Underground Economy Essay

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The term underground economy refers to economic activities that circumvent the formal system of rules and regulations that organize the processes of production and exchange. Underground economies are classified depending on either the particular set of rules that such activities violate or the nature of production, distribution, and the final product.

Within the first classification, four types of underground economies can be distinguished: the illegal economy, the unreported economy, the unrecorded economy, and the informal economy. Illegal economy refers to the production and exchange of prohibited goods and services, such as drugs or the sex trade. Unreported economy denotes activities that evade tax laws. The unrecorded economy consists of all activities that, under existing rules and regulations, should be recorded in national accounting systems (national income and product accounts) but are not. Finally, the informal economy comprises economic activities that circumvent the administrative rules covering property relationships, commercial licensing, labor contracts, social security systems, and so forth.

Within the second classification, the underground economy consists of “informal” economic activities carried out through illicit means of production and distribution but leading to a licit final product (e.g., a textile firm producing T-shirts and jeans by using informal labor) and “criminal” economic activities, carried out by either licit or illicit means (usually the latter) but necessarily leading to an illicit final product (e.g., drug trafficking).

Methods of Measurement

Because activities in an underground economy defy the law in one way or another, they do not easily lend themselves to observation, so any attempt to study, measure, and classify them remains fraught with problems. The measurement problem becomes even more pronounced when attempting to make cross-national comparisons. Because nations differ in political, legal, and economic structures, nations’ underground economies are organized differently and are composed of different activities; all of these factors pose a comparability problem for the researcher.

Despite these problems, scholars capture underground economies’ composition, size, and growth rates by one of three methods: the survey approach (also known as direct micro observation methods), the discrepancy approach (also known as the indirect macroeconomic methods), and the qualitative approach. Each of these methods has different strengths and weaknesses.

Direct micro observation approaches involve amassing data on underground activities through conducting surveys, auditing tax returns, or reviewing census reports. Although these methods yield detailed and firsthand information about the underground economy, they have several weaknesses. First of all, they lead to point estimates and fail to capture the big picture, giving little information about the underground economy and its historical development at large. Second, these methods remain costly and time consuming. Third, the lack of uniformity between surveys conducted at different points in time often makes it impossible to draw comparisons, thus decreasing their usefulness in uncovering temporal causes and consequences of underground economic growth. Moreover, because parts of these activities are illegal, survey response rates often remain low, leading to the problem of biased sampling.

Economists generally use indirect macroeconomic methods, also known as discrepancy approaches, to measure the underground economy’s size and development over time and across nations. These methods follow the traces that the underground economy leaves behind in the labor, money, and product markets. The difference between spending and savings accounts, the dissonance between official labor participation rates and the general growth trend, or the amount of currency in circulation above and beyond what is used in official transactions form the indicators of the underground economy. Among the macro approaches’ explicit benefits are their low costs, their objectivity (i.e., their insusceptibility to deliberate misrepresentation on the part of respondents), and their ability to provide temporal estimates of the size and growth of underground economic activities. On the downside, these methods do not provide information on the underground economies’ inner mechanisms, and because they are based on some a priori assumptions regarding the relationship between macroeconomic indicators (such as labor market or monetary market measures) and underground economic activity, their robustness depends on the reasonableness of the assumptions that underlie them.

The third major method, the qualitative approach, is preferred by anthropologists or ethnographically oriented sociologists interested in uncovering the mechanisms and the norms of exchange, trust, social capital, and reciprocal relations that underlie the underground economy. It entails assembling information on underground economic activities through ethnographic research and participant observation. Like the micro observation methods, the qualitative approach yields detailed information about the underground economy but fails to capture its overall trends.

Theories of the Underground Economy

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.

Policy Implications

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.


  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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