Under Ground Final
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Transcript of Under Ground Final
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I. Introduction:
The history of academic research in the field of underground economy is more
than thirty years old, yet to date, there has not been a common viewpoint on the use of
the term underground economy; furthermore, the conclusions that have been drawnare debatable with regard to the consequences produced by underground economy,
and possibly with respect to remedies proposed by public policy for decreasing it. One
of the reasons for insufficient attention to the academic research of the underground
economys consequences is a lack of systematically and by single methodology
collected information concerning the size and importance of underground economy in a
given economy.
There is widespread belief that underground economies arise due to high
statutory tax rates and excessive regulation imposed by governments that lack the
capability to enforce compliance. The presence of underground economies, however,
can hinder macroeconomic management and damage economic growth in several
ways.
First, the loss of government tax revenues can result in larger budget deficits,
which by leading to higher public borrowing requirements can crowd out private
investment. Lower tax revenues can also compromise the quality and quantity of publicgoods provided, thereby impairing economic growth. Second, firms operating
underground cannot make use of market-supporting institutions like the judicial system
and courts and, as a result, may invest too little. For instance, the inability to enforce
legally binding contracts can limit their access to formal capital markets. In addition,
efforts to avoid detection can generate distortions, resulting in a misallocation of
resources in the economy
Therefore, to make states economic policys implementation more effective a
more sophisticated academic research of the underground economys sector must be
undertaken. National policy that is set on information, where real causes of growth of
the underground economy have not been taken into account, can change the balance of
a stable economy to an unstable one, and the chief consequence of that would be
stagflation. If there is a growing underground economys sector, which is not
adequately reflected in statistics, incorrect interpretation of the situation could produce
political solutions that in time could bring on much more serious economic
consequences.
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Similarly, theoretical conclusions on the underground economys effects have
not produced a common viewpoint. On the one hand, the underground economy
damages the social equality principle by redistributing income more beneficially toward
one of the smaller groups of population, thus distorting market competition; on the
other hand, the underground economy sector could become the choice of certain
entrepreneurs in situations, where state transparently interferes excessively in the
individuals activities.
1.1 Background of the study
There is no agreement on how to define the underground economy, or even what
to call it. informal, shadow, black, unofficial, unrecorded, hidden, parallel,
concealed and second economy are all used by researchers to describe roughly the
same phenomenon. The underground economy(or illegal economy) covers market
production ofgoods and services, legal and illegal,which are sold or purchased
illegally. Itis composed of both the irregular economy,where legal goods and services
areproduced and exchanged under illegalconditions, and (productive) black markets,
the preserve of goods and servicesthat are illegal but satisfy all the partiesinvolved.
From table 1, it becomes clear that the underground economy includes
unreported income from the production of legal goods and services either from
monetary or barter transactions hence, all economic activities which would generally
be taxable were they reported to the state (tax) authorities. In general, a precise
definition seems quite difficult, if not impossible, as what Mogensen said that the
shadow economy develops all the time according to the principle of running water: it
adjusts to changes in taxes, to sanctions from the tax authorities and to general moral
attitudes, etc.See, for instance, the feature Controversy: On the Hidden Economy in the
Economic Journal, vol. 109, no. 456,
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It is widespread in time and in space. To some extent this phenomenon is so
deeply rooted that one can think about the existence of a natural rate of underground
economy. Despite improvements and efforts, national accounts are still biased by the
underground activities and this can mislead the policymakers; the shadow economy
affects the design of national tax systems and triggers links between legal and illegal
activities; the hidden economy may impose constraints to public revenues generation
and, therefore, limit the provision of public goods. Thus, in spite of the difficulty of
obtaining reliable statistics of the underground economy, it is important to gather
information about it.
History presents us with a largenumber of prohibition and taxation events that
gaverise to contraband. However, smuggling and otherforms of underground markets
are not only a historicalphenomenon, but an everyday fixture of contemporary
economies: drugs, alcohol, fuel, tobacco, etc.
One should not think of the underground economy as only black markets or
smuggling on irregular markets. The irregular economy mainly includes otherwise legal
services sold under the table like labour services sold to businesses or individuals (in
residential construction and renovation, for example).
