We often hear that that manufacturing is dying in the US because of unfair overseas competition. US manufacturers are either going out of business or shifting operations overseas. However global competition plays a role across all industries, not just manufacturing. Something else is at play. US tax policy singles out manufacturing (actually nearly any business dealing in tangible goods) with unfair rules designed to extract more tax relative to a service-oriented business with the same income albeit while claiming the same tax rate. As the owner of a small US manufacturing firm, I have sadly gained firsthand knowledge of the severe disadvantage one must contend with if they have the audacity to try and make or sell goods in the United States.

The signs of this are not immediately apparent since the nominal tax rate for all corporations (non-pass through) is 35%. The trick though is in the sleight of hand where the focus is on the tax rate while it is the definition of profit that is critical. The common definition of profit is any money remaining after subtracting all expenses from revenue. And we all know what an expenses is, right? Anything you spend in furtherance of the goal of obtaining said revenue. Well unfortunately it’s not that simple, at least as far as the IRS is concerned. In business there are both overhead expenses and capital expenses. Capital expenses are not immediately deducted against revenue but rather depreciated over many years. So if you buy a $100k piece of equipment you don’t deduct the $100k, you deduct maybe $10k that year and for the next 9 years. There may be legitimate business reasons to view the numbers that way for accounting purposes however beyond a certain minimal size a business may not use the cash method (which does not employ depreciation) for tax computation but instead must employ the accrual method which invariably yields a higher figure by shifting more future income into the present. This puts such businesses (primarily manufacturing which is a equipment intensive industry) at a severe disadvantage insofar as the part spent but not deducted accrues tax. But it gets worse. Manufacturing maintains inventory and the inventory is treated as a capital expenses as well therefore none of it can be deducted until sold. And even when sold it is not taxed at lower capital gain rates but at higher regular income rates. The IRS knows the game of “heads I win, tails you lose” quite well.

Ironically it is a rapidly growing business that is most susceptible to such tax harm as most if not all the profits are invested back into the company in order to grow the inventory to keep up with increasing sales. So if you make a $1 million but use it to buy $1 million in inventory you owe $350k in taxes even though you don’t have $350k on hand. Oops. So you either have to borrow it, incurring even greater costs, deliberately slow your rate of growth, or just go out of business. But wait, it gets even worse. If you do so well that your sales exceeds $1 million the IRS redefines expense once again (Section 263a) and says a certain percentage of your payroll, rent, utilities, insurance, etc that is indirectly associated with producing the inventory must also now be capitalized into the value of the inventory. This shifts even more money from the expense column to the profit column. So based on pure available cash flow you may have made $350k but based on IRS capitalization requirements they say you made $1million. So the entire $350k you made is sent to the IRS on your phantom $1 million income and you end the year with nothing.

Only manufacturing is subject to these absurd redefinitions of expense and profit. Service industries have no inventory and nearly no equipment so their profit more or less equals their cash flow. Farming gets a million loopholes to avoid these issues. The rules governing profit/income are far more germane to ones tax bill then the tax rate itself. If we want manufacturing to flourish in this country again perhaps we should stop punishing those who try to engage in it while crying crocodile tears about how US manufacturers are fleeing this country.