HM Treasury has issued a call for evidence to explore whether the design of the VAT threshold could better incentivise growth. Evidence suggests that the UK’s high threshold creates undesirable economic outcomes and, from the Treasury’s perspective, represents a significant loss of tax revenues. The Treasury document seeks evidence on the impact of the threshold and also references some possible policy solutions, such as the recent EC proposal for SMEs, administrative smoothings for businesses moving into VAT registration, and financial smoothings to address the current cliff-edge problem. While the chancellor has said he is not ‘minded’ to cut the threshold, it seems clear that the government is seriously considering its options.
As announced in December, the government wants to use its new Spring Statement as an opportunity to publish consultations, including initiating early stage calls for evidence. Indeed, the first Spring Statement saw the government delivering on this promise with a call for evidence on the VAT registration threshold, a topic considered last year by the Office of Tax Simplification (OTS) and one that continues to divide opinion.
For a good 45 years, the UK has maintained a high VAT registration threshold, with Conservative and Labour chancellors alike increasing the UK’s threshold with inflation, the maximum allowed under the EU rules. It now stands at £85,000, the highest in Europe and significantly in excess of the minimum allowed in the EU of nearly £9,000 and the global average of around £15,000.
The call for evidence focuses on three sets of issues:
So does the launching of a consultation on the level of the threshold mark a significant shift in government thinking? And, if so, what options are likely to emerge from the consultation process?
The principle underpinning this high threshold policy is that it offers an effective means of keeping smaller businesses out of VAT altogether, thereby avoiding the administrative burden of accounting for VAT.
The theory is quite sound, and at a macro level it is borne out in practice, with 55% of small businesses (3.5m in total) falling below the current threshold. Unfortunately, as is so often the case, practice throws up some problems. In particular, there is evidence to suggest that the operation of a very high threshold creates undesirable economic outcomes. Principal among these is the risk that the threshold creates:
The distortions around the threshold raise very real concerns. The OTS notes that many very small businesses, especially labour-only businesses, can make a profit that their owners regard as sufficient while remaining under the threshold. The Treasury is concerned that this distortion could be holding back productivity growth.
Beyond this, the government also notes that having a high proportion of businesses under the threshold (and therefore unregistered) could encourage more businesses to operate in the hidden economy, reducing their compliance with other taxes.
And, of course, from the Treasury’s perspective, a high threshold represents a loss of tax revenues. Compared with the EU minimum threshold, the annual cost of VAT forgone in the UK is over £2bn. Even setting a more realistic level of £43,000 would generate an increase of between £1bn and £1.5bn, which could be recycled into a rate cut for everyone.
Given that businesses can voluntarily register for VAT, those operating below the threshold in effect have a choice between being treated on the same footing as larger businesses (i.e. accounting for and charging VAT, and being able to reclaim input tax on its purchases); or being in the same position as a seller of exempt goods (i.e. not exposed to VAT on the value added that the business produces but suffering VAT on its purchases).
The benefit of being exempt from VAT (through being unregistered) applies particularly to those selling otherwise ‘VATable’ goods and services to customers who cannot recover VAT themselves (e.g. individuals or exempt businesses, such as banks). Businesses that sell to other VATable businesses are incentivised to register as the VAT does not represent an additional cost to their customers, and registration would then enable them to recover VAT that they incur on their costs. This is one of the key reasons behind the million or so businesses that register for VAT even though they are below the registration threshold.
The threshold, then, has a particular impact on two types of business: business to consumer (B2C) businesses, which sell to final consumers rather than to other businesses; and businesses with low VATable costs (those with large margins or where the primary costs are not subject to VAT, such as labour). For both these types of business, tripping over the threshold effectively equates to a cost increase of up to a sixth (i.e. 20%/120%).
The government recognises this and lists the primary sectors affected as tourism, construction, accommodation, food, tradespeople and professional, scientific and IT services.
Recent statements and actions from HM Treasury offer some pointers to where policy may be heading. The chancellor said in the Autumn Budget, and repeats in the call for evidence, that he is ‘not minded to reduce the threshold’. However, in the same Budget, the chancellor froze the threshold for two years, thereby delivering cut in real terms, and in the process generating the exchequer an additional £50m in revenues for next year.
The call for evidence notes that any discussion around the design of the threshold (and any ‘smoothings’) must necessarily include the level of the threshold and that the economic distortions in the UK appear more pronounced due to its comparatively high threshold. There may also be a link between the design of the threshold and the size of the hidden economy.
All this suggests that while the chancellor may not be ‘minded’ to cut the threshold, he has given himself enough room for manoeuvre should the facts emerging from the consultation lead to a change of mind (Keynes would be proud).
