To Escape Regulations and Taxes, People Hide in the Shadows

Economic freedom is the key to reducing shadow economics.

Reduced, if only figuratively, to shaking the dust from their piggy banks, government financial types from California to Cardiff have turned their eyes to that ever-elusive dream: Dragging those who have fled into the shadow economy back out into the open where they can be induced to keep the machinery of the state running just a little bit longer. Is there enough money out there to merit the taxman's interest? Almost certainly; California officials are salivating over the prospect of $7 billion in revenue, while the European Commission estimates that €2 trillion is hiding out there. Can the taxman actually collect any of that money? Well ... That's another question entirely. Left largely unasked by government officials, though, is this: Why have so many of their subjects chosen to operate in the shadows, forsaking the protections of legal status and effectively painting large targets on their backs? Could governments be chasing away the objects of their interest with excessive attention?

First of all, what do we mean by "shadow economy"? Are we talking hookers and blow? Black market plutonium? Human organs illegally harvested from nightclubbers left abandoned in tubs of ice in Newark motels? Not at all—that's all separate and in addition to the shadow sector. Friedrich Schneider, chair of the Department of Economics at Johannes Kepler Universitat in Linz-Auhof, Austria, and one of the world's foremost experts on "shadow" economic activity, put forward his widely accepted definition of such activity in a 2010 paper for the World Bank co-authored with Andreas Buehn and Claudio E. Montenegro:

[T]he shadow economy includes all market-based legal production of goods and services that are deliberately concealed from public authorities for any of the following reasons:

(1) to avoid payment of income, value added or other taxes,

(2) to avoid payment of social security contributions,

(3) to avoid having to meet certain legal labor market standards, such as minimum wages, maximum working hours, safety standards, etc., and

(4) to avoid complying with certain administrative procedures, such as completing statistical questionnaires or other administrative forms.

Say Schneider and his associates, "the overall tax and social security contribution burdens are among the main causes for the existence of the shadow economy." They also note that "[i]ncreased intensity of regulations is another important factor that reduces the freedom of choice for individuals engaged in the official economy" and they cite research by others concluding that "every available measure of regulation is significantly correlated with the share of the unofficial economy."

Writing in a widely cited Journal of Public Economics paper (PDF) in 2000, Eric Friedman, Simon Johnson, Daniel Kaufman and Pablo Zoido-Lobaton didn't quite agree. They believed that "relatively uncorrupt governments can sustain high tax rates," tolerated by business people and workers alike who appreciate being otherwise left alone, but that "when faced with onerous bureaucracy, high levels of corruption, and a weak legal system, businesses hide their activities 'underground'."

By either theory, if government officials want to keep business activity in sight where it can be taxed at any level, they have to learn to leave it largely unmolested.

If that's so, countries with handsy governments that can't keep their paws off the productive sector should have bigger shadow economies than countries with governments that mind their manners. As it turns out, that's largely true. To get an idea of what that means in as fair a comparison as possible, let's look at recent figures for 21 "highly developed" members of the Organization for Economic Cooperation and Development and compare their shadow economies as a percentage of their GDPs in 2007 (PDF).

  • Australia: 10.7
  • New Zealand: 9.8
  • Switzerland: 8.2

    *
  • Canada: 12.6
  • Ireland: 12.7
  • United States: 7.2
  • Denmark: 14.8
  • United Kingdom: 10.6
  • The Netherlands: 10.1
  • Finland: 14.5
  • Sweden: 15.6
  • Japan: 9.0
  • Germany: 14.6
  • Austria: 9.4

    **
  • Spain: 19.3
  • Belgium: 18.3
  • Norway: 15.4
  • France: 11.8
  • Portugal: 19.2

    ***
  • Italy: 22.3
  • Greece: 25.1

So you see ... Wait a minute ... That's not alphabetical! What kind of wacky ordering system is that? Oh, that's right—the countries are listed in the order of their ranking in the 2012 Index of Economic Freedom. The top three countries are ranked "Free," the countries between one star and two stars are "Mostly Free," and those between two stars and three stars are "Moderately Free." Italy and Greece are "Mostly Unfree" dumps—dumps with delicious food, yes, but authoritarian dumps where, as the Heritage Foundation, which sponsors the Index, says of Italy, "the foundations of economic freedom remain weak in the absence of an efficient judicial framework to provide effective and timely resolution of cases. Corruption, often involving government officials, is a growing concern, severely undercutting confidence in the government." As for Greece, "[t]he overall regulatory framework is hampered by government bureaucracy, and efforts to enhance the business environment have been sporadic at best."

