| The Labor Enforcement Task Force (LETF), under the direction of the California Department of Industrial Relations, is a coalition of California state government enforcement agencies that work together and in partnership with local agencies to combat the underground economy. In this joint effort, information and resources are shared to ensure that employees are paid properly and have safe work conditions and that honest, law-abiding businesses have the opportunity for healthy competition. 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Essential Reading Metadata Rights and Permissions AboutAbout Us Contact Us Content Directory Frequently Asked Questions IMF eLibrary Startup Guide Set Up A Personal Account SearchAdvanced search The underground economy: Causes and consequences of this global phenomenon Author: Mr. Vito Tanzi Contributor NotesThe causes and consequences of this worldwide phenomenon Publication Date:01 Dec 1983eISBN:9781616353551ISBN:9781616353551Language:EnglishKeywords:FD; F&D; government bond bond yield; cost; firm; interest rate; bond yield; goods markets regulation; tax authorities; untaxed income; economies of Europe; Personal income; Social security contributions; Global Download PDF (1.3 MB) This paper highlights the sources of payments problems in less developed countries. Growth in the industrial countries has a direct impact on the current account of the developing countries through its influence on both the prices and volumes of their exports. An increase in the real effective exchange rate is clearly a fundamental determinant of a deteriorating current account since, other things being equal, it tends to raise domestic demand for imports and to reduce foreign demand for exports. This paper highlights the sources of payments problems in less developed countries. Growth in the industrial countries has a direct impact on the current account of the developing countries through its influence on both the prices and volumes of their exports. An increase in the real effective exchange rate is clearly a fundamental determinant of a deteriorating current account since, other things being equal, it tends to raise domestic demand for imports and to reduce foreign demand for exports. Vito Tanzi In recent years, a growing number of observers of the economic scene have called attention to a phenomenon described by a variety of terms, of which the most common is “underground economy.” A range of names are used to describe this phenomenon, including “parallel,” “unofficial,” and “black.” Regardless of the appellation, the phenomenon relates to activities ranging from relatively legal to totally criminal that somehow escape official attention and may distort official statistics and lead to erroneous policies. The underground economy—as its plethora of names suggests—can be defined in various ways. If the relevant agency to which activities are not reported is the tax or customs authority, the definition is tax-related. If the relevant agency is the national accounts authority, then we get a definition that relates to the national accounts. More specifically, the underground economy can be defined either as the total of incomes earned, but not reported to the tax authorities, or as the total of incomes not included in the national accounts. There may be no close connection between these two definitions; an activity may not be reported to the tax authorities but may still be assessed by the national accounts offices if, for instance, national accounts data are compiled independently from tax data. Vice versa, there could be cases where some activities come to the attention of the tax authorities but not of the national accounts authorities. In this connection it should be realized that, depending on the country, the national accounts may be based more or less on tax information. For example, in the United States it is reported that only 6 percent of national income is based on information provided by the tax authorities. The causesIn a well-working market economy, without a public sector, there would be no underground activities. Incentives for the growth of these activities increase with greater regulation of the economy, larger public sectors, and higher levels of taxation. The factors that stimulate underground activities can be classified under four different headings: taxes, regulations, prohibitions, and bureaucratic corruption, although in several cases, underground economic activities may have been brought into existence by more than one factor. Taxes. The tax factor has been emphasized in most studies of the underground economy, and particularly in those dealing with the United States, the United Kingdom, and the Scandinavian countries. In recent years, the share of total taxes in the gross national product of many countries has increased substantially, reaching in some cases 50 percent. Further, the marginal tax rates associated with these taxes have been even higher. As tax rates increase, so does the incentive to evade them. When tax rates are high, the cost of honesty also becomes high, and many taxpayers who, under lower tax burdens, would have been honest, make the transition to tax evasion, even though in some cases only for parts of their incomes. It is not just the level of the tax rates that is important, but also the general mood of compliance that prevails in a country. This mood may itself be affected by perceptions about the public sector—if these are that public expenditure is wasteful or that the tax burden is inequitably distributed, there may be a tendency not to participate in “above-ground” activities. Further, when tax administration is good and the penalties for evasion significant, high marginal tax rates may not lead to a high level of underground economic activity. Thus, when the attitude vis-à-vis the government and its tax and