Exploring the VAT Gap: Understanding the Diverse Definitions and Calculation Methods

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Introduction

The concept of the “tax gap” has been widely studied and discussed by various nations and institutions to measure tax compliance. However, due to the complexity of tax gap measurement and the diversity of tax gap classification methods, its definition may vary significantly across sources.

In this article, we provide a variety of tax gap definitions and describe the most popular methods that are applied to the VAT gap, and used by such institutions as the European Commission, International Monetary Fund, the UK His Majesty Revenue and Customs (HMRC), and the United States Agency for International Development (USAID).

Definitions of the Tax Gap and the VAT Gap

The Tax Gap Concept

The origins of the tax gap measurement can be traced back to the implementation of the Taxpayer Compliance Measurement Program (TCMP) in the US in 1963. The TCMP aimed to estimate the number of taxpayers who fulfilled their tax obligations and evaluate potential tax revenue losses. The Internal Revenue Service (IRS) developed the concept of the tax gap to determine the level of taxpayer compliance with their federal tax obligations. Since 1979, the IRS has estimated the tax gap on multiple occasions using the TCMP, which was later replaced by the National Research Program (NRP) in 2001.^[1]

The national tax gap was defined as the difference between the revenue that would be collected if taxpayers reported all taxes owed and the revenue collected by the IRS. According to IRS, the tax gap measured the extent to which taxpayers did not file their tax returns and pay the correct tax on time.

In its studies, the IRS considers the gross tax gap (the amount of true tax liability that is not paid voluntarily and timely) and the net tax gap (the gross tax gap less tax that subsequently will be paid, either voluntarily but late or collected through IRS administrative and enforcement activities).

In the wake of the IRS’s efforts, various institutions and economies have begun to develop definitions and methodologies for measuring the tax gap. In this article, we examine the corresponding studies published by the EU Commission for the Member States, the IMF, and the HMRC, with a particular focus on VAT gap measurements. We also investigate the methodology employed by USAID to assess the overall tax gap, which is described in a separate section below.

Measuring the tax gap is crucial for countries, as it provides tax administrators and policymakers with a means of gauging the amount of tax revenues lost due to noncompliance, avoidance, and policy choices. It also helps to identify the root causes of non-compliance, determine which strategies are most effective in reducing errors and fraud, and ensure that the tax system is flexible, resilient, and responsive enough to keep up with rapid social, economic, and technological changes.

Countries need to assess the impact of each tax on the overall tax gap. Our investigation into the VAT gap measurement is primarily driven by the fact that only in the European Union member states VAT constitutes approximately one-fifth of all tax revenues, and its significance is growing globally.^[2]

VAT Gap Definitions by EU, UK, IMF, and USAID

In 2013, the European Commission released a study on the VAT gap, presenting estimated figures for 26 out of the 28 European Union member countries, covering the period from 2000 to 2011.^[3]

Subsequently, the European Commission released seven additional reports since 2013, with the latest one issued in 2020. In this report, the Commission used two types of VAT gap: compliance VAT gap and policy VAT gap.

The VAT gap was defined as the difference between the VAT collections recorded by Eurostat and the VAT total tax liability (VTTL) each year. The VTTL is the VAT liability specified by the VAT law, and the European Commission’s calculations mainly focused on the compliance VAT gap.

In addition, the European Commission’s study also considered the impact of exemptions and reduced rates applied by policies on the tax gap. The definition of the tax gap used by the UK HMRC is like the one provided in the EU study.^[4]

In line with the Revenue Administration GAP Analysis Program (RA-GAP), the International Monetary Fund (IMF) defines the VAT gap as the difference between actual VAT determined on the accrued collections basis and potential VAT estimated using the reference policy framework.^[5] This definition encompasses two components: the compliance gap and the policy gap.

The compliance gap represents the variance between actual VAT determined on the accrued collections basis and potential VAT estimated using the current policy framework. On the other hand, the policy gap refers to the difference between the potential VAT estimated using the reference policy framework and the potential VAT estimated using the current policy framework. The IMF report evaluates both components of the VAT gap.

The United States Agency for International Development (USAID) has a broader concept of the tax gap than that of the EU and the IMF. In the Collecting Taxes Data-base (CTD),^[6] the tax gap refers not only to actual losses and expenses that a national economy incurs due to non-compliance with the tax law and the application of reduced rates or exemptions but also includes a third component: the underestimated potential (loss of opportunity) of a country’s social and economic conditions.

Based on USAID’s perspective, the tax gap is not just the difference between what is collected and what could be collected under the existing tax law, but rather a more complex calculation that also includes the country’s tax capacity and tax effort. Tax capacity is the maximum amount of tax a country could collect based on economic, demographic, and institutional factors.

On the other hand, tax effort measures how close a country is to achieving its full tax capacity. These two factors provide a more comprehensive view of the tax gap, considering various economic conditions, government policies, tax collection systems, and processes.

All the above definitions refer to the national tax gap which is composed of various transactional tax gaps at a micro level. The transactional tax gap refers to the difference between the amount of tax owed on individual transactions subject to a tax and the amount of tax actually collected by the tax authority.

In business-to-business (B2B) transactions, the customer is always concerned with the deductibility or refund of the VAT charged by the supplier. Sometimes taxpayers may use optimization schemes with the help of “technical” and “terminal” firms to take advantage of their input VAT deduction right, but unintentional mistakes of taxpayers can also lead to transactional VAT gaps.

In business-to-consumer (B2C) transactions, VAT gaps appear mostly due to the failure of issuing receipts to consumers. The monitoring of the VAT Gap is crucial due to several reasons:

• The VAT Gap serves as a measure of the efficiency of national tax administrations in collecting VAT.
• Losses in VAT revenues can significantly impact public services such as schools, hospitals, and transportation.
• Assessing the magnitude of the VAT Gap can aid in developing targeted measures to address non-compliance and evaluating their effectiveness.

