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Is the VAT threshold in the UK too high?

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Is the VAT threshold in the UK too high?

by Ben Lockwood, Li Liu, Eddy Tam

In the UK, small and medium size firms (SMEs), which are 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 has a wide variety of initiatives to support small business growth, from loans to technical advice.

However, there is one feature of the UK tax system that may be actively discouraging the growth of SMEs, and that is VAT, and in particular, the requirement to register for VAT once taxable turnover exceeds the threshold, currently £85,000. There are a number of reasons why the presence of the VAT threshold might affect small firm growth. First and foremost, crossing the threshold generally increases the VAT paid by the firm, as the firm must remit VAT on its sales, while claiming back VAT paid on inputs. Of course, a non-registered firm generally pays the so-called “embedded" VAT on its inputs, but this will usually be less than the VAT charged on sales. Second, there is a one-off compliance cost to initially registering for VAT, and then a periodic compliance cost for completing a VAT return. In the UK, the compliance costs are relatively low by international standards, but are not negligible. For example, a survey by the Federation of Small Businesses indicates an average time spent by a small business on VAT compliance of 45 hours per year, the highest time compliance cost of all taxes.

The relatively high threshold in the UK (one of the highest in the OECD) means that firms can operate under the threshold for long periods of time, perhaps even permanently. For example, a recent survey of over 2,000 UK firms conducted by IPSOS for HMRC found that while most firms started planning for registration when their turnover approached the threshold, around 20% of unregistered borderline businesses admit to having taken some action to remain under the threshold and outside the VAT system, by for example, stopping advertising, refusing or turning down work, asking customers to purchase materials, or reducing prices of products.

In recent research, we study the effect of the threshold on growth using HMRC administrative data on all firms in the UK over the fiscal years period 2004-5 to 2014-15. We use exogenous changes in the threshold over time to identify the causal effect of the threshold on firm growth.

We find that annual growth in turnover starts to slow when the firm turnover gets within about £20,000 of the threshold and slows by up to 2 percentage points when firms get close to the threshold. As the average growth rate in the sample is 8 percent, this implies 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. Simulation results show that as a consequence, the size of the firm can be up to 6% smaller than in the absence of the threshold, although the long-run fall in firm size is only 0.5% on average. When a firm passes the threshold, growth in firm costs shows a similar pattern, indicating that the response to the threshold is likely to be a real response rather than an evasion response. We also find similar effects of the threshold on the growth of non-incorporated businesses i.e. sole traders, partnerships, and unincorporated associations.

We then turn to consider whether different types of firm respond in different ways to the threshold. We first distinguish between firms that are voluntarily registered (that habitually register even when their turnover is below the VAT threshold) and firms that are unregistered. We would expect voluntary registered firms not to respond to the threshold, as they have already decided to pay the compliance costs of VAT registration for other reasons e.g. to reclaim VAT on inputs. Confirming this conjecture, we find 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.

We also distinguish 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. We 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, as might be expected.

So, in conclusion, we find that the setting of the VAT at a relatively high level on the UK most probably inhibits the growth of small firms. This raises the possibility that setting the threshold at a lower level could effectively force firms to register at an earlier stage in the growth process, which may lead to smaller effects on growth in the long run.

This blog post was first publishedLink opens in a new window on the website of the Oxford University Centre for Business Taxation

Read the research

Li Liu, Ben Lockwood and Eddy Tam (2022), Small Firm Growth and the VAT Threshold: Evidence for the UK, CAGE working paper No. 631