The underground economy

Last week, the Organization for Economic Cooperation and Development in Paris issued a new report on the underground economy. This is only the latest study showing that a large fraction of employment and production in major countries as well as developing nations is taking place off the books, unrecorded in national accounts and untaxed by governments.

According to the report, the underground economy varies from 1.5 percent of gross domestic product in the United Kingdom to almost half in the Kyrgyz Republic. The OECD does not present data for the United States, but there is much data showing that it is a growing problem here, as well.

A recent book, "The Shadow Economy: An International Survey" (Cambridge University Press) by economists Friedrich Schneider and Dominik Enste, estimated the U.S. underground economy at between 6.7 percent of GDP and 13.9 percent in 1990, depending on the method used for calculation.

One common method is to look at currency in circulation as an indication of underground economic activity. By its nature, such activity is done almost entirely in cash so as to avoid detection by the authorities through checks or credit cards. On this basis, underground economic activity in the United States has probably risen sharply since 1990.

According to the Treasury Department, in 1990 there was $1,105 of currency in circulation for every American. By March of this year, that figure had risen to $2,455, an increase of 122 percent. It is highly unlikely that all of this increase is due to the needs of consumers to buy more goods and services, because per capita personal consumption expenditures only rose by 79 percent over the same period. This suggests that at least 35 percent of the increased demand for cash was for underground economic activity.

A further indication that this is the case is shown by looking at the composition of currency in circulation. Since 1990, 84 percent of the increase in currency is accounted for by $100 bills. Such bills now represent 71 percent of the monetary value of all U.S. currency, up from 52 percent in 1990. Average people do not ordinarily use $100 bills, but they are used heavily in the underground economy, which includes drug dealing and other illegal activity. Hence, it is reasonable to assume that the increased demand for $100s is due almost entirely to an increase in the underground economy.

Of course, even if this is true, it doesn't necessarily mean that the underground economy is growing here. U.S. currency is the medium of exchange of choice for underground activity worldwide. Indeed, 45 percent of U.S. currency circulates outside the United States for this reason. According to the Commerce Department, the United States "exported" $16.6 billion in currency last year, almost all of it in the form of $100 bills.

The former chief economist for the International Monetary Fund notes that the European currency, the euro, is now competing for the underground economy's business by having 500 euro notes, worth more than five times the U.S. $100, the largest bill printed by the Treasury in more than 50 years. He notes that $1 million in $100s would fit in a briefcase, but $1 million worth of 500 euro notes would fit in a purse -- a big advantage in the underground world.

The underground economy results from many factors, including criminal activity. But the bulk of it arises from ordinary businessmen and workers who are evading taxes and government regulations. The OECD downplays the importance of taxes and puts most of the responsibility on regulation. However, other studies have found that high tax rates are the most important factor in stimulating growth of the underground economy.

"In various surveys, the tax burden has always been identified as the main cause for the growth of the shadow economy," according to Schneider and Enste. Their analysis found that a 10 percentage point increase in the tax burden would cause the underground economy to rise by 3 percent of GDP. A Federal Reserve study found an even higher response, with an increase in the tax rate from 9.3 percent to 10 percent leading to a 1.5 percent rise in underground output.

A recent IMF study found that the composition of taxation was very important. High taxes on small businesses and the self-employed were most likely to lead to underground economic activity. "Raising tax rates too high drives firms into the underground economy," the study concluded.

One indication that taxes are stimulating tax evasion here is that the amount of income reported on tax returns has fallen compared to the amount of income paid as calculated by the Commerce Department. This income gap tends to rise and fall with the tax burden.

Whether caused by taxes or regulations, it is clear that government is the prime cause of the underground economy.

Bruce Bartlett is a senior fellow at the National Center for Policy Analysis, a Townhall.com member group.

Line		2001	2002
16	Equals: BEA-derived adjusted gross income	6,983.4	---
17	Adjusted gross income, IRS	6,170.6	---
18	Adjusted gross income (AGI) gap²	812.8	---

In the United States, sales and excise taxes provide the greatest incentive for the underground economy.

Excise taxes make up less than 5% of total consumption, state sales taxes are roughly the same.

Most of the incentive for the underground economy comes from the ease of evading income taxes by simply not reporting cash transactions and using barter. The incentive for doing so is tremendous, the marginal rates under current federal income/payroll tax system exceed 40% which makes not reporting that additional dollar earned under the table very attactive indeed.

