Closing the tax gap: HMRC's record at ensuring tax compliance: Government Response to the Committee's Twenty--ninth Report of Session 2010-12 - Treasury Contents

Appendix 2: Additional information about the Tax Gap


In the report Closing the Tax Gap: HMRC's record at ensuring tax compliance the Treasury Committee raised a number of concerns about HMRC's measurement of the tax gap and use of the estimates. Measurement issues raised included the inaccuracy of the measure, the range of methods used to produce the calculations, the wide range of behaviours included and the difficulty of making meaningful comparisons from year to year. In addition the committee were concerned that use of the tax gap risks focussing HMRC away from ensuring that all taxpayers pay the correct amount of tax. These doubts lead to the following three recommendations on the tax gap:

The tax gap can be a useful concept for assessing trends in the amount of possible unpaid tax. We are not, however, convinced that the process of calculating, publishing and publicising an aggregate figure for the tax gap is a sensible use of HMRC's limited resources. The aggregate tax gap figure is misleading and risks focusing HMRC on the wrong task as it only provides an order of magnitude (Paragraph 16)

We recognise that it is useful for HMRC's employees to have some idea of the difference between what HMRC should be collecting and what is collected, particularly in the case of criminal activity. However, in other areas it would be more useful for it to identify ambiguities in tax law rather than employ resources in calculating how much tax would be collected if everyone shared its interpretation of the law. Separate reports on how much tax was lost through criminal activity and areas where HMRC had encountered different interpretations of tax law would be a better use of resources (Paragraph 17)

We would welcome further submissions from HMRC and tax experts both on how the tax gap calculation can be improved, and on whether it serves any useful purpose in HMRC's work (Paragraph 18)

HMRC welcomes the opportunity to send this submission on the tax gap. In this submission we have tried to explain, (i) how the tax gap is useful to us, (ii) how it is calculated and how it can be improved, (iii) why we publish an aggregate figure and (iv) how HMRC's estimate compares to others.

Why does HMRC focus on the tax gap?

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. By the 'tax gap' we mean the difference between total revenues collected by HMRC in a year and the total revenues that we estimate that the tax system should generate. So measuring the size of the tax gap provides measures of the level of voluntary compliance and of HMRC's effectiveness in tackling non-compliance. We aim to reduce the tax gap by ensuring that our customers pay the tax that is due.

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. Measuring the tax gap helps us to understand whether increasing returns from compliance activity reflect improved effectiveness or merely a decrease in voluntary compliance. Recommendation One in the report of the TSC inquiry the Administration and effectiveness of HM Revenue and Customs says:

assessing HMRC's operational performance at ensuring compliance is complex. Tax receipts are affected by numerous factors—including changes to the law, economic performance, cultural attitudes to compliance and HMRC enforcement activity. We recommend that the Government commission a study to attempt to separate out the impact of these factors over time.

This study is underway and understanding movements in the tax gap is central to this work.

What do we use tax gap analysis for?

HMRC are pioneers in tax gap measurement. We first measured Excise gaps in the late 1990s, and the VAT gap in 2002, and over time we have learnt several lessons about how to use tax gap analysis effectively. We have found that tax gap measures are not sufficiently accurate or timely enough to use for setting targets and performance measurement. But we have also found that tax gap analysis is a very useful tool, alongside others, that 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.

Tax gap analysis provides a long term health check to validate the strategic decisions taken by the department and our effectiveness in tackling major risks. We have found that it is not useful to compare cash tax gap estimates across years because they are affected by factors such as inflation and rates changes that make comparisons misleading. However, the tax gap expressed as a percentage of tax due is suitable for tracking trends and is sufficiently accurate to show the impact of key developments in recent years. For example, the data series for the percentage tax gap clearly shows how the department has dealt with waves of criminal attack on the VAT system, how the recession increased debt and the increasing return from compliance activity. The total as a percentage of liabilities also allows us to benchmark levels of compliance in the UK against the other countries who measure and publish tax gaps.

