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Department of Economics

Is the VAT threshold in the UK too high?

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Is the VAT threshold in the UK too high?

Tuesday 1 Nov 2022

In the UK, small and medium size firms (SMEs - firms with less than 250 employees) are very important to the economy: they account for three fifths of the employment and around half of turnover in the UK private sector. So, it is not surprising that the UK government has a wide variety of initiatives to support small business growth, from loans to technical advice.

However, one feature of the UK tax system may be actively discouraging the growth of SMEs - the requirement to register for VAT once taxable turnover exceeds the threshold, currently £85,000.

Crossing the threshold usually increases the amount of VAT paid by a firm, and also incurs costs in complying with the rules, such as completing VAT returns. Are these costs sufficiently off-putting that firms deliberately restrict their growth in order to stay below the threshold?

To explore this question Professor Ben Lockwood, Dr Li Liu, senior economist at the International Monetary Fund and Dr Eddy Tam of King’s College London have studied the effect of the threshold on growth using HMRC data on all firms in the UK between 2004-5 and 2014-15.

They find that annual growth in turnover starts to slow when a firm’s turnover gets to within about £20,000 of the threshold and slows by up to 2 percentage points as firms get closer to the threshold - a slowdown of up to 25 percent in the growth rate. There is no evidence of compensating acceleration in growth once a firm crosses the threshold. The research finds similar effects of the threshold on the growth of non-incorporated businesses such as sole traders, partnerships, and unincorporated associations.

To explore this effect further the paper also compares data from firms that are voluntarily registered for VAT (even when their turnover is below the VAT threshold) with firms that are not registered, and finds a sharp difference between these two types of firms as they approach the threshold - voluntary registered firms do not slow down at all, whereas the other firms slow down sharply, with growth falling 3-4 percentage points.

The researchers also look at differences between firms that join the flat rate scheme (FRS), a simplified VAT scheme for small businesses in the UK that is explicitly designed to reduce compliance costs, and those that do not. A firm's VAT liability in the FRS is a single rate of tax times the total turnover of the business. As a result, the FRS is effectively a turnover tax, and only requires businesses to keep track of total turnover rather than a separate record of each purchase and sale, and should be less burdensome than regular VAT. They find that firms that register for VAT via the FRS slow down less before the VAT threshold than those that do not, so the FRS does appear to mitigate the effect of the threshold.

Professor Lockwood comments: “Our analysis finds robust evidence that growth in turnover slows down as firms approach the threshold, with no evidence of higher growth when the threshold is passed. We conclude that by setting the threshold for VAT registration at this relatively high level the government is inadvertently inhibiting the growth of small firms.”