I. INTRODUCTION
The United States patent statute offers exclusive rights in any new
and useful "process, machine, manufacture, composition of
matter" or new and useful improvements on existing processes,
machines, manufactures, and compositions of matter. (1) Courts have read
this Congressional subject matter mandate broadly, to include
"anything under the sun" developed by humans. (2) Among the
processes covered by the patent statute lie a variety of innovative
methods for accounting, investment, and other business strategies. (3)
And among such patentable business strategies lie a variety of methods
for sheltering income from taxation. (4)
Business method patents are relative newcomers to the patent
system, having been formally recognized as patentable subject matter for
a little less than a decade. Explicit realization that patentable
business methods necessarily include patentable tax shelters seems to be
even more recent. We are aware that this realization has been the
subject of controversy, and even alarm, among practitioners of tax
law--hearings have been held, opinions have been voiced, and legislative
action has been demanded. (5) The general tenor of the reaction from the
tax bar appears to be one of anxiety bordering upon panic.
But from the standpoint of patent law, none of this is particularly
startling or even especially exciting. To be sure, there has been an
enormous amount of discussion and controversy about the patenting of
business methods. Patents are typically justified as an incentive for
innovation. Numerous commentators have questioned whether such an
incentive is really needed in the area of business methods and, if an
incentive to innovation is needed, whether patents are the right
mechanism to do the job. (6) But once business methods are allowed as
patentable subject matter, the presence of tax shelters among such
methods is neither much of a doctrinal novelty nor much of a surprise.
Consequently, in this article we examine certain effects of tax
shelter patents but take the existence of tax planning patents as given,
assuming that the die for such patents was cast well over a decade ago
and is unlikely to undergo a reversal at this late date. As a matter of
U.S. patent law, the emergence of tax planning patents was probably
inevitable and is almost certainly irreversible. Accepting the patent
status quo allows us to move to the more interesting question of how
such patents are likely to affect the firms that specialize in tax
planning and the employees who move between such firms.
In approaching these questions, we draw upon our previous work
regarding the role of intellectual property in the theory of the firm.
(7) We compare the emerging regime of tax investment patents with the
confidentiality regime that has prevailed for investment methods in the
tax planning industry. Moving beyond the standard costs and benefits
analysis of patents as incentives for innovation, we discuss the likely
impact of tax investment patents on the profession and industry of tax
planning. We look in particular at the mobility of tax planning and
investment professionals before and after the implementation of tax
investment patents. We argue that the advent of tax investment patents
may benefit members of the profession, as opposed to their opportunities
under the alternative regime of confidentiality. In particular, it may
lead to increased labor mobility and to greater entrepreneurial
opportunities, with the growth of a new sector of start-ups specializing
in innovative tax planning strategies. We finish by considering the
social consequences of business method patents for tax planning
strategies. We conclude that although the effects are mixed, and
potentially negative on net, there is little that one can feasibly and
desirably do within patent law to address the resulting problems without
upsetting large parts of patent law.
II. BUSINESS METHOD PATENTS
The patentability of business methods has been manifest since the
United States Court of Appeals for the Federal Circuit in State Street
Bank (8) explicitly disclaimed any prohibition on the patenting of such
methods, although the patenting of such methods clearly occurred on an
intermittent basis even prior to State Street. (9) Patent doctrine had
traditionally resisted the patenting of processes that might be carried
out in the human mind, as well as the patenting of inventions consisting
of written or printed indicia. (10) This for many years effectively
precluded the patenting of the majority of business methods, most of
which involved mental processes, written methods, or both. (11)
But these prohibitions were largely eroded by the gradual
incorporation of software into the ambit of patentable subject matter.
(12) While software is at its core a set of voltages in a machine, these
are represented as a type of written code that can sometimes be read by
humans and sometimes read by machines--a functional form of writing that
"behaves." (13) Software also frequently implements
calculations or numerical manipulations that could otherwise be carried
out in the human mind. Consequently, the acceptance of software within
patentable subject matter undermined the prohibition on which the
preclusion of business methods from patent law was also grounded. (14)
The implementation of business methods as software cemented this
outcome, such that the State Street holding was primarily an admission
of de facto practice.
