Key Issues in Tax Reform: The Section 199 Deduction
Updated September 29, 2017
Key Issues in Tax Reform: The Section 199 Deduction
The Section 199 domestic production activities deduction
several other industries by reducing effective corporate tax
reduces the effective tax rate on certain types of activities,
rates.
primarily domestic manufacturing activities. Whether the
Section 199 deduction should be a part of a reformed tax
The Section 199 production activities deduction, as enacted
code is a question Congress may choose to address as it
in 2004, did not reach the full deduction rate of 9% until
evaluates tax reform options.
2010. During 2005 and 2006, eligible taxpayers could claim
a tax deduction equal to 3%. For tax years 2007, 2008, and
For additional background, see CRS Report R41988, The
2009, the deduction rate was 6%.
Section 199 Production Activities Deduction: Background
and Analysis, by Molly F. Sherlock.
Since being enacted, the Section 199 deduction has
undergone a number of minor modifications. The Tax
How the Deduction Works
Relief and Healthcare Act of 2006 (P.L. 109-432) added the
Currently, Section 199 allows a deduction equal to 9% of
benefit for Puerto Rico, on a temporary basis. The
the lesser of taxable income derived from qualified
temporary provisions allowing the deduction for qualifying
production activities, or taxable income. Qualified
activities in Puerto Rico has been extended multiple times
production activities are defined to include manufacturing,
as part of “tax extenders.”
mining, electricity and water production, film production,
and domestic construction, among other activities. For oil-
Additional changes were made to the Section 199 deduction
and gas-related activities, the deduction is limited to 6%.
as part of the Emergency Economic Stabilization Act of
Qualifying oil and gas activities include the production,
2008 (EESA; P.L. 110-343). Under EESA, oil-related
refining, processing, transportation, or distribution of oil,
qualifying production activities, including but not limited to
gas, or any primary product thereof. Across all sectors, the
oil and gas extraction, were permanently limited to a 6%
deduction cannot exceed 50% of W-2 wages paid by the
deduction for tax years starting after 2009. In addition, as
taxpayer for qualifying activities. In 2012, more than one-
part of EESA, the deduction was also modified to better
third of corporate taxable income was eligible for the
accommodate domestic film production industry operations.
Section 199 deduction.
The Section 199 deduction was enhanced for crude oil
The Section 199 deduction serves to reduce the effective
refiners that are not a major integrated oil company as part
tax rate—the actual rate of taxes paid relative to income—
of the Consolidated Appropriations Act, 2016 (P.L. 113-
on qualified activities. Generally, tax liability is calculated
114). Specifically, the provision limited the amount of
as follows:
transportation costs to be taken into account when
determining taxable income for the purposes of the Section
Taxes = [(Income – Expenses)(1 – p) × t] – Tax Credits,
199 deduction to 25%. The result is higher net income for
the purposes of calculating the deduction, and thus a larger
where t is the statutory tax rate and p is the production
deduction. This provision was enacted on a temporary basis
activities deduction rate. For income that does not qualify
to provide support for independent refiners following
for the production activities deduction, p is zero.
changes in crude oil export policy, and is set to expire at the
end of 2021.
When the production activities deduction applies, the tax
rate is the statutory tax rate (generally, 35% for
Economic Considerations
corporations) multiplied by (1-p). For example, when p =
The Section 199 production activities deduction increases
0.09, the effective tax rate becomes 31.85% (35% × 0.91).
the after-tax return to particular investments by lowering
When p = 0.06, as is currently the case for the oil- and gas-
the effective tax rate for income earned in certain industries.
related activities, the effective tax rate becomes 32.9%
As a result, the deduction may distort the allocation of
(35% × 0.94).
capital. This effect could reduce economic efficiency and
total economic output by directing capital away from its
Legislative History
most productive use. A 2017 Treasury report, “The Case for
The Section 199 deduction was enacted as a permanent
Responsible Business Tax Reform,” noted that “[t]he
provision by the American Jobs Creation Act (AJCA; P.L.
domestic production activities deduction is difficult to
108-357) in 2004, to address a number of policy concerns.
