Tax Assured and Tax Gap for the Federal Personal Income Tax System

This report is also available in PDF format (4507 KB).

Executive Summary

• Acting on the Minister of National Revenue’s commitment to work to estimate the tax gap, in June 2016, the Canada Revenue Agency (CRA) released two reports: Tax Gap in Canada: A Conceptual Study, and Estimating and Analyzing the Tax Gap Related to the Goods and Services Tax/Harmonized Sales Tax^{Footnote 1}.
  • The first report examined key considerations for tax administrations undertaking tax gap estimation, outlined the approaches used by tax administrations in other countries, and discussed the advantages and limitations of tax gap estimation.
  • The second report was prepared by the Department of Finance and examined the tax gap for Canada’s Goods and Services Tax/Harmonized Sales Tax (GST/HST). It estimated that on average, between 2000 and 2014, 5.6% of potential GST/HST revenues were foregone due to non-compliance.
• Building on these previous reports, this paper reviews the personal income tax system and provides an in-depth analysis of the level of compliance with Canada’s federal personal income tax laws using the concepts of tax assured and tax gap. Tax assured is a concept developed by the Organisation for Economic Co-operation and Development (OECD), which identifies portions of the tax base where the tax administrator has assurance of a low risk of non-compliance. The tax gap indicators presented in this report include the tax gap related to the non-payment of personal income taxes, and the gap resulting from unreported income earned in the domestic underground economy (UE).
• In reviewing the key systemic features of the personal income tax system, this paper finds that extensive third-party information reporting in combination with other features contribute to a tax base that is largely assured or at low risk of non-compliance with minimal direct CRA intervention. For the 2014 tax year, the report finds that 86% of income assessed, 74% of deductions reported and 83% of credits claimed were assured.
• These findings support CRA’s risk-based compliance strategy which aims to minimize compliance burden for the vast majority of taxpayers reporting correctly while dedicating valuable resources to high-risk areas.
• Using tax gap analysis, this report then estimates: 1) assessed taxes not collected by the CRA at about $2.2 billion for the 2014 tax year; and, 2) the contribution of domestic unreported income earned in certain key UE activities to federal tax loss at about $6.5 billion in the 2014 tax year. Combined, these tax gaps amount to $8.7 billion or 6.4% of personal income tax revenues in 2014.
• Of note, self-employment income is a completely non-assured income base, due to a near-complete lack of third-party reporting and a more complex reporting process. As well, the analysis in this paper suggests that self-employed individuals may contribute disproportionately to tax loss resulting from UE activity. While this does not mean that all self-employment income is reported inaccurately, it is at higher risk of reporting non-compliance, be it unintentional or intentional. Such findings have helped inform CRA outreach and the design of compliance efforts in this area of higher compliance risk.
• This report does not estimate the international component of the tax gap. The CRA is carefully studying the matter and is committed to producing a study on this issue in 2018.

Introduction

An effective personal income tax system depends on taxpayers reporting and paying the right amount of tax at the right time. While a significant majority of Canadians do meet this standard, some do not. Whether intentional or not, this non-compliant behaviour can lead to a tax gap.

The tax gap represents the difference between the taxes that would be paid if all obligations were fully met in all instances, and the tax actually paid and collected. As a tool, tax gap estimates, combined with other data on non-compliant behaviour, can provide tax administrations and governments with valuable insights into the general health of the tax system and the levels of non-compliance with tax laws.

Building on the research presented in previous reports, this paper will review the key characteristics of the personal income tax system and provide an in-depth analysis of the level of compliance with Canada’s federal personal income tax laws using the concepts of tax assured and tax gap.

As discussed in the conceptual tax gap paper published in June 2016, direct tax gaps like income tax gaps are best measured using bottom‐up methodologies that rely on a tax administrator’s internal administrative data to estimate the amount of taxes theoretically owing. A statistically representative sub‐set of taxpayers is used to estimate non-compliance, usually through a random audit program, and the results are then extrapolated to the full taxpayer population to produce a tax gap estimate.

While the CRA does have a random audit program to estimate non-compliance for small- and medium-sized businesses (both self-employed individuals and incorporated businesses), the CRA’s compliance strategy for personal income taxes does not include a comprehensive random audit program that covers the remainder of the individual population. Instead, the CRA applies a risk-based approach to compliance efforts, audits and review processes, and dedicates resources to targeted audits where the risk of non-compliance is greater. This approach helps to minimize the compliance burden on taxpayers, while ensuring a high degree of compliance.

In light of the above, this paper takes the following complementary approaches to analyzing personal income tax non-compliance. It first uses a tax assured framework to identify the portions of the assessed tax base that are at low risk of non-compliance. The tax assured concept was coined by the Organisation for Economic Co-operation and Development (OECD)^{Footnote 2} as being a “very strong measure because it summarises information on core compliance outcomes. It demonstrates where there is voluntary compliance, which is just as useful as identifying where there is non-compliance.” The tax assured analysis presented in this paper involves identifying income, deduction and credit amounts that are assessed and verified by the CRA by matching information reported by taxpayers with information provided by arm’s-length third parties (e.g., T4 slips issued to employees by their employer).^{Footnote 3} It is worth noting that our definition of tax assured is a conservative one in that the CRA carries out a number of verification activities beyond matching of third-party information that also lower the risk of non-compliance prior to intervention, but which are not added to tax assured amounts. Nevertheless, about 86% of income assessed in 2014 was considered tax assured. While the remaining 14% of income was considered to be at a higher risk of non-compliance than assured income, it does not necessarily mean it was reported inaccurately as it would have been subject to other compliance activities.

To discuss federal tax loss due to non-compliance, the report uses tax gap analysis to estimate assessed taxes not collected by the CRA, and to estimate the contributions to the tax gap of unreported income earned in the underground economy (not detected by the CRA).

Overall, this report finds that a relatively high proportion of amounts reported to the CRA is assured or reported accurately with minimal CRA intervention. The findings are consistent with CRA’s risk-based compliance strategy which has the objectives of minimizing compliance burden on the vast majority of taxpayers reporting correctly while dedicating valuable resources in high-risk areas.

The report also finds the tax gap related to the activities of the underground economy within the scope of this report to be about $6.5 billion while the gap related to payments is estimated to be about $2.2 billion for the 2014 tax year. Combined, these gaps amount to $8.7 billion, 0.4% of GDP or 6.4% of personal income tax revenues in 2014.

Of note, this report does not estimate the international component of the tax gap. The CRA is carefully studying the matter and is committed to producing a study on this issue in 2018.

The report is organized as follows. Section 2 first reviews the fundamental features of the personal income tax administration system, types of non-compliance and how to measure compliance. Section 3 presents the report’s first set of compliance indicators: tax assured indicators that reflect CRA’s confidence that tax information is reported correctly. This discussion complements the subsequent discussion of a second set of indicators: tax gap estimates. Section 4 presents an estimate of the payment gap and Section 5 presents estimates of the tax gap related to income earned in the underground economy. Concluding thoughts are presented in Section 6.

