My work on the Tax Gap is, I note, receiving widespread publicity (with, I know, more to come), and I’m aware that as a result of that wok this issue is now firmly fixed on the agenda for debate when it comes to how to manage the cuts.
Unsurprisingly as a result there are those who would like to suggest that I’ve got my calculations wrong. This is an inevitable consequence of promoting ideas that suggest that there may be more tax to be collected from the economy. I’ll deal with the politics of this in another blog. At this point I’ll deal with the question as to whether it is reasonable to, as I have done, extrapolate the tax gap that HM Revenue & Customs admit to with regard to VAT across the whole economy. This I did when calculating that tax evasion might amount to £70 billion per annum in the UK.
This matter was debated in parliament on June 16. David Gauke MP rejected my argument on behalf of the Treasury. In response I wrote:
The key questions is, then, whether it is reasonable to extrapolate what is likely to be a tax evasion rate of 13.7% for VAT, calculated over seven years, over all direct taxes. The Minister says that is not the case, stating as noted above that such a ratio could not apply to payment systems such as PAYE where error rates are low.
Unfortunately the Minister makes a fundamental error in stating this to be the case. Of course it is true that once wages are declared by a company it is likely that PAYE will reduce the risk of error in declaration and computation occurring. That ignores that fact that tax evasion means that paid are simply never declared and as such go nowhere near the PAYE system and therefore are subject to a 100% tax calculation error rate irrespective of the efficiency of PAYE with regard to declared wages. The question is therefore whether the existence of a VAT gap suggests it is likely that an income tax gap on wages is likely to follow as a consequence (and a corporation tax gap on profits, etc.,) and not what the Minister claims.
Explaining how the VAT gap gives clear indication of the scale of this issue takes some effort but is worth doing. It is important in the context to understand the points in the revenue cycle at which major taxes hit revenue generating operations such as companies (and government departments, charities, self employed people and so on). This diagram of an income statement / profit and loss account might help explain that:
Income / expense category
Tax charged
Income / sales
VAT charged to customers
Overheads
PAYE (made up of income tax and national insurance) on wages
VAT reclaimed on expenses incurred
Corporation tax if a company / self employed income tax if not incorporated
It is important to note that revenue flows down the system i.e. sales have to be made to enable cash to be generated to ensure wages (and the tax on them) can paid and in turn profit can be earned, again giving rise to tax due.
The VAT gap suggests that 13.7% of expected VAT is not paid to HMRC. Since VAT is eventually a tax on consumption this suggest in turn that 13.7% of turnover that should have been subject to AVT has not been reported for tax purposes.
In that case it is the contention of Tax Research LLP that the sales giving rise to that VAT liability are also not declared to HMRC when accounts are prepared (if at all) indicating profits earned. There is good reason for saying this: the most basic test a VAT inspector undertakes when looking at a company’s records is to ensure that the sale recorded in the accounts are the same as the sales recorded on the business’ VAT returns. In other words, given that this is widely known VAT evasion always gives rise to income suppression in accounts. Of course, in many cases it gives rise to no accounts being prepared or declared for tax purposes at all.
The latter case is, perhaps the best place to start the next stage of this explanation. It is very obvious that if someone runs a business where, to avoid VAT they take all their sales income in cash and put none of it on a VAT return or in a set of accounts that they will not then declare any tax due on wage payments they make. These wage payments will instead be settled illicitly out of that illicit cash. They will therefore be part of the tax evasion gap.
Alternatively, if the illicit cash is not used to pay wages (and maybe other costs) then it will flow straight through to the bottom line i.e. it will be profit in the hands of the person who has committed the VAT fraud. This should also be subject to income tax (or, maybe corporation tax — but this is unlikely).
In other words, if there is VAT fraud at the top of the profit and loss account it has to flow down through that profit and loss account and in the process give rise to fraud with regard to income tax on wages and national insurance or tax evasion on profits with regard to income tax or corporation tax as well. This is the inevitable consequence of suppressing the income that was illicitly received to ensure VAT fraud took place.
