CRS Says Manufacturing Tax Legislation Likely Depends on Tax Reform Outcome

Sparked in part by public statements by President Obama in favor of greater federal support for advanced manufacturing, a lively debate over whether additional federal assistance should be provided for manufacturing is taking place among policy analysts and lawmakers. Two key issues lie at the heart of the debate: (1) the contributions of manufacturing to the performance and growth of the U.S. economy, and (2) the steps that the federal government should take to spur faster economic growth in the short run and to lay a foundation for sustained high-wage growth in the U.S. economy in the long run.

The federal government supports manufacturing in a variety of ways. Current federal tax law contains nine provisions with the potential to provide significant tax relief to firms primarily engaged in manufacturing. A few are targeted at manufacturing, while the others tend to benefit manufacturers more than firms in most other sectors. The most important provisions ranked on the basis of estimated foregone revenue are the deferral of the active income of controlled foreign subsidiaries of U.S.-based corporations, the research tax credit, the expensing of the cost of research and experimentation, and accelerated depreciation for certain capital assets.

In the 113^th Congress, a number of proposals are pending that would expand federal tax and non-tax assistance for the manufacturing sector as a means of boosting the short-term and long-term prospects for domestic economic growth. At least eight bills would create new tax incentives intended to bolster domestic investment and job growth in manufacturing. Their prospects for passage hinge in part on the outlook for tax reform legislation in the House and Senate. Any proposal to broaden the income tax base by eliminating certain business tax incentives, lower corporate and individual tax rates, and possibly do so in a revenue-neutral fashion is likely to have implications for the taxes paid by many manufacturing companies.

Proponents of greater federal assistance for manufacturing make several arguments to support their stance. First, they say the assistance is needed to help the United States become more dependent on exports and domestic production as sources of economic growth. Second, increased federal support, in their view, could encourage the creation of more manufacturing jobs, which pay higher wages and benefits, on average, than non-manufacturing jobs do. Third, proponents point out that manufacturing industries perform the vast share of private-sector research and development, and that innovation is a primary engine of economic growth. Fourth, they note that manufacturing plays a critical role in the growth of the green economy. And finally, proponents argue that the United States will lose its long-standing leadership in advanced manufacturing if federal policy fails to bolster its support for manufacturing research and development, investment, and worker training.

By contrast, critics maintain that additional federal assistance for manufacturing is not warranted on economic grounds. In their view, unless there is evidence of a market failure linked to goods production, targeted aid for manufacturing should be decreased, not increased. They also contend that promoting job growth in manufacturing would do little to create the millions of jobs needed to achieve full employment again. And in their view, the U.S. gross domestic product and employment would benefit more from increased efforts by the federal government to dismantle foreign barriers to expanding exports of services than from policies aimed at boosting the competitiveness of U.S. companies involved in advanced manufacturing.

                               Contents

In his 2013 State of the Union speech, President Obama stated that "our first priority is making America a magnet for new jobs and manufacturing."¹ He was alluding to his strategy for promoting sustained growth in the U.S. economy. In late March 2012, Gene Sperling, the Director of the President's National Economic Council, elaborated on the rationale for this strategy in an address to the Conference on the Renaissance of American Manufacturing.² He argued that basing a strategic plan to revive the economy on manufacturing was justified by the "outsized" role the sector has long played in new technology development, the creation of high-wage jobs, and export growth. According to Sperling, the justification also stemmed from the spillover benefits that manufacturing often generated for local firms and the communities where factories are located, benefits that amplified the sector's impact on overall economic activity. In his view, the economic significance of these benefits, though difficult to measure, can be seen in the economic downturns in communities that lose major employers involved in manufacturing.

Calls to revitalize the U.S. manufacturing sector, particularly the segment involved in designing, making, and selling advanced technology products, have re-kindled a long-standing debate among lawmakers, economists, and other analysts over the economic role of manufacturing and whether the federal government should take steps to enhance that role. In the current policy debate on these issues, differences of opinion have emerged that evoke the disagreements that characterized the domestic debate over industrial policy in the late 1970s and early 1980s. Back then, proponents of government actions to promote the growth and competitiveness of U.S.-based manufacturing companies argued that such support was warranted because manufacturing contributed more to the performance and growth of the U.S. economy than any other sector. Critics disagreed on the grounds that what mattered most for future growth in jobs, real wages, and output was substantial and continuing public investments in the main forces propelling rises in the standard of living in the long run: worker skills, education, research and development (R&D), and the economic infrastructure. In their view, industrial policies were bound to fail because governments in general were not nearly as skilled as the private sector in identifying the industries and technologies that would be likely to generate large numbers of well-paying jobs in coming years.

The debate over federal policy toward advanced manufacturing has emerged as a policy issue in the 113^th Congress. Framing the debate is a bipartisan interest in reforming the federal tax code (especially as it relates to the taxation of businesses) as part of a plan to eliminate or substantially lower projected federal budget deficits and the federal debt. Some critics of the current federal income tax system see existing tax benefits for manufacturing as symptomatic of a critical problem with the system: that it is laden with special benefits that reduce effective tax rates and have the same effect as federal spending, except that these benefits are largely immune to the scrutiny and oversight built into the congressional appropriations and authorization processes.

This report examines the federal tax provisions from which many manufacturing firms derive significant benefits.³ More specifically, it describes those provisions and discusses the key arguments for and against targeting federal support (of all kinds) at the manufacturing sector. To set the proper context for the issues addressed in the report, it begins with a brief overview of the economic contributions of the sector, followed by a brief overview of the key elements of federal non-tax support for manufacturing. The report will be updated as warranted by changes in tax law or congressional action.

Manufacturing and the U.S. Economy

According to the North American Industrial Classification System (NAICS), the manufacturing sector is composed of establishments that are primarily engaged in the transformation of materials, substances, or components into products.⁴ Establishments in this case are the factories, plants, or mills that use power-driven machines and equipment to effect this transformation. But they also include individuals who transform materials, substances, and components into products by hand in their homes, as well as small businesses that sell directly to the public items they make on their premises.

Products made by manufacturing establishments typically are finished or semi-finished. The former are ready for consumption or final use, while the latter serve as inputs for the production of finished products. In the national income accounts, manufacturing is broken down into a variety of sub-sectors (or industries) that reflect three critical aspects of the production process: material inputs, machinery and equipment, and employee skills. Basically, the output of some manufacturing industries becomes the input of others and vice versa. For example, makers of machine tools buy needed materials and components directly from the producers of these items, while the latter purchase machine tools directly from the former to produce those materials and components.

Nonetheless, the economic boundaries between manufacturing and other sectors sometimes are blurred in ways that seemingly run contrary to this view of manufacturing. Two examples in particular illustrate this inconsistency. On the one hand, the bottling and processing of milk and spring-fed water are considered manufacturing activities under the NAICS, even though they involve no transformation of materials or components into a new product. On the other hand, the erection of an office building (including fabrication performed at construction sites) is considered a construction activity, even though the final product is the result of a complicated, drawn-out transformative process.

Manufacturing's role in the U.S. economy has changed considerably since 1960. Back then, it accounted for 27% of gross domestic product (GDP), 31% of non-agricultural employment, more than 20% of domestic non-residential fixed investment, nearly 99% of business investment in research and development (R&D), and 62% of exports. Since the 1970s, however, the manufacturing sector's contributions to GDP and employment have declined sharply.

The extent of this downturn can be seen in Figure 1. Basically, it traces the manufacturing sector's share of non-agricultural employment, gross domestic product (GDP), business investment in research and development (R&D), exports, and domestic investment in capital assets between 1960 and 2010. Manufacturing's share of exports in 2010 was 17% below its level in 1960; its share of business R&D investment fell 29%; and its contribution to non-agricultural employment decreased by 71%. With the exception of non-agricultural employment, manufacturing's share shrank because the contributions of other sectors rose faster than those of manufacturing. In the case of employment, manufacturing's share declined because it lost workers while combined employment in other sectors grew, except during recessions.

