Organisations and the Underground Economy: Issues and Challenges

Organisations and the Underground Economy: Issues and Challenges

Sam Choon Yin (11/04)

 Introduction

Usually, a more successful firm is able to produce goods and services desired by the consumers (to indicate its effectiveness) and at the lowest cost (to indicate its efficiency). The existence of firms may enhance society’s welfare because the society could access more variety of goods and services possibly at lower cost than the case where they have to ‘manufacture’ the products themselves. Credit should thus be given to entrepreneurs for taking the risk and venture into business.

Over the years, organisations have become larger and more powerful. In the United States, the percentage of workers receiving salaries had increased from 20 percent in the early 19th century to 50 percent in early 20th century and 90 percent today. As a consequence, we are seeing an increase in the average size of an organisation measured in terms of number of employees. For example, the average size of the 500 largest service corporations in US has increased from 1700 employees in 1982 to 2750 in 1993 (Perrow, 2002). One of the worries, as a result of this development, is the concentration of power in the hands of private corporations to shape the community, including their ability to set wages, ignore industrial accidents, withstand strikes, control the school system and hurt the environment without compensation.

American industries had begun to expand after the civil war as organisations attempted to combine with other businesses. For example, the Standard Oil Trust (invented in 1882 by John D. Rockefeller) issued trust certificates and acquired other oil companies throughout the country. Fear of concentration of monopolies, Congress passed the Sherman Anti Trust Act in 1890. At the beginning of the 20th century, retiring businessmen in some of the major corporations passed their controlling power to professional managers thus broadening the ownership of these corporations. This essentially led to the promotion of manager-oriented governance system whereby professional managers were given supreme power to guide business corporations. The managers were trusted to be the best persons in performing ways that would maximise social welfare.

However, the conventional wisdom now is that the managers serve mostly themselves rather than the interest of shareholders whom they supposedly represent. This concern was first recognised by Adolf Berle and Gardiner Means in 1932 (Berle and Means, 1932). Shareholders, preferring to be free riders, might fail to exert the necessary pressure for higher standards of governance thus requiring the government to step in and rectify the situation. Some of the relevant regulations imposed by the government to serve this cause included the Banking Act 1944, Securities Act 1933 and 1934, Investment Company Act 1940 and more recently, the Sarbanes-Oxley Act of 2002. Since the 1960s, there have been calls for greater control of the board with the appointment of board members from ‘outside’ (defined as individuals who are not employees of the organisation). Because of the possibility of appointing trusted relatives and close friends to the board, there has been a demand for the appointment of independent directors in the last decade or so.

There has been an extensive discussion on the agency problem and related corporate governance issues (the latter focusing on the structure of the board and its functions). What we want to do in this paper is to understand how firms could have contributed to the underground economy (UGE), crudely defined as that part of the country’s economy which the government fails to detect. While there are positive consequences of the UGE, the countries in general and legitimate businesses in particular are usually better off if the UGE is less intensive provided that institutional arrangements are properly set-up (more about this later).

About the UGE

            Edgar Fiege (1990) has referred the underground activities as those that fail to comply with formal rules. They include sales and production of prohibited goods. Operators in the UGE usually do not report or underreport their activities to the government for the purpose of evading tax and avoiding detection from the authority. Because the operators deliberately hide information, it is not easy to have a clear picture of the actual activities carried out in the UGE, the number of workers engaged there and the activities’ contribution to the economy (for market-based and legitimate activities).

            Nevertheless, some academics have tried estimating the size of the UGE. A comprehensive study was recently completed by Friedrich Schneider and Robert Klinglmair (2004). They found that on average, the UGE in developing countries accounted for 41 percent of official GDP in 1999-2000, 38 percent in transition countries and 18 percent in OECD countries.

Framework

            A legitimate business should be concern with the society’s well being for its long-term survivorship depends on the society’s prosperity and its standards of living. It is generally agreed that to be successful, company agents must work closely with the suppliers, creditors, employees and relevant government agencies to meet or exceed customer satisfaction. But in reality, the agents may be self-centred and care only about maximising their personal interest rather than the interest of the stakeholders.

A firm for example may expropriate company funds and choose not to comply with the formal rules established by the government. Underground works could take place in the transformation process at the ‘input’ and ‘output’ stages.

