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The Domestic Manufacturing Deduction: A Fossil Fuel Subsidy?

3 min readBy: Joseph Bishop-Henchman

In President Obama’s proposed FY 2012 budget, the section on proposed cuts and consolidations includes (PDF):

Eliminating 12 taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. breaks for oil, gas, and coal companies, closing loopholes to raise nearly $46 billion over the next decade.

The proposal is explained further in the budget’s Analytical Perspectives (PDF, p. 204), with the objective being “to phase out subsidies for fossil fuels so that we can transition to a 21st century energy economy.”

It’s hard for me to argue against eliminating subsidies of any kind, whatever the reason, but one non-subsidy jumped out at me: “the ability to claim the domestic manufacturing deduction against income derived from the production of oil and gas.” That’s referring to Internal Revenue Code Section 199, a deduction created in 2004 and broadly available to all manufacturers. Initially, domestic manufacturers were able to deduct 3% of income; this was increased to a 6% deduction in 2007 and a 9% deduction in 2010. What the budget proposes is to curtail this deduction so that out of all manufacturers, only oil and gas producers cannot take it.

Maybe Section 199 is a bad idea, for getting the tax code to value domestic manufacturing over other types of business activity. Maybe the real issue is the 35% corporate tax rate, since we keep creating new deductions and credits like Section 199 to allow corporations to pay less, rather than just lowering the rate for everyone. But it’s not correct to label Section 199 as a subsidy going to oil, gas, and coal companies. Any domestic manufacturer can take it, whether they make fossil fuels, renewable fuels, or widgets.

Indeed, the argument from supporters of the administration’s plan is not so much that it’s a giveaway to oil companies, but that it won’t affect oil prices. A study by the Democratic majority of the congressional Joint Economic Committee (JEC) found (PDF) that repealing Section 199 for oil companies wouldn’t drive prices up:

In the short run, these producers will continue to produce where the marginal cost of extracting (or refining or transporting) the next unit of crude oil (or natural gas) is equal to the price of crude oil (or natural gas). While an increase in the marginal income tax will raise average costs of engaging in the activity, it will not affect the short-run marginal cost. In the short run, firms make production decisions based only on marginal costs.

In the long run, it is likely that the high prices of crude oil will send adequate signals to investors in the domestic oil and natural gas industries. Indeed, an oil executive testified recently that removing the recent tax breaks (including Section 199) given to his company would not affect his company.

In other words, taxes don’t affect behavior: higher taxes on oil production won’t affect anything because prices will still exceed costs and the new taxes. However, the same report does admit:

The effect of eliminating this deduction for the domestic oil and gas industry will raise long-run average costs and generally decrease rates of return to investments in the oil and natural gas industry, all other things being equal.

They dismiss this warning, though, because they foresee crude oil price increases outstripping the proposed tax increase.

All this goes to show that what’s really behind this idea is the desire to extract revenue from a captive company (“What are they going to do, move the oil field?”) in the belief that higher taxes won’t affect their behavior. Let’s debate whether that’s good or bad policy, rather than sticking to the misleading claim that Section 199 is “a throwaway for oil companies.”