Made in the U.S.A.? A Study of Firm Responses to Domestic Production Incentives

• Published date: 01 September 2019
• Author: REBECCA LESTER
• DOI: http://doi.org/10.1111/1475-679X.12269
• Date: 01 September 2019

DOI: 10.1111/1475-679X.12269

Journal of Accounting Research

Vol. 57 No. 4 September 2019

Printed in U.S.A.

Made in the U.S.A.?

A Study of Firm Responses to

Domestic Production Incentives

REBECCA LESTER

∗

Received 29 August 2016; accepted 18 March 2019

∗Stanford Graduate School of Business, Stanford University.

Accepted by Christian Leuz. This paper is based on my dissertation at the Mas-

sachusetts Institute of Technology, Sloan School of Management, and it received the MIT

Sloan School of Management Thesis Prize, as well as the 2016 American Taxation Associa-

tion/PricewaterhouseCoopers Outstanding Tax Dissertation Award. I appreciate comments

from my dissertation committee—Michelle Hanlon (chair), S. P.Kothari, and Rodrigo Verdi—

as well as from two anonymous referees, Joshua Anderson, Anna Costello, Lisa De Simone,

John Gallemore, Joao Granja, Dominika Langenmayr, Patricia Naranjo, Michelle Nessa (dis-

cussant), Ralph Rector, Nemit Shroff, Eric So, Joe Weber, Bill Zeile, and seminar participants

at the 2015 AAA Annual Meeting, Duke University, MIT, Harvard Business School, the U.S.

Treasury Office of Tax Analysis, Stanford University, the University of Chicago, the University

of Illinois, the University of Michigan, the University of Notre Dame, the University of Penn-

sylvania, and Washington University in St. Louis. I thank Jeff Hoopes for assistance with data

collection and for sharing R&D credit tax data; Michelle Hanlon for sharing AJCA repatri-

ation tax data; Scott Dyreng for providing Exhibit 21 data; and Wonhee Lee, Mason Jiang,

Christina Becher, and Carl Rodriguez for research assistance. I appreciate institutional in-

sight from Harry Moser of the Reshoring Initiative, Joanne Bonfiglio, Jeff Cote, David Hoff-

man, Anne-Marie Petersen, Larry Salus, Ryan Stecz, and Todd Videbeck. I gratefully acknowl-

edge financial support from the MIT Sloan School of Management, the Stanford Graduate

School of Business, and the Deloitte Foundation. The statistical analysis of firm-level data

on U.S. multinational companies was conducted at the Bureau of Economic Analysis (BEA),

Department of Commerce, under arrangements that maintain legal confidentiality require-

ments. The views expressed are those of the author and do not reflect official positions of

the U.S. Department of Commerce. An online appendix to this paper can be downloaded at

http://research.chicagobooth.edu/arc/journal-of-accounting-research/online-supplements.

1059

CUniversity of Chicago on behalf of the Accounting Research Center,2019

1060 R.LESTER

ABSTRACT

How do U.S. companies respond to incentives intended to encourage do-

mestic manufacturing? I study the Domestic Production Activities Deduction

(DPAD), which was enacted in the American Jobs Creation Act (AJCA) of

2004 and was the third largest U.S. corporate tax expenditure as of 2017.

Using confidential data from the U.S. Bureau of Economic Analysis, I find

greater average domestic investment spending of $95.5–$143.6 million, but

only within the sample of domestic-only firms and not until 2010, when the

greatest statutory DPAD benefits were available. Additional evidence suggests

that U.S. multinational claimants invest abroad rather than in the United

States and that the increased investment by DPAD firms is accompanied by a

reduction in the domestic workforce, consistent with a substitution of capital

for labor. I also show that the delayed investment response is due to firms

engaging in other responses first, such as changing corporate reporting to

shift income across time and borders. Quantifying the extent of these effects

contributes to the literature that studies this tax deduction and informs pol-

icy makers as to the effectiveness of both manufacturing incentives and U.S.

corporate income tax rate reductions in stimulating real domestic activity.

