Capital Gains Tax, Venture Capital, and Innovation in Start-ups

We examine the effect of staggered changes in state-level capital gains tax rates on Venture Capital (VC)-backed start-ups and show that an increase in tax rates reduces patent quantity and quality. The results are consistent with a reduction in VC incentives to provide effort: VC-level tax increases lead to incrementally lower patent production by start-ups located out-of-state, and not linked by a direct flight to the VC investor. We also find evidence of a change in entrepreneurs’ incentives: after a tax increase, entrepreneurs decrease innovation risk, and stay invested for longer (the lock-in effect).