Exhaustiveness, part 2 Illegal Economy 1

Exhaustiveness, part 2 Illegal 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. The previous paper set out to provide some general background to the role of exhaustiveness in GDP compilation. We highlighted 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. 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 the previous paper as well, where we distinguished the following NOE categories: 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 first category, illegal activities, making up what is known as the illegal economy. What is meant by the illegal economy? SNA observes that Illegal actions that have the characteristics of transactions should be treated the same way as legal actions (SNA 3.96). The main characteristic of such illegal transactions is that there is mutual agreement between the parties involved in the transaction. Hence, illegal activities where the parties are willing partners in the economic transaction should be included in the production boundary and illegal activities where either of the parties are not willing participants are not economic transactions and so are not included in the production boundary. This criterion would include prostitution and the sale of drugs, but exclude theft. 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:http://circa.europa.eu/irc/dsis/snabuildingthebasics/info/data/website/index.html 2 Henceforth called the Handbook ; this paper is based on the second (2012) edition; it can be found at the following link: http://epp.eurostat.ec.europa.eu/portal/page/portal/product_details/publication?p_product_code=ks-ra-12-001 1

If the production or consumption of illegal goods (such as narcotics) or services (such as prostitution) were to be left out of the national accounts on grounds of (ethical or religious) principle, household saving would be overestimated and households presumed to obtain assets that they do not in fact acquire. Clearly, the accounts as a whole are liable to be seriously distorted if monetary transactions that in fact take place are excluded. It may be difficult, or even impossible, to obtain data about illegal transactions, but in principle they should be included in the accounts if only to reduce error in other items, including balancing items (SNA 3.96). The situation is different for illegal transactions in which one of the parties is not a willing participant. For example, theft is a form of externality in which damage is inflicted on another institutional unit deliberately and not merely accidentally or casually (SNA 3.97). SNA defines an externality as an economic action carried out by an institutional unit that cause changes in the condition or circumstances of other units without their consent (SNA 3.92). Such an externality can be regarded as an unsolicited service, delivered without the agreement of the units affected. It is an uncooperative action, usually with undesirable consequences, which is the opposite of a market transaction (SNA 3.51). Thus, thefts of goods from households are not treated as transactions and estimated values are not recorded for them under household expenditures. If thefts, or acts of violence (including war), involve significant destruction of assets, it is necessary to take them into account. In SNA they are treated as other flows, which are changes in the value of assets and liabilities that do not result from transactions (SNA 3.99). Other examples of such other flows are uncompensated seizures of assets and natural events such as earthquakes. The entries for other flows appear in one of the two accounts that comprise the other changes in assets accounts 3 : the other changes in the volume of assets account, which includes changes that lead to a change in value of an asset because of a change in the quantity or physical characteristics of the asset in question; The revaluation account, which includes changes in the value of assets, liabilities, and net worth due to only changes in the level and structure of prices, which are reflected in holding gains and losses. According to SNA there are two kinds of illegal production (SNA 6.43): The production of goods or services whose sale, distribution or possession is forbidden by law; examples are the manufacture and distribution of narcotics, illegal transportation in the form of smuggling of goods and of people, and services such as prostitution; Production activities that are usually legal but become illegal when carried out by unauthorized producers; for example, unlicensed medical practitioners. As SNA makes clear, both kinds of illegal production are included within the production boundary of the SNA provided they are genuine production processes whose outputs consist of goods or services for which there is an effective market demand. The units that purchase smuggled goods, for example, may not be involved in any kind of illegal activities and may not even be aware that the other party to the transaction is behaving illegally. 3 See paper 6, Introduction to the SNA 2008 Accounts, part 3: Accumulation Accounts 2

