Appendix 2: Additional information about
the Tax Gap
Introduction
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.
Measurement
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
|
Non-payment
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.
Avoidance
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.
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:
- 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.
Conclusion
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.Seehttp://www.hmrc.gov.uk/research/taxgap-workingpaper.pdf 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(http://www.irs.gov/pub/newsroom/overview_tax_gap_2006.pdf) 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 (http://unstats.un.org/unsd/nationalaccount/sna/nn22-en.pdf) Back
10
Reducing opportunities for tax non-compliance in the underground
economy, Forum on Tax Administration : SME Compliance sub-group
( http://www.oecd.org/dataoecd/41/16/49427993.pdf) Back
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