7. Tax gaps: Illustrative tax hole by behaviour

Tax gap by behaviour

The tax gap is composed of a range of customer behaviours: non-payment, use of avoidance schemes, legal interpretation of the tax effects of complex transactions, error, failure to take reasonable care, evasion, the hidden economy and criminal attacks on the tax system. A definition of each of these behaviours is given at the end of this chapter.

The tax gap breakdown by customer behaviour is illustrative since most methodologies used are not data-led. We use simple models that are subject to a wide degree of uncertainty and bias, which cannot be quantified. Therefore, the estimates provide broad indicators of the customer behaviours contributing to the tax gap and may not fully reflect how these are changing over time.

Figure 7.1 shows an illustrative estimate of taxpayer behaviours attributed to the tax gap for tax year 2020 to 2021.

  • failure to take reasonable care accounts for the largest proportion of the tax gap at 19% (£6.1 billion)

  • avoidance accounts for the smallest proportion of the tax gap at 4% (£1.2 billion)

  • criminal attacks, non-payment and evasion are similar in size at 16% (£5.2 billion), 15% (£4.9 billion) and 15% (£4.8 billion) respectively

  • legal interpretation is 12% (£3.7 billion), followed by hidden economy at 10% (£3.2 billion) and error at 9% (£3.0 billion)

Figure 7.1: Tax gap by behaviour – illustrative estimates of the value and share of tax gap, 2020 to 2021

Behaviour Value Share of tax gap
Failure to take reasonable care £6.1bn 19%
Criminal attacks £5.2bn 16%
Non-payment £4.9bn 15%
Evasion £4.8bn 15%
Legal interpretation £3.7bn 12%
Hidden economy £3.2bn 10%
Error £3.0bn 9%
Avoidance £1.2bn 4%

Notes for Figure 7.1

  1. Figures may not appear to sum due to rounding.

  2. ‘%’ refers to percentage of the total tax gap.

  3. The full data series can be seen in the online tables.

Table 7.1 in the online tables shows a time series of the tax gap by behaviour as a percentage of total theoretical liabilities. The main points are:

  • the failure to take reasonable care gap has remained broadly level as a percentage of total theoretical liabilities since 2005 to 2006; it was £4.7 billion (1.1%) in 2005 to 2006 and £6.1 billion (1.0%) 2020 to 2021

  • the criminal attacks gap has reduced from £7.1 billion (1.6%) in 2005 to 2006 to £5.2 billion (0.8%) in 2020 to 2021

  • the evasion tax gap has remained at broadly similar levels from £4.6 billion (1.0%) in 2005 to 2006 to £4.8 billion (0.8%) in 2020 to 21

  • the legal interpretation gap has reduced from £4.4 billion (1.0%) in 2005 to 2006 to £3.7 billion (0.6%) in 2020 to 2021

  • the non-payment gap has increased from £2.3 billion (0.5%) in 2005 to 2006, to £3.4 billion (0.6%) in 2016 to 2017 and to £4.9 billion (0.8%) in 2020 to 2021

  • the hidden economy tax gap has increased from £2.0 billion (0.5%) in 2005 to 2006 to £3.2 billion (0.5%) in 2020 to 2021

  • the error gap has remained broadly level in monetary amounts since 2005 to 2006; it was £2.8 billion (0.7%) in 2005 to 2006 and £3.0 billion (0.5%) in 2020 to 2021

  • the avoidance tax gap has reduced from £4.8 billion (1.1%) in 2005 to 2006 to £1.2 billion (0.2%) in 2020 to 2021

The percentage figures provide a better measure of compliance over time because they take into account changes to the tax base. They show that the breakdown of the total tax gap by customer behaviours as a percentage of total theoretical liabilities over the past 6 years has been broadly consistent. However, the tax gap breakdown by behaviour is subject to a high degree of uncertainty and the estimates may not fully reflect how behaviours are changing over time.

Avoidance

Avoidance involves bending the rules of the tax system to try and gain a tax advantage that Parliament never intended. It often involves contrived, artificial transactions that serve little or no purpose other than to produce a tax advantage. It involves operating within the letter, but not the spirit, of the law.

The avoidance tax gap is estimated to be £1.2 billion for tax year 2020 to 2021. About £0.4 billion of this relates to marketed avoidance schemes sold primarily to individuals and made up of unpaid Income Tax, National Insurance contributions (NICs) and Capital Gains Tax. The avoidance tax gap estimates reflect the laws that were in place at the time and do not include any subsequent changes to the tax law to prevent further use of avoidance.

Figure 7.2 shows how the avoidance tax gap is split by type of tax in 2020 to 2021. Around half of the avoidance tax gap (£0.6 billion) is attributed to Corporation Tax, with £0.4 billion attributed to Income Tax, National Insurance contributions and Capital Gains Tax, £0.1 billion to VAT and £0.1 billion to other taxes.

Table 7.2 in the online tables shows the breakdown of the avoidance tax gap by type of tax from tax year 2005 to 2006, to 2020 to 2021.

