Why do people participate in the underground economy?

Why do people participate in the underground economy?
Sam Choon Yin (August 2004)

 

Introduction

             In an earlier article, I have defined what could be constituted as operational activities in the underground economy (UGE hereafter) (Sam, 2004). There, I made the distinction between unrecorded and illegal sectors, both of which could contribute to the growth of the UGE. The former involves market based and legal activities which ought to be detected and measured by the government. Non-market based activities like doing household chores should not be a concern here for they are usually excluded in the computation of national income by convention.

The illegal sector on the other hand comprises criminal and non-criminal sectors.

Criminal activities like kidnapping, murdering and human trafficking wilfully inflict harms on the society. They are normally not included in the country’s national income even if the government authority could detect them. But incorporating them as underground appears appropriate because the operators deliberately hide their activities from the government, thus disallowing the latter from containing the growth and internalise the problem. The institutional economists have suggested their inclusion based on the wider definition of the UGE to include those acts that have violated the formal rules (Feige, 1990).

While non-criminal but illegal acts like petty trading, gambling and selling of pirated products do not wilfully inflict harm on the society, their presence could distort economic statistics like unemployment and inflation rates. This renders their relevance in the study of the UGE. In the Asian countries, focus has been placed almost exclusively on the informal sector (one where non-criminal but illegal activities are operated) with the unrecorded and criminal sectors taking a back seat (Fleming, Roman and Farrell, 2000).

Understanding what constitutes as underground is essential. One reason being that we could then identify the reasons why a country’s UGE might have grown. The other reason is to assess the contribution of each so that right remedies could be introduced to contain the growth of the UGE. The former is addressed in this essay. More specifically, we want to know why a person chooses to participate in the UGE.

 

Unrecorded economy

            Activities in the unrecorded economy are legitimate but the government fails to detect their size and existence at least in an accurate manner. Accordingly, the government does not fully measure and record these activities rendering the recorded gross domestic product (GDP) being less than its actual. This could pose a problem to the government in terms of choosing the right mix of policies to stabilise the country’s economy and raise its standards of living simply because the data and information on hand do not reflect accurately the country’s economic status.

            In addition, the government fails to collect tax revenue from such activities. This imposes limitations to the government in financing its expenditure programs. The society may eventually have to pay the price because of lower quantity and quality of public goods and services offered. Shortage of tax revenue may also compel the government in incurring debt because of its need to borrow.

            To resolve these problems, it is imperative that the government is aware of the reasons why legitimate activities fail to be reported. There could be several reasons.

            First, excessive regulations in the aboveground economy may compel individuals and businessmen to operate underground so as to get things done more effectively and efficiently. In this respect, it may be useful to note Hernando de Soto’s findings about the problems which excessive regulations could bring. In the ‘Mystery of Capital’, de Soto has documented how troublesome it was to obtain real estates legal rights in certain countries (de Soto, 2001). In the Philippines for example, it required 168 bureaucratic steps involving 53 public and private agencies. In Egypt, it required 77 bureaucratic procedures involving 31 public and private agencies. In Peru, it took a year or more to start a legal business costing, in government fees, 31 times the minimum monthly wage. Cutting red tape thus appears to be the feasible approach to minimize the problem. Measures aimed to facilitate transactions should be tried out while bureaucratic steps and excessive paperwork should be eliminated. In the era of globalisation, successes are essentially determined by how fast things could be done. A heavy regulated country will hinder business expansion plans and attract more to operate in the UGE.

            Public officers may take advantage of the weaknesses in the system to extract payments from the businessmen. To avoid the trouble altogether, the smaller businesses may decide to operate underground. To large businesses, avoiding the government altogether appears more difficult. Paying of bribes may be seen then as a viable alternative. Andrew MacIntyre has pointed out that strong investment growth in Indonesia was possible during the Suharto era despite the country’s institutional weaknesses because the government had allowed businesses to thrive by paying ‘affordable’ bribes to the top political leaders (MacIntyre, 2001).

Some observers have noted that corruption allows for more productive use of the country’s resources. Wong (1997) for example argued that corruption has improved the overall allocation of resources in China. Resources were directed from the low yield state sector to high yielding non-state sector leading to faster economic growth and improved general well being of the Chinese.

These inefficiencies were essentially a result of poor institutions that were established in the economy, and only unethical and myopic public officers would allow these to continue. The root causes must be identified and tackled.

