Chapter 4: Assessing the case for Making Tax Digital
35.The Government’s broad aspiration to encourage the use of digital tools when interacting with government departments and agencies was welcomed by all those submitting evidence to the inquiry.28
36.Speaking for the Administrative Burdens Advisory Board (ABAB), Roger Southam captured the tone of many representations saying that he was “fully supportive” of MTD. He wanted to work with HMRC to ensure “the best possible outcome”.29 Rebecca Benneyworth, Chair of the HMRC Digital Advisory Board, reflected the tax agents’ perspective in saying that they would be happy “when all their clients are using digital records to the extent of their capabilities”. Ms Benneyworth thought that overall HMRC were “absolutely doing the right thing.”30
37.The Government is right to modernise HMRC systems and seek efficiencies for taxpayers through the use of new technologies, but the digitally excluded, and less capable, should be properly catered for.
38.Where the evidence we received parted company with the Government’s narrative was in its assessment of (a) the MTD project’s impact on Exchequer receipts and on the costs and benefits accruing to the businesses affected; (b) the extent to which those businesses are ready to take on the new obligations proposed; and (c) the timetable for implementation. Chapters 4, 5 and 6 consider each of these areas in turn.
Reducing the tax gap: the Exchequer case for Making Tax Digital
39.The proposals for MTD were explained in Chapters 2 and 3 above. Jim Harra, giving evidence on behalf of HMRC, put the case for MTD, and its implementation sequence, most succinctly when he said:
“the prime reason for introducing making tax digital is to close part of the tax gap, which is mainly the small business error and carelessness gap.”31
Basis for HMRC’s estimates of tax gap reductions
40.HMRC’s case appears to rest on three propositions:
(1)that a substantial proportion of the ‘tax gap’—the difference between the amount of tax that should, in theory, be collected by HMRC, and what is actually collected—stems from taxpayer errors, or a failure to take due care, when completing tax returns;32
(2)that a disproportionate amount of such errors are committed by smaller businesses;33 and
(3)that requiring such businesses to keep digital records, on a timely basis, proven by making quarterly updates, will improve the quality of the information submitted to HMRC, thus reducing the annual loss of tax due to error and a failure to take due care.
41.According to HMRC’s latest estimates, the total tax gap amounts to £36 billion or 6.5 per cent of total direct and indirect tax liabilities.34 Professor Richard Murphy challenged HMRC’s methodology, arguing that the figure is an underestimate.35 For the purposes of this report we use HMRC’s estimates of the overall gap.36
42.On the first two propositions, Mr Harra of HMRC stated £8.7 billion of the tax gap stemmed from “error and carelessness”. £5 billion of this figure “related to small businesses”.37 He pointed out that:
“when you extrapolate forward both the growth in businesses and the growth in tax revenues it will probably go up to about £8 billion in the next few years. That is the scale of the error and carelessness gap that this solution is intended to reduce.”38
43.On the third proposition, Theresa Middleton, also representing HMRC, claimed, “there is £8 billion of error and failure to take reasonable care to go after in this [SME business] territory.” She explained that the new taxpayer obligations introduced by MTD would, over time, reduce the tax gap due to error and carelessness by about 10 per cent through largely straightforward things including software that “designs out” basic arithmetical errors made by many small businesses.39
44.On the basis of this analysis, HMRC estimates that the introduction of MTD would reduce the tax gap by £10 million in 2018/19, £400 million in 2019/20, £805 million in 2020/21, and about £1 billion per year thereafter.40 These figures cover not only income tax effects, but also VAT and corporation tax to which MTD is planned to apply from April 2019 and 2020 respectively. It is also important to note that, in contrast to previous better record-keeping initiatives undertaken by it, HMRC regard the behavioural changes, and therefore the tax gap reductions resulting from them, as permanent.41
45.HMRC’s estimates of the role of small business errors and carelessness in the total tax gap and of the likely reductions MTD might bring are based largely on analysis of its annual random sample of self-assessment tax returns and on the conclusions of experienced tax compliance experts “looking at the range of errors that were there and asking whether those errors lent themselves to being reduced by these proposals”.42
Evidence from stakeholders
46.Most of the evidence submitted to the inquiry challenged HMRC’s analysis of the behavioural effects of the measures arguing that the estimated tax gap reductions would either never materialise in full or might even go the other way.43 The Association of Chartered Certified Accountants (ACCA) spoke for many commentators in calling for greater clarity on how HMRC’s figures were arrived at, claiming that:
“the model overestimated the level of inaccuracy in small traders’ initial record keeping, and underestimated the role played by advisers in ‘tidying’ records at year end”.44
47.Some argued that, to the extent that record-keeping would improve, the result would not necessarily be in the Exchequer’s favour. Tina Riches of Smith and Williamson remarked that with smaller businesses she found “that when there are errors they go both ways … If anything, we tend to find that the errors are in HMRC’s favour.”45 Other submissions agreed that the impact could be asymmetrical, have more effect on the recording of expenses than income.46
