Small business income tax gap 2018-19
This information is for historical purposes only. If you require previously published content for past estimates, please email taxgap@ato.gov.au.
This estimate for the small business income tax gap relates to the 2018–19 financial year.
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This gap forms part of our overall tax performance program.
There are over four million small businesses in Australia they contribute around 30% of income tax paid. The small business population comprises a diverse range of structures and operations. It covers business with a turnover of up to $10 million.
Small business operating structures can include:
- companies
- sole traders
- small business proprietors
- trusts
- partnerships.
The taxation of small business income differs depending on the structure of the business, turnover and relevant tax rates for the income year.
When calculating the income tax gap, our primary focus is on entities that have an income tax obligation. In our small business population, this includes:
- companies with a turnover up to $10 million
- individuals associated with small business (including partnerships, trusts and companies with a turnover up to $10 million)
- sole traders receiving business income up to $10 million.
Around 96% of small businesses seek advice and services from a tax practitioner to help operate their businesses. This may be an accountant, tax agent, BAS agent or bookkeeper.
The latest estimate of the net small business income tax gap for 2018–19 is $12.5 billion or 12.7%. In other words, we're estimating small business to have paid around 87% of the total theoretical tax payable in 2018–19. This estimate is preliminary and subject to revision.
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Trends and latest findings
The small business net tax gap has ranged between 12.5% and 11.7% over the three-year period from 2015–16 to 2017–18. Over those three years, we have seen an increase in tax collected for this population. Through this period of increasing tax payments, the overall tax gap percentage has decreased slightly.
The estimate for 2018–19 is expected to be impacted by revisions in future years. At present the preliminary estimate shows an overall increase on the previous year but is more in line historical results.
Internationally, tax gaps are difficult to compare. There are large variations in legal and tax systems across tax jurisdictions. Market definitions, availability of data and the methodologies used to estimate gaps vary across countries.
Our findings are not directly comparable due to the administrative and legal differences between tax jurisdictions. But they are in line with research from other countries that also measure tax gaps, such as the United Kingdom.
Table 1 shows the tax reported, adjustments, gross and net gaps from 2015–16 to 2018–19.
Table 1: Income tax gap – small business income tax groups, 2015–16 to 2018–19
Element
|
2015–16
|
2016–17
|
2017–18
|
2018-19
|
Population (m)
|
4.73
|
4.78
|
4.83
|
5.0
|
Gross gap ($m)
|
11,816
|
12,188
|
12,119
|
13,451
|
Amendments ($m)
|
788
|
896
|
984
|
951
|
Net gap ($m)
|
11,027
|
11,292
|
11,135
|
12,500
|
Tax paid ($m)
|
77,527
|
78,754
|
84,336
|
85,946
|
Theoretical liability ($m)
|
88,554
|
90,046
|
95,470
|
98,445
|
Gross gap (%)
|
13.3
|
13.5
|
12.7
|
13.7
|
Net gap (%)
|
12.5
|
12.5
|
11.7
|
12.7
|
Figure 1 displays the gross and net gap for small businesses as a percentage over the same period.
Figure 1: Gross and net tax gap percentages, 2015–16 to 2018–19
Note: The estimate for 2018–19 is preliminary and is subject to revision
Tax gap components and the small business population
The main components of the small business income tax gap are:
- omitted income
- over-claimed deductions
- people outside the tax system, for example, cash-only businesses operating without an Australian business number (ABN)
- non-pursuable debt, that is not economical for us to pursue.
The extent to which these components impact the tax gap shifts depending on the segment of the small business population.
The following three charts split the tax gap by small business population and the main drivers of non-compliance for each of them.
Figure 2: Small companies
For the companies component of the gap, we see that omission of income accounts for almost half of the overall gap (48%). Over-claimed business deductions also represent a significant portion of the gap (38%).
Figure 3: Individuals in business
For the individuals in business component, the main driver of the gap relates to omission of income (71%). We also recognise the influence of people outside the system contributing to the overall gap.
Figure 4: Combined small business
The final combined view shows the overall influence of omitted income on the gap (68%).
Findings from the random enquiry program
The small business random enquiry program contributes to the calculation of the tax gap estimate and helps us to identify the most common issues and behaviours driving the tax gap.
Our findings are based on the outcome of 2,005 reviews and audits conducted across a representative sample of the small business population for 2015–16, 2016–17 and 2017–18.
