Exhaustiveness, part 3 Underground Economy 1

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1 Exhaustiveness, part 3 Underground Economy 1 Introduction This paper continues the series dedicated to extending the contents of the Handbook Essential SNA: Building the Basics 2. One of the main themes in this series has been GDP compilation since GDP (Gross Domestic Product) is the most important single indicator measuring economic activity in a country. Earlier in this series we reviewed the three main approaches to GDP compilation the production approach, the expenditure approach and the income approach. Since these separate approaches all aim to measure the same GDP, an important goal for national accountants is to minimize the discrepancies between these different compilations. A closely related goal is to make the estimates of GDP exhaustive. We also set out to provide some general background to the role of exhaustiveness in GDP compilation, highlighting some of the meanings of the term exhaustiveness, as used by national accountants. We saw that non-exhaustiveness may be caused by defective imputations, by missing units, by missing activities or by under-reported values. Finally, we introduced the Eurostat tabular approach to exhaustiveness which was designed to identify potential sources of non-exhaustiveness in the national accounts 3. In this paper we want to shift perspective from the overall exhaustiveness framework as provided by the Eurostat tabular approach to the particular groupings of non-observed economic activities as provided by the OECD Manual on the Non-observed economy. The concept of the Non-observed economy (NOE) was briefly introduced in a previous paper, where we distinguished the following NOE categories 4 : Illegal activities Underground activities Production of households for own final use Non-observed informal activities In this paper we will provide some background on the second category, underground activities, making up what is known as the underground economy 5. What is meant by the underground economy? The underground economy consists of activities that fall within the production boundary of the SNA but are deliberately concealed from public authorities. SNA mentions the following kinds of reasons (SNA 6.40): 1 This paper was initiated and financed by EUROSTAT through the Project Essential SNA: Building the Basics, implemented by DevStat Servicios de Consultoría Estadística in consortium with ICON Institute, for which information can be found at the following link: 2 Henceforth called the Handbook ; this paper is based on the second (2012) edition; it can be found at the following link: 3 See the papers: Exhaustiveness, part 1 Main issues 4 Ibid. 5 The first category was treated in: Exhaustiveness, part 2 Illegal Economy 1

2 To avoid the payment of income, value added or other taxes; To avoid the payment of social security contributions; To avoid having to meet certain legal standards such as minimum wages, maximum hours, safety or health standards, etc.; To avoid complying with certain administrative procedures, such as completing statistical questionnaires or other administrative forms. Also usually included is skimming, which is when firms under report revenue or over report expenses. Examples of underground activities range from undeclared construction activities to undeclared rent and undeclared tips. Shuttle trade is another example. This is an activity in which entrepreneurs buy goods abroad and import them for resale in street markets or small shops. Note that although cross border shopping also involves concealment of activities from public authorities with the intention of avoiding taxes, this is not a productive activity and thus does not constitute a part of the underground economy. Note that the delineation of the underground economy and the illegal economy, as elucidated in the previous paper, may not be precise, and certain overlaps are bound to appear. Illegal activities will meet many if not all of the above criteria and may therefore be included in the underground economy as well. On the other hand the evasion of taxes is itself usually a criminal offence. In this paper we will exclude illegal activities as defined in the previous paper from the scope of the underground economy, unless otherwise stated. Alternative names for the underground economy as understood here are: hidden economy and shadow economy 6. The importance of the underground economy According to an IZA study undertaken in 2006, the global shadow economy amounts to almost 35 percent of the world s official GDP in The study was based on the criteria for the underground economy as listed in the previous section. The methodology underlying this study was used in a later 2010 World Bank research paper in which results were extended to This latter paper analyzes the sizes and causes of the shadow economies of 162 countries in various stages of development across the globe. The following table presents the results from this paper. It gives the average size of the underground or shadow economy as percentage of official GDP for the period for the eight regions distinguished in the World Bank paper. The first column in the table gives simple averages over all countries in the region, with each country having equal weight. The second column in the table gives weighted averages for the regions, where each country is weighted by the ratio of its share of 2005 GDP in the region total. 6 The OECD manual on the Non-observed Economy list about 30 alternate terms in section Shadow Economies and Corruption All Over the World: What Do We Really Know? Friedrich Schneider, Discussion Paper No. 2315, September 2006, Institute for the Study of Labor (IZA) in Bonn, Germany ( 8 Shadow Economies all over the World, Friedrich Schneider, Andreas Buehn, Claudio Montenegro, World Bank Policy Research Working Paper 5356, July 2010 ( DF/WPS5356.pdf) 2

