Shadow Economies on the Rise Around the World

(An error was corrected in the second paragraph. It is as much as $1.2 trillion in taxable income, not taxes, that eludes the IRS annually because of the U.S.'s shadow economy.)

It turns out that countries have two economies: the official one and a shadow version. The official economy is the one that governments and banking institutions measure with gross domestic product, tax receipts, social security contributions, employment identification numbers, and the like. The shadow economy is all the money and jobs generated outside the official economy, whether legally or illegally. In more than 50 countries around the world, the shadow economy is at least 40 percent the size of documented GDP.

In percentage terms, the biggest shadow economy relative to official economic activity is in the former Soviet republic of Georgia. In 2007, the last year for which data were available, revenue from all Georgia's goods and services generated off the books amounted to 72.5 percent of official GDP. In other words, the government is losing out on billions of taxable dollars it could use to improve the national infrastructure, service debt, build schools and roads, even hire better tax collectors. At the other end of the scale, the U.S. shadow economy equaled only 9 percent of the country's official economy. Given U.S. GDP of $14.26 trillion, the world's largest, that could still be as much as $1.2 trillion in taxable income that slips through Uncle Sam's fingers each year.

The size of a shadow economy can be vitally important. As became painfully clear during the Greek economic crisis, one of the factors that nearly drove the country into bankruptcy was that Greek workers and companies skirted more than 31 billion euros in taxes, which is more than 10 percent of GDP.

In an updated report, Shadow Economies All Over the World: New Estimates for 162 Countries from 1999 to 2007, Greece comes across as a model of fiscal responsibility when compared with dozens of other nations. In the report's ranking from least to most shadowy, Greece is No. 57, with a shadow economy equal to 31 percent of GDP in 2007.

Wide Margin of Error

Nailing down shadowy numbers is difficult, of course. According to Friedrich Schneider, an economics professor at Austria's Johannes Kepler University of Linz who co-authored the study, the margin of error baked into the results is about 15 percent. Therefore, while the report says Georgia's shadow GDP in 2007 was 72.5 percent, that number could be less—or even more. What we do know is that Georgia's official GDP, according to the CIA's World Factbook, is approximately $20.3 billion, but if the shadow economy were added, it could potentially be as much as $30 billion or so.

Schneider points out that for the purposes of his study, he and his colleagues, Andreas Buehn of Technische Univerität Dresden, and Claudio E. Montenegro of the World Bank and the Universidad de Chile, excluded what they call "typical underground, classical economic crime activities," such as burglary and drug-dealing. They also did not focus on tax evasion. What they did focus on was what "all market-based legal production of goods and services that are deliberately concealed from public authorities" to avoid payment of taxes, social security obligations, and labor laws. That means basically small and large businesses, doctors, contractors, nannies, grocers, and others from a broad swathe of the economy who choose not to report income and transactions.

One notable finding is that from 1999 to 2007, shadow economies appear to be on the rise in nearly every country the study ranked. For example, America's shadow economy in 1999 was 8.6 percent and climbed to 9.0 percent in 2007. (The number was higher for developing countries, where shadow economies increased from an average of 36.6 percent in 1999 to 38.6 percent in 2007, as opposed to an increase of 16.8 percent to 18.7 percent for the 25 high-income OECD countries.) The reason behind the rising numbers? "Taxation and regulation increased in most countries" over the past 10 years, says Schneider. As he writes in his report: "reducing the tax burden is the best policy measure to reduce the shadow economy, followed by a lessening of fiscal and business regulation."

When the Shadow is Real

But for many developing nations like Peru, the huge shadow economy results from growing urbanization and more commerce, says Daniel Córdova, dean of the graduate school at Universidad del Pacífico and director of the Invertir Institute, an NGO that promotes entrepreneurship.

"What you call the shadow economy is the real economy" in Peru and other countries in Latin America, says Córdova. In the study, Peru has the fourth-largest shadow economy.

Many Peruvians do not have social security numbers and are not on a formal payroll, says Córdova. With a labor-intensive bureaucracy, it can be difficult to start a formal business. In Peru, the poor population's assets amount to $90 billion, according to the website of the Instituto Libertad y Democracia, a think tank in Lima.

What is clear is that regardless of what taxpayers believe, the countries with the most efficient tax collection and enforcement systems are the ones that tend to have the smallest shadow economies.

Schneider goes even further. He and his co-authors suggest that the solution is not just more efficient tax collecting and lighter regulation, but also to find a way to make work in the official economy more attractive and reduce the incentives to participate in the shadow world. At a time when official economies around the globe are dealing with high unemployment, it might be some time before shadow economies lose their appeal.