VAT turnover threshold keeps firms small – mainly due to compliance costs

The value added tax (VAT) threshold is clearly detrimental to the growth of small firms, a recent study by VATT observes.

Below the threshold (10,000 euros, previously 8,500 euros), which is based on the firm’s turnover, firms do not need to pay tax or to report sales or purchases. This threshold gives firms an incentive to stay small.

The research findings indicate that in Finland a large number of firms bunch just below the threshold. This observation is explained by the compliance costs of VAT reporting and understanding the details of the VAT system. On the other hand, even large changes in tax did not affect the bunching of firms below the threshold. Nor did the relief scheme introduced in 2004 have such effects.

An easing of the administrative requirements for VAT reporting, however, reduced the detrimental effects of the VAT threshold on the firm distribution and on firms’ growth. In 2010 small firms gained the right to move from monthly VAT reporting to annual reporting, and at the same time applying for VAT relief was made easier. These actions clearly reduced the bunching of firms.

VATT’s research shows that the VAT threshold has a detrimental impact on firms’ growth. This effect is especially evident for service-sector firms owned by low-income entrepreneurs. The study finds no evidence for the behavioural response induced by the threshold being caused by tax evasion or avoidance or firm-splitting. This suggests that firms react to the turnover threshold by reducing their sales.

The researchers estimate that the compliance costs of VAT reporting for entrepreneurs are on average around 1600 euros. This figure is considerably higher than estimates in previous studies.

”Compliance and the effort associated with reporting are what count for these firms, not the level of VAT as such. Our research findings support easing the compliance burden on small firms. This could be done for example by automatically granting VAT relief rather than the current system with its application procedure”, Senior Researcher Jarkko Harju proposes. The researchers also consider that the VAT threshold should be increased significantly from its current level.   

The research material comprises tax register data for the universe of Finnish firms and their owners for the period 2000–2013.

Research report:

The effects of size-based regulation on small firms: evidence from VAT threshold
VATT Working Papers 75

Furher information:

Jarkko Harju, Senior Researcher, +358 295 519 410