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Growing Underground Economy, A Cause For Concern

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Ominously, the underground economy (UE) in the United States has kept growing especially during recent years following the great recession of 2007. It is a ubiquitous problem and like other economic ills it has no definitive cure. 

For the most part, cash transactions or illegal enterprises such as drug trafficking, prostitution, and gambling constitute the lion's share of an underground economy; it is not, however, limited to such activities. Legal transactions may also take place under the table to dodge payment of taxes. 

 Whereas, a shadow economy can exist in any country, it is not as widespread in developed countries as it is in less developed economies because of their lack of effective fraud detection mechanisms, widespread corruption, inadequate law enforcement systems, or simply pervasive poverty. 

A major study for OECD (Organization for Economic Co-operation and Development) countries shows that the size of the UE, as measured by the percentage of GDP (Gross Domestic Product), is highest in Italy and Greece and lowest in Scandinavian countries, suggesting that a combination of high taxes and inefficient government institutions can trigger an UE. 

 In modern time, by u tilizing cyberspace resources, savvy crooks have been able to buy and sell stolen merchandize and illegally obtain vital personal information through the black market online thus adding a more elaborate dimension to this phenomenon. The majority of transactions in this market are related to credit cards and bank accounts, 51% and growing swiftly. This was up 38% between 2007 and 2009, according to a report by CNNMoney.com which claimed that "If every stolen credit card and bank account had been wiped clean last year [2008] that would have netted cybercriminals some $8 billion." Accurate assessment of the actual size of the UE is next to impossible for the obvious reasons that its activities are concealed and its inhabitants remain anonymous. As such, government is not able to deal effectively with its detrimental consequences. 

Even though there is no reliable data on the scope of the UE in the United States, the emerging evidence shows that it has been expanding briskly in recent decades. According to a report in Washington Times on 12/09/09, the UE accounts for as much 13% of the GDP of the U.S. economy, a sum of about $1.8 trillion annually. While these numbers might be a bit overestimated, the findings of one credible study show in 2006 the size of the UE was about 6% of the U.S. economy, up from 3.4% in 1973 and it is still the same. 

 Understandably, one can argue that the post-2007 recession surge of the UE is triggered by a high jobless rate and the decline in the level of middle-class income level and is evidenced by the growing popularity of cash transactions, despite the fact that other more convenient means of payment are readily available.   Not only has the total demand for cash increased, but real per capita currency has also increased, "Real per capita currency has been exploding from $160 in 1959 to $2,489 in 2006", it is about $3000 today. 

People demand currency for a variety of reasons, including paying for daily transactions and unexpected expenses as well as taking advantage of market opportunities through speculation. Logically, demand for money induced by these motives should have been declining in light of recent financial innovations and improvements in payment system and with the availability of modern payment instruments that are cheaper and more convenient, but it has not.

Additionally, the popularity of the Euro should have led to the weakening of international demand for the U. S. dollar. The upward trend in worldwide desirability of US dollar must be attributed, therefore, to the expansion of the underground economy. Cash is still the most frequently used medium of payment, particularly for hidden transactions. Besides, the lingering insecurity created by the off-putting effects of economic downturn has led to panic and an overall sense of frustration for the job-seeking populace. Foremost, high unemployment has made decent-paying jobs in an open economy hard to find for laid-off workers, forcing many of them to accept lower wage rate jobs in the underground sector. The taxes they don't pay while working underground recompense them not only for the loss of accepting lower wages, but also enables them to save more money for emergency expenses since cash-paying jobs do not include the benefits and safeguards that come with ordinary jobs. 

 Reiterating, all transactions in an UE are not connected to illegal activities; everyday legitimate activities or jobs can also go underground for various reasons, most notably the avoidance of having to pay taxes or receiving government handouts while working at a paid job. The desire to go underground may intensify when people think that they are being unfairly treated by the tax system or do not benefit deservingly from the outcome of economic prosperity. In particular, people get upset when they learn from the news that corporations do not pay their fair share of taxes because of countless numbers of loopholes they can take advantage of or learn about their symbiotic relationships with politicians. The tax-paying consumers feel betrayed when news media report about pay raises for already well-paid CEOs or they hear the phrase "tax cuts for the wealthy." They too try to escape paying taxes by defecting to the underground sector or resorting to cash business. 

Furthermore, the current harsh and long economic slump has created financial hardship for millions of households as well as for business firms, forcing them to craft creative ways to deal with burdensome expenses. Consequently, the UE has become a frugal choice for many individuals as well as business people who have watched their real income, their purchasing power, dwindle down because of escalating costs, a rigged economic system, and an unlevel economic playing field. 

Excessive regulatory constraints such as price controls and stringent working environment requirements can also inflict undue costs and thus erode the profits of business firms, forcing them to do business under the table. A number of experts blame illegal immigrants for the growth of the UE. The correlation between the number of illegal immigrants and the UE is based on the common sense proposition that illegal immigrants have to accept menial cash-paying jobs because they do not have work permits. 

