Underground Economy

Worms and moles mostly run the underground economy, trading shovels and hardhats.

Oh, you mean the other kind? That underground economy involves the dealings that go unseen, unaccounted for, and unregulated by the government. The black market. The shadow economy. The unregulated, wild, wild west economy.

The underground economy includes all illegal economic transactions. Some economic transactions might break the law directly (like child trafficking), while others might break it more indirectly, like selling cigarettes under the table to avoid paying high cigarette taxes.

What else is in the underground economy? There are the more obvious ones, like the sale of illegal drugs, illegal prostitution, all-things-mafia, and smuggling things or people across borders. You know, the stuff you see on the news, or when you’re bingeing Breaking Bad. The less obvious illegal transactions? Did Billy (the neighbor boy who rakes everyone’s yards in the fall) violate child labor laws? Shame on you, Billy. Shame. Okay, even if Billy was old enough to not be violating child labor laws...did he report that income to the IRS? His parents? Probably not. Same goes for Bonnie the babysitter. “Don’t have a permit for that lemonade stand, little 7-year-old? Then we’re gonna shut you down...” And yeah, that has really happened. The underground economy’s got some obvious illegal activity...and some less obvious illegal activity...but it’s still all illegal.

So just how widespread is all of this illegal economic activity? The underground economy is notoriously hard to measure, but according to the International Monetary Fund, the average size of the underground economy of 158 countries between 1991 and 2015 is almost a third of GDP: 31.9%. In some countries, like Zimbabwe, Georgia, and Bolivia, the shadow economy is about two-thirds of GDP. The smallest shadow economies can be found in the U.S., Austria, and Switzerland, which have underground economies estimated to be in the 7-9% range.

Underground economies aren’t necessarily stable though. For instance, there’s some evidence that, after the 2008 financial crisis, the U.S. underground market doubled from one trillion to two trillion dollars. As the legal economy plummeted, the underground economy picked up some of the slack.

Which begs the question: why is the underground economy a thing, anyway? Well, where there is demand, supply will find a way, even if the thing being demanded is illegal. For sellers, if the benefits of selling on the black market outweigh the costs, then the market will exist. For instance, marijuana was made illegal around the time of the Great Depression. It’s theorized that high unemployment and fears of Mexican immigrants led to marijuana being made federally illegal. Fast forward to today, and well over half the states have legalized marijuana medically, and many recreationally.

What changed as marijuana transitioned from the underground economy into the legal economy? First, governments get to tax marijuana, increasing their revenues, providing more money for schools, roads, etc. Second, money that used to be funneled through the underground economy is now being funneled through the legal economy, which has different rules and enforcement protocols. In the legal economy, we’ve got police, courts, and laws we can use to enforce the rules. In the underground economy, everyone has to fend for him-or-herself...which is why enforcement in the black market often results in violence. As the black market for a good like marijuana is being displaced by marijuana in the legal market, it also means that legal enforcement is displacing illegal enforcement. Courts and cops replacing black market violence for enforcement is a societal benefit.

When we make economic laws and policy, it’s important to consider the economic effect of “bans” and high taxes on the entire economy, including the underground economy. We’d like to think high taxes will bring in a ton of revenue, and that bans will be respected, but that’s just not the case. If the tradeoffs are worth it and the demand is there, taxes and bans can simply push transactions into the underground economy. Just as marijuana is moving from the shadow economy to the legal economy, drastic tax increases on commodities and bans can move goods and services from the legal economy into the illegal economy.

As in all of economics, whether a transaction is in the legal market or the illegal market, it comes with its own set of tradeoffs. For instance, food stalls on the street that avoid paying taxes mean less money for the government...but it could also result in an economic stimulus. There’s a good chance many food stalls that aren’t paying taxes wouldn’t exist if they did have to pay taxes. Since they do thrive, it means more money for them, but also more money injected into the economy from all of the economic transactions they’re creating.

It’s the same idea behind job creation via relaxing taxes. Feeling like the government is being gipped? Well, some governments have their own underground economy, too. Government officials tapping government coffers for their own purposes (a.k.a. corruption and fraud) is nothing new. Ironically, while governments are the enforcers of the legal economy, many have their own share of behind-the-curtains illegal dealings.

So yeah. Don’t try violating child labor laws and hiding income from the IRS. Or, you know...just make sure there are no neighborhood sticklers against lemonade stands or freshly raked lawns.