Though policymakers, researchers, journalists, and others speak frequently of the underground economy, they often talk past each other because underground economic activity has not been clearly defined. Is it the production and distribution of illicit goods and services, such as crack cocaine and prostitution? Does one instead mean economic production that is simply unaccounted for because the producers wish to avoid paying taxes--as in the case of a bartering transaction between a dentist and her manicurist? Or are we referring to home production--the value of output from the family garden plot?
These belong to different categories of economic activity. But what is common among all three is that they are difficult to measure systematically and often elude those drawing up the national income and product accounts. In this respect, official estimates of national income understate the true level of output.
To what extent is it a problem that we do not account for all economic activity? The answer depends on the activity's character. The implications of not accounting for home asparagus production are fairly inconsequential. In contrast, knowledge that the illicit drug trade has doubled has longstanding economic and social implications. Likewise, tracking growth in the level of tax evasion and understanding the degree of unreported economic activity that takes place are important. Increased tax evasion will result in a declining tax base, which will undermine the fiscal authorities' ability to finance infrastructure projects. Unregulated production, meanwhile, may have important consequences for worker safety. In this respect, the measurement of illicit economic activity and of unregulated and untaxed economic activity is vital. In what follows, I limit my discussion to these two broad categories of underground activity: illicit economic production and unregulated or untaxed economic production.
Clues and Traces of Underground Economic Activity
To measure the magnitude of underground activity, we can sum estimates of unrecorded economic production for each sector. However, such an analysis requires an inordinate amount of specialized information about illicit drug production, illegal prostitution, the loan sharking industry, tax evasion, and so forth. As such, the sector-by-sector approach is suboptimal if we wish to obtain time-series and comparable cross-country estimates. Alternative techniques are more easily applied to many countries and many time periods.
Economic production of goods and services leaves traces on the economy beyond the product or service itself. The mining of ore leaves tailings, and the production of irrigated crops decreases aquifer levels. For those of us interested in accounting for underground economic activity, these by-products constitute our main source of information. By analyzing their behavior, we derive conclusions about changing magnitudes of illicit, unregulated, and untaxed economic activity. We resort to a variety of techniques to uncover the traces left behind.
First, changing labor force participation rates may indicate underground activity. If individuals are trying to "hide" their participation in illicit or unregulated economic activity, or if they are engaged in tax evasion, they may decline to admit that they are in fact working. Increases in underground economic activity would then be reflected in labor force participation rates. In the United States, the labor force participation rate for men over age 20 is currently reported at about 75 percent. In 1970 the rate was much higher; about 83 out of every 100 males over age 20 worked. The eight-percentage-point decrease in official labor force participation is sometimes attributed to a shift in work from the formal economy to the underground economy. There are concerns, however, with this conclusion. Other plausible explanations may account for the large drop in recorded labor force participation: changes in family structure, increased labor market opportunities for women, and changes in retirement patterns are equally compelling reasons. …