On January 18, 2005, Anibal Acevedo Vilá was installed as governor of Puerto Rico. Puerto Rico, a Commonwealth in association with the United States, enjoys considerable autonomy in matters of taxation. Two weeks later, the governor established a Special Commission for Fiscal Reform (known as CERF by its Spanish acronym), instructing it to analyze Puerto Rico's tax system and make recommendations for reform.
CERF delivered its report on April 30. It recommended a 10-10-10 comprehensive reform of Puerto Rico's tax system.
1. A 10% flat tax on individuals, a marked reduction from the current top marginal 33% rate, which can reach 38% in certain conditions. Single taxpayers with annual income up to $15,000 would be exempt, as would married working couples with annual income up to $30,000. These levels would exempt 309,000 taxpayers from personal income tax, up from 180,000 under current law. Most of the newly-exempt would be taxpayers with annual income below $20,000. The 10% flat tax on individuals eliminates the taxation of poor persons.
CERF recommends that taxpayers be permitted to deduct mortgage-interest payments for their principle residence up to 30% of adjusted gross income. Additional deductions include contributions to retirement accounts, savings for dependents' education, and charitable donations. Taxpayers with more than $150,000 in reported income would only be able to deduct mortgage interest up to 20% of adjusted gross income, adding an element of progressivity to the system. No deduction would be permitted for social security and unemployment taxes (as in the mainland U.S.). Taxpayers with income of $100,000 or less would receive a tax credit of $500 per family member.
Individuals would pay 10% on dividends received from corporations, a small double tax after corporations pay 10% on business profits.
CERF estimates that the 10% flat tax would collect $1.25 billion, a reduction below the $2.8 billion paid in personal income tax in 2004. Personal income tax would fall from 36% of total revenue to 12%.
2. A 10% flat tax on corporations. Only about 35,000 of the 140,000 registered corporations file tax returns. Local corporations are subject to a 39% tax rate, while companies operating under the Puerto Rico Industrial Incentive Act (PRIIA) pay 0% to 7% in taxes. The uniform 10% rate is designed to refine the strategy of the PRIIA. Companies paying the proposed 10% tax would be able to take it as a federal deduction when profits are repatriated to the U.S. mainland. The corporate tax reform would double revenue from $2.4 billion to $5.7 billion.
Companies would receive tax credits for employment creation, infrastructure improvement, productivity, continuing employee education, environmental protection measures, and efficient energy use, which would reduce their effective tax burden.
3. A 10% consumption tax, reduced to 9% after five years, which would replace a 6.6% general excise tax. The current excise tax cascades from importer to wholesaler to retailer, resulting in higher prices for consumers. The 10% consumption tax would be a hybrid VAT that could be implemented in less than a year. Exempt items would include prescription drugs, raw and intermediate manufacturing materials, educational products, and real estate services. Special excise taxes would remain on gasoline, alcoholic beverages, cars, and jewelry. To minimize the regressiveness of the consumption tax, a "Social Fairness Fund" would be established to compensate families based on their income and spending capabilities.
The 10% consumption tax is projected to raise $3 billion, which would be added to the $1.2 billion raised in special excise taxes.
Altogether, CERF estimates that the reforms would result in tax revenue of $12.5 billion. After returning $2.5 billion in corporate tax credits and compensation to low-income and poor residents through the Social Fairness Fund, $10 billion would remain—$2 billion more than the government collected in 2004. The additional revenue, which would be collected from upper-income households and corporations, would stem from closing loopholes, and reducing evasion and avoidance.
CERF's report was printed only in Spanish. The English summary presented in the May 20, 2005, issue of Caribbean Business does not indicate how interest and capital gains would be taxed, and how corporations would depreciate investment.