Tax Incentives and Manufacturing Profitability in Puerto Rico

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Tax Incentives and Manufacturing Profitability in Puerto Rico

The tax incentives provided to U.S. manufacturing corporations under section 936 of the U.S. Internal Revenue Code and the Industrial Incentives Act of Puerto Rico have been a key factor determining the post-tax profitability, and thus the growth, of manufacturing on the island. The effectively tax-exempt status of manufacturing in Puerto Rico, however, has not been equally attractive to all U.S. firms, resulting in an industry mix on the island that differs considerably from that of the mainland. This study examines the present manufacturing industries in Puerto Rico with the intent of determining the sources of their relative profitability and of identifying characteristics favoring their location on the island.

The first part of this study compares U.S. mainland and Puerto Rican firms in terms of growth rates, pre-tax profit rates, and factors influencing relative costs. The second section constructs a weighted index which attempts to rank industries according to their likelihood of success in Puerto Rico in the absence of tax incentives. The final section summarizes the findings and draws some policy conclusions.

I. A Comparison of U.S. and Puerto Rican

Manufacturing

Theories of firm location build upon neoclassical principles of profit-maximizing behavior to predict that firms will locate their operations in accordance with the goal of cost minimization. Empirical studies have shown that while rational profit-maximizing behavior may inform location decisions, cost considerations regarding input and transportation costs are only part of the story. Less easily quantifiable historical, social, and market considerations also affect decisions. In one survey, 50 percent of respondents indicated that they never seriously considered building their new plant in a new location [Schmenner, 1982].

Nonetheless, studies of firm behavior indicate that competitive profitability is necessary for long-term survival [Winter, 1964] and that, particularly in larger firms, cost considerations influence location decisions [Schmenner, 1982]. The majority of manufacturing output in Puerto Rico is produced by U.S. firms that have located there within the last 30 years. To the extent that these firms were responding to factors influencing profitability, including tax rates, Puerto Rico must have compared favorably with other locations.

In the context of neoclassical theory, then, capital flows between countries are seen to be determined by factor costs, tax rates, and institutional arrangements affecting risk and the rate of return on capital. In the context of a two-country model built on neoclassical assumptions, and ignoring for the moment tax rates and risk, it is possible to identify some of the key variables influencing country profit rates and international capital flows.

Assume two autonomous countries which are not engaged in trade and in which capital and labor, the two factors of production, stay within their home countries. Then in each country, y = P - c(w,r), where y is the local profit per unit produced, p is the local unit price, c is the local unit cost of production, w is the local wage rate, and r is the local cost of capital.

Dropping the assumption of capital immobility, capital will flow into the country which has a local rate of profit initially higher than the world rate of profit R. Capital flows between countries cease once the rate of return on capital is equalized between countries. At that point, if technologies used are different in the two countries, wage rates will remain different even with one international rate of return on capital. If P is the world price, the associated equations are:

[y.sub.1] = P - [c.sub.1] ([w.sub.1,R]) in country 1

[y.sub.2] = P - [c.sub.2] ([w.sub.2,R]) in country 2

Applying this methodology to the case of Puerto Rico and the United States, then, the profit per unit produced in any given industry may differ between the two due to the different cost functions - regardless of any differences introduced by different rates of taxation or transportation costs - even though the marginal returns on capital should be the same. …