The Underground Economy and the Tax Gap

Underground economic activity has existed for as long as taxes have existedwhich
is to say, all of recorded history. In ancient Greece 2500 years ago, Plato wrote,
When taxes fall due, it is the just who will pay more than the unjust. The Ducal
Palace in Renaissance Venice had a hole through which informers could
anonymously snitch on tax deadbeats. In modern times, the underground economy
is often associated with hard crime and drug rings, yet to become a member you
need only to participate in any activity that generates income that goes unreported
to either the Internal Revenue Service (IRS) or the Labor Department. The
unreported income from summer odd jobs, paying the plumber, or housekeeper
with checks made out to cashall constitute part of the underground economy.
Recent attention on the underground economy in the United States derives from
efforts to reduce the nations enormous fiscal deficits. Part of the focus has been on
reducing the tax gapunrealized tax revenues from underreporting income or
overstating deductionsas an alternative to raising taxes or cutting spending. The
IRS estimates that the tax gap ran as high as $127 billion in 1992, fully one third of
the $300 billion budget deficit for that year.
To measure the amount of lost revenue to the Treasurys coffers one must estimate
the size of the underground economy. These estimates are tricky business and
results vary widely, from 5% to 28% of GDP. One conservative estimate concludes
that the total value of US underground activity was $337 billion in 1990, 6.2% of
GDP. Of this, $268 billion is estimated to be unreported income from legal activities,
with the remainder derived from illegal activity. A recent Labor Department study
using IRS data puts the annual income from underground activity at more than $500
billion, or roughly 10% of GDP. These figures, which do not include $200 billion
worth of additional criminal activity, suggest that a tax-free covert economic
sector the size of Canada exists within the overall US economy.
The underground economy is not static. Rather, it expands and contracts as
individuals weigh the expected costs and benefits of evading taxes and
circumventing government regulations. The gain is the expected value of the taxes
not paid or the extra income earned. The cost is determined by both the size of the
penalty and the probability of being caught. The government might try to drive
more people above ground by raising the lines for underground activity, but this
plan can backfire if the likelihood of being caught is low. Indeed, one IRS study
revealed that people who know someone who is being audited are more likely to
cheat, figuring the odds are now in their favor. Similarly, governments that raise
taxes may find that revenues increase less than proportionately as more people
jump into the underground economy to escape the new taxes. Opportunities for tax
evasion vary by sectorunderground activity typically concentrates itself in the

service sector, where income is easier to hide. Self-employed professionals and

establishments like the neighborhood grocery store account for over $200 billion in
unreported income every year.
An important telltale sign of the underground economys size can be gleaned from
monetary data. Because US law allows government prosecutors access to bank
records in criminal investigations, underground activity is rarely conducted with
checks, which are traceable. The preferred means of payment to underground
transactions seems to be cash, which leaves no audit trace. If we are to examine
the ratio of currency to deposits, we have an index of the publics demand for
currency, which is positively related to the volume of underground activity.
Historically, we find two major increases in the C/D ratio associated with the two
world wars. In 1917, the United States raised taxes to finance its entry into World
War I. It did the same for World War II during the 1940s. The evidence suggests the
public dramatically increased cash payments for goods and services to avoid the
burden of the war taxes. Curiously, the Vietnam War of the late 1960s did not
produce a sharp rise in underground transactions. This is due, in part, to the fact
that the war was financed by deficit spending instead of the proposition of stringent
new taxes.
The explosion in underground activity since the 1960s is reflected in the steady
climb in currency demand up until the early 1980s. Much of this increased demand
can be explained by the increased taxes the public paid due to inflation. In a
progressive tax system, such as that of the United States, tax rates rise as income
rises. Inflation pushes nominal incomes into higher tax brackets, so the public is
taxed harder even though there is no change in the tax schedule. As a result,
people may turn to currency as a way of evading taxes by not declaring income.
More troublesome however, is the growth in illegal drug trade. The Drug
Enforcement Agency (DEA) estimates the retail value of illegal drug trade in the
United States at over $100 billion. A closer look at the demand for currency reflects
this as well. A 1981 study showed that the Florida Federal Reserves Miami and
Jacksonville branch offices both exhibited unusual currency flows: both offices
consistently received more currency than they paid out, a trait observed in only
seven of the Feds 37 branches. These Florida branches also received a much higher
proportion of large denomination ($100) bills than the other branches, even after
correcting for the effects of tourism.
While underground activity in the United States is pervasive, it ranks low compared
to most industrialized countries. According to Business Week (February 15 1993),
high tax rates in the Netherlands have created a huge off-the-books economy,
and 40% of taxpayers in Italy evade taxes regularly. In many developing countries,
not paying taxes is common. It is also true, however, that many developing nations
experience difficulty in creating formal sector employment, leaving 25 to 40% of the
labor force to fend for themselves in the underground economy.

Questions for Analytical Thinking:

1. Do any signs of underground economy exist in your area? What impacts does
it have on the local economy?
2. Given the cost-benefit logic of those who participate in the underground
economy, what legal changes would you recommend to your Congressperson
to reduce the tax gap from the underground economy? How might tax
simplification reduce the size of the underground economy and the
government budget deficit?
3. Why might the sharp growth in the demand for currency during the Great
Depression of the 1930s reflect something other than an increase in the
underground economy?
4. If a countrys underground economy is large, how might its official GDP and
employment statistics be distorted? What impact can these activities have on
policy making? Should illegal activity be included in GDP?

Greece (2500 years ago When taxes fall due, it is the just who will pay
more than the unjust
Ducal Palace (Renaissance Venice) had a hole thro through which informers
could anonymously snitch on tax deadbeats ugh which informers could
anonymously snitch on tax deadbeats.
Modern times: Underground economy hard crimes and drug rings
Income that goes unreported to either the Internal Revenue Service (IRS) or
the Labor Department
Recent attention to US underground economy to reduce the enormous fiscal
deficits
Reduce Tax Gaps unrealized tax revenues from underreporting income or
overstating deductions rather than raising taxes or cutting spending
Tax gap ran as high as $127 billion in 1992, one third of the $300 billion
budget deficit for that year
To measure amount of lost revenue should estimate first the size of
underground economy
Estimates are tricky businesses that vary from 5% to 28% of GDP.
An estimate in 1990 US underground economy was valued at $337 billion,
6.2% of GDP
$268 billion of that was estimated unreported income from legal activities,
with the remainder from illegal activities
IRS puts the annual income from underground activity at more than $500
billion, roughly 10% of GDP

This figures does not include estimated $200 billion worth of additional
criminal activity
These figures can be compared to a tax-free economic sector with the size
of Canada, that exist in the US
Undeground economy is not static, it expands and contracts
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