Freakonomics Radio - 90. How Deep Is the Shadow Economy?

Episode Date: August 29, 2012

What we know -- and don't know -- about the gazillions of dollars that never show up on anyone's books.

So here are some activities that would go into the shadow economy that are legal, but most people often do, and they just don't report their income. Contracting, a lot of plumbing, painting homes, fixing homes, car repair. Sudhir Venkatesh is a sociologist at Columbia University. Tax preparation is a huge part of the shadow economy. Cutting hair, styling hair, personal training. If you've read either Freakonomics or Super Freakonomics, you may remember Venkatesh. In the first book, he was the deadhead grad student who embedded himself with a crack-selling gang in Chicago for about seven years. In Super Freak, we wrote about how Venkatesh hung out on street corners with prostitutes, interviewing them after each and every trick to learn more about who they are and how they do their jobs.

He spends a lot of time looking into substrata that most of us rarely even think about. Nannies, daycare, people who will bring prepared foods over to your house. So many of the kinds of things that we associate with the service economy are in fact likely to be also part of the shadow economy. And Sudhir, what share of goods sold on, let's say, Craigslist would you estimate to be going toward the shadow economy? I'd say conservatively about 99.9 percent. I'm glad you're in a conservative mood today. That's a conservative estimate. I could reframe those figures if I did study. From WNYC and APM American Public Media, this is Freakonomics Radio, the podcast that explores the hidden side of everything.

Here's your host, Stephen Dubner. Today's show is about the shadow economy, all the activities and the attendant dollars that are not counted in official economic statistics, that escape the attention of the government and especially the government's tax collectors. So, by its nature, this is an elusive topic, but it's made even more slippery, slipperier, by the fact that some of the activities that constitute the shadow economy are illegal and, therefore, even harder to measure.

Here again is the sociologist Sudhir Venkatesh. A lot of economists will take activities like drug dealing or prostitution and call them criminal and say, you know, they're part of the shadow economy, but they're just too hard for us to measure. So we're just going to focus on things that are legal. It's just that people aren't reporting their income to the state. So it seems as though most official or academic estimates of the size of a shadow economy are going to be missing what might be among the most profitable black market transactions, which are illicit transactions, yeah? It's really hard to try and figure out exactly how much drug dealing or prostitution or money lending that's off the books is going on. So usually what happens is that people will try to look only at the activities that are otherwise legal.

Maybe you use your car as a cab. Maybe you cut hair. Maybe you paint someone's house and they don't report the income and so on and so forth. Talk to me for a minute about how one, whether it's you or others, even try to go about and measuring the size of the shadow economy. What kind of methodology, what kind of data are involved? You have to be pretty creative and patient in trying to figure out how big the shadow economy is or what people are doing. Many social scientists, particularly those that want to see what the percentage of the shadow economy is in the country overall, they want big estimates. They'll often do surveys. So they might ask people

very directly, hey, how much did you work illegally in the U.S.? Well, you know, there's a problem. People might not be telling the truth. Other economists might say, you know, to avoid the truth-telling issue, we're just going to take careful estimates. And so they construct very elaborate models. Sociologists like me, who don't trust people at all and believe that we generally don't tell the truth at all, have to go and see someone perform something illegally. So that means we'll go and watch them. And in my case, I'll spend years watching them. The problem is I might only end up watching two dozen people. Well, it's hard to figure out what the country is doing as a whole

by watching two dozen people, let alone your neighborhood. So it's a problem. And as creatively as we want to try to be in measuring it, we often fall short. A lot of smart people have spent a lot of hours trying to get a grip on the size of the shadow economy, not only in the U.S., but around the world. In 2010, a World Bank analysis of 162 countries estimated that 17% of gross domestic product dollars were in fact hidden in the shadows. More recently, a pair of Turkish economists came up with a clever way to measure the shadow economy.

One of them is Ceyhun Algin. In Istanbul, if you go to the main center of the city, which is Taksim, you will see a bunch of people selling stuff on streets, which are legal goods like, you know, pants, T-shirts, whatever. But you can imagine how haphazard it would be to go around counting up all the under-the-table transactions in country after country. So Algin and his co-author took a different approach.

