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States Can Opt Out of the Costly and Ineffective “Domestic Production Deduction” Corporate Tax Break

Over the past year, state revenue collections have dropped dramatically, creating large budget gaps for many states. A contributor to this fiscal crisis in many states is a relatively new and rapidly growing corporate tax break — one that in most states never even received a vote in the state legislature but nonetheless is costing states hundreds of millions of dollars each year.

The federal government created this tax break, known as the “domestic production deduction,” in 2004. Since most states base their own tax codes on the federal tax code, the tax break was carried over into many states without specific legislative scrutiny or a vote. Now it is costing not only the federal government but also 25 states a large, and growing, amount of money. By 2011, it will cost these states over $500 million per year.

The deduction — enacted as Section 199 of the federal Internal Revenue Code — allows companies to claim a tax deduction based on profits from “qualified production activities,” a sweeping category that goes well beyond manufacturing to include such diverse activities as food production, filmmaking, and utilities — a substantial share of states’ corporate income tax base.

The revenue loss to states that still allow the deduction will increase steeply this year because of how the federal credit is designed. Initially, the cost was relatively modest because the deduction was limited to 3 percent of qualifying income. As of January 1, 2007, the percentage rate rose to 6 percent. The final increase to 9 percent takes effect in the 2010 tax year. Federal estimates suggest that allowing this deduction will reduce the revenue yield of corporate taxes by roughly 3.1 percent in 2011 and also reduce individual income taxes somewhat.

 States are not required to allow this deduction. Since 2008, Connecticut, New York, Wisconsin, and the District of Columbia have joined 18 other states in disallowing the deduction and thereby reducing their current budget shortfalls and benefitting their states’ economies. But another 25 states continue to permit it. (Four states lack personal and corporate income taxes and so are unaffected.) If they continue to do so, a conservative estimate suggests the tax break will cost those states almost $505 million in 2011. (These estimates are based on current levels of corporate profits.) [1]

There is no good reason why states should accept such revenue losses.

• The deduction is unlikely to protect or create jobs within the state, because multi-state corporations can claim the deduction for out-of-state “production activity” just as they can for in-state activity.
• The deduction provides little or no help to businesses that are struggling in the current downturn, since only profitable firms have taxable income for it to offset.
• The deduction is heavily slanted towards large corporations. In 2006, 94 percent of the deduction taken under the corporate income tax was claimed by the 0.4 percent of firms with over $100 million apiece in assets. Many of these large firms are multi-state corporations and may invest little or nothing in the state granting the tax break.
• Most importantly, given the large cuts most states are making in education, healthcare, and almost all other areas of spending, it makes little sense for them to be growing such a large new tax break. Maintaining the tax break would mean states would have to cut more elsewhere, and the jobs lost due to such cuts would almost certainly exceed any jobs created by maintaining this costly and inefficient deduction.

Decoupling from the domestic production deduction, as 22 states have already shown, is simple to enact and inexpensive to administer. [2] It can be done by adding a single sentence to state tax law requiring corporations to add back the deducted amount to their taxable income and a single line to state tax forms.

Indeed, decoupling might even spare a state entanglement in the extensive administrative and legal action that may occur in coming years. The Internal Revenue Service has stated that the provision is complex and difficult for taxpayers to understand. It also has noted that it could be subject to abuse. States that conform to the federal provision risk becoming involved with these difficult and time-consuming enforcement issues.

The Federal Domestic Production Deduction Is Costing States Hundreds of Millions of Dollars per Year — And Its Cost Is Rising

The domestic production deduction allows businesses to deduct — and hence pay no taxes on — a portion of their profits attributable to a broad range of “qualified production activities.”[3] Three percent of this income was deductible in 2005 and 2006; 6 percent is deductible in 2007, 2008, and 2009; and 9 percent is deductible in 2010 and years thereafter.

The deduction is broad in its scope and therefore costly in its fiscal impact. Although the deduction is often described as a tax break for manufacturing activities, it is actually much less targeted. In fact, deductible income can be any profits (that is, receipts minus costs) that a business can attribute to a broad range of activities, including:

• food processing (but not retail food sales),
• software development,
• filmmaking,
• mining and oil extraction,
• publishing,
• electricity/natural gas production, and
• construction.

Even firms outside these industries benefit. Virtually every sector of the economy has seen its taxes cut by this tax break, including firms whose primary business is retail sales, financial services, and entertainment.[4] Overall, business tax returns for 2006 claimed that about 29 percent of all corporate taxable income qualified for the deduction.[5] (See Table 1.)

