Going Underground: The Shadow Economy Is About To Top $1 Trillion–At A Great Cost To Many

January 3, 2005: Going Underground: The Shadow Economy Is About To Top $1 Trillion–At A Great Cost To Many

Going Underground – Barron's
The shadow economy is about to top $1 trillion — at a great cost to many


AMERICA HAS TWO ECONOMIES, and one is flourishing at the expense of the other. First, there's the legitimate economy, in which craftsmen are licensed and employers and employees pay taxes. Then there's the
fast-growing underground economy, where millions of nannies, construction workers and others are paid off-the-books, their incomes largely untaxed.

The best guess as to the size of the output of this shadow economy is about $970 billion, or nearly 9% that of the real economy. It should soon pass $1 trillion.

What is largely fueling the underground economy, experts say, is the
nation's swelling ranks of low-wage illegal immigrants. The government puts this population at 8.5 million, but that may represent a serious undercount.

Robert Justich, a senior managing director at Bear Stearns Asset Management in New York, makes a persuasive case in a forthcoming paper, “The Underground Labor Force Is Rising to the Surface,” that illegal immigrants actually number 18 million to 20 million. If true, the economic implications are profound and could help shape debates slated in Washington this year over both immigration policies and tax reform.

Measuring the size of the underground economy is, of course, more art than science, since most of its denizens seek to remain anonymous. But convincing anecdotal evidence and a number of credible academic studies suggest that it is expanding briskly — probably by an average of 5.6% a year since the early 1990s, edging out the real economy.
[Underground illustration]

In the process, the underground economy is undermining the effectiveness of the Internal Revenue Service, which is highly dependent on employees' withholding taxes. If the IRS could collect all the taxes it says that it is owed from the underground economy in a given year, then the current budget deficit would disappear overnight. And if the IRS could collect these taxes every year, then the nation would have surpluses as far as the eye can see.

The IRS has estimated that its tax gap — the estimated amount of taxes owed minus the amount collected — is around $311 billion in any given year. The agency will produce a new estimate in 2005, and it could be as high as $400 billion, says former IRS Commissioner Donald Alexander. Now a lawyer in Washington, he cites a rise in private contracting and the opportunities it affords for not reporting income.

The gap number measures only a portion of the underground economy. Because the number is extrapolated from audited returns, it makes no allowances for criminal enterprises that report no income, and it even fails to capture some garden varieties of nonreporting. The unreported wages of illegal immigrants alone could be costing the government another $50 billion a year, says Justich.

Growth of the underground economy is partly a result of corporate
downsizing, which has forced many former employees to go out on their own.

“We have had an 85% taxpayer compliance rate,” says Nina Olson, the IRS's taxpayer advocate. “I expect the number to decline,” because the portion of employees subject to withholding is on the wane. Such employees are 99% compliant with tax laws, she says, but in the 21st-century economy, “More and more people are being treated as independent contractors. We are losing people from the withholding environment.”

Entrepreneurs often are stymied by the complexity of estimating their taxes and making quarterly payments, which leads to mistakes or out-and-out avoidance. The growth of online commerce may be exacerbating the situation. There were over 40 million regular users of eBay alone in 2003, up from 23 million in 2002. The sellers are responsible for paying taxes. Some of them set up a business and get a taxpayer ID number; others don't. (An eBay spokesman says the company isn't a tax adviser — it's up to members to report their taxes.)

Most unsettling to IRS bureaucrats, taxpayers as a group appear to have become less honest. Former New York City Police Commissioner Bernard Kerik is the latest poster boy for the phenomenon. He had to drop his bid to become secretary of homeland security because he failed to pay Social Security taxes for his children's illegal-immigrant nanny.

Kerik is hardly alone: Any homeowner who has been offered two prices by a handyman or a gardener — a higher one for a payment by check, a lower one for all cash — knows how quickly the savings can add up. In one twist on off-the-books business, the New York Times recently reported on a rise in mechanics who repair cars at curbside for untraceable cash payments. They are not in want of customers. In some cities, including Boston, owners of battered cars get similar offers from itinerant body-repair “experts.”

In speeches, IRS Commissioner Mark Everson is fond of citing a survey by his agency showing that the number of Americans who consider tax-cheating acceptable rose from 11% in 1999 to 17% in 2003.

Former Commissioner Alexander, who ran the agency during the Nixon, Ford and Carter administrations, said he urged Congress to pass a law making customers responsible for withholding some taxes on services provided by carpenters, plumbers and other self-employed contractors. Customers would have had to hold back 5% of the cost of services and forward it to the IRS, but Congress failed to embrace the measure.

