Spring Budget 2024: Is it time to revisit the VAT threshold?
By Susan Cattell, Head of Tax Technical Policy
27 February 2024
Ahead of the spring Budget, we outline the problems caused by the frozen VAT threshold and take a look at some of the options available if the Chancellor decides to revisit it.
Recent history of the VAT threshold
Prior to 2017 it had become the norm for the UK VAT threshold to increase by inflation each year, with the threshold reaching £85,000 in 2017-18. Following a call for evidence on the threshold in 2018, the government announced that the threshold would be frozen at this level until 31 March 2022.
The threshold freeze was extended for a further two years to 31 March 2024 in the spring Budget 2021. Then in the autumn statement 2022, the Chancellor announced that it would remain at £85,000 for a further two years to 31 March 2026.
Consequences of the frozen threshold
In its 2017 report on VAT, the Office of Tax Simplification (OTS) highlighted that the UK’s £85,000 threshold was the highest in the EU (where the average was £20,000) and the highest general threshold in the OECD. While the threshold was often seen as a tax simplification because most UK businesses didn’t need to register for VAT, the OTS found clear evidence that the high level was having a distortionary impact on business growth and activity. It identified significant ‘bunching’ of businesses with turnover just below the threshold, and a very significant drop in business numbers immediately above it.
The OTS highlighted two main reasons for businesses wanting to keep their turnover below the VAT threshold; inability to pass on the cost of VAT to customers and fear of the administrative impact of registration. To stay below the threshold, some businesses were limiting their expansion in legal ways – for example, by not taking on an extra employee or an extra contract, or closing their doors for a period. Other businesses were adopting an illegal approach by deliberately suppressing their recorded takings.
In its March 2023 ‘Economic and fiscal outlook’ report, the Office for Budget Responsibility (OBR) pointed out that before 2017 the bunching of firms moved as the VAT threshold increased each year, but since 2017-18 (when the threshold reached £85,000) the scale of distortion below the threshold had increased. The OBR estimated that relative to 2017-18, it expected that the number of firms capping their turnover by 2025-26 would have almost doubled from 23,000 to 44,000. It also expected the lost turnover associated with this distortion to have risen from £110 million to £350 million.
What are the options for addressing the problems?
The OTS considered a range of possibilities in 2017. It concluded that increasing or reducing the threshold by small amounts would have limited impact on competitive distortions because of the relatively small numbers of businesses that would be affected. The overall effect of a small change might only be to shift the point at which bunching occurred.
Increasing the threshold by a significant amount, for example to £500,000, might lead to large numbers of businesses de-registering, with a reduction of the administrative burden and a possible reduction in competitive distortions between registered and unregistered smaller businesses. However, it would also cut the funds for the exchequer by between £3bn and £6bn per year and might shift competitive distortions upwards.
Reducing the threshold significantly to, say, £43,000 would reduce the number of unregistered businesses and competitive distortions and would raise between £1bn and £1.5 bn per year. However, it would increase compliance costs for a large number of businesses and involve additional costs for HMRC. Significant changes to the VAT threshold would have implications for economic growth and productivity, for pricing and for the impact of VAT on those in different income brackets.
Given that any threshold creates an incentive to operate below it, the OTS also considered how the distortive effect might be reduced by introducing a ‘smoothing’ mechanism. It reviewed various options for smoothing the cash and/or administrative impacts of becoming registered (some of which it understood would not be possible at the time under EU law).
It concluded that any of these options could increase complexity but might have a positive impact on growth and productivity. It would be challenging to develop a workable mechanism that balanced the risks (fraud, revenue loss and complexity) against the benefits of smoothing entry to the VAT regime and reducing business burdens.
2018 – call for evidence
In 2018, the government conducted a call for evidence into the design of the threshold. There were three main sections: Exploring the effects of the current threshold, understanding the reasons why businesses would want to remain under the threshold, and analysing policy solutions to the problem (which included reducing or increasing the threshold and several possible smoothing mechanisms).
The responses highlighted the fact that the UK VAT system is “inefficient, inhibiting productivity and growth beyond the registration threshold.” Businesses were keen on easing the financial and administrative burdens of VAT registration, but very wary of adding even more complexity.
Ultimately, the responses did not present “a clear solution to the problems surrounding the VAT registration threshold” and the government concluded that there was no lead option for reform. While some businesses favoured a smoothing mechanism, providing it did not increase complexity, at the time EU law would have meant that the UK would require a derogation. One of the criteria for this would have been revenue neutrality, so the smoothing mechanism might have had to be accompanied by a reduction in the threshold.
While the government said that it would revisit a possible smoothing mechanism once the terms of the EU exit were clear, successive chancellors have continued the freeze.
2024 – is it time to revisit the threshold?
Some business organisations, such as the Federation of Small Businesses (FSB), would like the Chancellor to increase the threshold. In January 2024 the FSB suggested an increase to £100,000 and the introduction of a smoothing mechanism for small businesses (using either a VAT allowance or rebate).
Tax Policy Associates (TPA) also produced a report in January 2024, which noted three ‘bad’ solutions to the problem (including some broadly similar points to those made by the OTS in 2017):
- Raise the threshold dramatically – which would simply move the bunching problem to a higher level and would be very expensive.
- Reduce the threshold to an OECD average – this would require small/micro businesses to apply VAT at 20% and does not seem politically realistic.
- Reduce the threshold ‘a bit’ – again, this is likely to be politically difficult and would also simply move the problem.
TPA also favoured some form of smoothing mechanism (potentially involving rebates), but identified numerous challenges with introducing one.
Clearly, the terms of the UK’s EU exit are now known. However, other factors identified by the OTS and the 2018 call for evidence remain problematic. Given the 2022 announcement that the threshold will be frozen until 31 March 2026, the other obvious option for the Chancellor is to do nothing in the spring Budget. TPA described this as a ‘boring solution’ – leaving it to inflation to reduce the threshold over time in real terms. TPA estimated that, assuming average inflation of 4%, the threshold (in real terms) would be £52,000 by 2034 and £35,000 by 2044.
As there doesn’t seem to be another simple solution that would be likely to command widespread support, the Chancellor may feel that the ‘boring’ option remains the best choice.
Let us know your views
ICAS responds to many tax calls for evidence and consultations, as well as producing tax policy papers and reports. We also regularly attend meetings with HMRC at which service levels, delays and other issues are discussed, and we raise problems being encountered by members. We welcome input from members to inform our work; email tax@icas.com to share your insights and feedback.
