Appendix I. The Revenue Administration-Gap Analysis Program Model and Methodology
Appendix II. The Danish Customs and Tax Administration Gap and Risk Management Program
Commonly used as a measure of the degree of VAT revenue mobilization for a given country’s economic level and composition, c-efficiency is defined as the ratio of VAT collections to final consumption, divided by the main VAT rate. It provides a more relevant measure of the generation of VAT in relation to economic aggregates than the simple ratio of collections to GDP, because it controls for VAT standard rates and (partially) the composition of GDP. However, other components of expenditure, such as intermediate consumption by government and exempt industries also contribute to net VAT collections and consequently to observed c-efficiency values. It has limitations, however, in that final consumption as measured for national accounts purposes is not exactly the same as the final consumption targeted by a VAT; for example in the national accounts treatment hotel services provided to nonresidents are not included in final consumption but treated as an export.
See “From Stimulus to Consolidation: Revenue and Expenditure Policies in Advanced and Emerging Economies,” by a staff team led by Benedict Clements, Victoria Perry, and Juan Toro (IMF, 2010) for a good discussion on the relationship between the c-efficiency measure and the compliance gap and policy gap.
As discussed in Appendix 1, while the model employs data on output, intermediate demand, imports and exports to determine the tax base, this is identical to final consumption.
The accruals values used are those as measured as of May 2014, the time at which the data extraction was performed. The time elapsed between the end of 2012 and the date of extraction is sufficiently large that any remaining late collections for tax periods used in this report will likely only have a very marginal impact on the total collections figures used in this report.
This issue will be examined in more detail in the analysis of the policy gap.
These basic measures, with compliance gaps in general, do not take into account uncollectible arrears. This would include arrears written off for cases of bankrupt businesses for example. As such, the collections gap will tend to overstate the amount of potential gain to be achieved from further closing the identified portion of the tax gap. In other words, there might be some normal, or even optimal, nonzero state for the collections gap.
In 2010 there was a minor change affecting some tourism services, duly captured in the model.
The set of minimum exemptions includes: maintaining the exemption for financial services, which is typical of almost all VATs in the world; retaining the current treatment of the public sector, since changes to the treatment of the public sector might yield revenue changes in the VAT model but would actually be netted out by increased public expenditures; and maintaining the exemption for housing, as this is a common characteristic of almost all VATs in the world, and the measurement of housing in national accounts includes imputed rents which are not actual market transactions and so would not be subject to VAT in any case. It should be noted that the EU’s sixth directive allows for a broader set of exemptions than the list included here; this normative structure is not meant to be a policy prescription, but is simply an attempt to establish a baseline value in line with international norms.
The actual VAT used in the calculation of the c-efficiency ratio is reported revenues, which are typically on a cash basis or in the case of European countries a lagged cash basis. For the tax gap measurement the RA-GAP methodology employs an accrued value for revenues. In addition the c-efficiency ratio uses final consumption as measured by national accounts as a proxy for the potential VAT base, but the model employed in the RA-GAP methodology makes some adjustments to this base to better align it with taxable domestic final consumption. In the National Accounts domestic consumption by nonnationals is treated as an export and removed from final consumption, but in most cases this is subject to VAT. Similarly the national accounts treats consumption abroad by nationals as imports and added to final consumption, but these are not subject to VAT.
It should be noted that SKAT’s VAT gap analysis, based on large random audit programs, finds that the Trade sector is the largest contributor to the VAT gap. In both cases the results are not conclusive, and should only be considered suggestive of where the gap for the full population lies. These differing results highlight why it is actually ideal to use both top-down estimates (like the RA-GAP approach) and bottom-up estimates (like the SKAT approach) to analyze the nature of the tax gap.
There are essentially two approaches to estimating compliance gaps: “top down” and “bottom up.” The former estimates the gap indirectly by constructing an estimate of the potential VAT and subtracting actual VAT, the latter method is a direct approach where data on the size of known compliance losses are used to estimate the overall losses due to noncompliance.
Reckon, 2009: “Study to quantify and analyse the VAT Gap in the EU-25 Member States,” Reckon LLP, September, 2009.
CASE, 2013; “Study to quantify and analyse the VAT Gap in the EU-27 Member States” Final Report Taxation and Customs Union (TAXUD)/2012/DE/316 for the EC, TAXUD.
CASE, 2014; “2012 Update Report to the Study to quantify and analyse the VAT Gap in the EU-27 Member States,” TAXUD/2013/DE/321 FWC No TAXUD/2010/CC/104 for the EC TAXUD.
