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Iran's Underground Economy

September 08, 2003
Middle East Economic Survey
By Jahangir Amuzegar

In the following article for MEES, Jahangir Amuzegar, a distinguished economist and former member of the IMF Executive Board, analyzes Iran's underground economy.

A highly distinctive feature of Iran's Islamic Republic is the relatively large size of its underground economy. Alternately called informal, parallel, unofficial, unregistered, gray, and a host of other labels, the underground economy refers to activities - both lawful and unlawful - that elude taxation or escape registration in the country's gross domestic product (GDP). The size of any country's underground economy normally depends on the burden and complexity of its tax system, the severity of its penal code, the enforceability of its financial regulations, and its society's tolerance for official corruption.

Iran is not alone in this dualism. But what sets the Iranian case apart from most others is that its underground economy is not an aberration, but a natural offshoot of its "Islamic" ideology and its unique political structure. It reflects a symbiotic relationship between the ruling theocratic oligarchs and their business supporters in the bazaar. Unlike the case in advanced liberal democracies where such unregistered activities are closely watched and the unlawful segment diligently dealt with, Iran's politico-judicial authorities knowingly or otherwise spawn and nurture them by either tolerating or only selectively punishing some of their glaring indiscretions. And, while often widely reported in the press, and publicly deplored by all political factions, these activities have rarely been seriously scrutinized or sufficiently exposed due to the power and influence of their principal beneficiaries.

Scope And Coverage

To get a clearer picture, Iran's underground economy should be examined in terms of its status before the law, and the character of its participants. In judicial terminology, this segment of the total economy should be divided into two parts: legal or extra-legal, and illegal. The legal part consists of the unrecorded and inestimable economic activities that are common to almost all developing countries, and excluded in GDP estimates even in some developed nations. They include the value of in-house services performed by unpaid family members; value-added by small businesses conducted out of homes; unregistered and unreported cash transactions; barter exchanges among skilled service providers; the real value of government perks enjoyed by high officials; and, capital transactions not recorded in the balance-of-payment statistics.

The extra-legal portion emanates from state-sanctioned private monopolies in foreign trade, exclusive franchises in domestic distribution, the bazaar credit network outside the state banking system, influence peddling within the bureaucracy; and a raft of "rent-based" transactions involving access to privileged information and arbitrage opportunities. Some activities in this extra-legal category are of a hybrid nature, and may fall somewhere in between legal and illegal due to the unclear reading of the law: their categorization, therefore, should be considered somewhat arbitrary.

The illicit part covers a range of operations conducted by criminal elements and underworld figures in solo practice or in conjunction with some mafia-type organizations involving narcotic traffic, smuggling, counterfeit reproduction of patented articles; violations of intellectual property rights; money-laundering; organized prostitution; white-slave operations; trades in transplantable body organs and unborn babies; kidnapping and ransom demands; dealing in protected antiquities; and bribes routinely paid and received in transactions involving state agencies.

Key Participants

Iran's underground economy resembles a vast arena stage where not only the performing actors but also some of the spectators all play a part - legally or otherwise.

Principal players and high-stake operators consist of scores of state-sponsored "private" enterprises engaged in money-making activities; a number of large quasi-public "charitable" bonyads and several hundred parastatal entities established since the 1979 revolution; some old private endowments (waqf); a large network of non-transparent credit markets in the bazaar; religious shrines receiving sizeable cash donations from the faithful; several thousand non-bank banks, Qarz al-Hasanah windows, and "not-for-profit" credit unions; and the private fiscal household (bayt) of the major clerics - including that of the Supreme Leader.

