Definitions

Why Do We Care about the Shadow Economy?

The Shadow Economy Invalidates Government Statistics and Policies

The Shadow Economy Affects the Official Economy

Shadow Economies Evince Citizens’ Discontent with and Serve as a Check on Government

Causes of the Shadow Economy

Methods of Measuring the Size of the Shadow Economy

Direct Approaches

Indirect Approaches

Estimates of the Size of the Shadow Economy

Characterizing the Shadow Economy

The Dual Nature of the Shadow Economy

Industries Most Susceptible to being in the Shadow Economy

The Changing Nature of the Shadow Economy

 

Introduction

Today, System D [the shadow economy] is the economy of aspiration. It is where the jobs are.

-- Robert Neuwirth, “The Shadow Superpower”
 

 

What is the biggest current problem facing all economies globally? Unemployment.

The financial crisis of 2008 and its aftermath has resulted in a global recession, together with a prolonged period of high unemployment in developed nations that hasn’t been seen since the Great Depression.

Joseph E. Stiglitz, in “Employment, Social Justice and Societal Well-Being” explains why it is so important for society to provide jobs for its citizens:

[F]or a large fraction of the world’s population, work – employment – is important. For individuals who lose their jobs, it is not just the loss of income that matters, it is also the individual’s sense of self. Unemployment is associated with a variety of problems and pathologies, from higher divorce rates, higher suicide rates to higher incidences of alcoholism. And the relationship is not just a correlation: there is a causal connection. Some individuals can keep themselves happy and gainfully “employed” without a job. But for many, employment – the fact that someone else recognizes their “contribution” by paying them – is important.

The difficulties plaguing developed nations in finding jobs for its unemployed over the past several years has also served to amplify the underlying transition at the heart of the matter: increasing globalization of the world’s economies.

Structural changes in global labor markets have benefitted unskilled (and semi-skilled) workers in developing nations, but at the expense of unskilled (and semi-skilled) workers in developed nations. Lesser skilled workers in developed nations will have to carve out a place for themselves within the new global economy. And that’s where the shadow economy comes in. The current environment in developed nations of high taxes and regulations, together with low official demand for unskilled labor (especially at the pre-crisis wage levels these workers had been earning), the newly disenfranchised have been increasingly turning to the shadow economy for work.

This analysis draws heavily on several articles authored or co-authored by Friedrich Schneider, Professor of Economics at Johannes Kepler University of Linz

Friedrich Schneider and Andreas Buehn (October 2012), “Shadow Economies in Highly Developed OECD Countries: What Are the Driving Forces?”

Friedrich Schneider and A.T. Kearney (2011), “The Shadow Economy in Europe, 2011”

Friedrich Schneider (July 2007), “Shadow Economies and Corruption All Over the World: New Estimates for 145 Countries”

Friedrich Schneider and Dominik H. Enste (March 2000), “Shadow Economies: Size, Causes, and Consequences”

 

Definitions

The definitions of underground and other such informal economies are subject to dispute. In this analysis, I define the terms and concepts as follows.

Economic activity includes all monetary and non-monetary (e.g., barter) exchanges the occur in society. Economic activity may be partitioned into two subgroups,

•  The formal economy – exchanges that are taxed by the government – and

•  The informal or underground economy – exchanges that are not taxed by the government.

The underground economy, also known as the informal economy, may be defined as “the exchange of goods and services which are hidden from official view.”

The formal economy may be further partitioned into two subgroups,

•  The official economy – authorized exchanges – and

•  The grey market – unauthorized exchanges, also known as channel diversion.

Grey market “commodities are distributed through channels which, while legal, are unofficial, unauthorized, or unintended by the original manufacturer.” Grey market activity is also known as product diversion, since it involves the purchase of products through one channel for resale through another channel. Examples include resellers taking advantage of education discounts, bulk purchasing discounts, or drug pricing discounts to buy products at a discount and resell them for a profit at higher prices.

The informal or underground economy may also be further partitioned into two subgroups,

•  The Black Market generally refers to the barter or sale of Illegal goods or services, such as drugs, prostitution, stolen or counterfeit products, and weapons.

