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The impact of the U.S. underground economy A note relating to the impact on state finances
Journal of Government
Pergamon
Information. Vol. 24, No. 2. pp. 113-117.1997 Copyright 0 I997 Elsevier Science Ltd Printed in the USA. All rights reserved 1352~0237/97 $17.00 + .OO
PI1 S1352-0237(W)OOOOS-1
THE IMPACT OF THE U.S. UNDERGROUND ECONOMY A Note Relating to the Impact on State Finances* BENJAMIN
J. SHELAK*’
Bureau of the Census, Governments Division, Washington, Internet: [email protected]
DC 20233-6800, USA;
Abstract -This
article explores the relationship between the underground economy and state finances by analyzing economic studies within a framework of finances developed by the U.S. Census Bureau. The conclusion drawn is that the underground economy imposes costs on the residents of a state by denying the state vital revenues while simultaneously draining expenditures. 0 1997 Elsevier Science Ltd Keywords-Underground evasion
economy,
State
finances,
THE U.S. UNDERGROUND
Gross
domestic
product,
Tax
ECONOMY
Defying precise methods of estimation, the underground economy persists as a misunderstood parallel economy that distorts any clear view of a national or state economy. In recent decades, micro- and macro-economic techniques have been applied toward a further understanding of the underground economy, but the results have been mixed. Perhaps the primary handicap in studying the underground economy is the lack of a precise definition. At the micro level, the dollar value of goods and services may be estimated, and the size, measured in terms of Gross Domestic Product (GDP), estimated. GDP is a market basket of all goods and services produced in the observable economy for a given year. A second method of analyzing the underground economy is by segregating this invisible sector into its basic components. The difficulty lies in determining what dollar amount to apply to industries such as illegal drug production and prostitution. From a macro perspective, the amount of currency relative to the money supply (or the amount of transactions occurring within the economy) is used to estimate the level of underground activity. A monetary figure is then produced and underground gross national product (GNP) calculated. The following tables illustrate the difficulties in attempting to derive a reliable estimate. Depending on a particular definition, all or some of the activities listed in Table 1 may be regarded as occurring underground [l].
“The views expressed are those of the author and are not necessarilv shared bv the U.S. Bureau of the Census. **Benjamin Shelak holds a Master of Arts degree in econom;cs from Bbwling Green State University. He is currently employed as a survey statistician by the Census Bureau and is responsible for researching government organization. 113
114
B. J. SHELAK Table 1. Underground activities Drugs Commercial vice and prostitution Loan sharking Gambling (except where permitted by law) Barter Illegal production of trademarked goods Employment of illegal aliens Do-it-yourself projects Skimming of business revenue Tax evasion
Table 2 illustrates some of the models that have been used to calculate the size of the underground economy and includes corresponding estimates of GNP. GNP is defined as the equivalent of gross domestic product (GDP) plus receipts of factor income revenue (goods and services produced from abroad with U.S. labor and capital) and less factor income expenditures (goods and services produced within the United States with foreign labor and capital). Although today’s indicator of choice is GDP, this is a recent change in standards, replacing GNP. The historical data illustrated in Table 2 are presented in terms of GNP. Estimates produced by these different models vary widely. The models include, either directly or indirectly, some or all of the activities listed in Table 1. The purpose of Table 2 is not to offer an explanation of the different methods, but to show the amount of disparity occurring between models [2]. Further complicating matters is the choice of a base year for use in developing a specific model. A base of 1950 will produce different results than a base year of 1990. Based on the crude framework provided above, a rough outline of the underground economy’s role in the world of state finances can be made. To understand this phenomenon more fully, however, the structure of state finances must first be explored. THE STRUCTURE OF STATE FINANCES In a New York State estimate for 1980, approximately $25 billion of potentially taxable income was attributed to the underground economy [3]. Total New York State revenue, according to the U.S. Census Bureau, stood at $30 billion for this same year [4]. The loss in taxes is staggering and has a limiting impact on the services New York State is able to provide its citizens. The structure of state government finances is presented in Table 3. Revenue is provided by transfers from the federal government to state government, via taxes and charges, from the sale of utility services, from employee/employer contributions to state insurance programs, and through the sale of alcohol by state liquor stores. Table 2. Real GNP (Base year = 1987) Year 1980 1980 1980 1980 1990
Estimation technique Transactions method Tanzi’s model (currency-ratio) Simple currency-ratio model Modified currency-ratio model Sectoral analvsis
Underground
GNP as a percentage of observed GNP 48.6 4.4 14.2 25.3 6.2
115
The U.S. underground economy and state finances Table 3. Summary Revenue General revenue Intergovernmental
of state government
finances
revenue
Taxes Sales and gross receipts License taxes Individual income Corporation net income Other Charges and miscellaneous
general revenue
Utility revenue Insurance trust revenue Liquor stores revenue Expenditure General expenditure Education services Social services and income maintenance Transportation Public safety Environment and housing Governmental administration Other LJtility expenditure Insurance trust expenditure Liquor stores expenditure Indebtedness and debt transactions Cash and security holdings Source: IJ.S. Department of Commerce, Bureau of the Census, &are Governmenf Government Printing Office, 1991): I.