2. Canada’s Self-Assessment System for Personal Income Taxes

“A well-functioning tax system is the foundation stone of the citizen-state relationship, establishing powerful links based on accountability and responsibility.”^{Footnote 4}

Angel Gurría, Secretary-General,
Organization for Economic Co-operation and Development

To maintain an efficient and effective tax administration system, it is important that personal income tax obligations be well understood by Canadians, and that the CRA be able to identify, monitor and address areas at risk of potential tax loss. This is even more critical given the reliance on personal income tax revenues to fund programs and services to Canadians. The federal Budget 2017 projects personal income tax revenues to be the largest source of federal revenues in 2016-17, accounting for $143.2 billion – or almost 50% of total federal government revenues.^{Footnote 5}

This section reviews the fundamental features of the personal income tax administration system, types of non-compliance, as well as the CRA’s compliance actions to protect the integrity of the tax base.

2.1 Self-assessment System

Filing a tax return every calendar year is a legal obligation for many Canadians. Individuals are generally required to file an Income Tax and Benefit Return (T1 Return) if they have any tax payable in a given tax year and to pay these amounts by April 30 of the following tax year. The CRA processes about 27 million returns each year.

Canada’s personal income tax system is based on self-assessment – like in many developed countries around the world. Under a self-assessment system, individual taxpayers are responsible for ensuring the information they report on their tax returns is accurate and complete. Individuals must report all sources of taxable income^{Footnote 6}, such as income from employment, investment, and self-employment, and the taxpayer is responsible for claiming any deductions and tax credits to which they are entitled.

In the absence of adequate administrative controls, a self-assessment system may be susceptible to higher levels of non-compliant behaviour. This non-compliance can take the form of deliberate acts of tax evasion or honest mistakes in interpretation and calculation. To help mitigate these risks, Canada’s self-assessment system is supported by accessible client services and information products, extensive withholding and instalment requirements, a strong mandatory third-party reporting regime, the use of advanced digital technologies for administrative and intelligence-gathering purposes, and a robust risk-based approach to the identification and correction of non-compliance.

• Client Services and Information Products: In a self-assessment system, the CRA must provide timely and accurate information to taxpayers to help them meet their tax obligations and receive the benefits to which they are entitled. The CRA uses its website as its principal means of communication, while also using other channels such as social media, written communication, and call centres.
• Withholding/Instalments: Income taxes are required to be withheld at source for most forms of income in Canada, including employment and pension income. The payer (for example, an employer) withholds income tax from sums paid to the employee and remits them to the Government of Canada on the payee’s behalf (in this example, the employee). When the income earned has no tax withheld or does not have enough tax withheld for more than one year, individuals may be required to pay tax by instalment. The need to pay by instalments is often triggered when an individual is in receipt of income which is not deducted at source such as rental income, investment income, or self-employment income.
• Mandatory third-party reporting: Third parties are required to report certain types of payments made to individuals directly to the CRA. For instance, employers providing T4 slips to employees regarding their employment income, and organizations providing T5 slips to individuals receiving certain types of investment income, are both required to file this information directly with the CRA. This regulated system of third-party reporting allows the CRA to verify income reported by individuals on their tax returns by matching it against information from these third parties. This process is called “data matching” (see Section 3 for more details).
• Use of Technology: The CRA is continuously refining its capability to detect and address suspected non-compliance by employing new and emerging tools. Using advanced analytics, the CRA can gather information from different sources to identify potential instances of non-compliance and focus the deployment of its resources for compliance follow-up. To stop non-compliance before it occurs, the CRA has employed new tools to conduct predictive analysis, which uses historical data as a basis for predicting taxpayers’ behaviour. These techniques have been applied by the CRA, for example, to identify non-filers and to design more effective strategies for dealing with tax debtors.
• Risk-based compliance review: The CRA carries out a number of activities to assess non-compliance risk and aims to select the most appropriate interventions to address a given type of non-compliance risk. This means that the CRA usually employs the least intrusive and most efficient approach to encourage taxpayers to comply with their tax obligations, while coercive enforcement interventions are reserved for those who do not intend to comply. This risk-based approach also underlies the CRA’s audit interventions. Overall, this contributes to the overall cost effectiveness of tax administration by allowing the CRA to focus the bulk of its resources on areas of greater risks.

These five key features of Canada’s self-assessment system are critical for maintaining an efficient and effective tax administration. They also help to minimize the compliance burden on taxpayers, while ensuring a high degree of compliance.

2.2 Compliance Activities

The CRA’s compliance activities help to protect the integrity and fairness of Canada’s self-assessment system by identifying and dealing swiftly with those who do not file when required, do not accurately report income, deductions and credits, or do not pay what is due when it is due. Compliance interventions follow an escalating approach, from encouraging compliance to enforcing it. The interventions seek to positively influence compliance attitudes through targeted taxpayer outreach, by providing high quality and easily accessible client services, and through ongoing awareness and education campaigns. The CRA also conducts examinations, audits, and investigations domestically and internationally to ensure individuals are in compliance with their tax obligations.

Compliance challenges are present at the three key stages in the tax administration process – filing, reporting and payment (Figure 1).^{Footnote 7} Each of these three types of non-compliance are discussed below.

Figure 1: Stages in the Tax Administration Process and Types of Non-compliance

2.2.1 Late-filing/Non-filing

As the Canadian income tax system for individuals is based on self-assessment, the first instance of non-compliance arises when individuals do not file their tax returns. There are many reasons why individuals do not file tax returns even when they are required to do so. Apart from those who consciously decide not to file to avoid paying taxes, some individuals may not be aware of their legal obligation to file, may not know how, or may forget. Late-filing is also a form of filing non-compliance and late filers are charged interest and/or assessed a penalty based on their outstanding tax debt and how late the return is received.

There are several dedicated CRA programs aimed at identifying non-filers and encouraging them to comply with their tax obligations. These programs identify individuals who have not filed a return but have had a previous reporting relationship with the CRA or who have third-party-reported amounts, and are determined likely to have taxes owing. In general, the CRA’s enforcement actions begin with letters asking or demanding the taxpayer to file. If unsuccessful, compliance actions may escalate and take the form of calls or visits to the taxpayer’s home or place of business. If, despite these efforts, an individual still does not file, the CRA may assess an individual’s tax liability based on available information^{Footnote 8} or the non-filer may be served a legal requirement to file. Failure to comply with a legal requirement can result in prosecution.

2.2.2 Non-reporting/Under-reporting

Once individuals have filed their returns, a second potential compliance challenge arises in regards to reporting. Individuals may fail to provide complete and/or accurate information in their tax return by under-reporting income, over-stating deductions, and/or claiming credits they are not entitled to. Reporting non-compliance can be intentional or unintentional.

To ensure that returns are filed correctly, the CRA undertakes the following steps in the processing of returns.

• First, once returns have been filed with the CRA, they are reviewed for apparent errors and omissions.
• Second, certain files are selected for a secondary review based on level of risk, using selection criteria such as amount of the claim, tax potential, and the taxpayer’s compliance history.
• Third, once issues are resolved, the CRA processes the return and sends taxpayers Notices of Assessment, which explain the details of any changes made by the CRA to their returns, and indicate tax refund amounts or the amount of taxes owing.
• Fourth, certain returns are flagged for re-examination or audit. This could be the result of returns having a certain risk profile, based on random selection, or at the request of the taxpayer (who, for instance, has additional information to provide). This may require that the CRA reach out to the taxpayer to request additional information.
• Lastly, the CRA re-assesses the taxpayer’s return based on any additional information received or uncovered during the re-assessment process. Taxpayers who are re-assessed are issued a Notice of Re-Assessment.