To aid departmental business planning, tax gap analysis is being split into risks for each tax regime. This is not the only tool that is used to allocate resources—we have some very sophisticated models that allow us to estimate the marginal impact of putting more or less resource on specific activities. But the tax gap analysis does provide helpful validation of the broad use of resources, which is an important check in the resource allocation process.

Tax gap analysis plays a key role in the design of departmental strategy, for example in shaping the investment proposition for the current Spending Review. Two specific contributions of tax gap analysis to the spending review process were:

  • Identifying areas where the department should look to investigate investment propositions by looking at the main causes of the tax gap by customer group and behaviour and seeing how these are distributed across the taxpayer population. The tax gap analysis showed that our effectiveness in tackling large business risks was already very high and that we should focus upon finding means of tackling evasion and reducing error amongst SMEs where greatest losses occurred, and
  • Testing the investment propositions that had been developed using a range of more detailed analysis and models. Tax gap analysis allowed us to assess whether the overall balance of the SR package was proportionate and whether it was sufficiently ambitious. Notwithstanding the concerns expressed by Treasury Committee tax gap analysis was used in exactly this way in paragraphs 19 and 21 of Closing the Tax Gap: HMRC's record at ensuring tax compliance to assess the scale and direction of the SR10 investment.

In addition to these high level strategic and business planning roles there is a host of other practical uses for the various tax gap measures. The trend in the VAT gap is used by OBR as part of the VAT receipts forecasting process. The data gathered through random enquiry programmes is used to test and tune our risk assessment systems. And tax gap analysis has played an important role in specific policy decisions. For example, the decision to raise the three line account threshold on the SA return for self-employed taxpayers—reducing taxpayer costs by £50m—could be made because tax gap data demonstrated that the risks could be managed.

Finally, on the basis of tax gap analysis we are able reassure the public that over 90% of liabilities are collected and that the great majority of UK taxpayers pay the tax that is due. This is important because the academic research strongly suggests that social norms—perceptions of attitudes and behaviour amongst peers—are an important driver of behaviour.


Tax gap measurement is not an exact science. The estimates will never be precise and some care needs to be taken when comparing estimates for different taxes. However HMRC has developed robust and internationally recognised measures of the tax gaps for the main indirect and direct taxes. We are confident that these are the best possible from the information currently available. And whilst we are not able to calculate a measure of the precision of the tax gap estimate we do know that the estimates are sufficiently sensitive to be able to identify significant developments affecting taxpayer compliance in recent years.

A 'top-down' approach is used to estimate tax gaps for indirect taxes. This is because we can use data on consumption that is independently gathered by ONS to compute how much tax should have been paid and so calculate a gap by comparing against tax receipts. We do not believe that the data needed for a top-down estimate for direct tax gaps exists—for example the data on income and business profits that ONS use comes from HMRC.[2] So direct tax gaps use a 'bottom-up' approach based on HMRC operational and intelligence data such as from random enquiries and risk registers. In both cases we calculate the net tax gap which is the tax gap arrived at after taking into account compliance work by HMRC.

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, top down measures capture all forms of loss in a single estimate, so further assumptions have to be applied in order to produce estimates by types of behaviour and customer group. 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.

We are keen to improve our tax gap and compliance measurement. We have a comprehensive work programme in place to gather more data and develop new methodological approaches. The primary aims for future work are to develop, (i) a more granular understanding of the causes of tax loss and (ii) a robust evidence base describing the full impact of HMRC upon behaviour and tax receipts. There are a number of strands to this work:

  • Developing a more granular view of the causes of non-compliance. For example, we are building upon our use of customer surveys and insight techniques to gather more detail on why customers make errors. This will lead to improvements in our processes that can prevent non-compliance occurring in the first place;
  • Using innovative experimental and laboratory approaches to evaluate the impact of HMRC interventions upon customers' understanding and behaviour;
  • Improving our knowledge of people and businesses operating in the hidden economy through use of surveys and exploiting our investment in cutting edge data matching technology to routinely measure the percentage of non-registered taxpayers found on external data sources;
  • Integrating tax gap measurement with the analysis of receipts, additional revenues generated by HMRC activity, economic and demographic trends and changes in customer attitudes, and
  • Engaging with external experts on how we can improve our approach. Specifically, we are endeavouring to engage academics' interest in the subject of tax gap estimation and design of laboratory experiments as part of the 2012-13 External Research Programme.

