Sunday, January 23, 2005

Higher Ground

The underground economy is a difficult subject for the right, we like smaller government (at least we did), but “fighting the power” and “sticking it to the man” is not our thing. It’s suspected that the underground economy makes up 10% of the overall U.S. GDP. This number has risen from 3% in 1970 to 9.4% of GDP in 1994 according to economist Friedrich Schneider. In 1998 the IRS commissioner, using different methods, estimated that $200 billion was owed in unpaid taxes each year, about what is spent on Medicare.
The rapid growth of the underground economy is especially interesting considering two of its largest activities have come out of the shadows and into the mainstream. Gambling and pornography until recently was controlled by organized crime which was all underground.

During prohibition in the 1920’s it was estimated that 5% of the U.S. economy was underground. This number declined until the 60’s when the counter-culture along with the anti-tax movement of the late 70s encouraged distain for the government. While conservatives point to high taxes and regulation liberals claim wage depression and the decline of unions responsible. As for European countries Great Britton (12.5% of GDP) has the lowest, most E.U. countries have around 20% of their GDP in the shadows, I wont even go into Russia or the 3rd world. Several studies have found strong evidence that taxation policy influences the underground economy. In Austria, the burden of direct taxes (including social security payments) has been the biggest influence on the growth of the underground economy, followed by the number of regulations affecting firms and workers, and the complexity of the tax system. Other studies show similar results for Germany, and the United States. In the United States, analysis shows that as the marginal federal personal income tax rate increases by one percentage point, other things being equal, the shadow economy grows by 1.4 percentage points. A Canadian study shows that people are highly mobile between the official and the unofficial economy, and that as net wages in the official economy go up, they work less in the shadow economy. This study also emphasizes that where people perceive the tax rate as too high, an increase in the tax rate will lead to a decrease in tax revenue.

The two big sources of unreported income are drugs (mostly marijuana) and work performed by immigrant labor. To reduce the percentage of underground GDP we could start with marijuana legalization. The taxes collected from sales and the money saved by reduction in enforcement and incarceration should more than make up for the increases in other social costs and bring the largest cash crop in the U.S. into the mainstream economy. The issue of unreported immigrant income is far more difficult both politically and economically to get a handle on. A study by the Pew Hispanic Center states remittances to Mexico have tripled to $13.2 billion between 1995 to 2000, yet “officially” the Mexican population has increased only 56% and wages rose only 10%. California alone loses $100 million in sales taxes. There is little effort to shutdown sidewalk vendors or landscape services in suburban neighborhoods and employers who hire undocumented workers have little to fear from the government right now. In 1997 there were 18000 arrests due to investigations of employers using undocumented workers, in 2002 that number fell to 1000. The focus should be on the employers, more aggressive audits and simplification of the process might make the transaction from under to over ground more attractive.


Blogger Outlier said...

I agree that any reform initiative for undocumented aliens has to focus on employers, whether it's an attempt to curb illegal immigration or just collect taxes. I also think you're right that we should capture marijuana revenue with a legalization program - cost savings + a new revenue stream (but I can't imagine our neighbors would like it too much)

I just don't quite buy the wage depression = illegal economy argument, but the taxation impact on the underground economy argument doesn't quite hold water either.

According to a 2000 CBO report distilled in this, the average effective federal income tax rate has fallen over the past two decades:

"In 1981, the CBO says, the average, effective federal income tax rate for middle-income families was 8.3 percent of total income, before any deductions or exemptions.

In 1999, according to the CBO, it was down to 5.4 percent.

Even for upper-middle-income families, the CBO says, the effective rate fell from 11.3 percent to 8.4 percent."

If you forget about effective tax rate, but just look at marginal tax rates, the highest marginal tax rate in the through the 1960s was 70%, and and 31% in 1992 - over a 50% reduction resulting in a 3x increase as underground economy as a percentage of GDP? Doesn't quite work out.

Why an increase in underground economy then? Even more so, people at the bottom income levels have a disincentive to go underground, since 1 out of every 3 legit employees doesn't pay any income tax and a lot qualify for tax credits - the government actually pays them to be legit!

There's something else at work here that isn't wage depression or marginal tax rates - you can lower tax rates all you want, but that isn't going get illegal immigrants on the books with their fear of "la migra". Even if everyone was making money like venture capitalists, people would still be doing cocaine and betting on football off the books. Do you just legalize everything, then tax it?

2:10 PM  

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