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Rum, like all spirits, falls under a United States (US) Federal excise tax of US$13.25 per proof gallon. The Federal tax revenue collected from rum produced in Puerto Rico, the US Virgin Islands, or internationally is transferred to the governmetns of Puerto Rico and the US Virgin Islands.
This transfer of revenue from the United States back to the location of production is called a “cover-over”. Puerto Rico and the US Virgin Islands each receive all of the revenue collected from rum produced in its territory. The two countries split revenue from foreign produced rum, based generally on how much rum they produce relative to each other. By producing more rum, each territory has the ability to increase its share of the rum tax.
When rum is produced in the US Virgin Islands that country is awarded all of the Federal excise taxes collected on that rum. If the rum is produced in Puerto Rico, the US Virgin Islands receives nothing. The amount of rum one country produces relative to the other also determines its share of the tax revenue from international production.
Increased rum production in the US Virgin Islands, relative to Puerto Rico or vice versa, increases the country’s share of cover-over payments from taxes on foreign produced rum. This strong incentive to boost local production for tax revenue from international production has led to a subsidies war between the two territories.
Over the past decade the US Virgin Islands has steadily increased subsidies to bolster rum production. The island’s native producer, Cruzan, receives a subsidy equivalent to 46.5 per cent of the tax revenue collected on the company’s rum. In 2008, the US Virgin Islands subsidised rum producer Diageo’s move to the island. Totalling an estimated US$2.7 billion over 30 years, the subsidies include a US$165 million distillery, market support payments to keep prices low for molasses – the main ingredient in rum – 35 per cent of what Diageo spends on advertising, a 90 per cent income tax break, exemption from property taxes, environmental mitigation supports, and a 47.5 per cent of all tax revenue collected on Captain Morgan rum. By one estimate, Diageo’s net cost to prpoduce rum is zero. Compounding perverse subsidy incentives, the rum cover-over programme has creaetd budgeting shortfalls. The treasuries of Puerto Rico and the US Virgin Islands are reliant on these Federal transfers as part of their yearly revenue.
A 1984 law capped the cover-over of the rum tax at US$10.50 per proof gallon, but since 1993 temporary tax extender legislation has removed this cap. The unpredictable biennial reauthorisation process of tax extenders often leaves the territories with uncertain revenues. The US Virgin Islands faces a $30 million deficit for the fisal year 2014 due to lower rum revenues, if the Federal extenders package is not approved. Unpredictability of tax extenders is only half of the budgeting uncertainties faced by the island nations. Because the distribution of the rum tax is dependent relative production, when rum production changes so does cover-over revenue.
The unintended consequences of the cover-over programme have led both Puerto Rico and the US Virgin Islands to manipulate their economies to maximise Federal subsidies. The ensuing subsidies race distorts the economy, creates perverse incentives, and destabilises local government.
Adam Michel is a Master’s Fellow at George Mason University, United States.