Figure 7.2: Avoidance tax gap by type of tax, 2020 to 2021 (£ billion)

Type of tax Value
Corporation Tax £0.6bn
IT, NICs and CGT £0.4bn
Other taxes £0.1bn
VAT £0.1bn

Notes for Figure 7.2

  1. ‘IT, NICs and CGT’ refers to Income Tax, National Insurance contributions and Capital Gains Tax.

  2. ‘Other taxes’ includes stamp taxes, Inheritance Tax and ‘other excise duties’ (betting and gaming duties, cider and perry duties, spirit-based ready-to-drink duties and wine duties).

  3. The full data series can be seen in the online tables.

Measurement methods

There are numerous approaches to measuring the tax gap by customer behaviour:

  • the criminal attacks, error, evasion and failure to take reasonable care gaps are estimated using HMRC operational expertise and insight

  • the non-payment gap is estimated, with the exception of VAT, mainly using revenue losses published in HMRC’s Annual Report and Accounts.

  • the legal interpretation gap is estimated using mainly HMRC operational expertise and insight for the remaining other taxes, levies and duties

  • the hidden economy gap is estimated using an established bottom-up survey-based methodology for Income Tax, NICs and Capital Gains Tax, and mainly HMRC operational expertise and insight for the remaining other taxes, levies and duties

  • the avoidance gap is estimated using information that HMRC collects on tax avoidance schemes and records on its management information system for Income Tax, NICs and Capital Gains Tax; and predominately HMRC operational expertise and insight for the remaining other taxes, levies and duties

The methodologies used to produce the avoidance and hidden economy tax gap estimates are summarised in the relevant chapters of this report and in the ‘Methodological annex’.

Description of behaviours

Failure to take reasonable care

Failure to take reasonable care results from a customer’s carelessness and/or negligence in adequately recording their transactions and/or in preparing their tax returns. Judgments of ‘reasonable care’ should consider and reflect a customer’s knowledge, abilities and circumstances.

Criminal attacks

Organised criminal groups undertake co-ordinated and systematic attacks on the tax system. This includes smuggling goods such as alcohol or tobacco, VAT repayment fraud and VAT missing trader intra-community (MTIC) fraud.

Non-payment

Non-payment refers to revenue losses when HMRC formally ceases collection activity. The vast majority are driven by individual and business insolvencies. Revenue losses are made up of remissions and write-offs. Remissions are debts capable of recovery, but HMRC has decided not to pursue the liability on the grounds of value for money. Write-offs are debts that are considered to be irrecoverable, because there is no practical means of pursuing the liability.

For VAT only, non-payment differs as it is based on the difference between new debts arising and debt payments (see Chapter 2 which covers VAT).

Evasion

Tax evasion is an illegal activity where registered individuals or businesses deliberately omit, conceal or misrepresent information in order to reduce their tax liabilities.

Legal interpretation losses arise where the customer’s and HMRC’s interpretation of the law and how it applies to the facts in a particular case result in a different tax outcome, and there is no avoidance. Specifically, this includes the interpretation of legislation, case-law, or guidelines relating to the application of legislation or case-law. Examples include categorisation, such as an asset for allowances or VAT liability of a supply, the accounting treatment of a transaction, or the methodology used to calculate the amount of tax due, as in transfer pricing, or VAT partial exemption.

Hidden economy

The term “hidden economy” refers to sources of taxable economic activity that are entirely hidden from HMRC. It includes businesses that are not registered for VAT, individuals who are employees in their legitimate occupation, but do not declare earnings from other sources of income (moonlighters) and individuals who do not declare any of their income to HMRC, whether earned or unearned (ghosts).

For tax gap behaviours, we treat the hidden economy and tax evasion as follows:

Error

Errors result from mistakes made in preparing tax calculations, completing returns or in supplying other relevant information, despite the customer taking reasonable care.

Avoidance

Avoidance involves bending the tax rules to try and gain a tax advantage that Parliament never intended. It often involves contrived, artificial transactions that serve little or no purpose other than to produce a tax advantage. It involves operating within the letter, but not the spirit of the law.

Some forms of base erosion and profit shifting (BEPS) are included in the tax gap where they represent tax loss that we can address under UK law.

As new measures introduced in accordance with recommendations made in the BEPS project by the G20 group of world-leading economic nations and the Organisation for Economic Co-operation and Development (OECD) take effect, our ability to address BEPS under domestic law will be greatly strengthened.

The tax gap does not include BEPS arrangements that cannot be addressed under UK law and that will be tackled multilaterally through the OECD. The OECD defines BEPS as ‘tax planning strategies that exploit gaps and mismatches in tax rules to make profits disappear for tax purposes, or to shift profits to locations where there is little or no real activity but the taxes are low resulting in little or no overall corporate tax being paid’.

Tax avoidance is not the same as tax planning. Tax planning involves using tax reliefs for the purpose for which they were intended. For example, claiming tax relief on capital investment, saving in a tax-exempt ISA or saving for retirement by making contributions to a pension scheme are all forms of tax planning.

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