TABLE 1: EXTENT TO WHICH DIFFERENT INDUSTRIES CLAIM Domestic Production Deduction Against Corporate Income Tax
Industry Grouping	Total Number of Returns	Total Taxable Income ($ millions)	Amount of Deduction Claimed ($ millions)*	Share of Deduction Claimed	Estimate of Qualifying Income as a Share of Taxable Income
Manufacturing	279,430	450,919	7,269	65.4%	53.7%
Information	128,343	85,349	1,224	11.0%	47.8%
Mining	36,946	44,646	743	6.7%	55.5%
Construction	780,579	25,907	577	5.2%	74.3%
Utilities	7,636	33,590	429	3.9%	42.6%
Wholesale Trade	382,521	82,846	390	3.5%	15.7%
Professional and Technical Services	813,266	20,114	141	1.3%	23.4%
Retail Trade	614,925	91,728	106	1.0%	3.8%
Finance and Insurance	249,876	222,419	70	0.6%	1.0%
Management of Companies	50,261	146,174	62	0.6%	1.4%
Agriculture, Forestry, Fishing, and Hunting	140,525	2,523	32	0.3%	41.7%
Accommodation and Food Services	288,783	15,831	22	0.2%	4.6%
Real Estate and Rental and Leasing	655,389	17,259	12	0.1%	2.3%
Administrative, Support, and Waste Services	267,624	9,118	12	0.1%	4.3%
Transportation and Warehousing	199,912	24,976	6	0.1%	0.8%
Other Services	369,214	2,783	6	0.1%	7.3%
Arts, Entertainment, and Recreation	120,163	2,253	4	0.0%	6.6%
Health Care and Social Assistance	400,591	11,354	4	0.0%	1.2%
Educational Services	47,349	1,638	1	0.0%	1.0%
Other Industries	7,466	2	0	0.0%	0.0%
Total	5,840,799	1,291,431	11,110	100.0%	28.7%
* Figures are based on tax year 2006 data. Because the deduction is phasing in, current figures are likely at least twice as large and the fully phased-in figures (tax year 2010 and thereafter) are likely at least three times as large. Source: IRS Statistics of Income Data.

The domestic production deduction affects states because states generally conform their tax codes to the federal Internal Revenue Code. For personal income taxes, most states use “taxable income” or “adjusted gross income” as calculated for federal tax purposes as the starting point for their own income tax calculations. Similarly, most states begin their corporate income tax calculations with federal “taxable income” from the federal corporate tax form. Therefore, when federal legislation narrows the definition of taxable or adjusted gross income, taxpayers report less income and states typically see a decline in revenue.

To understand how this deduction affects state income taxes, consider a hypothetical corporation with $10 million in “domestic production” income, located in a state with a 5 percent corporate income tax rate. For 2010, 9 percent of that income is deductible — meaning the corporation gets to claim $900,000 of profits as tax-free income. At a tax rate of 5 percent, the corporation gets a tax break worth $45,000.

Not surprisingly, such a broadly available tax break carries a heavy fiscal cost. The Joint Committee on Taxation (JCT), which estimates federal revenue impacts for Congress, projects that the Section 199 provision will cost the federal government $11.6 billion in 2011 — about 3.1 percent of projected federal revenue from corporate income taxes plus another 0.2 percent of projected revenue from personal income taxes. [6]

States face losses of comparable magnitude. In fiscal year 2011 and thereafter, when the deduction is in full effect, it is likely to cost conforming states almost $505 million a year. State-by-state amounts are shown in Table 2; the Appendix explains how these figures were calculated. [7]

The cost of the deduction could be even higher depending on exactly how it is utilized over time, given the likelihood that corporate tax accountants are devising new ways of exploiting it. The deduction has been widely derided by tax policy experts as an incentive for corporations to engage in complicated new accounting schemes solely for the purposes of reducing tax liability. Economist Kimberly Clausing, an expert on taxation of international firms, wrote at the time of the deduction’s 2004 passage:

The bill [will] create compliance and enforcement difficulties as firms [will] have incentives to characterize as much income as possible as production income. For instance, firms [will] have an incentive to make those divisions subject to favorable tax treatment more profitable than those that do not receive such treatment. By shifting paper profits among divisions, firms can reduce their overall tax liability. [8]

For the Internal Revenue Service, which is already short on resources, limiting the creativity of the bookkeeping will pose major challenges. [9]

States Can Decouple from the Section 199 Domestic Production Deduction

States are not required to accept revenue losses from the domestic production deduction. As of January 2010, 21 states plus the District of Columbia have “decoupled,” disallowing the deduction on state tax returns. Connecticut and Wisconsin decoupled in 2009; New York and the District of Columbia decoupled in 2008. Arkansas, California, Georgia, Hawaii, Indiana, Maine, Maryland,