48.The Chartered Institute of Taxation (CIOT) commented that they were not convinced that MTD would help close the tax gap because “businesses will make mistakes, both during the transition, and thereafter.”47 A survey of their members indicated that 41 per cent of them thought the changes would have little impact on the level of client errors and nearly 40 per cent considered that they would increase errors.48 The Association of Accounting Technicians (AAT) was concerned that “time consuming and costly quarterly reporting requirements would result in businesses turning to the black economy.”49
49.Professor Murphy was particularly critical about the impact of the quarterly update requirement considering it would “increase the error rate”. He pointed out:
“People who are forced to prepare accounts in a short period of time tend to make a lot more errors than people who have a little more time to get the thing right … there will be an inclination … for people simply to dump in estimates to meet a deadline for submission when there is a penalty attached to it.”50
50.HMRC’s response to these criticisms was that adjustments had been made in their estimates to take account of the various behavioural responses raised by critics and that its analysis suggested that a drift of small businesses to the hidden economy was unlikely.51 It emphasised that is methodology had withstood “rigorous scrutiny” from the OBR and that it was “confident that its estimates have a sound foundation, focus on relevant behaviours, and are prudent in what they are saying”.52
51.In their evidence on the tax gap, HMRC also highlighted their finding that around 31 per cent of small businesses under-declared their self-assessment tax liabilities.53 No detailed information is provided on how this is split across businesses of different sizes, but it states that approximately 20 per cent is attributable to businesses with annual turnover under £15,000; 60 per cent to businesses between £15,000 and the VAT threshold; and 20 per cent to businesses over that threshold.54
52.In response to a challenge that the policy costing for MTD had been assigned a ‘high’ uncertainty rating by the OBR, Lucy Pink, for HM Treasury, replied that this was “pretty standard for what [the OBR] says about a number of HMRC operational measures”.55
53.We do not share the confidence of HM Treasury and HMRC in their estimates of the tax gap reductions from the introduction of MTD from April 2018. On the evidence presented to us, those estimates appear very fragile and little more than guess work. They rely heavily on the untested proposition that sufficient numbers of taxpayers currently making errors will provide HMRC with correct information as a result of adopting digital record-keeping and quarterly reporting and that on balance changes would be in HMRC’s favour. At this stage we regard those estimated tax gap reductions, the main drivers for the mandating the new obligations, as not yet proven.
54.The Government is proposing to impose new obligations on the majority of businesses and landlords in order to resolve errors attributable to less than one third of that taxpayer population.
55.We recommend that, before implementing MTDfB, HMRC revisits and tests thoroughly, as part of its pilot, the behavioural assumptions underlying its estimated tax gap reductions to take into account the evidence suggesting that taxpayers may in fact respond in ways that invalidate those estimates.
Administrative costs and benefits for HMRC
56.Aside from the potential Exchequer benefits outlined in above, it is hard to set out the case for MTD from the viewpoint of HMRC as a department. It is clear from Mr Harra’s evidence that the overall cost of the MTD programme is £227 million, which is part of the £1.3 billion that the Government invested in HMRC in the spending review.56 However, it is not clear at this stage what activities that sum will cover except that “the main running cost will be in the support model, which we will work up in much more detail in the trial period”.57
57.HMRC confirmed that the quarterly updates would consist of raw income and expenditure data, not adjusted to reflect taxable profits. This means that the argument for them stems from their presumed benefits:
(a)to HMRC and the Exchequer, from their role in ensuring compliance with digital record-keeping requirements so helping to reduce the tax gap;
(b)to businesses generally by encouraging more timely record-keeping; and
(c)to businesses with regular income and few adjustments, who will be able to see an updated estimate of their tax liability on their digital tax account. This may also support a future pay-as-you-go taxation system.
58.More surprisingly perhaps, apart from the use of quarterly updates as a means of ensuring that business records have been kept in digital form, there are no initial benefits to HMRC of mandating quarterly reporting and future uses are yet to be determined.58
59.It is also surprising, given the international evidence on the efficiency savings from digitalisation projects in other tax administrations,59 that Mr Harra explained that in HMRC’s view MTD:
“will generate a very modest efficiency saving for HMRC of about £3 million a year. In practice it is not being done to generate cost efficiencies in the department; it is being done to reduce the tax gap. We do not expect the cost or saving in HMRC to be material.”60
60.At this stage, apart from a headline figure of £227 million allocated to HMRC over the current spending review period, the nature of any costs to or benefits for HMRC remains opaque. Full details of how HMRC intends to use the money allocated should be made available.