•  The Shadow Economy or “System D”

Schenider (2007) defines the shadow economy as follows:

a broad definition of the shadow economy includes unreported income from the production of legal goods and services, either from monetary or barter transactions – and so includes all economic activities that would generally be taxable were they reported to the state (tax) authorities. In this paper the following more narrow definition of the shadow economy is used. The shadow economy includes all market-based legal production of goods and services that are deliberately concealed from public authorities for the following reasons:

(1) to avoid payment of income, value added or other taxes,

(2) to avoid payment of social security contributions,

(3) to avoid having to meet certain legal labour market standards, such as minimum wages, maximum working hours, safety standards, etc., and

(4) to avoid complying with certain administrative procedures, such as completing statistical questionnaires or other administrative forms.

Robert Neuwirth, “The Shadow Superpower” defines System D as follows:

System D is a slang phrase pirated from French-speaking Africa and the Caribbean. The French have a word that they often use to describe particularly effective and motivated people. They call them débrouillards. To say a man is a débrouillard is to tell people how resourceful and ingenious he is. The former French colonies have sculpted this word to their own social and economic reality. They say that inventive, self-starting, entrepreneurial merchants who are doing business on their own, without registering or being regulated by the bureaucracy and, for the most part, without paying taxes, are part of "l'economie de la débrouillardise." Or, sweetened for street use, "Systeme D." This essentially translates as the ingenuity economy, the economy of improvisation and self-reliance, the do-it-yourself, or DIY, economy…

Andrew Leonard, in “A growing underworld bazaar” distinguishes the focus of conservatives from that of liberals when referring to the impetus for the shadow economy:

•  Liberals tend to focus on the circumvention of workers’ rights, such as those regarding the payment of minimum wage, overtime and benefits and those regarding health and safety of working conditions.

•  Conservatives tend to focus on the circumvention of excessive taxes and regulations.

The focus of this analysis is the shadow economy.

 

Why Do We Care about the Shadow Economy?

 

The Shadow Economy Is Large and Growing

The shadow economy has been estimated to encompass almost half the workers of the world in 2009, and it is expected to grow to encompass more than half (two-third’s by OECD estimates) the world’s workers within the next several years. (See sections below for more detail on the size of the shadow economy.)

 

The Shadow Economy Invalidates Government Statistics and Policies

The large size of the shadow economy invalidates many government statistics regarding the actual welfare and/or well-being of its citizens. Since government presumably uses statistics as the basis for its policies, then relying on invalid statistics will lead government to enact inappropriate policies.

For example, recent high unemployment rates in the US has led the US government to enact and extend unemployment benefits to those who cannot find jobs. However, the risk of losing such benefits discourages workers from finding jobs in the official economy, and instead, pushes them to work and earn money in the shadow economy. In this vein, Schneider and Enste (2000) note:

The social welfare system leads to strong negative incentives for beneficiaries to work in the official economy, since their marginal tax rate often approaches or equals 100 percent.

 

The Shadow Economy Affects the Official Economy

The official and unofficial economies do not exist independently from one another. In particular, the two economies compete and complement each other in the provision of workers and resources.

On one hand, higher tax burdens and regulations push workers out of the official economy and into the unofficial economy. This serves to divert labor and tax revenues away from the official economy. (See sections below for more detail on causes of the shadow economy.)

On the other hand, the majority of wages earned in the unofficial economy are spent in the official economy. And at the same time, many of the activities that take place in the shadow economy promote productive activities and/or social welfare for its citizens that would not have been achieved in the official economy.

According to Schneider and Enste (2000),

The effects of a growing shadow economy on the official one must also be considered. On the one hand, a prospering shadow economy may attract (domestic and foreign) workers away from the official economy and create competition for official firms. On the other hand, at least two-thirds of the income earned in the shadow economy is immediately spent in the official economy, thus having a positive effect on the official economy…

This [two-thirds] figure was derived from polls of the German and Austrian populations about the (effects of) the shadow economy... These polls also show that two-thirds of the value added produced in the shadow economy would not be produced in the official economy without the activities in the shadow economy.
 

