Think Tanks

« Sean Worth: This month’s Spending Review must pave the way for victory in 2015 | Main | Tom Papworth: Fiscal consolidation has been implemented poorly – here's how to fix it »

Philip Booth: Economic activity in the shadows – why it happens and how it might be prevented

PbProf. Philip Booth is Editorial and Programme Director at the Institute of Economic Affairs.

There is remarkably little economic commentary on the shadow economy. This is possibly because, by its nature, it is difficult to measure. Survey evidence tends to under-estimate the shadow economy because many respondents either do not wish to reveal their activities or they convince themselves that their activity is legal.

However, there are some more sophisticated ways of estimating the shadow economy than simply asking people. And, if we examine the latest research, the figures are quite alarming. In the UK, about 10 per cent of economic activity is unofficial. In Mediterranean countries, the figure is about 20 per cent. Some supporters of a free economy might be in two minds about this. For some people, the shadow economy is a great example of free, untaxed endeavour. Indeed, where I live, the smugglers of past centuries were known as “free traders” and they are still commemorated by the uniforms that the bonfire societies wear on November 5th. In Europe, the size of the shadow economy seems to be correlated with Catholicism; in Britain, support for the shadow economy seems to be correlated with enthusiasm for burning Catholics.

Supporters of free markets should, though, be worried about the shadow economy. Such activity can be marred by gang violence and coercion with little legal redress for victims. Also, operating in the shadow economy can be a serious impediment to the expansion of businesses: obtaining insurance, formalising employment relationships and advertising can all be difficult when a business is operating extra-legally. Thirdly, the shadow economy leads to those in the regular economy paying still higher taxes.

So, what are the causes of the shadow economy? It turns out that tax levels are a major driver. Indeed, in an analysis of causes of the shadow economy, the authors of today’s IEA monograph suggest the following contributory factors:


This is, of course, not remotely surprising. In 2010, EU figures suggest that non-wage costs for those in the bottom half of the earnings spectrum were nearly 50 per cent of the value added per worker in Germany. The low-wage trap (the proportion of earnings taken by the state in taxation or reduced benefits when a worker increases his earnings from one-third to two-thirds average earnings) is 80 per cent in Germany and only slightly lower in the UK.

Given these figures some people might think “why work?”. Others prefer to work – or employ people – but then do not declare it to the authorities. There are no comparable figures for the UK, but 30 per cent of “unemployed” people in Germany do some shadow work. However, undeclared work is not limited to those on unemployment benefits. Nearly 50 per cent of all construction workers in Denmark do some shadow work. It is worth noting that the proportion of shadow economy workers who are illegal immigrants is tiny.

The bad news is that there can be a vicious circle. Higher taxes, leads to more shadow economic activity, lower tax revenues, higher tax rates, lower quality public services, a reduction in tax morale (as people do not believe that others are paying their fair share of tax), higher shadow economic activity, and so on. The good news is that this circle can be turned virtuous. If taxes and burdens on employers and employees are reduced then the shadow economy is likely to shrink, tax revenues will rise and tax rates can be reduced further.

This really is an issue of great urgency in most of the euro zone crisis countries. Shadow economies of 20 per cent or so of national income suggest a complete breakdown in trust. There are, though, practical measures that can be taken even if it is difficult to reduce taxes in the short term. Business registration procedures should be as easy as possible. Another possibility is amnesties (which have to be occasional and unpredictable if they are not to be abused). An estimated half of all businesses start up in the shadow economy. However, it is very difficult to contact HMRC and say to them: “I have been operating in the shadow economy for the last ten years, I would now, however, like to start paying taxes”. The business owner would be swamped by investigations. Relatively little tax revenue is lost in the early years of a business operating in the shadow economy, so we may as well write that off and facilitate businesses regularising their affairs.

The shadow economy is, of course, both a moral issue and an economic one. In a society where honesty has broken down, the shadow economy will be large. However, trying to ensure that everybody behaves honestly when the penalties for declaring income are so large is like pushing water uphill. Indeed, one can ask whether it is moral for government to put such temptations in our way. When a couple with three children face taxes and a loss of benefits of 73 pence of every extra pound that they earn, is it surprising if they do a bit of babysitting “for cash”? We need to ask whether our tax and welfare systems are destroying – in many different ways – the moral fabric of society.


You must be logged in using Intense Debate, Wordpress, Twitter or Facebook to comment.