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

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.

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.