            Legal suppliers of labour and businesses may also decide to operate underground to evade taxes. Tax evasion is an illegal act to under-declare taxable income to the tax authority. In a progressive tax regime country, only relatively well off individuals and businesses pay income taxes. Thus, tax evasion of direct taxes could be regarded as a white-collar crime. Undoubtedly, tax evasion results in the loss of tax revenue to the government. Its negative implication is compounded if the tax data is used to compute the country’s economic statistics like the GDP. In this case, tax evasion distorts the national income statistics rendering the data improper for economic planning.

Tax evasion may also be common if the taxpayers could not relate to the benefits of paying taxes with the burden that they have to incur. What could be regarded as a sign of unhappiness expressed toward the government may eventually impose external cost to the society because of the possible deterioration in public services.

Also, the decision to evade taxes may be attributed to high tax rates. The word ‘may’ is used here because the actual impact of higher tax rates on the decision to evade taxes is inconclusive. According to Allingham and Sandmo (1972), changes in tax rates should lead to an indeterminate effect on tax evasion because of the interaction between the income and substitution effects. Consider for instance an increase in the tax rate. It is not possible to determine theoretically whether higher tax rates will increase (or reduce) the intensity of tax evasion as the income and substitution effects operate in opposite directions. The substitution effect is negative (that is, higher tax rate enhances tax evasion) because an increase in the tax rate makes it more profitable to evade taxes. The income effect, on the other hand, is positive because an increase in the tax rate makes the taxpayers less wealthy, and under the assumption of decreasing absolute risk aversion, this tends to reduce evasion. The net effect therefore is indeterminate, depending on the relative significance of the income and substitution effects.

             It should be in the interest of the government to lower the cost of tax compliance. Simplification of tax forms and tax procedures are some of the useful measures to promote greater compliance to tax rules. In this respect, one could learn from Singapore’s experience. For example, tax forms for individuals and businesses in the city-state have been simplified.  Personal income tax return Form B has been modified from an eight-page standard form to the new Form B1. The newer version requires taxpayers to fill in only the first two sections. From the YA1999, company tax return (Form C) has also been simplified. The number of pages in Form C for the YA1999 has been reduced from eight pages to six pages. The Inland Revenue Authority of Singapore (IRAS) has also allowed the taxpayers to file their tax returns through the Internet since the introduction of the electronic tax filing system (or e-filing) (from 16 February 1998). With these changes, time and resources spent in tax filing have been significantly reduced.

 

Illegal sector: Non-criminal activities

            Being illegal implies that the society is disapproved of the activities. In the usual case, the top politicians, being representatives of the society, determine the legality of a particular activity. While the traditional crimes like murdering, kidnapping and stealing are outright unacceptable in most societies, the distinction between what is accepted and what is not for non-traditional cum criminal activities like petty trading and selling of pirated goods, is difficult to ascertain. To some, gambling and selling of pirated goods may be considered acceptable as long as peace and order in the country are not disrupted. This appears to be the case in countries like Thailand and Indonesia. It is relatively easy for one to purchase pornographic materials and visit the prostitutes in Pattaya and Batam despite the fact they are illegal there. But in some societies like Singapore, the government is more stringent to curb the growth of the illegal sector. Some however have labelled such societies as nanny states and soft authoritarian because they impose restrictions on how private resources could be efficiently allocated.

            Generally, participants see the informal sector as a viable avenue to get jobs and earn income to survive. In Africa for example, more than 60 percent of the labour force engaged in the informal sector (Chaliha, 2003). Without this sector, more are likely to commit crimes to earn a living. This is particularly true to those who are marginalized and felt left out in the globalise world. Facing unequal opportunities, participating in the illegal sector might be seen as the only viable alternative to boost their self-esteem and maintain a reasonable real income.

            Thus, greed and sense of insufficiency may have compelled one to earn a living through the informal means. This is not surprising since operating in the informal sector generates potentially high positive returns although on the downside, the operators have to constantly avoid attention and detection from the public officers to minimise the risk of being caught and imprisoned.

            As I have noted elsewhere, it is interesting to know that the decision to participate in the informal sector is likely whether others participate along them or otherwise (Sam, 2003). If other persons did not participate in the UGE, one would be tempted to enter since the odds of ‘winning’ would then be enhanced. If others participated in the UGE, then the temptation for one to enter would still be very much present provided that the barriers to enter were not reasonably high. This would be so as he/she did not want to lose out to those who entered. He/she wanted to share the ‘winnings’ (if any) with the rests.

