Tax Policy to Stimulate Innovation and Entrepreneurship

Abstract

Taxation, undeniably one of the most influential tools at a policymaker’s disposal, plays a pivotal role in stimulating innovation and entrepreneurship. As such, we dedicate here a separate chapter to tax policy and the effects it can have. The tax structure influences not only the overall volume of innovative entrepreneurship, but also the channels through which it wields its impact. Tax rules and tax rates determine the extent to which net return differs from gross return for potential entrepreneurs and other actors in the collaborative innovation ecosystem.

Taxation, undeniably one of the most influential tools at a policymaker’s disposal, plays a pivotal role in stimulating innovation and entrepreneurship. As such, we dedicate here a separate chapter to tax policy and the effects it can have. The tax structure influences not only the overall volume of innovative entrepreneurship, but also the channels through which it wields its impact. Tax rules and tax rates determine the extent to which net return differs from gross return for potential entrepreneurs and other actors in the collaborative innovation ecosystem.

As we have emphasized throughout, the journey from a mere idea to a large-scale industrial enterprise is often an arduous, time-consuming, and expensive process, encompassing several stages. Taxation has a potential impact on each stage of this process, with the unique characteristics of each phase necessitating a comprehensive analysis to understand the effects of taxes.¹ Consequently, taxes influence the incentives for identifying and cultivating entrepreneurial opportunities, as well as the motivation to capitalize on these prospects.

5.1 Taxation of Ownership and Different Sources of Finance

The most important change agents in the economy—entrepreneurs—may have several and widely divergent motivations, but money and return on their work and firm ownership are undeniable driving forces.² Income from successful entrepreneurship often comes in the form of the rising value of shares in one’s own firm. Moreover, as already noted, innovation-based venturing is highly uncertain, and the cash flow of a project is always initially negative. Debt financing cannot be secured in such ventures. Financing by means of retained earnings is only possible in historically profitable incumbents. These have accumulated equity that their owners prefer to retain within the firm rather than dispensing it as dividends.

The real effective taxation on an investment assumed to yield a real return of ten percent at certain points over the 40 years 1970–2010 in Sweden is listed in Table 5.1,³ which shows the large differences in real effective taxation depending on type of owner and source of finance at various points. We start by illustrating four key aspects of the Swedish tax system during the 1970s and 1980s:

• 1. Debt financing enjoyed the most favorable tax treatment and new share issues the least favorable. More than 100% of the real rate of return was taxed away for an individual buying newly issued shares.

• 2. Retained earnings were taxed at lower real rates than newly raised capital for individuals, which favored incumbent firms over newly established firms.⁴

• 3. Individuals were taxed at much higher rates than the other two owner types. Moreover, individual taxation increased during the 1970s (except for retained earnings), whereas the reverse was true for insurance companies and tax-exempt institutions.⁵

• 4. Tax-exempt institutions enjoyed a substantial tax advantage relative to individuals and insurance companies.

Table 5.1 Effective marginal tax rates for different combinations of owners and sources of finance in Sweden, selected years, 1970–2010 (%)

The tax reform of 1991 entailed a significant levelling of the effective tax rate across ownership types and sources of finance, but institutional ownership and debt were still favored, albeit to a lesser extent. By 2010, the differences had diminished even further. This was an enormous shift relative to the period before the 1991 tax reform.⁶

The enormous shift in the real rate of taxation of direct individual ownership of stock becomes even more evident if we, as in Fig. 5.1, look at a broader time series covering the period 1970–2022. Here the real rate of return of ten percent before tax at the corporate level of a listed company is assumed to accrue to individual investors as follows: 40% in the form of dividends and 60% in the form of capital gains and taxed accordingly. It is clear from the graph that, on average, the real rate of taxation exceeded 100% significantly through 1990, despite our assumption that the largest portion of the return is taxed at the long-term capital gains tax rate (60% of nominal gains were tax-exempt 1974–1990, and it was even more advantageous before then).⁷ Since the early 1990s, the real rate of taxation has largely stabilized in the 30–40% range.

