The underground economy refers 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, or under-the-table payments made to laborers like house painters and construction workers, whose wages may go reported to tax authorities. Unreported income paid to illegal aliens or migrant workers also contributes to the underground economy.

Key Takeaways

  • The underground economy refers to money earned from illicit activities like prostitution and the sale of illegal drugs.
  • Analysts estimate that underground economic transactions account for one-third of the total economy in developing countries and slightly more than 10% of the total economy in developed countries.
  • Because underground economic transactions go unreported, they distort the accuracy of a nation's gross domestic product (GDP), which consequently may adversely affect a government's monetary policies.
  • The underground economy also causes billions of dollars in lost taxes.

The Underground Economy and GDP

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). However, analysts estimate that underground economic transactions account for one-third of the total economy in developing countries and slightly more than 10% of the total economy in developed countries. But because these transactions go unreported, they distort the accuracy of key economic measurements, such as the gross domestic product (GDP), which is calculated by totaling the following four components:

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

Notice how the aforementioned metrics fail to take consider any transactions that occur within the underground economic system. This is significant because a nation's less-than-accurate GDP figure can adversely affect government policies that are influenced by GDP numbers. For example, the U.S. Federal Reserve Bank relies on GDP figures set interest rates and create other monetary policies. If GDP numbers aren't technically accurate, such policy decisions can have a weaker impact, or negatively impact the economy.

Taxation is another major governmental concern related to the underground economy. A 2011 study determined that if all underground economic activities were legitimately taxed, it would generate $400 billion to $500 billion in annual revenue. That money could go a long way in rebuilding infrastructure, funding schools, and supporting other worthy causes.

Ways to Mainstream the Underground Economy

Fortunately, there are a number of steps governments can take reduce the effect that underground economic activity has on skewing GDP numbers. Reductions in personal income tax rates can encourage individuals to report income more accurately and completely. And then there's the tough love approach, where the installation of increased tax evasion penalties can discourage underreporting. Thirdly, a government may legalize certain underground economic activities, such as gambling and prostitution, as a way to legitimately tax the associated income, and increase revenue. Finally, governments can stimulate the creation of higher-paying legal jobs, which would theoretically shrink the underground economy.