Transparency and Performance of Economic Incentives
By Arnaldo Cruz- Co Founder of ABREPR
The Incentives Code is one of the most important initiatives of the Rosselló administration. Implemented correctly, it could become a powerful tool for the Island's economic development. The new code, Law 60-2019, consolidates dozens of incentives, subsidies, credits and fiscal benefits that Puerto Rico offers into one legislation. To this end, the new law establishes a legal and administrative framework that will oversee the solicitation, evaluation, concession or denial of incentives by the government of Puerto Rico. The Department of Economic Development (DDEC in Spanish), through its Secretary, will be the agency in charge of operationalizing this new code.
Incentives are a cost to the government, even when they are not budgeted. The majority of the costs is associated with the revenues the government stops receiving when they approve a tax rate to an individual or to a company different than the one established by the Internal Revenue Code. The cost of these incentives is not trivial; According to a study commissioned by DDEC, by V2A, a consulting company, in 2016 fiscal year alone these incentives cost the Puerto Rico government $7.4 billion, which is almost the equivalent to the budget in the general fund. These revenues could have been utilized for other essential services of the government, like health or education. Thus, it is crucial to make sure that the use of incentives is justifiable.
It is important to clarify that the use of incentives is not exclusive to Puerto Rico, as it is a common practice for governments around the world. The key to having a good incentive system is to limit them to high-impact activities and to ascertain that they are used to accomplish established objectives, in other words, not just giving them away blindly. To accomplish this, the government of Puerto Rico would need to incorporate transparency in the concession and evaluation of these incentives.
The sharing of information as an antidote against waste
Let’s begin with one of the most important tools to guarantee transparency and accountability in these programs: the tax expenditure report. This report describes what and how the government spends these funds and what it is achieving through these expenditures.
A tax expenditure report encourages accountability by allowing for the evaluation of every incentive at an individual level and thus identifying which incentives have the highest return. The amount of information that is made public varies from place to place. The experience in other jurisdictions is that constantly sharing information and analysis of these incentives has helped governments better evaluate tax agreements and minimized the misuse of limited resources.
The Puerto Rican government has never published a tax expenditure report on its incentives. The new Incentive Code, as approved by the Legislature, required the publication of an annual report as well as a tax expenditure report. However, the Law (as presented) was not sufficiently specific with the information requirements. Unfortunately, this part of the bill underwent amendments during the legislative process (for the worse), where legislators modified and limited the definition of public information.
Moreover, in the conference committee, the legislature eliminated the requirement of an annual tax expenditure report and only left the annual report previously mentioned. These amendments go against the best practices of disclosure and evaluation of incentives. They also contradict the arguments of transparency set for by this administration. Interestingly, in the final version of the Bill, one of the requirements of the annual report is to divulge the preferential tax rates provided to the individuals/companies and the corresponding cost/benefit analysis. This incongruence in the text of the measure could (fortunately) provide an opportunity to establish the correct criteria for disclosure in the regulation document.
ABREPR recommends a specific annual report by company/individual. The report should include the public costs (incentives) and the economic benefits created (jobs, salaries, etc.) related to every agreement that the Puerto Rican government enters with a company/individual. The report should be accessible, meaning, published regularly and available on the web. It should also include all the tax expenses in detail, including those of low cost, and the name of every company/individual who benefits from each program. Each entry should include the description of the section of the Law associated with the incentive along with the amount associated with the incentive. Finally, DDEC should include its ROI analysis for each incentive provided. All of this information should be compiled in a central database and published on the web, in a format that allows citizens to download the information, in other words, it should be available in EXCEL/CSV format. The information should be updated and published at least once a year.
In Puerto Rico, there has always been controversy surrounding the disclosure of the companies that receive incentives. However, today more and more states disclose all the names of the companies that receive economic development incentives. States like Massachusetts, Wisconsin, Ohio and North Carolina publish the most complete and accessible information regarding the incentives. Puerto Rico should follow their lead.
Based on the law requirements, ABREPR recommends the following columns for the disclosure of incentives:
Name of the company/individual
Year of establishment in Puerto Rico
NAICS
Date of incentive approval
The applicable section of the law
Cost of the Incentive
Amount used (in case of credits)
Amount of investment associated with the incentive
ROI/Cost-Benefit
Evaluating Incentives
The legislative intent is that priority in the approval of incentives should be given only to activities that can prove (with facts) a favorable macroeconomic impact on the island. According to the final text of the Bill, the DDEC is required to do an ROI analysis to evaluate the effectiveness of the incentives, although the statute is not specific on the methodological requirements. It is assumed that those requirements will be established in the regulation of the incentives in the code prepared by the Secretary of the DDEC.