Proposals to establish a National Sales Tax that is 5x greater than state tax rates will drive most people into the Black Market.

Tax Evasion: The Underground Economy

The FairTax and Tax Evasion
Opponents of the FairTax like to assert that a federal sales tax would increase tax evasion. It is more likely, however, that the FairTax would increase tax compliance while reducing compliance costs at the same time. It is impossible to argue in good faith that the current approach is doing its job since the problem is getting worse with the passage of time despite major and ever more intrusive attempts to address the problem.

***

Some of the problems regarding the underground economy that exist under the income tax would remain under the FairTax, particularly those involving cash transactions made in the illegal economy or with the explicit intent of evading taxation. However, as the costs of compliance shrink and the perceived fairness of the tax system increases, some of the hostility to the tax system will decline. People who are in noncompliance because they perceive the present system as unfair or illegitimate may choose to comply with the FairTax. Most importantly, because of lower marginal tax rates, the benefit from lawful tax avoidance or illegal tax evasion will be much less at the margin relative to either the present system[15] or competing alternative tax systems, such as the USA Tax or flat tax[16], that have higher marginal tax rates, particularly on wages or self-employment income.[17] Research has confirmed the intuitive relationship between higher marginal tax rates and higher rates of evasion.[18] Lower rates, all other things being equal, imply lower evasion because the benefits from evasion decline while the costs of evasion remain comparable.

Much is made from the fact that a federal sales tax would place the responsibility for tax collection with the retailer, a sector of the economy in which small businesses are better represented. Small businesses are viewed as more likely to evade taxes since the owner, and beneficiary of tax evasion, is more likely to also be responsible for keeping the books and filing the tax returns. While there is, of course, some truth to the proposition that evasion rates among small businesses are higher, it is highly implausible to suggest that evasion would increase under the FairTax. First, those small businesspersons that are inclined to cheat on their sales tax are probably already cheating on their income tax and would be inclined to do so under any tax system. Second, the economic importance of small firms in the retail sector is usually grossly overstated According to the Joint Committee on Taxation (JCT), small firms only account for 14.9 percent of gross receipts by all retailers, wholesalers and service providers.[19] Since the gross receipts of wholesalers would not typically be subject to tax, the true scope of the small "problem" companies is smaller still. However, sole proprietorships, perhaps the most likely to evade tax under the present system and under the FairTax, are not included in the JCT figures.

Share of Total Gross Receipt by Firms with less than $1 million of Gross Receipts[20] ($ millions, 1993)
Industry	Entity Type	Firm Sales Under $1 mil.	Firm Sales All Firms	Small Share Percent
Retail and Wholesale Trade	C Corp.	116,929	2,663,541	4.4%
Services	C Corp.	91,383	610,438	15.0
Retail and Wholesale Trade	S Corp.	358,566	959,501	37.4
Services	S Corp.	98,721	283,680	34.8
Retail and Wholesale Trade	Partnership	22,938	112,112	20.5
Services	Partnership	30,783	187,588	16.4
Total	Combined	719,319	4,816,860	14.9

Third, the necessary corollary of the tax collection point being concentrated at retail establishments, rather than with individuals or other businesses, is that there are fewer points where revenue agents must concentrate their enforcement efforts. The collection points in the FairTax system would be perhaps 10 percent of those under the current income tax system or other alternative tax systems.[21] Because the number of collection points is so much lower, if enforcement funding is held equal then the audit rate for potential evaders would increase considerably, and the likelihood of them being apprehended is correspondingly higher. In other words, the risk of detection would increase and risk-adjusted cost of evasion would increase. Increased evasion due to the greater concentration of small businesses in the retail sector would be outweighed by greater compliance due to greater simplicity and perceived legitimacy of the tax system, from reduced temptation due to lower marginal tax rates, and from higher risk of detection due to a smaller taxpayer population. Fourth, some small business owners evade taxes because they feel the present system is unfair or overly complex and burdensome, or that they have been wronged by the system. They are much less likely to feel that way about the FairTax. Fifth, and perhaps most importantly, the marginal benefit from evasion will decline under the FairTax since the marginal tax will decline. Thus, the incentive to cheat will decline markedly.

