Closing the tax gap

What is the tax gap?

The tax gap is the notional difference between the amount of tax that should, in theory, be paid to HM Revenue and Customs (HMRC) (‘theoretical tax liability’), and what is actually paid. The ‘theoretical tax liability’ is the amount of tax that would be paid if all individuals, businesses and companies complied with the letter of the law and HMRC’s interpretation of parliament’s intention in setting the law (referred to as the ‘spirit’ of the law). Hence, the total theoretical tax liability is the sum of the tax gap, plus the amount of tax actually received by HMRC.

Measuring the tax gap over time

The size of the tax gap has been under scrutiny for several years. Since 2009, HMRC has, on an annual basis, published their analysis entitled Measuring tax gaps. Data collected over almost 20 years shows that the tax gap rate has seen a slow but inconsistent decrease in percentage terms, albeit, in cash terms, it is at its highest level. The falling tax gap in percentage terms indicates there has been progress in collecting more of the tax that is owed. However, it is widely acknowledged that there is still a lot of work to be done to improve the efficiency of tax collection in light of recent HMRC challenges (see below).

According to HMRC, there are several behaviours that drive the tax gap. These include the failure by taxpayers to take reasonable care, avoidance, criminal attacks, errors and legal interpretation issues among others.

HMRC’s latest tax gap publication

In the latest update of 20 June 2024, HMRC estimated the tax gap to be 4.8% or £39.9 billion in absolute terms in the 2022 to 2023 tax year. Total theoretical tax liabilities for the year were £823.8 billion. In essence, this means that HMRC collected 95.2% of all tax due.

The largest tax types that contribute to the tax gap are the corporation tax gap and the income tax, national insurance contributions (NICs) and capital gains tax gap, both with a 34% share, followed by the Value Added Tax (VAT) gap with a 20% share of the overall tax gap. This is not surprising since most receipts for taxes collected come from three main sources: income tax, NICs and VAT.

In terms of who are the largest contributors to the tax gap, small businesses remain the largest component by customer group at a 60% share in 2022 to 2023 whereas, contrary to popular belief, the tax gap from two groups HMRC identifies as ‘wealthy’ and ‘individuals’ respectively make up a low proportion of the tax gap at 5% each in 2022 to 2023.  Alarmingly, about a third of small businesses’ corporation tax is not being paid!

Nevertheless, it is important to remember that the tax gap estimates only cover those taxes which are administered by HMRC, so they exclude any taxes and duties administered elsewhere, like council tax, business rates and vehicle excise duty for example, as well as charges such as the congestion charge. Fully devolved taxes, like the landfill disposals tax and land transaction tax, are also excluded from tax gap calculations because they are not administered by HMRC.

Impact of COVID-19

Throughout the pandemic, the COVID-19 support schemes helped millions of people and businesses. However, it was long foreseen by the Government authorities themselves that the schemes would be targets for fraud and that customers operating at pace and under pressure would make mistakes.

Post-payment compliance activity began in July 2020 once HMRC had been granted specific powers. To the end of March 2022, Government authorities were believed to have recovered more than £762 million lost to error and fraud in the COVID-19 financial support schemes through compliance activity. Similar to the position for taxes not administered by HMRC, estimates of error and fraud associated with the coronavirus (COVID-19) support schemes are not covered within HMRC’s publication on the tax gap.

HMRC challenges

Over time HMRC has faced challenge by the Public Accounts Committee (PAC), including that HMRC was not doing enough to reclaim the money and was also failing in its wider duties, including ensuring tax compliance and preventing people from being lured into avoidance schemes. For example, in the 2020-21 PAC report on HMRC performance, it was noted that HMRC had effectively written off £4 billion of COVID-related fraud and that the tax authority had completely unambitious plans to recover fraudulent payments at a time when customer service has also collapsed.  

Government action

In 2023 and 2024, the Government announced additional resources to tackle the UK’s tax gap. At the Autumn Statement 2023, the Tackling the Tax Gap package was announced aimed at raising £5 billion of tax revenue over the five-year Autumn Statement 2023 forecast period. The Government has also said that it is building on this with a new package of measures that will raise over £4.5 billion by 2028-29, including by ensuring taxpayers are supported out of tax debt faster.

So, what does this mean for the election?

Clamping down on tax avoidance and closing the tax gap are areas identified in a number of manifestos to raise additional funds. How much the parties think can be raised varies; the Conservatives have identified at least a further £6 billion a year, the Liberal Democrats proposing £7.2 billion and Labour a net £5 billion by 2029/30.

There is little detail in the parties' manifestos on how they actually plan to achieve this. In April 2024, the Labour Party published a document entitled Labour’s Plan to Close the Tax Gap outlining a number of proposals and in their manifesto of June 2024, they built on these plans by committing to giving HMRC additional funding of £855m each year to boost tax income, to close the tax gap and to increase regulation and reporting requirements.  From the manifestos of the different parties, that of the Labour party sets out a more defined plan to modernise HMRC by investing in its people, its technology and strengthening its powers.  

Conclusion

Whilst the tax gap has indeed decreased in percentage terms, it remains an important measure of our tax authority’s ability to administer and collect taxes and reminds us how far away we are from building a modern state-of-the-art tax system. Irrespective of which party wins the election, it is clear that HMRC's compliance activities will need to increase to fund the spending pledges proposed!