Desperate for taxes, Puerto Rico tries to get grip on underground economy

LARES, Puerto Rico (Reuters) - Mattress maker Angel Lopez is both a problem and an opportunity for the Puerto Rican government.

Mattress repairman and fruit vendor Angelo Lopez holds a coconut and a sugar-apple in the shed which he calls his factory in Lares, western Puerto Rico April 7, 2014. REUTERS/Ana Martinez

His one-man business works off the books as part of a vast underground economy, which doesn’t directly pay into the treasury’s coffers and is a major headache for an impoverished island that is $70 billion in debt.

But Lopez has dreams the island’s leadership is eager to foster. He wants to open a small factory, hire a few people and register with the town of Lares - as long as the taxes and fees from going above board don’t choke off his business.

The Lopez dilemma is playing out across Puerto Rico, which is a U.S. territory in the Caribbean. From the western mountain town of Lares to the capital San Juan, officials are wrestling with how to bring the underground economy out of the shadows and onto the tax rolls without creating such an onerous financial burden that thousands of small and medium businesses can’t survive.

More than a quarter of the island’s economy is informal, some studies say, from large companies evading taxes to individuals selling items for cash at roadside stands. But estimates vary widely because the activity can be so hard to track.

While not new, the problem has become urgent of late. The government desperately needs to find new revenue to bolster a budget full of holes and turn around an economy now eight years in recession. It is scrambling to avoid a painful debt restructuring some view as almost inevitable.

Last month’s $3.5 billion bond sale bought the island some time, but precious little else, with fundamental worries about its shrinking economy still unsolved.

“The government here, they want you to pay here, pay City Hall, pay the Hacienda,” said Lopez, referring to the local name for the island’s Treasury department.

The divisions between the government and its people leave policymakers in a damned-if-you-do, damned-if-you-don’t position.

“This is the conundrum for the island,” said Emily Raimes, lead analyst on Puerto Rico for Moody’s Investors Service. “Actions that they can take to help their finances may very well be actions that hurt the economy.”

The Puerto Rico Department of the Treasury knows it needs to jump-start both growth and revenue, said Melba Acosta, the island’s treasury secretary. But how to do both is a balancing act for policymakers.

“It’s the responsibility of the government to make sure that somebody who wants to establish a business doesn’t feel that it’s too burdensome to do so in a legal way,” she told Reuters.

Still, many entrepreneurs feel the costs of being legal are too big a burden, especially when conducting some or all of their business off the grid is a relative breeze. In fact, calling it the “underground economy” is a bit misleading when so much of it operates in plain sight.

Puerto Rico has its share of outright illicit activity, such as drug trafficking, but the vast majority of the $15 billion a year or more of informal commerce is simply activity that would be taxable if the government cracked down on it.

That covers everything from people such as Lopez, who also sells fruit to tourists, to retail chains that don’t send the sales taxes they collect to the government.

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And it’s not limited to traditional cash businesses like the retail trade. Even some professionals will accept cash only, a practice that makes it easy to hide revenue from tax collectors.

In upscale Condado, a beachfront neighborhood in the capital San Juan, for instance, it is common to see doctors’ offices with signs declaring cash as the only form of payment.

By its nature, it is difficult to measure the informal economy’s size with tremendous accuracy.

Jose Villamil, a local economist and head of consultancy Estudios Tecnicos, pegs it at about 27 or 28 percent of the formal economy of about $70 billion, as measured by its 2012 gross national product, although “that’s probably underestimated.”

Indeed, some estimates peg it closer to a third of the island economy.

By contrast, the informal economy in the continental United States is estimated to account for about 19 percent of all activity, according to Prof. Richard Cebula of Jacksonville University.

In 2006 the government instituted a sales tax in a bid to capture some of those informal dollars. Everybody spends, the thinking went, even people who are paid off the books and never declare their income. They still buy clothes, food, gasoline, and eat at restaurants.

But local economist Gustavo Vélez says the government only gets about 56 cents of every dollar it’s due from that tax, known as IVU in its Spanish acronym, based on his analysis of the tax capture rate.

The government disputes that number but acknowledges that stores from big to little evade the tax. Earlier this year the owners of two local stores were charged with tax evasion for collecting more than $1 million of tax since 2009 but not forwarding it to the Treasury, according to the government.

In other cases, shops simply do not collect the tax at all, keeping all their sales off the books entirely.

If Puerto Rico got the IVU capture rate up to 75 percent, the government could see another $391 million a year, Vélez said, based on a total IVU intake of about $1.2 billion last year.


Puerto Rico certainly does need the money.

All three major credit rating agencies slashed the island’s public debt to junk status earlier this year, a move that will make borrowing more expensive.

Many residents, especially the young and educated, have fled for the U.S. mainland, leaving behind an aging population with an overall poverty rate of nearly 45 percent. The island’s unemployment rate is 15 percent.

The administration of Gov. Alejandro Garcia Padilla, in office since early last year, has scrambled to get the economy humming and finances under control. Padilla has raised taxes, pledged to end years of operating deficits and overhauled retirement programs, despite union protests.

“Everything that we’ve been passing through the legislature has been hitting directly the underground economy,” said Rep. Rafael “Tatito” Hernández Montañez, who has recently sponsored bills to make it easier for the government to track businesses and figure out who is and isn’t paying the required fees.

The government is also pushing to enforce the laws already on its books.

The Treasury is hiring about 200 more tax specialists. Some of those will be checking on the books of businesses across the island, but some will be mystery shopping - making purchases at specially selected stores without identifying themselves to check for violators.

Sales tax evaders could get slapped with a maximum $20,000 fine.

But $20,000 for a small business could mean a hefty chunk of revenues. That means a delicate balance for the government: Changing attitudes so that more businesses register and pay their taxes and fees, while not piling so many bills onto small businesses that they collapse.

That is why the government is building exemptions into some laws for small businesses, said Rep. Montañez.

It is simply fairer for everyone, he said. For now, “the people who pay taxes pay double, because they pay for themselves and for those who don’t pay.”

A fifth of the sample in a 2008 study from the Center for a New Economy, a Puerto Rican think tank, did some informal work, even if they had a regular job.

Even Angel Lopez, with his dream of a small mattress factory, is not sure just how above board he’s prepared to be.

If he brings his dream to fruition, he might enter his business onto the rolls as a mattress repair shop instead of a production facility making foam mattresses from scratch. That way he says he won’t have to pay as much to the government.

Additional reporting by Reuters staff in Puerto Rico; Editing by Dan Burns, Ross Colvin and Martin Howell