Anatomy of a Budget Winner

How an obscure tax credit benefiting US subsidiaries in Puerto Rico was preserved

THE budget signed this week by President Clinton was Washington's version of a lottery. With hundreds of tax changes on the line, many companies wound up as losers while a golden few emerged holding winning tickets.

The real estate industry was one big winner, receiving generous treatment of its "passive losses" from rental property. The airline industry also did well, winning a two-year exemption from higher fuel levies. And yacht manufacturers, their cause championed by Sen. George Mitchell (D) of Maine, saw their 10 percent luxury tax repealed.

Sometimes companies won simply by minimizing losses. That was the case with firms that benefit from Section 936 of the tax code, which until now has provided a 100 percent credit for income generated by Puerto Rican subsidiaries.

The Clinton administration in February proposed eliminating the current tax break and replacing it with a credit worth 60 percent of wages. The move was designed to correct what some see as an inequity in the current setup: 63 percent of tax benefits go to a handful of companies that employ only 12 percent of all Puerto Ricans hired by United States-based firms. Who benefits?

The biggest beneficiaries of Section 936 are giant pharmaceutical companies, such as Merck & Co. and Pfizer Inc. They increase the size of their tax benefits by transferring "intangible assets," such as patents, to Puerto Rican subsidiaries. According to the General Accounting Office, drug manufacturers in Puerto Rico receive $71,678 in tax benefits per worker, while paying an average wage of $33,757.

"We wanted to shift the emphasis of the tax break to reward contributions to the Puerto Rican economy in wages or capital investment," says Norman Richter, a senior Treasury Department official.

The House of Representatives passed the Clinton plan intact, expecting to raise $6.7 billion from the Puerto Rican provision over five years. But it was a different story in the Senate, where the corporate giants who benefit from 936 geared up to defend their tax break.

The firms have long been represented in Washington by the Puerto Rico USA Foundation, run by the small lobbying firm of Groom & Nordberg. But on this issue there was a split in the business community between labor-intensive firms and more capital-intensive companies, which would receive different treatment under the Clinton plan.

Labor-intensive firms, such as General Electric Company and Motorola Inc., hired O'Brien Calio, a lobbying shop run by Lawrence O'Brien, a Carter Treasury Department official, and Nicholas Calio, President Bush's top lobbyist. Four drug companies, who are more capital-intensive, signed Peter Hiebert, a lobbyist with the law firm of Winston & Strawn.

These hired guns prowled the corridors of the Capitol, where they argued that the Puerto Rican economy would be decimated if the tax break were reduced. "We were pretty persistent in getting out that message that the House bill had simply gone too far," Mr. O'Brien says.

To complement their inside-the-Beltway efforts, companies organized a grass-roots campaign. Pro-deduction forces circulated petitions and advertisements among Puerto Rican immigrants concentrated in New York City, Chicago, and Newark, N.J. The annual Puerto Rican Day Parade, held in New York City in June, was devoted in large part to preserving the tax credit.

"It was a very demagogic campaign," says Carlos Romero-Barcelo, Puerto Rico's nonvoting delegate to Congress who favored the House version of the tax plan. "They created hysteria among mainland Puerto Ricans who don't even know what 936 is."

Thanks in part to the campaign, Rep. Luis Gutierrez (D) of Illinois and other congressmen of Puerto Rican ancestry pressed hard to preserve the 936 credit. They were backed by Sens. Daniel Patrick Moynihan (D) of New York and Bill Bradley (D) of New Jersey, who both represent many Puerto Rican constituents.

While Senator Moynihan wields more clout as chairman of the Finance Committee, Senator Bradley had plenty of leverage, too: The White House and the Democratic leadership couldn't afford to alienate any Senate Democrat if they wanted to get the budget passed. Corporate exodus forecast

Capitol Hill wasn't the only target for the lobbyists. "A major lobbying effort was directed toward convincing the Puerto Rican government that companies would" leave the island if the tax break were reduced, says one drug company lobbyist. "It wasn't a threat, it was just economic reality."

Gov. Pedro Rossello of Puerto Rico originally was sympathetic to the administration plan, but he soon became a leading advocate of a credit balanced between labor-intensive and capital-intensive firms. "The position of the Puerto Rican government was decisive in the debate," says another industry lobbyist.

The Senate, as part of its budget, passed a version of 936 far more favorable to business. The Senate plan increased the wage credit so that, together with a tax deduction, it covered 95 percent of all wages. It also preserved the income credit, which benefits capital-intensive firms, but phased it down to 40 percent by 1998.

Moynihan and other senators strongly backed their version of the plan in conference committee. On the other hand, House negotiators, led by Rep. Dan Rostenkowski (D) of Illinois, didn't support the administration's plan.

"This wasn't one of the provisions the House cared that much about," says a House Ways and Means Committee staff member. Even the president himself backed off. Under pressure from Moynihan in the Senate and the Hispanic Caucus in the House, Mr. Clinton announced July 22 that he would back the Senate version of the tax credit.

After that turnaround, conferees easily adopted the Senate plan. Along the way, they gutted an Indian empowerment-zone plan sponsored by Sen. John McCain (R) of Arizona that would have slightly reduced the size of the Puerto Rico tax break by $200 million. The final result was an estimated $3.8 billion over five years in revenues from narrowing Section 936.

It was less than the administration wanted, but about as much as business would tolerate. "It's a big improvement," says Peter Holmes, a lobbyist for the Puerto Rico USA Foundation, "but it still represents a very substantial reduction in the incentive to do business in Puerto Rico."

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