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The underground economy must be distinguished clearly and unmistakably from
the criminal activities of the underworld. Government officials and agents are ever
eager to lump both together, the criminals andtheir organization with the producers in
the underground. Both groups areknowingly violating laws and regulations and defying
political authority.But they differ radically in the role they play in society.
The underworldcomprises criminals who are committing acts of bribery, fraud,
and racketeering, and wilfully inflicting wrongs on society. The undergroundeconomy
involves otherwise law-abiding citizens who are seeking refugefrom the wrongs
inflicted on them by government. They are employersand employees who are
rendering valuable services without a license orinspection sticker, or failing to report
their productive activities to thepolitical authorities.
Underground activities can be grouped into four main categories:
1. Economic activity yielding income that is not reported to the tax authorities.
2. Economic production that violates one or several other mandates, such as
compulsory government licensing and rate making, inspection and label laws,labor laws, government regulations of agriculture, export and import controls,
government control over money and banking, governmental control of energy
production and distribution, and countless others. Violators may or may not
evade taxes, but they all work illegally, hiding from swarms of government
inspectors.
3. Productive activity by transfer beneficiaries who draw Social Security benefits or
receive public assistance. Their freedom to work is severely restricted.
4. Productive activity by illegal aliens without residence status. They may pay
income taxes and other taxes, but must remain underground for fear of
deportation.
The underlying cause of the underground economy is found in Adam Smiths
Wealth ofNations. Smith saw the foundation of modern society in the division of labor.
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Every time the propensity to exchange is constrained, individuals try to evade the
constraints in order to obtain what they perceive as the benefits of exchange.
The main impediments to exchange that push individuals to the underground
economy are taxes, excessive regulations, efficiency of the bureaucracy and
corruption. Empirical research shows that the underground economy is larger in the
countries where these impediments are more consequential.
TRENDS AND CURRENT DEVELOPMENT:
The existence of informal activities of underground economy is a fact of life
around the world. As some economists point out, there are also strong indications that
the size of the informal economy is increasing. Some present several hypotheses to
explain this growth. They suggest the expansion of the informal economy is:
Part of the process of economic restructuring following the structural crisis of the
1970sspecifically, the reaction of firms and individual workers to the power of
organized labor;
A reaction against the states regulation of the economy, both in terms of taxes andsocial legislation;
The result of increasing international competition, particularly in labor-intensive
industries;
The process of industrialization in many developing countries, characterized by social
and economic conditions that limit standards previously established by the state.
The result of poverty in which millions of people subject to harsh living conditions are
forced to accept any solution to their misery.
In a more recent survey, people with knowledge about it argue that the most
important and often cited reasons for the growth of the underground economy are the
rise of the burden of taxes and social security contributions; increased regulation in the
official economy, especially of labor markets; forced reduction of weekly working time;
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earlier retirement; unemployment; and the decline of civic virtue and loyalty towards
public institutions combined with decreasing tax ethic.
At the microeconomic level it is important to understand the rationale behind
engaging in informal or illegal activities or transactions. Using a cost-benefit approach,
it was been pointed out that Economic units choose to be partially or completely
informal by weighing the costs and benefits that a legal status entails and considering
their particular institutional and resource constraints. In this sense, the choice to be
illegal is a rational one, a fact which does not imply that some firms are not forced by
their constraints to be either legal or illegal. The price of formality includes costs to
access the formal sector which is the time and monetary costs for obtaining licenses
and registrations and costs to remain in it which is the taxes, regulations and
bureaucratic requirements.
ISSUES:
Many millions of elderly people have gone into retirement consuming their
savings and idling their days away searching for fun and play. They have flocked to
resort and retirement centers in some countries where they support successfulentertainment and amusement industries and promote uncontrolled real estate booms.
In reaction to ever-rising levels of taxation, younger workers may choose to work fewer
hours and take longer vacations. Many may seek to reduce the number of weekly hours
from forty to thirty-five, or even to thirty. Others may seek benefits that are tax-
exempt, such as expense accounts, stock purchase options, club memberships, health
care and insurance benefits, and countless other gratuities. They all are seeking escape
and shelter from the tax collector.
