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  • Small business income tax gap

    The small business income tax gap is the difference between the total amount of income tax collected from small businesses and the amount we estimate we would have collected if every one of these taxpayers was fully compliant with tax law.

    There are over four million small businesses in Australia. They contribute 30% of income tax paid. The small business population comprises a diverse range of structures and operations. It covers businesses 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, and the company's turnover and relevant tax rates for the income year.

    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 or bookkeeper.

    Estimate of the tax gap

    Our estimate for the small business income tax gap covers a single income year. For 2015–16 we estimate the net income tax gap for the small business population to be $11.1 billion or 12.5%. In other words, we estimate that small business paid more than 87% of the total theoretical tax payable in 2015–16.

    We estimated a significant portion of the gap from the results of our random enquiry program. This approach is considered best practice for large populations. We also measured the effects of the black economy in the small business population, which contributed to the estimate.

    The main issues we saw driving the gap were businesses:

    • not declaring all income
    • failing to account for private use of business assets or funds
    • not understanding their tax obligations.

    This is our first income tax gap estimate for the small business population. Consequently we have not drawn conclusions around long-term trends of the net gap. We will look to provide trends in future years as additional estimates are released.

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    Measuring the gap

    We used a bottom-up approach to measure the small business income tax gap. We drew on the results of our random enquiry program, along with other research and data we have access to.

    Random enquiry programs review the whole tax return (all items). They are therefore considered best practice when producing estimates for large populations. They allow us to estimate the general compliance levels of the lodging population.

    In addition to the random enquiry program, we used separate approaches to estimate other parts of the gap, including:

    • a modelling approach – to estimate the incidence and tax impact of people outside the system
    • a top-down approach – to estimate the impact of unreported wages
    • operational data – to identify the amount of debt that we expect will never be repaid (non-pursuable debt).

    We engage an independent expert panel to advise on the methodology used in our gap estimates. Information regarding the panel, including its members, is in Australian tax gaps – overview.

    To provide further assurance we engaged Stephen Frost, former Deputy President of the Administrative Appeals Tribunal (AAT). Mr Frost confirmed the accuracy and quality of a sample of the audit results underpinning our small business income tax gap estimate.

    We have assessed the reliability of this estimate as medium.

    Random enquiry program

    To undertake our random enquiry program, we selected a random sample of small business taxpayers for profiling. The profiling stage makes use of all information provided to us by the taxpayer. It also includes third-party data we collect and data in the public domain.

    We reviewed the affairs of the selected taxpayers as well as any of their directly associated individuals and entities. Where we identified issues, we made contact with these taxpayers and progressed them to the audit stage.

    Once we gathered information from the random enquiry program, we estimated the gap. We did this by using the incidence rate of adjustments and average value of amendments resulting from non-compliance. Adjustments are the changes we make to items on a tax return to correct errors.

    This method provides insights into the value of non-compliance. It also shows us the proportion of the sample (and by extension the population) that is incorrectly reporting.

    The small business income tax gap reflects the compliance gap. That is, it is an estimate of the tax revenue which is not collected as a result of small businesses failing to comply with the law at the time. This is whether inadvertently or intentionally.

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    Trends and latest findings

    Our small business income tax gap estimate for 2015–16 is based on a sample of 1,398 taxpayers. We are working to build a bundled sample of over 2,000 random enquiries. In this way we will look to provide a trend over time as we continue to progress the random enquiry program.

    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.

    The most common issues we observed from the random enquiry program included taxpayers:

    • not declaring all income
    • failing to account for private use of business assets or funds
    • not understanding their tax obligations.

    We observed a range of behaviours relating to the adjustments, including:

    • poor record keeping and lack of reconciliation processes
    • carelessness
    • 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 (that is, exhibiting black economy behaviour).

    The vast majority of small businesses have some form of tax practitioner representation. We saw many examples in the random enquiry program of tax practitioners helping small businesses to report correctly. However, we identified some mistakes as a result of tax practitioners failing to show due diligence.

    When we did need to make adjustments to tax returns, we saw three key areas warranting our attention:

    • the need to address black economy activity
    • the need for continued education and support
    • the need to reduce complexity – law, multiple taxes, business structures.

    The tax effect of the black economy for small business in 2015–16 is estimated to be $7.7 billion (or around 64% of the gross income tax gap). The majority of black economy activity ($6.5 billion) is associated with deliberate under-reporting of business income and over-claiming of business deductions.