Fig. 5.1

Effective real marginal tax rate in the case of direct individual ownership (1970–2022) and ownership through holding companies (2003–2022). Note: 60% of the return is assumed to be in the form of capital gains and 40% in the form of dividends. Actual inflation rates have been used in the calculations. Source: Henrekson et al. (2020) plus our own updates for 2019–2022

Several factors contributed to the precipitous drop in the real rate of taxation: the corporate tax rate, which peaked at roughly 60% in the 1980s,⁸ has been reduced six times and currently stands at 20.6% (since 2021); since taxation is nominal, the sharp drop in the average inflation rate from eight to roughly 1.5% (through 2021); a standard capital tax rate of 30% substituted for the marginal labor income tax rate (which was roughly 75% even at fairly modest incomes in the 1980s) when taxing dividends and capital gains; and finally, several measures were taken to reduce and finally eliminate the effect of the wealth tax on stock holdings (it was abolished on private firms in 1992 and repealed altogether in 2008).⁹

The real effective tax rate on firm ownership was roughly cut in half through a seemingly minor change in the tax code enacted in 2003. This change implies that no tax is levied on distributed profits to the parent company from ownership in other unlisted firms regardless of whether they can be considered part of the parent business.¹⁰ Capital gains on such stock also became tax-exempt. The tax exemption applies to all stock holdings in unlisted incorporated firms regardless of ownership share and to holdings of stock in listed firms as long as the holding company owns shares comprising at least ten percent of the votes or ten percent of the equity.

By owning stock through one’s own holding company rather than directly, it has become possible to avoid (or indefinitely postpone) owner-level taxation both for controlling owners of listed firms and for individuals with ownership shares in unlisted firms. Tax will then only be paid on that part of the return that the owner requires for private consumption purposes. Typically, such withdrawals will be subject to a 25% tax. In other words, since 2003, owners of large firms and large private investors in unlisted firms—such as the start-up sector—are subject only to a consumption tax, and profits remain untaxed as long as they are not paid out from their holding company.

At the same time, full tax exemption was granted to listed closed-end investment funds (Investor, Industrivärden, etc.) for dividends and capital gains from companies in which they hold at least a ten percent voting or equity share. Until then, listed closed-end investment funds, the most important vehicle for controlling the largest Swedish firms, had been taxed quite heavily unless they paid out dividends received and part of their market cap to their shareholders.¹¹ This gradually undermined their capacity to wield control over their portfolio companies.

To offset the incentives for business owners to lower their effective tax rate by redefining more highly taxed labor income as capital income, the sharp reduction in the real tax rate resulting from the tax reform in 1991 did not apply to closely held firms. A closely held firm is defined as an incorporated business with no more than four active owners controlling more than 50% of the voting rights. Initially, such firms were severely constrained to pay dividends taxed at the capital income rate of 30%, and half of any capital gains were taxed as labor income.¹²

Since 2006, a series of changes in the rules for closely held firms has been implemented that substantially expands the share of the owners’ income that may be taxed as capital income. In addition, the capital income tax rate on private firms was lowered to 25% for non-active owners and to 20% for active owners of unlisted firms in 2006. The complex rules are described in some detail in the Appendix to this chapter.

Following this characterization of the evolution of the taxation of Swedish business owners, we can now evaluate owner-level taxation of the various owner categories in the early 2020s. In laying out the collaborative innovation bloc in Chap. 3 (Fig. 3.3), we identified the ownership categories in Table 5.2.

Table 5.2 Equity financiers in early and later stages

All early-stage financiers—founders, family and friends, business angels, and venture capital firms—can now invest through holding companies which pay no dividend or capital gains tax. If shares are owned directly, the tax rate is limited to either 20 or 25%.

In examining later-stage financiers, we observe that the favorable tax rules lead to many more individuals/families that are sufficiently wealthy assuming a controlling ownership role for larger firms. Likewise, the elimination of the previously onerous taxation of listed closed-end investment funds, a very important controlling ownership category in Sweden, has greatly strengthened their capacity to assume an active ownership role in more mature firms.

The partners of buyout firms can invest through holding companies, institutional investors are invariably tax-exempt, and individual savers investing in a stock-market portfolio can do so through an individual investment savings account, for which taxation is a small percentage of the market value and thus unrelated to any dividends or capital gains.