We used data from the 2016–17 and 2017–18 reviews and audits in conjunction with lodgment data from 2018–19 to give us the projection of the small business income tax gap estimate for 2018–19.
Our observations from our reviews and audits highlight three key areas warranting our attention – the need to:
- address shadow economy activity (deliberate attempts to avoid paying the right tax – also known as black economy activity)
- continue to provide education and support
- make it easier to comply with the law, particularly where there are multiple layers of complexity.
Small business behaviours observed
Most of the small business taxpayers reviewed in the sample were found to have reported correctly or were considered to have genuinely attempted to do so.
Where incorrect reporting was identified, the most common issues we saw included:
- undeclared income
- business owners failing to account for private use of business assets or funds
- inadequate record keeping systems or business owners not keeping the required records.
We observed a range of behaviours relating to adjustments, including:
- misunderstanding or misapplication of tax law
- carelessness
- poor record keeping and lack of reconciliation processes
- business owners appearing to deliberately avoid paying the right tax (for example, making minimal effort to comply with their obligations)
- deliberate attempts to avoid paying the right tax (this behaviour is known as shadow economy or black economy behaviour).
Shadow economy behaviour observed
The tax effect of the shadow (black) economy for small business in 2018–19 is estimated to be $6.3 billion (or around 47% of the gross income tax gap). The majority of this activity ($4.3 billion) is associated with deliberate under-reporting of business income and over-claiming of business deductions.
While shadow economy behaviour is still contributing significantly to the tax gap, only 3.5% of the small business taxpayers reviewed as part of the random enquiry program sample clearly made deliberate attempts to avoid paying the right tax.
Tax practitioner behaviours observed
Tax practitioners can play a role in shaping the reporting behaviours of small business as most small businesses have some form of tax practitioner representation.
In the random enquiry program, we saw many examples of tax practitioners helping small businesses to report correctly. However, we also identified:
- some mistakes as a result of tax practitioners failing to show reasonable care
- a small number of tax practitioners aiding a taxpayer's deliberate attempt to avoid paying the right tax.
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ATO action to reduce the gap
It is important to acknowledge the impact that COVID-19 poses to Australia's small business community. While the longer-term effects are still unfolding, we are exploring ways to deliver quality services and provide ongoing assistance to help the community recover. Balanced compliance approaches are in place to support those in need and ensure fairness in the tax and superannuation systems.
Equally, it is important to recognise the role Australia's tax system plays in supporting the community. Protecting the integrity of the tax system and maintaining its effectiveness is critical.
The key to an effective tax system is a high level of willing participation. The extent of taxpayers' willingness to participate depends on whether they:
- value the tax and superannuation systems
- have trust and confidence in us as administrators.
Our strategies to reduce the gap and encourage willing participation are based on these principles. They include:
- offering a range of tools and services, making it easier for small businesses to get their tax and super right and navigate some of the complexities of the system
- working closely with tax practitioners and our other partners, helping us to deliver integrated strategies to engage with small businesses.
- balancing the small business community's need for guidance, support and empathy with our regulatory role.
The shadow economy has an impact on the tax gap, and on honest small business owners. We're continuing our focus on businesses that actively avoid paying the right amount of tax by:
- enhancing our enforcement strategies to better target those doing the wrong thing
- using data-matching, risk modelling, benchmarks and third-party data to identify at-risk businesses.
We also provide insights to government, through Treasury. We point out potential opportunities for statutory law reform to improve the tax system. We do this where we see the law is difficult to apply, and where compliance costs are unreasonable. In addition, we suggest where the law can be strengthened. This will allow us to more effectively deal with compliance risks.
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Methodology
The small business tax gap estimate is derived through applying the random enquiry program bottom-up method.
There are two population estimates within the small business population:
- individuals in business
- small companies.
Each estimate uses the same overall steps for determining the gap, but due to separate characteristics they are calculated separately. The steps we used are detailed below followed by a summary table for each population. Overall results for the combined estimate were shown in Table 1:
Step 1: Estimate unreported amounts and apply the estimate for people outside the system
Step 1 is the main step. It identifies the average amendment and rate of amendments of reviewed taxpayers for each population. This is drawn from the relevant sample data for up to three years for any one year. This average is then extrapolated to the relevant population to estimate the unreported tax liability base.
The estimate for people outside the system draws on comparisons of Australian Bureau of Statistics (ABS) Census of Population and Housing (Census) data with tax return data. This provides an estimate of the number of non-lodging individuals in business.
