The definition and meaning of the black economy, also called the underground economy, the shadow economy, the hidden economy, or the informal sector, involves business dealings that are untraceable and therefore untaxable. These dealings do not form part of a country’s official GDP (gross domestic product). The black economy is a cash-based system in which transaction records are either never kept or registered in secret account books, often referred to as ‘number two’ accounts.
Even though the black economy represents a considerable portion of incomes in developing nations, it is frequently stigmatized as unmanageable and troublesome. However, for people at the bottom of the socioeconomic ladder, it provides critical economic opportunities.
The Economist makes the following comment regarding the black economy:
“If you pay your cleaner or builder in cash, or for some reason neglect to tell the taxman that you were paid for a service rendered, you participate in the black or underground economy. Such transactions do not normally show up in the figures for GDP, so the black economy may mean that a country is much richer than the official data suggest.”
In the black economy, all transactions are done with cash. None of the income is declared. No taxes are paid. It is a shadow economy.
Black economy larger than in 1960s
Over the past fifty years it has been expanding, and as such, integrating the black economy into the formal sector is a challenge that most governments in the emerging economies are pursuing.
In repressive or anti-free market regimes, such as Cuba, North Korea, or the old Soviet Union, it is/was a survival practice for millions of citizens.
In many cases, black markets emerge when the government restricts an economic activity for specific products and services or pushes up taxes on them significantly.
During the US prohibition of 1920 to 1933, when the sale of alcoholic beverages was illegal, the black economy in that sector was huge. In the UK, where taxes on cigarettes are extremely high, the tobacco black market is enormous.
Criminal business activities such as drug pushing, illegal weapons sales, and human trafficking occur within the black economy. However, that does not mean that all black economy activities are criminal. A 13-year-old boy selling chewing gum at the traffic lights in Mexico City is working in the black economy – but his activity is not criminal.
A study carried out by Imperial College London estimated “that business activities conducted by informal entrepreneurs can make up more than 80 per cent of the total economic activity in developing countries.”
If I need a gardener and pay a man $100 to mow the lawn and prune some hedges and trees, the transaction would be part of the black economy if he does not declare that income. Gardening is not illegal, but charging for the work without declaring that income is. It is the non-payment of taxes that classifies the activity as part of the black economy.
USA black economy
There have been several estimates regarding the shadow economy of the United States. Some have included criminal activities while others have not.
Economist Friedrich Schneider, from Johannes Kepler University of Linz, Austria, carried out a comprehensive study and estimated that the US black economy represented 7.2% of GDP in 2007. His estimate did not include criminal activity such as drug dealing, weapons trading, prostitution, etc.
According to Prof. Schneider, since 1999 the trend in the OECD, including the USA, was a shrinking shadow economy. Several studies have shown that since the global financial crisis of 2007/8 and the Great Recession that followed, the trend has reversed.
According to the Federal Reserve Bank of St. Louis, the black economy is very hard to measure. It says there are several direct approaches – surveys, tax audits and other compliance methods – and indirect approaches – discrepancies between national expenditure and income statistics, discrepancies between the official and actual labor force, monitoring transactions, analyzing currency demand, and tracking electricity consumption.
Regarding monitoring electricity consumption, the Federal Reserve Bank of St. Louis wrote:
“This method assumes that electricity consumption is the best physical indicator of both formal and informal economic activity. It has been observed that the electricity/GDP elasticity is usually close to 1.8 So, by using electricity as a proxy for the overall economic activity and then subtracting from it the official estimates of GDP, we get an indicator of informal economic activity.”
“The difference between the growth of electricity consumption and official GDP is then attributed to the growth of the informal economy.”
Joshue Zumbrun, writing in Bloomberg in 2013, quoted economists who estimated that from 18% to 19% of US income was not reported to the Internal Revenue service. They estimated that $2 trillion of undeclared income gave rise to an annual tax gap of between $450 billion and $500 billion.
According to Inequality.org, in the state of California, the largest economy in the United States and the eighth biggest globally, between 15% and 17% of the labor force works in the black economy and generates from $60 billion to $140 billion annually in economic productivity. This means that the state is losing from $8.5 billion to $28 billion in personal, corporate, and sales and use taxes.
“Those who toil in the underground economy generally perform un- or semi-skilled labor, often with little opportunity for advancement, at significantly lower wages than those formally employed.”
“Moreover, they often rely on public assistance, in the form of food stamps and emergency room medical care, to subsidize this lesser pay. In many instances, workers receive wages for only a portion of the hours they worked in a given week, while others are paid on a piece rate basis—as low as $15 for a 10-hour workday hanging drywall.”
UK black economy
In the UK in 2012, the black economy was estimated to be worth £150 billion annually, according to a study carried out by the Institute for Economic Affairs, a free-market think tank. While the figure may appear huge, the authors pointed out that as a proportion of GDP, it is much lower than in most other advanced economies.
In 2012, the UK black economy was worth 10% of national income, half the level of Spain, Greece and Italy.
The study found that the average for the 34 developed nations in the OECD (Organization for Economic Cooperation and Development) was 13.4%.
According to the authors – economists Friedrich Schneider and Colin Williams – the most important factor determining the size of the black economy was the tax and benefits system. Much of this informal employment in the UK was blamed on the loss of benefits and tax credits for low-paid workers as their incomes rose.
The authors wrote:
“A reduction in the tax burden is therefore likely to lead to a reduction in the size of the shadow economy. Indeed, a virtuous circle can be created of lower tax rates, less shadow work, higher tax morale, a higher tax take and the opportunity for lower rates. Of course, a vicious circle in the other direction can also be created.”
“Given this relationship, the high level of non-wage costs (averaging 39% of total labor costs) and the penalty on individuals who move from earning one third to two thirds of the median wage (averaging 58% of the increase in earnings for a one-earner couple) in the European Union should be a matter of real concern.”
“The latter figure is 79% in the UK and thus low-paid UK workers have a huge incentive to supplement their incomes in the shadow economy.”
Video – What is the underground economy?
This video explains in easy-to-understand terms what the underground economy is.