Over at the New Yorker, James Surowiecki has clued in to the fact that much taxable income in the United States is going untaxed, and that Americans appear to be flocking to an underground economy beyond the reach of regulators and the Internal Revenue Service. He bemoans the resulting tax gap and the loss of "confidence in the system," but he barely touches in a credible way on why so many Americans seem to be surging into the shadow economy, even though most economists agree that people flee high taxes and strict regulations.
Surowiecki first notes the"tax gap" that has bedeviled tax collectors, politicians and economists for years. Writes Surowiecki:
When we all finished filing our tax returns last week, there was a little something missing: two trillion dollars. That's how much money Americans may have made in the past year that didn't get reported to the I.R.S., according to a recent study by the economist Edgar Feige, who's been investigating the so-called underground, or gray, economy for thirty-five years. It's a huge number: if the government managed to collect taxes on all that income, the deficit would be trivial. This unreported income is being earned, for the most part, not by drug dealers or Mob bosses but by tens of millions of people with run-of-the-mill jobs—nannies, barbers, Web-site designers, and construction workers—who are getting paid off the books. Ordinary Americans have gone underground, and, as the recovery continues to limp along, they seem to be doing it more and more.
Collecting those uncollected taxes is a long-time dream, but it's wildly unrealistic. As I wrote in the run-up to last week's tax day, "the IRS is already the envy of tax collectors around the world for the relatively large degree of cooperation it receives from the American people, resulting in a smaller tax gap than other nations could ever hope to achieve." In dollar terms, the amount of uncollected taxes in the United States seems vast, but as a percentage of taxes owed, it's smaller than that in any other country. The tax compliance figure in the U.S. is 83.10 percent; the next highest figure I've seen is 77.97 percent in the U.K.
But it's true that tax compliance seems to be dropping in the United States, and that Americans seem to be flocking to the shadow economy. As U.S. News & World Report's Rick Newman did, a few weeks ago, Surowiecki notes that consumer spending is strongly outstripping what you'd expect from official income numbers. Writes Surowiecki:
Measuring an unreported economy is obviously tricky. But look closely and you can see the traces of a booming informal economy everywhere. As Feige said to me, "The best footprint left in the sand by this economy that doesn't want to be observed is the use of cash." His studies show that, while economists talk about the advent of a cashless society, Americans still hold an enormous amount of cold, hard cash—as much as seven hundred and fifty billion dollars. The percentage of Americans who don't use banks is surprisingly high, and on the rise. Off-the-books activity also helps explain a mystery about the current economy: even though the percentage of Americans officially working has dropped dramatically, and even though household income is still well below what it was in 2007, personal consumption is higher than it was before the recession, and retail sales have been growing briskly (despite a dip in March). Bernard Baumohl, an economist at the Economic Outlook Group, estimates that, based on historical patterns, current retail sales are actually what you'd expect if the unemployment rate were around five or six per cent, rather than the 7.6 per cent we're stuck with.
I usually quote Friedrich Schneider for my shadow economy figures, mostly because he offers the widest range of countries to compare. But Edgar Feige is also well-respected, and the different approach he uses for examining the U.S. economy has been coming up with larger non-compliance rates than official numbers suggest. Reported Feige and Richard Cebula in a 2011 paper: "18-23 % of total reportable income may not properly be reported to the IRS."
The why of this flight from the legal protections and relative security of the above-ground economy isn't a huge mystery. Surowiecki tries to emphasize cultural changes that have companies and workers both preferring contactors and temp work, but many of those shifts seem likely responses to taxes and regulations that make traditional employment more expensive and less attractive than it once was. As Surowiecki concedes, "Feige points to the growing distrust of government as one important factor. The desire to avoid licensing regulations, which force people to jump through elaborate hoops just to get a job, is another."
Overall, though, Christie and Holzner conclude that tax rates matter — when rates are higher, people hide more money; when rates come down, people put less effort into evading the authorities. "[W]e found as our most general result that tax evasion is positively correlated with the tax rate itself … reducing average effective tax rates should positively impact on compliance rates."
Schneider agrees, writing in Shadow Economies of 145 Countries all over the World: What do we really know? (PDF), "In almost all studies it has been found out, that the tax and social security contribution burdens are one of the main causes for the existence of the shadow economy." He adds, "The bigger the difference between the total cost of labor in the official economy and the after-tax earnings (from work), the greater is the incentive to avoid this difference and to work in the shadow economy." …
But it's not only taxes – the rest of the economic environment matters, too. Remember, two of the four reasons Schneider gave for people fleeing the tax man have to do with regulations and bureaucracy. And, indeed, he finds, "every available measure of regulation is significantly correlated with the share of the unofficial economy and the sign of the relationship is unambiguous: more regulation is correlated with a larger shadow economy." In particular, enforced regulations — not just nominal red tape to which people turn a blind eye — drives people into the shadows.
Summarizing the argument, Professor Pietro Reichlen of Rome's Luiss University told the Financial Times in a June 2011 article on Europe's hidden economy, "Among the main causes of the black economy is the level of taxation. The higher the tax and the regulatory burden the bigger the shadow economy of the country." He recommended simplifying and reducing taxes, reducing the regulatory burden, including laws that make it difficult and expensive to hire and fire workers, and improving often-corrupt, archaic and unresponsive judicial systems.
Surowiecki bemoans the "damaging effects of this trend," but he should pay more attention to the damaging taxes and regulations that caused this trend by pushing people to work off the books. People aren't depriving themselves of legal recourse and traditional benefits because it's suddenly hip to do so — they're hiding in the shadows because red tape and taxes are strangling the legal economy.