Last month the UK Parliament’s Treasury Select Committee announced the launch of three new enquiries on different aspects of tax enforcement. Whilst the enquiries will address tax avoidance concerns, the biggest emphasis is on tax fraud and enforcement. This is very welcome. Whilst tax policy tends to get the headlines tax enforcement is fundamental for the functioning of the tax system. Tax enforcement should not be a secondary consideration to tax policy. Instead, the two are interlinked and interdependent: tax policy should be dependent on enforcement as much as enforcement depends on policy.
This is why a fair tax policy is not enough, tax enforcement must too be fair and respectful of the rule of law. And this is why recent trends on tax enforcement are so worrying.
When we think about tax fraud, we tend to think about it in terms of revenue loss. Tax fraud is, by nature, difficult to measure, so we tend to estimate the scale of fraud on the basis of estimates of lost revenue. Whilst this is a natural approach, it gives rise to the common misconception that the only costs of tax fraud are revenue costs. In reality, however, tax fraud gives rise to other costs, in particular: distortions to competition; taxpayer inequity; and, (in effect) subsidies to organised crime.
Tax fraud can impose significant costs upon legitimate traders by creating distortions to competition. A lobby group of UK-based SMEs has been drawing attention to the distortions caused by VAT fraud perpetrated online by non-EU traders, and research substantiates their reports. The impact is likely to affect SMEs more strongly than bigger firms, as the latter’s higher cash-flows allow them to better respond to the presence of fraudsters in the market.
Tax fraud also affects taxpayer equity, both horizontal and vertical: those with higher incomes are more likely to be able to engage in fraud; and taxpayers in similar circumstances, will be treated differently, since a fraudulent taxpayer will have a lower tax burden than that of an honest taxpayer. This is not only important in itself, but is also significant because there is strong evidence that perceptions of unfairness in the tax system are important for general tax compliance. A sense of unfairness may also affect social cohesion if the public believes that there are certain rules for some, and different rules for others.
The connection between organised crime networks and tax fraud, and its use as a financing method for illegal activities, has been acknowledged by EU institutions, and are a common feature of media reports. There is growing awareness that profit resulting from organised tax fraud is used to subsidise other criminal activities such as counterfeiting, human and drug trafficking, and more recently terrorist activities.
So, tax fraud has many costs that go beyond revenue loss. Yet our recent approach to combating tax fraud has tended to ignore these other factors, simply equating fraud with revenue loss. Indeed, whilst the last decade has witnessed significant intensification of anti-tax fraud policy worldwide, with an upsurge in both legislative and administrative measures, these measures are primarily designed to combat the revenue costs of fraud, not fraud itself.
Tax amnesties are a good example. Amnesties allow tax fraudsters to voluntarily repay all or part of unpaid taxes without being subject to criminal prosecutions or full penalties. Although they have been present since the 1980s, they have become particularly popular since the financial crisis, as governments have seen them as an efficient method of obtaining additional revenue. Yet tax amnesties do not address fraud itself: distortions to competition will not disappear, neither will tax inequity - as the expected value paid of what is paid by the fraudulent taxpayer is lower - or any potential subsidies to other criminal activity. Not only is the fraud itself not being addressed, there is strong evidence that lack of punishment creates a moral hazard, as it increases the expected value of the fraud. This reduces tax compliance, and so increases tax fraud in the medium term.
Tax amnesties are far from being the only manifestation of this approach to anti-fraud policy, which prioritises short-term revenue benefits over the elimination of tax fraud. Other examples can be found in many different taxes: from income taxes to VAT, from excise duties to customs duties. Nor are they geographically limited to one or two countries: this approach can be found in the UK, as well as many other European countries, in the US, Canada, and Brazil. These measures often result in a reduction in the measured tax gap, thus giving the impression of an effective anti-fraud policy, whilst in reality failing to tackle fraud itself, and in fact potentially increasing its future levels.
A mixture of public finance concerns, tax administration incentives and targets, and the genuine and significant difficulties and costs entailed in combating tax fraud has, progressively, perniciously, lead to an enforcement system that prioritises immediate revenue collection over other factors, such as equity or deterrence.
This endangers our rule of law. Equating revenue costs of fraud with fraud itself, and basing enforcement decisions only on revenue considerations has the potential to undermine the overall credibility of our legal systems.
These measures are part of our criminal justice systems, and yet can no longer be regarded as either deterrent or punishment. Rather, they are but a compensatory mechanism for the revenue lost through fraud. Tax fraud has become a crime whose effects are to be managed, rather than a crime to be suppressed.
Short-term revenue considerations should not be the primary criterion for tax enforcement. Focusing only on revenue inevitably leads to selective tax enforcement, fatally undermining both neutrality and equity; it leads to further inefficiency, by discrediting the tax system and undermining compliance; and crucially it undermines the rule of law, slowly corroding one of the core values upon which our society is based.
This blog is based on Oxford University Centre for Business Taxation Working Paper 18/02 entitled “Tax Fraud and the Rule of Law”, published in January 2018. Full references to the backing evidence for the statements made here are provided in the paper.