expenditure policies is negative, when the tax rates are high, and when tax administration is poor, underground economic activity is likely to flourish. Different taxes may stimulate these activities more in one country than in another. In the United States, the major cause of the underground economy has generally been assumed to be high income tax rates. As a consequence, the studies dealing with this country have emphasized that aspect. In other countries, and perhaps to a more limited extent even in the United States, social security taxes have also been important. In fact, it is likely that these taxes, which in some countries have achieved a very high level, may have been more important than the income taxes. Both of these taxes may bring about a kind of black market for labor; if workers can be hired without the payment of income taxes or social security contributions, they can be paid lower wages. The worker may gain, as the wage he receives will be free of income tax and of the employee’s contribution to social security, and the employer will gain by the lower wage bill and by not paying his share of the social security tax. Much of the material in this article is based on the author’s book, The Underground Economy in the United States and Abroad (Lexington books, 1982), which covers the United States, the United Kingdom, Italy, Norway, Sweden, the U.S.S.R., Canada, Colombia, Australia, and Israel. The estimates in the chart for these countries come from the book and from other published articles. Sales taxes also contribute to underground economic activities. The value-added tax, for example, is reported to have brought about a proliferation of small and difficult-to-control enterprises that produce services or goods sold net of taxes. For some countries (for example, Italy and Argentina) there are estimates assessing the value-added tax evasion at 50 percent. It is, thus, a fair question to ask whether the evading activity is being properly measured in the national accounts. For developing countries, other types of taxes are also important factors. Countries that impose high import duties, which in some cases exceed 100 percent, provide strong incentives to smugglers to bring those goods into the country without going through the customs offices. The higher the import duty, and the smaller, more easily transportable, and more valuable the product, the greater is the incentive to smuggle it into the country. As a consequence, smugglers make considerable gains from this activity and these gains are difficult to measure. Estimates for some countries indicate that they can be enormous. Export duties are another major cause of these activities. The coffee producers who smuggle coffee out of the country; the cattle raisers who simply cross the frontier with their cattle to sell them abroad; and the diamond or emerald miners who take their finds abroad are all avoiding export taxes and making profits that are not likely to be properly measured. Even capital gains and capital transfer taxes may induce those engaging in the transfer or sale of property to underassess for tax purposes the value of their property. In all of these cases, activities may have been brought into existence, or channels of distribution may have been created, or economic relationships may have been changed because of the taxes. The end result is higher incomes for some, lower tax revenue for governments, and highly distorted statistics. Regulations. By and large, the more regulated an economy, the greater will be the pressures within it to try to get around the regulations. In the process, various activities that cannot be controlled will come into existence; these will, to some extent, invalidate the objectives of the regulations and will be associated with the phenomenon of the underground economy. The regulations may relate to labor markets, goods markets, domestic financial markets, and foreign exchange markets. The regulation of the labor market may include laws pertaining to minimum wages, overtime, and the work of minors, aliens, retirees, and working women. Many of these are circumvented or ignored. In the process, output is produced, incomes generated, and labor utilized in ways not desired, or even contemplated, by the government. In many cases a black market for labor develops. Goods markets regulations include price controls, rationing, forced sales of commodities to the government or to marketing boards, import quotas, and export bans. All of these may generate a black market for goods as both producers and consumers try to escape the effects of these regulations by developing parallel or hidden markets. Again, the end result is the creation of unreported incomes, the distortion of measured levels of activity, and a loss of tax revenue. In the United States, the regulation of goods markets during the prohibition era and during World War II brought about widespread attempts at circumventing them. Available estimates indicate that underground economic activities were larger during World War II than in any subsequent period. Black markets for goods have reached epidemic proportions in some highly regulated African countries, and the same is reported to be occurring in some centrally planned economies of Europe. Regulations of domestic financial markets are often associated with constraints on interest rates and with credit controls. When these regulations of domestic financial markets exist, a black market for money, sometimes called a curb market, develops. In this case, interest received by lenders is for the most part unreported to the tax authorities and the extent to which it is properly reflected in the national accounts is an open question. Examples of regulations of foreign exchange markets abound. These are connected with the exchange rates, which may be widely out of line from the