The government should raise the turnover threshold for VAT from £85,000 to £100,000, according to the Federation of Small Businesses (FSB).

The business group said that this would give firms stepping into the VAT-paying ring crucial breathing space. It would also be an incentive to grow their turnover without fear of having to charge customers an extra 20% overnight, the FSB added.

The FSB also suggested bringing in a smoothing mechanism to ease the transition for small firms, owner-managed companies and some of the self-employed who go just over the threshold.

At the moment, thousands of small firms keep their turnover just below the £85,000 threshold, according to the Office for Budget Responsibility (OBR).

The OBR said that hundreds of millions of pounds of potential economic activity could be lost due to this ‘bunching’ just below the threshold.

Tina McKenzie, FSB’s Policy Chair, said: ‘VAT compliance flattens small firms by stifling their growth and emptying their coffers. It’s crying out for a modern makeover to match today’s economic landscape.

‘The flaws in our current system are glaringly obvious. We are at a breaking point – a drastic overhaul of VAT is needed.

‘Raising the threshold to reflect inflation, introducing a buffer to soften the blow for those just over the limit and demystifying the rules to save small business owners from a VAT-induced headache could unlock hundreds of millions in extra economic activity.’