Section 3 of this report provides additional details about the reporting stage.

High net worth individuals

Aggressive tax planning represents a significant threat to the tax base in Canada and in other countries. While some high net worth individuals may have genuinely complicated affairs that make it difficult to ensure they comply fully with their tax obligations, some wealthy individuals and related parties use private corporations and/or complex schemes to purposefully and inappropriately reduce or defer tax.

“High net worth individuals pose significant challenges to tax administrations because of the complexity of their affairs, their revenue contribution, the opportunity for aggressive tax planning and the impact of their compliance behaviour on the integrity of the tax system.”

OECD, Engaging with High Net Worth Individuals on Tax Compliance, 2009

The CRA is committed to combatting aggressive tax planning schemes used by individuals. In particular, the government has recently expanded the scope of a key audit program focussed on high net worth individuals and their related entities. The Related Party Initiative (RPI) was enhanced in Budget 2016 to include new risk assessment strategies and additional audit teams. The RPI is responsible for identifying and managing high-risk compliance issues involving high net worth individuals and their related entities. In this context, these individuals are considered to be those who alone, with family, or together with related entities control business activities in multiple entities and control at least $50 million of net worth. The RPI program reviews the tax risk of the entities within these corporate webs including a thorough risk assessment of the high net worth individual and related entities. This holistic approach is undertaken by examining the role of the various corporations, personal trusts, private foundations, joint ventures, and partnerships in the structure as well as evaluating the impact of offshore activities or investments.

Compliance issues detected through these reviews have been diverse including a wide range of complex and tailored tax avoidance arrangements.

To the extent that high net worth individuals engage in offshore activities, other CRA projects and initiatives are underway to curb offshore tax evasion and aggressive tax avoidance, including:

• Reviewing high-value money transfers as they cross borders to and from Canada and studying specific offshore locations and certain financial institutions;
• Collaborating and sharing information with international partners, through work with the OECD, aimed at promoting international tax standards, reducing tax barriers, and increasing transparency around global tax issues; and,
• Identifying international non-compliance and abuses through the exchange of information facilitated by Tax Information Exchange Agreements and through the multilateral Convention on Mutual Administrative Assistance in Tax Matters.

Self-employed individuals

Since self-employment income is not subject to third-party information reporting or withholding requirements, it is at a relatively higher risk of not being reported accurately. The CRA may not be able to detect this income other than by targeted intervention. As well, the deductions that can be claimed against this income are generally not reported by third parties and therefore generally cannot be data matched by the CRA.

As for the general population, the overall compliance strategy for the self-employed is about applying the right intervention for the risk. Interventions are tailored to detect, address, and facilitate compliance and deter non-compliance. The CRA dedicates resources to the audit and verification of returns filed by the self-employed. Because many self-employed individuals do not have sophisticated internal controls, books or records akin to those maintained by corporations, the CRA often relies on indirect techniques to detect and verify income and expenses.

The CRA also carries out random audits focussed on certain self-employed individuals in order to validate existing risk profiles and to detect emerging trends. Random audit results can be applied to the population studied even though only a small sample of the population has been audited.

For example, the CRA conducted a T1 Small and Medium Enterprises Research Audit Program (T1 SME RAP) during fiscal years 2011-2012 and 2012-2013 using a representative sample of individuals reporting self-employment income^{Footnote 9} for the 2009 tax year. The sample included about 4,700 individuals who were randomly selected for the T1 SME RAP. The main objectives of the program were to establish non-compliance rate estimates by industrial sector, and to validate and refine risk assessment systems.

Results from the T1 SME RAP show that if all 2.2 million self-employed individuals covered by the study had been audited, between $2.4 billion and $3.0 billion^{Footnote 10} (2009 dollars) in additional federal tax revenues would have been assessed. The T1 SME RAP results cannot be extrapolated to self-employed individuals who did not file or did not report self-employment income.

The results also indicate that slightly over half of the filers in the sample made reporting errors (or alternatively, slightly under half did not make any reporting errors) and more than 90% of the files with errors had a change in federal tax payable. The average amount of federal tax adjustment was $1,224 (2009 dollars) with about 12% of files accounting for over 70% of the adjustments.

It is also important to note that most adjusted files contained errors identified as unintentional. This result highlights the importance of CRA outreach efforts to small businesses to inform them of their tax obligations. In this regard, in addition to traditional compliance measures such as audits, the CRA has a number of initiatives in place to encourage compliance amongst the self-employed in situations where the non-compliant behaviour may be unintentional and compliance can be facilitated through education, outreach or assistance. This type of preventative approach underlies the following:

• The Liaison Officer Initiative (LOI): The LOI is designed to help small businesses meet their tax obligations. The initiative provides taxpayers with education and support to comply with tax requirements. A visit from a liaison officer does not constitute an audit and will not result in any CRA-driven changes to past tax filings. The focus of the LOI is to help businesses get it “right from the start” by providing them with in-person support and guidance at key moments of their business life cycle.
• Industry Campaign Approach: The CRA works with industry associations to provide businesses with sector-specific tax information that will help them to comply with their tax obligations. The objectives of the program are to:
  • Develop enhanced relationships with selected industry sectors;
  • Provide more useful information and education for businesses on how to avoid potential tax pitfalls; and,
  • Direct taxpayers to useful industry benchmarks that businesses may find helpful in assessing their financial performance in comparison to others in the same sector.
• Office Audit Letter Campaigns: The CRA has yearly letter campaigns to inform selected taxpayers about their tax obligations and to encourage them to correct any inaccuracies in their past income tax and benefit returns. As part of these campaigns, educational letters are mailed to certain individuals in selected activity groups where taxpayers are at risk of misunderstanding their tax obligations.

2.2.3 Late payment/Non-payment

Payment non-compliance arises when individuals have tax owing that they do not pay in full or at all by the payment deadline, which is April 30 of the year following the tax assessment year. The CRA takes a firm and efficient approach to collecting outstanding payments from tax debtors. In addition to charging interest on the outstanding debt, the CRA uses various escalating compliance activities that could lead to penalties or legal action if taxpayers do not settle their debts or make payment arrangements with the CRA.

2.3 Compliance Indicators

This report uses two types of indicators to illustrate the scope of non-compliance of individuals. First, the report presents indicators for the part of the tax base that is considered assured and wherein the CRA has a high level of confidence that taxes are correctly being assessed. Second, using tax administration data and other data sources, the report estimates tax gaps resulting from certain types of non-compliance. Tax gap analysis has been conducted in recent years by some tax administrations in other countries to help understand the extent of tax revenue loss due to non-compliance. These indicators, and their use in the present paper, are considered below.

2.3.1 Assurance Indicators

“Tax assured measures the proportion of the tax base where the revenue body has “justified trust” through its activities or others’ activities that tax is “under control” and so assured as accurate and paid.”

OECD, Measures of Tax Compliance Outcomes, 2014

Indicators of tax assured identify the part of the revenue base in which the tax administration has a high level of confidence that the risk of non-compliance is low. This confidence needs to be tested over time, as risks change.

