The underground economy or shadow economy which is also named as hidden economy, gray economy, black economy or informal economy, which is indeed difficult to measure includes all those activities whether legal or illegal whose incomes are not reported to government officials and thus remain unaccounted for the calculation of GDP.
Illegal activities involving monetary transactions like drug dealing, trade in stolen goods, prostitution, smuggling, gambling etc and those with non-monetary transactions like barter of drugs, stolen or smuggled goods etc are few examples which constitute underground economy. There can also be some legal activities which are not recorded in books of accounts, for an example, unreported income from self employment or wages and salaries from unreported work being carried out is the source of revenue but there are no records for it.
According to a 2018 report of IMF which emphasized on shadow economy around the world including 158 countries over the period 1991 to 2015, the countries with the largest share of underground economy were found to be Georgia (64.87%), Bolivia (62.28%) and Zimbabwe (60.64%). The countries with the smallest share were Austria (8.93%), The United States (8.34%) and Switzerland (7.24%). However, the size of this economy India was 23.91%. But the accounting of the share of shadow economy varies from year to year. For an instance, in 2009, the American underground economy was estimated to have reached $1 trillion which was approximately 8% of US GDP. On the other hand, in 2013 after 2008 global crisis which led to fall in the share of formal economy, the underground economy of US was estimated at $2 trillion. Some studies estimate its share to be 11 to 12% of the US GDP as of 2020 which accounts roughly for $2.5 trillion.
But the question arises what makes people so willing to work in hidden economy? What are the flaws in the current official economy? Is it the poor policy framework or just the desire to earn more and more?
Well, there can be many reasons for the growing level of underground economic activities in a country. The first and foremost being tax evasion. Due to large tax rates, people tend to indulge in unreported work to evade taxes. Thus, this may stimulate labor supply in shadow economy. The wedge due to overall tax burden may get reduced, and they turn to working off the books. Also, regulations in some sectors like labor market are not flexible enough in formal economy thus giving them the incentives to operate in informal with more individual choices and less legal framework. Another main cause could be corruption which is omnipresent. A study on interrelations between shadow economy, corruption and economic growth in the EU found a positive correlation between corruption level and shadow economy between 2005 and 2014. Thus, the more tainted the system is, the larger the size of shadow economy will be. The level of unemployment in the formal economy decides the labor force participation in informal economy. A nation facing economic slowdown would have high level of unemployment and with no means of earning or very meager available opportunities, the unemployed labor tends to work in shadow economy.
Another question that needs to be answered is if the activities being taken place in hidden economy are not accounted for, then how does its size estimated? What are the methods and models used to get an accurate figure of its share?
As it is apparent that it is highly difficult to calculate the level of underground economy as it is not recorded in calculation of GDP and it remains untaxed. Thus, there are various methods to estimate its level to get the best possible results but these have some unavoidable discrepancies. There are broadly two approaches to measure it: direct and indirect. The indicators used in both the methods are described briefly:
Some direct methods could be:
Sample survey: conducting surveys to know public perception, their participation and opinions.
Tax audit: estimating the size by auditing and measuring untaxable income
Indirect approach includes:
Estimating discrepancy between national expenditure and income statistics: the difference between them can be used to approximate the size of shadow economy.
Difference between official and actual labor force: a decline in labor participation in formal economy can be considered as increase in the operation in shadow economy.
Currency demand: shadow economy operates in cash to avoid its accounting and reporting, thus this will lead to increase in demand of cash in hand.
There can be other methods like estimating the overall transactions in the economy, using physical indicators like electricity consumption etc which can be used to interpret results and estimate the size but there can be fluctuations as all the indicators are not strong enough to give us the exact share of this economy. Thus, there is not the best method to calculate it but ways to estimate its approximate value are available.
The shadow economy has a great impact on the formal economy. It manipulates the official data due to which various monetary policies taken by central bank of a nation may not be effective in boosting the economy the way it was required. Due to increasing transactions and operations in shadow economy, labor participation and working hours in formal economy will fall and tend to rise in underground economy which may affect the official growth rate of economy.
The increase in size of the shadow economy will also reduce the govt revenue in the form of taxes which would highly impact the quality of public goods and services being offered by govt. thus in return, to cover the expenditure, government might raise the taxes and not improve the quality of services, thus this cycle will be perpetual.
Thus, this is highly needed that various policy measures are taken by the officials like reduction in tax rates, legalizing few activities of shadow economy, liberalizing regulations in official economy, enforcement of strict laws in cases of corruption etc. to counter the negative impacts of shadow economy and help stimulate the economy.