Disrupting the market for tax planning.

As Curry, Hill, and Parisi emphasize, the net effect is theoretically indeterminate. Nevertheless, given the long existence of the patent system, it is reasonable to assume that the best guess is that patents increase the supply of ideas. Whether this extends to tax patents depends on the particular cost structures in the industry (of tax advice).

One of the key features of the tax advice industry is that it is relatively inexpensive to create new tax ideas, at least compared with the costs of creating ideas in many areas. The costs of creating a very innovative tax strategy is likely to be at least one and maybe two orders of magnitude less than the costs of, say, finding a new drug. The implication is that inventors do not need a lot of incentives to come up with new ideas. They will arise without patents. On the other hand, the possibility of exclusion means that patents may significantly increase the reward to being first. In the normal (socially valuable ideas) case, the balance is likely to lead to the conclusion that patents are not helpful in these circumstances. Without patents, the ideas will be developed anyway, the benefits of acceleration likely to be small, and the costs of exclusion the same as in other areas. In the tax case (socially wasteful ideas), we might then want patents: the benefits of exclusion may exceed the costs of incentives.

Low cost of development is also what leads to the potential anticommons problem--whatever you find is very likely to have been found by someone else. Many industries live with this problem, so, tax lawyers, welcome to the club. You have got nothing special to complain about. Moreover, to the extent that the anticommons problem reduces tax reducing strategies, it is a good thing. On the other hand, the anticommons problem may reduce compliance, in which case tax patents would be undesirable. Remember that the original business methods patent case, State Street, (10) involved tax compliance--it was about a method of making reverse 704(c) allocations in a hub and spoke mutual fund system. Many complicated and potentially patentable tax ideals may also be about compliance: think about the record keeping complexities of many tax rules, such as the UNICAP rules or rules for interest allocations. It is easy to imagine innovative compliance mechanisms deserving of patents. One possibility could be a return to the days when the patent office examined whether patents were socially desirable before granting them.

A second factor is that patent holders would have no easy way to determine when someone else is violating the patent--tax returns are secret. On the other hand, if the tax advisor is potentially subject to malpractice for advising a client to enter into a patented strategy, even a remote possibility of enforcement may be enough.

Third, we need to understand the likely scope of the patents, a matter likely to be resolved only through litigation. If the scope is interpreted narrowly, substitutes may be readily available, reducing the ability of the patent holder to earn profit and also to restrict supply.

Fourth, we need to understand the effect of tax patents on how tax ideas get disseminated. Right now, there is a fairly robust discussion of ideas at conferences, in articles, and among professionals. Although undoubtedly some techniques are closely held, I have the impression that most top level professionals know what the leading techniques are. Patents may change that dynamic, although it is not obvious in which direction. One possibility is that there will be less sharing as the possibility of patents makes sharing costly. On the other hand, basic ideas might be shared more widely to establish clear evidence that they are not new and, therefore, cannot be patented. If so, the threat of patents may actually increase dissemination of tax ideas.

There is much work to be done to understand these effects. Moreover, other industries might be quite similar to the tax advice industry but are producing a socially valuable product. Whatever conclusions we draw about tax patents may have implications for those other industries and vice versa. Thus, if the speculation that tax patents may possibly reduce innovation is correct (which would mean that we want patents in tax), it would also mean that we would not want patents in similar areas.

Finally, I was struck by Curry, Hill and Parisi's suggestion that the government purchase some key tax patents and refuse to grant royalties. (11) This idea seems very clever, although the government, in such a case, could always simply prohibit the strategy by law rather than by owning the patent. Perhaps a more promising route is for a nonprofit who cares about tax compliance, to patent some tax ideas. For example, Citizens for Tax Justice could hire a few good tax lawyers to invent some strategies and patent them. It could then hold the patents tightly, thereby preventing a variety of tax shelters.

I do not yet have a well-informed view on tax patents, except that (i) the issue seems complicated and (ii) they may be here to stay, so that secondary issues such as their scope and which ideas can be patented, may be where the action is. Once we get over the fact of tax shelter existence, we can begin to work to ensure that they are socially valuable: to make them encourage or at least not hurt compliance, but discourage or at least not increase sheltering.

IV. THE TAX SHELTER MARKET

The heart of Curry, Hill, and Parisi's article is the idea that the government can reduce tax sheltering by creating or exploiting market failures. (12) This is a very interesting and, as far as I know, original idea. The analysis of tax patents naturally falls within this category, but it is much broader than patents alone. The authors take the usual list of market failures and see how they might apply in the tax context.

Curry, Hill, and Parisi go through all of the well-known reasons for market failure. Because they try to be complete, it is not the case that each of these failures has an equal likelihood of applying in the tax context. Thus, creating a lemons market does not seem likely to help, at least for corporate tax shelters where the taxpayers tend to be well advised. On the other hand, it might work in the individual tax shelter market, where individuals may have a harder time discerning quality. Misallocating risk, however, may work well in the corporate context, where the threat of sanctions on a tax advisor may substantially increase the effective risk aversion used when evaluating a strategy. Without taking a view on the merits of the recent indictments of tax advisors (mostly from KPMG), the threat of such indictments might be a way to inject a significant dose of risk aversion into the tax shelter market. Pressure on accounting firms with respect to their approval of accounting benefits for tax shelters may work for similar reasons--find a weak point in the chain of production where imposition of risk is likely to be very costly and put the threat of sanctions there.

One suggestion not pursued by Curry, Hill, and Parisi is preventing price discrimination. This prevents someone with an exclusive idea from fully capturing the benefits, thereby restricting supply to the monopoly supply. Limitations on charging fees based on a percent of tax savings can be seen in this light.

Curry, Hill, and Parisi point to four examples to illustrate their theories: the check-the-box regulations, (13) interest tracing (as opposed to pro rata allocation), (14) Circular 230, (15) and the Thompson/McNulty memo. (16) The check-the-box regulations and interest tracing, they argue, show that the government does not attempt to eliminate all tax reducing strategies, instead sometimes blessing them. Examples of this sort abound. The government lets taxpayers engage in tax reducing strategies all the time, with some of them producing significant revenue losses. It is difficult, for example, to estimate the revenue loss associated with tax havens, but if we wanted to eliminate them or at least significantly reduce their number, it would not be hard: the United States can have significant influence on the behavior of small, defenseless nations if it wants. My main comment is that it is difficult, however, to know whether holding back in such areas is a result of political failures (or more generally, political calculations), optimal tax policy, or just a mistake. Although I agree with Curry, Hill, and Parisi about the optimality argument, I do not know what to make of any particular example. On the other hand, the pervasiveness of tax planning and the corresponding limited attempt to reduce it by the government may be an indication that the costs of reducing tax planning are not worth the additional revenue that would be raised, consistent with Curry, Hill, and Parisi's suggestion.