During periods of high inflation, governments can raise more taxes by simply freezing tax bands and thresholds. This is because when salaries and revenues grow in line with inflation, people and businesses will either be dragged into higher fiscal brackets or lose tax reliefs for breaching certain ceilings.
This phenomenon, commonly known as fiscal drag, tends to be associated with income tax and more specifically frozen income bands, which ultimately increase people’s taxable income. However, fiscal drag can significantly impact indirect taxes, too – especially VAT.
Not raising the VAT registration threshold in line with inflation every year has by far the biggest fiscal drag effect on taxable businesses. The UK registration threshold, which is tied to the total taxable turnover of a business, remained the same (£85,000) from 1 April 2017 to 31 March 2024. In the same period, according to the Bank of England, prices in the UK increased on average by almost 31%.
The problem could be very acute for micro and small retail enterprises
Because revenues and expenses are strictly linked to prices, a business that in the past seven years has seen its turnover grow by about 30% may have simply stayed afloat because costs would have surged by the same percentage. However, if in 2017 it was not required to register for VAT by having a total income below the registration threshold, in 2024 (or earlier) it would have ended up above the limit and must now charge VAT to its customers.
SME victims
The problem could be very acute for micro and small retail enterprises, whose customers cannot recover VAT as input tax. These businesses, which must now charge VAT on their sales, may have had to reduce their net prices (and consequently their margins) to remain competitive.
The VAT registration threshold in the UK increased to £90,000 from 1 April 2024, but if it had been adjusted in line with inflation, as it used to be until 2016, it would have now reached £111,000.
The turnover test for the Flat Rate Scheme has not been adjusted in years
The fiscal drag effect of having the VAT registration threshold frozen for several years appears even more evident by looking at the statistics on the VAT population. According to HMRC figures, in 2020 52% of VAT-registered taxpayers had a turnover below the threshold and registered voluntarily. In the year ended 31 March 2024, just 41% of the VAT population had a total income lower than the registration limit.
Flat-rate freeze
Another threshold that has not been adjusted in years is the turnover test to remain eligible for the Flat Rate Scheme, designed for small or very small UK-based businesses.
The scheme, which was introduced in 2002 and partly reformed in 2017, allows qualifying taxpayers to apply sector-specific fixed VAT-rate percentages lower than the standard rate, simplify record keeping and obtain cashflow advantages.
In 2017 a business was eligible to join the scheme if its turnover was lower or equal to £150,000. Today the threshold is still the same. If it had been adjusted upwards in line with inflation, it would have reached £196,000 in 2024.
Fiscal drag doesn’t spare partially exempt companies or groups
The income ceiling having been frozen for so many years will likely have dragged many small businesses out of the scheme, since the value of their sales has exceeded the threshold due to inflationary pressures on prices.
Fiscal drag doesn’t spare partially exempt companies or groups either. For example, the de minimis threshold allowing input tax relating to exempt supplies to be recovered in full, provided it amounts to less than £625 per month on average, has never been increased; if we use the period 2017-24 as a reference and apply the inflation adjustment (+31%), the de minimis level should now be £817.
No change means that every year fewer and fewer UK-based partially exempt businesses can remain below the threshold and benefit from this VAT relief.
Taxpayers still able to enjoy the de minimis relief and deduct input tax that would not otherwise be deductible should continue to carry out a detailed annual review of their entitlement to full input tax recovery, particularly if in previous years they have been close to breaching the de minimis threshold.