Supporting actors are individual traders who evade foreign trade regulations and hide the true value of their cross-border commerce or those originated in the Free-Trade Zones; returning travelers who exceed their tariff-exempt foreign purchases; consumers who sell their ration coupons in the black market; small investors who engage in gold and currency speculations; employers who circumvent the harsh labor law by concealing the number of their employees in order to avoid paying social security and unemployment taxes; shopkeepers who supply price-controlled prescription drugs openly at higher prices to desperate buyers; health providers who charge more than authorized fees in under-the-table cash receipts; petty speculators who pay a deposit toward future delivery of goods in short supply (eg, automobiles, mobile phones, computers, housing) and later sell the vouchers or delivered goods in the open market at higher prices; and a large contingent of middlemen who "facilitate" citizens' transactions with government agencies - from repossessing confiscated private properties by obtaining new rulings from bribed courts or receiving difficult loans from bribed state bank officers, to fixing a traffic ticket or paying due taxes to the municipality or the treasury free from bureaucratic hassles.

Bit players include family members who handle various domestic chores such as cooking, washing, cleaning, baby-sitting and other works without cash compensation; operators of small businesses such as computer programming, consulting, catering, and various telemarketing conducted out of their homes; skilled service providers such as physicians, engineers, accountants and architects who engage in barter exchanges with one another; fulltime workers who take a second or third job to supplement their incomes; and street peddlers of legitimate articles or suppliers of illicit goods.

Roots And Causes

In addition to the universal and familiar reasons for the existence of underground economy, there are at least seven additional factors behind the Islamic Republic's own case. History, the Shi'a traditions, state sponsorship of non-transparent activities, misguided economic policies, government-imposed socio-cultural restrictions on daily life, gender discrimination, and poor governance constitute the seven sustaining pillars.

Iran's patrimonial and non-democratic history is a prime cause. The centuries-old wall of distrust between the government and the governed literally leads the citizenry to hide its identity and activity from the state to the extent possible. The government and the ruling establishment - being regarded by their subjects as greedy, oppressive, and exploitative - give the rank-and-file a "pseudo-legitimate" cause for hiding their assets and incomes from mistrusted authorities. Taxes, too, having been initially levied on individual Iranians by the Arab conquerors of the Persian Empire as a penalty for non-conversion to Islam have been intuitively regarded ever since as unfair, and therefore perfectly justifiable to evade and avoid - even though the original rationale no longer exists, and taxes are now imposed for the use of public services.

The Shi´a traditional edicts have provided the second pretext for concealing economic activity and evading civil taxation. The constitutionally mandated Islamic foundation of Iran's government tacitly allows and even encourages the continuation of an informal economy. Devout Muslims among the bazaaris and other traditional classes tend to justify their camouflage of business transactions and non-payment of taxes to the treasury by claiming to pay their dues in Islamic taxes of zakat and Khoms directly to their religious marja' (sources of emulation) as the so-called Imam's share. Currently, huge donations from wealthy merchants to individual clerics or the religious shrines in Mashad, Qom, Shiraz, Ray, and others are seldom, if ever, documented, acknowledged, or publicized by the donors or the recipients. These donations are a kind of slush funds or cash boxes at the disposal of religious divines to be used for educational, charitable, and religious purposes as they see fit - without any control or supervision by the state. Islamic injunction against usury (reba), and the limits imposed on nationalized banks in regard to interest payments and charges have spawned a thriving informal and somewhat extra-legal credit market in the bazaar which totally escapes taxation and GDP accounting.

The Islamic Republic, under its unique and hybrid nature of governance, provides a third reason for the creation and growth of undocumented economic activity. By the authorities' own admission, the ministries of security, defense, and law enforcement have at various times set up "private" companies to carry out money-making activities which could not be divulged for reasons of state security. Other ministries (eg, oil, energy, industry, commerce, finance and others) also own and operate hundreds of adjunct "private" corporations - ostensibly to assist the parent entities in specific tasks, but mostly to evade budgetary and accounting regulations (e.g., limits on salaries, bonuses, and other perks). The balance sheets of these subsidiaries are seldom fully published. Sales by the Central Bank of Iran petrodollars in the open market frequently result in capital flights without a clear trace in the balance-of-payments statistics. Compensation in the form of free housing, official cars, expense accounts, and various funds available to high elected and appointed officials also often escape budgetary and accounting scrutiny. The rapid establishment after the revolution of parallel government and semi-public "charitable" institutions to rival and overshadow those inherited from the previous regime, has opened up untold venues for the old revolutionaries to engage in shadowy businesses. The close ideological and blood relations between the clerics and the bazaaris have resulted in the birth and growth of a myriad of private monopolies. These monopolies in production, foreign trade, and domestic distribution have all been the sources of pervasive and unrecorded wealth which economists call "economic rent."