Result: The underground economy has kept growing nearly unchecked. Academics accept the work of Austrian Friedrich Schneider as the best estimate of the underground economy's size. Using data on currency flows and the consumption of electricity, he guessed that in 1996 it was about 8.8% of the nation's gross domestic product. This estimate was made before the flood of immigration from South America, so it might be conservative if used today, when the nation's GDP stands at $11 trillion.

To be sure, the U.S. underground economy, as a percentage of GDP, is smaller than those of some other countries. In a 2000 paper in a publication of the Independent Institute, a nonprofit research organization, Schneider found that Greece, as of 1998, had the largest underground economy, at 29% of its GDP, followed by Italy at 27.8% and Spain at 23.4%. Countries with high tax burdens and high social security costs lead the list.

But the sheer growth of the underground economy in the U.S. is cause for concern. If Justich's estimate of illegal immigrant workers is correct, the underground economy may now be growing at a markedly faster rate than the legitimate economy. Justich, working with Bear Stearns colleague Betty Ng, an emerging- markets economist, says he's found evidence of a larger illegal immigrant population by analyzing data on construction and on remittances sent from the U.S. to Mexico and other countries. He also had conversations with over 100 immigrants from Mexico, Brazil, the Dominican Republic, Guinea, China and Tibet. And he interviewed local business owners, real-estate sales people and police.

Justich, a veteran securities analyst, currently specializes in fixed-income strategies at Bear Stearns Asset Management, which oversees some $29 billion in investments. He began digging into the underground economy because of its broad ramifications for the real economy. In his spare time, he has been exploring the immigrant communities of northern New Jersey for his work as executive producer of a documentary film about immigrants and the importance of their former national anthems in their lives.

From all this, Justich concludes that Fed Chairman Alan Greenspan's
estimates of productivity gains are overly rosy. “The productivity miracle may be slightly overstated because they are counting the output of millions of illegal immigrants but not counting the input,” he says. Likewise, long-term budget projections could be overstating the potential growth of the legitimate U.S.economy or underestimating the need for high illegal immigrant flows to hit the forecast growth targets.

Ideas like that could well become food for thought for House Ways and Means Committee Chairman Bill Thomas of California. He wants to push ahead with tax reform this year, including the creation of a national sales tax and reduction of income taxes. In theory, a sales tax would capture the underground economy, since all wage earners have to spend money to live.

[Robert Justich] On the Beat: Robert Justich of Bear Stearns Asset Management scours the streets of New Jersey for clues about immigration trends.

A larger number of illegal immigrants also would have a profound impact on coming discussions on immigration reform. President Bush proposes temporary amnesty for illegal aliens already in the country, allowing them to obtain permits to work legally for three years and stay longer if their jobs otherwise can't be filled by native-born workers. But if there are, in fact, 20 million illegal aliens, the Bush proposal could engender a situation not unlike the German unification of the 1990s, which triggered huge demand for social services in East Germany. Unanticipated costs here could be enormous.

Steven Camarota of the privately funded Center for Immigration Studies in Washington asserts that the net cost to the government for amnesty, based on a population size of 10 million, would have been $10 billion if carried out in 2002. The total cost would be $26.3 billion minus about $16 billion in new taxes from the immigrants. The costs would arise because the illegal immigrants, most of whom are poorly educated, would begin to become heavier users of government services like food stamps, schools and Medicare.

Camarota, who does contract work for the Census Bureau, doesn't think that U.S. birth and death records support Justich's claim of 15 million to 20 million illegal immigrants. But Camarota says that he isn't suggesting that the debate is settled. There are other statistics, like unemployment data, that might suggest slightly larger numbers.

JUSTICH CERTAINLY HAS DUG DEEPER for data at the local level than most
researchers when preparing his report for his company's investors. He has unearthed data on building permits that show construction of multifamily dwelling units is up six-fold in immigrant communities while census data show just a small percentage increase in population in those same communities.

Justich's analysis of remittances from the U.S. to Mexico also indicates a larger population of immigrants than the official numbers show. According to a study by a Georgetown University professor, Manuel Orozco, for the Pew Hispanic Center, remittances to Mexico tripled to $13.2 billion between 1995 and 2000. Yet the official tally of Mexicans in the U.S. rose 56% and the estimate of their weekly wages rose 10%.

Similarly, a California official told Barron's of an anecdote that calls official numbers into real question. Bill Leonard, a member of California's Board of Equalization, said he was involved in redistricting his state's congressional districts in 2001. Some areas that were the same size in population as others, based on census data, ended up having five times as many unregistered voters. Most of the extra people were noncitizens, he says. Leonard also says that the number of active retail permits in the state has been stable for several years at one million — a sign, he asserts, that stiff competition from unlicensed businesses may be keeping new entrants out of the retail market.

Leonard estimates that California loses $100 million in sales taxes each year to the underground economy.

