Table of Contents
Why Is Europe Lagging Behind the US in Venture Capital and Innovation?
Explore the IMF’s strategic roadmap for revitalizing European venture capital. Learn why the EU trails the US in startup financing, how regulatory fragmentation stifles innovation, and which policy reforms are essential to unlock economic growth and R&D investment.
Concerned about Europe’s innovation gap? Read the full analysis now to understand the critical tax and regulatory changes needed to unleash the EU’s startup potential.
Recommendation
Venture capital promotes innovation and research which, in turn, boost economic development. Yet at both the national and supranational levels, venture capital investing lags in the European Union. IMF professionals Nathaniel Arnold, Guillaume Claveres, and Jan Frie explore the disadvantages of different tax and regulatory regimes and of less developed capital markets in promoting venture financing. They suggest incentives for greater investment by institutions and individuals. Financial professionals will find this a useful analysis.
Take-Aways
- The venture capital business is underdeveloped in the European Union.
- Promoting R&D and innovation requires venture capital.
- Policy reforms are necessary at the national and EU level.
Summary
The venture capital business is underdeveloped in the European Union.
The venture capital industry in the European Union averages 0.2% of GDP versus 0.7% in the United States. Europe boasts fewer VC funds as well. Universities, research centers, and technology firms are critical sources of innovation.
“Relative to the US, productivity growth and investment in R&D in lagging in the EU, where it is more difficult to finance and scale up promising, innovative startups. Many of the most successful EU startups move elsewhere for financing, causing the EU to lose out on both the direct growth benefits and positive spillovers from these innovative firms.”
Differences in law, taxation, and regulation affect the economies of EU member states and their ability to integrate. Product and labor markets vary, making expansion cumbersome and expensive. Banks have historically played a large role in the EU financial system, and capital markets are smaller as a result. Assets in private pension and insurance plans total nearly $12 trillion in the aggregate, far less than the more than $42 trillion in the United States. Venture capital has a shorter history in Europe, and it recently lost London, the region’s financial and private capital center, in the wake of Brexit. Capital raising has been a challenge due to EU investors’ lack of familiarity with venture capital, its due diligence costs, and regulation.
Promoting R&D and innovation requires venture capital.
Venture capital fosters innovation. Companies in the early stages of development benefit from the advice and networks of VC talent. Angel investors’ efforts promote economic growth and entrepreneurship.
“The positive effects of VC transmit to the broader economy through several channels. VC firms bring not only financing, but knowledge, advice, and professional networks.”
The creation of a single market for capital — a time-intensive and politically sensitive issue — would be an ideal fix for the lagging growth and productivity that plague the EU. Reduced barriers to economic integration would increase overall productivity. Innovative seed firms would benefit from greater investment in education and R&D. Immigration policy and labor law reform would enable start-ups to hire well-trained employees and expand.
Policy reforms are necessary at the national and EU level.
Reforms at the national level could include tax incentives to boost VC investment. More beneficial treatment of capital gains and losses could mitigate risk and increase returns. EU policy reform could include raising the capacity of the European Investment Fund (EIF) and European Investment Bank (EIB) to deploy capital to European VC. For example, the EIF might create a fund-of-funds for institutional investors to invest in EU-wide VC endeavors.
“Increasing private financing to scale up innovative firms on commercial terms is preferrable to relying on fiscally costly subsidies.”
Regulation should enable insurers’ greater investment in VC funds. A similar challenge exists for pension funds, in which rules vary by country and impede integration. The heterogeneity of public markets hinders liquidity, impedes valuation, and leads many seedlings to list overseas. A more homogenous and integrated capital market system would increase liquidity.
About the Authors
Nathaniel Arnold, Guillaume Claveres, and Jan Frie are with the IMF.