The Informal Economy Is Becoming Significant When you pay for a steak at a restaurant, you’re supporting the formal economy. Part of the price of your meal pays for taxes, which in turn pay for schools, roads, police and fire protection, and so on.
If you leave a tip for the server in cash, however, you’re supporting the underground or informal economy. Because there’s often no paper trail of the transaction, and the government relies on waiters to report their own tips, it’s up to the waiter to decide whether he will pay taxes on his earnings.
According to the job-search site Monster.com, the U.S. workforce includes 2 million waiters and waitresses, some of whom earn $50,000 or more a year, but pay very low taxes.
The Internal Revenue Service found that taxpayers reported total earnings from tips of $14.3 billion in 1999. However, every year, billions of dollars in tips are not reported.
And, that is just the tip of the iceberg. It doesn’t include the wages that are earned off the books by moonlighting plumbers, electricians, and carpenters. Nor does it count the day-care workers, maids, house painters, construction workers, or gardeners who are paid strictly in cash. Many of the estimated 8.7 million illegal immigrants in the U.S. in 2000 earn all of their income as undocumented workers.
Of course, the underground economy encompasses the black market for products like marijuana. About $25 billion worth of marijuana is grown in the U.S. each year, according to the book Reefer Madness, by Eric Schlosser, the author of Fast Food Nation. Because the drug is illegal, no taxes are collected on its sale. If the government legalized and taxed marijuana at 10 percent, it could generate $2.5 billion from sales of the domestic crop alone.
In all, the underground economy accounts for $2.35 trillion in tax-free wages, according to Edgar L. Feige, a retired economics professor at the University of Wisconsin. Feige reached this estimate by studying the amount of currency circulating in the economy ? about $1,600 for every adult and child in a recent year ? then subtracting the amount that could be expected to be used per person for legal transactions.
His conclusion is supported by research by the International Monetary Fund, which revealed that the underground economy has been growing in the U.S. for the past three decades. Economic activity from the underground activity, according to the IMF, has risen from 4 percent of the U.S. gross domestic product in 1970, to 6.7 percent in 1990, to 8.6 percent today.
In cities like Los Angeles, undocumented workers represent about 10 percent of the workforce. That leads to a fascinating two-tiered job market. While the formal economy and the labor market are stagnant, the underground economy is booming, according to the Los Angeles Times. The newspaper quotes UCLA labor economist Daniel Mitchell: “You often find this phenomenon in less-developed countries. Some have said we’re now importing that characteristic.”
In fact, all around the world, the informal economy is big business. According to the World Bank, it accounts for 40 percent of the GNP of low-income nations and 17 percent of the GNP of high-income countries. In industries like construction and retailing, four of every five workers may be paid “off the books,” as employees who officially do not exist.
Some government policy makers and academic scholars believe that the informal economy is good for society because it creates jobs for unskilled workers. Further, they assert that it will gradually disappear as more jobs emerge in the manufacturing and service sectors.
These theories are all wrong, according to research by the McKinsey Global Institute. The Institute studied informal economies over the past 10 years in such nations as India, Brazil, Poland, Russia, Turkey, and Portugal.
The study found that informal businesses exploit their savings on taxes to compete more effectively than companies that play by the rules. As a result, the informal companies win market share, stay in business, and keep employing people who might otherwise go to formal companies.
Informal companies actually enjoy several unfair advantages. They don’t have to pay taxes to the government, meet minimum-wage requirements for their employees, honor the copyrights and patents of their competitors, satisfy quality standards for their products, or provide guarantees to their customers.
Because of these advantages, the informal economy is growing in many countries. In Brazil, it employs 50 percent of nonagricultural workers, up from 40 percent 10 years ago, according to an article in The McKinsey Quarterly by Diana Farrell, the director of the McKinsey Global Institute. It’s also increasing in Sweden, because businesses are trying to dodge the country’s high taxes.
What is driving this trend? Farrell identified three forces:
Poor enforcement of laws. Because of inefficient bureaucracies and lax judicial systems, employers are seldom caught when they pay workers under the table, and those that are found guilty are given light punishments.
The cost of operating formally. Many businesses would rather break the laws than to try to comply with government regulations, obey safety codes, and pay high taxes.
Social norms. In some developing countries, people view the breaking of laws and the nonpayment of taxes as legitimate tactics that small underdog businesses must use to compete against big companies with superior technology and large budgets.
