Unwrapping the Depth of the Underground Economy Around the World

by Sultan Muhammad Raditya Sadek

UNDERGROUND ECONOMY

The underground economy is a complex system of transactions that take place outside of official channels, where goods and services are traded for cash without being reported to the government or other regulatory bodies. This shadow economy includes unreported income, barter, and unauthorised activities, such as tax evasion, money laundering, and smuggling. The underground economy operates on a large scale and has significant consequences for economic growth, social equity, and political stability. This article provides an overview of the underground economy, its causes and consequences, and the challenges associated with measuring its size and regulating its activities. It also discusses the policy implications of the underground economy and the need for innovative solutions to address its negative effects. 

The underground economy involves the exchange of goods and services that are hidden from official view and not reported to the government, making them beyond the reach of tax collectors and regulators. The underground economy can be divided into two broad categories: the unreported production and trade of legal goods and services, and the production of illegal goods and services. Examples of legal activities in the underground economy include unreported income from self-employment or barter, while illegal activities include drug dealing, trade in stolen goods, smuggling, illegal gambling, and fraud. Other examples of underground economic activity include the untaxed sale of physical goods and the smuggling of goods into a country to avoid paying duties at the border. The size of the underground economy is difficult to accurately gauge because it is not subject to governmental oversight and does not generate tax returns or appear in official statistical reports. The underground economy is also known as the shadow economy, the black market, and the informal economy. 

EFFECTS

The underground economy can have such significant effects on the formal economy, such as :

1.  Revenue losses for the government : The presence of a large underground economy is a source of considerable revenue losses for the government and can significantly affect public finances.

2. Reduced tax revenues : Transactions in the underground economy directly reduce federal, state, and local tax revenues. The government cannot collect income tax, sales tax, or excise duty because the markets are not regulated.

3.   Distorted economic measurements : Because transactions made in the underground economy go unreported, the distort the accuracy of key economic measurements, such as a nation's gross domestic product (GDP).

4. Unfair competition: The underground economy can create unfair competition for legitimate business that are subject to regulations and taxes.

Overall, the underground economy can have negative effects on the formal economy, including reduced tax revenues (we would get into this later), distorted economic measurements, unfair competition, reduced consumer protection, and increased crime rates.

It has been seen as a common activity in the world of underground economy. Tax evasion is an activity where individuals and businesses avoid paying taxes by hiding their activities and income from government agencies. The underground economy is difficult to measure, making it challenging to estimate the amount of tax revenue lost due to tax evasion. Tax evasion can take many forms, including failing to report income, claiming false deductions, and hiding assets in offshore accounts. 

As we can see in the chart, United States of America has the highest rate for tax loss, losing nearly almost $350 billion. Tax evasion can be deliberate or inadvertent and is distinct from tax avoidance. Deliberate evasion occurs when individuals do not report income or do not pay taxes, while unintentional mistakes made in filing tax returns can also give rise to inadvertent tax evasion. 

MONEY LAUNDRING

As we can see in the chart, United States of America has the highest rate for tax loss, losing nearly almost $350 billion. Tax evasion can be deliberate or inadvertent and is distinct from tax avoidance. Deliberate evasion occurs when individuals do not report income or do not pay taxes, while unintentional mistakes made in filing tax returns can also give rise to inadvertent tax evasion. 

The process of laundering money typically involves three steps: placement, layering, and integration. Placement surreptitiously injects the "dirty money" into the legitimate financial system, layering conceals the source of the funds through a series into the legitimate financial system layering conceals the source of the funds through a series of transactions and bookkeeping tricks, and integration combines the laundered funds with legitimate funds. There are several red flags to look out for that may point to money laundering, including suspicious or secretive behavior by an individual around financial transactions.

An example of a real life situation of money laundering are :

1. Using a legitimate, cash-based business owned by a criminal organization: For example, if the organization owns a restaurant, it might inflate the daily cash receipts to funnel illegal cash through the restaurant and into the restaurant's bank account

2. Real estate laundering: Someone could purchase a piece of real estate property with cash, and quickly sell it. Any profits made would be associated with the sale and are completely legal.

3. Trade-based laundering: This typically involves altering invoices or business documents in order to disguise dirty money as business profits. Because the money has a paper trail, the bank does not suspect the profits as "dirty" 

Note that these examples are not exhaustive, and money laundering methods vary endlessly.

SMUGGLING

Smuggling is a form of illicit trafficking that occurs in the shadow economy. As we talked about it before, it is a type of activity which encompasses a range of activities that are not reported to the government for tax or regulatory purposes. Why can it be hidden from the government? Types of items are regularly smuggled ranging from watches, to drugs, arms, and illegal immigrants, even exotic animals. Smugglers take advantage of people who need to escape natural disasters, poverty, conflict, and crises and they often recruit people from the same community or ethnic group as the migrants they are smuggling. Smugglers use various methods to avoid detection by authorities, such as using false documents, disguising themselves as legitimate travelers, using remote or less guarded border crossings, bribing officials, or using sophisticated technology to evade detection. 

It is difficult to determine the most smuggled country as smuggling involves a range of goods and activities, and accurate statistics are often difficult to obtain. However, some countries are known to have high rates of human smuggling, such as Eritrea, Turkey, Iraq, and Mexico. Additionally, some countries are known to be major producers and traffickers of drugs, such as Afghanistan, which is the biggest producer of opium worldwide and remains the most significant trafficking country. 

Furthermore, the shadow economy is a complex and constantly changing phenomenon that encompasses a range of activities. It can facilitate smuggling and open up possibilities for arbitrage in smuggles goods. Smuggling can also support wider illegal activity, such as drug dealing, human trafficking, and money laundering, and could even conceivably support terrorist activities. 

Recent changes in ways of working and business models, the growth of the digital economy, wider social changes, and globalization are causing new shadow economy activities to emerge and some existing ones to expand in scale or scope. While the shadow economy can have some positive impact, for instance providing employment opportunities, the negative effect wider aspect in the economy, such as undermining tax revenues, and creating new societal problems for the public. It is important for governments and policymakers to understand the nature and scope of the shadow economy and to develop effective strategies to address its negative impacts. 

References :

Nemec, Daniel, Eva Kotlnov, Igor Kotln, and Zuzana Machov. (2021) Corruption, Taxation and the Impact on the Shadow Economy. Economies 9: 18.

Adamoli, Sabrina. "money laundering". Encyclopedia Britannica, 25 May. 2023, https://www.britannica.com/topic/money-laundering. Accessed 29 May 2023.

UNODC, Global Study on Smuggling of Migrants (2018) (United Nations publication, Sales No. E.18.IV.9)

Friedrich, S. and Dominik, E. (2022) Hiding in the shadows : The Growth of the Underground Economy

Anna, E. and Ekaterina, N. (2015) Impact of Shadow Economy on Quality of Life : Indicators and Model Selection