Muni Credit News January 22, 2015

Joseph Krist

Municipal Credit Consultant


While it is widely expected that Puerto Rico’s electric utility will soon default, Standard & Poor’s revised its outlook on Virgin Islands Water & Power Authority’s (WAPA) electric system revenue bonds to stable from negative. At the same time, S&P affirmed its BBB- senior-lien rating and its BB+ subordinate debt ratings on the bonds. S&P said that “the outlook revision reflects our view of the improved competitive position from recent rate cuts and the progress that the authority has made in diversifying its outlook for energy costs.”

WAPA has reduced oil dependence in its generating fleet by converting two plants to burn propane, improved efficiency at its plants and in its distribution network, and adding renewable energy sources, such as solar power. Fuel accounted for 72% of fiscal 2014 operating expenditures which is actually slightly lower than in recent years. Generally high oil prices have stressed the authority’s financial performance, due to the lag in recovering fuel costs quickly from electric customers. Failure to recover fully and timely fuel costs affected debt service coverage. The recent decline in oil prices has improved WAPA’s cost profile.

The stable outlook is based on a view that while rates remain high, the recent drop-off in levelized energy adjustment clause rates and improved competitive position will be favorable for collections and electricity demand. Given the decline in oil prices and the expected drop in the authority’s exposure to oil price swings, near-term financial pressures are set to moderate. However, if the economic or oil price situations weaken, there could be downward pressure on the rating or outlook. Because of the system’s high debt burden, rates, and receivable balances, it is not expected that the rating will be upgraded in the next year.


Amendments to legislation increasing the petroleum-products tax, known locally as la crudita, which would authorize a bond deal of nearly $3 billion and passage of a sweeping tax reform, are at the top of the agenda for Puerto Rico. Officials and legislative leaders have dampened expectations of swift passage of both measures, with Gov. Alejandro García Padilla saying tax reform would be introduced by mid-February, with an eye to passage by March 31, and Senate President Eduardo Bhatia insisted that the upper chamber wouldn’t rush its consideration of sweeping tax reform.

The legislation raising the petroleum-tax hike and authorizing a $2.95 billion bond issue was approved in a special session in December. However, to win enough support, the final version of the legislation “imposed conditions that will delay and may even prevent the [bond] issuance,” said Moody’s at the time of passage. Those include making the petroleum-tax increase contingent on implementation of a broad tax overhaul. Another condition nixed a provision for annual inflation adjustments to the tax, while a third limits borrowing costs on bonds backed by the new tax revenue, capping the coupon at 8.5% and requiring a minimum issue price of 93 cents on the dollar.

Government estimates of how much the petroleum tax raised in fiscal 2014, which ended June 30, have fluctuated greatly from $255.5 million to $661.9 million, according to an NCM Noticias report. These estimates were made after the administration tripled the petroleum tax from $3 a barrel to $9.25 a barrel. In terms of revenue collected, the peak was in 1999 when $406 million was collected from the petroleum tax, with the low point dropping to $264 million in fiscal 2013.

The legislation was approved by only a single vote in both the House and Senate and changing the language could alienate swing votes. Many analysts still expect the measure to pass, given its importance in shoring up Government Development Bank (GDB) finances. The bond issue would repay $2.2 billion of principal and interest on loans the GDB provided to the Puerto Rico Highways & Transportation Authority (HTA). The legislation would transfer the GDB’s $2.2 billion loan to the HTA to the Puerto Rico Infrastructure Financing Authority (AFI by its Spanish acronym), along with the means to pay for it through revenue produced by increases in the petroleum tax. The bill also provides extra funding to cover operational budget gaps at the HTA, including its mass-transit assets that are being spun off into a new public corporation.

On paper, Puerto Rico has enough money to make it through the end of fiscal 2015, which ends June 30, but officials say boosting GDB liquidity is essential so that Puerto Rico can use the extra cash to plug any fiscal holes in this year’s budget and cover other emergency situations. If not amended, some think that the GDB could be forced to write off more than $2 billion of HTA loans, risking the possibility that the GDB’s auditors could determine the bank insolvent. More importantly, the GDB would be unable to cover potential central government and public corporation deficits, triggering a potential cash-flow crisis.

While the tax-reform proposal details are being kept under wraps, it is rumored  to exempt from income taxes those earning $35,000 a year or less, while making up for the lost revenue with a value-added tax (VAT) of about 15%, which would be levied on food, medicine and other items currently exempt from the 7% sales & use tax. Tax reform is also expected to overturn the gross receipts tax and increase property taxes.

There are significant risks entailed with the implementation of a VAT, which would be the only such tax in the U.S. The transition to such a tax would be challenging in the best of times. PR has a mixed record of implementing tax changes and there is a culture of evasion on the island.


Gov. Sam Brownback, who made cutting taxes and shrinking government the centerpieces of his government, proposed last week to close a huge projected shortfall in the state budget by increasing some sales taxes and sharply slowing his plan to gradually reduce the state income tax. The move marks a significant turn for Mr. Brownback, who has tried to make his state a national model for conservative governance and who criticized calls from his opponent in last year’s campaign to scale back his income tax cut.

