Consequences of the underground economy

Consequences of the underground economy

Sam Choon Yin (09/2004)

 The underground economy (UGE hereafter) encompasses the unrecorded sector (legal activities which are not detected by the public authority) and illegal sector (both criminal and non-criminal based). An act is deemed to be part of the UGE if it violates formal rules imposed by the government. Accordingly, the underground activities are disapproved by the society.

What are the problems which the UGE may create? Under what circumstances would the majority deem the UGE ‘acceptable’? I will address these two issues in this essay. Let me first consider the negative consequences of the UGE.

            Because the underground activities are deliberately hidden from the public authority, the recorded economic statistics tends to misrepresent the true economic status of the country’s economy. This is the case for activities in the unrecorded sector. The government is supposed to measure and record the legal and market-based activities but has failed to do so. Non-productive or non-market based activities like do it yourself gardening, plumbing and other household chores are not a concern here since they are usually excluded in economic statistics like national income by convention.

            Besides national income, data on unemployment, balance of payment (BOP) and demand for money are distorted by underground activities (Tanzi, 1983). For example, it is likely that the official unemployment rate is over-estimated. The reason being that some of the unemployed may be gainfully employed in the UGE but their employment status is not properly recorded in the official statistics. A robust UGE may also create mismatches in the demand for and supply of money.  Assuming that cash is extensively used as the main medium of exchange in the UGE, the rate of monetary growth determined on the basis of reported national income will not be sufficient to meet the demand for currency. The BOP statistics are also affected in the presence of the UGE. For example, improper declaration of trade transactions and improper measurement of capital and commodity flows could create distortions in BOP statements.

A consequence of the above is the inappropriateness of the economic statistics to guide politicians in making decisions. Policies implemented on the basis of these data may address the wrong issues. For example, the country may be in full-employment but the official statistics fails to reflect this. The official statistics, being distorted by the UGE, might have indicated a ‘depressing state’ instead. As a result, resources spent to expand the country’s economy could be misused.

This might have explained why certain governments failed to implement the right policies to address their economic problems, therefore resulting in their loss of credibility. Such lapses however may be acceptable if jobs are plentiful and incomes are rising. But this may not be the case when economies suffer from economic downturn. Low standards of governance and intensive underground activities would then be blamed, and result in changes in political regimes as in the case of Indonesia (removal of Suharto and Abdurrahman Wahid) and the Philippines (removal of Joseph Estrada) because of corruption allegations. Ian Patrick Austin made this point in his study on Goh Keng Swee’s style of governance. He wrote, ‘…it was the loss of confidence in the governance systems of South Korea, Thailand and Indonesia, both domestically and internationally, that saw their economies dragged down beyond anything previously contemplated. It was above all the coordinating ability between government and the bureaucracy, built up by Goh (Keng Swee) and his protégés over the thirty years, that enhanced Singapore’s reputation amongst international investors during the period of the 1997/98 crisis and after’ (Austin, 2004, p. 25). In this respect, containing the size of the UGE is desirable.

Taxes are usually not paid at all or in full in the unrecorded sector. What could be the consequences? Among other things, loss of tax revenue imposes unnecessary limitations to the government in financing its expenditure programs. To offset the loss, the government may raise tax rates. Those who are currently complying with the tax rules and paying taxes may perceive that they have been treated unfairly and decide to evade taxes in the next and subsequent fiscal years. Should this be the case, the society would eventually have to pay the price of extensive UGE in terms of lesser quantity and poorer quality of public services.

However, the evaded taxes need not necessarily be derived from the UGE. Decisions to evade taxes and participate in the UGE are related but they are not identical. It is possible for one to evade taxes even if he/she operates in the aboveground economy. The reason to evade taxes therefore could differ from the desirability to operate in the UGE. One may perceive the tax rates to be too excessive or that he/she could not relate to the benefits of paying taxes as compared to the burden borne, as reasons to evade taxes, although he/she may still choose to operate in the aboveground economy.

However, one who operates in the UGE usually does not pay taxes on the income earned from the underground activities. This is likely because similar accounting figures are submitted to the government and tax authority. The numbers were, after all, derived from financial statements, and submitted to the relevant institutions. Submitting the same figures to the government and tax authority avoids alarming the public authority, and minimizes the probability of being caught. The problem arises if the tax data is used by the government to compute the country’s national income. In this respect, tax evasion creates problems that are similar to those illuminated earlier (i.e., distorting the official economic statistics).

It may be appropriate at this juncture to talk about the distributional effects of the UGE. Most countries, as we know, apply the progressive tax regime. Tax evasion can be treated essentially as a white-collar crime (other white collar crimes include money laundering and expropriation of public and private funds). Because of tax evasion, the working class may perceive that they have been treated unfairly (since the rich gains at the expense of the poor). This may create discontentment among the working class toward the government in particular and the world in general. Some may turn violent and promote their ideology through illegal and criminal acts.

Furthermore, in the case where tax evasion is common, the burden on the middle and working class is generally heavier, possibly because the government has to resort to non-tax and more regressive means to collect its revenue. This in turn forces the middle and working classes to work in the UGE, earn some extra cash and avoid contributing further to the government’s pocket.

