Supporting High-Growth Startups: Do Investor Tax Credit Programs Live Up to Their Promise?

Angel tax credits are a popular policy measure aimed at boosting early-stage investments in high-growth startups.

More than 13 countries and 31 U.S. states offer angel investors a tax break in the hopes that more funding for nascent ventures will spur entrepreneurship.1  Proponents of such programs argue that they can boost job creation, innovation and economic growth.

The question is whether any of those claims are true. “There’s growing interest in implementing angel tax credits, but there’s been no systematic evidence that they are effective,” says Darden Professor Ting Xu, an expert in entrepreneurial finance, fintech and family firms. “That’s why it’s important to understand how those polices impact new business formation and young firm employment.”

Recently, Xu and his collaborators — Matthew Denes of Carnegie Mellon University, Sabrina Howell of New York University, Filippo Mezzanotti of Northwestern University, and Xinxin Wang of the University of California, Los Angeles — set out to study the effects of angel tax credits on investors and startups. They present their findings in a working paper, “Investor Tax Credits and Entrepreneurship: Evidence From U.S. States.” The paper offers the first analysis of U.S. angel tax credit programs and provides useful new information about them, raising serious concerns about using investor subsidies to promote entrepreneurship. 

Angels as a Source of Early-Stage Funding

Angel investors are wealthy individuals who provide personal capital to fledgling companies in exchange for equity. They are known as “angels” because they often invest in risky, unproven business ventures for which other sources of funds — such venture capital — are not available.  While angels don’t get the same attention as venture capitalists, who tend to focus on later-stage investment rounds, they do play a key role in the financial ecosystem for innovative, high-growth startups.

Angel Investor Tax Credit Programs

Tax subsidies targeting angel investors, says Xu, offer personal income tax credits equal to a certain percentage of the investment, regardless of the investment outcome. Those special tax breaks have several features that policymakers find attractive. “Compared to programs such as grants,” says Xu, “investor tax credits are more market-based tools that don’t require the government to identify which companies deserve subsidy. Instead, investors themselves pick promising startups to invest in.”

Angel Tax Credits and Entrepreneurial Activity

To evaluate the impact of angel tax credits on entrepreneurial activity, Xu and his collaborators reviewed the staggered introductions and terminations of those programs in 31 U.S. states, between 1988 and 2018. They studied whether investor tax credits indeed induced more angel investments. They examined which investors responded to angel tax credits and — through a large survey of angel investors — explored what drove their decisions.

Having analyzed data on angel activity from Crunchbase, VentureXpert, VentureSource, Form D filings and AngelList, Xu and his colleagues uncovered that angel tax credits significantly increase state-level angel investments. However, the increase in investments is mostly driven by a surge in inexperienced, new and local investors, many of whom are firm insiders. As Xu puts it, “We found that these additional investments flow primarily to lower-potential startups that are smaller, lower-growth, and have less experienced entrepreneurs at the time of investment.”

Consistent with those findings, the research team did not identify any significant impact of tax credit programs on state-level job creation, innovation or business entry.

“Stimulating high-growth entrepreneurship,” says Xu, “requires that investors with experience and skill invest in high-quality startups. Unfortunately, we found that angel tax credits failed to attract such investors.”

Drivers of Angel Investment Decisions

A survey of 1,411 angel investors, conducted by Xu and his collaborators, offers important insights into what drives angel investment decisions.

Participants were asked to rate nine factors, including angel tax credits. Tax credits proved to be a relatively unimportant factor for 51 percent of respondents. Among the most experienced investors, 71 percent reported that tax credits were “not at all important.” The survey also found that even when tax credits are available, professional investors tend not to use them because of information, coordination and administrative costs.

“Experienced angels,” notes Xu, “are looking for startups that have the potential to become ‘home runs.’ Such home run potentials depend more on qualitative factors such as the team or business idea, rather than the availability of tax credits.”

Unsurprisingly, 97 percent of surveyed angels rated the management team of a startup as a “very important” or “extremely important” factor when deciding whether to invest in a startup.

Policy Implications

Policymakers often state that angel tax credit programs increase local economic activity, particularly job creation and employment of high-skill workers. However, Xu’s study suggests that such programs fail to appeal to sophisticated investors, who have experience allocating capital to quality startups with high-growth potential. Instead, angel tax credits attract inexperienced investors, whose abilities to screen and access high-quality deals are limited.

“What we discovered,” says Xu, “is that angel tax credit programs did not achieve their intended goals, which are stimulating high-growth entrepreneurship and strengthening the economy.”

Findings from Xu’s study have important policy implications. In their current form, angel investor tax credit programs in most U.S. states are open to both experienced and novice investors. However, to be effective, government programs focusing on boosting high-growth startups should target and attract skilled investors or intermediaries who are capable of identifying and monitoring such startups. Otherwise, for all their good intentions, state governments will continue subsidizing capital for young firms with inferior prospects, failing to create significant economic impacts.

This article was developed with the support of Darden’s Batten Institute, at which Gosia Glinska is associate director of research impact.

• 1Countries with angel tax credits include Canada, England, France, Germany, Ireland, Portugal, Singapore, Spain, Sweden, China, Japan, Brazil and Australia.