Legislators across the country now have their eyes on a little-known experiment on the island of Puerto Rico this week.  At the beginning of the previous week, two major events occurred which could have national implications, and will, one way or another, prove to be an example to the rest of the country.

First, in a quick strike over the slow news cycle weekend, the legislature and the governor passed a law increasing taxes on 40-50 of the top manufacturing companies on the island.  The expected return is now suggested to be $5.8 billion over the next 6 years.  However, the concern becomes whether the negative effects of these tax increases will outweigh the positive return.  History has proven that organizations will make adjustments based on tax policy: sometimes companies reduce their payroll, sometimes they reduce their operations or overhead, and sometimes they move their operations elsewhere to take advantage of more favorable tax environments.  The question is not whether they will react, but how they will react.

On the following Monday, strategically timed to counteract the negative repercussions of the tax increase, a law was passed having the exact opposite effect for most of the rest of the island.  As the Puerto Rican Federal Affairs Administration states on their website:

For businesses, the plan provides immediate relief for the 2010 tax year, including an average 7 percent credit for corporations. Starting in 2011, a new streamlined tax code will provide across the board rate reductions, effective Jan. 1. Average rates will be reduced 30 percent for corporations. Under the plan, the top rate will drop from 39 percent (41 percent with AMT) to 30 percent, and the previous seven-tier corporate bracket will be simplified into three lowered rates – 20 percent, 25 percent and 30 percent.

Current
FROM UP TO MARGINAL RATE
$0 $100,000 25%
$100,001 $150,000 35%
$150,001 $200,000 36%
$200,001 $250,000 37%
$250,001 $300,000 38%
$300,001 39%
Gradual adjustment over $500,000 41%

 

Fortuño Tax Cut Plan – Starting Jan. 1, 2011

FROM UP TO MARGINAL RATE
$0 $750,000 20%
$750,001 $2,500,000 25%
$2,500,001 30%

No gradual adjustment

Everything else being equal, tax cuts generally provide an incentive for businesses to produce more in the immediate future, hire employees, increase research and development, and take risks that otherwise would not have had the potential for return necessary to incentivize the risk.  Remarkably, policies to reduce taxable rates often, but not always, increase tax receipts for governments.  Although seemingly counterintuitive, the idea is that business growth incentives provided by tax cuts counteract the reduction in tax revenues from lower rates.  Although perhaps best evidenced after the drastic tax cuts of the Reagan administration, the Bush tax cuts were somewhat overburdened by increased defense spending.

Although we can only speculate on the outcome of the current policies within Puerto Rico, one thing is for certain, politicians will be using them as either anecdotal evidence to support their own personal views or as an example to follow for years in the future.

See related articles in the left column from PRFAA.

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