If you live in Puerto Rico, you won’t pay federal income taxes on money earned in Puerto Rico (unless it’s paid by the federal government). Why not?
Section 933 of the tax code says there is an exemption for
income derived from sources within Puerto Rico (except amounts received for services performed as an employee of the United States or any agency thereof); but such individual shall not be allowed as a deduction from his gross income any deductions (other than the deduction under section 151, relating to personal exemptions), or any credit, properly allocable to or chargeable against amounts excluded from gross income under this paragraph.
The law exempting income earned in Puerto Rico from federal income tax was passed with the idea that Puerto Rico would have more flexibility in local tax collection if the residents weren’t paying federal income tax.
One law office put it like this: “Section 933 was not designed as an incentive for U.S. citizens trying to enjoy the benefits of Acts 20 and 22 (which are generally not available to ordinary Puerto Rican residents), but rather a mechanism to effectively allow Puerto Rico to apply its [local] tax laws to raise revenue (and provide benefits from such revenue to its residents).”
As the lawyer for the Department of Justice explained it during the oral arguments for Valleo-Madero, “Congress has expressly exempted them from the obligations to pay many forms of federal taxes, including federal income tax in most instances, excise taxes, gift taxes, and estate taxes, which means that much of the revenue that would have flowed into the federal treasury can instead be tapped by territorial government, which therefore has greater leeway to make different fiscal or economic choices consistent with its distinctive status as a self-governing commonwealth.”
The situation was explained during President Kennedy’s administration like this: “If the U.S. Government were to impose its income taxes in Puerto Rico, the Commonwealth would have to reduce its tax rates to something more like those prevailing in our states. The people would not be able to pay their current Commonwealth taxes and our Federal taxes at the same time. As a result, the Commonwealth would suffer a severe loss in revenue and presumably would have to receive financial assistance to maintain itself.”
The law recognized that the average household income in Puerto Rico is lower than in the states. If the government waived income taxes, the lawmakers figured, the money that would have gone to the federal government could instead go to Puerto Rico’s government. Puerto Rico would then be able to make its own decisions about how to spend that money. Puerto Ricans might not get the same benefits as the residents of states, but their tax dollars would stay in Puerto Rico.
Puerto Rico is a territory belonging to the United States. Its finances are overseen by a federally-appointed governing board and, as Justice Sotomayor pointed out in the same arguments, “It’s illusory to think that Puerto Rico’s local economy could match the federal economy and give those tax resources to its needy.”
Did the original framers of Section 933 believe that it would benefit Puerto Rico and its residents? It has not done so.
The average resident of Puerto Rico, like half of the households in the states, would not pay income tax. In fact, most would receive money back from the federal government because of the tax credits available for low income households. These tax credits might be extended to Puerto Rico bay the current Congress — but if so, they can be taken away again by a future Congress.
At the same time, residents of Puerto Rico pay income tax to Puerto Rico, just as residents of many states pay state income taxes. They also pay payroll taxes. But they do not receive equal federal benefits. Puerto Rico also does not receive federal benefits equal to the amounts the federal government pays to states.
The amounts of federal support available to states at the time that Section 933 was written were not the same as they are now. Tax credits are different now. But the exemption of Puerto Rico from federal income taxes remains the same.