This report defines portions of the tax base as assured where the CRA determines that amounts reported are at low risk of non-compliance. This judgement is made based on whether amounts are either subject to arm’s-length third-party information reporting or are legislated fixed claim amounts.^{Footnote 11} Third-party information allows the CRA to conduct data matching to identify and correct unreported or misreported income, or over/understated tax deductions and credits, based on information received independently of the taxpayer with minimal direct intervention. In this way, the CRA can have a relatively high degree of confidence in the reporting compliance/accuracy of amounts reported on a tax return that are verified and corroborated by data-matching. It is important to emphasize that non-assured components are not necessarily wrong or non-compliant; they are, however, not subject to data-matching and are at higher risk of non-compliance. Identifying the non-assured tax base allows the CRA to target its efforts at areas of greater risk of non-compliance.

We would note that our definition of assured for this analysis is a conservative one in that the CRA carries out a number of verification activities beyond data matching that add to enhance its confidence that taxpayers are reporting correctly.

2.3.2 Tax Gap Estimation

Broadly defined, the tax gap is the difference between the tax that would be paid if all obligations were fully met in all instances, and the tax actually paid and collected. Tax gap estimates are a function of the existing tax framework and of the quality of data available.

Direct tax gaps, including income tax gaps, are generally best estimated using a bottom-up methodology. Such an approach uses relevant individual-level data, which is most efficiently acquired through a comprehensive random audit program. The results of a random audit of a representative sample of the T1 population could be extrapolated to the T1 population as a whole and provide a statistically reliable and precise estimate of tax loss.

While the CRA does have a random audit program to estimate non-compliance for small- and medium-sized businesses (both self-employed individuals and incorporated businesses), the CRA’s compliance strategy for personal income taxes does not include a comprehensive random audit program that covers the remainder of the individual population. This is in part due to the fact that random audit programs are resource-intensive and can subject taxpayers, many of whom may be fully compliant, to a high degree of scrutiny. Instead, the CRA’s internal research and the design of most of its compliance efforts are risk-based.

3. Assured T1 Tax Base

In carrying out its mandate, the CRA strives to ensure that all individuals pay their required share of taxes, receive the benefits they are entitled to, and have avenues to seek an impartial and responsive review of contested decisions. To achieve these goals, the CRA has built a tax administration system aimed at ensuring that taxpayers report income correctly and abide by the rules.

In order to preserve the integrity of the system, it is critical that the CRA have appropriate indicators to monitor compliance and address sources of non-compliance. This section develops and presents a series of tax assured indicators based on the OECD framework on tax assured. According to the OECD, tax assured is a conceptually robust indicator of compliance which measures “the proportion of the tax base where the revenue body has “justified trust” through its activities or others’ activities that tax is “under control” and so assured as accurate and paid”. This report defines the portions of the tax base as assured where the CRA has confidence that amounts reported by taxpayers are at low risk of non-compliance because these amounts are subject to arm’s-length third-party reporting and data-matching by the CRA, or are fixed amounts specified in legislation (for instance, the basic personal amount).

3.1 Income Reporting and its Verification

One of the key characteristics of Canadian personal income tax administration is the important role played by the extensive system of arm’s-length third-party reporting of information. This means that a significant amount of information required to be reported by individuals on their T1 Return is collected from information slips received directly by the CRA from third parties. For example, the CRA has access to:

• T4 slips issued to employees by their employer, with a record of salary or wages paid and taxes, contributions to Employment Insurance (EI) and the Canada Pension Plan (CPP), and other amounts withheld;
• Annual information returns filed by financial institutions for Registered Retirement Savings Plans (RRSP) contributions made by an annuitant, or her/his partner;
• T4A(P) issued to individuals receiving CPP benefits;
• T3 slips issued to individuals for income and credit amounts designated to them by a trust (a fiduciary relationship in which an individual gives other parties the right to hold title to property of assets for their benefit); and,
• T5 slips issued by financial institutions on investment income earned by individuals.

One of many reviews conducted by the CRA aimed at monitoring compliance and ensuring the integrity of the Canadian tax system is the T1 matching process. Information on slips filed with the CRA by third parties, and information filed by individuals’ spouses, is matched to the amounts reported by individuals on their return. The CRA is able to identify many errors and omissions made by individuals in respect of their personal income tax through this process. Re-assessments based on matching do not necessarily lead to an increase in the tax liability for the taxpayer, as they could also lead to a reduction in taxes or an increase in benefits. In fact, ensuring that Canadians have access to their tax benefits is a key priority for the CRA.

Much of the matching process is automated and is able to correct data entry errors or fill in missing information. The CRA’s analytical models identify issues and automatically re-assess taxpayers. Although matching can confirm that the amount an individual reports is the same as what the third party reports, there is still a small risk of intentional or unintentional non-compliance. For example, an employer may unintentionally misstate amounts on an employee’s T4, or an employer and employee might collude in a tax evasion scheme (e.g., whereby the employer reports only a portion of the employee’s earnings).

For this analysis, we place the types of income that are required to be reported on the T1 Return into either assured or non-assured categories. Any lines of income that are subject to arm’s-length third-party reporting, and therefore covered by the data-matching process, are considered assured (e.g., T4 employment income reported on line 101), while other lines that can only be corroborated by the taxpayers themselves or by sources of information other than arm’s-length third-party information, are considered non-assured (e.g., self-employment income). Some lines have only portions that are subject to third-party reporting and therefore have both assured and non-assured components (for instance, capital gains).

Our analysis indicates that the CRA has justified trust that 86% of assessed income was reported accurately for the 2014 tax year (Figure 2) with minimal direct CRA intervention.^{Footnote 12}

Source: T1 Final Statistics, 2014 tax year: http://www.canada.ca/en/revenue-agency/programs/about-canada-revenue-agency-cra/income-statistics-gst-hst-statistics/final-statistics-2016-edition-2014-tax-year.html and Infodec data

Table 1 identifies the largest sources of income which are subject to third-party reporting and in which the CRA has justified trust that tax filers reported correctly, and those which it does not. Employment income is the largest source of assured income at 63% of total income assessed, with other pension and superannuation amounting to an additional 7%. This means that a majority of income reported by individuals is assured with little direct intervention by the CRA. On the other hand, the main contributions to non-assured income are dividend income (4%), self-employment income (4%) and income from capital gains (2%). These are the largest sources of income which the CRA is only able to verify with sources other than information slips.

It bears repeating that the 86% of income that is assured does not mean that the remaining 14% of income is being reported incorrectly. In this report, assured income is income for which information reporting and data-matching programs together provide the CRA justified trust that amounts are reported correctly with minimal intervention. By contrast, the remaining 14% of non-assured income are not subject to these same processes. As a result, the CRA does not have the same level of justified trust in the accuracy of this 14% of income reported and it is at higher risk of reporting non-compliance, especially before targeted interventions are carried out.

Source: T1 Final Statistics, 2014 tax year: http://www.canada.ca/en/revenue-agency/programs/about-canada-revenue-agency-cra/income-statistics-gst-hst-statistics/final-statistics-2016-edition-2014-tax-year.html and Infodec data

3.2 Deductions and Credits

A number of deductions and credits are available to individuals to reduce their tax payable.^{Footnote 13} These deductions and credits often serve objectives internal to the tax system (for instance, to prevent double taxation or promote fairness of the tax system), as well as other policy objectives (to encourage savings/investment or support competitiveness). Under Canada’s self-assessment system, individuals are responsible for determining their eligibility for these deductions and credits and claiming eligible amounts on their tax return that may reduce their tax owing. The following sub-sections discuss the extent to which these amounts are assured and the compliance activities undertaken by the CRA to determine if individuals are claiming the non-assured credits and deductions appropriately.