JEL codes: F23; G38; H25; M40; M48

Keywords: income shifting; investment; employment; tax

1. Introduction

This paper studies how U.S. companies respond to domestic production

incentives. Encouraging domestic manufacturing is a central goal of pol-

icy makers, as the industry employs over 12 million U.S. workers and con-

tributes $2.1 trillion to the U.S. GDP (Scott [2015], Bureau of Labor Statis-

tics [2017]). To evaluate the effectiveness of such incentives in increasing

domestic investment and employment, I study the Domestic Production Ac-

tivities Deduction (Section 199 deduction or hereafter the “DPAD”) passed

as part of the American Jobs Creation Act of 2004 (H.R. Rep. No. 108-393

[2004a]).1Firms have claimed over $70 billion in DPAD benefits since en-

actment, making the deduction the third largest corporate tax expenditure

as of the end of 2017 (Joint Committee on Taxation [2017]). However, be-

cause the law did not require firms to commit to new domestic investment

or employment, companies could claim the deduction with few, if any, op-

erational changes. Firms could also choose other less costly channels, such

as shifting income across time and countries, to increase the amount of

qualifying domestic income. In this paper, I examine (1) the extent of the

domestic investment and employment effects and (2) whether and to what

1H.R. Rep. 108-393 [2004a] confirms that this incentive was intended to increase domes-

tic investment and employment. This report states: “The Committee [on Ways and Means]

believes that a reduced tax burden on domestic manufacturers will improve the cash flow

of domestic manufacturers and make investments in domestic manufacturing facilities more

attractive. Such investment will create and preserve U.S. manufacturing jobs.”

FIRM RESPONSES TO DOMESTIC PRODUCTION INCENTIVES 1061

extent firms engage in other less costly income shifting activities first so as

to maximize the domestic manufacturing benefit claimed.

As a brief overview, the DPAD allows firms to deduct a portion of in-

come related to domestic production when determining their U.S. income

tax liability. To calculate the amount of the deduction, firms identify do-

mestic production gross receipts and the associated direct and indirect do-

mestic expenses. The deduction equals net domestic production income

(revenues minus expenses) times the statutory deduction percentage of

3% (2005–2006), 6% (2007–2009), or 9% (2010–2017). Thus, once fully

phased in, the deduction effectively lowers the corporate tax rate on qual-

ifying income by 3.15% (35% ×9% =3.15%). The DPAD was repealed

as part of the 2017 tax legislation H.R. 1 (referred to as the Tax Cuts and

Jobs Act of 2017, or TCJA), even though the intended goals of stimulating

domestic manufacturing and creating jobs are central to the new tax law

(Oliphant [2017]; Ryan [2017]; White House [2018]). Therefore, under-

standing the extent to which the incentive induced changes in corporate

reporting, in lieu of the intended real activities, is relevant to anticipating

and evaluating the effects of the 2017 tax law.

The literature (Kemsley [1998]) and other papers that study the DPAD

(Blouin, Krull, and Schwab [2014]; Ohrn [2018]) suggest that firms will re-

spond to a domestic tax incentive by increasing domestic production. How-

ever, Slemrod [1992] states that taxpayers often take less costly actions first.

The least costly response is for firms to shift transactions in time (intertempo-

ral shifting). Second, firms may use accounting discretion to recharacterize

transactions within the firm (accounting recharacterization). Finally, the costli-

est action is to make real operational changes (real changes). I test the extent

to which firms claiming the DPAD (“DPAD firms”) engage in each of these

activities, and I compare these responses to a set of matched control firms

that never disclose claiming the benefit.

My first hypothesis tests whether DPAD firms engage in intertemporal

income shifting to maximize the amount of the tax benefit. The literature

shows that firms will shift the timing of transactions to recognize income in

lower tax rate periods, thereby reducing the associated cash tax payments

(Scholes, Wilson, and Wolfson [1992]; Guenther [1994]; Maydew [1997]).

The DPAD provides similar incentives for shifting because income related

to domestic production is effectively subject to a lower tax rate once firms

can claim the tax benefit. I predict that DPAD firms shift more income into

the first year of claiming the DPAD, as well as subsequent years in which

the statutory DPAD rate increases (i.e., 2007 and 2010), relative to the

matched sample of control firms. However, I may not observe intertempo-

ral shifting because this action can be costly: the firm may have capital mar-

ket or debt contracting incentives that mitigate shifting (Scholes, Wilson,

and Wolfson [1992]; Maydew [1997]). Furthermore, firms may not shift

income forward if they received greater benefits by retaining income in

the pre-DPAD period to claim other tax incentives phased-out in 2005 and

2006.