The underground economy: new estimates from household income and expenditure surveys.

• Author: Paglin, Morton
• Position: Symposium: The Informal Economy

Morton Paglin shows how a misplaced reliance on households' reported income distorts governmental assessments of the underground economy in the United States. He proposes a solution that incorporates households' reported expenditures and shows how this information can be used to formulate more rational macroeconomics and poverty policies.

This essay develops new estimates of the size of the underground economy in the United States, based on an analysis of the household reports of income and expenditures published annually in the Bureau of Labor Statistics Consumer Expenditure Survey (CES).(1) Most of the economic literature on the underground economy has focused on the information-distorting effects that unreported economic activity has on the National Income and Product Accounts (NIPA)(2) and on the macroeconomic models that use this data. This concern may be misplaced. In recent years the Bureau of Economic Analysis (BEA), which prepares the national income and product figures, has worked to incorporate a large part of underground economic activity into the NIPA totals. A less recognized deficiency is in our household income statistics, where underreporting of income, along with other factors, has undermined the validity of one of our most important social indicators: the poverty rate.

Before delving into the statistical material that constitutes the core of this Essay, I will briefly review some conceptual approaches to the underground economy. Part I presents the economist's view of the underground economy in contrast to a simple law enforcement approach. Part II, using data from the CES, examines the reluctance of some households to report income fully (or at all), compared with their willingness to report expenditures. This comparison becomes the starting point for new estimates of the underground economy, covering the years 1984 to 1992. Part III carries forward the analysis of household income and expenditures by using the individual micro-data available on public-use tapes,(3) rather than the group averages shown in the published bulletins. Because households are unwilling to report fully, if at all, the income they receive from underground activity, reported household income statistics are a deceptive indicator of poverty status; but a dual standard, employing both income and consumption expenditures, allows us to separate the truly poor from the phantom poor. Part IV uses the insights gained from the analysis of income and expenditure data in Part III to reveal the limitations and defects of the official poverty statistics derived from the Current Population Reports (CPR).(4) Finally, this Essay shows that a few simple remedial measures could mitigate the distorting effects that unreported income has on our poverty statistics, and make those statistics more truly representative of the number of persons actually living below the poverty thresholds.(5)

1. THE ECONOMIC APPROACH TO THE INFORMAL ECONOMY

   The rationale for the law enforcement approach to the underground economy is straightforward: society through its elected representatives makes decisions to tax, constrain, or prohibit certain activities; unless these laws are enforced, there will be an erosion of confidence in the political process and in the institutions of democratic government. The economic approach, on the other hand, is less resolute in its condemnation. Laws and activities are evaluated in terms of economic efficiency and welfare criteria: Are the gains greater than the losses, so that real output is increased? Are the parties in a transaction made better off with little or no negative effects on others? Viewed in these terms, some underground activities can be shown to have net benefits; whereas, in other cases, particularly the sale of illegal goods, such as drugs, the detrimental effects predominate. In general, the existence of an underground activity on a wide scale may be a useful signal that the law is not effective and should be revised or repealed.

   An economic case for justifying underground activities can be stated in terms similar to those used to justify governmental measures to eliminate market failures. Markets fail to function efficiently when externalities produce major divergences between private costs and social costs (the pollution problem, for example); when collusion among firms results in restricted output and monopoly rents; and when, because of the difficulty of collective action, a market economy produces a sub-optimal level of public goods. The government responds to these market failures by enacting antipollution laws, pursuing antitrust actions, and providing public goods financed through taxation and borrowing.

   But what remedies do we have when government itself exacerbates market imperfections by restricting competition through exclusive franchises, raising farm prices through support programs, imposing regulations that discourage employment, or maintaining expenditure levels for public goods and entitlements (with a corresponding level of taxation) that the public deems too high? An obvious remedy is political action, but given the potency of special interest groups, change through the legislative process may be slow or not forthcoming. Another remedy, which requires no political organization, is the informal market. When laws make markets less efficient by imposing economic constraints, the informal market, through unrecorded private transactions, off-the-books employment, and barter, may improve economic efficiency. However, corrective mechanisms in the underground economy, like those in the government, have their own failures. Just as government regulatory agencies that are set up to protect the consumer (such as the Interstate Commerce Commission) may end up protecting established business interests, operators in the underground economy, who illegally dump toxic wastes, increase market failure by subverting the efforts of government to control externalities.

   The rationale for the more tolerant economic approach can be shown most strikingly in countries where burdensome laws and regulations cause the informal economy to become an important economic safety valve. After World War II, governments in Ghana and other West African countries required all cocoa farmers to sell their output to the government marketing board ostensibly to stabilize prices. Instead of passing the revenue on to the farmers, the board began to skim off an increasingly large margin, leaving many producers with incomes insufficient to maintain their farms, and eventually resulting in a decline in the supply of cocoa. Instead of selling all their cocoa to the government, some farmers resorted to smuggling cocoa across the borders to take advantage of the higher market price.(6) Becoming part of the underground economy posed risks, but it was the only way some of them felt they could survive. It was a rational response to a parasitic bureaucracy, and allowed more income to flow to the producers.

   In Italy over the past thirty years, the myriad laws relating to worker management, taxation, and restrictions on business have led to the growth of a vigorous and efficient informal sector. In the view of some Italian economists, this informal sector has kept the economy functioning in the face of a corrupt, unstable, and poorly managed government.(7)

   In the United States, laws that prohibit the employment of undocumented aliens have created a large underground garment industry with entry-level jobs for immigrants with little knowledge of English. Minimum wage, maximum hour, and rent control legislation has also enlarged the extent of informal negotiations to circumvent the laws. Though many argue that minimum wage' and rent control legislation(9) protects the public interest, most economists oppose such laws and regard individual negotiations to get around the restrictions as beneficial to the parties involved.(10) Raising the minimum wage produces greater unemployment in the ranks of unskilled and inexperienced workers, while those who keep their jobs are made marginally better off at the expense of the least advantaged. Economists oppose rent control legislation because it leads to inefficient use of the housing stock, deterioration and abandonment of buildings due to poor maintenance, reduction in the supply of new rental units, and an unfair redistribution of wealth.(11) If rent control regulations are loosely enforced, landlords will seek to collect something closer to the market rent, taking payment in cash under the table. This underground economy in rent-controlled apartments, although illegal, improves economic efficiency and, arguably, the general welfare.

   A very large part of the informal sector is inextricably linked with the regular economy. The two exist side by side in firms that report most of their income, or hire mostly legal workers, and in households that report regular employment income, from which taxes are withheld, but fail to report cash income from occasional part-time work. Sometimes money derived from the sale of illegal goods (drugs mostly) is used to purchase and operate legitimate businesses; in such cases, legal and illegal activities are linked by common ownership.(12) For the economist, the central concern is not the source of the income--whether from legal or illegal activities--but whether it is reported and included in the national income accounts, in the Census Bureau's household income surveys, and in the adjusted gross income totals of the IRS. The accuracy of the statistical data on which policy evaluations and policymaking depend is threatened when a large amount of income and economic activity is unreported. Some illegal income is reported to the IRS under "other income," and some is disguised as legitimate business income, because a high level of personal expenditure with no declared income makes one a prime candidate for investigation. But undoubtedly a high percentage of...