Since we have pretty good data on what people in different countries earn in formal income, as well as how they spend and save and borrow, these economists built a model that essentially filtered out all the shadow dollars from the formal dollars nation by nation. And what did they find? Well, it was a figure pretty similar to the World Bank estimates. They found that roughly one of every five dollars in the world is part of the shadow economy. That's 20 percent. Now, to be sure, there are great differences from country to country. In the U.S.,

the shadow economy is thought to be less than nine percent of GDP. Elsewhere, it is much, much higher. We took a look at these data with Sudhir Venkatesh. When you look at sub-Saharan Africa and you see 40% or even Egypt, you know, 67, 70% of the economy is considered a shadow economy. You got to wonder what they're putting in there. But the situation in some of these countries is that the government is so small, and they're really not used to doing a lot of surveillance over economic activities, that a whole range of otherwise legal activities are subsumed in the shadow economy simply because the government can't go around and find everyone.

So a lot of retail, you may be cutting hair, you may be having a little restaurant, you may never report that income in sub-Saharan Africa or in Egypt or in other parts of the continent, simply because you know that it just takes too much work for the government to find you. Talk to me for a minute about what you know about the size of the shadow economy in the U.S., or if it's better expressed in terms of a share of GDP? There are two estimates that I find reliable. The first is that as a share of GDP, roughly about 8% of GDP could be considered the shadow economy in the U.S. I think that's a conservative estimate, and that's a pretty good one. The other way of doing it, which I find kind of interesting,

is that one out of every five purchases an individual in the U.S. makes is in the shadow economy. So 20% of the consumption occurs in the shadow economy. The reason I like that is that it starts to account for the dollar flows. The thing we have to remember about the shadow economy is that just because what's happening in the economy between a trader and a customer is illegal doesn't mean that the money is actually completely separate from the legitimate economy. In fact, 75 to 80% of the money in the shadow economy eventually gets back into the legitimate economy anyway. It just goes around a couple times first, I guess then, yeah? It sort of goes around, but if it's like a Monopoly board game,

it skips over the little cube that would be the IRS. Now, let me ask you this. What do you know about a shadow economy and its relationship to the recession? Is a shadow economy counter-cyclical? Does it tend to grow during a recession, or do we not know? The best evidence that I've seen suggests that in developed societies, like the U.S. or in most parts of Europe, the shadow economy will grow during a recession, which kind of makes sense because people will look for ways to survive and make ends meet. Now, the exact opposite often happens in developing countries, which is to say that when business is booming in a developing country, the shadow economy will grow. And part of the reason for that is that when business booms, government simply can't keep up and regulate it. And so if

you know that the government is not going to come after you and tax you and regulate you, well, why would you be part of the mainstream economy? Why not just hide the taxes? Why not just do everything off the books so you can keep more of the money yourself? Sudhir, what do you know about the relationship between income level and off-the-book activities? In other words, is a shadow economy largely a feature of poverty or not necessarily? The one study that I've seen, which is interesting, is that as your income rises, the percentage of your trade, the kinds of things that you might trade illegally, grow relative to your consumption. So that in the inner city, if you're trading something for $5, that's probably not a great percentage of what you're making. But as you go up, now, if you're in the suburbs, if you're in the Upper East Side, if you're involved in the shadow economy, you're probably involved in some pretty serious stuff, some pretty serious betting or some financial transactions, money lending, etc. So there are significant dollars that are being exchanged in some places,

particularly as you go up the income spectrum. That's so interesting. It has me thinking about the insider trading trials of the last year or so. And obviously, the profits from those trades would not necessarily be part of the shadow economy because people sometimes pay capital gains taxes. But the value of the information, if one could measure that, that's certainly not being counted anywhere, is it? No, absolutely not. I remember talking to a number of traders in the financial services industry after the economic downturn asking, well, what are you going to do now? And they said, well, tomorrow morning I'm just going to go back to the same company and trade. But, you know, it's going to be totally off the books. And the reason is precisely because information was so valuable. They had the client base. They

had all of those relationships. So the company, they might have needed to lay them off, but they couldn't afford to lose them. There's a big difference. So how would that work? Well, they might say to somebody, we'll allow you to trade for a while. We'll keep the trades on the books, but you won't be recorded as having facilitated that trade. Or we're going to just say that it was done without a middleman. And at the end of the day, we'll give you an unstated commission. Now, all of this is illegal. It involves some fancy bookkeeping.