We then estimate a dollar impact drawing on the random sample data to determine the final amount. We discuss this further in Accounting for the shadow economy.
Step 2: Estimate for non-detection and hidden wages
For non-detection, we account for imperfections in the process that could lead to the final gap estimate not reflecting the true tax gap. We apply uplifts to observed results based on the midpoint of international ranges.
Additionally, we apply an uplift for hidden wages to the individuals in business population. This is consistent with our wider program for wages. We discuss this further in Accounting for non-detection in the gap.
Step 3: Estimate for non-pursuable debt
We add in the value of non-pursuable debt. This is debt that the Commissioner of Taxation has assessed as being not legally recoverable, uneconomical to pursue, or unable to be pursued due to another Act.
Debt trends show that it takes upwards of five years for non-pursuable amounts to crystallise in any one income year. As a result, we add a provisional amount of non-pursuable debt to the actual amount recorded, based on a three-year average from previous years. This is outside the data shown in Table 2 and smooths results, leading to all years below being the same. As we refresh and move these estimates forward, we will revise these figures.
Table 2 provides a summary of the actual and provisional amounts of non-pursuable debt.
Table 2: Summary of non-pursuable debt for small business ($ million)
Description
|
2015–16
|
2016–17
|
2017–18
|
2018–19
|
Actual non-pursuable debt
|
310
|
164
|
83
|
43
|
Provisional non-pursuable debt
|
269
|
415
|
496
|
536
|
Total non-pursuable debt
|
579
|
579
|
579
|
579
|
Step 4: Estimate gross gap
Next, we add the results of steps 1 to 3 to arrive at the gross gap estimate.
Step 5: Estimate net gap
This step takes the gross gap from Step 4. It then deducts compliance outcomes and voluntary disclosure amounts to arrive at the net gap estimate.
As it can take up to four years for all compliance results to be concluded, we use a provision in the three most recent years to reflect our expected final amendments. Where actual results are higher than this provision, we reflect the actual amendments present.
Step 6: Estimate the theoretical liability
We determine the tax paid by adding compliance outcomes and voluntary disclosures to the tax voluntarily reported and paid amount. We then add the net gap to tax paid amount to estimate the theoretical tax liability.
Summary of estimation process
Table 3 shows the dollar value in millions at steps 1 to 6.2 for the individuals in business element. Step 6.3 and 6.4 show percentage figures for the gross and net gaps.
Table 3: Applying the methodology – individuals in business element ($ million)
Step
|
Description
|
2015–16
|
2016–17
|
2017–18
|
2018–19
|
1.1
|
Estimate unreported amounts for sample and extrapolate to population *($m)
|
4,897
|
5,301
|
4,949
|
5,714
|
1.2
|
Apply estimate for people outside the system ($m)
|
1,002
|
1,058
|
1,311
|
1,450
|
2.1
|
Apply estimate for non-detection (excluding hidden wages) ($m)
|
3,190
|
3,359
|
3,337
|
3,757
|
2.2
|
Apply estimate for hidden wages ($m)
|
479
|
489
|
522
|
567
|
3
|
add Non-pursuable debt ($m)
|
348
|
348
|
348
|
348
|
4
|
equals Gross gap ($m)
|
9,915
|
10,554
|
10,467
|
11,835
|
5.1
|
subtract Compliance outcomes and voluntary disclosures ($m)
|
667
|
772
|
772
|
772
|
5.2
|
equals Net gap ($m)
|
9,249
|
9,782
|
9,694
|
11,062
|
6.1
|
add Tax paid ($m)
|
64,779
|
65,644
|
69,730
|
71,675
|
6.2
|
equals Theoretical tax liability ($m)
|
74,028
|
75,426
|
79,424
|
82,737
|
6.3
|
Gross gap (%)
|
13.4
|
14.0
|
13.2
|
14.3
|
6.4
|
Net gap (%)
|
12.5
|
13.0
|
12.2
|
13.4
|
Table 4 shows the dollar value in millions at steps 1 to 6.2 for the small companies element. Step 6.3 and Step 6.4 show percentage figures for the gross and net gaps.
