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