This is not to say that business method patents have been placidly
accepted or even that they have become uncontroversial. In one sense,
the grant of any patent is a troubling practice; patents and other forms
of intellectual property artificially raise prices, restrain trade, and
restrict access to what would otherwise be a publicly available good.
These costs of exclusivity are typically justified as being outweighed
by the benefit of intellectual property as an incentive to investment.
(15) Without some period of legal exclusivity to recoup the cost of
investment in what would otherwise be a public good, little investment
in new innovation would occur, resulting in the underproduction of
technical and creative works. The precise contours of the optimal
package of exclusive rights to encourage innovation is hotly contested,
as both the actual benefits and actual costs of such a system are
enormously difficult to quantify, and the correspondence between
economic theory and real-world implementation is highly uncertain.
Given the uncertain ratio of cost to benefit for any patent,
numerous commentators have challenged the expansion of patent law. Some
have argued that on doctrinal grounds, the patent statute contemplates
technological rather than business-oriented subject matter. (16) Other
commentators have questioned the procedural feasibility of business
method patents--the Patent Office has little expertise in evaluating
business-related innovation. (17) Yet other commentators have challenged
the policy basis for such patents; there is little evidence that
development of business methods requires the extra incentive provided by
intellectual property or that the costs of bestowing exclusive rights on
such innovations will be exceeded by the social gain in business
innovation. (18)
For all of these reasons, foreign patent examination corps,
especially the European Patent Office (EPO) have been fighting a losing
rearguard action to resist such patents, demanding that patent
applications have a "technical" aspect to them--a criterion
intended to exclude business methods and related subject matter. (19)
But in the United States, given the structure of the patent system,
patenting of tax planning methods was probably inevitable once software
patents became the norm. (20) If software is patentable, some number of
software implementations will be business related, opening the door to
patenting of business methods. If business methods are patentable, some
number of those business methods will concern investment strategies. If
investment strategies are patentable, some number of those strategies
will concern tax planning. QED.
We return to this question in more detail in Part VII, where we
examine the desirability of business method patents for tax planning
strategies. Here our point is that the specific questions regarding tax
planning patents do not exist in a vacuum; they are inextricably tied to
the general questions regarding business method patenting. Consequently,
any discussion of the effects of tax planning patents must begin by
considering the effects of business method patents; having considered
the characteristics of the business method genus, we can turn to the
peculiarities of the tax planning species. We approach both classes of
patent from the standpoint of confidentiality and disclosure, since
these are not only key considerations in implementing investment
strategy, but are also key considerations in justifying the patent
system generally. The issue common to all these contexts is the cost of
controlling of valuable information, which frames the discussion of tax
planning patents.
III. BUSINESS PATENTS IN AN EFFICIENT MARKET
While critics have questioned how well business method patents fit
standard patent justifications, that is, regarding their ability to
provide economic incentives for innovation, the special economic
peculiarities of such patents have received less scrutiny. In
particular, desirability of investment patents may deserve consideration
in light of the efficient market hypothesis. In its strongest form, this
economic theory holds that the prices in markets reflect all the
available information concerning traded commodities, so that excess
returns to investment are impossible. Weaker forms of this hypothesis
hold that some temporary disparity between market price and actual value
may be possible, allowing some excess returns to those who have access
to better value information, but that the very activity of pursuing
undervalued commodities will cause their prices to rise, rapidly
dissipating any advantage gained from the privately-held information. In
other words, the communicative nature of prices in markets rapidly,
although perhaps not instantaneously, makes privately held investment
information public. (21)
This hypothesis has important implications for investment
strategies generally and for the policy of patenting such strategies.
Investment strategies, whether patented or unpatented, are almost by
definition intended to outperform the market--there is no other reason
for the development of such strategies, since the recognized,
understood, and simple approach of buying and holding a diverse
portfolio of investment instruments would otherwise yield the optimal
outcome. The efficient market hypothesis predicts that attempts to
outperform an efficiently functioning market will fail. However, an
investment strategy that may be exploiting some imperfection or
inefficiency in the market may yield better returns than the market as a
whole, at least until the information about the inefficiency leaks out,
attracts other investment, and the profits from that investment anomaly
are competed away. (22)
The question for investment strategies based upon anomalies, then,
is how quickly they will be noticed and dissipated. If the market is
sufficiently transparent, this may occur simply by observation of
pricing in the marketplace. If for some reason market pricing does not
reflect the desirability of the investment strategy, the information may
reach the marketplace through other channels--such as gossip.