Table 4: Applying the methodology – small companies element ($ million)
Step
|
Description
|
2015–16
|
2016–17
|
2017–18
|
2018–19
|
1.1
|
Estimate unreported amounts for sample and extrapolate to population ($m)
|
1,221
|
1,026
|
1,054
|
1,003
|
1.2
|
Apply estimate for people outside the system ($m)
|
n/a
|
n/a
|
n/a
|
n/a
|
2.1
|
Apply estimate for non-detection (excluding hidden wages) ($m)
|
448
|
376
|
367
|
382
|
2.2
|
Apply estimate for hidden wages ($m)
|
n/a
|
n/a
|
n/a
|
n/a
|
3
|
add Non-pursuable debt ($m)
|
231
|
231
|
231
|
231
|
4
|
equals Gross gap ($m)
|
1,900
|
1,634
|
1,652
|
1,616
|
5.1
|
subtract Compliance outcomes and voluntary disclosures ($m)
|
122
|
124
|
212
|
179
|
5.2
|
equals Net gap ($m)
|
1,779
|
1,510
|
1,440
|
1,438
|
6.1
|
add Tax paid ($m)
|
12,748
|
13,110
|
14,606
|
14,271
|
6.2
|
equals Theoretical tax liability ($m)
|
14,526
|
14,620
|
16,047
|
15,709
|
6.3
|
Gross gap (%)
|
13.1
|
11.2
|
10.3
|
10.3
|
6.4
|
Net gap (%)
|
12.2
|
10.3
|
9.0
|
9.2
|
Limitations
The limitations associated with the estimation of the small business income tax gap are:
- The 2019 preliminary estimate uses two of the three finalised random enquiry program sample years. Future estimates will be updated to include outcomes from the 2019 sample.
- The 2018 sample year was impacted by a hold on compliance activities as a result of the COVID-19 crisis.
- The precision of our estimate is limited by the sample size of the random enquiry program. Through the use of an ongoing bundled sample we seek to maintain suitable confidence intervals over time.
- We are working to develop non-detection estimates for random enquiry programs in the Australian environment. In the interim we are using the midpoint estimate for credible international estimates used by the United Kingdom and United States.
- Estimates for the tax impact of people outside the system are difficult to estimate. This estimate will always be subject to significant uncertainty.
- There is no independent data source that can provide a credible or reliable macroeconomic-based estimate (unlike for indirect taxes).
Accounting for non-detection in the gap
The ability to discover the full extent of non-compliance is different across the small business income tax population. Applying uniform non-detection uplifts to the estimate would exaggerate the size of the final tax gap. A different uplift is applied to the deduction labels of small business tax returns.
The impact of non-detection across the small business income tax gap is also different across the two populations represented in this estimate:
Individuals in business
Within the individuals in business population, the following three areas require an estimate to account for non-detection:
- business income
- deductions
- wages received.
The uplift for business income not detected forms the largest component of non-detection. This recognises the difficulty in detecting omitted income where little or no third-party reporting systems are available. We apply uplifts to observed results based on the midpoint of international ranges. With increased third-party reporting and data matching being introduced, the uplift factors will be reviewed over the next 12 months.
Non-detection of deductions in the individuals in business population is applied differently. This is because there is no incentive for taxpayers to under-claim deductions on their tax return. Therefore, the uplift for non-detection for deductions is confined to the capacity to detect errors in tax returns where deductions have been claimed.
Actual wages received by individuals in business can be difficult to validate in a random enquiry program. We used a macro estimate based on the hidden wages element used in the pay as you go (PAYG) withholding and super guarantee (SG) gap estimates.
An estimate for wages not detected in the random enquiry program and wages not detected for people operating outside the system was reconciled to the hidden wages analysis undertaken in the PAYG withholding gap estimate. The result provides an estimate for the amount of wages not detected in the individuals in business population within the small business income tax gap population.
Small companies
The small companies element has only two areas that require an estimate to account for non-detection:
- business income
- deductions.
Like the uplift for individuals in business, the uplift for small company business income not detected forms the largest component of our estimate. We recognise the difficulty in detecting omitted income by small companies. This is where no, or limited, third-party reporting systems are available. We apply uplifts to observed results based on the midpoint of international ranges. With increased third-party reporting and data matching being introduced, the uplift factors will be reviewed over the next 12 months.
Similar to the individuals in business population, non-detection of deductions and other issues in the small companies population is applied differently. This is because there is no incentive for taxpayers to under-claimed deductions on their tax return. Therefore, the uplift for non-detection for deductions is confined to the capacity to detect errors in tax returns where deductions have been claimed.