Every indicator in Figure 1 trended downward except one: employee wages and salaries. Labor compensation per employee in manufacturing was somewhat larger in 1960 than it was in most other sectors. The difference grew steadily until the mid-1990s. In 2010, the gap was 7% smaller than it was in 1995 but nearly 18% larger than it was in 1960. Still, wages and benefits were consistently higher in manufacturing than they were in several other sectors (e.g., construction, mining, transportation, and utilities) from 1960 to 2010.

Several related and noteworthy trends do not appear in Figure 1. First, among all sectors, manufacturing held the largest share of GDP (measured in current dollars) until 1986, when the government sector surpassed it. Several other sectors have risen in importance since then, and in 2010, government; finance, insurance, real estate, rental and leasing; and professional and business services held larger shares than manufacturing.

Second, manufacturing had the largest share of non-agricultural employment among all sectors until 1989, when the government sector employed more persons. Since then, retail trade, professional and business services, education and health services, and leisure and hospitality have joined government as larger employers than manufacturing.

Third, although payroll employment in manufacturing has fallen gradually since 1979, when it reached an all-time peak of 17.985 million, the sector's value added (in current dollars), which is a measure of its contribution to GDP, grew by a factor of 11.9 from 1960 to 2010, when it reached an all-time peak of $1.7 trillion.

These contrasting trends underscore the relatively robust productivity growth in recent decades within the manufacturing sector. From 1988 to 2010, output per hour of labor rose at an average annual rate of 3.5% in manufacturing, compared to a rate of 2.2% for all non-farm businesses, including manufacturing.

 

Figure 1. Key Economic Indicators for Manufacturing, 1960 to 2010

 

 

 

Figure 1 also does not show the diverse outcomes among manufacturing firms from 1960 to 2010. Depending on how the manufacturing sector is sub-divided, many different industries could be identified and analyzed. Under the NAICS, which federal agencies use to organize and report industry data, manufacturing consists of durable goods industries and non-durable goods industries, and each group is in turn divided into 10 major industries. The performance of these 20 industries can be evaluated using the same set of indicators of economic importance.

A comparison of the change in full-time-equivalent (FTE) employment and real value added from 1998 to 2010 suggests that some manufacturing industries grew or declined in importance more than others.⁵ As the figures in Table 1 show, FTE employment fell in all the industries, but the extent of the decrease ranged from -9% for food, beverages, and tobacco products to -74.5% for apparel, leather, and similar products. A much wider range of results emerges when the focus shifts to value added. The 20 industries were evenly split between those whose real value added increased and those whose real value added decreased from 1998 to 2010. Among those whose contribution to GDP shrank, the decreases ranged from -9% for plastics and rubber products to -46% for apparel, leather, and similar products and -47% for textile mills and products. Among the industries whose contributions to GDP expanded, the increases ranged from 4% for electrical equipment, appliances, and components to a whopping 10,900% for computers and electronic products.

           Table 1. Percentage Change in Full-Time-Equivalent

Federal support for manufacturing encompasses a number of tax benefits, as well as several programs intended to promote advanced manufacturing technology. The tax benefits are discussed in the next section, while this section provides a brief overview of the other kinds of assistance.

Non-Tax Assistance

Several federal programs provide assistance for manufacturing firms of all sizes.⁶ The assistance mostly focuses on workforce training, export assistance, business counseling, and technology development. Foremost among the programs are the Department of Commerce's (DOC) National Institute of Standard's (NIST) Hollings Manufacturing Extension Partnership program (MEP), which provides technical assistance to small and medium-sized manufacturers to help them become more competitive and productive, and the Advanced Manufacturing Partnership (AMP) program, which was launched in June 2011 and uses federal funds to leverage the creation of partnerships among businesses, universities, and federal, regional, and state government agencies for the purpose of developing and encouraging the use of advanced manufacturing technology.

A variety of smaller programs at DOC, the Department of Energy (DOE), the Department of Defense (DOD), and the National Science Foundation (NSF) also support manufacturing, mainly by fostering the development of new manufacturing technologies tailored to the missions of those agencies.

There is no readily available estimate of the total amount of federal spending on programs to support the manufacturing sector. Generating such an estimate is difficult because the support is delivered through direct and indirect channels. Direct support comes in the form of programs that target most or all of their resources to manufacturing firms. A case in point is the MEP, which provides technical assistance to small and medium-sized manufacturing firms only. It is relatively easy to determine the amounts budgeted or spent through the program, and the same is true of the other programs.

But such is not the case with programs that indirectly support manufacturing. The main challenge here lies in accounting for the dollar value of such support, which can be defined as federal assistance not targeted at manufacturing that nonetheless benefits a substantial number of manufacturers. No such problem arises in the case of the research tax credit under Section 41 of the federal tax code. Although it is not limited to manufacturing firms, they are by far the biggest users of the credit among all sectors. Because the IRS publishes data on claims for the credit by industry and sector, determining the dollar value of the extent to which manufacturing benefits from it can easily be done through the IRS website. But no such transparency can be found among the programs administered by the Small Business Administration (SBA). While many small manufacturers have benefited from those programs over the years, it is unclear how much was spent for that purpose.

Much of direct federal non-tax support for manufacturing consists of funding for research and development (R&D). According to the most recent figures on industry spending on R&D issued by the NSF's National Center for Science and Engineering Statistics, the federal government funded an annual average of $30 billion of the R&D performed by manufacturing companies in 2008 and 2009.⁷ Current funding may be lower. President Obama's FY2014 budget request for federal R&D calls for $2.9 billion in federal spending for R&D targeted at advanced manufacturing technology, support that would be delivered through programs at NSF, DOE, DOD, DOC, and other federal agencies.⁸ In addition, the budget request would provide more than $150 million for MEP and $1 billion for a National Network for Manufacturing Innovation to be administered by NIST. The combined R&D budget authority for DOC, DOE, and NSF would total $21.5 billion, not all of which would be used to support manufacturing.

Legislation in the 113^th Congress

A number of bills to bolster federal non-tax support for manufacturing have been introduced in the 113^th Congress as of July 2013. A brief summary of each follows. None of the bills has been considered on the floor of the House or Senate, though the two amendments to measures considered by the full Senate were adopted.

In the House:

• H.R. 375 would create a new federal grant program (known as the Make It In America Incentive Grant Program) for the purpose of facilitating the modernization or expansion of domestic manufacturing facilities, the adoption of more energy-efficient production methods, worker training and education, increases in exports of manufactured products, and greater involvement of small firms in domestic supply chains with larger manufacturers.

• H.R. 1027 would reauthorize the Department of Energy's Vehicle Technologies research programs to encourage the domestic production of the next generation of advanced cars and trucks.

• H.R. 1127 would require the President to develop within 180 days of the enactment of the bill a "comprehensive national manufacturing strategy" for achieving a variety of goals, including boosting the number of manufacturing jobs so that they account for 20% of non-agricultural jobs and identifying emerging technologies that could strengthen the competitiveness of U.S.-based manufacturing firms.

• H.R. 1418 would reauthorize through 2018 the NIST competitive grant program for the regional centers for manufacturing technology transfer established under the MEP.

• H.R. 1421, among other things, would create two new programs within NIST, one to organize industry-led consortia to identify "long-term precompetitive industrial research needs" in advanced manufacturing, and the other to develop a pilot grant program to improve the innovative potential and competitiveness of small and medium companies through R&D in advanced manufacturing.

• H.R. 1524 would require that eligible green technologies purchased by the federal and state governments have a domestic content of 85%, meaning that at least 85% of the final manufacturing is done in the United States from "articles, materials, or supplies 85 percent of which are grown, produced, or manufactured in the United States. The bill would impose the same requirement on property eligible for the Section 45 renewable energy production credit and for the Section 48 energy investment credit.

