The UK’s VAT threshold, intended to support small businesses, has led to a ‘VAT trap’ that hinders business growth and productivity. Research shows that businesses actively suppress their growth to stay below the threshold. This intentional downsizing affects the broader economy.
Growth Suppression Near the Threshold
Data reveals that annual growth in turnover slows by approximately two percentage points when businesses approach the threshold, representing a 25% reduction in their average growth rate. This effect begins when firms get within £20,000 of the threshold, with no evidence of compensating acceleration once they cross it.
Sector-Specific Manifestations
This behaviour varies across different sectors. Businesses with high input costs and those dealing primarily with other VAT-registered enterprises are more likely to register voluntarily. However, consumer-facing businesses with low input costs, such as service providers and small retailers, will likely engage in growth-suppressing behaviours.
For example, a construction company may choose to grow and register for VAT because it primarily deals with other VAT-registered businesses, making it easier to reclaim input costs.
On the other hand, a self-employed hairdresser or a local plumber may deliberately suppress growth to avoid VAT registration, as their customers are not VAT-registered and are sensitive to price increases.
Measures Taken to Avoid VAT Registration
The impact is evident in real-world business decisions. HMRC research indicates that 78% of unregistered businesses near the threshold find increasing prices to cover VAT charges difficult, leading them to restrict their growth actively.
These measures include:
- Reducing working hours or days
- Turning down contracts
- Splitting businesses artificially
- Limiting marketing and expansion
- Avoiding hiring additional staff
- Refusing profitable opportunities
Economic Impact
The economic cost is substantial. By 2025-26, Office for Budget Responsibility (OBR) data shows approximately 44,000 firms will be artificially capping their turnover. This is nearly double the 23,000 recorded in 2017-18. The lost turnover associated with this distortion is projected to rise from £110 million to £350 million.
This behaviour creates a broader economic inefficiency. While the high threshold ([sc name=”current-vat-registration-threshold” ][/sc] in [sc name=”current-tax-year” ][/sc]) keeps millions of small businesses out of the VAT system, it also leads to market distortions and productivity losses.
The phenomenon is particularly pronounced in labour-intensive service sectors, where businesses have greater control over their turnover and fewer input costs to reclaim.
The impact extends beyond individual businesses to affect market competition and efficiency. Registered businesses often face challenges competing with unregistered competitors. Unregistered businesses do not add VAT to their prices, making them more competitive. This creates a two-tier market that exacerbates the UK’s broader productivity challenges.
Research indicates that this growth suppression is not temporary; many businesses permanently operate below their potential, which impacts economic productivity. The closer businesses get to the threshold, the more pronounced these effects become. The current system may inadvertently create a permanent ceiling for small business growth.
Potential Solution
One potential solution would be to lower the VAT threshold significantly to bring almost all businesses into the VAT system, while reducing the standard VAT rate to lessen the burden on businesses. However, this approach could present challenges, such as increased administrative burdens for small businesses and potential cash flow issues, which may disproportionately affect newer or less established enterprises.
