Mind the gap

KEY POINTS

• HMRC estimate the tax gap at £35bn.
• Avoidance causes loss of tax.
• Top-down approach for indirect taxes.
• Bottom-up method measures direct taxes.
• OECD model.

The difference between total revenues collected by HMRC and the total revenues that it is estimated the tax system should generate is called the tax gap.

Most UK taxpayers pay the tax that is due, and HMRC collected £468.9bn in revenues in 2010/11.

But not all businesses and individuals are paying their fair share and HMRC would have collected an even greater amount were it not for tax evasion, error, carelessness, avoidance, debt and criminal attacks on the system.

There will always be a tax gap. It is not possible to eliminate it completely without putting costly, burdensome reporting requirements on all taxpayers.

However, many of the activities that contribute to the gap damage growth, prevent a level playing field and put additional tax burdens on the honest majority.

That is why HMRC are committed to tackling the tax gap and ensuring everyone pays their fair share.

Our definition and estimation of the size of the tax gap have generated a good deal of vigorous discussion.

Academics and members of the accountancy profession have argued, most recently during the Treasury select committee hearing on the administration and effectiveness of HMRC, that the tax gap should exclude avoidance and that therefore HMRC’s £35bn estimate is too big.

Meanwhile, campaigning group Tax Research UK has calculated a tax gap of £120bn.

How do we use our tax gap estimates? Why we are confident that our figure is about right? Why is £120bn way off the mark?

Why measure?

Two of the fundamental aims of HMRC are to encourage, facilitate and increase voluntary compliance, and to crack down on those who choose to be deliberately non-compliant. We believe that these two aims are encapsulated in the concept of the tax gap.

Thinking about the tax gap forces the department to focus attention on the need to understand how non-compliance occurs and how the causes can be addressed, whether through tailored assistance, simpler legislation, redesigned processes or targeted interventions.

We have found that tax gap measures are not sufficiently accurate or timely enough to use for setting targets and performance measurement.

On the other hand, we have also found that tax gap analysis is a very useful tool, alongside others, which helps the department with strategic thinking and business planning in a number of ways – in particular, by giving an assessment of long-term trends and by quantifying types and causes of non-compliance by tax regime and customer group.

HMRC include avoidance for practical reasons. It is important to understand that the use of avoidance schemes is a tangible cause of tax loss.

Such schemes often rely on complex structures with tax effects contrary to the policy approach presented to parliament when legislation was enacted.

HMRC’s functions include challenging schemes that may be ineffective, and advising ministers whether legislation needs to be amended.

So it makes sense to include avoidance within the definition of the tax gap to give a complete picture of the challenges we face in designing our strategy and focusing our resources where they are needed.

Methodology

We believe our estimates of the tax gap for each of the main taxes we administer use the best achievable methods based on all the information presently available.

A ‘top-down’ approach is used to estimate tax gaps for indirect taxes. This is because we can use independently gathered data on consumption to compute how much tax should have been paid and so calculate a gap by comparing against tax receipts.

The data needed for a top-down estimate for direct tax gaps do not exist and so direct tax gaps use a ‘bottom-up’ approach based on HMRC’s operational and intelligence data, such as from random enquiries and risk registers.

In both cases, we calculate the net tax gap, which is the gap arrived at after taking into account tax yield generated by HMRC’s compliance work.

Top-down and bottom-up methods of measuring tax gaps are complementary. The former are better at capturing all forms of tax loss (whether they are known to the authorities or not), whereas the latter depend on HMRC’s ability to identify tax loss.

However, bottom-up methods do enable a more detailed breakdown of the causes of tax losses.

Ideally, we would use both methods for each tax, but this is not always practical, or even possible.

Numbers

HMRC’s estimate of a £35bn tax gap for 2009/10 is a big number but it is important to see it in context.

It means that HMRC collect more than 90% of the tax that is theoretically due. The UK compares well here internationally: the USA’s tax gap is 14%; in Sweden it is 10% and in Mexico it is 23%.

Estimating the scale of, and trends in, the tax gap is not widely attempted by most governments around the world because of the difficulties involved.

Getting more tax in will help reduce the public deficit faster, so we are transforming our compliance work and reinvesting more than £900m into our work against avoidance, evasion and criminal attacks to bring in additional revenues of £7bn a year by 2014/15 on top of the £13bn additional revenues to which we are already committed.

There is a huge difference between the £35bn and the £120bn figure for the tax gap quoted by Tax Research UK, and this has caused confusion and concern.

The figures are not directly comparable, partly because the definitions are quite different (see Two estimates).

HMRC think the £120bn figure is very misleading. It confuses the tax gap with cash flow and legitimate reliefs in a number of areas.

Unpaid tax

Unpaid tax of £28bn is a snapshot of the total amounts owing to HMRC on a particular day. But we think this approach gives a misleading impression of tax that is lost.

Most tax paid late is collected within a few days, and more than 90% is eventually collected.

Therefore HMRC’s tax gap figure shows only the amounts the department never collects and 90% of this arises because of insolvency.

Avoidance

For corporation tax avoidance, Tax Research UK calculates the ‘expectation gap’.

It describes this as a measure of the difference between the contribution society expects business to make by way of tax paid, and what is actually paid.