3.2.1 Assured Deductions and Credits

Like income, a number of deductions and credits are subject to third-party information reporting and data-matching, and are therefore at low risk of being reported incorrectly. In addition, there are credit amounts that are fixed amounts specified in legislation and are therefore at low risk of reporting non-compliance (for example, the basic personal amount which all individual taxpayers can earn without paying income tax is fixed for all taxpayers and leaves very little room for error or omission). Deductions and credits subject to arm’s-length information reporting or are fixed amounts are considered assured and at low risk of non-compliance. About 74% of deduction amounts are assured and 83% of credit amounts are assured (Figure 3).

Source: T1 Final Statistics, 2014 tax year: http://www.canada.ca/en/revenue-agency/programs/about-canada-revenue-agency-cra/income-statistics-gst-hst-statistics/final-statistics-2016-edition-2014-tax-year.html and Infodec data

Table 2 presents the largest assured deduction and credit amounts (Annex 2 lists all assured and non-assured deductions and credits).

Source: T1 Final Statistics, 2014 tax year: http://www.canada.ca/en/revenue-agency/programs/about-canada-revenue-agency-cra/income-statistics-gst-hst-statistics/final-statistics-2016-edition-2014-tax-year.html and Infodec

Contributions to Registered Retirement Savings Plans are matched against reports from financial institutions authorized to register individuals’ contributions to these retirement savings vehicles. Deductions related to these plans accounted for about 28% of the total value of deductions claimed in tax year 2014. The deduction that removes non-taxable benefits from taxable income, such as provincial social assistance benefits and the Guaranteed Income Supplement, is called the “other payments deduction” and represented another 19% of the total value of deductions.

With respect to credit amounts claimed, the basic personal amount represented over 60% of the value of all credits claimed for the 2014 tax year, while the age amount, the credit for Canada Pension Plan contributions, the Canada employment amount and the spouse/common-law partner amount added an additional 19% to assured credit amounts.

It is important to note that these assured values do not all have the same impact on tax revenues. In particular, the progressivity of the tax system will affect the actual tax value of deductions while the impact of credits on tax revenues depends on individuals’ effective credit rate.^{Footnote 14}

3.2.2 Non-assured Deductions and Credits

Although relatively smaller in value overall, there are many types of deductions and credits that are not subject to third-party reporting or have a discretionary element (e.g., a fixed amount is not set in legislation or eligibility is not universal). These present greater compliance challenges than assured deduction and credit amounts. For example, while taxpayers may receive receipts for donations made to registered charities, these charities are generally not required to send a copy of those receipts directly to the CRA, though the CRA may ask taxpayers for the receipts to verify their claims to the credit.

The CRA systematically reviews these deductions and credits, using both a risk-based approach and through random selection (on a deduction/credit basis) to test and ensure compliance with the Income Tax Act. Table 3 presents some of the most commonly required adjustments in risk-based reviews. Other deductions and the Northern Residents Deductions are among the largest value adjustments to deductions reported. Medical expenses are among the largest credit amounts, as well as tuition, education and textbook amounts and the public transit amount.^{Footnote 15}

When taken together, the total amounts claimed for these commonly adjusted deductions and credits are relatively small – representing 2% of the value of all deductions and 5% of the value of all credits claimed in the 2014 tax year.

Source: T1 Final Statistics, 2014 tax year: http://www.canada.ca/en/revenue-agency/programs/about-canada-revenue-agency-cra/income-statistics-gst-hst-statistics/final-statistics-2016-edition-2014-tax-year.html  

Regular reviews are conducted on high-risk deductions and credits. In a given review of a particular high-risk deduction or credit, the sample population is randomly selected from all individuals claiming that deduction or credit. The random selection is critical to determining deductions and credits that pose high compliance risk, patterns of non-compliance and the revenue implications. The recent random sample for the 2014 tax year indicated that approximately 22.5% of the claims were non-compliant, although non-compliance rates did vary between specific deductions and credits. The value of non-compliance was estimated to be an average of $92 per return.

In the absence of this type of review and subsequent compliance efforts taken, it is estimated that up to $1.5 billion would have been lost for the 2014 tax year in relation to the higher-risk deductions and credits. Risk scores from these types of reviews are critical for the CRA’s audit and verification programs to effectively protect the tax base.

4. Tax Gap Approach: Payment Gap

Section 3 introduced and developed the concept of assurance as an indicator of T1 tax compliance in Canada. To complement our discussion on compliance, the remainder of this report aims to estimate some key parts of the T1 tax gaps as indicators of T1 non-compliance, to the extent that available data allow. A tax gap can arise from filing and reporting non-compliance and, even if income is reported and assessed correctly, a tax gap can also arise when assessed taxes are not paid (i.e., “payment non-compliance” as explained in Section 2). This section of the report examines payment data and outlines a methodology for estimating Canada’s payment gap, while Section 5 presents analysis on the tax gap related to filing and reporting non-compliance in the underground economy.

4.1 Payment Data

Due to late-filing and the time it takes for compliance efforts to be completed (for example, audits, re-assessments, appeals, collection actions), data on the payment of tax debt become more complete over time. The analysis below is based largely on 2014 tax year data, but because of the time lag in resolving tax debt, the estimate of the payment gap is the upper bound of the range.

Historically, the highest risk for debt at initial assessment is related to taxpayers with income not subject to third-party reporting or withholding, such as self-employment income. The non-compliance risk for the self-employed is also higher compared to the rest of the T1 population because it may be more challenging for the self-employed to keep the records necessary to report income amounts and expenses accurately. Self-employed individuals may also be more at risk of bankruptcy than other individuals. Instalment requirements for individuals reporting self-employment however partially mitigate these risks.

4.2 Payment Gap

Based on 2014 tax year assessing and accounting data available at the time of writing, 16% of the $13.6 billion in debt at the Notice of Assessment stage remains outstanding, amounting to $2.2 billion, for the 2014 tax year.^{Footnote 16} This is generally in line with other research findings for other tax years. For instance, 2010 tax year initial assessment data showed 13% of debt still outstanding two years after the payment deadline.

This payment gap takes into account the 2014 tax year debt that has been written-off or removed from the federal government’s accounts ($6.5 million or less than 0.1% of debt at initial assessment). The CRA considers debtors’ ability to pay, individuals’ associated accounts (e.g., GST or payroll accounts), and third-party assessments within legislated time limitations on collections in its investigations leading to write-off decisions. Write-offs are amounts that were assessed as taxes payable but for various reasons are deemed to not be collectible (for example, due to bankruptcy of the taxpayer). From this perspective, they add to the payment gap.

By the above approach, the total payment gap for the 2014 tax year was about $2.2 billion^{Footnote 17}, amounting to 1.6% of personal income tax revenues in 2014. It should be noted that this payment gap is an overestimate to the extent that assessment and collections on 2014 tax year debt will in fact continue into the future and exceed write-offs. Indeed, we note that an alternative method for calculating a payment gap would be to tally all write-offs related to 2014 tax year debt once all collection efforts have been exhausted. This, however, would involve a significant time lag before a report could be produced.

5. Tax Gap Approach: Underground Economy

In this section, we discuss the tax gap that results from individuals not reporting income earned in the underground economy (UE) and where it is not detected by the CRA. The tax gap associated with UE activities within the scope of this analysis is estimated at about $6.5 billion for 2014. This represents about 4.8% of personal income tax revenues and 0.3% of GDP.

