You can't tax what you can't see

Underground economy skews statistics and shortchanges the tax man, but is it all bad?

David Fettig | Editor

Published April 1, 1994  | April 1994 issue

Report all wages, salaries, and tips you received, even if you do not have a form W-2.

That directive for Line 7 of the federal income tax form will be disregarded by millions of U.S. citizens this tax season.

Exactly how many will understate their income and how much money will elude the Internal Revenue Service is up for debate, but IRS estimates put the amount of unreported income at $675 billion in 1992, with a shortfall in tax revenues of $130 billion. And some analysts say that is a conservative guess.

Unreported income is part of the underground economy, a hidden sector that obviously includes illegal drug dealing, illegal prostitution, unlawful gambling and other criminal activity. While the amount of money involved in criminal activity—and the subsequent tax revenue that is lost—is of interest to economists and policymakers, it is largely considered unrecoverable; that is, criminal activity will always be conducted in the underground economy because that is its very nature.

Therefore, policymakers are more concerned about the size of the underground economy as it relates to otherwise legal enterprises, like off-the-books hiring—remember Zoe Baird?—and unrecorded retail sales. These are activities that normally appear above ground but sometimes go unreported or unrecorded, most often to avoid taxes or regulatory costs.

The underground economy's impact on economic statistics like GDP, the "tax gap" that results from untaxed economic activity, and the effect on government programs are foremost in policymakers' minds when they think about the underground economy. If policymakers do not—or cannot—account for the actions of those in the underground economy, then the goals of their new policies may be thwarted to some degree. For example, would a national health care plan that mandates certain costs, increase the incentive to avoid those costs? In theory, that is certainly the case, observers say, but most are skeptical that underground activity would hamper the effectiveness of a national health care system.

The presence of an invisible economy also skews our understanding of living standards; for example, are supposedly blighted rural areas or inner-city neighborhoods more "wealthy" in ways that statistics cannot tell us? Are segments of the underground economy, with their bartered favors and cash services, just another name for community?

Difficult to define and to measure

What is generally called the underground economy is also known as hidden, submerged, informal, secondary, parallel, shadow, irregular, clandestine and many other names. This identity crisis not only involves this sector's name, but extends to estimates of its size and its numerous definitions.

By its nature, of course, the underground economy is hard to measure, and in the 1970s and '80s some studies were cause for alarm among policymakers. Studies put the size of the underground economy at anywhere from about 4 percent to nearly 30 percent of the country's GDP.

Lawmakers, influenced by estimates of a huge tax gap, naturally saw an opportunity to increase tax revenues. For example, a portion of the 1982 Tax Enforcement and Fiscal Responsibility Act that was inspired by the reports on an underground economy, was based on the presumption that higher penalties would result in stricter compliance, according to a report prepared for the Minnesota Department of Revenue.

Edgar L. Feige, professor of economics at the University of Wisconsin in Madison, has done much research on this topic in recent years; his 1979 report on the underground economy was, in part, responsible for the growth in awareness on the topic. Today, Feige says we have a better understanding of the nature of the underground economy, which he says consists of many elements, the most important of which are the illegal economy, the unreported economy and the unrecorded economy. Although there is not universal agreement on this matter, most recent reports on the underground economy, including a 1992 US Labor Department study, use Feige's definitions:

  • Illegal economy—trading in illegal goods and/or services.
  • Unreported economy—legal activities meant to evade the tax code.
  • Unrecorded economy—failing to fully or properly record economic activity, such as hiring workers off-the-books.

Many people have likely participated in the underground economy—wittingly or not—through bartering services with a neighbor or colleague, paying cash for a household service that wasn't recorded, establishing babysitting co-ops, or from not reporting extra income, be it from a second job, a sale of used goods or a windfall at the local casino. Other examples of underground activity include retail shops, usually small, that may pocket a certain percentage of sales without recording them, or that may not report the income of a family member working in the shop.

Psst ... I'll give you nine zucchini for six tomatoes

Needless to say, some of that activity is the stuff of everyday life and of little concern to the IRS Enforcement Division or to policymakers. Exchanging zucchini for your neighbor's tomatoes is literally an underground exchange, says Minnesota state economist Tom Stinson, but it is hardly an issue for policymakers. Stinson says that, in many respects, the debate about the actual size of the underground economy is an "inside baseball issue," one that purveyors of statistics may care about, but of little interest to most others.

