Institutions, Underground Economy, and Economic Growth
Sam Choon Yin
of focus has been placed on the role of institutions in explaining the source of economic growth with particular attention
paid to the establishment of rule of laws and enforcement of property rights (Common, 1931; North, 1991). A number of studies
have shown that a good institutional environment is what a country needs to generate long run sustainable economic growth.
While this is generally true, some politicians and businessmen have shorter time horizons, which may compel them to resort
to unethical means in reaping economic rents. As a result, weak institutional settings prevail in some countries. And it would
be difficult to abandon or alter the status quo if the institutional economists fail to explain why strong economic growth
can be enjoyed in economies with seemingly weak institutional framework.
MacIntyre (2001a) illustrated this point succinctly for the Indonesian case in which he argued that strong investment and
economic growth appeared to be possible despite the fact that the country had a weak guarantee of property rights and a widespread
corruption. Three reasons were given. First, prior to the Asian crisis, strong macroeconomic fundamentals in Indonesia have
increased investments in the country for they enhanced the perceived rates of returns of the investments. Second, former President
Suharto was able to allow corruption to flourish while containing the cost imposed on the investors. The latter was necessary
so that corruption did not drive them away. And third, Indonesia was able to provide the investors the ability to withdraw
their capital relatively easy (due to the opening up of the country’s capital account). This was essential because of
the country’s lack of independent legal system.
the benefit of hindsight, we know that the lack of a good institutional environment could not bring forth benefits to Indonesia
in the longer term, although it has been possible for selected members of the elites to gain from the shortcomings at the
expense of the masses. In other words, absence of a good institutional environment does not necessary hinder economic growth
of the economies at least in the short run, a point which appeared to be in contrast to institutional economists like Douglas
North who supported the link between good institutions and economic growth.
De Soto (2001) is another prominent economist who argued that the assignment of property rights to the poor should be the
way to go to promote economic growth. With the entitlement, the poor could use them as collaterals and acquire the necessary
funds and capital to support their production means. But how much should one give support to this proposal? What if the poor
were not able to utilise the acquired funds in an effective manner? Would that lead to the loss of the entitlement, which
perhaps represents the only form of wealth they have? Even if the assigned property could be used as collateral, would the
financial institutions or lenders be able to collect the property from the poor when the latter’s investments failed?
Would they resort to the use of physical means to stop this from happening?
if institutions are properly established, there is no guarantee that economic growth will follow. It depends to an extent whether the people trust that the government would properly enforced the rules
and regulations. It takes time to gain trust from the people. Raghuram Rajan has argued that it might be so difficult for
the indigenous population to gain trust from the local public officers that it might be better for foreigners to first step
in and establish a good institutional environment for a period of time before handling the power to the locals. The intention
is to generate growth for the country which in turn would create the demand for higher standards of institutions and public
governance. As Rajan argued, economic growth could lead to the establishment of a good institutional environment followed
by even stronger economic performance (Rajan, 2004).
This is an important point. If the indigenous population were not able to relate to the benefits of complying with the formal
rules, they are not likely to contribute much to the development of the country like contributing to the government’s
pocket through tax and non-tax payments. Instead, they would find ways to evade payments thus hindering the government from
financing its expenditure programs. There would also be an incentive for them to operate in the underground economy so as
to avoid interacting with the public officers which they deem to be ineffective and corrupt. Underground activities escape
the detection from the government authority and national income statistics thus imposing problems to the government to correctly
and accurately identify the economic status of the country.
the problems are looked at differs between one country and the others. In some countries like Indonesia and Thailand, the
governments appear to be more relaxed and tolerant towards certain activities which might be viewed as intolerable in other
countries. It is relatively easy for example for a visitor in Thailand and Indonesia to purchase pornographic materials and
visit prostitutes although these activities are considered illegal there. It seems therefore that the governments perceive
the benefits such activities could bring to the countries’ economy outweighing the expected costs that they might impose.
careful examination on the notion of illegal activities is indeed worthwhile. While an activity may be illegal, it could be
tolerated in the country, as long the country’s safety and order are not disrupted. This appears to be the case for
prostitution and sale of pornographic materials in Thailand and Indonesia. These activities are allowed to operate essentially
because they are non-criminal based albeit illegal. Law enforcement officers however are commonly seen in places where such
activities are operated to see that peace and order are maintained.
the illegal operators to participate openly generates positive consequences to the country like creating employment opportunities
and earnings of foreign exchange from tourists, which could ease the country’s economic problems to some extent. In
countries where jobs are less abundant, the informal sector provides the people with jobs and income to support themselves.
Some observers have also argued that with greater freedom to decide what to do, the country’s resources could be more
efficiently allocated. For example, resources could be transferred from sectors with lower returns to sectors that could utilise
them more productively. This is particularly so in countries where government regulations are excessive. Getting things done
would appear to be so problematic that many may decide to avoid interacting with public officers altogether. Not only would
they be able to get things done faster but also at a lower price (for example, paying bribes to public officers may no longer
be necessary by operating in the underground economy). The general population could also be relatively happier since they
are less subjected to interference from the government on possibly minute matters.