Also, J.D. Tuccille, in “As Bad Times Continue, Shadow Economies Grow” notes

…[I]t [the shadow economy] helps to explain why countries like Spain, where unemployment now stands at a brain-buggering 24.4%, aren't now paving their streets with the bodies of the starving. Obviously, some significant percentage of those people are working off the books.

Yet, the diversion of tax revenues away from the official economy can lead to a vicious spiral that ends up harming social welfare by stymieing the adequate provision of public goods for society. Schneider and Buehn (2012) describe this phenomenon:

An increase of the shadow economy may lead to fewer state revenues, which in turn reduce the quality and quantity of publicly provided goods and services. Ultimately, this may lead to increasing tax rates for firms and individuals, although the deterioration in the quality of the public goods (such as the public infrastructure) and of the administration continues. The consequence is an even stronger incentive to participate in the shadow economy.

 

Shadow Economies Evince Citizens’ Discontent with and Serve as a Check on Government

From Schneider and Enste (2000):

A growing shadow economy can be seen as the reaction of individuals who feel overburdened by the state and who choose the “exit option” rather than the “voice option”. If the increase of the shadow economy is caused by a rise in the overall tax and social security burden together with “institutional sclerosis”, then the “consecutive flight” into the shadow economy may erode the tax and social security bases. The result can be a vicious circle of a further increase in the budget deficit or tax rates, additional growth of the shadow economy, and gradual weakening of the economic and social basis of collective arrangements…

The shadow economy can be seen as an indicator of a deficit of legitimacy of the present social order and the existing rules of official economic activities. The exit-option shadow economy is an important constraint on the Leviathan state and can help secure economic freedom.

 

Causes of the Shadow Economy

According to Schenider and Enste (2000)

The growth of the shadow economy is caused by many different factors. The most important and often cited ones are: the rise of the burden of taxes and social security contributions; increased regulation in the official economy, especially of labor markets; forced reduction of weekly working time; earlier retirement; unemployment; and the decline of civic virtue and loyalty towards public institutions combined with a declining tax morale.

Schneider and Buehn (2012) provide a very succinct summary table of the causes of shadow economies (see Table A.1 below). According to Schneider and Buehn, the shadow economy will be larger relative to the formal economy when

•  Regulations: There are more regulations restricting economic activity. Regulations include, for example, permits, licensing, unionization, and trade barriers or quotas.

•  Taxes: Direct taxes (taxes on labor) and indirect taxes (taxes on goods and services) are higher.

•  Corruption: There is more corruption, which may be defined as activities that increase the cost of doing business or otherwise restrict access to market activities.

•  Unemployment: More people are working fewer hours than they would like; this includes unemployment (people without any jobs), underemployment (people with jobs that do not challenge their abilities), part-time employment (people with only part-time jobs), and retirement (people forced to retire sooner than they would like).

•  Rule of Law: There is insufficient public infrastructure to enforce laws and contracts.

•  Education: People are less educated.

•  Tax Morale: People feel that government is not spending their tax dollars effectively or efficiently.

•  Currency: A greater portion of transactions use cash or are otherwise untraceable.

 

Methods of Measuring the Size of the Shadow Economy

By its very nature, the size of the shadow economy is difficult to measure. Scholars have used both direct and indirect methods of measurement to estimate its size. The following condensed descriptions are taken from Schneider and Enste (2000).

 

Direct Approaches

•  Surveys and samples based on voluntary replies, or tax auditing and other compliance methods.

The main advantage of this method lies in the detailed information that can be gained about the structure of the shadow economy. But results from these surveys are sensitive to the way the questionnaire is formulated, and, as with all surveys, precision and results depend greatly on the respondents’ willingness to cooperate.

•  Fiscal Auditing Programs based on the discrepancy between income declared for tax purposes and that measured by selective checks. Difficulties with auditing measures of the shadow economy

° Using tax compliance data is equivalent to using a (possibly biased) sample of the population.

° Estimates based on tax audits reflect only that portion of shadow economy income which the authorities succeeded in discovering, and this is likely to be only a fraction of hidden income.

A further disadvantage of the two direct methods (surveys and tax auditing) is that they lead only to point estimates.