Any one of the 118 million income tax filers can cheat the income tax system today, and a great many do so. Under the FairTax, however, only retailers (about 14 million-tax filers altogether) would be in a position to cheat In addition, the vast majority of retail sales, 90 percent, are made by large firms that are less likely or find it more difficult to cheat. A retailer who cheats under the income tax system has very similar, if not the same financial gain, as a retailer who cheats under the FairTax system. If a retailer under the FairTax system, failed to report taxable sales, the government would lose and the evader would gain by an amount equal to the sales tax on the good or service purchased. In an income tax system, the government loses and the evader gains by an amount equal to the marginal income tax rate times the amount not reported. An income tax evader will see his taxable income go down dollar for dollar, for every dollar of income not reported. Typically, failing to report a small fraction of a business' gross income will be sufficient to drive its reported profit to zero.

Even if, however, we were to make the unlikely assumption that evasion rates would be higher under the FairTax system than under an income tax system, they would have to be much higher to justify the income tax's huge compliance costs (estimated to be over $225 billion in 1996), many of which are incurred by businesses and are deductible as a business expense. Moreover, if compliance proved to be a problem, information reporting along the lines of present law (1099's) could be implemented to facilitate cross-checking by government auditors. These 1099s would reflect the quantity of product sold to retailers. An auditor could then ensure that the retailer's books either reflected a sale of these products or that the products were in inventory. The FairTax requires all businesses (including non-retailers) to keep business records kept in the ordinary course of business that would aid cross checking by government auditors.[22]

Conclusion
Tax evasion will undoubtedly be a problem under any tax system. It is a major and growing problem under the current tax system, despite very substantial efforts and increasingly harsh treatment of the taxpaying public. Almost 40 percent of the public, according to the IRS, is out of compliance with the present tax system, mostly unintentionally due to the enormous complexity of the present system. This breeds disrespect for the tax system and the law, and makes a system based on taxpayer self-assessment less and less viable.

The FairTax is likely to reduce rather than exacerbate the problem of tax evasion. The increased fairness, transparency, and legitimacy of the system will induce more compliance. The roughly 85 to 90 percent reduction in filers will enable tax administrators to address instances of noncompliance more effectively, and increase the likelihood that tax evasion will be discovered. The relative simplicity of the FairTax will promote compliance. Businesses will need to answer one question to determine the tax due: how much was sold to consumers? Finally, the dramatic reduction in marginal tax rates will reduce the gains from tax evasion. If the cost of noncompliance remains comparable (or even increases due to the increased likelihood of getting caught caused by the much smaller number of filers), then both the expected profit from and frequency of tax evasion will decline

I am shocked, shocked to find that people are evading a high sales tax!

Just as they are evading even higher income/payroll tax rates.

The electorate's tolerance for ever higher rates on sales taxes is substantially less than when those same rates are pushed behind the scenes as business income and payroll taxes.

One of the virtues of a retail sales tax or any excise is that it tends to be self limiting because of visibility, much more so than corporate taxes which like VATs tend to get hidden from view.

That my friend is a good thing.

Federalist #21:

"Imposts, excises, and, in general, all duties upon articles of consumption, may be compared to a fluid, which will, in time, find its level with the means of paying them. The amount to be contributed by each citizen will in a degree be at his own option, and can be regulated by an attention to his resources. The rich may be extravagant, the poor can be frugal; and private oppression may always be avoided by a judicious selection of objects proper for such impositions. "

"It is a signal advantage of taxes on articles of consumption that they contain in their own nature a security against excess.
They prescribe their own limit, which cannot be exceeded without defeating the end proposed - that is, an extension of the revenue."
When applied to this object, the saying is as just as it is witty that, "in political arithmetic, two and two do not always make four."
If duties are too high, they lessen the consumption; the collection is eluded; and the product to the treasury is not so great as when they are confined within proper and moderate bounds.
This forms a complete barrier against any material oppression of the citizens by taxes of this class, and is itself a natural limitation of the power of imposing them.

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National Income and Product Accounts Table
Table 7.19. Comparison of Personal Income in the National Income and Product Accounts with Adjusted Gross Income as Published by the Internal Revenue Service [Billions of dollars]
Today is: 5/13/04 Last Revised on May 7, 2004

National Income and Product Accounts Table