Why aggregate and publish a tax gap figure?

The Treasury Committee questioned the value of calculating the tax that would be collected if everyone were to share our interpretation of the law and then adding this figure to an estimate of losses from other behaviours to produce an aggregate estimate. There are two main reasons why we do this. One is a product of how we use the estimates within HMRC and the other is a technical point that comes from the way in which we calculate the estimates.

On the first point it is important to understand that the use of avoidance schemes and contentious issues around legal interpretation are tangible causes of loss of tax. The tax gap for avoidance comprises the tax lost through the use of avoidance schemes that HMRC was not able to successfully challenge. The tax gap for legal interpretation is primarily an estimate of the extent to which HMRC does not identify contentious tax issues, which if identified and tackled would have brought in additional tax. (This gap arises mainly amongst companies who are not large enough to have a HMRC customer relationship manager.) HMRC needs to both identify and quantify the scale of these issues in order to help set priorities for policy development and resource deployment. And we need to be able to compare these priorities against tax losses resulting from other types of behaviour. This informs the decisions about how much resource to deploy on large business and wealthy taxpayers compared to SMEs, Individuals and Criminal Gangs. Because the information is used in high level decision making we feel that we should be transparent about the figures we are using. We have been pressed by PAC and NAO to develop and use tax gap estimates in this way and to publish the figures. And the Information Commissioner has ruled that our estimates of tax gaps are a matter of public interest—and so should be published—because disclosure will facilitate public debate and enable the public to assess HMRC's performance.

The key to the technical point is that our methodologies first estimate tax gaps by regime rather than by behaviour. So for example the VAT gap is estimated as one figure and we then apply judgments to produce analysis by behaviour. This means that the estimates by regime are more robust than other types of split and that in order to understand the component parts it is necessary to understand how the total for the regime is estimated. Therefore in the interest of clarity we think it makes sense to describe all of our tax gap estimates in one document so that a reader can more easily understand how the figures are calculated and the methodological issues involved.

Finally we have to be aware that because the concept of a tax gap is of public interest others will calculate a total. The external work has tended to produce estimates that we think are misleadingly high. (See the annex for a detailed discussion of why we are convinced that our estimate of around £35bn is much more accurate than the Tax Research UK estimate of £120bn). We think that these estimates could be dangerous if not countered by HMRC's published estimates. Partly because they give a misleading view of HMRC's effectiveness and the amount of uncollected revenues. But also because they encourage the perception that deliberate non-compliance in the UK is the norm—a perception which could encourage further non-compliance. We are confident that deliberate non-compliance is far from the norm—and that it is important to demonstrate this by publishing our own estimate of the total tax gap.

Annex: External calculations of the tax gap

There is a huge difference between the £35bn tax gap calculated by HMRC and the £120bn figure for the tax gap quoted by Tax Research UK. The scale of the difference has caused confusion and concern. Part of the reason for the disparity is that the two estimates are not directly comparable—partly because the definitions used are quite different. Nevertheless we think the £120bn figure is very misleading. It confuses the tax gap with cash flow and legitimate reliefs in a number of areas.

Table 1: the table attempts to show where our estimates differ. The main points of difference are described below.
Tax Research UK HMRC (2009-10)
Unpaid Tax£28bn Unpaid Tax £4bn
Tax avoidance£25bn Avoidance£5bn
Evasion£70bn Hidden economy, evasion, error, failure to take reasonable care, legal interpretation and criminal attacks £26bn
Total£123bn £35bn


The figure for unpaid tax of £28bn that Tax Research UK use is a snapshot of the total amounts owing to HMRC on a particular day. We think this gives a misleading impression of tax that is lost. Most tax paid late is collected within a few days, and over 90% is eventually collected. Therefore the figure we include in our tax gap estimate shows only the amounts we don't ever collect. 90% of this arises because of insolvency.


