The case for tax: a comparative approach to innovation policy.

• Author: Mahaffy, Shaun P.

NOTE CONTENTS INTRODUCTION INNOVATION SUBSIDIES AND SOCIAL WELFARE A. Why Subsidize Research? B. Patents C. Tax II. AN INSTITUTIONAL COMPARISON A. Administrative Costs 1. Administrative Costs of Patent 2. Administrative Costs of Tax 3. Comparing the Administrative Costs of Patent and Tax B. Subsidy Timing 1. Subsidy Timing in Patent and Tax 2. Identifying and Curing High Delay Costs C. Rewarding Failure D. Institutional Competence 1. Comparing Institutional Competences of Tax and Patent 2. Policy Implications CONCLUSION INTRODUCTION

How should the federal government encourage innovation in the United States? Policymakers have a menu of choices at their disposal. They can give cash grants, issue patents, offer prizes, or provide tax breaks. But when legal scholars set about answering the question, they tend to focus on their areas of expertise. Intellectual property scholars typically talk about patent scope or duration, the doctrine of equivalents, and disclosure requirements. (1) Tax scholars argue that research tax credits should be larger, permanent, or more easily accessible. (2) Sometimes these scholars acknowledge that their chosen institution should treat different technologies or industries differently. (3) But how to deploy an institution--patent, tax, or spending--to encourage innovation should be the second question we ask. The initial, oft-overlooked (4) question is the following: which institution (or mix of institutions) should we use in the first place?

This oversight is surprising for the simple reason that the stakes are so high. Federal research and development tax incentives total more than $10 billion annually; (5) the rents that patent holders collect are hard to estimate, but they probably top $30 billion every year; (6) and the National Institutes of Health (NIH) alone distributed over $30 billion for medical research in 2012. (7) These cash and cash-equivalent distributions--which drive much of the research that fuels the U.S. economy--often have overlapping targets. Yet the subsidies themselves, the way they are allocated, and the institutions that distribute them are substantially different. These differences should inform our choice of how to encourage innovation.

To illustrate, consider the emerging technology of DNA computing, (8) There are several potential advantages to using DNA to store data and conduct computations. (9) The research is still mostly of the basic variety, although commercial entities have started to show some interest. (10) How should the government encourage this nascent research as it becomes commercially viable? One of the arguments that I will make in this Note is that the patent system may be a poor fit for such a field. For instance, the patentability of a DNA computer--and the computer's related interactions with human cells--seems presently uncertain. (11) The eventual patentability determinations will lag the technology by decades and will not necessarily be motivated by sound policy rationales. (12) Moreover, the patent system might underfund such early-stage research, as many of the developments--while critical to charting the field--will not themselves yield any commercially viable products. This decreases the value of patenting such discoveries. (13) Other subsidy systems are not so limited; research tax credits, for example, are distributed ex ante regardless of commercial success. Moreover, the institution overseeing the tax system has the data-gathering tools to make informed decisions about qualifying research. As will be discussed throughout this Note, these advantages recommend using the tax system to fund emerging technologies like DNA computing.

The thesis of this Note is that tax may be a more effective driver of innovation than previously recognized. But my suggestion is not an across-the-board increase in tax credits. Rather, I will recommend that Congress should reallocate the $10 billion in annual research tax expenditures to more narrowly target those domains where tax is most effective. To get to this conclusion, I will compare the institutions of patent and tax, and argue that the strengths of tax complement the weaknesses of the patent system. My suggestion is that Congress should focus its tax expenditures on those areas of research where patents fail and tax excels.

While my analysis will hopefully demonstrate the value in a comparative institutional analysis, I admit that I am not taking on the choice-of-institution question in its entirety. I am focusing on tax's strengths relative to patents--and largely ignoring grants and prizes--for a variety of reasons. First, patent and tax are the two institutions primarily focused on encouraging commercial research. Grants fill a different niche, as they tend to be directed at basic, university investigations. Second, neither patent nor tax requires that government officials decide ex ante whether or not any particular research qualifies for the subsidy. Federal grant programs involve scientist-officials approving promising research before it takes place. Traditional prizes require some upfront goal specifications. There are plausible arguments that this style of top-down directed research is inefficient. (14) Third, the case for prizes, in particular, has already been made. (15) Notwithstanding these cogent arguments, the federal government has shown little inclination to convert to a prize-oriented system of innovation subsidies. (16) By contrast, the government is extremely comfortable distributing tax subsidies to promote favored types of research. Thus, by focusing on tax, I hope to make a series of suggestions that might actually be implemented by the federal government. Finally, as I hope to show in this Note, patent and tax are complementary in many respects. Comparing these institutions illustrates their advantages and limitations. I leave for another day the question of whether prizes and grants have similar strengths and weaknesses and how they could be added to the institutional mix.

Part I of this Note lays the groundwork necessary for my argument: first, by explaining the economic logic for government subsidies to innovation; and second, by describing how patent and tax affect social welfare by encouraging more optimal research decisionmaking.

Part II analyzes several specific advantages of tax subsidies relative to the patent system. Along with exploring tax's comparative benefits, I describe the innovation environments in which these advantages are particularly important. I identify four considerations that should inform a choice between patent and tax when the government's goal is to foster socially beneficial research decisions. (Table 1 offers a summary.) The first important difference between tax and patent is tax's relatively low administrative cost. When inventors are filing low-value or multiple patents, these lower administrative costs will make tax comparatively efficient in encouraging innovation. The second difference is subsidy timing. In situations where credit markets are imperfect, tax's upfront payments ease the burden of research costs, which is particularly valuable for small inventors. The third difference is tax's reward for risk taking. When failure is valuable, tax may be preferable. The fourth and final point is institutional: tax's rewards are more flexible and immediate, while patent is perhaps more predictable over a longer time frame. These differences favor tax in situations of technological change and emerging industries. Implementing the changes that flow from these observations could dramatically improve the productivity of hitherto neglected research environments while simultaneously cutting the costs of duplicative subsidies.

1. INNOVATION SUBSIDIES AND SOCIAL WELFARE

   1. Why Subsidize Research?

      Innovations are slippery things. Sometimes they come unexpectedly and effortlessly, like a bolt in the night. But other times they are the product of systematic, careful investigation. This Note is concerned with how government policymakers should best stimulate such research-driven innovations. But first we must ask the prior question: why should we be encouraging research at all?

      Even in a world without any government help, entrepreneurs would still investigate new technologies. (17) Indeed, many of the most important inventions in history have sprung forth without much or any meddling from the government. (18) Nevertheless, there are good arguments in favor of subsidizing research. Perhaps the best reason is that research can produce spillover benefits--positive externalities benefiting someone other than the inventor. (19) These are benefits that the researcher herself cannot appropriate. Consider, for example, Ford Motor Company's development of the moving assembly line in the early twentieth century. To be sure, Ford made a handsome profit from this innovation--it was able to make cars much more cheaply. However, the value of this innovation far exceeded the value to Ford Motor Company alone. Other manufacturers soon imitated Ford's improved process, which allowed them to also use their capital and labor more efficiently. (20) In the parlance of innovation theory, we can say that Ford was unable to appropriate the full value of its innovation.

      As a general rule, individuals will engage in research when the research's expected value--to the inventor--is greater than the research's costs. But when researchers cannot appropriate the full value of their innovations, those innovations may be underproduced. (21) This is a critical point that motivates most government expenditure on research. Imagine that an executive at Ford is deciding whether to spend money researching an assembly line. She estimates that the company could undertake a project costing $100,000 that would yield a 50% probability of producing a productivity-enhancing process that could earn the company $150,000. As a profit maximizer, she will reject this research plan...