Introduction

In Budget October 2022–23, the Australian Government projects a large and persistent structural deficit (p. 81), against a backdrop of looming overseas recessions, natural disasters at home, war in Europe, a slowdown in China, an energy crisis, high inflation and rising interest repayments on national debts. The Budget depends heavily on personal and company income taxation, comprising on average 66% of all revenue over the forward estimates. (The remaining 34% revenue consists of the goods and services tax, excise and customs duty, superannuation, some minor indirect taxes and non-tax revenue.) The Australian Government confirms its election promises to initiate a multinational tax integrity package and extend existing compliance programs (p. 7) to raise revenue by addressing an existing tax gap.

This paper discusses major ‘tax gap’ measures in the Budget and points out that although addressing the tax gap is a welcome start, it alone won’t be sufficient to repair the structural deficit.

What is the ‘tax gap’?

The Australian Taxation Office (ATO) defines a ‘tax gap’ as:

an estimate of the difference between the amount of tax the ATO collects and what the ATO would have collected if every taxpayer was fully compliant with tax law.

Tax gaps are about measuring what is not directly observable – what people have not told us.

Our latest tax gap estimates show that for 2019–20, we received $446.4 billion or 93% of the $479.8 billion we would collect if everyone was fully compliant with tax law.

We collect most of this tax voluntarily, reflecting a system that is operating well. This means that the overall tax gap for 2019–20 is estimated to be $33.4 billion, or 7% of the tax that should have been reported.

Figure 1 illustrates the scale of the tax gap, relative to all collected taxes, according to ATO calculations. To be clear, the tax gap does not include revenue foregone in the form of ‘tax expenditures’, that is, tax concessions or exemptions applying to particular activities or classes of taxpayer (for example, the exclusion of personal homes from capital gains tax).

Figure 1: Comparing taxation revenue collected and tax gap in 2019–20 ($b)

Source: Parliamentary Library calculations based on numbers reported in ATO 2021-22 annual report, p. 64.

Causes of tax gaps identified throughout Budget October 2022–23: Budget paper no.2 include: tax avoidance practices used by multinational entities (MNEs), large Australian businesses and wealthy individuals; individuals’ non-compliance; shadow economy activities; and tax practitioners providing poor or unlawful advice. These behaviours impact all Australians, undermining the integrity of Australia’s tax and welfare systems, and creating an uneven playing field.

Major Budget receipt measures addressing the tax gap

Table 1 quantifies measures in Budget paper no. 2 that address the tax gap. Overall, the measures are expected to raise $6.6 billion in tax receipts over the forward estimates. In other words, they are expected to reduce 20% of the 2019-20 tax gap.

Table 1 Major receipt measures addressing the tax gap ($m)

* The nature of the measure is such that a reliable estimate cannot be provided. - Nil.

Source: Australian Government, ‘Part 1: Receipt Measures’, Budget Measures: Budget Paper No.2: October 2022–23, Table 1 Receipt Measures since the 2022 PEFO, pp. 4-5.

Assuming the $33.4 billion tax gap estimate in 2019–20 is still correct as of current, Figure 2 illustrates that 80% of the gap (or $26.7 billion) remains unaddressed even after applying the Budget measures to address the gap.

Figure 2 An illustration of remaining $26.7b tax gap after applying the measures ($b)

Source: Parliamentary Library calculations based on numbers reported in ATO 2021–22 annual report, p. 64 and Budget Measures: Budget Paper No.2: October 2022–23, Table 1 Receipt Measures since the 2022 PEFO, pp. 4-5.

Closing the Tax Gap: Multinational Tax Integrity Package

The Multinational Tax Integrity Package (MTIP) delivers on the Australian Government’s election promise, as well as Australia’s long-term commitment to implement the Organisation for Economic Co-operation and Development (OECD) Base Erosion and Profit Shifting (BEPS) 15 Actions. BEPS refers to the tax planning strategies used by MNEs to exploit gaps and differences between tax rules of different jurisdictions internationally. The OECD conservatively estimates the global annual revenue loss due to BEPS at US$100 to $240 billion. Following the G20 finance ministers’ request in 2013 to address the BEPS issues in a coordinated and comprehensive manner, the OECD released a final BEPS Actions package in 2015. (See Appendix A for a status on the Australia’s BEPS plan implementation.)