• H.R, 2447 would require the White House National Science and Technology Council to develop a "national manufacturing competitiveness strategy" for the purpose of creating well-paying jobs in the United States.

• S. 63 is the Senate version of H.R. 375.

• S. 453 would modify certain federal job training and post-secondary education programs to place a greater emphasis on programs that lead to certificates of qualification and achievement that are sought or accepted by employers within an industry as preferred or required for recruitment, screening, hiring, or promotion.

• S. 544 is the Senate version of H.R. 1127.

• S.Amdt. 455 to S.Con.Res. 8 (adopted) would create a "deficit-neutral" fund to establish a national network for manufacturing innovation that combines public- and private-sector investments for "proven United States based manufacturing industries."

• S.Amdt. 866 to S. 601 (adopted) would require the Secretary of the Army to use American-made iron, steel, and manufactured goods in projects intended to improve various harbors and rivers, with certain exceptions.

A logical and useful point of departure for a summary of current federal tax preferences that offer significant benefits to manufacturing is the definition of a tax preference. Such a preference (which is also referred to as a tax break, tax benefit, or tax expenditure) is a provision in the federal tax code that grants special tax relief to eligible individual or business taxpayers. The relief is generally intended to promote certain activities, such as the tax credit under section 41 for increasing research expenditures. In some cases, however, the relief serves the purpose of assisting taxpayers facing certain difficult economic or financial circumstances. The tax relief is considered special because it represents a departure from what the Congressional Budget and Impoundment Control Act of 1974 (P.L. 93-344) calls "normal income tax law."

Tax preferences assume any of the following forms: (1) exclusions, exemptions, or deductions, which reduce an eligible taxpayer's taxable income; (2) preferential tax rates, which apply lower rates to some or all of an eligible taxpayer's income; (3) credits, which reduce an eligible taxpayer's tax liability; and (4) tax deferrals, which postpone the recognition of current income for tax purposes or allow deductions in the current tax year that normally should be taken in future years.

Tax preferences also result in revenue foregone by the U.S. Treasury, relative to the revenue that otherwise would be raised. As a consequence, budget experts see them as federal spending that is funneled through the tax code. This explains why tax preferences are also known as tax expenditures. In addition, some contend that permanent tax preferences operate in the same way as entitlement programs do: in both cases, benefits are distributed or paid to qualified persons or corporations with no time limit.⁹

The federal tax code contains numerous provisions granting preferential treatment to companies in an array of industries. In recent years, congressional oversight of business tax benefits generally has been limited to periodic legislation to extend certain temporary benefits that have expired or are about to expire. Permanent business tax benefits have received less attention.

The business tax preferences from which manufacturing companies tend to derive the most benefit are listed in Table 2. Since not all business tax preferences are intended to benefit manufacturing firms, two methods are used to identify the relevant tax provisions. One is the share of overall use of a tax preference (as measured by the aggregate amount claimed on federal tax returns) held by manufacturing firms; the other is the design of the preference itself, and the extent to which manufacturing firms would be likely to benefit from it, given their lines of business. Of the business tax preferences listed in Table 2, only one arguably is designed to benefit the manufacturing sector more than others: the deduction for "domestic production activities" income under Section 199 of the federal tax code. While companies in a broad array of industries benefit in varying degrees from the other preferences, they generally do not benefit to the extent that firms primarily engaged in manufacturing activities do.

For each tax preference shown in the table, the following information is provided:

• a brief description of the tax provision,

• its section in the federal tax code,

• its current status: temporary or permanent,

• its estimated revenue cost in FY2012 for all firms (regardless of industry) that claim it, and

• a summary of its benefits for manufacturing firms.

With one exception, the other provisions in the table encourage the following activities: increased domestic investment and expansion by manufacturing firms (Section 199); a larger flow of equity capital to start-up manufacturing firms (Section 1202); greater cash flow among manufacturing firms of all employment sizes (Sections 491, 492, and 168(k)(4)); and increased U.S. exports of manufactured products (Sections 861, 862, 863, and 865).

The exception is the first provision shown in the table: the deferral of the active income of controlled foreign corporations (CFCs) under Section 11(b). It is the only tax provision from which U.S.-based manufacturing firms derive significant benefits that encourages them to invest outside the United States, especially in countries with lower tax rates than the United States. A CFC is any foreign corporation in which U.S. shareholders own 50% or more of its total voting power or the total value of its stock on any day of a tax year. The federal government taxes U.S.-chartered corporations on their worldwide income. U.S.-based corporations with CFCs are allowed to postpone indefinitely U.S. taxation of their subsidiaries' earnings, as long as the earnings remain in the control of the CFCs and are reinvested abroad. U.S. parent corporations pay federal tax on the earnings only when they are repatriated as intra-firm dividends or certain other income. That tax is reduced by a U.S. credit for income taxes paid by the foreign subsidiaries to the host countries on the same earnings; the credit is intended to avoid the double taxation of foreign-source income. The option for deferral and the availability of the foreign tax credit give U.S. firms an incentive to establish operations with their own profit centers in countries with relatively low tax rates.

While any U.S.-chartered corporation with CFCs can benefit from deferral, corporations engaged primarily in manufacturing have been major beneficiaries. The corporate response to a temporary reduction in the U.S. tax rates for repatriated earnings under the American Jobs Creation Act of 2004 (P.L. 108-357) illustrates this point. Under the act, U.S. corporations were allowed to take a one-time deduction equal to 85% of any increase in their repatriated foreign-source income in either their first tax year beginning on or after the date of enactment or their last tax year beginning before that date. For firms subject to a corporate tax rate of 35%, the deduction lowered the effective rate on the repatriated profits to 5.25%. Credits for foreign taxes paid on the repatriated earnings were reduced by the same amount. In order to claim the deduction, firms had to adopt a domestic investment plan for the repatriated funds. In addition, the deduction was limited to the greater of $500 million or the amount of earnings shown on a firm's books permanently invested outside the United States as of June 30, 2003. According to the conference report on the act, the tax reduction was intended to stimulate increased business investment and hiring and would not be extended or enacted again anytime soon.¹⁰ In a 2008 report on the one-time dividends received deduction, the Internal Revenue Service (IRS) found that manufacturing corporations filed 55% of the returns for the 2004 to 2006 tax years claiming the deduction, and they accounted for 81% of all qualifying dividends.¹¹ Nearly half of all qualifying dividends were repatriated by firms in the pharmaceutical, electronic, and computer industries.

• U.S.-based manufacturing corporations account for a substantial share of the accumulated earnings and profits held by the foreign subsidiaries of U.S. multinational corporations.

• Provision allows U.S. parent companies to defer U.S. tax on income earned and reinvested by their foreign subsidiaries until the income is repatriated as dividends.

• Provides an incentive to establish subsidiaries in countries with corporate tax rates lower than U.S. rates.

• Provision allows firms a tax credit equal to as much as 20% of qualified research spending above a base amount.

• As a result, it can lower after-tax cost of qualified research, encouraging more investment for that purpose.

• Manufacturing accounted for 69% of the total value of claims for the credit by corporations in the 2008 and 2009 tax years combined.

• Provision allows firms to deduct spending on qualified research as a current expense, rather than as a capital expense.

• This treatment lowers the marginal effective tax rate on returns to investment in such research.

• According to data published by the National Science Foundation, manufacturing firms performed or funded 64% of domestic basic and applied research in 2007.

• Section 168 generally allows firms to recover the cost of qualified assets sooner than they can be recovered under the alternative depreciation system in section 167.

• Section 168(k) establishes a 50% expensing allowance (also known as a bonus depreciation allowance) for qualified property bought and placed in service in 2012 and 2013; the allowance was 100% in 2011.

