Should the US consider a patent box?

By / 4.13.2015

Who will write the new rules of the global tax system? Right now risk-averse bureaucrats at the OECD’s Paris headquarters are busily constructing a new set of tax principles–known as the ‘BEPS project’–that could accidentally squash global growth, as we warned in our recently released policy brief, “Taxing Intangibles: The Law of Unintended Consequences.”*

Instead, the rulebook for 21st century global tax policy must be written by those policymakers, in the US and elsewhere,  who understand the importance of risk-taking and investment in innovation.  This imperative drives the United States to consider concepts such as the “patent box,” a tax instrument that discourages tax avoidance by large corporations while encouraging the creation of growth-enhancing knowledge.

The “patent box”—or as it is sometimes called, the  “IP box” or “innovation box”—is already in use by countries such as the United Kingdom and the Netherlands. It gets its name from the idea that companies invest in research and development that leads to patents.  These patents are metaphorically put into the patent box, where they are taxed at a lower rate. Sometimes the preferential rates are broadened to other types of intangible investments, which is why it sometimes goes by a different name.

The underlying economic insight behind the ‘patent box’ is the indisputable fact that global growth is increasingly driven by knowledge, in the form of patents, copyrights, data, and other intangibles.  Unfortunately, the rising importance of intangibles means current tax rules are simultaneously too strong in some aspects and too weak.  On the one hand, statutory tax rates on intangibles is almost certainly too high. Remember that the investment in knowledge by one company or country spills over to other companies and countries, creating a positive externality for the whole global economy.  As a result, many economists agree that intangibles should be taxed at a lower rate to acknowledge their benefits.

On the other hand, under the current rules, the same virtues of intangibles that enable global growth also enable knowledge companies to easily transfer nominal ownership of intangibles to subsidiaries in low-tax countries. The combination of high statutory tax rates and easy transfers means that corporations have both an incentive and the means to legally and dramatically cut their taxes.

This state of affairs cannot persist.  Faced with political and fiscal pressure, governments will take aggressive steps to bring in more tax revenues.  Indeed, the BEPS project is advocating that governments  give up long-held notions of tax sovereignty to “capture” the income from intangibles, even if these measures end up hurting global growth.  Unfortunately, as we showed in our paper, the tax approach advocated by the BEPS project is ultimately self-defeating, requiring enforcement of a tortuous set of transfer pricing rules every time an intangible crosses national borders—an approach that only a bureaucrat could love.

For US policymakers looking to spur growth, one better solution to this dilemma—though not the only one—is the patent or innovation box. In simple terms, the patent box offers corporations much lower tax rates on income from investment in intangibles such as R&D.  In return, this lower tax rate is only available to intangible investments made in that country—what tax experts call a ‘nexus.’

A patent box offers corporations both a carrot and a stick.  The carrot is the lower tax rate on the income from domestic investments in intangibles made in the United States. The stick is that this lower rate would not be available to companies that moved nominal ownership of intangibles to other countries, thus reducing the avenues for legal tax avoidance.

Many countries in Europe have already adopted varieties of the patent box approach, including the United Kingdom.  However, the patent box in the UK and elsewhere has come under pressure from supporters of the BEPS approach, who believe that such “preferential regimes” should be eliminated or greatly restricted.

By contrast, we believe that the patent box should be seriously explored in the United States as a means of encouraging growth while discouraging corporate tax avoidance.  It may not be the ultimate solution, but it’s one step in the right direction.

*BEPS stands for Base Erosion and Profit-Shifting. It’s a major OECD project for reworking the global tax system for the digital age. The BEPS project has many good points, in terms of reducing the opportunities for tax avoidance, but it may have a negative impact on global growth.