By Kevin O’Rourke

In November 2015 the ATO released a publication on measuring tax gaps in Australia. This followed the publication three years earlier of narrower work on the GST and Luxury Car Tax (LCT) gap in Australia.

Tax gap estimates are one of the high-level measures the ATO uses to track the performance and integrity of the tax system. The ATO has publicly committed to measuring the tax gap for all of the taxes it administers by 2017. At this stage New Zealand’s Inland Revenue (IR) has neither published nor indicated any intention to publish a tax gap analysis.

This article focuses on the Australian GST gap, which is the net theoretical GST revenue less the actual accrual GST revenue for any given period. There is currently a debate about tax reform and a possible change to the GST rate or base. Does the size of the GST gap inform that debate? In other words, if there is a GST gap wouldn’t it be better to simply raise additional revenue by just closing the gap? It isn’t that simple.

The measurement of the GST gap has several distinct objectives: to measure the types and levels of tax revenue losses from non-compliance; to support the efficient allocation of resources; and to support perceptions of fairness and transparency.

GST gap

So how big is the GST gap?

The GST gap of 4.9 per cent for 2013-2014 equates to $2.7b in revenue on a total base of $51b.

It is worth mentioning that the ATO’s 2012 report showed a 7.6% gap (rather than 6.9 per cent) for 2008-09 and 3.3 per cent gap (rather than 3.0 per cent) for 2009-10, so there has been a fair bit of revision over the past three years.

It can also be seen that there is a sharp fall in the GST gap to 3.0% in 2009-10. Back in 2012, the ATO acknowledged that a fall in non-compliance of such magnitude was highly unlikely and that the fall was more likely due to timing differences in the recognition of items such as dwelling investment and large input tax credit claims.

Perhaps this tells us that we should be wary about placing too much reliance on the individual percentage gaps in each year.

The ATO tells us that the GST gap is best viewed as a trend over time, but there is no discernible trend either. That is all the more so if you take into account the figures for earlier years as published in the 2012 report.

A further reason to be wary of placing too much reliance on the GST gap percentages is the margin of error in the gap calculations. The ATO acknowledges that estimating the magnitude of, and trends in, tax gaps is inherently difficult.

Tax gap accuracy

Giving evidence before the House of Representatives Standing Committee on Tax and Revenue in February 2014, Second Commissioner Neil Olesen was very frank: “We should never pretend that we can come up with any kind of precise estimate of a tax gap. One of the dangers here is that you end up with a headline figure and all people want to talk about is the headline figure, without necessarily understanding the confidence levels that might be around those figures. The confidence levels can be quite big, up to 80 per cent. If you have an estimate of a dollar, in fact the answer might be somewhere between nothing and $2. It can be a very big range that you are talking about.”

The reliability of tax gap estimates is assessed on a five-point scale (very low, low, medium, high and very high). The reliability of the GST estimate has been assessed as medium and is expected to remain at this rating in the future due to data limitations and margins of error inherent in the data.

A significant omission from the GST gap analysis is the size of the illegal non-observed economy. The Australian Bureau of Statistics makes no explicit estimates for such activities in the National Accounts due to the difficulty in identifying and valuing illegal transactions. However, the ABS has separately estimated that consumption expenditure on illegal drugs alone to be close to A$6b for the 2010 calendar year.

This means that the GST gap reported by the ATO is materially understated as such expenditure forms part of the theoretical GST base.

We should never pretend that we can come up with any kind of precise estimate of a tax gap. One of the dangers here is that you end up with a headline figure … without necessarily understanding the confidence levels that might be around those figures.

Sophisticated UK measurement

It is still early days for the ATO but overseas experience suggests that tax gap analysis can increase in its sophistication over time. HM Revenue & Customs (HMRC) in the United Kingdom is arguably the most advanced revenue authority in GST (or VAT) gap measurement. HMRC publishes tax gaps annually for most of the taxes it administers.

In 2013 an assessment of HMRC’s tax gap analysis was undertaken by a team from the International Monetary Fund (IMF) at the request of HMRC. According to the IMF, the HMRC produces one of the most comprehensive studies of tax gap estimates internationally.

A feature of the HMRC analysis is that it splits the tax gap by behaviour into avoidance, criminal attacks, error, evasion, failure to take reasonable care, hidden economy, legal interpretation and non-payment.

That is quite a sophisticated analysis and one which the ATO has not yet performed.

The HMRC analysis serves as a useful benchmark for future ATO work in this area, and there may be some merit in the ATO similarly requesting a review by the IMF.

The GST gap analysis does not point towards a simple way of raising additional revenue from just closing the gap.

The ATO acknowledges that it is generally not considered feasible to achieve full compliance with the tax laws and so it is not their expectation that the tax gap will ever be fully closed. Voluntary compliance together with targeted compliance activities is of course the best means of closing the gap, however theoretically large it may be.

The ATO should be commended for undertaking its tax gap analysis, but we should take care not to place too much faith in the numbers, at least at this early stage. The margins for error, the lack of distinct trends, the variations and revisions all point towards taking a cautious approach.

Kevin O’Rourke is principal at Ryan Australia Chair and sit so the Chartered Accountants ANZ Indirect Tax Committee.

This article was first published in the April 2016 issue of Acuity magazine.