Europe's Underground Economies

Brief Analyses | Economy | International

No. 278
Friday, September 04, 1998
by Bruce Bartlett

The underground economy also known as the second economy, parallel economy, unofficial economy, informal economy or just the black market is a phenomenon known throughout the world. It exists wherever governments excessively tax or unreasonably regulate economic activity. Although the underground economy also includes criminal activity, such as drug dealing, the overwhelming bulk of it consists of the provision of ordinary goods and services that in other times and other places would be perfectly legal and legitimate.

The growth of the underground economy is a matter of increasing concern throughout Europe. An unpublished report by the European Union says that underground economic activity may account for between 7 percent and 16 percent of the total gross domestic product (GDP) of its member nations, employing between 10 million and 28 million workers and accounting for between 7 and 19 percent of employment. The problem is especially acute in transitional economies in Eastern Europe, but is growing everywhere.

Great Britain. The underground economy has been a hot topic in Great Britain ever since 1979, when Sir William Pile, chairman of the British Revenue Board, said "it was not implausible" that untaxed earnings equaled 7.5 percent of GDP. This led academics to try measuring the underground economy by various methods. The American economist Edgar Feige thought Sir William was half right and put the true figure at closer to 15 percent of GDP in 1979.

Last year, a study by the accounting firm of Deloitte & Touche figured that the underground economy amounted to 12 percent of Britain's GDP and reduced income tax revenues by one-third. The latest study, by Austrian economist Friedrich Schneider of Johannes Kepler University in Linz, put the underground economy in Britain at 12.4 percent of gross national product (GNP) in 1994. [ See Figure I. ]

Italy. Twenty years ago Fiat Chairman Giovanni Agnelli reckoned that Italy's true output was 25 percent larger than official figures indicated, due to the vast amount of off-the-books economic activity. Academic estimates generally supported Mr. Agnelli's guesstimate. By 1987, economist Mario Deaglio of the University of Turin put Italy's underground economy at a minimum of 15 percent of GNP and a maximum of 25 percent.

Bolstered by such studies, the Italian government raised its official GNP statistics by 15 percent to account for all the unrecorded economic activity. This caused an uproar in Britain, since the recalculation propelled Italy ahead of it to become the world's fifth largest economy. But whatever the truth statistically, there is no doubt that tax evasion in Italy is pervasive. Even luminaries such as fashion designer Giorgio Armani have admitted to bribing tax officials for favorable audits.

Germany. It is tempting to blame Italy's large underground economy on the traditional Italian contempt for authority. But even Germany, with its long tradition of law obedience, has faced growing problems with tax evasion and illicit economic activity. In 1986 Heinrich Franke, head of West Germany's Labor Office, said the underground economy had risen to 10 percent of GNP, employing between 100,000 and 600,000 people. Lost revenues equaled DM 50 billion, or twice the federal deficit that year.

The problem of tax evasion in Germany appears to have escalated in the 1990s. In 1993 the government imposed a new tax on investment income that greatly increased the incentive to hide such income in accounts in Luxembourg and Switzerland. As a consequence, the government took in less than half the revenue it anticipated from the new tax. Recently, a number of senior officials at Germany's largest banks were implicated in tax evasion activities, and the government instituted payments for tax informants, despite widespread misgivings by civil libertarians. An August 1997 poll found 46 percent of Germans agreeing with the statement that "those who don't cheat on taxes deserve only pity."

Not surprisingly, problems with the underground economy and tax evasion escalate as one moves to Europe's periphery. In Spain, one-third of those officially classified as unemployed are thought to be employed in underground economic activities. In Portugal, several top government officials have been forced to resign in recent years after being caught evading taxes. Greece's efforts to crack down on tax evasion have led to nationwide strikes.

Russia and Eastern Europe. However, as Figure II shows, the largest underground economies of the area unquestionably exist in the formerly Communist countries. In Russia a U.S. Treasury-sponsored study put the underground economy at close to 50 percent of official GDP. Tax evasion is so rampant that it has caused a financial crisis for the central government. Similar problems exist in almost every former Soviet republic, including Ukraine, Georgia and Moldova. The situation is little better in the former Communist Bloc. A 1996 study by the prime minister's office in Hungary found that 17 percent to 25 percent of the average family's expenditures were in the black market. Earlier this year, Serbia demanded that all property and vehicle sales be transacted through the banks, in an effort to stamp out cash-only sales in the underground economy.

There does not appear to be a single country in Europe in which the underground economy is not a large and growing problem. Although the authorities frequently attack the problem with arrests and prosecutions, the incentive to make money free of tax or government control is too great for such methods to have more than a modest impact. In the end, successful efforts to reduce the underground economy must involve tax reduction, deregulation, privatization and other market-oriented measures.

This Brief Analysis was prepared by NCPA Senior Fellow Bruce Bartlett.

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