Massachusetts, Minnesota, Mississippi, New Hampshire, North Carolina, North Dakota, Oregon, South Carolina, Tennessee, Texas, and West Virginia are also disallowing the deduction, according to a survey by the Federation of Tax Administrators and information from state tax departments. [10]

Most of those states still conform to most other provisions of federal tax law, including other changes adopted by Congress at the same time that Section 199 was enacted. One change to federal law enacted in 2004 to which most states conform phases out the protection of certain “extraterritorial income” from foreign exports, protection that the World Trade Organization has said is illegal under international law. States generally also have conformed to the 2004 elimination of some costly and inappropriate tax shelters. But conforming to those other provisions does not require conformity to Section 199, nor do the merits of the other provisions enacted at the same time make conformity to Section 199 good state policy.

TABLE 2: APPROXIMATE REVENUE LOSS IN STATES THAT STILL ALLOW THE DOMESTIC PRODUCTION DEDUCTION
State	Annual Revenue Loss in 2011 (in millions of dollars)	State	Annual Revenue Loss in 2011 (in millions of dollars)
Alabama	$15	Missouri	$20
Alaska	11	Montana	6
Arizona	21	Nebraska	9
Colorado	20	New Jersey	N/A
Delaware	7	New Mexico	6
Florida	55	Ohio	23
Idaho	7	Oklahoma	15
Illinois	103	Pennsylvania	53
Iowa	12	Rhode Island	5
Kansas	17	Utah	11
Kentucky	4	Vermont	4
Louisiana	25	Virginia	41
Michigan	15	TOTAL	505

Domestic Production Deduction Was Created Without State Action and Without Consideration of Cost to States

In most of the 25 states that are losing revenue from the domestic production deduction, legislatures never voted to adopt the tax break. Most of those states have “rolling conformity” to the federal tax code, meaning that state tax law is defined by current federal law, so tax changes are incorporated without any action by the state. Therefore, when the federal government in 2004 enacted the deduction, it became part of state law automatically. The remaining states have “fixed-date conformity,” meaning that state law is tied to federal law as of a fixed date, and that date is updated periodically; these updates typically occur as a matter of course and without consideration of specific federal changes involved. The delayed phase-in of the deduction made scrutiny by state lawmakers especially unlikely. The full fiscal impact was delayed until 2010, which at the time of enactment was well outside states’ budget windows (which typically extend only one or two years into the future).

The federal government also did not explicitly consider the tax break’s cost to states. Federal lawmakers are required by law to consider the impact of tax cuts on federal revenue, but almost never give formal consideration to the impact on state revenue. [11]

In short, the federal government passed legislation that altered state tax law, costing states hundreds of millions of dollars. The change took effect without either federal or state lawmakers considering the cost to states.

Disallowing the Domestic Production Deduction Is Good Economic and Fiscal Policy

The domestic production deduction was depicted in some accounts at the time of its enactment as important aid for struggling industries and as a draw for manufacturing jobs. State conformity to the deduction is unlikely to achieve these goals. Furthermore, the economic downturn means states have more pressing uses for scarce funds than a subsidy for profitable corporations.

• A state-level domestic production deduction creates little incentive for corporations to create or protect jobs within that state. Firms can claim the domestic production deduction for profits from all qualifying domestic activities — meaning activities that occur anywhere within the United States. As a result, a multi-state firm can claim the deduction in a conforming state for production activities in any state, not just the state where the firm is filing. Thus states have no guarantee that firms claiming the deduction have a single employee working in a qualifying industry in that state.[12]
• The deduction provides little help to struggling businesses, since only profitable ones can use it. The domestic production deduction has been justified as assistance for struggling industries and protection for threatened jobs, but it is poorly designed for these goals. The reason is the amount of the deduction is tied to a firm’s qualifying profits, and the value of the deduction (like that of all deductions) is limited by a firm’s total profits. As a result, only profitable businesses can claim the deduction, and more profitable businesses benefit more. The deduction takes no account of the number of people a business employs.

This structure — favoring profitable businesses, excluding unprofitable ones, and ignoring employment — makes the deduction particularly ineffective at protecting jobs. Money-losing firms considering layoffs receive little or no benefit. Highly profitable firms benefit disproportionately whether or not they are creating jobs.

• The deduction favors large corporations over small businesses. The domestic production deduction has been praised as a boon to small business, but IRS statistics suggest otherwise. Among 2006 corporate income tax returns, 94 percent of the deduction was claimed by the 0.4 percent of firms with assets over $100 million. [13] Many of these large firms are multi-state corporations and may invest little or none of the benefit in the state granting the tax break.[14]
• State revenues lost to the deduction could be better spent on other priorities. Almost every state now faces fiscal distress, buffeted by a slowing economy, rising unemployment, and the housing crisis. [15] Unlike the federal government, states must balance their budgets each year. Many states have passed or are considering budget cuts, actions that may worsen the economic slowdown.[16] Within this context, corporate tax breaks — especially those costing states hundreds of millions of dollars per year — need to be carefully examined. The high cost of conforming to the domestic production deduction could be better spent on maintaining key spending priorities or on closing budget deficits.

