VAT Threshold Effectiveness: Behavioral Distortions, SME Growth Traps, and Perceived Fairness

Abstract

Value Added Tax (VAT) registration thresholds are designed to reduce
administrative burdens for small businesses, yet they often create
unintended behavioral and economic distortions. This study
synthesizes empirical evidence from twenty-seven selected journal
articles to evaluate the impact of VAT thresholds on business
decision-making, SME growth, and voluntary compliance. The review
identifies three critical findings. First, the threshold acts as a "fiscal
cliff," triggering widespread strategic distortions such as "bunching"
(turnover suppression) and "business splitting" (fragmentation), as
firms restructure to exploit horizontal inequities between taxed and
exempt entities. Second, the threshold functions as a "growth trap"
for Small and Medium Enterprises (SMEs); high, regressive
compliance costs deter formalization, incentivizing firms to stagnate
voluntarily rather than face the administrative burden of entering the
tax net. Third, the study establishes a causal link between perceived
horizontal inequity and eroded tax morale, demonstrating that
voluntary compliance is heavily dependent on the perceived
procedural and distributive fairness of the tax system. The findings
suggest that to mitigate these distortions, policymakers should
prioritize digital adoption to lower compliance costs, implement
smoothing mechanisms at the threshold, and enhance transparency
to restore taxpayer trust.