Tax Analysts Blog

Patent Box: Good Intentions Gone Bad

Posted on Jun 8, 2015

Tax reformers and economists usually hate tax breaks. The way they see it is like this: Unprincipled politicians can’t resist giving away goodies. So our tax code is littered with complications designed to channel subsidies to the well-connected. This makes a mess of the free market. The economy’s efficiency suffers. And the rest of us are stuck with higher tax rates.

There are rare exceptions, however, to the general rule. Sometimes -- and we must emphasize how rare it is -- targeted tax breaks can help growth.

In the course of doing business, firms sometimes make and do things that affect the rest of the economy, but the costs and benefits are not fully reflected in the firm’s bottom line. If those things are bad, like emissions of sulfur, the government can tax them to get the economy working properly again. If the things are good, like new knowledge that broadly supports advances in science, the government can provide tax subsidies to boost knowledge creation up to optimal levels.

So, while it would be foolhardy for the government to get into the business of making furniture, it makes economic sense for it to directly fund research. And while there is every reason to oppose tax subsidies for particular activities like watch-making or carpentry, it makes sense to provide tax subsidies for scientists and engineers doing research and development.

That’s why since 1981 we have had a tax credit for industrial research and development. Less well known, but just as important, is the provision in our law since 1954 that allows businesses to write-off their research expenses in the year they are incurred. (Under general principles investment in research, like investment in plant and equipment, should be written off over several years.)

Now several prominent members of Congress want to provide another tax break for research. At first glance, this seems like a very good idea since the usual objections to tax breaks don’t apply. And most regular people understand that the competitiveness of our nation -- or in politics-speak, the availability of high-paying jobs -- depends on technology.

The new tax break is called a patent box. (The “box” referred to here is the box checked on tax forms in Europe where this idea originated.) The general idea is that income from technology pays tax at a substantially lower rate than other income. So if under tax reform we could get the corporate rate down to 28 percent, patent box income would be taxed at a 14 percent rate.

The problem with this approach is that no one knows even a halfway good way of identifying “income from technology.” When a modern business generates profits, it is from a wide and often complex combination of inputs, such as plant, equipment, materials, good location, a skilled workforce, favorable government regulation, clever management, and technological prowess. It is hard to trace profits back to a particular input. If you ask a baker the cost of eggs that went into making a cake, she could tell you to the penny. If you ask the baker what the income is from those eggs, she would look at you quizzically, and then if you insisted, she would have to hire a consultant who, despite a lot of technical mumbo-jumbo, would only provide a good guess.

Trying to isolate subsidy-worthy income derived from innovation and technology is a fool’s errand. No, I take that back. It's a tax planner's errand. A lot of money can be made by thinking up all sorts of reasons why income from the sales of certain products is tech-related. And the flip side of that is the large tax savings that come from the simple allocation of expenses to other products that can’t qualify for the lower rate. For tax consulting firms this is a dream come true. For tax administrators it is a nightmare -- a needless expansion of the problems they already face in international taxation where aggressive profit shifting is rampant. In international tax, there is endless dispute about what portion of a multinational’s profit is in the United States and what portion is in a tax haven. With this new incentive there will be the same messy problem. But this time it will be about what portion of income is qualified for patent box treatment.

You may believe technology is so important to our economic future that giving the IRS headaches and letting some smart tax advisors make a little extra dough is worth it. And that may be true. But here's the kicker: There are far easier methods than a patent box for delivering tax benefits to technology.

The research credit has been in the law for over three decades. It is far from perfect and is complex in its own right. But compared with the integral calculus involved in a patent box, the research credit is third-grade arithmetic. If we want to promote technology we can just raise the 20-percent credit rate just passed by the House to 30 or 40 percent or whatever percentage Congress likes. Alternatively, Congress could -- as is done in some other countries -- allow more than 100 percent of expenses to be deducted in the first year. This is called a super-deduction.

These alternatives are not only simpler, they provide a far more cost-effective incentive to knowledge-creation because the incentive is proportional to the research effort. Patent boxes in practice often provide tax benefits to income from low-tech products. And once income from a product qualifies there is no incentive to increase research for further development of that product.

So we already have simpler and more efficient methods of delivering tax benefits to innovation and technology on the books. Why, in our attempts to make our economy smarter, would we adopt an incentive so dumb?

Read Comments (4)

edmund dantesJun 8, 2015

Great post, Mr. Sullivan. Couldn't agree with you more. Thanks for calling
attention to it, I hadn't heard about the patent box.

wolsonjrJun 8, 2015

considering the current state of our patent system, this is pretty scary

emsig beobachterJun 9, 2015

Research & development is already very heavily tax-favored, as you have so ably
explained. Why not give the patent holder a choice -- income from patents taxed
at one-half the current rate; or reducing the time the patent is in force by
one-half. I don't see any reason to over-subsidize the patent holders when they
are doing something they would do anyway. The R&D that is occurring is usually
in response to competitors' efforts; and, to earn super-normal profits. I
believe the protections provided by the patent system and the tax credits are
sufficient to compensate researchers for the positive externalities generated.

Jeff KadetJun 16, 2015

Marty, excellent summary. If you haven't already done so, you might consider
getting to word out to the masses through an op-ed piece or some other
appropriate mechanism.

Jeff

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