T he Section 199 domestic production activities deduction reduces tax rates on certain types of activities, primarily domestic manufacturing activities. While a policy objective of the provision was to reduce taxes for domestic manufacturing, in practice, a number of firms in other industries benefit. Many economists and policymakers believe that corporate tax reform could result in a tax code with a broader base and lower rates that could promote economic activity and growth. Arguably, provisions such as the Section 199 deduction that favor certain economic sectors may be inconsistent with this broad-base, low-rate objective. The Section 199 deduction was enacted 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 reduce effective corporate tax rates. As adopted, the definition of eligible domestic production activities extends beyond the manufacturing sector, reducing effective tax rates across a number of economic sectors. From an economic perspective, providing a deduction for selected domestic manufacturing activities is less efficient than an across-the-board cut in tax rates. By allowing only certain sectors to qualify for this deduction, the tax code creates an added incentive for capital investment in activities that would have produced lower pretax rates of return. This incentive distorts the allocation of capital. Targeted tax incentives may be inefficient, as they can drive capital away from its most productive use, reducing overall economic output. Such efficiency concerns are central to economic arguments in support of a broader tax base, with lower tax rates. Repeal of the Section 199 production activities deduction has been included in recent tax reform proposals. In 2010, both the Fiscal Commission and the Debt Reduction Task Force recommended eliminating Section 199, along with most other corporate tax expenditures, in exchange for a reduced corporate tax rate. The Tax Reform Act of 2014 ( H.R. 1 ) introduced in the 113 th Congress also proposed eliminating various corporate tax expenditures as part of corporate tax reform that would result in lower tax rates. The House Republican "Better Way" blueprint released in June 2016 during the 114 th Congress proposed eliminating Section 199 and most other tax expenditures while lowering the corporate tax rate to 20%. As Congress looks at options for reducing the corporate tax rate, possibly such that the reduction is revenue-neutral, eliminating the production activities deduction might be considered. Eliminating the deduction would allow for approximately a 1.4 percentage point reduction in the corporate tax rate. A targeted repeal or reform of the Section 199 deduction has also been considered. One common theme is to evaluate the eligibility of certain types of activities, notably those related to oil and gas. Already, the deduction for oil and gas is limited. Since 2007, Congress has voted numerous times on measures that would limit or repeal the Section 199 deduction for oil- and gas-related activities. However, in 2015, Congress passed legislation expanding the Section 199 deduction for certain domestic oil refineries. Currently, Section 199 allows a deduction equal to 9% of taxable income derived from qualified production activities. Qualified production activities are defined to include manufacturing, mining, electricity and water production, film production, and domestic construction. For oil- and gas-related activities, the deduction is permanently limited to 6%. Across all sectors, the deduction cannot exceed 50% of W-2 wages paid by the taxpayer for qualifying activities. This report provides a legislative history of the Section 199 deduction, details on how the deduction works in practice, an economic evaluation of the deduction, and analysis of the various economic sectors benefitting from the provision. A number of policy options related to the Section 199 deduction conclude this report. The Section 199 domestic production activities deduction was added to the Internal Revenue Code (IRC) as part of the American Jobs Creation Act of 2004 (AJCA; P.L. 108-357 ). The Section 199 deduction was designed, in part, to replace an incentive that had been found to be a prohibited export subsidy by the WTO. From 1971 through 2000, the United States attempted to promote exports through a variety of tax benefits that were found to violate export-subsidy agreements under the General Agreement on Tariffs and Trade (GATT) and later the WTO. The ETI provisions were the last in this series of export-related tax benefits. The ETI provisions exempted certain export income and a limited amount of income from foreign operations from U.S. tax. There were other policy motivations behind the Section 199 deduction, in addition to compensating for ETI repeal. Congress noted that the Section 199 deduction helped reduce U.S. corporate tax rates, address challenges imposed on the manufacturing sector during the economic slowdown of the early 2000s, and promote international competitiveness. As enacted, the estimated revenue loss over 10 years associated with enactment of the deduction was more than 1.5 times the revenues gained from repealing ETI. Over the 2005 through 2014 budget window, repeal of the ETI provisions was estimated to generate $49.2 billion in additional revenues. Over the same time period, revenue losses associated with enactment of Section 199 were estimated at $76.5 billion, for a net revenue loss of $27.3 billion. Since being enacted in 2004, the Section 199 deduction has undergone a number of minor modifications. TIPRA clarified that wages for the purpose of the deduction limit were those relating to domestic production activities. 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 have subsequently been extended 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 limited to a 6% deduction for tax years starting after 2009. The Section 199 deduction was also modified under EESA to take into consideration domestic film industry operations. Specifically, W-2 wage limitation restrictions were modified for the film industry, as was the application of the Section 199 deduction to partnerships and S corporations in the film industry. 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. 114-113 ). 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 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 production activities deduction allows taxpayers a deduction based on the lesser of taxable income derived from qualified production activities (qualified production activity income; QPAI) or taxable income. A taxpayer's QPAI is equal to the taxpayer's domestic production gross receipts (DPGR), reduced by (1) the cost of goods sold that is allocable to those receipts; and (2) other deductions, expenses, and losses that are properly allocable to those receipts. Eligible income includes that derived from production property that was manufactured, produced, grown, or extracted within the United States. Electricity, natural gas, and potable water production is also eligible. As noted above, film production also qualifies. Construction performed within the United States may also qualify for the deduction, as can engineering and architectural services associated with domestic construction projects. In 2012, more than one-third of corporate taxable income was eligible for the Section 199 deduction. The Section 199 production activities deduction, as enacted in 2004, was phased in such that the full deduction rate of 9% was reached starting in 2010. During 2005 and 2006, eligible taxpayers could claim a tax deduction equal to 3% of the lesser of taxable income or QPAI. For tax years 2007, 2008, and 2009 the deduction rate was 6%. When Section 199 was added to the code in 2004, the Treasury was granted broad authority to prescribe regulations necessary to carry out the purposes of the legislation. The Treasury defined qualified activities that were "manufactured, produced, grown, or extracted" to include minerals mining and refining activities. Oil refining is explicitly used as an example in the Treasury regulations as a qualified activity. The Treasury regulations also clarified that construction activities related to drilling of oil and gas wells were qualified activities for the Section 199 deduction. The deduction is permanently limited to 6% for oil-related qualified production activities. For the purposes of limiting the Section 199 deduction, EESA defined oil-related production activities as being related to the production, refining, processing, transportation, or distribution of oil, gas, or any primary product thereof. A primary product from oil includes crude oil, and all products derived from the destructive distillation of crude oil, such as motor fuel. The deduction cannot exceed 50% of the W-2 wages paid by the taxpayer during the year. The wage limitation effectively prevents sole proprietorships without employees from claiming the credit. Only wages allocable to qualifying domestic production activities qualify. Limiting the deduction according to wages paid for qualifying domestic production activities helps ensure that taxpayers claiming the deduction are paying wages to domestic employees. The Section 199 production activities 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 ) × 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.