Decoupling from Section 199 Is Administratively Feasible and May Protect State from Future Complications

From an administrative perspective, decoupling from the domestic production deduction is straightforward. It requires a simple statutory change, is simple to comply with, and does not interfere with state conformity to other federal provisions.

As a statutory matter, decoupling can be accomplished by adding a single sentence to state tax law disallowing the deduction. Compliance is equally simple: corporations just add back the deducted amount to their taxable income.

Decoupling does create some minor administrative difficulties for states, but it is possible that the administrative challenges of failing to decouple would be even greater. State revenue departments, along with the IRS, could well find themselves involved in extensive legal action as the courts try to resolve the exact limits to the deduction and prevent abuse.

In a letter to Congress discussing the pending legislation that included the domestic production provision, on October 7, 2004, IRS Commissioner Mark W. Everson wrote:

Many businesses, particularly small businesses, will find it difficult to understand and comply with these complex new rules, which will affect not only the computation of a taxpayer’s regular tax liability but also its alternative minimum tax liability. It will be difficult, if not impossible, for the IRS to craft simplified provisions tailored to small businesses or other taxpayers….

Taxpayers will be required to devote substantial additional resources to meeting their tax responsibilities, including not only employees and outside tax advisers, but also recordkeeping and systems modification resources. The resulting costs will reduce significantly the benefits of the proposal. Some small businesses may find that the additional costs outweigh the benefits, particularly during the initial phase-in period….

It will be necessary to devote significant audit resources to administering the new deduction. This will be due not only to the novelty of the rule but also to the benefits that are provided to “production activities” over other aspects of a taxpayer’s business. Taxpayers naturally will classify everything possible as production activities. Audits, particularly those involving integrated businesses, will have to focus on classification and the allocation of income and costs. Significant additional IRS resources will be needed to administer the provision to avoid diverting resources from other compliance issues (such as tax shelters)….

Finally, for all of the reasons discussed above, we anticipate a significant increase in controversies between taxpayers and the IRS. This will increase the number of IRS appeals cases and litigated tax cases.[17]

It remains too early to tell whether Everson’s prediction will come true. The deduction is fully phasing in this year, and it can take five years or longer for a tax case to come to trial, meaning that any excessively creative tax accounting related to the tax year 2010 may not become public until 2015 or later.

Appendix: Calculating the Impact of the Domestic Production Deduction

The state estimates in this paper represent an approximation of the impact of the domestic production deduction on state tax revenues.

The first step in the estimating process was to use the estimates of the Joint Committee on Taxation (JCT) on the impact of the deduction on corporate and personal income tax revenues in federal fiscal year 2011.[18] These figures were divided by the Congressional Budget Office’s (CBO) projections of actual corporate and personal income tax revenues for 2011. These calculations yielded estimates that the deduction would reduce corporate tax revenues by 3.1 percent in 2011. Personal income tax revenues would be reduced by about 0.2 percent in 2011.

This process was repeated based on projections issued by the Office of Management and Budget, which are much higher. [19] The OMB projections indicate that when fully implemented, the domestic production deduction will reduce corporate tax revenues by about 4.4 percent in 2011. Personal income tax revenues would fall by about 0.3 percent in 2011. However, the JCT/CBO estimates appear to more closely match the 2006 tax return data.

The third step was to multiply those percentage rates by the latest available corporate and personal income tax collections figures for each state, as reported by the U.S. Census Bureau.[20]

The spreadsheet used to generate these estimates is available upon request from Ashali Singham at singham@cbpp.org.

A number of state revenue departments and state fiscal offices have developed their own estimates of the cost of the deduction for one or more fiscal years, and in some cases these may be more reliable.[21] For instance, a state may have its own data on the types of industries that pay taxes, and may find that a higher or lower share of taxable income is likely to be eligible for the deduction. In addition, states may choose not to use the JCT or OMB estimates as a starting point, but rather generate their own estimates based on state-level data on production activities. Finally, given the volatility of these taxes over the last year and their unpredictability in the coming years, state analysts may want to adjust the estimates in this paper according to their own state’s revenue forecasts, simply by multiplying forecast corporate tax revenue by 3.1 percent and personal income tax revenue by 0.2 percent. In order to show comparable data representing a single methodology and timeframe, Table 2 includes only estimates based on the Center’s methodology.[22]

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