A Summary of Methods for Measuring the VAT Gap

There are several approaches for measuring the VAT compliance gap, including:

Top-down methods:

1. The consumption-side method
2. The production side method
3. VAT policy gap method
4. Econometric techniques

Bottom-up methods:

1. Risk-based audits
2. Random enquiry programs

Each method has its advantages and limitations, and the choice of method depends on the availability of data and the specific needs of the tax administration.

Top-down Estimation Methods

These methods estimate the VAT compliance gap by subtracting the actual VAT revenue from the estimated VAT liability, which is calculated using macroeconomic data from national accounts statistics, fiscal registers, and household budget surveys.

Consumption Method

This method estimates the VAT gap by comparing the estimated level of consumption in a country with the reported level of VAT revenue collected.

The Production Side Method

The production side method uses national accounts data by sector of economic activity to estimate the tax base and then applies the VAT rate to the estimated tax base to calculate the expected VAT revenue by sector. The difference between the expected VAT revenue and the actual VAT collected is considered the VAT gap.

VAT Policy Gap Method

The VAT policy gap analysis method is a framework used to estimate the potential revenue that could be collected in a VAT system with a uniform rate and the broadest possible base. It is needed for the assessment of the impact that the reduced rates and exemptions will have on the revenue losses. The VAT policy gap is defined by the UE as the difference between the notional ideal revenue (NIR) and the VTTL. The notional ideal revenue (NIR) is a benchmark or the potential revenue that could be collected with a uniform VAT rate and the broadest possible base.

Econometric Techniques

The use of General Equilibrium Models (GEM), Stochastic Frontier Analysis (SFA), and Time Series Analysis (TSA) in top-down VAT gap identification methods have been increasingly explored in recent years. GEMs can provide insights into the overall impact of VAT policy changes on the economy, while SFA models can estimate the upper bound of potential VAT revenue by identifying the most efficient taxpayers.

These models can help tax authorities to identify the VAT gap at a national level and target their enforcement efforts more effectively. However, the accuracy of the estimates depends on the quality and availability of data and the assumptions made in the models. Therefore, it is important to carefully design and calibrate the models and to continuously update the data to improve the reliability of the estimates.

This document’s “USAID’s Approach and Concept” section will briefly explain the SFA model.

Bottom-up Estimation Methods

These methods estimate the VAT gap by analyzing the data on a micro level such as tax returns, audits, and other administrative data to identify areas of noncompliance, and then estimating the amount of lost revenue via extrapolating methodologies (as a rule the bottom-up estimation methods are used by countries as additional investigation of the tax gap nature):

The Risk-based Audits

It involves identifying high-risk taxpayers who are more likely to underreport or evade VAT and conducting targeted audits on them. This approach focuses on detecting and correcting non-compliance with VAT regulations, which can help to reduce the VAT gap. The audit selection process is based on various risk factors such as industry sector, transaction type, and past compliance history. By targeting high-risk taxpayers, tax authorities can maximize the impact of their audit resources and improve the effectiveness of their VAT enforcement efforts.

The Random Enquiry Programs (REP)

This is a method used to estimate the VAT gap by selecting a random sample of taxpayers and conducting audits to identify non-compliance issues. To estimate the VAT gap, the results of the audits are then used to extrapolate the non-compliance rate to the entire population of taxpayers. This approach involves selecting a statistically representative sample of taxpayers and examining their VAT records to identify instances of non-compliance.

Examples of non-compliance include under-reporting or underpayment of VAT. The REP approach is particularly useful when other methods of estimating the VAT gap are not possible due to data limitations or other constraints. However, the accuracy of the estimate can depend on the representativeness of the sample selected and the quality of the audit process.

The table below provides a summary of the popular top-down and bottom-up tax gap measurement methods.

Method	Brief Description	Advantages	Disadvantages
1. Top-Down	Uses macro data from national accounts statistics, fiscal registers, and household budget surveys to estimate the tax gap	Provide a quick and cost-effective estimate of the tax gap for large populations of taxpayers	They rely on assumptions and estimates, which can lead to inaccuracies in the final measurement. May not account for variations in compliance rates among diverse types of taxpayers or industries.
1.1. The Consumption-Side Method	Estimates the difference between the expected VAT revenues from final consumption and the actual revenues collected	Simple and the level of accuracy of data is higher than in the case of the production-based approach	Reliance on survey data, difficulty capturing informal economic activity, and lack of breakdown by production sectors.
1.2. The Production Side Method	Estimates the VAT gap for different production sectors	Provides decomposition of tax gap by sectors of economic activity	More data-intensive than in the case of the consumption-based approach and frequent misalignments by the sectoral breakdown
1.3. VAT policy gap method	Estimates the difference between the potential VAT revenue and the actual revenue collected due to gaps in VAT poli-cies and regulations.	Provides a comprehensive assessment of the effectiveness of VAT policy, including its design and implementation, and can help identify areas for improvement.	May be limited by data availability, as well as difficulties in measuring and attributing policy changes to changes in tax revenue
1.4. Econometric techniques	Estimate the size of the tax gap by analyzing data on economic varia-bles that are likely to affect tax compliance	Ability to analyze a large amount of data and the potential to capture complex relationships among the variables	The complexity of the models, the need for extensive data and statistical expertise, and the potential for errors and biases in the estimation process
2. Bottom-Up Methods	Estimate tax gaps by analyzing individual taxpayer data and identifying instances of non-compliance to calculate the total tax gap. Involve a detailed analysis of micro-level data sources such as tax returns, audits, random inquiry programs, risk registers, or surveys	Provide a more detailed and accurate estimation by analyzing individual tax returns or conducting audits of taxpayers	Considerable time and resources are needed to conduct audits, the potential for sampling errors, and the need for comprehensive taxpayer data
Risk-Based Audits	Focuses on identifying high-risk taxpayers based on various risk factors, and conducting audits on those taxpayers to estimate the tax gap	Can provide a more accurate estimate of the tax gap for a specific taxpayer population, as they focus on high-risk taxpayers with greater potential for non-compliance	The prohibitive cost and resource-intensive nature of conducting audits may not be feasible for all tax administrations. Is limited by the effectiveness of audits and potential sample selection bias
Random Enquiry Programs	Involves selecting a statistically representative sample of taxpayers and examining their tax records to identify instances of non-compliance, such as under-reporting or underpayment of tax, and using the results to estimate the level of non-compliance in the wider taxpayer population.	Can provide a representative estimate of the tax gap and identify areas of non-compliance in the taxpayer population. May be useful when other methods of estimating the VAT gap are not possible due to data limitations or other constraints	Potential bias in the sample selection, limited coverage of the taxpayer population, and the high cost of conducting audits

European Union

In 2022, the EU Commission published a study titled “VAT Gap in the EU”, which ex-amines how member states measure compliance and policy gaps in VAT.^[7] The majority of member states began their calculations after the EU’s first report was released in 2013.

