With the budget deficit ballooning and politicians from both sides of the aisle paying lip-service to eliminating the state's overhanging debts, you might think Illinois officials would jump at the opportunity to close a corporate loophole that could save the state considerable money next year. Curiously, nobody has discussed exempting the state from a new and rapidly expanding tax break created by the federal government in 2004. It's time they do.

In 2004, as part of the American Jobs Creation Act, Congress approved Section 199 of the federal Internal Revenue Code, known colloquially as the “domestic production deduction." This deduction applies to 6 percent of qualifying income and was intended to provide tax savings to corporations, S corporations, and individuals that earn profits from domestic manufacturing. At the time, it was sold to taxpayers as a boon to the struggling manufacturing industry, specifically companies located in the industrial Midwest. And since most states base their own tax codes on the federal tax code, the same break was added to Illinois law, as well.

Unfortunately, there was one major problem with the law. The IRS' definition of manufacturing is extremely expansive. Along with items manufactured in the states, goods that are produced, grown, or extracted also qualify. What does that mean in practice? Construction firms, engineers, software developers, oil and gas conglomerates, food producers and distributors, media organizations, and electric and gas utilities all take advantage of the tax break, seriously eroding a substantial share of states’ corporate income tax base.

There's also legitimate evidence suggesting that the "domestic production deduction" fails to protect or create jobs within the state. The Center for Budget and Policy Priorities (CBPP) argues that it's unlikely to attract new investments because multi-state corporations can claim the deduction for out-of-state “production activity,” even if the work itself is done outside of Illinois' borders. What's worse, the amount of income that qualifies for the deduction increased in the 2010 tax year to 9 percent. According to CBPP's research, Illinois is scheduled to lose over $100 million* in FY 2011, double that of any state in the nation with the law still on its books.

The good news is that states have the power to block the deduction. In fact, 21 states and the District of Columbia have already decoupled. In 2008 alone, Connecticut, New York, and Wisconsin rescinded the tax break. All it takes is a simple statutory alteration to the tax code (CBPP explains those specifics here).

If lawmakers are serious about trimming the deficit without cutting crucial services, getting rid of this ludicrous and expensive tax break should be on the top of the agenda.

CORRECTION (Wednesday, 5:10 pm): This post originally stated that Illinois would save $1 billion by closing the loophole.  It has been updated to reflect CBPP's actual estimate of $100 million. We apologize for the error.

Image used under a Creative Commons license by Flickr user Jim Frazier.