• Section 179 makes it possible for firms to expense a limited amount of the cost of qualified assets placed in service in a tax year.

• Full (or 100%) expensing imposes a 0% marginal effective tax rate on returns to investment in affected assets.

• Though data on investment by industry in equipment and software are not readily available, it is likely that manufacturing firms account for a major share of total investment in those assets, especially equipment.

• Provision makes it possible for firms to take a refundable tax credit equal to the lesser of $30 million or 6% of unused AMT credits from tax years before 2006, reduced by (but not below $0) the sum of "bonus depreciation amounts" from all previous tax years.

• It enables firms in a loss position with long-standing unused AMT credits to increase their cash flow by claiming the optional refundable credit instead of a bonus depreciation allowance that would only boost their net operating loss in the current tax year.

• Historically, manufacturers have been among the industries most affected by the AMT. In 2008, mining companies accounted for 26.3% of AMT payments, followed by finance/insurance (24.2%), and manufacturing (16.8%).

• Provision allows firms to deduct 9% of qualified domestic production activities income; the deduction is 6% for activities related to oil and gas production; the deduction cannot exceed a firm's taxable income or 50% of wages linked to those activities.

• Qualified activities encompass manufacturing, mining, film production, energy, construction, engineering, and architectural services.

• Deduction lowers the top marginal tax rate on income earned from commercial use of favored property from 35% to 31.85%.

• In 2008, according to IRS data, manufacturing accounted for 66% of the total value of claims for the domestic production activities deduction by corporations.

• Provision allows non-corporate taxpayers to exclude from gross income 100% of any gain from the sale or exchange of qualified small business stock acquired after September 27, 2010, and before January 1, 2014; the exclusion reverts to 50% for stock acquired on or after January 1, 2014.

• To qualify for this treatment, a taxpayer must acquire the stock at original issue and hold it for a minimum of five years.

• Qualified small business stock must be issued by a C corporation with no more than $50 million in gross assets when the stock is issued.

• At least 80% of the assets must be used in a qualified trade or business (including manufacturing) during most of the required five-year holding period.

• Provision is intended to expand access to equity capital by small start-up C corporations that may otherwise have trouble attracting such capital. Large corporations do not benefit from the exclusion.

• Provision allows taxpayers that must maintain inventory records in order to account for the cost of goods sold to exclude any increase in the value of goods they buy or produce from taxable income.

• LIFO is most beneficial to firms facing rising costs for the goods in their inventories.

• Research indicates that the vast share of firms that use LIFO for tax purposes are involved in manufacturing.

• Provision enables taxpayers to reduce the tax burden on the difference between the sales price and cost of inventories.

• It also creates beneficial tax planning opportunities that do not exist with the first-in, first-out (or FIFO) method of inventory accounting.

• Provision allows U.S. exporters an exception to the rule that income is sourced according to the residence of the seller.

• Under the exception, inventory that is bought and then re-sold is governed by a rule known as the "title passage" rule.

• The rule sources income from the sale in the country where the sale occurs.

• Inventory that is made and sold by the company is treated as having a divided source: half of the income from a sale is sourced in the United States and half in the country where the sale occurs.

• U.S. companies with excess foreign tax credits may use them to reduce U.S. taxes if they can shift income from U.S. sources to foreign subsidiaries.

• Companies with excess foreign tax credits can take advantage of the inventory sales source rule exception to increase the amount of their credits that can be applied against their U.S. income tax liability. This has the same effect as exempting from U.S. taxation the income that was sourced in another country as a result of the exception.

• The source rule exception for inventory sales probably raises the rate of return from investing in exporting.

• Manufacturers account for two-thirds of U.S. exports of goods and services.

Legislation in the 113^th Congress to Extend or Expand Current Tax Benefits for Manufacturing Firms

A number of bills to extend or enhance current federal tax provisions that have the potential to benefit many domestic manufacturers have been introduced in the 113^th Congress. Summaries of the bills are given below. A bill is listed below if it would create a tax benefit targeted at manufacturing firms, a business tax benefit not targeted at manufacturing that many manufacturing firms might use, or a tax incentive to invest in domestic manufacturing production.

H.R. 394: the Nanotechnology Advancement and Opportunities Act

The bill is intended to encourage equity investment in companies developing nanotechnology by establishing a new non-refundable business tax credit that would apply to the amount paid (up to $10 million) by a taxpayer in a tax year for the acquisition of stock newly issued by a qualified "developer" of nanotechnology. The credit would be equal to 5.25% of the amount paid in the year of the purchase, 3.75% of that amount in the second year, 3% of that amount in the third year, and 1.5% of that amount in both the fourth and fifth years. Only stock issued by C corporations and limited liability companies that qualify as small business concerns under section 3(a) of the Small Business Act and that devote at least 51% of their resources to the "development, production, and sale of products using nanotechnology," as certified by the Treasury Secretary, would qualify for the credit.

Unused credits could be carried forward up to 20 years. Any credits taken would be recaptured if the investor were to sell the stock during the seven years after its acquisition, or if the issuing company were to lose its certification as a nanotechnology developer during that period.

H.R. 615: the Market Based Manufacturing Incentives Act of 2013

The bill would create a new non-refundable personal and business tax credit that would apply to a taxpayer's purchases of up to 10 "specified products." The credit would be equal to 5% to 20% of the total amount paid for those products in a tax year and would be available from five to 10 years. A specified product is defined as a product that has been designated by the Secretary of the Treasury as eligible for the credit. In doing so, the Secretary is required to consult with a commission that would be created by the bill. Up to 10 products may be deemed eligible for the credit. Each must satisfy certain criteria. More specifically, a specified product should be technically advanced, have a potential to create many domestic jobs in the long run, be assembled in the United States, and have a domestic content equal to 60% of its components. Taxpayers claiming the credit must satisfy two tests: (1) that the original use of the product commences with the taxpayer and (2) that the product is acquired for the purpose of using or leasing it, not reselling it.

The Treasury Secretary would determine the credit rate and period of availability for each of the 10 specified products, after consulting with the 21^st Century American Manufacturing Commission. In addition, the credit would be subject to the limitations on the use of the general business credit under Section 38 of the federal tax code. A taxpayer's basis in any product to which the credit applies would have to be reduced by the amount of the credit.

H.R. 616: Scaling Up Manufacturing Act of 2013

The bill is intended to encourage companies to transfer manufacturing operations to the United States by creating a new non-refundable tax credit equal to 25% of an eligible company's expenditures for the construction of a qualified manufacturing facility. A company may claim the credit if it is a C corporation or partnership engaged in an active trade or business that has its headquarters in the United States, undertakes most of its managerial and administrative work in domestic facilities, owns no domestic manufacturing facilities it placed in service, and has a credit rating of B- or higher from a credit rating agency registered by the Securities Exchange Commission and nationally recognized as such an agency under Section 3(a) of the Securities Exchange Act of 1934. The amounts paid or incurred by a company for the construction of a facility to produce qualified products and for the equipment required to do so would be eligible for the credit. A qualified product is defined as a product the taxpayer has produced and sold and buyers have used before it builds a manufacturing facility that qualifies for the credit.

Companies receiving the credit would be allowed to assign it to another entity. A company's basis in the assets for which the credit is claimed must be reduced by the amount of the credit. The Internal Revenue Service could recapture the credit if the company claiming it were to become insolvent, or if the qualified facility is sold to a company that is engaged in an ineligible business. Use of the credit would be subject to the limitations of the general business credit.

H.R. 1086: Offshoring Prevention Act

The bill's tax provision, though it would not directly benefit domestic manufacturers, is intended to encourage companies to produce, grow, or extract qualified property in the United States. It would do this by taxing "imported property income" as ordinary income under Section 954(a) of the federal tax code. Imported property income is defined as income derived from producing, growing, or extracting imported property; from selling or otherwise disposing of such property; or from leasing, renting, or licensing imported property. Income earned from foreign oil and gas extraction would be exempt from the tax. Imported property would be any manufactured item, agricultural product grown in the United States, or mineral mined in the United States that the foreign subsidiary (or controlled foreign corporation (CFC)) of a U.S.-based company exports to a related party in the United States for final use or further processing.

