Rum subsidies in U.S. Caribbean islands have sparked an internal trade war and are inviting a World Trade Organization (WTO) challenge from ill-affected countries in the region. According to an envoy representing a number of Caribbean countries that recently came to Washington, the U.S. government is unwittingly funding industrial policy in the U.S. Virgin Islands and Puerto Rico by tying aid dollars to rum production in a way that is inconsistent with our trade obligations and may cause the destruction of the entire foreign Caribbean rum industry. Under current law, U.S. Caribbean islands receive money from the U.S. treasury based on how much rum they import to the mainland. In recent years, they’ve begun to use that money to increase the amount of rum they produce, so they can get even more money. Although the total amount of money involved is low enough to keep it under Congress’s (myopic) radar, the resulting subsidies are too high for independent Caribbean economies to compete against. Unless Congress places restrictions on how the money can be used, the United States could once again find itself in the embarrassing position of being taken before the WTO for accidentally ruining the economy of a small Caribbean island.

The antagonist in this saga is something known as the “rum cover-over” program. As it does with all distilled spirits, the federal government charges an excise tax of $13.50 per proof gallon of rum sold in the United States. This equates to roughly $2 per bottle. Under the cover-over program, almost all of that money is directly granted to the U.S. Virgin Islands and the Commonwealth of Puerto Rico using a complex formula so that each receives a share of the money based on how much rum it produces relative to the other. The tax is collected from sales of all rum imported to the mainland, even from other countries, and in 2010 the cover-over amounted to approximately $450 million—$100 million to the Virgin Islands and $350 million to Puerto Rico.

The industrial death spiral began when the government of the U.S. Virgin Islands cleverly discovered that, instead of using the money for infrastructure and welfare programs, it could use the bulk of the money to entice Captain Morgan producer Diageo to relocate there from Puerto Rico. Because the move will increase rum production in the U.S. Virgin Islands relative to Puerto Rico, the subsidy more than pays for itself by it helping the territory capture a larger share of cover-over funds.

Puerto Rico initially asked Congress for help. There is currently no rule on how the two entities can spend the cover-over funds, so Puerto Rico’s non-voting delegate to Congress, known as a Resident Commissioner, proposed legislation that would cap at 15 percent the portion of the funds that could be used to subsidize rum production. When that effort failed, the Puerto Rican government reportedly responded by ramping up its own subsidy programs. The result has been an expensive trade war over mainland consumer tax dollars granted in return for rum production. For perspective on how important this is for the players involved, it’s worth noting that the U.S. Virgin Islands government has an annual budget of just under $1 billion dollars and is hoping to increase its cover-over revenue from $100 million to $240 million.

The new twist on this saga comes from the detrimental effect this subsidy war has had on rum production in other parts of the Caribbean. Matched up against firms receiving U.S. subsidies reported to be close to or even to exceed production costs, producers in other Caribbean countries are unable to compete in the U.S. market on price. These economies generally rely on tourism and raw material exports and have precious few value-added industries. If the United States is interested in economic development in the region, the least it could do is refrain from crippling emerging industries with unfair subsidies. While the two U.S. Caribbean governments spend federal tax dollars to entice major rum brands to their islands in order to earn more federal tax dollars, the rest of the Caribbean is struggling just to stay afloat.

It should not be surprising then that the form, size, and effect of these subsidies establish a strong case that the United States is in violation of its trade obligations, and Caribbean representatives have raised the possibility of a challenge at the WTO. WTO rules prohibit subsidies that are targeted to a single industry and cause injury to that industry in the territory of another member. Also, the size and amount of production covered by these subsidies may be so great that they could be considered “contingent in fact on export performance”—a kind of subsidy that is strictly prohibited.

This situation is certainly not just a local issue between two somewhat-foreign governments. The program implicates U.S. trade obligations toward vulnerable Caribbean neighbors, and Congress, being the enabler of the dispute, is already involved. A program that directly pits two U.S. jurisdictions against each other in a fight for hundreds of millions of dollars with no strings attached is unjustifiably irrational, and no one should be surprised that it hasn’t gone well. Capping the amount of the cover-over funds that can be used to support rum production, as originally proposed by Puerto Rico, is an effective and painless way to fix the problem, or at least to keep it from getting worse.