The post-revolution adoption of wrong macro-economic policies has provided a further economic incentive for the growth of the shadow economy. As a prime example, inflexibility and inefficiency of the nationalized banking system, combined with inadequacies of a functioning money market, has led to the rise of a large-scale and resilient informal credit network in the bazaar. Reluctance on the part of the state banks to lend to the more risky small borrowers without adequate collaterals and their preference for large and virtually secure loans to state enterprises has driven petty producers and up-start young entrepreneurs to resort to informal credit sources. By one private estimate, some 20-25% of annual agricultural credit is supplied by the bazaar. As a result, while no more than 20% of total annual private sector credit came from these sources in 1978, the corresponding percentage is now privately estimated to have surpassed 40%.

Instability of government regulations, and fear of renewed confiscation of private property reminiscent of the early post-revolution years, has intensified the problem by diverting private investments into hidden activities. Continued slow growth of Iran's formal economy and persistence of unemployment in the open market have also had their share. Insufficiency of investment and relatively slow pace of growth, combined with rising population, have resulted in declining per capita income and increased poverty. Measures to deal with these scourges such as price controls, across-the-board subsidies, rationing of staples, and emergency job creation funds - have, in various measures, contributed to the size of the underground economy. Black markets in price-controlled items, smuggling to neighboring countries of subsidized consumer goods, and ration coupon sales have been the outcome. The absence of wage employment has resulted in increasing hours worked at home. Finally, a host of government levies (inequitable taxes, high tariffs, nuisance fees) as well as burdensome regulations (investment permits, business licenses, bureaucratic procedures) have pushed many legitimate businesses to avoid registration.

Imposed Islamic dress codes, dietary restrictions, harsh and inhumane penalties for alcohol consumption, gambling, dancing, dating, watching foreign TV programs and censored foreign films, or embracing other so-called Western cultural products have been the fifth driving force behind the black market for these items. As a direct response to these unenforceable restrictions, drugs of all varieties, alcoholic beverages of all kinds, playing cards, popular CDs, and other forbidden items are abundantly available on demand through a legion of underground suppliers at higher costs.

The Islamic Republic's extensive restrictions on women's legitimate lines of work have been the sixth reason. Banned from working alongside men in many professions, the female share of employment in the country's official labor force has remained about 12% - or the same percentage as in 1976 - while unofficial employment has been vastly larger. The difference reflects the growth of a very large and lucrative home-based and female-owned urban cottage industry. Workshops of less than five employees headed by women have mushroomed in urban centers and in a variety of products not being included in GDP.

Finally, the administration's inability to enforce its own restrictive laws and regulations has allowed the underground economy to grow and prosper. The prevalence of cash payments in most ordinary transactions, the absence of enforceable laws regarding proper business bookkeeping and accounting, the lack of experienced and honest staff, necessary funds, and expertise to oversee business operations, and institutionalized corruption have all allowed a large segment of the economy to escape registration, inspection, and control. Private estimates point to such staggering figures of $2-4bn in annual imports smuggling; up to $3bn a year of capital flight to foreign safe havens; some $5bn or so in illegal drug trade; over $1bn of embezzlement in state-owned banks; and a similar figure resulting from state corporate fraud. While much of this data is uncorroborated and somewhat anecdotal, there is enough officially reported evidence to confirm the large magnitude and high social costs of illicit operations.

