Efficiency and welfare costs of VAT; evidence from VAT notches

Most countries have a threshold below which businesses do not need to register for value added tax (VAT). This column looks at the costs and efficiency of VAT by analysing behavioural responses of firms to the registration threshold. Voluntary registration appears more likely when the cost of inputs is high or when the proportion of business-to-consumer sales is low. There is bunching around the threshold, and this is more likely when the cost of inputs relative to sales is low or the proportion of business-to-consumer sales is high.

Research Highlights

VAT notches, voluntary registration and bunching: theory and UK evidence


Most countries around the world use VAT as their primary indirect tax. It is standard to set a minimum registration threshold, usually based on annual turnover, below which businesses do not need to register for VAT. In the EU, a large majority of countries currently have a registration threshold, with the UK threshold being the highest. As VAT rates are often quite high, this may create a large and salient tax “notch” for businesses whose turnover is around the threshold – that is there could be a significant jump in tax liabilities from going form just below, to just above, the threshold.  

Using confidential administrative tax records for UK businesses in the HMRC Datalab, the paper documents both (a) bunching in annual turnover just below the VAT registration threshold - that is a large number of firms have annual revenue just below the threshold; and (b) persistent voluntary registration by almost half of the firms below the threshold. At first sight, there two effects seem contradictory, in that the firms that bunch below the threshold are likely to be aiming to keep their revenue down so as not to have to register, while many of those below the threshold register voluntarily. 

The paper develops a conceptual framework that simultaneously explains these two apparently conflicting facts. The framework predicts that higher intermediate input shares, lower product-market competition and a lower share of business to consumer (B2C) sales would lead to voluntary registration. The predictions are the opposite for bunching. The paper tests the theory using linked VAT and corporation tax records from 2004-2014, and find empirical support for these predictions.

Li Liu, Ben Lockwood, Miguel Almunia, Eddy HF Tam ’VAT Notches, Voluntary Registration, and Bunching: Theory and UK Evidence‘, Review of Economics and Statistics, (2021) 103 (1): 151–164.



This research project uses linked UK VAT and corporation tax returns between 2004 and 2009 from the HRMC Datalab. Approximately 44% of firms with turnover below the threshold are registered for VAT. Some firms restrict their turnover to stay just below the registration threshold. We develop a conceptual framework that allows simultaneously for these two features which generates predictions about how voluntary registration and bunching just below the threshold are related to intensity of input use, the share of B2C  transactions for a firm, opportunities for evasion via under-reporting of sales, and the competitiveness of the market in which the firm is located. Consistent with the theory, we find that voluntary registration is positively related to the intensity of input use and negatively to the share of B2C transactions, and the amount of bunching is related to these variables in the opposite way. There is some evidence that product market competition leads to more voluntary registration, and less bunching.

Li Liu and Ben Lockwood. CBT Working Paper 16/10



Most countries around the world use the Value Added Tax (VAT) as their primary indirect tax, and most countries have thresholds, usually based on turnover, below which businesses do not need to register for VAT. As VAT rates are often quite high (in excess of 20% in many EU countries), this creates a large and salient tax notch above which the tax liability increases discontinuously for small businesses whose turnover is around the threshold.

In this research project, we develop a conceptual framework for studying VAT notches. We show first that the effect of the VAT system on profit can be captured by a “sufficient statistic” which combines the effects of both input and output VAT, and which applies to both registered and non-registered firms. We then show that voluntary registration is more likely, and the amount of bunching is smaller, when either (i) the cost of inputs relative to sales is high, or (ii) when the proportion of B2C sales is low. The intuition for (ii) is simply that if most customers are VAT-registered, the burden of an increase VAT can easily be passed on the form of a higher price, because the customer himself can claim back the increase. The intuition for (i) is that when input costs are important, registration allows the firm to claim back a considerable amount of input VAT.

We then bring these predictions to an administrative data set of VAT returns for the UK. In the aggregate, there is clear evidence of bunching at the VAT threshold. This is the first evidence, to our knowledge, that a VAT notch leads to bunching. Investigating further, we find that firms are less likely to “bunch” i.e. more likely to register voluntarily, even when their turnover is below the registration threshold, when either (i) the cost of inputs relative to sales is high, or (ii) when the proportion of B2C sales is low, consistently with the theory. We also show, again consistently with the theory, that among firms who bunch, the amount of bunching is increasing in the B2C sales ratio, and decreasing in share of ratio of input costs to sales. So, there is a clear pattern of heterogeneity in bunching.

The next question is how it is that firms bunch; that is, what is (are) the mechanism(s) at work? One possibility is that they genuinely restrict their sales so that turnover stays below the threshold. If so,  the distribution of input-cost ratio should be smooth around the VAT notch. We provide some suggestive evidence that part of bunching is driven by under-reporting of sales. Specifically, we find that the salary-inclusive input cost ratio moves in the parallel direction between the registered and non-registered group outside the bunching region, but starts to increase substantially for the non-registered companies just below the threshold. We interpret the large and sharp increase in the salary-inclusive input-cost ratio to be partly driven by the fact that it is costly to underreport salary expenses due to third-party reporting.

Finally, we estimate the structural elasticity of the tax base with respect to the VAT rate, which is in the range of 0.09 to 0.14.

Li Liu and Ben Lockwood, CBT Working Paper 13/09