While the underground economy—also known as the shadow or black economy—may conjure up images of drug deals and prostitution rings, the term actually has much broader scope. It refers not only to illegal economic activity, but all economic activity that goes unreported to government authorities and consequently, avoids being taxed.

Don’t worry, cooking a meal for your family or driving your neighbor's kids to school is typically not considered underground economic activity. But many food service workers, housekeepers, or construction workers who get paid under the table definitely do fall under this category. Basically, any economic activity that generates unreported income is considered to be underground. Here we look at causes of why such activity exists, how big the underground economy is, and how it has increased since the global financial crisis.

Why We Have an Underground Economy

If you haven’t guessed already, one of the primary reasons the underground economy exists is that people are trying to evade taxes. But increased government regulations that can make the cost of doing business higher also create an incentive to avoid reporting certain economic activity to the government.

Regulations that require businesses to pay employees certain social welfare benefits may encourage them to keep a certain number of employees off the books. If the payment of benefits is required only for full-time employees, this might unfortunately encourage employers to hire only part-time workers. The lack of full-time work may then push workers to find second jobs in the underground economy.

Immigrants without legal status often find themselves working for cash in the underground economy. Obviously, their illegal status keeps them from reporting their income, as doing so would likely result in their deportation.

The level of government and local corruption is another factor that may contribute to a larger shadow economy. The abuse of public power for private gain through rent-seeking types of regulations can encourage private actors to turn to the underground economy for refuge.

Considering the above, one would expect that countries with lower tax rates, fewer regulations, and less corruption would have much smaller shadow economies. This is precisely what an International Monetary Fund (IMF) study found stating, “Countries with relatively low tax rates, fewer laws and regulations, and a well-established rule of law tend to have smaller shadow economies.” (To read more, see: The Mechanics Of The Black Market).

How Big Is America’s Underground Economy?

Before we can answer the big question, we should note some of the complications in trying to determine the size of any country’s underground economy. Since such activity is by definition not reported, and since those engaging in such activity do their best to remain undetected, it can be extremely difficult to estimate how much of that activity is actually going on.

One approach to determining the level of shadow activity is the very direct one of using a questionnaire. However, it may be hard to get accurate results, as people are either afraid that they will be giving themselves up, or else they are just ashamed to admit what they’re doing.

There are other indirect approaches that try to use macroeconomic indicators as proxies for shadow economy activity. One example—and the most widely used of the indirect macroeconomic approaches—of such a method would be currency demand approach. Assuming most underground transactions use cash to avoid the paper trail, this approach tries to find deviations in the demand for cash that could be isolated to underground economic activity.

Despite the inherent difficulties involved in such measurement, economists have attempted to calculate the size of shadow economies. One such economist, Friedrich Schneider, estimated that the size of the U.S. underground economy (not including criminal activity such as drug dealing etc.) relative to GDP was 7.2% in 2007, which was below the OECD average of 13.9%. (See also: Countries With The Largest Shadow Markets).

While Schneider found that since 1999 the trend in the Organization for Economic Cooperation and Development (OECD), including the U.S., was a shrinking shadow economy, recent evidence suggests that since the global financial crisis in 2008, the trend has reversed. This trend could simultaneously explain the decline in the official U.S. labor force, the increase in U.S. currency in circulation, and the suspicious increase in retail sales despite relatively high unemployment. Indeed, economist Edgar Feige estimated that underground economic activity in the U.S. totaled $2 trillion in 2012, approximately 12% of GDP at the time.

The Bottom Line

As the economy moved into recession following the crisis, businesses looked to cut costs and employees looked to save more of their incomes. While this can act as a bit of a buffer until the economy recovers, there are a number of downsides to this increased underground activity. One of these downsides is the loss of government revenues, as the IRS reported that nearly $500 billion in taxes were lost in 2012 due to unreported wages. But other reasons to be concerned are that workers in the underground economy won’t qualify for social welfare benefits and legal protections. It is much easier for such workers to be exploited as their labor takes place under the radar of government regulatory institutions.  

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