The radical reversal in the taxation of firm owners and the concomitant strengthening of incentives for innovative entrepreneurship is also highly visible in the development of the stock market. In the 1970s, there were virtually no new rights issues in the Stockholm Stock Exchange, Tobin’s q, the market value of listed companies divided by their assets’ replacement cost was 0.3,¹³ and the p/e ratio of firms such as Electrolux and Ericsson was around three. A handful of listed closed-end investment funds controlled almost all large companies through a combination of dual-class shares, cross ownership, and pyramiding.¹⁴ In turn, the closed-end investment funds were often controlled by a family foundation.¹⁵ The number of listed firms was only 103 in 1975 and the total market capitalization as a share of GDP reached a nadir of ten percent.

As shown in Fig. 5.2, there was an extraordinary revival of the Stockholm Stock Exchange during the 1980s and 1990s, and market capitalization rose from ten to around 150% of GDP at the turn of the millennium. In line with the further changes in taxation outlined above, the Stockholm Stock Exchange—now Nasdaq Stockholm—has continued to develop strongly. The total market capitalization reached a record level of 227% of GDP in 2021. Despite a falling market in 2022, the market capitalization still exceeded 150% at the end of 2022. At the time of writing (April 2023), a total of 832 companies were listed on Nasdaq Stockholm with 365 companies on the main market and an additional 447 listed on secondary markets (Nasdaq First North and Nasdaq First North Premier). In addition, there were 295 companies listed on other markets (MRE, Spotlight, and Pepins).¹⁶

Fig. 5.2

Stock-market capitalization on the Stockholm Stock Exchange (Nasdaq Stockholm) relative to GDP, 1970–2022. Source: The Stockholm Stock Exchange Annual Reports (1970–1987), Annual Reports of the Riksbank (1988–1999), and NasdaqOMX (2000–2022)

Admittedly, the strong development of the Stockholm Stock Exchange from 1975 until the mid-1990s coincided with a renaissance for stock-market ownership across the globe. For instance, the number of listed firms increased by more than 50% in the United States from 1975 until the peak in 1995. Since then, the development has reversed. The number of U.S. listed firms was almost halved during the following two decades (Doidge et al. 2017). Although not as pronounced, the trend is similar for the OECD as a whole (Koptyug et al. 2020). Thus, Sweden stands out as an exception to this global trend.

Moreover, the stock market has not boomed at the expense of the private equity market. In fact, Sweden has the largest private equity market in the European Union. In the period 2017–2021, Swedish private equity funds annually raised funds corresponding to two percent of Swedish GDP, and in 2020, private equity-backed firms employed 240,000 people in Sweden (of which 20,000 by VC firms), corresponding to 7.1% of total private sector employment.¹⁷ In addition, the very early stages of new ventures have benefited from a dramatic increase in business angels and informal investors where Sweden presently ranks ahead of the United States (Thulin 2023).

The dynamic stock market as well as the large and highly competent private equity sector contributes both to a high valuation of firms and to ample exit opportunities, which results in stronger incentives to pursue innovative entrepreneurship (Norbäck et al. 2016).

Despite these reforms, which have sharply increased the incentives for founders and investors to engage in and finance innovative entrepreneurship, there remains one Achilles heel: the remuneration of key personnel (R&D specialists, experienced managers, etc.) that need to be recruited at an early stage when the firm’s future is still highly uncertain.

5.2 Taxation of Other Entrepreneurial Efforts

The above discussion mainly concerns financial investors. But several others are involved. Figure 3.4 in Chap. 3 described key phases in a firm’s development. A start-up firm based on a unique idea is normally established by one or more founders. Building a successful and fast-growing firm requires a skilled workforce, and part of the entrepreneurial function is performed in practice by employees who lack co-ownership in the firm, the so-called intrapreneurs. The tax burden on earned income has been very high in Sweden throughout the post-war period. Despite all the reforms, the marginal tax rate on higher incomes, including non-preferential social security contributions, is still around 65%.¹⁸

The previous chapter showed that employee stock options could be used to stimulate employees to become more entrepreneurial and to reward their entrepreneurial efforts. Stock options are most effective as incentive mechanisms in entrepreneurial firms largely financed by external equity investors if:

• 1. They can be granted to key personnel at zero or low cost without any immediate tax consequences

• 2. Additional layers of state-contingent contracting, vesting, is allowed; the grantee loses all or part of the options if he or she no longer remains an employee, and or the granted options are lost if the firm does not meet certain performance milestones

• 3. Gains are taxed at a low capital gains tax rate

• 4. The grantee can defer all taxation until the options or the shares received are eventually sold

• 5. No social contributions are levied on the value of the granted stock options

It is quite obvious that any form of taxation of stock options that falls due before the acquired shares are actually sold greatly reduces the attractiveness of this instrument for employees. By contrast, if obtaining or exercising stock options has no tax consequences and if the employee faces a low capital gains tax, then stock options can be used to create strong incentives for entrepreneurial effort. The key employees who drive the innovation and entrepreneurship in the firm can then receive a substantial part of the capital value created, even though they do not invest financially.

However, these instruments have historically been subject to high taxes in Sweden. If options are linked to employment, the return has always been taxed as labor income and full payroll tax has been levied (in practice, this means the highest marginal tax rate). Until recently, the only feasible way to set up an equity-based incentive scheme was therefore to use warrants. Employees must buy the warrants at market value. The warrants give the employee a right, but not an obligation, to buy shares at a fixed price (the strike price) at a later date. If the company does well, the warrants can become quite valuable. No tax on capital gains is due until the warrants or the acquired shares are sold.

The warrant premium depends on current company valuation, strike price, and time to maturity. If the tax authority deems the premium to be too low, the difference will be subject to immediate labor income taxation and payroll tax. If the strike price is fairly close to the current valuation and the time to maturity is long, the premium becomes sizable, possibly 20% of the current share price or even more.¹⁹ The employee needs to pay the premium to the company in cash even though the warrant may prove worthless, in which case the employee loses the initial investment. Finally, the employee can theoretically, after some years, sell the warrants rather than exercising them. In such a scenario, the purpose of the incentive scheme—to heighten the employee’s sense of co-ownership—is hardly achieved.

Effective beginning in 2018, a law was passed which instituted more beneficial tax rules for Swedish start-ups, allowing companies to grant the so-called qualified employee stock options (QESOs) to their employees. QESOs make it possible for most Swedish early-stage companies to provide stock options in a tax-efficient manner to key employees. In 2022, the system was extended and made even more generous.²⁰

If the company and the employee meet certain criteria, the company can grant stock options to the employee at no cost, which gives the employee the right (but not the obligation) to purchase shares or warrants in the company, or in a company within the same company group, for a fixed price (typically almost zero) at a fixed date 3–10 years in the future.

The future growth in the value of the shares (or warrants) is only taxed as capital gains (generally 25% for shares and 30% for warrants if the warrants are sold rather than exercised to buy the shares) when the employee sells the shares (or warrants), compared to traditional stock options, which are taxed as wage income.²¹ The stock options are tied to the employment position and cannot be resold. If an employee leaves the company prematurely, some of the stock options will become invalid based on a vesting schedule through which the employee gradually earns the right to retain an increasing share of the stock options.

In order to grant QESOs, the issuer must be a Swedish limited company (or a similar foreign company with a permanent establishment in Sweden), be less than 11 years old, have fewer than 150 employees, and have assets or revenues less than SEK 280 million (roughly USD 28 million in 2023). In the case of public bodies, these cannot control 25% or more of the company.²²

The grantee must serve as an employee of the company, work 30 hours per week, receive a moderate wage, and be a Swedish tax subject. At the signing date, the value of the employee’s total stock options cannot exceed SEK three million, and the total value of all employees’ stock options cannot exceed SEK 75 million (defined as the value of the underlying shares). At least three years (the minimum vesting period) must elapse from the signing date before the employee can buy shares and the right to buy shares automatically expires ten years after the signing date. The company is allowed to set the strike price as low as the nominal value (kvotvärdet), which in most cases is virtually zero.²³