If a foreign subsidiary were to sell any of these items to a non-related entity that imported them to the United States as components of other imported property, those items would also be considered imported property. But property that a CFC sends to the United States for further processing and then is shipped back to the CFC and sold, leased or rented to a foreign user, or property that a CFC exports to the United States and then uses as a component in other property it sells, leases, or rents would not be considered imported property. As a result, any income associated with these transactions would be exempt from the tax.

H.R. 1415: Innovative Technologies Investment Incentive Act of 2013

The bill is intended to stimulate equity investment in certain small companies involved in the commercial development of "innovative technologies" by creating a new non-refundable tax credit equal to 25% of that investment within an "investment period." Certain limitations on the use of the credit would determine the amount of the credit an investor receives. Specifically, there would be an annual limit for all companies on the amount of the credit that could be taken of $500 million. Under regulations that would be issued by the Small Business Administration (SBA), the Administrator of the SBA would allocate the credit among qualified investments by awarding a credit certificate for each allocation stating the maximum credit an investment could earn. This means that an investor awarded such a certificate could claim a credit equal to 25% of his or her qualified investment in a qualified firm, but that credit could not exceed the amount specified in the certificate. There would be a link between the credit and the SBA's Small Business Innovation Research (SBIR) program in that the combined allocation of credits for qualified investments in a single qualified firm could not exceed 50% of the amount awarded to it under the program.

An investment would qualify for the credit only if it involves the purchase of an ownership interest in a qualified small business at original issue in exchange for cash. No credit would be awarded for investments that give investors a majority stake in the ownership of the company. The stock or profit interest must be issued a company that employs fewer than 500 individuals and is involved in the development of new innovative technologies in biotechnology and other high-technology industries. An investor may claim the credit only during an investment period, which would be the 18 months following the date a qualified firm first is awarded funds under the SBIR program. The credit would be part of the general business credit and thus subject to the limitations on its use. If a taxpayer takes the credit as a personal credit and cannot use all of it in the current tax year, he or she may carry it forward up to 20 tax years. A taxpayer making a qualified investment and claiming the credit must reduce his or her basis in the equity interest by the amount of the credit. And with a few exceptions, the IRS would recapture the credit if an investor fails to hold his or her equity interest at least three years.

H.R. 1522: Manufacturing Economic Recovery Act of 2013

With the intention of spurring increased investment in domestic manufacturing production capacity, the bill would establish a new non-refundable tax credit equal to the sum of a taxpayer's applicable percentages of its basis in both real and tangible personal manufacturing property placed in service in a tax year. For real property (e.g., factories and office buildings), the percentages are 10% for property added to real manufacturing property constructed within the previous five years, 15% for property added to real manufacturing property built more than five years ago, and 20% for property built on real manufacturing property with no standing permanent structures. For tangible personal property (e.g., machinery and equipment), the percentages are 10% for purchases of $250,000 or less, 15% for purchases over $250,000 to $1,000.000, and 20% for purchases above $1,000,000. The percentage is increased by five percentage points across the board for real or tangible personal property placed in service in economically distressed areas; the increase rises to 10 percentage points for qualified property placed in service in an "extremely economically distressed area." The former is defined as an area with a five-digit postal zip code and a median household income of less than $40,000 a year; the latter meets the same criteria except that the median household income must be below $32,000. A taxpayer's basis in qualified property is reduced by the amount of any credit that is taken.

The bill would also encourage domestic manufacturers to hire more employees by creating a new class of individuals eligible for the work opportunity tax credit (WOTC) under Section 51 of the federal tax code. Under current law, employers that hire persons from a variety of groups deemed disadvantaged are eligible for a non-refundable credit equal to 40% of such an individual's first $6,000 in wages if she is employed at least 400 hours in a calendar year.¹² The credit rate decreases to 25% if a WOTC-certified employee is employed for 120 to 399 hours, and no credit may be taken if such an employee works fewer than 120 hours. H.R. 1522 would add a new class of WOTC-eligible individual known as a "manufacturing recovery employee." Such an individual is defined as someone who is certified by "the designated local agency" as having been hired after the date of enactment of the bill and before the end of the three years beginning with the date when an employer began to operate the domestic manufacturing facility where the individual is employed. In the case of a manufacturing recovery employee who received unemployment compensation for four or more weeks during the three years preceding his date of hiring, the WOTC credit rate is 50% instead of 40% for the employee's first $6,000 in wages. No credit could be taken for manufacturing recovery employees who are employed fewer than 35 hours a week at a manufacturing facility or who perform less than 90% of their services at such a facility. While the WOTC is scheduled to expire for all classes of disadvantaged persons at the end of 2013, the WOTC credit for manufacturing recovery employees would be made permanent.

H.R. 1737: Manufacturing Reinvestment Account Act of 2013

The bill would attempt to facilitate domestic investment in new capital assets and worker training in manufacturing by creating tax-free "reinvestment accounts" for domestic manufacturers. Under the measure, corporate and non-corporate manufacturing companies would be allowed to claim as an itemized deduction the amount of cash they pay into such an account up to a limit equal to the lesser of a company's domestic manufacturing gross receipts in the current tax year or $500,000. The deduction would be available to foreign-based companies with U.S. manufacturing subsidiaries. To be eligible for the deduction, the manufacturing reinvestment account must be organized as a trust for the exclusive benefit of the taxpayer. To retain its tax-exempt status, all contributions to the MRA must be in the form of cash, none of its assets may be invested in life insurance contracts or collectible items, and the trust's assets cannot be combined with other assets, except in a "common trust fund or common investment fund." Distributions from an MRA would not be taxed if they are used to pay for expenses related to job training and the acquisition of real or tangible personal property. Non-qualified distributions would be included in the taxpayer's gross income and subject to a tax penalty equal to 10% of the amount of the distributions. Deposits in an MRA that are not distributed within seven years would be subject to this penalty, as would the entire amount held in an MRA when a company ceases to qualify as a manufacturing business. The deduction would be available for 10 years after the date of enactment of the bill.

S. 277: Job Preservation and Economic Certainty Act of 2013

The bill has a much broader focus than manufacturing, but it includes one tax provision that would affect companies with domestic manufacturing operations. More specifically, it would create the same disincentive for investment in foreign manufacturing production capacity as H.R. 1086. This is to say that S. 277 would tax imported property income as ordinary income, repealing the deferral option that is available for such income under current law. U.S.-based mining, agricultural, and manufacturing companies with CFCs would be affected the most by the proposed change in tax law.

Current Policy Debate About Federal Support for the Manufacturing

Today's policy debate over federal support for advanced manufacturing has a precedent: the at-times heated debate over industrial policy that played a key role in U.S. economic policy discussions in the 1980s. In both debates, a primary concern was (and is) the long-term economic consequences of a continuing decline in the domestic manufacturing base driven by growing foreign competition in global markets, particularly for advanced technology products.

In the 1970s and early 1980s, U.S.-based companies in a broad expanse of industries (e.g., steel, automobiles, textiles, footwear, consumer electronics, semiconductors, and machine tools) experienced intensifying competition from companies based in Japan, South Korea, France, Canada, Italy, West Germany, and Great Britain. As a result, many U.S. producers lost market share at home and abroad, leading to slower growth and reductions in revenue and critical investments like R&D. Of particular concern to many lawmakers was the increasing competitiveness of European and Japanese companies in commercial markets for advanced technologies in aerospace, telecommunications, computers, electronics, semiconductors, and the equipment used to produce integrated circuits. Their gains in market share worldwide helped engender bipartisan support in Congress for several new initiatives to bolster the competitiveness of U.S. producers of advanced technology products, including the research tax credit that was enacted in 1981. Many of the industries targeted for federal assistance in the 1980s were part of the manufacturing sector.

