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The underground economy
We all know tax cheats who understate their income. Cosmetologists who report only half their tips, plumbers who give cash customers a break, and gamblers who keep no records are all engaged in the underground economy. Estimates of its size range from a conservative 3% to an astounding 20% of GDP, which means that underground participants may now cheat the U.S. Treasury out of as much as $300 billion in taxes annually.
Although researchers disagree on the size of the underground economy, one piece of evidence that the subterranean economy is increasingly significant is that the demand for the cash component in our money supply has grown sharply in recent decades. Large bills are the payment of choice in much of the underground economy.
Why is this happening? Part of the answer is that many Americans view high tax brackets as powerful incentives to cheat. This problem is compounded by the shrinking probability of an Internal Revenue Service audit. About 3% of all tax returns were audited in the 1960s; the proportion is now around 1.5%. In addition, tax evasion has become respectable in the eyes of some, who excuse their behavior with the argument that "everybody does it."
Cataloging all the ways people have found to cheat on their taxes would generate a book as thick as a New York phone directory. Legitimate businesspeople may not report cash income, or they may understate income by taking excessive tax deductions. If you claim new bedroom drapes as a business expense, you are involved in the underground economy. Barter is perfectly legal but it is a major avenue for tax evasion.
Nearly 70% of the underground economy consists of income that, if reported, would be legitimate; 30% or so of the funds flowing through untaxed channels are derived from criminal activities. Bank robbers, shoplifters, drug dealers, prostitutes, and loan sharks understandably try to minimize contacts with the IRS. Failure to pay legitimate taxes imposes higher rates on those of us who scrupulously pay our taxes.
Growth of self-employment in almost all economies during the past decade may signal a ground-swell in entrepreneurial instincts, but it also stimulates unreported transactions in nations ranging from the United States to Sweden to Taiwan. Tax evasion is far easier for the self-employed than for most other people.
What does the underground economy portend for economic statistics and public policy? For one thing, U.S. GDP growth may be understated to the extent that unreported income has grown in importance nationally
Another consideration is that unemployment statistics may be overstated (or labor force participation understated) if underground activity is not taken into account. Still another is that if poor people participate in cash or barter transactions proportionally more than high-income individuals, the degree of income inequality and the need for welfare programs may be overstated.
We can wish that compliance with tax laws were more widespread among Americans, but, at the same time, we can be grateful that we do not suffer from the underreporting that appears common in parts of Europe, where the underground economy is estimated to run as high as one-third of Italian GDP, or 30% of GDP in Greece. 2718 digits