- The Washington Times - Friday, November 27, 2009

ANALYSIS/OPINION:

The prospect of higher taxes, more regulation, continued high unemployment, and growing distrust of government is a recipe for a surge in the underground economy. (The underground economy has also been called subterranean, irregular, submerged, off-the-books, informal, parallel, hidden, unrecorded and shadow, among other appellations.)

Its inhabitants - individuals and businesses - range from criminals and illegal immigrants to self-employed professionals and ordinary people struggling to survive.

By eluding the tentacles of government, the unrecorded sector operates more like a free market than the above-board economy. Income is unreported and untaxed, and restrictions such as license requirements, permits, minimum wages and union rules are ignored. Competition is relatively unimpeded with business done largely in cash. Barter is not uncommon.

Unpaid taxes enable employers in the underground economy not only to survive, even thrive, but also to share tax savings with their customers through lower prices and with their workers through higher wages. This, in turn, puts more competitive, albeit unfair, pressure on legitimate businesses.

When workers in the regular economy become unemployed because of legislated increases in the minimum wage, they can often find jobs off the books in the underground economy at a sub-minimum wage, enabling them to gain the experience that leads to better wages in the future.

When times are hard, like now, more American job seekers are willing to accept low wages. This can displace some illegal immigrant workers.

The underground economy makes no pretence of being fair. Hundreds of billions of dollars in tax revenue are lost annually (the tax gap), with much of the burden shifted to honest taxpayers. With less revenue, the federal deficit increases, and there is more of a temptation for policymakers to inflate the economy and cheapen the dollar.

Because the underground economy is hard to measure, economists rely on indirect assessment techniques, such as tracking currency flows. Estimates are that the unrecorded economy is equal in size to something between 5 percent and 25 percent of our nation’s measured gross product, with 10 percent considered not unreasonable.

Growth in the underground economy is not just short term or cyclical. According to a study by the International Monetary Fund, the unrecorded economy in America has been expanding for a generation, more than doubling as a percentage of the measured economy since 1970.

A large and growing unrecorded sector can play havoc with key economic indicators, causing understatement of the level, and errors in the rate of change, of measured output, income, savings and jobs data - statistics that policymakers use to steer the overall economy.

Policy errors owing to misleading data can result in incomplete economic recovery from recessions and unanticipated inflation in periods of expansion, among other consequences.

The Federal Reserve itself has shown concern about the potential for error. According to an article in the Federal Reserve Bank of St. Louis Review: “It … is probable that the volume of such [underground] transactions have been expanding faster than the volume of recorded transactions…. As a result, economic policies [based on incompletely recorded transactions] are more apt to exacerbate inflation than if all activities were reported.”

An article in the Federal Reserve Bank of Philadelphia Business Reviewdiscussed the situation in which there is a recession in the reported economy accompanied by an expansion in the underground economy. “Observing the recession in the reported economy, policymakers become convinced that the economy is quite weak, and implement countercyclical policies to promote recovery. However, since the total economy is stronger than reported figures indicate, countercyclical policies … may only serve to increase inflationary pressures in the total economy.”

The threat of a growing shadow economy is not peculiar to America. According to University of Linz economist Friedrich Schneider, the underground economy in Germany, a high-tax country, could rise sharply this year, along with similar increases in Spain, Italy and Britain. The sharper the recession, warns Mr. Schneider, the more the underground economy will expand.

In the current U.S. labor market recession, which promises to stretch out for years, the prospect of a ballooning underground economy waves a red flag. Hard-pressed taxpayers and the unemployed are becoming angry and impatient. They bristle at government bailouts of businesses that continue to hand out huge salaries and stock options. They read daily about colossal government fraud and waste, pork barrel spending, and deception. They feel cheated and consequently become more willing to cheat on their own taxes. Earlier in the decade the Internal Revenue Service reported the results of a survey showing that an increasing number of Americans felt that tax cheating was acceptable.

How do we avoid a potential crisis of escalating underground activity? Perceptions are important, and for starters we should curtail big-bucks handouts to Wall Street and hand-picked businesses.

Dealing with the labor market recession is crucial, and that means doing something more effective than dishing out more “stimulus” payments in an effort to jump-start new jobs. The better alternative would be to lower payroll taxes immediately and put new or higher taxes of any sort on hold.

Alfred Tella is former Georgetown University research professor of economics.

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