An inherent problem with any sales tax is the appropriate tax treatment of small firms, both in industry and trade.

While the problem exists in all countries, it is particularly severe in the developing countries, with lower levels of education, record keeping and administrative competence.

Retailing in most developing countries is characterised by a large number of small firms -- the market stalls of Cambodia, the sidewalk sellers of Bangladesh, the endless small shops in Indonesia, Thailand and India, the tiny establishments of Latin America.

Even in developed countries in which some large retail establishments are there, a high percentage of retailing is in small scale.

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Most countries, therefore, allow small business to exempt their supplies on the condition that they do not deduct input tax. Reasons why a threshold should be there are the following:

• Relatively high compliance cost for small business,
• Higher administrative costs for the taxing authority,
• Political power of small businesses
• Improving tax administration if there are less dealers
• Relatively small amount of the VAT collected from small businesses.

Small business will make only modest contribution to gross VAT receipts. For example, in the UK, the million smallest registered businesses pay only about 7 per cent of total VAT revenue, although they constitute 76 per cent of registered traders, and in Mexico, almost 90 per cent of VAT revenue is collected from 10 per cent of the registered traders.

In both Korea and Taiwan, the smallest businesses, constituting approximately 75 per cent of all registered traders, produce only about 5 per cent of all VAT revenue.

High or Low Threshold: Whether the threshold level should be high or low is another issue, which is very crucial. Setting the threshold for a VAT is critical to the success or failure of the tax (Michael Keen, Jack Mintz -- The Optimal Threshold for a Value Added Tax, Journal of Public Economics, Vol 88, March 2004, p.559).

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Too high a threshold compromises the basic objective of raising revenue. Too low a threshold may have the authorities overwhelmed by the difficulties of implementation. Too high a threshold is not desirable for the following reasons:

• If the threshold is very high there would be far too many unregistered dealers who would snatch the market share in a big way from the registered dealers.
• If the competition from a large number of unregistered dealers gets too much, even the registered dealers would find it difficult to pass on the burden of the tax to the next purchaser. Under such circumstance, they will also be tempted to evade tax to remain viable.
• If the threshold is very high, there would be very few persons left in the wholesale and retail distribution sector.

For these reasons, most countries, including Canada, have kept the VAT registration threshold sufficiently low at a level below which the business can rarely by sustained for too long other than on a casual basis.

At the same time, if the threshold is too low, the administrative cost becomes correspondingly much higher. In Ghana, the low level of the threshold is cited as one reason for the failure of the 1995 VAT. VAT was reintroduced in Ghana in 1999 with a higher threshold of $75,000 compared with the earlier $20,000. Now it stands at $80,000.

In Uganda, the near failure of the VAT in 1996 is mostly attributed to a low threshold, which was raised from $20,000 at the time of introduction to $50,000 only five months later.

Even in the EU some thresholds are very low compared to others and it continues in spite the efforts at harmonisation by the Sixth Directive. In fact, the variation across the member states continues to cause some friction (Liam Ebrill et al -- The Modern VAT, p.115, IMF 2001).