            The means of production may be acquired legitimately or illegitimately. The latter involves the use of smuggled inputs, illegal workers and laundered money to support the firm’s production. Illegitimate acquisition of the means of production certainly contributes to the growth of the UGE regardless of whether the finished goods are prohibited or otherwise. The situation however is more uncertain in the case of legitimate acquisition of production means. Whether the firms contribute to the UGE or not depends on the legitimacy of the ends, which the means are used to support in the production.

            Finished goods and services could be non-prohibited or prohibited by law. The former includes products that are fit for use and accepted by a majority in the society. The prohibited outputs may include the production and sales of pirated materials, drugs, gambling activities and prostitution services.

Consider the supply of legitimate output. While the law does not prohibit the supply of the finished products, the means of production may be prohibited. If this is so, then the firm is essentially hiding some relevant information from the government despite itself being a legitimate business. For instance, the firm may resort to creative accounting to hide true sources of funds and real information on employees. In the process, it may also choose to misreport the total value of final goods and services supplied so as to minimise the chance of being detected.

As a result, the quality of economic statistics like national income, unemployment rate and demand for money may be adversely affected. This could affect the effectiveness of policies implemented by the government since the government usually implements policies based on the official statistics. Besides the impact on the economy, the firm itself may be required to constantly hide information from relevant public agencies thus compelling it to operate in constant fear, and resort to payment of bribes.

If legitimate means of production are used, the firm essentially operates in the aboveground economy if the finished products are also legitimate. However, the firm may still fail to comply fully with formal rules. It is important to recognise that decisions not to comply with formal rules does not necessarily imply that the firm is operating in the UGE. For example, a firm may evade taxes despite operating legitimately in the aboveground economy. But the firm misreports its total contribution to the government. As such, it is said to be operating in the unreported sector. There could be several reasons why tax evasion occurs. Tax evasion is generally more common in situations where tax rates are high, cost of compliance to tax rules are excessive and the inability of taxpayers to relate to the benefits of paying taxes with the burden that they have to incur. The economy suffers if tax evasion becomes too severe due to lower tax revenue collection by the government, and deterioration in the quality of economic statistics in the case where tax data is used to generate the statistical data.

Now consider the case where illegitimate outputs are supplied. They include sales and production of drugs, prostitution services and pirated goods. Terrorist attacks could also fall under this category. Obviously, the operators have to hide from domestic and international watchdogs. This is true regardless of whether the means of production are acquired legally or otherwise (for example, terrorist financing could be derived from legitimate sources like donations from charitable organisations and wealthy individuals).

It should be recognised that the government has no intention to record such operations in national income statistics even if they could be detected. This makes sense since they are illegal and ‘unproductive’ by nature. But to the nation, a growing illegal sector may undermine its growth potential. Investors for instance may be reluctant to invest in the nation if fear of terrorist attacks and government incompetence to handle related-problems persists. There may also be the problem of misallocation of the nation’s scarce resources. The society could benefit more if resources are directed away from the illegal sector to productive and market based sectors.

Firms producing illegitimate outputs may also face problems in their day-to-day operations thus undermining its chance to survive in the long-term. Eric Schansberg, citing the work of Hernando de Soto (1989), succinctly lists the ‘costs of informality’ that comprises the following: (1) an inefficiently low level of production because operations are on a smaller scale, (2) an inefficiently low capital-labour ratio, since capital (machinery and plant) is easier to detect and more difficult to transport and the chosen quantity of goods and services is not efficiently produced, (3) an inefficiently low level of inventories, (4) a greater burden from ‘inflation tax’ because people hold more money than is optimal, (5) limited growth in reputation and recognition (advertising through a variety of media is impossible), (6) additional costs for bribes and other expenditures to protect and extend property rights, (7) contracts are more difficult to enforce outside the law and the judicial system, and (8) higher interest rates if one is able to borrow at all, because using property as collateral is difficult or impossible (Schansberg, 1996, p. 222). Firms also tend to be more violent and uncooperative in the illegal sector. They may resort to the use of guns and other dangerous weapons to settle disputes and/or restrict competition rather than through legislative means.

Reforms

            In the preceding section, we have seen that the nation may benefit if organisations operate in the aboveground economy. In the case of unreported sector –where firms use legitimate means to supply legitimate output but fail to report fully their contributions to the public authority - the firms too would benefit if they comply with the formal rules. What can be done to entice these organisations back into the mainstream? Recall that the decision to underreport and/or non-reporting fully to the government is attributed to firms’ dissatisfaction with the status quo which could include the need to comply with excessive regulations (thus raising the administrative costs), pay high tax rates, and their inability to relate to the benefits of paying taxes with the burden that they have to incur. Each of these issues must be handled.

