Input:
	Introduction

There are 14 U.S. territories, or possessions, five of which are inhabited: Puerto Rico (PR), Guam, U.S. Virgin Islands (USVI), American Samoa (AS), and the Commonwealth of the Northern Mariana Islands (CNMI). Each inhabited territory's local tax system has features that help determine the structure of its public finances.
Additionally, U.S. law, including the Internal Revenue Code (IRC), provides the territories with certain authorities relating to each territory's tax system, while also placing limits on the taxing authority of local lawmakers. The IRC also establishes interdependencies between federal and territorial tax systems, such that changes to the IRC can have economic and revenue effects in the territories and vice versa.
These dynamics between federal and territorial tax policy could interest Congress for a number of reasons. First, the inhabited territories elect representatives to Congress. The U.S. insular areas of Guam, AS, CNMI, and USVI are each represented in Congress by a Delegate to the House of Representatives. PR is represented by a Resident Commissioner, whose position is treated the same as a Delegate. Although these representatives have limited voting powers relative to other Members of the House, Delegates and the Resident Commissioner can speak and introduce bills and resolutions on the floor of the House, offer amendments and most motions on the House floor, and speak and vote in House committees.
Second, Congress could be interested in using tax policies intended to improve the economic conditions of the territories. The expansion of several individual federal tax benefits that are currently used to assist lower-income households and increase participation in the labor market, or the introduction of new ones, could potentially improve the quality of living among the territories. Additionally, Congress could use business-related tax incentives to encourage capital investment and employment in the territories.
Third, U.S. tax policies could have revenue implications for the territories, and vice versa. For the United States, territorial policies meant to encourage the relocation of certain industries, high-income, or high-net-worth residents to the territories could compound concerns about the erosion of the U.S. tax base and profit shifting. For the territories, their fiscal balances could be positively or negatively affected by the mix of federal and local tax policies. Territorial fiscal imbalances could raise concerns in Congress, such as recent legislation to create a fiscal control board for the purposes of restructuring public finances in PR.
These policies could be considered by the bipartisan Congressional Task Force on Economic Growth in PR, created by the Puerto Rico Oversight, Management, and Economic Stability Act (PROMESA; P.L. 114-187 ). The Task Force has been directed to issue a report, by the end of 2016, providing recommended changes to federal law that would serve to "spur sustainable long-term economic growth, job creation, reduce child poverty, and attract investment" in PR. Although many of these issues are currently being considered within the context of PR, some of these issues have also been part of longer policy debates over U.S. tax policy toward the territories.
This report summarizes U.S. tax policy related to the territories, including what federal tax policies apply to residents in each of the territories and how federal law affects the different territorial tax systems. Multiple current tax policy issues related to the territories are then analyzed. This report is intended to provide Congress with an overview of tax issues related to the territories. It is not intended to be a comprehensive guide to territorial or federal tax policy or tax law. For more tax policy and tax law background on the U.S. territories, please see the list of related readings listed in the Appendix .

	Territorial Tax Authority: Mirror vs. Non-Mirror Code Jurisdictions

U.S. law restricts the territories' authority to impose territorial (local) taxes. Most importantly is the distinction between the mirror code and non-mirror code tax systems. Three territories—Guam, CNMI, and the USVI—are currently required by U.S. law to have a mirror code (see Figure 1 ). This means these territories must use the IRC as their territorial income tax law, substituting terms where appropriate (e.g., the territory's name for "United States"). The mirror code requirements relate only to the IRC's income tax provisions (individual, corporate, and noncorporate business income), and not the IRC's other provisions such as excise taxes. Also, while these territories use the IRC as their income tax system, the tax imposed is a local tax (see Table A-1 for a discussion of how this could also affect tax filing requirements).
In contrast, territories that are not bound by the mirror code (PR and AS) may establish their own local forms of income taxation and promulgate their own income tax regulations.
Regardless of whether territories use the mirror code, they are still allowed to enact additional forms of taxation within certain boundaries enacted by U.S. Constitution and applicable federal statutes. A number of territories have used this authority to enact additional types of revenue-raising measures, or provide rebates on territorial-source income taxes.

		Guam and the Commonwealth of Northern Mariana Islands

Although Guam and CNMI are mirror-code jurisdictions, they are authorized under Section 1271 of the Tax Reform Act of 1986 (TRA86) to delink from the IRC if certain conditions are met. In order to delink, Guam or CNMI would need to (1) enact a new, non-discriminatory local income tax system to replace the IRC that raised revenue during each of its first five years that is at least equal to the revenue raised during the final year under the old system; and (2) enter into an implementing agreement with the United States to address issues relating to tax administration. While Guam signed an implementing agreement with the United States in 1989, it has never gone into effect. CNMI, meanwhile, has not entered into an implementing agreement with the United States.

		U.S. Virgin Islands

USVI is required to mirror the IRC for its local tax code but has additional authority to levy taxes compared to Guam and CNMI. Unlike Guam or CNMI, TRA86 did not provide USVI with the authority to delink from the mirror code, reportedly by mutual agreement with the United States. TRA86 did grant USVI, though, with the authority to enact nondiscriminatory local income taxes in addition to those taxes mirrored in the IRC. However, USVI has not enacted any additional forms of income taxes to date. Under IRC Section 934, USVI is also allowed to provide tax benefits to its residents on their USVI-source income only.

		Puerto Rico and American Samoa

There is no requirement in U.S. law that PR and AS use a mirror code. Thus, these two territories may enact their own income tax laws, subject to any requirements in U.S. law (e.g., any such tax laws must comply with the U.S. Constitution). Congress recognized PR's authority over matters of internal governance, including territorial tax law and policy, in the 1950 Federal Relations Act (P.L. 81-600) and its approval of the territory's constitution in 1952. Since then, PR has enacted its own income tax laws. AS, meanwhile, has chosen to adopt a modified version of the IRC as its territorial income tax laws. The current version of AS's local tax code is the version of the IRC that was in effect on December 31, 2000, with some modifications. In other words, provisions in the IRC that were enacted after December 31, 2000 are not automatically incorporated into AS' mirror-code system, unless the AS' government passed legislation amending their local tax code.

	Applicability of Federal Taxes in the Territories

In addition to the imposition of local taxes in each territory, there are instances when federal taxes may apply as well. Two general principles are helpful in understanding when federal taxes apply in the territories. First, while the United States taxes its citizens, residents, and corporations based on their worldwide income regardless of whether the income is earned within the United States or abroad, for federal tax purposes the residents of the U.S. territories are generally treated more similar to foreign citizens (even though they are U.S. citizens or nationals) and corporations organized or created in the territories are treated like foreign companies. This means that federal taxes will generally only be levied when a territory resident or corporation has income that can be sourced (or connected) to the United States. Second, the territories are generally considered to be beyond the physical borders of the United States for federal tax purposes. Thus, any IRC provision whose applicability is limited to the geographic United States does not apply in the territories unless the provision specifically provides otherwise (such as the provisions listed in the " U.S. Tax Incentives Targeted to the Territories " section of this report).