The MTIP is expected to reduce the tax gap by around $970 million over the forward estimates, which is lower than the election estimate of $1.9 billion (ECR167). The downward revision is mainly due to the Treasury’s taking account of the substituted accounting periods for the change in the thin capitalisation rule (MTIP element 1) and the cumulative effect of other minor changes in policy specifications such as revising down the corporate tax rates from ‘below 24%’ (p. F-242) to ‘less than 15%’ (p. 16) for MNEs claiming deductions relating to intangible assets (MTIP element 2).

The MTIP consists of three elements, which are expected to commence on or after 1 July 2023. Although Treasury completed a public consultation on the package in September 2022, final details are yet to be released. The ATO provides a summary of the proposed changes for each element.

MTIP Element 1 amends Australia’s existing thin capitalisation rules to align with OECD’s best practice approach under Action 4. It affects most MNEs operating in Australia currently subject to thin capitalisation rules with at least $2 million in debt deductions.

Australia’s thin capitalisation rules limit ‘debt deductions’ for interest expense and borrowing costs where the debt-to-equity gearing ratios must be within the prescribed debt limits. The maximum debt allowed is calculated by one of three tests, namely, the ’safe harbour’ (an objective level of debt an entity can use to fund the assets used in its Australian operations), ‘arm’s-length’, and the ‘worldwide gearing’ (the Australian operations of certain entities can be geared up to the level of gearing of the entity’s worldwide group). Entities are allowed to choose the test that gives the highest deduction and is the easiest to apply.

In 2014, the OECD reported (p. 19) some thinly capitalised MNEs (whose assets are funded by a high level of debt and little equity) shift their profits to lower tax countries and minimise taxable income by way of excessive interest payments to foreign affiliated companies. To address the issue, the OECD BEPS initiatives may tighten the current rules, affect the debt limits, and lead to a lowering of tax deductions in Australia by a combination of narrowing the scope of arm’s length debt limit and reducing the safe harbour ratios.

As the ATO explains, the ‘safe harbour’ test is expected to be replaced with an earnings-based test so that: debt-related deductions exceeding 30% of earnings before interests, taxes, depreciation and amortisation (EBITDA, a measure of profits) will be disallowed and carried forward for up to 15 years; the ‘worldwide gearing’ test will be replaced with an earnings-based group ratio rule; and the ‘arm’s-length’ test will be amended to only allow an entity’s third-party debt deductions (while disallowing related party debt deductions).

MTIP Element 2 denies significant global entities (SGEs)—with global revenue of $1 billion or more— from claiming deductions for payments relating to intangible assets and royalties held in a low or no tax jurisdiction, which have either ‘a tax rate of less than 15%, or a tax preferential patent box regime without sufficient economic substance’(p. 16). In the 2021–22 Budget, the Coalition Government announced it would establish a patent box tax regime in Australia and introduced a bill to the Parliament. The bill lapsed with the dissolution of the 46th Government. The Australian Government confirmed its intention to legislate this regime by not removing the patent box measure from the Budget March 2022–23 (pp. 22-24).

Element 2 addresses problems involving MNEs shifting profits of highly mobile intangible assets to tax havens. This profit shifting trend is exacerbated by the increasing digitalisation and globalisation of the economy. The related Action 5 introduces new rules to constrain eligibility requirements for a patent box, including a requirement for sufficient economic substance in the jurisdiction with the intangible assets. For example, deduction claims for Patent Box expenses will be denied in a jurisdiction (for example, a tax haven) where economic substance is lacking.

MTIP Element 3 improves tax transparency by introducing reporting requirements for relevant companies to enhance the tax information they disclose to the public. SGEs will be required to prepare for public release of certain tax information on a country-by-country basis (Action 13) and a statement on their approach to taxation, for disclosure by the ATO. Australian public companies (listed and unlisted) will be required to disclose information on the number of subsidiaries and their country of tax domicile.

The October Budget package also complements another Australian Government election announcement in supporting the OECD’s ‘Two-Pillar Solution’ for a global 15% minimum tax, and ensuring profits of the largest multinationals (such as Alphabet, Amazon, Meta, Microsoft and Apple) are taxed where the products or services are sold. This Budget does not contain a ‘Two-Pillar Solution’ measure.