The two most well-known approaches for measuring the VAT compliance gap are the top-down, or macro-method, and the bottom-up, or micro-method. Of the responding administrations, 36% (eight member states) used more than one approach to calculate the gap. In Hungary, for example, four alternative approaches were implemented.

The top-down consumption-side approach was the most popular method used by administrations, with 13 member states employing this approach. In addition to this methodology, seven administrations also used the production-side approach as a complement.

Four member states relied on methods based on audit results. Specifically, two member states used only random audits, one administration used risk-based audits, and one administration used both random and risk-based audits.

The Top-Down Approaches for Measuring the VAT Compliance Gap

Top-down methods for measuring the VAT compliance gap typically include consumption- and production-side approaches. The consumption-side approach is the most used top-down method among Member States.

The EU’s report on the VAT gap focuses on the consumption-side approach. However, many Member States use both the consumption-side and production-side approaches in parallel to increase the accuracy of their estimates and to allow for the decomposition of the gap into different sectors and types of economic activity.

The Consumption-Side Approach

As previously mentioned, the VAT compliance gap is defined in the EU Study Report as the difference between the tax revenue that would be collected assuming full compliance with the tax base, known as the VTTL, and the actual revenue. Typically, the compliance gap is expressed either in absolute terms or relative to the benchmark, i.e., the VTTL:

• VAT compliance gap = VVTL – VAT actual revenue
• VAT compliance gap (%) = (VVTL – VAT actual revenue) / VTTL

Under this method, VTTL is composed of six main components:

1. Final consumption by households (HHC)
2. Final consumption by the government (GOV)
3. Final consumption by non-profit institutions serving households (NPISH)
4. Intermediate consumption (IC)
5. Gross fixed capital formation (GFCF)
6. Other, mostly country-specific adjustments such as the limited right to deduct VAT on fuel (net adjustments).

The top-down consumption-side approach is based on calculating the VTTL for a specific period and comparing it with relevant revenue figures. National accounts provide the data for estimating the VTTL, while fiscal registers and household budget surveys are used for the evidence base. To ensure accuracy, revenue included in the calculations follows accrual accounting instead of cash accounting.

In contrast to the production-side approach, which estimates VTTL payments for all sectors, the consumption-side approach examines the final liability by breaking down the products and correcting the liability estimates for non-deductible VAT hidden at the intermediate stage.

Advantages

Drawbacks

The method is relatively simple to implement. Standardization of the approach across Member States is possible. It provides a more accurate estimate of the overall size of the VAT compliance gap than the production-side method. The method is the least expensive due to the ease of data collection.

It is not possible to decompose the VAT compliance gap since the method models the VAT liability for groups of products and sectors of economic activity. Therefore, the consumption-side approach can only estimate the overall value of the VAT gap. The consumption-side approach does not allow for the analysis of types of irregularities and their contribution to the overall VAT compliance gap since the estimated VAT li-ability components cannot be aligned with the respective VAT revenue elements available for administrations.

The Production-Side Approach

In contrast to the consumption-side approach, the top-down production-side estimation method focuses on VAT liability from a sectoral perspective. For each sector, the VTTL is estimated as the sum of output and import VAT corrected by input tax liability. We provide a more detailed description of the production-side approach in the “International Monetary Fund (IMF) ” section of this article.

The Bottom-Up Approaches for Measuring the VAT Compliance Gap

The EU Commission’s study primarily investigated top-down methods. However, the report also discusses the bottom-up approach, based on the experiences of some Member States’ administrations. Bottom-up methods involve a detailed analysis of micro-level data sources that are typically available for a small portion of the tax base. These data sources include tax returns, audits, random inquiry programs, risk registers, or surveys, and allow for a determination of non-compliance in a sample or the population using statistical techniques.

The “core” bottom-up methods used by administrations for estimating the VAT compliance gap include the bottom-up approach based on targeted/risk-based audit data and the bottom-up approach based on random inquiry programs. Top-down methods operate with macro data, whereas bottom-up methods are based on micro-level data.

Risk-Based Audits

As previously mentioned, bottom-up estimation methods utilize micro-level data to assess the scale and types of non-compliance. Audit assessment databases are the largest source of relevant information available to authorities, allowing estimates to be extrapolated for the entire population of taxpayers by correcting for sample selection bias. The operationalization of the bottom-up method using risk-based audits requires sensitive micro-level data, such as VAT revenue and characteristics (e.g., sector of economic activity, number of employees) for all registered taxpayers, as well as risk scores for all registered taxpayers and audit assessments, including the characteristics (e.g., the experience of an auditor) and results (e.g., type of irregularity and penalty) of audits.

Since the primary information on irregularities comes from actual assessments, the accuracy of these assessments is crucial to the method’s effectiveness. Although the method provides a breakdown of the gap, its ability to estimate the overall gap is limited by the effectiveness of audits and potential sample selection bias. As a result, administrations using hybrid approaches typically use top-down estimates to rescale the results from the bottom-up analyses, which are prone to larger errors. Random inquiry programs, although less effective than risk-based audits, may also be used but require additional costly efforts and may target compliant taxpayers.

