Shadow economy is UK’s secret growth industry
By
Allister Heath
16 April 2006
Drugs, illegal workers, criminal gangs, the resale of looted goods, tax evasion
– it sometimes seems as if these are the British economy’s real growth sectors.
While the rest of the economy is growing at a meagre 2% or so a year, shackled
by oppressive tax rates and red tape, the underground economy is booming, its
horrifying and relentless rise a devastating indictment of governments of both
parties over the past 40 years.
The output of the so-called black economy does not appear anywhere in the
official figures for economic output or employment produced by the Office for
National Statistics. It remains largely virgin territory ripe for exploration by
brave economists. In the US, one academic went as far as to embed himself in a
drugs gang for several years, going on to publish a fascinating study on the
economics of the illegal narcotics trade and the complex mini labour market on
which the industry is based – an episode recounted in all of its horrible glory
in Steven Levitt and Stephen Dubner’s brilliant book, Freakonomics.
But in Britain there has been much less interest and nobody knows the real size
of the underground economy. There have, however, been many estimates of the size
of one of its key components: legitimate activities that are not declared to the
government to evade tax or regulatory requirements. This would include the
economic contribution of plumbers who ask to be paid in cash or illegal
immigrants manning kebab shops.
Strangely, it has become fashionable for supporters of the current high-tax
consensus to downplay tax evasion in the UK – they love to complain about tax
avoidance, which is entirely different and is about legally reducing tax bills
by using clever accountants and loopholes in the law. But the high-tax lobby
would like everybody to believe, however implausibly, that there is very little
cash-in-hand work going on in Britain today because everybody is very happy
handing over 42% or so of GDP to the taxman every year.
To concede that many people in Britain no longer accept that they must pay taxes
would, they believe, give ammunition to supporters of lower taxes, including
proponents of a flat rate of tax, and that could not possibly do.
Unsurprisingly, however, the evidence supports the commonsense view that tax
evasion is now rampant in the UK. In 1979, Sir William Pile, then chairman of
the British Revenue Board, produced the first modern estimate of tax evasion and
found that “it was not implausible” that untaxed earnings equalled 7.5% of UK
GDP. This led academics to try measuring the underground economy by various
methods. The American economist Edgar Feige thought Sir William was half right
and put the true figure at closer to 15% of GDP.
There have
been several estimates since then. One analysis was produced in 1997 by
Deloitte. It estimated that the underground economy was worth 12% of UK GDP and
reduced income tax revenues by one-third. A review published two years ago in
the Economic Journal of six independent studies found estimates ranging from
5.5% to 13.2%, with an average of 9.3%; under-reporting of incomes is more
prevalent among blue-collar workers than those in white-collar jobs. The three
authors of the review produced their own estimate at 10.6% of GDP for 2002. In a
separate paper published by Statistics Norway last year, the size of the UK
black economy was estimated at 12.4%.
However, what must surely be the seminal quantification comes in a study
published in Switzerland by the Center for Research in Economics, Management and
the Arts, written by Friedrich Schneider, of the Johannes Kepler University of
Linz, one of the world’s top experts on the shadow economy. Schneider argues
that the average size of the shadow economy as a percent of “official” GDP in
2002-03 in 96 developing countries was 38.7%, in 25 transition countries 40.1%,
in 21 OECD countries 16.3% and in three communist countries 22.3%. In Britain,
it is now 12.2% of GDP, Schneider believes.
Assuming the share has remained the same, on current levels of GDP of £1.16
trillion, the amount of legal activities underreported in 2005 would be about
£141.5bn. By contrast, the share in the US is a mere 8.4% but in France it is
14.5% and in Germany 16.8%.
Crucially, criminal activities are not included in Schneider’s research. He
defines the shadow economy as all market-based legal production of goods and
services that are deliberately concealed from public authorities to avoid paying
income, value added or other taxes or national insurance contributions; to avoid
having to meet certain legal labour market standards, such as minimum wages,
maximum working hours, safety standards; and to avoid the other kinds of red
tape with which the official economy is burdened, such as legal requirements to
fill in statistical questionnaires.
There are two ways of estimating the size of the black economy. The first is the
direct approach, which relies on polls and surveys and examining the result of
spot tax-audits. This method doesn’t work very well. People tend not to be
honest when replying and the findings from the government’s spot audits are not
representative of what is happening in the economy as a whole.
The second, indirect method, is much more effective. It is based on studying the
evolution over time of cash transactions, electricity consumption or other
proxies for economic activity or trade, and comparing these with official
figures. If the rate at which money is being used in the economy is going up
faster than the rate of economic growth, this would suggest the black economy is
growing.
What makes Schneider’s research especially interesting is that he examines the
reasons why the size of underground economies varies over time and between
different countries. “An increased burden of taxation and social security
contributions, combined with labour market regulation are the driving forces of
the shadow economy,” Schneider argues. Other variables include the population’s
attitude to the morality or otherwise of paying tax.
While tackling the problem that is the underground economy would require radical
policy changes across many departments, addressing the specific issue of tax
evasion and undeclared income is much more straightforward. The easiest way to
ensure that more people report more of their income is to reduce tax rates and
to simplify the tax system. Ideally, the government would introduce a
comprehensive flat tax system with low tax rates; this would broaden the tax
base by curtailing the incentive for an underground economy and thereby reduce
tax evasion, avoidance and underreporting.
All very simple – and such a shame that Chancellor Gordon Brown will never have
the imagination nor the vision to take such a bold step. We will be stuck with a
giant underground economy for a while longer.