Is our tax system fit for purpose?

Tax officials last night admitted mistakes could be found in the returns of millions more people on top of the 5.5 million they have already identified as having paid the wrong amount of tax.

As taxpayers began to receive letters potentially demanding many thousands of pounds – or offering rebates averaging £420 – for paying wrong amounts during the past two full tax years, HM Revenue & Customs (HMRC) admitted another vast backlog of older cases. It disclosed the existence of 17.9 million unfinished "open cases" prior to March 2008. Hundreds of extra checkers are working through the cases.

The official estimate of over- and underpayments for these earlier years is £3bn, although HMRC stressed that some cases would result in no errors being found, and would have to write off much money owed because it could no longer trace individuals.

MPs and consumer campaigners scorned the mistakes, which have been detected in a short period of time thanks to the introduction of a £140m computer system.

HMRC insisted the mistakes were a sign its new system was working and pointed out that people owing less than £2,000 would not be asked to pay back the money in a lump sum, which would instead be clawed back in their pay through the PAYE system next year. It also said it would consider leniency in individual cases.

However, tax advisers urged people asked to make repayments to appeal to the HMRC under a little-known rule. A19 states that where the inspectors have failed to take action for more than a year when it was supplied with the correct information, the public can argue they should not be required to repay. However, the rule is at the discretion of tax inspectors. Another route may be if people can prove they are now in hardship, for instance if they have retired or lost their job.

The mistakes follow a string of problems at the agency, which included overpaying £6bn in tax credits because of fraud and error. Last year, its customer contact centre answered only 57 per cent of 103 million calls, indicating 44 million callers rang until they put down the phone.

Earlier this year, HMRC admitted that "£11.2bn of the £27.7bn of tax debt at the end of March 2009 is unlikely to be collected". It added: "The Department has deferred its plan to invest in a new debt-management system."

There are also concerns that large sums from corporations and wealthy individuals are not being collected because HMRC is going soft on tax avoidance. An estimated £70bn is lost in the UK through the shadow economy each year. HMRC puts the "tax gap" – the difference between the tax they think is owed and the tax paid – at £40bn a year.

HMRC announced the problem on Saturday. While 4.3 million people will receive a total of £1.8bn of overpayment, averaging £420 each, a further 1.45 million will be asked for £2bn arrears, £1,380 per taxpayer. If the amount is over £2,000, HMRC will request payment in a lump sum by January 2012.

People who are likely to be affected are those who changed jobs, started a new job and had an emergency tax code, only worked for part of the year, had more than one job at the same time, were made redundant or became self-employed. Other cases involve reduced or increased investment income, including rents.

HMRC says it will contact all cases by Christmas, with the first tranche of 45,000 letters having been posted, second class, on Friday. Around 30,000 are due a rebate, while 15,000 have underpaid tax.

The HMRC head of national news, Paul Franklin, admitted the situation was unsatisfactory. "We have to improve accuracy, there's no argument about that. We're not happy with how PAYE has functioned, we're happy with the fact it taxes most people correctly, we're not happy with the fact that some people are wrongly taxed," he said.

The Conservative MP Michael Fallon, a member of the Treasury Select Committee, described the episode as "shocking" and called for HMRC to give people forced to pay arrears in lump sums a period of grace to pay.

Fearing that fraudsters would launch "phishing" attacks in email and phone calls, HMRC stressed that it would only write to people about the problems. It defended its behaviour, saying that 85 per cent of PAYE codes were correct.

It added: "As for the number of open cases still live from cases pre-2008, there are currently roughly 17.9 million cases open. However, five million of those cases will be designated unworkable for a variety of reasons (incomplete information on our records, customer is untraceable)."

Case study

Keith Watkins, 70

A retired former draughtsman and factory worker, he lives in Walsall and receives four separate pensions, three private and one OAP, totalling around £13,000 a year. "I got a letter on Monday. It doesn't say much, it looks more like a gas bill, just a load of numbers. But there's a deficit at the bottom showing I didn't pay enough tax in the year 2008-09. It says tax underpaid, £337.20."

Q&A: What should you do if you are told you owe tax?

Will I get a letter from the Revenue demanding money?

It's possible, but probably only if your circumstances have changed in the past two years (if you've changed jobs). The good news is that there's more chance that you could be in line for a windfall – some 4.3 million people have overpaid their tax and are in line for a refund averaging £419. However, if you're one of the 1.4 million people whom HMRC now calculates has underpaid tax, you will get a letter asking you to stump up an extra £1,428 on average.

Will I have to pay the money straight away?

No. The tax authorities are giving people until 2012 to clear the debt. If you owe less than £2,000 you will get a new tax code in the first three months of 2011 and the money owed will then be deducted through the PAYE system over 12 months from April. If you owe more than £2,000 you have until the end of January 2012 to pay it off in one lump sum.

When will I find out if I owe money?

Letters have started to be sent out and 45,000 people will get a brown envelope this week demanding cash or informing them they're getting a rebate. The Revenue will send the remaining 5.8 million letters by Christmas.

Can I appeal against HMRC's decision?

If you don't agree with the Revenue's calculation you should call them on 0845 3000 627 and tell them why. Bear in mind that the call will cost you at least 2p a minute, so be clear about why you are questioning the figures. However, you have every right to question the Revenue's calculations after their many previous cock-ups. The Low Incomes Tax Reform Group points out: "The tax calculation is just that; it is not a demand for payment; it is not an assessment which can be appealed; it is HMRC's estimate of the taxpayer's tax position."

What if I can't afford to pay the money back?

You may be able to claim hardship to get the money owed written off, points out accountant Tony Bernstein of HW Fisher & Company. "The Revenue has discretionary powers – under what is called extra statutory concession A19 – to waive what you owe if you can demonstrate a degree of hardship. It may not always work but it is certainly worth trying." The Low Incomes Tax Reform Group has some helpful notes about what to do if you can't afford to pay at its website www.litrg.org.uk

Simon Read, Personal Finance Editor