Tackling the tax gap Contents

1HM Revenue & Customs’ tax gap estimates

1.On the basis of a Report by the Comptroller and Auditor General, we took evidence from HM Revenue & Customs (the Department) and HM Treasury on tackling the tax gap.2

2.HM Revenue & Customs (HMRC) is responsible for administering the UK’s tax system. One of its three departmental objectives is to “collect revenues due and bear down on avoidance and evasion”. HM Treasury leads on the design of the tax system. It agrees HMRC’s revenue and efficiency targets, and levels of funding. HMRC reported record tax revenue of £627.9 billion in 2018–19, an increase of £22.1 billion (3.6%) on 2017–18. HMRC will report tax revenue for 2019–20 in its next Annual Report and Accounts, which are due in October 2020. Tax administrations rely heavily on taxpayers reporting and paying their taxes in line with the rules. In 2018–19 HMRC received 90% of total tax owed this way. Inevitably some taxpayers make mistakes, others choose not to comply, and some cannot pay because of insolvency. In other cases, taxpayers interpret tax rules differently from HMRC, or construct artificial arrangements to avoid tax.3

3.HMRC’s most recent estimate of the difference between the amount of tax theoretically owed and the amount collected, known as the tax gap, was £31 billion in 2018–19, equivalent to 4.7% of the total tax owed. HMRC estimated that its compliance activities, which range from educating taxpayers to fraud investigations, increased tax revenue by £34.1 billion in 2018–19 (5.2% of total tax owed) against a target of £30 billion. A wide range of factors affect the tax gap, some outside the control of tax administrators. For example, the state of the economy, demographic changes and the perceived fairness of tax policy can all affect how many voluntarily pay tax. HMRC considers the best way to tackle non-compliance is to: promote compliance by designing it into systems and processes; prevent non-compliance by, for example, using data to spot mistakes and preventing fraudulent claims; and respond to non-compliance by identifying and targeting the areas of greatest risk, and tackling those who deliberately try to cheat the system.4

4.The impact of COVID-19 on tax revenues and the tax gap is likely to be significant, with the UK government needing to prioritise support to businesses and taxpayers over tax collection. The pandemic may increase the risks of non-payment of taxes and more people may operate in the deliberately hidden part of the economy.5

Uncertainty in the tax gap measure

5.Measuring the true value of the tax gap is challenging because elements such as the hidden economy and evasion are inherently less visible, masking the extent of under-reporting. HMRC publishes its estimates of the size and composition of the tax gap annually.6 It uses a combination of established and “experimental” methods to estimate the size of the tax gap. Experimental methods are less accurate than established methods. Around 20% of the tax gap, by value, is estimated using experimental methods.7 We asked the Department about the reliability and accuracy of its tax gap estimates, particularly since HMRC does not publish the confidence intervals associated with its total tax gap estimates. HMRC told us that it publishes a detailed description of its methodology, which has been praised by the International Monetary Fund and the Office for Statistics Regulation (OSR) for “meeting best practice”.8 The OSR as well as praising HMRC’s tax gap statistics, for example, for the appropriateness of data sources, also highlighted areas where HMRC can improve the transparency and trustworthiness of the published statistics.9

6.HMRC highlights the uncertainties in its estimates by producing separate range estimates for around 42% (£13.1 billion) of the tax gap’s value but data limitations mean it cannot produce range estimates for the remainder. In 2018–19, the upper limit of the combined confidence intervals was £9.6 billion greater than the total reported tax gap for those elements. The lower limits were around £6.6 billion less.10 HMRC also explained to us that there are two main reasons for its significant revisions of the tax gap estimates for previous years. First, HMRC needs to revise its estimates of some aspects of the tax gap, for example the VAT gap, to account for revisions to the statistics provided by the Office for National Statistics about the size of the economy. Second, following the settlement of long-running cases, HMRC has to revise its original forecasts.11

7.HMRC measures the additional amount it generates by tackling tax avoidance, evasion and non-compliance, known as compliance yield. In its 2018–19 Annual Report, HMRC reported £34.1 billion of compliance yield, compared with £30.3 billion in the previous year.12 HMRC confirmed to us that it does not provide confidence intervals for its reported compliance yield.13 We asked the Department about the relationship between its tax gap and compliance yield estimates. HMRC explained to us that there are a number of reasons why it is “incredibly difficult to create an equivalence between the tax gap and the current compliance yield”. Cases that HMRC investigates can have yield going back over a number of years, whereas the tax gap estimates only relate to the year under consideration. There are also other factors that will impact the size of the tax gap, such as, economic conditions and the size of the taxpaying population.14 We also asked the Department about the level of uncertainty associated with its reported costs of compliance activities. HMRC explained to us that it is unable to measure the indirect effect of many of its activities, such as customer services, in promoting voluntary compliance. It therefore only includes the direct costs associated with the compliance part of the Department in its reported cost figures.15

