{"id":8642,"date":"2023-01-30T13:54:40","date_gmt":"2023-01-30T13:54:40","guid":{"rendered":"https:\/\/www.taxpolicy.org.uk\/?p=8642"},"modified":"2023-03-03T10:49:04","modified_gmt":"2023-03-03T10:49:04","slug":"vat_brake2","status":"publish","type":"post","link":"https:\/\/heacham.neidles.com\/2023\/01\/30\/vat_brake2\/","title":{"rendered":"Is VAT stopping 26,000 businesses from growing? More on the VAT growth brake."},"content":{"rendered":"\n
Tax Policy Associates has new data suggesting that around 26,000 businesses are stalling their growth for fear of hitting the VAT threshold. <\/em><\/strong> <\/p>\n\n\n\n This chart deserves more attention:<\/p>\n\n\n\n It shows the number of businesses at each turnover level in 2018\/19. 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 \u00a385,000 VAT registration threshold – the point at which they’d need to charge 20% VAT.1<\/a><\/sup>The HMRC FOIA response is here<\/a>, and our analysis preadsheet here<\/a>.<\/span>. The FT covered this here – apologies for not writing it up sooner.<\/a><\/p>\n\n\n\n What does that mean? It means that companies are holding back their turnover – slowing and stopping growth – to avoid having to charge VAT.<\/p>\n\n\n\n That looks much worse than the data HMRC published for 2014\/15, which I commented on here<\/a>.2<\/a><\/sup>from the OTS review of VAT<\/a> in 2017<\/span>.<\/p>\n\n\n\n Worse in two ways: more bunching before the threshold, and a steeper decline afterwards. About 3,500 companies per \u00a31k turnover band go “missing” (compared to about3<\/a><\/sup>I’m having to eyeball that, as we don’t have the raw data for 2014\/15, only the chart<\/span> 2,000 in 2014\/15) and about 4,500 sole traders (around 3,500 in 2014\/15). Why? I don’t know. 4<\/a><\/sup>An obvious response is “Brexit”, but I don’t think that can be right. Brexit certainly made things more complicated for cross-border sales, but only after legally effective exit on 1 January 2021. Some firms adapted their business models ahead of 2021, but those were generally larger firms. And in this case it would be odd for small firms to suppress their turnover (i.e. make less money!) or hide income (commit criminal tax evasion!) before it gave them any advantage. So I can’t immediately see why there would be any Brexit effects as early as 2018\/19. However, there could be significant Brexit effects from 1 January 2021, meaning that the effect could plausibly be much worse today than it was in 2018\/19.<\/span> One plausible cause is the significant limitations placed on the VAT flat rate scheme after 2015-16.5<\/a><\/sup>Many thanks to Damian McBride on Twitter for suggesting this.<\/a> The flat rate scheme was restricted for good reason – it was being widely abused – but it would be good to have some assurance that the cure is better than the disease… right now I don’t know<\/span><\/p>\n\n\n\n Why do we see the cliff-edge effect? Because businesses don’t want to have to charge VAT – and have to raise prices by up to 20%.6<\/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%. Of course they could instead eat some of the VAT cost in the form of reduced profits – but in most cases their profits will be too small to cover more than a teensy bit of the VAT cost<\/span>Compliance hassle is also a factor, but evidence suggests much less important than the cold hard cash cost. <\/p>\n\n\n\n So they suppress their turnover. If the 2022 Warwick paper <\/a>is correct, this is decelerated growth rather than failure to report income\/VAT evasion. I wrote about that more here<\/a>. <\/p>\n\n\n\n How? For example: plumbers don’t take on an apprentice. Contractors stop working in February. Accountants work separately rather than combining into one business. What effect is this going to have on overall UK productivity? I’m not an economist, but it doesn’t feel fantastic…<\/p>\n\n\n\n We can approximately measure the effect by measuring the size of the “bulge” before the cliff in the chart, and counting the number of firms in it: <\/p>\n\n\n\n That’s about 26,000 businesses whose growth has been stalled by the VAT threshold. <\/p>\n\n\n\n I continue to think that this is one of the most critical UK tax policy problems. <\/p>\n\n\n The UK has the highest registration threshold in the world:7<\/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 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 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 26,000 firms that are holding their growth 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 (they seem to have been the first people to write about the issue – full credit to them).