In recent years millions of law-abiding American workers escaped by illegal
methods; they joined the underground economy. High tax rates, soaring inflation, and a
growing doubt of government led them to take this desperate step. No one can know
with certainty just how many workers actually participate in the underground. Yet it is
common knowledge that huge amounts of goods and services are produced without
being reported to government authorities, that the unemployment rate is a lot lower
than the official rates of the Labor Department, and that the actual savings rate is
much higher that commonly thought.
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I.2 Review on related Literature
Theoretical and conceptual framework
Looking at the USA experience, in the 1970ies by utilizing economic prognoses
based on macroeconomic models a marked increase in prognoses errors occurred. This
generated an increased interest in the influence of the unofficial economic activities on
the US economy as a whole and what portion of the prognoses errors were attributable
to the underground economys sector.
Statistics bureaus, administrations, agencies and etc. disseminated information
give signs and promote the economic analyses and the politics. The increasing and
information system avoiding underground economy sector, in circumstances, when
government policy is oriented on full time job policy, can cause the stagflation
syndrome, that accord the changes equally turned against of unemployment rate and
inflation. On the contrary, if the policy is oriented on price stability, increasing
underground economy sector can cause budget deficit in the mentioned situation.
In the context of the fiscal economy, the observed sector refers to the amount of
income that is reported to the fiscal authority. Non-compliance with tax law
generates unreported income, i.e., the difference between the amounts of income
that have to be reported to the tax authority and the amount actually is reported. A
growth of unreported income reduces the ability of the fiscal authority to generate
revenues and, ceteris paribus, generates budget deficits.
Moreover, since the income recorded in the National Accounts system relies on
the data reported to the tax authorities, a growth of unreported income can also lead to
a growth of unrecorded income. In short, a large and growing unobserved sector
reallocates resources away from the sphere of the observation and control. It affects
perception of economic reality and the reality itself. Its allocation and distribution con-
sequences have an important implication for macroeconomic stabilization policy and
tax policy.
The history of academic research in underground economy is more than thirty
years old, but even now, in literature there is still missing unified approach to term use
underground economy. For indicating the phenomenon, underground economythere is called such notions as secret work economy, unofficial, hidden, grey,
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black, parallel, tax free. The use of different terms depends on context which
researchers choose for accenting.
It is possible to classify the underground economy by kind of activity in two ways.
Firstly, by legal transaction: legal (it is not forbidden by law, but for concrete individual itis much better not to declare this transaction) or illegal (those economic activities and
transactions, which are in contradiction with local laws and regulations); Secondly, is
money used as exchange leverage in those transactions.
The relation of economic activity to official sector in the underground economy can be
divided into three parts:
1) Parallel economy (in literature also referred to as white collar)
2) grey economy (informal);
3) Black economy ( secret work).
Table 1 Taxonomy of underground economy relation to official sector
Parallel and black economy induces benefits only for narrow group of individuals,
in the same time making loss to other individuals. On the contrary, grey economy could
induce benefits for all the society by being as an alternative, for example, in economy
with high bureaucracy and different restriction level. From the society and state
administration point of view, there are interesting questions on factors, which could
parallel economic gray economic black economic
subjects
objects
relation to
official
sector
employees in legal
sector
income distribution
without production
do not exist without
official sector
illegal employees
production of legal
goods and services
relatively independent
Criminal
production of illegal
and unlawful goods
and services
independent
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encourage in grey economy involved individuals to complete transition into official
sector. Parallel and black economy sectors have to be not integrated, but
exterminated, and that is why those sectors are analyzed separately from the grey
sector.
Relevant Literature
There is a vast literature on the determinants and consequences of underground
economies. The benefits of operating partially or completely in an underground
economy generally relate to firms desire to evade taxes, regulations or other
institutional distortions.
For instance, higher effective tax rates and other onerous regulations can make
operating in the underground economy more attractive by imposing high entry costs to
legality (de Soto (1987), Loayza (1996), Rauch (1991)). In many developing countries,
taxes on formal firms constitute a major source of government revenues, and narrow
tax bases for formal firms have often resulted in governments imposing very high
marginal tax rates.
