Patents, tax shelters, and the firm.

The results for industry structure and innovation depend on whether most firms usually follow a policy of secrecy or openness. The secrecy strategy slows the diffusion of new planning strategies across the industry. It also reduces employee mobility. On the other hand, it probably creates a stronger incentive to innovate in the first place, as innovators profit from their ideas for a longer time. This effect is complicated, though, by the fact that would-be innovators will be less aware of what their competitors are doing, and hence less able to borrow ideas from them. Particularly with the trade secrecy strategy there will be a tendency to relatively large firm size, as employees tend not to move and start up new firms and as older firms tend not to take on new ideas from innovative start-ups. For both reasons, there is less incentive for persons with interesting new tax planning strategies to go out and start up a new firm to develop, promote, and use that strategy.

VI. TAX PLANNING WITH BUSINESS METHOD PATENTS

What happens to the scenario we have described when one introduces a possible new strategy for tax planners, namely the option of patenting new planning strategies? The comparison to a regime without patents depends in part upon whether a firm that now decides to patent would otherwise have followed an approach of trade secrecy or of no protection. We assume that most firms that decide to patent a new strategy would have otherwise followed a trade secrecy approach. The expense of patenting will be worth incurring only if one expects a new strategy to be profitable for a long period of time. As we saw before, where that is true the trade secrecy strategy is more likely to be the more profitable approach as compared with no protection.

With a patent, a firm will have less fear of competitors copying its strategy, because if competitors do so, the firm will be able to take legal action to stop the infringement. Thus, the firm does not need to protect the idea via confidentiality agreements with its partners and its employees or via non-competition agreements with the latter. (37) The firm will be more willing to enter into arrangements with other firms to create, develop, and modify new planning strategies. Employees will be able to move between firms more easily, both because they are not subject to non-competes and also because they and their new employers will have a clearer sense regarding which ideas can and cannot be transferred with the employees from their old jobs. (38)

These changes are likely to have a decided effect on the creation, development, and diffusion of new tax planning strategies. New strategies will diffuse across firms more rapidly, as firms are more willing to share new strategies with business partners and as employees circulate more rapidly among different firms, taking their knowledge with them. (39) As these new strategies spread across firms, they will be modified and adapted into yet more new strategies. The creation of tax planning strategies is modular and cumulative--more complicated new ideas draw upon the elements of earlier, simpler strategies. (40) There will also be a somewhat increased incentive to develop new strategies as their creators are able to profit from the use of their strategies by others.

As our discussion of intellectual property and the theory of the firm suggests, this kind of change in the availability of proprietary rights is also likely to have effects on firm size and industrial structure. On balance, we would expect to see a move to something closer to the so-called "Silicon Valley model." Scholars who have studied the development and success of Silicon Valley have argued that innovation occurs because of employee mobility among firms, which seems in turn to be due to the relative lack of non-competition agreements and trade secrecy enforcement. (41) Similarly, in the tax planning industry, the introduction of patents may better allow entrepreneurial employees to launch innovative start-ups that have developed new planning strategies. If successful, these start-ups or spin-out firms will be able to license these strategies to others. Both increased employee mobility and greater ease of contracting with other firms tend to push in that direction.

There are a few counter-effects that could push the tax planning industry in a different direction. For one, the standard short-term effect of granting a degree of monopolistic power (42) to innovators may discourage diffusion to some competitors. Competitors will have to pay a licensing fee to use a patented strategy, and some may be unwilling to do so. If the patent holders could perfectly price discriminate, this would not be a problem, but perfect price discrimination is typically not possible. (43)

More interesting and serious is the possibility that patents could create an anticommons in tax planning. Scholars studying the proliferation of real property rights have held that granting rights to too many small parcels of land can create a "tragedy of the anticommons"--the inverse of the classic tragedy of the commons. (44) Property rights are typically granted as the private ordering solution to the tragedy of the commons; the inefficient over-use of resources. But too many property rights may lead to the inefficient under-use of resources. In this situation, property rights are too fragmented, and the transactions costs of negotiating with diverse property owners is too high, to accomplish comprehensive development projects. Some property owners may "hold-out" for excessive rents, inefficiently frustrating beneficial development that includes their parcel. Some follow-on scholarship has suggested that this same effect can occur with intellectual property, particularly with fragmented patent rights. (45)

In the case of tax planning, recall that creating new tax planning strategies is a cumulative and modular process that builds upon earlier strategies. If patents have a broad and vague scope, they may actually inhibit innovation. A would-be innovator might find that many firms hold patents on strategies that she could potentially use, and hence infringe upon, in her new strategy. The innovator would then need to negotiate licenses with the holders of the various patents. However, if there are many such holders and if the scope of their rights is unclear, negotiation may be costly and subject to breaking down. If these costs are high enough, they may stop some innovations from happening at all. The result may be less creation of new planning strategies and more limited diffusion than in the absence of patents. (46)

An extensive anticommons problem could also reverse the predicted effect on firm size. One way that firms may react to an anticommons problem is to integrate the holders of various complementary patents into one firm, thereby reducing or eliminating the anticommons problem. (47) Thus, the effect of introducing business method patents for tax planning strategies could conceivably be to increase the size of firms within the tax planning industry, rather than decreasing firm size as predicted above.

This sort of ambiguity in predicted effects is unfortunately endemic when considering the effect of intellectual property law on firm size and structure. (48) The effect of weak versus strong property right protection on inter-firm and intra-firm transactions is typically non-monotonic. For instance, increasing the strength of inter-firm property protection from a weak level initially leads to smaller firm size, as more firms choose to do transactions between firms rather than within. However, if property protection continues to increase beyond an optimal level, the anticommons problem kicks in, and further increases in the strength of property rights above that level will lead to larger firm size. A similar effect, with the directions reversed, occurs for changes in property rights that affect intra-firm transaction costs.

What then are the likely net effects of introducing business method patents into the tax planning industry? We suspect that the anticommons problem is not likely to dominate, although this is just an educated guess--we have no systematic empirical support for it. Indeed, it is probably too soon in the evolution of the industry to be able to tell, since the proliferation of business method patents is relatively recent. That makes this an interesting industry to watch in the coming years, to see how the changes in patent law affects the industry.

If we are right about the relative unimportance of the anticommons problem here, then the overall effects will be as suggested above. Average firm size will decrease, and there will be more innovative start-ups peddling new tax planning strategies. Firms are also likely to become more specialized. The creation of new tax planning strategies will increase, and the new strategies will diffuse more rapidly across the industry.

VII. EVALUATING THE CONSEQUENCES OF BUSINESS METHOD PATENTS

In the preceding parts we have considered the likely effects of business method patents for tax investment strategies on firm organization in the tax planning industry and on incentives to create and market new tax planning strategies. We found that the possible effects are complex and ambiguous. However, it seems to us most likely that the availability of business method patents will lead to smaller, more specialized, and more entrepreneurial firms providing a wider range of planning strategies, and also to faster diffusion of the new strategies.