The underground economy consists of activities that fall within the production boundary of the SNA but are deliberately concealed from public authorities. SNA mentions the following kinds of reasons (SNA 6.40):
To avoid the payment of income, value added or other taxes
To avoid the payment of social security contributions
To avoid having to meet certain legal standards such as minimum wages, maximum hours, safety or health standards, etc.
To avoid complying with certain administrative procedures, such as completing statistical questionnaires or other administrative forms
Also usually included is skimming, which is when firms under report revenue or over report expenses.
Examples of underground activities range from undeclared construction activities to undeclared rent and undeclared tips. Shuttle trade is another example. This is an activity in which entrepreneurs buy goods abroad and import them for resale in street markets or small shops. Note that although cross border shopping also involves concealment of activities from public authorities with the intention of avoiding taxes, this is not a productive activity and thus does not constitute a part of the underground economy.
Note that the delineation of the underground economy and the illegal economy may not be precise, and certain overlaps are bound to appear. Illegal activities will meet many if not all of the above criteria and may therefore be included in the underground economy as well. On the other hand the evasion of taxes is itself usually a criminal offence. Here we will exclude illegal activities from the scope of the underground economy. Alternative names for the underground economy as understood here are: hidden economy and shadow economy.
Why do economic units decide to “go underground”?
One of the main causes for the existence of the underground economy is the tax and social security contribution burdens. The bigger the difference between the total cost of labour in the official economy and the after-tax earnings from work, the greater is the incentive to avoid this difference and to work in the underground economy.
Another important factor is the increase of the intensity of regulations, which reduces the freedom (of choice) for individuals engaged in the official economy. Examples are labour market regulations, trade barriers, and labour restrictions for foreigners. Many researchers have also associated bribery or corruption with the existence of the underground economy, especially in the government sector. Also, the social welfare system may provide disincentives to work in the official economy. Besides receiving the welfare payments, some individuals might wish for higher income and cheat by pursuing the underground economy, since working in the official economy could reduce or discontinue their welfare income. Labour market regulations introduced by government and labour union are another catalyst of underground economy. The enforcement of maximum working hours and the bringing forward of the retirement age by the state governments or labour unions are likely to increase the incentives to work in the underground economy, as individuals may want to continue to offer their labour services, curtailed by regulations, to generate additional income.
An increase of the underground economy can lead to reduced state revenues which in turn reduces the quality and quantity of publicly provided goods and services. This can lead to an increase in the tax rates for firms and individuals in the official sector, possibly combined with a deterioration in the quality of the public goods (such as the public infrastructure) and of the administration, with the consequence of even stronger incentives to participate in the underground economy.
Finally, the general economic outlook is one of the factors that contribute to decision of individuals to work in the underground economy. Examples of determining factors are unemployment, high public debt and recession or inadequate economic growth.
Direct methods are often based on sample surveys, designed to estimate the underground economy. They are widely used in a number of countries and the OECD manual gives a number of examples, including:
Mixed household-enterprise survey. Enterprises that are not registered and are engaged in legal productive activities are likely to be very small. However, there may be quite a large number of such enterprises. Failure to register means that the enterprise will not be covered in any survey for which the frame is drawn from the business register. A mixed household-enterprise survey approach is a practical way of measuring such underground production.
Surveys of expenditure on goods and services from underground production. In most countries purchasing goods and services from underground producers is not against the law. Thus surveys of expenditure on underground production are more likely to give good results than surveys of underground income. Some household surveys attempt to identify expenditures on underground production by asking respondents to indicate separately those purchases that they suspect may have an underground character. Others ask respondents to describe the type of outlet or seller from among a list that includes those types most likely to be operating underground, including street-traders, independent artisans (plumbers, gardeners, electricians, etc.) and farm shops.
Surveys of labour input and income associated with underground production. In many countries underground work is considered a minor infringement of the law and thus at least some of the workers are willing to report their activities. Surveying supply of labour may provide more detail but needs careful design, involving questions that are sensitive and prone to item non-response and incorrect response.
