The effect of firm efficiency on firm performance: Evidence from the Domestic Production Activities Deduction Act

We use a quasi-natural experiment based on the 2005 Domestic Production Activities Deduction (DPAD) to test whether the benefits of tax incentives for domestic production are conditional on firm-level productivity. In a sample of 7,141 firms (48,921 firm-years from 1996 to 2012), we find no direct effect on operational performance, ROA, in the following year. However, using three total factor productivity functions and controlling for ROA in the current period, with increasing DPAD treatment and intensity, higher production efficiency was positively associated with the following year's ROA. The effect sizes are meaningful for the moderation effects. The findings are robust to a sub-sample of firms with only US-based operations, placebo estimates, effects of state-level depreciation rates and allowances, effects of DPAD treatment and intensity among industries of the supply chain members, and alternative control variables and sub-samples. The effects are present for ROA at t+1 but not at t+3 or t+5. The findings inform policy makers and managers on the plausible benefits of DPAD for firms with higher total factor productivity.