Budget 2025 – The case for a reduction in the VAT threshold

Lowering the VAT threshold. Why I believe it will make FHL (Furnished Holiday Let) and other small businesses more profitable and increase GDP.

“After all the FHL changes, if I have to go VAT registered and give away tax on turnover to the VAT man, that will be the final nail in the coffin of my holiday let business!”

I get it! But it doesn’t have to be that way!

Let’s start with the principles: VAT is a tax paid by consumers, not businesses. Businesses act as free collection agents on behalf of HMRC.

The “pass it on” system of adding VAT to your price and reclaiming it from the supplier that charges you, means that the end customer pays (normally) 20% VAT on the end price of the goods or services. Any VAT paid by the businesses in the supply chain is recovered and, therefore, is not a cost to the business.

In supplies where the consumer is “exempted” from VAT, the buck stops with the final business in the supply chain. Banks, Insurance companies, residential landlords and doctors do not charge VAT to their customers and do not reclaim VAT from their suppliers. They shoulder the burden of VAT. But that does not prevent them from making a profit. There is a level playing field and market forces mean the lowest price that can be charged is influenced by their increased cost of supply.

Problems emerge when the playing field is not level.

Hairdressers, beauticians, holiday let operators, bed and breakfasts, plumbers, electricians, hot food outlets are all businesses that are in sectors where there is a two-tier VAT trap. It is killing expansion, encouraging tax evasion and meaning many honest businesses can barely make a profit.

One thing all these businesses have in common is that it is normal for the owner of the business to be fee earning. The owner is also the worker, in most cases. That is not to say they don’t have staff, but if the business owner was to step back and simply employ staff to provide all of the service, then there would not be sufficient profit for the owner to feed themselves.

There are approximately three million businesses that have turnover below £90k and are not VAT registered, forming a very strong majority. Those businesses that expand to greater than £90k annual turnover are very much in the minority.

The issue with such services is that most customers are served by operators that are not VAT registered. Therefore, the market price is set without the addition of 20% VAT.

Those operators that are larger and tend to have a greater proportion of their service provision served by staff, rather than the owner, must compete for the same customer by charging the same market price as the majority that do not have to pay VAT. These suppliers can recover VAT on supplies, but that tends to be low as most of the supply is the provision of time. Like the exempt suppliers, the buck stops with the business supplying the customer, but not for their lower turnover competitors.

Putting numbers to the above

Where the net price of the services is £100, then the VAT-registered suppliers would normally charge the customer £100 plus 20% VAT = £120.

Due to the competition from non-VAT registered service providers, they must charge £100 and suffer the VAT cost of 16.67% = £16.67.

They are therefore left with £83.33.

They may recover some VAT on purchases, bringing the net to approximately 15% or £85.

If they are on the flat rate scheme, the net may be slightly better at £89.50, for accommodation providers for example. The flat rate scheme is not allowed above a higher turnover threshold of £230k.

This gives the larger operator a disadvantage over most of its competitors. Further, the larger operator needs to pay staff for a greater proportion of its provision than the smaller operator who uses their personal time.

The larger operator may get some benefits of economies of scale, but often also has other detriments such as not qualifying for small business rates relief on the premises. Expanding operators tend to suffer costs of extra marketing, recruitment, loan interest etc.

The difference of £10 – £15 per £100 may not seem a lot, but it needs to be considered that such service providers are happy to operate on a profit ratio of 10% to 20% of gross turnover. The VAT cost of a larger operator may be the difference between making a profit or a loss. For the smaller operator that is fee earning, their own time cost is added to that profit, meaning a healthy living can be made.

Considering the smaller operator, they have a big dilemma.

The threshold of £90k is sufficient for a decent personal income. Where the operator can take cash from loyal customers and not declare this income, they can earn above this threshold.

As a successful operator, the natural desire is to expand the business. But the requirement to register for VAT prevents many from choosing to do so. They could take on more staff and operate from additional premises to access a new market. But in doing so, they will then have to become VAT registered and lose that important advantage.

The two-tier system effectively converts a consumer tax to being a small business tax on service providers. It persuades many small owner-managed businesses to avoid expansion.

Inflation doesn’t help. The last change in the VAT threshold was seven years after the previous change. The fiscal drag caused by inflation means the small operator can raise their prices and undertrade or continue with the existing pricing as many do.

Therefore, in real terms the market price reduces over the years, whilst all other costs, including consumables increase.

Undertrading is rife amongst such service providers. An example is a bed and breakfast host that has 4 rooms who could sell 1460 nights. A good year is 1200 nights. Where 1200 nights at £75 is £90k, the operator (with a bit of cash trading) can avoid registering for VAT.

But inflation, over a seven-year period, has pushed the nightly rate to £90. This means she cannot sell more than 1000 nights, losing the income of 200 nights.

