The 'tax gap' gained significant attention during the General Election, with both major parties promising to reduce it to enhance state finances. However, reducing the tax gap is a complex issue due to several factors:
- Firstly, the UK tax gap is estimated at £39.8 billion, which, while substantial, represents only 4.8% of total tax liabilities and has decreased by about a third since 2005/06.
- Contrary to the common belief that wealthy individuals are the primary contributors to the tax gap, they account for less than 9% of it. Criminal activities contribute another 9%, while large and medium-sized businesses each contribute 11%. The majority, 60%, comes from small businesses.
- However, these figures should be interpreted cautiously. They are derived from multiple sources, but the only easily verifiable component is the VAT gap, estimated at £8 billion, calculated by comparing theoretical tax from national consumption with actual tax collected. This represents about 20% of the data used in arriving at the tax gap figure The remaining 80% is based on theoretical models, which, according to HMRC, have medium to very high uncertainty ratings, implying a considerable amount of estimation. 23% of the data falls into the “high” and “very high” categories.
- The potential for further reducing the tax gap remains uncertain. HMRC's efforts to curb 'aggressive avoidance' – referring to artificial tax schemes – have successfully reduced this part of the gap by two-thirds since 2005/06. However, the extent of 'less aggressive' avoidance, which is legal, is not quantified and undermines the credibility of the theoretical models.
- Even if undeclared economic activity occurs, it might not always result in tax liabilities. Many micro businesses, operating below the annual personal allowance of £12,570, fall outside the taxable threshold. Thus, the rise in the small business gap may to some extent simply represent low earners in the 'gig economy' who are not required to register for tax.
Despite the consistent methodology of these calculations indicating a steady year-on-year reduction in the gap, the absolute size of the gap remains debatable. In the long term, the gap will likely shrink due to several factors. Cash is gradually disappearing from the economy, and the 'Making Tax Digital' initiative from April 2026 will give HMRC greater access to business records. This might encourage more careful tax reporting or improve the accuracy of tax gap calculations. Nonetheless, whether these measures will significantly impact state finances remains uncertain.
*The views expressed are the author's and not ICAEW's