Sunday, April 28, 2013

The Underground Economy: Are We Becoming Greece?

Several references have appeared in the media discussing an estimate that about $2 trillion went unreported as income last year. Have we become a nation of tax dodgers? Is this a sign of a decaying society? Are we finally in danger of becoming Greece?

James Surowiecki provides a good summary of the issues in an article in The New Yorker.

"When we all finished filing our tax returns last week, there was a little something missing: two trillion dollars. That’s how much money Americans may have made in the past year that didn’t get reported to the I.R.S., according to a recent study by the economist Edgar Feige, who’s been investigating the so-called underground, or gray, economy for thirty-five years.

One usually associates tax avoidance on such a large scale with organized crime syndicates.   That is not the case here.
"This unreported income is being earned, for the most part, not by drug dealers or Mob bosses but by tens of millions of people with run-of-the-mill jobs—nannies, barbers, Web-site designers, and construction workers—who are getting paid off the books."

The existence of this underground or shadow economy and its size helps explain why the economy appears to be healthier than one might expect given the persistently high rate of unemployment.

"....even though the percentage of Americans officially working has dropped dramatically, and even though household income is still well below what it was in 2007, personal consumption is higher than it was before the recession, and retail sales have been growing briskly....Bernard Baumohl, an economist at the Economic Outlook Group, estimates that, based on historical patterns, current retail sales are actually what you’d expect if the unemployment rate were around five or six per cent, rather than the 7.6 per cent we’re stuck with. The difference, he argues, probably reflects workers migrating into the shadow economy."

Although the recent recession has probably contributed to the growth of this shadow economy, it has always been around.

"The increasing importance of the gray economy isn’t only a reaction to the downturn: studies suggest that the sector has been growing steadily over the years. In 1992, the I.R.S. estimated that the government was losing $80 billion a year in income-tax revenue. Its estimate for 2006 was $385 billion—almost five times as much (and still an underestimate, according to Feige’s numbers)."

Most of the people working in this shadow economy are probably low-wage workers who are spending all that they earn. Much of the unpaid taxes can be thought of as an unplanned stimulus program. Of greater concern is the effect this growing trend has on society. There is a degree of unfairness associated with all who participate. While not paying taxes might be seen as a plus, one also loses the benefits that accrue from having been a taxpayer.

"....the damaging effects of this trend are clear. It’s hard for businesses to play by the rules if their competitors aren’t paying payroll taxes or workers’ comp. And off-the-books workers have no benefits or Social Security, and not much recourse if a boss decides to shortchange them."

The oft-quoted claim that we are about to become Greece is usually associated with concerns related to national debt and budget deficits. That is not the issue about which we should be worried.

The function of a society depends upon the vast majority of its citizens playing by the rules. People will tend to not break rules if they believe others are obeying the rules. Once the notion is propagated that many, or most, are not following the rules, then others will be encouraged to also break the rules. We can have a reinforcing virtuous cycle, or a reinforcing destructive cycle.

In Greece, the tax dodging, bribery, and other forms of corruption are so pervasive that it is a wonder that the society continues to exist. The Greeks have lost all trust in their fellow citizens and in their national institutions.

Is our growing shadow economy a trend suggesting that we might one day lose faith in our institutions and in our neighbors?

Perhaps a bit of perspective is in order. An article in Bloomberg Businessweek provided estimates of the size of shadow economies in a number of nations.

It would seem that by this metric we have a long way to go before we begin to resemble Greece. We also have a ways to go before we begin to resemble Canada.

It is appropriate to be concerned about this shadow economy, and it is important to create conditions whereby it can be limited in size. Rather than worry about lost revenue, we should be focused on the threat to the credibility of our society’s institutions.

The greatest threat arises not from tax dodgers, but from politicians who continually criticize our government and its efforts for political gain. People who continually hear outrageous claims by politicians parroted by what passes for media reporting will eventually begin to believe the nonsense. Then we really have a problem.

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