Random Enquiry Programs (REP)

The bottom-up approach using random enquiry programs is rarely used by tax administrations. While audits and verification actions conducted for randomized groups of taxpayers have the advantage of reducing errors related to sample bias, they are costly to execute. Additionally, quick verification actions are more likely to miss irregularities and non-compliant behavior of audited taxpayers, which can bias the estimates. Another issue with this approach is that audit results often contain sensitive information that cannot be shared externally due to internal regulations. To balance the trade-off between error and resource intensity, tax authorities could use a synthetic method based on both random and non-random samples.

VAT Policy Gap Measuring

The VAT policy gap is defined by the UE as the difference between the notional ideal revenue (NIR) and the VTTL. The notional ideal revenue (NIR) is a benchmark or the potential revenue that could be collected in a VAT system with a uniform rate and the broadest possible base. It is needed for the assessment of the impact that the reduced rates and exemptions have on the revenue losses.

The VAT policy gap can also be expressed in absolute or relative terms:

𝑉𝐴𝑇 𝑝𝑜𝑙𝑖𝑐𝑦 𝑔𝑎𝑝 = NIR – 𝑉𝑇𝑇𝐿

𝑉𝐴𝑇 𝑝𝑜𝑙𝑖𝑐𝑦 𝑔𝑎𝑝 (%) = (NIR – 𝑉𝑇𝑇𝐿) / NIR

There is an apparent relationship between the VAT gaps and the respective bench-marks. The difference between the notional ideal revenue and the VAT receipts is the sum of the policy and compliance gaps, which accounts for all revenue losses in each VAT system.

The policy gap can be further decomposed into the rate gap and the exemption gap, which capture the loss in VAT liability due to the application of reduced rates and the loss in liability due to the implementation of exemptions or excluding part of household final consumption from the tax base.

The rate gap is defined as the difference between the VTTL and what would be obtained in a counterfactual situation in which the standard rate, instead of the reduced or zero rates, is applied to final consumption. The exemption gap is defined as the difference between the VTTL and what would be obtained in a counterfactual situation in which the standard rate is applied to exempt products and services and no restriction of the right to deduct applies.

International Monetary Fund (IMF)

For estimating the tax gap, the International Monetary Fund (IMF) uses a combination of the compliance gap and the policy gap measurement methods. This approach results in a tax gap structure that is similar to the one used by the EU, although with different names and graphics for the indicators. According to the graphical representation, the overall tax gap is determined by subtracting the actual revenue (Box ABFD) from the reference potential revenue (Box ACHE).

This process of the VAT gap estimation can be summarized as:

• Step 1: Estimate reference potential revenue, RPR, (Box ACHE).
• Step 2: Determine actual revenue, AR, (Box ABFD).
• Step 3: The tax gap = RPR – AR.

The RA-GAP methodology uses statistical data to estimate a reference potential revenue value, tax administration data to determine the actual revenue value, and then evaluates the difference between the two.

The Top-Down Production-Side Approach

The RA-GAP methodology uses a top-down approach to estimate the compliance gap by comparing potential VAT collections to actual VAT collections. However, unlike the EU method, the RA-GAP program applies the production-side approach. This approach estimates the VTTL from a sectoral perspective, by considering the sum of the output and import VAT corrected by the input tax liability for each sector.

To estimate the liability, the methodology uses national accounts figures as a source of information about the tax base. As the estimation requires accounting for the entire policy structure, VAT payments are modeled at all stages of production. This approach requires granular trade data broken by groups of products and sec-tors of economic activity, as well as sector-specific parameters from fiscal registers. The data requirements are substantially higher than in the case of the consumption-based approach.

The compliance gap, which represents the amount of revenue lost due to non-compliance with current policy settings, is estimated using a similar procedure to calculate the overall tax gap. In this case, the potential revenue used for comparison with actual revenue is constructed based on the current statutory framework, rather than a reference framework. The process involves the following steps:

• Step 1: Estimate the potential revenue under the current policy settings (CPR, box ACGD).
• Step 2: Determine actual revenue (AR) (Box ABFD).
• Step 3: The compliance gap is calculated as CPR minus AR.

Once the compliance gap is determined, the policy gap can be calculated as the difference between the estimated reference potential revenue (RPR) and the current potential revenue (CPR). Alternatively, it can be expressed as the difference between the tax gap and the compliance gap.

A. Potential VAT Revenue Calculation

The International Monetary Fund’s potential VAT revenue model is designed to estimate both RPR and CPR. The distinction between the two values lies in the policy structure used as input into the model. The potential VAT can be broken down by sector using two methods:

• A demand-based approach focusing on final consumption to estimate the base, or
• A value-added-based approach.

The RA-GAP methodology prefers the latter approach, using the VAT policy framework to model the value-added for each sector of the economy.

The value-added-based model for potential revenue can be expressed as:

Where S denotes a particular sector and:

• PV = the total potential VAT revenue.
• PVm^S = the potential VAT on the imports of sector S.
• PVo^S = the potential VAT on the output of sector S; and
• PVi^S = the potential VAT creditable on the inputs of sectors.

The value-added-based methodology enables the estimation of potential collections based on the sector of collection, which can be further disaggregated using taxpayer registry data to determine the sector of activity. This approach allows for gap estimates to be produced on a sector-by-sector basis, making it the preferred method for RA-GAP.

Each component of the expression is determined separately by the IMF and then applied to the resulting expression. When assembling inputs for the model, it is important to note that key areas in the model use definitions for data on economic activity that differ from the definitions used for tax purposes. However, in most aspects, the definitions are the same.

B. Actual VAT Revenue Calculation

Like potential revenue, actual revenue can be expressed as the sum of three components:

• VAT on imports
• VAT due on outputs, and
• VAT creditable for inputs in the period

Where:

• AV^S = actual VAT for sector S.
• Vm^t = VAT on imports for taxpayer t active in sector S.
• Vo^t = VAT on the output of taxpayer t; and
• Vi^t = creditable VAT on inputs of taxpayer t.