    For clients that deliberately under-report income and operate in the black economy, we have a continued focus on treatment strategies, both prevention and correction. Where we detect deliberate omission of income and over-claiming of expenses, we can apply correction strategies such as penalties and prosecutions.

    Findings from the random enquiry program highlight the need for continuous education. This is to support good record keeping practises, keeping evidence of expenses and the proper setup of systems. Our findings support the work we are doing to make it easier for taxpayers to comply and hard not to. For example, through recent initiatives such as Single Touch Payroll and e-invoicing.

    Table 1: Income tax gap – small business, 2015–16

    Income tax

    $m

    %

    Gross gap

    $12,058

    13.6%

    Amendments

    $972

    n/a

    Net gap

    $11,087

    12.5%

    Tax paid

    $77,398

    n/a

    Theoretical liability

    $88,485

    n/a

    Figure 1: Amount paid and net gap – small business, 2015–16

    Bar graph showing that small business income tax paid in 2015–16 was around $77 billion and the net gap estimate is around $11 billion.

    Tax gap by population and drivers – Small business income tax, 2015–16

    The following three charts split the tax gap by small business population and the main drivers of non-compliance for each of them. These relate to: omission of income, over-claimed deductions, people outside the tax system (for example, cash-only businesses operating without an ABN), and non-pursuable debt (that is not economical for us to pursue).

    For the companies component of the gap, we see that omission of income accounts for almost half of the overall gap (47%). Over-claimed business deductions also represent a significant portion of the gap (39%).

    Figure 2: Small companies

    Doughnut chart showing small companies had: 47% omitted income, 39% overclaimed deductions, and13% non-pursuable debt.

    For the individuals in business component, the main driver of the gap relates to omission of income (76%). We also recognise the influence of people outside the system contributing to the overall gap.

    Figure 3: Individuals in business

    Doughnut chart showing individuals in business had: 76% omitted income, 14% overclaimed deductions ,7% outside the system, and 4% non-pursuable debt.

    The final combined view shows the overall influence of omitted income on the gap (71%).

    Figure 4: Combined small business

    Doughnut chart showing combined small business had: 71% omitted income, 18% overclaimed deductions, 6% outside the system, and 6% non-pursuable debt.

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    ATO action to reduce the gap

    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. This will make 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 professionals and our other partners. This will help us to deliver integrated strategies to engage with small businesses.

    The black 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 tax by:

    • implementing an enhanced enforcement strategy to better target those doing the wrong thing. This will make it fairer for those doing the right thing
    • using data-matching, risk modelling, benchmarks and third-party data to identify at-risk businesses.

    We also provide insights to government, through the Department of 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 population comprises a diverse range of structures and operations. It covers businesses with a turnover of less than $10 million. These include companies, individuals in business (sole traders), trusts and partnerships.

    Small business income is subject to different taxation regimes depending on its operating structure. The tax rate for companies depends on its turnover by year.

    The small business income tax rates are:

    • Individuals in business (sole traders and small business proprietors)  
      • are taxed at their individual marginal rate (this can be up to 45%).
       
    • Company tax rate  
      • 2015–16 – small business companies with an aggregated turnover of less than $2 million were taxed at 28.5%
      • 2015–16 – all other small business companies with a turnover between $2 million to $10 million were taxed at 30%
      • 2001–02 to 2014–15 – all small business companies were taxed at 30%, regardless of turnover.
       

    All gap estimates are made on the basis of the law as applicable for the relevant income year. New or recent law changes will be reflected in future gap estimates for the year they take effect.

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    Selecting the methodology

    The selection of an estimate methodology depends heavily on the:

    • design of the tax system
    • characteristics of the population
    • data available.

    We held early discussions at the start of the tax gap program. These highlighted the need for a random enquiry program to produce a credible gap estimate for small business. In the case of income tax for small businesses, there are no aggregate macroeconomic data sources suitable for estimating the value of a tax gap. Therefore, a top-down approach was not possible.

    We considered a predictive statistical model based on data available to us. This would include individual taxpayer data and operational audit results. However, there are data limitations with this approach, including selection bias and sensitivity to key assumptions. Models developed to date show the results are not sufficiently credible.

    To generate suitable data for estimation and avoid selection bias, we adopted a random sampling method. This method is considered best practice and highly credible. It is commonly used by international jurisdictions to estimate the tax gaps of large taxpayer populations.