"Do people really care whether GDP numbers are accurate or not?" Stinson asks. Probably not, but they might, he adds, if the bad or biased information is incorrectly influencing fiscal, monetary, industrial or international policy. For example, if the underground economy is unchanged relative to the overall economy—that is, if it is always 5 percent of GDP—then policymakers need not be as concerned about its influence, Stinson says. However, if the relative size of the underground economy expands at a particular time, then it could understate the actual vitality of the economy; in such a scenario the levels of output, employment, savings and productivity could all be higher than the numbers would reveal.

In the early 1980s, the idea that the underground economy profoundly understated economic statistics was gaining prominence. One theory suggested that forecasters were misled into assuming that a recession was imminent in 1978-79 because of the high levels of consumer debt. The recession did arrive, but it came later and was shorter than expected, the theory goes, because underground income supplanted measured income, meaning that the fears of consumer debt were unfounded. Likewise, fiscal and monetary counter-recessionary policy was based on a distorted view of the economy, according to this theory.

Such speculative theories drove the Bureau of Economic Analysis (BEA), the division of the US Department of Commerce that reports economic statistics, to study the country's hidden economy. "BEA is always concerned when our source data might be missing things," says Carol Carson, now director of the BEA, who conducted that agency's 1984 study. In her study, Carson found that the underground economy has implications for economic statistics, but its effects are muted. "We do not believe that the underground economy can lead to wild understatements" of statistics, Carson says.

The BEA does make adjustments for underreporting of tax returns, Carson says, and as noted earlier, the IRS says $675 billion went unreported in 1992, meaning $130 billion was absent federal tax coffers last year. (The IRS estimates that it recovers about 10 percent to 15 percent of the tax gap each year.) But even more may be missing. When he makes his estimates, the University of Wisconsin's Feige employs a model based on currency ratios that estimates unreported income as a percentage of adjusted gross income. According to Feige, this measure of the underground economy means $800 billion—or 21.2 percent of adjusted gross income—went unreported in 1992, higher than IRS estimates.

"We know it's a problem out there and we're always looking for non-filers," says Jerry McClure, assistant commissioner in the Minnesota Department of Revenue. A study conducted by the Office of Tax Policy Research, University of Michigan, put Minnesota's 1990 tax gap at over $760 million. While that amount may seem high, the study's authors stress that estimates are difficult to make and are sometimes based on reports from other states that may—or may not—apply similarly to Minnesota.

Also, the total tax gap may not be the most important number, the Michigan researchers say. "While the potential generation of revenue is a justifiable motivation for researching the tax gap, it should be made clear that the recoverable amount of the tax gap is very different from the full amount," the report states.

And even the recoverable amount, like so much else about the underground economy, is something of a mystery. As Minnesota's McClure says, "I guess if we knew where this money was, we'd go get it."

'Everyone does it'

Tax evasion and the avoidance of what are considered unfair or costly regulations and laws, are the two most common reasons people engage in underground activity that isn't otherwise illegal, according to Harry Greenfield, professor emeritus at Queens College in New York and the author of the 1993 book, Invisible, Outlawed, and Untaxed.

Tax and regulatory incentives aside, Gary Becker, professor of economics and sociology at the University of Chicago, says that people's general attitude about government can influence their behavior. Do people feel good about their government? Do they believe that their dollars are put to proper use? People's feelings about their government change over time, he says, depending on various factors. [See interview with Gary Becker, The Region, June 2002.]

In his book, Greenfield cites the following responses as examples of such anti-tax, anti-government attitudes:

  • "I had a clerk job and I saw the federal taxes taken out. So I said forget it. I feel I'm contributing my share"—an Atlanta waiter.
  • "You know the big guys that make lots of money aren't paying much in taxes"—a Washington, D.C., cab driver.
  • "You have to be dumb to pay taxes on the extra income when the government is already taking a third of your pay"—a New York writer.
  • "Everyone does it. I thought it was the expected thing to do"—a Los Angeles carpet layer.

Other factors that may influence the amount of underground activity are economic downturns, Greenfield says, and the need to supplement other income that may be inadequate, such as pensions or a low-wage job, and the fear of losing government payments like unemployment compensation or welfare.

Greenfield writes that a 1978 Oregon survey showed that nearly one-fourth of the respondents admitted that they practice tax evasion. Five years later, a national survey reported that over 80 percent of respondents had made at least a small purchase from informal suppliers that provided services like babysitting, gardening, lawn care and auto repair, or that they had bought goods from itinerant street vendors and the like. A 1978 Detroit survey that focused on the sociological and ethnological aspects of the underground economy found that about 25 percent had purchased services through the "irregular economy," and that "cost was not cited as the most important consideration in choosing irregular producers," he says.