Sector information for a taxpayer is typically available from the taxpayer registry, so breaking down actual VAT by sector is typically straightforward.

Alternatively, actual VAT can be re-expressed as the VAT on imports plus the domestically declared net VAT for taxpayers in a debit Vdt^t position, plus the domestically declared net VAT for taxpayers in a credit position, Vc^t:

Where:

Vdt^t = (Vo^t – Vi^t), where Vo^t > Vi^t, and

Vc^t = (Vi^t – Vo^t), where Vi^t > Vo^t.

By rearranging the components of actual VAT, different measures for actual VAT can be created by varying the data sources for the last two terms. This provides an advantage for data analysis purposes.

The resulting actual VAT measures can be classified into four categories.

1. The first is net revenue, which uses data based on the date of the transaction of payments and refunds regardless of the tax period.
2. The second is accrued net revenue, which uses the same data as net revenue, but the transacted amounts are reallocated to the tax periods in which tax liabilities or credits arose
3. The third measure uses the self-assessment data supplied by the taxpayer on their tax declarations for tax periods.
4. Lastly, the fourth measure is accrued collections, which uses payment data for debits and assessments for credits.

Accrued collections are a hybrid of measures (ii) and (iii). These different measures can provide insights into the tax system’s performance and help identify potential areas for improvement.

C. Measuring and Reporting the Gap

Now that we have both potential VAT revenue and actual VAT revenue, we can calculate the tax gap. While the nominal value of the tax gap is useful for assessing the current fiscal impact, it is not useful in analyzing how the gaps are trending. This is because growth in nominal values can be due to simple inflation. Therefore, the RA-GAP generally reports the tax gap in relative terms.

The tax gap can be presented in terms relative to the relevant potential revenue. This means that the VAT gap and its two components would be expressed as:

,as a share of GDP.

Such presentations allow for making a nuanced assessment of the trends while allowing for comparisons across the various measures.

Despite the obvious benefits of the production-based approach over the consumption-based strategy, there are still some drawbacks as shown in the following table.

Advantages	Drawbacks
Estimation of the VAT gap on a sector-by-sector basis with the following ability to analyze the types of irregularities and their contribution to the overall VAT gap.	Fluctuations in time tend to be larger for the production-side approach, which signals a larger time-varying error in these estimates. Due to complications with the larger number of variables required to do the computations, the overall estimations may appear to be less accurate.

UK HMRC

Since the early 2000s, HM Revenue and Customs (HMRC) has been collecting data and producing annual estimates of the tax gap, which are published every year since 2008. HMRC is the only tax authority in the world that provides an annual estimate of tax losses for all forms of taxation.

In the UK, HMRC analysts adhere to the values, principles, and protocols outlined in the Code of Practice for Statistics to produce tax gap estimates. They use a variety of internal and external data sources and analytical techniques to produce annual estimates, which are updated as more accurate data becomes available.

The UK applies various approaches to measure tax gaps, with the VAT gap calculated as the difference between the VAT total theoretical liability (VTTL) and VAT received. The VAT compliance gap methodology follows a consumption-side top-down approach. VTTL is determined by estimating the total consumption of taxable goods and services.

In the UK, the VAT gap is assessed by gathering data on the total amount of expenditure in the economy subject to VAT, primarily from the Office for National Statistics (ONS). HMRC analysts then apply the rate of VAT on the ONS expenditure data based on commodity breakdowns to derive the gross VTTL.

Legitimate refunds occurring through schemes and reliefs are subtracted from the gross VTTL to arrive at the net VTTL.

Actual VAT receipts are then subtracted from the net VTTL to leave the residual element, which comprises errors, evasion, and debt.

The VTTL also includes irrecoverable VAT, which is VAT paid on “finally taxed expenditure” that cannot be reclaimed, for example, by those not registered for VAT.

Calculation of Gross VTTL

To calculate the gross VTTL, HMRC multiplies the total amount of VAT-able expenditure in the economy by the appropriate VAT rates. Expenditure data is categorized based on different VAT treatments, including zero-rated, standard-rated, reduced-rated, and exempt. However, to calculate gross VTTL, only the standard and reduced-rated expenditures are considered.

Total VAT-able expenditure for each sector is aggregated to represent an overall annual figure for the economy. To determine the VAT within VAT-able expenditure, the expenditure is multiplied by the VAT fraction. The annual gross VTTL is calculated by multiplying the annual expenditure figure for the economy by the respective VAT fraction.

The tax base comprises several expenditure streams, including EU consumption-based methodology, with household consumption being the primary contributor to VAT revenue.

The main expenditure categories that comprehensively cover VAT liabilities are:

• Household consumption.
• Non-profit institutions serving households.
• Government capital and current expenditure.
• VAT exempt sector capital and current expenditure.
• Housing capital expenditure.

Input Tax Adjustments

To estimate the net VAT liability, the difference between output tax and input tax must be calculated. While VAT liability for most sectors can be directly estimated from ONS National Accounts data, there is an exception for the VAT-exempt sector. As businesses making exempt outputs cannot reclaim all the VAT on associated inputs, a separate HMRC survey is utilized to determine the proportion of such irrecoverable input tax.

In addition, an adjustment is made for expenditures by businesses legitimately not registered for VAT who cannot recover their input tax. To estimate relevant expenditure, a combination of data from the Department for Business, Energy, and Industrial Strategy (BEIS) and HMRC information on the distribution of business turnover below the VAT threshold is used.

Moreover, HMRC data and third-party sources are used in conjunction with National Accounts data to inform estimates of business expenditure on cars and entertainment, for which VAT is due. Due to the complexity of calculating irrecoverable input tax, the level of uncertainty around input tax adjustments is higher than for other elements.

Deductions

The theoretical VAT calculated from the sum of VAT liability arising from each expenditure category provides an estimate of gross VTTL. However, several reasons prevent the collection of this theoretical VAT. These reasons fall into three broad categories:

• VAT refunds.
• Expenditure of traders legitimately not registered for VAT.
• Other deductions.