3 Region Region average Weighted with 2005 GDP East Asia and Pacific Europe and Central Asia Latin America and the Caribbean Middle East and North Africa High Income OECD Other High Income South Asia Sub-Saharan Africa World Table 1 Shadow economy as percentage of GDP, average The World Bank paper divides causal variables of the shadow economy into two categories: economic variables and policy variables. Economic variables describe a country s level of development and the state of its economy and include factors such as GDP per capita and the unemployment rate. Policy variables include regulations and various measures of the tax burden. When examining the results, the authors find that economic variables generally influence the size of shadow economies more than policy ones. The World Bank paper draws the following conclusions: For all countries investigated the shadow economy has reached a remarkable large size; There is a clear negative trend of the size of the shadow economy over time (34% in 1999 to 31% in 2007); There are regional disparities in the levels of the shadow economy, with Sub-Saharan Africa at the top and the OECD countries at the bottom; The shadow economy is a complex phenomenon that is present to a large extent in all types of economy (developing, transition, and highly developed). What factors contribute to this large size of the shadow economy? We will explore this question in the next section. Factors that contribute to the increase of underground economy Why do economic units decide to go underground? The IZA study mentioned in the previous section lists the following reasons 9 : One of the main causes for the existence of the underground economy is the tax and social security contribution burdens. The bigger the difference between the total cost of labour in the official economy and the after-tax earnings from work, the greater is the incentive to avoid this difference and to work in the underground economy. Another important factor is the increase of the intensity of regulations, which reduces the freedom (of choice) for individuals engaged in the official economy. Examples are labour market regulations, trade barriers, and labour restrictions for foreigners. Many researchers have also associated bribery or corruption with the existence of the underground economy, especially in the government sector. Also, the social welfare system may provide 9 We also included some additional factors found in: Underground Economy: Definition And Causes, Sim Wan Jie and others, Business and Management Review Vol. 1(2) pp , April, 2011 ( 3

4 disincentives to work in the official economy. Besides receiving the welfare payments, some individuals might wish for higher income and cheat by pursuing the underground economy, since working in the official economy could reduce or discontinue their welfare income. Labour market regulations introduced by government and labour union are another catalyst of underground economy. The enforcement of maximum working hours and the bringing forward of the retirement age by the state governments or labour unions are likely to increase the incentives to work in the underground economy, as individuals may want to continue to offer their labour services, curtailed by regulations, to generate additional income. An increase of the underground economy can lead to reduced state revenues which in turn reduces the quality and quantity of publicly provided goods and services. This can lead to an increase in the tax rates for firms and individuals in the official sector, possibly combined with a deterioration in the quality of the public goods (such as the public infrastructure) and of the administration, with the consequence of even stronger incentives to participate in the underground economy. The perception of individuals about the underground economy and their (moral) reaction to this phenomenon is also an important factor whether or not people decide to work in the underground economy. The study mentions a number of empirical studies, which investigate the tax moral of people and their attitudes on the underground economy. The study gives some results for Germany which clearly demonstrate that people have no bad (moral) feeling when working in the underground economy. Finally, the general economic outlook is one of the factors that contribute to decision of individuals to work in the underground economy. Examples of determining factors are unemployment, high public debt and recession or inadequate economic growth. The World Bank paper used in the previous section implies that if governments can implement incentive-oriented policy measures that make work in the shadow economy less attractive, this may lead to a stabilization, or even reduction, in the size of the shadow economy. While governments cannot change economic conditions such as GDP per capita by will, they can implement economyoriented policies that will induce, or increase the incentive for, certain behaviors, such as keeping one s money in the official economy. The results of the paper indicate that the best policy measure governments can take to reduce the size of the shadow economy is to reduce the tax burden. With lower taxes, there is less of an economic incentive to skirt those taxes and do business in the shadow economy or abroad. The next best option for reducing the underground economy s size would be lessening fiscal and business regulations, a policy with direct economic benefits for businesses that choose to operate in the official economy. Measurement tools In this section we will give an overview of the methods available to national accountants to come to an estimate of the national accounts aggregates related to the underground economy. We will distinguish between direct methods, indirect indicator methods and model-based methods This section is largely based on chapter 8 of the OECD Handbook on the Non-observed Economy and on the IZA study used in previous sections. 4