equilibrium level, or with capital controls. Distorted exchange rates, together with capital controls, are generally accompanied by attempts at getting around them. Obvious examples of this type are the overinvoicing of imports, which allows an importer to get some exchange at official rates and to leave some of this money abroad, or to sell it in the black market. Another example is the underinvoicing of exports. The exporter’s objective is to end up with unreported foreign exchange that can be kept abroad or can be sold in the black market domestically. In all these cases, a black market for currency exists in parallel with the official market. The exchange rates in the two markets can be significantly different, sometimes by as much as a ratio of ten to one. Again, untaxed incomes are created and economic statistics distorted as the relevant authorities are unable to tax those incomes and do not have the full range of information necessary to put out accurate statistics. Prohibition. In all countries some activities are forbidden by law. To the extent that individuals wish to engage in them, these will inevitably go underground. There are many such activities, including traffic in illegal drugs, illegal gambling, lending at extortionate rates, and so on. As long as individuals engage voluntarily in these activities, they can be deemed to generate incomes to some people and services to others. For example, illegal drugs imported into a country and sold in the street can generate phenomenal incomes, as the street value is likely to be far higher than the value at which they are bought at the place of origin. It is an open question, and a source of considerable controversy, whether the incomes generated by these activities should be measured in the gross national product of a country. Traditionally, incomes measured by the national accounts have not included those generated by criminal activities. In addition, if these activities were discovered and taxed, they would largely disappear, so that it is also controversial whether even the tax definition of underground economy should include incomes generated in these activities. On the other hand, one can take the position that they should be included, on the grounds that as long as people purchase these services freely, they are in some sense better off because of them. Moreover, the sellers of these services are earning incomes and using scarce resources, which, if used elsewhere, could increase the official gross national product. Only if the resources used in these activities would otherwise be completely unutilized would they have had no opportunity cost associated with them. In the United States, for which some estimates have been made, these illegal activities are reported to range somewhere between one third and one half the size of the underground economy associated with legal activities. But, of course, in view of the difficulty of finding any accurate information in this area, these are very unreliable estimates. The value of these activities depends to a large extent on the fact that they are prohibited. For example, legalizing narcotics would almost immediately sharply reduce their value; therefore, the incomes that the sellers of these drugs receive would also fall sharply. Bureaucratic corruption. In all countries, some public employees find themselves in control of powers that can be used to generate private gains. This private use of public power is obviously improper and frequently illegal, but it is a fact of life in some countries, and examples abound in the literature and in newspapers. In particular countries, for example, it has been reported that government jobs are sometimes literally sold by individuals with the power to dispose of them. In other countries, government contracts are awarded to individuals who are willing to make an under-the-table contribution to strategically located public employees. In still others, where economic activities may require specific licenses, acquiring a license, or, at times, acquiring a license without excessive delay, may be achieved in exchange for under-the-table payments. Licenses for investments, imports, construction, and waivers from particular regulations, or even obtaining public services which, because of supply bottlenecks, are not readily available (such as telephones), can often be obtained by literally purchasing the license, the waiver, or the service from the right person. The argument has been made that in some countries this payment to a certain extent compensates the public employees for low wages and oils the bureaucratic mechanism by introducing some spurious sort of efficiency. The common denominator of these activities is that they all generate incomes for some people and these incomes are not reported to the authorities. They are not likely to be taken fully into account by those who generate national statistics. ConsequencesThe existence of a sizable and possibly growing underground economy has obvious consequences that may or may not be serious, and it raises issues of equity, economic policy, and efficiency. This article cannot engage in a full discussion of these issues, but will make a brief reference to them. Equity. The issue of equity is particularly significant in the distribution of the tax burden and incomes. The fact that some people receive incomes that are not taxable implies that to raise a given level of tax revenues, the tax rate on officially recognized activities will have to be higher. Further, even when the economy expands because of underground economic activities, the need for additional public services will go up. For example, those who live on underground incomes still use roads and still send children to school. The reduction in tax revenues and the increase in the need for additional public expenditure as a result of