VAT refunds primarily benefit government departments, NHS Trusts, and regional health authorities for non-business contracted-out services. In addition, other categories of expenditure that cannot be identified in the overall VTTL calculation are eligible for VAT refunds. The value of these refunds is obtained directly from audited HMRC account data.

Traders who legitimately trade below the VAT threshold can exclude VAT from their sales. However, the expenditure on the output of these businesses contributes to the total theoretical liability. To adjust for this, an estimate of relevant expenditure is calculated using a combination of BEIS data and HMRC information on the distribution of business turnover below the VAT threshold.

Other deductions capture legitimate schemes and reliefs.

Net VAT Receipts

The model utilizes figures for actual VAT receipts obtained from HMRC’s published National Statistics tax receipts data. The receipts are adjusted to account for timing effects within each tax year. A summary of HMRC’s tax receipts can be accessed on the official UK government website, gov.uk.

VAT Gap

To determine the VAT gap, the net VAT receipts are subtracted from the net VTTL. The percentage gap is calculated by dividing the VAT gap by the net VTTL. HMRC’s published National Statistics tax receipts figures provide the actual receipts of VAT, which are adjusted to account for timing effects within each tax year before being used in the model. A summary of HMRC’s tax receipts can be found on gov.uk.

For the UK tax year, which runs from April to March, the receipts are compared to the total theoretical liability for the calendar year, assuming a 3-month average lag between economic activity and the corresponding VAT payment to HMRC. The VTTL and net VTTL calculations assume a 3-month lag between expenditure and actual VAT receipts. Therefore, expenditure data for the calendar year corresponds to tax year receipts.

United States Agency for International Development (USAID)

In 2008, the United States Agency for International Development (USAID) launched the Collecting Taxes Database (CTD),^[10] which assesses and measures 200 national tax systems using 30 indicators. The database is divided into three categories: Tax Rates and Structure, Tax Performance, and Tax Administrations. To measure the efficiency of revenue production by tax systems, the Tax Performance category is of particular interest in the context of the tax gap concept. This category includes two indicators: tax capacity and tax effort, both of which are expressed as a percentage of a country’s GDP.

Tax Capacity

The tax capacity indicator estimates the maximum amount of tax revenue that could be collected given a country’s specific socio-economic factors. This indicator is calculated using a Stochastic Frontier regression model that explains the frontier or optimal behavior of the indicator, considering inputs from the following socioeconomic factors:

• Tax as a percentage of GDP.
• GDP per capita in current US dollars.
• Agriculture Value Added as a percentage of GDP.
• Age Dependency Ratio (ratio of people younger than 15 and older than 64 to the working-age population aged 15 to 64).
• Trade openness (exports plus imports) as a percentage of GDP.
• The Control of Corruption Index.

Though there is no general agreement on the inputs that determine the tax capacity of a country.

The tax capacity is stored as exponentiated fitted values from the specified model:

𝑙𝑛 (𝑡𝑎𝑥 𝑟𝑒𝑣𝑒𝑛𝑢𝑒 𝑎𝑠 % 𝑜𝑓 𝐺𝐷𝑃_𝑖𝑡) = β₀ + β₁𝑙𝑛 (𝐺𝐷𝑃 𝑝𝑒𝑟 𝑐𝑎𝑝𝑖𝑡𝑎 𝑈𝑆𝐷_𝑖𝑡) + β₂(𝑎𝑔𝑒
𝑑𝑒𝑝𝑒𝑛𝑑𝑒𝑛𝑐𝑦 𝑟𝑎𝑡𝑖𝑜_𝑖𝑡) + β₃(𝑎𝑔𝑟𝑖𝑐𝑢𝑙𝑡𝑢𝑟𝑒 𝑎𝑠 % 𝑜𝑓 𝐺𝐷𝑃_𝑖𝑡) + β₄(𝑡𝑟𝑎𝑑𝑒 𝑜𝑝𝑒𝑛𝑛𝑒𝑠𝑠_𝑖𝑡) + β₅𝑙𝑛
(𝑔𝑜𝑣𝑒𝑟𝑛𝑚𝑒𝑛𝑡 𝑐𝑜𝑟𝑟𝑢𝑝𝑡𝑖𝑜𝑛_𝑖𝑡) + ε_𝑖𝑡 – 𝑢_𝑖𝑡,

where i is a country and t is a year.

The main sources for the indicators that USAID proposes are the respective reports of the IMF, the UN University World Institute for Development Economics Research, and the World Bank.

Tax Effort

Tax effort is a key indicator that measures a country’s performance in mobilizing tax revenue relative to its tax capacity. It is calculated as the ratio between the actual tax revenue collected as a percentage of GDP and the predicted tax capacity, also expressed as a percentage of GDP.

The Stochastic Frontier Regression model used by USAID allows for cross-country tax comparisons and provides measures of tax effort. A high tax effort measure indicates that a country effectively utilizes its tax base to exceed the stochastic frontier.

This model also has limitations. It does not define what part of the tax gap is due to inefficiency and what part is due to policy issues because of the lack of data to represent both causes. There is also disagreement about the appropriate economic, social, demographic, and institutional indicators for assessing a country’s tax capacity.

Additionally, according to USAID, given the inputs on socio-economic factors used in the study, this method is not viewed for assessing a country’s tax capacity and tax effort for individual taxes such as VAT or personal income tax.

However, some academic studies propose stochastic frontier analysis as an alter-native method to measure the VAT gap in the EU by using the variables most reflecting VAT capacity impact (corruption perception index, shadow economy, documents needed to import, time to import, and cost of import). The European commit-tee also considers it a useful tool that may be applied by countries during the observation of various data patterns. At the same time, it limits the methodologies described in the report with the top-down and the bottom-up as they have already gained the trust of national administrations.

