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Mixed results for the nation’s third-largest corporate tax break

Did the Domestic Production Activities Deduction work?

July 9, 2015

Becky Lester

Rebecca Lester, PhD ’15

A decade-old corporate tax break was meant to drum up business and jobs in the U.S. But was the end result just a big business shell game?

New research from MIT Sloan PhD graduate Rebecca Lester finds mixed results: more U.S. investment, no discernable effect on jobs, and a bit of creative bookkeeping.

Congress passed the Domestic Production Activities Deduction, part of the American Jobs Creation Act of 2004, to provide companies tax relief for transactions conducted in the U.S. Today, more than 100,000 companies have used it to take billions in deductions. In fact, says Lester, PhD ’15, it has become the third largest corporate tax break.

Lester wanted to find out whether the deduction delivered. Did companies invest more in capital and employment here at home? Did they also push pencils around until the books looked better? Her research on the topic won the $3,000 first prize in this year’s MIT Sloan Thesis Prize; the paper she wrote, Made in the USA? A Study of Firm Responses to Domestic Production Incentives, could help lawmakers grappling with the nation’s budget deficit.

Before attending MIT Sloan, Lester spent eight years in the Chicago tax practice of Deloitte. There she saw the Domestic Production Activities Deduction in practice.

“A lot of my clients were looking at it, thinking about it, and claiming it,” she says. The deduction has been controversial from the start. Right away, the World Trade Organization ruled the deduction violated agreements by subsidizing exports, so Congress tweaked the law. The Congressional Budget Office has suggested repealing it, while President Obama proposed doubling it. But no one knows what the real costs and benefits are.

“There wasn’t much academic literature about it,” Lester says. “There was a demand for, and an interest in, understanding the economic effects of it.”

Lester’s analysis of the deduction’s effects relies on data from the Bureau of Economic Analysis and publicly available information. She approached her work with three hypotheses:

  1. Companies would shift the timing of business transactions on paper so they could show more domestic activity after the tax incentive took effect.
  2. Companies would recategorize some income as domestic to take better advantage of the tax break.
  3. Companies would invest in US capital and workers—but not much.

“Are they really investing?” Lester asks. “From my institutional experience I was not convinced the law would create a big enough incentive to encourage significant investment and employment.”

Here’s what she found: companies did move transactions forward beginning in 2005 to take advantage of the Domestic Production Activities Deduction—about $9 million per firm. They also shifted more income into the U.S. from offshore activities once the largest tax benefit was available.  At the same time, some firms—especially smaller, more financially constrained firms—actually did invest in more capital, such as buildings and machinery, at home.

What they didn’t do was hire more Americans.

“I don’t see any employment response,” Lester says. “It’s not necessarily a failed incentive. It could be that the landscape of U.S. employment is changing. Maybe we have more machinery and we’re more productive so we don’t need more employees to run the newly purchased equipment.”

The study is part of a growing trend within accounting’s academic literature, Lester says. The past five to ten years has seen more research documenting the real effects of tax policy.

“This paper examines an important tax policy that has not been examined before,” says MIT Sloan Professor Michelle Hanlon, Lester’s advisor. “Rebecca analyzed the real behavioral effects—how companies respond to the tax policy, both in terms of real activities and reporting responses.” Now, Hanlon says, lawmakers can weigh the deduction’s true costs.

Lester has accepted a position as an assistant professor in the accounting group at the Stanford Graduate School of Business. She’s revising Made in the U.S.A. for submission for publication.