The UK’s looming general election brings a key fiscal debate into the spotlight: Can the next government truly bridge the £40bn ‘tax gap’?
Both Labour and the Conservatives claim they can narrow the gap—the difference between expected tax revenues and actual collections—primarily by targeting tax avoidance. However, experts question whether this approach will suffice.
Currently, both major parties have ruled out increases to income tax, national insurance, and VAT, which form the bulk of government revenues. While Labour might consider adjusting the capital gains regime, both parties believe up to £6 billion can be raised through combating tax avoidance.
HM Revenue & Customs (HMRC) estimates the tax gap at £39.8 billion, a figure exceeding the entire transport budget by about £10 billion. Labour has pledged £855 million to HMRC to reduce tax avoidance, while the Conservatives also plan to enhance resources for the tax office.
However, tax avoidance accounts for just a small portion of this gap—approximately £2 billion. Dan Neidle, founder of Tax Policy Associates, explains, “We can say with some confidence that neither Labour nor the Conservatives can raise £6 billion from clamping down on tax avoidance because there probably isn’t £6 billion of tax avoidance.”
Stuart Adam, senior economist at the Institute for Fiscal Studies, concurs, acknowledging potential revenue from reducing the tax gap but warning of possible downsides. “Placing more administrative burdens on compliant taxpayers to stop those who aren’t could be a risk,” he says. He also notes that most of the tax gap stems from small businesses and the self-employed rather than large corporations.
The Conservative Party has made some progress since 2010, with the Office for Budget Responsibility indicating that over 200 measures to tackle tax non-compliance have generated £6.7 billion annually. The tax gap, as a percentage of total theoretical revenue, has dropped from 6.4% in 2009-10 to 4.8% in 2022-23. Despite this, in cash terms, it remains at its highest level since 2005-06 due to recent high inflation.
Efforts to improve HMRC’s digital filing system have made tax declaration less burdensome for individuals and businesses. Historically, VAT has been the focus for better revenue collection efficiency, with underpaid VAT receipts now at 4.9% of potential income, down from 13.7% two decades ago.
Income tax and national insurance now lead the tax gap, with corporation tax also a significant contributor, partly due to Rishi Sunak raising the headline rate from 19% to 25% in March 2021. Small businesses are particularly problematic, with their corporation tax gap at 32.2%, compared to 6.7% for mid-sized firms and 2.9% for large companies.
“Small business is a hard nut to crack,” Neidle notes. “It’s a difficult political sell. It’s also not entirely clear why the small business tax gap is so large.”
Stephen Relf, tax technical manager at the Institute of Chartered Accountants in England and Wales, suggests that simplifying the tax system could help, as smaller businesses struggle with its complexity, leading to mistakes.
The most common issue is a “failure to take reasonable care,” meaning businesses and individuals often unintentionally fail to follow tax rules due to the system’s complexity. Amanda Tickel, head of tax and trade policy at Deloitte, advocates for significant tax system simplification and better support for small businesses in understanding their tax obligations.
Improving HMRC’s service is crucial. A National Audit Office report found that HMRC answered only two-thirds of calls in the first 11 months of last year, with an average wait time of 23 minutes. More officers could improve this performance.
Ultimately, both Labour and the Conservatives promise to enhance public services or reduce taxes by cracking down on tax avoidance. However, experts caution that relying on theoretical gains from narrowing the tax gap might be an uncertain strategy, potentially leading to fiscal plans that spend funds before they are actually raised.