The Primary Causes of the VAT Gap and Potential Solutions

The Causes of the VAT Gap in B2B

The tax gap for VAT in B2B is caused by several reasons:

• Non-registration of taxpayers. The non-registration of taxpayers is one of the main causes of the VAT gap. Businesses that operate below the threshold for VAT registration or those who are evading taxes might not register, which would result in a loss of tax revenue. An example of a tax optimization tool in this context is intentional business fragmentation without a real, well-founded purpose in which different entities engage in nearly identical activities in the same region and have the same ultimate owner.
• Errors in submitted VAT returns. Another reason for the VAT gap is errors in VAT returns. Businesses may make mistakes when filing their VAT returns, such as not reporting all their sales or claiming excessive amounts of input tax. Errors can arise due to the human factor. At the same time, they can be the result of sophisticated or unclear tax law provisions. These errors can lead to a loss of tax revenue.
• Non-compliance with VAT rules. Businesses may not comply with VAT rules, leading to a loss of tax revenue. Non-compliance may include not charging VAT on taxable supplies, not keeping proper records, or failing to submit VAT returns.
• Fraud and evasion. Fraud and evasion are significant contributors to the VAT gap. Fraudulent activities may include:
  • Issuing fake VAT invoices that are not supported by real transactions.
  • Execution of fraudulent transactions taxable with the reduced or zero VAT rates to claim VAT refund.
  • Execution of fraudulent transactions for VAT benefits application.
  • Creating fictitious short-lived companies for cash out and transfer of non-taxed funds to the beneficiary of the fraud.

The Causes of the VAT Gap in B2C

In B2C the most common reasons for the VAT gap may include:

• Not issuing fiscal tax receipts.
• Issuing fiscal tax receipts with higher amounts (deception of purchasers or collusion with them) with further cash register rewind and cash withdrawals.

The tax gap in B2C transactions is sometimes higher than in B2B transactions due to the difficulty of monitoring and enforcing compliance in this sector, especially regarding not issuing fiscal tax receipts.

Not issuing fiscal tax receipts in B2C allows businesses to underreport their sales and revenue, thereby reducing their tax liabilities. Without a receipt, there is no proof that a transaction has taken place, making it easier for businesses to underreport sales and not pay the appropriate amount of VAT. This leads to a reduction in tax revenue for the government and an increase in the tax gap.

Methods of Closing the VAT Gap

In the context of growing digitalization in the economy all over the world and the possibility of monitoring operations in real-time, many countries look toward the digitalization of the VAT administration to reduce the VAT gap. Modern digital solutions for VAT administration make it possible to identify and, in some cases, eliminate, both simple and complex (can occur when chains of more than two sellers and buyers participate in a scheme to evade paying VAT) tax gaps in B2B. Using the fully automated VAT administration system with electronic VAT invoices (Generation 3 of the VAT administration system)^[11] the tax administrations can find and measure the VAT gap as well as fix the source of the gap due to the VAT relationship tree.^[12]

Azerbaijan, Italy, Poland, and Turkey are implementing a so-called 4^th generation of the VAT administering system.^[13] It uses the split payment mechanism with the invoice total amount divided into the principal amount and the VAT amount. The principal amount goes to the supplier and the VAT amount is transferred to a special tax account in the accredited bank, making the tax administration virtually fraud-proof.

The advantages of this system include increased transparency, reduced risk of fraud, and improved tax collection. However, the disadvantages include increased administrative costs for businesses, the potential for a negative impact on cash flow, and the potential for reduced competitiveness in the market. Additionally, the effectiveness of the system may be limited if it is not widely adopted or if it is not accompanied by other complementary measures.^[14]

It is much more difficult to assess the VAT gap in B2C where the sellers accept revenues without issuing fiscal receipts. Therefore, preventing this should be the primary focus of the state’s efforts. Tax authorities need to implement effective measures in B2C to ensure that businesses issue fiscal receipts and that consumers demand them. This can be done by limiting the amount of cash that can be settled and implementing cashback and other motivational tools for both consumers and retailers.

Conclusions and Recommendations

As we see, measuring the tax gap is crucial for national economies as it helps to identify the extent of tax evasion and non-compliance, which can result in significant revenue loss. By understanding the tax gap, governments can develop effective policies and strategies to improve compliance, increase revenue collection, and ensure a fair and equitable tax system for all taxpayers.^[15]

As VAT among other taxes is most prone to fraud and different misunderstandings, VAT gap measuring should be of a special focus. The described methods for VAT gap measuring have advantages and disadvantages.

In our opinion, combining two or even three of them seems more efficient and productive. There may be the top-down consumption-based approach at the first stage of VAT gap measuring and then the productive-based approach with a bottom-up analysis of certain types of taxpayers. Such an approach will help define the VAT gap amount and identify the areas and reasons for irregularities.

If a country is not currently measuring its tax gap, here are some recommendations on how it can do that:

1. Evaluate the availability of data. The first step in implementing any tax gap measurement method is to evaluate the availability and quality of data. A country should determine what data is currently being collected and identify any gaps in data that need to be filled. This could involve conducting a comprehensive review of tax laws and regulations to ensure that all relevant information is being captured.
2. Choose an appropriate VAT gap calculation method. Once a country has evaluated its data availability, it should select an appropriate method or com-bination of methods that have been used successfully in other countries with similar tax systems or the country’s specific circumstances.
3. Develop a reliable data collection system. To ensure that the data collected is reliable and accurate, it is essential to develop a robust data collection system. This could involve training tax officials on how to collect data, implementing new data collection procedures, and using technology to improve the accuracy and timeliness of data collection.
4. Monitor and evaluate results. After implementing a tax gap measurement method, it is important to monitor and evaluate the results regularly. This could involve comparing the results of different methods, identifying any changes in tax policy that could affect the results, and updating data collection procedures to ensure that the data collected remains accurate and reliable.

By following these steps, countries can develop a reliable and effective system for measuring their tax gaps, which can help identify areas where tax collection can be improved and increase overall revenue collection.

