The Shadow Economy – A Critical Analysis

TABLE OF CONTENTS

EXECUTIVE SUMMARY

TABLE OF CONTENTS

LIST OF ABBREVIATIONS

LIST OF FIGURES

1 INTRODUCTION

2 WHAT IS THE SHADOW ECONOMY
2.1 An Approach to Define the Shadow Economy
2.2 Theoretical Explanatory Models
2.2.1 Model of time allocation
2.2.2 Model of tax evasion

3 MAIN CAUSES FOR THE SHADOW ECONOMY
3.1 Increase of Tax and Social Security Contribution Burdens
3.2 Density of Governmental Regulations
3.3 Unemployment and Reduction of Official Working Hours
3.4 Subjective Perception of Tax and Social Security Contributions burden
3.5 Tax Morale

4 EFFECTS OF THE SHADOW ECONOMY

5 THE DIMENSION OF THE SHADOW ECONOMY
5.1 Methods to Estimate the Size of the Shadow Economy
5.1.1 Direct approaches
5.1.1.1 Sample surveys
5.1.1.2 Tax audit method
5.1.2 Indirect approaches
5.1.2.1 Discrepancy between national expenditure and income statistics
5.1.2.2 Discrepancy between official and actual labour force
5.1.2.3 The transactions approach
5.1.2.4 The currency demand approach
5.1.2.5 The physical input (electricity consumption) method
5.1.3 The model approach
5.2 The Size of the Shadow Economy in the 21 OECD Countries
5.3 The Size of the Shadow Economy in Germany

6 MEASURE FOR LIMITING THE SHADOW ECONOMY
6.1 Cost-benefit Analysis of Combating Black Economy in Germany by Stricter State Control
6.2 General Economic Policy Recommendations
6.2.1 Reduction of tax and social security burdens
6.2.2 Reduction of density of regulations
6.2.3 Allocation of transfer payments
6.2.4 Consolidation of the public sector

7 CONCLUSION

BIBLIOGRAPHY

ITM-CHECKLIST

EXECUTIVE SUMMARY

According to the “Focus” magazine approximately 13 million Germans contributed to the shadow economy in 2006! The estimations of Friedrich Schneider, one distinguished expert in this area, showed that the extent of the shadow economy in Germany in 2007 was about 349 billion Euros, which equals to 14.7 percent of Germany’s gross domestic product (GDP)!

The scope of the present assignment is to provide an all-embracing and critical overview of the shadow economy, to introduce the main causes, effects and dimensions of the shadow economy and to find answer the question how shadow activities can be limited.

In this context the hidden sector can be defined as all economic activities that are not recorded in the national accounts, but normally should be a part of them and be included in GDP. These actions can be on the one hand absolutely legal in the self-sufficient economy like do-it-your-self, neighbourhood help, but on the other hand completely illegal activities like dealing with drugs and smuggling as well as legal activities, which are illegally being carried out, e.g. tax evasion or illicit work.

The main and most vital reasons for the existence and constant growth of the shadow economy are high taxes or social security contributions burden and the intensity of state regulations. But also sociological-psychological causes like subjective perception of tax burden, falling society values, a bad tax morale and declining loyalty towards the state can have a tremendous impact on the size of the hidden economy.

But is the shadow economy a threat to the official sector? At first glance, the question whether the shadow economy is dangerous might appear strange. However, there are several controversial opinions about this matter. The analysis of the effects caused by the existence and the growth of the shadow economy is a contradictory topic. The present assignment characterizes the main negative, e.g. distortion of official economic statistics, lower tax revenues and positive effects, e.g. price stabilization, creation of new jobs of the shadow economy and their influence on the national economy.

Following this, the study presents the most popular methods of measuring the shadow economy: direct methods that are mostly based on surveys, the indirect ones that attempt to quantify shadow economic activities by seeking traces left in the official sector and the so-called model approach, which tries to determine the hidden economy by correlating different indicators and statistical variables. Based on the currency demand approach the study provides an overview about the extent of the shadow economy in 21 OECD countries and in Germany.

