14 January 2020

Don’t scrap the tax break that gives Britain its edge

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If you were to ask most policy wonks what the Chancellor, Sajid Javid, should do to fix the UK’s tax system in the next budget, you’ll probably get the same answer. After conceding that merging NI and Income Tax or abolishing VAT zero-ratings is just too politically difficult, they’ll probably recommend scrapping Entrepreneurs’ Relief.

Entrepreneurs’ Relief enables business owners to pay a lower rate of Capital Gains Tax (10% instead of 20%) on their first £10m when they sell their business, provided that they owned at least 5% of the company when they make the sale. It was brought in by Alastair Darling in 2008 to support entrepreneurship after his controversial changes to Capital Gains Taxes were met with a steely response from business owners.

No tax relief attracts more criticism. The Resolution Foundation describes it as ‘the UK’s worst tax break’. The Institute for Fiscal Studies says it does little to promote business investment and only makes wealthy people even richer. Sir Edward Troup, who used to run HMRC, backs abolition, noting it costs the Exchequer £2bn plus a year and has “minimal impact on encouraging entrepreneurship in the UK”. Accountancy trade body AAT joined the chorus of disapproval, saying “it does nothing to initially encourage entrepreneurialism but instead unnecessarily rewards those who would have sold their businesses anyway”.

It looks like they might get their wish too. At the last election, the Conservatives committed to reforming and reviewing the relief, while Labour advocated abolition. The Mail on Sunday reports that it could be scrapped in the next budget. Some accountants even say that “clients who were planning to exit their businesses have been rushing to get those deals done” before any changes are announced.

I sympathise with many of the critics. If most business owners aren’t even aware of the relief until they sell up (as AAT research suggests) then the tax relief can hardly encourage them to start and grow a business. If your aim is to get businesses to invest in new equipment, then expanding capital allowances is a better bet. If small firms are struggling to access finance, then you’re better off focusing on tax reliefs targeted at investors such as EIS and SEIS.

But I’m concerned a hasty move to scrap the relief could backfire and have unintended consequences for the UK’s startups. Like most of Entrepreneurs’ Relief’s critics, I’m sceptical that the relief is prompting people to start new companies. But, unlike them, I think it might have a different benefit: giving the UK an edge in the race for global talent.

An under-discussed aspect of Entrepreneurs’ Relief is how it interacts with the Enterprise Management Incentive (EMI). Startups with fewer than 250 employees and £30m in assets can use EMI to offer workers share options – that is the ability to buy stock tomorrow at what it is worth today – where any uplift is taxed as capital gains. All shares acquired under EMI automatically qualify for Entrepreneurs’ Relief. It’s a powerful incentive to encourage skilled workers to trade the high salaries they could earn at Google or Facebook for lower-wages at a disruptive startup. This aspect of the status quo is worth preserving.

Britain’s startups have to compete intensely to attract highly skilled software engineers and data scientists, both with established tech firms like Facebook and Google, and startups in Europe’s capitals and Silicon Valley. The diversity of the founders of the UK’s 100 fastest growing startups highlights how mobile these workers are. Almost half of Britain’s fastest growing business had at least one co-founder born outside the UK.  The best and brightest can command large salaries and have dozens of options. It’s a seller’s market.

Money is tight when businesses first start out. As they lack detailed trading histories or collateral, raising funds can be expensive. So in order to compete with the high salaries that established businesses can pay, startups offer valuable workers like data scientists and software engineers the possibility of an even bigger payout down the line. As well as that, stock options solve a number of other problems too.

When employees trade lower salaries for the chance of a lucrative exit in the long run, it signals to the venture capitalists investing in these companies that their incentives are aligned – the workers, each of whom are enormously important in such small firms, have the same stake in long-term success that the investors do. It also deals with the fact that the firm’s value is heavily dependent on the continued employment of key people. In the US, three-quarters of VC-funded firms grant stock options to their employees.

