Shadow Economy

Here is a puzzle. US unemployment remains stubbornly high by pre-recession standards at 7.6%. The overall workforce participation rate continues to fall. Real income growth remains flat. Yet retail sales go from strength to strength. Where is the purchasing power coming from?

Bernard Baumohl, chief global economist of the Princeton-based Economic Outlook Group, has an intriguing explanation. What we are seeing, he thinks, is a growing underground economy which, if it were possible to include it in the official statistics, would push unemployment down to around 5 per cent. That is where, historically, it ought to be at current levels of personal consumption.

“We’re not talking about illicit activity, like selling stolen goods or drugs,” Mr Baumohl wrote in a March research note that is attracting a lot of attention. “It’s largely work where millions of unemployed have managed to earn cash “off the books” by repairing computers, doing carpentry or handyman work, selling goods at flea markets, tutoring, housecleaning or using their car as a private delivery service.”

How much income is not being reported to the Internal Revenue Service? Something on the order of $2 trillion annually, the University of Wisconsin’s Prof Edgar Feige, a leading expert on shadow economies, concluded in a 2011 paper.
That would put the gap between what the IRS is owed each year and what it actually receives at $450-500 billion, enough to halve this year’s projected budget deficit , and more than the entire GDP of South Africa. The IRS’ own calculations, most recently for 2006, had the gap at $385 billion.

As dire as that sounds, several studies have found American taxpayers more likely to cough up what they owe on time than their European counterparts. The IRS reckons the US tax compliance rate was 83.1% in 2006. The Vienna Institute for International Studies has estimated compliance in the UK, France and Germany at 77.97%, 75.38% and 67.72% respectively.

A cash economy requires physical cash, obviously, and for all the talk of the US becoming a cashless society, the opposite seems true. Until recently, it was received wisdom that around two thirds of greenbacks in circulation were located offshore. Prof Feige, using previously confidential data provided by the New York Federal Reserve, demonstrated in a separate paper last year that fully 77% of US currency remains at home, roughly $750 billion or $2250 per capita.

A lot of that may really be in people’s mattresses. The Federal Deposit Insurance Corporation reported in September last year the 10 million American households – one in 12 – were entirely unbanked. Another 24 million – 20 per cent — were “underbanked”, meaning members had deposit or saving accounts but relied on “alternative financial services” like non-bank check-cashing services and pawn shops.

If Baumohl is right, and growing numbers of Americans are operating in what Prof Feige prefers to call the “unreported” economy, is this a cyclical product of recession or structural, and if structural, what’s driving it? Are people bailing from the formal economy because they want to or because they have to? Here the debate heats up.

Certainly it has become cheaper for employers to rely on independent contractors responsible for their own pension contributions, Social Security taxes, health insurance and the like. The New Yorker’s James Surowiecki cites a recent survey of 300 000 California construction firms which found that fully two-thirds had no employees even though most clearly gave work to many.

However, there is little incentive for a legitimate company that hires independent contractors to hide what it pays them from the authorities. Such payments, to be deductible from the company’s taxable income, must be reported to the IRS on Form 1099 – which the taxman then uses to make sure contractors also pay what they owe.

John Mauldin, a well-known financial commentator to the right of spectrum, advances a provocative theory in his latest Thoughts from the Frontline newsletter. He sees a connection between the underground economy, the minimum wage and swelling welfare rolls.

Welfare recipients, he argues, have an incentive to work off the books in order to remain eligible for income support and free healthcare. “If you have a skill that pays you $20-30 an hour (closer to the median family income pay level) you are better off keeping the job and staying off welfare. But if you are minimum-wage labor (around $10 an hour) or not far above it, the equation works out better if you work off the books for that extra income.”

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