By contrast, "Australia’s regulatory environment is one of the most reliable, transparent, and efficient in the world, offering a high degree of certainty for business planning." In New Zealand, "The top income tax rate is 33 percent, and the top corporate tax rate has been cut to 28 percent.... Start-up companies enjoy great flexibility under licensing and other regulatory frameworks. With no minimum capital required for launching a company, it takes only one day to start a business."

Among the "Free" and "Mostly Free" countries above, the average size of the shadow economy is 11.4 percent. The average size of the shadow economy for "Moderately Free" and "Mostly Unfree" countries is 18.8 percent. Allowing for cultural differences and country-by-country oddities in tax rates, corruption, and regulation, that's a pretty strong correlation between economic freedom and smaller shadow economies, on the one hand and the lack thereof fueling larger shadow economies on the other.

So, as government officials around the world try to figure out the most effective way to bring businesses and workers out in the open, the best advice may be the simplest: Leave them alone.

J.D. Tuccille is managing editor of 24/7 News at Reason.com.

Editor's Note: We invite comments and request that they be civil and on-topic. We do not moderate or assume any responsibility for comments, which are owned by the readers who post them. Comments do not represent the views of Reason.com or Reason Foundation. We reserve the right to delete any comment for any reason at any time. Report abuses.

  • SIV||

    Part of the whole "free money" sell for the fair tax is all the revenue it will recover from the shadow/underground economy (illegal immigrants and drug dealers). Hard to believe this is now the #1 plank of the Libertarian Party presidential candidate.

  • Brandybuck||

    It's not his plank. He does want to replace the income tax with a form of a national sales tax, and he does sometimes call it a "fair tax". But it bears no resemblance to the bureaucratic monstrosity known as the FairTax(tm). The FairTax(tm) aims to be revenue neutral yet that LP candidate wants to cut spending 43%. Hard to square away if he wants a word-for-word implementation of FairTax(tm).

  • SIV||

    Cite?

    Gay Jay wants to cut defense spending 43%.I've seen nothing about an "across the board" cut of that magnitude.

    "Fair Tax" is capitalized repeatedly in his campaign blog. That indicates Gary supports the trademarked tax. I assume either the existing legislative proposal or the Boortz/Linder plan.

  • Calidissident||

    The defense cuts are part of an across the board cut.

    http://reason.tv/video/show/gary-johnson-candidate

  • Palin's Buttplug||

    Boortz is an AM radio wingnut fool and Linder retired long ago.

    Who is sponsoring the Fair Tax now? Anyone?

  • Libertarius||

    Boortz is the same kind of cowboy libertarian as Clint Eastwood and myself.

    "Liberals" like yourself are sycophantic feminist bitch boys who piss sitting down and tuck your balls so you can be "progressive" like those hipster faggots on tv

  • Libertarius||

    Boortz is the same kind of cowboy libertarian as Clint Eastwood and myself.

    "Liberals" like yourself are sycophantic feminist bitch boys who piss sitting down and tuck your balls so you can be "progressive" like those hipster faggots on tv

  • Libertarius||

    Boortz is the same kind of cowboy libertarian as Clint Eastwood and myself.

    "Liberals" like yourself are sycophantic feminist bitch boys who piss sitting down and tuck your balls so you can be "progressive" like those hipster faggots on tv

  • Brutus||

    That was worth saying three times.

  • Mr. FIFY||

    And you're still a cunt, shrike.

  • R C Dean||

    The FairTax(tm) aims to be revenue neutral yet that LP candidate wants to cut spending 43%.

    In order to balance the budget at current revenue levels, you will have to cut spending 43%. A revenue neutral change to our tax code of any kind plus 43% spending cuts equals a balanced budget.

