Tax Gap in Canada: A Conceptual Study

Chapter 2

The Tax Gap – Definition and Conceptual Issues

Photo of a laptop with graphs on the screen

2.1 What is the Tax Gap?

a. Definition

Broadly defined, the tax gap is the difference between the taxes that would be paid if all obligations were fully met in all instances, and the tax actually paid and collected.

The tax gap is sometimes seen as a measure of tax fraud or similar conduct. However, the tax gap encompasses revenues lost due to both intentional and unintentional behaviour, including tax evasion, taxpayer error, and in some cases unpaid and uncollectible tax liabilities (such as when a taxpayer is bankrupt).

While it may appear to be a relatively simple concept, tax gap estimation is complex and is grounded in the unique circumstances of each tax administration. The legislative and administrative framework of each particular country will influence whether and how tax gap estimates are undertaken.  

Estimating the tax gap will only be useful if the information gained through the process is (a) useful to taxpayers in better understanding both what the tax administrator is doing and its effectiveness in undertaking those activities, and (b) relevant for a tax administration in improving compliance.

On a conceptual level, the tax gap is multi-faceted.

In summary, the tax gap is a complex concept and its estimation is both nuanced and contentious. The following three sections examine additional challenges faced by tax administrators when estimating the tax gap.

The Underground Economy

On June 20, 2016, Statistics Canada released a study, commissioned by the CRA as part of our ongoing efforts to understand the underground economy, containing new estimates of the underground economy for Canada from 1992 to 2013. The study indicated that in 2013, total underground activity in Canada was estimated at $45.6 billion or 2.4 percent of Gross Domestic Product (GDP). These estimates represent an upper bound (or the maximum potential underground activity beyond what is already included in GDP). 

The Statistics Canada underground economy estimate is not a tax gap estimate. The Statistics Canada study provides information on the growth or decline of the underground economy in relation to the GDP for Canada and the provinces and territories. It does not estimate the total amount of taxes that are not reported or paid as a result of these activities.

That said, the results of the study are being used by the CRA, in conjunction with other information, to develop targeted strategies to combat non-compliance and to direct resources to the sectors of the economy at highest risk for underground economy activity.

b. Tax Avoidance

The appropriate treatment of tax avoidance for the purposes of tax gap estimation is a matter of debate internationally. While it is clear that tax evasion, or deliberate contravention or ignoring of a specific part of the law, should be considered to contribute to the tax gap, the appropriate treatment of tax avoidance is less clear.

Tax Avoidance vs. Tax Evasion

Tax avoidance results when actions are taken to minimize tax, and when – while within the letter of the law – those actions contravene the intent and spirit of the law, for example, where a person undertakes a series of transactions that have as a primary purpose to reduce or eliminate tax in a manner not intended by the law.

Tax evasion typically involves deliberately ignoring a specific part of the law. For example, those participating in tax evasion may under-report taxable receipts or claim expenses that are non-deductible or overstated. They might also attempt to evade taxes by willfully refusing to comply with legislated reporting requirements.

Tax evasion, unlike tax avoidance, has criminal consequences. Tax evaders face prosecution in criminal court.

The challenge with tax avoidance in particular is that, due to the highly complex nature of certain transactions, it is often difficult to distinguish between legitimate and abusive activities based on the information available to tax administrations. Some methodologies used to estimate the tax gap, by their very nature, may capture tax avoidance. For example, an estimate developed using high-level economic indicators such as national accounts data (otherwise known as the top-down approach, which will be discussed later in this paper) may capture tax avoidance since it is based on data external to the tax administrator that captures activities which may not be reported for tax purposes. However, this method may not necessarily be able to distinguish between tax evasion, acceptable tax planning, and tax avoidance.  

The United Kingdom explicitly includes tax avoidance in its tax gap estimates. Her Majesty's Revenue and Customs (HMRC), the United Kingdom's tax administration, views tax avoidance as "exploiting the tax rules to gain a tax advantage that Parliament never intended." In HMRC's view, this activity is different than tax planning, which involves using the various tax "reliefs" (that is, tax credits and deductions) for the intended purpose of reducing tax. Other countries examined in the course of this study do not specifically address tax avoidance in their estimates. 

The inclusion or exclusion of tax avoidance is one of the many decisions that must be considered by tax administrations when determining the parameters that apply to their tax gap estimates.
c. Gross vs. Net Tax Gap

Generally speaking, the gross tax gap is the total estimated tax gap, while the net tax gap takes into account the impact of a tax administration's enforcement activities.1 The Internal Revenue Service (IRS) in the United States refers to the net tax gap as "the portion of the gross tax gap that will not be paid."

The factors used to determine the net tax gap vary across countries – some (like Sweden) consider only the results of audits, while others (such as the United States) also include late payment and the impact of collections activities.