		U.S. Individual Income Taxation

As a general rule, individuals who are bona fide residents of a territory are eligible for a possession-source income exclusion, and therefore not subject to U.S. income tax on work or business income sourced from within the territories (except for compensation of federal government employees). Bona fide residents of a territory with income only from that territory need to only file one tax return with their local tax authorities. Table A-1 summarizes the general tax filing and income reporting procedures for individuals with territorial-source income.
The possession-source income exclusion currently applies to each of the territories through several sections of the IRC:
American Samoa (IRC Section 931) U.S. Virgin Islands (IRC Section 932) Puerto Rico (IRC Section 933) Guam and CNMI (former IRC Section 935)
The possession-source income exclusion and IRC tax coordination requirements between each territory and the United States will determine the filing situation of bona fide residents with income earned outside of their jurisdiction, and individuals who are not bona fide residents and earned territorial-source income. Bona fide residents with income from another jurisdiction (such as the United States) might have to file returns with the IRS or their local tax authorities (or both). For individuals who are not bona fide residents, tax filing requirements will depend on such things as the territory involved, the tax filer's citizenship and residency, and the source of the tax filer's income. U.S. tax-filing procedures also vary for excluding certain territorial-source income or allocating income earned in the territories versus the United States.
Bona fide residency in a territory is determined by the three-part test in IRC Section 937. To claim residency in a particular territory, the tax filer generally must
1. meet a physical presence test (e.g., present in the relevant possession for at least 183 days during the tax year); 2. not have a tax home outside the relevant possession; and 3. not have a closer connection to the United States or to a foreign country than to the relevant possession.
For both territorial and mainland residents, situations might arise as to whether or not U.S. or territorial income tax is due on certain sources of income. For example, residents of the territories might work part of the year on the U.S. mainland, earn rental property income, or collect income from U.S.-based investments or businesses. Similarly, U.S. citizens residing in the mainland might earn income attributable to the territories. Table 1 outlines the general rules as articulated by the IRS for determining U.S. source of income in certain situations.
Additionally, IRC Section 911 permits U.S. citizens and residents who live and work abroad a capped exclusion of their foreign wage and salary income. However, U.S. citizens and residents who reside in the territories cannot qualify for income or housing exclusions specified in IRC Section 911 because they are not classified as living abroad for the purposes of the foreign earned income tax exclusion.

		Corporate Income Taxation

U.S. corporations are subject to U.S. income tax on their worldwide earnings. U.S. tax on the earnings of foreign subsidiaries of U.S. corporations is deferred until these earnings are repatriated back to the United States in the form of dividend distributions to the U.S. parent corporation. Generally, income earned by the active business operations of U.S. corporations in the territories is considered foreign-source income, because the IRC does not define them as being within the "United States." As a result, active corporate income earned in the territories can be deferred. The income earned by foreign branches of U.S. corporations, however, is not deferrable.
There are two exceptions from the general deferral rule that result in taxation of certain forms of highly mobile income earned by a foreign subsidiary on a current year basis: (1) subpart F income of controlled foreign corporations (CFCs), and (2) passive foreign investment company (PFIC) rules. These forms of highly mobile income are not eligible for deferral because they can be transferred relatively easily to low-tax jurisdictions to lower U.S. income taxes. One exception to the current year taxation of subpart F income is for active financing income, which is income earned by U.S. corporations from the active conduct of a banking, financing, or insurance business abroad. This income can be deferred.
U.S. corporations can claim a foreign tax credit, for any qualifying taxes paid to foreign jurisdictions, including the territories, up to the amount of U.S. income tax due. For example, a U.S. corporation earns $30 million in worldwide income, of which $10 million is foreign source income attributed to a wholly-owned subsidiary in PR. Assume that the tax rate on PR-source income is 10% and the U.S. tax rate is 35%. In this example, the pre-credit U.S. tax liability faced by the corporation is $10.5 million ($30 million times 35%). The corporation pays $1 million in income tax to PR ($10 million times 10%), which can be credited against U.S. income tax. Thus, the corporation would owe $9.5 million in income tax to the United States after applying foreign tax credits.
U.S. subsidiaries of foreign-owned corporations (including corporations organized in the territories) are generally subject to U.S. corporate income tax on any income effectively connected to a U.S. trade or business.
Dividends paid by U.S. corporations to foreign companies (such as a foreign parent company) are generally subject to a withholding tax of 30% (unless reduced by bilateral tax treaty). Foreign corporations created or organized in AS, Guam, CNMI, or USVI are not subject to this 30% withholding tax so long as the foreign company receiving the dividends meets certain territorial ownership and activity requirements. Each of these territories has adopted local tax laws to waive withholding taxes on payments made by local corporations to corporations organized in the United States. For PR corporations meeting these territorial ownership and activity requirements, the U.S. withholding tax rate on dividends is reduced from 30% to 10% so long as PR imposes a withholding tax on dividends paid to U.S. corporations not engaged in a PR trade or business at a rate not greater than 10%.

		Payroll Taxes

For the purposes of Federal Insurance Contributions Act (FICA) taxes, wages paid to U.S. citizens, resident aliens, and nonresident aliens employed in the territories are generally subject to Social Security and Medicare taxes under the same conditions that would apply to U.S. citizens and residents employed in the United States. The FICA payroll taxes are comprised of two taxes: (1) a 1.45% tax paid by both the employee and employer for Medicare Hospital Insurance (plus an additional tax of 0.9% on any earned income in excess of $200,000, $250,000 if married filing jointly); and (2) a 6.2% tax on wages, up to a cap, paid by both the employee and employer for the Old Age, Survivors, and Disability Insurance (Social Security).
PR and USVI are eligible under federal law for the Unemployment Compensation program, and thus only employers in those territories that pay wages to U.S. citizens, resident aliens, and nonresident aliens employed in the territories are subject to the Federal Unemployment Tax Act (FUTA) tax at a rate equal to 6.0% of wages. Employers that make contributions to PR or USVI's unemployment insurance programs can be eligible for a credit against up to 90% of gross federal FUTA tax owed (i.e., 5.4% out of the 6% tax rate).
As with FICA taxes on employee wages, bona fide residents of a U.S. territory who have selfemployment income must generally pay selfemployment tax to the United States. Bona fide residents may be subject to U.S. selfemployment tax even if they have no income tax filing obligation with the United States.
Employers and employees in the territories are generally not subject to withholding for U.S. income tax, since most wages paid by an employer residing in the territory are subject to withholding by the territory and are generally subject to local income taxes.

		Excise Taxes

U.S. excise taxes generally do not apply within the territories, with a few exceptions. One exception includes environmental excise taxes, such as the ozone-depleting chemicals tax or the Oil Spill Liability Trust Fund tax on petroleum refiners, which are in effect in the territories. Another exception is a special excise tax imposed on products manufactured in PR and USVI that are shipped to the U.S. mainland for consumption or sale. The tax is equal to any U.S. excise tax (e.g., alcohol, tobacco) that would apply to the identical item produced on the mainland and was intended to prevent products that are manufactured in PR or USVI from having a tax advantage over similar products manufactured on the mainland. These "equalization taxes" are generally "covered over" to the respective treasuries, meaning that the U.S. Treasury transfers any taxes collected under this provision to the territories in the form of direct payments.
In addition to the equalization tax, a specific cover-over for federal tax is collected on rum imported to the United States. A portion of the $13.50 per proof gallon federal excise tax on rum imported into the United States from other sources—not including PR or USVI—is transferred to the treasuries of PR and USVI based on the estimated U.S. market share of rum produced in those territories. Under current law, the cover-over rate transferred to PR and USVI is $13.25 per proof gallon of rum taxed by the United States. The covered-over revenue has never been designated for particular purposes by Congress, but the territories have tended to dedicate some portion to fund marketing campaigns for the rum industry and general economic development.

		Estate and Gift Taxation

A U.S. citizen or resident is subject to tax on the value of bequests at death (regardless of where the property is located) as well as inter-vivos (i.e., during life) gifts. A tax rate of 40% is levied on the value of any estate exceeding the unified credit ($5.45 million in 2016, adjusted for inflation).
There is an exemption for U.S. citizens residing in the territories who acquired U.S. citizenship solely by reason of birth or residence within the possession. However, the estates of territorial residents could still be subject to U.S. estate and gift tax if the estate contains any tangible property (such as real estate) located in the United States.

		U.S. Tax Incentives Targeted to the Territories

Federal tax incentives are made available for certain activities in the territories. Some of these provisions include the deduction for state and local income or sales taxes, the exclusion of interest on state and local bonds, the credit for research and experimentation, the low-income housing credit, and the renewable energy production tax credit, among others.
There are also a few provisions in the federal tax code that effectively support specific industries in specific territories. As discussed in the " Excise Taxes " section of this report, rum cover-over payments are often used by the government of PR and USVI to support economic development projects for the rum industries in their respective territories. Additionally, the Section 199 deduction for certain manufacturing and production activities has been temporarily extended to include eligible activities in PR. Congress has also temporarily extended a corporate tax credit for business operations and investment activities in AS.

	Policy Issues for Congress

This section of the report summarizes three tax policy issues relevant to the territories that could be of current interest to Congress: (1) tax-based assistance to households in the territories, (2) tax policy and economic development of the territories, and (3) tax arbitrage and U.S. tax avoidance activities related to the territories.