Thus, the five conditions that make stock options most effective as incentives mechanisms for entrepreneurial firms largely financed by external equity investors are essentially met. As in the United States, it is now possible to create incentives for key personnel so that they will agree to work at a lower salary in exchange for a future ownership stake. Naturally, the system is not without its drawbacks. The value of the firm is not allowed to exceed SEK 280 million, and for promising tech start-ups, that valuation may be exceeded fairly quickly after one or two rounds of financing. Moreover, if the start-up is a spin-off from an existing firm that is older than ten years or if the firm (or holding company) that provides more than 50% of the original funding is older than ten years, then the QESO scheme cannot be used. In addition, if the firm is still defined as closely held at the time of sale of the shares received based on the QESOs and the QESO grantee owns less than four percent of the total number of shares in the firm, then the capital gains tax will be 52 instead of 25% (30% on capital gains exceeding 100 income base amounts, SEK 7.1 million in 2023).

Despite the changes, the Swedish tax rules tend to encourage the founder/founders to sell the entire firm as soon as external owners come in, as this is the most straightforward way to benefit from a lower tax rate on all or most of the capital gain. In that case, what has so often proved to be crucial for building a valuable firm is lost, namely an agreement whereby the entrepreneur and other bearers of key competencies have strong incentives to continue to create value precisely by guaranteeing them a future ownership stake in the firm without needing to subject themselves to the entire financial risk. If the founders sell the entire firm at an early stage, the possibility of staged financing also disappears as well as the well-known benefits this entails. The initial investment then becomes larger, since the risk and operational costs increase because the founder has left the business and key employees demand higher salary compensation if stock options cannot be used.

If the founder remains in charge, he or she will instead maintain control during the company’s development until an IPO or a trade sale. Thus, external owners cannot take control of the firm while at the same time retaining the founder and other key employees for as long as this is favorable for the firm. This is possible in the United States, where the founder receives stock options that can again make him or her the principal owner, provided that the firm has developed in accordance with the business plan (which may be revised along the way).²⁴

The fact that the tax rules have blocked the emergence of effective agreements between founders and key personnel, on the one hand, and external financiers on the other hand can be seen in the fact that the Swedish VC market is very small in relation to the buyout market. By contrast, together with the United Kingdom, Sweden has Europe’s largest buyout sector.²⁵ This significant difference between the buyout and VC sectors is in line with what we would expect based on the historical tax treatment of stock options in Sweden, where it has been almost impossible for external investors in start-ups to conclude effective agreements with founders and other key employees. However, we would expect this imbalance to be gradually reduced once market participants begin to exploit the new opportunities to remunerate key personnel utilizing the QESO scheme.

5.3 Taxation and the Return on Human Capital Investment

If labor income is highly taxed, it becomes more difficult for an efficient and transparent service sector to compete successfully with the self-employed working cash-in-hand. Profitable market transactions are blocked, as high taxes lead to an inefficient allocation of working time across tasks. Efficient jobs in the formal economy are crowded out by less efficient cash-in-hand employment. In addition to these static effects, at least three different dynamic effects have a negative impact on growth:

• A less extensive specialization of the workforce lowers productivity because some of the learning effects are absent.

• The reduced opportunities for workforce specialization weaken the impetus to invest in specialized human capital, i.e., to acquire specific skills through training or on-the-job experience (Rosen 1983).

• When the degree of specialization is lower, innovation incentives become weaker, since the smaller the share of total working time devoted to activities exploiting an innovation, the lower the return on that innovation. Many innovations also concern building organizational capital with the aim of reducing the cost of organizing a large number of highly specialized employees (Becker and Murphy 1992; Haskel and Westlake 2018).

High taxes thus block large portions of the service sector to entrepreneurial business development. This is a major concern—especially in light of what we have noted above regarding the Baumol effect. In the early 2000s, the number of hours of unpaid household work and work in the informal economy was almost as large as the number of hours worked in the formal economy (Davis and Henrekson 2005).

When services are provided professionally, incentives arise to invest in new knowledge and capital equipment, to develop new technologies, to enhance contractual arrangements, and to create more flexible organizational structures. High labor taxation counteracts the market production of goods and services that replace domestic labor, thereby reducing the scope for entrepreneurial expansion into new businesses that economize on people’s time.

