A Comprehensive Approach to Understanding Tax Gap

Tax gap, encompassing non-compliance (tax compliance gap) and policy aspects (tax policy gap), is crucial in closing financing gaps faced by developing countries. Understanding the difference between potential and actual tax revenue plays an important role in domestic revenue mobilisation (DRM) for sustainable development. It offers insights into tax policy effectiveness and administrative efficiency, helping tailor strategies for better compliance and tax collection.

The 2024 ATI Tax Gap Workshop, held on 19-21 March in Dar es Salaam, Tanzania, was a joint effort by the Addis Tax Initiative (ATI), the IMF’s AFRITAC East and FAD, UNU-WIDER, and the World Bank’s Global Tax Program. This capacity-building event was organised as part of the implementation of Commitment 1 of the ATI Declaration 2025 which focuses on enhancing revenue administration effectiveness and uses regular tax gap assessments for VAT, PIT, and CIT as a key indicator. Officially opened by Ms. Xiangming Li – the Center Coordinator of AFRITAC East, the three-day Workshop aimed to enhance understanding and knowledge sharing about tax gap estimation methodologies and practical challenges. It is also meant to contribute to developing more robust tax administration systems and foster greater collaboration among international organisations, tax administrations, and policymakers, addressing the challenges of tax gap analysis.

Day 1: The Imperative of Tax Gap (TG) Estimation  

Tax gap estimation emerges as a pivotal instrument in augmenting the revenue collection capabilities of nations, simultaneously acting as a barometer for the adequacy of governmental revenue streams. Beyond understanding the gap between own potential and actual tax revenue, this process enables countries to benchmark their performance against their international counterparts. However, caution is warranted in interpreting results due to the heterogeneity inherent in national tax systems and the diverse economic sectoral compositions.  

The unit in charge of tax gap estimation might be housed within the ministry of finance or the revenue authority though country experiences showed consultation between these authorities is common. The selection of an optimal methodology for tax gap analysis is not monolithic but contingent upon the nature of the data at hand. Challenges such as the lack of digitalisation and the absence of a synergistic relationship between entities entrusted with data collection and those in charge of analysing the tax gap are prevalent in partner countries. Despite these hurdles, there is a proactive engagement in utilising tax gap estimation to unearth underlying causes of low tax-to-GDP ratios by ATI Partner countries. The discussions on Day 1 extend to explore the implications of these challenges on international cooperation and the potential for shared solutions. Experts emphasised the need for a harmonised approach in data collection and analysis, advocating for the adoption of international standards in tax gap estimation to facilitate comparability and effective policy formulation.

The top-down approach

The top-down approach to TG analysis utilises national data to estimate tax liability and provides a macroeconomic perspective on tax implementation and compliance. This process involves adjusting Supply-Use Tables (SUTs) to reflect economic realities and tax policies, followed by analysing actual revenue to evaluate the efficiency of the current system. The final step involves creating a tax gap report to identify areas needing policy and administrative reforms. This approach, however, has limitations, including the absence of detailed taxpayer behaviour information and good-quality economic data. Day 1 also hosted country presentations on the estimation of VAT and trade tax gaps from Ghana, the Philippines, and Sierra Leone. The practical exercises on the top-down approach offered in different sessions further enriched the exchange.    

Day 2: Tax Gap Estimation Methodologies 

The two methodologies of tax gap estimation – top-down and bottom-up approaches – come with their own challenges and attributes. The top-down approach leverages macro-level data reflective of a nation's economic activities, while the bottom-up approach relies on microdata from tax returns and audits. Some countries supplement the latter with household surveys. Audit strategy variations are noted with a predominant inclination towards risk assessment over random selection among ATI partner countries.  

When conducting tax gap estimation, countries might decide to cover both policy and compliance gaps or either one of the two. The decision regarding the scope of the estimation, at times, is linked to the authority entrusted with such function. Key challenges affecting estimation results relate to complex tax designs, inadequate governance, constrained estimation capabilities, and weaknesses in data governance and day-to-day operations, all impacting the precision and efficacy of tax gap analysis.

The bottom-up approach 

The bottom-up approach to tax gap estimation utilises micro-level data from tax returns, audits, and risk registers to identify and quantify components of the tax gap, offering detailed and actionable insights. While it provides granularity, accuracy, and the ability to inform decisions in tax administration, it is constrained by data limitations, coverage gaps, and resource requirements.

Day 2 also featured in-depth country cases from various countries, illustrating the practical application of these methodologies. Ecuador, Nepal, and Zambia shared their experience in the use of a top-down approach to estimate CIT and PIT gaps, while Denmark and the USA showed the application of a bottom-up approach in PIT gap estimation. These cases provided valuable insights into the successes and challenges faced in different contexts, offering a rich learning experience for participants. The discussions underscored the importance of tailoring tax gap estimation methods to each country's specific economic and administrative context.

Day 3: Linkage between Tax Gap and Compliance Risk Management (CRM) 

The morning session on Day 3 focused on integrating tax gap analysis with Compliance Risk Management (CRM) in revenue administration (RA). The general trend suggests that TG, often underutilised, is an essential input for CRM. The aim is to support RA using a CRM framework to strategise overall tax compliance. The process involves identifying and monitoring non-compliance risks and creating models for compliance outcomes. Tax gap analysis can help estimate compliance gaps, aligning operational goals with strategic objectives and supporting risk identification at both macro and micro levels. 

The integration of TG and CRM involves a circular process including RA strategies and actions and monitoring changes in tax compliance. For effective use, TG needs to be segmented by taxpayer clusters, providing a two-dimensional view of risk based on consequence (impact on the public budget) and likelihood (probability of underreporting). This approach was applied in countries like Lithuania, Romania, and Uzbekistan, using standardised models and methodologies. 

The presentations also covered the use of TG in risk identification, emphasising its strategic-level importance. They suggested monitoring the direct and indirect effects of RA actions on compliance gaps using audit yields and changes in non-compliance indicators as measures. The aim was to reinforce the core strategy of revenue administration by focusing on voluntary compliance and adapting to new challenges like hiring skills in statistics and econometrics and focusing on tax gap nuances.

Key Takeaways and the Way Ahead  

The 2024 ATI Tax Gap Workshop highlighted the complexities of estimating the tax gap, revealing the challenges and benefits of existing estimation methods. The Workshop reflected on existing knowledge and tools to address challenges. Discussions underscored the interplay between tax policy design and implementation, linking technical challenges to broader economic and social goals. These insights are crucial for countries navigating complex fiscal landscapes, aiding efforts to improve the equitability and effectiveness of tax systems.  

Looking ahead, the Workshop’s outcomes aim to inform policy debates and research, especially for developing countries, refining their tax systems for resilience and equity. The collaborative nature of the event, bringing together various international organisations and stakeholders, highlighted the need for a unified approach to fiscal issues. Capitalising on this partnership and the momentum, it is proposed to start a Community of Practice (CoP) where ATI Partner Countries and other stakeholders continue their exchange and engagement on the topic. This CoP will facilitate knowledge exchange and the dissemination of best practices within the ATI community. In summary, the 2024 ATI Tax Gap Workshop once more emphasised the key role of DRM in financing the Sustainable Development Goals (SDGs) by spotlighting the need for international collaborative work to close national revenue leaks. 

More information on the development of the CoP and the technical report of the Workshop will be shared with ATI members in due course. 

For a recap of the Wealth taxation session from the afternoon of Day 3 of the Workshop, please follow the link here. 

You can access the detailed agenda of the three-day 2024 ATI Tax Gap Workshop (available in English, French, and Spanish) here. The presentations delivered throughout the workshop are compiled under this link.