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Robbery, larceny, blackmail, fraud, and other crimes with economic motives are likely to be as old as mankind, and the evasion of taxes and economic regulations can be assumed to begin with the introduction of taxes and economic regulations. Thus the shadow economy is certain­ ly not a new phenomenon. However, economists did not pay much attention to it until quite recently. P. GUTMANN in his pioneering article "The Subterranean Economy" (Financial Analysts Journal, Nov/Dec 1977, p. 24- 27) was first to point out that unreported economic activity cannot (or, at least, can no longer) be considered as a "quantite negligeable". Challenged by GUTMANN's hypothesis many economists have then tried to assess the quantitative and qualitative importance of the shadow economy (commonly also known as the underground, or subterranean, or black, or unreported economy, and by other names). There seems to be wide agreement nowadays that the shadow economy has not only reached a substantial portion of total economic activity in both Eastern and Western countries but that it is also growing at rates which can no longer be experienced in the official sector. The existence of a considerable volume of unreported economic activities implies that important macroeconomic variables are biased in the official statistics. The rate of unemployment, for example, may be over-estimated while production figures, on the other hand, tend to be underrated. The government could thus be mislead and choose inadequate policies.



Conceptual Questions


The Subterranean Economy, Redux

In the past six years there has been a revolutionary development in economics. Six years ago, the subterranean economy — that broad area of productive economic activity which wholly escapes the ministrations of the tax collector and largely that of the statistician — simply did not exist, in the official view, in the perception of the public and among economists.
Peter M. Gutmann

The Meaning of the “Underground Economy” and the Full Compliance Deficit

A growing amount of professional attention is now directed toward the issue of the existence and implications of the “underground” or “shadow” economy. Unfortunately, the terms “underground” and “shadow” have been used to mean quite different things by different investigators, and these unresolved questions of definition introduce considerable confusion in the literature. Theoretical and empirical research require a finer set of conceptual distinctions to clarify both the differences and the interconnections among the variety of descriptive terms presently employed by “underground economists.” To this end, I wish to put forward a taxonomic framework which distinguishes among economic, fiscal, and social concepts of income. The first section of this paper elaborates these income concepts and establishes their interrelationships.
Edgar L. Feige

Subterranean Labor Markets: A Conceptual Analysis

A taxonomy is developed in which subterranean markets are divided into two basic categories: those for goods and services that are intrinsically illegal (Category I) and those where the transaction rather than the object traded is illegal or constrained (Category II). The second category is subdivided into issues of explicit and implicit taxatation and various other applicable topics, which are treated in detail in the paper in an attempt to provide an analytic handle on the subject. The author notes that since market information is available to transactors it must be available to law enforcers. Since subterranean markets persist despite this, there may be some optimal tolerance point between the shadow and sunlight sectors.
Bruno Stein

Crime: What Should be Recorded in the National Accounts; and What Difference Would it Make?

There is a widespread belief that the national accounts give a biased view of economic development because they omit the “shadow economy”. The shadow economy is usually defined as consisting of two parts — illegal activities and activities that are legal in themselves but are carried out clandestinely so as to evade taxes. This paper deals with the first component. It considers what types of illegal transactions should, in principle, be included in the national accounts and presents “orders of magnitude” estimates suggesting that full coverage of illegal activities would have added, at most, only about 2 1/2 % to United States’ GDP in 1975. Since illegal activities are probably less important in other industrialised countries, the illegal part of the shadow economy appears to be relatively trivial.
Derek W. Blades

Empirical Evidence


The Parallel Economy in Austria

The paper is a summary of a few recent Austrian studies. Franz analysed official statistics for 1976, he estimated the volume of the hidden economy at AS 27 billion ( i.e. approximately 4 percent of the GDP). Mooslechner tried to use the monetary indicators for the same purpose. He failed because these data are too strongly influenced by changes in the financial system. The tax loss caused by the hidden economy in 1982 amounted, according to Lehner, to AS 18 billion (gross) and AS 13 billion (net). Neubauer has shown that the house-owners and moonlighters contribute about 40 percent of the value added of newly constructed family houses.
Jiri Skolka

Measuring the Shadow Economy: The Case of Switzerland

The structure, size and development of the shadow economy in Switzerland is analyzed using different methods of estimation: A survey among experts, the discrepancy between various income measures, the participation rate approach, the money approaches, the structural and the causal methods. There is strong evidence that the Swiss shadow economy has grown between the end of the 50s and 1980. The size is estimated to be in the range between 3 % and 4 % of GNP in 1975. Compared to other countries the shadow economy in Switzerland is estimated to be one of the smallest.
Hannelore Weck-Hannemann, Bruno S. Frey

The Unobserved Economy and the National Accounts in the Netherlands a Sensitivity Analysis

This paper investigates the sensitivity of the National Accounts estimates for understimation caused by fraud. It tries to establish reasonable upper bounds for the distortion in the level and the growth of the gross domestic product (GDP) caused by fraud. The conclusions are that a distortion in the level of GDP of 5 % and in the growth of 0.5% is very unlikely.
G. A. A. M. Broesterhuizen