    We are conscious of the potential inconvenience that random enquiry programs can have on taxpayers. So we implement them in a way that minimises the impact on small businesses. Key to this is to verify taxpayers by drawing on the data we have matched. This ensures we only contact people in the sample where we need to.

    Applying the methodology

    There are six steps in applying the random enquiry program bottom-up methodology to estimate the small business tax gap.

    Two separate calculations are used to account for the two groups within the small business income tax gap group:

    • individuals in business
    • small companies.

    The six steps are summarised in the following diagram and described in more detail below.

    Figure 5: Steps to estimate the small business income tax gap

    Six steps diagram: Step 1 - Estimate unreported amounts and extrapolate. Apply estimate for people outside the system. Step 2 - Estimate for non-detection and hidden wages Step 3 - Estimate for non-pursuable debt Step 4 - Add results from steps 1 to 3 to estimate the gross gap Step 5 - Subtract compliance outcomes and voluntary disclosures from step 4 to estimate net gap Step 6 - Add net gap and tax paid to step 5 to estimate theoretical liability.

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    Step 1: Estimate unreported amounts from the sample and extrapolate to population. Apply estimate for people outside the system.

    This is the main step. It identifies the average amendment and rate of amendments of reviewed taxpayers for each population. This 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 to 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 black 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. This is based on a three-year average from previous years.

    The following table provides a summary of the actual and provisional amounts of non-pursuable debt.

    Table 2: Summary of non-pursuable debt for small business ($m) in 2015–16

    Description

    2015–16

    Actual non-pursuable debt

    280

    Provisional non-pursuable debt

    415

    Total non-pursuable debt

    695

    Step 4: Estimate gross gap

    Next, we add the results of steps one to three to arrive at the gross gap estimate.

    Step 5: Estimate net gap

    This step takes the gross gap from step four. It then deducts compliance outcomes and voluntary disclosure amounts to arrive at the net gap estimate.

    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: Applying the methodology – Individuals in business element ($m)

    Step

    Description

    2015–16

    1.1

    Estimate unreported amounts for sample and extrapolate to population

    5,047

    1.2

    Apply estimate for people outside the system

    670

    2.1

    Apply estimate for non-detection (excluding hidden wages)

    3,417

    2.2

    Apply estimate for hidden wages

    484

    3

    add Non-pursuable debt

    426

    4

    equals Gross gap

    10,044

    5.1

    subtract Compliance outcomes and voluntary disclosures

    735

    5.2

    equals Net gap

    9,309

    6.1

    add Tax paid

    64,502

    6.2

    equals Theoretical tax liability

    73,811

    6.3

    Gross gap %

    13.6%

    6.4

    Net gap %

    12.6%

    Table 4: Applying the methodology – Small companies element ($m)

    Step

    Description

    2015–16

    1.1

    Estimate unreported amounts for sample and extrapolate to population

    1,269

    1.2

    Apply estimate for people outside the system

    N/A

    2.1

    Apply estimate for non-detection (excluding hidden wages)

    476

    2.2

    Apply estimate for hidden wages

    N/A

    3

    add Non-pursuable debt

    269

    4

    equals Gross gap

    2,014

    5.1

    subtract Compliance outcomes and voluntary disclosures

    236

    5.2

    equals Net gap

    1,778

    6.1

    add Tax paid

    12,896

    6.2

    equals Theoretical tax liability

    14,674

    6.3

    Gross gap %

    13.7%

    6.4

    Net gap %

    12.1%

    Table 5: Applying the methodology - Combined small business element ($m)

    Step

    Description

    2015–16

    1.1

    Estimate unreported amounts for sample and extrapolate to population

    6,316

    1.2

    Apply estimate for people outside the system

    670

    2.1

    Apply estimate for non-detection (excluding hidden wages)

    3,892

    2.2

    Apply estimate for hidden wages

    484

    3

    add Non-pursuable debt

    695

    4

    equals Gross gap

    12,058

    5.1

    subtract Compliance outcomes and voluntary disclosures

    972

    5.2

    equals Net gap

    11,087

    6.1

    add Tax paid

    77,398

    6.2

    equals Theoretical tax liability

    88,485

    6.3

    Gross gap %

    13.6%

    6.4

    Net gap %

    12.5%

    Limitations

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

    • The precision of this 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.
    • A further limitation of the random enquiry program, and of similar programs undertaken by tax administrators in other jurisdictions, is the uncertainty around the impact of the non-detection error. The enquiries undertaken do not discover the full extent of non-compliance.
    • 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 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 there are three areas requiring an estimate to account for non-detection:

    • business income non-detection
    • deduction non-detection
    • wages received non-detection.