Presentation of both a gross and net tax gap estimate may be the most complete for taxpayers and stakeholders, as it provides an estimate of the overall level of non-compliance, insight into the tax administration's effectiveness in promoting compliance, and an estimate of the amounts that are likely to remain uncollected. However, the ability to do so would depend on the information and resources available to undertake such analysis.

d. The International Component

The portion of the tax gap that could be attributed to overseas tax evasion and other cross-border transactions, or the international component of the tax gap, is of significant interest to the public and stakeholders, as uncollected taxes resulting from these types of activities are often thought to be substantial. Unfortunately, the international component is also the most complex aspect of the tax gap to estimate. This is not to say that tax administrators do not have an in-depth understanding of overseas evasion, but rather that it is exceedingly difficult to quantify.

Defining the international component of the tax gap is a complex matter; as a concept, the international tax gap could be understood in a number of ways. For example, the international component could be defined broadly as all aspects of the tax gap that have any international connection whatsoever. Alternatively, a narrower view could be taken that would define the international tax gap as including only those international transactions undertaken by taxpayers explicitly designed to evade taxes.

Further, as will be discussed in greater detail later, specific data challenges exist related to estimating the international component of the tax gap, which lead to a high degree of uncertainty when developing international tax gap estimates. 

2.2 How Are Tax Gaps Estimated?

To arrive at tax gap estimates, tax administrations rely on data from within and outside their organizations. The data are collected and analyzed through the lens of the definition of the tax gap adopted by the particular country, based on a variety of decisions about what should and should not be included in a tax gap estimate and the context of the existing tax framework.

The approaches used by tax administrators to undertake these estimates are constantly evolving but can be categorized as top-down or bottom-up methods.
a. Top-down Methodology

Broadly speaking, top-down methodology uses independent external data (usually national accounts data) to estimate the tax base, a figure that is then used to calculate a theoretical value of tax that should be paid and collected, by applying the appropriate tax rate to that high level figure. The actual amount of tax paid and collected is then subtracted from the theoretical value to estimate the tax gap. This approach is most commonly used to estimate tax gaps for indirect taxes (including VATs such as the GST/HST, as well as excise duties and taxes) and indeed is the method used to estimate the GST/HST gap in the study released concurrently with this paper. 

Theoretical value of tax minus Actual amount of tax equals tax gap estimate

The top-down approach is ill-suited to estimating tax gaps related to direct taxes, such as income taxes, because, although it can estimate a broad measure of income, it does not take into account the particular circumstances of taxpayers reflected in the various credits and deductions claimed. 

Key to top-down methodology is the extent to which economic activity is captured in the national accounts data and the level of detail they provide. In addition, national accounts data should be independent and not linked in whole or in part to tax data. 

Top-down estimates are limited in their usefulness from a tax administration perspective because the estimates are aggregate and can only indicate whether the tax administration collects a significant portion of the taxes that should be paid. In other words, it is difficult to determine from a top-down estimate which groups or sectors of taxpayers may be at risk of non-compliance, which in turn makes it difficult for the estimate to help target compliance activities to particular groups or sectors. This is reflected in the GST/HST study, which provides an overall estimate of the GST/HST gap but indicates that the study cannot pinpoint which "groups or sectors are the most likely to be non-compliant." Nevertheless, top-down estimates can identify relatively broad areas for further investigation using other data sources.

b. Bottom-up Methodology

Bottom-up methodology uses a tax administrator's internal administrative data to estimate the amount of taxes theoretically owing. In general, a statistically representative sub-set of taxpayers is used to estimate non-compliance, which is then extrapolated to the full taxpayer population to produce a tax gap estimate. This approach is used for estimating tax gaps related to direct taxes. 

Unlike the top-down approach, bottom-up estimation of the tax gap requires extensive individual taxpayer-level data on non-compliance. To gather that data, the bottom-up approach relies on methods such as random audit programs and data-matching 2 , resulting in the identification of specific tax segments of non-compliance, something that the top-down approach cannot do directly. 

For a variety of reasons, auditors do not always identify all sources of non-compliance in the course of conducting audits. As a result, bottom-up estimates are often subject to a significant adjustment factor to account for undetected non-compliance.

Given the type and extent of data requirements, bottom-up methodologies are significantly more expensive and burdensome for taxpayers, especially those based on random audits.

c. Data Considerations More Generally

One of the key challenges tax administrators face in estimating the tax gap is access to the comprehensive and good-quality data necessary to produce an estimate. Significant aspects of the tax gap, such as the domestic underground economy and international tax evasion, by definition involve unreported or under-reported income and assets and transactions that are deliberately hidden from the government. This makes it difficult to quantify the amount of tax revenue lost due to these activities. 

Tax gap estimates must be interpreted with the understanding that they are based on the tax administrator's knowledge at the time. 

The quality and quantity of data available is fundamental to every aspect of tax gap estimation.

