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Filling in the Tax Gap: Tax Avoidance Estimates and Options for Increasing Compliance in Canada
By Craig Alexander, Senior Vice-President and Chief Economist at The Conference Board of Canada.
Taxes are a necessary part of living in Canada. Our taxes pay for public services ranging from health care and education to law enforcement and national defence, and these services have to be paid for. While the amount of taxes and types of taxes is subject to regular debate, most Canadians are in agreement that all citizens should pay the taxes that they are legally-obligated to pay. However, not all the taxes that Canadians owe end up being paid to government.
When some individuals and companies do not pay their legal share of taxes, it increases the burden of funding public services on compliant taxpayers. At their most extreme, the use of offshore tax havens (small jurisdictions that offer exceptionally low business and personal taxation rates) can produce widespread public outrage — witness the 2016 revelations of the “Panama Papers”, an exhaustive list of clients using offshore tax havens. When these stories emerge, it increases the global focus on income inequality and tax fairness.
Amid complex schemes to elude taxes, governments around the developed world are actively trying to collect more of the revenue that they are legally entitled to obtain. The difference between the tax revenue that should be collected and the actual amount that governments collect is known as the tax gap. While the concept is simple, almost everything else about the tax gap is complicated.
The Many Components of the Tax Gap
For starters, the tax gap is comprised of numerous factors—including outright evasion, avoidance, mistakes and simple non-payment. A tax gap can arise from the purposeful under-reporting or non-reporting of income, legal actions to minimize taxes, or taxes assessed but not paid. The differences among these factors are subtle but significant. Evasion is deliberately ignoring a specific part of a law to avoid paying taxes. Unacceptable avoidance of taxation is undertaking activities that comply with the letter of a law, but contravene the spirit and intent of the law as defined by the courts.
Even in the absence of intentional behaviours to minimize or avoid taxes, a gap is still likely to exist due to unintentional mistakes made by tax filers. In the United States, an analysis of tax data by the Government Accountability Office found that 50 per cent of tax returns prepared by individuals contain mistakes, and 60 per cent of returns filed by hired tax preparers have errors.
Identifying and defining which components are included or not included is crucial to making an effective analysis of the size and scale of the tax gap. Taking actions to combat the tax gap is all but impossible when there is no accepted estimate of the gap. The size of the tax gap can have important implications for policy-makers since it could act as a potential guide for public resources and policy priorities devoted to increasing tax compliance. This discussion is overdue, and to contribute to the dialogue, The Conference Board of Canada has conducted research into the potential size of the gap in Canada and hosted a workshop in June 2016 on the best approaches to reducing the gap.
Tax Gap Estimates from Other Countries
Canada has only just begun to estimate the tax gap. The Canada Revenue Agency (CRA) published its first conceptual paper on tax gap estimation in 2016, finding that non-compliance has caused an average annual loss in potential GST/HST revenues of 5.6 per cent for every year from 2000 to 2014. The CRA plans to develop more papers on other aspects of the tax gap over the next two to three years.
Complicating efforts to assess the tax gap is the lack of a standard method for estimating the size of the shadow economy, which is generally defined as legal market-based activities that are hidden from authorities. Statistics Canada estimated the size of Canada’s underground economy at 2.4 per cent of GDP or $45.6 billion in 2013. Research from the World Bank defined a country’s shadow economy as legal activities that are deliberately concealed from public authorities and its estimate indicated that Canada’s shadow economy was worth 15.3 per cent of GDP in 2007.
Other developed countries have done more than Canada to estimate their tax gaps. The Conference Board of Canada looked at two in-depth estimates, one produced by the United States and the other by the United Kingdom.
The latest estimate by the Internal Revenue Service, based on averages from 2008 to 2010, pegs the U.S. gross tax gap at $458 billion. The IRS identifies three main components of the tax gap: non-filing (7 per cent); under-reporting (85 per cent); and underpayment (9 per cent). Through enforcement actions and collection of late payments, the IRS expected to collect $52 billion, reducing the net gap to $406 billion. This amount still represents just over 19.4 per cent of total taxes collected, or 16.3 per cent of the total true tax revenue it should collect.
The U.K. analysis is considered the gold standard in tax gap analysis, because the breakdown by type of behaviour is more thorough—the type of tax (such as personal income tax, corporate income tax, value-added tax), by type of entity (small and medium enterprises, large corporations and individuals) and by type of behaviour (hidden economy, criminal activities, and non-payment). In 2013-14, Her Majesty’s Revenue and Customs (HMRC) estimated its gap to be £34 billion, equivalent to 6.4 per cent of the total true tax liability in 2013–14—down from 8.4 per cent in 2005–06. The largest gap in dollar terms is on income taxes but the largest percentage gap in the U.K. is on their value-added tax (VAT), although it should be noted that value-added taxes are higher in the UK and Europe than in Canada (GST/HST). Identifying specific behaviours that lead to non-payment can help policy-makers to target compliance actions that can limit the tax gap.
