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Niko Bellic doesn't file his tax returns. The main character in the latest installment of the video-game series Grand Theft Auto willingly shoots cops, kidnaps heiresses and drives on the wrong side of the road. But while he defies police, gangsters and traffic regulations alike in his virtual kingdom, in the real world, Niko and his compatriots face a serious threat from an unexpected foe: the British Treasury.

As part of an austerity budget designed to bring Britain's public finances under control, the head of the British Treasury announced at the end of June that the government would not make good on plans to create a tax-break system for video-game companies that would have been similar to the one for the British film industry. As home to Grand Theft Auto creator Rockstar Games, Lionhead, the company behind Fable, and countless other game companies, Britain has long held a small but influential chunk of the $60 billion-a-year gaming industry. But industry lobbyists say tax breaks are required to keep the country on a level playing field with companies from countries like Canada and South Korea, which have been actively courting game companies for years and recently overtook Britain in a list of the world's largest video-game-producing nations. (Britain slipped to fifth; the U.S. and Japan hold the top two spots.)

With an end to the promised tax breaks, the British gaming industry was "let down, to put it mildly," says Richard Wilson, CEO of the Independent Games Developers Association (TIGA), an industry trade body that had been instrumental in pushing for the tax break and had succeeded in incorporating it into the previous government's April budget before it was scrapped. Wilson and other lobbyists say the $3 billion-a-year British video-game industry is a great model for the future of the British economy: it fosters innovation and investment, builds the high-tech sector and encourages education in science and technology. Implementing tax relief, says TIGA, will pay back twice as much as it costs and save more than 3,500 jobs.

But given its pledge to make savage cuts to public spending, the recently elected Conservative–Liberal Democrat coalition government felt such arguments did not justify an exemption for video games, calling the tax break, which would have been worth 20% to 30% of a game's budget, "poorly targeted." On July 14, Ed Vaizey, Minister for Culture, Communications and Creative Industries, faced a hostile yet muted reception when he addressed the new taxing system at Develop, a game developers' conference in Brighton. Stressing that the government's new budget would help all businesses, he said the industry had not justified a sector-specific tax break. "To put it bluntly," he told TIGA's Wilson after his address, "you haven't made the case, because the Chancellor didn't accept it." But he added that the government understands gaming is a serious player in the bid to build a highly skilled British economy. "I remain a committed champion of this industry," Vaizey told the conference. "The industry ticks every political box, going, 'It's high-tech. It's regional. It attracts graduates from the subjects we want to see more people studying.'"

Vaizey certainly knows his audience. While video games may have once stirred controversy with their graphic violence, they have recently become entrenched in the British mainstream. According to a report released earlier this year, 32% of the British public classify themselves as "gamers" and half of U.K. households contain at least one video-game console. In 2009, profits from video games in Britain surpassed the country's film revenue, including both box-office receipts and DVD sales.

Even so, gaming has hardly been the recession-proof industry that analysts once predicted — citing the success of leisure industries like film during past downturns — and the U.K. has suffered more than most. "At the beginning of 2009, some commentators were saying that video games are immune to recession," says Wilson. "That clearly wasn't true." Software sales were down 7% in the U.S. from 2008 to 2009, while total U.K. games revenue shrank 18% in the same period. 2010 isn't looking much better. Sales in the first half of the year are down even more from 2009's: 16% in the U.K. from 2009, 9% in the U.S.

This comparative decline is often cited by TIGA as a reason tax breaks are necessary. It estimates that about 700 highly skilled, highly transferable developers' jobs have been lost in the U.K. games industry since July 2008. Of those, about 300 have gone to Canada — home of developers like Bioware, creator of the successful Mass Effect franchise. "That gives you an indication of the direction of travel, metaphorically and geographically," Wilson says. "Skilled and talented staff are being poached away from the U.K."

While the British-made Niko Bellic may make death his business, it's that other great certainty — taxes — that could spell game over for the U.K.'s video-game industry. And with the British economy as it is, extra lives are in short supply.

• Adam White / London