		Tax-Based Assistance to Households in the Territories

As an alternative or complement to enhancing social welfare programs, Congress could consider using U.S. tax policy to provide economic assistance to households in some or all of the territories. While there are many ways to potentially structure this assistance, common proposals include (1) expanding the availability of the federal earned income tax credit (EITC) to households in the territories, (2) expanding the availability of the federal additional child tax credit (ACTC) to households in the territories, and (3) creating a payroll tax cut for territorial tax filers.

			Earned Income Tax Credit (EITC) and Additional Child Tax Credit (ACTC)

The EITC is a refundable tax credit available to eligible workers earning relatively low wages. The lump sum credit is issued to eligible households at one time during the year (after they file their annual federal tax returns), and the size of the credit depends on a variety of factors—namely the recipient's earnings and amount of dependent children. The EITC is a refundable tax credit, which means that it can benefit a taxfiler (in the form of a tax refund) even if they have no federal tax liability. The EITC is intended to encourage the nonworking poor to enter the workforce and reduce the overall tax burdens of working poor families.
The child tax credit (CTC) is a dollar-for-dollar reduction in tax liability and is partially refundable for low-income tax filers. The size of the credit depends on the tax filer's earnings and the number of qualifying children. The refundable portion of the CTC is known as the ACTC. The CTC is intended to reduce the financial burden that families incur when they have children.
Generally, bona fide residents of the territories do not meet the criteria to claim the federal EITC. Mirror code residents (Guam, CNMI, and USVI) and certain PR residents can claim the ACTC. Congress could expand eligibility of the EITC and ACTC to more residents of non-mirror code territories, as President Obama and others have called for in PR.
The research surrounding the economic impact of these refundable credits in the United States may prove insightful to policymakers interested in expanding eligibility of these credits to the territories. In theory, the CTC and ACTC could provide subsidies for low-income families to work and have children. However, researchers have found it difficult to isolate the labor market effects of CTC and ACTC, particularly with the presence of the similarly-targeted, but larger, subsidy provided by the EITC. Additionally, the CTC and ACTC are unlikely to have a significant impact on inducing families to have additional children, as the expenses associated with raising a child typically exceed the benefits associated the tax provisions.
In comparison, studies have found that the EITC is effective in encouraging single mothers to enter the labor force, as was the original intention of the provision, but the credit is less effective in increasing the labor supply of secondary earners. There is no significant evidence that the EITC increases the labor supply of individuals without children, likely because so few childless taxpayers receive the childless EITC. The EITC also generally reduces poverty but only for recipients who have children.
Given these findings, expanding access for territorial residents to claim the EITC and ACTC could increase labor supply and reduce poverty in these areas to the extent that these issues are concentrated in populations where the proposals have shown to be effective. For example, a single man without children or an unemployed spouse might not benefit much from these policies compared to a single mother with children.
There are several barriers that could prevent expanded EITC or ACTC from having the type of economic benefits claimed by the policies' proponents. Most notably, many territorial residents currently do not file a U.S. tax return, particularly if their income comes only from territorial sources (see Table A-1 ). Requiring these households to file a U.S. tax return to claim a federal tax provision could dissuade low-income territorial households from claiming the credit or raise tax compliance costs (especially if it requires accounting for income earned in the informal economy). Alternatively, the U.S. Treasury could offset the cost of such policies enacted via the local tax code. While this option could reduce the household tax compliance costs of filing a U.S. tax return, it could add responsibilities to territorial tax officials with little or no history of administering these provisions. Even in the United States, roughly one-quarter of EITC payments are issued improperly, with the most common errors being the claiming of ineligible children who are not qualified for the purposes of the EITC, income reporting errors, and filing status errors.
Additionally, other policies (such as the application of the U.S. minimum wage and local labor regulations) could constrain employer demand for new workers and potentially offset any labor supply effects of expanding the EITC to the territories. These constraints could be lessened by reducing the applicability of the minimum wage to the territories or by introducing a tax-based labor subsidy (explained in " Economic Development of the Territories " section of this report).
Expanding eligibility for these refundable tax credits could have significant budgetary costs. In 2006, the JCT noted that many people could be eligible for the EITC and ACTC in PR. On the one hand, a redesign of the benefit structure could lessen the revenue loss of expanding access to the EITC and ACTC for territorial residents. This could be achieved, for example, by reducing the income level at which the credits begin to phase out. Adjusting the phaseouts or reducing the benefit rates that apply to households on the U.S. mainland might also better target "low-income" households in the territories after adjusting for costs of living between territories and states on the mainland. If the thresholds are not adjusted, then higher-income households, by territorial standards, could receive "windfall" tax benefits that might not contribute much to improving the local economy or achieving the desired tax relief. On the other hand, the IRC typically does not adjust benefit or threshold amounts for differences in economic conditions between the states. Additionally, the cost of living varies across the territories, thus making it difficult to develop a single, alternative benefit formula just for the territories. One study found that some areas in the territories, such as San Juan (PR), have higher costs of living than average metropolitan areas in the United States.

			Payroll Tax Cut

Congress could increase the after-tax income of territorial households by reducing payroll taxes for territorial residents. A payroll tax cut would reduce the amount withheld from workers' paychecks, thereby increasing their take-home pay. Since all employees must pay payroll taxes on the first $118,500 of income (in 2016), a payroll tax cut would target lower-income households as well as upper-middle income households. Higher after-tax incomes could allow residents to more easily pay for basic needs. As previously mentioned, employers and workers in all five of the inhabited territories pay FICA taxes on their wages, and employers pay FUTA taxes on wages in PR and AS.
The most straightforward way to reduce payroll taxes would be to lower the payroll tax rates. For example, a temporary two-percentage-point reduction, or "holiday," in wages subject to OASDI payroll taxes was enacted in the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 ( P.L. 111-312 ). The reductions in payroll taxes to the Social Security trust funds were offset by transfers from the general fund.
Alternatively, a payroll tax cut could be modeled after the temporary Making Work Pay (MWP) tax credit that was enacted as part of the American Recovery and Reinvestment Act of 2009 (ARRA; P.L. 111-5 ). The MWP credit provided a refundable tax credit of 6.2% of wages (up to a certain dollar amount, based on filing status) through lower income tax withholdings in workers' paychecks. The credit phased in and phased out based on a worker's earnings, with the maximum credit amount being $400 for individuals ($800 for joint filers).
Still, both of these payroll tax options have an administrative advantage compared to the EITC and ACTC options in providing tax-based assistance to households in the territories. All territorial residents are subject to some form of federal payroll tax, while not all territorial residents file U.S. income tax returns. As a result, the territories would also not have to implement a new program for the U.S. Treasury to reimburse. The benefits of a payroll tax cut can also be delivered to households more quickly through workers' paychecks rather than through the EITC and ACTC, which are issued once per year during tax season.

