Business Law Blog

In June 2022, Canada published a report concerning its tax gap.^[1] A “tax gap” is the difference between (a) the amount of money a tax authority could collect, in theory, if everyone complied with the law; and (b) the amount in fact collected. Canada’s tax gap has remained stable for the period 2014 to 2018, at 9% of tax revenue.^[2] This translates to between $20 billion and $24 billion for the years in question (because Federal tax revenue increased). This briefing note addresses an interesting aspect of the Canadian approach to reporting the tax gap, namely the decision to publish both the “gross” and “net” gap (described in detail below) and makes certain comparisons with the UK and the US.

Gross vs. Net

As a preliminary matter, it is worth pointing out that estimating the tax gap is very difficult.^[3] This is because part of the tax gap is driven by non-reporting: some tax due is not paid because taxpayers either do not file at all, or deliberately do not report income, etc. There are broadly two approaches to measuring the tax gap: top-down and bottom-up. A top-down approach measures economic activity through national accounts, applies a tax base to those accounts, and then multiplies by the tax rate for a broad measure of expected tax liability. A bottom-up approach takes a sample of taxpayer returns, audits them for non-compliance, and then extrapolates the non-compliance rate to the whole taxpayer population. Depending on the tax in question, and the tax authority’s audit resources, one approach may be preferred to another, or perhaps a combination.

Canada reported both its gross and net tax gap for 2014 to 2018. The gross gap is measured as the difference between expected tax liability and the amount initially reported on taxpayer returns. The net gap is measured after the impact of audit and collection efforts by the Canada Revenue Agency (CRA). Although the net gap in Canada has remained stable, the gross gap grew over the period 2014 to 2018, from approximately 14% in 2014 to approximately 15.5% in 2018.^[4] The CRA is keen to emphasize that its audit and collection activities are “holding the federal tax gap stable.”^[5]

This is an interesting change of emphasis from 2017, when the CRA first began measuring the tax gap. At that time, the consensus was that the tax gap measurement should “not be used directly to measure the effectiveness of a tax authority.”^[6] In my view this is correct, particularly when one is dealing with the net tax gap. There are three main reasons for this. Firstly, the tax gap is driven in part by accidental non-compliance. This is, in turn, a function of legislative complexity, taxpayer inattention and suboptimal advice. None of these things are within the control of the CRA, and it is fair to say that Canada’s tax laws have become more complex in recent years. Secondly, a certain portion of non-payment may be driven by taxpayers in financial difficulties. This is a function of the economy, which is typically cyclical. Thirdly, neither the tax base nor rate remain constant, and it is well understood that broadening the base or increasing the rate will have an avoidance / evasion effect (as well as an increased tax revenue effect).

So why did the CRA chose to publish both gross and net figures? I suspect that this may be to do with the political environment. A tax authority which does not make inroads into the tax gap may be thought to fail in its duty to be “tough” on tax evasion. Since Canada’s net gap has remained stable, the CRA may wish to point to its increased efforts in dealing with the gross gap as a measure of its seriousness of purpose.

UK and US Approach

One of the ideas behind publishing the tax gap was to facilitate international comparison. HMRC in the UK has reduced its (net)^[7] tax gap to 5.1% for 2020-1,^[8] from a starting point of 7.5% in 2005-6.^[9] This compares favourably with Canada. On the other hand, the IRS estimates the U.S. federal tax gap to be 14.2% for 2011-2013.^[10] Drawing any conclusions from these comparisons is difficult, however, because the methodology used by each tax authority (whilst published) is far from straightforward, and likely differs in material respects.

Why should we care?

The Canadian tax gap data do contain some interesting items. There is a breakdown of gap by tax: more than half the gap is attributable to individual taxpayers, and little to GST / HST.^[11] In the popular imagination, the individual tax gap is attributable to wealthy taxpayers not reporting offshore investment income. But this is not borne out by CRA’s estimates. In 2018, for example, $7.7 billion of the (gross) tax gap was attributable to the domestic underground economy, compared with $1 billion to $3 billion for unreported offshore income.^[12] The domestic underground economy is made up of unreported cash income in the construction, restaurant, and other industries, along with unreported domestic rental income, etc.

We should also care that the gross tax gap is growing, and the net gap is not being reduced. The best way to address this is to make voluntary compliance easier and more predictable. This suggests a need for simplification of Canada’s tax statutes, a speedier advanced tax ruling system, and automatically matching taxpayer data received from banks and other institutions with pre-populated tax returns for most Canadian taxpayers.

  

_{[1] https://www.canada.ca/en/revenue-agency/corporate/about-canada-revenue-agency-cra/tax-canada-a-conceptual-study/tax-gap-brief-overview.html}

_{[2] Ibid.}

_{[3] Shawn Porter and Larry Chapman, "Policy Forum: The Tax Gap from the Perspective of Tax Practitioners" (2017) 65:4 Canadian Tax Journal 939-949.}

_{[4] https://www.canada.ca/en/revenue-agency/corporate/about-canada-revenue-agency-cra/tax-canada-a-conceptual-study/tax-gap-brief-overview/overall-federal-tax-gap-report.html?utm_source=Canada_dot_ca&utm_medium=Backgrounder&utm_campaign=No_Signature_Corporate_item+SIIB+Tax_Gap&utm_content=2022-06-28_0278#toc3 , Figure 1.}

_{[5] Ibid.}

_{[6] Porter & Chapman, (n 3).}

_{[7] “Tax gaps are calculated net of compliance yield — that is, they reflect the gap remaining after HMRC’s compliance work.” https://www.gov.uk/government/statistics/measuring-tax-gaps/1-tax-gaps-summary}

_{[8] https://www.gov.uk/government/news/tax-gap-remains-steady-at-51}

_{[9] https://www.gov.uk/government/statistics/measuring-tax-gaps/1-tax-gaps-summary}

_{[10] https://www.irs.gov/pub/irs-pdf/p1415.pdf The US estimate is expressed as an 85.8% compliance rate, which perhaps reflects an American optimism not shared by their Canadian or British counterparts.}

_{[11] https://www.canada.ca/en/revenue-agency/corporate/about-canada-revenue-agency-cra/tax-canada-a-conceptual-study/tax-gap-brief-overview/tax-gap-methodological-annex.html?utm_source=Canada_dot_ca&utm_medium=Backgrounder&utm_campaign=No_Signature_Corporate_item+SIIB+Tax_Gap&utm_content=2022-06-28_0276}

^{_{[12] Ibid.}}