Finances
1990 (Washington,
DC: U.S.
Direct expenditures (payments to employees and contractors) and the transfer of funds from state to local governments are both considered to be state expenditures. Expenditures also include the amounts spent on education, social services, roadway maintenance and transit subsidies, public safety, the environment, and government administration; funds spent on the construction and maintenance of utility facilities and on retirement and disability; and expenditures for the purchase of liquor. The long-term credit obligations of a state constitute its level of indebtedness, while cash and securities indicate the amount of funds readily available. This is a general framework of state finances. Having established the role of state government finances, it is now possible to examine the costs of the underground economy for the state.
FINANCIAL COSTS IN AN IMPERFECT
WORLD
The underground economy imposes certain costs on state finances and, by extension, society as a whole. Tax evasion, illegal and untaxed enterprises, and other activities deny a state large amounts of revenue. By its very existence, the underground economy has a further impact on state finances on the expenditure side, affecting the level spent on law enforcement, drug rehabilitation, and prisons. As a result, funding is reduced or diverted from education, transportation, housing, and other socially positive governmental functions. Intergovernmental revenue (funding received from the federal government) may suffer due to tax evasion at the federal level. Less income realized by the federal gov-
116
B. J. SHELAK
ernment implies less fiscal aid available to offer states. Federally funded mandates for education and social services may consequently suffer. In addition to transfers from the federal government, states also earn income through their power to levy taxes. In 1987, corporation and net income taxes totaled $96.7 billion for all 50 states and the District of Columbia [5]. Although figures do not exist on the potential income lost from tax evasion at the state level, the federal government was short an estimated $52 billion in 1987 [6]. This is 10.9 percent of the $476.5 billion realized through the federal collection of individual and corporation net income taxesa substantial amount [7]. Tobacco product taxes in 1990 amounted to $5.5 billion, the same year that approximately $200 million of unreported income was earned by tobacco smugglers [8]. Payment of parimutuel taxes is sidestepped by illegal gambling at the race tracks. Although the number of arrests due to illegal gambling has declined in the past decade, this may be the result of the legalization of gambling in a greater number of areas, not the actual consequence of a decline in the level of gambling. In addition, a certain amount of potential revenue is lost due to the illegal or legal sale of items for which sales tax is not paid. Conceivably, these items might be smuggled cigarettes or produce from a family garden sold at a roadside stand. The loss in revenue from tax evasion carries through to expenditures. Fifty million dollars in taxable income not realized by a state government is $50 million less that can be spent on providing a better education for children, services for the poor and unemployed, or funding to preserve a landmark or provide for the upkeep of a state park or with which to improve a deteriorating stretch of dangerous highway. To counter the reduced level of expenditures, long-term debt can be raised or taxes increased, thereby imposing a further cost on the citizens of a state. The threat of raising debt, however, is potentially to lower a state’s investment rating, costing it possible new business. The underground economy has an additional impact on finances by distorting any view of a state’s actual economy. Expansionary or contractionary economic policies undertaken by the state to prevent an undesired economic condition may not take into consideration the underground sector. How can an economic downturn be effectively dealt with when policy aimed at reducing an observed unemployment rate of 10 percent actually impacts a true rate of 5 percent, assuming that a certain part of the labor pool is working underground? Likewise, the observed level of a state’s GDP may be $100 million, but the underground economy produces goods and services in addition to this amount. One possible approach to correct this is to include underground GDP with the figures for state income. As a consequence, use of economic tools would be based on actual total GDP and not merely the observed level of GDP. CONCLUSION There exists a certain level of economic activity that effectively escapes any effort at precise measurement. The causes stem from both definitional weakness and from the impossibility of accurately calculating activity purposefully kept hidden. For these reasons, underground employment and activity distort any clear view of the state economy. Without exact figures on income and employment, economic indicators provide a flawed measure of economic health or illness, possibly leading to inappropriate stabilization policies. Additionally, the loss of revenue due to tax evasion, as well as to increased expenditures for police protection and rehabilitation centers, leaves less funding available to finance social services and other needed projects.