“I’d rather speed it up,” he said of his income tax cut. “But what we’re trying to do is balance the obligations we have as a state.” Mr. Brownback’s allies said the budget proposal represented necessary modifications that would keep alive the goal of someday eliminating the income tax, but opponents painted the plan as tacit acknowledgment of their longstanding argument that his policies were damaging the state’s finances.

Even some lawmakers who generally align philosophically with Mr. Brownback, who started his second term this month, seemed wary of parts of his proposal. Republicans control the Legislature. “He’s proposed some revenue enhancements that I think the Legislature will have a great difficulty passing,” said Senator Susan Wagle, the chamber’s Republican president. “That’s tax increase.” In 2012 and 2013, the governor championed and the Legislature passed the largest tax cuts in state history, eliminating taxes on non-wage earnings for nearly 200,000 small businesses and starting to phase in a series of cuts on individual income taxes.

The enacted income tax cut dropped rates this year to 4.6 percent on the top end and 2.7 percent on the low end. The lower rate was set to drop to 2.4 percent next year, but under the new budget proposal, it would fall only to 2.66 percent, while the higher rate would remain at 4.6 percent. By 2018, the higher rate was supposed to dip to 3.9 percent, and the lower to 2.3 percent. But under the governor’s new proposal, the rates would remain at 2.66 percent and 4.6 percent. The governor’s plan includes a mechanism for continuing the income tax decreases if revenue rises.

If revenue grows to 103 percent of the previous year’s amount, the plan calls for placing the additional revenue into a fund that the Legislature could use to implement more income tax reductions. The plan also creates a budget stabilization fund that would use revenue growth to fill deficits. The Governor also has asked lawmakers to begin reducing itemized deductions this year — those reductions were supposed to start in 2017 — and to increase sales taxes on liquor and tobacco products. Those changes, along with a tax amnesty for delinquent payers, would increase revenue by more than $423 million over the next two fiscal years, according to the governor’s estimates.

The big expenses in the state’s budget of more than $6 billion are pensions, Medicaid and K-12 education. With the deficit estimated at $650 million for the fiscal year beginning in July, Gov. Brownback proposed overhauling how each of those areas was funded. He called on lawmakers to rewrite the school funding formula, which has been the subject of a hotly debated lawsuit that has bounced around the state’s court system. While lawmakers contemplate how to rewrite the formula, the governor has suggested funding the schools over the next two fiscal years with block grants rather than through the traditional method. This has raised concern among some school advocates about whether districts would be shortchanged.


Gov. Jay Inslee, a Democrat, has called for the biggest increase in new tax dollars in state history. “The time of recession and hollowing out is behind us,” Mr. Inslee said in his State of the State address to lawmakers. “It is now time for reinvestment.” Mr. Inslee is seeking $1.4 billion in new revenue as part of a nearly $39 billion budget plan that includes a new capital gains tax on the wealthy and a cap-and-trade carbon tax system he said would also reduce climate-altering pollution.

The extra money, along with a projected $3 billion increase in revenue from existing taxes in a recovering economy, would be funneled heavily to one line item: education. This is in response to a decision of the Washington Supreme Court, which last fall found the state in contempt for failing to outline a schedule, in dates and dollar amounts, to remedy years of underfunding of schools. The justices issued a contempt order in September, after many failed promises by the Legislature, but held off enforcement until the end of the 2015 legislative session, which began last Monday and is to last for 105 days.

The imposition of a penalty, if it comes to that, could well be a first in American politics. Legal scholars could not cite another example of a state high court holding an equal branch of government in contempt. No one is certain what might happen. The court was vague about what it might do, leaving just about anything on the table, and there is no  relevant precedent. The court could, for example, order money deposited from state general funds into school accounts, legal scholars have said, or impose fines or do something else altogether.

Because the federal courts do not police disputes between branches of state government over the separation of powers, any challenge to the court’s action could be appealed to only the justices themselves, who would be asked to second-guess whether they had acted within constitutional bounds.  The Legislature is divided and less than 24 hours before the governor’s speech, the Senate changed its own rules to make any new tax harder to pass — requiring two-thirds approval of the chamber instead of a simple majority.

Gov. Inslee’s tax package would be the largest ever in dollar terms, but in terms of percentage increase, some tax hikes have been much bigger. Court orders on education are common in state politics. Particularly since the 1990s, lawsuits have focused on state constitutions, which vary greatly in their requirements for education. Sixteen states, for example, simply require a system of free public schools, according to the National Conference of State Legislatures. Washington’s constitution is one of the most stringent — one of only eight that call education a “fundamental,” “primary” or “paramount” state obligation. Some lawmakers say an increase in the range of $1 billion to $2 billion in the current budget would meet the court’s demands, while others cited higher or lower numbers.

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