Modernising the UK’s VAT system

While VAT remains a cornerstone of modern public finance, its foundational architecture is facing unprecedented strain in an increasingly digitalised global economy. In my book, Value Added Tax in the 21st Century: Design, Challenges, and Opportunities, I explore the key design challenges faced by VAT jurisdictions in modern economies. Although the book develops a universally applicable analytical framework aimed at a global audience, its insights are profoundly relevant to resolving some of the most contentious challenges within the UK VAT system.

VAT concessions

The UK is well-known for its extensive reliance on VAT concessions, most notably the zero-rating of food. However, these legal boundaries rarely align with commercial reality, leaving manufacturers, HMRC, and the courts to grapple with a persistent stream of classification disputes. Arcane legal battles routinely arise over whether everyday items such as brownies, snowballs, and fruit and nut bars should be categorised as zero-rated cakes or standard-rated confectionery. The sheer complexity of this regime was underscored in a recent First-tier Tribunal decision, WM Morrison Supermarkets Ltd v HMRC [2025] UKFTT 1542 (TC)., which looked at whether rotisserie-roasted chickens should be treated as standard-rated hot takeaway food or zero-rated food cooling naturally. The case yielded a judgment spanning over 100 pages—a striking illustration of the borderline anomalies inherent in the UK VAT framework.

While zero-rating basic necessities is traditionally justified on vertical equity grounds to reduce VAT’s regressive impact, the UK experience, illustrated in the political backlash surrounding the 2012 ‘pasty tax’ proposal, demonstrates that once concessions are embedded in the system, base-broadening reforms become politically perilous. This persistent policy friction sits within wider debates on the proposals for a progressive VAT through technological interventions, specifically the introduction of an automated, real-time cashback model. Under this digital framework, VAT at the standard rate is collected at the point of sale, with targeted relief refunded near-instantaneously into the dedicated bank accounts of vulnerable individuals.

To navigate the acute civil liberty concerns often linked with state-monitored consumption, these models should be structured to avoid transaction-level inventory tracking, and instead relyon a less intrusive aggregate subsidy cap. Designed in this way, the core attributes of the real-time cashback scheme may not be substantially different from traditional transfer mechanisms such as Canada’s GST/HST credit, a progressive and refundable tax credit incorporated in the income tax system that compensates for the VAT burden indirectly. What is new with the real-time cashback scheme is the delivery mechanism, in particular the use of digital technology to alter the frequency and timing of the delivery of subsidies.  

In a country like the UK, with a highly advanced and automated welfare system, a real-time cashback scheme is unlikely to deliver sufficient marginal improvements over existing transfer-based systems to justify their additional administrative and institutional complexity. Ultimately, it may be best to accept that a general consumption tax is ill-suited to achieving vertical equity and that progressive redistribution is more effectively delivered through direct, targeted welfare spending, possibly funded by a broad-based VAT.

High registration threshold

Another distinct feature of the UK VAT is its relatively high registration threshold, the highest among OECD countries. The structural omission of the smallest businesses from the VAT system is traditionally justified on pragmatic administrative grounds, specifically to balance revenue needs against administrative and compliance costs. Empirical studies have long documented that administrative and compliance costs fall disproportionately on small businesses, which often contribute to a tiny fraction of VAT revenues. 

Applying a registration threshold introduces economic distortions, as businesses operating above and below the line are subject to differential VAT treatment. The significant increase in tax liability and compliance costs once the threshold is exceeded often prompts firms to adjust their behaviour to stay outside the VAT system. An issue of considerable concern in the UK is the ‘cliff-edge’ created by the threshold: a sharp increase in the number of businesses falling into the turnover band just below it compared to the number in the band immediately above it. Businesses may adopt one or more tactics to remain below the threshold: deliberately holding back expansion; artificially splitting businesses into smaller separate entities; and fraudulently under-reporting sales.  

Much of the anxiety in the UK is with the first tactic, which is believed to discourage business growth and generate deadweight losses. However, the risk of economic harm is unlikely to be as significant as many had anticipated. Underlying the view that restraint is a prime concern is an assumption that small businesses have unlimited potential and desire for growth. But the reality is that businesses have different initial ambitions towards growth. The threshold will be an inhibition only for small firms with limited prospects for future growth in a no-threshold world. 