		Economic Development of the Territories

Congress could consider the role tax policies play in promoting economic development in the territories. For example, the Congressional Task Force on Economic Growth in Puerto Rico could consider options for the use of U.S. tax policies to encourage or discourage certain industries or types of jobs, or affect the structure of territorial public finances. Historically, Congress has deliberately structured provisions of the IRC to promote particular goals of economic development in the territories. Although a comprehensive historical analysis of U.S. tax policy toward the territory is beyond the scope of this report, notable examples include the now-repealed IRC Section 936 possessions tax credit (first enacted in 1976, but fully phased-out in 2005); deferral of tax on the earnings of territorial subsidiaries of U.S. corporations; and the federal, state, and local exclusion of interest on qualified public bonds issued by the territories.
Options available include tax policies that reduce the cost of capital investment. For example, one such option could provide a credit against U.S. income tax liability for new physical investment in the territories. Credits against U.S. income tax based on wages paid to new workers hired in the territories could reduce the cost of hiring workers. Both forms of tax incentives could be made available to encourage economic activity in any industry, or they could be structured to provide a relative boost to particular industries. However, these types of tax policies could redirect investment away from locations, industries, or modes of production that produce the greatest economic rate of return. Moreover, these policies might have unintended economic side effects. For example, tax incentives for capital investment in the territories could lead firms to engage in more capital-intensive modes of production, and reduce firms' reliance on labor. Even tax incentives for broader economic activity in the territories, including benefits for both capital- and labor-intensive producers, could leave the relative cost of both inputs unchanged, thereby generating little to no employments effects.
Most evaluations of U.S. tax policies encouraging development in the territories have focused on the effects that the Section 936 possessions tax credit has had on PR. Section 936 enabled certain U.S. corporations to pay little to no U.S. tax on income generated by PR affiliates. This, in turn, provided a substantial incentive for U.S. investment in PR. It also, provided an incentive to use tax planning techniques to book profits in PR with little change in real economic activity (i.e., engage in profit shifting). While the Section 936 credit was not exclusively tied to PR operations, a U.S. Department of the Treasury data analysis published in 1991, found that U.S. corporations with affiliate activity in PR accounted for 96.8% of all corporate filings claiming the Section 936 credit and 99.2% of Section 936 credit amounts in 1987.
Officials from PR claimed that Section 936 encouraged the development of a high-skilled labor force on the island, particularly in jobs within the pharmaceutical and electronics industries. The 1991 Treasury study confirmed these general arguments, as it found that Section 936 corporations employed 82.3% of manufacturing workers in PR and that the average annual wage for employees of Section 936 corporations was 59.5% higher than the average wage across all production workers in PR. With this said, though, the Treasury study also indicated that the Section 936 incentives effectively amounted to a subsidy almost equal to the average worker's salary in their respective industries. For corporations claiming the credit in 1987, the average tax benefit per employee was 94.5% of the average wage. Specifically in the drug, chemicals, and electronics manufacturing industries, the average tax benefit per employee were: 267.4%, 251.7%, and 116.3% (respectively). Other studies, such as those by the Government Accountability Office (GAO) in 1993, provided additional evidence that the average tax benefit for 936 corporations often equaled if not surpassed average compensation per employee. In 1996, Congress approved the ten-year phaseout of Section 936, in part, because the costs to taxpayers outweighed the benefits accumulating to the "relatively small number of U.S. corporations that operate in the possessions."
Subsequent economic analyses support the notion that Section 936 activity provided significant benefits to U.S. parent corporations. For example, Grubert and Slemrod (2008) indicated that the U.S. firms that benefited the most from Section 936 were those that were able to shift income earned from intangible property, such as patents, developed from research and development conducted elsewhere (such as the United States) to their PR affiliates. The authors concluded that income shifting opportunities represented the predominant reason for U.S. investment in PR, even overcoming higher labor and electricity costs for production in the territory. This income shifting activity provided abnormally large returns to investors in Section 936 companies. Bosworth and Collins (2006) found that the net return on stockholders' equity in 1997 was 112% for pharmaceutical firms in PR (compared to 25% for pharmaceutical firms in the United States) and 48% for chemicals firms in PR (compared to 16% for chemicals firms in the United States).

		Tax Arbitrage and U.S. Tax Avoidance

Tax arbitrage activity in the territories is symptomatic of the broader erosion of the U.S. tax base due to international income and profit shifting. Opportunities for U.S. corporate and individual taxpayers to avoid or reduce U.S. tax liability are created, in part, because the territories are generally treated like foreign countries for U.S. income tax purposes, and some of the territories provide tax incentives to attract overseas investment.
As mentioned in the " Economic Development of the Territories ," above, economic studies indicate that some U.S. corporations were able to pay low or zero income tax to the United States or local territories on income shifted to the territories during the era of the Section 936 tax credit. While the phaseout of Section 936 in 2005 ended this tax planning strategy, U.S. corporations can still take advantage of deferral, transfer pricing, low tax rates in third-party countries, and special tax incentives offered by the territories to lower their U.S. tax liability.
For example, media reports indicate that U.S. multinational corporations in the past have established holding companies in a low- or zero-income tax jurisdiction (such as the Cayman Islands) and transferred the ownership of intangible assets (such as patents) to that holding company. A PR subsidiary of the U.S. multinational corporation can manufacture a product with the support of special tax incentives offered by the PR government. The U.S. multinational corporation can shift any earnings from U.S. sales of this product to their PR subsidiary, who can then shift these earnings to their holding company in the zero-tax jurisdiction in the form of royalty payments for the use of the intellectual property in manufacturing products in PR. Corporations can use transfer pricing strategies to further reduce taxable income.
Additionally, U.S. individuals can use U.S. or territorial tax incentives to reduce or avoid tax that would otherwise be subject to U.S. tax. For example, a common strategy marketed by tax planning professionals is for U.S. individuals to first establish residency in PR (e.g., by residing on the island for at least half of the year) as a means to avoid U.S. worldwide tax from PR sources (because of the IRC Section 933 exclusion). These individuals would then qualify under PR's Individual Investors Act, which exempts most investment income of new residents from PR tax. Overall, U.S. taxpayers can accumulate capital gains on certain investments made in the United States but avoid both U.S. and PR tax when realizing those gains after establishing residency in PR (although their estate could still be subject to U.S. estate and gift taxes).
These tax avoidance strategies, both at the corporate and individual levels, could raise a number of concerns about the policy implications of these practices. First, tax arbitrage and avoidance strategies result in foregone revenue to the United States. In the territories, these policies could reduce or increase revenue, depending on whether the tax incentives redirected new investment to the territories or simply rewarded behavior that might have occurred even without the incentives. In any case, though, these tax strategies might be compared to alternative policy means to attract foreign capital or support economic growth. For example, the revenue raised by shutting off these tax strategies could be used for paying down government debt or on spending programs (such as infrastructure, workforce education, or general social services) that could potentially have a larger effect on growth or income security in the territories. Non-mirror-code territories could also use this revenue to lower statutory income tax rates for all territorial taxpayers (and not just those who are granted special exemptions).
Second, tax avoidance opportunities reduce economic efficiency by distorting relative rates of return to capital across locations. Additionally, capital allocation is distorted across industries, as incentives are offered in targeted industries and as more resources are devoted to international tax planning professional services than would otherwise occur under certain simpler international tax systems. A more efficient tax system would facilitate the flow of capital to locations and industries based on their economic returns, instead of gains from sophisticated tax planning.
Third, tax avoidance opportunities raise issues of economic equity, or fairness, as multinational corporations with the financial means and access to an in-house accounting department or outside consultants with tax planning expertise could pay a lower effective U.S. tax rate on their profits than similar-sized firms that only have U.S. operations. Similarly, individuals with the means to structure their finances offshore, travel and establish bona fide residency in the territories, and subsist on earnings from passive investments could end up paying a lower effective U.S. income tax rate (if any at all) than those who derive most of their earnings from wage income and do not have the means to establish residency in the territories.

			Appendix. Summary of Internal Revenue Code Tax Filing Requirements for U.S. Territories