As the CRA does not carry out a single random audit program that covers the entire T1 population, we are unable to take results from existing audit programs to extrapolate a tax gap for the general population (i.e., bottom-up approach). Instead, we adopt a top-down approach and leverage aggregate statistics on the UE published by Statistics Canada to approximate an income base for tax purposes and, in turn, the tax gap related to the UE. While there are a number of limitations to adopting a top-down methodology and using Statistics Canada’s estimates of the UE (as discussed below and in Annex 3), the estimates do provide a general indication of the potential tax revenue loss from UE activities within the scope of this report.

As noted previously, only the domestic components of the tax gap are addressed in this paper.

5.1 Underground Economy (UE)

The UE is commonly understood as economic activity or income that is purposely hidden from public authorities, which can include working under the table or skimming (when revenues are under-reported or costs over-reported to understate net income). A variety of definitions for the UE exist – depending on the context, it may include activities that are officially measured and unmeasured, taxable and non-taxable, legal and illegal, or even very small-scale economic activities that generate income. From the CRA’s perspective, the UE includes any activity that is unreported or under-reported for tax purposes.

5.1.1 Implications of Using Statistics Canada’s UE Estimates

The starting point for our analysis is Statistics Canada’s annual UE estimates for Canada.^{Footnote 18} Statistics Canada’s underground economy estimates aim to identify missing or unreported productive activity that is not captured in official Canadian Gross Domestic Product (GDP) statistics. Although these estimates of the UE can provide a general sense of the magnitude of T1 hidden taxable income in key activities, there are a number of reasons why using the Statistics Canada’s estimates for tax gap purposes cannot lead to a precise T1 tax gap estimate^{Footnote 19}:

• First, Statistics Canada’s methods were intended to provide an upper bound rather than a precise estimate of in-scope UE activities;
• Second, some estimates include components already embedded in GDP, which should theoretically be added to total UE estimates. Statistics Canada does not publish these amounts separately but have indicated that the amounts account for less than 10% of the hidden income base estimated in this analysis; and,
• Third, by its very nature, it is difficult to obtain information on UE activities so the estimates necessarily rely on assumptions, indicative information and various indirect methods.

In addition to limitations to using Statistics Canada estimates, there are also a number of caveats related to a top-down approach to estimate the tax gap and the methodology taken to adapt Statistics Canada estimates for the purpose of this report.

• A top-down approach does not account for the particular circumstances of individuals participating in the UE that would determine the actual effective tax rates these individuals would face if they were to comply.
• It was not possible to consider hidden income that is earned by activities outside the scope of the framework used to estimate GDP, such as unreported income from capital gains on the sale of assets. More details are provided in Annex 3.
• The UE estimates are produced on a GDP basis and therefore largely reflect activity that occurs within Canada’s borders. Therefore, consistent with the focus of this paper, international sources of UE income are outside the scope of Statistics Canada’s estimates.
• The analysis excludes illegal activities completely given the data limitations^{Footnote 20} and uncertainties about the amount of taxes that could actually be assessed and collected on these activities.

If this analysis seems highly-caveated, we would emphasize that all tax gap analysis requires some indirect estimation of hidden activities. While audit results can uncover some UE activities and unreported income, they provide an incomplete picture of the universe of undetected activity. This is because even if all individuals were subject to a comprehensive audit by the most skilled auditor, there could still be unreported income that would be go undetected. As a result, any tax gap analysis requires non-tax data to estimate income hidden for tax purposes, and, is therefore constrained by the methods used to collect this non-tax data, as well as how good a substitute the data is for direct measurement of hidden income.

5.1.2 Hidden Income by UE Activity

The activities within scope of our tax gap analysis of the UE fall under either the hidden sector or informal sector. The definition of these sectors, as outlined by Statistics Canada, are presented below.

• Hidden Sector: The hidden sector is comprised of “activities that are productive and legal but are deliberately concealed from authorities” due to individuals wanting to avoid taxes, social security contributions, labour standards, administrative procedures, or to increase the benefits they receive. Activities in the hidden sector include skimming, unreported construction-related activities (new homes or renovations), hidden rent income, undeclared tips and unreported trade-related activity.
• Informal sector: This sector includes informal production activities associated with establishments that are not registered with fiscal or social authorities. The activities within scope of Statistics Canada’s research are childcare in the home, private household services, other personal care services and direct sales of agricultural products. Although it is possible that UE activity exists in other industries in the informal sector, they have been excluded from Statistics Canada’s estimates until further research determines the magnitude of this missing productive activity.

Table 4 presents the estimated amounts of income earned in the UE for the activities within the scope of this analysis. These are based on Statistics Canada’s UE income-based GDP estimates. To allow for direct comparison with the 2014 tax year figures reported elsewhere in this paper, hidden income by UE activity is also expressed in 2014 dollars.^{Footnote 21}

Source: Statistics Canada, National Economic Accounts Division, 2016, special tabulation

On the whole, the estimated amount of hidden income for the activities within scope of this analysis was $31.9 billion in 2013. This is equivalent to $32.5 billion in 2014 dollars^{Footnote 22}, or about 2.5% of the reported income and 1.6% of GDP in 2014. Individuals hiding some form of compensation accounted for 78% of all hidden income while hidden income from self-employment accounted for the remaining 23%. Income earned in construction accounted for 27% and unreported tips accounted for 16% while UE activities in other sectors accounted for 49% of all hidden income. Other sectors include a number of smaller sectors participating in the UE, including maintenance and repair of vehicles, child care services, and services related to household maintenance (other than renovation).^{Footnote 23}

Of note, the amount of hidden income covered by this report account for about 70% of the total UE estimate published by Statistics Canada.^{Footnote 24} Our exclusions related to illegal activities ($4.1 billion) and incorporated businesses UE revenues ($12.9 billion) account for most of this difference.

5.2 Estimating Tax Revenue Loss

This section estimates the federal personal income tax revenue forgone as a result of UE activities within scope of this study. To determine the taxes that would have been paid if the income earned had been reported, we have assumed the tax rate to reflect the federal effective marginal tax rate (EMTR)^{Footnote 25} of individuals in similar circumstances or reporting income in similar activities.

An EMTR represents the tax rate that would apply on reporting an additional amount of income. The federal EMTRs used in this analysis account for statutory income tax rates, deduction and credits. As this tax gap analysis relates to federal income tax revenues, the EMTRs used do not account for provincial income taxes nor do they account for income-tested federal and provincial benefits. That is, the tax gap calculated represents the federal taxes foregone as a result of the UE hidden income. A detailed discussion on the assumptions underlying the calculation of the EMTRs are presented in Annex 3. The EMTRs assumed for each UE activity as well as the corresponding tax gaps are reported in Table 5.

The estimated tax gap associated with UE activities within the scope of this analysis is about $6.5 billion. The foregone revenues represent 4.8% of personal income tax revenues and 0.3% of GDP in 2014. The tax gap related to activities in the construction industry is estimated at $1.8 billion while that related to unreported tips accounts for $770 million. Of note, the tax gap related to the total of the smaller sectors is estimated at $3.3 billion, about half of the overall tax gap.