Magnitude And Size

The underground economy has had a long history in Iran both as a legal source of finance within the bazaar as well as a vast arena for both tax dodging and unlawful activities. In the post-1979 revolution, however, a notable decline in fiscal and monetary transparency seems to have increased the scope of this sector. Yet the actual size of this market is still largely a matter of pure conjecture.

A method chosen by one of the country's own Central Bank economists relies on two general indices to figure out its approximate magnitude: the aggregate annual demand for money; and the excess of "average" family expenditures over family incomes. The rise in total liquidity is taken to indicate an expansion in the size of the underground economy on the assumption that nearly all unregistered transactions are customarily conducted in cash. Similarly, when expenditures by households perennially exceed their declared incomes without corresponding increases in their debt, a logical inference would be that the gap is filled by earnings from undeclared sources.

Both of these proxy indicators lead to a similar conclusion. Data published by Iran's Central Bank show that the ratio of liquidity to real GDP which stood at 15.8 in 1979 (when a parallel economy was probably at its lowest level) rose to 244.35 in 1991 and reached 573.3 in 2001. Needless to say, this colossal increase is not all due to the expansion of the underground economy, but probably a good indication of its possible steady rise. Periodic surveys of household budgets, published by Iran's Statistical Center, also show a sizeable gap between annual incomes and expenditures in all household categories since the revolution. The latest survey conducted in 2001 shows that incomes of the average urban household covered only 92% of its total expenditure, and the figure for the average rural household was 87%. The gap - officially shown as filled by "other sources" - indicates the part of the underground economy. Although the figure for urban families seems to have narrowed since 1991, there is some evidence that the cause may have been a forced curtailment of family expenses rather than the shrinkage of the shadow economy.

A third indicator adopted here is the rise in non-wage employment since the 1979 revolution. The last three official decennial censuses show that the shares of wage-related employment for both urban and rural workers have persistently declined between 1976 and 1996, while those of non-wage-related work in both groups have increased. These changes also point to an increase in low-productive occupations requiring little capital. By one private estimate, some 12% of the urban labor force consists of one-man shopkeepers, street peddlers, cabbies, and delivery people. The transformation also indicates a substantial increase in the share of family workers in self-employment, and a decline in the share of wages in the average urban family income.

These three proxy indicators estimate the size of Iran's underground economy to have been in the neighborhood of about 22- 25% in the early 1990s. The steady rise of the demand for money, the continued gaps between family incomes and expenditures, and the increase in non-wage employment in the last decade tend to support the privately estimated figure of 30-35%.

Overall Implications

A flourishing underground economy affects, influences, and even conditions domestic economic performance. On the negative side, in addition to depriving the treasury of its due share of tax revenues and reducing needed public investment, it crowds out private investment by widening the budget deficit— requiring increased public borrowings or deficit financing through the printing press. The larger the size of the undetected economy, the poorer would be the quality and efficiency of public services. Distortions caused by the illicit nature of some economic activities would result in misallocation of resources. Non-transparent and secretive financial transactions allow the formation of private mafias that engage in intimidation, extortion, and terrorist operations at home or abroad. By distorting the size of GDP and particularly its internal distribution, the underground economy also stifles good governance and hampers the adoption of right economic policies. And, since only a small segment of the total population reaps the benefits of unlawful activities, the sector would have an adverse effect on optimum public welfare.

On the possible plus side in Iran's case, the continuity and resilience of the informal sector may add certain flexibility to the operation of the national economy. For example, the financial independence of the bazaar credit network from the state banking system provides a needed measure of stability in the financial field during unexpected monetary crises. Furthermore, the bazaar's credit arrangements, based on interpersonal relationships and trust, may tend to reduce both information and enforcement costs. In the same vein, the informal sector may provide employment for those who cannot find jobs in the formal economy. On the whole, however, the net impact will be negative - reflecting a misuse of resources, low priority investment, a significant drag on economic development, and a strong impediment to the establishment of good governance.

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