 Table A-1 provides a summary of the general U.S. income tax filing requirements, as imposed by the Internal Revenue Code (IRC), for two groups of tax filers: (1) U.S. citizens or residents who are not bona fide residents of the territories (e.g., residents of the 50 states or the District of Columbia); and (2) bona fide residents of the territories. Table A-1 also indicates whether a territory is a "single tax return filing jurisdiction"—meaning a territory in which a bona fide territorial resident generally has to file only one annual income tax return, either with the IRS or the local territory's tax department. General filing procedures and income reporting measures are discussed for residents of the mainland United States and the territories under the three scenarios: (1) tax filers with only territorial-source income, (2) tax filers with income only from non-territorial sources, and (3) tax filers with a both territorial and non-territorial source income.
 Table A-1 relates only to IRC's income tax filing requirements and does not apply, for example, to other types of taxes, including self-employment or payroll taxes (FICA) that are due to the United States. This table also does not discuss special tax filing procedures for certain groups, such as U.S. military servicemembers stationed in the territories. This table also does not provide details on income tax filing requirements imposed by the territories.
 Table A-1 is intended to inform the legislative debate by providing an overview of current administrative tax filing procedures for territorial residents and U.S. citizens who are nonresidents of the territories but have territorial income. It is also intended to supplement the discussion of potential administrative challenges and costs related to extending provisions in the IRC to certain territorial residents. It is not intended to be a comprehensive source of tax advice or a substitute for professional accounting advice. For more guidance on tax compliance, see the IRS's Tax Guide for Individuals with Income from U.S. Possessions (Publication 570).
For more background on tax law regarding the territories, the status of federal legislation to encourage development in the territories, see
CRS Report R43541, Recently Expired Community Assistance-Related Tax Provisions ("Tax Extenders"): In Brief , by Sean Lowry (discussing the American Samoa Economic Development Credit); Internal Revenue Service (IRS), Tax Guide for Individuals with Income from U.S. Possessions (Publication 570), at https://www.irs.gov/pub/irs-pdf/p570.pdf ; IRS, "Individuals Living or Working in U.S. Territories/Possessions," at https://www.irs.gov/Individuals/International-Taxpayers/Individuals-Living-or-Working-in-US-Possessions; Joint Committee on Taxation (JCT), Federal Tax Law and Issues Related to the Commonwealth of Puerto Rico , JCX-132-15, September 28, 2015, at https://www.jct.gov/publications.html?func=startdown&id=4840 ; and JCT, Federal Tax Law and Issues Related to the United States Territories , JCX-41-12, May 14, 2012, at https://www.jct.gov/publications.html?func=fileinfo&id=4427.

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There are 14 U.S. territories, or possessions, five of which are inhabited: Puerto Rico (PR), Guam, U.S. Virgin Islands (USVI), American Samoa (AS), and the Commonwealth of the Northern Mariana Islands (CNMI). Each of these inhabited territories has a local tax system with features that help determine each territory's local public finances.
The U.S. Internal Revenue Code (IRC) has two important roles in establishing the tax policy relationship between the United States and the territories. First, native residents of U.S. territories are U.S. citizens or nationals but are taxed more similar to foreign citizens because income earned from territorial sources is treated like foreign-source income. The IRC also treats U.S. subsidiaries formed in the territories as foreign corporations, which can generally defer U.S. tax on income earned from business or trade in the territories.
Second, the IRC serves as the local tax laws in the territories that are required to use a mirror-code system (USVI, Guam, and the CNMI), in which the territory substitutes its name for the "United States" to give the IRC the proper effect as the territory's local income tax system. AS is not bound by the mirror system but has chosen to adopt much of the IRC for its income tax. PR has its own income tax system, which is not based on the IRC.
These dynamics between federal and territorial tax policy raise several potential issues for Congress. First, economic development of the territories has been of perennial congressional interest. Tax incentives enacted by the territories and the United States have been shown to direct offshore investment to the territories. With this said, though, economic studies of one broader U.S. tax incentive, the now-repealed Section 936 credit, indicate that any employment effects are usually secondary to the magnitude of effects on shareholder earnings, and average tax benefit for corporations often equaled if not surpassed average compensation per employee. Tax policies that effectively subsidize a more narrow set of industries in certain territories, such as rum production in PR and the USVI and manufacturing in AS, still exist today.
Second, federal tax benefits could be used to assist low-income households living in the territories. For example, the Earned Income Tax Credit (EITC) and the additional child tax credit (ACTC) could be expanded to low-income territorial households. The EITC is typically not available to territorial residents and the ACTC is limited to residents of the mirror code territories and certain residents of PR. Although these options could target lower-income households, they could also impose administrative costs for territorial households that are not required to file U.S. tax returns (e.g., because they only have territorial-source income). A payroll tax cut could be administratively simpler (since all territorial residents withhold taxes for some federal payroll taxes), but it would also be less narrowly targeted to lower-income households.
Third, interactions and differences in tax rates between the U.S. and territorial tax policies also create opportunities for tax arbitrage and avoidance by corporations and certain individuals. For the United States, this tax revenue loss is part of a broader issue with international income and profit shifting. For the territories, the revenue lost from special tax incentives could be used to reform the local tax system, increase spending on social programs, or pay down their debt. Such tax avoidance opportunities can distort the allocation of capital away from locations and industries where investment earns the highest economic rate of return. Additionally, the ability for certain taxpayers to utilize sophisticated tax avoidance strategies could raise issues of fairness.
This report summarizes U.S. tax policy related to the territories, including a general discussion of how federal taxes apply to territorial residents and how federal law affects the different territorial tax systems in similar or different ways. This report is not intended to be a comprehensive guide to federal or territorial tax policy or tax law.


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	Background

DI and SSI are the two largest federal programs providing cash assistance to people with disabilities. Established in 1956, DI provides monthly payments to workers with disabilities (and their dependents or survivors) under the age of 65 who have enough work experience to be qualified for disability benefits. Created in 1972, SSI is a means-tested income assistance program that provides monthly payments to adults or children who are blind or who have other disabilities and whose income and assets fall bellow a certain level. To be considered eligible for either program as an adult, a person must be unable to perform any substantial gainful activity by reason of a medically determinable physical or mental impairment that is expected to result in death or that has lasted or can be expected to last for a continuous period of at least 12 months. Work activity is generally considered substantial and gainful if the person’s earnings exceed a particular level established by statute and regulations.In calendar year 2001, about 6.1 million working age individuals (age 18- 64) received about $59.6 billion in DI benefits, and about 3.8 million working-age individuals received about $19 billion in SSI federal benefits.
To obtain disability benefits, a claimant must file an application at any of SSA’s offices or other designated places. If the claimant meets the nonmedical eligibility criteria, the field office staff forwards the claim to the appropriate state DDS office. DDS staff—generally a team comprised of disability examiners and medical consultants—review medical and other evidence provided by the claimant, obtaining additional evidence as needed to assess whether the claimant satisfies the program requirements, and make the initial disability determination. If the claimant is not satisfied with the DDS determination, the claimant may request a reconsideration within the same DDS. Another DDS team will review the documentation in the case file, as well as any new evidence the claimant may submit, and determine whether the claimant meets SSA’s definition of disability. In 2001, the DDSs made 2.1 million initial disability determinations and over 514,000 reconsiderations.
If the claimant is not satisfied with the reconsideration, the claimant may request a hearing by an ALJ. Within SSA’s OHA, there are approximately 1,100 ALJs who are located in 140 hearing offices across the country. The ALJ conducts a new review of the claimant’s file, including any additional evidence the claimant submitted since the DDS decision. The ALJ may also hear testimony from medical or vocational experts and the claimant regarding the claimant’s medical condition and ability to work. The hearings are recorded, and claimants are usually represented at these hearings. In fiscal year 2001, ALJs made over 347,000 disability decisions.
SSA is required to administer its disability programs in a fair and unbiased manner. However, in our 1992 report, we found that, among ALJ decisions at the hearings level, the racial difference in allowance rates was larger than at the DDS level and did not appear to be related to severity or type of impairment, age or other demographic characteristics, appeal rate, or attorney representation. We recommended, and SSA agreed, to further investigate the reasons for the racial differences at the hearings level and act to correct or prevent any unwarranted disparities.

	SSA’s Study of Racial Disparities Was Extensive, but Methodological Weaknesses in Available Documentation Preclude Conclusions

Following our report, SSA undertook an extensive effort to study racial disparities in ALJ decisions at the hearings level, but weaknesses in available documentation preclude conclusions from being drawn. The study involved 4 years of data collection, outside consultants, and many staff who collected and analyzed data from over 15,000 case files. Although the results were not published, SSA officials told us that their statistical analyses of these data revealed no evidence of racial disparities. On the basis of our review of SSA’s internal working papers and other available information, we identified several weaknesses in sampling and statistical methods. Presently, SSA has no further plans to study racial disparities but, if it did, its ability to do so would likely be hampered by data limitations.

