Professor Vladimir G. Treml Economics 140, 240, 266 Spring 1997 SUMMARY NOTES ON SECOND ECONOMY Section 1. The underground economy is a term used to describe transactions that involve payment in money or in similar goods but which are not recorded in official economic statistics (such as the taxable income or the unemployment rate). These transactions may not be recorded for a number of reasons. For example, the goods or services sold may be illegal, as are narcotics and prostitution. On the other hand, the provider of these goods may want to avoid paying income, sales, or social security taxes or avoid obeying some frustrating government regulations. Children who sell lemonade in front of their homes, teenagers who babysit for their neighbors, and adults who use garage sales to clean out their attics are all participating in the underground economy if they do not report their income. However, as we will see in later chapters, one of the biggest segments of the underground economy is composed of workers who do not report all the income from their main job or from a secondary job, often demanding payment in cash so that there will be no record of their secret income. The underground economy is a worldwide phenomenon with different names in different countries. In England it is called "fiddling"; in France, "travail au noir"; in Germany, "schwarzar beit"; in Japan, "the hidden economy." An estimated six million workers in Italy, one third of the labor force, participate in that country's "lavoro nero." A recent study estimates that the income from this hidden labor was $43 billion in 1979.1 During the late 1970s, an increasing number of American finan- cial magazines and journals carried stories describing the surprising size and growth-of the underground economy in the United States. In 1976, James Henry pointed out in the Washington Monthly' that there was a $100 bill in circulation "for every man, woman, and child in the country." He suggested that the main users of these large denominations were people engaged in profit- motivated crime and people evading taxes by demanding cash for their services or products. ... We all agree that the national income of the underground economy is over 10 percent of the reported National Income, an amount that demands the serious attention of American policymakers. Because of the secrecy of the underground economy, official statistics about inflation, unemployment, and productivity are not presenting an accurate view of the American economy. Because the prices are often lower and employment is high in the underground economy, we have overestimated official inflation and unemployment. Feige' suggests that if underground prices and employment were included in our official statistics, we might even find a sufficient increase in employment and decrease in inflation to explain away the current appearance of "stagflation" (high unemployment plus high inflation) that has baffled many macroeconomic theorists. In any case, since over $11 billion of major government program expenditures are triggered by inflation and unemployment statistics, the systematic biases in recorded statistics which fail to take into account the underground economy lead to misguided (and probably overstimulatory) public policy decisions. Of course, the existence of an underground economy means that federal, state, and local governments are not receiving all the tax revenues that they are due. The $19 to $26 billion of lost federal income tax revenue described by the IRS's 1979 study would almost have been enough to wipe out the $27 billion deficit in the 1979 federal budget. More importantly, the growth of the underground economy is probably related to a growing frustration by many Americans with their higher and higher tax brackets and with gov- ernment regulations. An underground economy that is over 10 per- cent of the size of the regular economy implies that those who are resisting the temptation to join the underground economy are paying an inequitable portion of our country's taxes. If-this realization spreads, it would certainly weaken the voluntary compliance upon which our tax system is based and at the same time introduce a sense of animosity and non-cooperation between the American people and their government. The underground economy is an important economic phenomenon in the United States. We can no longer afford to ignore it. Carl P. Simon, Ann D. Witte et al., BEATING THE SYSTEM: THE UNDERGROUND ECONOMY, Boston, 1982 * * * Section 2. Underground Activities The economic activities variously discussed under such catchy titles as "underground" "unobserved," and "hidden" economy are numerous. Some of them are: -- working "off the books" or "moonlighting" (second-jobbing) for cash so that the wages are not reported to tax and social security authorities, -- smuggling, -- illegal gambling, -- working without a necessary permit, as in the case of illegal aliens, -- illegal trade in drugs, tobacco, and alcohol, -- bartering of goods and services, -- padding expense accounts and using office equipment for private purposes (concealing income-in-kind), -- illegal prostitution, -- working while collecting disability or unemployment insurance benefits, -- growing own fruits, vegetables, and other foods, -- loan sharking, -- selling homegrown produce, or homemade items, or personal services that provide income that is not, or is only partially, reported to tax authorities, -- "skimming," that is, pocketing some part of cash-register receipts, -- dealing in land and other assets that yields income not reported to tax authorities, -- working for tips that are not, or are only partially, reported to authorities, -- theft, including theft from business by shoplifters and employees, -- covert rentals. It is immediately apparent that these activities are quite diverse. Their diversity has several dimensions. First, they include the activities of wage earners, proprietors, investors in real and financial assets, and households-a wide range of economic transactors. Second, most involve production of some good or service. Others, such as theft from households, involve only redistributions of income or property from one person to another. Third, some take place in the market economy, others outside it. ... a 1983 international conference on the "shadow" economy included papers that ranged from household production to smuggling. However, work-largely by private researchers-has been underway on the measurement and analysis of the nonmarket economy for a number of years. Accordingly, the new interest has focused on the market underground. The fourth, and final, dimension of the diversity for the now narrowed list of activities-that is, those that will be referred to as part of the underground. These include activities that are illegal in themselves, as illustrated by income from trade in drugs, and activities that are legal except that the activities or income from them are not reported, as required, to tax, im- migration, licensing, or other authorities. Carol Carson, "The Underground Economy: An Introduction," SURVEY OF CURRENT BUSINESS, May, 1984 Section 3. "The Black Economy: The Ghostbusters" The Department of Employment this week proudly publicised the exploits of its "fraud squad" in damping down on workers who illegally claimed the dole. The department's 780-strong team investigated 264,616 cases, as a result of which 61,100 people withdrew claims to benefit (in one swoop at Heathrow airport more than 