NCPA - National Center for Policy Analysis

The Growing Underground Economy

July 13, 1998

Internal Revenue Service Commissioner Charles Rossotti recently estimated that the federal government is losing $195 billion per year in revenue due to the failure of people to report income and pay taxes on it. Other data show the substantial growth of the so-called underground economy -- economic activity that is illegal, or unreported to avoid taxes, that isn't included in gross domestic product.

An indirect way to measure its size is to compare income reported to the IRS with other measures of income, such as Commerce Department calculations of adjusted gross income (AGI) from sources such as total wages paid by corporations and total interest paid by banks.

In 1995 it is estimated that Americans failed to report $630 billion in AGI on their tax returns. That year they paid 14 percent of their AGI in federal income taxes (see figure).

  • Assuming they would have paid the same rate on their unreported income, this suggests that the federal government lost at least $88 billion in individual income taxes alone in 1995.
  • If that income were taxed at 22 percent (the average marginal tax rate for all taxpayers), the revenue loss rises to $139 billion.
  • Unreported income has risen from 10.1 percent of AGI in 1988 to 13.1 percent in 1995.

This may well be a response to the higher tax rates that were enacted in 1990 and 1993. As tax rates rise, hiding income becomes more profitable. Conversely, lower tax rates such as those enacted in 1986 reduce evasion because the cost of reporting one's true income is lower.

Source: Bruce Bartlett (senior fellow, National Center for Policy Analysis), "The Underground Economy," Brief Analysis No. 273, July 13, 1998, National Center for Policy Analysis, 12770 Coit Rd., Suite 800, Dallas, Texas 75240, (972) 386-6272.


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