Puerto Rico Government Financial Condition

Puerto Rico’s government has operated with a deficit—where expenses  exceed revenues—in each fiscal year since 2002, and its deficits grew  over time (see figure 2). Since then, Puerto Rico has defaulted on over  $1.5 billion in debt. In June 2016, Congress enacted and the President signed PROMESA in  response to Puerto Rico’s fiscal crisis. Officials and Experts Cited Various Factors as Contributing to Puerto Rico’s Financial Condition and Levels of Debt Factors that Contributed to Puerto Rico’s Persistent Deficits

Based on interviews with current and former Puerto Rico officials, federal  officials, and other relevant experts, as well as a review of relevant  literature, the factors that contributed to Puerto Rico’s financial condition  and levels of debt related to: (1) Puerto Rico’s government running  persistent deficits and (2) its use of debt to cope with deficits. Through interviews with current and former Puerto Rico officials;  federal officials; experts in Puerto Rico’s economy, the municipal  securities markets, and state and local budgeting and debt management;  as well as a review of relevant literature, we identified three groups of  factors that contributed to Puerto Rico’s persistent deficits: (1) inadequate  financial management and oversight practices, (2) policy decisions, and  (3) prolonged economic contraction. According to former Puerto Rico officials and  experts on Puerto Rico’s economy, high demand for Puerto Rico debt and  the Government Development Bank for Puerto Rico (GDB) facilitating rising debt levels enabled Puerto Rico to continue to use debt to finance  operations. Actions That Could Address Factors that Contributed to Puerto Rico’s Unsustainable Debt Levels

Through our interviews and an assessment of relevant literature, we  identified three potential federal actions that could help address some of  the factors that contributed to unsustainable indebtedness in Puerto Rico. Addressing the Challenge

Timely disclosure of information would help investors make informed  decisions about investing in municipal securities and help protect them  against fraud involving the securities. For example, establishing and enforcing initial and  continuing disclosure requirements for municipal securities issuers could  place additional burdens on state and local issuers, and not all municipal  issuers use standardized accounting and financial reporting methods. Action 2: Apply Federal Investor Protection Laws to Puerto Rico

To help address the factors that contributed to the high demand for  Puerto Rico debt relative to other municipal debt, Congress could ensure  that investors residing in Puerto Rico receive the same federal investor  protections as investors residing in states. As a  result, demand for Puerto Rico municipal bonds from Puerto Rico  investment companies and residents may have been lower had the 1940  Act requirements applied to all Puerto Rico investment companies, and it  may have been more difficult for the Puerto Rico government to issue  debt to finance deficits. Action 3: Modify the Tax Exemption Status for Puerto Rico Municipal Securities

To help address the factors that contributed to the high demand for  Puerto Rico debt relative to other municipal debt, Congress could remove  the triple tax exemption for Puerto Rico’s municipal securities. This action  would mean that interest income from Puerto Rico municipal securities  earned by investors residing outside of Puerto Rico could be taxed by  states and local governments, while still being exempt from federal  income taxes, similar to the current tax treatment of municipal bond  income in the states. Treasury and SEC provided technical comments,  which we incorporated as appropriate. It also  provided additional context on Puerto Rico’s accumulation of debt, such  as Puerto Rico’s territorial status and its effect on federal programs in  Puerto Rico and outmigration. Consistent with the provision in the Puerto  Rico Oversight, Management, and Economic Stability Act (PROMESA)  that was the statutory requirement for this work, we focused on actions  that would not increase the federal deficit. We also interviewed officials from the U.S. Department of the  Treasury (Treasury), the Securities and Exchange Commission (SEC),  the Federal Reserve Bank of New York, and the Financial Oversight and  Management Board for Puerto Rico (created by PROMESA). We also collected and reviewed Puerto Rico  government documents related to budget formulation and execution, debt  issuance, and financial management.
Why GAO Did This Study

Puerto Rico has roughly $70 billion in outstanding debt and $50 billion in unfunded pension liabilities and since August 2015 has defaulted on over $1.5 billion in debt. The effects of Hurricanes Irma and Maria will further affect Puerto Rico's ability to repay its debt, as well as its economic condition. In response to Puerto Rico's fiscal crisis, Congress passed the Puerto Rico Oversight, Management, and Economic Security Act (PROMESA) in 2016, which included a provision for GAO to review Puerto Rico's debt.
This report describes the factors that contributed to Puerto Rico's financial condition and levels of debt and federal actions that could address these factors. Consistent with PROMESA, GAO focused on actions that would not increase the federal deficit.
To address these objectives, GAO reviewed documents and interviewed officials from the Puerto Rico and federal governments and conducted a review of relevant literature. GAO also interviewed former Puerto Rico officials and experts in Puerto Rico's economy, the municipal securities markets, and state and territorial budgeting, financial management, and debt practices, as well as officials from the Financial Oversight and Management Board for Puerto Rico (created by PROMESA).
GAO is not making recommendations based on the federal actions identified because policymakers would need to consider challenges and tradeoffs related to implementation.
The Puerto Rico government generally agreed with the factors we identified and provided additional information. GAO incorporated technical comments from SEC as appropriate.

What GAO Found

The factors that contributed to Puerto Rico's financial condition and levels of debt relate to (1) the Puerto Rico government running persistent annual deficits—where expenses exceed revenues—and (2) its use of debt to cope with deficits. Based on a literature review and interviews with current and former Puerto Rico officials, federal officials, and other relevant experts, GAO identified factors that contributed to Puerto Rico's persistent deficits:
The Puerto Rico government's inadequate financial management and oversight practices. For example, the Puerto Rico government frequently overestimated the amount of revenue it would collect and Puerto Rico's agencies regularly spent more than the amounts Puerto Rico's legislature appropriated for a given fiscal year.
Policy decisions by Puerto Rico's government. For example, Puerto Rico borrowed funds to balance budgets and insufficiently addressed public pension funding shortfalls.
Puerto Rico's prolonged economic contraction. Examples of factors contributing to the contraction include outmigration and the resulting diminished labor force, and the high cost of importing goods and energy.
Additional factors enabled Puerto Rico to use debt to finance its deficits, such as high demand for Puerto Rico debt. One cause of high demand was that under federal law, income from Puerto Rico bonds generally receives more favorable tax treatment than income from bonds issued by states and their localities.
Based on an assessment of relevant literature and input from current and former Puerto Rico officials, federal officials, and other relevant experts, GAO identified three potential federal actions that may help address some of these factors. GAO also identified considerations for policymakers related to these actions.
Modify the tax exempt status for Puerto Rico municipal debt. Making interest income from Puerto Rico bonds earned by investors residing outside of Puerto Rico subject to applicable state and local taxes could lower demand for Puerto Rico debt. However, reduced demand could hinder Puerto Rico's ability to borrow funds for capital investments or liquidity.
Apply federal investor protection laws to Puerto Rico. Requiring Puerto Rico investment companies to disclose risks with Puerto Rico bonds and adhere to other requirements could lower demand for the bonds. However, this action could also limit Puerto Rico's ability to borrow funds.
Modify the Securities and Exchange Commission's (SEC) authority over municipal bond disclosure requirements. SEC could be allowed to require timely disclosure of materials—such as audited financial statements—associated with municipal bonds. Over the past decade, Puerto Rico often failed to provide timely audited financial statements related to its municipal bonds. Timely disclosure could help investors make informed decisions about investing in municipal bonds. However, a broad requirement could place additional burdens on all U.S. municipal issuers, such as the costs of standardizing reporting.