		SSA’s Effort to Study Racial Disparities Was Extensive, but Results Were Not Published

In response to our 1992 report, SSA initiated a study of racial disparities at the ALJ level that involved several components of the agency. SSA obtained help in designing and conducting the study from staff in its Office of Quality Assurance and Performance Assessment; the Office of Research, Evaluation and Statistics; and the Office of Hearings and Appeals. SSA also created a new division within the Office of Quality Assurance—the Division of Disability Hearings Quality—to spearhead the collection of data needed to study racial disparities and to oversee ongoing quality assurance reviews of ALJ decisions.
Data collection for this study was a large and lengthy effort. In order to construct a representative sample of cases to determine whether race significantly influenced disability decisions, SSA selected a random sample each month from the universe of ALJ decisions, stratifying by race, region, and decisional outcome (allowance or denial). This sample of over 65,000 cases was drawn over a 4-year period—from 1992 to 1996. Then, for each ALJ decision that was selected to be in the sample, SSA requested the case file and a recording of the hearing proceedings from hearing offices and storage facilities across the country. Obtaining this documentation was complicated by the fact that files were stored in different locations, depending on whether the case involved an SSI or DI claim, and whether the ALJ decision was an allowance or denial.
In addition to obtaining files and tapes, the data collection effort included a systematic review of each case—the results of which SSA used, in part, for its analysis of racial disparities. Specifically, each case used in the analysis received three reviews: a peer review by an ALJ, a medical evaluation performed by one or more medical consultants (depending on the number and type of impairments alleged by the claimant), and a general review of the documentation and decisions by a disability examiner. In total, a panel of 10 to 12 ALJs, whose composition changed every 4 months, worked full-time to review cases. In addition, over a 4-year period, 37 to 55 staff, including disability examiners, worked full- time reviewing case files that were used for this study. Ultimately, about 15,000 cases received all three reviews necessary for inclusion in this study.
During and after the 4-year data collection effort, SSA worked with consultants to analyze the data in order to determine the effect of race on ALJ decisions. SSA used descriptive statistics to show that overall application and allowance rates of African Americans differed from whites. In addition, SSA used multivariate analyses to examine the effect of race on ALJ decisions while controlling for other factors that influence decisions. One of SSA’s consultants—a law professor and recognized expert in disability issues—reviewed SSA’s analytical approach and evaluated initial results. In his report to SSA, this consultant expressed overall approval of SSA’s data collection methods, but made several recommendations on how the analysis could be improved—some of which SSA incorporated into later versions of its analysis. SSA subsequently hired two consulting statisticians to review later versions of the analysis. These statisticians expressed concerns about SSA’s methods and offered several suggestions. According to SSA officials, these suggestions were not incorporated into the analysis because they were perceived to be labor intensive and SSA was not sure the effort would result in more definitive conclusions.
According to SSA officials, the agency’s final analysis of the data revealed no evidence of racial disparities, but the results were considered to be not definitive enough to warrant publication. Specifically, SSA officials told us that, by 1998, they found no evidence that race significantly affected ALJ decisions for any of the regions. However, these officials also told us that, due to general limitations of statistical analysis, especially as applied to such complex processes as ALJ decision making, they believed that they could not definitively conclude that no racial bias existed. Given the complexity of the results and the topic’s sensitive nature, SSA officials told us the agency decided not to publish the conclusions of this study.

		Available Documentation of Racial Disparities Study Indicated Some Methodological Weaknesses

From our review of SSA’s internal working papers pertaining to the study, and information provided verbally by SSA officials, we identified several weaknesses in SSA’s study of racial disparities. These weaknesses include: using a potentially nonrepresentative final sample of cases in their multivariate analyses, performing only limited analyses to test the representativeness of the final sample, and using certain statistical techniques that could lead to inaccurate or misleading results.
Although SSA started with an appropriate sampling design, its final sample included only a small percentage of the case files in its initial sample in part because staff were unable to obtain many of the associated case files or hearing tapes. SSA was not able to obtain many files and tapes because they were missing (i.e., lost or misplaced) or they were in use and were not made available for the study. For example, according to SSA officials, files for cases involving appeals of ALJ decisions to SSA’s Appeals Council—about half of ALJ denials—were in use and, therefore, excluded from the study. In addition, SSA officials told us that, due to resource constraints, not all of the obtained files underwent all three reviews, which were necessary for inclusion in SSA’s analysis of racial disparities. In the end, less than one-fourth of the cases that were selected to be in the initial sample were actually included in SSA’s final sample.
With less than one-fourth of the sampled cases included in the final sample, SSA took steps to determine whether the final sample of cases was still representative of all ALJ decisions. While the investigation SSA undertook revealed no clear differences between cases that were and were not included in the final sample, we found no evidence that SSA performed certain analyses that could have provided more assurance of the sample’s representativeness. For example, SSA made some basic comparisons between claimants who were included in the final sample and those that were in the initial sample but not the final sample. SSA’s results indicate that these two groups were fairly similar in key characteristics such as racial composition, years of education, and years of work experience. However, we found no indication in the documentation provided to us that SSA tested whether slight differences between the two groups were or were not statistically significant. Further, we found no indication that SSA compared the allowance rates of these two groups. This is an important test because, in order to be statistically representative, claimants in the final sample should not have had significantly different allowance rates from claimants who were not included in the final sample. In addition, although children were not included in SSA’s analysis of racial disparities, SSA’s tests to determine the representativeness of the final sample included children in one group and excluded children from the other. By including children in one of the comparison groups, SSA could not assess whether characteristics of the adults in the two groups were similar.
Another weakness, as documented in internal working papers available for our review, was the inclusion of certain variables in the multivariate analyses of ALJ decisions, which could lead to biased results. SSA guidelines clearly define the information that should be considered in the ALJ decision, and SSA appropriately included many variables that capture this information in its multivariate analysis. However, SSA also included several variables developed during the review process that reflected the reviewer’s evaluation of the hearing proceedings. For example, SSA included a variable that assessed whether the ALJ, in the hearing decision, appropriately documented the basis for his or her decision in the case file. This variable did not influence the ALJ’s decision, but evaluated the ALJ’s compliance with SSA procedures and should not have been included in the multivariate analysis. This and other variables that reflected a posthearing evaluation of ALJ decisions were included in SSA’s multivariate analysis. If these variables are associated with race or somehow reflect racial bias in ALJ decision making, including such variables in multivariate analysis will reduce the explanatory power of race as a variable in that analysis. For example, if a model includes a variable that may reflect racial bias—such as one that indicates the reviewer believed that the original ALJ decision was unfair or not supported—then that variable, rather than the race of the claimant, could show up as a significant factor in the model. The statisticians hired by SSA as outside consultants also expressed concern about the inclusion of these variables in SSA’s analyses.
Finally, in its internal working papers, SSA used a statistical technique— stepwise regression—that was not appropriate given the characteristics of its analysis. Specifically, SSA researchers first identified a set of variables for potential use in their multivariate analysis—variables drawn mostly from data developed during the case file review process. Then, to select the final set of variables, SSA used stepwise regression. Stepwise regression is an iterative computational technique that determines which variables should be included in an analysis by systematically eliminating variables from the starting variable set that are not statistically significant. Using the results from this analysis, SSA constructed a different model for each of SSA’s 10 regions, which were used in SSA’s multivariate analysis to test whether African Americans were treated differently than whites in each region. Stepwise regression may be appropriate to use when there is no existing theory on which to build a model. However, social science standards hold that when there is existing theory, stepwise regression is not an appropriate way to choose variables. In the case of SSA’s study, statutes, regulations, rulings and SSA guidance establish the factors that ALJs should consider in determining eligibility, and thus indicate which variables should be included in a model. By using the results of stepwise regression, SSA’s regional models included variables that were statistically significant but reflected the reviewer’s evaluation of the hearing proceedings—which an ALJ would not consider in a hearing—and therefore were not appropriate. As mentioned earlier, including these variables may have reduced the explanatory power of other variables— such as race; this, in conjunction with the use of stepwise regression, may explain why race did not show up as statistically significant in the regional models. Had SSA chosen the variables for its model on the basis of theory and its own guidelines, race may have been statistically significant. The statisticians hired by SSA as consultants also noted this as a concern.
According to an SSA official, the analysts directly responsible for or involved in the study conducted other analyses that were not reflected in the documentation currently available and provided to us. For example, this SSA official told us that the analysts involved in the study would have tested the statistical significance of slight differences between the cases included and not included in the final sample. This official also said that the analysts used multiple techniques in addition to stepwise regression— and ran the models with and without variables that reflected posthearing evaluations—and still found no evidence of racial bias. However, due to the lack of available documentation, we were unable to review these analyses or corroborate that they were performed.