Surveys of time use. The advantage of the time use approach over labour force surveys is that it provides a framework for allocating all available time between productive and other activities.
Opinion surveys. Opinion surveys of enterprises and households are used in several countries to monitor underground activities. They can be designed to take very little time to complete. They can be made non-threatening by asking respondents to give their views about general practices in an industry or sector rather than asking respondents about their own particular underground activities.
Estimates of the shadow economy can also be based tax auditing, aiming to estimate the discrepancy between income declared for tax purposes and that measured by selective checks. Fiscal auditing programs have been particularly effective in this regard. Since these programs are designed to measure the amount of undeclared taxable income, they may also be used to calculate the underground economy.
A disadvantage of these direct methods (surveys and tax auditing) is that they lead only to point estimates, for the period during which they were carried out. They are unable to provide estimates of the development and growth of the shadow economy over a longer period of time. But they do have the considerable advantage that they can provide detailed information about the structure and composition of the shadow economy activities. In this respect such estimates can serve as benchmark estimates, which can be extrapolated with indicators to years for which such direct estimates are not available.
Method based on the discrepancy between expenditure and income statistics. This approach is based on discrepancies between income and expenditure statistics. Both income and expenditure approaches to GDP should give identical results for GDP. If all the components of the expenditure side are measured without error, then this approach would indeed yield a good estimate of the scale of the underground economy. Unfortunately, however, this is not the case. Also, not all income components may be estimated. Hence, the discrepancy reflects all omissions and errors everywhere in the national accounts as well as the underground (and illegal) economic activity. These estimates may therefore be very crude and of questionable reliability.
Method based on the discrepancy between the official and actual labour force. A decline in participation of the labour force in the official economy can be seen as an indication of increased activity in the shadow economy. However, differences in the rate of participation may have many other causes. Also, people can work in the shadow economy and have a job in the “official” economy. Therefore such estimates may be viewed as weak indicators of the size and development of the shadow economy.
Methods based on currency demand. Here one assumes that underground transactions are undertaken in the form of cash payments, so as to leave no observable traces for the authorities. An increase in the size of the underground economy will therefore increase the demand for currency.
Methods based on physical inputs. An example is the use of an indicator based on electricity consumption. Here we assume that electric-power consumption is one of the single best physical indicators of overall economic activity, including underground activities. This is corroborated by studies in which economic activity and electricity consumption have been empirically observed throughout the world to move in lockstep. By having this proxy measurement for the overall economy and then subtracting from this overall measure the estimates of official GDP, one can derive an estimate of unofficial GDP, including the illegal, underground and unobserved informal parts. As a fine-tuning of this method one may consider only household electricity consumption.
Indicator based methods described above are designed to estimate the size and development of the underground economy using just one indicator that is supposed to capture all effects of the underground economy. However, it is obvious that underground economy effects show up simultaneously in the production, labour, and money markets. The model approach explicitly considers multiple causes leading to the existence and growth of the underground economy, as well as the multiple effects of the underground economy over time.
Following the OECD manual, underground production can be considered as falling into two possible categories (OECD 8.33):
activities that are underground because the enterprises conducting them are not registered
activities that are underground because the enterprises conducting them (although registered) under-report
Enterprises that are not registered and are engaged in legal productive activities are likely to be very small. For example, persons with a regular paid job as a plumber or teacher, who work after hours for their own profit (“moonlighters”) count as such small-scale enterprises. However, because there may be quite a large number of such enterprises, the total production of such enterprises may be quite substantial. Failure to register means that the enterprise will not be covered in any survey for which the frame is drawn from the business register. A household or mixed household-enterprise survey approach is a practical way of measuring such underground production.
Estimating the effect of underreporting is difficult, since enterprises answer survey questionnaires using the same set of accounts as they prepare for tax purposes. Thus, underreporting of production and/or receipts to the taxation authorities in order to avoid taxes is likely to be reflected in the survey data submitted to the statistical office. Some overall idea of the magnitude of underreporting in specific industries may be obtained through commodity balances. The OECD manual gives the example of crop production that may be estimated from seed consumption or milk yield from estimates of forage consumed (OECD 8.37).