5.3 CRA Compliance Efforts that Uncover Underground Economy Activities

UE activities place an unfair burden on law-abiding taxpayers and businesses, and they jeopardize the integrity of Canada's tax base. As such, the CRA takes participation in the UE very seriously. In order to combat the challenge of identifying income that is deliberately hidden, the CRA has developed a series of strategies.

In the course of the administration of the tax system, the CRA finds evidence of UE activities in the form of non-reporting or under-reporting of income. This can occur either at the risk assessment stage or during the audit and verification process.

The CRA has a dedicated UE strategy and tactical plan focussed on 1) refining the CRA’s understanding of the UE; 2) reducing the social acceptability of participation in the UE; and 3) mobilizing a range of data, information and legislative tools, initiatives and partnerships to correct non-compliant behaviour and address persistent non-compliance. In harnessing research and advanced analytics, and through working with industry stakeholders, other levels of government and the Minister’s Underground Economy Advisory Committee, the CRA has positioned itself to better target UE participants and activities with its compliance activities. These activities are tailored to the attitudes towards compliance of UE participants and the risk of non-compliance associated with them.

In addition, the CRA conducts special UE projects in certain sectors or regions, where the risk of non-compliance has been determined or is thought to be high.

Beyond these specific projects, the CRA has programs that use third-party information and leads from the general public to identify different types of non-compliance. These programs may sometimes uncover UE activity or trigger audits to confirm whether UE activity is involved.

Voluntary Disclosures Program (VDP)

The VDP offers individuals a chance to correct inaccuracies in one or more tax returns that were previously filed or to file returns that should have been filed. By filing voluntarily before being identified by the CRA as non-compliant, individuals may be eligible for reduced penalties and/or be able to avoid criminal prosecution.

The VDP is intended for individuals to come forward to report previously undisclosed income from domestic or international sources. In 2015-16, 60% of the disclosures were related to domestic sources. Unreported wages and benefits accounted for 45% of these domestic disclosures, while only accounting for 6% of foreign source disclosures. For foreign source disclosures, unreported interest and dividend income accounted for the largest portion at 60%, and only accounted for 8% of domestic source disclosures.

Income declared through VDP reduces the income reported incorrectly and reduces the size of the tax gap that would exist in the absence of the program.

Informant Leads Program (ILP)

The ILP coordinates and reviews information provided by the public to assist the CRA in identifying taxpayers who may be violating tax laws. Lead information for this program pertains to tax evasion allegations on the part of an individual or a business taxpayer. After reviewing the information for elements of non-compliance with tax legislation, leads are referred to the corresponding compliance program for appropriate action. The number of leads that the ILP has received has been steadily increasing over the years. In 2015-16, the National Leads Centre received over 32,000.

Offshore Tax Informant Program (OTIP)

Based on international best practices, the OTIP allows the CRA to make financial awards to individuals who provide specific and credible information related to major international tax non-compliance that leads to the collection of taxes owing.

Since it was launched in January 2014, the OTIP has generated a great deal of interest. As of December 31, 2016, over 407 submissions have been received and over 200 taxpayers were under audit and a number of files have been referred for criminal investigation. The CRA has entered into over 25 contracts with informants who have provided specific and credible information on hundreds of taxpayers who are suspected of concealing income and assets offshore. At a minimum, each contract is expected to identify an additional $100,000 in federal taxes.

6. Conclusion

The federal government relies in large part on an effective personal income tax system to be able to raise the revenues needed to deliver public programs and services to Canadians. Preserving the fairness and integrity of the tax system while ensuring high compliance of individuals with their tax obligations is therefore a top priority for the CRA and the government.

By reviewing the T1 tax administration system, this report has shown how its key systemic features – which include accessible client services and information products, an extensive withholding regime, mandatory third-party reporting, use of digital tools and technology, and a strong risk-based compliance approach – ensure high compliance even before CRA compliance intervention. This paper also reports the indicators supporting CRA’s compliance strategy for personal income taxes, which is risk-based in approach for most of the predominantly-assured personal income tax base, with the exception of dedicating resources for random audits of high risk sources of income (self-employment) or for reviews of reported amounts at high risk of non-compliance (deductions and credits).

The effectiveness of these features is borne out in the assurance compliance indicators presented in this paper. This report finds that a relatively high proportion of amounts reported to the CRA is assured based on data-matching. For the 2014 tax year, the report finds that 86% of income assessed, 74% of deductions reported and 83% of credits claimed were assured with minimal direct CRA intervention. Identifying assured portions of the income base can inform compliance efforts and the targeting of more intense compliance efforts at non-assured components where there is higher risk of non-compliance.

To complement the tax assured analysis, this report also presented estimates of the tax gaps resulting from payment, filing, and reporting non-compliance. Assuming that any outstanding T1 debt for the 2014 tax year at the time of writing could be at risk of non-payment, this report estimates the payment gap to be about $2.2 billion for the 2014 tax year, representing about 1.6% of personal income tax revenues in 2014.

Transforming Statistics Canada’s estimates of the underground economy to approximate T1 income hidden from the CRA for tax purposes, this analysis estimates a gap of about $6.5 billion for tax year 2014, or 4.8% of personal income tax revenues, related to unreported income earned in the underground economy activities covered by this report. The total T1 tax gap within scope of this report amounts to $8.7 billion, 0.4% of GDP or 6.4% of personal income tax revenues in 2014.

By the approach used in this analysis, there are risks of overestimating the payment gap and underestimating the filing and reporting gap. However, in general, a $8.7 billion gap is likely an underestimate of the true T1 tax gap – the exclusions made to our analysis resulting from data limitations (such as capital gains and international reporting non-compliance) are likely more significant than the impact of payment gap underestimation. We note that attribution of a larger share of the personal income tax gap to filing/reporting non-compliance than to non-payment is consistent with the findings of other jurisdictions.

It also is worthwhile to note the risks associated with self-employment income that have been identified in this paper. Self-employment income is a completely non-assured income base, due to a near-complete absence of third-party reporting and a more complex assessment process. While this does not mean that all self-employment income is reported inaccurately, it is at higher risk of reporting non-compliance, be it intentional or unintentional. As a result, it is audited by CRA more often than the rest of the T1 income base.

The UE analysis also illustrated the large potential contribution of the self-employed to the total T1 tax loss resulting from hidden income earned in the UE. The SME RAP estimated that more than half of the self-employed population made some type of reporting error. However, it also found that the vast majority of errors were small and likely unintentional. Such findings have helped inform CRA outreach and the design of compliance efforts in this area of higher compliance risk.

The indicators developed in this report demonstrate the challenges of producing system-wide macro-level tax gap estimates and the difficulty in interpreting these estimates. The CRA is committed to improving transparency with respect to the administration of the tax system and will continue to release papers on key components of Canada’s tax gap over the next two to three years.