It is important to note that the same pattern recurs if a business records part of its income and suppresses part of its top line sales records to ensure VAT fraud is not discovered. In that case either wages are paid in cash, and PAYE is not operated, or if wages are properly recorded in full then profit is seriously under-recorded and the direct tax fraud takes place there. But missing trader fraud apart (and that is now small — but does give rise to direct tax evasion on the proceeds of the crime, a fact that should not be ignored) in every case atop line VAT fraud gives rise to a direct tax fraud as well. The Minister is wrong to deny this.
And of course the Minister cannot suggest that the problem only exists in VAT registered businesses: why those business should suppress income to save tax but those that are not VAT registered do not is an argument no one should seek to make. Nor should they argue that the shadow economy does not extend to the state sector where it takes a different form in bribes and other payments made to officials, a problem little acknowledged but which is universal, and which also contributes to the tax gap
To put it another way then, the figure for VAT fraud does inevitably act as a proxy measure for the size of the “shadow” economy. In Tax Research UK’s work on the tax gap it is assumed that this ratio is 13.7% - the average for the VAT gap over 7 years, and have been cautious in extrapolation. The suggestion is, as a result, that this proportion of the total gross direct tax that should have been collected is lost as a result of the impact of the shadow economy (distinct from tax avoidance and late and non-payment of taxes declared to be due but not settled on time) just as this proportion of the total gross VAT that should have been collected is lost. As is shown above, one conclusion flows from the other, inevitably.
The question to then ask is whether this is plausible. Work in estimating the shadow economy is always laden with the problem that people do, by definition, not wish to report their own tax fraud. However, an IMF estimate (admittedly relating to 1988 — 2000) suggests gat the shadow economy in OECD states might be in the band 14 to 15% of GDP. The Revenue has acknowledged this in their own internal (but now published) memos on this issue[i]. Other literature in academic journals confirms that this might be the lower end of the expected range, but that the UK might also be at that lower end[1]. However, what this confirms is that an estimate that the shadow economy might represent 13.7% of all economic activity within the UK is, on the basis of external studies, entirely reasonable. It follows that an estimate of this figure for the purposes of tax evasion is also reasonable.
In that case to assume that the VAT gap ratio applies to direct taxes as well is not only logical, it is the only rational assumption to make. To assume a substantially lower figure — of about 6% as HM Revenue & Customs have done — is outside the plausible expected range of outcomes and is therefore highly unlikely to be a correct figure for tax evasion.
[1] See for example, this paper which suggested 12.7%. http://www.dur.ac.uk/john.ashworth/EPCS/Papers/Schneider.pdf
[i] See bibliography regarding memos published February 2008
There seem two further issues to mention now.
The first is that the World Bank have now suggested the UK shadow economy is about 13.5% of GDP — a number so close to that I have used that the difference is immaterial. I count that as very powerful corroborating evidence for the assumption I have made — and which comes to a near enough identical estimate of the tax gap. I’m not sure how critics will dismiss this evidence when quite specifically the WB estimate is of shadow activity intended to result in tax evasion.
Second, critics like to suggest that the VAT gap relates largely to carousel fraud and say this cannot be extrapolated. However, carousel fraud is now of much reduced scale and less than 10% of the VAT gap. On the other hand the cash economy of small businesses is entirely outside the VAT net — these businesses being too small too register, and this is almost certainly more important in proportionate terms than carousel fraud — and is not reflected in the VAT gap. In other words, if there is bias it is on my side.
I do therefore stand completely behind the plausibility of my estimate and continue to suggest that which HMRC offer is not just wrong, it’s implausible.
The implausibility was obvious in the avoidance figures published at the same time where with respect to personal tax avoidance HM Revenue & Customs claimed that there was just £1.1 billion of tax avoidance for income tax, national insurance and capital gains tax combined and yet in his budget speech in June 2010 George Osborne straightforwardly contradicted that claim by saying that tax avoidance with regard to capital gains tax alone exceeded £1 billion, happening in the process to exactly confirm the estimate of avoidance with regard to that particular tax made by Tax Research UK for the TUC in The Missing Billions. This also meant that by implication there was no allowance left over at all for avoidance of income tax or national insurance — which is utterly implausible.