How to limit the size of the shadow economy? It is suggested to combat its causes throughout reforms of the tax and social security systems and the deregulation of markets instead of acting against the symptoms by punitive measures, intensified controls and stricter labour regulations.

In summary, the shadow economy has become an inseparable subsystem of the official sector with high growth rates of five to seven percent. It has evolved into an important economic factor and has doubtlessly a significant influence on every sector of the national economy. The shadow economy should be considered as a necessary evil and its extent as an indicator of governmental success or failure in economic policy. Hence, the shadow economy must be taken into account by policy makers in their decision making with regards to the official sector.

LIST OF ABBREVIATIONS

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LIST OF FIGURES

Fig. 1: Classification of the shadow economy

Fig. 2: Time allocation

Fig. 3: Main causes of the increase of the shadow economy

Fig. 4: Willingness to work illicitly, evade taxes and abuse the system in % of people polled

Fig. 5: The tax morale as an influencing factor for the rise of the shadow economy

Fig. 6: Estimation methods

Fig. 7: Size of the shadow economy in the 21 OECD countries

Fig. 8:Deployment of the shadow economy in the 21 OECD countries from 2000 up to 2008

Fig. 9: Historical development of the shadow economy in Germany

Fig. 10: Segmentation of the shadow economy in Germany in 2008

Fig. 11: Segmentation of the shadow economy in Germany in 2008 into the building sector and the trade and repair business

Fig. 12: Cost-value ratio of the abetment of the shadow economy in Germany

Fig. 13: General economic policy recommendations

1 INTRODUCTION

Shadow economic and do-it-yourself activities are widely spread and can be observed around the world having a tremendous impact on the official economy. It has reached a magnitude, which makes it an inevitable and considerable economic factor posing a challenge for every government¹. Institutional failure, high taxation and market regulations are alleged to be the main reasons for individuals working on the black economy².

Consequently, the interest in determine the very causes and the estimation of the size of the shadow economy and related activities have become a scientific ferventness in order to assess the unknown³.

While the official economy remains static the shadow economy is booming. During the last years the black economy has become a growth industry in Germany with constant growth rates of five to seven percent. The size of the shadow economy in Germany has reached almost 350 billion Euros, which equals to 15 percent of its gross domestic product. It is assumed that more than 13 million people are earning their money on the black economy⁴.

Although crucial information on the size of the shadow economy and the effects of the informal sector on the official economy are available, most governments still try to control those activities through education, punishment and prosecution with just little success.

Therefore, the following assignment has two major goals. The first is to provide an all- embracing overview over the topic shadow economy and to critically analyse the causes for the existence of the underground economy. Moreover different scientific approaches how to measure its size will be elaborated in due course. The second is to censoriously discuss measures to limit the shadow economical activities. In doing so, the authors try to address the German case.

At this point it should be mentioned that the current assignment can only provide a small insight into the wide field of research of the shadow economy. For further information please see the latest publications and research by Schneider⁵.

This study consists of seven chapters. After this introduction chapter two deals with the difficult matter of finding a general definition for the shadow economy by applying different explanatory models.

Part three determines the basic reasons for the existence of the shadow economy. The following chapter elaborates on the different economic effects of the black economy on the official sector, both positive and negative.

Chapter five provides different theoretical approaches to measure the black economy. Based on the currency demand approach estimated results for a large set of OECD countries are being presented. In a second step detailed data on the German case is being presented.

Part six tries to give an answer to the question how the shadow economy can be contained and reduced, providing promising approaches. The conclusion in chapter seven summarizes all findings and will give the finishing touch to the assignment.

2 WHAT IS THE SHADOW ECONOMY

A variety of names have been created by the English scientific landscape to describe the shadow economy or parts of it using terms like underground economy, hidden, parallel, invisible, black, grey economies, moonlighting or illicit work. A significant number of terms used to characterize the aspects of the shadow economy are also evident in the literature in other languages⁶.

Most scientists dealing with the problem of the shadow economy are facing big difficulty in defining it. The following chapter aims to introduce some of the commonly used definitions of this phenomenon as well as to show the main causes and effects of the shadow economy.