Thirty or so years later manufacturing accounts for smaller shares of GDP and employment. Some of this decline was due to the severe recession that began in December 2007 and ended in June 2009. Nevertheless, the sector again finds itself at the center of a lively policy debate. This time the main concern is not so much the potential long-term U.S. economic losses from intensified foreign competition, but the potential long-term U.S. economic gains from greater federal support for advanced manufacturing technology.

This section reviews the main arguments for and against targeted federal support for the manufacturing sector and examines their implications for public policy.

Arguments Made for Special Assistance

Proponents of increased government assistance for manufacturing offer several arguments in support of their position. The arguments relate to the sector's current and historical economic contributions. More specifically, they focus on the importance of manufactured products to U.S. exports, the wages and benefits available in the manufacturing sector, the role of manufacturing in technological innovation, the links between manufacturing and the commercial development of so-called green technologies, and actions taken by other countries to support manufacturing.

Driver of Export Growth

The case for greater federal aid for manufacturing rests in part on a consensus among economists that the United States would be better off relying less on consumption and imports financed by foreign borrowing to grow its economy and relying more on domestic production of goods and exports. Manufactured products (mainly chemicals, transportation equipment, computers and other electronic products, and machinery) account for 65% of U.S. exports of goods and 73% of U.S imports of goods,¹³ and the deficit in U.S. trade in goods exceeds the overall U.S. trade deficit. Proponents of more federal support for manufacturing maintain that these figures demonstrate that manufacturing has to play a leading role in any credible plan for reducing the U.S. trade deficit. In their view, the federal government should launch renewed efforts to dismantle the remaining foreign barriers to the export of U.S. manufactured products and persuade major exporting nations like China to adopt more flexible exchange rate regimes. They also call for the adoption of federal initiatives to bolster the competitiveness of U.S. manufacturers through subsidized investments in workforce development, new production facilities, and R&D.

Source of Relatively High Wages and Benefits

Proponents point out that the wages and benefits provided by manufacturing firms are larger, on average, than the labor compensation provided in other non-agricultural industries, (see Figure 1), though the gap has been shrinking over time. For instance, between 2005 and 2010, according to data from the Bureau of Labor Statistics, average weekly earnings in manufacturing were 21% greater than average weekly earnings in all private non-agricultural industries. And a recent study by Mark Price of the Keystone Research Center, which controlled for the key factors affecting wages such as the nature of the job and characteristics of workers, found that manufacturing workers earned 8.4% more each week than non-manufacturing workers from 2008 to 2010.¹⁴ Not all non-manufacturing industries pay less than the average wage in manufacturing. But the ones that do pay more, according to Price's research findings, such as mining, utilities, telecommunications, finance, insurance, professional and technical services, hospitals, and public administration, accounted for only 21% of total non-manufacturing workers. Price also found that low-wage workers benefitted the most from manufacturing jobs and high-wage workers benefitted the least, suggesting that manufacturing has the potential to lower wage gaps among workers. Proponents also note that manufacturing jobs are more likely to provide fringe benefits than non-manufacturing jobs, and that a higher share of manufacturing workers (48%) have no formal education beyond a high-school diploma than non-manufacturing workers (37%) do.¹⁵

These considerations, proponents say, demonstrate that added federal support for manufacturing could open up more middle-income job opportunities and promote less income inequality among domestic workers.

Primary Source of Technological Innovation

Proponents cite the critical links between manufacturing and technological innovation as yet another reason why federal policy should offer special support for manufacturing firms. According to data reported by the National Science Foundation (NSF), manufacturing firms as a whole were responsible for 70% of the domestic R&D conducted and paid for by companies in 2009,¹⁶ and they employed 34% more research scientists and engineers per 1,000 employees than did non-manufacturing industries in 2007.¹⁷ Since technological innovation is thought to be the principal engine of long-term growth in productivity and the economy, proponents maintain that the federal government should adopt policies that encourage U.S.-based multinational manufacturers to conduct more of their R&D in the United States. According to data reported by the Commerce Department, U.S.-based multinational companies in all lines of business conducted an average of 84% of their R&D in U.S. facilities in 2007 and 2008.¹⁸ But this share is reported to have been declining since then, as these companies have transferred some of their R&D operations to Asia to take advantage of growing markets, ample supplies of well-educated and well-trained researchers and engineers willing to work at salaries lower than U.S. salaries for comparable work, and generous government subsidies.

Major Player in Development of Green Technologies

Proponents say the manufacturing sector makes a "disproportionately large" contribution to the development and production of goods and services with clear environmental benefits. A 2012 report by the Brookings Institution estimated that 26% of the 2.7 million jobs in the "clean economy" are in the manufacturing sector, even though those jobs represent only 9% of private-sector jobs.¹⁹ Proponents also note that a number of critical green technologies and products are made by manufacturing firms, including electric vehicles, water-efficient products, energy-efficient appliances, and environmentally friendly chemical products. In their view, this role suggests that a competitive, growing manufacturing sector is needed to provide the United States with the workforce skills, engineering talent, and innovative capability required to meet the twin technological challenges of producing more clean energy and reducing the use of energy made from fossil fuels. Proponents argue that special federal assistance for manufacturers directly involved in the commercial development of green technologies is critical if these goals are to be achieved.

Other Developed Countries Support Key Manufacturing Industries

Yet another argument made in support of federal policies to assist manufacturing is that many other countries do so, some with notable success.²⁰ According to proponents, the exemplar is Germany. In their view, the federal government would do well to emulate German policy toward manufacturing, the constraints imposed by the U.S. political climate notwithstanding. Compared to the United States, Germany has achieved better outcomes in manufacturing in recent years, as exemplified by higher wages, a slower rate of job loss, and large trade surpluses. Some analysts attribute these results in part to public policies that have fostered the emergence and growth of dense German R&D networks. Among other things, these networks have aided the growth and competitiveness of the manufacturing sector in several ways, including supporting a system of continuous vocational training tied to industry needs, promoting stable access to finance for small and mid-sized German companies, and encouraging the rise of collaborative systems involving unions and companies for making important decisions on issues not subject to collective bargaining. Proponents of greater federal support for manufacturing point to the German example as proof that public policy can address the basic challenges facing the manufacturing sector in ways that help a country accomplish key policy objectives such as relatively high wages, increased technological innovation, larger trade surpluses, improved environmental protection, and greater energy conservation.²¹

Proponents seem divided on the question of which firms should be eligible for government assistance for manufacturing. This is a significant issue for public policy because the sector consists of firms in a range of industries that differ widely in the products they make and the markets they serve. Under the NAICS, manufacturing embraces products as basic as bottled water and as sophisticated as nanotechnology. Some proponents argue that federal policy toward manufacturing should take into account differences in financial condition and external economic benefits among industries involved in goods production so lawmakers can better informed about the need for policies that encourage the migration of workers to current and future high-growth industries, remedy market failures that permit relatively inefficient firms to remain in business, and help firms with relatively low productivity to raise it.²² To assist manufacturing firms that are hopelessly uncompetitive, they say, would be a waste of taxpayer money. Others contend that the federal policy should target its assistance to bolster the "ability of enterprises to develop and manufacture high-technology products in America."²³

Still others call for a shift in government policy toward manufacturing so that special assistance is directed to small companies only. In their view, such a focus makes sense for two reasons. First, proponents of this limited approach point to evidence that young startup firms serve as "key drivers of employment and technology growth" but lag behind large firms in adopting "new technologies that would make them more productive."²⁴ Second, they argue that small and medium firms face special difficulties in gaining needed public information and advisory services, but that they play "critical roles" in supporting the competitiveness of large U.S. manufacturers.