		Future Studies of Racial Disparities Would Be Hampered by Data Limitations

Since the conclusion of its study of racial disparities, SSA no longer analyzes race as part of its ongoing quality review of ALJ decisions, and SSA officials told us they have no plans to do so in the future. SSA still samples and reviews ALJ decisions for quality assurance purposes. However, since 1997, SSA no longer stratifies ALJ decisions by race before identifying a random sample of cases—a practice that had helped to ensure that SSA had a sufficient number of cases in each region to analyze decisions by race. Although the dataset used for SSA’s ongoing quality assurance review of ALJ decisions still includes information on race, SSA no longer analyzes these data to identify patterns of racial disparities.
Even if SSA decided to resume its analysis of racial disparities in ALJ decisions, it would encounter two difficulties. First, SSA collects files for only about 50 percent of sampled cases in its ongoing review of ALJ decisions for quality assurance purposes, such that its final samples may be nonrepresentative of the universe of ALJ decisions. SSA uses this review data to produce annual and biennial reports on ALJ decision making. Data in these reports are also used to calculate the accuracy of ALJ decisions—a key performance indicator used in SSA’s 2000–03 performance plans pursuant to the Government Performance and Results Act. The reasons for obtaining only half of the files are the same, potentially biasing reasons as for the racial disparities study—files are either missing or not made available if the cases are in use for appeals or pending decisions. However, SSA’s annual and biennial reports do not cite the number or percentage of case files not obtained for specific reasons. In addition, SSA officials told us that they do not conduct ongoing analyses to test the representativeness of samples used for quality assurance purposes, and SSA’s annual and biennial reports do not address whether the final sample used for quality assurance purposes and for calculating the performance indicator for ALJ accuracy is representative of the universe of ALJ decisions. In addition to not obtaining about 50 percent of the case files, SSA officials told us that medical consultants and disability examiners only review a portion of cases for which a file was obtained due to limited resources.
Second, future analyses of racial disparities at either the DDS or hearings level is becoming increasingly problematic because, since 1990, SSA no longer systematically collects race data as part of its process in assigning Social Security Numbers (SSN). For many years, SSA has requested information on race and ethnicity from individuals who complete a form to request a Social Security card. Although this process is still in place, since 1990 SSA has been assigning SSNs to newborns through its Enumeration at Birth (EAB) program, and SSA does not collect race data through the EAB program. Under current procedures, SSA is unlikely to subsequently obtain information on race or ethnicity for individuals assigned SSNs at birth unless those individuals apply for a new or replacement SSN (due to change in name or lost card). As of 1998, SSA did not have data on race or ethnicity for 42 percent of SSI beneficiaries under the age of 9. As future generations obtain their SSNs through the EAB program, this number is likely to increase.

	SSA Has Taken Limited Steps to Address Possible Racial Bias in Its Hearings Level Decision-Making Process

Concurrent with SSA’s study of racial disparities, SSA’s Office of Hearings and Appeals took several steps to address possible racial bias in disability decision making at the hearings level. These steps included providing diversity training, increasing recruitment efforts for minority ALJs, and administering a new complaint process for the hearings level to help ensure fair and impartial hearings. The complaint process was intended, in part, to help identify patterns of possible racial and ethnic bias and other misconduct; however, this process lacks mechanisms to help OHA easily identify patterns of possible racial or ethnic bias for further investigation or corrective action.

		OHA Has Taken Some Steps to Address Possible Racial Bias

SSA’s OHA adopted a mandatory diversity sensitivity program in 1992. All of SSA’s incumbent ALJs were required to attend a 2- or 1-1/2-day course immediately after its development. In addition, the course (now 1 day in length) is included in a 3-week orientation for newly hired ALJs. The course was designed and is conducted by an outside contractor. The course addresses topics such as cultural diversity, geographic diversity, unconscious bias, and gender dynamics through a series of exercises designed to help the ALJs understand how their thought processes, beliefs, and past experiences with people influence their decision-making process.
OHA also increased its efforts to recruit minorities for ALJ and other legal positions, although the impact of these efforts on the racial/ethnic mix of SSA’s ALJ workforce has been limited. According to OHA officials, OHA has attended conferences held by several minority bar organizations, to raise awareness about the opportunities available at SSA to become an ALJ. In addition to having information booths and distributing information on legal careers at OHA, OHA presented a workshop called “How to Become an Administrative Law Judge at OHA,” at each conference. Despite these efforts, there have not been significant changes in the racial/ethnic profile of SSA ALJs.
In addition to these efforts, in 1993 SSA instituted a complaint process under the direction of OHA that provides claimants and their representatives with a new mechanism for voicing complaints specifically about bias or misconduct by ALJs. The ALJ complaint process supplements and is coordinated with the normal appeals process. All SSA claimants have the right to appeal the ALJ decision to the Appeals Council and, in doing so, may allege unfair treatment or misconduct. According to OHA officials, the vast majority of allegations of unfair hearings are submitted by claimants or their representatives in connection with a request for Appeals Council review. Under the 1993 process, claimants or their representatives may also file a complaint at any SSA office, send it by mail, or call it into SSA’s 800 number service. Any complaints where there is a request for Appeals Council review are referred to the Appeals Council for its consideration as part of its normal review. For complaints where the complainant did not request an Appeals Council review, the complaint is reviewed by the appropriate Regional Chief ALJ, and the findings are reported to the Chief ALJ. Regardless of how the complaint was filed or which office reviewed the complaint, OHA’s Special Counsel Staff is notified of all claims and any findings from either the Appeals Council or the Regional Chief ALJ. On the basis of these findings, OHA may decide to take remedial actions against the ALJ, such as a counseling letter, additional training, mentoring or monitoring, an official reprimand, or some other adverse action. OHA’s Special Counsel Staff may also decide to conduct a further investigation. Regardless of which office handles the complaint, OHA acknowledges the receipt of each complaint in writing, notifies the complainant that there will be a review or investigation (unless to do so would disrupt a pending hearing or decision), and notifies the complainant concerning the results of the investigation.
Officials from the Special Counsel Staff told us OHA receives about 700 to 1,000 complaints (out of 400,000 to 500,000 hearings) per year. About 90 percent of these are notifications from the Appeals Council that involve an allegation of bias or misconduct. Officials from the Special Counsel Staff also said that few complaints are related to race. For example, officials noted that, in response to a special request, Special Counsel Staff reviewed all 372 complaints filed during the first 6 months of 2001, and found that only 19 (5.1 percent) were in some way related to race.

		ALJ Complaint Process Lacks Mechanisms to Identify Patterns of Racial Bias

While the ALJ complaint process provides a mechanism for claimants to allege discrimination, it lacks useful mechanisms for detecting patterns of possible racial discrimination. In SSA’s public notice on the creation of this process, it was stated that SSA’s Special Counsel would “collect and analyze data concerning the complaints, which will assist in the detection of recurring incidences of bias or misconduct and patterns of improper behavior which may require further review and action.” However, OHA’s methods of collecting, documenting, and filing complaints make this difficult to do. For example, in its instructions to the public, SSA directs complainants to describe, in their own words, how they believe they were treated unfairly. This flexible format for filing complaints may make it difficult for OHA to readily identify a claim alleging racial bias. In contrast, SSA’s Office of General Counsel’s complaint form specifically asks complainants to categorize their claim as being related to such factors as race or sex.
Similarly, OHA does not use a standardized internal cover-sheet to summarize key aspects of the review, such as whether the complaint involved racial or some other type of bias or misconduct, and whether the complaint had merit and what action, if any, was taken. The lack of a cover-sheet makes it difficult to quickly identify patterns of allegations involving race that have merit. In order to determine whether patterns exist, OHA staff would have to reread each complaint.
Additionally, OHA staff do not record key information about complaints— such as the nature of the complaint—in an electronic database so that patterns of bias can be easily identified. OHA’s Special Counsel Staff files complaints and related documents manually, and in chronological order by hearing office. According to OHA officials, this filing system was developed in 1993 when the process was created and complaint workloads were much lower. Today, SSA receives and reviews 700 to 1,000 complaints a year. In order to identify patterns of bias, Special Counsel Staff must not only reread each file, it must tabulate patterns by hand—a time-consuming process that it does not perform on a routine basis.
Finally, OHA does not currently obtain demographic information (such as race, ethnicity, and sex) on complainants, which are important in identifying patterns of bias. These data are important for identifying patterns of possible racial bias because complainants—aware only of their own circumstances and lacking a basis for comparison—may not specifically allege racial bias when they file a complaint about unfair treatment. Without demographic data, it is impossible to discern whether certain types of allegations are disproportionately reported by one race (or sex) and whether further investigative or corrective action is warranted. Although SSA is currently obtaining less race data in its process of assigning SSNs, OHA staff could still obtain data on race and sex for most complainants from the agency’s administrative data.

