Stock option taxation: a missing piece in European innovation policy?

Abstract

Europe continues to lag behind the USA in venture capital (VC) activity and in the creation of successful startups, and has recently been surpassed by China. This is despite the fact that many European countries have deep financial markets, strong legal institutions, and high R&D spending. We point to the tax treatment of employee stock options as an explanation for the stronger growth of the US VC sector. As a response to high uncertainty and transaction costs, VC financiers have developed a model in which founders and key recruitments are compensated with stock options under complex contracts. Low tax rates on employee stock options further raise the relative returns of working and investing in innovative entrepreneurial firms, and shift financial capital and talent to that sector. We measure the effective tax on stock options in VCbacked entrepreneurial firms in a number of developed economies. Countries with lower stock option taxation have higher VC activity and more high-growth expectation entrepreneurial activity. Based on these associations and the theoretical and empirical literature, we argue that more lenient taxation of gains on employee stock options can be a strategy for European countries to catch up in entrepreneurial finance. This tax policy would narrowly target entrepreneurial startups without requiring broad tax cuts. The favorable tax treatment of stock options allows the state to promote firms that rely on entrepreneurial finance and make use of these types of contracts without lowering taxes for other sectors of the economy.

Financial and Institutional Reforms for an Entrepreneurial Society

“…This is supported by the analysis carried out by Henrekson and Sanandaji (2018). They find a strong correlation at a worldwide level between the tax treatment of employee stock options and VC activity.…”

“…It is an open question whether promoting US-style venture capital (Grilli et al 2018;Henrekson and Sanandaji 2018), platform-based fintech solutions ), or perhaps a return to more traditional forms of relationship-based bank finance fit best in the European context. Policy experimentation by individual member countries is called for to find the best way forward in improving the access to external financing of innovative entrepreneurship.…”

“…Such policy experiments, as proposed in this special issue, should involve lower taxes and liberalization in well-defined areas and categories of taxation. Targeted interventions in the tax code may go a long way in promoting VC activity (Grilli et al 2018;Henrekson and Sanandaji 2018). But the proposed policy reforms should be designed as experiments.…”

The Entrepreneurial Society

“…In many EU countries, the lower taxation of gains on employee stock options in the start-up sector is necessary, both as a means to lure talented people away from traditional careers in incumbent firms and to channel institutional capital into the entrepreneurial sector, which should be mediated by a professional VC sector. A tax break that targets human capital in this segment would promote innovative entrepreneurship without the high fiscal cost of broad capital gains tax cuts (Henrekson and Sanandaji 2018c).…”

Small business property tax reductions and job growth

“…Small Business Economics has nurtured a robust and wide-ranging debate on the linkages between taxation or subsidies and entrepreneurial activity and this has generally found that neither is critical to future growth (Holtz-Eakin, 2000, b;Bruce and Mohsin 2006;Fotopoulos and Storey 2018). Although others who have examined general taxation rates (Baliamoune-Lutz and Garello 2014), corporation and income taxation (Nam and Radulescu 2007;Darnihamedani et al 2018) or innovative forms of support (Henrekson and Sanandaji 2018) have identified institutional sets up in which tax (subsidy) incentives can assist start up or investment decisions. We extend this debate in a new direction through our examination of property taxes and job growth.…”