Arguments Made Against Special Assistance

In spite of the widespread political appeal of calls for greater government support for manufacturing, not everyone agrees that such assistance is warranted on economic grounds. Critics offer several arguments to explain why they oppose increased government involvement. The arguments concern the lack of any market failures linked to the performance of the manufacturing sector, the sustained decease in the contributions of the manufacturing sector to job creation and GDP over the past 50 years or so, and the untapped potential for growth in U.S. exports of services in which the United States may have a comparative advantage.

Absence of Market Failure

Critics say the main reason why government assistance for manufacturing cannot be justified on economic grounds is that the performance of the sector is not directly affected by a market failure.

In general, a market failure is a condition that prevents or greatly hinders the emergence of an efficient allocation of resources within a particular market, such as the market for health insurance or passenger cars. Many economists agree that the government should intervene when markets fail to generate efficient outcomes. For instance, if competition in a market is dominated by a few companies, antitrust laws can be applied to lessen any welfare losses by curtailing the market power of those sellers. The main market failures involve the following conditions: public goods, externalities (positive and negative), a lack of competition, the absence of a market, incomplete and asymmetric information, and the principal-agent dilemma.²⁵

This basic principle of economic analysis implies that government support for an industry like manufacturing is warranted only if a market failure is distorting resource allocations within the industry. An example of this distortion is sub-optimal investment in R&D or capital assets like buildings and equipment. Some say that manufacturing is prone to market failures resulting from three activities that are characteristic of manufacturing: R&D investment, clustering of firms in the same geographic area, and the process of learning by doing. But critics disagree, arguing there is no evidence that these activities produce market failures that are limited to manufacturing.

One market failure some associate with manufacturing is inefficient levels of R&D investment. This linkage is not surprising, since the sector accounts for most of the domestic R&D performed in the private sector, and companies are thought to invest too little in R&D because of their presumed inability to capture all the returns from those investments. The returns captured by entities other than the innovator (i.e., other companies and consumers) represent the positive externalities or spillovers from R&D. Though there is no question that manufacturing is affected by this market failure more than other sectors, the problem arises in any sector where companies invest in R&D. It is well known that numerous non-manufacturing firms, such as those involved in software development (e.g., Microsoft and Google), invest substantial amounts in R&D and thus are as likely as any major manufacturing firm to underinvest in R&D relative to its overall economic benefits. In the view of critics, the appropriate policy response to the positive externalities associated with R&D investment is to offer a subsidy intended to boost such investment that is available to companies in all lines of business. Current federal policy does this by funding the kinds of research that most companies are loath or unwilling to undertake on their own and by providing tax subsidies for private-sector spending on qualified research.

Some have argued that manufacturing is particularly vulnerable to the market failure associated with a phenomenon known as industry clustering. This occurs when a number of businesses from the same industry set up shop in the same location. There is evidence that clusters of manufacturing firms can be more productive and innovative than similar firms operating in isolation from one another. As a result, when a company builds a plant in an area where such clustering exists, some of the returns on that investment are likely to accrue to other firms in the cluster. Leakages like this are identical in effect to the positive externalities from R&D investments. Without a government subsidy, companies would invest too little in joining clusters, relative to their economic benefits. But critics say that the studies that have been done on the economic benefits of clustering have yet to find evidence of such effects on a large scale.²⁶ They also point out that the external benefits from clustering should arise in any industry where clustering occurs on a significant scale, such as software, insurance, and entertainment.

Critics also cite "learning by doing" as another example of a possible market failure in manufacturing with little or no merit. They note there is no evidence that the process, which encompasses the time, analysis, and adjustments required to make a new production process work efficiently, prevents companies developing new production methods from reaping the returns from those investments. If this were not the case, then one could argue that government assistance is needed to ensure that firms invest in process innovations in optimal or near-optimal amounts. But such is not the case, say critics. To substantiate their point, they cite a recent study of the U.S. semiconductor industry that found that, while learning by doing was a substantial share of the cost of investing in new production methods, most of the rewards went to the companies making the initial investments.²⁷

Not even the external benefits associated with national defense spending justify special treatment for manufacturers, in the view of critics. They contend that not all such firms are equally critical to a war effort. And there is no reason to believe that the existing U.S. production base for defense goods, supplemented by military supply arrangements with allies, would be incapable of providing adequate supplies of weapons and other needed materials during a war.²⁸

Shrinking Source of Job Creation

A second argument against special assistance for manufacturing concerns job creation. Some critics say it would be misguided in light of recent history for the federal government to aid manufacturing in the expectation that doing so would trigger large employment gains over time.

Domestic employment in the sector has been gradually shrinking (with a few temporary upturns) since 1979 and now accounts for 9% of U.S. non-farm employment. In the view of critics, many of the factory jobs that were lost over the past three decades are not coming back. There are several reasons why they have this expectation. First, many of the jobs involved skills that are readily available in places like China and Mexico. Moreover, even if every U.S. multinational company were to stop outsourcing production and no imports of manufactured products were allowed in the United States, domestic manufacturing employment would be likely to continue to fall relative to other sectors for a simple reason: Americans have been spending less of their disposable incomes on goods and more on services since the late 1970s. Critics also note that the main cause of the sluggish U.S. job growth since the end of the Great Recession in June 2009 has been weak aggregate demand. Thus, increasing assistance to manufacturing firms would do little to boost job creation in the short run, since it would have little effect on overall demand.

Promoting Service Exports Would Do More to Stimulate the Economy

Finally, critics say the U.S. economy would probably benefit more in the short run from government efforts to dismantle foreign barriers to U.S. exports of services than from new programs to bolster the competitiveness of U.S. manufacturers. They say the United States has a larger comparative advantage in highly skilled services such as engineering, law, finance, and architecture than it does in products made with the use of low-skilled workers (e.g., apparel, wood products, processed foods). In addition, service industries, broadly defined, employ about 70% of American non-farm workers, and the United States is the leading exporter of services in the world. Nonetheless, according to critics, there is considerable untapped potential for expanding the U.S. share. Current service exports come from a small percentage of U.S. companies, and there has been an upsurge in infrastructure development in faster-growing economies like China, India, and Brazil in the past decade. According to an estimate by J. Bradford Jensen, an economist with the Petersen Institute for International Economics, the United States has the potential to more than double its current service exports if existing barriers overseas are removed, creating an additional $800 billion in tradable business services like law and engineering.²⁹ Such an increase would support or create nearly three million U.S. jobs, according to Jensen, and those jobs would be likely to pay higher wages than manufacturing jobs, on average. In light of such gains, critics argue that the federal government should focus more on pressing other governments to open up their service markets to U.S. companies than on promoting exports by domestic manufacturers with no foreign subsidiaries.

Implications of the Arguments for Federal Policy Toward Manufacturing

The "pro and con" arguments related to the federal support for manufacturing have several implications for federal policy toward the sector.

First, the weight of the evidence cited by both sides suggests there is no clear economic rationale for providing special federal support for the manufacturing sector. Goods production as an economic activity seems free of any obvious market failures. Some point to manufacturing's major contributions to technological innovation and the positive external benefits associated with R&D investment as evidence that the sector is subject to a market failure. But such an argument is difficult to reconcile with the fact that the positive externalities associated with R&D are not limited to manufacturing but extend to non-manufacturing companies that invest in R&D. Federal tax policy has recognized this economic reality for nearly 60 years. In 1954, Congress passed a sweeping revision of the federal tax code that included an expensing allowance for qualified research expenditures. In 1981, Congress added a research tax credit to the tax code. Both provisions remain in effect, though the credit has been modified significantly since its first iteration. Since eligibility for these tax subsidies depends critically on the nature of the research a firm finances and not on the industry in which a firm is classified, the subsidies have the potential to stimulate increased investment in innovative activity across all sectors, not just in manufacturing.

