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US Domestic Production Deduction Under Spotlight

by Mike Godfrey, Tax-News.com, Washington

06 September 2013


As part of its analysis and review of the various tax breaks under discussion as part of possible United States corporate tax reform, the Committee for a Responsible Federal Budget (CRFB) has examined how Congress could curb the domestic production activities deduction.

At a cost of USD14bn of foregone tax revenue in 2013, or nearly USD200bn over the next ten years according to the Joint Committee on Taxation, the domestic production activities, or Section 199, deduction is the second largest domestic corporate tax break, intended to provide an incentive to domestic manufacturing. A business with "qualified production activities" can take a deduction equal to 9 percent of related income.

While the qualifying activities concentrate on manufacturing, many other businesses qualify. Around one-third of corporate activities are said to qualify for the deduction. Two-thirds of the value of the deduction goes to the manufacturing industry, but the other third goes to non-manufacturers. In particular, the CRFB says, a large proportion of the deduction flows to information technology companies and mining operations.

According to the CRFB, if the deduction were repealed, the additional revenue from C-corporations could finance a corporate rate cut of 1.2 percent. If the deduction were also repealed for pass-through entities (PTEs), the corporate tax rate could decrease by 1.5 percent (but that would have the effect of raising the latters' own marginal individual income tax rates).

The deduction was first introduced, in another form, to boost domestic businesses in international markets that did not contravene World Trade Organization rules, and the CRFB points out that supporters of Section 199 argue that manufacturing still plays a critical role in innovation and faces intense international competition. Repealing the deduction would raise the effective tax rate on manufacturing by over 3 percent.

Opponents of Section 199, it is added, state that it is a "manufacturing tax break gone wild," arguing that the definitions of qualified activities are so broad that the provision does little to achieve its intended goal. By favoring some types of domestic production over others, it is noted that the deduction also distorts domestic investment.

Within the options for reform of the deduction, aside from its elimination to provide for a lower corporate tax rate for all businesses, the CRFB includes President Obama's recent Framework for Business Tax Reform that keeps Section 199 and still lowers the overall corporate rate to 28 percent. The proposal expands it to a 10.7 percent deduction, bringing the effective top rate on manufacturing down further to 25 percent. For advanced manufacturing, an 18 percent deduction would bring the effective rate to 23 percent.

Finally, while Congress could also reduce the size of the deduction, restrict it by industry (by bringing it closer to the deduction's original purpose of only incentivizing manufacturing), or prohibit oil and gas companies from claiming the deduction, limiting it to the 2004 level of 3 percent, or the 2007 level of 6 percent, the CRFB concludes that "since the deduction was originally intended to strengthen domestic businesses competing internationally, it could be repealed for businesses that would never be able to move overseas, such as agriculture, utilities, or natural resource extraction."

TAGS: tax | business | mining | corporation tax | oil and gas | manufacturing | tax rates | United States | tax breaks | tax reform | individual income tax | Tax

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