View Point
October 28, 2005
Focus on the underground economy

This year, the month of October is being featured throughout the OECS as Financial Literacy month, and this week “Viewpoint” has chosen to place the spotlight on the Underground Economy.

The informal, shadow, parallel or underground economy are terms which seek to define the same phenomenon, that is, unreported income from the production of goods and services emanating from activities that are legal or illegal. These are settled either through monetary or barter transactions. Hence, the shadow economy comprises all economic activities that would normally be taxable, had they been reported to the tax authorities.{{more}}

Estimating the shadow economy is difficult, but policy makers and government administrators need information about how many people are active in the shadow economy, how often the underground activities occur and the size of these activities so they can make appropriate decisions on resource allocation.

Participation in the shadow labour market includes all cases where employees or employers, or both, hold a shadow economy position, producing for the market regardless of whether they also have officially recorded positions. Some workers in the shadow economy take on second jobs often or even during their regular working hours in official employment.

Others work in the shadow economy because they find it more profitable to do so, or because they are barred from the official economy as in the case of illegal immigrants.

Research has shown that among the factors driving the size and growth of the shadow economy are an increasing burden of tax and social security payments, combined with rising restrictions in the official labour market.

In some countries, people are highly mobile between the official and the shadow economy, and as wages in the official economy rise, they would work less in the shadow economy. It is also the case where people perceive the tax base to be high; an increase in the marginal tax rate will lead to a reduction in the tax revenue.

Empirical studies are still inconclusive as to how an increase in the shadow economy affects economic growth. According to some the shadow economy depresses growth of GDP. They contend that shrinking the shadow economy will increase tax revenue, stimulating a rise in public spending, especially on infrastructure and services that support production expansion, leading to a rise in the overall growth rate. The contrary view is that the informal sector is more competitive and efficient than the formal sector and hence an increase in the shadow economy will stimulate overall economic growth.

Certainly, empirical studies have shown that at least two-thirds of the increase earned in the shadow economy is quickly spent in the official economy and this viewpoint supports the thesis that a balance growth in the shadow economy makes a positive contribution to overall growth in the economy.

Nevertheless, the introduction of certain economic reforms could further accelerate growth by attracting to the formal sector activities that were formally in the informal sector.

Growth in mainland China has benefited over the past two decades from the economic reforms introduced by the government but there was a major contributory factor, which should be instructive for us in the OECS. Although capital accumulation – growth in the country’s stock of capital assets such as factories, manufacturing machinery and communications systems – was important, a sharp sustained increase in productivity (that is increased worker efficiency) was the driving force behind the economic boom.

If the observation that the level of efficiency in our informal sector is higher than in many areas of the formal sector, then our economies could stand to benefit from accelerated growth, with a transfer of the informal economy culture to that of the formal economy in the years ahead.