2.1 An Approach to Define the Shadow Economy

According to Skolka the shadow economy consists of “(i) Production of goods that is quite legal in itself, but that one or more parties involved try to conceal from the public authorities to avoid paying taxes or similar charges; (ii) production of illegal goods and services; and (iii) concealed income in kind”⁷.

Broadly speaking, the shadow economy can be defined as umbrella term for all economic activities that are not recorded in the national accounts for certain reasons but normally should be a part of them and be accounted for in GDP⁸.

As shown in figure one, the shadow economy includes absolutely legal activities in the self-sufficient economy like do-it-your-self, neighbourhood help, but also completely illegal activities like prostitution, dealing with drugs and smuggling as well as legal activities, which are illegally being carried out, e.g. tax evasion or illicit work.

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Fig. 1: Classification of the shadow economy (cf. Schneider et al. 2002, p. 12)

The main focus of the present study lies on the illegally carried out legal activities like illicit work (moonlighting), offering illegal employment as well as the evasion of taxes and social security contributions.

2.2 Theoretical Explanatory Models

In the present paragraph two popular explanatory models are introduced trying to explain the micro-economical theoretical reasons why people act in the shadow economy. The authors of the study will present the theory of time allocation and the model of tax evasion.

2.2.1 Model of time allocation

Why do people engage in the shadow economy? The theory of the allocation of time elaborated 1965 by the American scientist Gary Becker considers time as a scarce good. As shown in figure two, an individual makes a decision about an effective distribution of time to be spending either working or with leisure time.

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Fig. 2: Time allocation (cf. Schneider et al. 2002, p. 17)

In case the job opportunities in the official sector are not attractive any more for an individual it can decide to spend more time in leisure and to abandon earning money. If an individual is not ready to abandon a higher income, it will start to work in the underground economy - resulting in less free time but more money. Another conclusion is that employees with shorter length of working time have more preparedness to act in the underground economy than people who work overtime⁹.

2.2.2 Model of tax evasion

The second approach, which explains activities in the shadow economy and analyses tax evasion behaviour, is the theory of tax evasion. The theory assumes that the individual’s decision whether to avoid paying taxes or not is rest upon a rational cost-benefit calculation. According to this theoretical model, tax evasion has potential benefits and costs. Saving money by evading taxes is such a potential benefit. On the other hand, there are also other potential costs like the risk of being spotted and punished or even arrested.

It is supposed that the taxpayers weight up the costs of evasion, i.e. the risk to be caught against the saving of money. The higher the potential benefits and the lower the risk of detection, the more probably a taxpayer will attempt to evade taxes¹⁰.

3 MAIN CAUSES FOR THE SHADOW ECONOMY

The existence and the development of the shadow economy are caused by various factors that can be partially explained based on the theoretical considerations described in the previous chapter. The most cited and doubtlessly important factors are the increase of tax and social security contributions burden, the raise of the number of governmental regulation in the official sector as well as the reduction of the length of working time. A high unemployment rate and the decrease of people’s income levels and wealth also contribute to the black economy¹¹.

But also sociological-psychological causes like subjective perception of tax and social security contributions, a bad tax morale caused by the changes in society’s values and a declining loyalty towards the state or the so-called snowball effect (if nearly everyone does it, why can not I do it also?) are responsible for the growth of shadow economical activities. The sociological-psychological approach, while analyzing the factors influencing the increase of the shadow economy is absolutely necessary, as economic factors alone can only partly explain the growth¹².

The results of 15 empirical studies are shown in figure three confirming that the increase of tax burden, the intensity of state regulations and falling tax morale are the three main driving forces into the shadow economy.

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Fig. 3: Main causes of the increase of the shadow economy (cf. Schneider 2006a, p. 14)

In the following the authors will give a brief overview of some of the above mentioned influencing factors.

3.1 Increase of Tax and Social Security Contribution Burdens

According to most studies on the shadow economy the increase of tax and social security contributions burden is, not surprisingly, one of the main causes for the growth of the informal sector since taxes distort the decision between labour and leisure time.

The bigger the discrepancy between the labour costs in the official sector and the aftertax income of employees, the bigger is the employees’ motivation to compensate a loss of income by working in the shadow economy or evading taxes. Since the size of the total labour costs is mainly determined by the costly social security system and the growing tax burden, they can be considered as key factors for the existence and the increase of the shadow economy¹³.