The tax wedge for some services has in recent years been greatly reduced by the introduction of the so-called “RUT” rebate in 2007—a tax cut for services performed around the home. Each taxpayer can buy household-related services (cleaning, childcare, gardening etc.) for up to SEK 75,000 per year and have the labor cost reduced by half by means of this tax rebate. Given this tax reduction, it is sufficient for the professional producer to have approximately 50% higher productivity than the buyer for it to be worthwhile to purchase the service rather than producing it herself. A similar system exists for the renovation or extension of one’s own home (the “ROT” deduction). Systems such as these soften the inhibiting effect of high taxes on the development of a private services sector.

These large reductions in the tax on household services should have significant effects in the long term. The sharp fall in unpaid household work documented by Statistics Sweden in their time use surveys is consistent with a trend towards increased professionalization of household services. Particularly striking is the sharp decline in women’s unpaid domestic work. This decreased by an average of one hour per day, or 20%, between 1990 and 2010, while their market work increased by around half an hour on average.

Payroll taxes have at times also been reduced through employment rebates and reductions in social security contributions, namely a halving of the payroll tax on young people under 26 years of age, a reduction from 24 to 10.2% for pensioners, and zero or sharply reduced payroll deductions for people who have been on long-term sick leave or taken early retirement. Restaurant VAT was also reduced in 2012, which means that professionally prepared food now has the same VAT rate as that cooked at home. These reductions make the tax system more opaque but, from an entrepreneurial perspective, still entail small steps in a more favorable direction.

To further stimulate innovation, we advocate reductions in the part of payroll taxes that are a pure tax. This would have major effects on the labor market, increase skills, reduce cash-in-hand work, and intensify competition for personal services. In addition, it seems to be a fair demand that the pure tax component of mandatory social security contributions (“the general wage fee”)—amounting to 11.42 percentage points, more than one third of the total—be made salient through separate itemization. Most importantly, no benefits accrue on social security contributions above an annual income of 7.5 income base amounts (a sum related to the development of the average wage). This corresponded to an annual salary of SEK 600,000 (roughly USD 60,000) in 2023. Hence, mandatory social security contributions of 31.46% above this threshold constitute a pure tax. If this tax were repealed, it would lower the top marginal rate (or more correctly the marginal tax wedge) from 63.4 to 52%.

A specific feature of the Swedish labor market we have already mentioned refers to the high tax on researchers and specialists. To alleviate this problem and make it easier for knowledge-intensive firms and organizations to recruit specialists from abroad, an expert tax relief scheme was introduced in 2001, the so-called expert tax rebate. This rebate comprises a 25% salary exemption from income tax for a maximum of five years. Effective from 2024 this will be extended to seven years. This reduces the marginal tax rate from 52 to 40%. In 2023, a person earning a monthly salary of at least SEK 105,000 (roughly corresponding to the 98th percentile in the wage distribution)²⁶ was automatically granted the rebate. If the salary is below the “automatic” threshold, the tax authority tends to be restrictive and slow in arriving at a decision in individual cases. This means that it is precarious for firms to rely on such a scheme in the attempt to increase their competitiveness in recruiting specialists from abroad.

We advocate that eligibility be a function of skills regardless of the specialist’s salary. With today’s rules, only senior managers (and top athletes!) are automatically eligible for the expert tax rebate. Paradoxically, it is extremely rare for prominent researchers to have such high salaries that they qualify for the rebate, especially if they are younger. In practice, it is thus the experts’ supervisors who benefit from the expert tax.

5.4 Conclusions Regarding Taxation

The evolutionary approach to understanding economic growth that we laid out in Chap. 2 emphasizes the roles played by experimentation, diversity, variety, and selection, placing the spotlight on the importance of the environment and of opportunities for individuals and firms to exploit new and existing knowledge. The design of the tax system is of fundamental importance here. Taxes affect the incentives to discover and create entrepreneurial opportunities and the desire to exploit these opportunities. The tax code must encourage entrepreneurship and active ownership. To fully compensate for a tax system that disincentivizes innovation and entrepreneurship by other measures is not only cumbersome and expensive, but also often impossible. The body of research on the role of innovation and entrepreneurship in a healthy economy leads us to the following conclusions regarding the appropriate design of the tax system:

• Owner-level taxation should treat all types of owners equally

• Labor income taxes should not inhibit individual incentives to invest in human capital nor its subsequent use

• Taxes should not prevent key employees and entrepreneurs from obtaining a fair stake in the substantial capital value that materializes when a successful firm is developed, even if they lack financial resources of their own

• The tax burden should be reasonably neutral with respect to the size, age, industry, and financing structure of a firm

• No wealth tax should be levied on corporate assets

• Dividend and capital gains taxes should be low. In particular, it is important that the capital gains tax is low on long-term holdings

Sweden still has relatively favorable conditions for entrepreneurship in the knowledge-intensive sector, which is due to a relatively high proportion of people with STEM degrees combined with several large, global, and R&D-intensive firms. However, in recent years, there are clear signs that Sweden’s advantages are eroding. Competition in this area, not least from China and India, has intensified significantly in recent years as the level of education in these countries has risen and continues to rise.

If the tax rules do not encourage entrepreneurship and active ownership, there will be a shortage of venture capital.²⁷ In the last few years, more generous and tax-efficient opportunities have featured stock options as a means to remunerate key individuals and facilitate scaling-up of young ventures. It is still too early to draw any firm conclusions regarding its effect on the supply of early-stage financing, but based on U.S. experience, there ought to be a substantial positive effect, although it may take some time to gain momentum.

With a more favorable tax system in place for most of the key agents in the collaborative innovation bloc, the government should refrain from additional interventions.²⁸ We are convinced that policies directed towards incentives to strengthen the impetus for productive entrepreneurial initiative are much more effective. This is likely to have a beneficial impact on both the demand for venture capital and the return on R&D investment. It is therefore important to maintain owner-level taxes and other taxes at levels that do not inhibit entrepreneurs’ ability to find venture capital.

Entrepreneurs who run successful, fast-growing firms in knowledge-intensive sectors tend to be exceptionally competent. This usually includes an extensive education, creativity, high risk tolerance, leadership skills, and industrial experience. Potentially successful entrepreneurs are therefore few and not easy to replace. Those with the greatest potential tend to already have well-paid, secure careers in existing firms. To abandon an attractive job and expose oneself to the risk of failure—which is always high, often well over 50%—requires a reward sufficiently attractive for those who succeed. This is not the case if the lion’s share of the return is paid as taxes.

It is therefore important to follow a general strategy for stimulating entrepreneurship rather than to spend resources on targeted subsidies of R&D expenditure and risk capital or to earmark public funds for investment in entrepreneurial firms (Svensson 2024). The public sector has—not unexpectedly—proven less successful than the private sector in identifying projects that can be developed into successful firms (Kärnä et al. 2023; Holcombe 2024). Selecting successful enterprises is difficult enough for the for-profit financial specialists. In addition, success seems to require tough company management and at times brutal corrective measures when something goes wrong—something that is not part of the public sector’s core competence, to put it mildly. Although the research is not unequivocal, reviews by Lerner (2009), among others, show that direct government initiatives to stimulate entrepreneurship have often failed when they are not coupled with specific measures regarding governance, evaluation, and funding structure (Lerner 2020).²⁹

In sum, the Swedish tax system has become much more beneficial to entrepreneurship compared to the 1970s and 1980s. It is particularly favorable for founders and external equity owners. The remaining problems mainly concern the lack of tax-efficient measures for compensating key personnel and intrapreneurs in the form of future ownership stakes in the values they are instrumental in creating. Moreover, financial integration has intensified institutional competition in the area of taxation, which makes it important to continuously benchmark the taxation structure applying to innovative entrepreneurship in one’s own country relative to other countries in a similar economic and demographic position.

5.5 Lessons from Chapters 4 and 5

In Chap. 4 and this chapter, we have argued that if an innovation is to be commercially successful, it is necessary to blend together a set of skills and competencies. The complexity of the process is often huge, and such obstacles as financing and recruitment of highly skilled people must be surmounted. The entrepreneur plays a decisive role here. Many new and initially fast-growing businesses subsequently fail. But those who succeed are major contributors to growth, development, and job creation.

