The Shadow Economy.

• Author: FLEMING, MATTHEW H.

"Implicit in much of the literature on the shadow economy is the view that shadowy activity is undesirable ... However, it is not certain that all shadow economic activity should be discouraged."

In seeking to understand the size of the world economy, we are usually guided by official statistics on output, trade and investment. But there is a driving force in today's world market that has, hitherto, rarely been recognized for its tremendous economic impact. It is what we will refer to as the shadowy economy. Its oversight in the calculus of the influences on the international economy is due to the statistical opaqueness that is part and parcel of criminal and informal transactions.

Economic activity that falls outside the purview of government accounting is known by various names: shadow, informal, hidden, black, underground, gray clandestine, illegal and parallel.(1) Implicit in each, save for informal, is that these economic activities include conscious efforts to avoid official detection. Indeed, some unrecorded activities, such as the drug trade, are illicit. Some activities, such as day labor, however, are legal but may include an illicit component, such as unrecorded payments. Still others, such as household production, are wholly legal. Finally, it may be that unrecorded activities occur in a sector of the economy that is simply unregulated, rather than illicit.

As these nuances indicate, simply defining the shadow economy is a challenge. Although most authors agree that it is a "fuzzy concept,"(2) the notion that activity in the shadow economy has important implications for the official economy is essentially unchallenged.(3) Despite decades of study on the issue from an empirical and historical point of view,(4) little agreement has been reached on the fundamental constructs that underlie the shadow economy.

The lack of consensus in formulating a unified theory of the shadow economy, or even a precise definition of the components that comprise it, suggests that important questions remain unanswered. To what extent does the exclusion of shadow economic activity distort official estimates of macroeconomic variables, including output, employment and inflation? What are the policy ramifications of these exclusions? What is the distribution of shadow economic behavior between unrecorded, but legal, and illicit activities? Can the overall size of the shadow economy be estimated, and is it changing over time? Do countries at different stages of development possess different types of hidden economies? What is the relationship between regulatory (in)efficiency and the size of the shadow economy?

This paper gives an overview of issues relating to these questions. We begin by discussing definitions of shadow economic activity and why the study of the shadow economy is important. We then review methodologies employed in the estimation of the size of shadow economies and present size estimates for several transition, developing and developed countries. We conclude with thoughts for future research.

DEFINITIONS

Unquestionably, the shadow economy represents some form of unofficial economy. However, there is extensive disagreement regarding the definition of the term. To some extent, the shadow economy is a "(pre)concept in search of a theory,"(5) and differences in the definitions of the shadow economy stem from differing research objectives, such as estimating the size of the shadow economy or explaining the motives for shadow economy participation. In general, there are two approaches to defining the shadow economy The first considers shadow economic activity as simply unrecorded economic activity (the definitional approach), while the second defines the shadow economy in terms of behavioral characteristics--its economic activity therein (the behavioral approach). The former is descriptive while the latter provides underpinnings of a theoretical explanation for shadow economic activity. As a result, the components included in these definitions are necessarily somewhat inconsistent.

A sampling of definitions illustrates these two approaches. Thomas notes that it is "difficult to provide a formal definition" of the shadow economy and suggests that it "covers those activities which ... are not recorded in the national income accounts."(6) Schneider and Enste define the shadow economy in a similar manner as "all economic activities which contribute to the officially calculated (or observed) gross national product."(7) Bhattacharyya argues that the hidden economy is best described as unrecorded national income, "calculated as the difference between the `potential' national income for the given currency in circulation and the recorded national income."(8) Smith defines this sector as "market-based production of goods and services, whether legal or illegal, which escapes detection in the official estimates of GDP."(9)

The alternative approach finds that shadow economic activities are best defined with respect to the particular behavioral characteristics of the activities in question. Feige reports that the distinguishing feature between official economic activity and informal (shadow) activity is:

whether the activity adheres to the established, prevailing institutional rules of the game.... Adherence to the established rules constitutes participation in the formal economy ... whereas noncompliance or circumvention of the established rules constitutes participation in the informal economy.(10) Feige adds an important caveat that is generally omitted from other definitions: "The characteristics of each distinct informal economy are determined by the particular set of institutional rules that its members circumvent." He notes that institutional rules cause members of the formal sector to "confront a different set of ... transaction costs than those faced by members of the informal sector."(11) Loayza expands on the argument by drawing on a definition used by Portes et al and states that the informal economy is "unregulated by the institutions of society, in a legal and social environment in which similar activities are regulated."(12) His suggestion is that the shadow economy feeds off "an excessive regulatory system [that] makes the formal economy unattractive."(13) Both Loayza and Feige argue that institutional constraints lead to the formulation of the shadow economy. In extreme terms, de Soto claims that the shadow economy that comes about as "[t]he traditional centralism of our society has proven clearly incapable of satisfying the manifold needs of a country in transition."(14) Overall, participation in the shadow economy can be seen as an explicit change in behavior by economic actors in response to institutional constraints.

Both the definitional and behavioral approaches divide the shadow economy into four broadly comparable components: the criminal, irregular, household, and informal sectors. The criminal sector is defined as illegally produced goods and services, such as the production and trade of illicit narcotics. The irregular sector is defined as legally produced goods and services which evade legal reporting requirements, such as tax evasion. The household sector is defined as household production. And the informal sector is defined as "economic activities that circumvent the costs and are excluded from the benefits"(15) of law, such as unregulated microenterprise.(16)

It is possible to combine the descriptive and behavioral approaches to create a definition with shared principles. Definitions of the shadow economy that include all four components, under the rubric of exclusion from official estimates of national income or output, appear to most accurately describe the shadow economy Definitions that relate economic activities to regulatory compliance begin to provide theoretical descriptions of economic behavior. The two definitions have only subtle differences, related to whether the definition is used as a basis for formulating an estimate of the size of the shadow economy (descriptive) or as an explanation for why shadow activity occurs (behavioral). The underlying theoretical basis for both approaches appears to be rather weak, so neither definition yet has substantial predictive powers.

THE IMPORTANCE OF STUDYING THE SHADOW ECONOMY

Why, then, should we be concerned about the shadow economy? Should we care if transactions occur in the shadow economy rather than the official economy? Tanzi notes that "there cannot be any question that the underground economy is a real phenomenon with important implications that deserve attention and study"(17) Of greatest concern is that this activity is unrecorded, and, as such, official national income accounts statistics do not accurately represent the true state of a nation's economy. Given that these statistics are employed to generate economic policies, inaccurate figures may lead to inappropriate policy responses.

At the same time, the emergence and growth of the shadow economy can also suggest that current policies are misguided. Indeed, the presence of an active shadow economy often suggests that existing economic policies, such as tax or regulatory policies, are overly burdensome or oppressive. Moreover, the shadow economy; which is untaxable, reduces potential state revenue. Finally; while some shadow economic activity is clearly undesirable, such as illicit trade in narcotics, much of it is generally constructive. It may provide basic needs, including income, for example, to consumers in developing countries. Therefore, it is difficult to arrive at an overall comprehensive assessment of the impact of the shadow economy on economic growth and development. The following sections discuss measurement difficulties, policy implications, and the normative impact of shadow economic activity

WHY THE SHADOW ECONOMY NEEDS MEASUREMENT

As noted above, the shadow economy is essentially unrecorded, so official national accounts statistics inaccurately...