How to combat tax evasion and illicit work caused by constantly increasing tax and social security contributions burden? A possible solution could be to reform the taxation system and to decrease the tax level. The lower the tax level, the lower the willingness of people to engage in the shadow economy or to hide their earnings. A frequent opinion is that tax reductions can lead to increased tax revenues and more employment in the official economy (for a detailed analysis see chapter six)¹⁴.

3.2 Density of Governmental Regulations

The higher the intensity of state regulations, the larger the sizes of the shadow economy! The density of state regulations, especially of labour regulations, is another important factor held responsible for the growth of shadow economical activities.

The density of regulations can be measured by the amount of labour market regulations, wage laws, trade barriers or working restrictions for foreigners. State regulations minimize the freedom of choice and lead to a significant increase of ancillary labour costs. As major components of these costs are shifted onto employees, it motivates individuals who work in the official sector to engage in the shadow economy, where these costs can be avoided.

Governmental regulations as well as state interventions on the economy, e.g. in forms of price dictates or controls, opening hours laws or master craftsmen’s diploma, provide also a strong incentive for companies to act illegally¹⁵.

Studies of Johnson, Kaufmann and Schleifer (1997) and Friedman, Johnson, Kaufmann, Zoido-Lobaton (1999) as well as empirical analysis supporting these studies show that countries with a higher density of economical regulation usually have a bigger share of the shadow economy in the total GDP¹⁶. The increasing number of state regulations is the main reason for the burden placed on companies and individuals dragging people into the underground economy.

The results of the studies intimate that the state should pay more attention to the improving enforcement of laws and regulations, rather than increasing their numbers¹⁷.

3.3 Unemployment and Reduction of Official Working Hours

Based on the model of time allocation described in chapter 2.2 one can conclude that the reduction in working time as well as unemployment or the possibility of early retirement creates free time for an engagement in the unofficial sector. Also part-time jobs, which are usually paid badly, are putting individuals into a position, where they have to earn additional money by adapting to a second job in the untaxed unofficial economy.

Several attempts to reduce the official length of working time made by German Labour Unions or the introduction of underpaid part-time jobs by the German state in order to downsize the unemployment missed their aim. The idea behind these attempts was to redistribute the work, which amount is limited.

However, several empirical researches showed that these measures just lead to more unofficial activities. Individuals can decide much too easy to spend their additional free time by working in the underground economy¹⁸.

3.4 Subjective Perception of Tax and Social Security Contributions burden

According to several scientists’ opinions (Lamnek, Olbrich, Schäfer) the perception of the tax and social security contributions burden is one reason for tax evasion and illegal labour activities. Surveys with respect to this topic showed that about two-third of Germany’s population regards the tax burden as to high. This subjective perception of insufferable burden can easily lead to illicit work and tax evasion¹⁹.

[...]

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¹ Cf. Schneider and Enste 2002, p. 178.

² Cf. Bovi 2002, p. 2.

³ Cf. Torgler and Schneider 2007, p. 2.

⁴ Cf. Schäfer 2004, p. 2.

⁵ Cf. Department of Economics 2008, p. 1.

⁶ Cf. Smith 1986, p. 6.

⁷ Skolka 1987, p. 35.

⁸ Cf. Smith 1986, p. 6-9.

⁹ Cf. Schneider and Enste 2002, p. 67.

¹⁰ Cf. Smith 1986, p. 25-28.

¹¹ Cf. Enste and Schneider 2000, p. 83.

¹² Cf. ebd., p. 77.

¹³ Cf. Enste and Schneider 2000, p. 83.

¹⁴ Cf. Mitchell 2003, p. 83.

¹⁵ Cf. Bühn et al. 2007, p. 10.

¹⁶ Cf. Enste and Schneider 2000, p. 86.

¹⁷ Cf. Schneider 2000, p. 20-21.

¹⁸ Cf. Enste and Schneider 2000, p. 87.

¹⁹ Cf. Schneider and Enste 2002, p. 93.