Opportunism or entrepreneurship on the part of those conducting the
investment transaction may also play an important role in disseminating
information about the strategy. Employees familiar with the strategy may
personally employ it for their own benefit or may use the information
gained in the service of the firm to service their own clients, perhaps
by leaving and founding their own brokerage. Indeed, competing
investment firms may attempt to hire experienced personnel away from
their competitors in order to get the benefit of that competitor's
specialized knowledge for their own clients.
This of course presents a problem of confidentiality for those
exploiting market anomalies. One strategy for containing such
information leakage is to treat the investment strategy as a trade
secret, prohibiting employees from discussing it with those outside the
firm, from using the information for their own benefit, or from using
the information in the service of a new employer. Obligations of trade
secrecy arise from a number of legal sources, including a duty of
loyalty to the employer in tort and prohibitions on unjust enrichment in
the law of restitution. But a common source of trade secrecy obligation
arises out of contract, through employment of confidentiality agreements
and possibly non-competition agreements. These agreements may be used to
obligate not only employees to secrecy, but also clients who will learn
of the transaction, as well as business entities that may be involved in
transactions under the investment system.
Such agreements are common in many industries, but may be central
to preserving the profitability of investment strategies that are
profitable only so long as the market does not learn of their existence.
Yet confidentiality agreements are cumbersome to draft, to police, and
to enforce. They are also subject to the famous "information
disclosure paradox" formulated by Kenneth Arrow: the possessor of
valuable information will be reluctant to disclose information unless a
confidentiality agreement is in place, but the potential recipient of
the information will simultaneously be reluctant to sign a disclosure
agreement until he knows what information is to be disclosed. (23)
Consequently, Arrow predicts that disclosures under confidentiality
agreement will be impeded and often will not occur at all.
Patents present one solution to the information disclosure paradox,
by occasioning exclusive rights on the publication of an enabling
disclosure of the claimed invention. (24) An important factor in the
calculus of patent benefits is the public benefit of disclosure. In
order to obtain a patent, the applicant must disclose the claimed
invention in sufficient detail that one of ordinary skill in the
pertinent art could make and use the invention by following the
disclosure. (25) This disclosure is published as part of the patent
document, providing the benefit of the information to the public at
large and allowing anyone to practice the invention after the expiration
of the exclusive rights in the patented invention. In the rationale of
the patent system, disclosure of the invention is the public's quid
pro quo for granting the inventor exclusive rights.
But quite apart from such public benefits to disclosure is a
private benefit for negotiation and licensing transactions. The
publication of the invention disclosure in a patent places potential
licensees or purchasers on notice as to the nature of the invention,
while the exclusive rights in the invention prevent misappropriation
based on the disclosure. (26) Thus, aside from any effect they may have
as an incentive to investment or any benefit due to the increase in
public knowledge, patents are expected to lower transaction costs
between firms by avoiding the information disclosure stand-off that may
occur under purely contractual disclosures.
However, the public information function of patents remains
troublesome. The corpus of published patent disclosures unquestionably
provides a valuable technical library to the public. But careful
observers of the patent system have long been aware of a paradox in the
patent disclosure rationale. (27) The exclusive rights in a patent are
only valuable in comparison to the patent holder's next best
alternative, which is trade secrecy. Patent protection lasts for a
little less than twenty years, but trade secrecy lasts so long as the
invention remains generally unknown--essentially, so long as it is not
independently recreated or reverse engineered by another. A rational
innovator would prefer perpetual protection to twenty years of
protection, and so would presumably opt for trade secrecy if the
invention can be maintained as a secret. This in turn implies that the
rational innovator will opt for a patent only when the invention cannot
be maintained as a secret. Or, in other words, patents only disclose
information which would have become public anyway.
