aníbal Acevedo Vilá passed along a link to a letter he sent on March 16 to Sen. Chuck Grassley (R., Ia.), chairman of the Senate Finance Committee, proposing that Congress provide “U.S. companies that invest in Puerto Rico with more competitive tax treatment as long as appropriate guardrails are designed to ensure the company is creating real economic activity and employment on the island.” He concludes, “It is not too late to make up for the lost production over the past 15 years.”
As former Governor of PR, this is an issue that I have followed for some time. Here copy of a letter that I sent yesterday to Senator Grassley precisely on this same issue. I would like your comments to my approch. Thanks - https://t.co/2P1sbEopZi
— Aníbal Acevedo Vilá (@anibalacevedo) March 17, 2020
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INVESTORS’ NOTE: The largest drug manufacturers by market capitalization include Gilead (NASDAQ:GILD), Pfizer (NASDAQ:PFE), Sanofi (NYSE:SNY), Merck (NYSE:MRK), and AstraZeneca (NYSE:AZN).