Limitations of HMRC’s tax gap analysis

8.HMRC publishes a breakdown of the tax gap by taxpayer group, tax type and behaviour.16 HMRC told us that it uses the outcomes of its tax gap analysis as indicators of trends in its performance, which allow it to consider its track record in tackling non-compliance in relation to specific behaviour types and taxpayer groups. HMRC, however, confirmed to us that it does not measure the tax gap in each of the four nations of the UK. HMRC told us that it could attribute a proportion of the total tax gap to each of the four nations based on factors such as, the size of the economy and the number of small businesses in different parts of the UK, and assuming that taxpayer behaviours are broadly consistent across the different regions. But it had not undertaken such an analysis.17 HMRC acknowledged that such an analysis could be beneficial, particularly in the context of the devolution of Income Tax powers to Scotland and Wales in 2016–17 and 2019–20 respectively. HMRC told us that the Scottish and Welsh Governments have an interest in how much combined yield it collects and its attribution to them. It said it has a formula to make sure that the yield compliance directorates recover for income tax is shared between Scotland, Wales and the rest of the UK.18

9.It also transpired, when we questioned the Department about the size of the tax gap in the construction industry, that HMRC does not assess and publish the relative size of the tax gap across different industries. The construction industry has traditionally had quite high levels of non-compliance. HMRC introduced the Construction Industry Scheme to tackle the risks in the construction sector but it has not assessed the tax gap in the sector since.19 Notwithstanding the lack of a tax gap estimate for different industries, HMRC has intelligence on the levels of non-compliance in different sectors, such as in the case of buy-to-let landlords.20 HMRC uses such intelligence to inform the targeting of its campaigns, where it contacts large numbers of taxpayers in a specific sector and invites them to revise their tax filings. A number of taxpayers that do not take action will then be subject to HMRC investigations.21

The completeness of the tax gap

10.HMRC’s estimate of the tax gap includes both non-compliance with the letter of the law, such as tax evasion, and non-compliance with the spirit of the law, such as tax avoidance.22 We asked the Department the extent to which the practice of ‘base erosion and profit shifting’ is captured in HMRC’s estimates of the tax gap. These are arrangements by which multinational companies are able to, via financial transactions, shift their profits to countries where the tax rates are lower than the country where the profits were generated. HMRC explained that the tax gap is a measure of non-compliance with the UK tax law, and it therefore includes the costs to the Exchequer of multinationals shifting their profits in breach of the UK tax law. It acknowledged, however, that tackling this risk to ensure companies pay more of their fair share of tax to the right jurisdictions requires the reform of international rules. The Organisation for Economic Co-operation and Development is taking the lead in this area.23

11.HMRC’s tax gap does not capture the ‘policy gap’, which HMRC characterised as the tax loss that is not due, but which might be due if the tax rules could be tightened up. HMRC confirmed to us that there is more “taxable capacity” in multinationals than the current law ensures.24 We questioned the Department about the extent to which its tax gap estimates underestimate the true scale of non-compliance, particularly in relation to the wealthy individuals and multinational companies, who tend to have the most capacity to arrange their financial affairs to avoid paying their taxes in a way that does not fall into the scope of HMRC’s tax gap estimate. HMRC confirmed that the wealthy individuals and large businesses are the taxpayer groups with the most capacity to partake in “sophisticated tax planning”. HMRC records such tax planning arrangements in its estimate of the tax gap where they are, in its view, non-compliant because they are deemed to be a form of tax avoidance or because HMRC deems them to be incorrect interpretations of the tax laws. But any sophisticated tax planning that is effective in legally achieving its objectives, will not be part of the tax gap no matter how undesirable it is from a policy point of view. If HMRC measured, in addition to the compliance gap, how much tax is not paid as a result of effective, legal tax planning, that however from a policy point of view is undesirable, it would produce another figure.25

2 C&AG’s Report, Tackling the tax gap, Session 2019–21, HC 372, 22 July 2020

3 C&AG’s Report, paras 1–2

4 C&AG’s Report, paras 2–4

5 C&AG’s Report, para 9

6 C&AG’s Report, paras 7, 1.12

7 Q 23; C&AG’s Report, para 1.12

8 Qq 23–25

9 C&AG’s Report, para 1.14

10 Q 23; C&AG’s Report, para 1.13

11 Qq 23, 25; C&AG’s Report, para 1.19

12 Q 26; C&AG’s Report, Figure 11

13 Q 28

14 Q 19; C&AG’s Report, paras 2.24–2.25

15 Qq 29–30; C&AG’s Report, Figure 14

16 Q 24; C&AG’s Report, para 1.5

17 Qq 19, 35

18 Q 36; National Audit Office, HM Revenue & Customs: Departmental Overview 2019, slide 6

19 Qq 37–38

20 Q 68

21 Q 20

22 Q 31; C&AG’s Report, Figure 1

23 Q 31

24 Q 31

25 Q 32

Published: 16 October 2020