Why U.K. Chancellor Rachel Reeves Should Approach Capital Gains Tax Decisions Like a Venture Capitalist

In September 2024, the United Kingdom saw its highest monthly capital gains tax (CGT) receipts since 2008. This surge in revenue has set the stage for considerable debate as the Autumn Budget approaches. Many business owners and investors are expressing alarm, anticipating a potential CGT increase exceeding 28% for the first time. While only approximately 3% of the population currently pays CGT, the potential consequences of such a significant tax hike extend far beyond the immediate revenue increase. Chancellor Rachel Reeves must carefully consider the long-term implications, particularly the risk of undermining the U.K.'s position as a leading global tech hub.

The U.K. has historically been a highly attractive location for entrepreneurs. Its robust financial markets, coupled with a concentration of skilled talent, have created a fertile ground for business growth. Government initiatives such as the Enterprise Investment Schemes (EIS) and Seed Enterprise Investment Schemes (SEIS) have further incentivized investment in early-stage companies by offering substantial tax breaks. These schemes provide significant tax relief to investors, encouraging them to support nascent businesses. For instance, an EIS can reduce an investor's income tax liability by up to 30%, effectively lowering the cost of investment in qualifying companies. Similarly, SEIS offers even more generous relief, potentially allowing investors to reclaim up to 50% of their investment.

However, the current support system for UK businesses has significant gaps. The benefits provided by schemes like EIS and SEIS are primarily focused on the early stages of a company's lifecycle. As companies mature and outgrow the scope of these schemes, the level of government support dramatically decreases, leaving founders facing a significant financial cliff edge. This abrupt shift in support can severely hinder growth, particularly for companies that have successfully navigated the initial phases but aren't yet large enough to absorb substantially higher tax burdens.

The situation is further complicated by the potential impact on other crucial incentive schemes. The Entrepreneurs' Relief, which reduces the rate of CGT on business assets, could face significant changes, adding further pressure. Furthermore, the effectiveness of the Enterprise Management Incentive (EMI) scheme, designed to incentivize employee ownership through stock options, is diminished if these options are taxed as capital gains. These factors collectively create a challenging environment for growth-stage companies, placing the UK's vibrant startup ecosystem at risk.

The increased global mobility of top talent exacerbates these issues. Skilled professionals and entrepreneurs can now launch and manage businesses from virtually anywhere in the world, leading to fierce competition between countries vying to attract top talent. The intense competition for investment and talent necessitates a nuanced approach from policymakers to ensure the U.K. remains a desirable location for entrepreneurs.

For example, a venture capital firm with global operations, operating from 27 international offices, recently conducted a program in the UK. This program engaged 66 founders representing 27 nationalities. The fact that these individuals, despite their diverse origins, chose to establish and expand their ventures in the U.K. highlights the country's enduring appeal. However, this advantage is not guaranteed. Financial centers like Singapore and Dubai are actively courting international businesses with attractive tax policies. An increase in the U.K.'s CGT could easily tip the balance, driving away the very entrepreneurs and investors crucial for innovation and economic growth.

A concerning trend is the tendency of successful U.K. tech companies to seek listings outside the country. Despite fostering world-class innovation, many promising firms opt for public listings on exchanges like the NASDAQ in the United States, rather than the London Stock Exchange. This trend demonstrates a lack of confidence in the U.K. market for later-stage companies. This phenomenon extends beyond mature companies; even early-stage artificial intelligence (AI) firms are relocating their operations to Silicon Valley. This exodus of companies, often accompanied by the dispersion of leadership teams and the shifting of operational centers, ultimately results in valuable exits occurring outside the U.K., diminishing the potential tax revenue and economic benefits for the country.

The venture capital power law highlights the significance of focusing on high-growth potential companies. This principle suggests that a small number of companies within a portfolio will generate the majority of returns. Studies show that a very small percentage (0.6% in one example) of funded businesses can contribute over 50% of total valuation growth. The government should adopt a similar perspective on CGT. Losing even one high-potential, rapidly growing company to another jurisdiction will result in substantial lost revenue and diminished economic value for the UK in the long run. The potential loss of future tax revenue from a company that chooses to relocate overseas significantly outweighs the short-term gains from a CGT increase.

The proposed CGT increase risks a short-sighted focus on immediate revenue generation at the expense of long-term economic prosperity. While initiatives like the 2023 Mansion House reforms aimed at increasing pension fund investment in later-stage growth companies are positive, their effectiveness will be limited if unfavorable tax policies drive away founders and talent.

A more comprehensive approach is needed, one that supports businesses throughout their entire lifecycle, not just in their initial stages. This could involve creating a more graduated system of tax support that adapts to the changing needs of a business as it scales. Addressing the support gap between early-stage tax relief and the higher tax burdens of mature companies would create a far more sustainable and attractive environment for business growth. Such a strategy would enable the U.K. to fully leverage its existing strengths: its history of innovation, its world-class universities, and its sophisticated financial services industry.

The U.K.'s vibrant startup ecosystem is the result of decades of careful policymaking. The current moment requires a reinforcement, not a dismantling, of these foundational elements. The goal should be to create an environment where the next generation of transformative companies not only starts in the U.K. but thrives and remains there, contributing to the country's economic growth and global competitiveness. A nuanced approach to CGT, informed by the principles of venture capitalism, is essential to achieving this goal. Instead of focusing solely on immediate revenue gains, the government should prioritize fostering a sustainable ecosystem that attracts and retains both entrepreneurs and investors, ultimately generating significantly greater long-term tax revenue and economic prosperity for the country. A well-structured system of tax support can help prevent the “brain drain” and ensure that the UK continues to be a global leader in innovation.