5 Direct methods Direct methods are often based on sample surveys, designed to estimate the underground economy. They are widely used in a number of countries and the OECD manual gives a number of examples, including: Mixed household-enterprise survey. Enterprises that are not registered and are engaged in legal productive activities are likely to be very small. However, there may be quite a large number of such enterprises. Failure to register means that the enterprise will not be covered in any survey for which the frame is drawn from the business register. A mixed householdenterprise survey approach is a practical way of measuring such underground production. We will look at such surveys in the next paper on the informal sector. Surveys of expenditure on goods and services from underground production. In most countries purchasing goods and services from underground producers is not against the law. Thus surveys of expenditure on underground production are more likely to give good results than surveys of underground income. Some household surveys attempt to identify expenditures on underground production by asking respondents to indicate separately those purchases that they suspect may have an underground character. Others ask respondents to describe the type of outlet or seller from among a list that includes those types most likely to be operating underground, including street-traders, independent artisans (plumbers, gardeners, electricians, etc.) and farm shops. Surveys of labour input and income associated with underground production. In many countries underground work is considered a minor infringement of the law and thus at least some of the workers are willing to report their activities. Surveying supply of labour may provide more detail but needs careful design, involving questions that are sensitive and prone to item non-response and incorrect response. Surveys of time use. The advantage of the time use approach over labour force surveys is that it provides a framework for allocating all available time between productive and other activities. Opinion surveys. Opinion surveys of enterprises and households are used in several countries to monitor underground activities. They can be designed to take very little time to complete. They can be made non-threatening by asking respondents to give their views about general practices in an industry or sector rather than asking respondents about their own particular underground activities. Estimates of the shadow economy can also be based tax auditing, aiming to estimate the discrepancy between income declared for tax purposes and that measured by selective checks. Fiscal auditing programs have been particularly effective in this regard. Since these programs are designed to measure the amount of undeclared taxable income, they may also be used to calculate the underground economy. A disadvantage of these direct methods (surveys and tax auditing) is that they lead only to point estimates, for the period during which they were carried out. They are unable to provide estimates of the development and growth of the shadow economy over a longer period of time. But they do have the considerable advantage that they can provide detailed information about the structure and 5

6 composition of the shadow economy activities. In this respect such estimates can serve as benchmark estimates, which can be extrapolated with indicators to years for which such direct estimates are not available. Indirect, indicator methods Method based on the discrepancy between expenditure and income statistics. This approach is based on discrepancies between income and expenditure statistics. As we saw in earlier papers on GDP compilation both income and expenditure approaches to GDP should give identical results for GDP. If all the components of the expenditure side are measured without error, then this approach would indeed yield a good estimate of the scale of the underground economy. Unfortunately, however, this is not the case. Also, not all income components may be estimated. Hence, the discrepancy reflects all omissions and errors everywhere in the national accounts as well as the underground (and illegal) economic activity. These estimates may therefore be very crude and of questionable reliability. Method based on the discrepancy between the official and actual labour force. A decline in participation of the labour force in the official economy can be seen as an indication of increased activity in the shadow economy. However, differences in the rate of participation may have many other causes. Also, people can work in the shadow economy and have a job in the official economy. Therefore such estimates may be viewed as weak indicators of the size and development of the shadow economy. Methods based on currency demand. Here one assumes that underground transactions are undertaken in the form of cash payments, so as to leave no observable traces for the authorities. An increase in the size of the underground economy will therefore increase the demand for currency. Methods based on physical inputs. An example is the use of an indicator based on electricity consumption. Here we assume that electric-power consumption is one of the single best physical indicators of overall economic activity, including underground activities. This is corroborated by studies in which economic activity and electricity consumption have been empirically observed throughout the world to move in lockstep 11. By having this proxy measurement for the overall economy and then subtracting from this overall measure the estimates of official GDP, one can derive an estimate of unofficial GDP, including the illegal, underground and unobserved informal parts. As a fine-tuning of this method one may consider only household electricity consumption. Methods based on models. Indicator based methods described above are designed to estimate the size and development of the underground economy using just one indicator that is supposed to capture all effects of the underground economy. However, it is obvious that underground economy effects show up simultaneously in the production, labour, and money markets. The model approach explicitly considers multiple causes leading to the existence and growth of the underground economy, as well as the multiple effects of the underground economy over time. An example is the MIMIC (multipleindicators multiple-causes) as used in the World Bank study mentioned earlier. 11 See the paper in footnote 7 for a list of such studies. 6

