Terry Baucher mulls the hidden economy and concludes IRD should look more closely at the tax gap

By Terry Baucher*

During TVNZ’s Breakfast’s recent story on tradies offering cash “discounts”, Inland Revenue’s Andrew Stott was asked about the size of the hidden economy, or the “tax gap”. He replied it could involve “hundreds of millions” of dollars, before conceding it was a “big problem”

How big? 

We don’t know. Or as a Treasury report put it in January 2013, “There are no reliable estimates of the size of the tax gap in New Zealand.” 

This is in part because measuring the tax gap is difficult. As Victoria University of Wellington researchers noted in a September 2012 methodological review of the tax gap “…almost all of the methods proposed or implemented have been subjected to severe criticisms” The Victoria University paper defined the tax gap as:

“broadly the difference between the tax revenue collected and that which would be expected to be collected in the absence of any evasion or late payment.” It therefore encompasses not just deliberate tax evasion as in the hidden economy but also aggressive tax planning and non-compliance through ignorance."

But if measuring the tax gap is difficult, this doesn’t stop an increasing number of tax authorities from attempting to do so. The Canada Revenue Authority’s first estimate of its tax gap in relation to GST put it at 5.6% of collections. 

Across the Ditch, the Australian Tax Office’s has been publishing tax gap estimates for GST and luxury car tax since 2012, and estimates its GST tax gap as 4.9% of collections. 

HM Revenue and Customs (HMRC) in the United Kingdom probably has the most comprehensive and sophisticated tax gap analysis at present. It’s been estimating its tax gap since 2000 and has been publishing annual reports since 2009. Its latest report estimates the British tax gap at £34 billion annually or about 6.4% of total theoretical tax liabilities. The tax gap for VAT, the British equivalent of GST, was the highest of all taxes measured at 11.1%. 

So what’s Inland Revenue doing about the tax gap? Not as much as perhaps it should. At the moment Inland Revenue doesn’t publish estimates of New Zealand’s tax gap and a search of its 2015 annual report found no mention of the term.

(Similarly, none of Inland Revenue’s Briefings to Incoming Ministers of Revenue between 2008 and 2015 contain any specific reference to the tax gap and also say very little about the hidden economy).

Although determining the tax gap might not be a specific priority for Inland Revenue, the hidden economy is one of its key focus areas. In the year to 30 June 2015 it identified discrepancies of $146 million in the sector and its investigation activities in countering aggressive tax planning yielded $336.9 million (including $191.1 million from examining complex finance and trust losses). 

With the current building boom in Auckland and Christchurch, Inland Revenue has plenty of targets. 

The Breakfast story revealed that 50% of the tradies working on house renovations for a TVNZ reporter offered “discounts” for cash without prompting from the reporter. This was for work with a value of between $10,000 and $18,000. As Mr Stott acknowledged Inland Revenue investigators have seen similar amounts. 

In the subsequent “Breakfast Club” panel discussion several participants admitted to paying tradies cash for minor repairs and renovations. No-one on the panel seemed particularly concerned about this.

Similarly, although Andrew Stott pointed out the risks of making cash payments, 70% of the nearly 4,000 respondents to a TVNZ Facebook poll saw no problem with tradies doing “cash jobs” that they don’t declare for tax.

A few hundred dollars here or there paid to tradies doesn’t seem like much. Although most people use eftpos when purchasing from cafes, dairies or restaurants, they probably think little of it if a cash sale is not rung through the till. 

But the hidden economy isn’t just the building and hospitality sectors. It includes any industry where cash is frequently used such as the scrap metal industry and also the myriad of micro-businesses carrying out service activities who do not register for GST. (Unofficially, maybe 15% of all contractors do not fully comply with their income tax and GST obligations). Then there’s illegal activities such as the drug trade and trading in stolen goods such as cigarettes. (Just because an activity is illegal doesn’t exempt it from tax, as Al Capone found out to his cost). 

All this adds up to a much bigger tax gap than most people realise. After noting the lack of “reliable estimates” Treasury concluded in its January 2013 report to the Long Term Fiscal External Panel:

“A reasonable general order of magnitude for the tax gap across OECD countries would be 5 to 20 percent of total tax collections. This implies a tax gap for New Zealand of around $3-11bn. We expect New Zealand to be at the lower end of this general range owing to our general broad-base, low-rate tax settings, significant reliance on indirect taxes, and low levels of corruption – all things that are thought to be correlated with a smaller tax gap.“ 

This seems a dangerously complacent view. Anecdotal evidence such as the TVNZ Facebook poll points to taxpayers having a somewhat “relaxed” view about accepting cash “discounts” from tradies. (On the other hand quite a few Facebook commenters also expressed dissatisfaction about multinationals not paying their fair share). In any case, even if the tax gap is at the lower end of Treasury’s estimate, $3 billion (in 2012 dollars) is hardly loose change. 

But on the basis of the maxim “What gets measured, gets managed”, maybe it’s time Inland Revenue and Treasury looked more closely at the tax gap. 

Such an investment would seem very worthwhile given that Inland Revenue’s return on investment during the 2014-15 year was $5.21 for every dollar invested into investigating the hidden economy and $34.10 for each dollar spent countering aggressive tax planning. 

Furthermore, once the tax gap is more accurately measured then Inland Revenue can use the data to promote awareness and better compliance. My impression is that most people greatly underestimate the size of the cash economy and this then colours their attitude towards accepting cash “discounts”. A wider education programme could change this attitude. 

Accordingly, I believe Inland Revenue should, like HMRC, report annually on the size of the tax gap and the measures it’s taken to reduce that gap. It would be a good step towards encouraging voluntary compliance and promoting support for the integrity of the tax system. Otherwise, it’s naïve to think that if managing and closing the tax gap isn’t seen as a major priority for Inland Revenue, the less scrupulous won’t try and take advantage.

---------------------

*Terry Baucher is an Auckland-based tax specialist and head of Baucher Consulting. You can contact him here »