An old Italian adage goes like this: “money makes war, war makes poverty, poverty makes the black market, the black market makes money, money makes war once again”. The saying has its roots in the aftermath of WWII, when Italy faced the dramatic economic crisis that followed the death and destruction brought by the war. At the time, most goods and supplies were widely unavailable to the general public as a consequence of martial law, and people had to somehow find a way to bring food and all sorts of commodities to their families. In this kind of environment, smugglers and mobsters started thriving, as they had connections in other countries, where they could buy the goods at a lower price and then bring them into Italy, where people would be desperate enough to buy them at an unreasonably high price. Those who were ruthless enough to engage in this type of business got incredibly rich during that period, at the expenses of people who were already in miserable conditions, but they did indeed contribute to the revival of the Italian economy and the following boom. After the Reconstruction, when the Italian government regained full control over the country and the economy started booming again, the iconic Black Market of many Italian films was mostly eradicated.
When we talk about a shadow economy, however, we are not referring to a single phenomenon, such as the post-war black market, but rather a complex system that continuously operates outside of the official, regulated economy: a real “State in the State” that functions according to its own laws, the extent of which is extremely hard to calculate because none of the economic operations and transactions that happen within the shadow economy is recorded. We can define the shadow economy as “market-based production of goods and services, whether legal or illegal, that escapes detection in the official estimates of GDP” (Smith, Philip. 1994. “Assessing the Size of the Underground Economy: The Canadian Statistical Perspectives,” Canadian Econ. Observer, Cat. No. 11–010, 3.16–33, at 3.18). Examples include the trade of illegal goods (e. g. drugs, prostitutes, weapons, organs), informal labor and tax evasion. Unlike the post-war black market, this form of shadow economy is unfortunately still alive and well in most contries of the world. As of 2007, the World Bank estimates the average size of shadow economies in 162 countries to be around 38.4% of GDP in Sub-Saharan Africa, 36.5% in the Europe-Central Asia macro-region, and around 13.5% in the top OECD countries. This implies that a substantial fraction of these countries’ economic production takes place outside of the official sector. The result is a significant unrealized tax revenue for the government, which in countries with a very high shadow economy size can severely limit the ability of the State to function properly. It is then in every government’s best interest to contain the size of the informal economy as much as possible.
Schneider and Enste (2000), who conducted the most extensive study on the topic, cite among other drivers of underground economic activity increased taxes and social security contributions, economic regulations and unemployment. The reason is very simple: when it becomes too much of a burden to find regular employment and pay income taxes and contributions, people just choose to find “alternative” solutions, either by performing their activities without recording them, often in secrecy and with very low regard for quality standards, or by working without a contract for someone with the same inclination. Apart from the negative externality caused to society by the unrealized tax revenues of the government, a growing shadow economy also raises health and safety concerns for the workforce, since their working conditions cannot be monitored, and it helps all sorts of illicit activities to proliferate. Using three different empirical models based on physical input and currency demand, Schneider and Enste came to the conclusion that it is indeed true that underground economic activity increases with lower welfare and higher regulations.
What can be done by governments to contrast this phenomenon? To begin with, one idea might be to get rid of cash, and make all payments electronic. By doing so, it would be much harder for professionals and general labor to receive unrecorded revenues, and all large transfers of money abroad would need to be authorized by the banks, therefore making it much harder to evade taxes by just transferring all money in some tax haven. Such a strategy is already being implemented in India and Sweden, with very different results: in the Indian case, for example, it turned out cash was a very flexible means for transactions especially in rural areas with limited access to electronic banking, and when the government suddenly declared all cash worthless, the entire country plunged into a deep crisis, which it has only lately started recovering from. Therefore, it is clear the strategic approaches to this problem should vary between developed and developing countries. But how?
A working paper by the International Monetary Fund (IMF) addresses this exact question. In particular, the paper highlights that countries with a significant share of output taken by the shadow economy usually tend to have much more strict tax laws and business regulations: for example, in Latin America it can take up to 62 days to register a business! In OECD countries, instead, the average is of 13 days. The paper then provides advice as to how to tackle the problem in such countries and, unsurprisingly, this is very much in line with Schneider and Enste’s study: governments should simplify regulations and invest in welfare. The reason is that by allowing businesses to proliferate more easily, competition will increase, thereby improving wages and contract conditions for workers, which will then find it more appealing to stay in the formal sector. In addition, ad hoc welfare programs of assistance can help workers in the transition from the informal sector to the formal sector. The paper concludes that there needs to be also a cultural shift in those countries, which currently accept the shadow economy as an inevitable fact of life. Businesses and private citizens should be educated on the procedures and benefits of correct tax filing, exemplary behavior should be rewarded with efficient services and unlawful practices should be punished with a credible enforcement. Once again, the famous carrot and the stick.