On May 3, the government of Puerto Rico declared bankruptcy after failing to reach a restructuring agreement with its creditors under Title 6 of the Puerto Rico Oversight, Management and Economic Stability Act (PROMESA). This federal law was passed last year to establish an oversight board and reorganize the commonwealth's finances, in order for it to resume economic growth and regain access to capital markets.

PROMESA's early shortcomings need not be permanent. The key is to create the correct incentives for the island's people to encourage — rather than discourage — their policymakers to implement necessary and difficult reforms. This is particularly true with regard to pension reform.

Dissatisfied with the government's apparent offer of about 50 cents on the dollar, plus a small kicker if fiscal conditions improve more than expected, many creditors have filed lawsuits claiming that PROMESA was not followed. The uncertainty, economic malaise and lack of access to capital that the legislation was supposed to address are, perhaps, deepening.

In fairness, Puerto Rico's government and oversight board have worked to identify areas to cut government spending and increase revenue — with the notable exception of unsustainable pension and health benefits to government workers and retirees. But the focus on austerity, while appropriate as an initial step, is also largely incomplete.

Emphasis should instead be put on the many necessary changes to Puerto Rican labor laws, welfare programs and business and tax regulations which could spur more private sector business and job creation, encourage more people to work, and allow economic growth to resume. These measures would simultaneously reduce the need for austerity and increase resources to repay debts outstanding.

Changes to U.S. laws and regulations discouraging labor force participation in Puerto Rico, such as the high minimum wage and easier eligibility for Social Security disability benefits for Spanish speakers, would also help greatly.

And most importantly, Puerto Rico's lingering pension crisis must be solved, both because of its fiscal significance and because it illustrates the lack of political courage and imagination by the government and the oversight board.

In the Detroit bankruptcy, all retiree health benefits were eliminated, and pension benefits — including cost-of-living adjustments — were reduced by about 20%. Moreover, the Detroit pension plans were moderately well funded.

By contrast, in Puerto Rico's current reorganization plan, pension benefits are reduced by 10%, even though the pension plans are nearly empty of assets. Retiree health benefits, although reduced, continue.

Hence the government and oversight board have taken a surprisingly light touch to pensions and retiree health expenses, an unfunded obligation nearly as large as the debt that Puerto Rico owes to creditors and of inferior legal priority to at least some of that debt.

The oversight board argues that Puerto Rican pensions are generally small, and reducing them would be a hardship for many. But the standard of living in Puerto Rico is also lower than on the mainland. Leaving the pensions of the impoverished elderly relatively intact does not also require holding largely harmless those who are better off — perhaps also collecting Social Security or other pensions, or with other assets — or living and working on the mainland.

Furthermore, many of the debt-holders are themselves retirees, whether living in Puerto Rico or, largely, on the mainland, who likely are counting on their bond interest and value to support their standard of living in retirement. In favoring pensions, therefore, the oversight board is treading on shaky fairness grounds.

More significantly, reformers have missed an opportunity (thus far) to create the right incentives for the Puerto Rican government to bring back economic growth. The oversight board should have insisted on a means-tested clawback of up to 40% in pension benefits, and the elimination of retiree health benefits.

In return, retirees and workers, rather than mainland creditors, should have been given a pension bonus. Then, if fiscal and economic conditions in Puerto Rico improved beyond a modest baseline, accrued benefits would be progressively restored.

This would establish an important, powerful and sympathetic domestic political constituency for fiscal responsibility and economic growth. Moreover, the restoration of benefits would be likely, because economic activity in Puerto Rico is now so severely depressed by a heavy government presence, and a lack of spirit and access to capital, but so much potential remains in a beautiful island rich in resources and people, and free of federal income taxes.

Perhaps it is not too late for the oversight board and the government of Puerto Rico to change direction, maybe encouraged by the judge recently appointed to oversee this bankruptcy morass, which Congress, in PROMESA, intended to avoid.