A peddler of vegetables on a Hanoi sidewalk; a heroin dealer in Paris. What do they have in common? More than you might think. Both are operating underground, meaning that, for one reason or another, they do not report their activities to the state. They pay no taxes on their earnings. The government does not regulate the purity of their wares. If they have employees, they are not subject to labor regulations on minimum wages and safety. They lack access to the financial system; if they wanted to expand their business, they could not get a bank loan. They lack access to the legal system, so if a customer or supplier cheats them, they cannot appeal to the courts.

The similarities between our Parisian heroin seller and our Hanoi vegetable seller aside, there is a big difference. One is supplying a socially harmful commodity. The other is supplying a necessity.

Markets for illicit goods and services—trafficking in drugs or nuclear weapons or human beings—necessarily work in secret. But destructive transactions like those make up only a fraction of the underground economy worldwide. Far more vital for most of the world’s people is the beneficent form of underground market: entities outside the official economy producing and selling ordinary goods and services like food, cookware, haircuts, clothing, machinery repair, house building—almost everything people use in everyday life. The activities in this kind of underground market are illicit, but unlike in the market for heroin they are illicit merely on a technicality.

You participate in the underground economy if, as a homeowner, you pay cash to a contractor to avoid taxes or if you buy a fake Rolex on a city street. (Less than one-tenth of the sidewalk vendors in New York City, for example, hold a license.) In the United States and Western Europe, such activities add up to perhaps 10 percent of national income. In poor countries, underground markets are far more prevalent. Nigeria, Egypt, and Thailand host the world’s largest underground economies, estimated—by Friedrich Schneider and Dominik Enste in the March 2000 Journal of Economic Literature—to be more than two-thirds the size of official gross domestic product (GDP). In Peru, the Philippines, Mexico, and Russia, the underground economy is about half the size of the official economy. In Tanzania, Chile, and South Korea, it is about a third. Why is so much market activity in developing countries conducted underground? So what? Does the underground economy generate inefficiencies? What policies should be implemented in countries with a bloated underground sector?

A billion people live on less than one US dollar a day. Another two billion live on one to two US dollars a day. Many of those living in unimaginable poverty are dependent on the underground economy. In it they earn their livelihood and purchase their food, clothing, and shelter. Devising ways to make underground markets work better, and ultimately to shift underground transactions into the formal sector, offers the world’s poorest people hope of escaping grinding poverty.

Failure of Government

In poor countries, the underground economy results from the inadequacy of the state. Entrepreneurs work outside the formal economy because the government is not doing its job. It is doing things it should not do and neglecting to do things it should do. The state is simultaneously too big and too small.

A firm may be underground either because it is not officially registered or because it is registered but hides some of its activities from the state. In the late 1990s, for example, Simon Johnson, Christopher Woodruff, and I surveyed small-scale manufacturing firms in Russia and Ukraine. Their managers reported that, though registered, they underreported their sales by an average of about one-third.

Government policies may drive firms underground. Entrepreneurs sometimes decide not to register their firms to evade punitive taxation. Or they may decide that the fees to acquire a business license are exorbitant. Registering a firm involves a number of steps. Entrepreneurs must apply for a business license, establishing that the company’s name is unique and providing proof of startup capital. Then they must file with the tax and labor authorities. Adhering to the rules can be astonishingly time consuming and expensive.

In Peru in the 1980s, economist Hernando de Soto found that establishing a small factory required 11 permits, which took nearly a year to obtain. A recent World Bank survey found that abiding by the law is still very costly in many countries. In Mexico setting up a new business takes an entrepreneur four months and costs about US$2,500 in official fees. In Bolivia the cost of working through the licensing procedures adds up to more than twice the level of per-capita income. In Tanzania a business license costs more than three times per-capita income; in the Dominican Republic, more than four times. Canada, where getting a business license takes just two days and costs US$260, illustrates the unnecessary encumbrance of such procedures. The size of the underground economy reflects the costs of entering the formal economy.

The government’s inability or unwillingness to prevent illegal activities is another factor. Rapacious bureaucrats often demand bribes in exchange for granting a business license. Where the police fail to control crime, firms often stay underground to escape the attention of the mafia, who demand “protection” money. In the sample of entrepreneurs in Russia and Ukraine, about 90 percent reported it was normal to pay bribes to government officials to acquire a business license or a permit to expand, and a similar percentage said it was normal for firms to pay off the mafia.

Government failure manifests itself not only in inflated costs to entrepreneurs of joining the formal economy but also in the inadequate provision of positive incentives to do so. In principle, a firm that is licensed receives support from the state. In most of the world’s poorest countries, however, the government does not supply the requisite market-supporting institutions. Firms stay small, even if they are well managed and have a good product because they are unable to access the external finance they need in order to grow. Where laws governing collateral are inadequate or not enforced, banks are reluctant to lend to small firms because it would be hard to get their money back if things turn bad. Where financial-market regulation is lacking, new firms cannot attract equity financing, because potential investors have no assurance that the firm will not misuse any money they invest in it. Where laws of contract are ineffectual, one of the incentives for entrepreneurs to register their firms—the added reliability of contracting—is absent.