{"id":7745,"date":"2023-01-02T09:00:22","date_gmt":"2023-01-02T09:00:22","guid":{"rendered":"https:\/\/www.taxpolicy.org.uk\/?p=7745"},"modified":"2023-03-03T10:50:17","modified_gmt":"2023-03-03T10:50:17","slug":"vat_brake","status":"publish","type":"post","link":"https:\/\/heacham.neidles.com\/2023\/01\/02\/vat_brake\/","title":{"rendered":"Why VAT may be a brake on UK growth, and how to fix it"},"content":{"rendered":"\n

UPDATE:<\/strong> new data suggests the situation is now much worse than suggested in this article. Please see our latest report for the details.<\/a><\/em><\/p>\n\n\n\n

This chart should keep the Chancellor up at night. It shows the number of businesses by turnover band.1<\/a><\/sup> from the OTS review of VAT<\/a> in 2017<\/span><\/p>\n\n\n\n

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You’d expect a reasonably smooth curve, falling from a large number of small businesses on the left side, down to a smaller number of larger businesses on the right. But we don’t see that at all – we see a massive cliff edge right on the VAT registration threshold. Businesses don’t want to have to charge VAT – and therefore either raise prices by up to2<\/a><\/sup>“up to” because many businesses will be able to recover significant input VAT. For example, if I run a restaurant with \u00a3100k of turnover, \u00a320k of ingredient costs (plus VAT) and \u00a330k of rent (plus VAT) then I’ll owe HMRC 20% of \u00a3100k but be able to recover 20% of \u00a320k and 20% of \u00a330k. My net VAT bill is therefore \u00a320 – \u00a34 – \u00a36 = \u00a310. So becoming VAT registered is actually costing me 10% of my turnover, not 20%. Contrast with e.g. if I’m a tax consultant operating out of my house with few VATable expenses – my VAT cost is then likely close to 20%<\/span>20% or reduce their profits by the same amount (and the admin hassle is likely also a factor, but I expect a much smaller one). So they suppress their turnover. <\/p>\n\n\n\n

This isn’t news – and it got some<\/a> coverage at the time. But a new paper <\/a>from the CAGE research centre at Warwick puts beyond doubt that this one of the most critical UK tax policy problems. <\/p>\n\n\n

New evidence<\/h2>\n\n\n

The CAGE team analysed a huge dataset of companies from 2004-2015, with sophisticated controls to minimise confounding effects. They find an even clearer effect than the simple OTS chart above. Here’s a chart showing the proportion of firms that are growing for given levels of turnover:<\/p>\n\n\n\n

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The ‘0’ point on the x axis and red line running through it) is the VAT threshold. Look how growth peaks immediately before that point and then slumps right on the threshold.<\/p>\n\n\n\n

By contrast, shrinking firms show the kind of smooth curve we’d expect:<\/p>\n\n\n\n

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The smooth shrinkage curves also suggests that the growth cliff-edge is real, and not being driven by failure to declare turnover (i.e. criminal tax evasion). If firms did evade tax to keep below the threshold, then we’d expect to see the same effect in reverse, with a cliff-edge for shrinking firms (so, for example, a firm with \u00a390k of revenue would fail to declare \u00a35k of that, to slip below the threshold before it’s entitled to do so). But we don’t see any evidence of that.<\/p>\n\n\n\n

The Warwick team goes further, and look at the impact on rates of growth on turnover and cost:<\/p>\n\n\n\n

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We can see the brakes being put on – with turnover and cost growth slowing down just before the threshold, but then returning to a higher level afterwards. The fact it happens to cost as well as turnover is important, because this again suggests the effect is real and not just turnover being kept “off the books” (you can’t keep costs off the books without conspiring with your supplier3<\/a><\/sup>The one exception here is the apparently (anecdotally) common tactic of builders asking clients to buy their supplies directly, so it doesn’t go through the builder’s books and therefore take them over the threshold. This may be tax avoidance (depending on your own perspective<\/a>), but in my view it’s not improper and certainly not criminal tax evasion<\/span>). <\/p>\n\n\n

How do firms manage their growth?<\/h2>\n\n\n

We can get a sense of this in research which HMRC commissioned from Ipsos MORI in 2017. The findings<\/a> were stark: <\/p>\n\n\n\n

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If 20% admit to restricting their turnover, I expect the real proportion is significantly higher.<\/p>\n\n\n\n

And this accords with the anecdotal evidence I hear from everyone I ask about the subject – whether SME consultants, accountants, coffee shop-owners, builders, builders’ clients… it’s common knowledge that small businesses depress their revenue, most typically by not expanding, not taking on apprentices, and\/or cutting back on hours when approaching the threshold. Such as<\/a>:<\/p>\n\n\n\n

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Anecdote is not data, but given we already have the data, I find the consistency of the anecdotes compelling.<\/p>\n\n\n

Are there similar effects elsewhere in the world?<\/h2>\n\n\n

Surprisingly little work has been undertaken in this area, and none that I can find elsewhere in the OECD. However, there has been a detailed analysis<\/a> of Thai VAT returns, which can be neatly summarised by this chart:<\/p>\n\n\n\n

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and this chart, from a preliminary analysis<\/a> of Indian VAT returns:<\/p>\n\n\n\n

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A similar effect to the UK, albeit more dramatic. Note how the Indian and Thai charts show a much more pronounced peak before the threshold than the UK chart. I would speculate this is because of increased tax evasion compared to the UK – i.e. businesses not just decelerating growth as they approach the threshold, but failing to report sales that would take them over it. <\/p>\n\n\n

How does the UK’s registration threshold compare with everyone else?<\/h2>\n\n\n

The UK has the highest registration threshold in the world:4<\/a><\/sup>The chart doesn’t include the US because, whilst many States apply sales taxes with thresholds as high as $500,000, they’re conceptually very different from VATs. The rates are much lower (averaging around 6%)<\/a>, they don’t apply B2B, and the tax bases are relatively limited. Singapore also isn’t on the chart, as it’s not an OECD member – it has a high<\/a> GST registration threshold of SGD 1m\/year, but that’s much easier in a country where the tax\/GDP ratio is less than half the OECD average<\/span><\/p>\n\n\n\n

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When the threshold is as low as $30,000, it becomes unrealistic for businesses to suppress their growth to keep below it. Only the most micro of micro businesses won’t charge VAT, and everyone else is on a level playing field.<\/p>\n\n\n

Why is this a problem?<\/h2>\n\n\n

One way to view this is that the UK is losing out on VAT revenue. I think that is to miss some much more important issues. <\/p>\n\n\n\n

It doesn’t seem fanciful to think that, some of the firms that are staying below the VAT threshold might have thrived if they’d gone beyond it. Hired more employees, grown from micro companies into small, then medium, then – who knows? – become large businesses. What is the impact on macroeconomic growth of some companies’ growth simply stalling? <\/p>\n\n\n\n

And could this be part of the productivity puzzle<\/a>? The effect of staying below the threshold is that businesses never grow past one employee… but there is good evidence<\/a> that businesses with more employees are more productive. There is an excellent article<\/a> making exactly this point from the Adam Smith Institute.<\/p>\n\n\n\n

I’d love to see an economist undertake some analysis on whether there is a material macroeconomic impact from the effects shown by the HMRC and Warwick data.<\/p>\n\n\n

What’s the solution?<\/h2>\n\n\n

Here are two bad solutions:<\/p>\n\n\n\n