Much evidence from around the world supports the view that small, high-tech firms contribute disproportionately to innovation and economic growth. The financing of entrepreneurship and innovative ideas will therefore play a significant role in facilitating economic growth and the competitive advantage of nations in the 21st century.

Policy-makers tasked with developing knowledge economies around the world have taken note of the importance of financing innovative growth. The Ontario Liberal government recently proposed a tax incentive for angel and institutional investors to support startups in the province. While the details have yet to be revealed, the basic proposal provides a 35% tax credit on angel and institutional investments in the province’s startups.

The announcement was greeted by start­ups and the venture-capital community with great enthusiam. But one should be careful before buying into the hype. Similar schemes have failed to produce much benefit, and may have doused rather than sparked innovation and wealth generation. If the Ontario Liberals or any other goverments truly want to support an economy of innovation and prosperity, they should look to the not so distant past for guidance.

If structured properly, the proposed credit would encourage many investors to shift more of their capital from the lower-risk, public equities market to risky venture capital. Given the size of the potential rebate, it would be stupid not to do so.

But as the old saying goes: “Things are not always what they seem. A stopped clock is right twice a day.” Problems arise when tax policies create distortions in markets, and tax cuts aimed at small businesses and their investors are no exception. There are at least four areas of concern:

Will the best investors be incentivized? Uncle Bob, a tradesman from rural New Brunswick, is an angel investor by virtue of buying into his nephew’s mobile-app startup in Toronto. Jim Treliving of Dragons’ Den also is an angel investor. While both may be able to invest the same amount of money in the startup, who would be better able to identify the investment risks and, more important, provide mentorship and strategic support? Effective angel investors and professional venture capitalists invest more than cash; they also offer their time, access to networks and industry know-how.

If the credit is contingent upon the qualifications of the investors rather than the companies in which they invest, such policies could create incentives for different types of investors to classify themselves as angels or institutional investors to obtain the tax breaks, even if they weren’t necessarily suited for venture-capital investments. The influx of new investors could artificially inflate valuations and crowd out some of the “smart money.”

A rebate program could push startups toward angels and VCs when other sources of capital, such as bank debt, would better suit their needs.

Will the incentive encourage individuals or corporations to create small entities that qualify their investors for the credit, thus depriving more worthy companies of that capital?

For a more concrete example of how well-intentioned tax policy can create unintended downsides, look no further than the Labour Sponsored Venture Capital Corporations (LSVCCs) that exist in all provinces save Alberta and Newfoundland. Unlike traditional VC funds, LSVCCs are funded by retail investors, who are rewarded with generous tax breaks—so generous that LSVCCs had become the dominant form of venture capital in Canada by the start of the last decade.

However, empirical evidence shows that returns on LSVCC investments have significantly lagged those of their private counterparts, due to legislated investment mandates and bureaucratic administration. More salient is the fact that companies receiving LSVCC investment are less likely to develop patents and become successful. LSVCCs were seen mainly as providers of cash, not the other strategic resources that I mentioned earlier. Moreover, because LSVCCs are tax-subsidized while other funds are not, they displace more efficient venture-capital investors.

Despite the lack of performance, LSVCCs fees are typically very high; their average management expense ratio (MER) tops 5%, which is more than twice as high as that for the typical Canadian mutual fund. Since their inception, the economic rate of return on LSVCCs has been significantly less than 30-day treasury bills—and even close to zero! The cost of LSVCC programs in terms of forgone tax revenue and the indirect costs of crowding out is estimated to exceed $1 billion annually across Canada.

For these reasons, Ontario announced the phase-out of the LSVCC tax credit in 2005—which, after some lobbying efforts, has been pushed back to become effective in 2012. Other provinces have not followed suit; arguably, their reluctance is rooted in the fact that LSVCCs have become entrenched in political connections and lobbying ability. Although LSVCCs are value-destroying, they are hard to remove since many livelihoods depend on their continued existence.

Policies that stimulate entrepreneurial activity and innovation are welcome so long as they do not create distortions. As governments consider their options, they should be very careful not to incentivize counterproductive activity. They must themselves be innovative.

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