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Three major schools of theories explain the development of underground economies. These are the modernization/development approach, the structural approach, and the institutional economics approach. The modernization/development approach, which became prominent in the 1960s and 1970s, viewed the underground economy's development as a symptom of a traditional, backward economy. In this view, the underground economy consisted of marginal activities not linked to the official sector or to modern capitalist development. A central assumption was that the underground economy would become extinct once underdeveloped nations attained sufficient levels of economic growth via the advance of modern capitalist development.

The structural view of the underground economy, which emerged in the 1980s, challenges the mainstream view of the informal sector as primarily a third world phenomenon and sees the rise in underground economic activities in highly developed and institutionalized European and North American economies as indicative of a reconfiguration of production and employment relationships under advanced capitalism. According to this view, by providing firms with flexible production and cost reductions, the underground economy constitutes a permanent feature of capitalist development, most likely to expand due to profit squeeze, increased labor costs, or increased competition from cheaper foreign goods.

The institutional economics approach attributes underground economies' development to the state's over-regulation of the economy. In this view, the underground economy provides the economic actors with the possibility of escaping the high bureaucratic and legal costs of operating in the formal economy. This view sees that underground economic growth can be limited or eliminated if a state reduces the bureaucratic requirements and the costs associated with operating in the official economy.

The underground economy has significant implications for a wide range of policy issues. First of all, without a profound understanding of the underground economy, governments lack a reliable estimate of overall economic conditions, and key economic indicators such as unemployment rates, saving rates, productivity, and price levels may well be biased, leading to suboptimal outcomes. This harms governments' ability to make informed policy decisions, leading to less than desirable outcomes.

Another oft-cited result of underground economic growth concerns the loss of tax revenue. Taxes are how states finance their services to citizens. When people or enterprises do not pay taxes, the state loses some of its tax base and hence its ability to effectively provide its citizens with services.

A third concern is the emergence of unfair market competition. Because businesses that operate underground avoid some or all regulations, such as taxes and labor benefits, they enjoy cost advantages over enterprises that operate formally. This leads to unfair competition between formal and underground businesses. Unless the state addresses this unfair competition, over the long run more and more businesses will go underground, leading to an increasingly informalized economy.

A fourth concern is the degree of exploitation that prevails in the underground economy. Workers in the underground economy do not enjoy the rights, benefits, and protections that their counterparts in the official economy have. This exploitation in underground economy remains a profit mechanism for companies operating in it. Also, more exploitation of female labor occurs than of male labor, further contributing to society's gender inequality.

Furthermore, the underground economy illustrates an unhealthy relationship between citizens and government. At the core of this relationship in a modern democratic polity rests a system of rights and duties recognized and upheld by laws. The underground economy functions by, and thrives upon, undermining this institutional relationship. Over the long run, this might lead to an erosion of trust between states and citizens and to a further extension of law-evading behavior into other realms.

In response to these oft-cited drawbacks, some scholars note the underground economy's positive implications. They argue that the underground economy can be beneficial because it responds to the economy's demand for urban services and small-scale manufacturing. The underground economy thus provides a dynamic and entrepreneurial spirit and can lead to more competition and higher growth; it also may help create markets, increase financial resources, and help transform the legal, economic, and social institutions necessary for wealth accumulation. Moreover, some scholars have found that large portions of the money earned by informal means return to the formal first economy. They also note that during an economic crisis, the underground economy can serve as a buffer zone that allows enterprises to operate with low costs to help meet people's needs.

References:

1) De Soto, Hernando. 1989. The Other Path: The Invisible Revolution in the Third World. New York: Harper & Row.

2) Feige, L. Edgar. 1990. "Defining and Estimating Underground and Informal Economies: The New Institutional Economics Approach." World Development 18(7):989-1002.

3) Portes, Alejandro, Manuel Castells, and Lauren A. Benton, eds. 1989. The Informal Economy: Studies in Advanced and Less Developed Countries. Baltimore: Johns Hopkins University Press.

4) Schneider, Friedrich and D. H. Enste. 2000. "Shadow Economies: Sizes, Causes and Consequences." Journal of Economic Literature 38(1):77-114.

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