    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 due to there being no incentive for taxpayers to under-declare deductions on their tax return. 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 cash wages element used in the pay as you go (PAYG) withholding and super guarantee 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 cash 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 non-detection
    • deduction non-detection.

    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 due to there being 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

    The following table shows a summary of the combined impact of non-detection on the tax gap.

    Table 6: Summary of the impact of non-detection on the gap ($m)

    Source of non-detection

    2015–16

    Business income

    3,836

    Deductions and other issues

    56

    Hidden wages

    484

    Total non-detection

    4,376

    Accounting for the black economy

    For tax gap purposes we focus on the black 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. This is to avoid payment of taxes and/or compliance with regulations. Therefore the black economy element in this gap is related to underground production.

    The black economy estimate within the small business income tax gap is also separated into 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 confronted with 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. This is to account for people outside the tax system. This element seeks to estimate the amount of omitted income from people outside the system. 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 black economy for small business in 2015–16 is estimated to be $7.7 billion. The majority of this ($6.5 billion) is associated with under-reported business income and over-claimed business deductions.

    The impacts of the black economy on the community, and how we address them, are outlined in Tax and small business.

    The following table shows a summary of the impact of the black economy on the gross tax gap. This amounts to 64% of the overall gross gap. For this estimate we assume the same percentage is present in the net gap.

    Table 7: Summary of the impact of the black economy on the gap ($m)

    Element

    2015–16

    Hidden wages

    484

    People outside the system

    670

    Undisclosed business income and over claimed business deductions

    6,542

    Total black economy impact

    7,697

    Data sources

    This gap estimate draws on the following information and data sources:

    • case data from the random enquiry program database
    • case data from our case management system
    • tax return data from our enterprise data warehouse
    • population information from our group wealth system and related entity model
    • debt written off from our enterprise data warehouse
    • demographic information from the Taxation statistics data series.

    Reliability

    An independent expert panel has assessed the ATO estimate of the small business income tax gap. This is described in Principles and approaches to measuring gaps.

    Based on advice from the independent expert panel, the reliability rating for the small business income tax gap estimate is medium.

    We have stratified the sampling process to ensure it is representative of the wider population. However, it is worth noting that we are only two years into the program. Additionally the estimate for people outside the tax system is preliminary and will require further development.

    We engaged a former Deputy President of the 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

    Chart to show the reliability rating scale from very low, low, medium, high and very high. The small business tax gap has a rating of medium.

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    Definitions

    The defined terms following are used specifically in relation to the small business income tax gap. Further definitions in relation to our broader tax gap program are available from Principles and approaches to measuring gaps.

    Black economy

    The black economy includes the 'cash economy' or 'non-observed economy'. The OECD refers to the 'economic underground'.

    The black economy involves economic activity not declared. This may be a result of attempts to avoid tax obligations.

    National Accounts data makes a small allowance for expenditure associated with the 'underground economy'. This includes cash economy transactions, transactions relating to other avoidance measures, and understating income in Australian Bureau of Statistics (ABS) surveys.

    Bottom-up approach

    A bottom-up approach involves a detailed examination of data sources. For example, tax returns, audit results, risk registers or third-party data-matching information. We then extrapolate the results to establish the extent of non-compliance across the whole population. From this we estimate the tax gap.

    This approach generally involves applying statistical techniques. These estimate the incidence of adjustment and the average value of non-compliance. A bottom-up approach is typically used for direct taxes, such as income tax.

    Individuals in business

    Individuals in business are commonly referred to as sole traders. Our definition includes individuals running a business and those with business connections. This can be through a company, partnership or trust.

    Non-detection

    Some errors are not identified in bottom-up methodologies. To fully estimate the gap, we increase the amounts that we do identify to account for the amounts we don’t. We refer to this increase as an 'uplift factor'. Non-detection is inherently difficult to estimate. We will revise the uplift factors applied as our methodologies improve.

    People outside the system

    We estimate a tax impact for people outside the system, meaning they do not lodge a tax return. This includes people who are registered in the tax and super system but fail to lodge a tax return. It also includes those who have not registered.

    Stratified sampling

    A type of statistical sampling method in which a population is divided into small sub-groups known as strata. The members within each strata will have shared characteristics that will be unique to that strata.

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    Last modified: 03 Oct 2019QC 59986