Cutting taxes and red tape are, according to this view, the main ways of bringing
firms into the official economy. A related view is that the unofficial economy may arise
due to predatory behavior of corrupt officials, seeking bribes from anyone engaging in
officially registered economic activity (Shliefer and Vishny (1997), Kaufman (1994),
Johnson et al (1998)). In this view, the problem that needs to be addressed is
bureaucratic corruption.
In reality, it may be difficult to determine the direction of this causality asenterprises may be able to profitably avoid paying taxes by bribing officials, resulting in
higher level of corruption in the economy. However, informality can impose significant
costs to firms operating in the underground economy. If, for instance, penalties for tax
evasion increase with the amount of unpaid taxes, higher tax rates may not create an
incentive to hide (Andreoni, Erard, and Feinstein (1998)).
In addition, firms in the underground economy may face higher bribes to avoid
detection. An important cost of operating in the underground economy is the inabilityto enforce contracts. For example, firms may have to deal with a restricted set of
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trading partners; foregoing gains from trade arise from a broader set of potential
trading partners (Johnson, Mc Millan, and Woodruff (1999)). It may also be difficult to
raise equity capital or to borrow from capital markets because to do so would require
official documentation (Loayza (1996)). As a result, firms may face higher borrowing
rates, thereby reducing incentives to invest.
Relevant Studies
Most of the studies discuss about the size and impact of the underground
economy instead of its various names and phenomenon (Frey and Pommerehne, 1984;
Thomas, 1992; Loayza, 1996; Pozo, 1996; Lippert and Walker, 1997; Schneider, 1994a,
1994b, 1997, 1998a; Johnson, Kaufmann, and Shleifer, 1997; and Johnson, Kaufmannand Zoido- Lobatn, 1998a).
For an overall survey of the global evidence of its size in terms of value added
was done by Schneider and Enste (2000). A range of literatures depicts about the size
of underground economy which the academicians came out with various
measurements based on the underground activities. The impact of the underground
economy is differing towards developed and developing countries.
Hubbard and OBrien (2006) state that few economists explain the underground
economy in the United States amounts to more than 10 percent of measured GDP.
However, the underground economy in some developing countries may be more than
50 percent of measured GDP. They added that one of the reasons of the high rate of
the underground economy in the developing countries is due to the high taxes and
extensive government regulations.
When the governments calculate the size of their economies, a lot of activities is
not captured (Kasipillai, 1998). These activities are not necessarily involving illegal
goods or services perhaps we may be closer with them than we think. The current
economic slowdown may increase the underground economy activities. Kasipillai
(1998) states that in Malaysia construction is likely to be the sector in Malaysia that
generates the highest hidden income. This is due to this building industry number ones
position is due to its heavy reliance on foreign labor. The legal procedures of recruiting
foreigners are complicated and costly. So, hiring illegal foreign workers is to be anotherunlawful cost advantage. The other sectors are prostitution, unlicensed money lending,
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cuts and kickbacks from contracts, and smuggling. As such, smuggling activity will be
the focused because of the scarce study in the underground economy perspective.
According to Park (2003), the average size of underground economy for eight
Asia countries (e.g Bangladesh, Cambodia, Hong Kong, Indonesia, Korea, Malaysia,
Thailand and Singapore) in percentage of official GDP increased from year 1992 to
2003. His study shows that Thailand has the highest size of underground economy in
2003 while Singapore is the lowest with 54.1% and 13.7% respectively while Malaysia
recorded 32.2% officially. (See Table 2).
On the other hand, smuggling has various effects towards our economy. It can
caused losses in government revenues, bad impact towards internal structure of
society by promoting illegal institution besides changing the patterns of consumption
(Dominguez, 1975). Hence, the GDP and income distribution will also be effected.
(Farzanegan, 2008). By definition, smuggling can be explained as the clandestine
import of goods from one jurisdiction to another (Deflem and Henry, 2001). Merriman
(2003) states smuggling as the evasion of taxes on goods circumvention of border
controls.
In theory, the magnitude of supply and demand could create smuggling.Farzanegan (2008) corroborates that when the state intervention brings a wedge
between international and domestic prices through customs and excise duties and
trade restrictions, there is a chance for the underground economy to develop. By
earning income from importing goods through the state border as violating the rules,
smugglers could earn a handsome profit. Smugglers obtained their income by avoiding
state control, regulations and related costs ((Lithuanian Free Market Institure, 2004).
