How the underground economy affects GDP
The underground economy refers to the money earned through illicit activities such as prostitution and the sale of illegal drugs. But it also generally refers to any unreported income, such as unreported tips or gambling winnings, or below-the-table payments made to workers such as house painters and construction workers, including wages may not be declared to the tax authorities. Unreported income paid to migrant workers or those without valid visas or work permits also contributes to the underground economy.
Key points to remember
- The underground economy refers to the money earned through illicit activities such as prostitution and the sale of illegal drugs.
- Analysts estimate that underground economic transactions represent a third of the total economy of developing countries and just over 10% of the total economy of developed countries.
- Because underground economic transactions go unreported, they distort the accuracy of a nation’s gross domestic product, which can therefore negatively affect a government’s monetary policies.
- The underground economy also causes billions of dollars in lost taxes.
The underground economy and GDP
Due to its hidden nature, it is difficult to assess the true extent of the money changing hands through the underground economy (sometimes referred to as the underground economy). However, analysts estimate that underground economic transactions represent a third of the total economy of developing countries and just over 10% of the total economy of developed countries. But because these transactions go unreported, they skew the accuracy of key economic measures, such as gross domestic product (GDP), which is calculated by adding the following four components:
- Personal expenses
- Business expenses
- Government spending
- Net exports
Notice how the aforementioned measures do not take into account the transactions that occur in the underground economic system. This is important because an inaccurate country’s GDP figure can have a negative impact on government policies that are influenced by the GDP figures. For example, the US Federal Reserve relies on GDP numbers to set interest rates and create other monetary policies. If the GDP figures are not technically accurate, such policy decisions may have a lower impact or have a negative impact on the economy.
Taxation is another major government concern related to the underground economy. A 2011 study determined that if all underground economic activities were legitimately taxed, it would generate $ 400 billion to $ 500 billion in annual revenue. This money could go a long way to rebuilding infrastructure, funding schools and supporting other worthy causes.
Ways to integrate the underground economy
Fortunately, there are a number of steps governments can take to reduce the effect of underground economic activity on skewed GDP numbers. Reductions in personal income tax rates can encourage individuals to report their income more accurately and completely. And then there’s the hard love approach, where installing increased penalties for tax evasion can discourage under-reporting. Third, a government can legalize certain underground economic activities, such as gambling and prostitution, as a way to legitimately tax associated income and increase income. Finally, governments can stimulate the creation of better paying legal jobs, which would theoretically reduce the underground economy.