Underground economy (informal economy, parallel economy)

The underground economy, also called informal or parallel economy, is economic activity that is not recorded in NATIONAL INCOME ACCOUNTING. Generally underground economic activity includes BARTER, illegal business activity (black markets), and unreported payments for goods and SERVICES. The most frequently cited unreported activity is EMPLOYMENT of household help. Many candidates for executive positions in the U.S. government have been rejected when it became known that they hired people to work as nannies or household help without paying taxes for their services. Barter, by its nature, does not include cash exchanges. In some U.S. communities there are small, local barter exchanges. Because records are kept of these exchanges, participants usually report the value of these exchanges as INCOME, but in many markets barter goes unreported. With the 1990s, collapse of the Russian currency, even more exchanges in that country have been made using barter. One economist estimated 90 percent of business activity in Russia is not reported to tax authorities. Illegal economic activities such as drugs, gambling, and prostitution are also part of a country’s underground economy. One of the arguments for making some illegal activities legal is to then be able to generate tax revenue. During the period known as Prohibition in the United States, alcohol was easily available but not subject to taxation because such sales were illegal and thus not reported. High tax rates and overregulation of economic activity are the major forces stimulating underground economies. In the 1990s, Italy’s underground economy was estimated at over 25 percent of GROSS DOMESTIC PRODUCT (GDP). At the time, employer’s COSTS for workers, taxes, and government- mandated benefits were 200 percent of wages. This encourages employers and workers to agree to work “off the books.” U.S. estimates of underground economic activity range from approximately 5 percent to over 16 percent of GDP. Given the size of the U.S. economy, this represents a significant amount of unreported and untaxed income. In many countries, home-based subcontract work such as sewing operations, even though they are linked to formal business activity, are not included in official statistics, also reducing reported income. One way the U.S. Treasury Department estimates the value of illegal drugs coming into the country is by measuring the relative deposits of cash versus checks in known drug-importation cities such as Miami and Los Angeles. Officials found a significantly higher amount of cash transactions in these cities compared to rest of the country and used this disparity to estimate the value of drug business coming into the country. Estimating underground economic activity is difficult. In a groundbreaking study, economist Hernando DeSoto conducted in-depth surveys of people in the barrios around Lima, Peru, documenting the organization and cooperation of participants in what he called the parallel economy. Because they were not legally allowed to be living where they were, residents in the barrios created their own system to supply basic goods and services, in full view of the country’s capital but unreported to authorities. While the popular image of underground economic activity is associated with illegal businesses and EMERGING MARKETS, economists recognize significant amounts of unreported income occur in the United States among high-income citizens and among self-employed people. Higher marginal tax rates encourage underreporting of income, and self-employment creates greater opportunities to control the amount of income reported and deductions taken from gross income. Antigovernment political attitudes are also reported as encouraging misrepresentation of income to tax authorities.