Other countries' experiences demonstrate that a lack of available data may lead a tax administrator to determine that estimation of a particular aspect of the tax gap is not feasible. Available, but poor-quality, data may allow an estimate to be calculated, but with a lower level of reliability or confidence and usefulness.

Finally, the process of undertaking a tax gap estimate may in fact identify areas where information and data are lacking and so may be helpful in highlighting areas for future development or investment.

d. International Component – A Special Case

Estimating the international component of the tax gap, or tax revenues lost to overseas tax evasion and other cross-border transactions, with a sufficient degree of accuracy presents a distinct set of challenges. In addition to requiring the estimation of income and assets that are deliberately hidden from the government, estimating the international tax gap requires reliable and consistent data from other jurisdictions – this is a difficult task, given the large number of countries and institutions/intermediaries involved (e.g. foreign governments and tax administrators, financial institutions etc.). Other countries also face this challenge; the CRA is not aware of any countries that currently estimate the international component of the tax gap.

That said, in 2008, Sweden estimated the international component of its tax gap – which appears to be the only estimate of its kind published to date by any country. The international estimate prepared by Sweden in 2008 was based on the experience of the tax authority's foreign sections and some top-down estimation using national accounts and financial account data. Sweden described the estimate as highly uncertain due to a lack of data to quantify the gap.

In 2014, when the Swedish Tax Authority (STA) published a new tax gap report, it was not able to estimate the overall tax gap or the international component due to data limitations. In fact, the tax authority indicated that:

"Tax gaps due to international evasion have not been studied explicitly, even though it has previously been acknowledged that gaps within this area are likely to be substantial. The STA has a relatively high level of knowledge regarding the nature of gaps in the international field, but finding data that would make it possible to quantify the gap is particularly difficult since it generally concerns activities and/or persons located overseas."
Tax Gap Map for Sweden, How it was created and how can it be used?
Report 2008:1B
, Swedish Tax Agency

There are a number of significant data issues that make estimating the international component of the tax gap especially challenging for tax administrations, including the availability of third-party data (e.g. from financial institutions). There are generally no prohibitions to overseas investment, provided that the investor follows tax rules that apply in his or her particular circumstances. As noted earlier in this paper, it is often difficult to distinguish between legitimate and abusive activities based on the information available to tax administrations due to the highly complex nature of certain transactions.

Developing a bottom-up estimate of the international component of the tax gap would likely require expanded collaboration with international partners, not only on data sharing issues, but also on the larger question of the overall feasibility of undertaking this type of estimate. Further, the generality of top-down estimation would likely not be able to capture the complexities, such as varying tax rates and return on investment, that would be required to achieve a reliable estimate.

Taxes lost to offshore evasion or avoidance are of great interest both to tax administrations and to the public. In recent years, there has been increasing international pressure to improve transparency and the exchange of information internationally to enable tax administrations to address tax avoidance and evasion. Ongoing work with the Organisation for Economic Cooperation and Development (OECD) and a significant increase in international cooperation is expected to provide more information and lead to better and more consistent methodologies to produce more reliable estimates.

International Cooperation

The Government of Canada continues to play a leadership role in the growing global network of tax administrations that work together to fight offshore tax evasion and tax avoidance. Information sharing and international cooperation are paramount to fighting international tax evasion and aggressive tax avoidance, serving as a deterrent and a means to identify non-compliance.

Canada is working in conjunction with the OECD to combat the adverse fiscal and economic impacts of base erosion and profit shifting (i.e. tax avoidance or aggressive international tax planning). Canada, together with its OECD counterparts, is participating in a Base Erosion and Profit Shifting (BEPS) project. As part of the its work to tackle BEPS, the project seeks to improve access to and analysis of available data across jurisdictions and to collect new data to measure, monitor and take action to address base erosion and profit shifting. 

Work by the OECD on data sharing issues, both within and outside of BEPS, has led to the adoption of new initiatives related to data sharing.

  • Country-by-Country Reporting: almost 40 jurisdictions now require large multinational enterprises (MNE) to report, for each tax jurisdiction in which they do business, on key aspects of their operations, including the MNE's revenue, profit before income tax, number of employees, income tax paid and accrued, retained earnings, and tangible assets. This applies to fiscal years beginning on or after January 1, 2016.
  • Common Reporting Standard: beginning in 2018, 101 participating jurisdictions will automatically exchange the financial account information of resident individuals and entities (e.g. trusts and foundations) reported to them by financial institutions. Information will include balances, interest, dividends and sales proceeds. 

Canada has one of the most extensive tax treaty networks in the world, with 92 tax treaties and 22 Tax Information Exchange Agreements in force at this time. Canada has also recently ratified the multilateral Convention on Mutual Administrative Assistance in Tax Matters, which further expands our international information sharing network.

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