Disclaimer: I am not an expert on VAT and I am not providing advice. I am simply trying to expand the discussion around VAT from how it is applied to what it might mean to business strategy.

The first point that I want to discuss is the idea that this is a value added tax levied by the government and collected by various vendors and suppliers. From my understanding this is a legally correct definition. The problem is that this phrasing does not change the laws of supply and demand. If the price of a good or service moves, it matters not why it has moved in terms of the effect of demand. Price up, demand is usually down.

The second issue is that there seems to be the feeling that 5% is somehow not significant. The question is: 5% of what? Applying 5% of VAT on the sale price is effectively applying a 5% tax on revenue. The pertinent question is how does this affect profits, assuming prices don’t move? The answer lies in the net profit margin (NPM). The NPM is simply the percentage of revenue that becomes profit. Simplistically, assuming all revenue is subject to VAT, then the NPM will decrease by amount of VAT, which is 5%, in percentage points. So if NPM is 20%, then profits will drop 25% to 15% NPM post VAT. If NPM is 5% then 100% of profits are lost. For comparison, Etisalat NPM for the past few years was 16%. Forbes has a list with the average NPM for private businesses (pre-tax) at about 9%.

So businesses are facing at least two major factors. The first is VAT’s impact on demand if it is passed on. The second is VAT’s impact on profits if it is not passed on. Now we should look at other factors. One important factor is the competition, especially those with monopolies. Some, such as Etisalat and du, already pay royalties for their oligopoly so in such cases things are relatively fair. But for groups who have agency monopolies then the effect of VAT on demand for their products and services would be far less than pure capitalistic businesses.

A second factor is size. A company generating AED 1 billion in revenues will have far more pricing power and be able to withstand profit compression than a company generating AED 1 million in revenue. This would lead to knock-on effects such as reduced lending to smaller companies.

This brings us to the question of business strategy. I’ll focus on smaller players who, clearly, don’t have monopolies. One strategy would be to not pass on the VAT and live with reduce profits. If this strategy leads to a loss, then this must be considered temporary, and the business should think long and hard about  burning cash to keep the business going. Sooner or later the cash will run out. Cutting expenses goes without saying. What is left?

One idea that smaller businesses might consider is merging. Why? Merging, if done correctly, should end up with a much larger revenue relative to fixed costs, which would automatically lift NPM. Now, I know that mergers are difficult. But when the companies are small and business survival is at stake, then perhaps merging is an option worthy of appraisal.

I’d like to close with an important point: VAT is vital for the economy. We have lived a wonderful few decades with great infrastructure being built at a low cost to us as businesses and consumers. We now need to build efficient companies that can compete in a more balanced environment whereby we pay for this great infrastructure. I’m talking about the capitalist companies of course, the monopolists don’t face the same challenges.