Why I stand by my tax gap estimate – including on the tax rate at which evasion takes place

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I feel somewhat reluctant to return to the issue of my tax gap estimate,  but since it is causing further debate I will.

Let’s be clear why I prepared my tax gap estimate, published last week. It was to make clear what are, in my opinion, the serious deficiencies in HMRC’s tax gap methodologies. These are numerous. I have explained them before. So let me offer just three here.

One is the failure of all these estimates to be based on top down data, VAT excepted, which is GDP based and in my opinion is pretty reliable as a result. The IMF has suggested that this top down demand is an appropriate request to make as it could give rise to significantly different estimates. I agree.

Another is that I think the bottom up estimates are based on some wholly inappropriate assumptions. For example, on average about 400,000 companies a year do not submit the corporation tax returns requested of them and many hundreds of thousands more are not even asked to submit returns. Sampling on these companies - which I would venture create much of the VAT gap - hardly takes place, the assumption being that they do not trade. I think that quite inappropriate.

Third, the assumption that the shadow economy is made up of marginal, low paid employment is again, I think wrong, and deeply politically biased. 

And I would stress, these errors of assumption will not be reflected in the HMRC reliability stats, because they test what is tested and not what is not. So for the record, I also question HMRC’s declared error rate. 

Might we bear all this in mind? I am doing this to suggest change is necessary. And those who like the status quo - and no one does that more than HM Treasury - will not like that.

Then let me come to the criticisms. They are:

a) I use GDP at face value, subject to my noted discussion on whether it includes the shadow economy or not. The suggestion is that this estimate may contain significant errors. 

b) I have used an average of three shadow economy estimates, two published by major international organisations (the EU and IMF) which  are probably as good as any estimates are likely to be. The suggestion is, again, that these estimates may be wrong. 

c) To estimate the tax lost to the shadow economy I use the average UK tax rate because i) that rate is remarkably consistent across all income levels ii) it is lower than almost all likely marginal tax rates ii) I can see almost no reason why the shadow economy should - when of this aggregate size have a much different rate to the rest of the economy and iv) I am seeking an aggregate rate because as far as I am concerned the tax gap is not a microeconomic measure of the efficiency per se of any one tax but is instead, as modern monetary theory suggests, a measure of the failure of the state to impose its fiscal policy. Others may disagree.

The criticisms arise for a very common reason. Those who do not like the implication of my suggestion, for whatever reason, are using a common technique: they are playing the methodology and not the arguments. The argument made is that statistically I compound the errors in each estimate and therefore any conclusion I come to is much less reliable than anything HMRC offer. 

I disagree. First, that is because I suggest the tax bases HMRC do not consider are more significant than any error I might make.

Second, I would argue that unless any GDP based estimate  used for any reason is rejected because GDP is unreliable, for reasons I have noted, then to suggest I cannot use the figure at face value is just hyperbole. I am particularly amused that someone who has self-identified as a former Treasury official has made a big play on this GDP issue. It is as if I am not allowed to use GDP data for any purpose but those they have sanctioned when the Treasury not only obsess about GDP but never issue appropriate risk warnings as to its use. Very clearly different rules are being applied to me than are suggested for their own use.  

I would actually say the same of using the best available peer reviewed data. Of course there are margins in there. And I sought to reduce those by looking for a variety of sources - plus the HMRC VAT gap data - and they all support each other. I would say that appropriately manages the risk. And that is as much as anyone can do. 

Unless we are to say using estimates in economic analysis is not acceptable I think these first two claims of no real significance, and any likely error (and I accept there will be some) are lower than those HMRC create, so comparison with them remains valid.

So what of the use of the average tax rate of 33%, or thereabouts? This seems to be the basis of most criticisms. So let me justify this, from first principles.

First, let me ask why people evade tax by suppressing report of their income? There is only one rational explanation and that is that tax is not paid as a result. So let’s not pretend that, as some claim, that many of those in the shadow economy would not be taxable anyway. I suggest that is utterly implausible. In fact, some on very low apparent taxable incomes might have very high marginal effective tax rates if their income was declared because of the interaction with benefits. This argument does then hold no water. 

This brings me to my second point. This is that for everyone engaged with tax evasion evades tax at their highest marginal tax rate. So, when appraising the likely tax evaded a consideration of marginal tax rates is what is appropriate. Now, I accept there is no one simple answer here, but let’s just look at income tax and national insurance to start. No one’s marginal tax rate here is going to be much less than 32%, which is basic income tax rate plus basic NIC. I know it is slightly different for the self employed, but not wildly so. I still suggest we can ignore corporation tax, although section 455 has been noted. These evaded sums do not remain in companies. And I will still suggest that marginal relates can frequently be much higher than this. Gabriel Zucman has suggested most evasion is by the top earners in any society. Their marginal rates will exceed 40%. Add in VAT evaded and employers NIC as well, and potential rates go much above that.

When saying so I might add that the claim also being made that tax evasion is mainly by low earners is ridiculous. That is because a) they simply don’t earn enough to make up the numbers and b) we know the vast majority of small businesses in the UK are not VAT  registered, and therefore have low earnings, and that this is allowed for in VAT gap calculations, but that gap remains about 9% of yield and even after allowing for debt this can only be because more substantial businesses, likely as a result to yield higher earnings, is where the problem arises. Indeed, this has to be the case.  Just as most tax has to be paid by high earners, by definition or the sums don’t add, it pretty much follows that this must be true of evasion too. Claims otherwise make no sense, and indicate prior research bias if they suggest they are evidence based - as HMRC work in the shadow economy (which as they define it is not the same as the tax evasion base) makes clear.

I admit I have not modelled all these likelihoods, but the fact is that finding arrangements where the marginal tax rates, which are what is overall lost, are less than 32% is fairly hard, and exceptional, whilst the vast majority has to be at significantly higher rates. In other words, I think all rational evidence suggests I have under-estimated this tax rate, which I did, knowingly. 

Do I accept the criticisms made then? No I don’t. They simply do not stack. Or to put it another way, they look like excuses to me.

Might I suggest that we talk about what we do about this instead, then? 

And please note I am not interested in hearing past criticisms again. Please move on, or don’t bother commenting. I’ve dealt with the above issues now, unless new evidence is added.