NCPA - National Center for Policy Analysis

THE UNDERGROUND ECONOMY

July 14, 2004

A recent book, "The Shadow Economy: An International Survey," (Cambridge University Press) by economists Friedrich Schneider and Dominik Enste, estimated the U.S. underground economy at between 6.7 percent and 13.9 percent of gross domestic product in 1990, depending on the method used for calculation.

The underground economy results from many factors, including criminal activity. But mostly it arises from ordinary businessmen and workers who are evading taxes and government regulations. In various surveys, the tax burden has always been identified as the main cause for the growth of the shadow economy, according to Schneider and Enste:

  • Their analysis found that a 10-percentage point increase in the tax burden would cause the underground economy to rise by 3 percent of GDP.
  • A Federal Reserve study found an even higher response, with an increase in the tax rate from 9.3 percent to 10 percent (which is a smaller rise) leading to a 1.5 percent rise in underground output.

A recent IMF study found that the composition of taxation was very important; high taxes on small businesses and the self-employed were most likely to lead to underground economic activity. One indication that taxes are stimulating tax evasion in the United States is that the amount of income reported on tax returns has fallen compared to the amount of income paid as calculated by the Commerce Department. This income gap tends to rise and fall with the tax burden. Raising tax rates too high drives firms into the underground economy, the study concluded.

Source: Bruce Bartlett, "The Underground Economy," National Center for Policy Analysis, July 14, 2004.

 

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