The temporary reduction in UK VAT (effectively Britain’s sales tax) has come to an end.

On 1^st December 2008 UK VAT was reduced from 17.5% to 15%. This was a temporary measure designed to ‘stimulate’ the economy and the rate returned to 17.5% on 1^st January 2010.

At the time of the reduction many business commentators decried the move, claiming it was tokenistic, too little and misdirected.

Initially we were inclined to agree but on reflection we saw two good arguments in its favour:

First, though the cost of vatable goods (assuming the VAT reduction was passed on to consumers) would have fallen by a pretty paltry £2.13 for every £100 spent, the net effect throughout the economy would have been £billions and this money would have ended up somewhere. If spent it would have had the effect of reducing recessionary effects if not actually stimulating recovery.

Second, and of far more interest to small businesses, is the effect on our profit margins if we did not pass this VAT reduction on to consumers. Note this effect only applies to businesses supplying end consumers (businesses supplying other businesses don’t benefit as their customers reclaim the VAT paid and, aside from minor cashflow considerations, are immune to the VAT rate). And, it only applies where those businesses are able to maintain prices paid by consumers at the old VAT rate.

Imagine an item on sale for £100 prior to the VAT reduction.

Old price including 17.5% VAT                 £100.00
VAT @ 17.5%                                          £14.89
Old price excluding VAT                            £85.11

After the new 15% takes effect, if the retail price is maintained at £100, we have:

New price including 15% VAT                  £100.00
VAT @ 15%                                             £13.04
New price excluding VAT                          £86.96

The difference between the old and new ex-VAT prices is (£86.96-£85.11) £1.85.

By not passing on the VAT reduction, those businesses selling to consumers can increase their profits by £1.85 per £100 paid by customers.

Now, this may not sound like a great deal, but when we look at profit margins it has a startling effect:

Typically, a business might operate at a 10% net profit margin. This means the profit before the VAT rate cut would have been £8.51 per £100 paid by consumers.

After the VAT rate cut it would have been £10.36 (£8.51+£1.85). This is an increase in profits of around 22% - a pretty decent and welcome increase in times of recession.

If, however, the business was operating on a 5% margin prior to the VAT rate cut, which might be pretty likely in times of recession, the profit on the pre VAT rate cut £100 sale would have been £4.26, while after the VAT rate cut it would have been £6.11.

That is a whopping great 43.5% increase in profits. Small changes in price can have a huge effect on profitability.

So, again finding ourselves out of step with much mainstream thinking, we concluded this VAT cut was extremely welcome for those businesses that both sold to VAT paying consumers and who could maintain the pre-rate cut price paid by those customers.

Nevertheless, we should also note that even if the VAT rate had not returned to 17.5% at the start of the year, this effect would have only been temporary. Eventually inflationary and competitive pressures would have led to margins returning to more normal levels, and if this benefit was to be maintained VAT would have to be incrementally cut year after year.

But, this temporary respite, at a time it was most needed, would have been most welcome for those businesses able to take advantage of it. And, we hope, a few who would otherwise have been wiped out by the recession have lived on to fight further battles.