Since smuggling is part of the underground economy, there is a scarce study on it with
limitations in measuring this kind of activity.
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Theoretical aspects of underground economy
Within National Account system, unregistered economy activities are
divided into five groups: underground work, illegal, unofficial, household
production for own use and production, which is not accounted as a result of
incomplete data compile program.
Obviously, the forms of underground economy typology are not
eliminating each other. For example, organized crime income from drug
producing and trade (black economy; illegal production), or collected duties from
illegal producers, are legalized by using official enterprises. It is the reason for
using general definition of the underground economy in this research work,
which is mainly used also in other research works on underground economyvaluation by modelling method:
Underground economy is the gross domestic product, which in the result
of being unreported and/ or underreported is not accounted for in the official
statistics.
Motives of individual, which encourage them to operate in underground
economy transactions, could be divided into two groups: structural and
economic. The structural motives has no influence on individuals tendency to
operate in underground economy transactions in short time period, it is invariant
against concrete
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governments political decisions, but it could change individuals attitude in me-
dium or long time period. The economic motives influence individuals tendency
involve into underground economy transactions in short time of period, it canchange with concrete changes in governments policy.
Structural motives can be examined in three sections:
1) Governments rules (restrictions);
2) Governments perception;
3) individuals discretion.
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Figure 1: Corruption perception index and underground economy (2000)
[vertical axes underground economy size (% GDP); horizontal axes
corruption perception index]
Source: Schneider, Klinglmair(2004)
Transparency International Releases, The Year 2000 Corruption Perceptions Index
For estimating in cross section of Europe Economic Area state, how close is the
connection between structural motives and underground economy segment,
there were analysed data of 22 EU countries and Norway (except Malta, Cyprus
and Luxemburg).
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As the indicator of structural motives in 2000 there were chosen Transparency
International organizations calculated corruption perception indexes in the
cross-section of countries. After developed methodology, interviews andquestionnaires results are standardized in the scale from 0 to 10. The bigger is
index, the smaller is the influence of corruption by the opinion of business
leaders (the structure is not obstructing the entrepreneurship). Data on the
underground economy amount for year 2000 are taken from the research of F.
Shneider and R. Klinglmair in which the underground economy estimation are
acquired by money demand model in the crosscut of countries (Figure 1).
From acquired correlation it is possible to make the conclusion: in the context of
Europe Economic area in effect is the statement as the structural motives less
direct to waste recourses and promotes production, as smaller is the under-
ground economy amount. Consequently, for decreasing the underground
economy amount, it is necessary to improve the economics structure.
There are four economic motives which could encourage individual to operate in
underground economy:
1) friends or relatives;2) for avoiding from tax payments;
3) for not losing any of state benefits;
4) inflation.
The motive to operate in the underground economy could be individuals
awareness of the fact that relatives works in the underground economy. By
knowing the fact that other individuals does not declare all their revenues or
does not declare it at all, and usually they avoid of control institutions, others
also are motivated to involve in the underground economy operations. This
motive is closely connected to structures motives examined before especially
with government regulations, but also there is necessary to remember the
influence of local traditions on operations in economics.
By increasing taxes and social security payment burden, it is influenced work
leisure option. The bigger is labour costs in official economy and disposable
income difference, the bigger is tendency to avoid this difference and to operate
in the underground economy.
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However Latvias tax burden comparing to EU, candidate countries and European
economic area countries is rather low, separately examining tax burden of
individuals with low income, it is possible to make a conclusion that in Latvia it is
the highest among all examined countries (41.4%). On the contrary, expenses on
social protection in Latvia (by Eurostat data 15.3% of GDP in 2000) are one of the
lowest (expenses on social protection: social benefits, which includes money or
cash transfers; for households and individuals to protect from getting into
definite risk group; administrative expenses).
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Examining in the context of mentioned 23 countries united expenses on social
protection relation to individuals tax rate with low incomes correlation with the
underground economy amount, it is possible to make a conclusion that for thedecreasing the underground economy amount, there must be balanced budget
of expenses on social protection and tax burden level to individuals with low
income.