For corporation tax avoidance, Tax Research UK calculates the 'expectation gap'. They describe 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. This is defined as:

the difference between the headline or declared tax rate for companies, and the rate of tax they actually pay.

This means that legitimate use of specific exemptions and 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.


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:

  • 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;
  • the use of the VAT gap in this way counts debt and avoidance twice for direct taxes—an arithmetical error, and
  • very importantly, tax gaps vary considerably by type of tax.

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 US and Denmark[3] and borne out by UK experience. Using the percentage VAT gap—9.7% for 2010-11 is the latest estimate—to estimate a tax gap for business profits of companies and sole traders may give an answer of the right order of magnitude. 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 the £120bn estimate.

Tax Research UK have supported their evasion estimate through comparison with an academic paper produced for the World Bank[4] which contains estimates of the size of the hidden economy for a number of countries including the UK. The estimate for the hidden economy in the UK is 13% of GDP which Tax Research UK then convert to a tax gap estimate of £73bn. Rather than support the Tax Research UK figure we believe that this comparison, if anything, further undermines it. The methodology uses a variant of a 'currency demand' model to estimate the size of the hidden economy. The use of 'currency demand' models for this purpose has been comprehensively and extensively criticised in unusually strong terms by other academics[5] [6] and national statistical bodies.[7] [8] The main theme of the criticism is that the methodology relies upon the application of assumptions which result in estimates that are much too large to be plausible. For example the Australian Bureau of Statistics explore what it would mean for Australia to have a hidden economy of 15% (as predicted in an application of this methodology by the same author). Critically they point out that a hidden economy of this overall size 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 single self-employed taxpayer—which they reject as being implausible. Certainly non-compliance of the scale suggested for the UK is completely incompatible with all of our customer research and operational data.

As a result of the general concern about the use such models a body consisting of a number of international organisations including OECD, IMF, the World Bank, UN and the European Commission have issued a strongly worded statement advising against use.[9] Part of their statement says:

Unofficial estimates are often based on macroeconomic models. For instance, they may assume a fixed relation between the size of the economy and money in circulation. Such methods may yield grossly exaggerated results, attracting the attention of politicians and newspapers and thereby gaining wide publicity.

In a more recent report 'Reducing opportunities for tax non-compliance in the underground economy',[10] OECD comment:

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.

Gross or net?

HMRC's published estimates are net of compliance yield. The Tax Research UK figures do not take into account direct tax compliance yield—for example £13.9bn for year 2010-11.


Tax gap measurement is not an exact science. But we are confident that £35bn is a much more realistic estimate of the tax gap than £120bn.

2   We periodically review this conclusion to check whether there are top down techniques for the direct taxes that we could use. Our latest review was published in August 2011.See Back

3   Unwilling or Unable to Cheat? Evidence from a Randomized Tax Audit Experiment in Denmark, Henrik J Kleven, Martin B. Knudsen, Claus T. Kriener, Soren Pederson , Emmanuel Saez;Tax Gap for Tax Year 2006, IRS( Back

4   Shadow Economies All over the World New Estimates for 162 Countries from 1999 to 2007; Friedrich Schneider, Andreas Buehn, Claudio E. Montenegro July 2010 Back

5   Estimating the Underground Economy MIMIC models-Trevor Breusch, November 2005 Back

6   The Shadow Economy in OECD Countries : Panel Data Evidence-Konstantin Kholodilin, Ulrich Thiessen, May 2011 Back

7   The Underground Economy and Australia's GDP-Australian Bureau of Statistics, March 2004 Back

8   Estimating the Underground Economy in Canada, 1992-2008-Statistics Canada June 2011 Back

9   Estimates of the unrecorded economy and national accounts, Declaration of the ISWGNA ( Back

10   Reducing opportunities for tax non-compliance in the underground economy, Forum on Tax Administration : SME Compliance sub-group ( Back

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