The Relationship between the Formal and Hidden Economies: An Exploratory Analysis for Four Countries

Much of the hidden economy literature suggests an inverse relationship between the health of the formal and hidden economies — a suggestion with important implications for both economics and politics. This paper examines, conceptually and empirically, the nature of this relationship for a number of countries. It suggests, cautiously, a less straightforward picture: the size of the hidden economy is generally positively related to the size of the measured economy — but also to inflation, while unemployment has no clear effect. The paper concludes that structural rather than cyclical phenomena may explain the growth of the hidden economy.
Michael O’Higgins

Belgiums’s Irregular Economy

This paper presents a survey based estimation of the size and nature of irregular activities in Belgium from both a demand and a supply side viewpoint. It starts off with a distinction between two main types of such activities: off the books activities (which mostly concern the self-employed) and black labor (which rather involves salaried or unoccupied people). This empirical study essentially deals with the latter and shows that they are supplied by low-income groups: pensioners, unemployed, blue-collar workers... and cater to relatively richer groups. It also explores alternative hypotheses as to the main determinants of hidden activities.
Pierre Pestieau

Market Motives in the Informal Economy

This paper presents estimates of the size of the informal economy in the United States and examines the motives individuals have for dealing in the informal economy.
The research reported used survey research techniques to measure the value of goods and services purchased from informal vendors over a one-year period. Respondents were also asked about their motives for purchasing from informal vendors and a limited amount about their own role as an informal vendor.
James D. Smith

Theoretical Approaches


Macroeconomic Policy and the Shadow Economy

Previous studies on the underground economy have almost exclusively focused on conceptual questions and empirical research. Together with a few other articles in this volume this paper is a first and tentative approach to a theoretical analysis of an economy with a shadow sector. In the framework of a two-sector general equilibrium model we discuss the impact of government expenditure and of unemployment compensation on the employment in the two sectors, on the real wage, and on relative commodity prices. Furthermore, a welfare analysis of different policy options is carried out.
Benjamin Bental, Uri Ben-Zion, Alois Wenig

Macroeconomic Policy in the Presence of an Irregular Sector

This paper is concerned with the policy implications of the combined presence of a regular observed and an irregular unobserved sector. It develops a two-sector model in which the regular sector is subject to fixed prices and wages, while the irregular sector wages may move freely. A number of regimes are shown to be possible and for each, we examine the effects of different policies on regular and overall employment. Ignorance of the existence of an irregular sector can lead to employment policies which ultimately reduce the overall level of employment.
V. Ginsburgh, Ph. Michel, F. Padoa Schioppa, P. Pestieau

A Microeconomic Analysis of Black Labour Demand and Supply

Taking into account the risk to be fined firms maximize their expected profits and workers their expected utility by determining the optimal demand for and supply of homogenous legal and black labour inputs. Comparative static results are presented showing how a change in the tax rate, in the black and legal wage rate as well as in the probability to be fined affects individual and market demand for and supply of black (legal, total) labour hours. Employment in the black labour market rises if the tax rate rises provided that the probability to be fined does not exceed a critical level. The same will be true if the probability to fined is lowered and if the demand for total labour hours becomes constrained because of firms being rationed in the product market and the legal wage rate being inflexible.
Peter De Gijsel

The Behavior of Tax Evaders

Tax evasion in this paper manifests itself in two forms, underreporting of ordinary income and working in the hidden economy. Based on a specification of a utility function as well as on a tax function it is found, somewhat surprisingly, that an increase in the marginal tax rate in Norway reduces hours of work in the hidden economy. Underreporting of ordinary income increases as expected. The effect on total tax evasion is indeterminate. However, employing survey data and maximizing a likelihood function, an increase in the marginal tax rate turns out to have the expected positive effect both upon the supply of black labor and on under-reporting of ordinary income. This latter approach also revealed that tax evasion is a more common phenomenon among men than women, and that for both sexes hours of work in the hidden economy peak in the mid-thirties.
Arne Jon Isachsen, Sven Ove Samuelson, Steinar Strøm

Optimal Tax Evasion & Optimal Tax Evasion Policy Behavioral Aspects

This paper explores some important behavioral aspects of tax evasion — subjective probability bias, perception of other people’s behavior, social stigma — by building on work of Tversky & Kahneman (1979, 1981), Sagi & Weinblatt (1982) and Benjamini & Sagi (1983). The conventional expected-utility model of optimal tax evasion is portrayed graphically, then modified to include stigma and fear of apprehension, probability bias and misinformation. A game-theoretic model of tax evasion emphasizes the importance of one’s expectation about other people’s decision to evade or be honest. The next section develops a formula for optimal government policy against evasion, once evasion behavior is known. The final part of the paper describes a game-simulation study of tax evasion that relates underreporting of income to both tax parameters and individual personality.
Yael Benjamini, Shlomo Maital

The Shadow Economy and Morals: A Note

If the established rules are obeyed spontaneously in an economy, this increases economic efficiency since the uncertainties, monitoring costs and incentive problems induced by opportunism can be avoided. Opportunism will be increased by increasing the incentives for unlawful behaviour, however, and a slight increase in these incentives might cause a cumulative and self-nourishing breakdown of morals. The dangers of the growing shadow economy are louring here.
Ekkehart Schlicht