Transactions in which illegal goods or services are bought and sold need to be recorded not simply to obtain comprehensive measures of production and consumption but also to prevent errors appearing elsewhere in the accounts (SNA 6.45). The incomes generated by illegal production may be disposed of legally. Vice versa, expenditures on illegal goods and services may be made out of funds obtained legally. The failure to record illegal transactions may lead to significant errors within the accounts if the consequences of the activity are recorded in, for example, the financial account and the external accounts, but not in the production and income accounts. Therefore, if illegal activities fall inside the production boundary, they must be included in national accounts estimates. This can be done, for example, by expanding the volume of recorded (legal) activity by mark-ups for the unrecorded elements. Details depend largely on the specific circumstances of national law and data sources. However, for practical reasons and due to a lack of data, illegal activities are not included in the national accounts estimates of many countries. Eurostat on their website mentions the following illegal activities 4 : 1. Production of drugs; 2. Smuggling; 3. Prostitution; 4. Unlicensed gambling; 5. Re-production of copyrighted material. National accountants are usually most interested in the first three types, and little attention has been given to the others 5. We will examine these three types in the next sections in somewhat more detail. Narcotics The production and trafficking of drugs is illegal in all countries. But since drugs are no different from any other product we can include it in the regular national accounts framework by focussing on the usual aggregates such as domestic production (gross output), imports, exports and final consumption. In terms of economic activities we should distinguish between drugs trade (trafficking) and drugs production. Drugs can be imported or produced locally. If produced locally, some or most of it may be exported. If imported, most or all can go to final consumption, or some of it may be reexported. In this latter case, the country may serve for the transit of drugs. Due to the illegal nature of these activities data related to production and trafficking of drugs and drugs consumption are difficult to obtain 6. Estimates usually rely on administrative information from police, customs or ministries (in form of reports or expert opinions), reports from health/welfare or specific drug institutions, research reports, information from drug assistance or other non-profit organisations, or international research projects. Important information can also be from 4 http://epp.eurostat.ec.europa.eu/portal/page/portal/national_accounts/documents/faq_na_1.pdf 5 In fact the OECD Handbook on the Non-observed Economy gives many more examples (9.8 9.11) 6 Examples of compilation practices can be found in the following two studies: The illegal economy in the Netherlands, Statistics Netherlands, August 2005 (http://www.cbs.nl/nr/rdonlyres/3c62d796- A06D-4DBC-9F18-CC2045CD41BB/0/200505X10pub.pdf) Illegal activities in the Swedish National Accounts, Statistics Sweden, 2008 (http://www.scb.se/statistik/nr/nr0102/ Illegal%20activities.pdf) The models discussed in this section are based on these reports. The next two sections are also based on these reports. 3

international sources. An example is the annual report by the United Nations Office on Drugs and Crime (UNODC) 7. It provides information on individual countries but also gives some recent background information on the drugs market and enables a comparison of national estimates with other countries to be made. Even if data are available, it may be problematic to fit them in the national accounts framework. Data may differ in numerous aspects (e.g. population covered, periods covered, type of drug users covered) and may be difficult to compare or to combine. Typical indicators based on these data sources are the number of addicts in relation to the population, the amounts and rates of drug seizures by types of drugs and purity, street and wholesale prices, number of people that are in the drug addiction treatment facilities, kinds and doses of drugs in use, etc. Estimation of the national accounts aggregates usually takes place on the basis of a model. We can distinguish between supply side models and demand side models. Supply side models focus on production and supply, demand side models on consumption and use. Demand side estimates can be made independently of the supply side and when both estimates are available balancing procedures can be used to come to a final estimate. Estimates are usually made separately for different types of drugs, such as cannabis, heroin, cocaine, amphetamines and ecstasy. Sometimes a distinction is made between heavy abuse users (daily use) and other abuse users (more incidental use). Let us first model the trafficking of drugs. We assume that all drugs are consumed by households. Direct imports of drugs by households are not taken into account or considered negligible. The value of expenditures on drugs can be estimated with average street prices and is allocated to household final consumption expenditure (HFCE): Expenditure = Quantity consumed x average street price = HFCE In order to calculate the quantity consumed we may use data on the number of drug users and the average daily dose. Due to dilution the imported quantity can be different from the quantity consumed for certain drugs. A purity factor indicates the average dilution of "pure" drugs before putting them on the market: Import Quantity = Quantity consumed / purity factor The import value can be estimated with an average "wholesale" prices of the drugs: Imports = Import Quantity x average wholesale price Output is the trade margin achieved by the trafficker for drugs sold to households: Gross Output = Trade Margin = Sales Imports 7 http://www.unodc.org/unodc/en/about-unodc/annual-report.html?ref=menutop 4

