The VC sector is interesting both in its own right and as a proxy for entrepreneurial finance in a broader sense. We highlight the tax treatment of stock options as an important factor for variations in the size of the VC sector. VC often relies on complex mechanisms and option-based contracts to mitigate incentive problems. Granting stock options to founders and key employees also allows credit-constrained start-ups to attract and retain top talent. This type of compensation cannot be unambiguously classified as either capital or labor income. Some tax systems treat stock options in VC-funded firms as employee compensation, which is subject to payroll taxes with high progressive rates, whereas others treat them as capital gains with low flat tax rates. The effective rate depends on tax practices and is not readily indicated by statutory taxes.
The tax consultancy firm PwC calculated the effective tax rate for a standardized entrepreneurial case in 22 countries, which is supplemented with our own calculations for 16 additional countries. In this sample of 38 countries, we find a negative cross-country relationship between the effective tax rate on employee stock options and the rate of VC activity. This negative effect is stronger for countries with high R&D investments and weaker in countries with low R&D spending.
