The Underground Economy

Individuals and firms sometimes conceal the buying and selling of goods and services.

What Is Underground Economy?

Economists have termed this concealed buying and selling as underground economy, in which case their production won’t be counted in GDP Opens in new window.

The underground economy (sometimes referred to as the cash economy, black economy or shadow economy) is the buying and selling of goods and services that is concealed from the government to avoid taxes or regulations or because the goods and services are illegal.

Individuals and firms conceal what they buy and sell for three basic reasons:

How the Underground Economy Hurts Developing Countries

Estimates of the underground economy in Australia range widely, between 1.5 percent and 14 percent of measured GDP.

However, the underground economy in some developing countries may be more than 50 percent of measured.

In developing countries the underground economy is often referred to as the informal sector, as opposed to the formal sector, in which output of goods and services is measured.

Although it might not seem to matter whether production of goods and services is measured and included in GDP or unmeasured, a large informal sector can be a sign of government policies that are retarding economic growth.

Because firms in the informal sectors are acting illegally they tend to be smaller and have less capital than firms acting legally.

The entrepreneurs Opens in new window who start firms in the informal sector may be afraid the government could someday close or confiscate their firms. Therefore, the entrepreneurs limit their investments in these firms.

As a consequence, workers in these firms have less machinery and equipment to work with and so can produce fewer goods and services.

Entrepreneurs in the informal sector also have to pay the costs of avoiding government authorities.

For example, construction firms operating in the informal sector in Brazil have to employ lookouts who can warn workers to hide when government inspectors come around.

In many countries, firms in the informal sector have to pay substantial bribes to government officials to remain in business.

The informal sector is large in some developing economies because taxes are high and government regulations are extensive.

For example, firms in Brazil pay 85 percent of all taxes collected, as compared with around 20 percent in Australia. Not surprisingly, about half of all Brazilian workers are employed in the informal sector.

In Zimbabwe and Peru the fraction of workers in the informal sector may be as high as 60 percent or 70 percent.

One estimate put the size of the informal sector in India at nearly 50 percent.

Many economists believe taxes in developing countries are so high because these countries are attempting to pay for government sectors that are as large relative to their economies as the government sectors of industrial economies.

Bringing firms into the formal sector from the informal sector may require reductions in government spending and taxes.

In most developing countries, however, voters are reluctant to see government services reduced.