The IRS's Olson, who operates as Joe Taxpayer's ombudsman, says that tax collectors and cops enthusiastically pursue two groups of tax evaders — the underpayers and the crooks. But she says there's little effort at the federal level to capture the sidewalk vendor who's hiding most of his income or to ferret out which of the many lawn-care services operating in suburban neighborhoods is skipping taxes. The authorities just don't perceive a big enough bang for the enforcement costs.

The truth is, employers hiring illegal workers have little to fear from the government right now. Data from the U.S. Citizenship and Immigration Services, as the old Immigration and Naturalization Service has been dubbed since being shifted to the Department of Homeland Security, show that enforcement actions against employers and illegal workers have dropped sharply since 1997.

Back then, there were about 18,000 arrests a year resulting from investigations of employers using illegal alien workers, but in 2002 there were fewer than 1,000 arrests. Instead, agents are trying to catch workers at border-crossing points. Opponents argue that cracking down on employers would be more effective. If immigrants couldn't get work, the argument goes, they wouldn't bother to come.

THE DECLINE IN ARRESTS COINCIDES with a broader easing of enforcement
actions by the IRS — following criticism of overzealous collections in the early 1990s. Audits of individuals dropped from three for every thousand tax returns in 1998 to two in 1,000 in 2003, according to Syracuse University's Transactional Records Access Clearinghouse. And audits of corporations dropped 26% in the first six months of 2004 from the same period a year earlier.
[Lengthening Shadows]

There are signs that tide may be turning. The IRS last year added 2,200 enforcement employees. Olson, for her part, favors more spot audits of even the smallest small businesses because, she says, word of enforcement actions spread like wildfire and make others think twice about cheating. And Sen. Kent Conrad, a Democrat from North Dakota, has been calling vociferously for an increase in the IRS budget to allow for more aggressive enforcement.

In the meantime, however, employment of illegal immigrants is flourishing. Justich believes that undocumented workers now hold 12 million to 15 million jobs in the U.S. If those showed up in official data, the Bush administration's job-creation record would look significantly better. In fact, four million to six million of these positions have moved from the legitimate economy into the underground economy in recent years, he says.

While exploring northern New Jersey for the documentary — he's producing it with Gary Dial of the Manhattan School of Music and singer Terre Roche –Justich was struck by the economic impact of Brazilian immigrants on a neighborhood of Newark adjacent to the city's Penn Station. Sidewalks and stores are packed with shoppers. Restaurants are filled with diners. New three-family housing units are popping up block after block.

Justich began doing some detective work. He and his colleague Ng compared housing permits in the gateway communities with census data and were shocked at the results. The census data indicate that the populations of Newark, New Brunswick and Elizabeth grew by 5.6% between 1990 and 2003, and less than the 9% growth in their three corresponding counties. Yet housing permits in the three cities were up six-fold versus a three-fold increase for the counties; and 80% of the permits in the cities were for multifamily dwellings. That struck him as a huge disconnect, suggesting the immigrant populations are larger than shown by the census.

Leonard of California holds a seminar on the state's underground economy every year for officials and legitimate businessmen. They brainstorm ways to bring entrepreneurs out of the shadows and onto the tax roles. Leonard says the state has tried tax amnesty programs: “We had a 60-day window and waived a 10% penalty for nonpayment,” he recalls. But the accumulated interest on the unpaid taxes for many people was more than their back taxes, so the
program didn't go far enough to get more people to come out, he says.

A state amnesty program in 2004 netted $1.4 billion in back taxes from 857 individuals and 340 businesses. For the most part, these were wealthy people who had become involved with questionable offshore tax shelters. Most of the illegal immigrant businesses gross less than $100,000 a year, but there are so many, they probably owe even more.

Los Angeles, Barron's found, is the most aggressive and successful
jurisdiction in the country in moving people from the shadow economy into the light. The reason for this may be that that the state's amnesty program is mostly carrot: Small businessmen have more to gain by going legal than they do by remaining in the shadows.

One piece of the L.A. program provides an exemption from the business tax for two years for new licensees with under $100,000 in annual gross receipts. For bigger businesses that owe back taxes, the city offers flexible repayment plans. Penalties, but not interest, are forgiven. Renata Simril, Los Angeles' deputy mayor for economic development, says the city spent $2 million to advertise the most recent amnesty project, begun in 2002. It was money well-spent. L.A. collected business-tax revenues of $21.7 million and added 47,000 new tax accounts.

As Olson points out, it's hard work for someone to stay submerged in the underground economy in the 21st century. At some point, perhaps when the tax evader wants to buy, say, a house and encounter lenders who demand tax returns, the incentive to turn legal can become great. Besides more aggressive audits, simpler forms might make the transition from shadow to light more attractive, Oslon says.

One thing is certain: The rest of America is subsidizing the other half's free ride, and the costs will only grow if authorities continue to underestimate the scope of the problem.