The Conference Board of Canada used these estimates from other studies and analysis to assess the potential Canadian tax gap. In the absence of an overall estimate, this analysis seeks to provide a range of the potential size of Canada’s tax gap using the assumption that the size of the Canadian gap is similar to that of other countries. While this approach has obvious limitations, it does provide a comparative measure of the types of tax avoidance and a sense of how much each component contributes to the overall gap in other jurisdictions.
By applying estimates used in other countries and assuming Canada’s tax gap was the same, the available literature suggest that Canada’s federal tax gap could range from $8.9 billion to $47.8 billion annually. Since the federal government has accounted for 41 per cent of total taxes collected in Canada over the past five years, the full tax gap for all governments in Canada would be significantly greater.
A Menu of Options to Reduce the Tax Gap
One way to shrink the part of the gap due to unintentional misreporting is to reduce the complexity of the tax code. The Canadian tax system is known to be complex; however, estimates of the number of returns in Canada with errors could not be found. As a result, streamlining tax codes could be one avenue for reducing the tax gap.
In recent years, the federal government has stepped up its efforts to increase tax collections. The 2013 federal budget devoted additional resources to tax enforcement and recently published figures indicate that these measures increased tax collections by $1.6 billion in 2014-15. The 2016 budget included a commitment of $444 million over five years to combat tax avoidance and evasion. The budget estimates indicate that these measures will increase tax collected by $7.6 billion over five years.
The 2016 budget also provided details on an implementation plan to share information with other tax agencies in an effort to reduce base erosion and profit shifting (BEPS). The government indicated that Canada will join the more than 90 other jurisdictions that are implementing the Common Reporting Standard developed by the Organisation for Economic Co-operation and Development (OECD). The OECD is spearheading the development of guidelines to address BEPS, with the aim of minimizing sophisticated tax avoidance schemes that move profits to more favourable jurisdictions. Canada is set to implement the standard in July and begin sharing information with other countries in 2018.
CRA has demonstrated success in using additional resources to increase collections. The extra funding committed in the 2016 budget, and Canada’s plan to share financial information with other tax agencies to minimize BEPS, are positive steps toward reducing the tax gap.
In addition to increased financial resources for enforcement agencies and signing on to international standards, Canada can learn from other countries that have adopted measures to do their work smarter. Consultations with other tax administration authorities and learning from best practices internationally should be at the centre of strengthening efforts to reduce the Canadian tax gap.
For instance, in Belgium, an advanced analytics technique called the hybrid detection model has almost eliminated carousel fraud from value-added tax (VAT) revenues. A carousel scheme sees one individual charge its buyer VAT on a product sale, but does not remit the VAT to the government. The buyer can then get a VAT refund and resell the product, often to the original seller – hence the description of a carousel. In 2002, losses in Belgium from VAT fraud totalled €1.1 billion in 2002. In 2012, they were down to €18.5 million—a reduction of 98 per cent. The hybrid detection model picks through vast streams of transaction data and determines the most relevant to identify the source of fraud, so that collection resources can be targeted most effectively.
The UK has made the most progress over the past decade in reducing the gap on corporate income and excise taxes. HMRC has invested in advanced analytics to derive risk profiles and improve the targeting of resources to boost tax compliance. A 2014 report showed that these investments enabled HRMC to increase its year-to-date yield by £2.6 billion while employing 40 per cent fewer staff. The UK has also improved reporting on carousel schemes and releases estimates annually.
The Office of the Revenue Commissioners in Ireland has also been using advanced analytics to improve the identification of cases for audits. In a pilot project, it evaluated whether predictive analysis could identify which cases would yield the highest return. The results showed that by identifying risky cases and potential yields, predictive analysis did indeed produce better results compared to traditional measures employed by the agency. The U.S. IRS is increasing its use of analytics through several programs designed to identify mistakes in filed returns, detect fraud, and extract information from credit and debit card transactions to identify under-reported income.
CRA is already using data to better target its actions in many of these areas. By increasing the use of data analytics, CRA can optimize its workload allocation and improve processes to detect evasion and errors. These are the kinds of steps that will enable Canadian government to collect more of the revenue that they are entitled to, and to lessen the burden on the taxpayers who already play by the rules.