            Cutting red tape, simplifying the procedures (and forms) and leverage on technology may be useful to lower the cost of compliance. While high tax rates are attractive to governments, it has been the generally accepted that lowering tax rates is the way to go for nations to remain competitive (Laffer curve tells us that the move may raise government’s tax revenue). There has been a growing interest on the value added tax to provide funds to the government. So, lowering tax rates is not an impossible task although it must be done tactfully. In addition, public sector managers should constantly inform the public about how public funds are spent, without giving the impression that the public sector is inefficient and wasteful. As Mark Moore, a professor at the Department of Criminal Justice Policy and Public Management at Harvard University and founder of John F Kennedy School of Government, notes, ‘Managers in the public sector have to justify their actions at all times. They must understand that citizens have a right to say how they want their money spent for public purposes. Talk to them (the citizens) to find out what is it that they value, and then work with your organisation to determine whether you are achieving that value’ (Today, 25 October 2004).

            Curbing corruption is another important task to accomplish. Corrupt public officers may allow some firms to under declare their output in exchange for commissions and votes during elections. The challenge is to better align the interest of public officers with that of the citizens. If corruption problems are properly resolved, firms may be able to relate to the benefits of complying with formal rules.

            Combating corruption is particularly pertinent to prevent the illegal sector from growing too excessively. The sector is involved in the sales and production of prohibited goods by law regardless of whether the means of production are acquired legitimately or otherwise.

            There have been several suggestions on how a nation could curb corruption. They include, (1) paying competitive salaries to public officers; (2) increasing the penalty rate and probability of catching corrupt public officers (these could be done by strengthening anti-corruption legislations and agency). It may be useful to recognise the practical difficulty in detecting some illegal activities like sales of drugs, pirated goods, prostitution services and gambling. The reason being that both the consumers and producers benefit from the transactions thus lowering the incentive for them to provide evidence against one another. The problem is of course worsened if corruption is rampant in the nation. A non-corrupt government may have to rely almost exclusively on tip-offs from third parties to enhance their chances of catching the offenders; (3) having strong support from political leaders to inculcate the incorruptible virtue, and (4) striving to provide excellent public service since it is usually difficult for a corrupt culture and service excellent to co-exist. Learning from low corrupt nations like Finland, New Zealand, Norway, Singapore and Hong Kong may be useful.

            As economies become more integrated, sources of illegal activities could be initiated from elsewhere. Terrorist cells for example source finances from donors located in various parts of the world including businesses that are supposedly legitimate. The expansion of drugs and prostitution industries is possible essentially because such products are strongly demanded from countries around the world, particularly the richer ones. It does not help that human trafficking and smuggling of drugs could be carried out relatively easy in some countries due to corruption and lax customs procedures at the checkpoints. It is precisely because of more intensive integration that corruption must be curbed and securities at checkpoints strengthened.

As crimes and other illegal acts become internationalised, it requires governments from all countries to work closely together, share information and combat international crimes involving organisations. Current efforts undertaken by international institutions like the Financial Action Task Force to control money laundering must be credited. So are regional and multilateral groupings like ASEAN + 3 and the United Nations. The challenge is for the governments to voluntarily cooperate, follow-up with the recommendations and translate all talks into actions.

The discussion so far concentrated on externally imposed measures first, to encourage firms to re-enter the mainstream (from the unreported sector) and second, to prevent organisations from engaging in illegal activities. Could internal governance in the organisations play a role?

The decision to misreport firm’s output to the public authority may be a result of the managers’ desire to enhance their personal interest. Manipulation of financial statements is attractive because the managers’ compensation is positively linked to firm financial performance. There is nothing wrong with the notion of maximising firm’s profit and manager’s compensation but the means to do so must be ethical and legal. We know that manipulation of financial statements is immoral for stakeholders like shareowners, employees, suppliers and customers would ultimately have to pay the price if the organisations are caught. This happened for example in the case of Enron.

