The unobservable variables technique employs a multitude of propagator and indicator variables simultaneously, increasing information and reducing the reliance on one imperfect measure. For example, size estimates of US underground activity using a currency approach run at about 20 percent of gross domestic product (GDP), while the unobservable variables technique place it closer to nine percent of GDP. The estimates derived from currency alone exaggerate the degree of US underground activity because of difficulties in accounting for overseas holdings of US currency.

In addition to being less sensitive to one indicator variable, the unobservable variables technique can be widely applied because it relies on macroeconomic time series data that are more easily available for a large array of countries. This technique enables global comparisons of underground economic activity. However, as with the previous methodologies, observable outputs cannot always be correctly measured, and the information on causal variables is sometimes unreliable. We must take care in generalizing from these techniques.

What Gives Rise to the Underground Economy?

Size estimates of underground economic activity range from a low of 8.7 percent of GDP in the United States to a high of 67 percent in Azerbaijan. Why do some countries appear to generate very high levels of underground economic activity while others have smaller underground economies? What are the determinants of underground economic activity? Answers to these questions will aid in devising and evaluating policies concerning underground activity.

Most policy prescriptions suggest that lowering taxes and limiting government regulation of the economy will reduce underground economic activity. However, the notion that high tax rates (and hence large government) increase underground activity is not supported by the data summarized in the graph to the left. The figure plots each country’s tax rate index for the year 1999 (obtained as an unweighted average of corporate and individual marginal tax rates as reported by World Bank Indicators), along with estimates of the size of the underground economy in that same year for a sample of 70 countries from around the globe, derived from a cross country study by Friedrich Schneider.

If higher tax burdens increased underground economic activity, then we would expect these points to be higher as we moved from left to right, suggesting a positive relationship between tax rates and the size of the underground economy. But we actually observe a slight negative or perhaps no relationship. While this scatter plot oversimplifies the case, these data do not support the claim that high tax rates raise underground activity. This result should cause us to reconsider the notion that high taxes and large government are the source of the hidden economy and that by simply reducing taxes, underground economic activity would diminish.

Indeed, by all accounts, the United States has one of the smallest underground economies in the world. US tax rates are also, relatively speaking, higher than average. But the higher taxation does not seem to draw as much US economic activity underground. This fact is simply explained. In the United States, most businesses and individual taxpayers feel that taxes do provide us with worthwhile services and public goods. Taxpayers are not generally concerned that collectors pocket the proceeds. This results in higher tax compliance; economic activity remains, by and large, above ground.

By contrast, in countries where residents place little faith in the taxing authorities—where it is likely that tax collectors will pocket tax proceeds and bureaucracies will partner with national leaders to whisk these into secret bank accounts—it is less likely that individuals will comply with tax law and other regulations. The graph on the opposite page underscores that respect for the authorities is an important deterrent to underground activity. In this figure, Transparency International’s Corruption Perceptions Index is plotted against the size of the underground economy (measured as a percentage of national income). The Corruption Perceptions Index is modified from the original index so that higher values signify greater levels of perceived corruption. The results suggest a decidedly positive correlation between underground economic activity and perceptions of corruption. This observation is consistent with the notion that individuals who have less respect for the integrity of government will engage in underground activity. When citizens feel that corruption is not an issue, there is less need to protect one’s economic production from the grabbing hands of unscrupulous government officials.

Given the differing types of underground activity, it would be simplistic to expect a basic model to fully account for the variation observed in the level of underground activity across countries. It is worthwhile to distinguish between what is generally responsible for illicit and unregulated economic activity. The production of cocaine and the bartering of manicures for dental fillings have different causes. Consumer demand for prohibited goods and services may be initially responsible for the development of illicit markets, while unrecorded and untaxed economic production are more likely due to poor governance. Corruption and inadequate legal infrastructure nurture both types of activity.

It is also important to consider the byproducts of the various policies that target illicit activities. For example, although more enforcement resources may reduce the volume of illicit drug transactions, enforcement will also raise the price of these goods—thereby raising companion criminal activity, as individuals require more resources to feed an addiction. It is preferable, then, to deter illegal activity by attacking the problem at its source. The availability of good jobs, education, and opportunities for youth is more likely to yield lifestyles devoid of criminal activity. Societal norms, perceptions and willingness to confront inequalities in opportunities are most important in reducing such activity.

Selective Policies Toward Underground Activity?

In this essay, I have differentiated two types of underground economic activity—the production of goods and services that are licit yet unaccounted for (what is often referred to as informal economic activity), and the production of illicit goods and services. Can a case be made for instituting policies that would stem illicit activity but tolerate informal activity? According to some, if informal activity is simply the expression of legal economic activity that would otherwise be stifled, we should celebrate its growth. This argument may be fallacious, however, because informal economic activity often gives shelter to illicit economic activity.