Going Underground: America's Shadow Economy
By: Jim McTague
Baron's | Thursday, January 06, 2005
America has two economies, and one is flourishing at the expense of the other. First, there's the legitimate economy, in which craftsmen are licensed and employers and employees pay taxes. Then there's the fast-growing underground economy, where millions of nannies, construction workers and others are paid off-the-books, their incomes largely untaxed. The best guess as to the size of the output of this shadow economy is about $970 billion, or nearly 9% that of the real economy. It should soon pass $1 trillion.
What is largely fueling the underground economy, experts say, is the nation's swelling ranks of low-wage illegal immigrants. The government puts this population at 8.5 million, but that may represent a serious undercount.
Robert Justich, a senior managing director at Bear Stearns Asset Management in New York, makes a persuasive case in a forthcoming paper, "The Underground Labor Force Is Rising to the Surface," that illegal immigrants actually number 18 million to 20 million. If true, the economic implications are profound and could help shape debates slated in Washington this year over both immigration policies and tax reform.
Measuring the size of the underground economy is, of course, more art than science, since most of its denizens seek to remain anonymous. But convincing anecdotal evidence and a number of credible academic studies suggest that it is expanding briskly -- probably by an average of 5.6% a year since the early 1990s, edging out the real economy.
In the process, the underground economy is undermining the effectiveness of the Internal Revenue Service, which is highly dependent on employees' withholding taxes. If the IRS could collect all the taxes it says that it is owed from the underground economy in a given year, then the current budget deficit would disappear overnight. And if the IRS could collect these taxes every year, then the nation would have surpluses as far as the eye can see.
The IRS has estimated that its tax gap -- the estimated amount of taxes owed minus the amount collected -- is around $311 billion in any given year. The agency will produce a new estimate in 2005, and it could be as high as $400 billion, says former IRS Commissioner Donald Alexander. Now a lawyer in Washington, he cites a rise in private contracting and the opportunities it affords for not reporting income.
The gap number measures only a portion of the underground economy. Because the number is extrapolated from audited returns, it makes no allowances for criminal enterprises that report no income, and it even fails to capture some garden varieties of non-reporting. The unreported wages of illegal immigrants alone could be costing the government another $50 billion a year, says Justich.
Growth of the underground economy is partly a result of corporate downsizing, which has forced many former employees to go out on their own.
"We have had an 85% taxpayer compliance rate," says Nina Olson, the IRS's taxpayer advocate. "I expect the number to decline," because the portion of employees subject to withholding is on the wane. Such employees are 99% compliant with tax laws, she says, but in the 21st-century economy, "More and more people are being treated as independent contractors. We are losing people from the withholding environment."
Entrepreneurs often are stymied by the complexity of estimating their taxes and making quarterly payments, which leads to mistakes or out-and-out avoidance. The growth of online commerce may be exacerbating the situation.
There were over 40 million regular users of eBay alone in 2003, up from 23 million in 2002. The sellers are responsible for paying taxes. Some of them set up a business and get a taxpayer ID number; others don't. (An eBay spokesman says the company isn't a tax adviser -- it's up to members to report their taxes.)
Most unsettling to IRS bureaucrats, taxpayers as a group appear to have become less honest. Former New York City Police Commissioner Bernard Kerik is the latest poster boy for the phenomenon. He had to drop his bid to become secretary of homeland security because he failed to pay Social Security taxes for his children's illegal-immigrant nanny.
Kerik is hardly alone: Any homeowner who has been offered two prices by a handyman or a gardener -- a higher one for a payment by check, a lower one for all cash -- knows how quickly the savings can add up. In one twist on off-the-books business, the New York Times recently reported on a rise in mechanics who repair cars at curbside for untraceable cash payments. They are not in want of customers. In some cities, including Boston, owners of battered cars get similar offers from itinerant body-repair "experts."
In speeches, IRS Commissioner Mark Everson is fond of citing a survey by his agency showing that the number of Americans who consider tax-cheating acceptable rose from 11% in 1999 to 17% in 2003.
Former Commissioner Alexander, who ran the agency during the Nixon, Ford and Carter administrations, said he urged Congress to pass a law making customers responsible for withholding some taxes on services provided by carpenters, plumbers and other self-employed contractors. Customers would have had to hold back 5% of the cost of services and forward it to the IRS, but Congress failed to embrace the measure.
Result: The underground economy has kept growing nearly unchecked. Academics accept the work of Austrian Friedrich Schneider as the best estimate of the underground economy's size. Using data on currency flows and the consumption of electricity, he guessed that in 1996 it was about 8.8% of the nation's gross domestic product. This estimate was made before the flood of immigration from South America, so it might be conservative if used today, when the nation's GDP stands at $11 trillion.
To be sure, the U.S. underground economy, as a percentage of GDP, is smaller than those of some other countries. In a 2000 paper in a publication of the Independent Institute, a nonprofit research organization, Schneider found that Greece, as of 1998, had the largest underground economy, at 29% of its GDP, followed by Italy at 27.8% and Spain at 23.4%. Countries with high tax burdens and high social security costs lead the list.
But the sheer growth of the underground economy in the U.S. is cause for concern. If Justich's estimate of illegal immigrant workers is correct, the underground economy may now be growing at a markedly faster rate than the legitimate economy. Justich, working with Bear Stearns colleague Betty Ng, an emerging- markets economist, says he's found evidence of a larger illegal immigrant population by analyzing data on construction and on remittances sent from the U.S. to Mexico and other countries. He also had conversations with over 100 immigrants from Mexico, Brazil, the Dominican Republic, Guinea, China and Tibet. And he interviewed local business owners, real-estate sales people and police.
Justich, a veteran securities analyst, currently specializes in fixed-income strategies at Bear Stearns Asset Management, which oversees some $29 billion in investments. He began digging into the underground economy because of its broad ramifications for the real economy. In his spare time, he has been exploring the immigrant communities of northern New Jersey for his work as executive producer of a documentary film about immigrants and the importance of their former national anthems in their lives.
From all this, Justich concludes that Fed Chairman Alan Greenspan's estimates of productivity gains are overly rosy. "The productivity miracle may be slightly overstated because they are counting the output of millions of illegal immigrants but not counting the input," he says. Likewise, long-term budget projections could be overstating the potential growth of the legitimate U.S. economy or underestimating the need for high illegal immigrant flows to hit the forecast growth targets.
Ideas like that could well become food for thought for House Ways and Means Committee Chairman Bill Thomas of California. He wants to push ahead with tax reform this year, including the creation of a national sales tax and reduction of income taxes. In theory, a sales tax would capture the underground economy, since all wage earners have to spend money to live.
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