Combined impact of non-detection
Table 5 shows a summary of the combined impact of non-detection on the small business income tax gap.
Table 5: Summary of the impact of non-detection on the gap ($ million)
Source of non-detection
|
2015–16
|
2016–17
|
2017–18
|
2018–19
|
Business income
|
3,579
|
3,673
|
3,651
|
4,079
|
Deductions and other issues
|
59
|
62
|
54
|
60
|
Hidden wages
|
479
|
489
|
522
|
567
|
Total non-detection
|
4,117
|
4,223
|
4,226
|
4,706
|
Accounting for the shadow economy
For tax gap purposes we focus on the shadow economy definition in the Black Economy Taskforce final report. This is based on Organisation for Economic Co-operation and Development (OECD) definitions of underground production and illegal activityExternal Link.
The OECD definition of underground production is key. It covers activities that are productive and legal but are deliberately concealed to avoid payment of taxes or compliance with regulations (or both). Therefore, the shadow economy element in this gap is related to underground production.
The shadow economy estimate within the small business income tax gap is also separated into the calculations for individuals in business, and companies. Within these two broad categories, there are three main elements:
- deliberate non-disclosure of business income and deliberate over-claiming of business deductions
- hidden wages – predominantly individuals in the population receiving cash-in-hand wages. This is estimated using a top-down model approach drawing on random enquiry observations
- people outside the system – where we use an ABS Census comparison approach.
When analysing the reasons for non-compliance, we sought to identify aspects of behaviour that indicated a deliberate intention to hide business activity.
We added a component to the individuals in business population gap estimate that is not included in non-detection, which is to account for people outside the tax system. This element seeks to estimate the amount of omitted income from these people. To quantify this element, we assumed that the incidence and relative magnitude of income non-compliance in the random enquiry sample is also representative of people outside the system.
The tax effect of the shadow economy for small business in 2018–19 is estimated to be $6.3 billion. The majority of this ($4.3 billion) is associated with under-reported business income and over-claimed business deductions.
The impacts of the shadow economy on the community, and how we address them, are outlined in Tax and small business.
Table 6 shows a summary of the impact of the shadow economy on the gross tax gap. This amount has declined from 56% of the overall gross gap in 2015–16 to 47% of the gross gap in 2018–19. For this estimate we assume the same percentage applies to the net gap.
Table 6: Summary of the impact of the shadow economy on the gross gap ($ million)
Element
|
2015–16
|
2016–17
|
2017–18
|
2018–19
|
Hidden wages
|
479
|
489
|
522
|
567
|
People outside the system
|
1,002
|
1,058
|
1,311
|
1,450
|
Undisclosed business income and over-claimed business deductions
|
5,106
|
4,544
|
3,690
|
4,256
|
Total shadow economy impact
|
6,586
|
6,091
|
5,523
|
6,273
|
Updates and revisions to previous estimates
Each year we refresh our estimates in line with the annual report. Changes from previously published estimates occur for many reasons, including
- improvements in methodology
- revisions to data
- additional information becoming available
We have refreshed our previous estimate to consider updates in underlying data and refinements to the methodology, so that the results between years remain comparable.
Figure 5 displays the net gap from our current model compared to the previous estimate, undertaken in 2020.
Figure 5: Current and previous small business net tax gap estimates, 2015–16 to 2018–19
The data is set out as a percentage in Table 7.
Table 7: Current and previous small business net tax gap estimates, 2015–16 to 2017–18
|
2015–16
|
2016–17
|
2017–18
|
2018–19
|
2019 Program
|
12.5%
|
n/a
|
n/a
|
n/a
|
2020 Program
|
12.2%
|
12.5%
|
11.5%
|
n/a
|
2021 Program
|
12.5%
|
12.5%
|
11.7%
|
12.7%
|
Reliability
We seek feedback and advice about the methods we use to estimate the gap from our external and internal subject matter experts. Based on the advice and assessment, the reliability rating for this estimate is medium (with a score of 19).
We have stratified the sampling process to ensure it is representative of the wider population. Additionally, the estimate for people outside the tax system is preliminary and will require further development.
We engaged a former Deputy President of the Administrative Appeals Tribunal (AAT), Mr Stephen Frost, for further assurance. He verified the accuracy and quality of a sample of the audit results that underpin our tax gap estimate.
Figure 6: Reliability rating scale from very low to very high – small business income tax gap
This estimate for the small business income tax gap relates to the 2018–19 financial year.