Patents, tax shelters, and the firm.

Notwithstanding the indeterminacy of intellectual property's incentive costs to benefit ratio and the dubious rationale for patents on a theory of disclosure, patenting may have other welfare enhancing benefits. Some commentators recently have begun looking at the potential benefits of intellectual property grounded in the theory of the firm, as articulated by Ronald Coase and subsequent contributors. (28) The theory of the firm argues that the size and structure of firms will be determined by the relative cost of transactions in a structured hierarchy versus in the open marketplace. (29) At some organizational size, for some purposes, a command and control type of hierarchy will be more efficient than market negotiations. Firms will form and grow to the point where the efficiencies of hierarchy are supplanted by the efficiencies of market competition.

Modern theories of the firm have identified property rights, including intellectual property rights, as important instruments in lowering transaction costs in the market. (30) Firms may negotiate with one another for production inputs and outputs, but the contracts covering such bargains will not foresee every contingency, and business partners may take such ambiguities as occasions to act opportunistically. Property rights serve as default rules to allocate resources when contracts are incomplete and parties behave opportunistically. Intellectual property may be especially important to such transactions, because unlike physical property, over which control can be maintained by actual possession, control over valuable information is surrendered as soon as it is revealed to a business partner. The availability of such residual rights in a firm's assets lowers transaction costs between firms, by providing some degree of security when bargained-for deals go sour.

At the same time, property rights, including intellectual property, may lower transaction costs within the firm as well. (31) The interactions of organizational divisions and personnel within the boundary of the firm may also be costly and uncertain, leaving room for shirking, self-dealing, and other opportunistic behaviors. Property rights help to ameliorate such behaviors, by securing legal ownership of the firm's assets to the firm and allocating the fruits of production between employee and employer. Intellectual property may be particularly important to employee mobility, by defining what types of intellectual assets may be taken by employees leaving the firm for new opportunities and what assets remain the assets of the firm they leave behind.

In previous work we have explored in detail the role of intellectual property rights in lowering transaction costs both within firms and between firms. (32) Since Coase and his successors predict that the boundary of the firm will be determined based upon the relative cost of transactions within the firm and between firms, we have argued that the optimal intellectual property regime must consider the interplay between both sets of costs. In some instances, a weak property regime such as trade secrecy will do too little to prevent employees or business partners from misappropriating the firm's knowledge assets. In other instances, a strong property regime such as patents will overly hamper employee entrepreneurship within the firm and negotiations between firms. Thus, we have argued that to strike the proper balance of transaction costs between firms and within firms, intellectual property regimes must be calibrated "just right." (33) For some industries and their constituent firms, the optimal regime might be a weak misappropriation right such as trade secrecy, but for others the optimal regime might be a strong property system such as patenting.

We have also suggested that a focus of particular scholarly interest should be industries that are transitioning between intellectual property regimes, for it is there that the effects of different forms of intellectual property on transaction costs should be most apparent. (34) The adoption of patent protection for tax planning strategies represents just such a transition, from a regime of confidentiality to a regime of strong exclusive rights--effectively from trade secrecy to patent. Even more than other investment strategies, tax shelters are likely to rely on confidentiality to remain viable. First, a stampede of investors toward a particular method of investment that exploits an unanticipated outcome of the tax system is likely to attract unfavorable attention from the Internal Revenue Service (Service) and Congress due to lost revenue; either legislative or administrative action may result to close the loophole. Additionally, to the extent that the shelter is dubious or possibly illegal, open disclosure may prompt administrative action including prosecution, fines, or penalties. Because of these additional concerns, the Service has issued rules requiring disclosure of potentially problematic investments, not to the public, but to the Service itself. The availability of patents as an alternative to confidentiality changes the transaction cost picture in each of these considerations.

V. TAX PLANNING WITHOUT BUSINESS METHOD PATENTS

The theory of the firm may therefore have a good deal to tell us about the consequences of tax shelter patenting, particularly about the effects of such patents on firms that offer tax advice and on the employees of such firms. Consider first the structure of the tax planning industry and firms that engage in tax planning before the introduction of business method patents. This was a regime of weak property rights--innovators in tax planning had to either rely on trade secrecy or else let others use their innovations without compensation. What were the effects of that regime on the incentives to innovate and to spread the use of new strategies? How did the weak property right regime affect the relative attractiveness of innovating and developing new strategies within firms versus between firms, and hence how did it affect the boundaries of firms within the industry?

As just mentioned, firms may respond to the absence of strong property rights (i.e. patents) by pursuing one of two strategies: protecting innovations via trade secrecy or just letting others take their ideas. Consider the trade secrecy strategy first. A firm with an idea for a new tax planning strategy may want to partner up with another firm or firms, either in developing the basic idea or else in letting the other firm develop modified versions of the basic strategy. However, here Arrow's Information Disclosure Paradox (35) arises: in negotiating with such potential partners the innovator will be afraid that if the partner learns about its idea, the partner will be able to use the idea for its own without compensation. Innovators can respond in two basic ways. They might refuse to share their ideas with any partners and keep them hidden from potential competitors or else they might negotiate confidentiality agreements with potential partners before sharing ideas. Both approaches tend to slow down the rate at which new planning strategies will diffuse among firms within the industry.

Similarly, the lack of the patent option also affects the relationship of firms with their employees. Its employees generate a firm's new planning strategies, and the set of its existing strategies exist within the minds of its employees. A firm trying to keep its competitors from copying its innovations must worry about its employees leaving to go work for those competitors, taking the ideas behind the innovations with them. A firm following a trade secrecy strategy will try to stop its employees from doing this. One way to do so is to have its employees sign non-competition agreements, at least where and to the extent that such agreements are legally valid. Another way to do so is to have their employees sign confidentiality agreements or in other ways agree not to use the firm's trade secrets if they go to work for others. This in turn will make the employees less attractive in the job market, as competitors are worried about what the employees will and will not be able to use if they come and work for them. Thus, in several ways a trade secrecy strategy will limit inter-firm mobility of employees, in turn reducing the spread of new planning strategies across firms.

The other strategy that firms might follow, in the absence of patents, is to simply not take any special precautions against competitors stealing their innovations in planning strategies. Even without such precautions it will naturally take some time for new ideas to spread through the industry, and a firm may profit from its innovation during the interval before competitors have adopted the innovation as well. (36) Such reliance on "first mover advantage" may be more attractive in the tax planning industry that in many others in that the useful life of many tax planning strategies, particularly abusive ones, is quite short. A firm and its clients can benefit from an abusive strategy only until the Service catches on and shuts down use of the strategy. It may be that this time period is short enough that few competitors will catch on in that time, and hence taking expensive precautions against being copied does not make sense. On the other hand, non-abusive strategies may continue to be used for a very long time, and so for such strategies, allowing one's competitors to copy will be more costly.