Institutions, Underground Economy, and Economic Growth (August 2004)

Institutions, Underground Economy, and Economic Growth

Sam Choon Yin

August 2004


A lot 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.

Andrew 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.

With 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.

Hernando 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?

                Even 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.

How 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.

A 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.

Allowing 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 underground sector. 

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.

But 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.

The 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).

While 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?

It 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.

In 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.

The 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.

Andrew 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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