Second, the arguments also suggest that increased aid for manufacturing would be unlikely to spark a significant rise in domestic job creation. The sector's contribution to overall employment has been declining for more than three decades and now stands at 9% of U.S. non-farm employment. In an economy marked by relatively weak job growth tied to relatively slow growth in aggregate demand, many would argue that increased support for manufacturing would do less to spur faster job growth in the short run than policy measures intended to deliver a quick, sizable stimulus to aggregate demand.

Third, the arguments leave the distinct impression that policy initiatives to bolster the international competitiveness of U.S. manufacturers may have similar benefits for other sectors. Some proponents of a greater federal role in manufacturing say federal policy should focus on four objectives: increased R&D support, greater investment in worker training, improved access to investment capital, and new mechanisms for creating and sharing productivity improvements and other innovations among smaller firms. Unless policy measures to promote those objectives are strictly targeted at manufacturing firms, it is likely that many firms in other industries could benefit from them. Rather than focusing on manufacturing as a pathway to stimulate the economy, Congress could alternatively consider policy options for providing more R&D support, improving worker training to reduce mismatches between employer skill needs and the skill sets of workers, expanding access to credit for small and medium companies, and encouraging the growth of industry-specific networks that could offer a range of collaborative services for the mutual benefit of individual firms that would apply to all industries.

Finally, though this issue is not the primary focus of the arguments addressed here, Congress could look at the advantages and disadvantages of using tax incentives as a primary tool for achieving any policy objectives it may set for manufacturing industries. Tax incentives require no annual appropriations or other congressional action to have their intended effect. They operate like hidden entitlements that impose significant compliance burdens on companies and enforcement costs on the IRS. By contrast, policy initiatives based on spending can be more transparent and open to congressional oversight. The comparative advantages of spending programs (including credit guarantees) and of tax incentives could receive greater scrutiny as Congress considers options for achieving long-term reductions in budget deficits and federal debt, including tax reform, in the coming months.

Author Contact Information

² For a text of the speech, see http://www.whitehouse.gov/sites/default/files/administration-official/sperling_-_renaissance_of_american_manufacturing_-_03_27_12.pdf.

³ Federal support for manufacturing is spread among several agencies and lacks centralized control and coordination. The Department of Defense funds research on new product and process technologies through its Manufacturing Technologies Program and the Defense Advanced Research Projects Agency. Under its Industrial Technologies Program, the Department of Energy enters into partnerships with industries to improve their energy efficiency through the development of new process technologies. The National Institute for Standards and Technology (NIST) devotes about half of its annual budget to promoting improved competitiveness among small and medium-sized manufacturing companies through two programs: the Manufacturing Extension Partnership and the Engineering Laboratory. NIST also supports research in advanced manufacturing technologies through the Advanced Manufacturing Technology Consortia Program and the NIST Centers of Excellence program. In addition, the Obama Administration is proposing that Congress appropriate $1 billion through the NIST budget for a competitive grant program to establish a network of regional institutes for manufacturing innovation. In addition, the National Science Foundation funds a significant share of the federally supported basic research done at American colleges and universities. Some of the research funded by NSF has applications in manufacturing; those funds are distributed largely through the Directorate for Engineering's Civil, Mechanical, and Manufacturing Innovation Organization.

⁴ See http://www.census.gov/cgi-bin/sssd/naics/naicsrch?code=31&search=2012 NAICS Search.

⁵ The comparison does not stretch back before 1998 because that is the first year for which the Bureau of Economic Analysis at the Commerce Department provided an estimate of FTE employment by industry.

⁶ See Nisha Mistry and Joan Byron, The Federal Role in Supporting Urban Manufacturing, Brookings Institution, Pratt Center for Community Development, April 2011, p. 34.

⁷ Raymond M. Wolfe, Business R&D Performed in the United States Cost $291 Billion in 2008 and $282 Billion in 2009, InfoBrief, National Center for Science and Engineering Statistics (Arlington, VA: Mar. 2012), table 2, p. 2.

⁸ See Office of Management and Budget, Fiscal Year 2014 Budget of the U.S. Government: Analytical Perspectives (Washington: GPO, 2013), p. 371.

⁹ U.S. Congress, Senate, Committee on the Budget, Tax Expenditures: Compendium of Background Material on Individual Provisions, 111^th Cong., 2d sess., S. Prt. 111-58 (Washington: GPO, December 2010), p. 3.

¹⁰ U.S. Congress, Conference Committee on the American Jobs Creation Act of 2004, conference report to accompany H.R. 4520, H.Rept. 108-755, 108^th Cong., 2^nd sess. (Washington: GPO, 2004), p. 314.

¹¹ Melissa Redmiles, The One-Time Received Dividend Deduction, Statistics of Income Bulletin, Washington, DC, Spring 2008, available at http://www.irs.gov/pub/irs-soi/08codivdeductbul.pdf.

¹² This wage limit applies to all classes of WOTC-eligible individuals except summer youth and veterans entitled to compensation for service-related disabilities. For the former, the wage limit is $3,000, and for the latter, $12,000.

¹³ These figures represent the average shares for the first three months of both 2011 and 2012 and are based on the latest report by the U.S. Bureau of the Census on U.S. international trade in goods and services. See http://www.census.gov/foreign-trade/Press-Release/2012pr/03/ft900.pdf.

¹⁴ Susan Helper, Timothy Krueger, and Howard Wial, Why Does Manufacturing Matter? Which Manufacturing Matters? Metropolitan Policy Program, Brookings Institution, February 2012, p. 4.

¹⁵ Ibid., p. 5.

¹⁶ Raymond M. Wolfe, Business R&D Performed in the United States Cost $291 Billion in 2008 and $282 Billion in 2009, National Science Foundation, National Center for Science and Engineering Statistics, InfoBrief, NSF-12-309 (Arlington, VA: March 2012), p. 2.

¹⁷ National Science Foundation, National Center for Science and Engineering Statistics, Research and Development in Industry: 2006-07, detailed statistical tables, NSF 11-301 (Arlington, VA: June 2011), Table 68.

¹⁸ Kevin B. Barefoot and Raymond J. Mataloni, Jr., "U.S. Multinational Companies: Operations in the United States and Abroad in 2008," in Survey of Current Business, Department of Commerce, Bureau of Economic Analysis, vol. 90, no. 8, August 2010, Tables 15, 16.1, and 16.2 (pp. 221-223).

¹⁹ Helper, Krueger, and Wial, Why Does Manufacturing Matter? p. 14.

²⁰ For an assessment of the support for manufacturing offered by Australia, Canada, Germany, Japan, Spain, and the United Kingdom, see Information Technology & Innovation Foundation, International Benchmarking of Countries' Policies and Programs Supporting SME Manufacturers (Washington: September 2011). Available at http://www.itif.org/publications/international-benchmarking-countries%E2%80%99-policies-and-programs-supporting-sme-manufacturer.

²¹ Helper, Krueger, and Wial, Why Manufacturing Matters, p.28.

²² Ibid., p. 15.

²³ Gary P. Pisano and Willy C. Shih, "Restoring American Competitiveness," Harvard Business Review, July-August 2009, p. 114.

²⁴ Stephen Ezell, "Revitalizing U.S. Manufacturing," Issues in Science and Technology, Winter 2012, available at http://www.issues.org/28.2/ezell.html.

²⁵ For more on market failures, see Joseph E. Stiglitz, Economics of the Public Sector, 3^rd ed. (New York: WW. Norton & Company, 2000), pp. 76-90.

²⁶ Christina D. Romer, "Do Manufacturers Need Special Treatment," The New York Times, February 4, 2012.

²⁷ Ibid.

²⁸ Ibid.

²⁹ Catherine Rampell, "Some Urge U.S. to Focus on Selling Its Skills Overseas," The New York Times, April 10, 2012.