How Effective Are State Angel Tax Credits?

March 20, 2013

Last week, the SSTI Weekly Digest offered an overview of the many TBED-focused tax incentives currently under consideration in a number of state legislatures. Tax credits for research and development and for angel capital investment, in particular, appear to be under consideration in many parts of the country. At the same time, there appears to be a renewed emphasis on transparency in the operation and effectiveness of these kinds of tax credits.

In response to these trends, the Digest is is reviewing the current state of research on the usefulness of state tax incentives for the innovation economy. Last week, we addressed the academic and policy literature on R&D tax credits, finding that the limited available literature tends to suggest that, depending on implementation, R&D credits can be effective in attracting research investment. However, researchers have found little evidence that R&D tax credits actually encourage new research activity rather than simply capturing investment that would have happened in another state. This week, we focus on the effectiveness of angel investment tax credits in growing the pool of in-state investors and investment dollars and in creating new companies and jobs.

Angels are individual investors that make high-risk investments in exchange for partial ownership of a company. These investments are high-risk because angel investors frequently engage with companies that are at the riskier seed and early stages of development. Angels also are often very far down the list of people to be paid should the firm go into bankruptcy proceedings. Thus, these investors are likely to lose their full investment should the company fail. Angel investors often will join networks or groups in order to decrease their risk in a number of other ways, including improving the volume and quality of their dealflow, co-investing and conducting more thorough due diligence research. Because angel investors are valuable in helping companies bridge the gap between the earliest stages, when they usually appeal to friends and family for financial support, and later stages, when they seek support from venture capitalist, many states have introduced policies to mitigate the high level of risk and encourage the formation of angel groups.

Angel investor tax credits are one of the approaches used by states to attract and encourage angel investment. These credits, however, differ both qualitatively and quantitatively by state. According to Jeffrey Williams of Belmont University in a 2008 article, state angel tax credits represent a dollar-for-dollar reduction in an investor's tax liability. Credits currently range between 10 percent to 100 percent of the investment in qualified companies. These credits are usually non-refundable, though in a few states investors can receive a cash refund if the amount of the credits exceeds their tax liability. Most states with non-refundable credit allow for a carry-forward period, and some allow the benefits to be transferred to other taxpayers, if certain conditions are met. Qualifying investments often are capped, either for a particular business or for a particular investor. States also have provided capital gains deferral instead of credits on new investments.

States also differ in their requirements for the companies that can receive qualified investments. Firms are often required to be in strategic industries, make a certain level of investment in research and development, to have a sufficiently small level of revenue and employees or to have received less than a certain amount of outside financing. A few states also require businesses to be in rural or economically distressed areas.

The diversity of angel tax credits, along with the wide variety of economic metrics associated with them, complicates the task of evaluating their effectiveness. In a 2008 issue brief from the National Governors Association (NGA) Center for Best Practices, NGA warns that the economic benefits of these credits are unknown. While credits appear to increase the size of completed deals, they do not seem to increase the number of ventures funded and do nothing to improve deal quality. Also, the specific benefits incurred by the credits depend on the stipulated requirements and other factors, such as whether the credit is temporary or permanent. NGA's research suggests that these tax credits may do little to increase the total number of angels or companies receiving support.

Researcher Scott Shane has written extensively about angel investing and its importance in the high-tech economy. Shane, however, has expressed doubts about value of angel tax credits. In a 2010 Bloomberg Businessweek article, he notes that surveys indicate business angels do not make specific investments to obtain credits. In fact, by increasing the size of deals and lowering the risk involved in investment in an unchanging number of deals, these credits may increase company valuations and competition amongst investors. In that case, credits could actually reduce potential returns to angels.

Last year, three University of Arkansas Little Rock researchers, John R. Hendon, Joseph R. Bell and Don K. Martin, provided an examination of the perceived effectiveness of angel tax credits in six states with very different incentives for angel investors. Their research revealed that states have a wide variety of motivations for enacting angel tax credits, and that no single credit can accomplish all goals that drive their creation. The authors conclude that in order to implement a successful angel credit, states must first consider their particular aims. While tax credits have the potential to attract angel investment, build a local angel community, support businesses in currently underserved regions and boost strategic high-tech industries, a state must be more specific in its goals in order to design a credit that will be at all effective. The work of crafting specific regulations and metrics can begin only after a state knows what its wants from the incentive.

capital, tax credits, angel capital, ssti features