While this is true, there are conflicting, and thus inaccurate, accounts of the number of illegal workers in the U.S. According to a report by the WSJ, April 2005 , " The government puts this population at 8.5 million, but that may represent a serious undercount." PEW Hispanic center estimates the number of unauthorized immigrants in the U.S. about 11.2 million for the years 2009 and 2010, nearly 3.7 % of the U.S. population. A slight decline in 2007, after many years of persistent growth, occurred because the U.S. economy fell into a deep recession, and it continued to descend thereafter. Out of the 11.2 million unauthorized immigrants, nearly 8 million of them were participating in the unofficial labor force in 2010 according to PEW. 

An important lesson learned from the stability of this statistic is that illegal immigrants come to the U.S. basically in search of jobs, especially during good economic times. While the employment rate dropped drastically in the aboveground economy in recent years, it seemed as though it remained stable in the underground economy simply because jobs in this sector are mostly in labor intensive industries providing essential goods and services whose demand deemed to be impervious to business fluctuations. 

Livesafely.org provides a list of 67 industries that rely heavily on unskilled laborers. They pay their workers in cash under the table and are growing, especially in such areas as in-home repair services, tutoring, snow removal, construction, babysitting, farming, food processing, janitorial, and garment manufacturing. According to the Policy Institute of California, Arizona has the highest percentage of illegal immigrants than any other state: "The institute estimates that in 2006, 8.3 percent of Arizona's population consisted of illegal migrants, followed by California with 7.8 percent; Texas, 7.1 percent; and Florida, 5.5 percent." A recent report by the WSJ, February 17, 2011, suggests that not only the increasing numbers of illegal immigrants but also industry proprietors are contributing to the intensification of the UE. 

The inclination for small businesses to go underground is evidently strong since their operation is usually labor-intensive, and they can augment their profit by hiring undocumented workers at lower wages and without job benefits. They can also operate on a cash basis, thus evading paying taxes. The U.S. Census Bureau reports more than 10 million Americans are self-employed, up from about 8 million in 1980. Even more suspicious, is the number of "nonemployer firms," business firms with no payroll. The number of such entities is estimated to be around 20 million, up by 33% since the late 1990s. The possibility of earning good wages by working underground is the main attraction for illegal immigrants. 

By working in the UE in their adopted countries, they have been able to earn good money and send part of their income back to their home countries, as much as $276 billion according to an estimate by World Bank in 2007. This number has grown by more than 100% since the year 2000. World Bank economist, Dilip Ratha, believes "the United States lost $41.1 billion in 2005" and this amount was transferred to other countries, first and foremost to India, by illegal immigrants. It is like a revolving door analogy; low income, heavily populated poor countries keep sending workers to developed countries and cash is returned home on a revolving basis. Consequently, host countries suffer a double whammy by losing tax revenue as well as cash that could potentially create demand for domestic products. One can argue that fraudulent activities are driven either by greed and the desire to earn money by any means including illegal undertakings, or are in response to unfavorable economic condition, high unemployment, inability to attain a decent level of living, and the high cost of doing business stemming from hefty regulation.   Examining the evidence deemed relevant, the correlation between effectiveness of government institutions, its regulatory constraints, and its tax system was palpable. The distortionary effects created by the UE are damaging not only to the official economy but also to government policy makers because these distortions impede their ability to make appropriate macroeconomic decisions based on accurate assumptions about important economic indicators such as unemployment rate, the poverty rate, , and the pace of aggregate income and spending.   

For instance, one the one hand, the increasing global demand for US dollars cash hinders the ability of the Fed to keep track of monetary aggregates; on the other hand, the increasing frequency of clandestine transactions, hinders the ability of IRS to collect all the taxes owed, creating a costly tax gap, currently between   $350 to $00 billion. Such a short fall of revenue not only exacerbates the already ballooning national debt and deficit, but also jeopardizes the viability of social programs that are financed by taxes. Adding to costs, state governments must devote a great deal of money and manpower to tackle the costly consequences of the UE. In addition, businesses in the UE put law-abiding competitors in the open economy at a disadvantage; full-tax-paying companies can no longer compete with them and hence lose revenue. Based on the foregoing analyses, one can argue that fairer income distribution and closer attention to the issues related to equality will certainly help to mitigate the pent up frustration that inspires some people to defect to the UE. Had ordinary people in middle class not been denied their fair share of the national output, they would not have been forced to resort to deceitful means of making money and hiding it for tax benefit purposes. 

The political debates should address this issues related to UE with attention to the strengthening of American households, especially those in middle class, and the overall good of the economy rather than on politics and personal self-interests.  

 

Reza Varjavand (Ph.D., University of Oklahoma) is associate professor of economics and finance at the Graham School of management, Saint Xavier University, of Chicago. He has been an avid participant in many professional organizations and active in (more...)
 
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Funny how imperial monsters make the same mistake ... by Sister Begonia on Tuesday, Apr 12, 2011 at 3:28:27 PM
Thanks for your comments, it seems people are fru... by Reza varjavand on Sunday, Apr 24, 2011 at 11:44:32 PM