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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.

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    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

    Actual non-pursuable debt

    311

    164

    83

    Provisional non-pursuable debt

    269

    415

    497

    Total non-pursuable debt

    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

    1.1

    Estimate unreported amounts for sample and extrapolate to population *($m)

    4,881

    5,226

    4,928

    1.2

    Apply estimate for people outside the system ($m)

    951

    967

    969

    2.1

    Apply estimate for non-detection (excluding hidden wages) ($m)

    3,168

    3,343

    3,313

    2.2

    Apply estimate for hidden wages ($m)

    482

    491

    493

    3

    add Non-pursuable debt ($m)

    348

    348

    348

    4

    equals Gross gap ($m)

    9,829

    10,376

    10,051

    5.1

    subtract Compliance outcomes and voluntary disclosures ($m)

    748

    748

    748

    5.2

    equals Net gap ($m)

    9,081

    9,628

    9,303

    6.1

    add Tax paid ($m)

    64,870

    65,440

    70,594

    6.2

    equals Theoretical tax liability ($m)

    73,952

    75,067

    79,897

    6.3

    Gross gap (%)

    13.3

    13.8

    12.6

    6.4

    Net gap (%)

    12.3

    12.8

    11.6

    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

    1.1

    Estimate unreported amounts for sample and extrapolate to population ($m)

    1,201

    1,083

    1,275

    1.2

    Apply estimate for people outside the system ($m)

    n/a

    n/a

    n/a

    2.1

    Apply estimate for non-detection (excluding hidden wages) ($m)

    459

    413

    459

    2.2

    Apply estimate for hidden wages ($m)

    n/a

    n/a

    n/a

    3

    add Non-pursuable debt ($m)

    231

    231

    231

    4

    equals Gross gap ($m)

    1,891

    1,727

    1,966

    5.1

    subtract Compliance outcomes and voluntary disclosures ($m)

    155

    155

    188

    5.2

    equals Net gap ($m)

    1,736

    1,572

    1,777

    6.1

    add Tax paid ($m)

    12,842

    13,290

    15,080

    6.2

    equals Theoretical tax liability ($m)

    14,578

    14,863

    16,858

    6.3

    Gross gap (%)

    13.0

    11.6

    11.7

    6.4

    Net gap (%)

    11.9

    10.6

    10.5

    Limitations

    The limitations associated with the estimation of the small business income tax gap are:

    • The 2018 estimate uses two of the three finalised random enquiry program sample years. This will be updated in future estimates.
    • 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.

    Non-detection of deductions in the individuals in business population is applied differently. This is because there is no incentive for taxpayers to under-declare 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 declared.

    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.

    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-declare 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 declared.

    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

    Business income

    3,568

    3,696

    3,715

    Deductions and other issues

    58

    60

    57

    Hidden wages

    482

    491

    493

    Total non-detection

    4,108

    4,248

    4,265

    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 2017–18 is estimated to be $6.7 billion. The majority of this ($5.2 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 65% of the overall gross gap in 2015–16 to 56% of the gross gap in 2017–18. 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

    Hidden wages

    482

    491

    493

    People outside the system

    951

    967

    969

    Undisclosed business income and over-claimed business deductions

    6,172

    5,259

    5,215

    Total shadow economy impact

    7,605

    6,718

    6,677

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      Last modified: 19 Oct 2020QC 59986