these activities is an aggravation of fiscal difficulties. Equity considerations arise also in connection with income distribution, as very large incomes may be made in connection with underground activities, which may distort the distribution of income that the government wants to achieve. Policymaking. The implications of underground economic activities for economic policy are perhaps more serious. A large underground economy will inevitably be associated with greater difficulty in properly assessing the size of variables that are important for policymaking. For example, if the underground economy is growing faster than the official economy, and is not properly measured by the national accounts authorities, the rate of growth of the country will be underestimated. This could lead to policies that, on the basis of what is officially known about the economy, seem appropriate but are actually overly expansionary. Measuring the underground economy Economists have been very resourceful in devising different methods for estimating the size of the underground economy. One method is based on attempts to measure directly the various activities that make up this phenomenon, and, through a process of aggregation, the calculation of the total. This method has been used mainly in the United States. Its main weakness is that many underground economic activities are not observable. A second method, which has given interesting results for Norway and Sweden, includes the use of questionnaires to elicit answers from persons interviewed as to whether they have participated in these activities either as buyers or as sellers. In the case of noncriminal activities, selling the service may imply violation of some law; buying the service does not. Therefore, if the answers received from the buyers give more or less the same magnitude for underground economic activities as the answers received from the sellers, one can have some confidence in them. A third method, which has been applied in Italy, is based essentially on the difference between the population that, on the basis of demographic data, could be assumed to be part of the labor force and those who officially report to be part of it. These estimates need to be accompanied by some assumptions about productivity in the underground sector. A fourth method, used in the United States and in the United Kingdom, has attempted to estimate the size of the underground economy by comparing the official estimates of the gross national product made from the consumption side with those made from the incomes side. The assumption is that underground economic activities would affect only the income estimations of national product. There are difficulties with this method, as the underground economy is likely to affect both consumption as well as incomes. Thus, some studies of the United Kingdom have attempted to estimate the underground economy by analyzing household budget studies for unusual levels of consumption corresponding to given reported income. Many studies for a large number of countries have also attempted to measure the activities in question by analyzing monetary statistics, on the assumption that certain monetary aggregates—for example, currency or currency in large bills—may be directly influenced by the size of the underground economy. Still other methods have related electricity use to official output for a region or a town. If the electricity used is much higher than one would expect from the official production level, one can assume that unofficial production is taking place. Whatever method is used to estimate the magnitude of the underground economy, it is evident that it is considerable. The accompanying chart provides some available estimates from studies of the underground economy for 19 countries from various parts of the world and with different social systems. Many of these studies indicate that the underground economy is not only sizable but is also growing faster than the official economy. The figures shown in the chart should be accepted with considerable caution as they are the result of applying different methodologies and, in some cases, even of different concepts. Therefore, it would not be prudent to make precise cross-country comparisons without first consulting the studies themselves. As research techniques and factual information improve, it will probably become easier to generate estimates that warrant a greater degree of confidence. Estimated size of underground economy Citation: Finance & Development 20, 004; 10.5089/9781616353551.022.A003 These data show the ranges of estimates made for each country at different times; they are suggestive and should not be taken to be precise.What is the definition of underground economy?"Underground economy" is a term that refers to people and businesses that deal in cash or use other schemes to hide their activities and their true tax liability from government licensing, regulatory, and taxing agencies.
What is the underground economy quizlet?Underground economy refers to buying and selling of goods and services that are concealed from the government to avoid taxes or regulations or because the goods and services are illegal.
Which of the following are included in the underground economy?The first category includes drugs and prostitution in most jurisdictions. The second includes untaxed labor and sales, as well as smuggling goods to avoid duties. The underground economy is also referred to as the shadow economy, black market (not gray market) and informal economy. Source: Investopedia.
What is the underground economy sociology?Definition of Underground Economy
(noun) An unregulated economic system where goods and services are produced, distributed, and consumed, involving income that is not reported to the government or taxed.
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