Economics: Off the Books: The Underground Economy

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[S represents solicitor at door; P represents the professor]
S: [Knocking sound, door is opened.] Hi, I was just in the neighborhood, and I have a lawn mowing service, and I was just wondering if you would like your lawn mowed.
P: Oh, well, I usually mow my own lawn, thanks.
S: Well, it looks kind of tall out of there, and so I just thought -
P: Well, I've been kind of busy this week. I haven't really gotten to it yet.
S: You know, it's only $35.00, and I'm going to school right now, and I could really use it for my chemistry books.
P: $35.00 - you know, I think maybe I'd pay $15.00 to do it.
S: These are really expensive books.
P: Oh.
S: $25.00?
P: Is that your lawn mower?
S: Yes.
P: You really use that thing?
S: Yeah. Oh, it works. I mean, it's guaranteed to cut lawns.
P: $20.00.
S: $20.00? Cool, $20.00.
P: Great. I've got to see this.
Given how much I hate to mow my lawn, I think I just got a good deal, but I feel a little bit guilty. I mean, is she going to report that income to the Internal Revenue Service and pay taxes on it? Most likely, she's a participant in what economists call the underground economy. The term "underground economy" refers to any economic activity that takes place outside of government supervision; and usually this activity is undertaken by its participants to avoid the law or to avoid paying taxes.
One example of an underground economy is the activities that surround illegal trade - traffic in narcotics, or people who drive illegal immigrants across international boundaries. Another set of underground transactions are those undertaken expressly to avoid paying taxes. So when people get paid in cash like she is, chances are, she's not going to report that income to the government, and if she doesn't, she's part of the underground economy.
Another example of underground economic transaction is barter. If my neighbor comes over and rakes my leaves and I go over and paint his living room, our trade involves value for both of us. But if don't report this value to the Internal Revenue Service and pay tax on this in-kind income, then we're avoiding taxes, and are part of the underground economy.
Now, is this something that we should be worried about? The underground economy may account for a relatively large chunk of the economic output of the United States. Some economists estimate that somewhere between 3% and 20% of gross domestic products comes from this kind of underground transaction. In the United States, this is even a relatively small amount of our economy. A country like Italy, we might be talking about upwards of one-third of GDP coming from underground activities.
So is it a problem? Well, first of all, anytime a transaction like this occurs, taxes are being avoided. Consider then that in 1992 the Internal Revenue Service estimated that about $100 billion worth of tax revenue was lost because people didn't pay taxes on activities like this one. By 1998 the amount lost in taxes was estimated to be as high as $200 billion, and that amount will probably increase as the underground economy grows. So not only is tax revenue lost, but also, there are resources tied up in the enforcement of tax laws. And the more people turn to underground activities, the harder police and the taxmen have to work to make sure that we get the money to fund government programs, and pay for public goods like streets, and street lights, and schools, and so forth.
So as people avoid their taxes, there's less revenue to provide the goods and services that government provides for us. Then, there's all of the wasteful activity that people do to try to avoid the police, like hiding their lawn mowers and doing this activity after dark and so forth. Next thing you know, however, she's going to need protection for her property rights, or someone's going to find out that she's doing this activity on the sly, and threaten to blackmail her and turn her in. Then we've got organized crime surrounding this activity - people who are tough, people who are strong - forming kind of their own law around underground activities. That's happened around alcohol in the U.S., around the turn of the last century, and it happens around narcotics today, so we get that kind of stuff. In the end, there's a lot of waste that surrounds underground economic activity.
On the other hand, there's a lot of innovation that surrounds it as well. People who don't yet have the resources to go and apply for a license and deal with all the government regulation can start their own simple job by getting a lawn mower and going out and mowing lawns for people. Of course, they're putting themselves in a position of risk and liability, but at the same time, they are making a living, and she's probably going to be discovering some new things about mowing lawns that she can share with other people. Innovation is likely to occur as well. So while the underground economic activity may create a greater dispersion of wealth - meaning that some people pay taxes and other people don't - this kind of activity can also level the playing field by giving anybody a chance to get in and try to make their way.
So what can we do about the underground economy? If we're concerned, and, in fact, we're losing too much money in taxes, we really have two alternatives. One is to increase enforcement, and go after people like her and her lawn business and make them pay their taxes. That involves a big expenditure of resources. The second thing is simply to legalize activities and bring them under the auspices of the government so that they can be taxed more thoroughly, as happened with alcohol around the turn of the last century.
Now legalization isn't going to change her lawn business. Maybe we should have more enforcement to make people like her pay taxes. On the other hand, if she weren't here, I'd have to mow the lawn myself. So you see, I'm in a quandary - the underground economy has costs for society, but it also has benefits.
Macroeconomic Measurements
Aggregate Output and Income
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