VAT/GST Thresholds and Small Businesses: Where to Draw the Line?

Abstract

Inherent features of any tax are the imposition of relatively higher compliance costs on small businesses and higher administration costs faced by tax authorities in respect of these firms, allied with low net tax revenue collected from the sector. A common response in jurisdictions levying a VAT is the adoption of a registration threshold to remove small businesses from the formal VAT system, with the threshold set at a level that does not seriously undermine VAT revenue. However, the distinction caused by the threshold between enterprises excluded from the VAT and others fully incorporated into the tax system gives rise to competitive distortions ameliorated for some through a voluntary registration option while inducing some others to adopt behaviour that will allow them to remain below the registration threshold. Taking the form of commercial restraint, enterprise splitting or under-reporting sales, this behaviour leads to further distortions and threatens revenue collection. This article reviews the key considerations and challenges in setting a VAT registration threshold and the consequences of adopting that boundary. Two issues related to the choice of threshold concern the use of transitioning subsidy regimes adopted in some jurisdictions to reduce the tax discontinuity as enterprises move into the full VAT system and the special concessional regimes used in some countries to reduce the compliance burden small businesses face once they are subject to VAT. Another approach found in some jurisdictions is the use of a tax regime border instead of a registration threshold, with a full VAT levied on enterprises above the border and a substitute turnover tax imposed on small businesses below the border. The turnover tax alternative has been variously explained as a system intended to achieve simplification or revenue raising objectives. The benefits of the transitioning and simplification schemes may be exaggerated while their unintended costs and distortions may be insufficiently recognised. A review of these systems can provide guidance to policy makers contemplating reform or adoption of new regimes.