The U.S. underground
economy and state finances
117
In summary, the underground economy affects government finances in such a way as to impose costs on the residents of a state. Reduction of these costs can only be to the benefit of society. NOTES 1. Carol S. Carson, “The Underground Economy,” Survey ofcurrenf Business 64, no. 5 (1984): 21-24. 2. Richard D. Porter and Amanda S. Bayer, “A Monetary Perspective on Underground Economic Activity in the United States,” Federal Reserve Bullerin no. 70 (March 1984): 177-90; Harry 1. Greenfield, Invisible, Outlawed and Untaxed (Westport, CT: Praeger Publishers, 1993): 65. 3. Porter, 69. 4. U.S. Department of Commerce, Bureau of the Census, Governmental Finances in 1980-81 (Washington, DC: U.S. Government Printing Office, 1982): 23. 5. U.S. Department of Commerce, Bureau of the Census, Governmental Finances in 198687 (Washington, DC: U.S. Government Printing Office, 1988): 7. 6. Greenfield, Invisible, 40. 7. Government Finances in 1986-87.7. 8. U.S. Department of Commerce, Bureau of the Census, State Government Finances 1990 (Washington, DC: U.S. Government Printing Office, 1991): 1; Greenfield, Invisible, 65.
Pergamon
Information. Vol. 24, No. 2. pp. 113-117.1997 Copyright 0 I997 Elsevier Science Ltd Printed in the USA. All rights reserved 1352~0237/97 $17.00 + .OO
PI1 S1352-0237(W)OOOOS-1
THE IMPACT OF THE U.S. UNDERGROUND ECONOMY A Note Relating to the Impact on State Finances* BENJAMIN
J. SHELAK*’
Bureau of the Census, Governments Division, Washington, Internet: [email protected]
DC 20233-6800, USA;
Abstract -This
article explores the relationship between the underground economy and state finances by analyzing economic studies within a framework of finances developed by the U.S. Census Bureau. The conclusion drawn is that the underground economy imposes costs on the residents of a state by denying the state vital revenues while simultaneously draining expenditures. 0 1997 Elsevier Science Ltd Keywords-Underground evasion
economy,
State
finances,
THE U.S. UNDERGROUND
Gross
domestic
product,
Tax
ECONOMY
Defying precise methods of estimation, the underground economy persists as a misunderstood parallel economy that distorts any clear view of a national or state economy. In recent decades, micro- and macro-economic techniques have been applied toward a further understanding of the underground economy, but the results have been mixed. Perhaps the primary handicap in studying the underground economy is the lack of a precise definition. At the micro level, the dollar value of goods and services may be estimated, and the size, measured in terms of Gross Domestic Product (GDP), estimated. GDP is a market basket of all goods and services produced in the observable economy for a given year. A second method of analyzing the underground economy is by segregating this invisible sector into its basic components. The difficulty lies in determining what dollar amount to apply to industries such as illegal drug production and prostitution. From a macro perspective, the amount of currency relative to the money supply (or the amount of transactions occurring within the economy) is used to estimate the level of underground activity. A monetary figure is then produced and underground gross national product (GNP) calculated. The following tables illustrate the difficulties in attempting to derive a reliable estimate. Depending on a particular definition, all or some of the activities listed in Table 1 may be regarded as occurring underground [l].
