James Gibney is an editor for Bloomberg Opinion. Previously an editor at the Atlantic, the New York Times, Smithsonian, Foreign Policy and the New Republic, he was also in the U.S. Foreign Service from 1989 to 1997 in India, Japan and Washington. Read more opinion SHARE THIS ARTICLE Share Tweet Post Email

Photographer: Susana Gonzalez/Bloomberg Photographer: Susana Gonzalez/Bloomberg

To understand how Puerto Rico dug itself $73 billion in the hole, consider the highly attractive tax status of its bonds, which are exempt from local, state and federal taxes everywhere in the U.S. That exemption was granted by Congress in 1917 to help Puerto Rico develop. But without the financial controls Congress also imposed, which have long since been lifted, it's a standing invitation to fiscal misadventure.

Fast-forward a century and Puerto Rico's debt outstrips its gross domestic product; according to Moody's, the island's debt per capita of $15,637 is more than 10 times higher than the average per-capita debt of the 50 states. Debt payments eat up more than one-third of Puerto Rico's tax revenues, starving essential government services and preempting badly needed investments in infrastructure and improvements.

Puerto Rico's Slide

What led to Puerto Rico's economic meltdown is a matter of endless finger-pointing. But whoever lit the match, Puerto Rico's triple-tax exempt bonds fueled the fire. Their tax-free status -- which the bonds of Guam and the U.S. Virgin Islands also enjoy -- made Puerto Rican paper an attractive proposition for investors; even now, more than 50 percent of all open-end municipal bond funds hold Puerto Rico's bonds. Such bonds have also been a bonanza for financial firms: Banks handling Puerto Rico's debt have earned more than $900 million in fees since 2000.

For Puerto Rico's government, meanwhile, bonds came to look like hot credit cards -- max out one, pay it down with another. As the island's economic and fiscal conditions deteriorated, it tapped ever-more creative revenue streams, rolling over debt and papering over deficits with money from bonds secured by future tax revenues.

That was not what Congress had in mind when it granted the triple-tax exemption in the Jones-Shafroth Act of 1917, which set up a new civil administration and granted Puerto Ricans U.S. citizenship.

True, even those who were opposed to making Puerto Ricans into Americans recognized the island needed financial help. As Mississippi's white supremacist Senator James K. Vardaman (whose U.S. Army service included a stint in Puerto Rico) put it, "Those people there are undeveloped, and it is for the purpose of enabling them to develop their country to make the securities attractive by extending that exemption."

Yet Congress also limited public indebtedness to 7 percent (later raised to 10 percent) of the total tax valuation of the island's property. Moreover, the act imposed governing rules that further limited the possibility of fiscal misbehavior. Puerto Rico's governor was appointed by the U.S. president, and had the equivalent of a line-item veto on the budget prepared by Puerto Rico's elected legislature. If the legislature overrode his veto, he had the option of kicking the matter upstairs to the president, whose veto was subject to no such restrictions. Meanwhile, the president also appointed an auditor, operating under the governor, who had oversight of the territory's accounts.

Such paternalistic controls, along with many others imposed on Puerto Rico, understandably came to be seen as insufferable. (Congress even resisted islanders' efforts to change its name from the anglicized "Porto Rico.") In 1947, Puerto Ricans were given the right to elect their own governors, and three years later, a referendum on drafting their own constitution, which they and Congress approved in 1952. In 1961, Congress allowed the then-burgeoning commonwealth to lift the 10 percent limit on indebtedness and set its own. Its constitution was duly amended to create a debt ceiling that is supposedly reached once principal and interest payments hit 15 percent of the average of the past two years' tax revenues.

But that limit was quickly blurred by fuzzy math and executive and legislative legerdemain. So, for that matter, were the commonwealth's subsequent pretensions to a balanced budget. As the National Puerto Rican Chamber of Commerce noted in 2015, total national debt doubled in the 1980s and 1990s, and has tripled since 2000.

Any resident of Detroit could tell you that Puerto Rico isn't uniquely profligate or irresponsible. On the other hand, U.S. territories operate under a curious burden, straitjacketed by federal regulations and laws that hurt their competitiveness, dependent on huge federal transfers, yet lacking meaningful political representation.

Puerto Rico, Guam, and the U.S. Virgin Islands face similar challenges in developing their economies, and each has a history of structural budget deficits and using bonds to cover the difference. Including pension obligations, the U.S. Virgin Islands actually has by some reckonings a higher per-capita debt than Puerto Rico; if Guam didn't have a slightly more restrictive cap on debt (not to mention big economic benefits from the island's military bases), it might well be in the same boat.

The political and economic relationship between U.S. territories and their neglectful overlords in Washington is a blueprint for continuing moral hazard. Under those circumstances, the ability to issue triple-tax exempt bonds seems like an unhelpful anachronism -- another tax gimmick that encourages bad policy choices and increases territorial dependence.

Puerto Rico was granted its triple exemption when it was operating under the equivalent of a federal control board--a condition to which few Puerto Ricans want to return. But given the commonwealth's demonstrated failure to adhere to its own self-imposed debt limits, for the short term at least, greater external controls on its ability to issue debt may be the price it must pay to continue enjoying its tax-exempt funding privileges.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author of this story:

James Gibney at jgibney5@bloomberg.net

To contact the editor responsible for this story:

Christopher Flavelle at cflavelle@bloomberg.net