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. Also called the shadow economy, the black market, or the informal economy, the underground economy in the United States is comprised mainly of the sale of street drugs and illegal prostitution. However, other examples of the shadow economy exist as well.

Understanding the Underground Economy

It is difficult to accurately gauge the size of underground economies because, by nature, they're not subject to governmental oversight. Therefore, the economic activity does 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, the money spent—that's not accounted for in recorded transactions—theoretically represents the breadth of black market activity.

Key Takeaways

  • While estimates vary, some put the underground economy at 11% to 12% of U.S. gross domestic product (GDP), or roughly $2.25 to $2.5 trillion. 
  • Elements of the underground economy vary from nation to nation, state to state, and in some cases, municipality to municipality.
  • Alternative names for the underground economy 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 examples of activity in the underground economy.

The American underground economy was estimated to have reached $1 trillion in 2009, representing approximately 8% of U.S. gross domestic product (GDP). However, by 2013, largely due to the long-term effects of the 2008 financial crisis and the resulting contraction of the formal economy, underground economic expenditures reached an estimated $2 trillion. As of early 2020, the underground economy is estimated at 11 or 12% of U.S. GDP, or roughly $2.5 trillion total.

Compared to most other nations, America's underground economy has stayed 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%).

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 slow 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.

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 racist sentiments at the time) led to research that linked 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. Instead, proponents argue, marijuana has proven to be therapeutically helpful in treating illnesses such as cancer and AIDS.

Other Examples of the Underground Economy

The list of activities deemed to be underground economic transactions varies, depending on the laws of a given jurisdiction. For example, in some countries, alcohol is banned, while other nations encourage legal brewery, distillery, and distribution operations. Similarly, 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. As of early 2020, cannabis is fully illegal in less than a dozen U.S. states, with some states allowing recreational use and other states allowing cannabis sales for medical purposes only.

Meanwhile, according to a CNN Business article, an estimated 60% of cigarette sales in New York City are facilitated through underground economic transactions. Although tobacco is legal in New York City, the product 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 cash that they pocket after watching Junior down the street.

The IRS considers money earned from babysitting as taxable self-employment income and, when the amount is greater than $400 for the year (as of 2019), must be reported when the individual files their tax return.

Other primary examples of underground economic activity include 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.