            To conclude this section, it may be useful to reiterate that participants in the informal sector do not willfully inflict harm on the society at least in a direct sense. They are however disapproved by the society because of the perceived costs that they could bring to the society. Some governments have allowed the sector to flourish because it generates employment opportunities and foreign exchange earnings to the country. Gambling, petty trading and prostitution for example are potential attractions to tourists.

One solution that has been floated around to match the needs of both parties (government and society) is to legalise the activities. However, changing the status quo will be difficult. Some of the prominent politicians may want the status quo to remain so that they can continue earning commissions from the operators, and ‘buy’ votes during elections. In the case of prostitution, legalizing the trade has met with strong protests from the prostitutes themselves because they wanted to remain ‘anonymous’. Labeling them legally as prostitutes may increase their difficulty in getting back to the society should they decide to leave the ‘profession’ one day.

 

Illegal sector: Criminal activities

            If the UGE is defined broadly as activities which failed to comply with the formal rules, criminal acts can be considered ‘underground’. Criminal acts like kidnapping, murdering, protesting, stealing and workplace sabotaging are committed by the working class. White collar crimes like tax evasion, bribing, manipulating of financial statements are committed by relatively more well off individuals.

            The Father of Economics Adam Smith has considered containing the growth of crimes as an area where government intervention is required, namely, to strengthen the country’s national defence and domestic security (the third task for the government, according to Smith, is provision of public goods). The involvement of the government should not be viewed as surprising because of the external costs which criminal acts create. Expenditures on alarm and security systems and fear of going out when someone has been murdered around the neighbourhood are examples of the external costs. Welfare economic theory has suggested that leaving the task to the private sector would lead to under allocation of resources in tackling this problem, below what is desired by the society. In addition to the total allocation of resources, problem is likely to emerge in terms of the distribution of resources should the private sector decides to take the lead. More resources for instance may be allocated to wealthier neighbourhood than that of the poor because of the former economic status (White and Witt, 2003, p. 209).

            There have been a number of explanations on why a crime is committed (see White and Witt, 2003, for an excellent discussion). It may be useful to group them under two broad banners. Let us labelled the first as internally driven factors. They are based on the notion that the decision to commit crime is not driven by individual choice.

Before proceeding, it might be useful to note that an understanding on the micro basis of committing crimes could indeed be essential. There is a problem of over generalising the causes of crime. The reason being that in every society, there are law abiding and non-abiding residents. For instance, there are the poor who abide to the law and the more well off individuals who commit crimes. Thus, linking crime to economic causes may not provide a complete picture of what motivates one to act criminally.

The advocates of the internally motivated factors (i.e. positivists) tend to view deviance to behavioural problems in terms of individual pathology including those factors relating to biology and psychology. For example, from the biological perspective, intelligence is believed to correlate positively with deviance acts. Physiology or body structure of the individuals also matters. More energetic, courageous and assertive individuals are found to be most likely to become criminals (ibid, p. 44). Genetic factors provide another explanation. According to the XXY Chromosome theory, person with the genetic make-up of XYY combination is more ‘predisposed’ to criminal acts because of their ‘abnormal height and mental structures’ (ibid, p. 44).

From the psychological perspective, individuals experienced with problematic childhood experience are more likely to commit crimes than those who have a more proper upbringing (all other factors remaining exchanged). In addition, personality traits like aggression and passivity are believed to have relations with deviance behaviour.

Let me now discuss the second group of causes, which argues that the decision to commit crime is driven by personal choice. In other words, decision to act criminally can be externally influenced. On the economic front, poverty and unfair distribution of opportunities could flame one’s passion to commit crime so as to enhance their economic status and match their aspirations. The Marxian approach views the lack of opportunities to, and exploitation of the masses as the main causes of crimes. Marginalization and alienation from the mainstream serve as ingredients to deviance behaviour among the poor.