And it also involves a wish and a prayer that the IRS or the SEC doesn't come looking at your books. That's so interesting. So when someone like me naively thinks of shadow economies, just haircuts and nannies and whatnot, we're missing a lot. That would be missing a lot of it. Looking at a financial services industry and trying to figure out what role the shadow economy plays for them,

the off the books activity. Well, you know what? It's a lot like looking at a developing country. In both places, the people are making a strategic bet, which is that government is too busy to look at them, and they'll look somewhere else, and they're not going to pay attention, and they won't get caught. From WNYC and APM American Public Media, this is Freakonomics Radio. Here's your host, Stephen Dubner. When Sudhir Venkatesh arrived in Chicago as a grad student in 1989, he started hanging out in a very poor neighborhood on the city's south side.

As someone who had grown up in a pretty mellow suburb of San Diego, he was transfixed by what he saw. He hung out more and more and more. And eventually, he wrote a book about what he learned. It's called Off the Books, The Underground Economy of the Urban Poor. The shadow economy in Chicago that I studied could probably best be described by saying that it's comprised of illicit goods or services, meaning things that people do that are completely illegal, drug selling, prostitution, things that are in the shadow economy, not just simply because you're not reporting the income, but you're doing something that's against the law. And those are the things that I studied

actively in Chicago for many, many years. In the mainstream economy or legitimate economy, whatever you want to call it, we have all kinds of regulations and rules and contracts and enforcement. What about in the shadow economy? How are disputes settled? How are contracts, even if just oral, enforced and so on? I once did a study in Chicago where I found that 75% of the conflicts that occur in the shadow economy, meaning that you might say it costs $20 and I heard you say $10 and then we have an argument. Most of those conflicts are solved in 24 hours by just the two of us just trying to figure things out. The reason they resolve so quickly is that you and I probably need each other again and again and again. So we have an incentive to solve it quickly. But in many cases, we may have a disagreement, it may turn violent, and there usually is a third party. So there's another part of the shadow

economy, which is about dispute resolution and conflict mediation. And there are a lot of people out there selling their services as brokers or mediators who will say, you know, for 5% of that exchange or for a couple bucks, I'll hear both of your grievances and I'll tell you who I think is right and who is wrong. And I understand that you settled one or two disputes yourself, yes? Unwittingly, I was drawn into a number of disputes. And they were fascinating because they were everyday exchanges, in one case between a car mechanic and a customer. And it was interesting to see in these communities where you think that just because there's a shadow economy, things are totally chaotic, or there's no law. There are, in fact, a lot of norms, and there's norms about fairness and equity. And again, that's because people have to use each other the next day. So they have an incentive to keep the relations good

for a while. All right. So what are some of the policy ramifications here? I mean, I think my and everybody's first thought is, of course, lost tax receipts. Most economists would probably be drawn to the tax revenue that we lose. But there are a lot of other costs. For example, if you go into an inner city neighborhood and you walk into a public park, you might see people actually fixing cars. Now, that's part of the shadow economy. You can get your carburetor fixed for a few dollars. Now, that's an environmental hazard. You don't want oil all over your park. You don't want people to be slipping on it. That's a health hazard. You don't want people solving problems in the shadow economy by themselves because that can often turn violent.

So there are a lot of public health hazards, a lot of environmental hazards, in addition to the lost revenue that occur. And that's partly why we as a society want to limit or regulate the existence of such a large shadow economy? On the one hand, if you are a law-abiding taxpayer, you may think it's not fair that so much money goes untaxed while you pay your share. On the other hand, you may not want the watchful eye of the government looking at every haircut and paint job and office bedding pool, especially if you come out on the winning end. On the third hand, don't you wish you sometimes had a third hand? On the third hand, you're thinking, yeah, I feel kind of bad about not paying taxes on some of the money I make, but I don't really want to just pay more taxes. So maybe I should find somebody else to send some of that extra money to.

Someone I like. Someone who performs a valuable service but is probably underpaid because, I don't know, they work in public radio or something. You feeling it? Good. You can make your checks payable to Freakonomics Radio. Cash is also fine. Also, gift cards. Amazon would be nice. Or the iTunes store. Oh, and I really need some new golf clubs.

Freakonomics Radio is produced by WNYC, APM, American Public Media, and Dubner Productions. Our staff includes Susie Lechtenberg, Catherine Wells, David Herman, Beret Lam, and Chris Bannon. Colin Campbell is our executive producer. Thank you. Hey, podcast listeners. College football season is starting up, and you know what that means. Tailgating outside the stadium? Drunken fights? Arrests? Next week on Freakonomics Radio, we will hear one man's counterintuitive solution to this problem.

Selling more beer inside the stadium. That's next time on Freakonomics Radio.