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Comparison of Tax Incentives of Domestic Manufacturing: 108th Congress

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Abstract:

Several tax bills have been introduced to eliminate the extraterritorial income (ETI) provision of the U.S. tax code that has been found to contravene trade agreement restrictions against export subsidies by the World Trade Organization (WTO). These bills contain tax cuts for domestic manufacturing which offset the loss of the export benefit, but take different approaches to the design of the manufacturing tax benefit. H.R. 1769 (Crane and Rangel), would allow a percentage reduction of the corporate tax rate that is proportional to the share of total output that is domestic. (A similar bill, S. 970, was sponsored by Senator Hollings.) An initial version of H.R. 2896, sponsored by Ways and Means Committee Chairman Thomas would have provided accelerated depreciation for manufacturing equipment in a bill that has many other provisions, although that provision was replaced by a reduction in the tax rate on manufacturing. (A similar bill, S. 1475, was sponsored by Senator Hatch.) S. 1637, originally sponsored by Senate Finance Committee Chairman Grassley and Ranking Member Baucus, and reported from the Senate Finance Committee would provide a rate cut similar to that in H.R. 1769. It would incorporate, but then phase out, the provision adjusting the cut for the share of production that is domestic. This bill also contains a number of other provisions.

Although the overall revenue cost of the rate cuts is larger than the effect of accelerated depreciation initially proposed in H.R. 2896, the provisions overall have about the same magnitude of effects on manufacturing tax burdens on new investment, reducing them by about 4%. The small revenue cost of accelerated depreciation can produce a similar incentive effect because it does not benefit the return to existing capital. These incentive effects would more than offset the lost benefit from the repeal of ETI. The approach in H.R. 1769 would, however, have a more certain and larger effect on encouraging domestic investment in manufacturing. First, additional domestic investment would have both a direct tax benefit effect, and an indirect effect through increasing the ratio of domestic to world production. Secondly, if one considers the other provisions of H.R. 2896 and S. 1637, these provisions provide benefits (in some cases quite large benefits) to investment overseas that could more than offset any domestic incentive.

Within manufacturing, accelerated depreciation tends to introduce distortions across asset type, while rate reductions, particularly if confined to corporate rates, reduce distortions between debt and equity and corporate and noncorporate investment. The two approaches have quite different implications for tax administration and compliance. Although any provision that singles out an activity to favor will encounter administrative costs in ascertaining the qualified activities, accelerated depreciation applied to manufacturing assets is probably feasible to administer without a great deal of additional cost. A rate reduction for a specific activity would, however, potentially lead to significant increases in these costs as firms that operate in many different activities attempt to claim manufacturing status and to transfer taxable income into their manufacturing activities through distortions in withincompany transfer prices and misallocations of deductions and passive income. This report will be updated to reflect legislative developments.