A reference to the underground economy—also known as the shadow or black economy—may conjure up images of drug deals and prostitution rings, but the term actually has a far broader scope. It refers to any economic activity that is not reported to government authorities and, consequently, is not taxed.
- The underground economy includes any paid work or transaction that is not reported to the government and therefore is not taxed.
- During economic downturns, the underground economy grows as more workers unable to get legitimate jobs turn to working off the books.
- Countries with high levels of taxation, government corruption, and regulatory barriers tend to have the largest underground economies.
Cooking a meal for your family or driving your neighbor's kids to school is typically not considered underground economic activity. But food service workers, housekeepers, and construction workers who get paid under the table definitely are in this category, as are self-employed people who work for cash.
Basically, any economic activity that generates unreported income is considered to be underground.
How Big Is the Underground Economy?
Estimates vary widely, but some put the underground economy at 11% to 12% of U.S. gross domestic product (GDP). In 2018, GDP was $20.5 trillion, so that puts the underground economy at about $2.25 trillion to $2.46 trillion.
That number must be taken as a guesstimate. There's an obvious complication in trying to determine the size of any country’s underground economy. The activities in it are by definition not reported, and those engaging in it do their best to remain undetected.
Some indirect approaches have been used to estimate its size.
One approach uses macroeconomic indicators as proxies for tracking shadow economy activity over time. One of the most widely used of these is currency demand. Most underground transactions use cash to avoid leaving a paper trail. So, this approach tracks deviations in the demand for cash that could be attributed to underground economic activity.
Economist Friedrich Schneider estimated that the size of the U.S. underground economy, excluding criminal activity like drug dealing, was 7.2% of gross domestic product (GDP) in 2007. That put the U.S. well below the global average for that year of 13.9% of GDP, according to the Organisation for Economic Cooperation and Development.
11% to 12%
The estimated size of the U.S. underground economy as a percentage of GDP in 2018.
At the time, Schneider found that the shadow economy was in decline, not just in the U.S. but around the world.
The Rise and Fall of the Shadow Economy
The 2008 global financial crisis, however, appears to have rejuvenated the shadow economy.
Economist Edgar Feige estimated that underground economic activity in the U.S. in 2012 totaled $2 trillion, approximately 12% of GDP.
Evidence of this can be found in a number of macroeconomic figures from the worst of the Great Recession years: A decline in the official U.S. labor force, an increase in U.S currency in circulation, and a curious increase in retail sales despite relatively high official unemployment numbers.
The pattern was easy to spot. As the economy moved into recession, businesses cut workers and consumers cut back on spending. Many people forced out of their jobs wound up working in the underground economy and hoping for better times ahead.
One downside is the loss of government revenues. The IRS estimated that nearly $500 billion in taxes were lost in 2012 alone due to unreported wages.
But there are other reasons to be concerned. Workers in the underground economy are truly under the radar. They don’t receive health insurance or worker's compensation benefits, and they have less legal protection. They are not contributing to their future Social Security benefits. It is much easier for such workers to be exploited.
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 there are other reasons.
Avoiding the government also can mean circumventing government regulations related to employee benefits, working conditions, and safety regulations, not to mention a great deal of regulatory paperwork.
The Undocumented Factor
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 could result in their deportation.
One alternative for these undocumented immigrants is to purchase fake documents. In a 2018 article, The New York Times reported that these are readily available on the streets of Los Angeles, with a complete set including a Social Security card and a green card going for $80 to $200. The papers can enable them to get better jobs (and pay taxes on the salaries they earn).
The level of government and local corruption is another factor that can contribute to a larger shadow economy. The abuse of public power for private gain can drive businesses and workers to the underground economy for refuge.
All of the above makes it unlikely that the underground economy will ever disappear. But it is true that some countries have a much bigger problem than others.
This is precisely what an International Monetary Fund (IMF) study found. “Countries with relatively low tax rates, fewer laws and regulations, and a well-established rule of law tend to have smaller shadow economies," the study concluded.