Moreover, it is unlikely that they capture all shadow activities, so they can be seen as providing lower-bound estimates. They are unable (at least at present) to provide estimates of the development and growth of the shadow economy over a longer period of time.

 

Indirect Approaches

These approaches, which are also called indicator approaches, are mostly macroeconomic, and use various economic and other indicators that contain information about the development over time of the shadow economy.

•  Discrepancy between National Expenditure and Income Statistics:

In national accounting, the income measure of GNP should be equal to the expenditure measure of GNP. Thus, if an independent estimate of the expenditure side of the national accounts is available, the gap between the expenditure measure and the income measure can be used as an indicator of the extent of the shadow economy…

Weaknesses:

[T]he discrepancy … reflects all omissions and errors everywhere in the national account statistics as well as the shadow economy activity. These estimates are therefore of questionable reliability.

•  Discrepancy between Official and Actual Labor Force

A decline in labor force participation in the official economy can be seen as an indication of increased activity in the shadow economy, if total labor force participation is assumed to be constant …

Weaknesses:

The weakness of this method is that differences in the rate of participation may have other causes. Moreover, people can work in both the shadow and the official economies. Therefore, such estimates may be viewed as weak indicators of the size of the shadow economy.

•  The Transactions Approach

[This approach] assumes that there is a constant relation over time between the volume of transactions and official GNP. This approach therefore starts from Fisher’s quantity equation, MV = pT (with M = money, V = velocity, p = prices, and T = total transactions). Assumptions have to be made about the velocity of money and the relationships between the value of total transactions (pT) and total (= official + unofficial) nominal GNP. Relating total nominal GNP to total transactions, the GNP of the shadow economy is calculated by subtracting official GNP from total nominal GNP…

Weaknesses:

In general, although this approach is theoretically attractive, the empirical requirements necessary to obtain reliable estimates are so difficult to fulfill that its application may lead to doubtful results.

•  The Currency Demand Approach

[This] approach assumes that shadow transactions are undertaken in the form of cash payments... An increase in the shadow economy will therefore increase the demand for currency. To isolate the resulting excessive demand for currency, an equation for currency demand is econometrically estimated over time… The excessive increase in currency— the amount unexplained by the conventional factors mentioned above—is then attributed to the rising tax burden and other factors leading people to work in the shadow economy… The currency demand approach is one of the most commonly used methods…

Weaknesses:

(i) Not all transactions in the shadow economy are paid in cash…

(ii) Most studies consider only one particular factor, the tax burden, as a cause of the shadow economy…

(iii) Increases in currency demand deposits are due largely to a slowdown in demand deposits, rather than to an increase in currency caused by activities in the shadow economy…

(iv) …the assumption of the same velocity of money in both types of economies…

(v) …the assumption of no shadow economy in a base year is problematic…

•  The Physical Input (Electricity Consumption) Method

Overall (official and unofficial) economic activity and electricity consumption have been empirically observed throughout the world to move in lock-step, with an electricity/GDP elasticity usually close to one. By having a proxy measurement for the overall economy and subtracting it from estimates of official GDP, Kaufmann and Kaliberda derive an estimate of unofficial GDP…

Weaknesses:

(i) Not all shadow economy activities require a considerable amount of electricity (e.g. personal services), and other energy sources can be used (gas, oil, coal, etc.), so that only a part of the shadow economy will be captured.

(ii) Over time, there has been considerable technical progress. The use of electricity is more efficient than in the past, in both official and unofficial uses.

(iii) There may be considerable differences in the elasticity of electricity/GDP across countries or changes over time.

 

Estimates of the Size of the Shadow Economy

Due to the inherent weaknesses of all methods of estimating the size of the shadow economy, I’m skeptical of any absolute estimates. However, Friedrich Schneider presents results for estimates of the sizes of shadow economies in various countries across time. Due to the internal consistency of his estimates, I think they should provide a reasonable indication of the relative sizes of shadow economies across countries (e.g., shadow economies in undeveloped countries are larger than those in developed countries) and how the sizes of the various shadow economies have been changing over time (e.g., most scholars agree that they have been growing in size).