Consider now the issue on allocative efficiency. Asher and Wong (1980) have argued that the society’s resources may be inefficiently allocated in the UGE if the gross returns from underground activities are lower than that derived from the regular sector. The authors cited the example of potential misallocation of skilled labor force such as accountants and lawyers. These skilled labors have the necessary skills to hide underground activities from the government. Their services are strongly demanded by producers and sellers of underground goods and services like drug lords and mafia chiefs. Some of the accountants and lawyers may enter the trade either willingly or by force. Regardless of which, their operations in the UGE are likely to impose negative consequences on the society because of (1) lower tax revenue collection for the government and (2) their lower productive performance in the UGE. Also, it is possible that their participation in the UGE will adversely affect the morale of salaried and aboveground professional ‘who are indispensable for the running of modern economies’ (ibid, p. 9).

            Profits earned in the UGE must be diverted somewhere. Because of their illegal nature, the profits are often laundered to avoid detection from the financial institutions and public authority. For example, the dirty money could be deposited in a bank and then wire on small amounts to other bank accounts around the world. Detecting them is not easy, and requires strong cooperation from the international financial institutions. Some financial institutions may be hesitant to cooperate and monitor their customers, possibly fearing that being too nosy in enquiring secretive information may lead to ‘loss’ of their high net worth customers.

            While the issues on money laundering have been in discussion for quite sometime, they have become more intensively discussed in recent years attributed mainly to more serious and greater number of terrorist attacks (particularly in the aftermath of the 911 incident). Accordingly, there is an urgent call to cease money laundering and flow of funds to the terrorist groups. In a recent article, Schneider (2002) has found that at least 50 percent of the finances of Al Qaeda terrorist cells were obtained through illegal and underground channels. The author estimated that of the US20-50 million dollars flowed to the group each year, 30-35 percent were obtained from drug businesses, 10-15 percent were obtained from classical crime activities (like blackmailing and kidnapping), and 10-15 percent from illegal diamond trading, while the remaining were obtained from donations and other sources (both legal and illegal). It is essential therefore to curb the UGE and consequently the flow of funds to terrorist groups. Some of the international institutions working on this cause include the Financial Action Task Force (FATF), the Egmont Group of Financial Intelligence Units, the G-20 and international financial institutions.

            Having explained the negative consequences of the UGE, I will proceed to exposit briefly some of the positive consequences. Under certain circumstances, underground activities could be accepted. During economic recessions for example, the UGE provides employment opportunities to those who are affected (like the rural migrants and urban poor) so that they could earn income to feed their loved ones. Otherwise, problems like theft and kidnapping may become more pronounced. However, it matters very much what kind of underground activities are being operated. While petty trading like selling of food, clothing and toys on the streets are acceptable, the society would be better off if trafficking of human beings, kidnapping and smuggling of drugs and arms are avoided and eradicated.

            In some countries, it is generally easy to visit prostitutes, gamble and purchase pornographic materials despite being illegal, as long as the activities do not impose harm on others and disturb peace in the areas concerned. The argument for allowing certain underground activities to flourish is libertarian based. It is believed that providing one with the freedom to choose could lead to more efficient choices made. Government intervention, so the libertarians argued, should be kept to the minimum so long as the externalities or market failures do not get too significant.

Moreover, participating in the UGE is deemed beneficial if government regulations become too excessive. Excessive regulations essentially raise the cost of getting things done. In the ‘Mystery of Capital’, Hernando 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. The need to comply with so many laws and regulations encourages entrepreneurs to pay bribes to speed up the process. Some choose to avoid the hassle altogether by operating in the underground sector.

The above problem is a result of poor governance. A change in the regime may possibly be desirable for the overall betterment of the country. The UGE in this context may be deemed welfare enhancing because it signals the need and urgency for the country to introduce the necessary reforms. Having excellent democratic and economic institutions is essential then so that political and economic reforms could be carried out smoothly and successfully. This should be the right step to take so that more people are brought back to the mainstream for better regulation and for the government to collect more taxes. Otherwise, excessive underground activities will bring about problems which we have identified earlier.

However, one should not expect to see changes in the short run. Changes in the political regimes take time and may create disruptions and impose social cost along the way as was observed recently in Indonesia (social unrest), Taiwan (more trouble with the mainland), South Korea (an impeachment effort), Sri Lanka (the strengthening of the anti-negotiation party) and India (voting out a seemingly competent government).

To sum up, this essay has argued that underground activities may be acceptable at least in the short run under three circumstances; (1) to provide employment opportunities when times are bad, (2) to provide individuals with freedom to choose (this is inconclusive; the debate on capitalism and socialism is still ongoing), and (3) to avoid complying with rules and regulations imposed by an ineffective government. Otherwise, it is more beneficial for the UGE to remain inactive.



Asher, Mukul and Wong, Chin Yeow, 1980, The Economics of Tax Evasion and Avoidance, Concise Tax Program, Inland Revenue Department, Singapore.

Austin, Ian Patrick, 2004, Goh Keng Swee and Southeast Asian Governance, Marshall Cavendish International (Singapore) Pte. Ltd., Singapore. 

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

Schneider, Friedrich, 2002, The Hidden Financial Flows of Islamic Terrorist Organisations: Some Preliminary Results from an Economic Perspective, paper presented to the DIW Workshop on ‘The Economic Consequences of Global Terrorism’, in Berlin 14-15 June 2002.

Tanzi, Vito, 1983, The Underground Economy: The Causes and Consequences of this Worldwide Phenomenon, Finance and Development, December issue, pp. 10-13. International Monetary Fund, United States.