Optimization Frictions in the Choice of UK Flat Rate Scheme of VAT

UK VAT offers an optional Flat Rate Scheme (FRS) for small businesses to reduce compliance costs. FRS replaces VAT with a turnover tax and creates tax saving opportunities for some traders. Using the universe of VAT returns between 2004-05 and 2010-11 financial years I find 26 percent of eligible VAT traders gain from FRS but only 3 percent join the scheme subsequently. This is despite high persistence and non-negligible size of FRS gains. FRS gainers who remain on VAT in the following year, have 70 percent probability of being an FRS gainer and the median gainer continue to save 10 percent on VAT payments upon joining. I use date of VAT registration and registered postcode district of traders to show traders registering later and those registering in high FRS regions are more likely to join FRS. These patterns favor broadly defined information frictions as potential hurdles for joining FRS.