What Is the Underground Economy?

The underground economy refers to economic transactions that are deemed illegal, either because the goods or services traded are unlawful in nature, or because transactions fail to comply with governmental reporting requirements. Alternatively referred to as the shadow economy, the black market, or the informal economy, the underground economy in the United States mainly comprises the sale of street drugs and illegal prostitution.

Other primary examples of underground economic activity include untaxed labor, the untaxed sale of physical goods, and the smuggling of goods into a country to avoid paying duties at the border. Human trafficking operations also comprise the underground economy, as do the markets for copyrighted materials, endangered animal species, antiquities, and illegally-harvested human organs.

Measuring the Underground Economy

It is difficult to accurately gauge the size of underground economies, because by nature they're not subject to governmental oversight, and they, therefore, do not generate tax returns or appear in official statistical reports. However, tracking outgoing expenditures, even though the transactions are cloaked, can give a sense of statistics. In other words: money spent, that's not accounted for in recorded transactions, theoretically represents the breadth of black market activity.

Key Takeaways

  • In 2013, the American underground economy represented approximately $2 trillion.
  • Elements of the underground economy vary from nation to nation, state to state, and in some cases, municipality to municipality.
  • Alternative names include the shadow economy, the black market, and the informal economy.
  • Marketing in illegal drugs, human trafficking, endangered species, human organs, antiquities, and stolen goods are common underground economy activities.

According to 2009 estimates, the American underground economy reached $1 trillion, representing approximately 8% of the gross domestic product (GDP). However, by 2013, largely due to long-term effects of the 2008 financial crisis and the resulting contraction of the formal economy, underground economic expenditures reached an estimated $2 trillion.

Compared to most other nations, America's underground economy is relatively flat, according to findings published by a 2018 International Monetary Fund study in progress, which explored the shadow economic activity of 158 countries, between 1991 to 2015. Some of the chief takeaways of the report are as follows:

  1. The mean value of the size of the shadow economy across all nations was 31.9%.
  2. The nations with the three largest shadow economies were Zimbabwe (60.6%), Bolivia (62.3%), and Georgia (64.9%).
  3. The three smallest shadow economies were Austria (8.9%), the United States (8.3%), and Switzerland (7.2%).

Effects of the Underground Economy

Depending on the context, the impact of underground economies can range from harmful to helpful. For example, in developing countries with large shadow economies, the uncollected tax revenue can retard economic growth and hamper the creation of public programs. However, in other cases, participants in underground economies who retain income that would usually go to taxes can boost overall economic activity and stimulate demand. This situation holds especially true in nations where the withheld tax revenues would have been siphoned off by corrupt government officials.

Activities and Participants in the Underground Economy

The list of activities deemed underground economic transactions varies, depending on the laws of a given jurisdiction. In some countries, alcohol is banned, while other nations encourage legal brewery, distillery, and alcohol distribution operations. While drugs are illegal in most countries, some nations, plus an increasing number of U.S. states, have legalized the sale and use of cannabis. In 2018, 33 states and the District of Columbia passed laws legalizing the plant, which is now abundantly present in some food products, as well as many topical and oral medications.

According to a CNN Business article, an estimated 60% of cigarettes sales in New York City are facilitated through underground economic transactions. Although tobacco is legal in New York City, it carries an exorbitant sin tax, and so many sales go unreported or "under-the-table."

All such "under-the-table" transactions, in which participants fail to report their income to the IRS or the state, are technically considered to be underground economic activities. This status can even apply to babysitters, who don't report the money they pocket for watching Junior down the street—assuming they make more than $400 a year in 2019.

Real World Example of the Underground Economy

In the early 1900s, Mexican immigrants introduced recreational marijuana use to the United States. During the Great Depression, high unemployment rates triggered a spike in marijuana consumption, which—coupled with irrational racist sentiments—led to research linking marijuana to violent crime.

Consequently, by 1931, 29 U.S. states outlawed the drug. Nonetheless, many people deemed the plant to be harmless and continued buying and selling it illegally. Subsequent studies refuted the idea that marijuana was linked to crime while declaring that the drug was neither addictive nor a gateway to other drugs. Proponents argue that marijuana has been proven to be therapeutically helpful in treating illnesses such as cancer and AIDS.