The primary question, however, is how to address the distortions around the threshold. The OTS notes that this issue will apply at whatever threshold is chosen. Drawing on the work of the OTS, the chancellor’s consultation document raises the following core issues:
As well as seeking evidence and data on these points, the Treasury document gently floats some possible ‘policy solutions’, mentioning the recent (European Commission) EC proposal for SMEs, administrative smoothings for businesses moving into VAT registration, and financial smoothings to address the current cliff-edge.
Administrative smoothings
A key question is about the distortion caused by the increase in administration. The concern is that, faced with the burdens and costs involved in administering VAT, small businesses approaching the threshold will deliberately supress their turnover in order to avoid tipping over into VAT registration. That suppression could take a variety of forms, ranging from the legitimate, such as not taking on further work or not investing in equipment that might increase their productivity, to the illegitimate, such as fraudulently not declaring income or seeking to split income between two different registrations.
This could be a case of information failure; i.e. that the administration is not actually as bad as is feared and therefore the actions to keep turnover levels down are disproportionate to the actual burdens experienced. Indeed, as the consultation notes: ‘There may be a distinction between perception of the administrative burden of VAT and the reality.’ HMRC’s standard estimate is that the administrative costs for an average small business are around £675 per year, which is small compared to the threshold of £85,000. If this is the case, then one key policy response is to educate those near the threshold about the limited burden involved in complying with the VAT processes.
There does seem to be some evidence to support for this argument. The fact that a million businesses below the threshold are opting to pay VAT (and hence recovering input VAT) would imply that the additional administration is not acting as a deterrent for them. And with initiatives like the flat rate scheme, which radically simplifies the VAT calculation and reporting, it is clear that VAT administration can be kept manageable.
Nevertheless, the government is considering other options to minimise the increase in administrative burden as businesses cross the threshold. When it comes to practical ways of achieving this, however, the call for evidence suggests only two options before asking for more ideas.
The first option builds upon the system in New Zealand where smaller businesses file their returns every six months, rather than under the general system of every one or two months. The UK would extend the first period for which a business has to account and pay VAT obligations from three months to six months – somewhat less helpful than the New Zealand option. Reducing the returns by one in the year of registration may be helpful but business owners are likely to be thinking about the ongoing full year cost.
The second option would be to apply the threshold test over two years rather than one, such that the taxable turnover of a business would need to be over £170,000 in total over two years before registration is required. This might keep some businesses out of registration, but would not seem to reduce the administration once the business needs to register.
Financial smoothings
While the jury may still be out on the issue of administrative burdens, the financial disincentives to moving just above the VAT registration threshold are clear.
Here, the government has a few more ideas. It cites Finland and the Netherlands, which graduate the amount of tax paid as the turnover increases, rather than applying the full VAT rate once the threshold is reached. It also considers having different thresholds for different sectors and mimicking the slice system inherent in income tax into the VAT system, such that the rate would increase as turnover increases until at some turnover point the business has to pay over the full rate of VAT to HMRC.
In the questions asked, the government comes back to the idea of two thresholds: a lower threshold, below which financial obligations are removed; and a higher threshold, below which some of the administrative obligations are reduced. Finally, this section reverts to the idea that these issues could be reduced by either increasing or decreasing the threshold. Of course, the financial impact of going over the threshold reduces as the threshold is reduced.
It is clear that the government is seriously considering its options, now that it is expecting to be freed from the constraints imposed by being a member of the European Union. This includes the freedom to change the threshold – and indeed to change it again if needed in the future.
Despite the comments in the Budget, a cut in the threshold does seem to be on the cards. From an economic and purist perspective, the best VAT threshold to have would be no threshold at all. This would bring all businesses into the VAT net, broaden the tax base, and remove any distortions between those VAT-registered and those non-registered. In practice, the attractiveness of this apparently idyllic state of affairs (from a Treasury perspective) is undermined by the burdens of administering the tax and complying with its requirements, both for businesses and HMRC.
A cynic might see the focus on reducing the burdens as a stepping stone to a reduced threshold. Cynicism aside, would that be such a bad thing? Perhaps the timing is not ideal, given the imminent application of making tax digital for VAT to those over the registration threshold. But, once that has settled down, if the additional revenue for the exchequer is redeployed to provide support to small businesses elsewhere, including the million small businesses that currently register for VAT, might this be a better use of the £2.1bn per annum cost of the threshold?
The call for evidence is an early stage in the consultation process and there will be plenty of opportunities over the coming months to explore these issues further and assess the options open to the chancellor. The government will be hoping that people accept the challenge and respond. With a deadline of 5 June 2018, there is still time to come up with new ideas.
For details of the call for evidence, see bit.ly/2FPZLog. The views expressed in this article are those of the authors alone.