Debates are often centred on whether increasing or lowering the threshold is a preferable response to business bunching. Nevertheless, a change of the threshold level does not remove the temptation to restrain production to stay below the threshold; instead, it simply shifts it to a different group. If the threshold is raised to a level inhabited by fewer enterprises, there will be a much smaller pool of potential restrainers, prima facie translating to less bunching. However, restrainers at a higher threshold might have greater potential for growth, making the overall impact of their restraint more significant. In practice, policymakers are often unable to compare the actual behaviours at both points. The distortions and inefficiencies caused by a threshold may need to be accepted as a necessary trade-off for securing administrative and compliance cost savings, which may not warrant specific policy responses.

Sharing economy

A more recent global challenge in VAT is the treatment of the sharing economy. The rise of platform-based business models has exposed structural tensions within VAT systems that were largely manageable in the traditional economy, particularly in relation to the identification of suppliers, the reliance on agent and principal doctrines and the use of registration threshold. In VAT systems with a registration threshold, the classification of a platform as either agent or principal can have significant VAT implications.  

Where the platform acts as an agent for the underlying supplier, the underlying supplier is treated as receiving a supply of intermediary services from the platform, while making a supply of underlying services to the customer. If the underlying supplier is below the registration threshold (as is often the case in the UK), VAT is collected only on the intermediary services provided by the platform, leaving the underlying supply outside the scope of VAT. By contrast, where the platform acts as a principal, it is regarded as first receiving the supply from the underlying supplier and then making an onward supply to the customer. In this case, VAT is collected on the full value of the supply made to the customer, irrespective of the registration status of the underlying supplier.

The tensions are most severely exposed in the VAT treatment of private hire vehicle (PHV) services in the UK. This has been illustrated in a series of court proceedings brought by private hire vehicle operators (PHVOs), particularly Uber, over the past five years. Most of these cases concerned whether PHVOs could lawfully act as agents or principals under licensing laws, which, as widely accepted by the government and the business community, may have knock-on effects on the VAT consequences. Additional complexity arises as, for historical reasons, England and Wales are governed by three separate pieces of licensing legislation (London, Plymouth, and the rest of England and Wales). The position following the prolonged series of legal battles is that PHVOs must operate as principals in London, but they are not required to operate as principals elsewhere in England and Wales (with the exception of Plymouth). Perhaps unsurprisingly, while Uber must contract as a principal with passengers in London, it rewrote its contract with drivers outside London so that it could act as an agent rather than as a principal. 

These non-tax cases led to a bizarre outcome that similar, or even identical, PHV services are subject to substantially different VAT treatments under the same VAT legislation, depending on geographic locations. The UK experienceoffers an extreme example where the licensing laws differ across regions within a country, which indirectly determine the VAT consequences through the law of contract and agency. As a result, VAT liability in platform markets is increasingly contingent on external legal classifications rather than tax design choices. However, it is important to point out that licensing laws have entirely different objectives from VAT law and should not determine the VAT consequences. More fundamentally, the current landscape in the UK suggests that reliance on agent and principal doctrines to determine VAT consequences on a case-by-case basis is no longer sustainable in the sharing economy. The only sensible solution is legislative intervention to address the underlying tax issues, thereby rendering the agent-principal distinction irrelevant.

In other countries, including in Canada, New Zealand and the EU, legislative measures have been adopted to bring certain sharing economy activities into the scope of VAT. These measures typically rely on a ‘deemed supplier model’, under which the liability to pay VAT is shifted from unregistered underlying suppliers to the digital platforms that facilitate the supplies. The UK could consider combining platform liability with a platform-level presumptive input tax entitlement regime similar to the flat rate scheme, through which approximated input tax credits are provided to unregistered underlying suppliers. As the platform liability model essentially removes the threshold for remitting VAT for underlying suppliers through the back door, it also removes the associated bunching problem. The wider adoption of platform liability may gradually weaken the policy justifications for a high registration threshold, making it increasingly feasible for the government to lower the threshold over time.   

Design, challenges, and opportunities

The three challenging issues of VAT design discussed in this article illustrate the constraints that social and economic objectives, as well as administrative and compliance considerations, place on real-world policymaking. Although technological advancements provide new opportunities, many of the structural issues cannot be resolved by technology.

In my book, I move beyond an economics-dominant approach to VAT design and develop reform proposals that take account of the political, technical and administrative constraints faced by policymakers. The issues discussed in this article represent only a small part of the broader agenda explored in the book. Other issues examined include small business regimes, financial supplies and insurance services, international cross-border issues, and VAT in federations. For policymakers, tax administrators, professionals and academics alike, the book provides a valuable framework for thinking through contemporary challenges and future developments of VAT in an increasingly complex economy.

Yige Zu, Associate Professor in Tax Law (City University of Hong Kong)

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