Intermediate consumption (IC) of traffickers consists of costs for transport and storage. This needs to be estimated on the basis of expert estimates, Gross value added (GVA) is then obtained as: GVA = Trade Margin IC Drug traffickers are usually considered to be self-employed. For the transition from GDP to GNI the crucial question is which part of the generated GVA is attributed to resident and which to nonresident units. The non-resident part will be transferred abroad and should be recorded as property income paid to the rest of the world. The estimate of the non-resident share is usually based on expert estimates. It needs to be investigated carefully to what extent these flows are already included in existing balance of payments flows. Next, let us model the domestic production of drugs. The quantity of a specific drug produced on the domestic territory needs to be estimated first, e.g. as a share of total domestic consumption or as an independent estimate. Output is then estimated with average street prices: Gross Output = Quantity produced x average street price. Output is sold to households only. In some cases a part of domestic production may be exported. The intermediate consumption for drug production needs to be estimated as a share in output, and is usually based on expert opinion. GVA is then obtained as: GVA = Gross Output IC. Total GVA for drugs is the sum of GVA from trafficking and domestic production. The preference is generally for a demand side based approach, focusing on the consumption of drugs. A supply side based approach, based on quantities seized by law enforcement authorities, is considered as potentially too instable. The seizure quota can vary sharply over the years and is dependent on many external factors (e.g. customs strategy and priorities, customs equipment and staff numbers, strategy of drug traffickers). In case seizures are used it is recommended to use longer time series to determine average seizure quotas under similar conditions. However, at least for benchmark years it is recommended to confront the results from the demand side with supply side estimates. Prostitution For prostitution services there is the complicating factor that prostitution, at least in certain forms, is legal in many countries. Of course there is a clear requirement to include these legal prostitution services in national accounts estimates. On the other hand, all prostitution services that do not fulfill the characteristics of an economic transaction, i.e. are performed without mutual agreement, have to be excluded from the measurement. Standard data sources, such as administrative records (e.g. tax, social security) or business surveys are likely not to provide reliable data on the activity, even for the legal part, as respondents are prone to respond conforming to moral standards rather than economic reality. However, in many countries at least some data sources are usually available. In most cases these are ad hoc studies on the subject or irregular reports by police, government institutions or welfare organisations.. As in the 5

case of drugs, the data sources available usually do not fit national accounts purposes as such but can be used as basis for further estimates. We can again distinguish supply side models, focussing of the services provided by prostitutes, from demand side models, focusing on the expenditures on prostitution by consumers. Estimates based on the supply of prostitution services generally seem to be more suitable for national accounts estimates. Starting point for GVA compilation is an estimate of the number of prostitutes in the country. Depending on the specific situation in the country and available data sources this should be broken down by different types of prostitution services, such as Street, individuals working; Hotels, escort services, advertising; High-end prostitution. In some countries it could be useful to further differentiate between legal and illegal prostitution. For each type of prostitution the average number of contacts per prostitute per period should be estimated in order to achieve the total number of contacts. Estimates on the average prices for the different types of prostitution seem to be relatively easily available. With this information output can be calculated: Gross output = Sales = Number prostitutes x Number contacts per prostitute x Price Intermediate consumption is relevant for some types of the prostitution activity, e.g. rental payments and payments to owners of brothels. GVA is then obtained as: GVA = Sales IC Prostitutes are generally considered as self-employed. The prostitution services could be offered by residents and by non-residents, i.e. prostitutes working for less than one year and not repeatedly in the country. The share of non-resident prostitutes needs to be estimated. Only the output and GVA of the residents has to be recorded: Resident Sales = Share of residents x Sales Resident GVA = Share of residents x GVA We assume that all prostitution services are consumed by households. No relevant amounts appears in IC of enterprises. The Resident Sales can be purchases by resident households or non-resident households. The share R consumed by non-resident households (tourists) needs to be estimated. This estimate can be based on expert estimates or specific studies. Exports can then be estimated as: Resident Sales x R = Sales to non-resident HH = Export Household final consumption expenditure can be estimated as: Resident Sales x (1-R) = Sales to resident HH =HFCE 6

