Adam N. Michel
President Trump has repeatedly suggested Congress should cut the corporate tax rate to 15 percent for “companies that make their product in America.” This continues to be one of the administration’s demands for the tax package Republicans are piecing together.
As I’ve written before, a 15 percent corporate tax rate for all businesses is a very worthy goal that should be included in this year’s tax package. However, Congress has tried activity-specific tax cuts before. The previous “domestic production activities deduction” was a failure, and Republicans repealed it in 2017 in favor of lower tax rates for all businesses. Reviving the deduction or anything like it is a mistake.
A Case Study in Tax Policy Failure
Enacted in 2004, Section 199 of the Internal Revenue Code allowed firms to deduct up to 9 percent of income derived from “qualified production activities,” a loosely defined category that included manufacturing, mining, software development, film production, agriculture, and even roasting coffee beans. The deduction reduced effective tax rates by 3.15 percentage points for eligible firms and reduced federal revenue by about $20 billion in 2016.
In theory, the deduction was meant to encourage domestic investment and job creation. In practice, it did neither in any meaningful way.
Empirical research by Rebecca Lester and Eric Ohrn shows that big and domestic-only firms made modest increases in capital expenditures. However, Lester finds that the deduction is also associated with about 14 percent lower employment. Similar results in a Federal Reserve working paper support the theory that the deduction encouraged substitution of capital for labor.
Due to incentives inherent in its design, the domestic production deduction may have resulted in lower employment despite modest investment gains in some firms. The deduction included anti-abuse rules that effectively penalized labor-intensive firms by capping the deduction at 50 percent of W‑2 wages paid. It also encouraged firms to maximize profit margins within the targeted income category by recharacterizing activities and through automation.
Poor design led to results that are at odds with decades of empirical work showing that investment is closely associated with higher wages and additional employment. Neutral investment incentives, such as full expensing, are more clearly associated with both higher investment and better labor market outcomes.
Distortion Without Justification
Perhaps the strongest case against the special deduction is not just that it failed to achieve its goals but that it introduced enormous complexity and arbitrariness into the tax code. Defining what qualifies as “domestic production” proved nearly impossible.
World Wrestling Entertainment (WWE) films counted as production; sports teams did not, but the networks televising them got the deduction. Restaurants were ineligible, but the Cheesecake Factory qualified by garnishing and cutting prebaked cheesecakes. One gift basket company won a court case arguing that adding cardboard dividers to their assembled baskets constituted “manufacturing.” Coffee shops counted as domestic production only if they roasted their own beans. These line-drawing exercises encouraged aggressive tax planning and wasteful litigation.
Reviving a version of the domestic production deduction would magnify all the old problems. To reduce the effective corporate tax rate from 21 percent to 15 percent, the new Trump deduction would need to be roughly three times larger or 28.6 percent of qualified income (up from the previous 9 percent). The larger deduction would significantly increase the incentive to recharacterize income, litigate definitions, and lobby for additional expansions.
A Better Way
Better reforms exist to boost American productive capacity. Neutral tax policy that lowers rates across the board is the most effective way to encourage domestic investment, manufacturing, and economic growth. Cutting the corporate tax rate for all businesses and allowing full deductions for all types of investments, such as full expensing and neutral cost recovery, will be much more successful at meeting the goals of supporting domestic manufacturing.