“The views expressed are those of the author and are not necessarilv shared bv the U.S. Bureau of the Census. **Benjamin Shelak holds a Master of Arts degree in econom;cs from Bbwling Green State University. He is currently employed as a survey statistician by the Census Bureau and is responsible for researching government organization. 113
114
B. J. SHELAK Table 1. Underground activities Drugs Commercial vice and prostitution Loan sharking Gambling (except where permitted by law) Barter Illegal production of trademarked goods Employment of illegal aliens Do-it-yourself projects Skimming of business revenue Tax evasion
Table 2 illustrates some of the models that have been used to calculate the size of the underground economy and includes corresponding estimates of GNP. GNP is defined as the equivalent of gross domestic product (GDP) plus receipts of factor income revenue (goods and services produced from abroad with U.S. labor and capital) and less factor income expenditures (goods and services produced within the United States with foreign labor and capital). Although today’s indicator of choice is GDP, this is a recent change in standards, replacing GNP. The historical data illustrated in Table 2 are presented in terms of GNP. Estimates produced by these different models vary widely. The models include, either directly or indirectly, some or all of the activities listed in Table 1. The purpose of Table 2 is not to offer an explanation of the different methods, but to show the amount of disparity occurring between models [2]. Further complicating matters is the choice of a base year for use in developing a specific model. A base of 1950 will produce different results than a base year of 1990. Based on the crude framework provided above, a rough outline of the underground economy’s role in the world of state finances can be made. To understand this phenomenon more fully, however, the structure of state finances must first be explored. THE STRUCTURE OF STATE FINANCES In a New York State estimate for 1980, approximately $25 billion of potentially taxable income was attributed to the underground economy [3]. Total New York State revenue, according to the U.S. Census Bureau, stood at $30 billion for this same year [4]. The loss in taxes is staggering and has a limiting impact on the services New York State is able to provide its citizens. The structure of state government finances is presented in Table 3. Revenue is provided by transfers from the federal government to state government, via taxes and charges, from the sale of utility services, from employee/employer contributions to state insurance programs, and through the sale of alcohol by state liquor stores. Table 2. Real GNP (Base year = 1987) Year 1980 1980 1980 1980 1990
Estimation technique Transactions method Tanzi’s model (currency-ratio) Simple currency-ratio model Modified currency-ratio model Sectoral analvsis
Underground
GNP as a percentage of observed GNP 48.6 4.4 14.2 25.3 6.2
115
The U.S. underground economy and state finances Table 3. Summary Revenue General revenue Intergovernmental
of state government
finances
revenue
Taxes Sales and gross receipts License taxes Individual income Corporation net income Other Charges and miscellaneous
general revenue
Utility revenue Insurance trust revenue Liquor stores revenue Expenditure General expenditure Education services Social services and income maintenance Transportation Public safety Environment and housing Governmental administration Other LJtility expenditure Insurance trust expenditure Liquor stores expenditure Indebtedness and debt transactions Cash and security holdings Source: IJ.S. Department of Commerce, Bureau of the Census, &are Governmenf Government Printing Office, 1991): I.
Finances
1990 (Washington,
DC: U.S.
Direct expenditures (payments to employees and contractors) and the transfer of funds from state to local governments are both considered to be state expenditures. Expenditures also include the amounts spent on education, social services, roadway maintenance and transit subsidies, public safety, the environment, and government administration; funds spent on the construction and maintenance of utility facilities and on retirement and disability; and expenditures for the purchase of liquor. The long-term credit obligations of a state constitute its level of indebtedness, while cash and securities indicate the amount of funds readily available. This is a general framework of state finances. Having established the role of state government finances, it is now possible to examine the costs of the underground economy for the state.