HM Treasury has issued a call for evidence to explore whether the design of the VAT threshold could better incentivise growth. Evidence suggests that the UK’s high threshold creates undesirable economic outcomes and, from the Treasury’s perspective, represents a significant loss of tax revenues. The Treasury document seeks evidence on the impact of the threshold and also references some possible policy solutions, such as the recent EC proposal for SMEs, administrative smoothings for businesses moving into VAT registration, and financial smoothings to address the current cliff-edge problem. While the chancellor has said he is not ‘minded’ to cut the threshold, it seems clear that the government is seriously considering its options.
As announced in December, the government wants to use its new Spring Statement as an opportunity to publish consultations, including initiating early stage calls for evidence. Indeed, the first Spring Statement saw the government delivering on this promise with a call for evidence on the VAT registration threshold, a topic considered last year by the Office of Tax Simplification (OTS) and one that continues to divide opinion.
For a good 45 years, the UK has maintained a high VAT registration threshold, with Conservative and Labour chancellors alike increasing the UK’s threshold with inflation, the maximum allowed under the EU rules. It now stands at £85,000, the highest in Europe and significantly in excess of the minimum allowed in the EU of nearly £9,000 and the global average of around £15,000.
The call for evidence focuses on three sets of issues:
So does the launching of a consultation on the level of the threshold mark a significant shift in government thinking? And, if so, what options are likely to emerge from the consultation process?
The principle underpinning this high threshold policy is that it offers an effective means of keeping smaller businesses out of VAT altogether, thereby avoiding the administrative burden of accounting for VAT.
The theory is quite sound, and at a macro level it is borne out in practice, with 55% of small businesses (3.5m in total) falling below the current threshold. Unfortunately, as is so often the case, practice throws up some problems. In particular, there is evidence to suggest that the operation of a very high threshold creates undesirable economic outcomes. Principal among these is the risk that the threshold creates:
The distortions around the threshold raise very real concerns. The OTS notes that many very small businesses, especially labour-only businesses, can make a profit that their owners regard as sufficient while remaining under the threshold. The Treasury is concerned that this distortion could be holding back productivity growth.
Beyond this, the government also notes that having a high proportion of businesses under the threshold (and therefore unregistered) could encourage more businesses to operate in the hidden economy, reducing their compliance with other taxes.
And, of course, from the Treasury’s perspective, a high threshold represents a loss of tax revenues. Compared with the EU minimum threshold, the annual cost of VAT forgone in the UK is over £2bn. Even setting a more realistic level of £43,000 would generate an increase of between £1bn and £1.5bn, which could be recycled into a rate cut for everyone.
Given that businesses can voluntarily register for VAT, those operating below the threshold in effect have a choice between being treated on the same footing as larger businesses (i.e. accounting for and charging VAT, and being able to reclaim input tax on its purchases); or being in the same position as a seller of exempt goods (i.e. not exposed to VAT on the value added that the business produces but suffering VAT on its purchases).
The benefit of being exempt from VAT (through being unregistered) applies particularly to those selling otherwise ‘VATable’ goods and services to customers who cannot recover VAT themselves (e.g. individuals or exempt businesses, such as banks). Businesses that sell to other VATable businesses are incentivised to register as the VAT does not represent an additional cost to their customers, and registration would then enable them to recover VAT that they incur on their costs. This is one of the key reasons behind the million or so businesses that register for VAT even though they are below the registration threshold.
The threshold, then, has a particular impact on two types of business: business to consumer (B2C) businesses, which sell to final consumers rather than to other businesses; and businesses with low VATable costs (those with large margins or where the primary costs are not subject to VAT, such as labour). For both these types of business, tripping over the threshold effectively equates to a cost increase of up to a sixth (i.e. 20%/120%).
The government recognises this and lists the primary sectors affected as tourism, construction, accommodation, food, tradespeople and professional, scientific and IT services.
Recent statements and actions from HM Treasury offer some pointers to where policy may be heading. The chancellor said in the Autumn Budget, and repeats in the call for evidence, that he is ‘not minded to reduce the threshold’. However, in the same Budget, the chancellor froze the threshold for two years, thereby delivering cut in real terms, and in the process generating the exchequer an additional £50m in revenues for next year.
The call for evidence notes that any discussion around the design of the threshold (and any ‘smoothings’) must necessarily include the level of the threshold and that the economic distortions in the UK appear more pronounced due to its comparatively high threshold. There may also be a link between the design of the threshold and the size of the hidden economy.
All this suggests that while the chancellor may not be ‘minded’ to cut the threshold, he has given himself enough room for manoeuvre should the facts emerging from the consultation lead to a change of mind (Keynes would be proud).
