The VAT threshold creates a “cliff edge” that encourages small businesses to limit their growth to avoid paying VAT, leading many to deliberately slow their expansion or reduce activity near the £90,000 mark. This systemic effect is widespread, with research showing around 30,000 businesses intentionally constraining their growth, which distorts market dynamics and hampers entrepreneurial development.
The speaker discusses a situation faced by small business owners, using a plumber as an example. When the plumber’s turnover approaches £90,000, he becomes liable to charge VAT on his services. Until then, he operates below this threshold, avoiding the added VAT cost. This creates a significant advantage, as he can charge customers less than competitors who have exceeded the threshold and are now including VAT in their prices.
Once past the £90,000 threshold, the plumber must add 20% VAT to his bills, effectively increasing his prices and reducing his competitiveness. Since he likely has minimal input VAT recoverable, he faces a direct 20% cost on his services, which he cannot pass on fully to customers without risking losing business. This situation puts him at a disadvantage compared to others who haven’t yet crossed the threshold.
In response, the plumber may deliberately hold back his business growth to stay just below the VAT threshold. He might avoid purchasing supplies, discourage hiring additional staff or apprentices, and even modify his work schedule by taking extended breaks or holidays to prevent surpassing £90,000 in turnover. This deliberate slowing of business activity is a rational response to financial disincentives created by the tax system.
The speaker highlights that such behavior isn’t just individual, but widespread. Data indicates around 30,000 small companies intentionally limit their growth near the VAT threshold. This is supported by research from the University of Warwick, which confirms that these actions are genuine and not merely tax evasion or figure fiddling. Instead, they represent a real, systemic effect of the tax design.
Overall, the current VAT threshold system creates a “cliff edge” that discourages small businesses from expanding beyond certain income levels. Such policies inadvertently incentivize businesses to restrict growth, leading to a distortion of natural market dynamics and potentially stifling entrepreneurship and economic development among small firms.