2 March 2023

No relief in sight: a few simple tax changes could fatally undermine UK startups


Regular readers of CapX are probably used to hearing about how we can’t get anything right in this country – our housing market is broken, childcare is exorbitant, and our energy system is dysfunctional. But for all that doom and gloom, there is a bright spot. Over the past decade or so, the UK has managed to build Europe’s pre-eminent startup ecosystem.

The stats are strikingly clear: London is Europe’s top destination for startup capital, with twice as much equity investment as second-placed Paris; investment in UK startups has increased more than 17-fold, from £1.6bn in 2011 to £27.7bn in 2021; and despite having a smaller economy than countries like Japan and Germany, the UK is a clear third-place behind the globe’s dual startup hegemons – America and China.

However, we face some pretty severe economic headwinds. The UK is the only G7 country predicted to have a smaller economy in 2023 than it had before the pandemic and this has started to impact our startups too. Matching global trends, last year was the first year on record when the startup market shrank.

A key reason the UK’s startup ecosystem has grown so much – and why it is now under threat – is our tax treatment of investment.

At a basic level, any system that levies capital gains tax (CGT) deters risky investment. CGT only taxes the upside on investments and while there are efforts taken to cushion the downside, they only go so far. Say you are a new angel investor, and you have a potential company in front of you asking for £100,000. You estimate that there is a 50% chance of losing your investment and a 50% chance of returning £111,111 (including your original stake). In a world without CGT that would be a positive investment. But with CGT at 10%, you would only break even, meaning there is zero financial incentive to invest in the first place.

There are, however, a whole suite of tax reliefs – from the Seed Enterprise Investment Scheme (SEIS), Enterprise Investment Scheme (EIS), and Venture Capital Trusts (VCTs) – all of which are designed to correct for incentives against investing in young and risky companies.

They have worked very well to date, and entrepreneurs are incredibly enthusiastic about them.  When The Entrepreneurs Network asked founders what they thought of the schemes the answer was resounding.  Melissa Morris, the CEO of healthcare platform Lantum,​​ echoed the feelings of many when she said her business ‘would never have got off the ground’ without the EIS.

Unfortunately, these schemes are under threat from the forces of political inertia.

The problem is that EIS and VCTs were both brought in during the 1990s while we were members of the European Union. As a condition for creating these tax breaks, we agreed to put a time limit on them. That means without fresh legislation the schemes will simply disappear in April 2025. While successive governments have said that they are keen for them to continue, political crises have meant that none of the necessary legislation has actually passed.

This is especially worrying as there is still an open question about whether the Northern Ireland Protocol means that these schemes need to be approved by the EU. Current thinking indicates that we have the power to prolong them in most of the UK, but that special arrangements will have to be made for businesses in Northern Ireland.

Uncertainty about the future of these tax reliefs is already decreasing investment in the UK’s startups, as prospective investors looking at seed companies do not know if these companies are going to face a much worse investment environment in the future. As I argue in a new report for the All-Party Parliamentary Group for Entrepreneurship, ministers need to act urgently and get the legislation done as soon as possible.

There are plenty of deep, complex reforms we could introduce to make the British economy more dynamic. From planning reform to sharper procurement, better childcare and smarter science funding. All of those however, take time and care to put into place. Rolling over a few tax breaks really is the kind of low-hanging fruit governments crave: as the Budget approaches, it would be a shame if the Chancellor passed it up.

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Aria Babu is Head of Policy at The Entrepreneurs Network.

Columns are the author's own opinion and do not necessarily reflect the views of CapX.