The Problem with Tax Credits for Angel Investors

Representative Chris Van Hollen (D-Md.) and four other House colleagues recently introduced the Innovation Technologies Investment Act in Congress.If passed, the law would give a 25 percent tax credit for angel investments made in recipients of Small Business Innovation Research (SBIR) grants. While SBIR, which involves federal agencies supporting small businesses on innovative research projects, is far from a universally recognized program, it's a valuable tool for increasing small company involvement in federal research and development.

Many angels support the proposed law because it would allow them to reduce their tax bills by 25¢ for every $1 they put into eligible startups.

Most people who are already making angel investments would gladly accept a tax cut for doing deals they would have done anyway. The problem is, this bill is not good public policy.

Proponents of angel tax credits argue that without the credits, private capital markets fail to provide sufficient equity financing for high potential businesses. Investing one's own money in startups—which is what angels do—is risky, because few angel-backed companies are successful enough to provide an adequate return to investors. Given the high risk, many potential angels fail to invest in new companies. By lowering the amount of money an angel can lose, proponents claim, a tax credit encourages angels to make marginal investments they would not have otherwise made—investments that advocates argue create wealth and jobs.

Many economists are skeptical of the value of angel tax credits, arguing that they are based on the unproven assumptions that the private sector is underinvesting in new businesses and that tax credits will counteract that underinvestment. The reality is, whether angel tax credits provide a net benefit is unknown, because no credible cost benefit analysis of these tax credits has ever been conducted.

The Costs Might Outweigh the Benefits

Observers point out several problems with angel tax credits:

First, as a 2008 National Governors Assn. issue brief highlighted, a tax credit might simply reward angels for the investments they are already making. As a result, tax revenues decline but no new angel investment occurs in response to the credit.

Second, as the issue brief also explains, an angel tax credit may not increase the number of companies receiving angel money but simply increase the size of investments (that would have been made anyway). Because tax credits don't improve the quality of the unfunded deals, angels might remain focused on the deals they were willing to make without the credit.

Third, although some angels claim they would make more investments if they could make use of tax credits, we have no solid evidence that angels increase the number of startups they fund in response to tax credits. In fact, surveys of business angels reveal that they don't make specific investments to obtain these credits.

Fourth, a tax credit might attract more investors to the same deals, leading not to more companies getting funded, but to competition for deals.

Such competition would increase valuations and reduce returns. In fact, if venture capitalists compete for the same deals as angels but can't make use of the credits, then the tax credits might drive the VCs out of the market—especially if angels offer valuations that venture capitalists cannot match.

The Problem of a Tax Credit Linked to SBIR Funding

Limiting an angel tax credit to investments in companies that have received SBIR funding raises other problems. SBIR companies might not be the businesses with the greatest prospects for job and wealth creation. SBIR grants are made by government agencies on the basis of the value of the applicants' technologies, not on their prospects for job and wealth creation. Therefore, an angel tax credit for SBIR companies could lead investors to shift funds to SBIR recipients from businesses that would have generated more jobs and wealth.

Much as I would like to see policymakers encourage more high-growth entrepreneurial activity, I don't believe that an angel tax credit for SBIR recipients is the way to do it. A capital gains tax cut for shareholders in startups (including angel investor holders of equity) would stimulate more high-growth entrepreneurship with fewer adverse effects than the proposed angel tax credit.

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