FINANCIAL COSTS IN AN IMPERFECT
WORLD
The underground economy imposes certain costs on state finances and, by extension, society as a whole. Tax evasion, illegal and untaxed enterprises, and other activities deny a state large amounts of revenue. By its very existence, the underground economy has a further impact on state finances on the expenditure side, affecting the level spent on law enforcement, drug rehabilitation, and prisons. As a result, funding is reduced or diverted from education, transportation, housing, and other socially positive governmental functions. Intergovernmental revenue (funding received from the federal government) may suffer due to tax evasion at the federal level. Less income realized by the federal gov-
116
B. J. SHELAK
ernment implies less fiscal aid available to offer states. Federally funded mandates for education and social services may consequently suffer. In addition to transfers from the federal government, states also earn income through their power to levy taxes. In 1987, corporation and net income taxes totaled $96.7 billion for all 50 states and the District of Columbia [5]. Although figures do not exist on the potential income lost from tax evasion at the state level, the federal government was short an estimated $52 billion in 1987 [6]. This is 10.9 percent of the $476.5 billion realized through the federal collection of individual and corporation net income taxesa substantial amount [7]. Tobacco product taxes in 1990 amounted to $5.5 billion, the same year that approximately $200 million of unreported income was earned by tobacco smugglers [8]. Payment of parimutuel taxes is sidestepped by illegal gambling at the race tracks. Although the number of arrests due to illegal gambling has declined in the past decade, this may be the result of the legalization of gambling in a greater number of areas, not the actual consequence of a decline in the level of gambling. In addition, a certain amount of potential revenue is lost due to the illegal or legal sale of items for which sales tax is not paid. Conceivably, these items might be smuggled cigarettes or produce from a family garden sold at a roadside stand. The loss in revenue from tax evasion carries through to expenditures. Fifty million dollars in taxable income not realized by a state government is $50 million less that can be spent on providing a better education for children, services for the poor and unemployed, or funding to preserve a landmark or provide for the upkeep of a state park or with which to improve a deteriorating stretch of dangerous highway. To counter the reduced level of expenditures, long-term debt can be raised or taxes increased, thereby imposing a further cost on the citizens of a state. The threat of raising debt, however, is potentially to lower a state’s investment rating, costing it possible new business. The underground economy has an additional impact on finances by distorting any view of a state’s actual economy. Expansionary or contractionary economic policies undertaken by the state to prevent an undesired economic condition may not take into consideration the underground sector. How can an economic downturn be effectively dealt with when policy aimed at reducing an observed unemployment rate of 10 percent actually impacts a true rate of 5 percent, assuming that a certain part of the labor pool is working underground? Likewise, the observed level of a state’s GDP may be $100 million, but the underground economy produces goods and services in addition to this amount. One possible approach to correct this is to include underground GDP with the figures for state income. As a consequence, use of economic tools would be based on actual total GDP and not merely the observed level of GDP. CONCLUSION There exists a certain level of economic activity that effectively escapes any effort at precise measurement. The causes stem from both definitional weakness and from the impossibility of accurately calculating activity purposefully kept hidden. For these reasons, underground employment and activity distort any clear view of the state economy. Without exact figures on income and employment, economic indicators provide a flawed measure of economic health or illness, possibly leading to inappropriate stabilization policies. Additionally, the loss of revenue due to tax evasion, as well as to increased expenditures for police protection and rehabilitation centers, leaves less funding available to finance social services and other needed projects.
The U.S. underground
economy and state finances
117
In summary, the underground economy affects government finances in such a way as to impose costs on the residents of a state. Reduction of these costs can only be to the benefit of society. NOTES 1. Carol S. Carson, “The Underground Economy,” Survey ofcurrenf Business 64, no. 5 (1984): 21-24. 2. Richard D. Porter and Amanda S. Bayer, “A Monetary Perspective on Underground Economic Activity in the United States,” Federal Reserve Bullerin no. 70 (March 1984): 177-90; Harry 1. Greenfield, Invisible, Outlawed and Untaxed (Westport, CT: Praeger Publishers, 1993): 65. 3. Porter, 69. 4. U.S. Department of Commerce, Bureau of the Census, Governmental Finances in 1980-81 (Washington, DC: U.S. Government Printing Office, 1982): 23. 5. U.S. Department of Commerce, Bureau of the Census, Governmental Finances in 198687 (Washington, DC: U.S. Government Printing Office, 1988): 7. 6. Greenfield, Invisible, 40. 7. Government Finances in 1986-87.7. 8. U.S. Department of Commerce, Bureau of the Census, State Government Finances 1990 (Washington, DC: U.S. Government Printing Office, 1991): 1; Greenfield, Invisible, 65.