How the Underground Economy Affects GDP

Economic analysts differ in their estimations of the size of the underground economy, but all agree on the fact the size of the underground economy affects to some extent gross domestic product (GDP) figures and other key economic measurements. In short, underground economic activity not reflected in official economic activity figures causes GDP and other economic metrics, such as unemployment, to be less accurate.

The underground economy, also known as the shadow economy, is often associated with criminal activities, such as prostitution, the sale of illegal drugs or unreported gambling winnings. However, the underground economy is larger than purely criminal monetary transactions, as it includes any income or sales transactions that are unreported.

Some economists draw a distinction between black market, illegal activity, such as drug or weapons sales, and shadow economic activity that is illegal only because it is unreported to tax authorities. But the distinction is primarily a technical one rather than a substantive one, since both black market and shadow economy transactions are part of the total underground economy.

The shadow economy includes unreported income earned from activities such as painting a house or performing roofing repairs for someone. The individual performing the work is paid "under the table" in cash and does not report the income to tax authorities. Other elements that make up the shadow economy are unreported work and income of illegal aliens or migrant workers, unreported tip income and the sale of stolen goods. One growing part of the underground economy consists of unemployed professionals who have turned to doing off-the-books work simply to survive financially.

GDP is calculated using the total of four components: personal spending, business spending, government spending and net exports. The underground economy is primarily made up of transactions that constitute unreported personal spending and business spending.

The underground economy is estimated to account for as much as one-third of the total economy in developing countries and slightly more than 10% of the total economy in developed countries. Estimates of the size of the underground economy in the United States range between 7 and 11% of the total economy as of 2016. It is estimated that the inclusion of just part of the underground economy in the United Kingdom could increase the country's GDP by approximately 4%. The worldwide underground economy adds up to trillions of dollars and has grown substantially in the wake of the 2008 financial crisis.

The primary concern in relation to the underground economy's impact on GDP is that by rendering a nation's GDP a less-than-accurate figure, this can adversely affect government policies that are at least partially based on GDP numbers. For example, in the United States, the Federal Reserve Bank relies on GDP figures to make decisions about monetary policy, such as interest rates. If GDP numbers are not accurate, it is theoretically possible that the Fed may make an improper monetary policy decision that negatively impacts the economy.

There is an ethical or moral issue that arises in attempting to include the underground economy in official GDP figures. The question that comes to the forefront is if activities such as drug sales or prostitution are recognized as activities that provide economic growth and contribute to a nation's GDP, on what basis then can the government brand such activities as illegal?

The other major concern of governments regarding the underground economy is the issue of taxation. One 2011 study estimated that underground economic activity leads to approximately $400 billion to $500 billion in lost tax revenues annually.

There are a number of steps that governments can take to bring more of the underground economy into the official economy and thereby solve the problem, at least partially, of underground economic activity skewing GDP numbers. Reductions in personal income tax rates can encourage individuals to report income more accurately and completely or increased tax evasion penalties can discourage underreporting. A third suggestion is government legalization of underground economic activity, such as gambling and prostitution. Of course, a stronger economy overall with more good-paying jobs would also help to shrink the underground economy.