The HMRC methodology for calculating direct tax gaps is simply wrong. And as a result I suggest my data is, for the time being, the best there is.
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The beauty of having land values as the prime tax base is that you always know the real collection rate. You cannot say that about the other direct taxes on labour and capital, nor indirect taxes.
Of course Richard is correct in his figure work. It does not take a mathematical genius to work that out. We know that sales are being underdeclared. We know that wages are not being disclosed for PAYE purposes. We also know that a significant amount of people are working in the black economy and are not being detected and that HMRC have no intention of doing so. You only have to look at the work of the present Permanent Secretary to HMRC to see why people have lost heart. Thats because he presided over a regime whereby he allowed Vodafone to discount £5BN worth of tax when aquiring capital assets and said that the outfall of £1.25BN as a contribution to the tax gap. With a thought process like that from the chief of HMRC there is really very little to be said.
We need a system put into place whereby evaded and uncollected taxes are detected and put back into the national exchequer. I dont know why Osborne cannot see this, I really dont.
The £64,000 question is what scope there is for reducing the size of the informal economy and/or taxing it. Clearly there’s a difference between the theoretical tax gap (calculated across the whole of the informal economy) and the actual achievable tax gap – but it’s not at all clear to me what this is. Has research been carried out in this area?
@Carol Wilcox
Carol, has any country in modern times used land values as its prime tax base?
@Marc Daniels
I’ll get back to you on this in more detail
But let’s also accept the bleeding obvious: an absence of tax inspectors will not help
And an absence of local tax inspectors will hep even less
At the most superficial level it’s hard to disagree, surely?
Especially when average investigation yield is 20 to 30 times salary
I agree you can’t extrapolate forever – but it’s a good start
@Marc Daniels
“has any country in modern times used land values as its prime tax base?”
Quote from a paper by Ole Lefmann of the International Union for Land Value Taxation:
In 1957 the three political parties: the biggest the Social Democracy and the two smaller: the Radical Wing of Liberals and the Justice Party, got enough votes to construct the so called Ground Duty Government who declared from its beginning that based on the values of land it would collect as much rent as was politically possible.
In 1960 when the mandate to the Ground Duty Government had to be renewed all the three government parties lost seats, but the Justice Party lost all theirs.
Economic analysts could all say that the defeat of the Ground Duty
Government and the wiping out of the Justice Party was not the result of bad economic administration. During the period of the Ground Duty Government, 1957 – 1960, Denmark enjoyed prosperity better than ever, the real income of workers increased more than ever, and entrepreneurs earned better than ever. In 1960 there was almost no unemployment (around 1%), diminutive foreign debt, almost no inflation, expanding domestic and foreign trade, and no forecast predicted bad times to come. The analysts all agreed that the defeat of the Ground Duty Government was caused ONLY by political reasons.
Richard, I agree it’s obvious more tax inspectors will eat into at least some of that gap – I just don’t know how much, and when diminishing returns set in. It’s something I’ve no knowledge of at all: my experience lies in large companies, who are guilty of many things but not (generally) tax evasion.
@Carol Wilcox
You’ll forgive me for thinking that a three year failed experiment in Denmark during the 50s is not particularly persuasive, particularly when no details are given of the rate of LVT or whether it replaced income tax.
All this debate about the tax gap ignores what is surely an obvious point: that the authorities must set tax rates knowing that not every penny of it is going to be collected because of the impossibility of eliminating the black economy.
Which makes Richard’s declaration that he is to do more work on the question of how practicable it is to eliminate the shadow economy seem bizarre….shouldn’t this have been asked first?
@Alan Barnes
Alan
What you say i very important. Yes, Iam sure they do set rates on that basis. This is why those who act honestly pay higher rates of tax than they would if the tax gap was markedly smaller.
A serious attempt to reduce the tax gap should result in a reduction of tax rates paid paid by the honest taxpayers.
Your other point is chicken/egg, isn’t it? Should you work out whether tax tax gap can be reduced and then see if it is significant or vice versa.