Source: T1 Final Statistics, 2014 tax year: http://www.canada.ca/en/revenue-agency/programs/about-canada-revenue-agency-cra/income-statistics-gst-hst-statistics/final-statistics-2016-edition-2014-tax-year.html and Infodec data

Source: T1 Final Statistics, 2014 tax year: http://www.canada.ca/en/revenue-agency/programs/about-canada-revenue-agency-cra/income-statistics-gst-hst-statistics/final-statistics-2016-edition-2014-tax-year.html and Infodec data

Source: T1 Final Statistics, 2014 tax year: http://www.canada.ca/en/revenue-agency/programs/about-canada-revenue-agency-cra/income-statistics-gst-hst-statistics/final-statistics-2016-edition-2014-tax-year.html and Infodec data

Source: T1 Final Statistics, 2014 tax year: http://www.canada.ca/en/revenue-agency/programs/about-canada-revenue-agency-cra/income-statistics-gst-hst-statistics/final-statistics-2016-edition-2014-tax-year.html and Infodec data

Annex 3: Technical notes

A3.1 Defining Tax Assured

A number of different categories of entities report information to the CRA. They include employers, financial institutions, governments, and large firms. These are considered to be third parties when they report information to the CRA independently from the taxpayer to which the information reported relates.

For the purposes of the tax assured analysis, all income, deduction and credit lines in the T1 General Form and Schedule 1 were operationally defined as assured in the following way:

• For income, deductions and credits amounts: subject to arm’s-length third-party reporting supported by the T1 matching program; and
• For deductions and credits amounts: fixed deduction and credit amounts (e.g., age amount).

Some lines are only partly assured according to the above definition. In such cases, lines were split into assured and non-assured portions. Partially assured amounts included:

Income

• Taxable amounts of dividends from taxable Canadian corporations;
• Other income;
• Interest and other investment income; and,
• Taxable capital gains.

Deductions/Credits

• Registered Pension Plan (RPP) deduction;
• Annual union, professional or like dues;
• Federal dividend tax credit; and,
• Total tax credit on donations and gifts.

A3.2 Transforming Statistics Canada Underground Economy Estimates to a T1 Hidden Taxable Income Base

Statistics Canada Underground Economy (UE) papers report upper-bound estimates of the extent of underground economic activity in Canada beyond what is already included in GDP. The estimates of UE activities are first prepared by Statistics Canada on an expenditure by sector approach to arrive at expenditure-based UE GDP. A number of key assumptions are made at this stage: 1) underground activity occurs mainly in the household sector; 2) unincorporated businesses are more likely to participate in the UE than corporations; 3) the non-profit and government sectors do not take part in the UE; and 4) residential construction is considered the only investment activity that has UE activity in the corporate sector.

Statistics Canada's estimates of income-based UE GDP are then developed by benchmarking to the expenditure-based estimates, with income allocated to factors, including compensation to employees, gross operating surplus (corporations) and gross mixed income (unincorporated businesses), according to a set of fixed allocation assumptions.

Estimates of Statistics Canada’s income-based UE GDP are not perfectly aligned to the concept of taxable income. As a result, for the purposes of this report, it is necessary to take certain steps to transform the estimates into a domestic T1 hidden taxable income base.^{Footnote 30} This transformation first requires removing the gross operating surplus (corporations) component of income-based UE GDP, leaving only the components relevant for T1 income (compensation to employees and gross mixed income (unincorporated businesses)). Compensation to employees is then broken out into UE activities consistent with the income allocation assumptions in Statistics Canada’s studies.^{Footnote 31} Finally, other hidden sources of taxable income, outside the calculation of GDP^{Footnote 32}, need to be added, which we assume to be negligible other than unreported capital gains.^{Footnote 33} That said, there are data limitations related to adding taxable capital gains to the UE estimates and they are not included in our tax gap analysis. Related considerations are discussed in the section below.

It is important to highlight that the tax loss estimates related to UE activity are sensitive to the estimation methods used for each UE activity and the assumptions for how income earned through these activities is allocated between individuals, corporations and the self-employed. Different methods and assumptions would lead to different gap estimates.

A3.3 Capital gains

Taxable sources of capital gains are generally realized when individuals are considered to have sold capital property, which includes land, buildings, shares, bonds, personal property (for instance, residences) and listed personal property (for example, artwork), at a price in excess of the adjusted cost base.^{Footnote 34}

Statistics Canada’s UE estimates do not cover capital gains. Relevant data on which to base an estimate of unreported capital gains was not available for the purposes of this report. While special projects, audits and other compliance activities are conducted by the CRA to verify reported capital gains or to identify unreported capital gains, they are risk-based and cannot be extrapolated and scaled up to give an indication of non-compliance within the entire T1 population for the purposes of this report.

Of particular note are capital gains realized on the sale of real estate. The CRA uses a combination of advanced risk-assessment tools, analytics, leads, and third-party data to detect and address non-compliance in this sector, which can contribute to both the domestic and international tax gaps. The Housing Statistics Framework announced in Budget 2017, in combination with recent changes to reporting requirements (regarding, for instance, the sale of principal residences), will enhance the data available on residential properties in Canada, purchases and sales. This information will further enhance the targeting of CRA’s compliance activities in this area.

A3.4 Limitations of a Top-down Approach

This report’s filing and reporting gap is intended to estimate the unreported income of both filers and non-filers who would have a tax liability if they filed. Non-filers in this context are filers that are not identified by CRA’s non-filer programs by June 2016. They are distinct from those non-filers that were identified by dedicated CRA programs and were subsequently factored into assessed income for tax year 2014. Because of the top-down nature of our approach to estimating T1 hidden income, the tax loss due to non-filing and under-reporting cannot be broken out into two separate filing and reporting gaps.

As well, given how CRA audit activity is tracked internally, it is not possible to remove UE-related income actually identified through the CRA’s audits and verification activities from global estimates of hidden income. This is to say that we are not able to estimate an audit gap, or the amount by which the estimated 2014 filing and reporting gap related to UE activities was actually reduced by compliance activities. In this respect, the actual 2014 tax gap may be somewhat over-estimated.

A3.5 Effective Marginal Tax Rates

The Department of Finance’s T1 micro-simulation model was used to determine the effective marginal tax rates (EMTRs). An EMTR represents the tax rate that would apply on reporting an additional amount of income – that is, it reflects the change in tax liability as a result of a marginal change in income.

The EMTRs calculated by the model account for federal and provincial statutory income tax rates, deductions and credits, and, when applicable, the clawbacks of federal income-tested benefits delivered using the tax system (e.g., Working Income Tax Benefit and child benefits). For the purpose of this study, only the component of the EMTR as it relates to the federal personal income tax system was used to determine foregone federal tax revenues.

Typically, EMTRs are calculated on a small marginal change in income (e.g., a marginal dollar of additional income). Given that UE participants are likely hiding more that a marginal dollar, we have assumed a larger margin to be conservative (i.e., a larger margin would result in higher EMTRs on average). In absence of statistics on the average amount of hidden income by individuals participating in the UE, we have assumed individuals would hide an amount equivalent to 20% of reported income.

Finally, EMTRs by sector were calculated under the assumption that UE participants have the same marginal tax rate as filers reporting income in similar sectors of activity (as presented in Table 5). For individuals in the hidden construction and tips sectors, we were able to link the employees to the employer’s North American Industry Classification System (NAICS) code. We have assumed the sectors related to tips to include food services and drinking places, travel accommodations, taxi, limousines, personal care services and other personal care services. The EMTRs for individuals under other UE activities and UE trade-related activities assumes the average EMTR for employees and self-employed individuals, respectively.

The average EMTR used for the self-employed in hidden construction corresponds with that of the self-employed who declared the construction NAICS code on their T1 Return. The EMTRs used for the self-employed earning hidden income from other UE activities and from hidden rent/room and board corresponded to those for the self-employed generally and for rental income, respectively.

Glossary