Economics

To Escape Regulations and Taxes, People Hide in the Shadows

Economic freedom is the key to reducing shadow economics.

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Shadow economy

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.