A patent box provides a lower tax rate on income from patents. In some cases, the lower rate applies to income from other intellectual property. Such a subsidy is sometimes referred to as an innovation or IP box. In this report, the term "patent box," the most popular name, will be used to refer to all of the special tax rate regimes related to income from intellectual property. A number of countries, including the U.K., France, the Netherlands, and China, have adopted a patent box. The income tax rates of those boxes generally range from 5% to 15%. Patent boxes, as noted, can have narrow coverage (providing a lower tax rate on royalties and licenses from patents) or broadly cover income attributable to intellectual property, including that used directly by the firm in production. The purpose of a patent box is to encourage research and development, and, in some cases, to encourage the location of profits from intellectual property in the country. The design of patent boxes raises several issues. One is the breadth of coverage. Specifically, should a patent box restrict coverage to licensing fees and royalties from patented inventions or include income embedded in products produced with patented inventions? Should it include income embedded in products produced from non-patented innovations? Should it include income from items not reflecting technological innovation such as trademarks, business names, and copyrights? Other design issues include whether to restrict the benefit to innovations developed in the United States and to income from products derived from the innovations that are produced in the United States. The European patent boxes generally do not have these restrictions. Another issue is the treatment of income from existing patents and innovations. If the objective is to encourage domestic innovation, limiting benefits to new innovations may be appropriate, although administratively difficult. Finally, as will be discussed subsequently, whether the tax rate is applied to gross or net income significantly affects the benefits of patent boxes. Proposals for a patent box in the United States include a draft proposal by Representatives Boustany and Neal, the Innovation Promotion Act of 2015, proposed legislation made by Senator Feinstein in the 112 th Congress, and a bill introduced by Representative Schwartz in the 113 th Congress ( H.R. 2605 ). The Feinstein proposal provided a 15% tax rate on income from patents developed and used for manufacture in the United States, whereas the Boustany-Neal proposal and H.R. 2605 allowed a 71% deduction of income, which produces an effective 10% statutory rate on income in the patent box. The Boustany-Neal proposal covers income from patents, inventions, formulas, processes, knowhow, computer software, and other similar IP, and is for domestic earnings. This report focuses on the effects of a patent box on encouraging research and development in the United States. It begins with brief description of current research and development (R&D) incentives, and follows with a discussion of the justification for R&D subsidies. In its remaining sections, the report looks at the potential impact of a patent box as a supplement to or a substitution for current R&D tax incentives. It concludes with a discussion of the effect on patent boxes on the location of research and amount of profit-shifting by multinational corporations. All of the discussion considers a patent box that is restricted to domestic innovation and manufacture. Current law contains two provisions that benefit research spending: expensing of intangible costs (which constitute the bulk of the cost of R&D) under Section 174 of the Internal Revenue Code and research tax credits on the same costs under Section 41. Expensing allows costs to be deductible immediately rather than being recovered over the life of the assets from investment. When the investment is marginal (earns just enough to break even), expensing is the equivalent of a zero tax rate. The credit for research, officially termed the research and experimentation (R&E) credit, is also allowed on intangible investments. After many years of being a temporary provision that was typically extended every one to two years, the credit was made permanent in the Consolidated Appropriations Act, 2016 ( P.L. 114-113 ). Companies generally choose between two types of credits. One is a credit of 20% in excess of a fixed base that is unrelated to prior R&E spending and thus has a marginal effective rate of 20%. The other is a credit of 14% in excess of 50% of the past three years of research expenditures. Because additional research spending increases the base in the future, reducing future credits, the marginal effect of the credit is smaller, estimated (see Appendix ) at 7.9%. Weighting the credit by the spending on the 20% and 14% credits results in an effective credit of 11.3%. A full basis adjustment is made, meaning that the amount of the deduction for research is reduced by the amount of the credit. The patent box, rather than providing an up-front investment subsidy, provides a lower tax rate on the profits from innovation. Economic theory indicates that the private market can invest too little or too much in R&D. The potential underinvestment in research arises from the spillover effects that benefit other firms. Even when products are patented, new innovations may give rise to similar products or direct competition following the expiration of the patent. For that reason, the true value to society is greater than the value earned by the firm, and more of these valuable investments would be desirable. It is also possible to overinvest in R&D if firms are engaged in a competitive race to make discoveries before other firms do and secure a larger share of the market, a phenomenon sometimes called product market rivalry or business stealing. In this case, the private return to the firm may displace the return to another participant and the social benefit will be below the private benefit. Which effect dominates is an empirical matter. Empirical studies have more often found that research and development has positive spillover effects, although some studies have found negative or ambiguous effects. A 2010 review covering 20 studies found that half produced positive effects, a quarter negative effects and the remainder ambiguous effects. A more recent study explicitly attempted to deal with the two opposing forces (spillovers and product rivalry). It found the social return to be 3.5 times the private return. The majority of studies suggest a positive spillover effect. These positive spillover effects mean that firms, based on their own private return, will not invest in the optimal amount of R&D, even in the presence of patent protection. Evidence indicates that R&D tax subsidies in general are effective in encouraging R&D spending, although estimates of the extent of the stimulus vary substantially across studies. Patent boxes are too recent to have been the subject of more than a preliminary assessment. There is a broader question of whether R&D tax subsidies are the most desirable method of subsidizing R&D (for example, as compared to government spending on R&D), although this question is beyond the scope of this report. The existing tax benefits for R&D provide significantly lower effective tax rates for investment in R&D compared to the tax rates on other investments in the economy, such as investments in plant and equipment generally. A way to compare the incentive effect for investment in research and development is to examine the effective tax rate on a new investment at the margin (that is an investment that is worth making because it earns a high enough rate of return to satisfy stockholders). The effective tax rate is the share of the return that is paid in taxes. (See Appendix for data and methods of calculation.) If income is measured correctly (in that the present value of depreciation deductions for tax purposes equals the present value of economic depreciation), the effective tax rate is the statutory tax. If costs are recovered more rapidly than the rate of economic decline in value of the asset, or if credits are allowed, the rate can fall below the statutory rate, or even become negative. The effective tax rate captures the value of tax subsidies in a single measure, and the lower the tax rate, the greater the subsidy. Another way of capturing the effects of a subsidy is through a percentage change in the user cost of capital (also termed the rental price of capital), a measure that determines how much should be paid for the use of the investment if rented. The user cost of capital is the sum of the pre-tax rate of return on investment and its rate of economic depreciation. Table 1 compares the effective tax rates for intangible investments in research with investments in tangible assets. The expensing of intangibles results in an effective tax rate of zero on income earned from intangibles compared to tax rates of 24% or more for tangible assets. With the research credit in place, the effective tax rate is a negative 99%. That is, with the credit the project earns a return that is below the required after-tax return: the tax system provides a subsidy. As the effective tax rate falls, the required pre-tax return falls. As the pre-tax return is pushed lower, more projects that were not otherwise profitable would now earn a large enough return to be undertaken. Most investment in R&D is in intangibles (such as salaries for scientists and supplies) and subject to a zero or negative rate, but a portion reflects tangible investment A Canadian study used to compare taxation of intangibles across countries used a 7.3% share for equipment and a 6.6% share for structures. Assuming the equipment category of instruments, with an estimated effective tax rate of 27% and industrial structures with an effective tax rate of 36.6%, the weighted overall effective tax rate is estimated at 6.1% without the credit and -57% with the credit. Although tax rates provide a useful comparison, the negative tax rates are not as large as they appear because they are a percentage of the pre-tax rate of return, which can be very small. Another way of considering the effect of these subsidies is based on the effect on the rental price (or user cost) of capital.