VAT: Barrier To Entry

For the sake of this comparison, we will imagine two very similar countries with different business tax systems. In Country A they have 43% Corporation tax (and no VAT or Sales Tax) and in Country B they have 15% Value Added Tax (or Sales Tax) but no corporation tax.

And we'll imagine that in their capital cities, London A and London B, advertisers (mainly private people and banks, who cannot reclaim VAT) are prepared to spend £1,150,000 per year (inclusive of VAT) on advertising in the newspapers that are distributed free at train stations (like City AM, Metro and Evening Standard). It costs £200,000 a year to run such a newspaper, being mainly staff costs, so any newspaper needs to have a net turnover of at least £200,000 a year to at least break even.

We also assume that the usual 80/20 rule applies and so the proprietor of the business expects to make at least £50,000 a year in net profits (after tax) on top of salary costs, so in the longer run, we'd expect any newspaper with turnover of less than £250,000 to go out of business or to be taken over by a competitor (who basically shuts it down).

In the long run, we would expect to see no more than four free newspapers in either London A or B, as follows:
You will note that in both countries, total taxes collected from those newspapers are £150,000.

We know that this equilibrium with four newspapers is unlikely to last for long and sooner or later one newspaper will go out of business; the market will henceforth be shared between the three survivors who are now coining it in:
We note that mathematically, the newspapers in London B have benefitted more from getting rid of a competitor, their profits leap from £50,000 a year to £133,000; while in London A they have 'only' doubled to £105,000. Let's assume that the market trundles along with just three newspapers for a while until a potential new entrant spots how much profit they are making, does his homework and decides to have a go at setting up. He estimates that
- it would take him two years to build up to a quarter of the advertising market, i.e. from Year 3 onwards his turnover would be a quarter of the total market,
- that his turnover in Year 1 would be a third of that and in Year 2 would be two-thirds of that,
- and that his costs would also be £200,000 per year.

Question: should our potential new entrant have a crack in London A (where they have corporation tax but no VAT) or in London B (where they have VAT but no corporation tax?)? He knows that if he succeeds in either town, that his long run profits will be about £50,000 a year, so their current levels of net profits are misleading.

Answer: London A is a much safer bet. His start up losses will be about £112,000 and after three years four months he will have positive cash flows. If he were to start in London B, his start up losses would be £150,000 and the business will not be cash positive for five years.

Why? Look at the cash flows:
Summary: large businesses and incumbents actually quite like VAT, and they certainly prefer it to corporation tax, as VAT acts as a barrier to entry. This is not so in industries where there are lots of competing businesses and/or lower barriers to entry. For the self-employed who only provide their own skills and labour, there is in practice no real difference between a tax on gross profits (VAT) or a tax on net profits (income tax or corporation tax). Every £1 they earn above and beyond their VAT-able input costs is subject to VAT and to income tax or corporation tax.

We see that it is far more likely that there will only be three newspapers sharing the market in London B, making profits of £133,000 each; and far more likely that a fourth competitor will attempt to break in to the market in London A.

Of course, in Country C where they have neither VAT nor corporation tax and all taxes are collected via higher Business Rates, things look even rosier, but that's another topic.

Also of course, you might argue that having four duplicated newspaper teams is a waste of money and resources, and maybe we'd be better off with a maximum of three. In which case, the correct tax raising strategy is to exempt newspapers from VAT and corporation tax and to simply auction off three licences. Using the same figures and assumptions as above, and assuming that proprietors are happy with long run average profits of £50,000 a year, the licences would be worth up to £83,000 a year each. it would be a very big barrier to entry (bad) but an excellent way of raising non-distortionary taxes (good), quite how you calculate the trade-off between the two, I don't know.