The Marxian approach essentially reminds us not to forget about the crimes committed by the rich and powerful which include violation of labour laws, pollution and misuse of public funds. Such acts by the rich and powerful could be viewed as unfair by the masses thus leading the latter to rebel against the incumbent powerful through illegal channels. In this respect, careful examination of issues affecting the well being of the masses (like trade talks) is essential to ensure that the lives of the working class do not get worse with changes that could come along (the quality of government thus matters). This will eventually benefit the whole society because of lesser crime committed by both the working class and capitalists.

The extent of fairness viewed by persons in the society generally depends on the social norms. In a communitarian society, care for others is given a high priority thus reducing the harmful effects of strains. On the other hand, an individualistic society places himself/herself above the rests. Those who are disadvantaged might resort to criminal acts to get even, and shape and raise their status even at the expense of the others’ interest.

An important point to note is that the social behaviour could be altered over time. This is in support of the observation made in Liang (2004). Known as the butterfly effect, it was argued that a slight change in the initial condition(s) could lead to substantial and unpredictable alterations in the behaviour. The human thinking system is thus a ‘complex adaptive system’ which learns and evolves to ever changing circumstances and information uploading. Cognitive science has indeed emphasised that human beings are information-processors who interacted closely with the environment.

Moreover, observing what others do could have an effect in shaping how individuals interact with others. The reason is that, with imperfect information, individuals are more likely to adopt the ‘follow-the-norm’ mentality.  Ferrell, Fraedrich and Ferrell (2002) have noted that as many as 80 percent of the workforce adopted the follow-the-norm mentality rather than following their own instincts or go against the norms. 

Also of importance is how others view a criminal after he/she is being labeled as one. An unforgiving society that stigmatizes the ex-criminal may compel him/her to commit more crimes so as to fit the label. This calls for a serious examination on the need to arrest offenders for less serious offences as opposed to say mere imposition of fines.

 

Conclusion

            This essay briefly discusses the possible reasons why one may decide to participate in the UGE. It initially identifies the UGE as a combination of the unrecorded sector and illegal sector where the latter is sub-categorized as criminal sector and non-criminal (or informal) sector. For each, the reasons in participating are examined. This framework appears attractive and relevant in this context because it allows us to zoom in our efforts in containing the growth of the respective sectors, eventually leading to a more respectable and reasonable size of the UGE. A further discussion of the UGE should involve touching on the consequences of greater intensity in the unrecorded and illegal sectors.

 

References

1.                  Allingham, M.G. and Sandmo, A., 1972, Income Tax Evasion: A Theoretical Analysis, Journal of Public Economics, Vol. 1, pp. 323-38.

2.                  Chaliha, Kumar, 2003, Lessons from the Asian Underground Economy, The Diaspora Magazine, September/October 2003, Edition Number 4.

3.                  De Soto, Hernando, 2001, The Mystery of Capital: Why Capitalism Triumphs in the West and Fails Everywhere Else, A Black Swan Book, Great Britain.

4.                  Feige, Edgar, 2000, Defining and Estimating Underground and Informal Economies: The New Institutional Economics Approach, World Development, 18, No. 7, pp. 989-1002.

5.                  Ferrell, O.C., John Fraedrich and Linda Ferrell, 2002, Business Ethics: Ethical Decision Making and Cases, 5th Edition, Houghton Mifflin Company, United States.

6.                  Fleming, Matthew; John Roman and Graham Farrell, 2000, The Shadow Economy, Journal of International Affairs, Spring 2000, 53, No. 2, pp. 387-409.

7.                  Liang Thow-Yick, 2004, Organizing Around Intelligence, World Scientific Publishing Company, Pte. Ltd., Singapore.

8.                  MacIntyre, Andrew, 2001, Investment, Property Rights, and Corruption in Indonesia, in: Edgardo Campos (editor), Corruption: The Boom and Bust of East Asia, Ateneo de Manila University Press, Manila.

9.                  Sam, Choon Yin, 2003, Understanding the informal sector, mimeo (available on http://choonyin.tripod.com/informal)

10.              Sam, Choon Yin, 2004, What constitutes operational activities in the underground economy?, mimeo (available on http://choonyin.tripod.com/definingtheuge)

11.              White, Rob and Fiona Haines, 2003, Crime and Criminology: An Introduction, Second edition, Oxford University Press, Australia.

12.              Wong, Yue Chim Richard, 1997, Reform and China’s Underground Economy, in: Lippert, Owen and Michael Walker (editors), The Underground Economy: Global Evidence of its Size and Impact, The Fraser Institute, Canada.