Wednesday, October 11, 2017

The Case for a Patent Box with Strings Attached

[This post is co-authored with Daniel Hemel, an assistant professor of law at the University of Chicago Law School, and cross-posted at Whatever Source Derived.] 

Trump administration officials are hoping that their plan for steep business tax cuts will spur economic growth. Economists are skeptical of the administration’s rosy growth projections. But there may yet be a way to reduce business taxes that accelerates growth, encourages innovation, and delivers tangible benefits to American consumers.

To achieve these objectives, administration officials and lawmakers should consider implementing a “patent box” — a reduced tax rate for revenues derived from the licensing and sale of patents. But unlike the patent box regimes that the United Kingdom and several other advanced economies have implemented, a U.S. patent box should come with strings attached. Specifically, the reduced rate on patent-related revenues should be conditional upon the patent holder agreeing to a shorter patent term.

Here’s how it could work: Right now, a patent confers exclusivity for 20 years from the date of application. If the patent is held by a U.S. corporation, the corporation pays a top tax rate of 35% on patent-related income. Under a “patent box with strings attached,” the corporation would have the option to pay no tax on patent-related income in exchange for a shorter patent life.

The system would be structured such that the net present value of the patent holder’s expected income stream — in after-tax terms — would be slightly more attractive under a patent box and a shorter patent life than under the status quo. For example, assuming a 5% interest rate and a 35% corporate tax rate, the net present value of a constant stream of tax-free payments over 11 years is slightly more than the net present value of a constant stream of taxable payments over a 20-year term. Thus, if utilizing the patent box meant accepting an 11-year term, patent holders would have an incentive to choose the patent box and relinquish the last 9 years of exclusivity. (If we assume instead that the prevailing tax rate is 20%, as the Trump administration and congressional Republican leaders have proposed, then the patent box with strings attached becomes preferable to a 20-year term plus full taxability if the patent box allows 15 years of exclusive rights.)

The economic case for creating a patent box with strings attached is strong. Patents are generally thought to enhance “dynamic efficiency” by giving individuals and firms an incentive to innovate. But patents also lead to “static inefficiency” — or “deadweight loss” — when patent holders set the prices of their products above marginal cost. As we’ve argued elsewhere, one can think of the higher price of patented products as a “shadow tax,” and the corresponding reward to innovators as a “shadow government expenditure.”

Ideally, society could find a way to deliver this same reward to innovators without the deadweight loss associated with the patent system’s shadow tax. A patent box with strings attached accomplishes that result. To be sure, it leads to a loss of tax revenue because the patent holder is no longer paying tax on patent-related income. The federal government would need to fill the revenue gap somehow — e.g., by raising taxes across the board. But note that it’s generally more efficient for society to pay for public goods via a broad-based income tax instead of through a narrow tax on a subset of products. In effect, our patent box proposal shifts some of the burden of paying for patented products toward a broad-based income tax and away from the inefficient patent shadow tax we have today.

Not only would consumers pay lower prices if innovations entered the public domain many years earlier, but follow-on innovators would become free to build upon prior discoveries. That would likely speed up the pace of innovation: while potential patentees would have just as strong a financial incentive as before, follow-on innovators could spend less time and money conducting patent searches and obtaining licenses.

The details of a patent box with strings attached would need some working out. For one thing, our calculations assume a 20-year term when in fact, the effective patent term is likely to be closer to 18 years because of the time between application and grant. (The duration of exclusive rights under a patent box with strings attached could be adjusted accordingly.)

More difficult questions arise from the fact that a single product often will be covered by multiple patents. Should a patent holder be able to place some of the patents in our proposed box — claiming a tax exemption for doing so — while keeping other patents outside the box and asserting them for a full patent term? We would suggest an all-or-nothing rule instead: a taxpayer would be eligible for a zero rate on income from a given product only if all patents covering that product are inside the box. This, in turn, would require patent holders claiming the benefit of the box to identify which patents cover which products — a change that, as Jeanne Fromer has argued, would strengthen the patent system overall.

Another complication involves products covered by patents held by multiple firms. For example, the iPhone is covered not only by Apple-owned patents but also by patents (relating to videocoding, chipsets, and other aspects of the device) that Apple now licenses from Nokia. Should Apple be able to take advantage of the patent box with strings attached if Nokia chooses to opt out? (We can anticipate arguments going either way.)

A further wrinkle has to do with patents on products with a longer times-to-market — e.g., early-stage cancer drugs that will require years of clinical trials before they begin to generate revenue. For these products, an 11-year patent life with a tax-exempt income stream is almost certainly not equivalent to a 20-year patent life and normal tax treatment, because patent-related income is heavily backloaded. One possible response is to modify patent box rules for pharmaceuticals and products with similar regulatory barriers to market. Alternatively, the designers of a patent box with strings attached might decide that subject matter-specific rules would complicate matters too much, and that a one-size-fits-all regime is preferable even if one size doesn’t really fit. Note, moreover, that a patent box with strings attached would be optional — thus, a patent holder who thought she would be disadvantaged by participating (e.g., because of a long time to market) still would have the option to stick with the status quo of 20-year patents.

Last but not least, many U.S. corporations already shift patent-related profits to subsidiaries in low-tax jurisdictions through intra-firm licensing arrangements, asset sales, and cost-sharing agreements. For these corporations, the carrot of a tax exemption might not be enough to convince them to agree to shorter patent lives. To persuade patent holders to opt in, the tax reform plan would need to place limits on income-shifting opportunities (a move that is advisable irrespective of our patent box proposal).

In any event, the challenges of ironing out a patent box with strings attached do not seem so daunting as to outweigh the potential benefits. The proposal would draw inventions into the public domain sooner without dampening the incentive to innovate. If administration officials and lawmakers are serious about using rate reductions to spur economic growth, then a patent box with strings attached should be one option on the table.

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