	Conclusions

The steps SSA has taken over the last decade have not appreciably improved the agency’s understanding of whether or not, or to what extent, racial bias exists in its disability decision-making process. SSA’s attempt to study racial disparities was a step in the right direction, but methodological weaknesses evident in SSA’s remaining working papers prevent our concluding, as SSA did, that there is no evidence of racial bias in ALJ decision making. SSA does not have an ongoing effort to demonstrate the race neutrality of its disability programs. Moreover, the continuing methodological weaknesses in SSA’s ongoing quality assurance reviews of ALJ decisions hamper not only its ability to ensure the accuracy of those reviews but also its ability to conduct future studies to help ensure the race neutrality of its programs. Furthermore, in the longer term, SSA’s ability to analyze racial differences in its decision making will diminish due to a lack of data on race and ethnicity. Finally, SSA’s complaint process for ALJs lacks mechanisms—such as summaries of key information on each complaint, an electronic filing system, and information on the race and ethnicity of complainants—that could help identify patterns of possible bias. SSA is not legally required to collect and monitor data to identify patterns of racial disparities, although doing so would help SSA to demonstrate the race neutrality of its programs and, if a pattern of racial bias is detected, develop a plan of action.

	Recommendations

To address shortcomings in SSA’s ongoing quality assurance process for ALJs—which would improve SSA’s assessment of ALJ decision-making accuracy—we recommend the agency take the following steps:   conduct ongoing analyses to assess the representativeness of the sample used in its quality assurance review of ALJ decisions, including testing the statistical significance of differences in key characteristics of the cases included in the final sample with those that were not obtained; include the results of this analysis in SSA’s annual and biennial reports on ALJ decision making; and   use the results to make appropriate changes, if needed, to its data collection or sampling design to ensure a representative sample.
To more readily identify patterns of misconduct, including racial bias, in complaints against ALJs, we also recommend that SSA’s Office of Hearing and Appeals:   adopt a form or some other method for summarizing key information on each ALJ complaint, including type of allegation;   use internal, administrative data, where available, to identify and document the race and/or ethnicity of complainants; and   place the complaint information in an electronic format, periodically analyze this information and report the results to the Commissioner, and develop action plans, if needed.

		Agency Comments and Our Response

We provided a draft of this report to SSA for comment. SSA concurred fully with our recommendations and agreed to take steps to implement them. In its general comments, SSA expressed concern that the title of the report might foster the perception that its disability decision making, particularly at the OHA level, is suspect. Although we believe the draft report’s title accurately reflected the report’s content and recommendations, we have modified the title to ensure clarity. SSA also cited a number of reasons for the low percentage of cases included in its final sample, as well as steps it took to ensure the representativeness of its final sample. Nevertheless, we continue to believe that SSA could have performed additional analyses to provide more assurance of the sample’s representativeness.
SSA also provided technical comments and clarifications, which we incorporated in the report, as appropriate. SSA’s general comments and our response are printed in appendix I.
We are sending copies of this report to the Social Security Administration, appropriate congressional committees, and other interested parties. We will also make copies available to others on request. In addition, the report will be available at no charge on the GAO Web site at http://www.gao.gov.
If you or your staff have any questions concerning this report, please call me or Carol Dawn Petersen, Assistant Director, at (202) 512-7215. Staff acknowledgments are listed in appendix II.

Appendix I: Comments from the Social Security Administration

	GAO Comments

1.  Although we believe the draft report’s title accurately reflected the content of our report and recommendations, we have modified the title to ensure clarity. This report and its recommendations are not restricted to a discussion of only two races. Although we referred to race and ethnicity in the second objective and the conclusion section of the draft reviewed by Social Security Administration (SSA), we added the word “ethnicity” to the recommendations and the body of the report to further clarify this issue. 2.  We added language to a note in the report regarding the litigation SSA mentions and that SSA has increased the number of Regional Chief Administrative Law Judges (ALJs) who are members of a racial minority group from 1 to 3 since 1992. 3.  We agree with SSA that the low proportion of cases included in the final sample is due to several factors. In our report, we cited several reasons for cases not being included in the final sample that are significant in terms of the number of affected cases and that we believe have the potential for being nonrandom in nature. On the basis of a subsequent discussion with SSA officials, we added a note in our report that a small proportion of cases were excluded because they were later identified as being cases that were not intended to be included in the sample. 4.  Although SSA noted that it used “holdout samples and cross modeling” to ensure that the group of cases sampled for this study was essentially free of sampling bias, SSA officials explained to us that these techniques were not used to test for the representativeness of the final sample. 5.  We agree with SSA that, with large sample sizes, even small differences generally are statistically significant, and that such statistically significant differences are not always substantively significant. We do not believe, however, that a large sample is sufficient reason to forego significance tests. Moreover, our report cited additional analyses that SSA could have performed to provide more assurance of the sample’s representativeness. Another approach that we do not cite in the report—but which SSA may wish to consider—is multivariate analysis of nonresponse. SSA performed bivariate comparisons of samples to determine whether they contained different proportions of cases with various characteristics. However, two samples can have very similar percentages of, for example, women and African Americans, but be very different with respect to the percentage of African American women. In contrast, multivariate analysis would allow SSA to look systematically and rigorously at different characteristics simultaneously.

Appendix II: GAO Contacts and Staff Acknowledgments

	GAO Contacts

	Staff Acknowledgments

In addition to those named above, the following individuals made significant contributions to this report: Erin Godtland, Michele Grgich, Stephen Langley, and Ann T. Walker, Education, Workforce and Income Security Issues; Doug Sloane and Shana Wallace, Applied Research and Methods; and Jessica Botsford and Richard Burkard, General Counsel.

Output:
What GAO Found

The Social Security Administration (SSA) is responsible for administering the Social Security Disability Insurance and the Supplemental Security Insurance programs--the nation's two largest disability programs. SSA is required to administer its disability programs in a fair and unbiased manner. Nevertheless, the proportion of African American applicants allowed benefits has been historically lower than the proportion of white applicants. These allowances rate differences have occurred with respect to disability determinations made by state Disability Determination Service offices and in decisions made at the hearings level by Administrative Law Judges (ALJ). In response to GAO's 1992 report, SSA initiated an extensive study of racial disparities in ALJ decisions, but methodological weaknesses preclude conclusions being drawn from it. The study--the results of which were not published--set out to analyze a representative sample of cases to determine whether race significantly influenced disability decisions, while simultaneously controlling for other factors. SSA officials told GAO that, by 1998, they found no evidence that race significantly influenced ALJ decisions. However, GAO was unable to draw these same conclusions due to weaknesses in sampling and statistical methods evident in the limited documentation still available for GAO's review. Concurrent with SSA's study of racial disparities, SSA's Office of Hearings and Appeals (OHA) took some limited steps at the hearings level to address possible racial bias in ALJ decision-making. OHA instituted a mandatory diversity sensitivity training course for ALJs. Additionally, OHA increased its efforts to recruit minorities for ALJ and other legal positions by attending conferences for minority bar associations, where SSA distributed information and gave seminars on how to become an ALJ. Finally, in keeping with its commitment to provide fair and impartial hearings, SSA established a new process under the direction of OHA for the review, investigation, and resolution of claimant complaints about alleged bias or misconduct by ALJs.