The ROI framework that gets adopted will be one of the most important elements of the Code, as it will serve as the base for the evaluation of all the incentive. According to presentations given by DDEC officials, it appears that the analysis of the ROI will be focused on maximizing revenues to the government. It is difficult to substantiate the argument that the incentives are provided solely for that purpose. In the majority of cases, incentives are motivated by matters of public policy, be it increasing exports, substituting imports or helping small businesses. Even though the fiscal impact information could be useful at this moment for the government, the information on the economic impact could guide all economic development efforts of DDEC, which is where the Code and agency should focus. Thus, ABREPR recommends that in addition to the tax revenues generated by the activity, the ROI analysis should also measure the economic impact of the incentivized activity. In other words, it should account for jobs created, new capital investments and gross product associated with the activity.
A traditional ROI or cost/benefit analysis includes all these elements in order to quantify the true benefit of an activity, versus just measuring the fiscal impact. To incorporate all these elements, it is crucial to have a robust focus on evaluation, using Input/Output tables and General Equilibrium models that can estimate the true impact of an incentivized activity.
In addition to calculating the jobs created and the economic activity reported by the company, it is necessary to evaluate if the incentive was responsible for increasing such economic activity. Do we know if the number of jobs created by that company would have happened in the absence of the economic incentive? For example, if the goal is to increase the activities of Research and Development (R+D), first we must evaluate if the incentive influenced the decision of the company to invest more in (R +D), so we can then calculate the benefits of that particular increment. This is the most important principle in a cost/benefit analysis, estimating what would have occurred without the incentive.
Many governments consider the incentives to be indispensable for their economic development strategies. Even if the government has admirable intentions, the evidence on the effectiveness of these programs in stimulating economic activity is fragile at best. In the best scenario, the influence that an incentive may have in the decision-making of a company is minimal. This, of course, varies from jurisdiction to jurisdiction, as there are governments that have used these incentives effectively and others that have not.
The success will depend on the capacity of the government to distinguish between a new economic activity and one that rewards a company for the what they had been doing or would be doing in absence of the incentive. Meaning, if the company would have created 100 jobs without the incentives, then the impact of the incentive would be zero, even if the company is generating economic activity. The government cannot make this distinction without comparing the behavior of companies that receive incentives with those that do not. To determine just that, the government will need the correct evaluation framework, and will thus universally accepted program evaluation tools, like experimental design, regression analysis, and the matching technique.
For example, in an experimental design, the DDEC would provide a group of incentives randomly. By doing this, it can compare the results of the companies that received the incentive with those that did not. The examples of experimental methods are few though, due to the political limitations. Meaning, it would be politically unfeasible to deny incentives to a company simply because you are doing a program evaluation and not necessarily because they do not fulfill the law requirements. On the contrary, the other non-experimental methods, the regression analysis, and matching technique are more widely used. To do a regression analysis, you need a wide variety of datasets. The precision in the regression analysis depends on the quantity and quality of the available data. Many times, the information available are not enough to make a robust regression analysis. In those cases, the matching technique is doable and recommended.
The matching technique consists of taking a sample of companies that did not receive an incentive and comparing its results with companies that did receive an incentive during a determined time period. Both samples would have similar characteristics (income, employees, industry). Data from the Department of Treasury could be used to obtain information on companies that did not receive an incentive, and thus are no part of the DDEC database. This type of evaluation would not be done for all incentives at the same time but would be conducted in a cycle and by section of the code. For example, in a fiscal year, the DDEC could evaluate the incentives associated with the Visitor Economy and in another year evaluate the incentives associated with the export of services. This way, evaluation of all sections of the code becomes viable, like what the Comptroller's office does with the agencies and municipalities. All these evaluations would then become public.
To develop and implement a robust program evaluation unit, the DDEC will need diverse teams that work together in the evaluation of incentives. For example, teams comprised of public policy analysts, economists, tax experts, CPA's, attorneys, etc. Having professional and diverse staff deeply analyzing the incentives will allow DDEC to know their impact and whether they are helping with public policy objectives. As well, systemizing the evaluation process will also allow DDEC to prioritize the approvals of incentives given the budgetary limitations. For example, if there are only $100 million in the budget to provide as incentives this year: Which companies should have priority? With these evaluations, the DDEC could assign funds to the activities with the highest economic benefit or that contribute the most to its public policy objectives.
Given how difficult it would be to recruit capable personnel to execute these functions, the DDEC could contract an external and independent entity to undertake the work. This would only work if there is a commitment to make public the results and there is a guarantee in the independence of the analysis. Regardless of the mechanism, the DDEC should commit to making periodic evaluations of all the incentives in the code. Only then could the government guarantee that the funds are being destined to increase competition, innovation, and to support emerging industries and technologies, within the larger context of Puerto Rico's fiscal reality.