HMRC’s impact assessment
61.The Government’s response on 31 January included a revised assessment of the impact of the MTD proposals on those businesses affected by them, building on information gathered as part of the HMRC consultation. This impact assessment attempted to quantify: (a) any costs to businesses of complying with the new digital record-keeping and quarterly update requirements, and the revised end-of-year process; and (b) any administrative savings and other benefits accruing to businesses from the use of digital tools and more timely reporting.61
62.The transitional costs HMRC considered included the purchase of new apps and software, the purchase or upgrading of any hardware, familiarisation time, and any additional accountancy and agent fees. HMRC estimated that, although there would be significant variations between businesses, the average one-off cost per business would amount to £280 in the year of transition.
63.HMRC argue that, following transition to MTD, businesses in general would experience increases in ongoing compliance costs (in the form of time, agents or software costs) and ongoing administrative savings (from tasks made unnecessary by the digital tools). These costs and benefits are set out in the table below:
Table 1: HMRC estimated costs (£ million)
2017–2018 |
2018–2019 |
2019–2020 |
2020–2021 |
2021–2022 |
2022–2023 |
|
|
Steady state costs |
£50 |
£150 |
£170 |
£170 |
£170 |
|
|
Administrative burden savings |
- £150 |
- £270 |
- £270 |
- £270 |
||
|
Transitional costs (one-off) |
£100 |
£200 |
£590 |
£100 |
||
|
Net impact |
£100 |
£250 |
£590 |
£0 |
- £100 |
£ -100 |
Source: HMRC, Policy Paper, Overview of Making Tax Digital, 8 March 2017: https://www.gov.uk/government/publications/making-tax-digital-for-business/making-tax-digital-for-business
64.The profile of total costs per year reflects the fact that the transition to MTD will not be completed until 2020–21.62 They amount to a total transitional cost of nearly £1 billion. The steady-state costs suggest that, in aggregate, businesses affected will experience a net benefit of £100 million per year from 2021/22 onwards.63
65.HMRC stress that these estimates are not final:
“Estimated costs depend on final software solutions, the availability of free software and individual providers’ pricing structures. The government recognises that this produces a broad estimate, and so we will review and test this analysis and our assumptions through ongoing extensive engagement and consultation with businesses, and through further research and analysis.”64
Stakeholder evidence on revised impact assessment
66.Commenting on HMRC’s methodology, some criticised the Standard Cost Model (SCM) they used to gauge compliance coats. John Whiting of the OTS noted that the model used was devised and developed 20 years ago. The OTS was not “convinced that it is capturing all the data and costs.”65
67.Mr Southam of the ABAB noted that his organisation had been trying to persuade HMRC to adopt a more stratified approach to costing business impacts, breaking figures down by business type, moving away from a “blanket assessment”.66
68.More specifically, the evidence we received reflected widespread criticism, sometimes verging on disbelief, of most aspects of the HMRC impact assessment. The CIOT, for example, was “concerned that HMRC has both underestimated the costs to businesses, and overestimated the revenue benefits of the measures”.67
69.Kevin Hart, representing the Business Applications Software Developers Association (BASDA), pointed out that if training is required, “£280 will disappear in a morning seminar.”68
70.Mr Hart thought that the transitional cost would be at least double the £280 average HMRC suggested. Kevin Dady of the IRIS Software Group concurred.69 Michael Steed of the Association of Tax Technicians went further, suggesting the cost could be three times HMRC’s estimate.70
71.Similar reservations were expressed about the ongoing cost estimates. Commenting on assisting clients with quarterly reporting, Tina Riches of Smith and Williamson estimated this increased interaction could cost her clients £2,000 plus VAT per client, a year.71
72.Most witnesses found it hard to see how HMRC’s administrative savings estimates had been derived. The CIOT reported that, of a small sample of volunteer participants, “not one respondent estimated an ongoing saving from MTD”.72
73.Quarterly updates were an area of particular concern to the National Union of Farmers (NFU), who noted that for more complex and seasonal businesses already making quarterly VAT returns, MTDfB could increase burdens.73 Their understanding was that “where accounting periods for multiple trades or businesses do not align multiple Making Tax Digital updates will be required for each.”74
74.HMRC’s response suggested such businesses would have the flexibility to change their reporting periods to reduce this impact, which appears to reinforce concerns that the approach to digitalisation adopted by HMRC was that businesses needed to adapt to their systems rather than the reverse. 75
75.The NFU also commented that for diversified, seasonal businesses, quarterly cash flow is not a reliable indicator of accruing tax liabilities, so the figures provided by a digital tax account update were unlikely to reflect the tax liability accruing.76
76.More generally, and contrary to the HMRC view, these updates were seen as providing little or no administrative benefit to most businesses. For the Residential Landlords Association (RLA), Douglas Haig stressed that there were unlikely to be any savings for smaller landlords, but for landlords with 15 to 20 properties there would be “some saving because people can analyse their costs much better … and they can do much better planning overall.”77
77.The Government’s estimates of both the initial and the ongoing costs of complying with MTD requirements do not fully reflect the costs likely to be borne by a very diverse range of businesses and the differences between them. This is particularly true of the smallest and least digitally engaged businesses, many of whom will have to purchase both new hardware and new software.