7 This model is based on the statistical theory of unobserved variables, which considers multiple causes and indicators of the phenomenon to be measured, i.e. it explicitly considers multiple causes leading to the existence and growth of the shadow economy, as well as the multiple effects of the shadow economy over time. For the World Bank study mentioned earlier causal variables are: size of government, share of direct taxation, fiscal freedom, business freedom, unemployment rate, GDP per capita and government effectiveness. Indicator variables are: growth rate of GDP per capita, labor force participation rate, growth rate of labor force and currency. The first step in the MIMIC model estimation is to confirm the hypothesized relationships between the shadow economy (the latent variable) and its causes and indicators. Once the relationships are identified and the parameters estimated, the MIMIC model results are used to calculate the MIMIC index. However, this analysis provides only relative estimates, not absolute, of the size of the shadow economy. Therefore an additional procedure, benchmarking or calibration procedure, is required in order to calculate absolute values of the size of the shadow economy. Measurements of underground production Following the OECD manual, underground production can be considered as falling into two possible categories (OECD 8.33): activities that are underground because the enterprises conducting them are not registered; activities that are underground because the enterprises conducting them (although registered) under-report. Enterprises that are not registered and are engaged in legal productive activities are likely to be very small. For example, persons with a regular paid job as a plumber or teacher, who work after hours for their own profit ( moonlighters ) count as such small-scale enterprises. However, because there may be quite a large number of such enterprises, the total production of such enterprises may be quite substantial. Failure to register means that the enterprise will not be covered in any survey for which the frame is drawn from the business register. A household or mixed household-enterprise survey approach is a practical way of measuring such underground production. Estimating the effect of underreporting is difficult, since enterprises answer survey questionnaires using the same set of accounts as they prepare for tax purposes. Thus, underreporting of production and/or receipts to the taxation authorities in order to avoid taxes is likely to be reflected in the survey data submitted to the statistical office. Some overall idea of the magnitude of underreporting in specific industries may be obtained through commodity balances. The OECD manual gives the example of crop production that may be estimated from seed consumption or milk yield from estimates of forage consumed (OECD 8.37). Concluding remarks This paper set out to provide some background on the underground economy, the second NOE category we distinguished in an earlier paper. The main reason for undertaking underground activities is to avoid paying taxes. Although this is illegal, such underground activities are usually not treated as illegal activities as defined in the previous paper. Hence the underground economy should be distinguished from the illegal economy, although in practice the distinction may be difficult to make. As the World Bank study made clear, underground activities are widespread throughout the 7

8 world, and national accountant should make every effort to include them in GDP. We reviewed a number of methods that may be used to do this. In the next paper we will focus on the final major NOE category: the informal sector. There is quite a bit of overlap between the underground and informal economies; hence some of the issues covered in this paper will come back and we will have a chance to explore them some more. This pertains especially to the measurement tools. To find out more, Measuring the Non-Observed Economy, OECD 2002, Chapter 8 8