Farrell found that once a company makes the choice to operate informally, it is almost impossible to reverse the decision. Informal companies typically work with informal suppliers. In Russia’s grocery industry, India’s apparel industry, and Brazil’s beverage industry, companies have built whole value chains on informal transactions. This means they can offer lower prices than formal competitors. But it also means that their customers now expect lower prices, and any attempt to become a formal business would lead to higher costs ? and lower sales.
Despite their unfair cost advantages, informal companies are actually less productive than legitimate businesses. One problem is that they can’t borrow from banks, so they have to turn to unregulated lenders for loans at enormous interest rates. Another obstacle is that they can’t use the legal system for protection from fraudulent suppliers or deadbeat customers.
For these reasons, Farrell found, informal businesses damage the productivity of countries like Portugal or Turkey, accounting for 50 percent of the productivity gap with the U.S.
Meanwhile, in India, the pirating of software by informal competitors is cutting into the profits of the innovative firms in that industry. According to Farrell, if software pirating dropped in India to U.S. levels, India’s productivity and profits would rise by up to 90 percent.
What lies ahead for the underground economy? Based on our analysis, we offer the following five forecasts:
First, the underground economy will continue to grow dramatically in the United States until the government takes action to curtail it. This prediction is backed by trends that strongly indicate that as the economy continues to grow, it will demand more services. For example, the rising number of women in the workforce will continue to drive up demand for child-care workers. And the increase in the hours worked per week by men and women suggests that more people will have less time to handle their own chores, so they will pay others to paint their houses, mow their lawns, and serve their meals.
Second, the IRS could soon crack down on the 2 million waiters and waitresses in the U.S., many of whom underreport their income from tips. In a 2002 decision, the Supreme Court ruled that the IRS can determine a restaurant’s share of FICA taxes by making a reasonable estimate of its employees’ earnings from gratuities. As a result, the IRS was permitted to demand an additional $23,000 in taxes from a San Francisco restaurant for tips that were paid in cash. Now that it can estimate employees’ tips in order to collect FICA contributions from restaurants, it is only one step away from pursuing individuals who earn most of their living from gratuities.
Third, tax codes will be simplified. It’s hard to collect the right amount of taxes based on revenues when the accuracy of those revenues cannot be verified. One sensible solution is now being used in Spain. Restaurants and grocery stores are taxed on the size of their sales floor. Under this innovative approach, Spain has boosted the amount of taxes it has collected from smaller businesses by 75 percent. Another more radical approach is to implement a national sales tax of say 17% to replace the income tax. This makes revenues and profits irrelevant for tax purposes and removes much of the incentive to become part of the underground economy.
Fourth, the penalties for tax evasion will be increased, especially in developing nations. In developed countries, tax cheats are often fined 200 to 300 percent of the tax and given prison sentences. In emerging markets, the punishment is typically light. For example, in Turkey, businesses that avoid the value-added tax on retail sales, which is 18 percent, are fined less than $20. When the punishments are increased, tax evasion will drop. This should apply to businesses failing to properly remit sales or value-added taxes, as well as those evading income taxes.
Fifth, stricter enforcement of tax laws will unleash a virtuous cycle of lower taxes and higher productivity over the long term. If the government collects taxes from more companies and individuals, it can lower the tax rates for all of them. With lower taxes, companies can invest in new technologies and market new products. Individuals who pay lower taxes will have more money to spend on those new products, which in turn will lead to more money for companies to invest in R&D. For example, in Turkey, the McKinsey Global Institute discovered that the government collected only 64 percent of the value-added tax it should receive from retail sales. If Turkey received 90 percent of the tax, it could lower the tax rate from 18 percent to 13 percent, which would lead to more consumer spending, greater revenues, and a stronger economy.
References List :
1. Reefer Madness: Sex, Drugs, and Cheap Labor in the American Black Market by Eric Schlosser is published by Houghton Mifflin Company. ⓒ Copyright 2003 by Eric Schlosser. All rights reserved.2. Fast Food Nation by Eric Schlosser is published by Houghton Mifflin Company. ⓒ Copyright 2001 by Eric Schlosser. All rights reserved.3. Barron’s, August 4, 1997, "Casting a Long Shadow: The Sprawling U.S. Underground Economy May Exceed 11% of GDP," by Gene Epstein. ⓒ Copyright 1997 by Dow Jones & Company. All rights reserved.4. The McKinsey Quarterly, 2004 Number 3, "The Hidden Dangers of the Informal Economy," by Diana Farrell. ⓒ Copyright 2004 by McKinsey & Company. All rights reserved.5. To access the article "Prepare to Pay Taxes on Your Tips," by John Rossheim, visit the monster.com website at: www.hourlyandskilled.monster.com/rest/articles/taxingtips