One further element that could be relevant for some countries are purchases of prostitution services from non-resident prostitutes on the domestic territory and as tourists abroad. The element of expenditure as tourists abroad is in theory already included in the tourism balance. The corresponding amount should be included in HFCE and imports (IM) and as such does not impact GDP. Therefore, it is not necessary to separately identify this item for the national accounts. For the transition from GDP to GNI the question is which part of the generated GVA and income is finally attributed to non-residents and transferred abroad. The part transferred abroad should be recorded as property income paid to the rest of the world. An estimate of the transferred share can be based on expert estimates or specific studies. A reasonable approximation might be to use the share of foreign prostitutes. Also, it needs to be investigated to what extent these flows are already included in existing balance of payments flows. As consumption patterns are relatively stable an extrapolation of a benchmark year result for a number of years is generally acceptable. Smuggling of alcohol and tobacco Smuggling is defined as the illegal import or export of goods which are legal products in themselves. The incentive for smuggling alcohol and tobacco products usually derives from high price differences due to import duties or excise taxes. For tobacco, there can be legal domestic production by tobacco companies, in which case there may be legal exports as well. If not produced domestically, tobacco products need to be imported. If price differences between domestic and foreign products are sufficiently high there may be incentive for illegal imports, illegal exports and illegal transit trade. For alcoholic beverages the same situation applies, with the important difference that ( underground ) production may be undertaken by households as well, reducing the incentive for illegal imports. The basic model for smuggling of alcohol and tobacco products can be derived in a similar manner as shown earlier for narcotics and prostitution. The contraband goods illegally cross the border, i.e. without or with wrong declarations to the authorities. This always involves a change of ownership for the smuggled goods between non-residents and residents. Up to the border this is exports by the exporting country, after the border it is imports: Exports = Quantity x Price(fob); Imports = Quantity x Price(fob) The export/import price can be approximated with the wholesale price of the relevant good in the exporting country. Any transit of contraband through a country is excluded from export/import figures. We assume that the smuggled goods are only sold to resident households and exclude that part of the smuggled goods that enter the legal distribution chain (retail sales or hotels and restaurants). The sales value of smuggled goods is then attributed to household final consumption expenditure: Sales = Quantity x Price(sale) = HFCE The average sales prices of smuggled alcohol or tobacco products need to be estimated. Expert estimates can be used to determine this average price. The output consists only of the trade margin achieved for the smuggled goods: 7

Output = Trade Margin = Sales Imports Intermediate consumption of smugglers consists of transport and storage. The share of IC needs to be estimated on basis of expert estimates and information from similar activities. GVA is then derived as: GVA = Trade Margin IC For the transition from GDP to GNI the question is which part of the generated GVA is attributed to resident and which to non-resident units. The non-resident part will be transferred abroad and should be recorded as property income paid to the rest of the world. For countries with illegal production of alcohol or tobacco products the standard requirements, as for other hidden production, apply. GVA generated by this production and possibly a trade margin need to be estimated. For countries with relevant export of contraband the related trade margin (up to the border) needs to be estimated. Concluding remarks This paper set out to provide some background on the illegal economy, the first NOE category we distinguished in the previous paper. We examined three particular types of illegal activities: narcotics, prostitution and smuggling of alcohol and tobacco. In each case we showed how national accounts aggregates such as output, gross value added, imports, exports and household final consumption expenditures can be obtained, thus enabling the (exhaustiveness improving) inclusion of the illegal sector into the GDP by output and by expenditures approach frameworks reviewed in earlier papers. In the next papers we will focus on the other NOE categories: the underground sector and the informal sector. To find out more, Measuring the Non-Observed Economy, OECD 2002, Chapter 9 8