But what do such surveys really tell us about the level of underground activity? As Greenfield notes, fear of reprisal means that not all survey respondents are completely forthcoming about such matters. "Inevitably, biases resulting from problems of non-response and false response are endemic to such surveys."

Does activity underground improve life up above?

In Italy, where some estimates put the underground economy at well over 30 percent of the country's production, and where its presence (beyond the criminal syndicates) is acknowledged and even accepted by authorities, some economists and policymakers extol its virtues. The underground economy brings income to people who might otherwise have too little, they say, and fosters enterprise that would be too difficult to establish in the formal economy.

Frank Cowell, reader in economics at the London School of Economics, agrees that the underground economy has redeeming features. Writing in the November/December issue of International Economic Insights, he says that in the face of "wrong-headed or slow-witted" government policy, the underground economy can provide an "economic ventilation shaft to enterprise in danger of suffocation." Without such ventilation, services like plumbing and auto repair might otherwise be unprofitable and in some cases would not get done. Besides, he says, imagine a situation where the state would be so strong and all-pervasive that it could negate all such behavior: "A world of perfect enforcement could be an intolerable place."

There may be other, more intangible, benefits to the underground economy, according to Tom Dewar, recently a professor at the Humphrey Institute of Public Affairs at the University of Minnesota, and now affiliated with Rainbow Research, a Minneapolis-based non-profit organization that works to resolve social problems. There is a certain amount of "wealth"—not necessarily measured by dollars—that is generated when people barter services and goods, or do "cash work" in the neighborhood, Dewar says. "Sometimes that interaction builds up the social capital of a community."

Dewar says that he used readings in his university courses that would sometimes surprise his "middle class" students, who were unaware of the sense of pride and belonging in some poor neighborhoods or communities. He attributes that sense of community, in part, to people's dependency on one another—a dependency that can be reflected in the amount of underground economic activity.

David Scheie, associate director of Rainbow Research, says inner-city neighborhoods and rural communities are developing home health care programs that depend on the volunteer services of neighbors. One Minneapolis woman, describing the economic relationships in her neighborhood, says people feel a level of trust with people they know. Such relationships aren't unusual, she says, "That's what communities do."

John Kretzmann, director of the Neighborhood Innovations Network at the Center for Urban Affairs and Policy Research, Northwestern University in Evanston, Ill., says that when the center asks inner-city residents if they've ever been in business, they usually answer no. But when residents are asked if they've ever made money on the side, "the stories come pouring out."

As part of its efforts, the center works with residents to bring them into the formal economy, says Kretzmann, the co-author of the recent book, Building Communities from the Inside Out. For example, in one Chicago public housing project, a group of residents with a reputation for cooking soul food began their own catering service.

Underground economy may grow

Gary Becker says that the underground economy is probably growing, in part, because of increased taxation and regulation over time, but also because of the rising tide of illegal immigration and—in the criminal markets—the seemingly burgeoning market for such contraband as drugs and guns. He has recently written about the proposals to heavily tax guns and ammunition as a means of discouraging sales. Such efforts, he says, will not reduce the supply of guns to criminals because it will simply increase the underground market for firearms.

The influx of immigrant workers combined with increasing competition from foreign markets has led some in the apparel industry underground in recent years. The Wall Street Journal reported in March that the U.S. Labor Department has conducted 487 home-sewing investigations in the Dallas area in the past three years (250 last year), and the General Accounting Office has been investigating the connection between home sewers in the Dallas area and brand-name garment makers and retailers. (Federal law prohibits at-home production of certain types of clothing and jewelry for interstate commerce.) Many of the home sewers are reportedly immigrant workers who are paid in cash.

Another aspect of the current economy that may lead to increased underground activity is the growth in small, consulting-type, businesses. Computers and telecommunications equipment—combined with white-collar, middle management layoffs and companies' growing use of contract workers—means that more people are establishing businesses in their own homes. "If you do your work at home on a computer, it's very difficult for anyone to know about it," Greenfield says.

But the former economics professor doesn't necessarily agree that the opportunity to work underground will mean that people will decide to do so. Minnesota's Tom Stinson shares those doubts, arguing that the growing market for contract work doesn't necessarily mean a subsequent rise in underground activity. "I'm not sure that I agree with the underlying premise that most people aren't honest."