NCPA - National Center for Policy Analysis


August 26, 2004

The gray economy consists of legal activities whose participants fail to pay taxes or comply with regulations. This informal sector has costs for both the economy and the country. An article in the Economist details these costs.

According to observers, the size of the underground economy is substantial:

  • In 2000, the gray economy was equivalent to 41 percent of developing countries gross domestic product (GDP).
  • In Brazil and Turkey, around half of non-farm workers are in the informal sector.
  • In rich nations, the share of the informal economy was lower, but far from negligible, at 18 percent.

Why do informal economies exist? There are many advantages to operating outside of the legal sphere. First, there are no income taxes to pay. Avoiding social security taxes fattens both employers' profits and employees' paychecks. Companies can also save a significant amount by ignoring safety, environmental, and health rules, not to mention intellectual property rights.

However, gray economies do cause problems. Companies outside the legal economy cannot afford to grow too large and reap the benefit of economies of scale. As a result some industries, especially labor-intensive ones, such as retailing, stay fragmented and inefficient.

Observers note that formalizing the informal sector would be profitable. Doing so would boost Portugal's productivity growth by 0.8 percentage points and Brazil's by 1.5 percentage points. Brazil's construction industry would gain because it would not need to employ lookouts to tell unregistered workers to scatter when government inspectors turn up.

Source: "In the Shadows," Economist, June 17th, 2004.


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