<\/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 Here are three bad solutions:<\/p>\n\n\n\n And a boring solution, which is probably what’s happening at the moment:<\/p>\n\n\n\n What we need is a way to eliminate the dramatic “cliff-edge” effect that takes less than twenty years, doesn’t just move the cliff-edge elsewhere, and is neutral in government revenue terms. And one benefit of Brexit is that we have the freedom to change VAT however we like.9<\/a><\/sup>mostly<\/span><\/p>\n\n\n\n Here’s one potential idea:<\/p>\n\n\n\n Instead of a dramatic threshold, that takes VAT from zero to 20%, let’s smoothly phase it in. So, for example, at \u00a330,000 VAT would be applied at 1% (and input tax recoverable at 1%), with the rate increasing bit-by-bit until by \u00a3140,000 VAT would fully apply at 20% (with the intention that the overall effect is revenue-neutral). The OTS proposed further investigation of such a system back in 2019, but I don’t believe it went any further.10<\/a><\/sup>See paragraph 1.29 here<\/a><\/span><\/p>\n\n\n\n This would once have been impractical, given that the complications it creates for business customers of a business applying (say) 7% VAT. But all VAT returns will soon be digital<\/a> – so that element now feels like a relatively trivial technical problem, rather than a difficult human one. <\/p>\n\n\n\n I shouldn’t understate the challenges. One particularly difficult element is how you decide in advance what rate a business should charge. Easy(ish) for an established business with a consistent quarterly turnover. Hard for a new business, or one that’s growing or shrinking unpredictably.<\/p>\n\n\n\n You could sidestep that difficulty, but achieve an economically identical result, with a rebate system. Everyone charges 20% VAT from (say) \u00a330,000 of turnover, but 19% of that is rebated for \u00a330k businesses. The rebate drops as turnover increases, vanishing entirely at (say) \u00a3140k. If you pay the rebate quarterly in arrears then that removes the need to predict future turnover – that does, however, create a three-month cashflow problem for small businesses, and trying to solve that problem just runs into the predictability issue again. Rebate systems also can create tricky issues with cross-border supplies – how do we give foreign suppliers a rebate? And if we don’t, how can we avoid distortions and unfairness (and potentially WTO\/GATS difficulties)?<\/p>\n\n\n\n And we shouldn’t minimise the political difficulties with any proposal which increases prices\/reduces profit for \u00a330k-\u00a385k businesses. I don’t expect the immediate beneficiaries (the \u00a385k-140k businesses) would call many demonstrations in support. So it would take a brave Government, which recognises a potential brake on growth and is willing to court unpopularity to release it. <\/p>\n\n\n\n I\u2019d love to see this issue becoming part of the public tax debate. I can\u2019t lie: solving it will be really hard, and require input from people with expertise that I don\u2019t begin to have. Specifically, economists need to confirm the intuition that this is a serious problem for the UK economy, and compliance specialists (in HMRC and the private sector) need to work up a solution that doesn\u2019t cause more problems than it fixes. It’s possible we end up concluding that the current situation is bad, but any radical solution would be worse, and we just have to sit tight for ten\/twenty years and let inflation erode the VAT threshold to something sensible.<\/p>\n\n\n\n All of this would need very serious thought, and I am absolutely not saying I have all the answers. Very possibly I have none of the answers. I do, however, believe I have a question.<\/p>\n\n\n\n <\/p>\n\n\n\n This website has benefited from some amazingly insightful comments, some of which have materially advanced our work. Comments are open, but we are really looking for comments which advance the debate – e.g. by specific criticisms, additions, or comments on the article (particularly technical tax comments, or comments from people with practical experience in the area). I love reading emails thanking us for our work, but I will delete those when they’re comments – just so people can clearly see the more technical comments. I will also delete comments which are political in nature. <\/p>\n\n\n\n Image by DALL-E<\/a>: “a colourful set of equal-sized cubic children’s wooden building blocks with the letters VAT (in order), on a wooden table, digital art”<\/p>\n\n\n\n<\/figure>\n\n\n\n
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How does the UK’s registration threshold compare with everyone else?<\/h2>\n\n\n
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Why is this a problem?<\/h2>\n\n\n
What’s the solution?<\/h2>\n\n\n
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