Studies conducted in Denmark by SKAT and the independent research foundation, Rockwool Foundation Research Unit, have found that around 20 percent of the Danish population spend an average of over three hours per week in informal, cash employment. (The cash economy was found to be predominantly in the building, hotel and cleaning sectors, which is a common finding internationally). This work is likely not declared for tax and so represents a component of the tax gap. However, the total hours worked in such informal circumstances only amounts to about 3 percent of all hours worked, with relatively low income. This suggests that overall the amounts involved are only equivalent to around 1–2 percent of tax revenues. As well, the same studies suggest that not all of this nominal tax loss would be recoverable even if SKAT could achieve perfect compliance by taxpayers. The studies found that if such work was taxed, only about one-third would continue; the remainder would either be substituted by purchasers doing the work themselves or simply not be done at all. So, of Danish krone (Kr)16 billion nominally due on such work, less than Kr8 billion would actually be recoverable. (This is of course an argument to introduce appropriate minimum income thresholds for PIT and CIT, and raise the threshold for VAT registration; so that they better match the realities of tax compliance and administration in Denmark.)
There is a strong argument that these sort of ‘losses’ should not be included in the compliance gap, because they are legal (i.e., policy) issues, not compliance issues. This is something of a grey area, and these types of activities range from entirely acceptable (e.g., using agreed retail schemes to estimate VAT liabilities on mixed supplies and cash sales) to extremely egregious (e.g., value shifting not reflecting actual economic rents). In practice, most administrations estimating top down gaps include avoidance in their compliance gap. This is partly a pragmatic reflection of the difficulty of estimating the amounts lost via avoidance for the purposes of making an adjustment to the model; and partly a reflection of the fact that tackling egregious avoidance is generally part of the tax administration’s remit and should therefore be reflected in the tax gap as a high-level performance indicator for the tax administration.
Normally, the exclusion of outlier results would be expected to reduce the observed losses and consequently the estimated gap. However, this is not necessarily so. In 2008, the random audits program found that one business had failed to claim a large VAT deduction to which it was entitled—they had overstated their net liability. The amount involved made this finding an outlier, so excluding this outlier actually increases the estimated VAT gap
For example, in an extreme case where a subpopulation consists entirely of businesses making supplies to fully taxable, compliant businesses, nonreporting of output tax in the subpopulation becomes irrelevant because any output tax that they did declare would be recovered by their customers as input tax credits. In such a case apparent VAT gap losses in subpopulation do not contribute to the total net VAT gap. This scenario is admittedly unlikely, but does illustrate that not all losses observed for individual subpopulations contribute to the total gap—compliance gaps in one subpopulation may be reversed by ‘negative’ compliance gaps in others (i.e., where too much net VAT is paid relative to theoretical liabilities).
Tax gap estimates for those years not covered by a random audit program are projected from the years that are by using growth in the relevant head of duty receipts.
For example, the report of the 2010 random audit program for private individuals shows a hit rate of 31.4 per cent for high risk cases, 22.9 per cent for medium risk, and 3.7 per cent for low risk taxpayers.
As well, under-reporting of consumption of alcohol and tobacco is an endemic issue found internationally in consumer surveys. The reasons for this under-reporting are not entirely clear, but may be due to a combination of consumers genuinely under-estimating their consumption (for example, reporting ‘typical’ consumption and excluding special events or binge consumption) and being reluctant (perhaps even unconsciously) to admit to their full consumption of commodities held to be social ‘bads.’ Studies have established that such under-reporting can be as much as 40 percent, so an appropriate adjustment must be made to reported consumption when comparing it to declared clearances of such goods.
Such surveys achieve high response rates in Denmark, which indicates that the risk of significant selection bias and under-reporting is relatively low. This is thought to be due to the fact that (a) the surveys are carried out by independent researchers; and (b) Statistics Denmark has a very good reputation among the public.
An alternate model structure for estimating the potential revenues for a VAT is to use statistical data on final consumption to determine the VAT paid by the end consumer, and then add an estimate of the amount of final VAT borne by exempt businesses using statistics on intermediate demand. In theory both methods should yield similar results, as they are both theoretically identical definitions of the potential tax base. This equivalence is similar to the basic National Accounts identity:
The consumption based approach to estimating the base would be represented by the left-hand side of the equation, with the value-added based approach represented on the right hand-side. “G” is appearing as potentially being on either side of the equation, as its location, for a VAT gap model, would depend on the precise treatment of government—whether they have to pay tax on their purchases, and so more closely relate to final consumption, or whether they are not subject to the VAT and so are excluded from the potential VAT base.
