Missing: pounds 7bn of our taxes

The economy is expanding, but the Treasury's share of the national tax cake is shrinking. Why? Diane Coyle investigates

The case of the Government's missing tax billions is an unsolved mystery. Some of the finest minds at the Treasury and Customs and Excise are working on the case. The sums are so large it is difficult to imagine how they might have gone missing without anyone knowing their whereabouts. Yet the plain fact is that the Government is short of about pounds 7bn worth of tax revenues this year.

Officials at Customs and Excise have been running an investigation into lower than expected revenues from Value Added Tax for more than a year. According to one of them: ``We're still stumped. There's something funny going on and we have no idea what it is.''

Several culprits have been canvassed. The most recent suspect was large- scale tax avoidance organised for multi-national companies by an army of advisers. Yet the solution to the mystery is almost certain to lie closer to hand. The profound changes that have reshaped the British economy in the past decade - deregulation, growing self-employment, the increasing number of people in low-paid jobs - may have made tax collection more difficult and tax returns more volatile.

The cost of creating a more open, flexible, entrepreneurial economy is that it makes tax receipts far less predictable. The shortfall in tax revenues may make it more difficult for the Government to afford pre-election tax cuts. The sums involved appal ministers.

In the 1994 Budget, just 17 months ago, total government income in 1995/96 was forecast at pounds 278.9bn. The Treasury cut the figure by pounds 2.5bn in a new forecast published in June. In last November's Budget the expected total was down to pounds 271.9bn. Figures due out today are likely to show the actual total to be another pounds 1bn-pounds 2bn lower.

In other words, despite the economy growing at a rate healthy enough to reduce unemployment to a five-year low, about pounds 7bn-worth of tax revenues, that is about twice the value of the income tax cuts that come into effect this month, has evaporated.

Where could this missing pounds 7bn have gone to?

Lower income tax payments account for the smallest chunk of this total, at just over pounds 1bn of the missing money. In its forecast last summer the Treasury gave its explanation: Britain's growing inequality of income meant the Government was collecting less tax. The mandarinese explanation was: ``higher employment and lower earnings within a given level of wages and salaries'' means a lower tax take. Put more simply, more people in low-paid jobs pay less tax than the same number of people in higher-paid jobs.

Another pounds 1.7bn of the revenue shortfall is due to lower than expected receipts from corporation tax. This shortfall is a bit of a surprise. Companies should be paying tax now on the bumper profits they earned in 1994. Companies are allowed to offset some losses against their corporation tax liability, and large companies sensibly try to organise their losses by different subsidiaries to the best tax advantage. Some of the missing money could be the result of - thoroughly legal - corporate ``tax mitigation''. Yet overall corporation tax receipts are up sharply, from pounds 15bn in 1993/94 to about pounds 25bn in 1995/96.

The core of the puzzle is Value Added Tax, which is more than pounds 4bn lower than the Government expected as recently as mid-1994. At the current rate of VAT that missing tax corresponds to nearly pounds 25bn of missing spending from which VAT should have been collected. Put another way, about pounds 1,200 for every household in the UK is being spent VAT free. It is as if every household has awarded itself a tax cut by not paying VAT on some purchases. This is a mystery of enormously worrying proportions.

Where is this money going?

Big corporations may be pocketing some of it. They have some scope to reduce their liability to pay VAT, and they use it. Large companies can be safely presumed to save more than the pounds 100m a year which the big accountancy firms receive in fees for this type of tax avoidance work. Even so, big companies are unlikely to account for as much as a quarter of the VAT shortfall.

There are two other possible explanations. To take the most straightforward answer first, patterns of spending have probably changed in ways that are unfavourable to VAT receipts. The best example is spending on the National Lottery. The lottery is estimated by City economists to have diverted spending away from items mainly liable for VAT by about 3 per cent in a year, or roughly pounds 4bn. The VAT loss could therefore be up to pounds 700m. Spending on the lottery is not liable for VAT. We have splashed out a total of pounds 6.6bn on tickets and scratchcards since the lottery started 16 months ago.

These calculations still leave the biggest part of the missing tax revenues unaccounted for. The remaining pounds 2bn-plus corresponds to average household spending of more than pounds 600 a year. This shortfall is a feature of the "enterprise" economy the Government has created.