Policy Implications


Public Policy and Tax Evasion: Some Problems

Will a reduction in tax evasion increase social welfare? And will evasion always be reduced by an increase in the penalty for evasion or the probability of being caught? This paper examines these two questions allowing for the asymmetric information available to the tax authority and the tax evader, and for the possibility of elastic factor supply.
Frank A. Cowell

Tax Evasion and Government Policy

The effects of government policy that aims to deter tax evasion are examined in a qualitative and quantitative two-sector general equilibrium model. Policy instruments that i) increase disutility from tax evasion and ii) decrease productivity in the tax-evading sector are concluded to decrease tax evasion under specified sufficient assumptions. Counteracting welfare effects are involved. The simulation analysis reveals ambiguous welfare effects for the first and negative welfare effects for the second policy. Tax evasion is also concluded to increase in the tax rate, while a reallocation of government expenditures away from transfers decreases tax evasion.
Ingemar Hansson

Is a Growing Unobserved Sector Undermining Monetary Policy in the Federal Republic of Germany?

Empirical evidence indicates that the shadow economy in West-Germany is growing more rapidly than the official economy. Therefore the observed deceleration of potential output, an important determinant of the monetary growth rate of the Bundesbank, is overestimated. However, despite the growing unobserved sector, the hypothesis of a stable, traditional demand for money function could not be rejected. As to the management of the money supply process, there is no theoretical or empirical evidence that it is aggravated by a more intensive use of cash in the underground sector.
Enno Langfeldt

Household Production


The Disappearance of Domestic Servants and the Underground Economy

Several papers have reported a sharp rise in the relative size of the underground economy in the U.S. beginning in the late 1960s. This paper examines this issue for one particular segment of the economy, the employment of domestic servants. There was a sharp decline in both the relative level and the absolute level of employment of household workers, starting in 1964. Moreover, on prima facie grounds, household employment seems an obvious candidate for underreporting, since it is very easy not to report earned income. A model is developed to relate household worker employment to traditional consumer demand variables. The outcome of the study is that the decline in the employment of household workers can be well explained by these traditional variables.
Edward N. Wolff

Household Composition, Social Networks and Household Production

Household production contains activities and their outcomes in the private households which concern the production of goods and the performance of services by household members and their social networks for themselves. In the area of goods examples vary from everyday housework to housing construction, in the area of services from child care to caring for old aged household members. Important outcomes are not only economic values but also immaterial contributions to the individual well-being. The questions put in this framework concern selected aspects of household production in relation to the performance of the market system and the welfare state, the amount of household production in households of different composition, and the influence of factors like income level, social class and age of household members on household production activities.
Wolfgang Glatzer, Regina Berger

Eastern Countries


Peculiarities and Limits of the Second Economy in Socialism (The Hungarian Case)

The second economy in socialism is neither identical to the small capitalist sector nor the shadow economy of the Western countries. This paper’s aim is to present a picture of some constraints that form the second economy’s character and determine its possible development. The crucial problem is the relationship between the state and the second economy. The state expects the second economy to play an auxiliary role and this explains the restrictive character of the state’s regulations. While the state stimulates the growth of the second economy’s natural output it tends to eliminate the negative unintended side effects going together with the growth itself. But the two objectives can hardly be reconciled with each other and this results in a particular type of growth where increasing illegitimacy, capital income formation and stagnant productivity go hand in hand.
During the last decade social scientists have become interested in the so-called second economy of socialist countries. However, in spite of the growing number of publications on the subject we do not seem to have made significant progress in interpreting the characteristics of this sector, especially its relationship to the state and the first economy.
This short paper aims to present some system-specific peculiarities of the second economy in socialism in order to improve our under-standing of this little known area. l)
Peter Galasi

The Second Economy in the Soviet Union and its Implications for Economic Policy

A survey of the activities of the second economy in the Soviet Union and its causes is given. The impact of the second economy for Soviet economic performance is analysed with respect to the supply of consumer goods, the input of labor, the functioning of the planning mechanism, the distribution of income, and the moral and politicalideological implications. The second economy appears to have positive impacts with respect to increasing consumer goods, to improving plan coordination and the flexibility of the official planning mechanism. On the other hand it loosens the planners’ control, leads to an active role of money and weakens socialist ethics. On balance, the second economy has a stabilizing impact on the economy which works to the benefit of the Soviet leadership and which leads to a certain toleration of this phenomenon.
Horst Brezinski

Repressed Inflation and Second Economy under Central Planning

Repressed inflation arises under central planning when excess demand on the consumer goods market does not lead to appropriate price increases. If prices in the second economy are allowed to increase the excess demand would seem to disappear. In reality this process would only partly take place and “speculative” money balances for future purchases in the first economy would arise. The accumulation of these balances is a rising function of the price-difference (between the second and first economy) ratio and of the probability of buying on the first market in the future, and a falling function of the pure rate of time preference.
Wlodzimierz Brus, Kazimierz Laski


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