The primary question, however, is how to address the distortions around the threshold. The OTS notes that this issue will apply at whatever threshold is chosen. Drawing on the work of the OTS, the chancellor’s consultation document raises the following core issues:
As well as seeking evidence and data on these points, the Treasury document gently floats some possible ‘policy solutions’, mentioning the recent (European Commission) EC proposal for SMEs, administrative smoothings for businesses moving into VAT registration, and financial smoothings to address the current cliff-edge.
Administrative smoothings
A key question is about the distortion caused by the increase in administration. The concern is that, faced with the burdens and costs involved in administering VAT, small businesses approaching the threshold will deliberately supress their turnover in order to avoid tipping over into VAT registration. That suppression could take a variety of forms, ranging from the legitimate, such as not taking on further work or not investing in equipment that might increase their productivity, to the illegitimate, such as fraudulently not declaring income or seeking to split income between two different registrations.
This could be a case of information failure; i.e. that the administration is not actually as bad as is feared and therefore the actions to keep turnover levels down are disproportionate to the actual burdens experienced. Indeed, as the consultation notes: ‘There may be a distinction between perception of the administrative burden of VAT and the reality.’ HMRC’s standard estimate is that the administrative costs for an average small business are around £675 per year, which is small compared to the threshold of £85,000. If this is the case, then one key policy response is to educate those near the threshold about the limited burden involved in complying with the VAT processes.
There does seem to be some evidence to support for this argument. The fact that a million businesses below the threshold are opting to pay VAT (and hence recovering input VAT) would imply that the additional administration is not acting as a deterrent for them. And with initiatives like the flat rate scheme, which radically simplifies the VAT calculation and reporting, it is clear that VAT administration can be kept manageable.
Nevertheless, the government is considering other options to minimise the increase in administrative burden as businesses cross the threshold. When it comes to practical ways of achieving this, however, the call for evidence suggests only two options before asking for more ideas.
The first option builds upon the system in New Zealand where smaller businesses file their returns every six months, rather than under the general system of every one or two months. The UK would extend the first period for which a business has to account and pay VAT obligations from three months to six months – somewhat less helpful than the New Zealand option. Reducing the returns by one in the year of registration may be helpful but business owners are likely to be thinking about the ongoing full year cost.
The second option would be to apply the threshold test over two years rather than one, such that the taxable turnover of a business would need to be over £170,000 in total over two years before registration is required. This might keep some businesses out of registration, but would not seem to reduce the administration once the business needs to register.
Financial smoothings
While the jury may still be out on the issue of administrative burdens, the financial disincentives to moving just above the VAT registration threshold are clear.
Here, the government has a few more ideas. It cites Finland and the Netherlands, which graduate the amount of tax paid as the turnover increases, rather than applying the full VAT rate once the threshold is reached. It also considers having different thresholds for different sectors and mimicking the slice system inherent in income tax into the VAT system, such that the rate would increase as turnover increases until at some turnover point the business has to pay over the full rate of VAT to HMRC.
In the questions asked, the government comes back to the idea of two thresholds: a lower threshold, below which financial obligations are removed; and a higher threshold, below which some of the administrative obligations are reduced. Finally, this section reverts to the idea that these issues could be reduced by either increasing or decreasing the threshold. Of course, the financial impact of going over the threshold reduces as the threshold is reduced.
It is clear that the government is seriously considering its options, now that it is expecting to be freed from the constraints imposed by being a member of the European Union. This includes the freedom to change the threshold – and indeed to change it again if needed in the future.
Despite the comments in the Budget, a cut in the threshold does seem to be on the cards. From an economic and purist perspective, the best VAT threshold to have would be no threshold at all. This would bring all businesses into the VAT net, broaden the tax base, and remove any distortions between those VAT-registered and those non-registered. In practice, the attractiveness of this apparently idyllic state of affairs (from a Treasury perspective) is undermined by the burdens of administering the tax and complying with its requirements, both for businesses and HMRC.
A cynic might see the focus on reducing the burdens as a stepping stone to a reduced threshold. Cynicism aside, would that be such a bad thing? Perhaps the timing is not ideal, given the imminent application of making tax digital for VAT to those over the registration threshold. But, once that has settled down, if the additional revenue for the exchequer is redeployed to provide support to small businesses elsewhere, including the million small businesses that currently register for VAT, might this be a better use of the £2.1bn per annum cost of the threshold?
The call for evidence is an early stage in the consultation process and there will be plenty of opportunities over the coming months to explore these issues further and assess the options open to the chancellor. The government will be hoping that people accept the challenge and respond. With a deadline of 5 June 2018, there is still time to come up with new ideas.
For details of the call for evidence, see bit.ly/2FPZLog. The views expressed in this article are those of the authors alone.
