Informal and Underground Economics

Abstract

There is a widespread feeling that the underground economy is of substantial size and, compared to the officia economy, has been growing rapidly. This holds in particular for developing and transition economies, but also for developed economies. The major concern is that government revenue is thereby lost and the cement of society is undermined. On the other hand, underground economies are value-creating and introduce a dynamic element into the economy. The underground economy is variously defined, but the predominant definition is to comprise all at present not officially recorded productive (i.e., value-adding) activities, which should be part of gross national income. This definition excludes activities not in the GNP (e.g., housework), and it is not identical to tax evasion (which is mostly redistributive) nor to illegal activities (some activities are legal but not subject to taxes, and therefore tend to escape being recorded). Economists have devised a considerable number of approaches to measure the size of the underground economy. The direct approaches are based on surveys and the examination of tax returns. The indirect approaches analyze the discrepancies between what would be ‘normal’ and what is actually observed with respect to spending, employment, the use of money, and physical input (such as electricity). A more refined approach constructs a model identifying the incentives to work in the underground economy: the burden of taxation and social security contributions, expected punishment, and the moral cost of being active in the illegal economy. Empirical estimates of the size and the development of the underground economy relative to official recorded GNP are presented for developed, transition, and developing economies. In most countries and periods, the underground economy has been negatively evaluated and therefore considerable efforts have been expended in fighting it. Most policies seek to increase deterrence by stepping up controls and raising punishment, often with doubtful success. More promising policies are to lure people from the underground economy into the official economy by legalizing part of the respective activities, improving the efficiency of public services and the relationship of the state to its citizens, thereby raising civic virtue, and thus reducing the incentive to work in the underground economy.