Defined as the difference between the headline or declared tax rate for companies, and the rate of tax they actually pay, this means that specific exemptions and legitimate reliefs such as capital allowances or double taxation relief, which reduce the amount of tax payable, are badged as avoidance.

Avoidance is also drawn very widely, for example it includes tax not paid by non-domiciles who choose not to remit their income to the UK. We do not consider this part of the tax gap: the remittance basis is a choice intended by parliament.

Evasion

Tax Research UK particularly criticises HMRC’s use of bottom-up methodologies to measure the direct tax gap and applies the VAT gap rate to arrive at an evasion figure for all direct taxes.

This is highly inappropriate for three reasons:

1. the VAT gap includes all forms of non-compliance such as non-payment, avoidance and criminal attack as well as evasion. So the VAT gap arises from much more than just suppression of turnover that might feed through to evasion of direct taxes;
2. the use of the VAT gap in this way counts debt and avoidance twice for direct taxes – an arithmetical error; and
3. very importantly, tax gaps vary considerably by type of tax.

Gaps for taxes using deduction of tax at source, or with significant third-party reporting requirements are much lower than for taxes without these features.

This is established by very detailed research in the USA and Denmark and borne out by UK experience.

Using the % VAT gap – 9.7% for 2010/11 is the latest estimate – gives an answer that is in the right order of magnitude also for business profits of companies and sole traders.

But it gives completely the wrong answer for the income tax due from employees where PAYE is operated.

International research suggests a tax gap for this of around 1%. This incorrect assumption accounts for £30bn of Tax Research UK’s £70bn evasion estimate.

In comparison, HMRC’s figure of £26bn in the Two estimates table covers a wide range of tax gap causes, from simple error through to organised criminal attack.

Including ‘legal interpretation’ in the evasion part of the tax gap has raised questions. This element, roughly £5bn in 2009/10, derives from two sources.

First, adverse litigation decisions. Second, and this is where the bulk of the figure comes from, an estimate of potentially contentious tax issues that are never identified by HMRC.

Tax lost from adverse litigation decisions is included for the same practical reason as avoidance: it allows tracking of the extent to which legislation may not deliver the intended tax policy.

Where disputes are resolved by agreement we do not count a tax gap (although extra tax is often collected as a result of the discussion).

Gross or net?

HMRC’s published estimates are net of the revenue generated by the department’s compliance activity, for example £13.9bn for 2010/11.

The Tax Research UK figures do not take into account HMRC compliance activity. While it is perfectly acceptable to report a gross figure, it should not be compared with HMRC’s net figure.

Other approaches

Tax Research UK and others have asked why HMRC do not estimate the tax gap for direct taxes using the top-down approach, as we do for indirect taxes.

HMRC regularly review potential methods for a top-down approach for direct tax gaps, such as those based on national accounts data or surveys of income. The experience of other tax administrations in estimating tax gaps is a key consideration.

The results of our latest review are published in a working paper on HMRC’s website.

We are convinced that the current approach to direct tax gaps of bottom-up methods remains the only feasible option for producing full estimates.

A top-down approach to estimating entire direct tax gaps in the UK requires calculation of a theoretical tax-collectible figure to compare receipts against.

This is impractical because there are no suitably robust sources of independent data on income and profits. In fact, the Office for National Statistics takes its data on income from HMRC.

Some academics have put forward macro-economic models as a means of estimating the size of the informal economy, typically estimating the hidden economy for most countries to be more than 10% of gross domestic product.

We have reviewed these models and concluded that they do not produce results that we can use for calculating tax gaps.

HMRC are not alone in this view. Academics and national statistical bodies, for example the Australian Bureau of Statistics in The Underground Economy and Australia’s GDP, have severely criticised the modelling and found the resulting estimates of the hidden economy to be implausibly high.

As a result the Organisation for Economic Co-operation and Development (OECD) and other international organisations have strongly advised against the use of such models.

In a recent report, Reducing Opportunities for Tax Non-cCompliance in the Underground Economy, the OECD said:

‘The OECD (and other international organisations) reject these methods as being useful in obtaining exhaustive estimates of GDP or in estimating underground production and have observed that when applied they produce for most countries spectacularly high estimates of NOE [non observed economy] activities which have no sound scientific base but which, nevertheless, attract much attention from the media and other parties.’

HMRC agree that the scale of these estimates does not seem credible. A hidden economy that is above 10% of GDP overall implies much higher levels of non-compliance in the areas of the economy where there is scope for underreporting.

For example, it implies underreporting of around 50% for every self-employed taxpayer or, put another way, that one in ten of the working population understates income by £50,000 a year.

This is completely contradicted by our operational data and customer research which show that while mistakes do happen, deliberate non-compliance is far from the norm.

In summary, tax gap measurement is not an exact science and there are limitations to the methodologies we use.

However, HMRC have developed robust and internationally recognised estimates of tax gaps for the main direct and indirect taxes.

We believe these are the best current estimates, based on all the information presently available.

Further work is under way to establish more robust measures including all elements of the tax gap, and we would welcome engagement with the academic community to progress our understanding of this difficult but important problem.

Issue: 4365 / Categories: Comment & Analysis , tax gap , Admin