78.For the smallest businesses and landlords, any benefits from moving to digital record keeping are likely to be very limited. Only those simpler businesses with regular flows of income are likely to realise the benefits claimed for quarterly reporting, namely the potential to have a clearer view of their tax liabilities.
79.Under HMRC’s own estimates of the costs and benefits accruing to businesses, it would take more than 10 years for businesses to recoup their aggregate initial outlay. We find it difficult to see the case, from a business viewpoint, for proceeding with the MTD proposals.
80.We recommend that before proceeding with the implementation of Making Tax Digital, HMRC extend its assessment of the business impact by carrying out and publishing a comprehensive analysis of that impact stratified by business type, size and initial digital capability, and explain what financial support is available to assist them.
81.HMRC has yet to take a final decision on the threshold for inclusion in the scheme. We recommend that below the VAT threshold, digital record keeping and quarterly reporting should not be made mandatory. HMRC may argue that this would leave a lot of tax uncollected. We do not find this plausible. What is at stake is how much extra tax would be collected simply by mandating record keeping and quarterly reports.
82.We recommend that the Government consider whether businesses with diverse and seasonal affairs, such as agricultural businesses, should be exempt from the quarterly reporting requirements.
28 This was also the case for witnesses giving evidence to the House of Commons Treasury Committee Treasury Committee, Making Tax Digital (Tenth Report, Session 2016–17, HC 927), paras 21–29
34 HMRC, Measuring Tax Gaps 2016 edition: Tax Gap estimates for 2014–15, October 2016: https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/561312/HMRC-measuring-tax-gaps-2016.pdf [accessed March 2017]
35 Prof Richard Murphy, The Tax Gap: Tax evasion in 2014 and what can be done about it, 2014: http://www.taxresearch.org.uk/Documents/PCSTaxGap2014Full.pdf [accessed March 2017]
36 HMRC defended their tax gap estimates: “they are produced in accordance with the Code of Practice for Official Statistics, which assures objectivity and integrity. The methodology is judged by independent third parties to be robust, having been intensively reviewed by the International Monetary Fund and scrutinized by the National Audit Office.” Written evidence from HM Treasury and HMRC (FBS0065)
37 Q 48 (Jim Harra). This is across all taxes for all small and medium-sized enterprises (SMEs). The tax gap statistics use the EU definition of SME; businesses with up to 250 employees and either a balance sheet total of up to €43 million or turnover of up to €50 million.
38 Ibid; see also HMRC, Policy Paper, Overview of Making Tax Digital, 8 March 2017: https://www.gov.uk/government/publications/making-tax-digital/overview-of-making-tax-digital [accessed March 2017]
40 HMRC, Policy Paper, Overview of Making Tax Digital, 8 March 2017: https://www.gov.uk/government/publications/making-tax-digital/overview-of-making-tax-digital [accessed March 2017]
43 Professor Murphy challenged all three of these propositions in his evidence.
48 Ibid.
52 Ibid, para 115
59 Institute of Chartered Accountants of England and Wales, Digitalisation of Tax: International perspectives, 2016: http://www.icaew.com/-/media/corporate/files/technical/digital-tax.ashx?la=en [accessed March 2017]
62 HMRC, Policy Paper, Overview of Making Tax Digital, 8 March 2017: https://www.gov.uk/government/publications/making-tax-digital/overview-of-making-tax-digital [accessed March 2017]
63 Ibid.
64 Ibid.
67 Written evidence from Chartered Institute of Taxation (FBS0023); see also written evidence from Federation of Small Businesses (FBS0032) and written evidence from UK200Group (FBS0049)
75 HMRC, Making Tax Digital: Bringing business tax into the digital age, summary of consultation responses, 31 January 2017: https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/587433/Making_Tax_Digital_-_Bringing_business_tax_into_the_digital_age_-_Summary_of_responses.pdf [accessed March 2017]