Consider the following anecdote. In Golders Green, north London, there were six florists' shops in 1990. Now there is one - but at least six people in the area selling flowers out of the back of transit vans. The florists' shops pay VAT; the men with the transit vans do not. The level of spending on flowers in Golders Green may be exactly as it was six years ago but the VAT receipts will be much lower. That story is likely to be repeated time and again across the country.

Recent estimates put the size of the underground economy at 12 per cent of GDP, twice its mid-1980s scale. But some experts doubt this. According to Andrew Dilnot, director of the Institute for Fiscal Studies: ``There are very many people involved in it but it does not add up to very much. The amounts of spending are too small to make a figure of 12 per cent plausible.''

However, others think the recent growth of the underground, cash-in-hand economy could hold the solution to the puzzle of the missing billions. Simon Briscoe, an economist at the City of London investment bank Nikko, says: ``There has been a broad shift in the structure of the economy. This is not necessarily subversive but it does mean there is less flowing towards the Exchequer.''

Evidence for the growth of the informal or underground economy is necessarily mainly anecdotal. Yet the forces driving its growth are clear. The Government itself has deregulated to take more smaller businesses out of the VAT net. Self-employment is growing and with it cash payments for services. Consumers in the 1990s are determined not to pay more than necessary for anything.

The rapid growth of cash in circulation lends weight to this explanation. Cash in circulation has been growing at more than six per cent a year for two years, partly because of low interest rates and easier access to cash, but partly also due to an increased desire to use it.

The negative side of the enterprise economy as far as the Government is concerned is symbolised by the huge popularity of car boot sales. A recent study by the researchers Nicky Gregson at the University of Sheffield and Louise Crewe at the University of Nottingham estimated that a million people a week visit a car boot sale, spending nearly pounds 8 each on average. The most popular purchases are children's clothes, which are not liable to VAT. But that leaves up to pounds 500m in spending each week that has been switched from VAT-paying shops to non VAT-paying car boots.

Dr Gregson and Dr Crewe found that few of those who visited car boot sales were unemployed - they are not the preserve of the underclass. They are frequented by ordinary shoppers looking for bargains supplied by small-scale entrepreneurs.

The authors celebrate this ``world beyond the high street and mega-mall'', for its energy and conviviality. But if this is the new shape of the British economy, the Treasury will have to rethink its tax arithmetic.

Corporate tax

There is almost no hard data on the extent of avoidance of corporation tax. But it has become a burgeoning business for consultants and accountants.

Increasingly, companies see tax as just another cost to be cut, with complex schemes to reduce tax liabilities.

The shortfall of almost pounds 2bn in corporate tax suggests that companies have been more successful at reducing their tax liabilities, with big companies using losses at some subsidiaries to offset tax liabilities.

The 14.4 per cent jump in company profits in 1994 should be showing up in corporate tax returns. But as yet it isn't.

However, straightforward avoidance of corporation tax is not the main cause of the tax shortfall.

Income tax

The Government's reforms to make the labour market more flexible may have reduced its potential to collect income tax revenues.

The rise in self employment is a major factor behind lower tax revenues. There are now about 3.25 million self-employed, almost 1 million more than in the mid-Eighties. Self-employed workers pay less tax than those on pay-as-you-earn schemes.

The growth of low-income jobs has also reduce the tax take. One indicator of that is that the percentage of workers with an income below half the average income has risen from about 10 per cent in the mid-Eighties to about 19 per cent in 1993. The growth of low- income jobs means that a larger proportion of the workforce pay less tax then they used to.

Value added tax

The largest shortfall of all - about pounds 5bn. Big companies account for three-quarters of VAT revenues. Their tax avoidance has become more professional since the rate went up from 15 per cent to 17.5 per cent in 1991. The Big Six accountancy firms' earnings from VAT advice have risen from almost nothing to pounds 100m a year in the Nineties.

The VAT threshold was raised to pounds 47,000 from this year, taking many small companies out of the tax net.

Spending on the National Lottery, about pounds 4.5bn or 1 per cent of disposable income in its first year, has cut spending on items on which VAT is paid.

The informal cash-in-hand and non-VAT paying economy has doubled in size since the mid-1980s to about 12 per cent of GDP.