100 "unemployed" minicab drivers were caught). The department estimates that 8% of all unemployment claims are fraudulent. It boasts that its fraud squad saved the British taxpayer 45 million pounds ($63 millions) in 1992-93. That is peanuts compared with the total amount of tax lost because of the black economy - those wide-ranging activities, from prostitution to baby-sitting, which evade the taxman. By definition there are no official statistics on the size of this unofficial economy, only inspired estimates. Various studies have put Britain's black economy at anywhere between 3% and 15% of GDP. A popular figure is around 7%. If so, more than 40 billion pounds- worth of economic activity escapes government statisticians, and the Treasury is robbed of perhaps 10 billion in taxes. Yet the black economy is probably less pervasive in Britain than in many other OECD countries. Greece, Italy, Portugal and Spain are all thought to have shadow economies amounting to 20-30% of their GDPs. These countries have high rates of self-employment, which offers ample opportunity to conceal income from the taxman. Also, as a rule, the higher the taxation and the more onerous the regulations in the formal economy, the bigger the informal one is likely to be. This explains why the black economy is reckoned to be smaller in Britain than in Germany and France, say, where taxes are higher and hiring-and-firing laws stricter. Employers and workers alike have a greater incentive to go "black". A study published in die Economic Journal in 1990 estimated that Britain's black economy fell from a peak of more than 11% of GDP in the late 1970s to 7.6% in the mid-198M. It sounds plausible since tax rates and labour regulations fell over this period. But might the share have crept back up again during the recession? Probably not. It is true that higher unemployment means there are more people looking for work on the side. But, more important, when times are tight households have less spare cash to pay somebody to clean their windows or repaint their house. Most studies suggest that recession tends to squeeze the black economy as much as the formal one. So the overall size of the black economy may have suffered even as the numbers of people taking part in it -- and the potential target for government fraud squad -- has grown. The Black Economy as Percent of GDP (Latest) Greece 30 % Spain 25 Italy 20 Portugal 20 Sweden 14 Germany 8 France 7.5 US 6 Japan 4.5 Switzerland 4.5 THE LONDON ECONOMIST, August 14, 1993 Section 4. SECOND ECONOMY IN THE SOVIET UNION IN THE 1970S AND 1980S Summary of findings of the Berkeley-Duke-George Mason research project based on a study of Soviet emigres. -- The second economy has comprised an important segment of the overall Soviet economy: in the late 1970s, private incomes comprised between 30 and 33 percent of total money incomes of the urban population, and labor inputs into the second economy accounted for between 10 and 12 percent of total employment measured in full year equivalents. Hourly earnings per person operating in the second economy were on the average five to six times higher than in state employment. -- Some illegal private activities always existed under the Soviet system as they do in all countries. These activities began to grow rapidly in the more liberal atmosphere of the early 1960s and rates of growth of the second economy far exceeded rates of growth of the official state economy. -- Second economy activities were made possible and profitable by a number of features of the Soviet (or socialist) economic system such as high and differentiated excise taxes on selected consumer goods (e.g., the excise tax comprised about 90 percent of the retail price of vodka), perpetual excess demand for many consumer goods, multiple prices for identical goods, and state-imposed restrictions of consumer goods deemed to be unnecessary or morally corruptive. Relatively low wages of state officials in charge of allocating scarce resources made rent seeking attractive. -- Second economy activities were important in both private production of goods and services and in redistribution of national income through theft, bribes, etc. The largest and essentially the only legal private sphere in the Soviet Union was production and sale of agricultural produce grown on private plots. The largest (in terms of the overall ruble volume of transactions) illegal second economy markets were found to be in the illegal distillation and marketing of moonshine, consumer services (repair of soft goods, appliances and autos, medical services etc), residential housing, resale of scarce consumer goods procured in state trade, prostitution, and production and distribution of narcotics. While small in terms of the overall value of transactions, illegal incomes per worker were particularly high in funeral services, smuggling of foreign-made consumer goods, prostitution serving foreigners, and illegal foreign currency transactions. Illegal production of scarce goods, ex-market distribution of goods and services, private "arrangements," "side payments," graft and bribes permeated the entire Soviet economy and affected incomes and expenditures of a dominant share of the Soviet people. Law enforcement agencies had little success in eradicating or slowing down the growth of illegal second economy activities. This is explained both by the fact that the second economy has corrupted a large part of the law enforcement and managerial cadres who accepted bribes to look elsewhere, by the amazing ingenuity and skills of private entrepreneurs acquired over decades of onerous state controls, and by the small scale, informal and unorganized character of private operations. -- What was the overall impact of the second economy on the official state economy? The second economy provided the stimulus for corrupting the society, thereby significantly reshaping the character of the polity and administration and, with time, led to the present situation of a largely corrupt officialdom, mafias, and organized crime. The second economy's largest adverse impact on the first economy was effected in wide-spread theft from the state (including employee theft of materials from places of employment), large-scale theft of time from state employers, and income and sales tax evasion (i.e., nonpayment of income taxes on private incomes and private illegal production and sale of goods subject to high sales taxes.) Ubiquitous opportunities to engage in profitable illegal activities have also adversely affected labor productivity in state enterprises. State directed allocation of resources was thus significantly distorted by the second economy. On the other hand, the second economy facilitated and lubricated operations of the first economy by compensating for and correcting at least some inefficiencies and errors in state planning, administration and management. Thus, wrong goods delivered by state planners to wrong localities at wrong times would not stay in stock rooms of retail stores but would be reshipped by private middlemen to markets where the goods were in demand. This "greasing the wheels of state planning" and the illegal production of consumer goods in short supply increased the welfare of the people. Most Western and Russian specialists believe that in overall terms the rapid growth of the second economy in the 1970s and 19809s had a detrimental effect on the effectiveness of the official Soviet economy and ultimately contributed to its collapse.