Weak incentives for knowledge transfer, innovation, and firm building among those directly involved—researchers, universities, entrepreneurs, businesses, commercial knowledge brokers, and capital brokers—are sometimes replaced by an extensive bureaucracy to offset this deficiency. In Sweden, measures to facilitate commercialization have to a large extent been designed from above, but these cannot compensate for a lack of good financial incentives. Both may be needed, however. A comparison can be made with the United States, where legal structures (including pertinent tax rules) have been introduced that encourage spontaneous emergence from below of appropriate incentive structures.³⁰ Such a “bottom-up policy” constitutes a broad-based, market-compliant instrument to encourage voluntary profit-sharing arrangements between universities, researchers, institutions, venture capital firms, entrepreneurs, and all other actors necessary to transform knowledge and innovation into growth and prosperity (Elert et al. 2019; Henrekson and Stenkula 2024; Sanders et al. 2024).

To connect the specific competencies of all the various actors, well-functioning institutions and policies are thus required in a wide range of areas, from taxes to product market regulations, from education to social insurance. Some of the building blocks that must exist to ensure rapid structural transformation and successful innovation activities include the following:

• The legal system must be characterized by certainty, transparency, and efficiency in the handling of legal disputes, both between individual actors and the state and between individual firms.

• Regulation should prevent abuse and frivolous entrepreneurship in an effective way without burdening firms with unnecessary costs. These act as barriers to the establishment of new enterprises.

• The labor market must be sufficiently flexible and encourage mobility so that labor can be reallocated from workplaces with lower productivity to those with higher productivity at the lowest possible cost and with the shortest possible period of unemployment. Such flexibility also promotes the diffusion of knowledge embodied in labor.

• Safety nets provided by the government and through contracts should be designed in such a way as to facilitate and encourage the individual to seek employment with more productive firms and workplaces.

• Product markets should be sufficiently competitive to prevent firms from becoming or remaining dominant, either because they have established market power that cannot be challenged, or because they enjoy unfair advantages through special benefits from the government.

• The regulation of financial markets, including the tax system, should be designed in such a way that new and potentially fast-growing firms can readily access external capital.

• The infrastructure should be of such high quality that both start-ups and existing firms with high growth potential are not hindered by bottlenecks in the form of substandard transport and communication.

• The education system should prioritize quality throughout the entire system, from elementary school through PhD programs. This requires, for instance, independent and impartial evaluation of education providers, whether public or private.

• Agglomeration forces should be welcomed and facilitated through appropriate policy measures. These embrace several of the policy areas referred to above; the ultimate objective is to build an environment that attracts businesses and talent. Important but often overlooked factors are the infrastructure and the housing markets.

Appendix: Owner-Level Taxation of Closely Held Firms

Since 2006, a series of changes in the rules for closely held firms have been implemented that substantially expand the share of the owners’ income that may be taxed as capital income. In addition, the capital income tax rate on private firms was lowered to 25% for non-active owners and to 20% for active owners of unlisted firms in 2006. Regardless of the size of the firm, the owner can always pay a dividend taxed at 20% of 2.75 income base amounts (SEK 204,325 in 2023). If the owner does not select this option, low-tax dividends can be paid based on the sum of an imputed rate of return equal to the government bond rate + nine percentage points, plus a so-called wage-base allowance. To exercise the wage-base allowance option, the owner must receive an annual salary of 9.6 income base amounts. In such a case, the owner(s) can pay total dividends based on the wage-base allowance amounting to 50% of the total wage bill of the firm (however, the total low-tax dividend payouts cannot exceed 50 times the annual wage of the owner).³¹

These rules have created substantial room for paying low-tax dividends to owners of large and medium-sized closely held firms. For example, in such a firm with a total wage bill of SEK 20 million, the owner can pay dividends of up to SEK 10 million taxed at 20% even when the firm’s original equity base is a mere SEK 25,000 (assuming that the firm has sufficient profits to pay this amount). Unused dividend allowances are carried forward and can be accumulated at an interest rate equaling the government bond rate plus three percentage points. For passive owners of unlisted shares, both the dividend and the capital gains tax rate are 25% instead of the standard 30%.