Schenider and Enste (2000) report

The general impression from the results of these estimates is that, for all countries investigated, the shadow economy has reached a remarkably large size. Although the different methods provide a rather wide range of estimates, there is a common finding that the shadow economies of most transition and all investigated OECD countries have been growing over the past decade [the 1990s].

Schneider (2007) provides the following estimates:

Note that Schneider does not weight his estimates of shadow economy sizes across countries. The appropriate weights would be country GDPs. Developing countries have smaller GDPs than developed countries, but larger shadow economies. It follows that Schneider’s reported unweighted averages over all countries of the size of the global shadow economy (e.g., 34.3% in 2004/2005) overstate the corresponding weighted averages (whatever they may be).

In “The Shadow Superpower”, Robert Neuwirth reports (emphasis mine):

…as trade has expanded and globalized, System D has scaled up too... In 2009, the Organisation for Economic Co-operation and Development (OECD) … concluded that half the workers of the world -- close to 1.8 billion people -- were working in System D: off the books, in jobs that were neither registered nor regulated, getting paid in cash, and, most often, avoiding income taxes…

In many countries -- particularly in the developing world -- System D is growing faster than any other part of the economy, and it is an increasing force in world trade. But even in developed countries, after the financial crisis of 2008-09, System D was revealed to be an important financial coping mechanism…

By 2020, the OECD projects, two-thirds of the workers of the world will be employed in System D…

Schneider’s estimates of the size of the shadow economy as a percentage of GDP allow workers to be employed in the official AND/OR the shadow economies simultaneously. On the other hand, it’s not clear whether the OECD estimate of “half the workers of the world” being employed in the shadow economy allows for simultaneous employment in both economies. Regardless, there are more workers (greater populations) in lesser developed countries, and lesser developed countries have larger shadow economies. It follows that Schenider’s estimates and the OECD estimates are mutually consistent, if we assume the shadow economy increased in size by a reasonably significant amount since the global financial crisis of 2008. And I consider this to be a reasonable assumption.

 

Characterizing the Shadow Economy

 

The Dual Nature of the Shadow Economy

The changing nature of the global environment (globalization of economies, increasing competition, increasing uncertainty, increasingly knowledge-intensive) has led to a bifurcation of the workforce involved in the current and future shadow economies.

On one hand, you have the traditional, low-skilled workers, providing low-level services. This group will increasingly include the recently disenfranchised middle classes in developed countries, who will find it increasingly difficult to find jobs and earn the wages they have been accustomed to earning in the formal economy.

On the other hand, you have the newer classes of knowledge-intensive workers (including information technology specialists) who can provide much-needed freelance consulting services to the upper echelons of businesses. From “America's 'shadow economy' is bigger than you think - and growing“:

There are two informal economies, says Saskia Sassen, a sociology professor at Colombia University in New York. “You have a poverty kind of informal economy, and you have an informal economy that feeds into the high end,” she says. These are creative professionals such as freelance designers and performers. It’s the first group, however, that’s much larger in terms of manpower, she adds.

As Ms. Sassen indicates, the less-skilled workers surely make up the lion’s share of actual and potential shadow economy workers globally. However, I think the knowledge-intensive consultants (in the developed economies) will make increasingly significant contributions to the shadow economy in the future. This is due to a combination, first, of increasing amounts of government taxes and regulations which will increase the financial benefits of working in the shadow economy, relative to working in the formal economy. And second, the increasing sophistication and decreasing costs of information technology and communications systems will make it easier for these workers to participate in the shadow economy under the radar of governments’ view.

 

Industries Most Susceptible to being in the Shadow Economy

One means of dividing the economy into sectors would start with resources and raw materials and then continually move farther away from the natural environment. This method would result in the following partition of the economy:

•  Resource Extraction: agriculture (both subsistence and commercial), mining, forestry, farming, grazing, hunting and gathering, fishing, and quarrying.

•  Manufacturing: metal working and smelting, automobile production, textile production, chemical and engineering industries, aerospace manufacturing, energy utilities, engineering, breweries and bottlers, construction, and shipbuilding.

•  Services: retail and wholesale sales, transportation and distribution, entertainment (movies, television, radio, music, theater, etc.), restaurants, clerical services, media, tourism, insurance, banking, healthcare, and law.