Where investment methods are concerned, this problem is even more
troubling. On a strong theory of the efficient market, information about
investment strategies will by their very implementation be communicated
via the market and their benefits dissipated away by the response of
other market participants. Patenting the investment strategy, however,
may legally exclude other market participants from responding to the
price information signaled by the behavior of the patent holder--in
other words, patents may lock in inefficiencies that the market would
have corrected. On this view, the patent grant not only exchanges
exclusive rights for information the public would have had anyway, it
also locks in a market distortion for a period of nearly two decades.
And since, on a strong theory of the efficient market, investment
strategies would be impossible to maintain in secrecy, the incentive of
a patent never prompts disclosure of otherwise inaccessible information.
On a weaker view of the efficient market, the prospects for patent
disclosure may be somewhat less bleak. Patenting will presumably still
not be an attractive option for investment strategies that might remain
viable and confidential indefinitely. However, it may be that the patent
will prompt disclosure sooner in those cases where the investment
strategy could not be maintained in secret for seventeen or eighteen
years, but might have been maintained for a significant period of time
less than that. Risk averse business innovators may opt for a certain
seventeen or eighteen years of exclusivity over a lesser period of
uncertain use, during which the strategy might be inadvertently
disclosed or independently discovered by another (and, indeed, patented
after independent discovery by another business innovator, in which case
the earlier innovator will be excluded or end up paying patent royalties
to the later discoverer). We suspect that it is in this class of
investment strategies where patenting will have the greatest effect,
particularly for tax investment strategies. And so it is in this class
of investment strategies that we consider the effects of the shift from
trade secrecy to patenting, in light of the theory of the firm.
IV. PATENTS AND THE THEORY OF 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.
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.
For most goods and services, the normative evaluation of these
effects would be relatively simple. Insofar as most goods and services
that meet a market demand increase net social welfare, then a policy
that leads to more creation and faster diffusion of those goods and
services is generally a good thing. However, tax investment strategies
may not be an ordinary service. There exists a fairly strong argument
that such strategies create a net social harm--they induce citizens to
waste resources on planning that lowers income to the government. (49)
Of course, this is to some extent a cost of adopting a tax system
in the first place. Taxation itself introduces distortions into the
market, changing the effective prices of goods and services, altering
price signals, and so changing the output of goods and services in
response to such signals. (50) At its best, taxation aims to solve the
problem of underproduction of public goods--the same problem addressed
in part by the patent system. However, depending upon the placement of
tax surcharges, the distortions created by taxation may run the gamut
from intentional corrections for market failures, to intentional
subsidies for politically favored outcomes, to unintentional penalties
for otherwise productive activity.
If a tax investment strategy constitutes a deliberate governmental
correction of a market failure, or subsidy or incentive toward a
preferred type of economic activity, then patenting that strategy might
frustrate Congressional purposes by excluding investors from the desired
activity. This scenario seems unlikely to us, however, as patents must
meet statutory criteria of novelty and non-obviousness. (51) If a
particular investment strategy has been openly contemplated and debated
by Congress, that public discussion likely renders it obvious and
publicly known, and so by definition unpatentable. In order to be
"innovative," patentable tax shelters are likely to be
previously unnoticed and probably unintended "loopholes" in
the tax system.
We leave it to others in this symposium to argue whether
non-abusive tax planning is a social bad. For this portion of our
article, we assume that it is a bad, because that complicates our
normative analysis. If you reject this assumption, you can ignore the
remainder of this part, and simply conclude that business method patents
are likely to have a net positive effect if our analysis in the
preceding parts is correct.
Given our assumption regarding the downside of tax planning, does
it make sense to use patent law as the preferred tool to intervene, in
order to dampen the effect of business method patents toward increased
use of new tax planning strategies? A simplistic initial answer might be
to concentrate instead on Service enforcement as the best way to
discourage tax planning strategies rather than tweaking patent law to
achieve this goal. However, a relatively simple theory of the
second-best approach (52) calls that answer into question. Service
enforcement and rulemaking are highly imperfect in their ability to
discourage inefficient planning strategies. Given such limitations,
perhaps it makes sense to use another policy tool, patent law, to
supplem