@Marc Daniels
I do not have the details on Denmark LVT rates. You can choose to ignore the good effects if you want because I can’t be bothered to do any more. There are plenty of examples of other states/municipalities which collect some land rent for public benefit. Harrisburg is a prime example rising from most distressed city to near the top when it adopted a low rate of LVT. Pittsburg by contrast has slipped down the league since it abandoned LVT in 2001. I believe it is true to say that land values are the main tax base in Hong Kong, although they do not use LVT, historically since the land is all state owned.
That’s a little unfair – Richard clearly doesn’t think the shadow economy can be eliminated. But even reducing it by one or two %, would surely raise a significant amount of additional revenue, and seems achievable looking at international comparative tables. On the other hand, thinking we can push the black economy smaller than (say) Japan does not seem realistic.
Richard, have amnesties ever been considered? Seems odd to have a series of generous amnesties for those hiding cash in offshore bank accounts, but nothing for those at the other end of the spectrum. Why not announce a one-off 12 month amnesty for individuals and small businesses, in which back-tax would be limited to (say) three years with no penalty, but after which all penalties will double?
@Carol Wilcox
It’s funny about Hong Kong. It’s cited all over the web by LVT proponents as a successful example. But it’s not remotely like a land value tax, as it’s not charged on land value at all (but rather on a % of rental income less limited deductions).
This, plus the sketchy Danish example, leave me rather unconvinced of the case for shifting the tax base towards LVT (a quite different proposal from the low rates adopted in a few jurisdictions).
I’m sorry you don’t want to engage on this. But if you can’t persuade someone of the Left, who happens to have some expertise in the field, then you have quite an uphill struggle ahead of you.
@Marc Daniels
I don’t think it’s fair to Richard to monopolise this thread. If you want to understand the importance of land in the economy and how LVT could solve some of the basic economic problems we have you should take a look at http://www.landvaluetax.org, http://www.labourland.org or just google land value tax.
@Marc Daniels
I think that’s a good question
I would not presume it is more than £20 billion
Part would be tax collection – say £5bn – 20% of that gap
On avoidance I think one third is recoverable as I define it by measures on income shifting, domicile, residence, a General Anti-avoidance Provision – that’s £8bn
That leaves 10% off evasion – £7 bn
I see no reason why this is not achievable
And of course I could be wrong – either way
I set out some measures in The Great Tax Parachute
@Carol Wilcox
Feel free…..
I’ve no complaint
@Alan Barnes
James rightly dismisses your observation and points out a whole political agenda the tax gap opens up that no one has exploited to date
But you also show a lack of knowledge / thinking:
a) You assume government’s know how much they will raise – and they don’t
b) You assume tax is only raised to cover spending – and it isn’t
c) You assume government’s know how big the gap is – and I have shown they don’t
For all these reasons your observation falls short
@Alan Barnes
Of course the tax gap is substantial. We know for instance right now that the Chair of HMRC has personally presided over a settlement whereby Vodafone owed £6.25BN for CGT in mergers and acquisitions, only to settle for £1.25BN which he proclaimed a victory.
And if that is the tip of the iceberg we must assume that the real figure is somewhere in the hundred billion range. Why should it not be so?
Of course the government are not going to admit to it; none of them ever worked in the Revenue (or probably anywhere else for that matter) and their knowledge of accounts and calculations could be surpassed by a seven year old.
Thats the problem these days; too many people buying into the government’s hype and tripe and not enough people really thinking the problem through.
Actually I’m not inclined to try to convert just one person on this site to LVT. It’s much more important to work on those who have influence, like you Richard. I think it was me who got Andy Burnham on the bandwagon recently by speaking to him and handing him a copy of Land Values .. for Public Benefit by Jerry Jones of the Labour Land Campaign. He appears to have got it right away. Sometimes it happens like that. One day perhaps AndyB will be our Chancellorhttp://www.taxresearch.org.uk/Blog/wp-includes/images/smilies/icon_lol.gif
@Richard Murphy
I don’t actually make any of those 3 assumptions. Whatever made you think I did?
@Alan Barnes
Because I can’t otherwise make sense of what you did say