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Updated September 29, 2017
Key Issues in Tax Reform: The Section 199 Deduction
The Section 199 domestic production activities deduction
reduces the effective tax rate on certain types of activities,
primarily domestic manufacturing activities. Whether the
Section 199 deduction should be a part of a reformed tax
code is a question Congress may choose to address as it
evaluates tax reform options.
For additional background, see CRS Report R41988, The
Section 199 Production Activities Deduction: Background
and Analysis, by Molly F. Sherlock.
Currently, Section 199 allows a deduction equal to 9% of
the lesser of taxable income derived from qualified
production activities, or taxable income. Qualified
production activities are defined to include manufacturing,
mining, electricity and water production, film production,
and domestic construction, among other activities. For oil-
and gas-related activities, the deduction is limited to 6%.
Qualifying oil and gas activities include the production,
refining, processing, transportation, or distribution of oil,
gas, or any primary product thereof. Across all sectors, the
deduction cannot exceed 50% of W-2 wages paid by the
taxpayer for qualifying activities. In 2012, more than one-
third of corporate taxable income was eligible for the
Section 199 deduction.
The Section 199 deduction serves to reduce the effective
tax rate-the actual rate of taxes paid relative to income-
on qualified activities. Generally, tax liability is calculated
as follows:
Taxes = [(Income Expenses)( 1 p) x t] Tax Credits,
where t is the statutory tax rate and p is the production
activities deduction rate. For income that does not qualify
for the production activities deduction, p is zero.
When the production activities deduction applies, the tax
rate is the statutory tax rate (generally, 35 % for
corporations) multiplied by (1 -p). For example, when p =
0.09, the effective tax rate becomes 31.85% (35% x 0.91).
When p = 0.06, as is currently the case for the oil- and gas-
related activities, the effective tax rate becomes 32.9%
(35% x 0.94).
LN~ade History
The Section 199 deduction was enacted as a permanent
provision by the American Jobs Creation Act (AJCA; P.L.
108-357) in 2004, to address a number of policy concerns.
In part, the deduction was designed to compensate for the
repeal of the extraterritorial income (ETI) provision that
had been found to be a prohibited export subsidy by the
World Trade Organization (WTO). The deduction was also
designed to support the domestic manufacturing sector and
several other industries by reducing effective corporate tax
rates.
The Section 199 production activities deduction, as enacted
in 2004, did not reach the full deduction rate of 9% until
2010. During 2005 and 2006, eligible taxpayers could claim
a tax deduction equal to 3%. For tax years 2007, 2008, and
2009, the deduction rate was 6%.
Since being enacted, the Section 199 deduction has
undergone a number of minor modifications. The Tax
Relief and Healthcare Act of 2006 (P.L. 109-432) added the
benefit for Puerto Rico, on a temporary basis. The
temporary provisions allowing the deduction for qualifying
activities in Puerto Rico has been extended multiple times
as part of tax extenders.
Additional changes were made to the Section 199 deduction
as part of the Emergency Economic Stabilization Act of
2008 (EESA; P.L. 110-343). Under EESA, oil-related
qualifying production activities, including but not limited to
oil and gas extraction, were permanently limited to a 6%
deduction for tax years starting after 2009. In addition, as
part of EESA, the deduction was also modified to better
accommodate domestic film production industry operations.
The Section 199 deduction was enhanced for crude oil
refiners that are not a major integrated oil company as part
of the Consolidated Appropriations Act, 2016 (P.L. 113-
114). Specifically, the provision limited the amount of
transportation costs to be taken into account when
determining taxable income for the purposes of the Section
199 deduction to 25%. The result is higher net income for
the purposes of calculating the deduction, and thus a larger
deduction. This provision was enacted on a temporary basis
to provide support for independent refiners following
changes in crude oil export policy, and is set to expire at the
end of 2021.
The Section 199 production activities deduction increases
the after-tax return to particular investments by lowering
the effective tax rate for income earned in certain industries.
As a result, the deduction may distort the allocation of
capital. This effect could reduce economic efficiency and
total economic output by directing capital away from its
most productive use. A 2017 Treasury report, The Case for
Responsible Business Tax Reform, noted that [t]he
domestic production activities deduction is difficult to
justify without clear evidence that it provides offsetting
social benefits of some kind. Without such a social benefit,
then to the extent that it is targeted to particular industries
or activities it could inefficiently encourage such activities
over others that do not benefit. When evaluating the
deduction in light of economic efficiency concerns, it may
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