•  Intellectual Services: government, culture, libraries, scientific research, education, and information technology.

•  Decision Making: top executives or officials in such fields as government, science, universities, nonprofit, healthcare, culture, and the media.

Now, if I were to characterize the exchanges that are most susceptible to being in the shadow economy, I would come up with the follow list (see Schneider and A.T. Kearney (2011)). Exchanges in the shadow economy are more likely to:

•  Be less dependent on government resources and institutions.

•  Involve (small) cash payments, which are easier to hide from government. It has been suggested that Bitcoin might become the official currency of the unofficial economy.

•  Involve smaller amounts of manpower, which are easier to hide from government.

•  Be more idiosyncratic in nature, as opposed to involving regular exchanges between the same parties.

•  Not involve large capital assets, which are difficult to hide from government.

•  Be more modular (less complex) in nature, that is, less subject to misinterpretation or dispute, which would necessitate the use of contract resources (attorneys, arbitrators, and courts).

•  Be more local in nature, which are easier to coordinate outside the scope of government.

However, moving into the future, the decreasing costs and increasing sophistication of communications technologies will enable projects that are less locally concentrated, more complex, and involving more manpower to be achieved outside the purview of government.

Comparing the characteristics of exchanges that are more amenable to taking place in the shadow economy with the list of sectors above, we get the following list of industries that are more amenable to taking place in the shadow economy:

•  Relatively small scale agriculture, hunting, and fishing

•  Relatively small scale manufacturing

•  Relatively small scale services – both unskilled and skilled in nature

Schneider and A.T. Kearney (2011) came up with the following breakdown of shadow economy exchanges by industry in select European countries:

Schneider and A.T. Kearney’s results suggest that for developed countries, underreporting is more prevalent in B2B than it is in B2C exchanges. However, completely undeclared exchanges represent roughly two-thirds of the value of shadow economy exchanges. In other words, exchanges tend to be all in the shadow economy (undeclared), rather than only partially (underreported). The results also suggest that services that involve fewer tangible products (that is, inputs into the exchanges rely more on manual or intellectual labor than on physical products or resources) are more likely to be undeclared than simply underreported.

 

The Changing Nature of the Shadow Economy

The nature of the shadow economy seems to have changed in the past few decades. Instead of being countercyclical with the economy, since 1990, it’s taken on a more permanent form. From Andrew Leonard, “A Growing Underworld Bazaar”,

High unemployment, unsurprisingly, has also been correlated with a larger informal economy. But what’s interesting, says [Pascale] Joassart [professor of geography at San Diego State and the co-author of a groundbreaking study of the growth of the “informal economy” in Los Angeles.], is that in the past, the informal economy rose and fell in a cyclical pattern. In a recession, the informal economy would grow, but when the economy returned to health, it would decline. That pattern is no longer visible. Since 1990, the shadow economy keeps growing, irrespective of what’s happening in the business cycle.

These changes in the nature of the shadow economy are consistent with the structural nature of changes in the global labor markets that I discussed in an earlier blog post, and which Pascale Jossart goes on to confirm:

What’s really going on … is that there has been a restructuring of the economy which, in order to promote flexibility and global competitiveness, has led to greater reliance on part-time and contingent labor.

This includes a large informal sector made up primarily of lower-skilled workers who are required to work (such as former welfare recipients) and immigrants who have limited protections … I would argue that it is a deregulation of the economy, including a decline in welfare programs and an increase in free trade and global competition, that has led to an increase in informal work in industrialized nations.

Furthermore, Robert Neuwirth indicated that System D proved to be more resilient during the financial crisis and its aftermath:

A 2009 study by Deutsche Bank, the huge German commercial lender, suggested that people in the European countries with the largest portions of their economies that were unlicensed and unregulated -- in other words, citizens of the countries with the most robust System D -- fared better in the economic meltdown of 2008 than folks living in centrally planned and tightly regulated nations.

Resiliency will prove to be an increasingly important characteristic of local economies in the future in the face of an increasingly complex world.

The combination of greater globalization, greater competition, greater uncertainty, more regulations, and greater taxes in nations throughout the world will indeed continue to provide a healthy environment for the growth of the shadow economy.