There is an assumption here that the same value of rs applies across Y, X, I, and N. It can be shown that this assumption is only of consequence if there are any significant difference between the level of rs for Y and X. As the level of rs is generally fairly close to one, the results are not that sensitive to this assumption. As such, while it might be more technically correct to come up with separate values for Y and X, this would likely greatly increase the time and effort required to construct the model with no discernible difference in the final results.
This assumes that the proportion of inputs to output used in producing the taxable supplies and nontaxable supplies is identical. While this is most likely not the case for any individual taxpayer, many jurisdictions use just such an apportionment rule to determine the allowable amount of input tax credits for businesses making split supplies (taxable and exempt supplies). In such case this model treatment would exactly coincide with the statutory requirement. In jurisdictions where taxpayers are allowed to apportion their supplies based on actual use, es could be determined by tax return data on the proportion of input tax being creditable to those sectors with exempt output—presuming the required information is being captured on the return.
In a best case scenario the supply and use tables will specifically include the data used for these out these special categories of imports and exports (domestic consumption by nonnationals, and consumption abroad by nationals) making it simple to adjust the tables to the definitions for VAT purposes. In cases where this specific data is not available, an approximation can be made by removing values for the import or export of services which are typically consumed at the place of supply—such as hotel and restaurant supplies, and local transportation supplies.
While in the long run cash collections and accrual cash collections should balance out, there can be wide variations between the two for a given period, as cash collections will include arrears collections from other periods and the stock of arrears changes.
While the transactions database may include data on actual refunds paid, data on the value of excess credits accrued in a period will be needed in order to properly measure the accrued collections. If the excess credit is used to offset other tax obligations, it should be recognized as a reduction in net VAT collections.
In order to properly measure excess credit for a given period, it may be necessary to compute it from some of the fundamental line items on the return, rather than using the reported value for net tax owing. The proper computation of net tax for the period should be: output tax on supplies made in the period, plus any self-assessed VAT on imports, minus VAT paid on inputs used in making taxable supplies. If this value does need to be recomputed, it will need to be computed on a taxpayer by taxpayer basis.
The amount of excess credit used to offset tax owing is generally not recorded explicitly on either the return or in the return database. The method for determining this value is: if the net tax owing (as determined above) is greater than zero, and the excess credit carried forward is greater than zero then the amount of excess credit used as a tax payment is either the net tax owing, if the excess credit carried forward is greater than the net tax owing, or the excess credit carried forward, if the net tax owing is greater than the excess credit carried forward.
Most tax administration information systems keep track of the original values on a tax return, plus all subsequent changes. As the notion with this compliance gap measure is to attempt to measure only voluntary compliance, then it is important that the return values used not reflect any subsequent assessment actions by the authorities.
Some compromise might be needed in regards to the assessed values, as not all administration information systems record the date for all changes to a return. As such, the compliance gap calculation might have to specify that it is based on the assessed data as of the date of extraction. Managing a consistent timeframe between each annual measurement would then involve maintaining a fairly consistent data extraction anniversary date.
While an argument could be made that a value for the compliance gap measured purely as CPV—AV is of more relevance, as it provides the authorities and policy makers a value for the potential yield to be gained in particular period from increased compliance efforts, this can be misleading—the value does not on its own give an indication of how much of that yield might be reasonably gained.
However, the sample used for the business survey excludes firms employing more than 250 people (see below).
The registration threshold for VAT in Denmark is Kr 50,000 per year, which is very low; so businesses in this context include individuals with part-time self-employed work or hobby sales. There is no lower threshold for PIT and CIT so all active businesses, including the self-employed, should be registered for tax.
Tax gap estimates for those years not covered by a random audit program are projected from the years that are by using growth in the relevant head of duty receipts.
Until 2011, the Finance Act specified that the tax gap for PIT should be estimated using national accounts data to estimate the potential revenue. However, SKAT found that the national accounts data was insufficiently detailed and that the results of such an approach were very volatile. Consequently, they used the results of their random audit program to estimate the PIT gap, which approach is now supported by the Finance Act.
For VAT, SKAT attributes observed noncompliance to 69 error types. However, for the majority of these types only a very small number of instances are observed in random audit programs. Estimates of the impact of each of those types are not published, because the sub samples involved are too small to allow reliable inferences to be drawn. For example, in the 2008 program, the individual impacts of 22 of the 69 error types were reported in SKAT’s report.
SKAT reviewed the possibility of estimating tax gaps for tobacco, alcohol and soda water excise duties some years ago, but were unable to identify a sufficiently robust and cost-effective methodological (top-down) approach to such estimates. Their current proposal is to use a random audit program for excise duties.
The correspondence between this number and the number of error types reported in SKAT’s tax gap reports is simply a coincidence—there is no link between the two groupings