By increasing the high cost of living, the real tax burden can increase and
wherewith, probably, can increase motivation to operate in the underground
economy. Especially, if incomes are not indexed in official economy or tax
system is not indexed at all, then, when high cost of living increases, the
underground economy incomes becomes relatively attractive in comparison with
real after tax incomes in official sector.
The relative income level in Latvia is one of the lowest in EU, but one of the
highest income level increase rate. According to economic growth theory, real
growth rate should decrease by getting closer to EU average level. One of the
ways in as long time period as it is possible to keep high real growth rate, is to
restrain and decrease inflation level. Thereby, it is possible to make a conclusion:
to decrease or at least to restrain the underground economy amount is possible
by ensuring bigger real income level increase as much as possible, or at least
decreasing inflation level.
Theoretically, the effect of the underground economy is not possible to rate
unequivocally. The underground economy distorts social equality principle by
redistributing incomes in favour of one of the smaller group of population and
distorts market competition. In the same way, it distorts the standard of ethics. It
distorts state economic policy, as basing on false official statistics it is possible to
make an improper decision; for example, existing of illegal employment leads to
governments decision to promote new work place formation, and it will not de-
crease supposed unemployment rate, but budget deficit will increase.
It is usually the case that the economy is better off if, ceteris paribus, an activity
is done officially, than when it is carried out in the underground economy.
However, it is much less obvious, that it is better that the activity has not be
rather done at all than has be done in the underground. This presents a majordifficulty to the policy analysis, since the simple fact that we observe a large
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underground economy does not reveal what there were alternatives to the
underground.
The underground economic activity is combined with various negative welfare
effects. The main problem is the distortion of competition between the twosectors.
Lower capital intensity in the underground economy can be explained by the
assumption that unregistered workers cannot use credit markets, except at a
high cost. Thus, they have no incentive to use them at all. If the probability of
being detected is relatively high then it is equal to a high risk of losing the
capital. As a result, capital is relatively cheaper in the official economy and
thereby firms utilise
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it more intensively than it could be sensible for scarcity reasons. The capital
coefficient in the regular sector is too high, as the labour factor is done more
expensive artificially due to state and collective agreements. This implies thatproduction in the unregistered sector is too labour-intensive, as this factor is
relatively cheaper than capital.
As all the accumulated knowledge that the individual has gathered in the un-
registered sector becomes worthless, when this person is discovered, their
training or on-the-job education is not profitable. This slows down economic
growth even further and, in the long run, could increase long-term
unemployment, as it becomes harder for unregistered workers to obtain a
regular job, due to lack of education. However, unregistered workers on the side
(works underground parallel to official work) do not have this problem.
Furthermore, weak intellectual property rights on real capital, prevents even the
most innovative firms from developing new and better products or services. In
the long-run scarce human resources lead to decreased growth potential as the
development and application of modern technologies, increasingly fail due to the
lack of the workers knowledge. Nor can productivity be augmented with more
capital input.
Higher labour intensity in the underground economy can be explained by in-
creased service concentration. The service sector is more labour-intensive and
unregistered work covers services in general. The effect is that labour becomes
more expensive in the official economy as result of rationalisation and capital-
intensive production.
The official economy can much deviate from perfect competition by regulations.
In the underground economy, many of these state and collective agreement
interventions do not exist, resulting in a higher amount of consumer sovereignty,
individual freedom, and price fl exibility, where the latter can function as
indicators of scarcity. This is an important presupposition for the efficient input of
resources. Price equalises supply and demand, and as well coordinates the
individual decisions of households and firms. Thus, the underground economy has
almost ideal conditions for an optimal resource allocation. The economy is not
burdened by over-regulation and administration, as in the official sector, which
holds back economic growth considerably. From an allocation point of view, the
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underground sector is cheaper alternative for small enterprises in urban
surroundings, particularly in transition and developing countries.
In the long-run, the pressure from underground economic activity can help to
transform legal regulations as well as social and economic institutions. If thestate budget situation becomes poorer, market reforms are anticipated by
government.
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2. Methods to estimate the underground economy
There are three kinds of methods which are most widely used to estimate the
size of the underground economy: direct approaches, indirect approaches and
modelling.
