How can we harness the black market?

19th July 2012

For many the black market economy conjures up images of shady figures, alleyways and drugs. Though these things do undoubtedly play a part, there is also a great deal of black market business done in plain sight by otherwise perfectly law-abiding individuals.

On paper, the HSBC case offers a clear example of an institution that sought to circumvent a regulatory framework in order to conduct its business affairs with the minimum oversight. For employees the US Senate Subcommittee on Investigations' report the list of the bank's activities will certainly make for uncomfortable reading.

The charge sheet includes: failure to properly monitor foreign affiliates; circumventing trade sanctions; disregarding links to terrorism; clearing more than $290 million worth of suspicious travellers cheques and opening secretive accounts for wealthy clients.

Coming so soon after the Libor scandal this latest revelation of unethical banking practices is likely to confirm many people's concerns about the industry. Yet in confirming our own preconceptions, the debate may miss a more fundamental look at what the committee's findings also clearly show – the huge scale of the black economy.

Friedrich Schneider, professor of economics at Johannes Kepler University of Linz, released a paper in March in which he estimated that for the 21 advanced OECD countries the shadow economy accounted for the equivalent of 13.9% of GDP in 2007. His definition of the shadow economy "includes all market-based legal production of goods and services that are deliberately concealed from public authorities", meaning the actual size including illegal economic activities is likely to be substantially higher.

Unsurprisingly the figures differ widely from country to country. In Britain, for example, the report suggests it accounted for around 12.2% of GDP, while in Greece that figure was as high as 26.5%. Considering the difficulties facing the Greek economy no doubt the government would be extremely keen to prize open this particular treasure chest.

That is not to say that all of the activities concerned should be condoned but the growth of the black market economy is linked to particular problems that can be addressed by policymakers. While many of the studies into this area have disagreed on the range of causes for its appeal, almost all conclude that tax and social security contribution burdens are among the main causes for the existence of the shadow economy.

So what could policymakers do to make inroads into the shadow economy?

Legalising dubious activities by financial institutions is unlikely to yield many rewards. After all accessing another country's black market could leave firms vulnerable to criminal enterprises operating within them, and could cause them to fall foul of legal frameworks.

In Europe, some countries have already attempted to go down the legislative route. The Spanish government passed a law last April increasing fines for those found guilty of social security transgressions. Last month, Soraya Sáenz de Santamaría, a spokesperson for the government, reiterated their commitment to "eradicating the inherent conduct of the black economy of not paying taxes, of collecting undue benefits, of making unregistered employees work, of creating fictitious companies in order to collect subsidies or benefits, and so on".

Yet it remains unclear whether the punitive approach has helped rather than hindered. So far this year total tax revenue in Spain reached €66.73 billion from January to May, some €3.41 billion less than during the same period in 2011.

Shaun Richards, Mindful Money's resident economist blogger, says:

"Everything that can be done in this area should be done, although perhaps the country that could most be helped is Italy.

"Whilst apochryphal evidence is that there is a substantial black economy in Spain by definition it is always hard to measure."

Being able to bring those who have chosen to work outside of the taxable economy back into the system voluntarily is by far the preferable solution. It would, however, require bold action from the government in order to cut back the tax burden for individuals, particularly for those on lower incomes where tax liabilities have the largest impact on lifestyle.

Professor Schneider concedes "we do not know the exact motives, why people work in the shadow economy and what is their relation and feeling if a government undertakes reforms in order to bring them back into the official economy". Nevertheless we do know that the cost to society of having so many workers outside of the taxation system is significant, especially during a period of public sector spending cuts.

 

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