The Section 199 Production Activities Deduction: Background and Analysis

Summary

In 2004, Congress added the Section 199 domestic production activities deduction to the Internal Revenue Code (IRC). The deduction was intended to achieve a number of policy goals, including compensating for repeal of the extraterritorial income (ETI) export-subsidy provisions, supporting the domestic manufacturing sector, and reducing effective corporate tax rates.

Under current law, qualified activities are eligible for a deduction equal to 9% of the lesser of taxable income derived from qualified production activities, or taxable income. Eligible income includes that derived from the production or property that was manufactured, produced, grown, or extracted within the United States. Electricity, natural gas, and potable water production is also eligible, as is film production. Domestic construction projects, as well as engineering and architectural services associated with such projects, also qualify. Overall, roughly one-third of corporate activity qualifies for the deduction.

In 2008, 66% of corporate claims of the Section 199 deduction were attributable to the manufacturing sector. Another 12% of the value of corporate claims came from the information sector, while 7% were attributable to the mining sector. Other large sectors of the economy, such as finance and insurance as well as wholesale and retail trade, had few Section 199 claims, relative to their contribution towards economic activity. In practice, the Section 199 deduction reduces corporate tax rates for certain selected industries.

Providing a tax break for certain industries can distort the allocation of capital in the economy, reducing economic efficiency and total economic output. Economic efficiency could be enhanced by repealing the Section 199 deduction and using the additional revenues to offset the cost of reducing corporate tax rates. Repealing the Section 199 deduction could allow for a revenue-neutral corporate tax rate reduction of an estimated 1.2 percentage points.

For companies currently claiming the Section 199 deduction, repeal of the deduction in exchange for a reduced corporate tax rate could lead to increased effective tax rates. Under current law, activities eligible for the deduction receive a tax break equal to 3.15 percentage points. Further, the deduction can currently be claimed by pass through entities, including S corporations and partnerships, that would not benefit from a reduction in the corporate tax rate.

Repeal of corporate tax expenditures, which could include the Section 199 deduction, has been part of the tax reform proposals put forth by the Fiscal Commission, Debt Reduction Task Force, and Gang of Six. The Obama Administration’s FY2013 Budget proposes to repeal the Section 199 deduction for oil and gas related income, using the added revenues to double the deduction for advanced technology manufacturing activities. The President’s framework for business tax reform also proposes modifications to the Section 199 deduction.

Repeal of the Section 199 deduction for certain activities has been considered by the 112th Congress. The Senate voted not to advance legislation to repeal the Section 199 deduction for large oil and gas companies (S. 940). Repealing the Section 199 deduction for the oil and gas sector, or for certain firms in the sector, might help to eliminate tax-induced investment distortions caused by the deduction for those sectors. The deduction would continue to distort economic activity for sectors that are still eligible. Given the inefficiencies associated with the Section 199 deduction, repeal could be an economic efficiency enhancing component of a base-broadening, rate-reducing, corporate tax reform.