In direct approaches are used designed surveys or/and samples based on vol-
untary replies or fiscal auditing. The main disadvantage of surveys is that the
average precision and results depend greatly on the respondents willingness to
cooperate, and the results from these kinds of surveys depend on the way the
questionnaire is formulated. Since fiscal auditing programs are designed to
measure the amount of undeclared taxable income, they have been effective to
calculate the underground economy. Estimates based on fiscal audits disclose
only that part of income generated in the underground economy which the tax
authorities succeed to uncover. A further disadvantage of the direct approaches
is that it only leads to point estimates, but the purpose of this study is to attain
estimates of the growth of the underground economy over the period 1995
2003.
The number of respondent has to be sufficient for the interpretations of regressionresults. Further, there have to take into account the problem of heteroscedas-
tity.
In such open and democratic societies as in Canada and Norway, the level of
respondence is 63-74%. In other economic countries which are not so open, the
level of respondence is seemed to be much lower. It is the reason why for
acquiring valid results, from the very beginning, it is necessary to provide com-
paratively much bigger representative sample to population when in Canada orNorway. And it turns to the fact, that it is necessary to provide the research
budget big enough. First of all for having the possibility to attract researchers,
who could develop qualitative questionnaire. Secondly, for the having the
possibility to pay for the social research company service representative
selection developing and mediatising/interviewing organizing, responses
database forming. And thirdly, for attracting researchers to result analyses.
Because of big costs, direct methods in underground economy researches,
mainly are done by support of state institutions or society organisations.
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Indirect approaches, which are also called indicator approaches, are mostly
macroeconomic ones and in it there are used various economic and other indica-
tors that contain information about the development of the underground
economy. Currently there are five indicators that leave some traces of the
underground economy:
(1) The Discrepancy between National Expenditure and Income Statistics;
(2) The Discrepancy between the Official and Actual Labour Force;
(3) The Transactions Approach;
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53
(4) The Physical Input (Electricity Consumption) Method;
(5) The Currency Demand Approach.
All these methods are designed to estimate the size and development of theunderground economy by considering that just one indicator must capture all
effects of the underground economy.
It is obvious that underground economy effects are shown up simultaneously in
production, labour, and money markets. And even more important critique is
that the causes that determine the size of the underground economy are taken
into account only in some of approaches. For example, in currency demand
approach studies it is considered one cause the burden of taxation. The mostwidely used methods to get underground economy time series are currency
demand method and electricity consumption method.
In (household) electricity consumption method there are questionable two basic
assumptions. Firstly, electricity is not necessary used in all economic activities,
moreover, it is possible to use alternative source of energy. Secondly, there are
economic activities which are not related to sector of households. As information
about household electricity consumption is restricted, more attention is paid for
analysing currency demand model. Money indicators are more available than
electricity indicators, and linkage is clearer between underground economy and
money indicators than between underground economy and electricity indicators.
The model approach considers that multiple causes are leading to the existence
and growth of the underground economy, as well as the multiple effects of the
underground economy over time. The econometric method is based on the theory
of unobserved variables. The dynamic Multiple Indicators Multiple Causes
Figure 2: The size of the underground economy as unobserved variable
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model allows to get a time series indexes of the unrecorded vs. recorded output
of the state.
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54
The method is based on the factor analytic approach, where is assumed that the
underground economy is an unobserved variable over time. The unknown
coefficients are estimated in a set of structural equations within which the un-observed variable cannot be measured directly. The MIMIC (multiple-indicators
multiple causes) model in general consists of two parts, with the measurement
model linking the unobserved variables to observed indicators. The structural
equations model specifies causal relationships among the unobserved variables.
In this case, there is only one unobserved variable the size of the underground
economy. There is assumed that the underground economy could be influenced
by a set of exogenous determinants (causes). The second set consists of
indicators for the underground economy, which are capturing the effects of the
underground economy. The relation between causes Di(i =1,2,...,n), the
underground economy H, and indicators Ij(j=1,2,...,m) are shown in Figure 2.
This is an inappropriate approach for estimating the size of the underground
economy in Latvia due to the time series shortage and/or absence of some
causes data. As further, for converting this index into percentage units there is
necessary to have a benchmark the long-run average value of unrecorded vs.
recorded output. To obtain this benchmark there could be used any of theindirect approaches.
