What is the 'Underground Economy'?

The underground economy refers to illegal economic activity. Transactions in the underground economy are illegal either because the good or service being traded is illegal or because an otherwise licit transaction does not comply with government reporting requirements. An example of the first category includes drugs and prostitution in most jurisdictions. An example of the second category includes untaxed labor and sales and the smuggling of goods to avoid duties. The underground economy is also referred to as the shadow economy, black market (not gray market) and the informal economy. 

BREAKING DOWN 'Underground Economy'

Measuring the Underground Economy

It is difficult to gauge the size of underground economies because, by nature, they are not subject to government oversight and do not generate tax returns or show up in official statistics. Discrepancies in these statistics can indicate the approximate size of informal economies. For example, national income and national expenditure would, in theory, be identical if every transaction were fully visible. In practice, expenditures exceed income because income from an illegal transaction will not appear in the data but will be included in expenditures. Similarly, if electricity consumption grows faster than GDP, this suggests that the underground economy is growing at the formal economy's expense. 

According to estimates, the American underground economy was approximately 8% of GDP, or $1 trillion, in 2009. By 2013, largely due to the financial crisis and the resulting contraction of the formal economy, the amount had reached $2 trillion. The share of America's underground economy is relatively small. The OECD average underground economy was approximately 20% from 1999 to 2010. France underground economy was closer to 15% while Mexico's was closer to 30%. On the other hand, as with formal economies, underground economies are not isolated. Demand for narcotics in the United States, for example, fuels much of the underground economy in Mexico and elsewhere.

Effects

The underground economy can be benign or harmful, depending on the perspective and economic context. In developing countries, the share of the informal economy is relatively large, around 36% in 2002 to 2003, compared to approximately 13% for developed countries. This is a disadvantage for developing country governments, which forgo tax revenue on a large share of transactions. 

On the other hand, retaining income that might otherwise be taxed can benefit participants in the underground economy and boost economic activity overall through added demand. This is especially true if tax revenues would be siphoned off by corrupt officials rather than being used to fund the government – another aspect of the underground economy.

Activities and Participants

Many activities are considered part of the underground economy, and the list varies depending on the laws of a given jurisdiction. In some countries, alcohol is banned while, in others, brewers, distillers and distributors operate openly. Drugs are illegal in most places, but some U.S. states and a few countries have made the selling of cannabis legal. Tobacco is legal in New York City, but steep sin taxes mean that perhaps 60% of cigarettes in the city are sold illegally as part of the underground economy.

Forced labor, the sex trade (where illegal) and human trafficking are part of the underground economy. Black markets exist for copyrighted material, endangered animals, products subject to sanctions or tariffs, antiquities and organs. In addition, anyone who does not report taxable income to the IRS – even if it's $50 for babysitting – is technically participating in the underground economy. 

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