She wanted to employ a cleaner to help with the changeovers and laundry, but that would mean she needs to sell 1200 nights to cover the salary. By doing so, she would register for VAT and lose approximately £12k. So instead, she works her aging body to the bone and closes the guest house for six weeks each year.

Meanwhile, her real term income declines. Eventually, she considers enough is enough and puts the building on the market. The agent asks for the accounts to value the property. The accounts, that do not include the cash takings, nor the six weeks of under trading, result in a valuation tens of thousands lower than it would otherwise be.

The two-tier business model created by the VAT threshold prevents businesses from expanding.

Expanding businesses contribute to GDP. They employ staff, they utilise trades for building and marketing and they increase the prosperity of the local economy. The issue is not isolated to FHL. Across the country, millions of would-be entrepreneurs are being held back by the VAT threshold. Further, they are being forced into the cash economy and non-disclosure by the current threshold.

One way to alleviate this would be to increase the threshold. This would not solve the problem but simply move it to a different level.

However, if the VAT threshold was removed or dramatically reduced, then there would not be a two-tier business model. The service providers would all have to charge VAT and there would be no option, but to reflect this in the market pricing of the services.

Clearly, an overnight 20% jump in prices of hairdressing, plumbing, short stay accommodation other services would be a shock to the economy. The effect would be inflationary. Consumers may tighten their purses, and the trades may suffer temporarily.

But equally, a removal of the VAT threshold without any change in the rate of VAT would also bring considerably more tax revenue to the treasury. Whilst this may be desirable for a government, it is not the objective sought. The objective is to remove the two-tier business model and facilitate the expansion of small businesses to the benefit of GDP.

So, there will be room to reduce the rate of VAT on selected supplies coincident with the removal or reduction of the threshold. This would reduce the inflationary effect of the change to a manageable level.

Given the vast majority of plumbers are below the threshold, the VAT paid on plumbing is currently low. Therefore, there is an argument to have a much lower VAT rate on plumbing, but apply it to all plumbers. This would have a neutral effect on treasury revenue and on inflation.

If the rate of VAT on selected services was 4%/5%/6% or whatever figure the graduates at Price Waterhouse Coopers calculate to be the compensating rate, then this would mean the market would gradually rebalance to the new norm. It also gives the government opportunity to increase the VAT rate on these services over subsequent budgets.

If the VAT threshold was removed or dramatically reduced in conjunction with a corresponding VAT rate for the relevant sector, then all serious operators would become VAT registered, and the door would be opened for future expansion. A holiday let operator can invest in a second, third and fourth holiday let. The bed and breakfast operator can take on a cleaner and focus on improving the business rather than making beds. The plumber can take on an apprentice, or two and perhaps buy a new van.

A specific advantage to a FHL business is that a VAT registered entity can reclaim VAT on any capital expenditure that has taken place up to four years prior to registration, so long as the capital still exists. In the case of renovation and repurposing for FHL, this figure could be substantial.

Which level the threshold should be reduced to is not clear. What is clear is that where the threshold (plus an allowance for additional cash takings) can support the living of a sole trader, the two-tier business model will continue to cause the described problem.

We can look overseas for the experience of other countries to determine a suitable threshold. I prefer a threshold that enables a new start-up to commence their business without the administration of VAT but must register as soon as the business becomes a significant activity of the individual. My chosen figure would be £15k.

The VAT thresholds of other European countries is listed below. Most are considerably lower than UK with only Switzerland being slightly higher.

Austria (AU) EUR 55,000
Belgium (BE)EUR 25,000
Bulgaria (BGN) EUR 51,000 (BGN 100,000)
Czech Republic (CZ)EUR 85,500 (CZK 2,000,000)
Cyprus (CYP) EUR 15,600
Denmark (DK)EUR 6,700 (DKK 50,000)
Estonia (EE)EUR 40,000
Finland (FI)EUR 15,000
France (FR)EUR 34,400
Germany (DE)EUR 22,000
Greece (GR)None
Hungary (HU)EUR 30,000 (HUF 12,000,000)
Ireland (IE)EUR 37,500
Italy (IT)None
Latvia (LV)EUR 40,000
Lithuania (LT)EUR 45,000
Luxembourg (LU)EUR 35,000
Netherlands (NL)EUR 20,000
Norway (NO)EUR 4,250 (NOK 50,000)
Poland (PL)EUR 46,500 (PLN 200,000)
Portugal (PT)EUR 15,000
Slovak Republic (SK)EUR 49,790
Slovenia (SI)EUR 50,000
Spain (ES)None
Sweden (SE)EUR 7,000 (SEK 80,000)
Switzerland (CH)EUR 106,000 (CHF 100,000)
United Kingdom (GB)EUR 105,000 (GBP 90,000)