VAT produced 22.5% of all tax revenue in 2016-17. £120 billion was raised in that year through a system largely based on EU rules that is generally considered overly complicated and an administrative burden. The Office of Tax Simplification (OTS) published its first review focussed specifically on VAT on 7 November. It suggests steps for the government to change the VAT system. These include a review of the VAT registration threshold. The Chancellor announced in the budget that the threshold will not be reduced for two years, but what then?

At £85,000 it is one of the highest in the world and allows many small businesses to not have to deal with often complex VAT compliance. The OTS gives the example that a gingerbread man with chocolate eyes is zero-rated but will be standard-rated if it has chocolate trousers. However, the OTS found that there is ‘bunching’ around the threshold with many businesses staying just below and few being just above. The OTS review says this has a ‘distortionary impact on business growth and activity’ and is a cause of illegal under-reporting. It is difficult to be surprised by this. The current rules result in a business being £17,000 worse off after crossing the threshold unless it can pass the cost on. The OTS suggests ‘smoothing mechanisms’ might encourage businesses to increase turnover beyond the £85,000 ‘cliff edge’. These would add complexity.

The EU average threshold is £20,000. The OTS has considered lowering the threshold to nearer to the national average wage of £26,000 which may raise £2 billion more VAT a year from an estimated extra one million VAT registered businesses. Unless advanced AI is to be used in HMRC’s Making Tax Digital reforms, there would be a corresponding cost in addressing the severe burden this would place on HMRC. Otherwise, swamped by the potential errors of all of the new ‘entrants’ who are unfamiliar with the byzantine nature of VAT, the system will fail. Recent HMRC pressure on Amazon and other online platforms to police traders (with no powers like HMRC to do so) shows the fragility of the present system. Expanding the applicability of VAT by lowering the threshold may encourage more evasion and not stop rogue or missing traders.

The EU Commission has announced a major overhaul of the EU VAT system and a move to a destination based system (i.e. taxed in the country of consumption not supply). If UK VAT rules diverge post-Brexit from the EU rules then VAT compliance for traders operating in the EU will get even more complex without the benefits of the simplifications proposed in the Commission’s announcement.

It is difficult to estimate how many businesses would close when faced with the cost, complex compliance and penalty regime. Uber drivers, Deliveroo riders and Travel Counsellors may seek employment instead. The recent cases about whether they are employed or not are indicative of HMRC’s preference to want to collect NIC and income tax through PAYE. The Treasury is also considering extending its crackdown on what it considers to be bogus self-employment in the public sector to the private sector. Self-employment may become unpopular. If businesses close there may be more unemployment at a cost to the state.

It seems likely that those that register will pass on most of the cost. The poorest members of society spend a higher proportion of their disposable income on VAT and will bear more of it. Price increases will result in less goods and services being traded due to affordability. Tax is inefficient in raising revenue if more is lost due to supply and demand shifts than is gained in tax - unless the tax revenue is spent productively in stimulating the economy and not consumed in the cost of its own administration or paying increased welfare benefits.

With a developing ‘gig’ economy, low unemployment and the economic growth that a flexible workforce can give it may be better to develop tax systems to promote that growth and entrepreneurialism rather than trying to use systems that have the opposite ‘distortionary effect’. The question for the Chancellor when considering the OTS review is whether the tax system should promote economic growth to increase the base that can be taxed or increase the yield from the taxed base. It is a difficult balance and an electoral tightrope.

This article originally featured on taxation.co.uk (subscription required)