While the above has discussed the positive consequences of allowing ‘illegal’ and non-criminal based activities
to operate openly, there are also problems. One of which is the inability of the government to correctly monitor the true
economic status of the country. Because the activities escape the detection from the government, the official economic statistics
tend to under estimate the total output produced in the nation, while potentially overestimating the severity of the country’s
unemployment problem. As a result, the government may have problems introducing the right mix of policies to stabilise the
economy. The other problem relates to the inability of the government to collect more tax revenue to finance its expenditure
programs since operators in the underground economy usually pay no taxes. The level and quality of the public goods may accordingly
be affected. Tax rates may need to be raised as a result to compensate the government for the loss of government revenue due
to extensive operations in the underground economy, which might subsequently force more people to enter and operate in the
fact that illegal and non-criminal based activities are allowed to operate openly in some countries like Indonesia and Thailand
suggests that the positive consequences might have outweighed the negative consequences, at least as perceived by the political
leaders. However, it is important to note that when activities are both illegal and criminal-based, strong enforcements are
carried out to see that they do not flourish. Such activities include killing,
raping, arsonist, kidnapping and stealing.
not every country tolerates the growth of the illegal sector regardless of whether the activities are of criminal or non-criminal
kind. This appears to be the case in Singapore. The Singapore government strongly enforces the formal rules to curtail the
growth of the illegal sector. Law enforcement officers are generally more diligent in arresting and issuing fines on offenders
(this could have prompted some observers to label the city-state as a ‘fine’ city). Efforts were put in to promote
voluntary compliance to the formal rules through improvements in the operations procedures. For example, allowing taxpayers
to file their tax returns electronically reduced costs of compliance to tax rules in Singapore. Tax forms were also 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. With these changes, time and
resources spent in tax filing have been significantly reduced.
government does not hesitate to punish any offenders found guilty of committing illegal acts regardless of the positions that
they have held. There have been cases in Singapore where prominent politicians and businessmen were convicted of corruption.
For example, the then Minister of National Development, Teh Cheng Wan, was accused of accepting two bribes from two developers
to allow one of them to retain the land which had already been acquired by the government, and the other to purchase state
land for private development. They took place in 1981 and 1982. On the 12th day after the CPIB had launched an
investigation, Teh committed suicide on 26 January 1987 by a lethal dosage of barbiturate pills. He maintained that he was
innocent right till the end. In 1995, Choy Hon Tim, then Director of the Electricity Department and Deputy Chief Executive
(Operations) of the Public Utilities Board (PUB), was investigated for receiving kickbacks for awarding contracts to suppliers
and contractors of the PUB. Hailed as the biggest case in CPIB’s history, Choy was subsequently charged and convicted
for obtaining gratifications totalling S$13.85 million. He was sentenced to 14 years’ imprisonment and ordered to pay
back S$13.85 million (Quah, 2003, Chapter 5).
the political leaders viewed such involvements from the government as necessary to maintain peace and order in Singapore,
there were observers who had labelled the political system as ‘authoritarian capitalism’ (Lingle, 1996). It prompts
us therefore to question what is supposedly to be right level of interference from the government? Is there an optimal level?
Should the illegal non-criminal based activities be allowed to operate like in the case of Indonesia and Thailand? Should
they be strictly restricted and contained at all costs like the case of Singapore?
is not possible to address these big and important issues here but I want to highlight two broad suggestions on the proper
role of the government that have been floated.
the ‘Power and Prosperity’, the late Mancur Olsen (2000) warns that it might be difficult for the autocratic system
to survive on a sustainable basis. He was referring to the former Soviet Union. In the initial stage, the system might work
well because of the willingness of the autocrats to provide public goods. This might be the case because there is an incentive
for the autocrats to maintain their monopoly power. Taking care of the masses under their control could benefit them in the
longer term as more can be ‘stolen’ from the population later. But Olsen argued that public officers would eventually
be able to find ways in beating the system leading to the emergence of the upper class represented by the businessmen and
prominent politicians. Essentially, the public officers misused the power entrusted to them by expropriating the nation’s
funds. As the disadvantaged were unable to relate with the country’s prosperity, they would become more politically
active and consequently organise themselves to revolt against the incumbent.
implication is that the residents of the nation are not blind and ignorant of the circumstances. Public officers, as representatives
of the residents, must take into consideration the interest of the masses. The political leaders must establish proper monitoring
mechanism and incentive structure to see that their subordinates are doing their work diligently and ethically. Thus, besides
emphasising the production side of the economy, it is imperative that the distributional issues are given equal if not more
effort in correcting.
MacIntyre (2001b, 2003) provides another useful framework. He links the political institutions with investment and economic
growth. He argued that two extreme political institutions exist, one with extreme rigidity and the other with high volatility,
both of which could be detrimental to a country particularly when crises hit. The former was applicable to the political structure
of those found in Indonesia and Malaysia where their former Prime Ministers had a dominant control over their respective countries.
Such a system provides an environment which might be ‘incapable of taking believable policy actors in circumstances
where credibility and constancy are critical’ (MacIntyre, 2001b, p. 87). On the other end of the spectrum, we have the
political structure that have many veto players (like in Thailand because of its multiple weak parties being elected into
the Parliament) which may not be responding quick enough to situations where ‘timeliness’ in critical. In Thailand
for example, political decisions might be delayed because the Prime Minister was reluctant to make decisions which could oppose
one or more of the members of the coalition. According to MacIntyre, locating somewhere between the two extremes appear to
be most favourable in retaining investors’ confidence during the crisis as in the case of the Philippines. This was
based on the observation that the country was least affected by the Asian
crisis which hit the region in mid-1997.
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