Closing the Tax Gap: Domestic measures

Certain ATO and Tax Practitioners Board compliance programs are extended with additional government funding. These programs are briefly discussed below.

Personal Income Taxation Program

This program is expected to close the tax gap by $674.4 million over the forward estimates. It will focus on key non-compliance areas such as individuals overclaiming deductions and misreporting income. The ATO’s Second Commissioner re-raised the issues in October 2022 (p. 4):

we estimate that individuals are correctly paying about 94% of the tax they should be at lodgement … [Work related expense] claims account for almost $4 billion of the individuals not in business tax gap – or 44%. So many claims are an optimistic characterisation of personal expenses as work related, while others are even more creative claims … [The ATO estimates] the portion of the tax gap for 2018–19 attributable to unreported income was over $1 billion … Currently rental income and deductions contributed over $1 billion to the net tax gap. In the 2020–21 tax return (as of 30 June 2022), over 2 million rental property owners declared over $45 billion in income and about $43 billion in expenses. The Random Enquiry Program that helped determine this estimate showed that 9 out of 10 returns reporting net rental income required adjustment. This is startling and clearly something we need to address.

Shadow Economy Program continuation

The program is expected to reduce the tax gap by $2.1 billion over the forward estimates.

The ‘shadow economy’ refers to dishonest and criminal activities that take place outside the tax and regulatory systems. It is complex and multi-faceted. Examples of shadow economy behaviours include tax and identity fraud, dealing in illegal drugs and tobacco, and money laundering.

In 2016, it was estimated that the size of the shadow economy had likely doubled since 2012 from 1.5% of GDP to around 3% of GDP, or approximately $50 billion (p. 7). For that reason, the Government established the Black Economy Taskforce in 2016 to combat the shadow economy. The Taskforce released the Black Economy Taskforce Final Report in 2017. In the 2018–19 Budget, the Coalition Government responded to the report with a whole-of-government program for tackling the shadow economy and the implementation of the Taskforce’s recommendations is ongoing.

Closing the Tax Gap: Domestic and International combined

Tax Avoidance Taskforce

The Tax Avoidance Taskforce is expected to reduce the tax gap by $2.8 billion over the forward estimates. It will achieve this by ensuring large businesses and wealthy individuals pay the right amount of tax in Australia. It focuses on targeting promoters of tax avoidance who support or promote illegal behaviours and arrangements. This Taskforce works with partner agencies and other jurisdictions to protect the integrity of the tax system.

Established in 2016, the program has helped collect a total of $12.7 billion from 1 July 2016 to 30 June 2021. Recent audit cases in the public domain involve companies such as Apple, BHP, Chevron, Facebook, and Google. In some cases, tax revenues from these entities in Australia have increased up to 5 times. The taskforce ‘will pursue new priority areas of observed business tax risks, complementing the ongoing focus on multinational enterprises and large public and private businesses’. (p. 12)

Conclusion

Tax gap estimates measure the performance of the tax system in the past. An efficient tax system should minimise the tax gap. The current Budget measures addressing the gap are important. However, as the Budget strategy and outlook: budget paper no. 1 October 2022–23 (Chart 3.2) projects the cash deficit to be around 2% of GDP from now to 2032–33, addressing the tax gap alone is insufficient, and the Australian Government is likely to need to utilise more ‘tools’ to fix the deficit problem.

On Budget day, the Treasurer confirmed (p. 15) that ‘tax needs to be part of the [national conversation about Budget repair] going forward’. He further explained (p. 15) that:

what we've done in this Budget is we've built a foundation of a more sustainable Budget, but there's more work to do and that will involve ongoing spending restraint, it will involve trimming spending where we can, targeted investments and also tax reform.

Tax reform is an economic and social process that requires the Parliament to reach a political consensus on the trade-offs between the criteria for a good tax system (economic efficiency, equity, simplicity, flexibility, sustainability and policy consistency). This Budget seems to be a catalyst starting that conversation.

Appendix A: Progress summary of Australia’s implementation of the BEPS 15 Actions

Note: The information in this table is correct at the publication date. The information may change as Australia progresses with the implementation of the remaining outstanding BEPS actions.

Source: Australian Taxation Office, Base erosion and profit shifting.

All online articles accessed October 2022

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