Feedback on the Innovation Promotion Act

Executive Summary

The Act, as written has a broad scope in terms of qualified property and gross receipts, and has three potential normative economic justifications.

The first normative economic justification is in stimulating innovation. Other Acts (Patent Act, R&D tax credits, etc.) share this justification. This Act’s incentives are not sufficiently orthogonal and are less clearly coupled to desired activity as compared with pre-existing legislation that this economic justification would likely be better pursued by extending pre-existing legislation or developing new legislation.

The second normative economic justification is to increase US welfare by encouraging local ownership of intellectual property. This could work if the externalities of innovation would be increased with proximity. It seems likely that this Act was conceived with this basis in mind. However, it is local invention (R&D effort), and not local ownership of IP, that is key to this argument. It also seems likely that ownership will flow to the least-tax-cost jurisdiction and that the return to being a second-place jurisdiction will be low or even negative.

The third normative economic justification would be to stimulate the development of a market for ideas and mitigate market failures that could be induced in IP transactions. Under this rationale, one would not want to incentivize ‘other dispositions’ outside of licensing, infringement settlements, outright sale, and a narrow set of other activities. However, encouraging the activities that are central to a well-functioning market for ideas could bring benefits substantial to the US economy. Realignment of the Act towards this third normative economic rationale would likely require substantial modification. Weighting the deduction by R&D expense would then also require considerable study.

Each rational only applies if qualified property is reduced to just patents. Including film and video, computer software, and trade-secrets in the Act drastically undermines it. Moreover, implementation under any rational is infeasible for gross receipts from ‘other dispositions’, particularly the sale of complex products that embody a great deal of intellectual property.

Economic Foundations

Innovation suffers from market failure due to information problems and positive externalities. As such, we expect innovation to be underprovided by private firms, relative to social optimal levels. Policy to increase innovation, like patent policy and R&D tax credits, may still not increase innovation to optimal levels. Thus Innovation Tax Boxes could have a role to play.

However, innovation policies involve trade-offs. For example, patent policy trades-off releasing information about the invention that can stimulate subsequent invention, and protecting the inventor from appropriation and so allowing commercialization of the invention, with imperfect competition: Patents confer rights to exclude and so market power. Policies can also have adverse consequences and create additional market failures, especially when firms can engage in moral hazard. For example, R&D tax credits incentivize firms to engage in moral hazard by making expenses that conform to the credit’s definition, irrespective of their positive externalities. Given current policy, whether innovation levels are still suboptimal is a difficult to answer empirical question. Even if they are, or are assumed to me, whether even a well-designed Innovation Tax Box policy is merited under this rationale is questionable.

A second economic justification for innovation tax boxes could come from externalities. Supposing that the externalities to innovation decrease with distance, then having innovation occur locally, particularly within national boundaries, could be important. There is a large literature suggesting that this is the case. A nation may capture only limited benefits from innovation undertaken outside of its borders, even by its own firms.

However, the location of ownership of intellectual property (IP) is largely irrelevant to this argument – what matters is where the interactions between people and the intellectual property take place (i.e., where the invention is invented, refined, tested, deployed, and ultimately consumed). There may be an advantage to being the lowest tax-cost jurisdiction in attracting taxable ownership of specific types of IP, like patents, but there are likely no returns to advanced economies in achieving second place. The limited literature on Patent Boxes suggests that results for (more targeted) legislation in other jurisdictions are mixed at best.

A third normative economic justification for the Act would be to stimulate the development of a market for ideas. A market for ideas brings specialization in innovation, which increases economic efficiency. Moreover, there may be market failures in IP transactions. For example, if legislation effective reduced licensing costs then firms should be more willing to take licenses. They may then do so rather than engage in costly infringement, or they may include more license-dependent features in their products, and so forth. This could particularly benefit small firms, which are more dependent on the market for ideas.

This final economic justification is very attractive, at least if the Act could be realigned to it. However, one immediate issue would be whether or not the deduction should be weighted by R&D expense. Specialization would require entities that do not conduct R&D. But this may encourage another kind of moral hazard: abuse of patents and “trolling” behavior

Questions and answers

Question: The proposal includes a broad definition of “qualified property” for purposes of determining qualified gross receipts. Is that the appropriate scope of intellectual property that should qualify for the deduction?

Answer: No. Any scope beyond just patents has little if any normative economic justification. Even patents suffer from a moral hazard issue.

• There is no market failure associated with films and video tape.

• There is limited (if any) market failure associated with closed-source computer software. Unless an outsider can review the source, the release of a piece of closed-source software does not provide information about the nature of the invention, save as through its observable functionality, and so cannot generate positive externalities.

• Incentives for either computer software or patents creates a moral hazard problem. Trivial code or patents, that do not constitute true innovation, will be claimed by firm as the basis of products or processes in order to minimize taxes.

• Section 936(h)(3)(B)(i) implicitly includes trade-secrets through ‘invention, formula, process, design, pattern, or know-how”. Providing incentives for firms to keep trade-secrets directly induces the market failures than much innovation policy is intended to mitigate. It also has an extensive moral hazard issue.

Question: To what extent should gross receipts from services that are directly related to a product that uses qualified property be included in the determination of qualified gross receipts?

Answer: It depends. Innovation is invention followed by commercialization. To the extent that a service is associated (directly or indirectly) with the commercialization of an invention, incentivizing such a service with a tax deduction will incentivize innovation.

• However, allowing deduction for associated services will induce moral hazard as it will be difficult, if not impossible, in practice to discern between directly associated services and indirectly associated or unassociated services.

• Correctly allocating value (for example between services associated with externality-generating innovations and externality-less innovations) is highly problematic. See below.

• Weighting deductions by R&D expenditure disincentivizes the creation of a market for ideas, where many participants act as intermediaries.

Question: What would be the appropriate approach in determining the expenses properly allocable to innovation profits? Should the proposal just include authority for the Secretary to adopt allocation rules or is more specific guidance necessary?

Answer: There is no appropriate approach, save as in very in specific instances, nor are there any well-founded rules for the Secretary to adopt. It is essentially impossible to design welfare-maximizing rules that have generally applicability for ‘other dispositions’.

• Allocating value to single component products is feasible. Many pharma products are associated with single patents, or a small number of patents all held by a single manufacture. One can deduct manufacturing and other expenses at cost (one can assume that these are essentially competitively provided and so accrue no value beyond cost) to calculate component value. IP is estimated to account for 80% of value in some pharma. However, R&D tax credits already incentivize this activity.

• Using bargained value as a measure of allocable value is straight-forward. Thus patent licenses (even for portfolios), as well as infringed settlements bargained through the courts) could be rewarded by new legislation.

• Allocating value efficiently to components of a multi-component product (‘other dispositions’) is, in general, an extremely difficult problem in economics.

o Suppose that two firm’s patents are used to make a product and that the patents are complementary: one alone would make a product with $10 value but together they make a product with $40 value. How do you allocate the $20 complementarity created between the two of them?

• Given information asymmetries between the firm and the tax collector, any allocation of value will lead to moral hazard.

o Patents on ‘valueless’ inventions will be sought. Suppose that a firm can build a component using public domain knowledge or pursue an almost identical method that embodies the tiniest and least useful of inventive steps but that could be patented. As the patent would qualify the firm for a tax deduction on some allocation of the product’s value, the firm should pursue the patent.