justify without clear evidence that it provides offsetting
In part, the deduction was designed to compensate for the
social benefits of some kind. Without such a social benefit,
repeal of the extraterritorial income (ETI) provision that
then to the extent that it is targeted to particular industries
had been found to be a prohibited export subsidy by the
or activities it could inefficiently encourage such activities
World Trade Organization (WTO). The deduction was also
over others that do not benefit.” When evaluating the
designed to support the domestic manufacturing sector and
deduction in light of economic efficiency concerns, it may
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Key Issues in Tax Reform: The Section 199 Deduction
be helpful to consider (1) whether targeted tax benefits for
Policy Considerations and Options
manufacturing provide desired social benefits, and (2)
Repeal of the Section 199 deduction has been considered as
whether the Section 199 deduction is an effective tool for
part of some comprehensive tax reform packages. Recent
providing the desired benefits.
proposals would repeal the Section 199 deduction as part of
a reform that repeals or restricts various tax expenditures in
The Section 199 deduction and the associated regulations
exchange for reduced rates. The Unified Framework for
are complex, and impose an administrative burden on both
Fixing Our Broken Tax Code, issued by the Office of the
taxpayers and the government. Taxpayers wanting to claim
Speaker on September 27, 2017, takes this approach, as did
the deduction must allocate costs and jobs devoted to
the House Republican 2016 “Better Way” Tax Reform
activities performed in the United States to determine both
Blueprint. The Blueprint noted that “section 199 is highly
receipts associated with the qualified activities and
complex, often frustrating both those businesses that fail to
associated costs. The largely fixed-cost nature of these
qualify as well as businesses that do qualify but only after
burdens may favor larger firms over smaller firms,
navigating a substantial paperwork burden.” The Tax
potentially distorting firm size choices. Further, given that
Reform Act of 2014 (H.R. 1), introduced in the 113th
production activities are tax favored, firms have an
Congress, also proposed repealing the Section 199
incentive to shift profits among divisions, and characterize
deduction as part of a rate-reducing tax reform.
income as being related to domestic production activities,
where possible. From the perspective of the government, to
Repealing the Section 199 deduction is not without
the extent that Section 199 deduction claims are a point of
tradeoffs. In isolation, repealing the Section 199 deduction
contention, this incentive may stress the enforcement
and providing a revenue-neutral reduction in tax rates could
resources for the Internal Revenue Service (IRS).
increase the effective tax rates of taxpayers previously
qualifying for the deduction. In addition, if the deduction is
The Deduction’s Cost
repealed for all businesses, but the revenues are used only
During 2016, the production activities deduction was
to reduce corporate tax rates, the effective tax rate on pass-
expected to result in $20.0 billion in foregone federal
through entities could increase. The issues raised by these
revenues ($14.5 billion for corporations, $5.5 billion for
trade-offs, however, may be addressed with other changes
pass-through businesses with income reported on individual
included in a broader tax reform proposal.
returns). The foregone revenues associated with the
deduction have generally increased over time, in part
Another policy option related to the Section 199 deduction
because of the increased deduction rate (see Figure 1).
would be to modify the deduction to address economic
efficiency concerns. One way this could be achieved would
Figure 1. Section 199 Tax Expenditures
be to allow the deduction for activities that tend to be
2005-2016
associated with positive externalities, or tend to generate
external benefits that are not reflected in market prices. The
Obama Administration’s 2016 “Framework for Business
Tax Reform,” citing research on the importance of the
manufacturing sector in the economy, included a proposal
to increase the Section 199 deduction, but to focus the
deduction more on manufacturing activity.
Repealing the Section 199 deduction for certain sectors,
such as the fossil fuel sector, may help eliminate tax-
induced distortions that might lead to overinvestment in
those sectors while generating additional revenues. For
example, the Obama Administration’s FY2017 budget
proposed to repeal the Section 199 deduction for fossil
fuels-related activities. This proposal was part of a broader
objective to “phase out subsidies for fossil fuels” that
encouraged “more investment in the fossil fuels sector than
Source: Joint Committee on Taxation.
would occur under a neutral system.”
Repealing the Deduction to Offset the Cost of Rate
Finally, a key part of the intent of the Section 199 deduction
Reduction
was to support the domestic manufacturing sector. While
Repealing the deduction would generate additional
economists sometimes question whether there is an
revenues. These revenues could be used to offset the cost of
economic rationale for supporting the domestic
a tax rate reduction. Eliminating the deduction for all
manufacturing sector, there may be other policy
businesses would generate enough additional revenue to
motivations for writing tax policies that favor domestic
offset the cost of approximately a 1.4 percentage point
manufacturing.
reduction in the corporate tax rate. If the deduction were
eliminated for corporations only, it could offset the cost
Molly F. Sherlock, Specialist in Public Finance
associated with approximately a 1.0 percentage point
corporate rate reduction.
IF10688
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Key Issues in Tax Reform: The Section 199 Deduction
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