UK Value-Added Tax | Tax Foundation Europe

The United Kingdom’s Treasury is reportedly considering another increase in the value-added taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. (VAT) registration threshold from £90,000, citing officials in search of a “measure for growth.” This would be a mistake. The UK already applies one of the highest VAT registration thresholds in the Organisation for Economic Co-operation and Development (OECD), and raising the threshold further would deepen a costly distortion that holds back small business growth, reduces the efficiency of the VAT system, and leads to a revenue shortfall that the government may compensate for with more distortive taxes.

Instead of raising the threshold, the government should consider lowering the threshold or abolishing it altogether. The Treasury could avoid higher administrative and compliance costs by simplifying the UK’s VAT system and striking exemptions and reduced rates.

What the VAT Registration Threshold Does

If a business is below a certain annual revenue threshold, it is not required to participate in the VAT system. This means that small businesses, unlike businesses above that threshold, are not required to collect VAT on their outputs sold to customers, but will then also not receive a refund for VAT paid on business inputs. Small businesses with negative VAT liability tend to register voluntarily even below the threshold.

In the UK, businesses must register for VAT at a turnover of £90,0000, raised from £85,000 until 1 April 2024. In terms of purchasing power parity (PPP), this makes the UK VAT registration threshold the third-highest among 38 OECD countries, at 132,500 USD-PPP, nearly twice the average among 31 OECD countries that apply a VAT threshold at all. Only the Czech Republic (154,300 USD-PPP) and Italy (139,200 USD-PPP) impose higher thresholds.

Although exempting very small businesses can save administrative and compliance costs, these savings come at the cost of lost government revenue from fewer taxpayers and efficiency losses from favoring smaller firms.

How a High Threshold Distorts Markets

A high registration threshold saves small firms from the VAT’s administrative and compliance burdens. Yet, this creates a distortion: favoring smaller businesses over larger ones can prevent businesses from realizing productivity gains from economies of scale, as tax-advantaged micro businesses substitute more productive larger ones.

High VAT thresholds also create a large “notch,” or tax cliff, at the cutoff. Businesses with turnover close to the threshold face a sudden and substantial tax and compliance cost if they cross it. Empirical work shows that firms reduce reported turnover or slow growth to remain below the threshold.

In the UK, the Office of Budget Responsibility (OBR) estimated the annual lost turnover through this distortion in business size was £350 million in 2023. A recent study published by the International Monetary Fund (IMF) has found evidence that annual growth in turnover in the UK slows by about one percentage point as firms approach the threshold. The growth in input costs follows the same pattern, indicating that the response to the threshold is largely driven by businesses reducing their output instead of falsely underreporting their turnover.

Revenue Effects and Compensation

Freezing or lowering the threshold raises revenue. A 2023 OBR report suggests that freezing the threshold at £85,000 instead of annually adjusting it for inflationInflation is when the general price of goods and services increases across the economy, reducing the purchasing power of a currency and the value of certain assets. The same paycheck covers less goods, services, and bills. It is sometimes referred to as a “hidden tax,” as it leaves taxpayers less well-off due to higher costs and “bracket creep,” while increasing the government’s spendin would have raised £1.4 billion each year in additional VAT revenues by fiscal year 2027-28. Nonetheless, in April 2024, the threshold was again raised to £90,000.

VAT is among the most important sources of tax revenue in the UK, raising more than 21 percent of total tax revenue in 2021. A well-designed VAT system is also among the least distortive ways to generate tax revenue. However, due to a mix of various exemptions, reduced rates, and non-compliance, the UK’s VAT covers less than half of the potential consumption base. If not paired with reductions in government spending, the revenue loss resulting from an increased VAT threshold is likely to be compensated for by an increase in more distortive taxes that will do additional damage to economic growth.

Conclusion

The UK today has one of the highest VAT thresholds in the developed world that is holding back business growth while giving up government revenue. Further raising the VAT registration threshold would be a step in the wrong direction. Instead, the government should consider reducing the threshold to a value closer to the OECD average or abolishing it altogether. While a larger number of small taxpayers means more aggregate administrative costs, the right response would be to simplify the VAT system by ridding it of its various exemptions and reduced rates, moving the UK toward a simpler VAT system with a broader base.