By reposing on underground economy estimation method analyses done in
research work, it is possible to make a conclusion, that for Latvia the most
suitable is money demand method. Direct method is eliminated because of it
gives assessment only for concrete time period; moreover, it is very expensive
method, mainly because of the fact that Latvias respondence level could be very
low. To convert by the model approach acquired indicators to ratio ofunobserved and observed sector, it is a priori necessary to have information
about this relation in a long time period. That is why more logically to begin the
underground economy assessment by indirect methods especially with
developing money demand method.
A general currency ratio model contains the following specifications:
= Cu+Co and (1)
D = Du + Do (2)
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where C currency stock in circulation and D actual stock of demand deposit
are decomposed by unobserved sector (subscript u) and observed sector
(subscript o).
Currency and demand deposit ratios:
(3)
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,o
o
oD
Ck =
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55
(3)
can be viewed either as functions of constants, according to assumptions of
money demand approach.
Assumes that Youn Yuare observed and unobserved income, accordingly, then:
and (5)
(6)
are income velocity in observed and unobserved sectors. To solve the model for
Yu, we must evaluate (6) in terms of the models observable variables, namely, C,
D, and Yo. Repeated substitution and rearrangement of terms yields the general
solution for unregistrered income as:
(7)
u
u
u
D
Ck =
oo
o
o
DC
Y
+
=
uu
u
u
DC
Y
+
=
,))(1(
))(1(1
CDkk
DkCkYY
uo
ou
ou +
+=
u
o
=
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where
Equation (7) expresses the unreported sector as a function of three observable
variables -observed income Yo, actual currency stock C, actual stock of demand
deposit D, and three parameters or functions , ku, un ko .
The simple Simple Currency - Ratio Method employs the following restrictive
assumptions:
(1) Currency is the exclusive medium of exchange in unreported
transactions
(Du > 0; ku ). Assumption implies that unreported transactions are never paid by
check.
(2) The ratio of currency to demand deposits remains constant except
for changes induced by the growth of unreported income (k0 = const).
(3) The amount of unreported income produced by currency unit
transacted in the unreported sector is the same as the amount of reported
income produced by
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56
currency unit transacted in the reported economy. Assumption implies that
income velocity is equal in both sectors.
Imposing these restrictions on the general model presented as (7) produce the
restrictive form (set =1 and examines limit when ku ):
Dk
DkCYY
o
oou
)1( +
= (8)
which represents the simple currency - ratio method.
In the model (8) retained assumption that =1, namely, the income velocities
for reported and unreported income are identical. If unreported income is mainly
concentrates in the service sector, which requires much few intermediate
transactions, then income velocity in unoffi cial sector could be greater than in
offi cial sector, so 1. If1, the estimates are too
high.
The foregoing simulation of the currency - ratio model assumes that the
benchmark estimate for this ratio is constant (k0 = const).The currency ratio, kot
may be regarded as a stable function of other economic variables.
The currency -deposit ratio:
uo
u
uo
o
uo
uo
DD
C
DD
C
DD
CC
D
C
+
+
+
=
+
+= (9)
is assuming that Du 0 (assumes that actual and official deposit stocks are close
D D0) could be rewrite as follows:
if Du 0 (10)
or if use (3).
,D
C
D
C
D
Cu
o
o+
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D
Ck
D
Cu
o+ if Du 0 (11)
So, for estimating currency ratio by using econometric methods, equation (11)
items could be described with two functions:
(12)
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=
=
)(
),,(
2
1
fD
C
w sryfk
u
o
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57
where
y reported income;
r rate of interests;
ws income share of wages and salaries;
average effective marginal tax rate.
First function is described by factors which have an effect on official currency
demand. To describe second function, as the most important factor which has an
effect on currency demand in unofficial sector, is used tax index.
According to these assumptions, actual currency and deposit ratio is defined as
follows:
(13)
Equation (13) can be estimated to obtain a forecast of currency ratio C/D.
Method based on assumption that currency demand created by unrecorded
sector exclusively is produced by taxes. So to obtine estimates of function ko, the
tax rates are set to zero in the model (13)
)(),,( 21 fwsryfD
C+=
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