How the Underground Economy Affects Gross Domestic Product (GDP)

The term "underground economy" is often used to refer to money earned from illicit activities like prostitution and the sale of illegal drugs. But it also broadly refers to any unreported income, such as undeclared tips or gambling winnings and under-the-table payments made to workers. Unreported income paid to undocumented immigrants also contributes to the underground economy, as do sales made in the so-called black market, where buyers and sellers rely on cash transactions to avoid sales and income taxes.

Where the Underground Economy Flourishes

Due to its cloaked nature, it's difficult to gauge the true extent of the money that changes hands through the underground economy, sometimes referred to as the shadow economy.

Not surprisingly, it appears to be higher in troubled and underdeveloped countries than in countries with healthy economies and strong government institutions.

In Ukraine, for example, the government Economy Ministry estimated that the country's shadow economy accounted for about 31% of its GDP in the period from January to September 2020.

Some of the contributing factors, such as COVID-19 restrictions on business, could be seen around the globe.

Other factors were peculiar to Ukraine. The ministry cited the country's poor judicial system, high level of corruption, and a lack of government control over some regions as enabling or even necessitating underground economic activity.

The Worst and Best

An International Monetary Fund white paper, released in 2018, estimated that Bolivia's shadow economy was 60.6% of GDP while Switzerland's was only 7.2%.

The underground economy of the United States averaged about 8.34% over the years from 1991 to 2015, according to the IMF estimate. In fact, the U.S., Switzerland, and Austria have the world's smallest underground economies in terms of GDP.

The Underground Economy and GDP

Because transactions made in the underground economy go unreported, they distort the accuracy of key economic measurements. A nation's gross domestic product (GDP) is calculated by totaling the following four components:

• Personal spending
• Business spending
• Government spending
• Net exports

None of these components record transactions that occur within the underground economic system. This is significant because these numbers, accurate or not, are used to set government policies.

For example, the U.S. Federal Reserve Bank relies on these numbers to set interest rates and create other monetary policies. If GDP numbers aren't accurate, such policy decisions can have a weaker impact or an adverse impact on the economy.

Taxation is another obvious governmental concern related to the underground economy. Transactions in the underground economy directly reduce federal, state, and local tax revenues.

Ways to Mainstream the Underground Economy

There are a number of steps governments can take to reduce if not eliminate underground economic activity.

Reductions in personal income tax rates may encourage some individuals to report their real income more accurately and completely.

And then there's the tough love approach. Increasing tax evasion penalties can discourage underreporting.

Thirdly, a government may legalize certain underground economic activities in order to at least enjoy the benefit of taxing them. Marijuana legalization is certainly a case in point. California alone brought in an additional $629.3 million in taxes on marijuana in 2019.