CAN’T SEE IT: The IRS can’t get its grubby hands on the fruits of the shadow economy. Maybe that’s why it’s become a larger and larger share of the American economic pie in recent years.
By Eric Boehm | Watchdog.org
Millions of Americans dutifully trudge to the local Post Office each year to mail their tax returns to federal, state and local governments.
And there’s good reason. Failing to pay your taxes can result in expensive penalties, if you’re lucky, or armed federal agents breaking down your door to take their share of your pie.
But those who fail to pay their taxes in full might be doing the American economy a favor. And their numbers are growing.
The so-called “shadow economy” in the United States accounts for as much as $2 trillion in economic activity, according to Edgar Feige, a professor of economics at the University of Wisconsin-Madison.
That’s larger than the GDP of Canada and India.
Feige says more people are participating in the shadow economy than at any time since World War II, when strict price-controls and rationing drove many people to the underground economy for goods and services.
In an interview in July 2013, Feige said there are a variety of reasons the underground economy is booming – but it mostly has to do with tax policy.
“The more people view the tax code as inequitable, the more they will try to evade it. The higher the effective tax rate, the higher the incentive to try to evade it,” Feige said. “And of course the greater the complexity of the tax code and the consequent cost of compliance, the more incentive there is to evade it.”
In other words, the government can only get its grubby hands on the parts of the economy that it can track. And as tax rates rise, the part of the economy that is beyond governments’ grasp continues to grow.
THE BLACK MARKET: It’s more than just a place for illegal drugs and other illicit purchases. The American shadow economy accounts for $2 trillion in economic activity per year, larger than the GDP of Canada.
As Milton Friedman put it: “The black market is a way of getting around government controls.”
Feige estimates unreported economic activity causes the government to miss out on $400 million to $500 million in taxes, which would be collected if there was full compliance.
Last year, the underground economic boomlet in the United States might have been enough to keep the economy as a whole from tumbling back into a recession. And for thousands of workers who have seen hours cut or jobs disappear, the shadow economy provides opportunities.
The effects are seen on a larger scale, too.
Though the officially reported unemployment numbers remain high, consumer spending tallies suggest a lower level of unemployment. One possible explanation: People who are earning their pay in the shadow economy, thus appearing to be unemployed by official measures but still having cash to spend.
In some other countries, the underground economy is so large — in Spain, it’s estimated that 20 percent of all economic activity takes place behind the purview of the taxman — it is the main reason the on-the-books economy can continue to function at all.
The happy news is that the size of the underground economy means that more Spaniards are working than it might seem, and that the official unemployment figure of 24.4 percent — the highest in Europe — may be overstated by as much as five to nine percentage points, economists say. That has given the Spanish government an important safety valve.
“Without the underground economy, we would be in a situation of probably violent social unrest,” said Robert Tornabell, a professor and former dean of the Esade business school in Barcelona. “A lot of people are now staying afloat only thanks to the underground economy, as well as the support of their family network.”
Around the world, the shadow economy may account for as much as $10 trillion, according to Robert Neuwirth, who has written several articles and a book on the subject.
In America, the shadow economy is likely here to stay, with employers reducing hours because of Obamacare and tax rates likely to climb in the coming years.
Boehm is a reporter for Watchdog.org and can be reached at EBoehm@Watchdog.org. Follow @WatchdogOrg and @EricBoehm87 on Twitter for more.