Scandinavian Working Papers in Economics

Working Paper Series,
Research Institute of Industrial Economics

No 1168: Stock Option Taxation: A Missing Piece in European Innovation Policy?

Magnus Henrekson () and Tino Sanandaji ()
Additional contact information
Magnus Henrekson: Research Institute of Industrial Economics (IFN), Postal: P.O. Box 55665, SE-102 15 Stockholm, Sweden
Tino Sanandaji: Institute for Economic and Business History Research (EHFF), Stockholm School of Economics

Abstract: Europe continues to lag behind the U.S. in venture capital (VC) activity and the creation of successful startups and has recently been surpassed by China. This is despite the fact that many European countries have deep financial markets, strong legal institutions and high R&D spending. We point to the tax treatment of employee stock options as an explanation for the stronger growth of the U.S. VC sector. As a response to high uncertainty and transaction costs, VC financiers have developed a model in which founders and key recruitments are compensated with stock options under complex contracts. Low tax rates on employee stock options further raise the relative returns of working and investing in innovative entrepreneurial firms and shift financial capital and talent to that sector. We measure the effective tax on stock options in VC-backed entrepreneurial firms in a number of developed economies. Countries with lower stock option taxation have higher VC activity and more high-growth expectation entrepreneurial activity. Based on these associations and the theoretical and empirical literature, we argue that more lenient taxation of gains on employee stock options can be a strategy for European countries to catch up in entrepreneurial finance. This tax policy would narrowly target entrepreneurial startups without requiring broad tax cuts. The favorable tax treatment of stock options allows the state to promote firms that rely on entrepreneurial finance and make use of these types of contracts without lowering taxes for other sectors of the economy.

Keywords: Entrepreneurship; Innovation; Institutions; Tax policy; Stock options; Venture capital

JEL-codes: H25; H30; K34; L26

24 pages, First version: May 12, 2017. Revised: February 20, 2018. Earlier revisions: December 15, 2017, February 20, 2018.

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