Government and Rum

One of the most important exports in Puerto Rico and the U.S. Virgin Islands (USVI) is rum.  Puerto Rico has the larger and older market, including the production facilities for the world’s largest rum maker, Bacardi.  Another popular brand of rum produced in Puerto Rico is Captain Morgan’s, currently produced by British conglomerate Diageo in a facility located near San Juan.  Captain Morgan has been thinking about setting sail for the U.S. Virgin Islands, prompting a legal exchange of cannon fire that reaches all the way to the United States Congress, and illustrates the immense power governments exercise through taxation.

At the beginning of the 20th century, the United States government arranged a unique system of financing for Puerto Rico, as detailed in “The Rum Excise Tax Cover-Over: Legislative History and Current Issues,” a May 2010 report from the Congressional Research Service.  The U.S. government levies an excise tax against rum imported from its territories.  In the Jones Act of 1917, it was stipulated that most of the money collected from this tax would be “covered over,” or given to the treasury of Puerto Rico, whose government could use the money in any way it deemed appropriate.  This was supposed to make it unnecessary for Congress to appropriate money from the United States to fund the Puerto Rican government.

The system worked well enough to be expanded to cover the U.S. Virgin Islands in 1954.  Both Puerto Rico and the Virgin Islands use some of this income to support the development of the profitable rum industry, which naturally attracts the operations of numerous international distillers. 

In 1983, with the economic situation in both territories looking grim, Congressed passed a Caribbean Basin Economic Recovery Act, which diverts the majority of all excise taxes on rum imported from any source into the treasuries of Puerto Rico and the USVI.  The money is split roughly according to the relative market share of the two possessions, which means the larger Puerto Rican market earns about 86% of it at present, amounting to about $400 million per year.

The Captain Morgan brand of rum was originally produced by the Seagram Company, which responded to Puerto Rican incentives by building a distillery and manufacturing facility near the capital city of San Juan in the 1950s.  It sold the Captain Morgan brand to Diageo in 2001.  After years of negotiations, Diageo failed to reach an agreement with its third-party Puerto Rican distiller, and began looking for alternatives.  The USVI decided to win their business with a tremendous package of incentives, including tax breaks and a direct subsidy of half the money remitted from rum taxes by the U.S. government, in exchange for a 30-year commitment.  The value of these incentives is better than $3.5 billion dollars, rendered over the 30 years of the contract.

Why would the USVI offer such a high price to attract the Captain Morgan facility?  Well, it represents a gigantic amount of rum production – better than nine million proof-gallons per year.  This would significantly increase the USVI share of the Caribbean rum market… and earn them a higher share of the excise taxes covered over from the sale of foreign rum in the United States.  As you’ll recall, this income is divided between Puerto Rico and the USVI based on a formula derived from their relative market share.

Puerto Rico stands to lose about $6 billion when Diageo pulls out.  This includes not only income from Diageo’s operations, but also a sizable chunk of the excise tax remittance.  Since Captain Morgan had already decided to set sail before the booty of the U.S. Virgin Islands caught his eye, the only thing Puerto Rico can do to mitigate its losses is drive production out of the possessions altogether.  That way, Captain Morgan will become a foreign import, and Puerto Rico will receive its lions’ share of the covered-over taxes levied against it.  The balance of production with the USVI also will not be shifted as drastically.

Everyone involved has lobbyists, so a swordfight worthy of any pirate crew has broken out from K Street to the Capitol.  The killing stroke is a bill introduced by Senator Robert Menendez (D-NJ) that would cap the amount of its excise tax remittance the Virgin Islands can spend on industrial subsidies to rum producers.  This would put cold Puerto Rican steel through the heart of the Diageo deal, which was negotiated long before any such law existed, but would be retroactively invalidated by it.

Supporters of the Menendez bill argue that vast industrial subsidies are “a misuse of taxpayer dollars,” as the Congressional Research Service report puts it.  Individual states within the United States do this sort of thing all the time, to win industrial contracts away from each other, and as the CRS report points out, such activities produce no net gain in the overall national Gross Domestic Product.  In this case, however, Diageo will pull investment and jobs out of the American possessions altogether, if the deal with the U.S. Virgin Islands falls through.

Whatever the other merits and drawbacks of the Menendez proposal might be, it is clearly a case of one territory using raw federal power to dictate the economic policy of another.  This is possible because both Puerto Rico and the U.S. Virgin Islands depend on a massive subsidy from the United States government, and with such subsidies come control.  Removing the “cover-over” program of excise tax remittance would devastate the economies of both possessions.  Artificially restricting the way the USVI can spend its income would penalize it for failing to obey a law that didn’t exist when it began negotiations with Diageo years ago, and it would enforce Puerto Rican market dominance – and excise tax remittance – at the cost of American jobs.

Is $3.5 billion an excessive investment to secure $6 billion worth of business for three decades?  Does the answer change when we consider that some of that $6 billion comes from a massive tax subsidy?  Who should decide what is “excessive,” and who really “owns” all the money flying around in the Caribbean rum war?  Who takes responsibility for the jobs lost if Captain Morgan changes course for foreign waters?  It’s a messy issue.  Few clean fights are resolved by lobbyists and senators.