  • Overt||

    Not sure how the fair tax will necessarily remove a shadow economy...Nor any sales tax that is sufficiently large to capture the level of federal revenues needed for the leviathan. Even if reduced to smaller amounts a, say, 20% sales tax would be a pretty good incentive to conduct transactions off the books.

  • SIV||

    It's human nature to avoid paying taxes. The Fair Tax is sold as the way to recover more revenue. No one can buy everything off the books. Particularly with the leviathan of the IRS switched over to Fair Tax compliance.

  • Overt||

    I'm actually a fan of the Fair Tax. However I find these types of claims to be less persuasive.

    The first step after adopting the FT is turning the Leviathan of the IRS into a nice pool of potential accountants and financial analysts in the private sector. Those that remain will not be able to deal with chasing around bootleg cigarette sellers.

    Actually, I wonder if there isn't a stronger correlation between "Consumptive Tax" (Sales tax, VAT, etc) and Shadow Economies.

  • Libertarius||

    Dude...our giant, bloated, rotten income tax system doesn't capture nearly enough revenues for leviathan as-is, and it also kills incentive for investment and production (and thus employment) to boot.

    The FairTax is by far the best tax system I've seen proposed.

  • David_TheMan||

    The No tax is the best system I've seen proposed.

  • Overt||

    That list is not at all statistically compelling to prove the author's thesis that "less free" countries encourage more shadow economies. France (3rd cohort) is only 10% different than Australia (1st Cohort). 5 of the 11 "somwhat free" countries have smaller economies than Australia- the most free of them all.

    That isn't to say that the author's thesis is wrong, just that it is a pretty bad analysis.

  • Libertarius||

    The "free money sell of the FairTax", i.e. taxing the expenditures of "ill-gotten gains" when they are spent in public commerce, is a side-issue to supporting the FairTax.

    The FairTax is about making taxation voluntary (as voluntary as it can be) and removing the disincentives for investment and production which are inherent in an income tax system.

    I am a Libertarian who lives on earth, and I support the FairTax.

  • SIV||

    A national consumption tax is the perfect tool for social engineering and crony capitalism.

  • Harvard||

    A case can be made that one's true patriotic duty is to avoid paying any tax, ever, insofar as that's possible.

    Barter! The new fife and drum.

  • ||

    And a progressive tax isn't?

  • Libertarius||

    You can't be serious. A national, universal sales tax is going to foster cronyism--as opposed to 100,000 pages of an income tax code that no one understands (including those who are supposed to enforce it), and makes a potential criminal of anyone who makes any money?

    Fuck man, the income tax is what pays the bills on K Street and you say the FairTax will be a boon for cronyism? Nuts.

  • Brutus||

    If a NST (which I favor) is going to be implemented, I see several things that need to happen along with it:

    * Amendment that not only repeals the 16th Amendment, but which also prohibits the taxation of income on any entity (there's a debate about whether A16 actually did anything...I think it did not)

    * Same Amendment requires that the percentage levied must either be equal across the board or within a tight range to prevent just what you're saying, and no exemption may be granted

    * I can see per-person exemptions, but those would be hammered out in statute.

  • Palin's Buttplug||

    Hilarious. Australia is often cited for its economic freedom by wingnuts yet has national healthcare and is instituting a carbon limit/trading tax.

  • Libertarius||

    Australia is a Chinese mining colony, their healthcare sucks, and carbon taxes will be the death of environmentalism.

  • Mr. FIFY||

    "China... is instituting a carbon limit/trading tax"

    And you consider this to be a good thing, shrike?

    Goddamn, you're a fucktard.

  • ||

    Attempting to push that shadow eonomy into the taxed and regulated legal economy might just bethe fastest ay to turn progressive hipsters into libertarians.

  • blackjack||

    Here in CA, the shadow economy is driven more by regulatory burdens than taxation. Open a shop and the 'crats show up like flies demanding tribute (all of the tributes have at least doubled since '08)

    Consumption tax scares me, because it will be phased in piggy backed on existing taxes, like Europe. there's no way they will ever release their grip on income and all the other taxes. Just talking about consumption taxes at a national level might plant seeds. But, again, I live in CA, so paranoia isn't too crazy.

  • Canman||

    When it comes to economic issues, conservatives and libertarians tend to present data that show a correlation.

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