List of Sources

[1] Understanding the Tax Gap. IRS. FS-2005-14, March 2005. URL: https://www.irs.gov/pub/irs-news/fs-05-14.pdf

[2] Consumption Tax Trends 2022: VAT/GST and Excise, Core Design Features and Trends. OECD iLi-brary. URL: https://www.oecd-ilibrary.org/sites/6525a942-en/index.html?itemId=/content/publication/6525a942-en

[3] Study to quantify and analyse the VAT gap in the EU-27 Member States. European Commission. Report 2013. URL: https://op.europa.eu/en/publication-detail/-/publication/c188b7a4-27e1-11ec-bd8e-01aa75ed71a1

[4] Tax gaps: VAT. Official Statistics. HRMS. Updated 23 June 2022. URL: https://www.gov.uk/government/statistics/measuring-tax-gaps/2-tax-gaps-vat#methodology-and-data-issues

[5] The Revenue Administration—Gap Analysis Program: Model and Methodology for Value-Added Tax Gap Estimation. Eric Hutton. IMF. URL: https://www.imf.org/-/media/Files/News/Seminars/2017/oap-adb-seminar-in-manila-2017/fadimf-tnm-1704-the-ragap-model-and-methodology-for-vat-gap-estimation.ashx

[6] USAID’s Collecting Taxes Database (CTD). URL: https://idea.usaid.gov/domestic-revenue-mobilization

[7] European Commission, CASE, Poniatowski, G., Bonch-Osmolovskiy, M., Śmietanka, A., Pechcińska, A., VAT gap in the EU – Report 2022, Publications Office of the European Union, Luxembourg, 2022. URL: https://op.europa.eu/en/publication-detail/-/publication/030df522-7452-11ed-9887-01aa75ed71a1

[8] “VAT gap in the EU. Report 2022”, the European Commission. URL: https://op.europa.eu/en/publication-detail/-/publication/030df522-7452-11ed-9887-01aa75ed71a1

[9] “The Revenue Administration—Gap Analysis Program: Model and Methodology for Value-Added Tax Gap Estimation”, IMF, March 2017. URL: https://www.imf.org/en/Publications/TNM/Issues/2017/04/07/The-Revenue-AdministrationGap-Analysis-Program-Model-and-Methodology-for-Value-Added-Tax-Gap-44715

[10] Collecting Taxes Database (CDT). USAID. URL: https://idea.usaid.gov/domestic-revenue-mobilization

[11] Anatoly Gaverdovsky, Four Generations of VAT Administration Systems. URL: https://taxtech.digital/2020/09/02/four-generations-of-vat-administration-systems/

[12] Read more about Digital Tax Administration for B2B, B2C, and C2C taxpayers with DTT’s Tax Revenue Suite (TRS) at https://taxtech.digital/tax-revenue-suite/

[13] Anti-VAT fraud VAT splitting measure. VAT Calc. URL: https://www.vatcalc.com/italy/italy-updates-companies-subject-to-vat-split-payments/

[14] We discuss the benefits and drawbacks of this system and propose the alternative idea of the Virtual VAT Control Accounts in the following article: “A New Approach to the Digital VAT Admin-istration for B2B”. Anatoly Gaverdovsky. URL: https://taxtech.digital/2022/12/05/virtual-vat-accounts/

[15] Read more about the global experience in fighting the tax gap in “Global Experience and Best Practices in Reducing the Tax Gap”. Anatoly Gaverdovsky. URL: https://taxtech.digital/2021/12/01/best-practices-in-reducing-the-tax-gap/

List of Acronyms

B2B	Business to Business	A type of commerce transaction that exists between businesses, such as those involving a manufacturer and wholesaler or retailer.
B2C	Business to Consumer	A type of commerce transaction that exists directly between a business and consumers.
EU	European Union	EU is a supranational political and economic union of 27 member states that are located primarily in Europe.
GDP	Gross Domestic Product	Gross domestic product is a monetary measure of the market value of all the final goods and services produced and sold in a specific period by countries.
GEM	General Equilibrium Model(s)	Applied general equilibrium models describe the allocation of resources in a market economy as the result of the interaction of supply and demand, leading to equilibrium prices.
GST	Goods and Services Tax	An indirect value-added tax like VAT on the supply of goods and services, right from the manufacturer to the consumer.
HMRC	HM Revenue and Customs or His Majesty’s Revenue and Customs	The United Kingdom’s tax, payments, and customs authority
IMF	International Monetary Fund	IMF is a major financial agency of the United Nations and an international financial institution
IRS	Internal Revenue Service	The United States Internal Revenue Service administers and enforces U.S. federal tax laws.
NIR	Notional Ideal Revenue	A benchmark or the potential revenue that could be collected with a uniform VAT rate and the broadest possible base.
RA-GAP	Revenue Administration GAP Analysis Program	Revenue Administration’s Gap Assessment Program is an IMF’s systematic evaluation of a revenue administration’s operations designed to assess their effectiveness in collecting taxes.
REP	Random Enquiry Program(s)	A random enquiry program involves reviewing the returns of a sample of taxpayers and applying them to the broader population.
SFA	Stochastic Frontier Analysis	A body of statistical analysis techniques used to estimate production or cost functions in economics, while explicitly accounting for the existence of firm inefficiency.
TCMP	Taxpayer Compliance Measurement Program	The Taxpayer Compliance Measurement Program is periodically conducted by the United States Internal Revenue Service (IRS) to estimate compliance with tax laws and revenue lost from non-compliance.
TSA	Time Series Analysis	Time series data records quantities that represent or trace the values taken by a variable over some time such as a month, quarter, year, etc.
UK	United Kingdom
USAID	United States Agency for International Development	An independent agency of the U.S. federal government that is primarily responsible for administering civilian foreign aid and development assistance.
VAT	Value-Added Tax	A value-added tax, known in some countries as a goods and services tax (GST), is a type of indirect tax that is assessed incrementally on the value added to goods and services sold through supply chains from manufacturers to consumers.
VTTL	VAT total tax liability	The VAT liability is specified by the VAT law.