Missing the point on the underground economy

Massachusetts Governor Deval Patrick has launched something of a jihad against the state's growing underground economy. Patrick recently established the Joint Task Force on the Underground Economy and Employee Misclassification, headed up by former prosecutor Michael Bradley. The reason for the effort is simple: tax dollars. About $152 million is kept out of the hands of Bay State tax collectors each year simply by illegally classifying workers as independent contractors who then underreport their income, according to a 2004 Harvard study (PDF). That study found that 13% of Massachusetts employers were misclassifying workers in 2001-2003. That represents an increase from 8% of employers in 1995-1997.

Writing for AllBusiness, Keith Girard knows who to blame, and his thinking seems to be in synch with the of Massachusetts officials. Says he, the trouble is lax regulation and those damned foreigners.

Better enforcement of wage and hour laws, for example, would be a good place to start. But unless more rational, workable policies on immigration are adopted and enforced, the underground economy will only get bigger.

To put it mildly, that seems to be missing the point. The fact is, when researchers look at underground economic activity, the big motivators for people to operate in the shadows are always the same: troublesome regulations and onerous taxes.

In his 2006 study, Shadow Economies of 145 Countries all over the World: What do we really know?, Prof. Friedrich Schneider, of the University of Linz, defined the underground economy:

The shadow economy includes all market-based legal production of goods and services that are deliberately concealed from public authorities for the following reasons:

(1) to avoid payment of income, value added or other taxes,
(2) to avoid payment of social security contributions,
(3) to avoid having to meet certain legal labor market standards, such as minimum wages, maximum working hours, safety standards, etc., and
(4) to avoid complying with certain administrative procedures, such as completing
statistical questionnaires or other administrative forms.

More specifically, with regards to taxes, Schneider writes, "In almost all studies it has been found out, that the tax and social security contribution burdens are one of the main causes for the existence of the shadow economy... The bigger the difference between the total cost of labor in the official economy and the after-tax earnings (from work), the greater is the incentive to avoid this difference and to work in the shadow economy."

So what about those laws that Girard like so much? Can those help?

Not so much.

Says Schneider, "The increase of the intensity of regulations (often measured in the numbers of laws and regulations, like licenses requirements) is another important factor, which reduces the freedom (of choice) for individuals engaged in the official economy. One can think of labor market regulations, trade barriers, and labor restrictions for foreigners. ... Regulations lead to a substantial increase in labor costs in the official economy. But since most of these costs can be shifted on the employees, these costs provide another incentive to work in the shadow economy, where they can be avoided."

When Massachusetts officials accuse employers of "misclassifying" workers and so allowing their employees to escape the full reach of the income tax, that should be a clear indication that taxes are high enough to fuel a demand by employees as well as employers for off-the-books work. Of course, the lower costs achieved by going underground then make some companies more competitive than than others, spurring further shadow activity.

And when Girard (and Sen. John Kerry) call for vigorous enforcement of labor regulations as a means to combat the underground economy, they're actually setting the stage for more workers and businesses to move into the shadows and so escape expensive and intrusive regulation. That's especially the case when we're talking about targeting illegal immigrants, who then must, of necessity, work beyond the notice of the law.

More enforcement may trim some underground activity at the margins, but Massachusetts isn't the first jurisdiction to come up against this challenge -- and fail. As it is, Massachusetts has a relatively small "problem" since the U.S. underground economy, equaling about 8.4% of official GDP, is just about the smallest in the world. Canadian officials, by contrast, have been unable to put their shadow 15.2% of official GDP within reach of tax collectors and regulators.

Strictly speaking, an underground economy isn't a problem in itself -- it's an indicator that a big chunk of the population perceives taxes as too high and regulations as too oppressive. Those taxes and regulations are the problem. You may disagree and have a fine justification for each law and an outstanding purpose for each levy, but it's the opinions of the people who slide under the radar that matter.

Massachusetts officials are in for some unwelcome revelations.