Because of recent corporate scandals, the US Congress has enacted the Sarbanes-Oxley Act in 2002 which include certain mandatory regulations on corporations. For example, the Act calls for national securities exchange such as the New York Stock Exchange and NASDAQ to adopt listing standards mandating listed companies to have audit committees comprising solely of independent directors. However, some of the measures were viewed as unnecessary, wrong and risk being obsolete quickly. Among other things, the Act was accused of trying to fit the regulations to all organisations without recognising the diversity of firms. As Stephen Bainbridge notes, ‘The NYSE’s new standards strap all listed companies into a single model of corporate governance. By establishing a highly restrictive definition of director independence and mandating that such directors dominate both the board and its required committees, the NYSE fails to take into account the diversity and variance among firms’ (Bainbridge, 2003, p. 29).

The specifics on corporate governance must come from within the corporations. The board members must take the initiative to enact internal mechanisms, question managers’ decisions, hold them accountable of actions if need to and take responsibility of the decisions. Obviously, misreporting of financial statements to the government and evading tax payments are wrong, subjecting the corporations liable to corporate offences. If caught, their reputation will be ruined. It is important in this respect for board members to ensure proper reporting with assistance probably from the audit committees.

There are many checks that the corporations could rely on to align the interest of the agents with that of the principals. Greater transparency is one way. Others include (1) establishing a reliable compensation system, (2) auditing by outside auditors, (3) stronger market for corporate control (threat of takeover), (4) reducing likelihood of shirking (depending on the corporate culture and attitude of personnel), and (5) raising the standards of capital and product markets within which the firm functions (Bainbridge, 2003, p. 29).

Governance in firms operating in the illegal sector is different. Power concentration in the hands of a few is more likely. Their relationship with the agents is usually informal where the virtue of trusts tends to be more important than formal contracts. If this is true and the informal element is strong, it would be difficult to rely on the firm’s internal governance structure to improve the situation. The organisations are likely to remain in the status quo and contribute to the UGE unless the leaders have a change in mindset to turn over a new leaf. Otherwise, the nation may have to rely more exclusively on external monitoring mechanisms in the form of government controls and regulations rather than internal mechanisms to contain the growth of the illegal sector.

Conclusion

            This paper examines the channels in which an organisation could have contributed to the UGE. A firm that goes by the book, acquiring legitimate means of production and producing goods and services that are not prohibited by law, essentially operates in the aboveground economy. But there may be cases where some firms do not report their production fully to the public authority possibly with the intention to evade taxes. In this respect, the firms are said to be working in the unreported sector. They do not participate directly in the UGE although they impose very similar problems as those that are produced by firms operating in the UGE. On the other hand, if the means of production are acquired illegitimately and/or the law prohibits the output supplied, the firms operate in the illegal sector and they contribute to the UGE.

            There have been suggestions that the UGE could benefit the society because it provides employment opportunities to the population and promotes entrepreneurship (in the UGE, businessmen usually do not have to comply with regulations imposed by the government). While some of these claims may be true in some countries, the root cause really lies in the government’s failure to facilitate economic development through the imposition of more pro-business policies and procedures. The quality of public governance thus matters as our recommended reform measures might have suggested. Moreover, the nature of business contributing to the UGE must be taken into consideration. While petty traders selling food, cloths and other ‘friendly’ stuffs on the streets do not impose much of a problem to the society, many would agree that the world would be a better place to live in if organisations in support of (1) sales and production of illegal drugs, (2) terrorist activities, and (3) money laundering, human trafficking and drugs smuggling, are detected and eradicated.

References

Bainbridge, Stephen, 2003, The Creeping Federalization of Corporate Law, Research Paper No. 03-7, UCLA, School of Law Research Paper Series, University of California, Los Angeles.

Berle, Adolf and Gardiner Means, 1932, The Modern Corporation and Private Property, MacMillan, New York.

De Soto, Hernando, 1989, The Other Path: The Invisible Revolution in the Third World, Harper and Row, New York.

Feige, Edgar, 1990, ‘Defining and Estimating Underground and Informal Economies: The New Institutional Economics Approach’, World Development, 18(7), pp. 989-1002.

Perrow, Charles, 2002, Organizing America, Princeton University Press, United States.

Schansberg, Eric, 1996, Poor Policy: How Government Harms the Poor, Westview Inc, United States.

Schneider, Friedrich and Robert Klinglmair, 2004, Shadow Economies Around the World: What do we Know?, Working Paper No. 0403, April 2004, Department of Economics, Johannes Kepler University of Linz.