In 2004, the World Trade Organization outlawed several U.S. export subsidies that had been on the books for years. Congress responded by passing a special “production activities” income tax deduction for domestic manufacturers to offset the lost revenue. But exporters weren’t the only companies to take advantage of the new tax break, which allowed corporations to reduce their taxable income from domestic activities by 9 percent. Among the big winners were domestic oil and gas producers, which claimed 16 percent of the $18.4 billion in tax reductions taken by all corporations in 2008. Software, television and other “information” producers took an additional 12 percent of the deductions, according to a recent Congressional Research Service (CRS) report.
“It’s a rather ill-defined subsidy,” says Eric Toder, a tax analyst for the Tax Policy Center, a joint project of the Brookings Institution and the Urban Institute. “All activities produce jobs. Why would we want to encourage one activity over another?”
That question will be front-and-center if Congress turns its attention to corporate tax reform this fall, which both the Obama administration and Republicans on Capitol Hill say is high priority. However, with the election season already underway, no one in Washington believes anything will happen until after the 2012 election.
When tax reform finally does make it onto the policy agenda, the effect of proposed changes on different sectors of the economy will play a huge role in determining how revenue -neutral the final legislative package turns out to be. The CRS report said removing this single tax break – known as the Section 199 production activities deduction – could offset lowering the overall corporate tax rate by 1.2 percentage points.
That would be a tremendous boon for a host of fcompanies that pay near the current 35 percent statutory rate because they don’t receive many special deductions. They include health care providers, restaurant chains, and retailers,. But it could prove a mixed blessing for the hard-pressed manufacturing sector, which and has been hemorrhaging jobs for years even as it benefits from more than half the breaks handed out under the law.
President Obama has been selective in his approach to reforming Section 199. He called for eliminating the tax break just for the oil and gas industry in every budget he’s submitted to Congress since he entered office. Lobbyists have successfully fended off those efforts, although the break for oil and gas producers was lowered to 6 percent in 2009.
Other industries that benefit from the break are leery of further tampering with the deduction. The software and movie industries lobbied to have their activities included in the definition of domestic production after the Internal Revenue Service issued a preliminary rule shortly after the law was passed that would have limited the deduction to just manufacturers.
“We felt we were unfairly excluded,” says David LeDuc, head of government affairs for the Software & Information Industry Association. “If there was going to be a deduction to encourage jobs in the U.S., it should certainly cover us since we provide high-wage jobs and they ought to be here.” The IRS broadened the definitions in its final rule.
Would software developers support repeal of the rule in exchange for lower overall income tax rates? “We’re generally supportive of the tax code being made more efficient,” LeDuc says, “but repealing Section 199 would be an admission that it hasn’t been effective in creating jobs. I don’t know what the experts say on that.”
Even liberal tax reformers, who want to see the corporate sector pick up a larger share of the tax burden, are leery of eliminating the tax break entirely. Manufacturing historically has provided middle-class job opportunities for people with limited skills and educational attainment, and the sector has received numerous tax breaks and subsidies in recent decades in an effort to stem its steady decline.
“We shouldn’t take raising corporate taxes off the table in an era where we’re talking about cutting investments in research, infrastructure and other critical areas,” says Charles Marr, a federal tax expert for the Center on Budget and Policy Priorities. “But even in that context, I don’t think you’d like to talk about curbing tax breaks that could help domestic manufacturers.”
Section 199 serves as a counterweight to other tax breaks in the code, such as deferral of taxes on overseas income, that encourage manufacturers to ship jobs abroad, argues Seth Hanlon, director of fiscal reform for the Center for American Progress, a liberal think tank with strong ties to the Obama administration. “In a system that has a more level playing field, Section 199 might not be needed,” he said.