Because of Entrepreneurs’ Relief, startup employees in the UK pay less tax (10%) on the exercise of stock options than in any other OECD country. That’s a powerful incentive to draw innovators to the UK. While awareness of Entrepreneurs’ Relief appears low among the owner-managers who stand to benefit from it, and so seems unlikely to affect their incentives much, that’s not the case with EMI. Employers have to actively set the scheme up and would only give up equity if it was a major factor in drawing in talent. Anecdotally, when I’ve spoken to startup founders they’ve repeatedly mentioned the importance of stock options and tax breaks such as EMI.

If Entrepreneurs’ Relief was abolished, the effective tax rate on stock options would double. The UK would, admittedly, still have a competitive tax scheme for stock options. But our startup ecosystem would lose a major advantage and with the disruption of Brexit, Paris or Berlin may begin to look increasingly attractive to more people.

That would be a major loss for a number of reasons beyond the simple value of having more highly productive people in the UK paying tax. First, there is an agglomeration effect that means that more tech sector workers tend to increase the productivity of existing workers. Highly skilled tech workers command higher salaries in places where there are other workers like them. That’s because employers seek out large labour markets. This is why Silicon Valley can attract the best and brightest despite the cost of living being sky high. That’s not the only benefit of agglomeration. Chance meetings in coffee shops lead to ideas spilling over. To use an example from manufacturing, in the five years after a new large manufacturing plant opens, productivity improves at pre-existing factories nearby. The implication is that good practices spillover when managers from different firms meet for a drink after work.

Second, money follows ideas. The supply of venture capital (VC) follows the demand for entrepreneurship. A classic paper by Paul Gompers and Josh Lerner found that tax-exempt institutions were just as responsive to capital gains tax cuts as taxable investors. This implies that venture capital activity increases as a result of more workers being spurred into entrepreneurship.

More directly, there’s evidence that lower rates of taxation on stock options are strongly associated with greater venture capital activity. A cross-country analysis by Magnus Henrekson and Tino Sanandaji find that a 1% (not percentage point) drop in the tax rate on options is associated with a 1% increase in VC activity.

Third, VC-backed startups create innovation spillovers that drive productivity growth, but are hard to target with formal research subsidies or protect with patents. As Stanford economist Charles Jones writes – “think about the business methods of Walmart, the creation of Uber, or the “idea” of Amazon.com”. Lower tax rates on the rewards of innovative entrepreneurship can fill the gap as an imperfect research subsidy.

People often make the mistake of talking about entrepreneurship as if it were a homogenous blob. For example, in their assessment of Entrepreneurs Relief the Resolution Foundation note that the number of self-employed people with employees hasn’t increased since Entrepreneurs Relief was brought in. Yet, not all entrepreneurship is equal. High rates of small-scale entrepreneurship may be a sign of economic weakness rather than strength. For instance, Greece has around twice the rate of self-employment as the US.

It’s hard to identify innovative entrepreneurship before the fact. True Schumpeterian entrepreneurs represent only a tiny proportion of entrepreneurs. Yet high-potential startups are disproportionately likely to seek venture capital funding and pay workers with equity. Just 0.1% to 0.2% of US firms received early-stage finance from VCs but they represent a majority of the firms that go public.

The virtue of EMI (and the added boost it gets from Entrepreneurs’ Relief) is that by targeting this segment directly, it’s a relatively cost-effective way to incentivise high-growth entrepreneurship compared to across the board tax cuts.

Paradoxically, the case against Entrepreneurs’ Relief is strongest when we’re talking about actual entrepreneurs. The right reform might be to scrap Entrepreneurs’ Relief in general, but keep it for workers with share options – a name change might be in order. This reform would still incentivise innovative entrepreneurship, but it would no longer act as an unexpected retirement bonus as EMI schemes have to be registered in advance.

It would also remove the perverse disincentives associated with Entrepreneurs’ Relief identified by the Office for Tax Simplification. Outside of EMI, entrepreneurs are discouraged from raising funds externally as if their ownership is diluted below 5% they no longer qualify for the relief.

It’s right that the Government is looking to review and reform Entrepreneurs’ Relief, but it must be careful not to throw the baby out with the bathwater. London’s spot as Europe’s tech capital is highly coveted, and we would be fools to chuck out  one of its biggest selling points in the first post-Brexit budget.

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Sam Dumitriu is Research Director at The Entrepreneurs Network